Peer Analysis on UAE Banks

Country Risk Analysis

Management of Credit Risk at times goes beyond just managing a portfolio of corporates and FIs. At the macro level, we may have to allocate country limits for cross border exposures or at times may have to underwrite a Sovereign with regards to investments into its debt securities or public sector entities.

Viewing a Company or an FI, despite how large it may, would appear as an achievable task, spelling out from the very basic business model to its earnings ability or debt management. But what about a country? How do we comprehend its enormous budgets, deficits, geo-political risks and currency management? Well, we will have to take it one bit at a time, and then try to pull it all together as a puzzle and pray it makes sense.

I’ve listed below the major building blocks of Country analysis and how to approach each of those.

1.    GDP

Gross Domestic Product, as the name goes, shows what gets produced in a country in a year. Now how do we estimate that? You can’t possibly add up all the invoices raised by all manufacturing and service entities of the Country - so you look at it from a different angle - from the consumers who used up all that production. The basic premise is that all that was produced was consumed by different participants in the economy, namely:

C.       Household Consumers, who ate up all end products and services.

I.         Private Investments, who purchased all the machineries and equipment.

G.      Government, who purchased all the roads, bridges and factories that was made, paid the public servants, teachers.

X.       Then there are exports that didn’t get consumed in the country, but it was produced here, so you add that up.

M.    Then there are imports that you consumed in the country, but didn’t get produced here, so you deduct that.

So to summarize, GDP is calculated as Y = C + I + G + X - M

We are really not getting into how statisticians estimate this, because we analysts would work on available data - but its worth noting that GDP only covers final goods and services - it eliminates all intermediate goods or raw material production, quite obviously to avoid double counting. So when you look from end consumer angle, this is automatically taken care of. Also informal works, household chores, informal unorganized sector, which does not really report its activity anywhere, illegal works etc are not counted.

While GDP shows us the overall scale of an economy, its also important to analyze the composition. If a country has a high GDP attributed to Government spending, then that may not last long. That may just having a crowding out effect on private investments. If GDP has a strong component of private investment, then there is an efficient capital market functioning and chasing yields  may result in long term benefits. A strong consumer base is also relevant, because you really don’t have to be exposed to trade shocks - a good consumer base can keep the economic engine ticking - ex. China. Then there is the net exports - its good to have a surplus but not overly dependent.

How does various countries fare in this aspect? Refer graph below, where countries are ranked top to bottom based on their S&P ratings. The composition varies across the rating class, but towards the lower end you could see very low government spending, again which would show the lack of ability of government to spent on investments, while the large consumer base is being fed using imports, rather than inhouse production. Nevertheless, you can see that Household consumption is a major component across the world and drives the GDP.

2. Debt to GDP

A very widely used metric is Debt to GDP. Maastricht treaty for Eurozone membership talks about a 60% max level for debt to GDP. But what is Debt to GDP? Is it like Debt to EBITDA? Or is it like Debt to Income? Neither, this is merely a measure of Debt Burden - it shows the total national debt against a country’s size of economy. If you think of a country as a household, then GDP is what the household produced and sold the whole year, while debt (also called public debt or national debt or sovereign debt) is the debt taken by the guy who runs the household, on behalf of the household.

So in simple terms, if the father takes the debt and uses all of the household’s revenues to pay it off, that is a country dedicate all of its GDP for debt repayment, how many years would it take to repay? A 50% debt to GDP would mean half an year of repayment, a 200% debt to GDP would mean 2 years of toil to settle all of public debt. You get the idea. But that’s a bit too much right? You really wont be taking GDP created by all the companies and individuals in the country and use it to settle Government debt. Government at the most would only have access to the tax that can be generated on this GDP and of course that component of GDP that they themselves produced (say, national oil companies). This does not show debt affordability or serviceability. So what does debt to GDP actually say? It gives the following indicators:

-          Indirectly, it shows the size of debt relative to overall scale of Government’s revenue base - because GDP is what Government can tax. A larger economy also means a broader capital market access which can be tapped by the Government to issue more debt. Hence ability to repay is a function of how big is it, relative to GDP size.

-          An elevated debt level to GDP constrains the sovereign’s capacity to provide fiscal support to the economy, especially in times of need, impacting its growth. This is because a large debt would mean larger interest payments in the budget, leaving only the reminer for boosting growth.

