"Markets are Smart! Structural Reforms and Country Risk,"
CEPII Working Paper 2016- 23 , September 2016 , CEPII.
The level of public debt and other macroeconomic fundamentals are the main variables used in economic literature to explain the evolution of sovereign debt risk premiums. We show that the evolution of sovereign credit default swaps (CDS) is explained not only by the evolution of these fundamentals, but also by the structural capacity of countries to grow. Introducing a set of structural capacity variables along debt-to-GDP ratio in estimations explains a much higher share of the variation in the CDS data. Moreover, we show that all optimal models to predict the behavior of risk premiums (defined by the residual sum of squares and common information criteria) include several variables describing the growth potential of countries. Many of the optimal models include only structural capacity variables. The results suggest that markets take into account the future benefits of structural reforms when evaluating the risk of investing in sovereign debt.
structural reform ; risk premiums ; sovereign debt