Who Saw Sovereign Debt Crises Coming?
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Who Saw Sovereign Debt Crises Coming?

This paper studies sovereign debt crises through the prism of the primary sovereign bond market and describes the behavior and interactions among the principal actors in the sovereign bond market before and after a sovereign debt crisis. The study finds that investment banks price sovereign default risk well before crises occur and before investors detect default risk. As early as three years before a crisis, countries that will eventually enter into a debt crisis pay underwriting fees that are almost twice as high as the underwriting fees paid by the average emerging market country. In contrast, sovereign bond spreads do not seem to be good leading indicators of debt crises. Between three years and one year before a crisis, there is almost no difference between the bond spreads paid by countries that will eventually enter into a crisis and the spread paid by the average emerging market country. The paper also shows that investment banks' behavior differs depending on the type of sovereign debt crisis. While Investment banks charge higher underwriting fees to countries that will later enter into crisis because of high risk of sovereign default, they do not appear to charge higher fees to countries that will eventually suffer a liquidity crisis driven by external factors or banking problems. Given that my results suggest that investment banks price default risk well before investors do, they raise the puzzle of why underwriting fees, which contain valuable publicly [End Page 125] available information, are not used in pricing bonds issued by emerging market countries.

While there are many papers that study how emerging market countries access the international bond market (Grigorian 2003; Gelos, Sahay, and Sandleris 2004; Fostel and Kaminsky 2007), studies of the formation of prices in the emerging sovereign bond market are rare and tend to focus on the incidence of pricing of certain covenants, such as collective action clauses (for different perspectives, see Eichengreen and Mody 2004; Gugiatti and Richards 2003; Becker, Richards, and Thaicharoen 2003).1 This stands in contrast to the massive literature on the determinants of underwriting fees in the primary corporate market. This literature shows that the main determinants of underwriting fees are the characteristics of the issue (such as maturity, amount, regulation, and currency denomination), the characteristics of the issuer (for example, credit risk as measured by credit rating, size of the firm, profitability indicators, and activity sector group), and a set of market variables that include secondary market conditions and volatility of prices (West 1967; Higgins and Moore 1980; Rogowski and Sorensen 1985; Lee and others 1996; Livingston and Miller 2000; Kollo and Sharpe 2006; Melnik and Nissim 2003; Hua Fang 2005). These studies tend to find an inverse relationship between the quality of the issuer and the level of underwriting fees. This is usually interpreted as a consequence of the greater effort required from intermediaries when they act as underwriters of lower-quality issues (Altinkihc and Hansen 2000).

In this paper, I ask how important credit risk is for the underwriting fees charged by investment banks in the sovereign bond market. While most of my results are based on formal econometric analysis, I also show that my results are corroborated by the responses to a survey that covered the main institutional investors in and originators of sovereign bonds issued by emerging market countries.2 [End Page 126]

How the Primary Sovereign Bond Market Works

The analysis of the primary market is a key element to understanding the behavior of investment banks and investors, and the formation of fees and primary sovereign bond spreads. This section describes the structure of the primary sovereign bond market and the main risks faced by investment banks when they act as lead managers in this market (for more details on the structure of the primary market and the critical steps of the issue process, see Flandreau and others 2010b).

A simple version of the structure of the sovereign bond market is summarized in Figure 1which illustrates the interactions among actors in the sovereign bond market throughout the execution of a financial transaction. It is investment banks that act as lead managers in the...