-          It shows that the Country was/is running persistent deficits which built up debt gradually. As per Moody’s this shows legacy weakness. As debt goes higher, incremental debt becomes costlier, making it harder to manage deficits which may lead to a recession.

-          Apart from legacy weakness, it would also show contingent liabilities that the Government was forced to take up in the past, like recapitalization of loss making state owned enterprises, debt taken to manage currency depreciation etc.

We like this ratio to be below 60% and okay even if its around 80%. But beyond that, it is considered high. You have to be careful of what constitute debt in the ratio you are looking at - In all normal scenarios, debt to GDP is ‘public debt’ against country’s GDP. This public debt may include debt at provinces/states and debt at large state owned entities, if data is available and material.

As seen above, a larger economy like the USA may be running debt above 100% and that would be ok, but a smaller economy like Greece and Lebanon running 150% debt would not be ok. You get the drift, right? That’s what debt to GDP shows.

 

For a sovereign, what is Debt to EBITDA then?

To realistically assess a sovereign’s repayment capacity, we need to move ahead from Debt burden to assess the Debt Affordability. We can use the following indicators:

-          Government Interest Payments to Government revenues, which would be influenced by

o   The debt burden itself as seen above (scale of debt relative to size of economy) - higher debt means higher interest payments.

o   Cost of debt - which shows the risk premia.

o   Government revenues in its budget - lower revenue means lower debt serviceability.

-          General government debt to general government revenue - this is more like a debt/EBITDA and shows the repayment capacity.

-          Government revenue to GDP or tax revenue to GDP, as per data availability, which shows the footprint of Government earnings against the national economic activity. This sort of shows how wide the tax net is and how efficient is government in its collections. A very efficient economy, like Norway has a very high government revenue to GDP level, close to 60%, followed by Denmark, France, Finland all closing around 50%. Saudi Arabia, even with all its oil, has only revenues covering 30% of GDP given the very low tax net. US too has it close to 30% but with half of it coming from taxes.

Composition of this public debt?

Not all debts are created equal and hence our analysis needs to be make adjustments for them.

-          LCY debt from domestic creditors - more easily accessed, refinanced. A deep local domestic capital market is hence considered a credit strength for a country, if it helps government to issue various types of instruments of various maturities. Developed countries normally have a deep domestic market for its government bonds.

 

Another option for the Government to tap funds locally is through the banking channel. We see this in Egypt and Pakistan, where the banks hold their funds primarily with government bonds, given the lack of solid credit growth opportunities in those countries. This is advantageous if such demand from banks for government bonds is stable, driven by conservative approach and there are advantages on regulatory frameworks that support such government holdings - but this would lead to saturation - if this demand from banks taper out, then Government may find it hard to raise further funds.

 

Such a domestic market would depend on a stable and lower inflation target (as the investors would want a real return on such government bonds) and a wider set of participants, like insurance companies, pension funds etc who has the business need to face higher duration on investments.

 

-          LCY borrowing from external creditors - Mainly relates to the FIIs who shops around for government debt, either for the high yield (in case of developing nations) or for risk aversion (US treasuries, bunds etc). This widens a government’s borrowing base and provides easier access (take our example of Egypt and Pakistan above, such broader access would reduce reliance on Banking network). In addition to domestic pension funds or insurance companies, you are also now looking into foreign investors. There are many emerging markets opening up, mainly Indonesia. This depends upon capital account frameworks, FDI laws etc. Indian government bonds are soon expected to be inducted into the FTSE Russel index, which would further broaden its investor base.

 

-          FCY Borrowings, from domestic creditors: See the graphic below, Emerging market economies normally hold less of FCY borrowings and even if they do that, it may be FCY borrowings from domestic investors.

-          FCY borrowings, typically from external creditors. This broadens the market access substantially, as the investors does not have to take currency depreciation risk. This alleviates liquidity risk to a large extent, depending upon track record and stability of such issuances in the past. Also, if last resort lenders like IMF and other official parties are the main investors, then it wont necessarily show breadth of the market, but rather weakness in accessing other investors.

However, FCY debt as a component of total debt, above say 40%, opens up its own set of problems:

o   Value of debt in LCY terms or relative to LCY revenues becomes larger if the currency depreciates.

o   Currency depreciation may also lead to higher interest rates.

