World financial cycles

Data shows that, in the cross section of emerging countries, sovereign spreads are highly correlated, much more so than local economic conditions. However, in standard models of sovereign default the main drivers of sovereign spreads are local conditions. This paper proposes a mechanism that can explain, at the same time, the high correlation of spreads and the low correlation of local conditions. The model features a large developed economy, which lends to a large number of developing economies, using long run bonds that can be defaulted on. The key feature of the model is the presence of long run risk (as in Bansal and Yaron, 2005). We first show that the model can account for the dynamics of several real variables and of sovereign spreads in the cross section of developing economies. We then use the model for examining how much of the fluctuations in spreads in developing economies arise from the changes in long risk in the developed economy (the price of risk), v/s changes in long run risk in the developing economies themselves (the quantity of risk). We find that 2/3 of fluctuations in spreads are explained by the quantity of risk. Our conclusion is that world financial cycle is largely driven by a world-wide, low frequency long run risk component, rather than simply by fluctuations in the price of risk driven that shocks in developed countries that alter their willingness to lend.