Emerging Markets and Sovereign Risk

An important controversy in modern finance is the conclusion by some researchers that countries with high economic growth rates do not deliver superior equity returns versus nations growing slowly. The absence of a positive growth-return correlation was first suggested by Siegel (1998). In a comprehensive and influential study covering 16 countries and using a century of history extending back to 1900, Dimson, Marsh, and Staunton (henceforth DMS) (2002) found that the growth-return correlation was actually negative. Ritter (2005) employed somewhat different sources and reported that the growth-return correlation was zero for 19 developed markets from 1970 to 2002 and negligible for 13 emerging markets using data from 1988 to 2002. DMS (2010) updated their original work and confirmed that for 44 countries, there was no statistically significant relationship between growth and returns.

This chapter analyses the drivers of sovereign debt default risk for the following Central American countries: Belize, Costa Rica, Guatemala, Honduras, Panama, and El Salvador. Table 2.1 presents the long-term credit ratings of government bonds for these countries by Moody’s, Standard & Poor’s, and Fitch. We use daily data on the yield spread of bonds issued by the governments of these states. Spreads are computed with respect to the fixed income instruments issued by the United States (US) Treasury. We are motivated to use the yield spread variable since it reflects investors’ evaluation about the default probability of sovereign debt. We measure the sensitivity of yield spreads to several global, regional, and country-specific factors. The dynamic econometric models applied in this chapter are new in the literature of default risk analysis. In particular, we use the recent beta-t-EGARCH dynamic volatility model of Harvey and Chakravarty (2008) and Harvey (2013a) combined with the autoregressive (AR) model, to specify the conditional volatility and mean of yield spreads. Moreover, we use a Markov regime switching AR model for the yield spread that identifies high- and low-volatility sub-periods and involves time-dependent effects of default risk factors. To the best of our knowledge, this study is the first in the literature about the determinants of sovereign bond default risk in Central America.

Emerging markets (EM) are experiencing continued high economic growth that accompanies strong corporate earnings growth, usually associated with large financial assets returns. Moreover, this class of assets is offering a broader diversification to international portfolios by usually being only weakly correlated with the assets of developed countries. These particular features have greatly enhanced the attractiveness of EM to the financial industry, scientific community, and other stakeholders. Sullivan (2008) even advises developed-world investors to allocate more capital to those countries, if that is indeed the case.

This chapter examines the implications for European investors of the recent European Union (EU) expansion to encompass former Eastern bloc economies. It is questionable whether the formation of the European Monetary Union (EMU) within the EU has increased the correlation of national assets. This clearly has important implications for investors wishing to diversify across national markets, such as the implications of growing asset correlations, if they are displayed, and whether investors should diversify outside the Central and Eastern European (CEE) countries. It could be argued that the former Eastern bloc economies constitute emerging markets which typically offer attractive risk-adjusted returns for international investors. Therefore, this chapter explores a number of important aspects of portfolio selection and investment opportunities and their implications for CEE-based investors, culminating in a Markowitz efficient frontier analysis of these markets pre- and post-EU expansion.

This chapter puts forward the idea that investors face a new type of political risk arising out of the increased international regulatory focus on financial crimes, such as money laundering, terrorist financing, foreign bribery, tax evasion, and financial sanctions. This political risk is manifested in the policies of international regulators towards offshore financial centres (OFCs), especially in emerging economies, and includes powerful policy making bodies, such as the Financial Action Task Force (money laundering, terrorist financing) and the Organisation of Economic Co-operation and Development (OECD) (foreign bribery, tax evasion), as well as the International Monetary Fund (IMF), the World Bank, and the Bank for International Settlements (financial stability). Both the G7 and G20 have drawn a link between systemic risk and weak anti-financial crime laws and practices, and have made the assumption that OFCs are more likely to present systemic risks arising from weak anti-financial crime laws.

Rating agencies have long served as convenient scapegoats for sovereign downgrades that reflect years of fiscal mismanagement and growing economic and political risks.¹ The irony is that the existence of sovereign ratings reflects the need for external accountability of governments’ fiscal management.² Politicians in both the developed and developing world have repeatedly demonstrated a remarkable ability to ignore fiscal realities and dissemble until a crisis is at their doorstep. For this reason markets value sovereign ratings both as proxies on how close governments are to the precipice of a default and as a tool of public pressure for fiscal restraint.³

The objective of this paper is to explore the academic and other literature associated with the development and practices of international rating agencies and to develop a framework to understand the various rating agency methodologies.

