how to measure country risk? - bbva research · for the occasion of: second bbva resarch emerging...

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

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

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


Gross Public Debt(% GDP, average 2010-2011)

0

50

100

150

200

250


External Debt(% GDP, average 2010-2011)

012345678


Reserves to Imports( average 2010-2011)

Extracting the Global Component

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

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


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


US

Jun

k B

ond

Spr

ead

(ML)

0

20

40

60

80

100

0 100 200 300 400 500


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

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

Global developments (global risk aversion) do matter even in thelong run with a higher than unitary elasticity

Long RunShort Run

Long –term results relevant

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

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‐ECMEmerging

CD Swaps Long Run Elasticities: Consumer Prices

0.000 0.050 0.100 0.150 0.200



Dynamic Panel‐ECMEmerging

Relevance of Public Debt & Institutions

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




CD Swaps Elasticities: Public Debt (% GDP)

‐0.040 ‐0.020 0.000 0.020 0.040




Relevance of external liquidity measures

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




CD Swaps Elasticities: Reserves to Imports

‐0.050 ‐0.040 ‐0.030 ‐0.020 ‐0.010 0.000




3 .Results 3.b Differences across regions

Developed Europe: Actual vs Equilibrium CR

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

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

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

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

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

how to measure country risk? - bbva research · for the occasion of: second bbva resarch emerging...

Documents