Determinant Factors of Brazilian Country

Risk: An Empirical Analysis of Specific

Country Risk
Mariana Felix Teixeira*
Marcelo Cabus Klotzle**
Walter Lee Ness Jr.***

Abstract
Many studies in international finance try to investigate to what extent domestic and exter-
nal economic factors constitute significant determinant factors of international country risk.
This article tries to analyze, for the period 1992-2003, Brazilian country risk from the point
of view of three empirical models: i) First, the internal economic determinants of the coun-
try risk; ii) the second has the same purpose as the first, with the difference that the variable
“intensity of global risk aversion”, that serves as proxy for the external component of the
risk, is included in the group of explanatory variables; iii) in the last model the emphasis is
on the relation between specific country risk (country risk minus the external component)
and the internal and external economic determinants.
Keywords: country risk, specific country risk, determinant factors, Brazil.
JEL Codes: D53, E44, F30, G15.
Resumo
Muitos estudos em finanças internacionais tentam investigar até que ponto fatores econô-
micos externos e internos constituem fatores determinantes significativos do risco-paı́s. O
presente artigo tem como finalidade estudar o Risco Brasil no perı́odo 1992-2003, com
base em três modelos: i) o primeiro modelo analisa os determinantes econômicos inter-
nos do risco-paı́s; ii) o segundo modelo tem o mesmo propósito do primeiro, sendo que
a variável grau de aversão ao risco global, que serve de proxy para o componente externo
do risco, é incluı́da no grupo de variáveis explicativas; iii) no último modelo, o enfoque é
sobre a relação entre o risco-paı́s especı́fico (risco-paı́s menos o componente externo) e os
fundamentos econômicos.
Palavras-chave: risco-paı́s, risco-paı́s especı́fico, fatores determinantes, Brasil.

Submitted in October 2007. Accepted in May 2008. Article was double blind referred and eval-
uated by the editors. Chief-editor: Ricardo P. C. Leal. We are greatful for the useful comments of two
anonymus referees.
*Pontifı́cia Universidade do Rio de Janeiro. Rua Marquês de São Vicente, 225 Gávea.
CEP: 22453-900, Rio de Janeiro - RJ - Brasil. Tel: +55-21-2138-9310 - Fax: +55-21-2138-9272.
E-mail: klotzle@iag.puc-rio.br
**Pontifı́cia Universidade do Rio de Janeiro. Tel: +55-21-2138-9310 - Fax: +55-21-2138-9272.
E-mail: klotzle@iag.puc-rio.br
***Pontifı́cia Universidade do Rio de Janeiro. Tel: +55-21-2138-9314 - Fax: +55-21-2138-9272.
E-mail: ness@iag.puc-rio.br

Revista Brasileira de Finanças 2008 Vol. 6, No. 1, pp. 49–67, ISSN 1679-0731
c 2004 Sociedade Brasileira de Finanças
 Teixeira, M., Klotzle, M., Ness, W.

1. Introduction
Unlike the 1980s, which where characterized by the inaccessibility of interna-
tional capital markets for most emerging nations, the 1990s saw a reversion in this
picture by the intensification of international capital flows to emerging economies,
mostly by acquisition of shares, bonds or by making direct investments. Motivated
by this movement, many researchers draw their attention to the investigation of the
most important factors behind this dynamic. Among the most important studies
are those of Calvo et al. (1993), Fernandez-Arias (1996), Taylor and Sarno (1997)
and Chuchan et al. (1998), which distinguish two important types of factors as
determinants of these capital flows: internal and external factors.
The internal factors are related to the own opportunities and risks that a specific
market offer to international investors. In this case the country’s internal econom-
ical factors are often used to represent this risk.
On the other side, the external factors are associated with external opportu-
nities and risks, such as the macroeconomic situation in the industrial countries,
international interest rates and the intensity of risk aversion of international in-
vestors.
An alternative to the analysis of international capital flows is the investigation
of the internal and external determinant factors of international emerging market
bond prices: international movements of those bond prices, from the country risk’s
point of view, are not only consequence of the perception of macroeconomic con-
ditions, but also of the perception and valuation of global risk.
The nineties and the beginning of the twenty-first century give an interesting
example of the impact of external factors on the price of sovereign debt bonds,
given the high frequency of crises and turbulences occurred during this period,
such as the Mexican Peso Crisis (1995), the Asian Crises (1997), the Russian
Crisis (1998), the Brazilian Crisis (1999), the Argentine Crisis (2001), and the
terrorist attacks of September 11, 2001.
Given the existence of some studies that already analyzed the relationship
between internal and external factors and country risk, like Canton and Packer
(1996), Min (1998) and Nogués and Grandes (2001), the main objective of this
study is to extend the existing research by estimating three key models and apply-
ing these models to the analysis of Brazilian country risk in the period ranging from
1992 to 2003: i) in the first model the domestic determinants of the country risk
are tested; ii) in the second model the variable “intensity of global risk aversion”
is included in the model as proxy variable for the external county risk factor; and
iii) in the third model the dependent variable is modified to measure the “specific
country risk”, defined as country risk less the estimated external component.

