How to measurecountry risk?
Produced by: Cross-country Emerging Markets Unit
For the Occasion of: Second BBVA Resarch Emerging Market Seminar
Madrid, July 13, 2011
Road map to the presentation
1. Previous work on country risk (CR)
2. Our methodology
3. Results
3.a Key determinants of CR
3.b Differences across regions
4. Conclusions
1. Previous work on country risk
Previous Economic Policy Research
Page 4
IMF1
Bank ofEngland3
Dependentvariable
GlobalVariables
IdiosyncraticVariables
Type ofModel
IADB2
StaticLong run(panel)
EMBISpread(Levels)
3 month Fed FundsVolatility Fed Funds
VIX
Credit RatingIndex
10 year US bondHigh Yield US corporate paper
Credit RatingIndex
Dynamic &Static
(panel ECM)
EMBISpread
(Differences)
EMBISpread
(Differences)
Dynamic &Static
( PMG)
10 and 30year US bondUS Baa-Aaa spread
SP500 index
Fiscal Budget, OpennessAmortization to Reserves
Current AccountShort term Ext Debt /Reserves
ECB4 Sovereign DebtRatings (Levels)
GDP per capita, GDP growth, Unemployment, Inflation,Gov. Debt, Govt.Balance,
Govt EffectivenessExternal Debt, Curr.Account,
Reserves, Default History
Static( Ordered
Probit)
(1) Hartelious et al (2008): “Emerging Market Spread Compression:Is it Real or is it Liquidity?”. IMF WP 08/10(2) Gonzalez Rozada and LevyYeyati (2006): Global Factors and Emerging Market Spreads. IADB WP 552(3) Ferruci (2003) Empirical determinants of emerging market economies’ sovereign bond spreads BOE WP 205(4) Afonso et Al (2007). What “HIDES” Behind Sovereign Debt Ratings. ECB WP 711
2. Our methodology
Sample coverage
Developed CountriesEurope
Emerging Countries
Asia
AustriaBelgiumDenmark
FranceGermany
GreeceIrelandIceland
ItalyNorwayPortugalSweden
Spain
AustraliaJapan
EMEA Asia Latam
BulgariaCroatia
Czech RepHungaryPoland
RomaniaRussia
SloveniaSlovakiaTurkey
South Africa
ChinaIndonesiaMalaysia
PhilippinesS.Korea
Thailand
ArgentinaBrazilChile
ColombiaMexico
PeruVenezuela
Country risk (CR) proxied by CDS spreadsSample period: lifespan of CDS (2004 to 2001)Number of countries: determined by data availability (mainly CDS but also CR determinants)
Variables chosen
Page 7
CDSSpreads
GlobalFactor
IdiosyncraticFundamentals
General
Fiscal
External
Institutional
Public Debt(% GDP)
External Debt(% GDP)
International Reserves to imports
GDP
ConsumerPrices
PCA Rule of lawCorruption
Gov. EffectivenessPolitical Stability
Investor ProtectionDays to start business
Global Commonfactor
Extracted withKalman filter
A quick look at the data
0
50
100
150
200
Total Developed Emerging0
1
2
3
4
5
Total Developed Emerging0
1
2
3
4
5
6
7
Total Developed Emerging
CD Swaps(spreads in bp, average 2010-2011)
GDP(% yoy, average 2010-2011)
Inflation(Cons. Prices % yoy, average 2010-2011)
01020304050607080
Total Developed Emerging
Gross Public Debt(% GDP, average 2010-2011)
0
50
100
150
200
250