-          The ease of access is then assessed against the urgency of access. The stronger the access, higher the tolerance for funding needs. Large principal repayments coming due in FCY poses risk, including nervous investor base, pressure on currency if you refinance in LCY to repay FCY and chances that you may deplete your reserves in order to service the repayment.

 

 

 

2.    The current account deficits

The current account deficit shows the net position of transactions between a Country’s residents and non-residents. This includes exports, imports, workers remittances, grants, dividend income, dividend payouts, interest income and payouts (basically current account items, not capital movements). If this account goes into deficit, this will have to be plugged by bringing in funds from outside the country. This would lead to borrowings at government level to match its balance of payments. Egypt normally takes such borrowings at its oil company levels to fund import of oil.

 

A deficit indirectly means that you are sending more money abroad (for purchases, cost of debt etc), than what is coming in to your country (as interest income, export proceeds etc). Now if you then take debt to plug this, then you are becoming a debtor to the world for funding consumption and not long term growth.

 

A current account deficit is also viewed as lower level of savings in a country vs. its investments. How is that? In a country, what is saved by the residents is what gets invested - theoretically. Savings go into the banking system, which goes out as loans for investments. Now, if people stop saving and starts spending, then obviously it would require more imports and hence a deficit. Now, with no savings, there is no funds for investments as well, which requires capital flows from abroad (CA deficit = capital inflows). Conversely, if a Country saves a lot, it doesn’t spend much, that means it would import less expensive cars, TVs etc. It would then have a current account surplus and so much savings, that they will start looking for opportunities abroad to invest. Capital flows outside (CA surplus = capital outflow).  Now this savings/investments approach means that protectionism doesn’t work and has no impact on current account deficit - because, protectionism doesn’t impact savings and investments.

 

Current account deficit also means that the country is focused on short term consumption (imports) than longer term investments in export sector. Such deficits naturally depreciates local currency, given that there is strong requirement of dollars to fund the deficit. This makes imports costlier, which then pushes the deficit wider and results in inflation. This in a way makes exports attractive, increases demand and may help in the long run. If it’s a floating rate, market forces would adjust itself.

 

Hence, its imperative to understand how the deficit is financed. You then look into capital account and the financial account. Capital account is the book of tangible assets - money that went out to buy tangible assets net of money that came in for same purpose. If more investors are buying companies in our country and piling money into our account for that, then yes, that excess fund will then plug the deficit in current account. It’s a good thing if we are funding the current account deficit through long term investments coming into the country, and not just debt. Such long term investments will then increase productivity, which may lead to lower imports or higher exports and then arrest the deficit altogether. If the Country enjoys stable inflows of FDI, provides good return to investors, then that would be considered an acceptable proposition.

 

But how far can persistent deficit continue? You are at the end of the day financing a deficit through liabilities taken on the world, which needs to be repaid. If you are borrowing to fund consumption with no longer term benefits, then its ability to repay may be curtailed. Like a corporate, is the borrowing resulting in incremental EBITDA? So these borrowings should go into finance investments with a higher marginal production rate than the interest paid on these foreign liabilities. To repay debt taken to fix CA, you should eventually return to CA surplus. Now some countries are just able to run consistent deficits and gets capital inflows to plug it (Australia, USA), but some countries (like the Asian countries during 1997 crisis) would just see an arrest of capital inflows to fund the deficits and gets massive shock to its currency as it finds it hard to get FX.

 

 

So is current account deficit good or bad?

o   Case for good: If its funded by a stable FDI inflow, country has a stable exchange regime, not exposed to trade shocks, a well regulated banking sector, good import cover, diversified export base not dependent on any partners, then deficit may not be that bad. Also, if deficit is due to higher investments than savings, which would just mean a country raring to go, to invest, and there is no enough savings domestically to fund it.

o   Case for bad: If the deficit is because of low savings (and not high investment) and reflects issues with competitiveness on the export front, lack of austerity measures pushing up consumption, it may not be all that good. Also if country is just taking short term debt (rather than FDI) to just plug the consumption and not investing in improving competitiveness and yield so as to reverse the position later on, then a persistent deficit would backfire.

