Determinants of emerging market country risk: Country fundamentals or common factors

This paper achieves two major objectives. The first objective is to identify the determinants of two emerging market country risk indicators sovereign credit ratings and sovereign bond spreads. The second objective is to measure the degrees of co-movement for recent sovereign credit spreads and thereby investigate changes in emerging bond market investors' attitudes toward country-specific fundamentals. To meet these objectives, this paper considers 14 emerging market countries located in three different regions (East Asia, Latin America, and Transition Europe) for a period between 1995 and 2004. Panel data framework estimations are used to identify sovereign risk determinants. Co-movement degrees of spreads are measured using correlation analysis, concordance analysis, and common factor analysis.By comparing the identified country specific variables in credit ratings and spreads, this paper shows that the models used by credit rating agencies to evaluate country risk are different than the models used by investors. Bond market investors are not solely relying on credit ratings. Political risks were identified as a determinant of sovereign credit ratings. World interest rates, global equity market returns, financial market uncertainty are identified as determinants of sovereign spreads.By measuring co-movement patterns of spreads, this study shows evidence that after the market turmoil period (1994--1999) emerging bond market investors began to pay more attention to country-specific fundamentals and events. This paper's findings contradict the results of Mauro et al. (2002) who compared the co-movement patterns between historical times (1870--1913) and modern times (1994--2000) and concluded that the higher co-movement pattern of modern period is accounted for the two factors: first, co-movement of economic fundamentals of emerging market countries is higher in modern times than in the historical times second, while making investment decisions, the investors of modern times seem to pay less attention to the country-specific events or fundamentals than the investors of historical times. By expanding the sample periods through the year 2004, this paper found that after year 2000, when emerging bond markets went into tranquil period, co-movement degrees of spreads decreased into the levels of historical times as defined by Mauro et al. The results implies that the investors of modern times seem to pay less attention to the country-specific events or fundamentals than the investors of historical times is true only if we consider modern times to be the recent emerging market turmoil period from 1994 to 2000. A robustness test using the updated data of Mauro et al. (2002) also supports the findings of this paper by showing that the co-movement degree of modern updated times (2000--2004) dropped dramatically and is approximately the same as the historical one. In addition, this paper found that investors began to differentiate between emerging market countries based on their fundamentals after 2000. The co-movement degree of investment-grade countries has not changed but that of speculative-grade countries' has decreased dramatically after 2000, when emerging bond market went into tranquil period. This result implies that investors consider countries of sound fundamentals as a unified group and pay little attention to their fundamentals, while at the same time investors pay much more attention to the country-specific events in relatively vulnerable countries.