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

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