Institutional quality and sovereign credit default swap spreads

• Date: 01 June 2019
• DOI: http://doi.org/10.1002/fut.21990
• Published date: 01 June 2019
• Author: Jian Yang,Wei Huang,Shu Lin

Received: 20 March 2018

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Revised: 7 December 2018

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Accepted: 7 December 2018

DOI: 10.1002/fut.21990

RESEARCH ARTICLE

Institutional quality and sovereign credit default swap

spreads

Wei Huang

1

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Shu Lin

2

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Jian Yang

3

1

Shidler College of Business, University of

Hawaii at Manoa, Honolulu, Hawaii

2

Department of Economics, Chinese

University of Hong Kong, Shatin,

Hong Kong

3

The Business School, University of

Colorado Denver, Denver, Colorado

Correspondence

Jian Yang, The Business School,

University of Colorado Denver, Denver,

CO 80217‐3364.

Email: Jian.Yang@ucdenver.edu

Funding information

National Natural Science Foundation of

China, Grant/Award Numbers: 71571106,

71773027; Center for Economics, Finance

and Management Studies (CEFMS)

Abstract

We examine how the quality of political, legal, and regulatory institutions

impacts sovereign risk premia. An improvement in institutional quality

significantly lowers a country’s sovereign credit default swap (CDS) spread,

even after controlling for domestic and global macroeconomic factors. The

incremental effect of institutional quality may also be economically important

in explaining the variations in the level of sovereign CDS spreads. The basic

results are robust to alternative model specifications, samples, control variables,

measures of institutional quality, estimation methods, and controls for

endogeneity. Overall, the evidence suggests that institutional quality may play

a significant role in explaining sovereign CDS spreads.

KEYWORDS

credit default swap, sovereign credit risk, sovereign credit rating

JEL CLASSIFICATION

F34, G15, G32

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INTRODUCTION

The recent European (i.e., Eurozone) sovereign debt crisis illustrates the importance of understanding the determinants

of the behavior of prices in the sovereign credit market. As discussed in the literature (e.g., Bulow & Rogoff, 1989a,

1989b; Panizza, Sturzenegger, & Zettelemeyer, 2009), due to sovereign immunity laws and other legal principles or

conventions, there is a lack of a straightforward legal mechanism to enforce repayment of sovereign debt. Thus, a

fundamental characteristic of sovereign debt is the far more limited legal enforcement compared to corporate debt,

where domestic court actions and corporate governance may play important roles in affecting its repayment.

The earlier literature on the sovereign credit market (e.g., Bulow & Rogoff, 1989a, 1989b) has focused on sovereign

defaults on bank loans to emerging markets, as motivated by the fact that in early to mid‐1980s many emerging markets

repeatedly “rescheduled”their payments to their lenders from developed markets such as the United States. Clearly,

while it is crucially important, sovereign defaults are at the extreme end of the sovereign credit risk spectrum, and do

not provide information about other interesting and practically perhaps more relevant scenarios of high sovereign credit

risk and yet not involving sovereign defaults.

1

With the development of financial markets, researchers tend to explore

sovereign credit risk using sovereign bond data (e.g., Bailey & Chung, 1995; Gande & Parsley, 2005; Hilscher &

Nosbusch, 2010) and more recently using sovereign credit default swaps (CDS) data (e.g., Ang & Longstaff, 2013; Doshi,

Jacobs, & Zurita, 2017; Longstaff, Pan, Pedersen, & Singleton, 2011; Pan & Singleton, 2008). These studies, particularly

J Futures Markets. 2019;39:686–703.wileyonlinelibrary.com/journal/fut686

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© 2019 Wiley Periodicals, Inc.

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The literature on sovereign defaults also focuses on the impact of macroeconomic conditions (e.g., Mendoza & Yue, 2012; Reinhart & Rogoff, 2009).

more recent ones exploiting sovereign bond or CDS data, typically focus on the effect of economic and financial factors

(including macroeconomic and financial market variables) on various measures of sovereign credit risk.

2

This paper aims to explore how quality of institutions, including legal and political institutions, affects the sovereign

CDS market. Sovereign CDS are bilateral insurance‐type contracts that offer buyers protection against default by

sovereign debtors. The sovereign CDS market has become one of the largest and most important international credit

markets (Longstaff et al., 2011). The importance of institutions has received much attention in the finance literature.

The term institutions may refer to a wide range of social structures such as country‐level creditor rights, property rights,

contract enforcement, investor protection, and the political system. In particular, since seminal papers by La Porta,

Lopez‐de‐Silanes, Shleifer, and Vishny (1997, 1998) and La Porta (1999), legal institutions have been shown to affect

various aspects of the financial sector, including bank loan terms (e.g., Bae & Goyal, 2009), trading cost (e.g.,

Eleswarapu & Venkataraman, 2006), liquidity (Lesmond, 2005), and bond covenants (Miller & Reisel, 2012), among

others. By contrast, while political institutions might be as important as legal institutions in shaping financial market

development, they have received serious attention only until recently in the finance literature (e.g., Qi, Roth, & Wald,

2010).

