Investor Sentiment, Sovereign Debt Mispricing, and Economic Outcomes

IMF Working Papers, August 14, 2020

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Canonical URL: Investor Sentiment, Sovereign Debt Mispricing, and Economic Outcomes

Countries 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.
Past sovereign debt mispricing is relevant for predicting future outcomes: incorporating mispricing measures reduces the RMSE of real GDP growth forecasts by as much as 15 percent.
Results provide strong support for theories of sentiment affecting the business cycle.
Countries should not solely rely on spread levels when determining 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.

Two-stage empirical procedure:
- Stage 1: regression linking sovereign spreads to fundamentals.
- Stage 2: residuals from the Stage-1 regression (interpreted as mispricing / investor sentiment) deployed to assess impact on future outcomes (real GDP growth and the occurrence of fiscal crises).
Out-of-sample validation exercises and cross-validation procedures (including a leave-one-out procedure) are used to confirm predictive relevance.

Reduction in RMSE of real GDP growth forecasts by as much as 15 percent when including measures of past sovereign debt mispricing.
Primary assessed future outcomes:
- real GDP growth
- occurrence of fiscal crises

Fiscal strategy should be informed by underlying fundamentals in addition to observed spread levels.
Reliance solely on low spreads can be misleading if spreads reflect investor over-optimism rather than fundamentals, increasing the risk of later economic difficulties.
Historical relationships between spreads and fundamentals often persist into the medium-to-long run and should therefore guide policy decisions.

Subjects: Balance of payments, Current account deficits, Economic forecasting, External debt, Government consumption, National accounts, Public debt
Keywords: credit rating, cross-validation procedure, Current account deficits, debt crises, Government consumption, growth forecast, growth forecasting, investor sentiment, leave-one-out procedure, over-optimism, real GDP growth, sentiment, Southern Europe, sovereign debt, sovereign spreads, spread discount, spreads data, sub, WP