ECR Survey Results Q3 2011: Past defaults offer little comfort to troubled eurozone


Andrew Mortimer
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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?

This article was published using data from Euromoney Country Risk (ECR), the online service from Euromoney dedicated to country and sovereign risk. To view the latest country rankings go to

FOUR YEARS AGO, the sovereign debt of eurozone member states was perceived as having zero risk of default. Concern about the risks posed by high debt levels in the region was dismissed as paranoia by those who thought the price of a Greek bond could be judged simply by movements in the instrument’s spread over German Bunds. The tail risk of a eurozone sovereign default was ignored by investors, who focused instead on inflation and interest rate risk.

Fast forward to the summer of 2011 and the eurozone faces the overwhelming likelihood that one or more member states will default on their sovereign debt and leave the single currency in the process. The prospect has sent shockwaves through financial markets and clouded the economic prospects of an already embattled region. When default happens, as the market believes it must, no one can say how badly European banks will be hit, or with what severity global markets for credit, derivatives and foreign exchange might become dislocated.

Top 10 largest deteriorations in country risk scores
Country Crisis periodPre-crisis scorePost-crisis score deterioration * (out of 100) Sept 2011 score
1IndonesiaMar 1996–Mar 200073.2-40.458.2
2Greece Sept 2008– 82.7-33.040.6
3MalaysiaMar 1996–Mar 199984.5-32.866.6
4RussiaSept 1997–Mar 199950.7-29.956.9
5IrelandSept 2008– 92.4-29.060.8
6ArgentinaSept 1999–Sept 200353.8-28.043.7
7Thailand Mar 1996–Mar 200082.1-27.461.7
8South KoreaMar 1996–Mar 199985.0-23.473.3
9PortugalSept 2008– 83.0-22.355.9
10SpainSept 2008– 86.6-20.166.0
* For countries still considered in crisis, the most recent country risk score from Sept 2011 is included

In quantitative terms, Europe’s problems dwarf those of all other distressed sovereigns in recent history. Greece’s indebtedness, forecast to reach 145.5% of GDP in 2016 by the IMF, puts even pre-default Argentina in the shade. Italy, a core member state recently drawn into the crisis, has the third-biggest bond market in the world after the US and Japan. Few believe that it can be rescued by either the European Central Bank or the European Financial Stability Facility (EFSF). The big current account imbalances between the surplus economies of the north and the deficit addicts of the south have existed for decades.

The eurozone’s ailments bear a closer resemblance to Latin America’s in the 1990s than the lightning strikes that hit Asia in 1997 or Russia in 1998. Europe’s is a slow-burning crisis, with each piece of bad news provoking pessimism, followed by a counter-measure that only brings short-lived relief. But the periods of calm are becoming shorter. Now that the markets have threatened to deny core member states such as Spain, Italy and even France access to international capital, the viability of the euro itself has come into question.

Historical data from Euromoney’s country risk survey illustrate the sharp deterioration of affected sovereigns from Mexico’s Tequila Crisis in 1994 to the Dominican Republic’s restructuring in 2005. The results show the lasting effect financial crises can have on risk perception of the countries involved. Already, they show something potentially more serious: the present crisis is more severe than any in the past 20 years.

Since 2008, Greece’s fall from grace has already been more profound than that of any country but Indonesia after the devaluation of the rupiah in 1997. Greece has fallen further than Malaysia during its own crisis in the same period, and further than Argentina when it defaulted on external debt owed to private and official bilateral creditors in 2001.

Ireland, forced to accept an €85 billion bailout package last year after its banks were wiped out by exposures to the domestic real estate bubble, has already suffered a 29-point fall in its country risk score. Ireland’s score had previously peaked at sixth in the world in March 1998. Its position mirrors Thailand, whose own real estate boom contributed to the severe recession it suffered in the late 1990s. Thailand had previously been ranked as high as 26th globally, a position it has never regained.

Portugal and Spain have also suffered falls in their scores of more than 20 points since the collapse of Lehman Brothers. Indeed, country risk data show that the scores of the peripheral eurozone economies have been reduced to a level not seen since they joined the euro. In other words, the dream that Greece, Italy, Spain and Ireland would converge with the core economies has been reversed: the Piigs have diverged.

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.

Could Greece be the new Uruguay?

One of the few sovereigns to have come close to reclaiming its pre-restructuring country risk score, Uruguay is the last example of an investment-grade sovereign to have come close to default. Uruguay had exhibited vulnerabilities since entering a lengthy recession in 1999. The government ran persistent budget deficits during this period. In 2002, after a massive withdrawal of Argentine foreign-currency deposits, Uruguay suffered a banking crisis and subsequently struggled to service its government debt. The country’s ECR score sunk as low as 30 in the aftermath of the restructuring, leaving it ranked 144 globally.