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 Determinant Factors of Brazilian Country Risk: An Empirical Analysis of Specific Country Risk

The most important difference of this study, if compared to similar studies,

is that it uses a new approach to the analysis of country risk, called ARDL (Au-
toregressive Distributed Lag) Model. In this context, the main advantage of this
technique is that it can be applied to models irrespective of whether the regressors
are I(0) or I(1) or mutually cointegrated. It avoids the conventional pre-testing
procedure of unit roots associated with cointegration analysis and has the advan-
tage of be easily understood within the framework of traditional error correction
modeling approaches.

2. Review of Studies of Country Risk

As already mentioned, the nineties experienced expressive international cap-
ital flows to emerging markets, mostly in form of investments in bonds, shares
and direct investment. This reverted the tendency of the eighties, characterized
by a continuous fall in capital transfers to these countries, as consequence of the
default crises during this period. In this context, one key variable reveals itself
as one important determinant in the explanation of the international capital flows
dynamic: the country risk.
From the definition used by Claessens and Embrechts (2002), country risk is
a measure associated with a country’s default probability and is caused by events
which can be at least to some degree under the control of the government but
definitely not under the control of a private enterprise or individual. In quantitative
terms, country risk is represented by the yield difference between a risky and a
non-risky asset, which is, in turn, dependent on the general liquidity conditions in
international markets and the behavior of international investors, their degree of
risk aversion and the risk attributed by them to single assets (Canuto and Santos,
2003).
Basically country risk has two components: domestic and external risk. Do-
mestic risk refers to the specific country risk determinants, which are related to the
economic fundamentals, such as for example the fiscal and balance of payments
situation, the stock of international reserves, the real growth rate of the economy
and the inflation rate. The external risk, on the other side, includes all the global
factors, which are mainly represented by the risk free interest rate, by the con-
tagion effects of financial crises and by the degree of international investor risk
aversion Calvo et al. (1993), Fernandez-Arias (1996), Taylor and Sarno (1997),
Kim (2000).
In a recent study Fiess (2003) investigated the relation between country risk
and capital flows to Argentina, Brazil and Mexico in the period 1990-2001, and
Venezuela, in the period 1996-2001. Starting from the idea that capital flow dy-
namics can be explained both by domestic and external factors, the author decom-
posed country risk in two components: i) specific country risk, which comprises
opportunities and risks of domestic investment; ii) global risk, which reflects in-
vestment risk in industrial countries. Using a VAR methodology, the author found
strong evidences that specific country risk exercises a strong influence over capital

Revista Brasileira de Finanças 2008 Vol. 6, No. 1 51

 Teixeira, M., Klotzle, M., Ness, W.

flows. In the case of global risk there was also a strong statistical representative
effect, except for the case of Argentina.
Departing from this relation between international capital flows and country
risk, we can conclude that the analysis of the determinants of both variables is
quite similar. In both cases the risk-return perception of foreign investors results
in changes in the risk premium and in the direction of international capital flows.
The advantage in the analysis of country risk lies in the empirical finding that the
asset prices adjust themselves more quickly to a change in domestic and external
factors than the quantities of capital flows (Oks and Padilla, 2000).
Based on this discussion following question is posed: what are the most impor-
tant determinant factors of country risk? Many of the studies cited below have been
developed about this topic and most of them come to the conclusion that country
risk is basically explained by both domestic and external factors. Among the do-
mestic factors most frequently cited as being statistically significant are: public
debt, inflation, real economic growth rate, external debt, international reserves and
current-account surplus. As for the external factors, two variables are constantly
tested: the U.S. Treasury Notes interest rate and the degree of risk aversion of
international investors. While there seems to be a positive influence of the latter
one over the country risk, the effect of the U.S. Treasury Notes interest rate is still
subject to strong controversy.
The high intensity of international emerging markets bond trading during the
nineties lead to the growing interest of many researchers in the relation between
yield spreads and economic fundamentals. In this category we can include Min
(1998), which studied this relation for the US dollar denominated, fixed-income
securities of emerging markets issued during the period from phonelstrans1991-
1995. The study was realized by the decomposition of the explaining variables
in four groups: i) liquidity and solvency: external debt/GDP ratio (+)1 , debt ser-
vice/exports ratio (+), international reserves/GDP ratio (-), current account sur-
plus/GDP ratio (-), imports growth rate (+), exports growth rate (-), real GDP
growth rate (-) and net foreign assets (-); ii) macroeconomic fundamentals: do-
mestic inflation rate (+), terms of trade (-) and real foreign exchange rate (+); iii)
external shocks: international oil price and three-month U.S. Treasury bill rate;
and iv) dummy variables: whether the issue was made before or after Mexican
Crisis (1995); the emission was public or private; the emission was made by a
Latin-American or Asiatic country. Besides that, the author included two other
variables: maturity of the asset and amount issued. The results of the panel re-
gression were very satisfactory since all the variables of liquidity and solvency
had statistically significant coefficients and their signs were in conformity with the
expected ones. In the variable group “external shocks”, none of the variables pre-
sented a coefficient which was statistically different from zero. Finally the results
for the dummies lead to following results: i) private issues have a tendency to show
higher yield spreads than public ones; ii) there is significant difference between the
yield spread before and after the Mexican Crisis; iii) the region of origin of the is-

