Sovereign credit risk contagion in emerging markets
| Autor | Laura Ballester, David Adrián García, Ana González-Urteaga |
| Páginas | 3-36 |
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Impreso en España – Printed in Spain.
SOVEREIGN CREDIT RISK CONTAGION IN EMERGING MARKETS1
Laura Ballestera,2 , David Adrián Garcíab, Ana González-Urteagac
a,b University of Valencia, Avda. Los Naranjos s/n, 46022 Valencia, Spain; c Public
University of Navarre, Arrosadia Campus, 31006 Pamplona, Spain
ABSTRACT
We document a framework for the analyses of contagion among sovereign
credit risk markets concretely through sovereign CDS spreads of different emerging
economies and regions during a period of prolonged financial distress. Following a
Generalized VAR (GVAR) approach, we firstly observe a significant amount of
commonality in emerging CDS portfolios over time that can be seen as previous signals
of contagion. Secondly, we found a high degree of relationship between the events
originated in the advanced economies and the total contagion in the CDS emerging
markets. Third, we found a high degree of credit risk transfer among emerging
economies, differentiating between transmitting and receiving risk portfolios. BRIC and
CIVEST portfolios are net transmitters of credit risk to all others emerging portfolios
during all the sample period. By contrast, Asian, Middle East Asian and African
portfolios are mostly credit risk receivers from all other portfolios and Eastern European
and American emerging portfolios are transmitters and receivers of contagion
depending on the evolution over time. Finally, there is enough evidence of credit risk
contagion to support the importance of this study.
Keywords: CDS spreads, emerging markets, spillover effects, GVAR
JEL codes: F30, G15, C32
1 The authors would like to express their gratitude for the grant received from the Fundación Ramón
Areces. A. González-Urteaga acknowledges financial support from ECO2012-35946-C02-01 and
ECO2012-34268. We thank Óscar Carchano, Mª Paz Jordá, and Ana María Ibáñez for valuable comments
and discussions on earlier drafts of this paper.
2 Corresponding author: Laura Ballester: Laura.Ballester@uv.es
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1. INTRODUCTION
Following the collapse in September 2008 of Lehman Brothers, the fourth
largest US investment bank, financial markets experienced tremendous distortions and
credit spreads rose to unprecedented levels. This had important implications for the
financial and sovereign system at international level, since financial institutions are
closely interrelated through derivative contracts so the bankruptcy of one of them could
cause losses to the counterparty, producing, as a result, new bankruptcies. This large
interconnection has increased in recent years as credit derivatives have been trading in
all financial markets, being the credit default swap (CDS hereafter) the most commonly
used instrument for transfer credit risk. CDS is a contract in which the protection buyer
makes a series of premium payments in exchange for the right to receive a payoff from
the protection seller if the underlying debt defaults. The premium payment made by the
protection buyer is called the CDS spread. CDS are quoted in basis points of the
notional value of the underlying debt instrument, typically a corporate bond. In fact,
CDS spreads theoretically reflect the credit quality of a particular country/firm and are
considered a good proxy of credit risk and the probability of default, and they also
reflect market perceptions about the financial health of a country.
The financial crisis not only affected the advanced economies. Emerging
countries were also affected by this situation. Among other consequences, the GDP of
the BRIC grew on average 7.25% in 2007 however in 2008, GDP grew 5.1% which
means that these emerging economies reduced their GDP growth in a 29.66% due to the
financial crisis that began in 2007 September. In addition, the most affected economies
by the financial crisis were Brazil and Russia. The first, registered a GDP growth for
2009 of -0.2%, which means the first contraction in 18 years of the country's economy.
While Russia's economy is more affected by the subprime crisis of 2008 as it recorded a
GDP growth for 2009 of -7.8% . Also, at the end of 2008, the government rescued four
of the largest banks in Kazakhstan; in March 2009, Arab banks had lost three billion
dollars, reaching in September almost four billion dollars loss since the onset of the
global financial crisis. In addition to the deteriorating economic conditions, it favored
the emergence of mass protest movements in North Africa and the Middle East, even to
government’s overthrown in some countries within these geographical areas that were
traditional allies of the West.
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Nowadays, emerging sovereigns are among the largest high-yield borrowers in
the world; however, their nature is different to other high-yield obligors. Since rating
agencies usually assign them the non-investment grade status, they are more likely to
default. However, emerging countries in financial distress generally do not enter
bankruptcy proceedings or ever liquidate their assets, but go through debt restructuring
mechanisms, which allow them to exchange defaulted bonds for new longer maturity,
lower yield debt instruments.
Using emerging market CDS spreads as indicators of sovereign credit risk, this
paper aims to identify the transmission mechanism of risk in the emerging market
during the prolonged crisis period. In this study, we define contagion as the change in
the propagation mechanism when a shock occurs and we measure it in terms of return
spillovers. We aim to shed some light on how contagion works among these economies,
as this is the key to understanding the sovereign propagation of financial crises. Firstly,
we employ a common approach to measure contagion using the correlation coefficients
across markets. That way we test initial signals of credit risk contagion between
emerging markets. Secondly, following a Generalized VAR (GVAR) approach (Diebold
and Yilmaz, 2012) we estimate contagion, in terms of return spillovers, between CDS
returns portfolios. In addition, the examination of the net directional return spillover
measures enables us to identify emerging portfolios that can be seen as net transmitters
and receivers of credit risk contagion. Unlike the majority of existing contagion studies
look at a combination of developed and emerging countries, we focus exclusively on
emerging markets, given the significant growth that their credit market has experienced
in last years and the serious consequences for some emerging countries during the
recent global financial crisis.
The large amount of data used and the existing heterogeneity between all the
emerging countries considered could cause a significant diversity of spillover effects,
which we will analyze in terms of portfolios. In particular, the data set consists of
sovereign CDS for 45 emerging countries, which we use furthermore to construct seven
emerging credit risk representative portfolios: BRIC, CIVEST, Eastern Europe, Asia,
Middle East Asia, America and Africa. Moreover, given the advantages of CDS spreads
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