Sovereign Risk, Exchange Rate Volatility, and Economic Activity

Periods of financial stress in emerging markets are characterized by high and volatile sovereign spreads, increased real exchange rate volatility, and low economic activity. Motivated by these observations we develop a quantitative model in which a sovereign trades defaultable debt of different maturity with ambiguity averse lenders. Both the trading behavior in the presence of default risk and the preferences of the lenders give rise to countercyclical movements in the level and variance of spreads. As simultaneously and for the same reasons the volatility of international flows increases, the real exchange rate becomes more volatile. This increase in risk makes producers more cautious to commit in advance to certain trades as both the revenue and the costs become more uncertain. The resulting fall in economic activity in turn worsens the downturn inducing additional adjustments of the sovereign and rising spreads. We use the model to quantify the importance of this transmission channel and show that foreign assistance programs can have additional benefits by reducing the effect of sovereign risk on firms’ expectations.