An Analysis of the Impact of External Financial Risks on the Sovereign Risk Premium of Latin American Economies*

Rodrigo Alfaro Alfaro, Carlos A. Medel, Carola Moreno

Abstract


This article presents a quantification of the response of the sovereign risk premium (EMBI) of a group of Latin American countries, to unexpected changes (shocks) in external financial variables. The main contribution of the paper is to use the estimated parameters of a vector autoregression (VAR) model using a special Cholesky variance-covariance decomposition as a tool for risk scenario’s assessment. The proposed interpretation of the estimated matrix allows for the quantification of the impact of more than one shock and also to quantify spillovers. A VAR is estimated for each country (Colombia, Chile, Mexico, and Peru) in monthly frequency that includes China’s and Brazil’s EMBI, the global volatility index (VIX), plus the value of the dollar against a basket of currencies (Broad Index) and a proxy of the slope of the US Treasury yield curve (Spread US). The VIX and Broad Index shocks turn out to have a relatively homogenous effect on each country’s EMBI, while shocks to the China and Brazil EMBI are more heterogeneous. For the case of Chile, we further study three alternative risk scenarios, incorporating the copper price as an additional variable. The most disruptive scenario at the time when the shock hits is the “Volatility driven” one. Nevertheless, it is the “Emerging markets” scenario (namely one with simultaneous shocks to China’ and Brazil’s EMBI) the one with the most harmful dynamics, as it dyes out slower. Finally, a “Copper price bust” scenario, in which the price of copper drops significantly in addition to a shock to the EMBI China, is the one with the least effect as the price of copper is relatively less affected by shocks to other variables, displaying lower spillovers.

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Keywords


Chile, China, Latin America, external financing cost, vector autoregressions, scenario analysis.

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