Mapping Sovereign Risk BlackRock Sovereign Risk Index BlackRock Investment Institute FOR PROFESSIONAL CLIENTS / QUALIFIED INVESTORS ONLY
Notions of safety have been rocked Implied probabilities of default Some developed market sovereigns have behaved have ballooned like (bad) structured credit Source: Standard and Poor‟s and IMF staff estimates Note: For each country, the implied probabilities of default Source: CIRA are estimated from its observed CDS spreads. The probabilities of default shown here are averages for countries whose ratings fall within specific S&P rating ranges FOR PROFESSIONAL CLIENTS / QUALIFIED INVESTORS ONLY 2
Markets have been dominated by exceptional policy actions … Source: CIRA FOR PROFESSIONAL CLIENTS / QUALIFIED INVESTORS ONLY 3
… making for a very different investing landscape (until recently) Interactive Version FOR PROFESSIONAL CLIENTS / QUALIFIED INVESTORS ONLY 4 Interactive Version
Fiscal Austerity = social unrest Source: “Austerity and Anarchy: Budget Cuts and Social Unrest in Europe, 1919 - 2009”; Jacopo Ponticelli and Hans-Joachim Voth; Centre for Economic Policy Research Note: CHAOS is the sum of demonstrations, riots, strikes, assassinations, and attempted revolutions in a single year in each country. FOR PROFESSIONAL CLIENTS / QUALIFIED INVESTORS ONLY 5
Austerity can work – IF there’s external growth FOR PROFESSIONAL CLIENTS / QUALIFIED INVESTORS ONLY 6
Monetary policy: the path of least resistance (and effect) FOR PROFESSIONAL CLIENTS / QUALIFIED INVESTORS ONLY 16 June 2011 7
The BlackRock Sovereign Risk Index (BSRI) Interactive Version FOR PROFESSIONAL CLIENTS / QUALIFIED INVESTORS ONLY 8
BlackRock Sovereign Risk Index: Key Ingredients Fiscal Space 40% Willingness to Pay 30% External Finance Position 20% Financial Sector Health 10% FOR PROFESSIONAL CLIENTS / QUALIFIED INVESTORS ONLY 9
Sovereign Risk Index : Fiscal Space Fiscal Space (40% weight) Proximity to Distress • The accumulated liabilities of a sovereign in relation to the size of its economy is a starting point, but to determine proximity-to- distress we must also have a notion of each country‟s palatable debt limit. Idiosyncratic factors, such as reserve currency status, have a significant impact on this limit • Bond markets are historically less concerned by countries with higher productivity per capita, and in contrast are likely to become uncomfortable with debt burdens at lower levels in entities with unsteady track-records for growth (and hence revenue streams), and for keeping inflation under control • Similarly, the „breaking point‟ can be expected to be lower in countries anticipating greater demographic burdens, higher where sovereign debt enjoys a strong domestic base • Tailoring notional limits by these factors, we determine the time-to-distress at current forecasts of the burn rate of Budget Deficits Distance from Stability • This measure gauges the required structural adjustment needed for the country to achieve a stable and palatable Debt/GDP level over an arbitrary 10 year period, using consensus projections 10
Sovereign Risk Index : Willingness to Pay Willingness to Pay (30% weight) Institutional Integrity and Stability • Default by regime-change, or impairments arising from fraudulent national accounts are examples of qualitative risks that are well-reflected in quantitative ordinal data sourced to the World Bank, Euromoney and Political Risk Services Group • Subcomponents of our composite assess changes to bureaucracy quality, contract viability, corruption, democratic accountability, government cohesion and stability, law and order, legislative strength, and other political risks with a monthly frequency 11
