A Quantitative Approach to Assessing Sovereign Default Risk in Resource‐Rich Emerging Economies

Abstract

Abstract The problem of sovereign default is a tricky one for bankers, policy makers, politicians and investors alike. Purely financial models are likely to miss nuance and cultural idiosyncrasies. Nonetheless, risk metrics must play a role. Using a stochastic growth model in an open economy, we propose a Kealhofer, McQuown and Vasicek (KMV)‐style approach for assessing sovereign default risk in resource‐rich emerging economies. As is well known, financial effects, specifically external debt, can make a country vulnerable to economic shocks. Excessive external debt is, thus, a prime indicator for financial health in both resource‐poor and resource‐rich countries; yet, safe ratios are difficult to determine. Using a straightforward and easily implementable methodology, we show how optimal debt ratios may be used to define a ‘distance from default’ indicator variable. Further, we demonstrate that this is a plausible risk metric for a number of different developing countries, including representatives from Latin America, Africa and Asia. Copyright © 2015 John Wiley & Sons, Ltd.