Sovereign Risk, Financial Development and Capital Flow in Emerging Markets

Master Thesis

International Business and Management

Specialization in International Financial Management

Sovereign Risk, Financial Development and

Capital Flow in Emerging Markets

2009

Supervisor:

Dr. N. Brunia, ing

Coordinator:

Prof. Dr. C.L.M.Hermes

Abstract

Kim and Wu (2008) investigated the influence of sovereign risk on financial development and international capital flows in emerging markets by using sovereign credit ratings. Credit ratings are from rating agencies’ perspective and have been blamed to be a lag to market events. In comparison, sovereign bond spread1 is a more objective and timely indicator to measure sovereign risk. By using a longer and more recent time series, I will investigate the influences of sovereign risk on financial development and international capital flows in emerging markets by employing EMBI (Emerging Market Bond Index) Global. It is found that sovereign bond spread is an impulse to stock market but deterioration to bonds market. Different types of capital flows are influenced by sovereign bond spread dissimilarly.

Keywords: Sovereign risk, sovereign bond spread; financial development;

Table of Content

ABSTRACT ... 2

1. INTRODUCTION ... 4

2. LITERATURE REVIEW ... 6

2.1SOVEREIGN BOND SPREADS AND SOVEREIGN CREDIT RATING ... 6

2.2ESTIMATIONS ... 8

3. METHODOLOGY ... 10

3.1FINANCIAL SECTOR DEVELOPMENT MODEL: ... 11

3.2INTERNATIONAL CAPITAL FLOW MODEL ... 12

3.3CONTROL VARIABLES ... 13

3.4STATISTICAL DATA PROCESSING ... 13

4. DATA ... 16

4.1INDEPENDENT VARIABLE ... 16

4.2DEPENDENT VARIABLES ... 17

4.3CONTROL VARIABLES ... 18

5. RESULTS ... 18

5.1RESULT OF FINANCIAL SECTOR DEVELOPMENT ... 18

5.2RESULTS OF INTERNATIONAL CAPITAL FLOW _{... 22}

5.3OTHER FINDINGS _{... 24}

6. CONCLUSION ... 25

REFERENCE ... 28

1. Introduction

In the past decades, sovereign risk has started playing an influential role in an integrated financial and economic world. Therefore, governments, financial institutions and international investors have all been keeping their eyes on a country’s creditworthiness. According to Obstfeld and Rogoff (1996), sovereign risk can be defined as ‘any situations in which a government defaults on loans contracts with foreigners, expropriates foreign assets located within its borders, or prevents domestic residents form fully meeting obligations to foreign creditors’.

on domestic financial development and international capital flows. Amadou (2002) states that sovereign bond spreads as an indicator of default risk can be used to assess a country’s economic and political fundamentals, and a proxy for capital market access as well. The levels of economic and political risks can be reflected by both credit ratings and bond spreads. However, Larrain et al. (1997) depict that credit ratings are point of views of analysts, which may contain the information which may not be the same as sovereign risk.

time after. In this vein, sovereign bond spread is more accurate than credit rating and might be more appropriate to measure sovereign risk.

Financial development will be measured by investigating equity market, banking sector and bonds market. FDI flows and portfolio flows are considered to measure international capital flows. JP Morgan’s EMBI Global is employed as an indicator of sovereign risk. The whole dataset of EMBI Global is considered, which includes 41 emerging markets for the period from 1993-2007. Due to the different time of joining EMBI Global Index, there are only 12 countries that cover the whole period of 15 years, and the rest of 29 countries have different time series. Elaborated explanations of variables will be discussed in the later section.

I will adopt the empirical models of Kim and Wu (2008) and compare my results with their findings. Four types of ratings are concerned in the study of Kim and Wu (2008), while bond spread only provides one value so that it makes the comparison difficult. Moreover, short-term ratings of Standard and Poor’s only include bonds with the maturity of less than 12 months and EMBI Global only considers issues with more than 2.5 years maturity. The differences in time period and currency will help to examine whether the sovereign risk’s influences on the development of financial sectors and international capital flows vary because of time period or currency differences. To find out where the potential risk exactly exists, it can help international investors to find the right solutions to deal with the risk, and make better investment decisions.

2. Literature Review

2.1 Sovereign Bond Spreads and Sovereign Credit Rating

unexpected defaults and sudden credit downgrade in recent years show that there is scant informational value of credit ratings (Partnoy, 2001).

