Local Currency Sovereign Risk

Abstract

We introduce a new measure of emerging market sovereign credit risk: the local currency credit spread, defined as the spread of local currency bonds over the synthetic local currency risk-free rate constructed using cross-currency swaps. We find that local currency credit spreads are positive and sizable. Compared with credit spreads on foreign-currency-denominated debt, local currency credit spreads have lower means, lower cross-country correlations, and lower sensitivity to global risk factors. We discuss several major sources of credit spread differentials, including positively correlated credit and currency risk, selective default, capital controls, and various financial market frictions. WHEN A SOVEREIGN borrows in its own currency, the spread it pays over the U.S. Treasury risk-free benchmark might contain two major types of risk: currency risk and credit risk. We introduce a new sovereign risk measure, the local currency (LC) credit spread, to measure the credit risk component of LCdenominated debt. We find that the LC credit spread is positive and sizable for emerging market sovereigns, despite their ability to print their own currency to repay the debt. Furthermore, we document significant differences between the LC credit spread and the conventional measure of emerging market sovereign * Wenxin Du is with the Federal Reserve Board and Jesse Schreger is with Princeton University and Harvard Business School. We are especially grateful to

Deviations from Covered Interest Rate Parity

“…This is the case for the euro basis, as investors are likely to expect the euro to depreciate against the dollar upon a KfW default. However, as explained in Du and Schreger (2016), such a covariance adjustment should be very small in magnitude because the credit spread of the KfW is small and directionally at odds with a negative cross-currency basis for the euro.…”

Localising sovereign debt: The rise of local currency bond markets in sub‐Saharan Africa

“…International foreign currency borrowing tends to be cheaper, in nominal terms, than local currency borrowing in domestic markets. In the latter case, investors require additional compensation for currency risks, higher expected inflation, changing local regulations and financial market frictions (Du & Schreger, 2016). Conversely, for the debtor government foreign currency borrowing comes with substantial exchange rate risks.…”

Asset Prices and Macroeconomic Outcomes: A Survey

“…Chinn (2006), using data for major advanced economies and EMEs, shows that the evidence against UIP in the current floating rate era is not as strong as is commonly thought (see also Ismailov and Rossi (2017)). 48 Based on a new measure of sovereign credit risk, "the local currency credit spread", defined as the spread of local currency bonds over a synthetic local currency risk-free rate based on cross-currency swaps, Du and Schreger (2016) find that local currency credit spreads are positive and sizeable. However, they are lower than credit spreads on foreign currency-denominated debt as well as less correlated across countries and less sensitive to global risk factors.…”