Fundamentals and sovereign risk of emerging markets

Joshua Aizenman, Yothin Jinjarak, Donghyun Park 14 July 2013



In striking contrast to advanced economies, which still remain mired in stagnation and uncertainty, emerging markets are once again growing at a healthy pace despite remaining exposed to growth deceleration due to the persistent weaknesses of advanced economies. Economists these days talk much about a ‘two-speed world economy’, where visibly faster and stronger momentum of recovery and growth in the emerging markets outpaces the advanced economies.

While ‘decoupling’ is, at first sight, a plausible interpretation, more rigorous analysis highlights the need for caution in interpreting the two-speed world economy as definitive evidence of the decoupling hypothesis. In this context, the IMF (2012) warns that it may be premature to jump to hasty conclusions about the resilience of emerging markets in the post-Global Crisis period. For one, it is not at all clear whether even the most dynamic emerging markets had decoupled themselves from the business cycle of the advanced economies.1

Regardless of the validity of the decoupling hypothesis, what is beyond dispute is that emerging markets have fared much better than expected during and after the Global Crisis than widely expected. The key question then becomes: What explains the apparent resilience of emerging markets? One leading candidate is relatively strong fundamentals or sound policies throughout emerging markets. Asian countries have long had strong fundamentals such as healthy fiscal positions and these help explain their superior performance during the past few decades. More recently, emerging markets outside Asia, most notably Latin America, have also raised their game. According to the IMF (2012), good policies indeed play a major role, explaining about three fifths of the improved macroeconomic performance of emerging markets. Luck accounts for the rest.

In Aizenman, Jinjarak and Park (2013) we empirically assess the relative importance of key economic factors such as fiscal balance/GDP ratio, inflation, external debt/GDP ratio, trade openness, and state fragility in accounting for the sovereign credit default swap spreads in emerging markets during 2004-2012. We use the credit-default swap spreads to capture vulnerability to shocks.2 We also compare the role of fundamentals across Asia versus Latin America.3

New research

We organise the events around the Global Financial Crisis into three phases: the pre-Crisis period of 2004-07, the Crisis period of 2008-09, and the post-Crisis period of 2010-11. Our sample comprises 20 emerging-market countries, of which seven are in Asia, six in Latin America, five in Europe, and two in Africa. These countries were selected on the basis of data availability, especially sufficient information on the fundamental variables and external shocks.4 

Table 1 reports the difference between its average for Asia and for Latin America. From 2004-2012, sovereign bond yields (EMBI) and sovereign credit default risks (CDS prices) are clearly on the rise. Both bond yields and default risks tend to be lower for Asian countries than for Latin American countries, and this gap widened during the Crisis of 2008-09. Looking first at internal factors, the summary statistics do not clearly indicate which type of internal factors might contribute to the difference between the regions.5 


Using annual data covering all 20 countries, we regress sovereign credit default risks, measured by credit default swap prices, on both internal and external economic fundamentals. Based on our estimation results, we calculate the economic significance of each variable. The results are reported in Figure 1a for our whole sample of emerging markets for the pre-Crisis period.

  • Trade openness is the most important factor – one standard deviation increase of trade openness is associated with a 19 basis points drop in sovereign credit-default swap spreads;
  • The second most important variable is state fragility – a ten basis points increase.

The results for the Crisis period are shown in Figure 1b.

  • External debt/GDP ratio is the most economically significant – one standard deviation increase is associated with 21 basis points increase in sovereign credit-default swap spreads;
  • The second most important variable is inflation – 13 basis points increase.

Figure 1c shows the results for the post-Crisis period. Inflation and public debt/GDP ratio are most closely associated with sovereign credit default swap spreads. One standard deviation increase of inflation and public debt/GDP ratio is associated with 27 basis points and 16 basis points increase of sovereign spreads, respectively.

Figure 2 reports how the economic significance of each fundamental variable can explain the differences in vulnerability facing Asian countries vis-à-vis Latin American countries.6

  • In the pre-Crisis period, shown in Figure 2a, Asia’s higher trade openness is the most important factor that explains regional differences in sovereign-default risks;
  • Asia’s higher level of trade openness is associated with 37 basis points lower sovereign credit-default swap spreads;
  • State fragility – 18 bps higher in Asia – is the next most important factor.

During the Crisis of 2008-09, shown in Figure 2b, lower inflation is the most economically significant in explaining the difference – 11 basis points lower credit default swap spreads in Asia. The external debt/GDP ratio – five bps higher in Asia – is the next most important factor. After the Crisis, shown in Figure 2c, lower inflation is the most significant in explaining the difference between the two regions – Asia’s 44 basis points lower sovereign spread. The public debt/debt ratio – 13 b basis points higher in Asia – is the next most important factor.

Concluding observations

Using 2004-2012 data from 20 major emerging markets in four regions, we find that inflation, state fragility, external debt, and commodity terms of trade volatility were positively associated, while trade openness and more favourable fiscal balance/GDP were negatively associated with sovereign credit default swap spreads. The key factors accounting for sovereign spreads are trade openness and state fragility in the pre-Crisis period, external debt/GDP ratio and inflation in the Crisis period, and inflation and public debt/GDP ratio in the post-Crisis period. Comparing Asian to Latin American emerging markets at broadly similar income levels but with significantly different fundamentals, we find that Asian countries enjoy lower sovereign spreads than Latin American countries, and this gap widened during and after the Crisis. High trade openness was the biggest factor behind Asia’s lower sovereign spreads before the Crisis, and low inflation during and after the Crisis. The lower sovereign spreads enjoyed by Asian countries relative to Latin American countries is probably due in part to their stronger fundamentals.

