ECONOMICS RESEARCH

9 September 2010

OUR MEASURE OF FISCAL VULNERABILITY A systematic global approach

We introduce our Fiscal Vulnerability Index, which aggregates comparable metrics on government solvency, external and fiscal financing needs, financial sector health and institutional quality across a sample of 47 countries in various stages of development into a single index of fiscal strength and weakness. Our index suggests that most developed economies in our sample are more fiscally vulnerable than emerging economies. Not surprisingly, the euro area periphery countries such as Portugal, Italy, Ireland, and, notably, Greece, stand out for their challenging solvency indicators in the developed world. Germany is the only large developed country that ranks in the top 25%. Solvency and lower external financing dependence indicators are the two main sources of differentiation among developed economies, while the quality of institutions is key in keeping several developed economies such as the US, UK, and Japan from dropping below the middle of the ranking table. We also find that advanced emerging economies rank much better than non-advanced countries, mostly because of a better combination of institutional strength and government solvency. Indeed, Hong Kong, Singapore, Korea, Chile, Taiwan, and South Africa rank at the top of our measure of fiscal strength. We argue that our Fiscal Vulnerability Index is a useful tool for assessing the fiscal strengths and weaknesses of governments around the world. Indeed, together with a simple measure of market bid for government bonds, the index explains 70% of the wide cross-sectional variation observed in 5y CDS around the world. Figure 1: The world according to our Fiscal Vulnerability Index
0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 HKG SGP KOR CHL TWN GER ZAF CZE MYS URY CHN ARG RUS PER MEX BRA IDN THA BGR USA ISR GBR EUR JPN TUR PHL IND PAN FRA COL POL ESP DOM VEN SRB HUN SLV TUN PRT ROU ITA LTU IRL EGY UKR VNM PAK GRC Developed Advanced EM EM Weaker Stronger

Piero Ghezzi +44 (0) 20 3134 2190 piero.ghezzi@barcap.com Christian Keller +44 (0) 20 7773 2031 christian.keller@barcap.com Jose Wynne +1 212 412 5923 Jose.Wynne@barcap.com

Fiscal vulnerability

Source: Barclays Capital

PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 21

Barclays Capital | Fiscal Vulnerability Scorecard

Our approach to assessing fiscal vulnerability

We expand our analysis of the euro-area periphery countries

to include advanced and emerging market countries

Since the emergence of problems in Greece and euro area periphery, markets have increasingly focused on indentifying public debt-related vulnerabilities. In Euro area periphery: Implications of the EUs mega package (12 May 2010), we proposed a set of indicators to address the issue, but limited our focus to the euro area periphery. While fundamental debt dynamics remain the central focus of attention (as detailed in Greeces adjustment challenge, 15 February 2010), we argue that a broader set of factors that indirectly affect a countrys fiscal strength should also be part of any fiscal vulnerability toolkit. Naturally, relevant comparisons across countries span several dimensions. This report elaborates on this idea and proposes a systematic method of aggregating relevant country characteristics to assess fiscal vulnerabilities in advanced and emerging economies. In generating the scorecard, we focus on five areas: 1. Solvency (i.e., basic debt dynamics) 2. Fiscal financing needs and debt composition 3. External financing dependence 4. Financial sector health 5. Institutional strength

Our framework accounts for differences in institutional strength

We introduce institutional strength as a new category since our analysis of the euro-area periphery. Countries with a history of reliable institutions and good governance are more likely to be able to sustain higher debt levels and muster the political support necessary to undertake fiscal adjustments. Its inclusion is motivated by the fact that countries with higher income per capita sustain higher levels of public debt-to-GDP ratios (Figure 2). Indeed, institutions account for a significant part of the dispersion in countries development stages, not only within the relatively homogeneous euro periphery countries (e.g., Portugal versus Spain), but also among G3 and EM countries (e.g., Germany versus Indonesia).

Figure 2: Richer countries tend to be able to sustain higher debt

140.0 Gross Public Debt, % GDP (2010F) 120.0 100.0 Hungary 80.0 60.0 40.0 20.0 0.0 0 10000 20000 30000 GDP-per-capita 40000 50000 60000 India Turkey Portugal UK France Germany US Ireland Greece y = 0.0013x + 26.159 Italy R = 0.4588
2

Spain Poland Colombia Brazil Mexico Indonesia South Africa Czech Republic Korea Chile China Russia

Source: Eurostat, IMF, Barclays Capital

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Barclays Capital | Fiscal Vulnerability Scorecard

We assign equal weights across our main categories, in line with our flat priors

Our indicators draw in part from the literature on fiscal sustainability, sovereign debt crises, and early warning systems (EWS), which includes much empirical work. 1 While we tried different weights, we found that a rather simplistic assumption of flat priors on weights works to produce a meaningful Fiscal Vulnerability Index according to current 5y CDS prices, as discussed in detail below. Because finding optimal weights for the five categories within the Fiscal Vulnerability Index resulted in surprisingly similar coefficients across categories, we decided to adopt equal weights. Figure 3 summarizes the variables and respective weights used in the Fiscal Vulnerability Index. While we think that the index provides strong signals for credit markets, we agree with earlier conclusions by the IMF that identifying danger zones is still more an art than a science, with a large element of judgement required. 2

Figure 3: Inputs to our fiscal vulnerability measure (and their weights)

Weights 20% 75% Indicators 1. Solvency (i.e., basic debt dynamics) Distance to sustainable level In our previous research on Greece and the euro area periphery, we calculated the accumulated adjustment in the primary fiscal balance over the next five years needed to achieve a government debt-to-GDP ratio of 60% by 2050 for each country. In its Fiscal Monitor from May, the IMF uses a similar approach, calculating the adjustment needed in a countrys cyclically adjusted primary fiscal balances in 2010-20 to bring debt-to-GDP ratios to 60% in advanced economies and 40% in EM economies by 2030, with the difference in thresholds reflecting lower debt tolerance in EM economies. Our approach uses elements of both but simplifies calculations to facilitate updating our large set of countries. First, we chose sustainable government debt-to-GDP benchmarks of 40% for EM and 60% for advanced economies, in line with the IMF. We give the US and Japan a higher threshold of 90%, in part reflecting their safe haven status. Second, we calculate the distance between that sustainable debt ratio and the actual debt-to-GDP ratio (distance to sustainable level), using public debt held outside the public sector in the case of Japan. We measure the required primary balance adjustment needed to stabilize debt-to-GDP at current levels. We use primary balance adjustment in percent of government revenues as a gauge for the achievability of such an adjustment. This also indicates the pace at which the debt-to-GDP ratio is moving toward or away from the sustainable level. In addition, we calculate the primary fiscal balance adjustment needed in a country to keep the debt-to-GDP ratio stable at current levels. See Appendix A for a detailed discussion. We use a combination of the fiscal balance and the duration (weighted average) of government bonds as a proxy for governments gross financing requirements (i.e., borrowing needs and potential rollover pressure). The share of debt not denominated in local currency is a proxy for government FX exposure. We increased the foreign currency exposure to Greece, Ireland and Portugal to 50%, as we expect them to have little influence on weakening the EUR in times of domestic fiscal stress. France and Germany were assigned 25% weights to FX exposure, as they are expected to have more influence on ECB monetary policy in response to stressful domestic fiscal events. For the final measure of fiscal financing needs and debt composition, we use an equally weighted average of the three. This combination of external exposure inputs is an indicator of dependence on foreign capital inflows and how effectively a country can cover its external debt servicing needs through exports. Comment

25%

Required primary balance adjustment (% of public revenues) needed to achieve stable debt/GDP ratio

20% 33%

2. Fiscal financing needs and debt composition Fiscal balance (average 2010-11)

33% 33% 20% 50% 50% 20% 33% 33% 33% 20% 100%

Average duration of government bonds Share of debt denominated in local currency 3. External financing dependence Forecast 2010 current account balance External debt divided by last 12 months of exports 4. Financial sector health Capital adequacy ratio NPLs as % of total loans Loans-to-deposit ratio 5. Institutional strength Six World Bank governance indicators, each with equal weight

These three main indicators of banking system health reflect liquidity, asset quality, and wholesale funding dependence, respectively.

