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Sovereign credit ratings play an important part in determining countries' access to international capital markets and the terms of that access. In principle, there is no reason to expect that sovereign credit ratings should systematically predict currency crises. In practice, in emerging market economies there is a strong link between currency crises and default. Hence if credit ratings are forward-looking and currency crises in emerging market economies are linked to defaults, it follows that downgrades in credit ratings should systematically precede currency crises. This article presents results suggesting that sovereign credit ratings systematically fail to predict currency crises but do considerably better in predicting defaults. Downgrades in credit ratings usually follow currency crises, possibly suggesting that currency instability increases the risk of default.

PurposeThe purpose of this paper is to show that economic policy impacts sovereign debt risk in addition to economic performance.Design/methodology/approachRegression analysis was employed to determine the factors that contribute to sovereign bond ratings and bond spreads for a sample of 93 countries from 2000 to 2006.FindingsAfter controlling for common factors like per capita gross domestic production, growth, and political regime, the results suggest that a two unit (or a 2.4 standard deviation) drop in the economic freedom index represents approximately a 50 percent higher cost of borrowing for a country.Originality/valueThe paper contributes to the empirical literature on sovereign credit risk by identifying factors found to be the most significant in determining sovereign credit ratings and bond spreads.

We study financial networks and reveal a new kind of systemic risk arising from what we call default ambiguity-that is, a situation where it is impossible to decide which banks are in default. Specifically, we study the clearing problem: given a network of banks interconnected by financial contracts, determine which banks are in default and what percentage of their liabilities they can pay. Prior work has shown that when banks can only enter into debt contracts with each other, this problem always has a unique maximal solution. We first prove that when banks can also enter into credit default swaps (CDSs), the clearing problem may have no solution or multiple conflicting solutions, thus leading to default ambiguity. We then derive sufficient conditions on the network structure to eliminate these issues. Finally, we discuss policy implications for the CDS market.