Sovereign Credit Risk Research Articles

Did interest rate guidance in emerging markets work?

Central banks in emerging market economies experimented with explicit interest rate guidance during 2020-2021. We explore the effectiveness of this policy. Despite some heterogeneity, interest rate guidance generally provided additional monetary stimulus, as reflected in lower medium-term yields and lower term spreads. The magnitude of the reduction in 10-year yields ranged between five and twenty basis points. In the immediate aftermath of the guidance, we do not observe a systematic negative market reaction – such as de-anchoring of inflation expectations, currency depreciation pressures, or increased sovereign credit risk – that would be associated with a loss of central bank credibility or with concerns about fiscal dominance.

Assessing the Influence of Earthquakes on Sovereign Credit Risk: An Event Study on CDS Market Dynamics of Selected Countries

This study analyzes the effects of earthquakes on sovereign credit default risk. The study examines whether 20 major earthquakes that occurred in Türkiye, Mexico, Chile, South Africa, and Greece after 2010 have made a difference on CDS markets using the event analysis method. The results indicate that the earthquakes increased uncertainty in the CDS markets of all countries. These results prove that uncertainty about the ability of countries to repay their public debt has significantly changed compared to the pre-earthquake period.

Does a country’s sovereign credit rating drive capital inflows into emerging European markets? Evidence from Balkan region

This study investigates the impact of sovereign credit ratings on capital inflows and their composition for emerging European economies in the Balkan region. This study sheds light on this nexus by selecting Bulgaria, Croatia, Greece, Romania, and Slovenia between 2006-2018 using panel data analysis. The estimation results underscore that a sovereign credit rating is a significant driver of capital inflows, and a decline in sovereign credit risk leads to increased foreign direct investment and portfolio inflows. Furthermore, the estimation results demonstrate the importance of the country’s specific pull factors and reveal that a country characterized by a larger market size, better institutional quality, a stable macroeconomic environment, and a more developed financial market could attract more capital inflows. Moreover, the results highlight that global risk and liquidity push factors have a significant effect on driving cross-border capital inflows into the Balkan economies. The findings suggest that policymakers should reduce sovereign credit risks and increase the country’s absorptive capacity and competitiveness in order to attract more capital inflows to the investigated Balkan countries.

Sovereign Credit Risk in Saudi Arabia, Morocco and Egypt

The purpose of this paper is to assess and predict sovereign credit risk for Egypt, Morroco and Saudi Arabia using credit default swap (CDS) spreads obtained from the DataStream database for the period from 2009 to 2022. Our approach consists of generating the implied default probability and the corresponding credit rating in order to estimate the term structure of the implied default probability using the Nelson–Siegel model. In order to validate the prediction from the probability term structure, we calculate the transition matrices based on the implied rating using the homogeneous Markov model. The main results show that, overall, the probabilities of defaulting in the long term are higher than those in the short term, which implies that the future outlook is more pessimistic given the events that occurred during the study period. Egypt seems to be the country with the most fragile economy, especially after 2009, likely because of the political events that marked the country at that time. The economies of Morocco and Saudi Arabia are more resilient in terms of both default probability and credit rating. These findings can help policymakers develop targeted strategies to mitigate economic risks and enhance stability, and they provide investors with valuable insights for managing long-term investment risks in these countries.

Sovereign momentum currency returns

We study the relationship between cross-sectional sovereign credit risk and currency spot prices. We find that past (up to 12-month average) sovereign credit risk, measured by sovereign credit default swap (CDS) spreads, predict future currency spot returns. In particular, we document a significant cross-sectional currency portfolio spread in excess of the risk-free rate of return (up to 9.6% p.a.) between the highest and the lowest quintile sovereign CDS spreads. Overall, our results indicate that sovereign credit risk is systematically important for currency returns. Moreover, the level of sovereign credit risk has a persistent effect on currency returns which is consistent with a sovereign momentum effect.

Examining the nexus between oil shocks and sovereign credit risk: Multidimensional insights from major oil exporters

This paper investigates the frequency and quantile connectedness between oil market shocks and sovereign credit risk of seven major oil exporting countries: Saudi Arabia, Russia, the United Arab Emirates, Norway, the United States, Brazil, and Mexico. We apply the time-domain approach of Diebold & Yılmaz (2012), the frequency-domain approach of Baruník & Křehlík (2018), and the quantile-based connectedness approach of Ando et al. (2018). Empirical results indicate that (i) spillover effects vary significantly across different investment horizons, with Mexico, Brazil, and Saudi Arabia emerging as key transmitters of credit risk volatility, (ii) the United Arab Emirates consistently appears as a major net receiver of these risks, highlighting its vulnerability to external shocks, (iii) in both short-term and long-term horizon, demand shocks stand out as the most influential determinants of volatility in sovereign credit risks, and (iv) during periods of heightened credit risk perception, the exacerbating role of oil demand shocks becomes more pronounced..

Borrowing from China and Sovereign Credit Risk

China's lending to developing nations has surged since the mid-2000s, making it these nations' largest official creditor. Contracts frequently feature unique terms, indicating China's substantial privileges as a lender. However, other lenders are also involved. We examine how these lending relationships with China affect access to credit from international bondholders. Combining data on external marketable debt and prices with Chinese lending data, we find that Chinese funding events decrease marketable debt issuance and sovereign yields. Conversely, debt restructuring with China leads to higher spreads. These findings underscore the impact of China's lending on international credit access.

Volatility Spillovers among Sovereign Credit Default Swaps of Emerging Economies and Their Determinants

This paper aims to investigate the volatility spillovers among selected emerging economies’ sovereign credit default swaps (SCDSs), including those of Saudi Arabia, Russia, China, Indonesia, South Africa, Brazil, Mexico, and Turkey. Using data from January 2010 to July 2023, we apply the time-domain and the frequency-domain connectedness approaches.Empirical results show that (i) Indonesia, followed by China and Mexico, are the main transmitters of sovereign credit risk volatility. (ii) Among global factors, the volatility index (VIX), economic policy uncertainty (EPU), and global political risk (GPR) positively impacted spillover on lower and higher quantiles. The results offer critical insights for international investors, policymakers, and researchers, emphasizing the importance of risk-aware investment strategies and cautious policy formulation in the context of financial crises and political events.

The asymmetric response of sovereign credit default swaps spreads to risk aversion, investor sentiment and monetary policy shocks

This paper investigates the determinants of sovereign credit default swaps spreads in the case of European countries. More specifically, it purposes to yield insight into how sovereign credit default swaps spreads respond to changes in investor sentiment, risk aversion, and monetary policy shocks during different market states. Using monthly data from May 2009 to December 2021 and running the quantile regression model, we show that risk aversion, investor sentiment and monetary policy affect the sovereign credit risk changes, and their effects vary across countries and markets states. More importantly, Risk aversion and monetary policy display the major asymmetric role in explaining CDS premia. However, limited asymmetric explanatory power is shown for investor sentiment. Furthermore, our findings demonstrate that the recent European debt crisis has significantly shaped the sensitivity of the sovereign credit risk spreads to the studied determinants. The findings of this study are helpful for investors in forecasting sovereign European credit spreads and hedging the countries default risk.

Моделирование суверенного кредитного риска с учетом экологической эффективности

This study contributes to the evaluation of the role of the eco-efficiency factor in explaining sovereign credit risk. The purpose of the study is to develop a model of sovereign credit risk taking into account the environmental efficiency factor. The sample includes the following countries: Argentina, Belgium, China, China, Egypt, Germany, Greece, Nigeria, Pakistan, Portugal, Spain. 58 % of the world’s countries are categorized as investment grade, indicating that more than half of the countries have high and very high solvency. Using the multiple regression method, the factors affecting the sovereign credit rating are identified: GDP per capita, annual change in inflation, international reserves, private sector credit, total public debt, and environmental performance. The results show a strong positive relationship between credit rating and GDP per capita, private sector lending volume, indicating that countries with better GDP per capita have lower credit risk. To prove the relationship between environmental and credit risk, two multiple regression models were constructed: without and with the environmental factor. The results show that including the environmental factor in modeling a country’s credit rating is appropriate because it improves the quality of the model. According to the two comparison criteria, the model including the environmental factor had better results; the coefficient of determination was larger and the approximation error was smaller. Countries have different environmental situations and different degrees of environmental policy management. There is a relationship between environmental and credit risk of countries, but the environmental situation of a country is not the only determinant factor affecting credit risk. If a country has a high environmental performance index value, it may have an average sovereign rating and vice versa. The scientific usefulness of the study lies in the fact that the constructed model can be used by investors, creditors, rating objects to calculate their own values of sovereign credit ratings.

