Sovereign Default Risk and Financial Market Returns in Africa

This paper investigates the nexus between sovereign credit rating (SCR) changes and financial market returns in African financial markets. It enquires whether sovereign default risk explains financial market returns and whether African financial markets anticipate SCR changes. We apply the Arellano-Bond Model, the Dumitrescu-Hurnin (DH) test, and the Event Study Methodology to data from 28 African countries from 1996-2020. We find that adverse SCR changes result in higher bond yields and increase financial market vulnerability to crisis, particularly for countries with under-developed financial systems. Contrary to expectation, we find that adverse SCRs have a positive, though statistically insignificant, effect on stock market returns regardless of the level of financial system development. We also find evidence that most SCR determinants have statistically significant, though mixed, causal effects on stock market returns and market pressure indexes for African countries. Market anticipation tests reveal that financial market participants anticipate adverse SCR changes across many African countries, with only a few markets anticipating positive rating changes. Overall, the study reveals that SCR events significantly impact daily bond and stock market returns in African markets. It is recommended that policymakers in African sovereigns improve the determinants of sovereign creditworthiness to guarantee improved credit ratings and financial market returns.