New Determinants of Sovereign Risk Premia: Identification through Asset Price Shocks, Credit Premia, and Financial Cycle Synchronization

Do asset price shocks and credit premia affect sovereign risk premia? Sovereign credit risk in developed countries was essentially non-existent prior to 2009. We find new factors suggesting that a part of sovereign risk premia is exogenously determined. We capture a novel phase synchronization among asset prices and credit premia that is associated with an increase in the cost of public debt. We start by showing that the financial and economic impact of credit premia, and asset price shocks have changed over time, even though the magnitude of the shocks is similar across different episodes. To explain this change, we suggest that the magnitude of the effect is different in 2008 because there is “phase synchronization” where financial cycles (à la Claessens, Kose, and Terrones, 2012) and credit cycles are synchronized in an unprecedented boom and bust episode. To test this hypothesis, we propose a novel econometric procedure, by introducing a Markov-Switching VAR model, and matching it with estimated asset shock episodes (à la Blanchard and Galí, 2009) and credit booms (Jordà, Schularick, and Taylor, 2013). Once we establish the relationship between the cycles and the financial and economic aggregates, we estimate impulse response functions to find that only during the phase synchronization the magnitude of the effect is strong with a clear sign across the whole time period and transmits to the sovereign credit market.