Interaction between Sovereign Quanto Credit Default Swap Spreads and Currency Options

This study analyzes the term structures of sovereign quanto credit default swap (CDS) spreads and currency options, which are driven by anticipated currency depreciation risk following sovereign credit default (Twin Ds). We develop consistent pricing models for these instruments using a jump-diffusion stochastic volatility model, which allows us to decompose the term structure into the risk components. We find a common risk factor between the intensity process of sovereign credit risk and the stochastic volatility of the exchange rate, and the depreciation risk mainly captures the dependence structure between these markets during periods of high market stress in the Eurozone countries. Depreciation risk is an important component of sovereign quanto CDS spreads and is evident in the negative slope of the volatility smile in the currency option market.

Re-examining the Impact of Oil Price Uncertainty on Sovereign CDS Spread of GCC Countries: Accounting for the Asymmetry and Outliers

We examine the effect of oil price uncertainty on sovereign credit risks in Gulf Cooperation Council (GCC) countries. Unlike past studies, we employ a structural vector autoregression with multivariate GARCH-in-mean (VAR-GARCH-in-mean) approach after filtering out outliers in the observed series. The findings show that uncertainty in the oil market has a positive impact on the sovereign Credit Default Swap (CDS) spreads of the GCC countries. Furthermore, we find that GCC sovereign CDS spreads react asymmetrically to positive and negative oil price shocks.

The role of climate change in sovereign credit risk spillovers? Evidence from G20 countries

This study investigates sovereign credit risk spillovers in G20 countries, emphasizing the impact of climate policy uncertainty using DY spillover index framework and GARCH-MIDAS model. Empirical results show Mexico, Brazil and South Africa as primary transmitters, with the G7 countries as net receivers. We find an inverse relationship between climate uncertainty and sovereign CDS spillovers, particularly affecting highly integrated G20 countries. These results highlight the need to incorporate climate policy into risk management.

Spillover among Sovereign Credit Risk and the Role of Climate Uncertainty

This study investigates sovereign credit risk spillovers in G20 nations, emphasizing the impact of global climate policy uncertainty. This study analyzes the dynamics of these spillovers using sovereign credit default swap (SCDS) spreads and the time-varying parameter vector autoregressive approach. The study finds that Indonesia and Mexico are key risk transmitters within the G20. Linear and quantile regressions show an inverse relationship between climate uncertainty and SCDS spillovers, particularly affecting highly integrated G20 countries. These results highlight the need for coordinated and transparent climate policies to ensure financial stability among G20 nations.

Investor behavior around targeted liquidity announcements

We exploit announcements related to targeted longer-term financing operations (TLTROs) as exogenous shocks in investor perceptions to test recent theories on bank funding liquidity (Ahnert et al., 2019; Liu, 2015). We find that banks with high derivative holdings and more exposed to sovereign credit risk respond better to the announcements, consistent with the view that lower funding costs benefit banks with higher asset encumbrance and located in more vulnerable Eurozone countries. The TLTRO announcements also elicit reductions in short positions on bank stocks relative to stocks of non-financial corporations without impairing their market liquidity. Robustness tests rule out that our results are driven by confounding events and anticipation effects. Placebo tests confirm that the TLTRO announcements are driving the estimated price reactions and changes in short positions.

The pass‐through effects of oil price shocks on sovereign credit risks ofGCCcountries: Evidence from theTVP‐SVAR‐SVframework

