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Credit Risk in Emerging Markets or The Importance of Country Risk in a Portfolio Model

Credit Risk in Emerging Markets or The Importance of Country Risk in a Portfolio Model. Oliver Blümke Erste-Bank oblumke@csas.cz. Question 1: How can Country Risk be defined and how can it be measured?

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Credit Risk in Emerging Markets or The Importance of Country Risk in a Portfolio Model

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  1. Credit Risk in Emerging MarketsorThe Importance of Country Risk in a Portfolio Model Oliver Blümke Erste-Bank oblumke@csas.cz

  2. 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?

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

  4. 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

  5. In a distressed situation of a Sovereign, two kinds of Country Risk can be observed: • Direct Country Risk • Indirect Country Risk

  6. Direct Country Risk: Possibility of FX controls imposed by the Sovereign  Transfer Risk

  7. Direct Country Risk can be measured by f.e.: Moody’s Foreign Currency Ceiling

  8. 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

  9. Indirect Country Riskcan be measured by f.e. Moody’s Local Currency Guidelines

  10. Why you should not rely fully on Rating Agencies’ Rating? S&P’s 16. April 1997, Foreign Currency Ratings: • South Korea AA- • Malaysia A+ • Thailand A • Indonesia BBB • Philippines BB+ • Russia BB-

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

  12. Which Inputs of a Portfolio Model are affected by Country Risk? • Default Probability (Rating) • Recovery Rate • Default Correlation Model

  13. How does Country Risk influence a Default Correlation Model?

  14. Portfoliotheory (Markowitz) Risk = systematic Risk + unsystematic Risk

  15. Firm Risk Unsystematic Risk or Firm-specific Risk Systematic Risk Country Risk Industry Risk

  16. Asset-Value Models: Return = systematic Return (Country, Industry) + unsystematic Return

  17. Default-Probability Models: Default Probability = systematic Default Probability (Inflation Rate, GDP growth, etc. \ per Country) + unsystematic Default Probability

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

  19. Since 1975: • 78 sovereigns defaulted on their foreign currency obligations • 17 sovereigns defaulted on their local currency obligations

  20. Crises in Emerging Markets in the 1990‘s: • Mexico 1994 • Asia 1997 • Russia 1998 • Brazil 1999

  21. Two Examples from the 1990‘s: • Default of Indonesia in 1998:  Nonperforming loans reach 75% • Mexico 1994:  Nonperforming loans reach ca. 50%

  22. 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!

  23. Question 4: How should Country Risk be incorporated in a Portfolio Model?

  24. 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

  25.  Portfolio Model should contain: Probability of a Currency Devaluation Conditional Probability of Sovereign Default Conditional Probability of Sovereign Non-Default Default-Correlation: 75% Default-Correlation: 50% VaR, ES VaR, ES

  26.  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

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