Sovereign Credit Research Articles

Dynamic connectedness between credit and liquidity risks in euro area sovereign debt markets

We examine the dynamic interconnections between sovereign credit and liquidity risks in ten euro area countries at the 5-year maturity with daily CDS data from IHS Markit and high-frequency data from MTS between 2008 and 2018 using the extended TVP-VAR connectedness approach of Antonakakis et al. (2020). We find that, for most of the period, net connectedness is from credit risk to liquidity risk, but this indicator is time-dependent, detecting some episodes where it goes from liquidity risk to credit risk. We set up an event study and discover that most of the latter episodes can be related to several unconventional monetary policy measures of the ECB. Then, we examine the drivers of the connectedness indicator using a Probit model. Our results suggest that a decline in global funding liquidity, monetary policy shocks and economic policy uncertainty increase the probability of risk transmission from liquidity to credit, while tensions in financial markets and the deterioration of fiscal sustainability are factors that reduce such a probability.

Sovereign default network and currency risk premia

We construct a sovereign default network by employing high-dimensional vector autoregressions obtained by analyzing connectedness in sovereign credit default swap markets. We develop four measures of centrality, namely, degree, betweenness, closeness, and eigenvector centralities, to detect whether network properties drive the currency risk premia. We observe that closeness and betweenness centralities can negatively drive currency excess returns but do not exhibit a relationship with forward spread. Thus, our developed network centralities are independent of an unconditional carry trade risk factor. Based on our findings, we develop a trading strategy by taking a long position on peripheral countries’ currencies and a short position on core countries’ currencies. The aforementioned strategy generates a higher Sharpe ratio than the currency momentum strategy. Our proposed strategy is robust to foreign exchange regimes and the coronavirus disease 2019 pandemic.

Rating sovereign credit risk: A simulation for advanced economics and finance students

The authors of this article propose a classroom simulation designed for advanced economics or finance courses whereby student teams role-play Moody’s sovereign credit risk analysts. Despite the importance of sovereign credit risk ratings in affecting the funding liquidity of countries, the process generating ratings is a black box. The authors use active and experiential learning techniques to guide student teams in mimicking the process used by Moody’s analysts to assign a sovereign credit risk rating to one of 12 diverse countries. An accompanying YouTube video guides students in navigating three Web sites to retrieve macroeconomic data informing sovereign credit risk ratings. The simulation may be utilized in face-to-face and synchronous online environments.

The informational content of sovereign credit rating: another look

The informational content of sovereign credit rating: another look

Informal Sector, ICT Dynamics, and the Sovereign Cost of Debt: A Machine Learning Approach

We examine the main effects of ICT penetration and the shadow economy on sovereign credit ratings and the cost of debt, along with possible second-order effects between the two variables, on a dataset of 65 countries from 2001 to 2016. The paper presents a range of machine-learning approaches, including bagging, random forests, gradient-boosting machines, and recurrent neural networks. Furthermore, following recent trends in the emerging field of interpretable ML, based on model-agnostic methods such as feature importance and accumulated local effects, we attempt to explain which factors drive the predictions of the so-called ML black box models. We show that policies facilitating the penetration and use of ICT and aiming to curb the shadow economy may exert an asymmetric impact on sovereign ratings and the cost of debt depending on their present magnitudes, not only independently but also in interaction.

A robust examination of COVID‐19 and country risk: Perspectives from the G10 countries

AbstractThis paper examines the effects of COVID‐19 new infections on the financial sovereign risks in the group of ten (G10) countries. The paper utilises panel least squares regression using monthly data over the period February 2020–July 2021. Two sovereign risk measures are examined: the Spread of Government Bond Yields and Sovereign Credit Default Swap spread. The results of the robustness tests show that the spread of the COVID‐19 has affected the sovereign risks significantly and positively. Contagion risks have been extended to exchanges rates and growth rates of international reserves. This paper offers two contributions. First, the results show robust evidence on the impact of COVID‐19 on country's sovereign risks. Second, the severity of COVID‐19 on country's sovereign risks is further. The empirical results carry policy implications that (a) countries must sustain efforts for safeguarding the evolution of COVID‐19 pandemic since it is hindering country's credit worthiness, thus increasing sovereign risks, (b) the G10 countries are advised to follow the zero COVID‐19 strategy, (c) macro prudential measures have to be implemented along with monetary policies that mitigate the sovereign risks and (d) implement social measures to restore the health system and contain the uncertainty on both economic and social grounds.

Reserves and risk: Evidence from China

We consider if Chinese accumulation of reserves is associated with private sector risk taking. Using sovereign credit default swap spreads and stock index prices as indicators of risk taking we provide evidence to suggest that as reserve holdings increase, so does the willingness to take on more risk.

U.S. MONETARY POLICY AND SOVEREIGN CDS MARKETS

This paper analyzes the effects of U.S. monetary policy on sovereign credit default swap (CDS) markets in a total of 66 countries including both advanced and emerging market economies at the monthly time horizon from 2001 to 2016. We employ a four-variable vector autoregression (VAR) model to estimate the monetary policy shock and examine the pass-through of U.S. monetary policy shocks to sovereign CDS markets. We find that the effect of monetary policy shocks on CDS markets is strong, especially during the European sovereign debt crisis and the period the U.S. monetary policy rate was near zero. Our analysis indicates that expansionary U.S. monetary policy leads to the widening of the sovereign credit spreads and the heightening of the CDS market volatility.