 

IMF lists out the following major risk factors for current account deficits:

o   Overvalued currency which makes inflows costly.

o   Inadequate forex reserves to give stability for imports.

o   Excessive domestic credit growth which may result in a banking sector meltdown.

o   Unfavorable terms of trade shocks

o   Low growth in partner countries impacting exports,

o   Increasing balance sheet vulnerabilities at corporate levels.

o   Increasing ADRs at banking sector which shows borrowings from abroad to fund weaker domestic credits.

o   Composition of capital inflows - stable FDIs vs short term investment flows into capital markets (equities and bonds).

 

3.    The budget Deficits

a.       Fiscal Deficit = Government’s expenditure - income. This also means the borrowing requirement of the Government.

b.       Primary Deficit = Borrowing requirement as above - interest expense of previous borrowings. This basically shows how much of the deficit is excluding interest expenses and taken to meet other expenses of the Government.

Looking at it backwards,

Primary Deficit = Government’s expenditure (excluding interest payments on previous debt) - income.

              Fiscal Deficit = Primary deficit + interest expense of previous debt.

So if a country is running a primary deficit, it means that its having a deficit even before considering interest payments - i.e., it is not making enough money to even service debt. So more borrowings to even pay interest. That’s not that good. As interest rate goes up, interest expense shoots up and fiscal deficit grows even bigger, pushing debt to GDP even higher. Now if you run a primary deficit, then government can either reduce spending or increase taxes to plug the deficit OR it can just keep on printing money to make payments - now all economies does not have that easy way out. Such excessive growth in money supply (too much money chasing too few assets) would lead to inflation, which would then lead to further deficits.

Now what are the effects of a persistent budget deficit?

Positive: A deficit arising from high government spending would help an economy recover faster from a recession, provide jobs etc. If its for infrastructure projects, then it would mean money going into contractors, material suppliers etc, basically bills getting paid, which is a good thing for economy. A deficit would help in implementing socialist welfare programs, bring in political stability etc.

Negative: Such high level of government spending and resultant government borrowing pushes interest rates higher, which then impacts cost of funding for private sector and leads to lower private investments, thus dragging the economy. If government starts issuing bonds substantially and increases the rate in order to get maximum subscription, then other bonds needs to be priced at a premium to this rate - thus increasing cost in the economy (may not have much of an impact if the economy is stuck at near zero interest rates).

Also, if Government issues bonds and notes and all savings goes into those assets, then there wont be any left for credit growth. Private investment is always considered more productive and capitalist than public spending, so such deficits would carry negative impacts in the long term.  Thus a deficit reduces capital available in an economy (think about open market operations of Fed - It would sell its holding of US Treasuries to suck out extra funds kept with banks - which leads to higher interest rates and buy treasuries if it wants to give more money to banks, thereby making loans easier and cheaper - when Fed just keeps on printing money to buy these bonds and flush economy with cash, that’s called QE).

So how we analyze it?

o   See if the economy is running a primary deficit. Is that persistent? For ex, India has been running a fiscal deficit for last 40 years.

o   Is this deficit boosting the economy? Are the contractors getting paid and is the deficit used for productive investments? Or is it just welfare economics? Or is it just mismanagement or poor taxation programs? Or is it just defense spending?

o   Is debt to GDP increasing year on year to fund the same?

o   Can they keep on printing money to manage this borrowing? Is there a risk of inflation?

o   Especially in COVID time, Governments would be forced to spent more to keep the economic clock ticking. Is it something that can be addressed and are there chances of a recovery soon?

4.    GDP Per Capita

While not exactly true in all aspects, this metrics basically shows how prosperous a country is, at least in terms of wealth available for each participant of the economy. It does not capture the disparity of this allocation (Something that a gini coefficient may pick up) or happiness metric of a country - just total wealth divided by population. Nevertheless, this is seen as higher in developed nations (see US below) or in very small counties (see Singapore below) - but with countries arranged from best to worse in credit rating - you can see that the GDP per capita sort of tapers down as we get to the other end.

If a country has a lower per capita base, say $1000, a 10% growth would mean only adding $100 more to it and country can plan for it, but if its already at $100,000, then adding 10% would mean $10,000 per head which may not be easy.

