2. How can we evaluate the sovereign risk ? Contradictory points of view Rating Agency Private companies analyze sovereign credit of each country based on political and economic risks. The rating is a public indicator of the solvency of each country Credit Scoring Based on a cross-country analysis, a logistic regression could fit the current long term rating. A good expectations of different variables could help to anticipate the ratings changes Fundamental Analysis A rigorous analysis of each country independent of rating agencies is based on economic approach and fiscal simulations Market Valuation The bonds prices are defined by supply and demand and reflect an implied probability of default for each country
3. Sovereign Credit Ratings Sovereign ratings history 1900 Moody’s established issued its first sovereign rating 1920 Rating agencies rates an increasing number of sovereign Yankee bond issues 1929 Poor’s published rating of Yankee bonds issued by 21 national governments 1930 Sovereign defaults spiked during the 1930s depressions. By 1939, all European sovereign ratings were in the speculative grade 1940 Most ratings were suspended during the war with the exception of the Canada or the Usa 1963 Introduction of Interest Equalization Tax in the Usa and creation of European bonds market The best rating ‘AAAAA’ for Usa and ‘B’ for China and Greece By 1935, Standard rated Chile and Peru at ‘D’ and Germany and Japan in the low speculative grade By 1939, UK remained at ‘AA’ but Germany was downgraded to ‘D’ In 1968, S&P suspended all sovereign ratings except those on Canada and Usa which remained at ‘AAA’ Rating Agency
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5. Sovereign Credit Ratings The ratings methodology Economic and growth prospects General government debt burden Monetary flexibility External liquidity Rating Agency
6. Sovereign Credit Ratings A chronology of European sovereign default 1820 1824 Greece 1840 1860 1880 1900 1920 1940 1960 1980 2000 1831 Spain 1834 Portugal 1867 Spain 1868 Austria 1876 Turkey 1892 Portugal 1893 Greece 1914 Austria 1915 Bulgaria Romania 1917 Russia 1932 Austria Bulgaria Germany 1940 Turkey 1981 Poland Romania 1978 Turkey 1983 Yugoslavia 1998 Ukraine Russia 2002 Moldova 1933 Yugoslavia Romania 1931 Hungary Great Recession in US & in Europe Russia revolution and the first world war Defaults in Africa Defaults in Latin America Defaults in Latin America Rating Agency (worldwide)
7. Sovereign Credit Ratings An evaluation of credit rating Sample of involuntary debt restructurings Rating Agency
8. Internal Credit Rating Explanatory variables % of variables with missing values per country % of countries with missing values per variable Credit Scoring
9. Internal Credit Rating Logistic Regressions Distribution of long term foreign currency rating Cumulative Distribution of long term foreign currency rating Credit Scoring 3.940 0.032 0.008 -0.018 - Public Debt 51 123.630 0.000 0.187 1.177 + Corruption Perception Index (2009 Score) 50 9.379 0.000 0.144 0.573 - External debt stocks, total (DOD, current US$)* 46 7.088 0.000 0.029 0.110 + Current account balance (% of GDP) 37 13.312 0.002 0.038 -0.120 - Inflation, consumer prices (annual %) 26 43.986 0.014 0.024 0.060 + Gross domestic savings (% of GDP) 25 4.020 0.044 0.034 0.068 + Gross capital formation (% of GDP) 24 19.042 0.000 0.123 0.461 + Health expenditure, total (% of GDP) 3 5.507 0.001 0.775 2.526 + Economic Development 1 Deviance p-value S.E. Coeff. E.S. Variable Nr.
14. Internal Credit Rating Corruption Perception Index The CPI index as been created in 1995 and ranks today more than 150 countries in term of perceived levels of corruptions. There exits a clear relation between the corruption perception index and the long term rating Credit Scoring
15. Market Valuation Does the credit rating explain the level of spread ? Market From a long term perspective, the degradation of long term ratings coincides with a global spread widening… … but the relation is clearly less relevant on short term ! + - AAA AAA
17. Market Valuation Implied probability of a default Market Based on recovery value close to 50%, we can extract from the market the cumulative implied probability of default
20. Fundamental Analysis Determination of a debt limit Analysis Behavior of the primary balance as function of debt At low levels, there is little response of the primary balance to rising debt As debt increases, the balance responds more vigorously When the level is too high, impact could decrease Interest rate schedule The interest rate schedule = (interest rate – growth) x debt ratio If we assume that growth is independent of the level of debt, the function is linear 1 2 3
23. Conclusion Investment opportunities Rating Agency Probability of default implied by ratings Credit Scoring Probability of default implied by internal ratings Fundamental Analysis What is the probability to expect a default ? Market Valuation Probability implied by the market Investment Strategies