Restructuring and its implications for business economics
Financial institutions that do business in emerging markets take on a great deal of sovereign risks, if only indirectly. In finance, these risks are commonly known as country risks, and they reach beyond market risk to include exchange rate, interest rate, and liquidity risks.
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An emerging market also should be viewed in the context of numerous other factors, including that country’s economic, financial, and political risks. In a full risk evaluation, analysts use comprehensive models to support decisions about a market and also to determine the institution’s relative and absolute exposures to a country.
Banks frequently use forecasting and modeling in their analysis of emerging markets. The model my company uses looks at a country’s economy from the ground up, studying its fundamentals and its macroeconomic performance indicators. With such a model, it is possible to generate a balance sheet for a country that reflects how your bank sees that country in credit risk terms. And from this balance sheet, your institution can get a better understanding of the credit needs of that country and can extract certain indicators–for example, credit risk indicators–while noting any financial stresses or peculiarities. It’s also important to assess qualitative factors such as economic structure, politics, development policies, and regulatory structures.
Forecasting for emerging markets is complicated but not impossible. These markets have unique financing needs and sources, and financial institutions must understand these completely to be able to service the markets profitably. For example, the gross external financial needs of emerging markets in Eastern Europe are expected to reach $400 billion in 2008, which could pose financing difficulties in today’s more anxious credit market.
By contrast, emerging markets’ gross external financial needs in Asia are expected to decline slightly, to around a low of just $150 billion. Latin America’s external financing requirements also have fallen markedly in recent years, as countries such as Brazil have benefited from better domestic policies, new trade surpluses in booming commodity exports to Asia, and the government’s sensible debt switch to domestic sources of finance.
After a particularly troubled financial history stretching over decades, Brazil’s improved position is welcome news. Several other countries are placed similarly to Brazil, in Latin America and elsewhere in the still expanding emerging-market universe.
The long-run trend over the last decade has been one of falling emerging-market risk spreads, to a record low of just 151 basis points (or 0.151%) in June 2007. However, the credit crunch since mid-2007 has driven spreads wider by around 150 basis points, with only more recent tentative signs of re-tightening since April 2008. With lower and lower emerging-market risk spreads over their AAA-rated sovereign equivalents in the West come almost continuous profits as benchmark bonds rise steadily in value.
A Narrowing of Market Risk Premiums
Overall, emerging-market risk has fallen over the past 10 years, both from a fundamental credit-risk-rating perspective and in terms of more market-driven risk spreads. But what is really driving the decline in observable market risk premiums? You have to return to the indigenous nature of credit–at a country’s credit fundamentals, its finances, and other factors–before you talk about market risk. If that credit has improved, then it is likely the market risk premium will narrow.
The size of a country’s market risk premium can be measured as a basis points interest rate spread over an equivalent triple-A-rated government bond that is essentially credit risk free. The actual size of this country risk market premium will be determined by the country’s credit fundamentals, although day-to-day asset values may fluctuate around this level. For example, if Argentina wants to move up the credit-rating ladder on the heels of Brazil, then it will have to sort out its internal policies and workout agreements with some of its key creditors, both official and commercial. There had been a lot of talk about Brazil being upgraded into the much vaunted “investment-grade” and this has now happened. While there are lingering fiscal and domestic debt issues, further investment-grade endorsements are likely, despite the credit crunch and global economic slowdown.
Another example is Eastern Europe, which has been a phenomenally profitable “convergence play” for bankers over the past 10 years, as benchmark bonds and other assets in its trail have risen steadily, precisely as country risks and domestic interest rates have declined, or at least have moved closer to or in convergence with Western European levels. All this has happened because of the widening umbrella of European Union membership and its tough entry criteria. These countries adopted market policies and opened their markets to the West, so much so that their market risk premiums narrowed tremendously.
Look at the politics and economy of Poland, for example, and you will see the market risk premium narrowing. If your institution had been in that market early on, it would have been a quite profitable venture. That’s the idea behind extracting value by examining the relative credit risk performances of countries over real time. If you can identify the countries that are quietly making their way up the ratings ladder, you are more likely to make sustainable long-term capital gains by investing in the country’s assets early on in the ascent–which is preferable to sitting on the outside, observing in a world of comparative trading-screen statistics.
In short, you need to know what’s happening behind the trading screens. You need to find a more fundamental credit risk level–a due diligence lesson perhaps lost on those who invested in subprime–both to extract longerterm sustainable value and to help set your bank’s overall relative country exposures (or simply its country dollar limits).
Emerging Markets to Watch
What are the emerging markets to watch? Everyone in the banking industry talks about the BRICs–Brazil, Russia, India, and China–and I believe most banks have some sort of strategic policy for and involvement in those countries. I have some concern about Russia, as its politics and policies have, if anything, regressed, despite the undisputed improvement on financials, drawn rather narrowly from a fortuitous boom in energy and commodities in recent years. There have been less credit improvements elsewhere in Russia, and “bad politics” can so easily trump “good financials” (just look at Iran or Venezuela).
By contrast, Brazil has finally turned the corner after 20 years, not only generating large trade surpluses and making the most of its raw materials and increasingly prized agriculture, but also stabilizing its macroeconomy by finally expunging the ghost of hyperinflation. In addition, Brazil’s banking system is in relatively good shape, a key factor in country risk learned since the Asia crisis, supporting a broad, healthy bedrock of thousands of expanding small and medium-sized enterprises (unlike in Russia) that are crucial to further development.
Although its economy is smaller, Turkey is another country where banks are likely to find opportunities. Turkey has an incredibly buoyant underlying economy that has always managed to rescue the country from a string of financial crises since independence–crises driven largely by corruption and poor policies and always resulting in a financial crisis, one usually involving a collapsing currency. Over the past 30 years, despite corrupt governments that have hindered the Turkish economy, the country had managed to bounce back from crisis to crisis as tourism, agriculture, and manufacturing expanded competitively abroad.
The big break with the crisis finally came after yet another exchange rate collapse in 2001, when the International Monetary Fund (IMF) successfully diagnosed corrupt practices that linked previous politicians with compliant state-owned banks. The IMF agreed with the new Erdogan government to root out, once and for all, the bad banks and corruption that had regularly undermined the economy and living standards. Now, Turkey has better policies and structures in place, much lower inflation, and a less dysfunctional financial system, allowing it to achieve its full economic potential.
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