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 Determinant Factors of Brazilian Country Risk: An Empirical Analysis of Specific Country Risk

sues is not a relevant factor to explain differences in the yield spread. In relation
to the amount issued and the maturity, this last variable showed a negative signal,
as expected.
Concerning articles analyzing exclusively the time series analysis of Brazil-
ian country risk, Andrade and Teles (2003) analyzed the effect of macroeconomic
policies on the Brazilian country risk in the period from January 1991 to December
2002. They used a model called Country Beta Market Model, where the country-
risk is a time varying coefficient. The model starts from the idea that the beta of a
CAPM model that measures the covariance of the Brazilian Stock Exchange with
the market return of the rest of the world is a proxy for the Brazilian country risk.
In order to capture the effect of the macroeconomic policies, the following vari-
ables were selected: i) budgetary necessity of the public sector – primary concept;
ii) oil prices; iii) international reserves; and iv) the interest rate, measured by the
Brazilian Selic Rate. The initial estimation of the model showed the variable re-
ferring to the fiscal situation of Brazil as not being statistically significant, which
was then excluded from the model. For the following estimations, the Kalman
filter was applied to the coefficients in order to test their long run stability. The
study showed that during the observed period monetary policy played a relevant
role, the interest rate exerting a negative influence over the Brazilian country risk.
It could also be observed that international reserves had a negative effect over the
country risk. However their effect seemed to be more important during the fixed
exchange-rate regime.
Grandes (2002) changed the focus of the study from that of Andrade and Teles
(2003), which emphasized the effect of monetary policy over the country risk, and
tried to identify the permanent and transitory impacts of macroeconomic funda-
mental variables and of variables related to external monetary policy on the Brazil-
ian, Argentine and Mexican sovereign risk during the 1993-2001 period. Based on
the empirical analysis of Kharas (1984), the following macroeconomic variables
were considered: current account deficit/GDP ratio (+/-), debt service/GDP ratio
(+) and GDP growth rate (-). Grandes selected, as variables representing the exter-
nal factors: i) the FED funds rate (+) as proxy for monetary policy; ii) the 30-year
U.S. Treasury rate (+/-), which may capture the so called portfolio substitution ef-
fect (+) and the “fly to quality” effect (-); and iii) dummy variables respectively for
the Mexican, Russian and Brazilian crises. In relation to the effect of the 30-year
U.S. Treasury rate it should be mentioned that through a substitution effect, it was
expected that increases in the 30-year bond interest rate made investment in these
bonds more attractive, so that the supply of loanable funds for emerging coun-
tries would diminish and, therefore, the country risk would increase. On the other
hand, Grandes (2002) argumented that in periods of extreme crises –which was a
frequent observation over the period under his analysis- the flight-to-quality effect
seemed to prevail. A more risk-averse behaviour could push U.S. bond rates down
(excess demand of USTB bonds) and increase country risk of emerging markets.
Hence, the expected sign of the 30 year U.S. Treasury rate was ambiguous.

Revista Brasileira de Finanças 2008 Vol. 6, No. 1 53

 Teixeira, M., Klotzle, M., Ness, W.

For each country, Grandes (2002) estimated individual equations using the
SUR-SYS (Seemingly Unrelated Regressor System Equation) technique. The es-
timations showed that the permanent effects of the debt service/GDP and current
account deficit/GDP ratios are statistically significant for Argentina and Brazil.
Concerning the variable GDP growth rate a statistically significant negative per-
manent effect was observed for the three countries. The analysis of the dummy
variables demonstrated that the Mexican and Russian crises propagated to Ar-
gentina and Brazil and that the Brazilian crisis affected the Argentine economy.
Finally the FED funds rate was significant for the Brazilian (positive sign) and
Mexican (negative sign) country risk. The impact of the 30 year U.S. Treasury
rate was statistically significant only for Brazil, indicating that a rise in that rate
reduces the Brazilian country risk.
The main difference between the present study and the studies discussed above
is in the use of a new methodology, called ARDL approach. The use of this statis-
tical method allows testing the influence of selected factors on Brazilian country
risk both in the short and in the long run, making the analysis more dynamic as
compared to previous studies.

