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News, Country Risk, and Sovereign Default

We show evidence that news about future productivity play an important role in the dynamics of country risk leading to a sovereign debt crisis. We show that a news shock has a significantly larger contemporaneous impact on sovereign credit spreads than a comparable shock to labor productivity. We develop a quantitative model of news and sovereign debt default with endogenous maturity that can generate impulse responses very similar to the empirical estimates. The model also highlights that the effect of a news shock is stronger for an economy with shorter debt maturity. Finally, our analytic framework also suggests that as the precision of news increases, the economy may not increase its total indebtedness, but will be able to borrow at shorter maturities and pay lower spreads, especially during periods of high financial stress.

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https://doi.org/10.20955/wp.2018.033


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