A Comparative Analysis of the Investment- and Speculative-Sovereign Credit Ratings

This paper examines the variability of emphasis on sovereign credit ratings (SCRs) issued by three leading credit rating agencies: Moody’s, S&P, and Fitch. Using the sample of 55 countries with observations from year 1998 to 2017, this study reveals a clear variation of emphasis on these determinants in assessing the investment-grade versus speculative-grade rated countries. For the speculative-grade rated countries, only determinants representing the Institutional and Susceptibility to External Event factors matter during the post-global financial crisis (GFC) period. Despite the observed variabilities, there is no evidence to support the argument that the CRAs changed their criteria in SCR determination after the global financial crisis. The seven-determinant model continues to have high predictive power for SCRs of all three leading issuers in a rage of 68 to 71% for investment-grade ratings and 81 to 87% for speculative-grade ratings.

Oil price bubbles: The role of network centrality on idiosyncratic sovereign risk

We investigate the effect of network centrality on idiosyncratic sovereign risk during oil price bubbles by constructing a high-dimensional network based on the data of 60 sovereign credit default swaps over 12 years. By specifying four types of centrality—degree, betweenness, closeness, and eigenvector—for each node in the network, we determine that idiosyncratic sovereign risk increases during oil bust periods and decreases during oil boom periods. We also identify the core–periphery structure of the sovereign default network, which leads to an asymmetric effect on idiosyncratic sovereign risks across bubble episodes. Our findings demonstrate that idiosyncratic sovereign risk transforms into systematic sovereign risk during oil price boom periods and that idiosyncratic contagion occurs during oil price bust periods. Our results emphasize the importance of sovereign default networks in the transmission of idiosyncratic sovereign risk and systematic sovereign risk across bubble episodes.

Modeling the global sovereign credit network under climate change

Climate change is becoming an urgent issue for the global economy. Our study employs a multivariate extreme value regression model that incorporates a LASSO-type estimator to investigate the tail dependence of the global sovereign credit default swap market conditional on climate change. Herein, we propose an extremal connectedness measure based on tail dependence to construct a sovereign credit network. The findings show that extreme weather or climate disasters significantly impact country-specific sovereign risk with heterogeneous network structure outcomes. Specifically, extreme weather conditions have a strong impact on countries' sovereign credit and magnify their influence on the global sovereign credit network. Furthermore, we identify an asymmetric risk spillover effect in the global sovereign credit network, where the degree of risk spillover is higher under extremely hot weather conditions. Our analysis provides new insights into the role of climate change in sovereign risk.

Does Geopolitical Risk Matter for Sovereign Credit Risk? Fresh Evidence from Nonlinear Analysis

The recent geopolitical uncertainty and the alarming increase in the sovereign credit risk of many countries have motivated us to investigate the potential asymmetric co-movement between geopolitical risk and sovereign credit risk for nineteen countries (China, Russia, USA, Brazil, UK, South Korea, Mexico, Saudi Arabia, Turkey, Sweden, Spain, Norway, Italy, Morocco, France, Bahrain, Abu Dhabi, Japan, and Greece). Using data consisting of Sovereign Credit Default Swap (SCDS), Geopolitical Risk (GPR), and the Quantile-on-Quantile approach (QQA), empirical findings indicate that (i) the effects of GPR on SCDS were heterogeneous, mainly positive, asymmetric, and varied across quantiles and countries; (ii) when the SCDS and GPR are both in upper quantiles, the impacts of GPR are more pronounced; (iii) the countries with the most significant sovereign wealth funds (Norway, China, Saudi Arabia) are less affected by geopolitical uncertainty.

Euro area sovereign bond risk premia before and during the Covid-19 pandemic

We provide a novel modeling framework to decompose euro area sovereign bond yields into five distinct components: (i) expected future short-term risk-free rates and a term premium, (ii) a default risk premium, (iii) redenomination risk premium, (iv) liquidity risk premium, and (v) segmentation (convenience) premium. Identification is achieved by considering sovereign yields jointly with other rates, including sovereign credit default swap spreads with and without redenomination as a credit event trigger. We illustrate our model by studying yield components embedded in German, French, Italian, and Spanish sovereign bonds, before and after the onset of the Covid-19 pandemic in 2020, and by examining the impact of European Central Bank (ECB) monetary policy and European Union (EU) fiscal policy announcements in response to the pandemic. We find that all five risk premia became sizable following the onset of the pandemic, and that both monetary and fiscal policy announcements had a pronounced effect on yields, mostly through default, redenomination, and segmentation (convenience) premia.