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Of course, the types of institutions important to the finance sector could go beyond well‐known legal and

political regulations, and such a consideration is even more relevant given the fact that often only a limited (sometimes

a very small) number of indicators are used in the literature to measure even legal and political institutions.

This paper makes several contributions to the literature. First, we contribute to the growing literature on the

dynamics of sovereign CDS spreads. Prior studies have stressed the impact of global risk factors and mainly the US

financial market variables (e.g., Longstaff et al., 2011; Pan & Singleton, 2008) as well as the domestic financial sectors

(e.g., Acharya, Drechsler, & Schnabl, 2014; Dailami, Masson, & Padou, 2008; Gennaioli, Martin, & Rossi, 2012;

Weigel & Gemmill, 2006) on sovereign credit risk premia. Recent studies also examined the predictability of CDS

spreads. For example, Lecce, Lepone, McKenzie, Wong, and Yang (2018) found that lagged short‐selling metrics

forecast changes in CDS spreads. However, we have little understanding about what drives the variations in sovereign

CDS spreads. In addition to the global and domestic economic variables, we document incremental significant impact

of institutional quality on sovereign CDS spreads. While some studies also allow for the potential effect of legal and

political institutions on sovereign bond markets and yield mixed evidence (e.g., Cuadra & Sapriza, 2008; Gande &

Parsley, 2005), we extend the previous literature by employing comprehensive measures of institutional quality

covering more than legal and political institutions. Such measures are also derived from hundreds of indicators from

numerous different sources, which differ from above‐mentioned studies on legal or political institutions. With such

measures, we are able to demonstrate the pronounced effect of the quality of various institutions on the sovereign CDS

market, which is as important as the effect of economic factors considered in the existing literature.

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As discussed

further below, our result showing institutional quality is a major determinant of sovereign CDS spreads is new to the

literature.

Second, and perhaps more important, different from numerous earlier studies based on the sovereign bond market

data, we explore sovereign spreads measured by the sovereign CDS market, a huge and economically important credit

market by itself. As pointed out by Pan and Singleton (2008) and Longstaff et al. (2011), in contrast to many emerging

market sovereign bonds, sovereign CDS contracts are designed without complex guarantees or embedded options, and

they can be easily mapped into returns due extensively to sovereign credit risk. Sovereign CDS contracts are also more

liquid than most of underlying sovereign bonds.

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Therefore, the use of sovereign CDS contracts may allow for more

accurate estimates of credit spreads and returns, and offers “a nearly unique window for viewing investors’risk neutral

2

As a notable exception in the early literature, Bulow and Rogoff (1989a) address the role of institutions in sovereign lending contracts. Specifically, they emphasize the importance of political and/or

legal rights of creditors to enable them to threaten foreign debtors’interest outside their borrowing relationships. Our study extends Bulow and Rogoff (1989a) by comprehensively investigating the

role of institutions of debtors.

3

Some earlier studies (e.g., Eleswarapu & Venkataraman, 2006; Lesmond, 2005) report much smaller economic significance of political institutions than legal institutions (as measured by magnitudes

of relevant coefficients), while Qi et al. (2010) provide the evidence that political institutions impact international debt markets as much as legal institutions.

4

Butler and Fauver (2006) also used similar measures of institutional quality to examine their effect on sovereign ratings and report significant results. Our focus is on sovereign CDS spreads as the

primary measure of sovereign credit risk. In addition to differences betweensovereign CDS and sovereign bond markets as discussed above, sovereign bond ratings typically have little change even at a

yearly frequency, while sovereign CDS spreads have much time variations at monthly or even daily frequencies. Also relevant to this study, rating agencies have been fiercely blamed for their poor job

in measuring (particularly corporate) credit risk. Furthermore, our study differs from Butler and Fauver (2006) in the analysis on bond ratings in the following aspects. First, our results on sovereign

ratings not only confirm but also extend Butler and Fauver (2006) by exploring many additional model specifications including a quasi‐natural experiment (i.e., the impact of elections). Second, we run

the horse race to compare the relative importance of institutional quality versus macroeconomic conditions, which is not much explored in Butler and Fauver (2006). Finally, Butler and Fauver (2006)

employ cross‐sectional data only, while we exploit panel data (as well as cross‐sectional data), more adequately allowing for and extracting potentially additional information from the time series

variations in the dependent variable sovereign CDS spreads and independent variables (despite less frequent changes in the independent variable institutional quality during the sample period).

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Even compared with the corporate CDS market where trading is concentrated on the 5‐year maturity contract, the sovereign CDS contracts are actively traded at multiple (rather than one) maturity

points.

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