In this paper, Marshall Stocker, Ph.D, CFA, explores the key drivers of sovereign bond ratings, spread performance and frequency of defaults, paying particular attention to the determinant role that economic policy plays.
The triumph of free markets following the collapse of command economies from 1989 to 1991 made clear which economic system produced superior socioeconomic outcomes - at least, so far as the outcomes could be observed anecdotally.
By the 1990s, academicians began to empirically measure levels of economic freedom; the Fraser Institute's Economic Freedom of the World Index, first published in 1996,¹ and the Heritage Foundation's Index of Economic Freedom are perhaps the most well known.
Utilising these tools, researchers started to investigate the relationship between economic policies and outcomes for GDP growth, poverty, child labour, life expectancy, literacy, potable water and a host of other development indicators.²
Not surprisingly, these studies moved beyond the anecdotal, showing that higher levels of economic freedom correlate positively to desirable socioeconomic outcomes.
Research into the relationship between the absolute level of economic freedom and investment outcomes yielded a different conclusion, however, showing no correlation.³
In this paper, we share proprietary research findings to show that what affects the investment returns of emerging markets debt (EMD), through changes in cash flow or the discount rate, are government policies that change the level of economic freedom, not the absolute level of economic freedom itself.
There is a paucity of research in this area. We believe our research helps to fill this gap, while also providing insight into Eaton Vance's approach to country research and investing in the EMD asset class.
Methodology. In this study, we analyse hard-currency sovereign bonds of 127 different countries from 2000 to 2016 (Exhibit A). Confirming the earlier work of Roychoudhury and Lawson,⁴ we first show how sovereign spreads and credit ratings correspond to economic policy orientation using the Fraser Institute's Economic Freedom of the World Index dataset.
Second, we present the findings of our regression analysis investigating how significantly economic policy and key macro factors impact sovereign bond ratings, spreads and the frequency of defaults. The results for each variable are ranked by order of impactfulness
25 (2005): 583. ⁴Roychoudhury and Lawson. "Economic freedom and sovereign credit ratings and default risk." Journal of Financial Economic Policy 2, no. 2 (2010): 149-162.
¹Gwartney, Lawson, and Block. Economic freedom of the world, 1975-1995. The Fraser Institute, 1996. ²Gwartney, Hall, and Lawson. Economic freedom of the world: 2018 annual report. The Fraser Institute, 2018. ³Stocker. "Equity returns and economic freedom." Cato Journal. 25 (2005): 583. ⁴Roychoudhury and Lawson. "Economic freedom and sovereign credit ratings and default risk." Journal of Financial Economic Policy 2, no. 2 (2010): 149-162.
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