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Country risk September 2011: Past defaults offer little comfort to troubled eurozone

Andrew Mortimer

The euro crisis has already resulted in the region’s country risk scores falling by a greater margin than the Asian economies in 1997. That’s before any of the countries involved has actually defaulted. Andrew Mortimer asks: how many years will Europe take to recover?

But it is at the policy level that Europe faces its biggest challenges. Eurozone leaders have been found badly wanting by the crisis. Jerome Booth, head of research at Ashmore Investment Management, says: "The ability and the willingness of a sovereign to change its debt ratios, and so alter market perceptions towards itself, is not a function of numbers: it’s a function of policymakers and political constraints. What Europe’s crisis has brought into stark relief is that its policymakers have proved to be inflexible and unable to react to events in real time. In some ways this is unsurprising, since policymakers in Europe have little experience of dealing with crises, in contrast with many of their emerging market peers."

Can Europe recover?

The history of sovereign defaults in emerging markets provides little comfort to those tasked with solving Europe’s deep-seated fiscal and structural problems. Of those sovereigns that have restructured their debts or defaulted, only a handful have recovered their previous country risk scores. The lengthy recovery times illustrate both the damage default can have on investor sentiment and the lengthy recessions that have frequently followed financial crises.

External factors have frequently played a strong role in post-crisis recoveries. Russia, which remains the only country that has defaulted to recover its previous ranking, is an obvious example. Following its disastrous default on short-term treasuries in 1998, Russia’s ECR score fell by 30 points, leaving it ranked 161 globally. The default destroyed the domestic banking sector, but where smaller countries without its resources would have required international assistance, Russia benefited from the turnaround in global energy prices. "There was zero foreign investment in Russia in the period immediately following default," says George Nianias, manager of Denholm Hall Russia Arbitrage Fund. "Instead, Russia used the state banks to finance the economy, while Russian private investors appeared out of nowhere to finance SMEs and start-ups." Swollen by oil revenues, Russia ran trade surpluses in 1999 and 2000, and had recovered its previous ECR score in 2004.

When a series of political disasters in early 1994 sapped investor confidence in Mexico, events quickly span out of the government’s control. But by 2000 Mexico had an investment-grade rating and was judged the best sovereign borrower in North America by Euromoney. How was such a rapid transformation engineered?

Mexico’s growing current account deficit, which had been increasing for a decade, reached 8% of GDP in 1994, and was mostly financed short-term. When investors became reluctant to take on Mexican currency risk, the government issued the infamous tesebonos, dollar-indexed short-term securities, through which it took the currency risk off their hands. A large volume of maturities at the end of 2004 led to a bungled devaluation of the peso in December, and default looked inevitable. Mexico’s country risk score, which had peaked at 62 points that year, plunged to 57.

Mexico, thanks to a $50 billion international rescue package spearheaded by the US in March 1995, did not default. That year, Mexico suffered its worst recession in 60 years, with GDP dropping some 7% as resources were switched from domestic needs to meeting short-term debt obligations and closing the yawning current-account deficit. Real living standards plummeted and more than a million Mexicans were thrown out of work.

The end of convergence
Periphery ECR scores, 1994 to 2011
Asian crisis
ECR scores, 1994 to 2011 
Source for both: ECR 

GDP recovered strongly in the following two years, growing by 5.1% and 6.8% in 1996 and 1997. During the recovery, the proportion of growth provided by exports fell but the level of fixed investment increased, and continued to provide a large share of growth in the post-crisis period. Mexico’s policy response and the swift intervention succeeded in quickly encouraging investment.

In the aftermath, Mexico’s policy response focused on strengthening lax banking sector regulations. Unsustainable exchange rate policies were removed, and the country’s weak fiscal policy, which had been largely determined by the political cycle, was strengthened with larger foreign exchange reserves. "In Mexico, policymakers focused on the diseases rather than the symptoms of the crisis," says Richard Segal, an economist at Jefferies.

Furthermore, the country benefited from a wave of investment by US companies through the recently ratified North American Free Trade Agreement, becoming a low-cost export platform for multinationals selling into the US and Latin America. "Intelligent macro-policy was at the heart of Mexico’s economic recovery, although the economy also benefited from devaluation," says Robert Parker, a senior adviser at Credit Suisse.

In 1999, while other Latin American sovereigns were experiencing deep recessions, Mexico, buoyed up by strong links with the US and a rising oil price, achieved growth of 2.5% in the first half of the year compared with the same period in 1998.