AbstractWe implement a two‐stage methodology based on the structural vector autoregressive and time‐varying parameter vector autoregressive models to examine the time‐varying effect of distinct types of oil‐price shocks on sovereign credit risks measured by credit default swap (CDS) spreads in Gulf Cooperation Council countries. Using monthly data for the period from May 2011 to February 2022, our results show time‐varying responses to structural oil shocks in the short‐ and medium‐run periods, with more fluctuations in responses detected over the full sample period in the former. Overall, we detect a break in the contagious impacts of oil shocks during and in the aftermath of, the 2014–2015 oil crisis and COVID‐19 crisis. Specifically, the Bahraini market is found to exhibit a positive (negative) reaction to the oil supply shocks (OS) and oil market‐specific demand shocks (OSD) throughout the pandemic period. Furthermore, we uncover a transient response from the Saudi and Qatari CDS spreads to the aggregate demand shocks (ADS) and the OSD over the full sample period, indicating the need for portfolio rebalancing. In the UAE, we detect a positive impact over the three sampled years of OSD since 2011. Moreover, a notable decoupling pattern continues to appear between short‐ and medium‐term innovations in the ADS. Our results suggest adopting more conservative trading in the CDS markets while understanding the oil price and the economic state. The complexity of the trading strategy should also depend on the target Gulf market itself and that seems essential when it comes to investing in Qatar and Saudi Arabia.

Does climate change affect sovereign credit risk? International evidence

This paper fills a crucial research gap by investigating the connection between climate change and sovereign credit risk. While the economic implications of climate risk have long been acknowledged, limited attention has been given to understanding its impact on sovereign credit risk. To address this gap, we provide novel empirical evidence on the influence of climate change readiness and vulnerability on sovereign credit default swaps (SCDS). Utilizing a panel quantile regression approach, our study reveals the following key findings: (i) Climate change readiness harms SCDS spreads across all quantiles; (ii) Climate change vulnerability positively affects SCDS spreads, except for the extreme upper quantile; and (iii) The relationship between climate change readiness and SCDS spreads is particularly pronounced in higher quantiles. By shedding light on these relationships, our analysis offers fresh insights into the intricate dynamics between climate change and sovereign credit risk.

Exploring the market risk profiles of US and European stock insurers

AbstractMarket risks account for an integral part of insurers' risk profiles. We explore market risk sensitivities of insurers in the United States and Europe. Based on panel regression models and daily market data from 2012 to 2018, we find that sensitivities are particularly driven by insurers' product portfolio. The influence of interest rate movements on stock returns is 60% larger for US than for European life insurers. For the former, interest rate risk is a dominant market risk with an effect that is five times larger than through corporate credit risk. For European life insurers, the sensitivity to interest rate changes is only 44% larger than toward credit default swap of government bonds, underlining the relevance of sovereign credit risk.

An explained extreme gradient boosting approach for identifying the time-varying determinants of sovereign risk

We use a combination of Extreme Gradient Boosting and SHAP Additive Explanations to uncover the determinants of sovereign risk across a wide range of countries from 2002 to 2021. By considering numerous variables established in existing literature within a single framework, we identify year-by-year determinants of sovereign credit risk. To gage the liquidity and solvency aspects of sovereign risk, we utilize 5- and 10-year yield spreads as proxies. Our findings show that the key variables driving sovereign risk have remained relatively stable over time and exhibit similarities in both liquidity and solvency components. Among the prominent variables, various macroeconomic fundamentals play a crucial role, including the current account, GDP growth, per capita GDP growth, and the real exchange rate. Prior to the Global Financial Crisis, macroeconomic variables, particularly the current account, held the highest importance in explaining sovereign risk. However, following the GFC, the relative importance of these variables diminished, giving way to institutional variables, especially the rule of law.

Sovereign bond and CDS market contagion: A story from the Eurozone crisis

We examine the asymmetric and nonlinear nature of the cross- and intra-market linkages of eleven EMU sovereign bond and CDS markets during 2006–2018. By adopting the excess correlation concept of Bekaert et al. (2005) and the local Gaussian correlation approach of Tjøstheim and Hufthammer (2013), we find that contagion phenomena occurred during two major phases. The first, extends from late 2009 to mid 2011 and concerns the outright contagion transmission from EMU South bond markets towards all European CDS markets. The second, is during the revived fears of a Greek exit in November 2011 and is characterized by contagion from (i) CDS spreads in the EMU South towards bond yields in the same bloc and Belgium, and (ii) from Italian and Spanish CDS spreads towards all European CDS spreads. Consistent with their “too big to bail out” status, Italy and Spain emerge as pivotal for the evolution of sovereign credit risk across the Eurozone. Our examination of the relevant mechanisms, highlights the importance of credit risk over liquidity risk, and the containment effect of the naked CDS ban.