3. Methodology
3.1 Data
As already mentioned, this study covers the period 1992-2003. All the data
are quarterly and were extracted from IPEA-Data, with the exception of the proxy
used for the Brazilian country risk, obtained from JP-Morgan.
In this study, the dependent variable on which we will analyze the influence
of selected economic indicators is the specific country risk. Obtaining the specific
country risk is directly related to the isolation of the external risk component. A
variable indicated in the literature as representative for this risk is the so called
high yield U.S. bond spread over the U.S. Treasury rate, which acts as proxy for
global risk aversion.
High yield bonds are debt instruments issued by firms to finance diverse activ-
ities and are considered being of speculative grade by most of the rating agencies.
The most important characteristic of these bonds, also known as junk bonds, is
that they offer a high expected return as function of their high default risk. In our
work, in order to extract the external component of the country risk we regressed
the EMBI+ spread (defined below) against the high yield spread. The residual
obtained in this regression, which characterizes the part of the country risk not
explained by the external risk, was given the name “specific country risk” or “do-
mestic country risk”.
The most well known indicator for measuring the emerging markets risk pre-
mium is the Emerging Market Bond Index Plus (EMBI +), calculated by J.P. Mor-
gan. The index is composed by external federal debt instruments of emerging
countries, denominated in foreign currency and negotiated in secondary markets.

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 Determinant Factors of Brazilian Country Risk: An Empirical Analysis of Specific Country Risk

A large portion of these instruments is composed by Brady Bonds, followed by ne-

gotiated loans, Eurobonds and domestic bonds. In quantitative terms the EMBI+
Index is published by J.P. Morgan in two ways: in absolute level and sovereign
spread, the last one being the most well known measure for country risk. In level,
the EMBI+ is calculated on the basis of the price average of the bonds that com-
pose the basket, weighted by their traded volume on the secondary markets. On
the other hand, the sovereign spread is calculated on the basis of the difference
between the returns of sovereign bonds of a given country and the returns of the
U.S. Treasury Notes, considered to be free of risk.
Knowing that the dependent variable is the domestic or specific Brazilian coun-
try risk, we then defined which economic variables would be included in the econo-
metric model. Based on the academic works discussed above, the selection of the
models took two requisites into account: i) economic relevance and ii) the perfor-
mance of the variables in previous studies. For better understanding of the model
each of the selected variables is defined and its supposed relation with the country
risk will be explained.

1. GDP growth [GROWTH]: this variable is of great importance, being a syn-

thesis of the general economic conditions in a country. We use here the real
GDP growth. Furthermore, higher economic growth is associated with a bet-
ter relation between public debt and GDP, implying a smaller country risk.
We expect a negative correlation between GDP growth and country risk.
2. Fiscal Surplus as percent of GDP [FISCSUR]: the amount of resources that
the public sector of a country can generate is directly related to the percep-
tion that the economic agents have about the solvency of a country. The
bigger the fiscal surplus, the greater are the conditions of maintenance or
even reduction of the public debt/GDP ratio and consequently the smaller
is the default probability. We can therefore expect a negative correlation
between the fiscal surplus and the country risk.
3. Public Debt as percent of GDP [PUBDEBT]: this variable is often used as an
indicator of the accumulated fiscal performance of a country. A larger debt
stock usually results in more difficulty of the public sector to honor the debt
service, which increases the default risk (Guardia, 2004). We thus expect a
positive correlation between public debt and country risk.
4. Inflation rate [INFL]: according to Min (1998), the inflation rate serves as
reference for the quality of the economic policy of a country. The same argu-
ment is found in Pinheiro (2004), who argues that without a stable economy
and correct prices there is a rise in the economic risk coupled with a fall in
productivity and in investment. In other words: the higher the inflation, the
higher the uncertainty about the economic environment and consequently
the higher the risk perception of the economic agents. We can therefore
expect a positive correlation between the inflation rate and country risk.

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 Teixeira, M., Klotzle, M., Ness, W.

5. Current account surplus (deficit) as percent of GDP [CURRAC]: as dis-

cussed in Pinheiro (2004), one way of reducing the country risk is raising
its current account surplus, as this increases the liquidity of a country, re-
ducing the default probability. In this sense there we can expect a negative
correlation between the current account surplus and country risk.

6. External Debt as percent of Exports [EXTDEB]: according to Underwood

(1990) and Cohen (1996), the ratio of external debt to exports is an important
indicator of a country’s solvency and the probability of default is very high
when this ratio assumes values in the interval between 200% and 250%. As
a consequence, the impact of this variable on the country risk is often taken
into account, being one of the few variables considered in the evaluation of
the country risk rating of the Institutional Investor Magazine together with
the default history and the country’s macroeconomic stability. Therefore,
we can expect a positive correlation between external debt and country risk.

