Sovereign Credit Research Articles

What drives the dynamic relationship between sovereign credit default swaps and exchange rates?

What drives the dynamic relationship between sovereign credit default swaps and exchange rates?

African Sovereign Risk Premia and International Market Assets: A Relook Under The COVID-19 Outbreak

Using the wavelet multiscale coherence technique, the paper examines the interdependences between global market assets, sovereign credit default swap (CDS) and yield-to-maturity on bond spread for African economies from January 2019 to March 2023. The empirical results primarily reveal a high level of coherence between global market assets and Africa’s sovereign CDS and yield-to-maturity, although varying across countries and time-frequency domain. Notably, the high degree of coherence and the positive co-movement between sovereign CDS and global market assets are more concentrated at the medium and upper frequency bands. The observed intensity of co-movements between global market assets and sovereign CDS/yield-to-maturity (YTM) of bond spread, with global market assets broadly serving as leading variables, suggests that an increased global investor’s risk aversion positively affects the yields on Africa market bonds. Among the global market assets, we identified that VIX (which is implied volatility of S&P500) has the dominant influence on Africa sovereign CDS/YTM compared to that emanating from Bitcoin and Godman Sachs Commodity Index. This is highly conceivable as VIX gauges bubbling global risks and uncertainties which considerably influences investor’s risk aversion. The heterogeneous lead/lag dynamics also provide useful information to global investors, including by utilizing African markets to rebalance their portfolios for risk management purposes. The empirical findings thus provide further critical information to investors for hedging purposes, and to policymakers in formulating sovereign risk management policies oriented towards minimizing sovereign default risks.

The impact of changes in macroeconomic factors on banks’ lending behaviour

Loans are a critical transmission channel for commercial banks as well as an important revenue source. Macroeconomic factors are not within the control of commercial banks, however, select factors are observed to have a direct impact on lending behaviour in studies around the world. This study examined the relationship between macroeconomic variables and the lending behaviour of banks in South Africa for the period ranging from 2001 to 2022. Quarterly time series data was employed using the Autoregressive Distributed Lag Model (ARDL). The empirical results of the paper revealed that there is a long-run relationship between the repurchase rate (repo rate), inflation, the real effective exchange rate (REER) and lending behaviour in South Africa. The REER and inflation were both found to have a positive relationship, whilst the repo rate had a negative relationship. In addition, Gross Domestic Product (GDP), the activity rate and sovereign credit rating (SCR) changes returned insignificant results. Overall, these findings show that select macroeconomic factors do influence lending behaviour in South Africa. Furthermore, the results suggest that monetary policy decisions have a direct influential effect on lending and the South African Reserve Bank (SARB) has implemented their policies effectively.

Assessing State Resilience: Lynching and Its Ramifications on State Credit in the United States

ABSTRACTThe importance of state capacity and institutional quality has received significant attention within the academic literature. This is especially true as it relates to the protection of property rights and, ultimately, the role it plays in economic development. This study adds to this literature by considering how lynching activity across US states impacts sovereign credit. Given that lynching tends to be associated with weak public‐sector institutions, limited‐access social orders, and the weak protection of individual and property rights, we posit that as lynchings increase so too will bond yields. The analysis covers the period 1883–1920 and find support that state borrowing costs rose as lynching activity increased. The results are robust to a number of specifications, demographic groups, and regions. Implications are discussed.

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.

Time-varying co-movement of sovereign credit default swaps markets: Evidence from Asia-Pacific countries

This study explores the drivers of the co-movement of major sovereign credit default swaps (CDS) markets in Asia-Pacific countries. The lower differentials in fiscal performance among the sample countries contribute to an increase in the co-movement of the CDS markets. The political clearance differentials of corruption control among the sample countries turned out to have a negative relationship with the market co-movement. A higher similarity of social labor risk among the sample countries is positively associated with the co-movement of the CDS markets.

