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Balance of payments, country indebtedness and
country risk ratings
The Balance of Payments - what it is and why it matters. By Dermot McAleese, Whatley Professor of Political Economy at Trinity College Dublin, and taken from his book 'Economics for Business', second edition to be published by Prentice Hall in April 2001.
A country‚€ôs foreign indebtedness (private and public sector) is by definition related to the sum of its past balances on the current account. A highly indebted country has acquired its debt through running large deficits at some time in the past. As the current account worsens, foreign indebtedness increases and country risk ratings might be expected to increase.

Country credit ratings are compiled regularly by international banks. Banker judgements, as represented by country credit ratings, are published regularly in Institutional Investor, a monthly financial journal read primarily by market professionals. The published risk rating for a country is derived by averaging approximately 100 individual bank ratings of that country.

One obvious and important question is to identify the variables which are believed to exercise the most influence on bankers‚€ô assessment of country risk. Research suggests that the Institutional Investor country rating is determined by the variables indicated in the table:*

The first three variables influence country ratings just as one would expect. Thus, countries that have accumulated large amounts of public external debt (i.e. government foreign debt) relative to exports tend to have higher country risk profiles.

By contrast, those with high investment ratios and high reserves tend to have lower risk profiles. This means that bankers look not so much at the current account deficit in any one year (a variable not found to be significant), but at the accumulation of deficits over time by the government sector. They take solace from the fact that investment ratios are high and that reserves are sufficient to cover a reasonable proportion of imports. This model is consistent with the view that a current account imbalance must be interpreted in a broad context. According to the Somerville-Taffler view, long-term balance of payments variables do have an impact on country risk.

The reason for the positive sign on the level of real debt is difficult to explain. Perhaps, as the authors suggest, it indicates that larger economies have larger debt in absolute terms. For this reason there are more bankers who are familiar with its problems. And bankers tend to feel more comfortable about lending to those countries whose economies they feel they know well. This may well be yet another example of the triumph of hope over rational assessment.

Comparing Institutional Investor ratings with actual outcomes, the study shows that bankers are poor forecasters of debt-servicing difficulties among less-developed countries. But so is the equation used to represent their forecasts. Hence the shortcomings of banker judgement are of a fundamental and systematic nature.

Alternative country ratings, prepared by the Economist Intelligence Unit (EIU), are published regularly by The Economist. These are drawn from EIU‚€ôs own estimations, based on economic and political factors. Country ratings of Institutional Investor and the EIU, issued before the Mexican crisis of late 1994, suggested no imminent vulnerability of the Mexican economy or currency. Yet in retrospect we know that the worsening balance of payments current account, the shortened maturity of government external debt and the pessimistic assessments of the Mexican government‚€ôs ability and willingness to deal with its economic and political problems all played a role in the stampede out of the Mexican peso in late December 1994. Recent crises have included South East Asia, the Russian default, August 1998, and Brazil 1998/1999. In none of these cases did the institutional investor ratings show a significant dip ahead of the onset of the crisis.

*R.A. Somerville and R.J. Taffler, ‚€ėLDC credit risk forecasting and banker judgement‚€ô Journal of Business Finance and Accounting (2001).

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