Toward a Bottom‐Up Approach to Assessing Sovereign Default Risk

Abstract

The authors propose a new approach to assessing sovereign risk that focuses on the underlying profitability and financial condition of a nations private corporate sector. More specifically, the authors show how their new Z‐Metrics™ approach—an updated and expanded version of the Alt‐man Z‐score methodology—can be used to measure the (cumulative) median probability of default of the non‐financial sector for the next five years, both as an absolute measure of corporate vulnerability and a relative measure that can be compared to the risk of other sovereigns and to the market's assessment as reflected in the prices of credit default swaps.In testing their approach, the authors measure the default probabilities of listed corporate entities in nine European countries, as well as the U.S., at two different points in time: the start of 2009 (and thus prior to the recognition of the Euro crisis by markets and most credit professionals) and for the first four months in 2010 (essentially, the beginning of the recognition of the crisis). Based on these two observations, the authors suggest that their corporate health index of the private sector would not only have served as an effective early warning indicator, but provided a (mostly) useful hierarchy of relative sovereign risks. In addition to predicting sovereign default risk, another potentially valuable use of the authors' model is to remind policy makers of the importance of a profitable private sector to the financial health of sovereign governments.