Sovereign default risk and state-owned bank fragility in emerging markets: evidence from China and Russia

In this paper we investigate the interdependence of the sovereign default risk and banking system fragility in two major emerging markets, China and Russia, using credit default swaps as a proxy for default risk. Both countries’ banking industries have strong ties with their governments and public sector, even after a series of significant reforms in the last two decades. Our analysis is built on the case studies of each country’s two biggest banks. We employ a bivariate vector autoregressive (VAR) and vector error correction (VECM) framework to analyse the short- and long-run dynamics of the chosen CDS prices. We use Granger causality to describe the direction of the discovered dynamics. We find evidence of a stable long-run relationship between sovereign and bank CDS spreads in the chosen time period. The more stable relationship is found in cases where the biggest state-owned universal banks in emerging markets are closely managed by the government. But the fragility of those banks does not directly affect the state of public finances. However, in cases where state-owned banks directly participate in large governmental projects, banking fragility may result in the deterioration of state funds, while raising the risk of sovereign default.