Sovereign Risk Index : External Finance External Finance Position (20% weight) Current Account Deficit as a % of GDP • In very general terms, net importers of goods tend to be net issuers of liabilities. The bigger the import ratio of a country, the more vendor financing it is likely to require, and therefore the more prone it might be to building up a large debt load External Debt vs Foreign Currency Reserves • Governments cannot “print money” to finance non -domestic debt, which means that it must be paid out of FX reserves or current income at spot exchange rates. Exposure to foreign currency liabilities includes the contingent liability of net external debt issuance of the financial sector Maturity Structure of External Debt • The degree to which external debt must be serviced in the near-term is of particular consideration, as rollover risk can exacerbate problems for a currency in difficulties. The interest and principal exposures over the 2 year horizon as a proportion of total external debt complements the solvency indicator above 12
Sovereign Risk Index : Financial Sector Health Financial Sector Health (10% weight) Financial Sector Debt as a % of GDP • Assuming that an over-stretched domestic private sector can be a contingent liability of the state, its size relative to the sovereign presents the scale of the potential burden Capital Adequacy Ratio, • The total capital of the banking system expressed as a percentage of its risk-weighted credit exposures; based on Basel rules and including Tier 2 capital. Sourced to Fitch, the caveat that bank financial and regulatory reporting varies widely across jurisdictions is well-flagged Banking Sector Risk • Composite drawn from bottom-up analyses of domestic banks from Moodys and Fitch, and current non- performing loans as a % of total loans Credit Bubble Risk • If the growth of domestic in recent years far-outpaces the general economic growth over the same period, this can be indicative of overly-loose credit standards and poor lending practices 13
Initial Work on the BlackRock Sovereign Risk Index Comparison With Sovereign CDS highlighted Italy’s BSRI Profile (06/2011) a strong cross-secti o nal relationship Source: BlackRock, CDS from Bloomberg (18 th June 2011) “Taking these points into consideration, we believe that Italy may be a case where markets are too sanguine about sovereign risks, and would be inclined to be defensive on this market within an index.” Introducing the BlackRock Sovereign Risk Index, (June 2011) FOR PROFESSIONAL CLIENTS / QUALIFIED INVESTORS ONLY 14
Backtesting the BlackRock Sovereign Risk Index Eurozone Periphery 1 , Ratings vs BSRI Eurozone Periphery 1 , CDS vs BSRI Source: BlackRock, Standard & Poor‟s, Moody‟s, Fitch Source: BlackRock, Bloomberg (1) Eurozone „periphery‟ includes Greece, Ireland, Portugal, Italy and Spain Note: Backtest only uses unrevised data that was available at the time. FOR PROFESSIONAL CLIENTS / QUALIFIED INVESTORS ONLY 15
BSRI time series: case study Ireland 12 -1.2 1.5 BlackRock Sovereign Risk Score : Ireland 11 -1.0 1.0 Ireland Component Zscores Ireland Average Rating Bucket 10 -0.8 0.5 9 -0.6 (Zscore, Inverted) 8 0.0 -0.4 7 -0.5 6 -0.2 -1.0 5 0.0 4 -1.5 0.2 3 0.4 -2.0 2 0.6 -2.5 1 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 0 0.8 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Fiscal Space Score Health of External Finance Score Financial Sector Health Score Willingness to Pay Score Ireland Average Rating Bucket BlackRock Sovereign Risk Score : Ireland Source: BlackRock Model-Based Fixed Income Agency From To Date The contingent liabilities represented by the credit bubble in S&P AAA AA+ Mar-2009 Fitch AAA AA+ Apr-2009 Ireland take pole position in December 2008, an early warning S&P AA+ AA Jun-2009 Moodys AAA AA1 Jul-2009 from banking metrics available at the time, of what would later Fitch AA+ AA- Nov-2009 Moodys AA1 AA2 Jul-2010 follow. S&P AA AA- Aug-2010 Fitch AA- A+ Oct-2010 S&P AA- A Nov-2010 While Ireland’s distress is characterised by its banking Fitch A+ BBB+ Dec-2010 Moodys AA2 BAA1 Dec-2010 weakness, the other components of the index also deteriorated S&P A A- Feb-2011 S&P A- BBB+ Apr-2011 over the backtest period. Moodys BAA1 BAA3 Apr-2011 Moodys BAA3 BA1 Jul-2011 Average rating bucket calculated mapping ratings to an ordinal structure, (e.g. AAA = 1; AA1 = 2 ; AA2 = 3; through to 25) 16
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