7. International Reserves as percent of GDP [INTRES]: the volume of interna-

tional reserves has a direct relationship to a country’s degree of international
liquidity. Starting with a definition by Williamson (1973) that international
liquidity measures the ability of a country to honor a current-account deficit,
without having to recur to restrictive adjustment measures, we can conclude
that the higher the ratio of international reserves to GDP, the higher the coun-
try’s adjustment flexibility in case of economic shocks. We can expect there-
fore a negative correlation between international reserves and country risk.

Using these independent variables, we can define the three models that will be
studied in this work: in the first model we will test the relation between total coun-
try risk and fundamental domestic economic variables; in the second model the
analysis will be exactly the same, with the only difference that the external com-
ponent will be added to the group of explanatory variables; and the third model,
on its turn, will test the relation between specific country risk and the economic
fundamentals.
Starting with the estimation of these three models applied to the Brazilian case,
it will be possible to evaluate to what degree there is relationship between the
economic determinants of the country risk and the specific country risk.

3.2 ARDL model

In this work, the relationship between country risk and their determinants will
be examined in the long and short run using the methodology developed by Pesaran
and Shin (1999), which has its emphasis on the ARDL (Autoregressive Distributed
Lag) Model. Later this model was also used by Pesaran et al. (2001) in order to
develop new approaches, called bounds testing, to the analysis of level relation-
ships between variables with no need to conduct unit root tests. In other words,
the main advantage of this procedure is that it eliminates the need for pretesting

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 Determinant Factors of Brazilian Country Risk: An Empirical Analysis of Specific Country Risk

the variables for the order of integration (and cointegration) and it does not require
that the variables be of the same order of integration. It can be used whether the
variables are I(0) or I(1) irrespective of whether they are cointegrated or not. As is
known from time-series analysis the use of first-differenced (stationary) variables
in regression models is necessary to reduce the spurious results that are likely to
arise when the variables are specified in their level (non-stationary) form. How-
ever, when variables are used in their differenced form, (long-run) information
from the data is removed, resulting in a model that can only provide partial (short-
run) information on the relationship between the variables. Further, by not taking
into account the potential long-run relationship among the variables, models con-
structed using only differenced data may be misspecified if there exist such long-
run influences, resulting in biased parameter estimates. To avoid such problems,
one must test if there is a long-run relationship between the variables in the model.
Therefore, in the present context, application of cointegration technique would en-
able us to examine the long-run equilibrium relationship between country risk and
its determinants. The technique would also enable us to trace out the long-run and
short-run response of country risk to changes on its determinants.
The ARDL method of testing the long run relationship between variables is
based on the estimation, by ordinary least squares, of an unrestricted Error Correc-
tion Model (ECM) in following form:

X
p−1 X
q−1
∆yt = a0 + a1 T + φyt−1 + δxt−1 + ϕ∆yt−1 + y∆xt−1 + ǫt (1)
i=1 i=0

where yt is the dependent variable and xt is a vector of independent variables of

rank k.
In this case, if φ 6= 0 and δ 6= 0 there is a long run relationship between the
levels of yt and xt which is given by:

yt = θ0 + θ1 T + θ2 xt + vt (2)
where θ0 ≡ −α φ , θ1 ≡ φ , θ2 ≡ φ and vt is zero mean stationary process.
0 −α1 −σ

If φ < 0 , the long run relationship between yt and xt is stable. In this case,
equation (1) can be expressed as an ECM of following form:

X
p−1 X
q−1
∆yt = ao +a1 T +φ (yt−1 − θ2 xt−1 )+ i = 1ϕ∆yt−1 + y∆xt−1 +ǫt (3)
i=0

Following equation (3), testing the null hypothesis that φ = 0 can be inter-
preted as a test of existence of a long run relationship between yt and xt . In the
ARDL methodology, this test is made following the joint hypothesis that φ 6= 0
and δ 6= 0 based on the ECM defined in equation (1).

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 Teixeira, M., Klotzle, M., Ness, W.

To perform this test, Pesaran et al. (1996) tabulate the critical bounds of the
F-statistics for different numbers of regressors. Two sets of critical values are pro-
vided, with an upper bound calculated on the basis that the variables are I(0) and,
a lower bound on the basis that they are I(1). The critical values for this bounds
test are generated from an extensive set of stochastic simulations under differing
assumptions regarding the appropriate inclusion of deterministic variables in the
ECM. Cointegration is confirmed irrespective of whether the variables are I(1) or
I(0) if the computed F-statistic fall outside the upper bound; and rejected if falls
outside the lower bound. Nevertheless, if F-statistic falls within the critical value
band, no conclusion can be drawn without knowledge of the time series properties
of the variables.
However, it should be emphasized that the ARDL methodology developed by
Pesaran and Shin (1999) has a serious limitation. This methodology is only valid
for the cases where there is only a linear relation between the dependent variable
and the independent ones (this would be the same as having only one cointegration
relation).