5.    GDP Growth

As important as GDP, we should also keep an eye to GDP Growth. More importantly, it should be the Real GDP growth, which takes out the impact of inflation. If a Country’s nominal GDP grew from 1,000 to 1,100, that’s a 10% growth, but if country had a 8% inflation, then actual growth would be only 2%, as an example. Also, we can’t keep a blanket benchmark of say 7% growth for all countries we are analyzing - as is the case with per capita, a larger base would only allow for a 2-3% growth while developing economies with smaller base should thrive for a 7-10% growth rate. In current situation when 2020 was battered by COVID, the base is low for many countries and hence 2021, being recovery year, may come up with good growth rates, but that may still be lower than where we stood in 2019. The map looks all green now, but that’s because of the lower base - see 2020 on the left - COVID effect and the greener 2021 on the right, with strong growth rates given the lower base of 2020.

So let’s go back one more year to have a normal distribution - no COVID, no recovery from COVID, just normal economics. See below for 2019 - that’s more like it - the developing nations like India and China would thrive for a 3-6% growth, while the developed economies would have a 0-3% growth.

 

6.    Forex Reserves and Import Cover

One of the lessons learned by emerging markets from the Asian crisis of the 90s is that they need to maintain a good forex reserve balance. Primarily this helps maintain the value of the currency, if suddenly capital flow stops and people start dumping the LCY to take funds out. A good forex base helps in maintaining LCY purchases to maintain its value and also provides comfort on FX available to meet the country’s imports - its always good to have minimum 4 months of imports in the reserves.

 

A country’s forex is primarily built up through its exporters, who receive FCY against their invoices as credit to their bank accounts (or FCY cash that they deposit into the banking system). Banks gives them LCY in return and move this FCY currency to Central bank in return for LCY. Banks needs LCY for their local banking operations and the exporters need LCY for meeting their local expenses. Hence eventually FCY ends up with Central Bank - and what do they do with it? Buy dollar or euro denominated sovereign bonds (US Treasuries mainly), even high yielding corporate bonds to certain extent and even keep it with IMF as reserve balances.  A part may even be held converted and held in gold.  

 

Among other things, Central Banks built up reserves to manage currency rate (mainly to buy FCY and keep LCY competitive), maintain liquidity in terms of import cover - even in case exporters stop earning FCY temporarily due to a trade shock, government would still be able to use its reserves to provide dollars to fund imports, keep markets steady in case of a capital flight from the economy, maintain ability to meet FCY debt payments and use it for investments abroad or even as a war chest if required, for domestic investments.

 

IMF uses a metric called Reserve Adequacy, which captures the following dynamics:

o   Reserves to cover 20% of M2 Broad Money. A country should keep enough reserves to cover a portion of cash and bank deposits with maturity less than 2 years - this is to capture FX requirements which potential capital flight happens, when confidence in LCY is lost and investors (both domestic and foreign) liquidates savings held in cash and deposits and covert it to FCY. Even domestic investors would be interested in moving their assets abroad. Now this risk is exacerbated if the currency regime is considered very volatile (say Turkey), where investors expect massive devaluations and hence it may be better to convert the holding to FCY now or if the banking sector is considered very weak and investors consider keeping money with the banks as risky.

o   Import Coverage: As mentioned before, ideally covering 3-6 months of imports, to capture FX requirements during a balance of payments crisis, when exports narrow and no other FX revenue is available.

o   Coverage against short term external debt: The rule states that the FX reserve should cover debts maturing within one year. While import cover would capture balance of payments risk, this indicator covers the volatility in capital transactions. Basically, this ratio says that a country should be able to live without any new foreign borrowing for up to one year and still be able to meet its short term external debt repayments (both LCY ad FCY denominated).

The recently published position of IMF Reserve Requirements in emerging markets shown below.

 

 

EMEs have experienced frequent crises since the 1980s: Latin America in the 1980s, Mexico in 1995, East Asia in 1997, Russia in 1998, Turkey in 1994 and 2001, Brazil in 1999, and Argentina in 2002 and 2018. One salient characteristic of these crises has been sudden stops in capital flows, which have disrupted the financial system and caused large and mostly permanent output losses. This has led to EMs slowly taking an insurance by building up reserves. A pictorial representation of FX reserves as a % of its GDP (that is amount of reserves held with regards to the scale of the economy) and its import cover given below.

