COUNTRY RISK

ASSESSMENT USING ITS

ECONOMIC AND POLITICAL
FACTORS

Mentor:
Dr. S.K. Mathur
Assistant Professor of Economics
Department of Humanities and Social Sciences
Indian Institute of Technology, Kanpur
Submitted by:
Suyash Baderiya(Y9616)
Undergraduate Student
Department of Humanities and Social Sciences
Indian Institute of Technology, Kanpur

Abstract
This paper aims to develop a multiple regression model for country risk
assessment using its economic and political factor and analyze the effect of
changes in these factors on risk ratings. The ratings are as per Standard &
Poors sovereign foreign currency sovereign rating. The analysis is based
on data for 28 Asian countries provided by some international organizations
as well as data from various other trusted organizations.

Introduction
Currently, country risk is considered as the probability that a country will
fail to generate enough foreign exchange in order to pay its obligation
toward the foreign creditors (Kosmidou et al., 2008, p.1). In the present
scenario, where recession and debt has caused many governments to
default, the factors that influence the probability of default by a country and
the impact they have on it are issue of major concern.
Many institutions, like Standard & Poors, Moodys, etc. have developed
various methods to assess country risk. These estimates are presented in
a form of ratings, which are indicator of probability of default by the country.
For our analysis, we are going to use Standard & Poors rating. The ratings
by Standard and Poors are based on the information provided by the
debtors themselves and a few other sources. This analysis is mostly based
on the past financial history of the country.
This paper is an extension of the paper by Raluca, Zizi in 2011. In this
paper, we attempt to develop a multiple regression model for assessing
country risk and analyze the effect of change in economic and political
factors on a countrys rating. In our analysis, apart from economic
variables, we have also included political variables because in the current
scenario various political factors play an important role in economic
decision making and thus they have great influence on the economic
condition. The factors in our model are chosen on the basis of significance,
availability and uniformity of data.

Review of Literature
Most of the empirical research in this field suggests that there is a direct
effect of economic factors on risk rating. A recent research by Raluca,
Zizi(2011) also explained the effect of a political factor, i.e., corruption on a
countrys rating. This paper is an extension of the above paper where we
have included another political factor and removed a few factors, which we
found to be highly correlated or data was not available for the countries in
our analysis.

Specifications of the Model

In this paper, we aim to develop a multiple regression model for analyzing
the effect of various economic and political factors, such as, GDP per
capita, exchange rate, and coalition government on the risk ratings
provided by Standard & Poors. Our model is as follows:

Y i= 0 + 1 GDPi + 2 infl i + 3 egi + 4 fd i+ 5 cpi i + 6 fb i+ 7 col i + 8 tb i + 9 ir i + 10 er i +ui

The dependent variable used in this model is:

Standard & Poors foreign currency sovereign ratings(Y): The country
risk ratings provided by S&P is based on the probability that a sovereign
fails to make its full payment on time. The probability is measured using the
information provided by the past debtors and the financial history of the
country.
The ratings provided by S&P(least risky to most risky) are D, C, CC, CCC-,
CCC, CCC+, B-, B, B+, BB-, BB, BB+, BBB-, BBB, BBB+,A-, A, A+, AA-,
AA, AA+. For simplicity of our analysis, I have divided the ratings into three
groups:

1. Worst group: Ratings range from D to BB.

2. Moderate risk group: Ratings range from BB+ to A.
3. Best group: Ratings range from A+ to AAA.
The value of Yi varies as follows:
Yi = 1, if rating of the country lies in worst group.
2, if rating of the country lies in the moderate risk group.
3, if rating of the country lies in the best group.

The independent variables used in the model are:

1. GDP: It is the gross domestic product per capita of the country. For
our analysis we will use the definition provided by World Bank, which
is: GDP per capita is the gross domestic product divided by midyear
population. It is the sum of gross value added by all resident
producers in the economy plus any direct taxes and minus any
subsidies not included in the value of the products calculated without
making deduction for depreciation of fabricated assets or for
depletion and degradation of natural resources. The data is in US$.
We have used this variable as it is an indicator of development.
2. Infl: We use the World Bank definition for inflation, consumer price
index (annual %). It is defined as the change in the cost to the
average consumer of acquiring a basket of goods and services. The
Laspeyres formula is generally used for calculating inflation. We have
chosen this variable as high inflation rate shows that there is some
problem in the economy. If the inflation rate is high, the government
increases its interest rate to control inflation, which again hinders
economy. Moreover, when governments go for deficit refinancing
when they are unable to meet the budget deficit. Thus, high inflation
shows that there is some problem with the economy.
3. eg: It is the percentage change in the volume of goods and services
exported by a country. We have chosen this variable because the
countries with higher export growth rates are considered to be less
risky in terms of credit as export of goods and services is the primary
source of revenue in foreign currency and therefore it can influence

ability of a country to make timely payment of debt and finance its

import.
4. fd: Financial depth is the ratio of domestic credit provided by
banking sector to GDP(expressed in %). We have chosen
variable as it is a measure of the level of banking system in
country. Thus, it shows that how well finance is managed in
country.

the
this
the
the

5. cpi: Corruption perceptions index is the measure of corruption.

