What Drives Credit Risk in Emerging Markets? The Role of Country Fundamentals and Market Co-movements

Abstract

This paper investigates how the creditworthiness of Argentina, Brazil, Mexico and Venezuela as reflected by their bond prices, is influenced by both global factors and country-specific fundamentals. We use an extended structural model suggested by Cathcart and El-Jahel (2003) and a Kalman Filter to obtain the distance-to-default implicit in prices of each country's Brady bonds. We find that a small set of country fundamental variables and external factors, including a variable that measures market sentiment, are able to explain up to approximately 80% of the variance of the distance-to-default of each country. Whereas country specific factors are statistically significant in explaining the distance-to-default, external factors (such as the US stock market index, interest rates and market interdependence across countries) are much more important in explaining the dynamics of this variable. Using principal component analysis we find that there is a common factor for all of the countries which explains approximately 60% of the remaining variance (of the residuals). This common factor is therefore systematic and purely related to the bond market.