It Is Not Your Risk but It Is Your Problem: Peer Country Effects on Emerging Market Credit Default Swap Spreads

ABSTRACT In this paper, we attempt to introduce peer effects as a new channel in pricing emerging markets credit default swap spreads and study the impact of peer effects on 17 countries for the period 2006–2022. Unlike spillover models, we exploit spatial econometrics to distinguish between direct (country‐specific) and indirect (non‐country‐specific) effects in the credit default swap spreads. We are motivated by the fact that the connectedness among emerging market credit default swaps is proportionally high based on the similarity concerning the dimensions of economic development, governance and uncertainty. Adopting a spatial modelling strategy allows us to consider such similarity to unravel non‐country‐specific channels driving the shifts in sovereign credit risk. On top of documenting significant spatial interactions, we find that indirect effects are roughly as important as the direct ones in explaining the credit default swap spread movements. Our findings are robust to a set of additional analyses and modelling choices. The findings underpin a plethora of attempts on the importance of coordinated policy actions in the international regulatory fora to alleviate sovereign risk. This paper also calls for careful use of credit default swap spreads as a sovereign credit risk indicator. After all, these measures are already a cost indicator but the idiosyncratic risk may be quite different.