Transparency International, an independent organization, publishes
this index for each country according to their perceived level of
corruption. This index varies in between 0 to 10, where zero implies
highly corrupt while 10 implies very clean. We have chosen this
variable as corruption is one of the major problem in most of the
developing countries and it has its impact on the economy also.
6. fb: It is the fiscal balance of the central government of a country,
expressed as percentage of GDP. Fiscal balance is the difference
between the revenue and expenditure of the government. We have
chosen this variable as it is an indicator of the ability of government to
extract revenue from taxpayers and thus its ability to make timely
payments.
7. col: It is a dummy variable, which is equal to 1 if there has been a
coalition central government in the last 10 years and 0 otherwise. We
have chosen this variable because coalition decreases the decision
making ability of the government and thus its efficiency and ability to
make timely payments.
8. tb: It is the ratio of balance of trade of goods and services to
GDP(Purchasing Power Parity), expressed in the form of percentage.
Trade balance is the difference between a countrys total exports and
imports. We have used this model as trade deficit is the main cause

of current account deterioration, which may lead to high debt and

unstable financial condition.
9. ir: It is the value of gross international reserves in terms of the
number of months it can sustain imports. We have used this variable
as it is an indicator of an economys short term capacity to meet its
import demand.
10. er: It is the ratio of current value of USD in terms of local currency to
its average in last five years. This ratio is an indicator of, whether the
local currency has depreciated (ratio>1) or appreciated (ratio<1) in the
last five years. We have chosen this variable because high depreciation
in local currency indicates reduction in quantity of available foreign
currency.
11. u: It is the error term.
In our analysis, we have excluded government debt to GDP ratio, which
was included in the paper by Racula, Zizi(2011) because it is highly
correlated to the fiscal balance. We have also excluded unemployment
rate because its impact on risk rating wont be very significant. We are
analyzing the data of 28 Asian countries rated by S&P.

Methodology
In our analysis, we will use ordered logit, which is as follows:

Y* = X + u
where,
Y* is latent variable which cant be observed
X denotes matrix of explanatory variables

denotes matrix of coefficients

Y=0, if Y*< v1
1, if v1 < Y*< v2
2, if Y* > v2
where vi s are the cut off points which we get after regression and
v1 < v 2 < v 3

Probabilities can be given as:

P(Y = 1) = P(Y*< v1 ) = F(v1 X )
P(Y = 2) = P(v1 < Y*< v2 ) = F(v2 X ) - F(v1 X )
P(Y = 3) = P(Y*> v2 ) = 1 - F(v2 X )

To analyze the effect of change in explanatory variables on the probability

of dependent variable attaining a certain value, we need to calculate the
marginal effects:
P(Y =1)
=f (v 1X)
Xi
P(Y =2)
= [f ( v 1X ) f ( v 2X ) ]
Xi
P(Y =3)
=f (v 2 X)
Xi

Here, we can observe that the sign of marginal probability of (Y = 1) and

(Y = 3) have opposite signs. This is because the choices are in order. So,
if increase in a variable cause increase in Y *, the first will be negative while
the latter will be positive.

Before using regression, first we will eliminate those variables which can
cause multicollinearity. For this purpose, we will use the Variance Inflation
Factor method. In this method, we apply OLS procedure and eliminate
those variables whose VIF comes out to be greater than 5.
VIF i=

where

1
1R2i
2

Ri

is determined by regressing

Xi

on all other explanatory

variables. After the removal of those variables which can cause

multicollinearity, we apply ordered logit to our model.

Empirical Analysis
For all the analysis below, we are using Stata SE.
Before applying ordered logit regression, we need to remove those
variables which can cause multicollinearity for which we will be using VIF
method. Stata output after OLS and then finding VIF was as follows:
. vif
Variable

VIF

1/VIF

GDP
infl
cpi
er
tb
fb
col
fd
ir
eg

7.39
4.96
4.24
3.57
2.34
2.11
1.80
1.73
1.45
1.34

0.135288
0.201652
0.236097
0.279893
0.427647
0.473261
0.557093
0.577243
0.687579
0.743683