The term ‘sovereign wealth fund’ (SWF) covers a wide spectrum of State-owned investment vehicles which have in common to be funded from budget surpluses but which diverge in purposes, strategies, assets, investment choice, and legal form. As their investment strategies are mainly focused on foreign financial assets, this definition necessarily excludes those funds which invest solely in domestic assets. The investment in foreign assets may be distinguished in portfolio investment and in direct investment: the latter enables the investor to exert a certain influence on the target enterprise, where the former consists of purchasing bonds or equity for pure return purposes without the intention to influence the management of the enterprise.

External imbalances and political issues are often the sovereign rating factors that best signal future default. External imbalances are associated with public or private sector excesses, and they generally have fiscal and monetary repercussions. In Standard & Poor’s Ratings Services’ view, no single measure consistently serves as a good leading indicator of sovereign default. Instead, a confluence of factors, including economic policy shortcomings, underlies most sovereign defaults.

In the search for untapped economically viable natural resources, the extractive industry is increasingly being forced to target larger, more capital-intensive projects in less developed countries. Such mega-projects can have a transformative impact, good or bad, on small host economies. The nature of such projects, and the way that they are typically structured and developed, unintentionally leads to specific economic problems that put pressure on host governments and project developers alike. Conventional approaches can lead to higher risk of expropriation, widespread and destructive rent-seeking behaviour, and intensified corruption. In projects of significant scale relative to the host economy, these unintended effects can lead to an increase in the overall level of sovereign risk in the territory.

One striking feature following the Asian economic crisis of 1997 is that many emerging economies have built up a large stock of international reserves (Aizenman & Marion, 2003; Aizenman & Lee, 2007; IMF, 2010). This reflects an important fact that sound macroeconomic management with low inflation may not insulate an economy from the likely adverse impact of volatile capital flows in the current international monetary system. The international monetary system has been observing global imbalances and unpredictable, volatile cross-border capital flows (IMF, 2010). A sharp accumulation of international reserves in many emerging countries in response to this has generated widespread concern among both policy makers and academic circles (Obstfeld, Shambaugh, & Taylor, 2010; IMF, 2010; Aizenman & Lee, 2007).

Given the current state of the world capital markets, more emphasis is being placed on the growing importance of credit rating agencies in providing standardised assessment of credit risk. One of the main applications of credit ratings is to assess the risk exposure of a national market. Sovereign credit ratings often serve as a ceiling for private sector ratings of any given country, which stretches their influence far beyond government securities. The change of sovereign ratings is one of the key factors that may trigger re-weighting of the portfolios held. One component of the literature assesses the national stock market impact of sovereign ratings changes (see for example Brooks, Faff, Hillier, & Hillier 2004; Pukthuanthong-Le, Elayan, & Rose 2007; Ferreira & Gama, 2007). Most of the studies in this area have used an event study methodology to assess the impact of sovereign ratings changes on stock market return. It should be noted though that most of these studies have used the conventional market model to calculate the abnormal return in the event study. The sovereign rating literature suggests that rating downgrades generally have a significant impact on the market, while rating upgrades do not have the same informative value. This study uses different benchmark models to test the validity of the results that are found in previous papers.

The optimal level of reserves has been a controversial issue from the times of fixed exchange rate regimes to the recent times of exchange rate flexibility. Earlier literature such as that of Heller (1966) points out that reserve accumulation has been driven by a precautionary motive against balance of payments imbalances. Similarly, Clark (1970) notes that even in the presence of a temporary deterioration of the balance of payments, international reserves enable a country to follow its domestic policy goals and reserves are beneficial because they provide a country with leeway to adopt suitable policies in the event of a permanent deterioration. Amongst others in recent times, Lee (2004) mentions that international reserves may mitigate international liquidity constraints encountered by a country. Yet again in recent times, reserve accumulation has been considered to be motivated by a need to insure a country against balance of payments risks. This is evident in the view of using reserves as an insurance mechanism against sudden stops. For example, Jeanne and Ranciere (2006) argue that reserves can smooth domestic absorption in the event of a sudden stop when debt is not rolled over and instead reserves can be used to repay the debt. In a similar perspective, such a possibility and theoretical construct is outlined by Aizenman and Lee (2007) where long-term investment projects are financed using foreign assets and, in the event of sudden stops and capital flight, international reserves can help long-term investment projects to continue rather than be liquidated.

The impact of credit ratings on financial markets has gathered new interest in the wake of the European sovereign debt crisis. Some have suggested that credit rating agencies (CRAs) amplify contagious effects and create additional financial instability,¹ a charge which of course is at odds with another frequent complaint that rating agencies respond too slowly to new information and lag markets.² The current crisis has prompted some calls to limit the freedom of action of CRAs at least in the sovereign markets.³