A MODEL-BASED ESTIMATION OF THE PROBABILITY OF DEFAULT IN SOVEREIGN CREDIT MARKETS

A model of sovereign credit markets is built to estimate the probability of default. The model shows that equilibrium implies credit rationing and that it is inadequate to include both the level of debt and the spread over LIBOR as determinants of this probability. Likewise, the model incorporates the idea of sanctions in case of default and it is demonstrated that they play an important role in deterring a country from defaulting. The elements that are found useful in explaining the probability of default are: the degree of openness, a degree of 'unluckiness', international reserves and the risk-free interest rate. Mode was validated for 33 debtor countries. The empirical results suggest that economic liberalization decreases the probability of default, which implies that such a policy enhances creditworthiness. Also, they suggest that external conditions have contributed substantially to the financial crisis tat major borrowers face today; in particular, unluckiness and the persistence of shocks are shown to be important when explaining the probability of default. In addition, penalties reduce the DWL inherent in defaulting. The determinants of the spread over LIBOR are tested separately as an important implication of the model.