Total Developed Emerging
External Debt(% GDP, average 2010-2011)
012345678
Total Developed Emerging
Reserves to Imports( average 2010-2011)
Extracting the Global Component
Page 9
We use the State Space Model to isolate the Global from the idiosyncratic model in the most possible orthogonal way
,
,
1,1,,
,,,,,1,
−− +=
++=
tjtjtj
titjitjtti
tion State Equa
vxCDSwapsn t EquatioMeasuremen
βωββ
βμ
UnobservedCD Swaps
GlobalComponent
Sta
te
Sp
ace
M
od
el
),0(~ and ),0(~ Where, tttt NNv Ω∑ ω
),1(),,1( nirj ∈∈
1,11,1,1 −− += ttt μωμμ
0
500
1000
1500
2000
Jan-07
Apr-07
Jul-07
Oct-07
Jan-08
Apr-08
Jul-08
Oct-08
Jan-09
Apr-09
Jul-09
Oct-09
Jan-10
Apr-10
Jul-10
Oct-10
Jan-11
Apr-11
CD Sw ap Global ComponentUS Corporate Aaa SpreadUS Corporate Baa SpreadUS Corporate Junk Bond Spread (ML)
Our global component vs other measures
Page 10
CD Swap Global component vs alternative measures(spreads in bp)
0
100
200
300
400
500
0 100 200 300 400 500
CD Swap Global Component
US
Aaa
Cor
pora
te B
ond
Spr
ead
0
100
200
300
400
500
600
700
0 100 200 300 400 500
CD Swap Global Component
US
Baa
Cor
pora
te B
ond
Spr
ead
0
400
800
1,200
1,600
2,000
0 400 800 1,200 1,600 2,000
CD Swap Global Component
US
Jun
k B
ond
Spr
ead
(ML)
0
20
40
60
80
100
0 100 200 300 400 500
CD Swap Global Component
SP
500
VIX
Inde
x
Our measure vs alternatives Measures ofGlobal Risk Aversion
(spreads in bp)
The extracted Global Component moves close to other alternative Global Risk Measures… Specially the US Baa Corporate Bond Spread. Junk bond too volatile
tiititittiti FEffXCDSwapGlobalCDSwapCDSwap ,1,1,11,, ))()log()log()log( υγλφβ +−−+Δ+Δ=Δ −−−−
Panel Data Model to explain SR
Page 11
Deviation from Long RunGlobal & Idiosyncratic
Fundamentals includingFixed EffectsShort run
Dynamics
Short runEffect of Global
Component
Panel Data Dynamic Error Correction Model (ECM)
Speed of Adjustment toLong Run Equilibrium
(<0)
ChangeIn Spreads
3 .Results 3.a Key determinants of CR
CD Swaps Long & Short Run Elasticities: Global Factor
0.000 0.200 0.400 0.600 0.800 1.000 1.200 1.400 1.600 1.800
Dynamic Panel ‐ECMTota l
Dynamic Panel ‐ECMDeveloped
Dynamic Panel ‐ECM Emerging
Global risk aversion matters in the long run
Page 13
Global developments (global risk aversion) do matter even in thelong run with a higher than unitary elasticity
Long RunShort Run
Long –term results relevant
Page 14
This is because the stimated speed of adjustment to the equilibrium isquick (75% of the shock adjusts in 1 year).
* Grey bars stands for non significant variables at 1% level
CD Swaps Speed of Adjustment to Long Run Equilibrium
‐0.07 ‐0.06 ‐0.05 ‐0.04 ‐0.03 ‐0.02 ‐0.01 0
Dynamic Panel‐ECMTotal
Dynamic Panel‐ECMDeveloped
Dynamic Panel‐ECM Emerging
Relevance of GDP& inflation
Page 15
Economic growth does not seemrelevant for emerging markets but itis for the developed world.
