Economic Policy Uncertainty as a Driver of Risk Premia in Emerging Market Swap Spreads

We examine the impact of domestic and global economic policy uncertainty (EPU) on interest rate swap spreads in the BRIC economies, representing the leading emerging markets. We mainly find that the impact of EPU is state-dependent and follows a regime-switching model. On applying the Markov regime-switching model, the effect of EPU was found to be statistically significant only in the relatively less volatile regime. During the high-volatility regime, the impact of EPU is surpassed by noise and other extraneous variables of the term structure and volatility index. When the impacts of domestic and global EPU are examined separately, global EPU is found to reduce swap spreads across all major maturities. This pattern suggests the relative resilience of these economies during periods of heightened global uncertainty and reflects investors’ tendency to drift toward safer fixed-income instruments. In contrast, the effects of domestic EPU are maturity-specific. During low-volatility regimes, higher levels of domestic EPU were causing widening of long-term swap spreads. This divergence indicates that domestic policy uncertainty is more potent in transmitting adverse credit and liquidity conditions over longer horizons, thereby increasing long-term risk premia in the swap market.