The Effect of Private Sector FX Indebtedness on Sovereign Risk in Emerging Markets

In this study, the spread of default risk on local currency (LC) sovereign bonds serves as the metric for assessing country risk across 17 emerging nations. Despite traditional theoretical views deeming these bonds risk-free or default- free, recent research indicates that they carry a risk premium and are not priced at risk-free interest rates. The intriguing explanation lies in the cost of printing money. When local companies have excessive FC debt funded by LC assets, then printing money to pay LC debt will trigger an inflationary process, eventually ending up with a collapse in the real economy and LC. Thus, we run a panel VAR model, spanning a period between 2010-2020, where LC sovereign default risk, LC public debt, FC public debt, private sector external debt, and external finance need are included in the main model. Results show that public debt in LC and private external debt are found to be positively associated with LC sovereign spread, in line with the literature. However, the observation that the need for one-year external financing relative to gross reserves has a much stronger effect on the country's risk premium than the total effect of private sector external debt and public debt in local or foreign currency represents an original contribution of this study.