Sovereign Credit Risk and Business Cycles in Emerging Market Economies

Abstract

This paper investigates the effects of sovereign credit risk shock on business cycles of emerging market economies. The empirical research is conducted with panel vector auto-regressive model and economic variables of both real and financial sectors. This includes domestic bank lending-borrowing spread to demonstrate the transmission channel by incorporating bank balance sheet effect. Sovereign credit default swap (CDS) spread is used as sovereign credit risk measure. The main findings are: (1) the sovereign spread shock has negative effects on GDP, investment and domestic credit

and (2) the shock increases domestic banking spread, which shows that the shock would be transmitted through banking sector

(3) narrowing down to pre-crisis period, this research finds that impacts on output, investment and credit are smaller than that of whole period while banking spread surges more.