Preliminary draft BALANCE SHEET EFFECTS AND THE COUNTRY RISK PREMIUM : AN EMPIRICAL INVESTIGATION

Juan Carlos Berganza, Roberto Chang and Alicia García Herrero October 15 2003 Abstract This paper investigates empirically whether there is a negative relationship between a country’s risk premium and its net worth, as implied by recent theories emphasizing financial imperfections, balance sheet effects, and liability dollarization. We find evidence that balance sheet effects, given by the increase in the debt burden because of an unexpected real depreciation, significantly raise the risk premium. We argue that such an effect is unlikely to reflect the impact of the amount of debt on the risk premium. While the result holds for the whole sample, we show that it is mainly driven by those countries with the largest financial imperfections, as argued by imperfect capital market theories. Particularly large depreciations also seem to be disproportionately important, meaning that the balance sheet effects of a devaluation may be strongest at times of economic crisis.