Economic Report President

Box 6-4.—Sovereign Spreads in Emerging MarketsThe Asian crisis has introduced into popular parlance a numberof terms formerly encountered only in arcane financial discussionsamong bankers and economists. One of these is “sovereign spread.”A simple definition of sovereign spread is the difference betweenyields on bonds issued by the government of one country (forexample, an emerging market country) and those (safe) bondsissued by the government of a major industrial country. The yieldin question is the yield to maturity, or the rate of return earned byholding the bond until it matures (including all interest and principalpayments), and the bonds being compared must be of thesame maturity and currency denomination for the comparison tobe valid.Using the prices of bonds issued by governments in emergingmarket economies, one can measure the implicit risk premiumthat the market demands to compensate for the extra default riskentailed in holding a bond from a particular emerging market.(Default risk is the risk that the debtor will fail to pay all principaland interest on its obligation on time. The bonds of the majorindustrial country governments are considered to carry little or nodefault risk.) The sovereign spread on foreign currency-denominatedbonds measures only the default risk of a country’s obligations—notcurrency risk, because payments are to be made inforeign currency.During the periods of extreme market turbulence following theMexican peso crisis in 1994 and the Russian default in 1998, sovereignspreads rose sharply. In the latter episode these spreadsreached about 1,500 basis points by mid-September (Chart 6-2).Estimates of the default probabilities incorporated in emergingmarket bond prices can be derived fairly easily from their sovereignspreads, given the assumption that U.S. government bondsare default risk-free. At their height, these spreads implied veryhigh default probabilities for many countries, leading to the conclusioneither that markets were exceptionally pessimistic or thatinvestors were becoming exceedingly risk averse.A second interesting comparison relates to the difference inyields on dollar- and local currency-denominated bonds. As long asthe default risk on these bonds is the same, this differential measuresthe market’s assessment of currency risk, that is, the riskderiving from changes in the international value of the currency.Interestingly, even under most “fixed” exchange rate regimes, apositive currency risk premium can be observed, suggesting thatinvestors expect a devaluation at some point or that they requirean implicit “insurance” premium to compensate for that possibility.234