Investor Sentiment, Sovereign Debt Mispricing, and Economic Outcomes

August 14, 2020

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Ramzy Al Amine, and Tim Willems. Investor Sentiment, Sovereign Debt Mispricing, and Economic Outcomes, (USA: International Monetary Fund, 2020) accessed September 19, 2024

Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

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.

Subject: 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

Publication Details

Pages:

28
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2020/166
Stock No:

WPIEA2020166
ISBN:

9781513550855
ISSN:

1018-5941

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