A new approach to K-nearest neighbors distance metrics on sovereign country credit rating

This study introduces feature importance K-nearest neighbors (FIKNN), an innovative adaptation of the K-nearest neighbors (KNN) algorithm tailored for classifying sovereign country credit ratings. The primary objective is to enhance KNN's predictive accuracy by integrating a feature importance mechanism derived from the random forest algorithm, which prioritizes significant features and reduces the impact of less relevant ones, refining the distance computation within KNN. Utilizing a comprehensive dataset of sovereign credit ratings, the performance of FIKNN was assessed against traditional KNN using various feature sets and bootstrap samples. The FIKNN model consistently outperformed the standard KNN by approximately 1% in classification accuracy, attributed to the weighted distance metric adjusting feature influence based on importance. Key findings indicate that FIKNN effectively manages datasets with varying feature relevance and demonstrates a positive correlation between feature diversity and model performance. Future research will explore other distance metrics and refine the feature importance weighting mechanism to broaden FIKNN's applicability in diverse predictive tasks.

Sovereign Credit Rating: Impact on Social Investment and Role in Financial Subordination

This article examines sovereign credit rating methodologies and their impact on fiscal space in developing economies. While sovereign ratings are meant to reflect default risk, the biases embedded in the rating methodologies result in overly punitive rating actions in developing economies that often limit their ability to implement countercyclical policies. In addition, with a singular focus on austerity, they tend to shift focus away from critical development priorities and social welfare spending. Using panel data of credit rating changes in 133 countries over the period 2000–2020 from Moody’s, we explored the long-term trends in the impact of ratings. Negative rating actions have been intensifying in developing economies since 2010. We found that rating changes did tend to influence fiscal priorities. Downgrades lowered the proportion of spending on health and education and increased the proportion of spending on interest payments. We situate this examination of credit ratings within the framework of the financial subordination literature. We suggest that credit ratings are a new manifestation of financial subordination and have created a new dimension in reproducing and deepening the inequalities in the global financial system. JEL Classification: B5, F34, F02

Rating Politics: Sovereign Credit Ratings and Democratic Choice in Prosperous Developed Countries – A Summary of the Argument

Abstract This article summarizes the core argument of ‘Rating Politics: Sovereign Credit Ratings and Democratic Choice in Prosperous Developed Countries’, co-authored by Zsófia Barta and Alison Johnston and published by Oxford University Press. The book shows that credit rating agencies have become central actors in global governance by dint of their propensity to assign penalties and rewards to the political and policy choices of sovereign governments. It explores the logic according to which those penalties and rewards are meted out, and argues that these rewards and penalties not only constitute a violation of democratic sovereignty, but potentially undermine long-term economic growth and social and political stability, thereby also weakening countries’ long-term debt-servicing capacity.

The investment grade and funds' portfolio allocation in Greek assets

The importance of investment funds for the global economy has increased in the aftermath of the global financial crisis. In the present paper, we focus on the case of Greece and the developments in investment funds’ portfolios, with a special emphasis on the period before the sovereign credit rating upgrade of Greece to investment grade. By means of a differences-in-differences estimator, we find that, in the aftermath of the change in Greece’s sovereign credit rating outlook to positive by the rating agency Standard and Poor’s (S&P), investment funds increased their holdings of Greek sovereign bonds in relation to other comparable euro area sovereign bonds. Next, in a dynamic panel data model setup we find that this increase in investment funds’ positions in Greek government bonds (GGBs) explains about 80% of the reduction in Greek sovereign bond spreads. Our results highlight the strong association between investment funds’ portfolio allocation and the underlying assets’ credit ratings, and provide incentives for continuing reforms that may lead to rating upgrades, as a means of increasing demand for Greek sovereign bonds and controlling the cost of debt. This is especially important when the monetary policy environment becomes tighter and interest rates, as well as the cost of funding, increase.

An Alternative Approach to Parliamentary Oversight of Sovereign Guarantees in South Africa

The research paper constructs and compares two structural risk models. A South African sovereign risk model and an ESKOM credit risk model. The interaction between these models explains the statistically significant causal relationship between corporate governance practices at the level of a public entity and government finance conditions between 2004 and 2019. It shows that a more effective approach to parliamentary oversight of government guarantees in South Africa can deliver better sovereign credit rating outcomes in post-COVID-19 South Africa. It will require proactive innovative measures in the application of government guarantees issued to SOEs aimed at improving institutional operational performance within a government-wide risk management framework. The paper concludes that economic transformation, with restitutive intent, is advanced with the adoption of a dynamic and evidenced-informed approach in addressing the complex interplay of prevailing socio-economic, government finance, and political environmental conditions in South Africa.

