Political Uncertainty, Sovereign Default, and Interest Rate Spreads: What’s the Connection?

With hopes dwindling of rate cuts later this year in the US – following unexpected hikes from central banks in Canada and Australia – attention is recentered on the effect on some emerging markets’ currencies and debt repayments.

But what complicates the picture?  For example, what is the effect of political uncertainty on sovereign default and interest rate spreads in emerging markets?

This paper from the working paper series of the Bank of Mexico develops a quantitative model of sovereign debt and default under political uncertainty in a small open economy. Consistent with empirical evidence – and using our ICRG data – the quantitative analysis shows that higher levels of political uncertainty significantly raise the default frequency and both the level and volatility of the spreads. When parties borrow from international credit markets, the presence of political uncertainty induces a short-sight behavior in politicians.

Have a quick look when time permits:

https://www.banxico.org.mx/publications-and-press/banco-de-mexico-working-papers/%7B01A3DA6B-F6E7-771C-BA85-251B02923801%7D.pdf

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