We use these to take into account a countrys stage of development and the reliability of its institutions, measured in terms of the following six World Bank governance indicators: 1) voice and accountability, 2) political stability and absence of violence, 3) government effectiveness, 4) regulatory quality, 5) rule of law, and 6) control of corruption.

Source: Barclays Capital. Please refer to Figure 16 for the sources of the indicators which form our inputs.

1 2

For literature, see Appendix; eg, Manasse, Roubini, Schimmelpfennig (2003). IMF World Economic Outlook, September 2003.

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Barclays Capital | Fiscal Vulnerability Scorecard

BOX: Calculating z-scores We use z-scores to compare countries categories and the overall Fiscal Vulnerability Index described in Figure 1, whereby the standard score (z) is: z = (x- ) / ; and x is the raw category data to be standardized, is the populations mean of the respective indicator, and its standard deviation. That is, z represents the distance between the raw score and the population mean in units of standard deviation. For some z-scores, we use the negative to ensure that directionality is consistent with the characteristic of the indicator the NPLs-to-total loans zscore, for example. We then calculate a weighted average to give five category z-scores. Finally, we assign weights to the categories themselves and compute a weighted average to form an overall fiscal vulnerability z-score according to: Final z-score = a.Z(1) + b.Z(2) + c.Z(3) + d.Z(4) + (1-a-b-c-d).Z(5) This is repeated across all countries, with the scores then simply ranked to provide an overall score table, whereby higher scores indicate fiscal strength and lower scores fiscal weakness.

Figure 4 shows the z-scores for each major category, ranked according to the overall Fiscal Vulnerability Index. Notice that all indicators, from solvency to institutional strength, have a positive correlation with the final fiscal vulnerability score. In other words, all categories contribute to the final index, as intended. Now, what do the 16 subcomponents of these indicators have to say about the sources of fiscal strength and weakness globally?

Figure 4: Distribution of final z-scores for public debt-related vulnerabilities (in descending order)
0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 HKG SGP KOR CHL TWN GER ZAF CZE MYS URY CHN ARG RUS PER MEX BRA IDN THA BGR USA ISR GBR EUR JPN TUR PHL IND PAN FRA COL POL ESP DOM VEN SRB HUN SLV TUN PRT ROU ITA LTU IRL EGY UKR VNM PAK GRC
Source: Barclays Capital

Fiscal vulnerability
Stronger

Developed Advanced EM EM Weaker

Main lessons from our Fiscal Vulnerability Index categories

Solvency and external financing dependence, rather than institutions, drive the large differentiation on fiscal strength among developed economies

Within the group of developed economies that we examine, solvency and external financing dependence, rather than institutions, seem to drive differentiation in the Fiscal Vulnerability Index. Euro area laggards such as Portugal, Italy, Ireland, and, notably, Greece, stand out for their challenging solvency indicators in the developed world, in sharp contrast to France and Germany. While the euro area in aggregate looks similar to the US (Figure 5.b), our fiscal vulnerability approach shows stark intra-regional differences in solvency, fiscal financing needs, external financing dependence, and banking system health (Figure 5.d).

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Barclays Capital | Fiscal Vulnerability Scorecard

Institutions keep several developed economies such as the US and Japan from falling below the mid-range of the ranking, where they currently stand

Institutions are key in keeping several developed economies such as the US, the UK, and Japan from dropping below the middle of the ranking table. Indeed, because of their high debt-to-GDP ratios, both the US and Japan would have scored worse had we not given them a higher debt sustainability threshold of 90% to account for their safe-haven status. These countries have issued all of their public debt in local currency, and their interest rates tend to fall in times of global or domestic turmoil. 3 The low score on our Fiscal Vulnerability Index driven by fundamentals means that the US and Japan are now much more reliant on the markets respect for solid institutional frameworks to retain their safe haven status. Interestingly, institutions also explain the large contrast between solvent emerging and more fiscally vulnerable developed nations such as China and the US, as highlighted in Figure 5.a. The combination of good institutions and government solvency places advanced emerging countries such as Hong Kong, Singapore, Korea, Chile, Taiwan, and South Africa at the top of our ranking of fiscal strength (see Advanced Emerging Markets (AEM): The list, 17 December 2009, for a full analysis of AEM characteristics). They benefit from low initial debt ratios, robust growth forecasts, strong external balances, and relatively robust financial sectors. Among our selected sample of developed countries US, Japan, UK, Germany, France, and the euro area periphery countries Germany is the only one in the top quartile, with relatively solid indicators across the board. Also notice that the BRICs display significant disparities in our index (Figure 5.e). China and Russia appear relatively robust although less strong than most of the smaller advanced EMs driven by their low initial debt ratios. Brazil is still in the upper half of the distribution, whereas Indias relatively poor result is driven by its comparatively higher debt stock, significant primary adjustment, and large financing needs. Interestingly, institutions again play a determinant role in differentiating fiscal vulnerabilities among advanced and non-advanced emerging markets and between advanced and emerging markets (Figure 5.a). While interesting themes emerge from the differentiation in selected categories, the overall Fiscal Vulnerability Index provides strong signals for assessing fiscal strength.

Advanced emerging countries rank at the top of our Fiscal Vulnerability Index

The Index highlights stark differences within BRICs, with China and Russia stronger and Indias fiscal stance weaker

Our additional adjustment for market bid which we discuss later further helps the US and Japan in this regard

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Barclays Capital | Fiscal Vulnerability Scorecard

Figure 5: Larger area indicates less vulnerability a) US versus China: Stark asymmetries
United States China Solvency 1.50 0.50 Institutional strength -0.50 -1.50 External fin. Dependence Institutional strength

b) US versus euro area: A similar web

United States Solvency 1.50 0.50 -0.50 -1.50 External fin. Dependence Euro area

Financial sector health

Fiscal financing needs & debt composition

Financial sector health

Fiscal financing needs & debt composition

c) US versus Japan: Solvency versus external dependency

United States Japan Solvency 1.25 0.25 Institutional strength -0.75 -1.75 -2.75 External fin. Dependence

d) Euro periphery: Greece weakness stands out

Greece Ireland Italy Portugal Spain Institutional strength

Solvency 1.25 0.25 -0.75 -1.75 -2.75 External fin. Dependence

Financial sector health

Fiscal financing needs & debt composition

Financial sector health

Fiscal financing needs & debt composition

e) BRICs: Similar tilt but significant differences

Brazil Solvency 1.1 0.6 0.1 -0.4 -0.9 -1.4 Russia India China External fin. Dependence

f) Advance EM: Institutions and solvency, sources of strength

Institutional strength

Institutional strength

Solvency 1.1 0.6 0.1 -0.4 -0.9 -1.4

Chile Korea Czech Republic External fin. Dependence

Financial sector health

Fiscal financing needs & debt composition

Financial sector health

Fiscal financing needs & debt composition

Source: Please refer to Figure 16

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Barclays Capital | Fiscal Vulnerability Scorecard

