COUNTRY RISK RATINGS: STATISTICAL AND COMBINATORIAL NON-RECURSIVE MODELS

The central objective of this paper is to develop transparent, consistent, selfcontained, and stable country risk rating systems, closely approximating the country risk ratings provided by a major rating agency (Standard & Poor). We propose two models that achieve the stated objectives, the first one utilizing the classical econometric technique of multiple linear regression, and the second one using the combinatorial-logical technique of Logical Analysis of Data. The proposed models use economic-financial and political variables, and are nonrecursive (i.e., they do not rely on the previous years’ ratings). The accuracy of the proposed models’ predictions, measured by their correlation coefficients with Standard and Poor’s ratings, and confirmed by k-folding cross-validation, exceeds 95%. The stability of the constructed non-recursive models is shown in three ways: by the correlation of the predictions with those of other agencies (Moody’s and The Institutional Investor), by predicting 1999 ratings using the non-recursive models derived from the 1998 dataset applied to the 1999 data, and by successfully predicting the ratings of several previously non-rated countries. The confidence in the results and in the validity of both models is strongly reinforced by the fact that the traditional linear regression model and the qualitatively different combinatorial-logical model produce almost identical results. Acknowledgements: The authors express the appreciation to Dr. Sorin Alexe for his invaluable help in the execution of computational experiments with LAD. 1 Country Risk, Country Risk Ratings and Objectives of the Paper 1.1 Country risk, country risk ratings and their importance The globalization of the world economies, and in particular the internationalization of financial markets in the last decades, have dramatically expanded and diversified investment possibilities, leading to numerous new opportunities, accompanied by new risks. Consequently, there has been growing interest in obtaining reliable estimates of the risk of investing in different countries. These concerns have led to the development of the concept of country risk, and even to the regular publication of country risk ratings by various agencies. The importance of ratings has been magnified by the recommendations addressed in the Basel Capital Accord (2001), that pinpoints the role of agencies’ ratings for the assessment of credit risk. Different definitions have been proposed for country risk, i.e. for the risk that a country defaults on its obligations. The existing literature on the topic recognizes both financial/economic and political components of country risk. According to the degree to which some of these components are emphasized, country risk is viewed either from the financial/economic perspective only, or from the combined financial/economic and political perspectives. There are two basic approaches to the interpretation of the reasons for defaulting. The debtservice capacity approach focuses on the deterioration of solvency of a country, which prevents it from fulfilling its commitments. For instance, Bourke and Shanmugam (1990) define country risk as “the risk that a country will be unable to service its external debt due to an inability to generate sufficient foreign exchange”. Within this framework, country risk is viewed as a function of various financial and economic country parameters. The cost-benefit approach views a default on commitments or a rescheduling of debt as a deliberate choice of the country, which may prefer this alternative over repayment, in spite of its possible long-term negative effects (e.g. the country’s exclusion from certain capital markets (Reinhart,2002), reputation damage). Since the deliberate decision to default results from a political process, political country parameters are included in this type of country risk modeling, along with the financial and economic ones. This approach is strongly recommended by Brewer and Rivoli (1990, 1997) as well as Citron and Neckelburg (1987), who emphasize the impact of the political stability indicator on country risk ratings. In response to the increased demand for the evaluation of creditworthiness, several agencies such as Moody’s, Standard & Poor, Fitch, The Institutional Investor, Euromoney, Dun & Bradstreet, etc. have developed expertise in estimating country risk. These estimates are presented in the form of ratings, or scores, and are generally viewed as indicative of possible future default. Haque et al. (1996) define country credit risk ratings compiled by commercial sources as an attempt “to estimate country-specific risks, particularly the probability that a country will default on its debt-servicing obligations”. Sovereign ratings can be viewed as the probability that a borrowing country will fail to pay back. Country (or sovereign) risk ratings impact countries in a number of ways. The primary significance of ratings is due to their influence on the interest rates at which countries can obtain credit on the international financial markets: the higher the ratings (i.e., the lower the risk of