Estimating debt limits for emerging countries

Abstract

The relationship between sovereign risk and indebtedness level is an important guide for evaluating the probability of a debt default. The market discipline hypothesis establishes that the risk premium increases with debt-to-GDP ratio. According to this hypothesis' strong version, this relation is non-linear, and there is a threshold - here called debt limit - from which the credit access would be very difficult. This study provides debt limits for a panel of 18 emerging countries, using generalized method of moments for joint estimation of the thresholds. The countries studied were grouped by cluster analysis, and separately analyzed for each group. We find statistical evidence against the hypothesis of a common debt limit for all emerging countries. The main conclusion of the work is that those countries whose debt-to-GDP ratio exceeded their limits either had problems to get new loans to finance its debt and/or needed help from international institutes, as expected by the strong version of the market discipline hypothesis.