Academic journal article Journal of International Business Research

Do International Banks' Assessments of Country Risk Follow a Random Walk? an Emperical Examination of the Middle East

Academic journal article Journal of International Business Research

Do International Banks' Assessments of Country Risk Follow a Random Walk? an Emperical Examination of the Middle East

Article excerpt

ABSTRACT

The article empirically investigates the stochastic properties of a widely used indicator of country risk: Institutional Investor's creditworthiness ratings. It tests whether Institutional Investor's ratings of Middle Eastern countries follow a random walk by checking for unit root. It is important to test for unit root because estimated relationships between environmental variables and indicators of country risk may exhibit spurious relationships. Furthermore, if the variable contains a unit root the impact of changes in perceptions of creditworth may have a long-lasting effect rather than a temporary one. Our analysis reveals that country risk ratings for some countries in the Middle East follow a random walk, even after adjusting for structural changes.

INTRODUCTION

Country risk analysis has increased in importance in recent years. "The phenomenal growth of international capital flows is one of the most important developments in the world economy since the breakdown of the Bretton Woods system of fixed exchange rates in the early 1970s" (Council of Economic Advisers, 1999, p. 221). This increase in cross-border capital flows to developing countries created the need to understand the risks associated with these monies. In response to this growing need, which began to develop rapidly in the 1970s, a number of institutions have constructed methods to measure the country's credit worthiness (also referred to as country risk) to help investors and lenders evaluate their various exposures. Recent crises in the global economy serve to underline the importance of country-risk analysis.

While "country risk" refers to the ability and willingness of a country to service its foreign debt, private firms are also influenced by country risk because their ability to pay their foreign obligations can be seriously impaired by a sudden depreciation of the currency, exchange controls, or insufficient foreign currency in their respective central banks (Wells, 1997). Therefore, foreign companies have adjusted the level and type of investment, and the organizational form of entry into emerging countries based on their perceptions of country risk.

Because country-risk ratings are supposed to reflect the probability of default on foreign financial obligations, the extant literature on the topic shows that country risk impacts a variety of economic factors such as foreign direct investment (Gross & Trevino, 1996), equity ownership (Pan, 1996), stock market returns (Erb, Harvey & Viskanta, 1996), as well as bank loans, bond prices and bond yields (Scholtens, 1999).

Banks' loan practices in developed economies have been called into question when economic crises have unsettled emerging markets. In response to changes in a country's credit ratings, banking institutions have adjusted the volume and interest-rate spread for syndicated commercial loans to developing countries. Feder and Ross (1982) ascertained a systematic relationship between bankers' assessment of country risk and interest rate differential in the Euromarket. This paper is concerned with examining the stability of Institutional Investor's country-risk ratings over time for selected Middle Eastern countries using unit root analysis.

Measure of Country Risk

Despite the widespread use of Institutional Investor's country-risk ratings in academic research (e.g., Cosset & Roy, 1991; Lee, 1993; Somerville & Taffler, 1995; Grosse & Trevino, 1996; Pan, 1996; Haque et al., 1996), no known studies have examined the stationarity of this measure over time. The focus of this article is to find whether international banks' assessments of country risk follow a stationary path or a random walk or unit-root process. While several measures of country risk exist, we chose Institutional Investor's rating system because (1) it is the only measure that is based solely on the ratings of leading international bankers, (2) it is offered free to Institutional Investor's readers ensuring widespread dissemination, (3) it is a widely accepted measure by both industry and academia, and (4) it correlates closely with other leading measures of country risk. …

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