Macroecnomic effects on emerging-markets sovereign credit spreads

In this paper we consider how much of the variation in yield spreads across countries and over time can be explained by forward looking macroeconomic fundamentals. We focus in particular on the explanatory power of the country macroeconomic market value developed by Clark and Kassimatis (2011) (hereafter C&K). Macroeconomic market value is a forward looking concept defined as the present value of an economy’s expected total income and expenditure. C&K have shown that macroeconomic market values can be used to generate explanatory information, incremental to what is available in traded asset prices, that is significant for explaining individual asset returns over an asset universe which includes stocks, bonds, money markets and commodities. From a theoretical perspective, the macroeconomic market value should matter for the pricing of defaultable debt, just as the market value of a company does in the structural models pricing corporate debt (see, for example, Merton, 1974). All else being equal, a country with higher market value is less likely to default. This should be reflected in lower yield spreads. While this idea is well understood in theory, it has been largely ignored by the empirical literature on sovereign debt, which, in the absence of a reliable measure of macroeconomic market value, has tended to focus exclusively on backward-looking accounting data. In contrast, the empirical analysis in this paper includes the forward looking macroeconomic variables as complements to the conventional accounting variables.

      Specifically, the macroeconomic and financial variables that we construct are i) the economy’s expected annual rate of return; ii) the correlation coefficient between the economy’s rate of return and its exchange rate against the US dollar. iii) the theoretical financial risk premium of a sovereign’s debt.

      For the empirical study we employ the yield spread on external US denominated debt for 22 emerging economies, reported by JP Morgan’s Emerging Market Bond Index Global database (EMBI Global) over the period 1995 to 2010. We find that these variables are statistically significant determinants of sovereign spreads and their significance is robust to the inclusion of other macro and financial variables in the analysis. Moreover, we find that they have forecasting power not included in other macro variables for large changes in spreads that extends up to 12 months outside the sample period. The forward-looking variables that we construct are significant and complement and enhance the explanatory content of the conventional variables found in the extant literature.