Mean VIF

3.09

Here, we can see that the VIF of GDP is greater than 5. Thus, we will
remove this variable from our analysis as it can cause multicollinearity. So,
our new model becomes:
Y i= 0 + 1 infl i + 2 eg i+ 3 fd i+ 4 cpi i+ 5 fb i + 6 col i+ 7 tb i+ 8 iri + 9 er i +ui

The model thus obtained is free from those variables which can cause
multicollinearity. Stata output after regressing using ordered logit model
was as follows:
. ologit Y infl eg fd cpi fb col tb ir er, level(90)
Iteration
Iteration
Iteration
Iteration
Iteration
Iteration
Iteration
Iteration
Iteration

0:
1:
2:
3:
4:
5:
6:
7:
8:

log
log
log
log
log
log
log
log
log

likelihood
likelihood
likelihood
likelihood
likelihood
likelihood
likelihood
likelihood
likelihood

=
=
=
=
=
=
=
=
=

-30.211782
-12.276868
-9.2919335
-7.7803876
-7.3095361
-7.2143445
-7.2122002
-7.2121958
-7.2121958

Ordered logistic regression

Number of obs
LR chi2(9)
Prob > chi2
Pseudo R2

Log likelihood = -7.2121958

Y

Coef.

Std. Err.

infl
eg
fd
cpi
fb
col
tb
ir
er

.9163996
-.0311513
-.0368201
4.623579
.4007487
-6.448815
.1683288
.7909788
-54.07455

.7475124
.1114258
.0281814
2.758492
.5475104
3.671518
.0982859
.4277838
30.85314

/cut1
/cut2

-35.26547
-21.72721

22.95747
19.04497

z
1.23
-0.28
-1.31
1.68
0.73
-1.76
1.71
1.85
-1.75

Note: 3 observations completely determined.

P>|z|
0.220
0.780
0.191
0.094
0.464
0.079
0.087
0.064
0.080

=
=
=
=

28
46.00
0.0000
0.7613

[90% Conf. Interval]

-.3131489
-.2144304
-.0831744
.0862632
-.4998258
-12.48792
.0066629
.087337
-104.8234

2.145948
.1521278
.0095342
9.160894
1.301323
-.4097042
.3299947
1.49462
-3.325656

-73.02715
-53.05339

2.496215
9.59897

Standard errors questionable.

Here, I have done my analysis at 10% level of significance. The points cut1
and cut2 represent v1 and v2 respectively. To analyze the effect of change in
explanatory variables on probability of dependent variable attaining a
particular value, we need to calculate the marginal effects for being in the
best, moderate risk and worst region.

Marginal effects for being in the best region

. mfx compute, predict(outcome(3))
Marginal effects after ologit
y = Pr(Y==3) (predict, outcome(3))
= .00052121
variable
infl
eg
fd
cpi
fb
col*
tb
ir
er

dy/dx
.0004774
-.0000162
-.0000192
.0024086
.0002088
-.0397507
.0000877
.0004121
-.0281697

Std. Err.
.0021
.00008
.00009
.01025
.00089
.12163
.00038
.00178
.12308

z
0.23
-0.19
-0.23
0.23
0.23
-0.33
0.23
0.23
-0.23

P>|z|

95% C.I.

0.820
0.847
0.822
0.814
0.815
0.744
0.819
0.817
0.819

-.003643
-.000182
-.000186
-.01768
-.001543
-.278149
-.000665
-.003069
-.269412

.004597
.000149
.000148
.022497
.001961
.198648
.00084
.003893
.213072

X
5.15
13.88
78.4704
4.09643
-2.63393
.678571
3.22286
12.3204
1.0075

(*) dy/dx is for discrete change of dummy variable from 0 to 1

.

Marginal effects for being in the moderate risk region:

. mfx compute, predict(outcome(2))
Marginal effects after ologit
y = Pr(Y==2) (predict, outcome(2))
= .99695489
variable
infl
eg
fd
cpi
fb
col*
tb
ir
er

dy/dx
.0018297
-.0000622
-.0000735
.0092314
.0008001
.02007
.0003361
.0015793
-.1079643

Std. Err.
.00486
.00026
.00021
.02367
.00206
.08865
.00092
.00414
.29153

z
0.38
-0.24
-0.36
0.39
0.39
0.23
0.37
0.38
-0.37

P>|z|

95% C.I.

0.706
0.811
0.720
0.697
0.698
0.821
0.714
0.703
0.711

-.007691
-.000571
-.000476
-.037158
-.00324
-.153676
-.001459
-.006541
-.679362

.01135
.000447
.000329
.05562
.00484
.193816
.002131
.0097
.463433

(*) dy/dx is for discrete change of dummy variable from 0 to 1

.

