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Credit Risk in Emerging Marketsor

The Importance of Country Risk in a Portfolio Model

Oliver BlümkeErste-Bank

oblumke@csas.cz

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•Question 1: How can Country Risk be defined and how can it be measured?

•Question 2: How is Country Risk incorporated in many Credit Portfolio Models in use?

•Question 3: How likely and to what extent can Country Risk influence the performance of a credit portfolio?

•Question 4: How should Country Risk be incorporated in a Credit Portfolio Models?

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Question 1:

How can Country Risk be defined and how can it be measured?

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Elements of Country Risk:

• Political Risk: f.e. change of the political system

• Social Risk: f.e. strikes or law and order problems

• Economic Risk: f.e. cyclical slowdown, fiscal policy

• Transfer Risk: Exchange Rate Controls

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In a distressed situation of a Sovereign, two kinds of Country

Risk can be observed:

• Direct Country Risk• Indirect Country Risk

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Direct Country Risk:

Possibility of FX controls imposed by the Sovereign

Transfer Risk

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Direct Country Risk can be measured by f.e.:

Moody’s Foreign Currency Ceiling

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Indirect Country Risk:General Macroeconomic Risk• Macroeconomic Volatility / Recession

cut of demand• Currency Depreciation

higher costs of FX-financing• Decrease of Liquidity

cut in (foreign) lending• Inflation

cut of demand• Increase of Local Interest Rates

higher costs of financing

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Indirect Country Riskcan be measured by f.e.

Moody’sLocal Currency Guidelines

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Why you should not rely fully on Rating Agencies’ Rating?

S&P’s 16. April 1997, Foreign Currency Ratings:• South KoreaAA-• Malaysia A+• Thailand A• Indonesia BBB• Philippines BB+• Russia BB-

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Question 2:

How is Country Risk incorporated in many Credit Portfolio Models in use?

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Which Inputs of a Portfolio Model are affected by Country Risk?

• Default Probability (Rating)• Recovery Rate• Default Correlation Model

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How does Country Risk influence a

Default Correlation Model?

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Portfoliotheory (Markowitz)

Risk = systematic Risk + unsystematic Risk

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Firm Risk

Systematic RiskUnsystematic Risk or

Firm-specific Risk

Industry Risk Country Risk

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Asset-Value Models:

Return = systematic Return (Country, Industry) +

unsystematic Return

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Default-Probability Models:

Default Probability =

systematic Default Probability (Inflation Rate, GDP growth, etc. \ per Country)

+ unsystematic Default Probability

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Question 3:

How likely and to what extent can Country Risk influence the performance of a credit portfolio?

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Since 1975:

• 78 sovereigns defaulted on their foreign currency obligations

• 17 sovereigns defaulted on their local currency obligations

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Crises in Emerging Markets in the 1990‘s:

• Mexico 1994• Asia 1997• Russia 1998• Brazil 1999

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Two Examples from the 1990‘s:

• Default of Indonesia in 1998: Nonperforming loans reach 75%

• Mexico 1994:

Nonperforming loans reach ca. 50%

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Conclusion:

• A sovereign default is not a rare event!• A country crises is not a rare event!• The outcome of such an event can be

enormous!

A portfolio model should incorporate the possibility of such events!

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Question 4:

How should Country Risk be incorporated in a Portfolio Model?

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Crises in the 1990‘s (Mexico 1994, Asia 1997, Russia 1998):

• Local currency was pegged to the USD Real appreciation of the local currency

(caused by differences in inflation) Trade deficit Devaluation of the local currency• Corporates / Banks had unhedged FX positions Enormous amount of payment disruptions /

defaults

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Portfolio Model should contain:

Probability of a Currency Devaluation

Conditional Probabilityof Sovereign Default

Conditional Probabilityof Sovereign Non-Default

Default-Correlation: 75% Default-Correlation: 50%

VaR, ES VaR, ES

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VaR & ES depending on Sovereign DP

050100150200250300

0 0.13 0.22 0.29 0.57 0.89Sovereign Default Probability (%)

Perc

enta

ge

VaRES

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Portfolio Managers have to:

• Identify pegs• Estimate the probability of a significant

currency devaluation• Identify those obligors in the portfolio with

an unhedged currency position, or in general, vulnerable to a currency devaluation