In addition, credit ratings have been said to be a lag the market instead of leading to the market events. During the Mexican crisis in the middle of 90’s, before the Mexican Peso suffered devaluation and affected the worldwide financial markets, the credit rating from Standard and Poor’s still had a positive outlook for Mexico (Larrain et al., 1997). Similarly, International Monetary Fund (1998) depicts that during the Asian crisis, only Thailand was downgraded by Moody’s in the April 1997, but no other East Asian countries were downgraded in the whole year of 1996 and the first half of 1997. Instead of foreseeing and downgrading the countries before the crisis, some of the countries such as Indonesia, Korea and Thailand were downgraded below the investment level during the crisis. That is the reason for saying that credit ratings not only fail to predict but also deteriorated the crisis (Mora, 2006). Ferri et al. (1999) argued that rating agencies amplify the crisis by downgrading the countries during the crisis, which can not be explained by their economic fundamentals. Similarly, Kaminsky and Schmukler (2002) state the credit rating amplify the boom-bust cycle. In their study, they find that changes and outlooks of credit ratings not only affect the bonds market but also the stock market. These results indicate that rating agencies acting with a lag only convey bad news in bad times and good news in good times.

Mora (2006) states that changes of credit ratings might be depended on the spread movements, because the data’s nature from rating agencies has a limit to control for country’s fundamentals. Altman and Rijken (2004) depict that as one of the shortcomings, credit ratings from rating agencies are usually long-term oriented, which means rating agencies only respond to those credit quality changes that they perceive as permanent.

Sovereign bond spreads provide investors who care about short-term risk assessment with accurate point-in-time measures of risk (Remolona et al., 2007). The most important point is that Larrin et al. (1997) and Reisen and von Maltzan (1999) tested Granger causality between credit rating announcements and sovereign bond spreads. They find that in the anticipated direction, sovereign bond spreads move before the changes of credit rating.

2.2 Estimations

Kaminsky and Schmukler (2002) used sovereign credit rating of sixteen emerging countries for the period from 1990 to 2000, and examined whether stock market spillovers will influence market instability across securities and countries. They find that in emerging markets, changes in credit ratings of sovereign bonds are inter-related with returns on stock. And these changes are usually due to the expectations according to the new information (Li, et al., 2008).

Brooks, et al. (2004) did an empirical study of how changes in sovereign credit ratings influence the stock market. The results show that the information conveyed to the market only when the downgrades in ratings happened. Similarly, Rigobon (2002) conducted a research about the impact of an upgrade in Mexico’s non-investment level to investment level in 2000. The result shows that when the upgrade was announced, statistically, there was a huge change of the propagation of shocks (Gande and Parsley, 2005). The two researches have different arguments, still conclusions of both studies agree on one opinion, which is that the stock market is affected by the changes of sovereign credit ratings. Kim and Wu (2008) find that sovereign credit ratings do have a significant influence on stock market. However, the different measures show different associations with the four types of ratings. An improvement in credit rating signals a low sovereign risk, it may stimulate stock market development. Based on the previous studies, proposition is made as following:

Kumhof (2004) depicts that once a country experiences sovereign defaults, a domestic financial crisis usually occurs. Kumhof and Tanner (2005) state that when financial crisis occurs, it will lead to a country’s debt devaluation, and after that, it always comes up with the domestic banking problems. This situation happens especially when the income of the country is mainly based on taxation of non-tradable goods, and the sovereign debt is denominated in foreign currency. It will usually end up with sovereign defaults because of the devaluation to domestic currency. However, conflicting results are found by Kim and Wu (2008) that both long-term and short-term local currency ratings have a negative impact on banking sector. A higher sovereign risk means more possibility to suffer a default. According to the findings and explanations of Kumhof and Tanner (2005), the proposition of banking sector is:

Sovereign risk has a deteriorating effect on the development of banking sector.

Kabn (2005) depicts that default risk and high inflation are impediments to the development of domestic bonds market. Kim and Wu (2008) find various results of using four different types of ratings. In emerging markets, the problem of lacking development of local currency denominated bonds generally exists. This is what called ‘original sin’, Eichengreen and Hausmann (1999) use the term firstly to refer to ‘the inability of developing countries to borrow abroad in their own currency’. Based on the theory, the proposition is:

Sovereign risk discourages the development of domestic bonds market

theoretical argument of ‘pull and push’ factor approach, which advocates that when the country risk is low, capital flows to the receiving country will be increased. Similar studies were done by Eaton and Gersovitz (1981, 1984), Cohen and Sachs (1986), Marcet and Marimon (1992), and Thomas and Worrall (1994). Their findings all share one conclusion that capital flows from rich to poor countries can be reduced by sovereign risk (Maliar, et al., 2004). However, Kim and Wu (2008) find conflicting results indicate that the improvements in ratings generally hamper international capital flows into the emerging markets. According to the findings of previous studies mentioned above, I would like to estimate that:

Sovereign risk deters international capital flows.