The Fiscal Vulnerability Index, a key driver of 5y CDS

Our Fiscal Vulnerability Index is highly correlated with 5y CDS

We find that our simple measure of fiscal strength goes a long way toward explaining the wide cross-sectional variation in 5y CDS spreads. Figure 6 shows the negative correlation between 5y CDS spreads and the Fiscal Vulnerability Score for our sample of 47 developed and emerging economies. Ignoring a few outliers, the sample exhibits a strong negative correlation between fiscal vulnerability and 5y CDS spreads (-0.57). Credits such as the US, the UK, Italy, and Germany stand on the low (expensive?) side of the cross-sectional spectrum, as opposed to credits such as Venezuela and Argentina. Greece, Spain, Portugal, and the BRICs appear harder to categorize.

Figure 6: 5y CDS, highly correlated with our Fiscal Vulnerability Index

1200 VEN 1000 GRC 5Y CDS 800 600 UKR IRL VNM EGY ITA -1.0 -0.8 -0.6 -0.4 -0.2 ROU HUN SRB 400 PAN ESP FRA BGR PER PHL RUS CZE CHL KOR 200 BRA TUR IND TWN ZAF SGP GBR IDNMEX MYS GER 0 JPN USA THA 0.0 0.2 0.4 0.6 Fiscal vulnerability ARG

PAK

SLV PRT

HKG 0.8 1.0

Source: Please refer to Figure 16

Yet we expect capital markets to condition the ability of sovereigns to borrow in difficult times, independently of their Fiscal Vulnerability Score

In spite of the strong informational content of our fiscal indicator, we expect market differentiation across our sample to go beyond our Fiscal Vulnerability Index. US dollar and Treasury yields tend to rally when the global or US domestic environment deteriorates, providing the government with a large and deep borrowing platform in difficult times. Japanese government assets also display similar patterns, even at times when markets strongly discriminate against some emerging credits with a decent fiscal stance.

A measure of market bid for sovereign bonds

To complement our systematic approach to fiscal strength, we come up with a measure of market bid for government bonds in difficult times

To complement our systematic approach, we estimate the sensitivity of the 5y US dollar rates paid by sovereigns to fluctuations in S&P500 as a measure of the market bid for government bonds. When markets fall on global growth concerns, 5y US Treasury yields tend to rally and the US benefits from lower funding cost and a large demand for bonds (or deep capital markets). In contrast and despite the 5y US Treasury yield rally, 5y USD bonds in emerging markets with limited access to capital tend to rise, driven by higher defaultperceived risk and less appetite for holding debt. We estimate the sensitivity of 5y US dollar rates by regressing 5y US dollar synthetic rates for each sovereign against the S&P500 Index over the past three years. The last column in Figure 15 shows the betas of interest rates paid by sovereigns against the S&P500 Index. Figure 7 shows the negative correlation of our measure of market bid (betas) against 5y CDS (-0.75).
7

Then, we use our fiscal vulnerability measure and our measure of market bid in a model predictor of 5y CDS

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Barclays Capital | Fiscal Vulnerability Scorecard

Figure 7: Market bid for government bonds also seems to drive 5y CDS
GRC 800 700 600 5Y CDS 500 SRB ROU BGR RUS -0.50 -0.40 IDN HUN SLV 400 300 IRL THA VNM ZAF ITA 200 COL TUR ISR MEX POL MYS TWN 100 KOR PER BRA CHN 0 CHL PAN -0.20 -0.10 0.00 0.10 Market bid for government bonds PRT ESP LTU PHL IND USA 0.30 0.40 0.50 JPN HKG LBN

EGY URY

-0.30

GBR SGP FRA GER 0.20

Source: Please refer to Figure 16

Explaining the cross-sectional variation of 5y CDS

Our Fiscal Vulnerability Index and a simple measure of market bid help explain 70% of the wide cross-sectional variation of 5y CDS around the world

When combined with the above measure of market bid, our Fiscal Vulnerability Index manages to explain 70% of the cross-sectional variations in 5y CDS. To understand the role of our fiscal vulnerability indicator in explaining observed 5y CDS spreads across our sample of 47 countries, we estimate a model of credit default swaps by regressing 5y CDS against a linear and a quadratic term on our fiscal index, as well as our constructed measure of market bid. Both indicators turn out to be significant and with the expected signs (see details in Appendix B). Figure 8 shows the fitted model versus actual 5y CDS for our cross-sectional universe of developed and emerging economies. The goodness of fit is most striking if one considers that fundamentals (i.e., as the main determinant of default probabilities) are only one of the drivers of CDS, particularly at low levels, where technical factors are normally more important.

Our model suggest that the US, the UK, France, and Japan look expensive, with Germany and Ireland fair and Spain and Portugal cheap within the developed world

Among the developed world, 5y CDS levels for the US, the UK, France, and Japan look somewhat tight relative to our model, with Germany and Ireland fair and Spain and Portugal wide. The measures of fiscal strength/weakness for the US, the UK, France, and Japan look worse than currently priced by the market, but their safe haven status and, therefore, the large and deep bid for government bonds in turbulent times partially compensate. The balance of fiscal strength and market bid for Spain and Portugal suggest that actual 5y CDS levels are too wide according to our simple model of CDS.

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Barclays Capital | Fiscal Vulnerability Scorecard

Figure 8: Fiscal vulnerability and a measure of market bid explain 70% of the cross-sections variations in 5y CDS
1100 1000 900 800 700 600 500 400 300 200 100 0 ARG BRA CHL CHN COL CZE EGY FRA GER GRC HKG HUN IND IDN IRL ISR ITA JPN KOR MYS MEX PER PHL POL PRT ROU RUS SGP ZAF ESP TWN THA TUR GBR USA VEN BGR DO SLV LBN LTU PAK PAN SRB TUN UKR URY VN
Source: Please refer to Figure 16

Model 5Y CDS

The model and our measure of fiscal vulnerability also provide some strong buying and selling views among high yielders

