Debt arrears as a signal of sovereign defaults

The accuracy of the inference about the risk of default is very important to the potential creditors in their lending decisions. In the literature, the usual used indicators of sovereign default in a given country (debtor) are either a rescheduling agreement between the debtor and the creditor or the presence of a credit from the International Monetary Fund (IMF). The purpose of this note is to investigate an alternative indicator of a sovereign default that precedes the default itself, and thus could be seen as an early warning signal for policymakers. In this note, debtor countries are considered “defaulted” on sovereign debt if they have a debt rescheduling agreement with at least one creditor. To address our research question, a panel dataset running from 1970 to 2010 and spanning 186 countries with at least one year of debt accumulation is used. First a Panel Probit model is estimated including all the variables along with the lags of Arrears. Then, in order to explore the role played in countries that have defaulted; we divide the sample into countries with a history of sovereign defaults, and countries with no such history. Further, in order to explore the role played in countries that have defaulted; we divide the sample into countries with a history of sovereign defaults, and countries with no such history. If a country has at least one rescheduling agreement during the years 1970-2010 then the country is considered defaulted and it is included in the “default” subset. To be included in the “no default” subset, the country should not have had any rescheduling agreement during the aforementioned period. Our results show that debt arrears are not only a good determinant of default as argued in the literature but their lagged arrears can also be used as an early warning signal for sovereign defaults. However, the accumulation of arrears does not automatically trigger a default. Moreover, the likelihood to default rises when the failure to pay debt obligations continues overtime until the actual default occurs after the obligations in the third year are not paid. These results are very crucial to both debtors and creditors. Arrears, consequently, could be used as an inducement for debtors to take preemptive actions to minimize exposure to sovereign default risk. However, even in the case of default, observing arrears will provide ample time for policy makers in debtor countries to take necessary precautionary measures.