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Credit Risk in Emerging Marketsor
The Importance of Country Risk in a Portfolio Model
Oliver BlümkeErste-Bank
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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