Do Macro-economic Fundamentals Price Sovereign CDS Spreads of Emerging Economies?

Abstract

This paper studies the extent to which macro-economic variables govern the dynamics of emerging markets sovereign CDS spreads. I propose a structural model of sovereign credit risk based on observed exports, imports and international reserves. Using these macro fundamentals, I define a country's ability to pay as the maximum amount of foreign currency available for repayment of non-domestic debt. The joint dynamics of the ability to pay and a sovereign's outstanding external debt determine the level of country default risk and thus the CDS spreads. I implement the model for a sample of 6 emerging economies for a period covering the recent financial crisis. A calibrated version of the model captures the widening of sovereign spreads during the crisis and provides a good _t for the time-series dynamics of CDS spreads. Lastly, I use the model to measure the market-implied level of country liabilities. On average, the value of implied external debt is 13% larger than the reported level of debt.