Taken together, sovereign risk has negative influences on both financial development and international capital flows.

3. Methodology

3.1 Financial Sector Development Model:

Kim and Wu (2008) used the following equation (1) to estimate the impact of sovereign risk on domestic financial sectors. The difference here is that sovereign risk is measured by sovereign bond spreads instead of sovereign credit ratings.

FINDEVi, f, t =

α

α1, i, f

α

∑

α

∑

α

ε

FINDEV – financial sector development

f – stock market, banking sector and bonds market variables i – country

t – year

EG – EMBI Global ECON – economic variables

WGI – world governance indicators

To measure the level of financial sector development, same as Kim and Wu (2008), I will take stock market, banking sectors and bond market into consideration. While several indicators used to measure the development of each sector are slightly different.

In stock market three ratios are used. The first is the total value of shares traded to GDP ratio, which is the amount of stock traded in value divided by GDP. It reflects the liquidity on a national economy basis. The second is market capitalization to GDP ratio, which equals the value listed shares divided by GDP. The last one is stock market turnover ratio. It is the amount of stock traded in value divided by the average market capitalization for the period (Hamid and Sumit, 2004).

by leading-deposit spread; it equals to the interest rate charged by banks on loans to prime customers minus the interest rate paid by commercial banks for demand, time, or savings deposits. The ratio of banking non-performing loans to total gross loans is used to measure the banking sector stability.

In bonds market, two ratios are used. The first is the private bonds market capitalization divided by GDP; it is the ratio of the total amount of outstanding domestic debt securities issued by private or public domestic entities divided by GDP. The second ratio is international debt issues to GDP; it is the international debt securities (issued by all issuers) as a share of GDP

3.2 International Capital Flow Model

In the equation (2) as following, the model is used by Kim and Wu (2008) to measure how sovereign risk influences the international capital flows in emerging markets.

CAPFLOWi, f, t =

α

α

α

∑

α

∑

α

ε

CAPFLOW – international capital flow

f – international capital flow variables i – country

t – year

EG – EMBI Global

ECON – economic variables

WGI – world governance indicators

investment and bond portfolio investment. The flow of equity portfolio investment is the sum of country funds, depository receipts, and direct purchases of shares by foreign investors. The flow of bonds portfolio investment consists of bond issues (the sum of public bonds, publicly guaranteed bonds and private nonguaranteed bonds) purchased by foreign investors.

3.3 Control Variables

Kim and Wu (2008) state that with the improvement in financial development and international capital flows, it would result in better credit ratings. This might lead to an endogenous relationship between financial development, international capital flows and sovereign risk. To reduce the effects, Kim and Wu (2008) use the initial levels of financial development in each sector and types of capital flows. The initial level is deputized by using a lag of the dependent variable. This paper will adopt the same method to avoid the endogeneity.

Gande and Parsley (2005) depict that sovereign risk should not be considered as an isolated effect.Therefore, in addition to the variables mentioned above, there are also other factors which are commonly recognized to have influences on sovereign risk; such as political risk, inflation, exchange rate etc. Consumer Price Index (CPI), ratio of bank liquid reserves to bank assets and annual GDP growth are used to respectively control the development of stock market, banking sector and bonds market. World Governance Indices (WGI) is the aggregated world government indicators containing six different governmental dimensions, which are one of the most comprehensive political indicators.

3.4 Statistical Data Processing

Table 2-a: Descriptive Statistics

Mean Median Maximum Minimum

EMBI _{152.04 134.97 1.00 599.46} Stock Traded _{9.32 2.92 0.11 89.93} Turnover _{31.32 14.75 0.20 251.92} MC _{28.31 16.53 0.19 197.80} M2 _{38.36 32.75 1.23 149.54} IRS _{9.71 5.97 -6.91 58.36} Nonperforming Loan _{10.30 8.40 0.90 34.40} Private Bond MC _{0.37 0.27 0.11 0.99} Inter. Debt _{0.41 0.33 0.11 1.18} FDI _{3.11 2.58 -8.52 12.88} Equity Portfolio _{825345.40 193.00 -32272.00 134200000.00} Bond Portfolio _{343665.82 16959.00 -4435766.00 4716426.00}

EMBI – EMBI Global; Stock Traded – Total value of shared traded/GDP; Turnover – Stock market turnover ratio; MC – Stock market capitalization/GDP; M2 – M2/GDP; IRS – Interest rate spread;

Nonperforming Loan – Banking nonperforming loans/total gross loans; Private Bond MC – Private bond market capitalization/GDP; Inter Debt – International debt issues/GDP;