Among the high yielders, Venezuela and Greece look stronger than priced by 5y CDS, Argentina and Pakistan about the same, and Serbia worse. Notice that the solid fiscal stances of Argentina and Pakistan are offset by the low market bid for government bonds in difficult times. In contrast, the rather weak fiscal stance of Lebanon is compensated by a lower beta of government bonds to global markets. Venezuelas strong fiscal position and limited negative market bid suggest that, overall, the credit is stronger than priced by the market. The case of Greece is harder to read but instructive. Despite being the most fiscally vulnerable country in our sample, Greeces current CDS levels look wide relative to model predictions. This is explained by a measure of market bid that is calculated over a longerthan-relevant sample, hence not capturing the structural change that recently took place in the market bid for Greek bonds. This highlights the unavoidable element of circularity that may lead to instability in our predictions. The fair CDS spreads of the US and Japan are helped by their status as safehaven or reserve currencies. If the market perceives that those currencies are no longer safe, a worse market bid measure would be expected, leading CDS to trade wider according to our model. While the empirical model accommodates this sort of jump, the predictions of fair CDS levels hold true only for a given measure of market bid. Because this measure comes from forward-looking market perceptions and they are subject to change, the model predictions are sensitive to sudden jumps. In other words, the model does not explain where these perceptions come from, limiting the predictive power of our CDS model. This is, indeed, what we believe happened with Greece at the end of last year. We think these sorts of jumps are less likely in countries that keep fiscal vulnerability at bay. Beyond these caveats, we find that the Fiscal Vulnerability Index alone explains 47% of the cross-sectional variation in 5y CDS. We think this indicates that our equal weighting across the five main categories, as well as the subcomponent weightings within, provides a useful metric for assessing fiscal vulnerability.

The case of Greece highlights an important feature of the 5y CDS Model

Market perceptions are subject to change

making the model predictions subject to sudden jumps although these should be less likely under fiscal strength Our Fiscal Vulnerability Scores are a useful comparative metric to assess fiscal strength around the world

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Barclays Capital | Fiscal Vulnerability Scorecard

Figure 9: Overall fiscal vulnerability ranking

Fiscal vulnerability
0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0 -1.2 HKG SGP KOR CHL TWN GER ZAF CZE MYS URY CHN ARG RUS PER MEX BRA IDN THA BGR USA ISR GBR EUR JPN TUR PHL IND PAN FRA COL POL ESP DOM VEN SRB HUN SLV TUN PRT ROU ITA LTU IRL EGY UKR VNM PAK GRC LBN Developed Advanced EM EM Weaker Stronger

Figure 10: Solvency ranked by overall fiscal vulnerability

Solvency
1.1 0.6 0.1 -0.4 -0.9 -1.4 -1.9 -2.4 -2.9 -3.4 HKG SGP KOR CHL TWN GER ZAF CZE MYS URY CHN ARG RUS PER MEX BRA IDN THA BGR USA ISR GBR EUR JPN TUR PHL IND PAN FRA COL POL ESP DOM VEN SRB HUN SLV TUN PRT ROU ITA LTU IRL EGY UKR VNM PAK GRC LBN Developed Advanced EM EM Weaker Stronger

Figure 11: External financing dependence ranked by overall fiscal vulnerability

2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 -3.0 Developed Advanced EM EM HKG SGP KOR CHL TWN GER ZAF CZE MYS URY CHN ARG RUS PER MEX BRA IDN THA BGR USA ISR GBR EUR JPN TUR PHL IND PAN FRA COL POL ESP DOM VEN SRB HUN SLV TUN PRT ROU ITA LTU IRL EGY UKR VNM PAK GRC LBN
Source: Barclays Capital

External financing dependence

Stronger

Weaker

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Barclays Capital | Fiscal Vulnerability Scorecard

Figure 12: Fiscal financing needs and debt composition ranked by overall fiscal vulnerability

Fiscal financing needs & debt composition

1.0 0.5 0.0 -0.5 -1.0 -1.5 HKG SGP KOR CHL TWN GER ZAF CZE MYS URY CHN ARG RUS PER MEX BRA IDN THA BGR USA ISR GBR EUR JPN TUR PHL IND PAN FRA COL POL ESP DOM VEN SRB HUN SLV TUN PRT ROU ITA LTU IRL EGY UKR VNM PAK GRC LBN Developed Advanced EM EM Weaker Stronger

Figure 13: Financial sector health ranked by overall fiscal vulnerability

Financial sector health

1.0 0.5 0.0 -0.5 -1.0 -1.5 HKG SGP KOR CHL TWN GER ZAF CZE MYS URY CHN ARG RUS PER MEX BRA IDN THA BGR USA ISR GBR EUR JPN TUR PHL IND PAN FRA COL POL ESP DOM VEN SRB HUN SLV TUN PRT ROU ITA LTU IRL EGY UKR VNM PAK GRC LBN Developed Advanced EM EM Weaker Stronger

Figure 14: Institutional strength ranked by overall fiscal vulnerability

Institutional strength
1.4 Stronger 0.9 0.4 -0.1 Developed -0.6 -1.1 -1.6 HKG SGP KOR CHL TWN GER ZAF CZE MYS URY CHN ARG RUS PER MEX BRA IDN THA BGR USA ISR GBR EUR JPN TUR PHL IND PAN FRA COL POL ESP DOM VEN SRB HUN SLV TUN PRT ROU ITA LTU IRL EGY UKR VNM PAK GRC LBN
Source: Barclays Capital

Advanced EM EM Weaker

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Figure 15: Fiscal Vulnerability

