Fundamentals or market sentiment: what causes country risk?
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The country risk indicator, as measured by the JP Morgan's EMBI or grades of rating agencies such as Standard Poor's (SP's) or Moody's, does not seem to truly reflect the fundamentals of an economy. Countries that pursue sound economic policies are frequently placed on the same level as countries with a populist orientation or with a recent history of default or debt restructuring. Such circumstance generates a feeling of unease with regard to these ratings. The objective of this article is to investigate whether these indicators truly reflect market fundamentals or whether some sort of prejudice, or intolerance towards certain countries, can be identified. We use the Oaxaca-Blinder decomposition to analyse the differences in country risk, measured as by EMBI+, for a group of emerging markets. This decomposition allows us to separate the 'justified' (differences in fundamentals) from the 'unjustified' differences (same fundamental differently evaluated).