Local or global: What drives interest rate spreads for developing countries?

Governments of developing nations typically pay much higher interest rates to borrow than governments of developed countries pay. This “emerging market spread” on sovereign debt has also been volatile in recent decades, creating a debt market for poorer countries that can feel expensive and, at times, out of their control.

Economists have advanced contrasting models and arguments to explain the size of emerging market spreads. The traditional view holds that spreads are primarily a natural market response to risk, based largely on growth and other local economic conditions in developing countries. However, a more recent “global cycle” view observes that developing country spreads often appear correlated with each other and with financial conditions in developed economies—especially in the U.S. In this story, the changing views and conditions of creditors in rich nations drive the borrowing costs of poorer ones.

Neither theory on its own appears sufficient to understand recent movement in sovereign spreads. New research from Minneapolis Fed monetary advisors Patrick Kehoe and Fabrizio Perri finds that local and global factors have dominated at different times, and to different degrees (Staff Report 666, “A Neoclassical Model of the World Financial Cycle,” with Yan Bai and Pierlauro Lopez). When the economists calibrate their model with data from the U.S. and 12 emerging market economies, they identify four phases in sovereign spreads since 1994 (see figure, in which U.S. corporate bond spreads convey financial conditions in the U.S.).

In their unified neoclassical model, the economists integrate standard models of asset pricing and sovereign default, which respectively process shocks to developed and developing economies. They augment this theoretical model with a particle filter, a statistical technique useful in deciphering patterns that might morph over time.

In the first period of the sample (1994–2002), financial conditions in the U.S. were expansionary (U.S. asset prices were high and U.S. corporate bond spreads were low). Yet emerging markets were plagued by financial crises and high spreads. The year 1994, for example, brought the sudden devaluation of the Mexican peso; debt and currency crises haunted Latin America and Asia through the early 2000s. The economists’ model finds that during that phase, tight financial conditions in emerging markets were not driven by developed economies. Rather, the borrowing spreads for developing countries were largely a consequence of their own shocks and policies.

This volatile era was followed by a phase of moderation in the mid-2000s, in which many developing economies stabilized and grew while sovereign interest rates fell. Their model finds favorable borrowing conditions in emerging markets were again driven mostly by local conditions and not by the developed economies.

The economists find that the global cycle view—in which financial conditions in rich creditor countries drive the borrowing costs of developing nations—only fits the data well in the period from 2008 to 2016. The spreads on sovereign and U.S. corporate debt rose together amid the weak growth and sputtering stock markets of the global financial crisis and Great Recession.

Starting around 2016, however, the economists borrow the term “geoeconomic fragmentation” from the International Monetary Fund to describe a new phase when the traditional, local view of spreads returned to dominance. The U.S. economy began to stabilize and grow, while continued risks in some poorer countries increased the dispersion of spreads among developing countries.

Across the full period from 1994 to 2023, local factors accounted for 80 percent of the fluctuations in the average emerging market spread in sovereign debt. During the global cycle phase, however, growth shocks and volatility in the U.S. economy were driving most of the borrowing cost for developing countries. While the global cycle view appears not to be the historical norm, the model suggests poorer countries may be particularly vulnerable to global cycle effects during periods of global stress.

The economists confirm their model is robust to different measures of financial condition in the U.S. bond and stock markets.

Much prior research on sovereign debt has abstracted from these movements of financial assets in developed economies. Kehoe, Perri, and co-authors provide a model that integrates the values and volatility of U.S. assets with the spreads on emerging market debt. This allows the lending decisions of rich-country creditors to emerge within the model itself, interacting with local conditions that shape the risk in emerging markets. The authors emphasize that explicitly considering the financial conditions in developed countries is essential to distinguish the role of local versus global shocks on borrowing conditions for emerging financial markets.

The relatively simple model thus reveals a complex view of recent history, marked by shifting patterns over three decades. “A comprehensive model must contend with four distinct phases of the world financial cycle,” they write, “of which the global cycle phase is only one.”

Read the Minneapolis Fed staff report: “A Neoclassical Model of the World Financial Cycle”