Category Gross Sustainable public debtdebt-toto-GDP (in GDP (in %) %) Solvency Required primary Distance to balance adjustment sustainable (% of public debt revenues) to (%GDP) achieve stable debt/GDP ratio 0.20 0.75 0.25 34.4 6.9 -70.0 -36.4 11.0 -29.0 18.0 -2.6 7.0 10.9 -13.2 7.0 16.0 4.7 27.5 10.6 -10.4 6.9 0.6 -12.7 22.6 0.8 -7.4 -27.2 32.7 5.9 13.3 -2.9 11.6 0.7 -2.8 -4.2 9.9 -6.9 11.4 12.9 22.4 4.5 6.5 25.3 -35.4 -0.1 -8.1 21.9 -32.0 37.7 -7.7 9.2 -14.7 -3.4 -10.9 4.4 -6.0 -9.8 -21.9 10.9 4.2 2.4 -6.4 11.8 6.8 23.0 11.5 -5.6 21.7 -9.1 -4.0 8.2 -38.3 -1.1 -14.3 8.9 -6.6 -0.5 -16.8 13.5 18.6 18.2 -55.8 4.0 3.1 19.7 -4.0 28.5 -30.9 -3.0 5.1 4.4 6.2 0.9 -16.5 -15.8 -55.1 16.9 -94.7 -0.2 External financing dependence Current account balance, % GDP 0.20 0.50 12.05 21.99 1.61 -0.79 8.49 5.46 -4.95 -1.71 15.38 -0.98 6.24 2.77 5.15 -0.69 -1.12 -2.91 1.41 2.50 -6.26 -3.29 3.88 -1.66 2.84 -3.99 3.49 -2.17 -8.47 -1.93 -3.13 -2.79 -5.27 -6.10 10.46 -8.25 -0.43 -2.67 -2.70 -8.98 -5.55 -2.79 2.71 0.39 -2.56 -2.29 -6.91 -3.82 -9.69 -12.79 0.50 2.11 2.19 1.11 1.38 0.42 4.59 1.26 0.77 0.49 2.15 0.00 2.10 1.55 1.33 0.88 1.81 1.48 0.46 3.35 13.04 2.19 26.25 3.60 2.63 1.39 1.59 9.38 10.76 1.64 2.05 11.53 1.51 1.28 3.41 2.75 2.76 1.59 12.42 1.57 6.31 2.01 19.88 1.44 2.60 0.42 2.29 29.50 6.23 External debt-toannual exports Fiscal financing needs & debt composition Public Government Weigthed average debt in balance, % duration of public local GDP (2010- debt (bonds only), currency 2011 average) years as % of total 0.20 0.33 0.33 0.33 -1.10 2.75 15 0.10 2.75 100 0.00 4.36 99 -2.55 5.98 77 -2.20 6.25 100 -4.80 5.30 100 3.90 6.40 88 -4.85 5.21 87 -3.70 4.43 97 -1.3 4.11 34 -2.35 7.59 99 -2.51 9.00 51 -3.35 5.88 67 0.13 8.90 40 -2.34 5.50 80 -2.40 4.72 91 -1.51 5.95 46 -5.00 5.86 96 -2.8 3.47 55 -7.75 4.61 100 -4.50 4.35 83 -8.31 10.59 100 -8.75 5.64 100 -4.60 3.31 71 -3.85 5.35 57 -7.90 6.97 95 -1.9 8.80 0 -7.60 6.07 100 -3.24 7.18 69 -6.45 4.34 77 -9.3 5.98 75 -2.4 5.11 38 -2.25 6.27 35 -7.1 4.04 90 -3.70 2.66 57 -4.8 5.11 0 -3.4 5.66 41 -7.5 5.97 50 -7.50 1.76 54 -5.15 5.99 75 -8.1 2.67 21 -10.90 5.91 50 -8.30 1.72 81 -6.0 4.41 31 -5.00 3.31 12 -4.4 2.53 48 -7.85 6.61 50 -10.2 2.58 56 Financial sector health Total regulatory capital-torisk weighted assets (%) 0.33 16.6 16.5 14.2 14.3 10.0 13.6 13.6 14.1 14.6 17.0 10.0 18.6 20.9 13.5 15.9 18.2 17.5 13.8 17.3 14.3 12.6 13.3 14.3 20.4 15.8 13.2 15.9 10.2 15.1 13.1 12.2 14.5 15.0 21.2 13.1 16.5 11.7 10.3 13.7 10.8 14.2 10.6 15.3 15.6 14.1 11.7 12.4 Nonperforming loans, % of total 0.20 0.33 1.5 2.3 1.5 1.4 1.6 2.8 5.5 5.3 3.8 1.0 1.6 3.1 9.6 2.7 3.4 4.5 3.8 5.7 6.0 5.4 1.5 3.3 1.8 5.7 4.6 2.4 1.4 2.8 4.6 7.0 5.1 4.0 2.6 15.5 5.9 4.4 15.5 2.8 14.8 6.2 19.4 7.5 14.7 33.8 12.2 7.2 6.0 Institutional strength Fiscal vulnerability Market bid

Variable

3-digit Code

Loans-todeposits ratio (%)

World Bank Governance Overall index Indicator (6 factors) 0.20 1.00 1.40 1.51 0.49 1.02 0.58 1.43 0.14 0.70 -0.04 0.42 -0.91 -0.68 -1.22 -0.70 -0.50 -0.31 -0.94 -0.69 -0.05 1.26 0.38 1.41 1.07 -0.41 -0.91 -0.55 -0.12 1.13 -0.79 0.39 0.78 -0.68 -1.72 -0.64 0.62 -0.46 -0.43 0.93 -0.15 0.30 0.47 1.55 -0.99 -0.83 -1.04 -1.62 0.33 -1.27

Sensitivity of 5Y USD Rates to S&P500

Weight by category Weight within category Hong Kong Singapore Korea Chile Taiwan Germany South Africa Czech Republic Malaysia Uruguay China Argentina Russia Peru Mexico Brazil Indonesia Thailand Bulgaria United States Israel United Kingdom Japan Turkey Philippines India Panama France Colombia Poland Spain Dominican Republic Venezuela Serbia & Montenegro Hungary El Salvador Tunisia Portugal Romania Italy Lithuania Ireland Egypt Ukraine Vietnam Pakistan Greece Lebanon

HKG SGP KOR CHL TWN GER ZAF CZE MYS URY CHN ARG RUS PER MEX BRA IDN THA BGR USA ISR GBR JPN TUR PHL IND PAN FRA COL POL ESP DOM VEN SRB HUN SLV TUN PRT ROU ITA LTU IRL EGY UKR VNM PAK GRC LBN

5.6 110.0 29.0 22.0 33.0 73.2 24.0 32.5 50.4 39.4 17.4 47.4 7.3 26.7 28.4 42.8 30.1 28.6 17.6 83.5 75.4 68.1 122.0 47.7 54.7 50.9 46.0 81.9 35.8 46.4 53.2 28.5 18.3 44.0 78.3 54.3 46.6 76.8 21.4 115.8 36.9 64.0 70.9 34.9 33.8 56.5 115.1 134.7

40 40 40 40 40 60 40 60 40 40 40 40 40 40 40 40 40 40 40 90 40 60 90 40 40 40 40 60 40 40 60 40 40 40 40 40 40 60 40 60 40 60 40 40 40 40 60 40

0.33 0.6 0.9 1.8 1.6 1.3 1.1 1.7 1.9 1.2 1.0 1.3 1.7 1.2 0.9 1.9 1.7 1.3 1.2 1.6 1.4 0.9 1.3 2.0 1.3 1.0 1.2 1.3 1.6 3.4 2.4 1.4 2.9 5.7 1.4 2.4 1.5 1.8 1.7 2.0 1.8 3.5 4.1 1.1 2.7 1.3 3.5 1.1 0.8

0.74 0.62 0.54 0.54 0.47 0.42 0.38 0.36 0.34 0.31 0.31 0.29 0.28 0.26 0.18 0.16 0.16 0.12 0.10 0.08 0.06 0.05 0.02 -0.03 -0.03 -0.04 -0.04 -0.05 -0.09 -0.10 -0.11 -0.14 -0.18 -0.20 -0.21 -0.26 -0.28 -0.30 -0.32 -0.37 -0.39 -0.43 -0.52 -0.61 -0.64 -0.69 -0.90 -1.19

0.13 0.18 -0.11 0.03 0.08 0.20 -0.08 0.01 0.04 -0.29 0.08 -4.26 -0.42 -0.02 -0.14 -0.01 -0.37 -0.02 -0.33 0.27 0.04 0.19 0.17 0.04 0.24 0.24 -0.03 0.19 0.00 -0.07 0.12 -1.30 -2.25 -0.35 -0.32 -0.28 0.00 0.13 -0.47 0.08 0.19 -0.08 -0.29 -3.57 -0.15 -2.80 -0.05 0.38

Sources: IMF, BIS, Eurostat, National Statistics, Haver, Barclays Capital. Our Fiscal Vulnerability Index ranks countries according to their standardized deviation from the mean, with higher scores indicating lesser fiscal vulnerability and lower scores indicating greater fiscal vulnerability.

