The shortcomings of models in country risk management

Abstract

Risk management models are supposed to help anticipate and manage risks; that is, to reduce the level of uncertainty. The objective is to come up with a number of early warning signals that will awake the attention of financial analysts and fund managers. Overall, econometric models aim at simplifying the current reality to better predict the future around a limited number of scenarios. Too often, however, risk management models are based on unrealistic assumptions and assume normal probability distributions. Despite incorporating expertise and judgment to avoid any dogmatic view of models, they fall short of representing the true picture and complexity of a sovereign country with its complex legal, economic, institutional and cultural characteristics. Whatever the quality of econometric models, data sources and economic intelligence, they will never match the information and signals that domestic residents receive and accumulate daily. Country residents are embedded into an endless flow of sociopolitical, cultural, economic and financial inputs. This paper discusses a pragmatic solution to enhance the quality of risk assessment models, eg incorporating capital flight as an early warning indicator of country risk volatility. There is large evidence that in countries with weak institutions, private capital outflows and dollarisation are the by-product of a political and regulatory environment that is not conducive to dynamic and inclusive socio-economic growth.