 

 

7.    Banking Sector

Can a Country’s banking sector take the Country down as it goes haywire? Quite obviously, it would depend on the size of the banking sector relative to the economy (total banking sector assets to GDP) and strength of the sector, without any government assistance. Many a times in recent past, we have seen Government stepping in to bail out banks which would add to Government’s debt burden or deplete its reserves. If the size of domestic banking assets to GDP is less than 80%, no material impact is expected, but if its say above 200%, that’s worth taking into consideration.

 

We are not going in detail on banking sector analysis here, but presence of weaker state owned banks with depleted capital position and high levels of legacy NPA levels, generally would show years of mismanagement and dire need for recapitalization, which then puts pressure on budget deficits and debt levels (say, Bangladesh). But if the banking sector is well capitalized, good management of assets and liquidity, then that can be a credit positive for a country, while it manages other challenges (Say Turkey). Also, if a banking sector is running too low an ADR and not really contributing to credit growth of a country, with assets mainly tied up with government bonds, then that increases the correlation risk (like Egypt and Bangladesh). A good regulator keeping banks in check and acting independent is a huge plus. Weak governance structures, favored connected lending, high concentration etc are huge negatives. A good banking sector results in efficient allocation of resources, even credit growth and a resultant even growth rate.

 

8.    Inflation

This is a double edged sword which needs to be controlled carefully. Inflation basically means higher amount of money in an economy chasing far fewer goods. Low inflation encourages consumption which leads to further investments to increase production, further employments and wage increases. But when this inflation becomes too high, economy starts suffering - people find it hard to make ends meet and then government intervenes by raising interest rates and sucking out funds from the economy. This reduces demand and stabilizes prices.

 

When a country increases its money supply and more currency is available in the country, it chases existing set of goods and inflation creeps up. Now that may not be the case in US, because these excess dollars gets utilized by other countries holding the same as reserve currency and hence there is no increased supply domestically and hence inflation may remain muted. Then there is the concept of exporting inflation. For example when US prints a lot of dollars, dollar supply increases which mathematically weakens the dollar. The emerging economies find it hard when its currency strengthens, as it impacts export competitiveness, and then in turn starts measures to devalue its currency - say through dollar purchases - which sucks out dollar from US domestic market and ensures there is no inflation in US, but as currency gets devalued, imports gets expensive to these countries, who then starts facing food and commodity inflation. SO effectively, US just exported inflation to other counties. This is an element of trade war.

 

Coming back to the topic of analyzing inflation for country analysis, I would say keep an eye on inflation above 10% - those countries are bleeding and may be facing severe stress on its currency. Higher inflation means purchasing power of its currency is going downhill, which essentially means currency will weaken. Now it’s a chicken and egg situation - this further makes imports costlier. Inflation will also lead to higher interest rates - that’s because government bonds becomes unattractive as they don’t cover inflation and government will be forced to issue new bonds with better yields, which then makes credit linked to bond prices costlier.

 

9.    Exchange Rates

Historically, this is something that has broken the back of several economies. Its always advisable to have a flexible exchange rate, one that moves along with the market - but some countries do try to keep it fixed or pegged for various reasons - one being it favors foreign investments - investors wont really like the currency to have devalued over a year which would wipe out their returns for that year. It will also help if you are majorly dependent on a particular commodity which is traded in dollars and want to take out forex risk from the equation - you would know what you will earn when you produce and also your customers know how much to pay - you don’t want them to walk away to another country only because your exports became costlier (through a dollar weakness).

 

But this peg has to be at an appropriate level. If you keep it the peg too low, that is your currency is very weak, say INR at 150 for a dollar, then purchasing power of domestic consumers is very low. For 15000 Rs, they can only import 100 dollar worth of goods. India would hence reduce their imports, impacting business of US and Middle East countries, losing India as a trade partner. Hence currency cannot be too undervalued or weak.

 

What if its held too high or too strong, say INR at 30 per dollar, that’s too much power to consume so much - that will lead to high deficits, impact the country’s credit rating and market would push the currency down - government will have to use up all of its reserves to defend the peg and eventually give up. Something like Soros breaking the back of the Bank of England. Losing a peg has huge short term ramifications - imports becomes expensive, you lose suppliers, investors lose their returns, inflation creeps up. Think Egypt when they decided to devalue the currency after IMF intervention. But overtime, markets adjust to the devalued currency as exports becomes attractive, tourism booms and investors adjust expectations to the new normal.