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Data sources
Figure 16: Explaining the sources
Indicator Gross public debt (% GDP) Primary fiscal balance adjustment necessary to reach stable debt ratios Fiscal balance (average 2010-11) Average duration of government bonds Share of debt denominated in local currency 2010F CA balance External debt divided by last 12 months of exports Capital adequacy ratio NPLs as % of total loans Loans to deposit ratio Governance indicators for voice and accountability, etc. Source Haver Analytics, national statistics offices Barclays Capital Barclays Capital Economists estimates Bloomberg National Statistics Offices, Haver Analytics Barclays Capital Economists estimates Haver Analytics IMF (Global Financial Stability Report, April 2010) IMF (Global Financial Stability Report, April 2010) Haver Analytics, National Statistics offices World Bank

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Appendix A: Assessing fiscal fundamentals

Solvency
We start with a simple equation stating that the change in a countrys stock of debt is equal to its fiscal deficit:

Dt = FDt = rt Dt 1 PBt
(a.1) where D is the public debt stock, FD is the fiscal deficit, r is the average nominal interest rate paid on the debt, PB is the primary fiscal balance (i.e., revenues minus no debt servicerelated expenditures), and indicates change over the previous year. 4 Since any assessment of debt sustainability will focus on the evolution of the debt-to-GDP ratio, it is useful to express equation (a.1) in terms of GDP (Y) ratios, so it becomes:

D r g t D PB = t 1 + g Y Y Y t t 1 t t

(a.2)

The initial conclusion is that it is not the stock of debt alone that matters for debt dynamics but the interaction between stock of debt, interest on the debt, growth rates, and the governments primary balance. The larger the stock of debt and the average interest rate paid on the debt, the larger the increase in the debt-to-GDP ratio. Conversely, the higher the GDP growth and the primary balance, the larger the decrease in the debt-to-GDP ratio. Assuming that interest and growth rates in (a.2) are constant, we can show that the primary balance target required maintaining the debt-to-GDP ratio at current levels (i.e., the LHS of equation (a.2) is equal to zero), equals:

PB r g D = Y 1 + g Y t 1

(a.3)

An assessment of debt sustainability (or solvency) needs to go beyond the static case described above. To define fiscal sustainability, we first need to decide the objective for the evolution of the debt-to-GDP ratio. Broadly speaking, there are two alternative approaches: (a) The debt-to-GDP ratio reaches a certain level (say, 60%) by a certain year, 5 or (b) The debt-to-GDP ratio does not explode (and, hence, remains generally around current levels). We normally prefer (b) as the definition of stable debt dynamics. The choice of the debt target or (particularly) the year it is reached using criteria (a) is somewhat arbitrary. But results normally do not differ significantly if the year of choice is relatively far in the future. If we use (b) while still assuming constant growth and interest rates, we can show that the conditions for fiscal sustainability are determined by 6:

To avoid complicating the explanation of debt dynamics unnecessarily, we do not include other debt-creating items and ignore asset accumulation. 5 The IMF uses a target ratio of 60% for advanced economies and 40% for EM countries. We assign the US and Japan a target ratio of 90% (using net debt in the case of Japan) in order to account for their special safe haven status. 6 Equation (a.4) assumes that r>g and is obtained by solving the difference equation forward imposing the condition that the debt-to-GDP ratio grows less than (1 + r ) /(1 + g ) and, hence, in net present value converges to zero.
4

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D 1 + g PB = Y t s =t +1 1 + r Y S s t *

(a.4)

Despite first impressions, the intuition of equation (a.4) is relatively straightforward: the net present value of future primary surpluses needs to equal the stock of current debt. In other words, to avoid running a Ponzi scheme the government needs to generate sufficiently large primary surpluses in the future to pay back its debt. Equation (a.3) is a specific case of (a.4): if the objective is to keep the debt-to-GDP ratio constant at current levels (and, hence, the primary balance unchanged as well), equation (a.4) collapses to (a.3). 7 If, alternatively, we use criteria (a) the evolution of debt becomes:

D Y T

T arg et

1+ r = 1+ g

T t

T 1+ r D Y t s =t +1 1 + g

T s

PB Y S

(a.5)

where the LHS term denotes the target debt-to-GDP ratio by year T and the RHS is simply the rule of debt accumulation. Before proceeding further, it makes sense to define more precisely the difference between debt sustainability and solvency. Sometimes, the concepts are used interchangeably; however, they are not exactly the same. Debt sustainability refers to the evolution of the debt-to-GDP ratio without a change in fiscal policy stance (i.e., without any explicit policydriven adjustment). Hence, a countrys debt dynamics are on an unsustainable path if, under an unchanged fiscal policy, the debt-to-GDP ratio explodes. Using this definition, many developed countries currently face unsustainable debt dynamics. But insolvency is a more stringent (and perhaps subjective) concept and refers to the inability to make such a fiscal adjustment. An insolvent country has unsustainable debt dynamics and is not able to make sufficient fiscal adjustment to stabilize these dynamics within a reasonable timeframe. One useful number in assessing a countrys solvency risk is the fiscal adjustment (as a percentage of GDP or of tax revenues) over a number of years required to stabilize debt dynamics. This adjustment needs to be compared with the path of unchanged fiscal policy stance, a concept that in the past we have referred to as the inertial primary balance. In particular, even without a change in fiscal policy, primary balances may change because of growth (more on this below), one-offs, and demographic factors, among other things. In terms of equation (a.4), the challenge is therefore to determine the cumulative fiscal adjustment ( ) that stabilizes debt dynamics.
s t Inertial D 1 + g PB + s = Y t s =t +1 1 + r Y s

(a.6)

Obviously, for a given path of inertial primary balance and interest rates, there is not a unique fiscal adjustment path. However, the net present value of the adjustment (i.e., the sum of in net present value) is unique. In the past, we have preferred to utilize (somewhat arbitrarily) the cumulative fiscal adjustment over five years (i.e., summarize a countrys solvency challenge.

5 )

to

We can generalize further by assuming that growth and interest rates change over time. This is, indeed, what we do in the quantitative simulations. However, the equations get messier without generating additional intuition.

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Similarly, if we use (a.5) as the criteria for solvency, the cumulative fiscal adjustment required would be determined by:

D Y T

T arg et

1+ r = 1+ g

T t

T 1+ r D Y t s =t +1 1 + g

T s

PB Inertial + S Y S

(a.7)

All else equal, the larger the cumulative adjustment needed, the more likely that a country may be insolvent and, hence, eventually default/restructure its debt. Thus, the default probability is closely linked to the probability of not making a fiscal adjustment within a given timeframe. The length of time provided by the market is not predetermined and will be based primarily on the governments credibility in implementing fiscal adjustments. 8

Box 1. The inertial primary balance and the power of growth

The role of growth in debt dynamics is often not fully appreciated. The obvious channel through which growth affects debt sustainability calculations is that the higher the growth rate the higher the increase in debt (and, hence, the larger the fiscal deficit) that is still consistent with a stable debt to GDP path. 9 However, there is another equally powerful channel. Tax collection normally has an elasticity of more than one with respect to GDP growth, meaning that tax revenues as a percentage of GDP increase with growth. Similarly, it is much easier to reduce fiscal spending (as a percentage of GDP) with high growth, given that keeping it constant in real per capita terms is still consistent with a declining spending-to-GDP ratio. Thus, inertial primary balances are likely to increase faster the higher the economic growth. This implies that the higher the growth, the lower the residual (proactive) fiscal adjustment to stabilize debt dynamics. Indeed, instead of finding the primary balance adjustment ( ) that stabilizes debt dynamics, we can obtain the growth rate that does the same:
1+ g D = Y t s =t +1 1 + r s t Inertial PB (g) , s Y

where g is affecting debt dynamics both directly (through the discount factor) and indirectly (through the inertial primary balance). 10 Historical experience shows the importance of fiscal adjustment to growth: countries that grew faster were able to make more sizable fiscal corrections (Figure 17).

