RBS' Sovereign Crisis Flow Pyramid
In a report "Predicting Sovereign Debt Crises: 2010 Update" RBS' Timothy Ash is the latest one to chime in on the sovereign risk theme, a topic that has been prevalent ever since Bernanke did the great private-to-public risk bait and switch, which in turn was followed to a great extent by all the countries in the world. Soon, in addition to a risk to the bottom in carry trades, and inflation expectations, we will see a risk acceleration, once countries realize the fringe benefits arising from being the first defaulting sovereign in a global moral hazard climate.
RBS provides a useful visual aid to see just which countries fall in what specific risk bucket based on a flow-chart analysis of soverign risk in various crteria. Here is the firm's opinion for 2009
And this is how they envision 2010's key risk actors:
RBS shares the following perspective on where the risk flaring will emerge. No surprise - Eastern Europe is still the hotbed of risk. A pity the Burj Dubai was not built in Romania.
Perhaps it will come as no surprise that the bulk of the economies identified as most vulnerable for both 2009 and 2010 (and indeed for 2007 and 2008 as per our previous analysis) are located in Emerging Europe. Indeed, the potential vulnerability of the region in the context of the current crisis is something that we have highlighted consistently over the past year.
Vulnerabilities in Emerging Europe essentially reflect years of gorging on cheap foreign credit, which fed wide current account deficits, and saw the accumulation of hefty stocks of external liabilities. Financing wide current account deficits and rolling over large external liabilities was not problematic when global markets were flush with liquidity between 2000 and 2007, but as liquidity tightened post the collapse of Lehman, these countries appeared increasingly vulnerable.
The adjustment process for many of these economies is nevertheless now in motion with current account deficits narrowing rapidly over the course of 2009, and REER depreciation of currencies where these are allowed to float significantly. However, many of the vulnerable countries have rigid exchange rate regimes, and as such the economies have not been able to adjust via this outlet, finding themselves hugely uncompetitive to regional floating peers. These economies are instead experiencing a huge deflation in domestic demand (so-called “domestic depreciation”) which in many respects is passing on the problem from one largely of private sector external indebtedness, to public finances, as recession weighs on budgets (cutting revenues), while the need to reign in spending just adds to the depth of the recession, arguably just increasing the chances of a sovereign debt crisis at some point in the future.
The fact that in our updated model, Hungary drops out of the “at risk” category in 2009, only to return in 2010, as does Romania, is perhaps somewhat surprising given that both economies were forced to secure emergency IMF financing, in response to the current global crisis. However, in both countries, their reduced vulnerability in 2009 partly reflects the impact of the IMF-imposed adjustment, as domestic demand deflated, narrowing the current account deficit and hence external financing requirement. The fact that they return to the “at risk” category in 2010 reflects that as they emerge from recession, current account deficits and external financing requirements re-widen, perhaps reflecting the structural nature of these deficits. It also suggests that given the shear scale of the problems, e.g. in Hungary, which suffers a very significant weight of public sector and external indebtedness (~80%% and 135% of GDP respectively) it will likely be a long run project to move them away from crisis mode on a more sustained basis. More generally this suggests the region will remain on watch for some time yet to come.
And some specific trading recommendations from RBS:
- Hungary 5Y CDS appears cheap at present, at around 237bps, against close to 280bps for Romania, and 230bps for Bulgaria. Hungary’s ratios (public and external debt/GDP) are much worse than either of these latter two credits. Romanian protection widened towards the end of 2009, amid concerns over political instability in the run up to Presidential elections, and in the immediate aftermath of these elections. However, with a new government now confirmed, and a budget for 2010 approved the outlook for the current year arguably looks much better; we do not think that Romania should trade with a 40bps discount to Hungary.
- Iceland’s ratios remain acutely onerous with its disproportionately sized banking sector continuing to weigh down the sovereign (see 2010 Key vulnerability data). Interestingly its ratios appear much worse than even those of Latvia, which still trades around 100bps wide (5Y CDS) to Iceland. This might suggest going long Iceland 5Y CDS against Latvia, which implies a positive carry. Arguably the size of the problem in Iceland is still disproportionately much larger than those of Latvia, which will weigh on the sovereign story for much longer to come.
- Despite its problems, Ukraine 5Y CDS at 1,200bps still seems too wide. It has been a crisis country, but given the light sovereign debt service schedule over the next year, strong support from official creditors (and even Russia these days) and a reasonable chance that the presidential elections will yield an improved policy environment, we think that at least investors are being more than paid for the risk. We would advise short Ukrainian protection.
- Both Russia and Turkey escape from the “at risk” category through the years 2007 – 2010 under the sovereign debt analysis above. Arguably Turkey has “out-performed” Russia through the current crisis, in terms of sovereign debt performance; pre-Lehman Turkey traded significant wide of Russia, but currently it trade s flat. Russia’s broader credit matrix remains significantly better than that of Turkey though, and as global markets continue to stabilise, “normal” service arguably should resume, with Russia trading through Turkey, likely by as much as 30-40bps this year. Rising political risks in Turkey (e.g. over Ergenekon) might well act for the catalyst for this normalisation process.
- In the GCC region, despite emerging from the “at risk” category in 2010, Qatar only trades 10bps wide of Saudi Arabia at present, at 100bps for 5Y CDS. This seems too tight, given Saudi Arabia’s much stronger credit matrix, while Qatar has recently “leveraged” up to boost its gas production/processing capability. Arguably in a scenario where political/security tensions in the region heighten (e.g. over Iran), Saudi Arabia has much deeper pockets to ride through such an eventuality, relative to Qatar. Thus, despite Qatar’s arguably improving credit matrix, protection seems cheap.
- Similarly, given its positioning in the “at risk” category, and its dire ratios still, Lebanese 5Y CDS trading at just 275bps looks perverse, and very cheap, albeit Gulf inflows to the local banking sector and indeed by providing a parallel bid for sovereign debt continues to provide an underpinning herein. We would probably recommend a punt, buying Lebanon 5Y protection outright herein.
As always, the mother of all risk trades continues to be USA CDS. With financial, political and philosophical (who pays out if and when the US defaults) considerations, this will be the number one spread to watch in 2010 in the sovereign risk arena.