Country risk index and sovereign ratings: do they foresee financial crises?

Nerea San-Martín-Albizuri and Arturo Rodríguez-Castellanos

Abstract

ABSTRACT

In this paper, we discuss the evolution of the financial economic events that preceded the triggering of the subprime crisis. This crisis shares similarities with episodes that occurred in the previous two decades, coinciding with the development of the globalization process; one of them is the unpredictability of the events. There are a multitude of prediction and analysis models that are becoming increasingly more advanced, but they have shown a limited capacity to foresee financial and monetary crises. In this sense, the main objective of our research is to test the predictive validity of both the country risk index, published by Euromoney, and the credit ratings variable included therein, as a combination of the sovereign debt ratings issued by the three most relevant rating agencies. Specifically, we seek to verify if these country risk models are capable of foreseeing in the medium term the external financial crisis that occurred between 1992 and 2011. To this end, we apply logistic regression. We find that the results are negative, so it seems that neither the index nor the sovereign ratings are able to reflect the imbalances that may trigger crisis episodes. In this respect, we propose the development of new models for the correct management of country risk.