Nouriel Roubini. (Photo: AP)

Credit ratings are a big part of how many investors decide where and how much to invest. In addition, ratings influence how much banks are willing to lend, and how much countries and their citizens must pay to borrow.

And yet – as Nouriel Roubini recently argued – ratings agencies are often too slow to downgrade countries.

Meanwhile, investors behave like herds – ignoring the buildup of risk for too long, before shifting gears abruptly and causing “exaggerated market swings,” Roubini says.

This is why Roubini, professor at NYU’s Stern School of Business and chairman of Roubini Global Economics, is arguing for a better “financial early-warning system.”

“Recent market volatility – in emerging and developed economies alike – is showing once again how badly ratings agencies and investors can err in assessing countries’ economic and financial vulnerabilities,” Roubini wrote on the Project Syndicate website. “Given the nature of market turmoil, an early-warning system for financial tsunamis may be difficult to create; but the world needs one today more than ever.”

The current credit ratings system is based on statistical models of past defaults, Roubini says. But, because few national defaults have actually occurred, he adds that sovereign ratings often become subjective.

“Analysts at ratings agencies follow developments in the country for which they are responsible and, when necessary, travel there to review the situation,” he wrote. “This process means that ratings are often backward-looking, downgrades occur too late, and countries are typically rerated based on when analysts visit, rather than when fundamentals change. Moreover, ratings agencies lack the tools to track consistently vital factors such as changes in social inclusion, the country’s ability to innovate, and private-sector balance-sheet risk.”

This is why Roubini believes there needs to be a different approach to assessing sovereign risk. He suggests an assessment that is systematic and data-driven.

“A comprehensive assessment of a country’s macro investment risk requires looking systematically at the stocks and flows of the national account to capture all dangers, including risk in the financial system and the real economy, as well as wider risk issues,” Roubini wrote. “As we have seen in recent crises, private risk taking and debt are socialized when a crisis occurs. So, even when public deficits and debt are low before a crisis, they can rise sharply after one erupts. Governments that looked fiscally sound suddenly appear insolvent.”

Roubini put his own ratings theory to a test, using 200 quantitative variables and factors to score 174 countries on a quarterly basis.

In doing so, Roubini identified three areas where investors are missing risks – and opportunities. 1. China

According to Roubini, China’s home developers, local governments and state-owned enterprises are “severely over-indebted.”

“China has the balance-sheet strength to bail them out, but the authorities would then face a choice: embrace reform or rely once again on leverage to stimulate the economy,” he wrote. “Even if China continues on the latter course, it will fail to achieve its growth targets and will look more fragile over time.”

2. Brazil.

“Brazil should have been downgraded below investment grade last year, as the economy struggled with a widening fiscal deficit, a growing economy-wide debt burden, and a weak and worsening business environment,” Roubini wrote. “The corruption scandal at energy giant Petrobras is finally causing ratings agencies to reassess Brazil, but the move comes too late, and their downgrades probably will not be sufficient to reflect the true risk.”

He adds that other emerging markets also look fragile and “at risk of an eventual downgrade.”

3. Eurozone

“In the eurozone, shadow ratings already signaled red flags in the late 2000s in Greece and the other countries of the periphery,” Roubini wrote. “More recently, Ireland and Spain may deserve to be upgraded, following fiscal consolidation and reforms. Greece, however, remains a basket case. Even with substantial reform to improve its growth potential, Greece will never be able to repay its sovereign debt and needs substantial relief.”

—Related on ThinkAdvisor: