The impact of global shocks on sovereign risk: Role of domestic factors

This paper explores how domestic factors affect the linkages between global market uncertainty and sovereign credit risk in emerging market economies (EMEs). First, we assess the dynamic conditional correlations (DCCs) between sovereign credit default swap spreads and the VIX as a measure of the linkage between sovereign risk and global financial uncertainty. Second, we estimate how domestic idiosyncratic factors influence the calculated DCCs for periods before, during, and after the global financial crisis (GFC). Our findings reveal that the sensitivity of sovereign risk to global financial uncertainty (the calculated DCC series) was higher during and after the GFC and in EMEs and responded to domestic economic conditions particularly in EMEs. Specifically, the magnitude of the DCCs was higher in EMEs with lower domestic stock market returns in the post-GFC period. In addition to the postcrisis period, domestic factors influenced the DCCs of EMEs before and during the GFC. • Domestic factors affect the impact of global market uncertainty on sovereign risk. • We assess the linkage between sovereign CDS spreads and the VIX using DCC-GARCH model. • The calculated DCCs are larger in emerging countries and in the period since the GFC. • Domestic factors affected the DCC series in emerging market economies. • Good domestic conditions can mitigate the impact of global shocks on sovereign risk.