TOWARD A BOTTOM-UP APPROACH TO ASSESSING SOVEREIGN DEFAULT RISK: AN UPDATE

AbstractWe propose a totally new approach toward assessing sovereign risk by examining rigorously the health and aggregate default risk of a nation's private corporate sector. Models such as our new Z-MetricsTMapproach can be utilized to measure the median probability of default of the non-financial sector cumulatively for five years, both as an absolute measure of corporate risk vulnerability and a relative measure compared to other sovereigns and to the market's assessment via the credit-default-swap market. Specifically, we measure the default probabilities of listed corporate entities in nine European countries, and the U.S.A., as of 2009 and 2010. These periods coincide with the significant rise in concern with sovereign default risk in the Euro country sphere. We conclude that our corporate health index of the private sector measured at periods prior to the explicit recognition by most credit professionals, not only gave an effective early warning indicator but provided a mostly appropriate hierarchy of relative sovereign risk. Policy officials should, we believe, nurture, not penalize, the tax revenue paying and jobs generating private sector when considering austerity measures of distressed sovereigns.