4. Results
Writing the models in the form of an ARDL model, we have following equa-
tions to be estimated:

Model 1

X
n
∆ LEM BI = α + λ LEM BIt−1 + β Ht−1 + γj ∆Kt−j + σ ∆Ht + ǫt (4)
j=1

where, Kt = (LEM BI, GROW T H, EXT DEB, P U BDEBT, F ISCSU R,

IN F L, CU RRAC, IN T RES) = (LEM BI, Ht ); LEM BI = log of EM BI
and Ht−1 and Ht = all the variables with exception of LEM BI in t − 1 and t.

Model 2

X
n
∆ LEM BI = α + λ LEM BIt−1 + β Ft−1 + γj ∆Gt−j + σ ∆Ft + ǫt (5)
j=1

where, Gt = (LEM BI, GROW T H, EXT DEB, P U BDEBT, F ISCSU R,

IN F L, CU RRAC, IN T RES, LHY IELD) = (LEM BI, Ft ); LEM BI =
log of EM BI and Ft−1 and Ft = all the variables with exception of LEM BI in
t − 1 and t.

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 Determinant Factors of Brazilian Country Risk: An Empirical Analysis of Specific Country Risk

Model 3

X
n
∆LREM BI = α+λ LREM BIt−1 +βWt−1 + γj ∆Zt−j +σ∆W t+ǫt (6)
j=1

where, Zt = (LREM BI, GROW T H, EXT DEB, P U BDEBT, F ISC-

SU R, IN F L, CU RRAC, IN T RES) = (LREM BI, W t); LREM BI = log
of the residuals from the regression of EM BI+ spread against the high yield
spread, defined as the specific country risk and Wt−1 and Wt = all the variables
with exception of LREMBI in t − 1 and t.
Before presenting the results of the long and short run estimation of the three
models presented above, we test the existence of a long run relation between the
dependent variable and the independent ones.
Departing from an optimal lag number of 4, selected on the basis of the AIC -
Akaike Criterion - and HQC - Hannan-Quinn Criterion, Table 1 presents the values
found for the F-statistics.
Table 1
Test for the long run relation

Models F Statistics Critical Values

Model 1 1.645 2.365-3.553
Model 2 2.190 2.272-3.447
Model 3 1.389 2.365-3.553

According with the test from Pesaran et al. (2001), if the value of the F-
Statistics, obtained after the estimation of the regression equation by OLS, is out
of the range of critical values, we can reject the null hypothesis of no long run
relation between the variables. If contrary, we accept the null hypothesis.
For the null hypothesis H0 := λ = γ = 0 we can accept, using a statistical
significant level of 5%, for the three models the alternative hypothesis of a long
run relation between the variables. After confirming the existence of this long
run relation between the variables in the three models, the next step consists of
estimating the long run coefficients and the short run dynamics coefficients from
the ARDL model. In this case, for a number of variables (7 in model 1 and 3) and
(8 in model 2), with a maximal number of lags corresponding to 4, we processed a
total of (4 + 1)(7+1) = 390.625 and (4 + 1)(8+1) = 1.953.125 ARDL regressions
for the models.
In the following tables the results of the estimated models are presented.

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 Teixeira, M., Klotzle, M., Ness, W.

Table 2
Long run domestic determinants of the country-risk

Explanatory Variables AIC HQC

Current Account/GDP 0.008 0.008
(0.055) (0.055)
International Reserves/GDP -0.044 -0.044
(0.105) (0.105)
Inflation Rate 0.002 0.002
(0.013) (0.013)
External Debt/Exports 0.001 0.001
(0.003) (0.003)
Public Debt/GDP -0.002 -0.002
(0.017) (0.017)
Primary Surplus/GDP -0.052 -0.052
(0.037) (0.037)
Growth Rate -0.008 -0.008
(0.044) (0.044)
AIC = Akaike Criterion
HQC = Hannan-Quinn Criterion,
* = statistically significant at the 1% level
** = statistically significant at the 5% level
*** = statistically significant at the 10% level
standard error in parenthesis

Table 3
Short run domestic determinants of the country risk

Explanatory Variables AIC HQC

∆ LEMBI(-2) 0.363 0.363
(0.083) (0.083)
∆ Current Account/GDP 0.001 0.001
(0.006) (0.006)
∆ International Reserves/GDP -0.044** -0.044**
(0.019) (0.019)
∆ Inflation Rate 0.000 0.000
(0.001) (0.001)
∆ External Debt/Exports 0.000 0.000
(0.000) (0.000)
∆ Public Debt/GDP 0.017** 0.017**
(0.008) (0.008)
∆ Primary Surplus/GDP -0.005*** -0.005***
(0.003) (0.003)
∆ Growth Rate -0.001 -0.001
(0.004) (0.004)
Error Correction Term -0.100* -0.100*
(0.034) (0.034)
Notes: See Table 2.