Forecasting sovereign CDS spreads with a regime‐switching combination method

AbstractWith the growing importance of the sovereign credit default swap (CDS) market, accurate forecasting of sovereign CDS spreads has gained significant attention. In view of the complex volatility in the series of sovereign CDS spreads, this study presents a novel combination forecasting framework, which introduces time‐varying weights to effectively combine diverse individual models. To identify optimal subsets of models, a mutual information approach is employed, while the regime‐switching method is utilized to integrate the selected models. The proposed method's efficacy is validated using data from 65 countries. Empirical findings underscore the superiority of the proposed approach over benchmark models in terms of both horizontal and directional prediction accuracy, particularly when the sovereign CDS data exhibits a balanced distribution between high and low volatility regimes.

The Impact of The Sovereign Credit Rating on The Possibility of Financing External Loans to The Iraqi Economy

External loans are a source of credit revenue. The process of obtaining it requires determining the degree of credit risk by predicting the financial solvency of the economy to judge its financial ability to pay the principal and interest dues of the loan at the specified maturity date. Considering that ability is a determinant of the creditworthiness of his economy, the extent to which financing can continue with this external credit source and its cost. The government of Iraq faced the difficulty of financing external loans from the international capital markets with its high return due to the lack of a sovereign credit rating that measures the risk of default through a process to determine the degree of that risk for investors of external lending funds. Therefore, the research came to show the effect of determining the sovereign credit rating on the extent to which the Government of Iraq can finance foreign loans, whether from capital markets or foreign governments and the impact of this classification on the credit facilities granted. The research concluded that the economy of Iraq got a sovereign credit rating within the degree of creditworthiness according to the classification of speculation to reflect the possibility of default in payment due to the dependence of the financial solvency of its economy on oil revenues, as the credit risks rise due to the inability to pay in the event of a decline in prices in the foreign market. However, relative stability within the short term enabled the Iraqi government to obtain foreign loans, with the requirement that Iraq provide guarantees by foreign governments and institutions in exchange for this source of credit.

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.

The Study of Bond Spreads and Credit Ratings in Honduras

This research rigorously examines the intricate influences on Honduras' cost of borrowing from 2013 to 2022. The study employs the Corruption Perceptions Index (CPI) and Standard and Poor's as main determinants. Control variables include macroeconomic fundamentals that pertain to a country’s performance such as GDP growth, inflation and international reserves, fiscal variables such as debt-to-GDP ratio, and the central administration’s balance, and global factors such as global risk aversion measured by the Chicago Board Options Exchange's CBOE Volatility Index (VIX) and U.S rates. The study finds that country-specific fundamentals, global factors, corruption perceptions, sovereign credit ratings, and political risk all play significant roles in influencing Honduras’ cost of borrowing. It also exposes the limitations of credit ratings in capturing the truth about bond pricing in Honduras. These findings highlight the complex interplay of economic, global, and sociopolitical factors in shaping Honduras' bond spreads, emphasizing the need for a comprehensive approach to credit risk assessment and bond market analysis. The results from this research contribute to economic stability strategies for policymakers, enhance understanding for economists, and assists investors and financial analysts in making informed decisions based on identified variables impacting bond spreads.

European Financial Markets Integration and the Politics of Credit Rating Agencies: An Econometric Approach to Study Microeconomic Dynamics and Sustainability

Abstract On sovereign credit default swaps markets, contagion serves as a sobering reminder of the interconnectedness of global financial systems. Like ripples in a pond, the impact of sovereign default or downgrades can cascade across borders, highlighting the intricate web of dependencies among nations. Utilizing sovereign CDS spreads between 2006-2020 on local European markets, the study employs an event study methodology to assess the effects of rating changes on CDS spreads, focusing on negative events such as sovereign rating downgrades. The findings reveal that negative events have a greater impact on the CDS market than positive events, abnormal returns are higher during economic crises, and states with public debt exceeding the Maastricht criteria experience higher abnormal returns. These results suggest that investors are sensitive to adverse news and risk factors, see opportunities for profit during economic turmoil, and closely monitor fiscal sustainability metrics. Understanding and managing contagion risk in these markets requires not only vigilance but also cooperation and coordination among policymakers and market participants.

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..