Once we have presented all different concepts that can influence country risk, we are going to briefly analyse the different aspects that can influence the risk of default on external debt because of country risk.
• In the political field it is necessary to analyse political stability, government effectiveness, the strength of institutions, the risk of inter- nal and external political conflicts, geographical location considering political or military conflicts in the area, the extent of corruption and debt payment culture. Political risk can be measured by the governance indicators of the World Bank which evaluate the set of traditions and institutions used to exercise authority in a country, including the elec- tion process, control and replacement of governments, the ability of the government to effectively formulate and implement sound policies, and the respect that the citizens and the state have for the institutions that govern economic and social interactions between them.
• In the macroeconomic sphere the following characteristics must be observed: the rate of economic growth and its potential volatility over time, the inflation rate, the credibility of monetary policy instruments, the level of the nominal and real interest rates, the public sector balance sheet and, in the event of a deficit, its financing, the level of public debt, and the degree of development in the local bond market.
• The economic structure sphere comprises the level of per capita income, income distribution, social mobility, country size, product diversification, concentration of exports in a few goods or services and energy dependence.
• In the banking sector, the following features must be noted; the proportion of poor quality bank loans, the profitability of banking, foreign bank penetration, the rate of domestic savings, access to bank credit, the balance of bank assets and liabilities in foreign currency, the
existence of a deposit insurance institution, and the degree of develop- ment and effectiveness of banking supervision.
• In the foreign sector, the features that must be analysed include the balance of trade and current accounts, the exchange rate regime, the level of foreign direct and foreign portfolio investment, the existence of exchange controls, devaluation history, the level and structure of external debt, payment history and refinancing, and the level of foreign reserves.
• Markets also provide valuable information about the country’s risk of default through indicators such as the sovereign spread or the interest rate spread of sovereign debt in dollars relative to the interest rate of US Treasury bonds in ten years as measured by the JP Morgan EMBI index (Emerging Market Bond Index) and the credit default swap (CDS) spread. In addition to these indicators, the long-term sovereign credit rating in a foreign currency assigned by credit rating agencies constitutes an important reference in markets, as do the Organisation for Economic Co-operation and Development (OECD) country risk classifications.
The EMBIþ or EMBI Plus (Emerging Markets Bond Index Plus) developed by the US investment bank JP Morgan is the best known index used to measure country risk from a market perspective. The EMBIþ began publication in July 1995 with the aim of creating a reference to reflect the returns of a debt portfolio of emerging markets.
In total, the index consists of 107 instruments from 16 countries: Argen- tina, Brazil, Bulgaria, Colombia, Ecuador, Egypt, Indonesia, Mexico, Panama, Peru, the Philippines, Russia, South Africa, Turkey, Ukraine and Venezuela. In order to be included in the EMBI, debt instruments must have a minimum live nominal value of 500 million dollars.
Brady bonds, Eurobonds, loans and debt instruments from sovereign issuers are included in the bond index denominated in foreign currencies, mainly in US dollars, and since 31 May 2002 debt under local jurisdiction has not been eligible for inclusion in the index where inclusion is limited to issuers with legal jurisdiction in a country of the G7. Since the index includes the debt of emerging countries in dollars, the sovereign credit
rating of countries cannot be greater than BBBþ on the scale of the credit rating agency Standard and Poor’s, or Baa1 on Moody’s scale. Normally, the index is expressed as a spread in basic points on the yield of US Treasury bonds in ten years.
The JP Morgan EMBI Global index is itself an extended version of the EMBIþ created to be fully representative of the emerging countries in general by covering a wider range of debt values with lower liquidity requirements, a greater number of countries which are classified as low or middle income by the World Bank (having a per capita income below
$11,116 in 2006) and countries which enjoy a higher credit rating than BBBþ or Baa1. Specifically, EMBI Global includes 27 countries, those in the EMBIþ as well as countries like Algeria, Chile, China, Malaysia, Morocco, Nigeria and Poland.
The EMBI, both in its plus version and in its global version, tradition- ally referred to as one of the main indicators of country risk, has recently lost some relevance as a risk indicator of emerging countries, as at present dollar-denominated bonds only represent about 28 % of outstanding sovereign debt, while the remaining 72 % of debt consists of bonds denominated in local currency, which have recently been attracting con- siderable interest from investors. For this reason, in 2005 JP Morgan added the Government Bond Index–Emerging Markets (GBI–EM) to its family of emerging market indexes, an index that allows the sovereign debt in the local currency of 19 emerging countries to be monitored:
Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hun- gary, India, Indonesia, Malaysia, Mexico, Peru, Poland, Russia, Slovakia, South Africa, Thailand and Turkey.
Another market indicator used to assess country risk is the credit default swap spread. As discussed, when dealing with credit risk, this instrument is a financial derivative which allows credit risk to be trans- ferred because it is a bilateral over-the-counter (OTC) contract which is used to transfer risk from the protection buyer to the protection seller.
This is the risk of a“credit event”specified in the contract occurring, such as bankruptcy, default, restructuring, breach of obligations, repudiation and so on by a company or sovereign issuer. The protection buyer pays a periodic premium on the face value, usually expressed as an annual rate, called spread, until the expiration of the contract or until the credit event
specified in the protection contract occurs. Since it is a contract which hedges credit risk, the amount of the CDS premium provides information on the credit quality of reference entities and the increases in spreads indicate increased risk, while decreases indicate decreased risk and, there- fore, in the event that the reference entity is a sovereign state, the CDS premium can be used as an indicator of country risk.
Market indicators such as the EMBI Plus and CDS spread give an immediate idea of the level of country risk assigned by the market as it can be measured using the corresponding risk premium, and in that sense they constitute an important reference for issuers and investors. However, they have an important inconvenience for country risk analysts, which is the excessive value placed on short-term events which may cause significant alterations in the level of premiums but do not reflect the actual risk of the country. This evolution contrasts with the stability of the OECD’s country risk ratings, which usually only vary in response to more enduring factors in the medium and long term. Furthermore, the evolution of these indicators comprises the variation in country risk attributable not only to country- specific factors but also to external factors, such as the situation of the international economy or the degree of liquidity in financial markets.
Similarly, the long-term sovereign credit rating in foreign currency measures the default risk on sovereign debt in foreign currency due to the lack of ability or willingness to pay. In this case, the variables considered by agencies for the development of ratings vary in each case but coincide with important features which have already been mentioned previously. The main variables that influence country risk have been summarised in Table15.1.