DP3785 Learning to Forget? Contagion and Political Risk in Brazil

Author(s): Marcus Miller , Kannika Thampanishvong , Lei Zhang

Publication Date: February 2003

Keyword(s): sovereign spreads , political risk , bayesian learning , time-consistency

JEL(s): E61 , E62 , F34

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP3785.asp

We examine whether Brazilian sovereign spreads of over 20% in 2002 could be due to contagion from Argentina or to domestic politics, or both. Treating unilateral debt restructuring as a policy variable gives rise to the possibility of self-fulfilling crisis, which can be triggered by contagion. We explore an alternative political-economy explanation of panic in financial markets inspired by Alesina (1987), which stresses exaggerated market fears of an untried Left-wing candidate. To account for the fall of sovereign spreads since the election, we employ a model of Bayesian learning and analyse the effects of contagion and IMF commitments.