Notice that the stock of debt enters our calculations of require fiscal adjustment but it is not included as a separate variable to determine solvency. However, the level of debt may be one variable considered by market participants to determine the governments credibility to make such an adjustment. 9 Indeed, under large growth rates, equation (a.4) may not even hold if g>r, as net present value of the LHS would not converge. Equation (a.3) would still hold, however, and suggests that countries with high growth rates may actually run primary deficits and still have sustainable debt dynamics. 10 If the growth rate that stabilizes debt dynamics is sufficiently large (and, hence, g>r) the relevant equation would be different for the reasons expressed in footnote 9.

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Figure 17: Fiscal adjustment and the power of growth

Average real GDP growth during adjustment (%) 5 4 3 2 1 0 0 -1 Adjustment needs 2010-14 -2 Primary fiscal balance adjustment per year during adjustment period (% of GDP) 0.5 1 1.5 2 2.5 3 Greece 3.5 Size of bubble = total primary balance adjustment (% GDP) UK (1993-99) Finland Denmark (1993-00) Ireland (1982-86) (1981-89) Sweden Portugal (1993-98) Ireland (1978-84) Italy Belgium Portugal Spain Greece (1981-90) (1989-94)

Spain (1982-89) Italy (1985-97)

Source: Eurostat, Haver Analytics, Greece Ministry of Finance, Barclays Capital

Fiscal financing needs and debt composition

Solvency is the most important determinant of the probability that a country will eventually default. However, fiscal financing concerns may be relevant as well. We believe that, at least in one sense, liquidity is overrated: solvent countries normally do not default purely because of liquidity problems. Markets normally remain open to reasonably solvent countries, and even if they were closed, multilateral/bilateral resources would normally be available to solvent countries facing a fiscal financing shortage. However, this does not make liquidity irrelevant. Countries in which solvency is a question and with large financing needs are more vulnerable than those with limited or no financing needs, as they will need to issue more frequently and, hence, test the market often. Liquidity also matters because of changes in the average interest paid on debt stock. For example, a country with a 10% fiscal deficit and amortizations of 15% of GDP will have financing needs of 25% of GDP meaning that if the stock of debt is, say, 80% of GDP, roughly one-fourth of its new total stock of debt will be set during the year at current market interest rates, which may change sharply on short notice (as shown during the recent experience in Greece and the rest of Southern Europe). Liquidity needs are obviously related to the average duration of debt and the size of the fiscal deficit. But in addition to the debts maturity profile, its currency composition matters. Countries that issue most of their debt in their own currency rarely default, as they can always inflate the debt away. This means that debt should reflect inflation/depreciation risk more than credit risk per se, implying that the higher the percentage of domestic currency-denominated debt, the better. In principle, we agree with the benefits of domestic -currency debt. However, the reasons may be somewhat different. While it may be theoretically possible to liquefy debt, in practice, it will be much more complicated. First, the government would need to be willing to generate high inflation to improve debt dynamics significantly. This may be difficult with an independent central bank. Second, even if investors are surprised initially, new debt will be issued at yields that reflect the enhanced inflation risk; hence, the benefits are only on the old debt. 11 But we see another benefit of domestic currency-denominated debt. During periods of increased risk aversion, currencies are likely to depreciate relative to safe haven currencies. In that case, the larger the percentage of foreign currency debt, the larger the increase in the debt-to-GDP ratio and,
11

For countries in the euro area, the problems are somewhat different. Governments issue in local currency but do not have locally controlled central banks; hence, it is akin to having a pegged FX system.

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hence, the greater the likelihood that a country may engage in self-reinforcing negative debt dynamics, with currency depreciation increasing the debt-to-GDP ratio, which, in turn, increases credit risk and induces further currency depreciation.

External financing dependence

The risk of excessive reliance on foreign creditors extends beyond government debt. Persistent and large current account deficits imply significant dependence on continuing foreign capital inflows that may result in large private sector external debt. In principle, private sector-related capital inflows do not affect sovereign solvency directly. Furthermore, imbalances may be good or fundamentally justified (see, e.g., Global Rebalancing is for real, 12 April 2010). However, to a certain extent and independent of the good or bad nature of current account deficits, a sudden reduction in capital flows affects current account deficit countries more than surplus countries (with the US a possible exception owing to issues again related to its safe-haven status). The main transmission channels would be: 1) through lower growth and higher unemployment, with the resulting negative implications for debt dynamics, as seen previously; and 2) through the balance sheet effect associated with the currency depreciation resulting from the flows contraction. A sudden sharp reduction in capital inflows to the private sector and a concomitant crisis among private non-financial sector companies would, therefore, also adversely affect the sovereign. This makes countries with the largest current account deficits and most negative IIP more vulnerable. Because the IIP includes private and public asset liabilities, it is not a pure measure of the private sectors exposure to a sudden stop. Furthermore, it also includes FDI (including in real estate) as liabilities flows that are not easily reversed. We thus use it only as a rough indication (and give the foreign flow criterion a low weight when determining a countrys overall vulnerability).

Banking sector health

Because of the need to safeguard the banking system, bank debt is effectively implicit government debt. This implies potential increases in the stock of public debt, as in Ireland. The banking system and government finances are intimately linked and typically interdependent. A banking crisis can ruin government finances, and similarly, a sovereign crisis typically pulls down the banking sector as well. This makes banking sector health probably the most important variable not included directly in the debt dynamics equation. Three key aspects of bank balance sheets are liquidity, asset quality, and wholesale funding reliance, so we choose a proxy for each, taking the average of all monetary institutions/deposit money banks excluding the central banks. For liquidity, we use the average bank capital adequacy ratio (total regulatory capital as a proportion of risk-weighted assets). This is an important concept, as bank capital is the cushion protecting depositors money from losses that the bank might incur during difficult trading times. The Basel II minimum for regulatory capital ratio is 8%. The total regulatory capital ratio consists of Tier 1 and Tier 2 capital less supervisory deductions. To measure asset quality deterioration, we examine non-performing loans as a percentage of total loans. The concept of NPLs varies a little across countries, but the IFRS definition is delinquent loans for which payments were overdue by more than 90 days. These loans would be identified as problem loans for which provisions would be necessary and, thus, would eat into banks profits. An extreme scenario would be severe asset quality
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deterioration that engulfs profits and potentially leaves the bank with negative equity i.e., insolvent. If the bank is considered too big to fail the government might need to step in to bail it out, which would be an extra burden on public finances. Finally, we use the loans-to-deposit ratio as a proxy for reliance on wholesale funding. The higher the ratio, the more the bank is relying on borrowed funds, which are generally more costly than most types of deposits. If the ratio is too high, banks might not have enough liquidity to cover unforeseen fund requirements.

