Not surprising, sovereign credit risk has increased with the global economic crisis. We have seen an increase in downgrades most recently with the credit watch of a number of EU countries. The macro fundamentals that measure sovereign risk have started to move to indicate increased risks.
Sovereign risk will become increasingly important in the currency markets. The deterioration of credit risk carries over to currency markets. Increased risk lead to capital outflows and depreciation. Our own research suggests that sovereign risks increase in importance when there is a turning point in business cycles especially for the case of a downturn. The behavior of sovereign risks is non-linear or rests on thresholds which are the reason why we favor conditional forecasting. The risk will not be an issue until it hits a threshold.
This is similar to what some IMF economists have called the rules of thumb approach. See “Rules of Thumb” for Sovereign Debt Crises by Paolo Manasse and Nouriel Roubini. In this paper, Manasse and Roubini use the Binary Recursive Trees approach to help identify risk situations. The Binary approach tries to find conditional breaks or classifications in the data which suggest what are the conditions for risky sovereign debt. A set of conditions or factors are necessary at specific levels or thresholds to trigger sovereign risk situations. Finding the critical values for a set of macrovariables allows for the determination of safe versus risky sovereign debt and currency situations basedon trigger or conditional values.
Safe countries with minimal risk would be those that have a set of economic conditions which include low total external debt, low short-term debt, low public external debt and an exchange rate that is not overvalued. The risky sovereign environments can be classified as those that have debt unsustainability, illiquidity, or macroexchange rate risks. In the first case, high external debt above 50% of gdp with monetary and fiscal imbalances as well as large external financing needs make for a risky situation. Illiquidity risks are characterized by high short term debt in excess of 10 percent of reserves with political uncertainty and tight international capital markets. The macroexchange risk comes from low growth and fixed exchange rates.
Unfortunately we are having a number of emerging market countries that are falling into the illiquid and debt unsustainable conditions. Reserves are falling for a number of countries so short-term debt as a percentage of reserves is rising. External debt and total debt levels are also increasing with the growth of fiscal imbalances. The table hows that foreign exhange reserves have been falling fast for some countries. We are watching for these trigger points because there will be greater risk differentiation across countries as this crisis continues.
Sovereign risk will become increasingly important in the currency markets. The deterioration of credit risk carries over to currency markets. Increased risk lead to capital outflows and depreciation. Our own research suggests that sovereign risks increase in importance when there is a turning point in business cycles especially for the case of a downturn. The behavior of sovereign risks is non-linear or rests on thresholds which are the reason why we favor conditional forecasting. The risk will not be an issue until it hits a threshold.
This is similar to what some IMF economists have called the rules of thumb approach. See “Rules of Thumb” for Sovereign Debt Crises by Paolo Manasse and Nouriel Roubini. In this paper, Manasse and Roubini use the Binary Recursive Trees approach to help identify risk situations. The Binary approach tries to find conditional breaks or classifications in the data which suggest what are the conditions for risky sovereign debt. A set of conditions or factors are necessary at specific levels or thresholds to trigger sovereign risk situations. Finding the critical values for a set of macrovariables allows for the determination of safe versus risky sovereign debt and currency situations basedon trigger or conditional values.
Safe countries with minimal risk would be those that have a set of economic conditions which include low total external debt, low short-term debt, low public external debt and an exchange rate that is not overvalued. The risky sovereign environments can be classified as those that have debt unsustainability, illiquidity, or macroexchange rate risks. In the first case, high external debt above 50% of gdp with monetary and fiscal imbalances as well as large external financing needs make for a risky situation. Illiquidity risks are characterized by high short term debt in excess of 10 percent of reserves with political uncertainty and tight international capital markets. The macroexchange risk comes from low growth and fixed exchange rates.
Unfortunately we are having a number of emerging market countries that are falling into the illiquid and debt unsustainable conditions. Reserves are falling for a number of countries so short-term debt as a percentage of reserves is rising. External debt and total debt levels are also increasing with the growth of fiscal imbalances. The table hows that foreign exhange reserves have been falling fast for some countries. We are watching for these trigger points because there will be greater risk differentiation across countries as this crisis continues.
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