Inflation appears to be more relevant forthe developed world (or the absence of it)
* Grey bars stands for non significant variables at 1% level * Grey bars stands for non significant variables at 1% level
CD Swaps Long Run Elasticities: GDP
‐0.040 0.000 0.040 0.080 0.120 0.160
Dynamic Panel‐ECMTotal
Dynamic Panel‐ECMDeveloped
Dynamic Panel‐ECMEmerging
CD Swaps Long Run Elasticities: Consumer Prices
0.000 0.050 0.100 0.150 0.200
Dynamic Panel‐ECMTotal
Dynamic Panel‐ECMDeveloped
Dynamic Panel‐ECMEmerging
Relevance of Public Debt & Institutions
Page 16
The increase in public debt worsenscountry risk in developed countries.The result is inconclusive for emergingeconomies
Institutional factors affect country risk, especially for developedeconomies
* Grey bars stands for non significant variables at 1% level* Grey bars stands for non significant variables at 1% level
CD Swaps Elasticities: Institutional (kauffman)
‐3.000 ‐2.500 ‐2.000 ‐1.500 ‐1.000 ‐0.500 0.000
Dynamic Panel‐ECMTotal
Dynamic Panel‐ECMDeveloped
Dynamic Panel‐ECM Emerging
CD Swaps Elasticities: Public Debt (% GDP)
‐0.040 ‐0.020 0.000 0.020 0.040
Dynamic Panel‐ECMTotal
Dynamic Panel‐ECMDeveloped
Dynamic Panel‐ECM Emerging
Relevance of external liquidity measures
Page 17
External debt matters but especiallyin emerging markets
A confortable liquidity position in terms of international reserves toimports helps to reduce the spreads
* Grey bars stands for non significant variables at 1% level
CD Swaps Elasticities: External Debt to GDP
0.000 0.005 0.010 0.015 0.020 0.025 0.030
Dynamic Panel‐ECMTotal
Dynamic Panel‐ECMDeveloped
Dynamic Panel‐ECM Emerging
CD Swaps Elasticities: Reserves to Imports
‐0.050 ‐0.040 ‐0.030 ‐0.020 ‐0.010 0.000
Dynamic Panel‐ECMTotal
Dynamic Panel‐ECMDeveloped
Dynamic Panel‐ECM Emerging
3 .Results 3.b Differences across regions
Developed Europe: Actual vs Equilibrium CR
Page 19
Core Europe(Germany, France , Austria, Norway, Sweden)
Europe Periphery I(Belgium, Italy, Spain)
Europe Periphery II(Portugal,Ireland,Greece)
0
20
40
60
80
100
120
140
Jan‐04
May‐04
Sep‐04
Jan‐05
May‐05
Sep‐05
Jan‐06
May‐06
Sep‐06
Jan‐07
May‐07
Sep‐07
Jan‐08
May‐08
Sep‐08
Jan‐09
May‐09
Sep‐09
Jan‐10
May‐10
Sep‐10
Jan‐11
May‐11
Actual
Estimated
0
50
100
150
200
250
Jan‐04
May‐04
Sep‐04
Jan‐05
May‐05
Sep‐05
Jan‐06
May‐06
Sep‐06
Jan‐07
May‐07
Sep‐07
Jan‐08
May‐08
Sep‐08
Jan‐09
May‐09
Sep‐09
Jan‐10
May‐10
Sep‐10
Jan‐11
May‐11
Actual
Estimated
0
100
200
300
400
500
600
700
800
Jan‐04
May‐04
Sep‐04
Jan‐05
May‐05
Sep‐05
Jan‐06
May‐06
Sep‐06
Jan‐07
May‐07
Sep‐07
Jan‐08
May‐08
Sep‐08
Jan‐09
May‐09
Sep‐09
Jan‐10
May‐10
Sep‐10
Jan‐11
May‐11
Actual
Estimated
• Core Europe remains above but near “safe” long run equilibrium levels
• Portugal, Ireland and Greece current CDS level is similar to the equilibrium one
• Spain, Belgium and Italy´s country risk is clearly above the equilibrium: Contagion exists
Actual CD Swaps and estimated equilibrium CR from panel ECM (median CDSwaps by region)
Emerging markets: Actual vs Equilibrium CR
Page 20
Actual CD Swaps and estimated equilibrium CR from dynamic ECM (median CDSwaps by region)
Emerging Europe Emerging Asia Latam
0
100
200
300
400
500
600
Jan‐04
May‐04
Sep‐04
Jan‐05
May‐05
Sep‐05
Jan‐06
May‐06
Sep‐06
Jan‐07
May‐07
Sep‐07
Jan‐08
May‐08
Sep‐08
Jan‐09
May‐09
Sep‐09
Jan‐10
May‐10
Sep‐10