Appendix B: Estimation of 5y CDS Model

We estimate the following model:

Yi = 0 + 1 * X i1 + 2 * X i2 + 3 * ( X i1 ) 2 + i
Where

(b.1)

Yi

is the current 5y CDS for country i,

X i1 is our measure of fiscal vulnerability for

country i,

X i2

is our measure of market bid for country i, and

is an error term. We

synthetically proxy 5y US dollar rates in sovereign yield curves using 5y US Treasury yields and 5y CDS. This construction provides a measure of 5y generic USD rates paid by each of the sovereigns at every period in our sample, disregarding shrinking maturity issues for US dollar bonds along the time series. According to our measure of market bid, the US and Argentina have the best and worse market bids for government bond indicators. The UK, Japan, Germany, Singapore, and China rank among the group of countries with solid bids for government bonds in bad times, while Serbia, Pakistan, and Venezuela rank among the worse. The measure works, as it shows that interest rates paid by these sovereigns widen when the global outlook deteriorates, even though Venezuela and Argentina enjoy pretty strong fiscal positions. In contrast, Greece remains an outlier, displaying a high CDS spread for a relatively decent measure of market bid. Interestingly, there is a pretty good reason: the 5y CDS remained relatively stable during the Lehman Brothers collapse, widening only later, when global markets were recovering and the S&P500 was rising. This positive correlation between the rates paid by Greece and the S&P500 Index shows a spurious neutral sensitivity of Greece 5y CDS to global markets. A more forward-looking and subjective estimate of the perceived sensitivity of Greece 5y CDS to global markets would likely be below its current market bid measure. The regression results are summarized below:
Coefficients Intercept Fiscal vulnerability Market bid Fiscal vulnerability^2 R Square Adjusted R Square Standard Error Observations 149.2 -181.7 -161.2 75.7 0.70 0.68 127.4 48 Standard Error 23.0 52.7 19.7 82.3 t Stat 6.5 -3.4 -8.2 0.9 P-value 0.00 0.00 0.00 0.36

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All coefficients have the expected signs, and predicted 5y CDS levels fall with higher vulnerability scores (along the relevant range) and with our measure of market bid for government bonds. The quadratic term is not significant, but we see no harm in leaving it in the model, as it marginally improves the fit (without changing any of the main conclusions across our sample) and we think the lack of significance is driven by a small sample size (48 observations). Figures 18 and 19 present the goodness of fit of our model to 5y CDS. We plot 5y CDS against the predicted 5y CDS according to our model. Points above (below) the 45% line indicate that the credit is cheap (expensive) relative to the prediction of the model; the line represents points at which actual 5y CDS levels are equal to the models predictions (fair). Figure 18: CDS versus model (for countries with 5y CDS below 350bp)
350 300 250 5Y CDS 200 150 100 50 0 0 BGR PRT LTU ESP TUR PHL RUS ZAF KOR ISR MEX POL CZE COL BRA TWN MYS JPN IND PAN HKG CHL CHNGBR FRA GER USA SGP 50 100 150 200 ITA SRB HUN IRL SLV VNM EGY ROU

250

300

350

5Y CDS Model
Source: Please refer to Figure 16

Figure 19: 5y CDS versus model (for countries with high 5y CDS)
1150 1050 950 5Y CDS 850 750 650 550 450 350 350 450 550 650 5Y CDS Model
Source: Please refer to Figure 16

VEN

ARG GRC PAK

UKR

750

850

950

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LITERATURE
Berg, Andrew, Eduardo Borensztein, and Catherine Pattillo, 2005, Assessing Early Warning Systems: How Have They Worked in Practice? Staff Papers, International Monetary Fund, Vol.52 (December), pp.462-502. Hemming, Richard, and Murray Petrie, 2000, A Framework for Assessing Fiscal Vulnerability, IMF Working Paper No. 00/52 (Washington: International Monetary Fund). Available on the IMFs website, www.imf.org/external/pubs/ft/wp/2000/wp0052.pdf. International Monetary Fund, 2001, Involving the Private Sector in the Resolution of Financial Crises Restructuring International Sovereign Bonds. Available on the IMFs website, www.imf.org/external/pubs/ft/series/03/IPS.pdf. 2003c, World Economic Outlook, September 2003, World Economic and Financial Surveys (Washington). www.imf.org/external/pubs/ft/weo/2003/02/index.htm. Manasse, Paolo, Nouriel Roubini, and Axel Schimmelpfennig, 2003, Predicting Sovereign Debt Crises, IMF Working Paper No. 03/221 (Washington: International Monetary Fund). Available on the IMFs website, www.imf.org/external/pubs/ft/wp/2003wp03221.pdf. Reinhart, Carmen M., Kenneth S. Rogoff, and Miguel A. Savastano, 2003, Debt Intolerance, NBER Working Paper No. 9908 (Cambridge, Massachusetts, National Bureau of Economic research) Rosenberg, Christoph, Ioannis Halikias, Brett House, Christian Keller, Jens Nystedt, Alexander Pitt, Brad Setser, 2005, Debt-Related Vulnerabilities and Financial Crises. An Application of the Balance Sheet Approach to Emerging Market Countries. Occasional Paper 240, International Monetary Fund, Washington DC.

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Analyst Certification(s) We, Piero Ghezzi, Christian Keller and Jose Wynne, hereby certify (1) that the views expressed in this research report accurately reflect our personal views about any or all of the subject securities or issuers referred to in this research report and (2) no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this research report. Important Disclosures For current important disclosures regarding companies that are the subject of this research report, please send a written request to: Barclays Capital Research Compliance, 745 Seventh Avenue, 17th Floor, New York, NY 10019 or refer to https://ecommerce.barcap.com/research/cgibin/all/disclosuresSearch.pl or call 212-526-1072. Barclays Capital does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that Barclays Capital may have a conflict of interest that could affect the objectivity of this report. Any reference to Barclays Capital includes its affiliates. Barclays Capital and/or an affiliate thereof (the "firm") regularly trades, generally deals as principal and generally provides liquidity (as market maker or otherwise) in the debt securities that are the subject of this research report (and related derivatives thereof). The firm's proprietary trading accounts may have either a long and / or short position in such securities and / or derivative instruments, which may pose a conflict with the interests of investing customers. Where permitted and subject to appropriate information barrier restrictions, the firm's fixed income research analysts regularly interact with its trading desk personnel to determine current prices of fixed income securities. The firm's fixed income research analyst(s) receive compensation based on various factors including, but not limited to, the quality of their work, the overall performance of the firm (including the profitability of the investment banking department), the profitability and revenues of the Fixed Income Division and the outstanding principal amount and trading value of, the profitability of, and the potential interest of the firms investing clients in research with respect to, the asset class covered by the analyst. To the extent that any historical pricing information was obtained from Barclays Capital trading desks, the firm makes no representation that it is accurate or complete. All levels, prices and spreads are historical and do not represent current market levels, prices or spreads, some or all of which may have changed since the publication of this document. Barclays Capital produces a variety of research products including, but not limited to, fundamental analysis, equity-linked analysis, quantitative analysis, and trade ideas. Recommendations contained in one type of research product may differ from recommendations contained in other types of research products, whether as a result of differing time horizons, methodologies, or otherwise.

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