1. Sarah Brooks,€ Raphael Cunha¥ & Layna Mosley £
How do Sovereign Debt Investors React to Political Events in Emerging Market Countries?
Sarah Brooks,€ Raphael Cunha¥ & Layna Mosley £
Ohio State University € Princeton University ¥
UNC, Chapel Hill £
Prepared for the 2017 Meeting of the International Political Economy Society, University of Texas, Austin.

2. Elections, Partisanship & Sovereign Risk
Investors in sovereign bonds worry about inflation, currency and (especially) default risk.
Difficult to assess willingness (vs. ability) to repay debt.
Elections & changes in government could affect
Ability to pay: political business cycle; changes in monetary and fiscal policy.
Can be measured more objectively
Willingness to pay: some domestic groups benefit from greater public borrowing/spending, as well as from default.
More uncertain, subject to politics and partisanship

3. Do Markets Dislike Left Governments?
France, May 1981
Mitterand: first socialist president since 1936.
Recession, 13% inflation: domestic support for dramatic changes.
First year in office: lower retirement age, increase paid vacation, increase gov’t spending, corporate tax increases, bank nationalizations
Results: devaluations, capital flight, collapse in growth.
1983: Policy U-turn
Brazil, October 2002

4. Do Markets Dislike Left Governments?

5. Political Risk in Emerging Markets
How do sovereign debt investors respond to political events?
Mixed findings regarding how and whether political events – elections, partisan switches, ideology – matter.
Greater perceived political risk in emerging markets vs. developed economies
Government ideology serves as an information shortcut for internationally-diversified investors.
As governments reveal their intentions vis-à-vis economic policy, ideology matters less for market outcomes
Investors’ (anticipated) responses matter because they can affect government policy choices.

6. Political Risk in Emerging Markets
Markets should respond differently to “risk” - events that can be predicted with a certain probability and “uncertainty”- unknown future shocks
Elections can present significant risk (changes in gov’t) and uncertainty (could be difficult to predict policy).
Uncertainty over outcome (who governs)
Uncertainty over future policy
At election time: partisan signals become less precise, and future policy trend more uncertain
The consequence is greater volatility: movement in & out of markets; disagreement among investors regarding how to price risk.

7. Conditional Theory of Political Risk
Volatility should be amplified by uncertainty about the precision of the partisan signals from newly elected (or frontrunner) when future policy is uncertain
Left governments generate higher uncertainty, due to heterogeneity in market-orientation
Whereas investors demand higher premiums in response to risk, markets become more volatile in times of uncertainty – such as elections
Global conditions may amplify or dampen market reactions to uncertainty
Liquidity, volatility affect risk appetite

8. Measuring Political Risk
Dependent variable:
Volatility of EMBI Spreads ln(σ) – Monthly
Model: Heteroskedastic regression
Mean and variance of EMBI spreads
CSTS with lagged DV, country fixed effects
Political Variables:
Left Executive, Months in Office (Non-linear),
Left Executive × Months in Office × Global Liquidity
Controls
Growth Rate, GDP, Inflation, Current Account, Debt, Reserves
US Yield, US Stock Market, VIX, Global Default Rate, Commodity Prices

9. Results

10. Predicted volatility under Left vs
Predicted volatility under Left vs. Center/Right governments as a function of time in office

11. Conditioning effect of global liquidity

12. Findings and Next Steps
Sovereign spreads are largely the result of macroeconomic and political factors, and past government repayment behavior
However: the impact of partisan and macroeconomic risk signals are mitigated by governments’ experience in office
Enabling market participants to resolve uncertainty, update prior beliefs regarding default risk
Next steps:
Interdependence: the effect of partisan signals (“Left” government) also may depend on peer group effects
Policy content may vary over time for Left v. Right governments, given different types of appointees, as well as different economic structures (e.g. commodity price booms)
Selection: govts in the EMBI index (or w/ CDS), vs. all sovereign borrowers.