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 Determinant Factors of Brazilian Country Risk: An Empirical Analysis of Specific Country Risk

Tables 2 and 3 show, respectively, the long and short run domestic determinants
of the country risk. Following both selection criteria, the chosen ARDL model was
of type (2, 0, 0, 1, 0, 0, 1, 0).
In Table 2, it can be observed that none of the estimated coefficients is statis-
tically significant. In other words, this table shows that the Brazilian country risk
has no long run relation with their domestic determinants. In the short run (Table
3), however, three variables were identified as determinants of the Brazilian coun-
try risk: public debt/GDP ratio (+), primary fiscal surplus/GDP ratio (-) and the
international reserves/GDP ratio (−)1 .
Going to the second model, Tables 4 and 5 present the domestic and external
determinants of the Brazilian country risk, the external risk being represented by
the high yield spread. Based on both selection criteria, the ARDL model chosen is
of type (2, 0, 1, 0, 0, 0, 0, 1, 0).
In Table 4 it can be seen that the domestic determinants are not long run ex-
planatory factors for the Brazilian country risk. A contrary result can be observed
for the external risk component. The regressions lead to the conclusion that there
is a statistically significant long run relation between the high yield spread and the
Brazilian country risk. The short run analysis (Table 5) shows that the determi-
nants are the same ones identified in the first model: public debt, primary surplus
and international reserves. Beside those, the high yield variable, when included in
the second model, also turns out to be statistically significant.
Table 4
Long run domestic and external determinants of the country risk

Explanatory Variables AIC HQC

Current Account/GDP 0.018 0.018
(0.045) (0.045)
International Reserves/GDP 0.015 0.015
(0.096) (0.096)
Inflation Rate -0.006 -0.006
(0.012) (0.012)
External Debt/Exports 0.002 0.002
(0.002) (0.002)
Public Debt/GDP -0.037 -0.037
(0.027) (0.027)
Primary Surplus/GDP -0.050 -0.050
(0.030) (0.030)
Growth Rate -0.008 -0.008
(0.036) (0.036)
High Yield Spread 1.269*** 1.269***
(0.721) (0.721)
Notes: See Table 2.

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 Teixeira, M., Klotzle, M., Ness, W.

Table 5
Short run domestic and external determinants of the country risk

Explanatory Variables AIC HQC

∆ LEMBI(-2) 0.378* 0.378*
(0.083) (0.083)
∆ Current Account/GDP 0.002 0.002
(0.006) (0.006)
∆ International Reserves/GDP -0.044** -0.044**
(0.019) (0.019)
∆ Inflation Rate -0.001 -0.001
(0.001) (0.001)
∆ External Debt/Exports 0.000 0.000
(0.000) (0.000)
∆ Public Debt/GDP 0.014*** 0.014***
(0.008) (0.008)
∆ Primary Surplus/GDP -0.006*** -0.006***
(0.003) (0.003)
∆ Growth Rate -0.001 -0.001
(0.004) (0.004)
∆ High Yield Spread 0.153*** 0.153***
(0.091) (0.091)
Error Correction Term -0.121* -0.121*
(0.036) (0.036)
Notes: See Table 2.

Finally in Tables 6 and 7 the long run and short run determinants of the specific
country risk are illustrated. According to the selection criteria AIC and HQC, the
chosen ARDL models for the long run and short run differ from one another. They
are respectively of following type: (3, 0, 0, 1, 0, 0, 1, 0) e (2, 0, 0, 1, 0, 0, 1, 0). Si-
milar to the first 2 models, the domestic determinants do not exercise any long run
effect over specific country risk, as can be observed in Table 6.
However, as it can be seen on Table 7 in the short run, two economic variables
presented coefficients statistically different from zero and with the expected signs:
public debt/GDP ratio and international reserves/GDP ratio.

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 Determinant Factors of Brazilian Country Risk: An Empirical Analysis of Specific Country Risk

Table 6
Long run domestic determinants of specific country risk

Explanatory Variables AIC HQC

Current Account/GDP 0.024 0.024
(0.130) (0.110)
International Reserves/GDP -0.008 -0.008
(0.222) (0.187)
Inflation Rate 0.008 0.004
(0.030) (0.025)
External Debts/Exports 0.004 0.003
(0.006) (0.005)
Public Debt/GDP -0.037 -0.035
(0.035) (0.030)
Primary Surplus/GDP -0.056 -0.050
(0.073) (0.060)
Growth Rate -0.107 -0.093
(0.100) (0.082)
Notes: See Table 2.