Our results suggest that the pricing of risk depends both on external and internal fundaments. Prior to the Crisis, the markets placed greater importance on external factors, in particular trade openness. The higher the degree of exposure to foreign trade, the more dependent an economy is on the global business cycle and hence the larger the impact of foreign output shocks. The Global Crisis and its aftermath brought to the fore the challenge of managing Crisis. The markets thus gave a bigger weight to the scope for the government to use fiscal and monetary policy to mitigate the adverse impact of Crisis. As a result, public debt/GDP ratio and inflation – indicators of fiscal and monetary space – became more important in explaining sovereign credit default risks. In addition, external debt/GDP ratios also gained significance.

The results suggest that the Global Crisis has heightened market awareness of tail risks and the varying capacity of emerging-market governments to cope with those risks.

Table 1. Descriptive statistics

Figure 1a. Economic significance of internal and external shocks, all emerging markets, annual data: Pre-Crisis, 2004-07

Figure 1b. Economic significance of internal and external shocks, all emerging markets, annual data: Crisis, 2008-09

Figure 1c. Economic significance of internal and external shocks, all emerging markets, annual data: Post-Crisis, 2010-12

Figure 2a. Economic significance of internal and external shocks, Asia versus Latin America, annual data: Pre-Crisis, 2004-07

Figure 2b. Economic significance of internal and external shocks, Asia versus Latin America, annual data: Crisis, 2008-09

Figure 2c. Economic significance of internal and external shocks, Asia versus Latin America, annual data: Post-Crisis, 2010-12

Note: This figure plots the economic significance of each fundamental variable on the sovereign credit-default risk, comparing Asia and Latin America. Each bar is calculated by multiplying a coefficient estimate with a difference between Asia and Latin America (a former minus a latter) of a concerning variable. The plots are reported in basis points of sovereign CDS prices.

Disclaimer: The views expressed here are those of the authors and do not necessarily represent those of the institutions with which they are affiliated.


Aizenman, J, Jinjarak, Y and Park D (2013), “Fundamentals and Sovereign Risk of Emerging Markets”, NBER Working paper 18963.

Aizenman, J, Hutchison, H, and Jinjarak,Y (2013), “What is the Risk of European Sovereign Debt Defaults? Fiscal Space, CDS Spreads and Market Pricing of Risk”, Journal of International Money and Finance 34, 37-59.

Beirne, J, and Fratzscher, M (2013), “The pricing of sovereign risk and contagion during the European sovereign debt crisis”, Journal of International Money and Finance 34, 60–82.

Didier T, Hevia C and Schmukler S (2012), “How resilient and countercyclical were emerging economies during the global financial crisis?”, Journal of International Money and Finance 31(8), 1971–1975.

Elson, A (2006), “What Happened?”, Finance and Development 43(2), 37-40.

World Economic Outlook (WEO) (2012), “Coping with High Debt and Sluggish Growth”, International Monetary Fund, October.

1 Didier et al. (2012) concluded that “Contrary to popular perceptions, emerging economies suffered growth collapses relative to the pre-crisis levels comparable to those experienced by developed economies, even when they continued growing. Afterwards, most economies returned to their pre-crisis growth rates. Although emerging economies were not able to avoid the collapse originated in the US and then transmitted across countries, they were more resilient during the global crisis than during past crises. Moreover, breaking with the past, emerging economies did not fall more than developed economies during the global crisis and were able to conduct countercyclical policies, thus becoming more similar to developed economies”.

2 See Aizenman, Hutchison and Jinjarak (2013) and Beirne and Fratzscher (2013), for the varying importance of the fundamentals in pricing sovereign risk in the context of the euro debt crisis.

3 Elson (2006) provides a good summary of the structural and policy differences between the two regions.

4 The sample countries are Argentina, Brazil, Chile, China, Colombia, Czech, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Philippines, Poland, Russia, South Africa, Thailand and Turkey. Note that all these countries are included in benchmark global bond and equity indices such as EMBI and MSCI. They are thus recognised as significant emerging economies in the global capital markets.

5 Relative to Latin America, Asia’s domestic credit/GDP ratio is higher, and both public debt/GDP and fiscal balance/GDP ratios have deteriorated, most likely as a result of the massive fiscal stimulus put in place to boost aggregate demand during the global crisis. State fragility also deteriorated in Asia relative to Latin America but inflation has been lower and industrial production higher throughout the period of study. While Asian countries had higher current account surplus/GDP ratio, their external debt level increased relative to Latin America. Latin American countries have a higher gross FDI/GDP ratio than Asian countries, although the gap is narrowing. While it is not evident that net foreign assets are increasing for the emerging markets in our sample, they clearly experienced foreign exchange reserve accumulation and appreciation of real effective exchange rates. The coefficient of variation of commodity terms of trade has risen whereas activity in the global commodity markets declined markedly after the crisis of 2008-09.

6 We do this by multiplying the coefficient estimate by the difference in the averages between the two regions, for each variable.



Topics:  International finance

Tags:  emerging markets, CDS

Dockson Chair in Economics and International Relations, USC, and Research Associate, NBER

Associate Professor, School of Economics and Finance, Victoria University of Wellington, New Zealand

Principal Economist at the Economics and Research Department of the Asian Development Bank


CEPR Policy Research