X
5.15
13.88
78.4704
4.09643
-2.63393
.678571
3.22286
12.3204
1.0075

Marginal effects for being in the worst region:

Marginal effects after ologit
y = Pr(Y==1) (predict, outcome(1))
= .00252389
variable
infl
eg
fd
cpi
fb
col*
tb
ir
er

dy/dx
-.0023071
.0000784
.0000927
-.01164
-.0010089
.0196807
-.0004238
-.0019913
.136134

Std. Err.
.00666
.00033
.00028
.03227
.00281
.04756
.00124
.00564
.39588

z
-0.35
0.23
0.33
-0.36
-0.36
0.41
-0.34
-0.35
0.34

P>|z|

95% C.I.

0.729
0.814
0.739
0.718
0.720
0.679
0.733
0.724
0.731

-.015354
-.000576
-.000452
-.074885
-.006526
-.073537
-.002857
-.013049
-.639775

.01074
.000733
.000637
.051605
.004508
.112898
.002009
.009067
.912043

X
5.15
13.88
78.4704
4.09643
-2.63393
.678571
3.22286
12.3204
1.0075

(*) dy/dx is for discrete change of dummy variable from 0 to 1

.

Interpretation of Results:
Using the co-efficients found in the regression, we can develop a
regression model for country risk assessment.
At 10% level of significance, corruption, coalition, international
reserves, trade balance and exchange rate are significant variables
as their p-value was less than the level of significance, i.e., 0.10.
With per unit increase in inflation rate, the probability of being in the
worst region decreases by 0.23% while the probability of being in the
best region is almost unaffected.
Export growth rate, trade balance and financial depth almost do not
affect of probability of being in either of the two regions.

 With per unit increase in corruption perception s index, the probability

of being in the worst region decreases by 1.16% while the probability
of being in the best region increases by 0.24%
The probability of lying in the worst region is 1.97% more for a
country who had coalition government in last 10 years than a country
with single-party government. On the other hand, probability of being
in the best region is 3.98% less for a country who had coalition
government in last 10 years than that of a single-party government.
With per month increase in fiscal balance( as percentage of GDP),
the probability of being in the worst region decreases by 0.10% while
probability of being in best region is almost unaffected
With per month increase in the period of sustaining current import
with existing gross international reserves, the probability of being in
the worst region decreases by 0.20% while probability of being in
best region is almost unaffected.
With per unit increase in the ratio of current value of USD in terms of
local currency to the last five year average of the same, the
probability of being in the worst region increases by 13.61%, while
the probability of being in the best region decreases by 2.82%.

Conclusions
Increase in inflation rate is likely to improve the credit rating or the
probability of making timely payment because sometimes
development may also cause inflation.
Less corrupt countries are more likely to have a good rating because
in these countries, the public funds are used in a more efficient
manner and thus their probability of defaulting is less.

 The countries with a single-party government are more likely to have

a good rating as coalition reduces the decision making capability of
the government because some decisions, which are politically correct
to satisfy all allies may be economically incorrect and thus leading to
poor performance of the economy.
The country with higher international reserve to import ratio is less
likely to have a bad rating because it would be more stable in terms
of sustaining imports due to its high reserves.
The country with higher fiscal balance to GDP ratio is less likely to
have a bad rating as the ability of government to extract revenue from
the taxpayers is high and thus is less likely to default.
The country whose currency has depreciated less is more likely to get
a good rating as currency depreciation can be a result of poor
performance of the country in the international market and thus the
country with highly depreciated currency may not be able to earn
enough of foreign currency to make its payment on time. That is why,
the probability of default is high for the country whose currency has
highly depreciated in the past.

Data Sources

http://www.standardandpoors.com
Transparency International
Central Bank of Bahrain
http://www.indexmundi.com
CIA World Factbook
IMF, World Economic Outlook, September 2011
United States Department of States
United Nations comtrade database
http://www.armbanks.am
Asian Development Bank Asian Development Outlook 2011

References
Danciu Aniela-Raluca, Goschin Zizi (2011)A Multiple Regression
Model for Country Risk Assessment for European countries
Academy of Economic Studies, Bucharest.
GUJARATI, D. (1995), Basic Econometrics, Third edition. New
York: McGraw-Hill.
Standard & Poor (2011), Ratings Performance. New York: Standard &
Poor.
Alexe S., Hammer P. L., Kogan A., Lejeune M. A. (2003b), A
Combinatorial Approach to Country Risk Rating. New Jersey:
Piscataway, RUTCOR, Rutgers University
Verbeek M(2000)., A guide to modern econometrics Third
Edition. Sussex: John Wiley and Sons Ltd
Greene, William H. (2008), Econometric Analysis Sixth Edition.
New Jersey: Pearson-Prentice Hall Press.
http://www.worldbank.org
http://www.standardandpoors.com
http://www.wikipedia.org