Uruguay underwent a so-called friendly restructuring of its debts in 2003. The voluntary debt exchange involved swapping $5 billion of outstanding debt in April 2003 with new bonds with a five-year grace period and entailed a low principal reduction of just 1%. "Uruguay’s politicians had no wish to default," says David Nowakowski, director of credit strategy at Roubini Global Economics. "The extension bought them time to implement policies, without the need for a second restructuring."

Although there were similarities between the causes of the crises in Uruguay and Greece, there were also big differences. Uruguay had neither Greece’s weak history of growth nor its fiscal indiscipline, and its much smaller deficit meant that it did not require the same order of fiscal adjustment. Uruguay benefited from terms-of-trade improvements after its devaluation and the subsequent global economic recovery.

"The best lesson we can learn from Uruguay is to ignore it altogether," says Segal at Jefferies. "Uruguay’s starting point was so much better than Greece’s both in terms of its debt burden and it’s much smaller fiscal deficit that the two situations are incomparable."

Arguably, in previous crises of confidence, such as that which afflicted the Asian economies in 1998, a combination of sizeable currency devaluation, fiscal retrenchment and a restructuring of the domestic banking sector inspired a relatively quick recovery. Not options that the eurozone countries can readily adopt.

Nicolas Firzli, managing director of the World Pension Council, says: "Unlike the recession of the early 1990s, the path to recovery will be longer and more tortuous this time around: our research suggests that the price of oil and commodities could remain at a relatively high level in the coming quarters, as Latin American, Gulf Arab and Asian governments are less inclined to accommodate Washington. More importantly, US and western European industrial firms (notably in strategic fields such as infrastructure, construction, energy and aviation) will have to vie for business under difficult circumstances, competing with new big global companies from rapidly growing nations such as China, South Korea, India, Brazil, Turkey and South Africa, as well as commodity-rich and infrastructure-savvy OECD countries such as Canada, Australia and Norway."

Will Greece default?

The markets long ago priced in a default on Greek debt far in excess of the 20% net present value reduction outlined by the Institute of International Finance’s (IIF) recently agreed rescheduling package.

In reality, Greece has few options. The fiscal targets it has been set are possible in theory, yet few economists believe they are politically viable. In the absence of a substantial haircut to its existing debt, Greece’s only other option is devaluation. A return to the drachma, alongside the conversion of its existing euro-denominated debt into the new currency, would substantially reduce the debt burden as well as enabling Greece to become more competitive.

Michael Wong, founder of rating agency CTrisks, says: "When currencies depreciate sharply there is a danger that long-term investor sentiment may be damaged, which is crucial to a country’s recovery prospects. But a country that is a strong exporter will also see commensurate benefits via improved terms of trade."

Yet aside from the distress that devaluation would cause the Greek banking sector, economists are divided over whether Greece would see real benefit from devaluation. "Greece is not a trading nation," says Parker, at Credit Suisse. "Aside from shipping, which is a dollarized industry, and tourism, which is aided to an extent by the euro, and some agriculture, Greece’s economy wouldn’t benefit from devaluation in the way that Argentina’s did."

Jerome Booth disagrees: "Don’t be fooled by talk that devaluation wouldn’t help Greece," he argues. "A devaluation of 30%, allied to debt relief of 70%, would strongly benefit the Greek economy and is the most likely solution."

Such a move would mimic Argentina’s decision to bail-in its creditors in 2005. The country’s government refused to give an inch during negotiations of its global debt exchange deal and successfully demanded a 70% principal reduction. Default and devaluation had already ravaged the economy, and Argentina’s country risk score plummeted to 27 points following the decision.

Argentina experienced a more rapid recovery than many had expected, averaging 8% growth between 2003 and 2007. However, the country is still effectively shut out of the international capital markets. "If Argentina wanted to come back today with a jumbo Eurobond, it would have serious problems," says Parker. "There is still outstanding debt from the default."

Stuart Culverhouse, chief economist at Exotix, says: "Debt sustainability analysis would show that the debt relief was excessive. Argentina now has $50 billion-worth of reserves. The ability to repay returned as quickly, perhaps more quickly, than people believed possible."

This article was published using data from Euromoney Country Risk (ECR), the online service from Euromoney dedicated to country and sovereign risk. To view the latest country rankings go to

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