Table 7
Short run domestic determinants of specific country risk

Explanatory Variables AIC HQC

∆ LRSEMBI(-2) 0.360* 0.334*
(0.089) (0.088)
∆ LRSEMBI(-3) -0.139 -
(0.088)
∆ Current Account/GDP 0.003 0.003
(0.016) (0.016)
∆ International Reserves/GDP -0.087*** -0.087***
(0.048) (0.049)
∆ Inflation Rate 0.001 0.001
(0.003) (0.003)
∆ External Debt/Exports 0.000 0.000
(0.001) (0.001)
∆ Public Debt/GDP 0.033*** 0.034***
(0.019) (0.019)
∆ Primary Surplus/GDP -0.007 -0.007
(0.008) (0.008)
∆ Growth Rate -0.013 -0.013
(0.011) (0.011)
Error Correction Term -0.119* -0.141*
(0.046) (0.043)
Notes: See Table 2.

It should be emphasized that the error correction term had, for all three models,
a statistically significant coefficient at the 1% level, indicating that disequilibria
which occurred in a period were corrected in the subsequent one.

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 Teixeira, M., Klotzle, M., Ness, W.

Resuming the discussion above, we come to following interesting conclusions:

first, in all three estimated models, the long run relation between the domestic vari-
ables and the measures of risk (country risk and specific country risk) is not statis-
tically significant. However, when the external risk component is included in the
group of explanatory variables, its coefficient turns out to be statistically different
from zero, which means that what really matters on the long run is the relation
between the external factors and Brazilian country risk. In this study, the indicator
used as proxy variable for the external factors was the high yield spread, which
is a measure of the degree of risk aversion of the international investor. Second,
it could be verified that, in the short run not only the external component affects
country risk, but also the domestic components, such as external debt, primary sur-
plus and international reserves. With the exception of the primary fiscal surplus,
these same domestic variables revealed themselves as explanatory variables of the
specific Brazilian country risk in the short run, leading to the conclusion that there
is a consistency among the models.
Briefly, the main idea defended in our current work is: even when the devia-
tions of the domestic variables from their long run tendencies affect the country
risk in the long run, if the external conditions are favorable, it is more probable
that this deviations will get smaller along time, making the country risk smaller as
well. On the other hand, if the long run perspectives about the external scenario are
unfavorable, the long run deviations of the domestic variables will be greater, with
the consequences of a greater country risk. That means that the external scenario
reveals itself as the most important explanatory variable of country risk.

5. Conclusion
The objective of this article was to identify the determinants of Brazilian coun-
try risk and the specific Brazilian country risk during the 1992-2003 period. To
achieve this goal, three models were estimated: i) country risk versus domestic
variables; ii) country risk versus domestic and external variables; iii) specific coun-
try risk versus domestic variables.
As most studies divide country risk into domestic and external components, the
following domestic explanatory variables were selected for the analysis of country
risk in this work: growth rate, external debt/exports ratio, public debt/GDP ratio,
primary surplus/GDP ratio, international reserves/GDP ratio and the current ac-
count/GDP ratio. As indicator of the external risk component, the variable high
yield spread was used, as it can serve as proxy for the analysis of the international
investor’s degree of global risk aversion.
In the short run it could be verified that, in addition to the external component,
three domestic factors affect the country risk. These are: public debt/GDP ratio,
primary surplus/GDP ratio and international reserves/GDP. These same variables,
with exception of the primary surplus, are also related with the specific country
risk.

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 Determinant Factors of Brazilian Country Risk: An Empirical Analysis of Specific Country Risk

In the long run, however, the country risk is explained only by the external
component, as the domestic determinants are not statistically significant. In the
same way, the specific country risk does not have a long run relation with the
domestic variables.
In other words, the results obtained indicate that the country risk is influenced
by the deviations of the domestic economic variables from their long run tenden-
cies in different points of time. However, if we assume that the intensity and
direction of those deviations depend on external conditions, the results show that,
in the long run, the external scenario has the greatest influence over the country
risk.
For example, in a favorable external scenario the expectative is that a vari-
able like public debt, which empirically affects country risk, shows a declining
tendency line over time. That means, on the long run we have the direct relation
between external scenario and the country risk. On the other hand, on the short run,
we should expect that the deviations from public debt from its long run tendency
line will be smaller under these conditions, having therefore a favorable impact
over country risk. In this case, on the short run, we have an association between
the external and domestic scenarios and country risk.
However, it should be noted that the findings of this study are based on the
results from Brazil. In order to generalize them more studies of specific country
risk are needed. In the case of Brazil, one another suggestion for future studies
would be to consider narrower periods of time. In our case, for example, the period
analyzed (1992 to 2003) includes several breaks that should be considered, such
as periods of fixed and floating exchange rate, hyperinflation and stabilization,
external shocks, capital market and economic reforms.

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