IMF Working Papers

Investor Sentiment, Sovereign Debt Mispricing, and Economic Outcomes

Author/Editor:

Ramzy Al Amine ; Tim Willems

Publication Date:

August 14, 2020

Electronic Access:

Free Download. Use the free Adobe Acrobat Reader to view this PDF file

Summary:

We find that countries which are able to borrow at spreads that seem low given fundamentals (for example because investors take a bullish view on a country's future), are more likely to develop economic difficulties later on. We obtain this result through a two-stage procedure, where a first regression links sovereign spreads to fundamentals, after which residuals from this regression are deployed in a second stage to assess their impact on future outcomes (real GDP growth and the occurrence of fiscal crises). We confirm the relevance of past sovereign debt mispricing in several out-of-sample exercises, where they reduce the RMSE of real GDP growth forecasts by as much as 15 percent. This provides strong support for theories of sentiment affecting the business cycle. Our findings also suggest that countries shouldn't solely rely on spread levels when determining their fiscal strategy; underlying fundamentals should inform policy as well, since historical relationships between spreads and fundamentals often continue to apply in the medium-to-long run.

Series:

Working Paper No. 2020/166

Subject:

Balance of payments Current account deficits Economic forecasting External debt Government consumption National accounts Public debt

Frequency:

regular