Leading Behavior of Interest Rate Term Spreads and Credit Risk Spreads in Korea

Interest rate term spreads and credit spreads have been well known to have a predictive power for future fluctuations of output in many developed countries. This study examines leading behaviors of interest rate term spreads and credit risk spreads in Korea in two ways. First, we apply various empirical methods for finding leading behavior of interest rate term spreads and credit risk spreads in business fluctuations over the period spanning from May 1995 to January 2012. Second, using structural VAR models, we decompose the sources of fluctuations of output and interest rate spreads into two sorts, permanent real shocks and temporary financial shocks and examine the impulse response of each variable to the shocks focusing on the leading behavior of the spreads over the business cycle. We establish successfully the leading behavior of the term spread and the credit risk spread in Korea that the term spread tends to increase and the credit risk spread tends to shrink about 4 to 6 months before an expansion. We also find that much of the output fluctuations are attributed to real shocks while fluctuations in the interest rate spreads come from temporary financial shocks.