Jan‐11
May‐11
Actual
Estimated
0
50
100
150
200
250
300
350
400
Jan‐04
May‐04
Sep‐04
Jan‐05
May‐05
Sep‐05
Jan‐06
May‐06
Sep‐06
Jan‐07
May‐07
Sep‐07
Jan‐08
May‐08
Sep‐08
Jan‐09
May‐09
Sep‐09
Jan‐10
May‐10
Sep‐10
Jan‐11
May‐11
Actual
Estimated
0
100
200
300
400
500
600
700
Jan‐04
May‐04
Sep‐04
Jan‐05
May‐05
Sep‐05
Jan‐06
May‐06
Sep‐06
Jan‐07
May‐07
Sep‐07
Jan‐08
May‐08
Sep‐08
Jan‐09
May‐09
Sep‐09
Jan‐10
May‐10
Sep‐10
Jan‐11
May‐11
Actual
Estimated
Emerging Markets seem to be somehow overvalued by the market:Equilibrium CR appers to be above current CDS level
Page 21
Global Risk Aversion vs idiosyncratic CR across regions
Average Contribution of different determinants of CR (based on coefficients estimated in Panel ECM)
0
50
100
150
200
250
300
350
400
450
500
Western Europe Core Europe PeripheralEurope
Emerging Europe Emerging Asia LatamexArgVen
Latam World
Global Idiosyncratic + Fixed Effect
•Global risk aversion explains as much as half of CR across regions
•More relevant the riskier the region: Latam and Pheripheral Europe
Page 22
Fiscal dominating idiosyncratic CR across regions
Average Contribution of different determinants of CR (based on coefficientes estimated in ECM)
• Fiscal factors clearly dominate: specially important in Peripheral Europe and Latam• External debt most relevant for Europe• Quality of institutions specially important for Latam, followed by Asia• Macro variables hardly relevan
-10.0
0.0
10.0
20.0
30.0
40.0
50.0
60.0
70.0
WesternEurope
Core Europe PeripheralEurope
EmergingEurope
Emerging Asia LatamexArgVen
Latam World
Macro Fiscal External Institutional
Page 23
In most recent period fiscal continues dominating
Contribution of different determinants of country risk (based on coefficientes estimated in ECM)
-20
0
20
40
60
80
100
120
140
WesternEurope
Core Europe PeripheralEurope
EmergingEurope
Emerging Asia LatamexArgVen
Latam World
Macro Fiscal External Institutional
•External liquidity factors become more relevant for pheripheral Europe
•Institutions less relevant for Latam and Asia
4. Conclusions
On our methodology• Our CR aims at:
– Estimating true CR of a country, compared to the market one (CDS)
• Key is to separate global factors from idiosyncratic ones: strong methodology- Robustness tests to be conducted with other indicates
• Focus on long-term CR because- Easier to separate global market factors from- Estimated speed of adjustment relatively short so long term relevant for policy making/risk
assessment
– Determining which are the key factors determining country risk
• This allows to have different early warning indicators for different groups of countries
– Model can also be used to predict CR
• Using our forecasts of idiosyncratic variables
• Forecast of global risk aversion harder- Work to be done on the latter
On our findings
• Global risk aversion is a key component of country risk even in long term
• In Western Europe, global risk aversion worsening CR beyond equilibrium level
• The opposite is true for the Emerging Word: markets seem to be underestimating risk
• Among the idiosyncratic determinants of CR:
– The fiscal situation has and continues to be the most relevant
• Important warning for countries conducting reckless fiscal policies
– External debt more relevant for European countries
– Quality of institutions for emerging countries