The impact and the contagion effect of natural disasters on sovereign credit risk. An empirical investigation

This paper investigates the relationship between natural disasters and the reaction of sovereign CDS spread in Europe. By applying an event study methodology during the period January 2007–December 2021 on an original database in which we identify 92 natural disasters in 17 European countries, we assess the reaction of the sovereign CDS market to a natural disaster. We find a heterogeneous response of the European sovereign risk to a natural disaster, as the response of the sovereign CDS market differs from region to region. The advent of a natural disaster can increase inequality between the regions due to the higher cost of credit for sovereigns and the reduced scope for manoeuvring public finances. Also, the results of the contagion effect confirm the hypothesis of a cross-border propagation effect, as natural disaster, in general, is not local event but spreads to other countries.

Political institutions, economic uncertainty and sovereign credit ratings

Sovereign credit rating is an important factor for countries to access funds in the international bond market. First, we jointly analyzed political institutions and uncertainty as determinants of sovereign credit ratings; and second, we test whether the interaction between them matters. Using a sample of 71 countries from 2003 to 2020 for the major agencies Moody’s, Standard & Poor’s, and Fitch, we find that political institutions have a positive effect, whereas uncertainty has a negative effect, and their interaction is systematically negative. These results indicate that lower uncertainty could strengthen the positive effect of political institutions on sovereign credit ratings.

Sovereign portfolio composition and bank risk: The case of European banks

We extend the literature on the sovereign-bank nexus by examining the composition effects of sovereign portfolios on banks' risk profile, unlike previous studies which generally analyzed the determinants of banks’ sovereign portfolios or the size effects of these portfolios. We also differ from previous studies with respect to the measures of risk considered and by covering a sample period that goes well beyond the Global Financial Crisis (2009–2018). Drawing on granular data from the European Banking Authority, we find that banks are riskier when their portfolio includes a higher proportion of securities that are issued by higher risk sovereigns or when they are themselves domiciled in a country with high sovereign credit risk. But we do not find concluding evidence that larger holdings of government securities of the country where the bank is incorporated increase bank risk ex-post. However, the risk profile is higher for banks that received government capital injections than for banks that did not receive capital support in the aftermath of the Global Financial Crisis. Banks that received government capital injections are less risky when their portfolio includes a higher proportion of securities that are issued by higher risk sovereigns. These results may indicate that regulatory arbitrage motives at these banks are particularly important.

Sustainability and sovereign credit risk

The study investigates the impact of Environmental, Social, and Governance (ESG) ratings on sovereign credit risk. The study measures sovereign credit risk using a market-based, structural and an analyst-based approach, while ESG scores are obtained from three different rating agencies. The contributions of this paper are multifold. First, we discover that higher sustainability performance at the corporate level significantly decreases market-based (CDS spreads) and structural (Distance-to-default) sovereign credit risk but has no consistent impact on analyst-based (Credit ratings) sovereign credit risk measure. Second, by expanding our research to include the concept of financial materiality based on the SASB materiality map, we break down and highlight the sustainability themes that require the most attention at the sovereign level and those that can affect the credit health of countries. Third, we demonstrate that the relationship between sustainability and sovereign credit risk varies across ESG rating providers, supporting the widespread belief that sustainability metrics lack standardization and are difficult to compare across providers.

What is mine is yours: Sovereign risk transmission during the European debt crisis

We develop an empirical network model to characterize the density of bilateral sovereign credit risk spillovers during the European debt crisis. We show that the spillover density is often asymmetric with heavy tails and that its location and shape vary strongly and systematically in relation to published indicators of systemic stress. Using auxiliary panel data models, we show that the intensity of bilateral spillovers is related to the portfolio investment exposures among country pairs. Because our spillover statistics can be updated daily, they represent a valuable supplement to existing weekly and monthly measures of systemic stress.

DETERMINANTS OF SOVEREIGN CREDIT RATINGS: THE CASE OF INDONESIA AND PEER GROUP COUNTRIES

This paper aims to identify the predominant determinants of sovereign credit ratings in Indonesia and its peer countries from 2004 to 2019 by considering GDP per capita, official reserve, government debt, Current Account Balance, Credit Default Swap (CDS), and Sovereign Credit Rating used by the three major rating agencies. CDS is considered a newly proposed variable with predicting capacity as a measure of default. Sovereign credit ratings, which are forward-looking measures of the probability of default provided by rating agencies, are being criticized for their predictive capacity with the incorporation of historical data and information in their assessment. Therefore, this study also explores the possible effect of a newly proposed variable with predicting capacity, the CDS, as a pure measure of default. The correlations among the variables were analyzed with Panel Vector Autoregressive (PVAR) as all variables were treated as endogenous and interdependent. The empirical results demonstrate that among the variables tested, GDP Per Capita, Government Debt, and CDS, as a newly proposed variable, have statistically stronger relationships with the sovereign credit rating. The authority that manages the engagement with rating agencies is expected to develop a more focused strategy when taking this aspect into account. Keywords: Financial Market, Rating Agencies, Risk, Panel VAR, Sovereign Rating DOI： https://doi.org/10.35741/issn.0258-2724.58.1.78

Sovereign Credit Ratings, Environmental Performance, and Voice & Accountability: A Nexus

Sovereign Credit Ratings, Environmental Performance, and Voice & Accountability: A Nexus