Political Stability, External Vulnerability, and Bond Spreads

Recently, the UK bond and currency markets acted as stabilizing or corrective forces in the political risk game, obliging an unpopular – and arguably less-than-prudent – PM and her cabinet power by creating conditions that make it near impossible for them to continue.

PRS has always considered these forces as part of the ‘push’ and ‘pull’ that operates in the capital markets, which is intimately related to political risk.

We were recently pointed to a good study that tested the impact of country-specific and global explanatory variables on bond spreads across regions and economic periods.  The question the authors of the study sought to answer was whether the difference between the yield of a given emerging market sovereign bond and that of a US T-note of a comparable maturity – the sovereign bond spread – was appropriately priced in relation to the country-specific fundamentals of that emerging economy. If the sovereign bond spread remained at very low levels for long without reflecting the economy’s fundamentals, sudden shifts in the investors’ perception of risk may lead to sharp changes in the cost of external borrowing for that economy. 

Using the political, economic, and financial risk data from the International Country Risk Guide (ICRG) as ‘pull’ factors in a baseline regression, the authors estimated sovereign bond yield spreads for 28 emerging market economies from January 1998 to December 2011. A similar regression was run to allow the dimensions of the panel to change for an improvement in the fitted bond spreads following a hypothetical positive change in the country-specific explanatory variables. 

The results of the study were many, but one that stood out for the purposes of this piece was that a low degree of external vulnerability and a high degree of political stability can substantially reduce the cost of external borrowing. From a policy perspective, this underscored the importance of adopting measures that would reduce a country’s external vulnerability (e.g., issuing local debt to reduce external debt financing), or have in place strong institutions to foster political stability. (https://www.imf.org/external/pubs/ft/wp/2012/wp12212.pdf)

Have a look at ICRG here (https://www.prsgroup.com/explore-our-products/icrg/)

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