 

Most past sovereign defaults have been surprisingly linked to coming off a peg - Thailand, Brazil, Argentina, Indonesia, Mexico. In all these cases, a persistent current account deficit and depletion of forex reserves which deemed it insufficient to defend a peg, led to capital flight and eventual defaults by these sovereigns.

 

 

Lessons from the past:

Now that we have covered the basic blocks of country analysis, it would be good to go through some of the major global financial meltdowns and see what went wrong:

-          Asian Crisis of late 90s - The Asian countries in 1990s enjoyed a stable exchange rate, high interest rate on domestic deposits and rapid economic growth coming from these investments - current and budget deficits being funded by external flows. A rising current account deficit was being plugged by these foreign inflows - however, these inflows were understood to be going into productive investments and not just to fund consumerism and hence many decided to overlook the same. Also a lot of debt was being raised by private sector directly - which does not show up at government level economic ratios.

 

But the type of debt is also important - if this was long term FDI flow, that would have been ok - but here it was more of short term interest hunting foreign funds and that too in FCY. Such debt depends on timely rollovers through ample liquidity and stability in exchange rates so that returns don’t get eroded away. But here, short term debt was invested in domestic assets and there was no FCY income per se to repay FCY debt One wrong news about the economy and an erosion of confidence, would take out liquidity and stability in exchange rates - that’s what happened - trigger was the discovery that Thailand’s reserves had been overstated - that would mean that Thailand wouldn’t have the reserves necessary to maintain the exchange rate - this led to doubts on reserves of other countries as well and lead to a classic bank run, but on the countries.

Countries have learned following lessons from the crisis:

o   Have an efficient banking sector to keep confidence in investors, have a credible regulator.

o   Maintain exchange rate flexibility ,

o   Manageable debt to GDP levels

o   An independent regulator ensuring an inflation targeting policy or exchange stability.

o   Have a good reserve base to make the country resilient to external shocks.

-          Barbados Default 2018 - fiscal deficits averaged to around 8% of GDP with large requirements for transfer to state owned enterprises and high interest expenditure. Public Debt to GDP went from 77% to 158%, with composition shifting from long term to short term gradually - leading to unsustainable maturities and credit downgrades. Import cover fell from 4 months to 5 weeks between 2007 to 2017. They finally defaulted to maintain their reserves. Larger component of debt was domestic, with banks and insurance companies.

-          Venezuela Default 2017 - Larger issue of mismanagement and corruption, despite having one of the largest oil reserves in the world.

-          Russian Financial Crisis 1998 - In hindsight, economists say that a fixed exchange rate of Ruble vs major currencies and a chronic fiscal deficit were the reasons that led to the crisis.

I’ve summarized below some available data on sovereigns, during years that lead up to its default.

Metrics leading up to Default	Lebanon	Argentina	Barbados	Venezuela	Greece
Default Year	2020	2020	2018	2017	2015
GDP (USD bn)	36	383	5	93	195
Growth rate last three years	(11.3)	(4.9)	0.9	(19.0)	(3.0)
Debt to GDP (last 3 years average)	165.0	91.8	100.3	181.0	173.0
Debt to Govt Revenue (last 3 years avg)	867.7	508.7	362.0	NA	361.0
Inflation year of default	146.0	36.1	0.6	863.0	0.4
Budget Deficit Average of last 3 years (% of GDP)	(9.8)	(5.8)	(4.5)	(15.0)	(7.5)
Trade Deficit Average of last 3 years (% of GDP)	(20.4)	(1.9)	(4.0)	(0.1)	(1.9)
Forex Reserve Position ($bn)	18.6	33.9	0.5	10.0	1.5
Currency per dollar	3500	84	2.0	10.0	0.9
Devaluation over last 3 years	132%	419%	-	-	21%

Conclusion

It’s not always easy to spot a sovereign treading a weaker path. It wont be easy to convince an audience as to why you think a sovereign that’s investment grade or considered too big to fail is actually at risk. Your best bet would be to focus on key critical variables and use it to drive down the message - import cover, FX stability, reserve adequacy and the component of public debt and also the ancillary debt and debt requirements of a sovereign (arising from the banking sector or SOEs). If you are convinced that the debt is affordable over your investment horizon, take the plunge, or stick to your convictions and hold your gun.

Cheers.