Economic Integration and Latin American Spreads: The Effects of Bilateral Free Trade Agreements with the U.S. on Country Risk Premia

Abstract

Latin American debt markets are affected by numerous particularities, including political and economic risk. The rise of free trade agreements and trade blocs, such as The Pacific Alliance, has provided member-countries with lower transaction costs and free capital movements. Most importantly, free trade agreements lure foreign investors through greater levels of transparency and domestic stability within the host country. This paper analyzes the effect of bilateral free trade agreements – defined here as a trade agreement between one country and the United States – on the country-risk premium assumed for purchasing foreign government bonds. Specifically, this study utilizes a two-way fixed-effect analysis, in addition to several other tests, to measure robustness. Overall, the paper finds that bilateral free trade agreements generally have considerable power in decreasing country risk premium. This result is then stress-tested by controlling for established macroeconomic determinants of country risk premium. An event study visualizes the dynamic decreasing effect of FTAs on country risk premium. Falsification tests corroborate that the outcomes of this study are generally not attributable to measurement error or assumption flaws. Interestingly, a heterogeneity analysis by political affiliation reveals that, on average, right-leaning governments experience greater decreases in country risk premium than do their left-leaning counterparts, although with no statistical significance. A similar heterogeneity study by economic crisis suggests countries with bilateral FTAs experienced decreases in country risk premium during the Great Financial Crisis. Finally, the study also unintuitively finds that OECD membership, through the lens of Chile as a proxy, increases country risk premium.