Fundamentals or market sentiment: what causes country risk?

Abstract

The country risk indicator, as measured by the JP Morgan's EMBI or grades of rating agencies such as Standard & Poor's (S&P's) or Moody's, does not seem to truly reflect the fundamentals of an economy. Countries that pursue sound economic policies are frequently placed on the same level as countries with a populist orientation or with a recent history of default or debt restructuring. Such circumstance generates a feeling of unease with regard to these ratings. The objective of this article is to investigate whether these indicators truly reflect market fundamentals or whether some sort of prejudice, or intolerance towards certain countries, can be identified. We use the Oaxaca–Blinder decomposition to analyse the differences in country risk, measured as by EMBI+, for a group of emerging markets. This decomposition allows us to separate the ‘justified’ (differences in fundamentals) from the ‘unjustified’ differences (same fundamental differently evaluated).

Notes

¹ Tests on a specification of nonlinearity of debt to output ratio in the fiscal fundamental was not significant.

² The EMBI+ has been computed from 1993 on and many countries were excluded from the sample because they did not meet the standards. The countries in Fig. 1, plus Qatar and Nigeria, make up the current sample.

³ We use the inverse of time since the last default so as not to exclude countries that never defaulted from the analysis.

⁴ There are other methods to estimate the nondiscriminatory structure such as in Oaxaca and Ramson (1994) and Shrestha and Sakellariou (1996).

⁵ All significant fiscal fundamentals were used to perform the tests (Model 2 in Table 1).