FDI – Net inflow of foreign direct investment/GDP; Equity Portfolio – Flows of equity investment portfolio; Bond Portfolio – Flows of bond investment portfolio;

Table 2-b: Descriptive Statistics

Standard Deviation Skewness Kurtosis

EMBI _{131.95 1.74 1.29} Stock Traded _{15.73 7.73 2.72} Turnover _{44.13 7.74 2.62} MC _{35.55 6.31 2.48} M2 _{27.68 3.06 1.54} IRS _{10.48 6.14 2.44} Nonperforming Loan _{8.08 -0.26 0.81} Private Bond MC _{0.25 -0.41 0.86} Inter. Debt _{0.27 -0.84 0.68} FDI _{2.77 1.81 0.72} Equity Portfolio 10400286.89 158.16 12.61 Bond Portfolio _{951384.81 7.58 1.45}

net inflows of foreign direct investment divided by GDP conform to the criteria. Data transformations are applied to the variables which fail to meet the normality test. One of the most common non-linear data transformation logarithm is used to the variables with all positive values, which are the total value of shared traded divided by GDP, turnover ratio, market capitalization divided by GDP and M2 divided by GDP. Inverse (1/x) transforms are used to deal with the variables contain negative values (interest rate spread, flows of equity investment portfolio, flows of bond investment portfolio). P-P Plot is used to check the acceptance of the transformed variable; such an example is exhibited in Appendix - Figure 2.

Table 3 presents the results of correlation coefficient test of all the variables. When the correlation between two independent variables is high, it causes the problem of collinearity. The problem of collinearity can be fixed by dropping the offending variables from the regression equations. The normality and heteroscedasticity of residuals are diagnosed by plotting scatterplot and PP plot. An example is shown in Appendix -Figure 3. Residuals of all the estimations are all checked by using the same method.

4. Data

4.1 Independent Variable

Cunningham et al. (2001) state that sovereign bond spreads in emerging markets are generally perceived to be the risk of default, as it is the additional compensation for investors to hold the bonds from emerging markets. EMBI Global from JP Morgan is used to measure sovereign bond spread in this study.

issued by sovereign and quasi-sovereign entities including U.S dollar denominated Brandy Bonds, Eurobonds, traded loans, and local market debt. The index only concerns emerging markets issues denominated in U.S. dollars with a minimum current face outstanding of US$500 million. Besides, the issue in EMBI Global must have at least 2.5 years to maturity, and will be removed from the index 12 months before its mature (Cavanagh and Long, 1999).

As EMBI Global is produced on regular business days (U.S. bond market calendar), I collected the daily bond spreads from EMBI Global for the period from 1993 to 2007. There are 41emerging economies listed in the index till 2007; all these 41 countries are considered in this study. Since countries joined the EMBI Global Index in different times, which means the countries in the sample have different time series. The data is available from DataStream’s Bond Indices section. Compared the time period from 1995 to 2003 in the study of Kim and Wu (2008), this paper consists a longer and more recent data.

4.2 Dependent Variables

As mentioned in the last section, international flows are measured by using three capital sources, which are the net inflows of FDI as the percentage of GDP, flows of bond portfolio investment and flows of equity portfolio investment. The data are available from the World Bank Development Indicator 2007.

4.3 Control Variables

Citron and Nickelsbrug (1987) find that political stability is statistically significant related to the level of sovereign risk. Kim and Wu (2008) state government policies and fiscal position of an economy play a crucial role at the early stage of financial systems in emerging markets. Annual GDP growth, consumer price index (CPI) and ratio of bank liquid reserves to bank asset2 are used to control for the outcomes. The data of the variables are available in the database of the World Bank Development Indicator 2007. WGI is perceived as one of the most comprehensive integrative indicators, it measures governance from six different dimensions. It includes voice and accountability, political stability, government effectiveness, regulation quality, rule of law, and control of corruption. The data of WGI are from the official website of The World Bank.

5. Results

5.1 Result of Financial Sector Development

Results of financial sector development are shown in Table 4. The results indicate that sovereign bond spreads do not always have an influence on all the variables of each financial sector. The r-square of the estimations vary from the lowest 30% to the highest 99%. It is found that the developments of stock and bonds market are significantly related to the sovereign bond spreads. However, no evidence is found that sovereign bond

spreads have an effect on the development of banking sector. A comparison of results to Kim and Wu (2008) is exhibited in Appendix - Table B.

In the stock market, total value of shares traded divided by GDP is positively related to sovereign bond spread. No evidence shows that stock market turnover ratio is influenced by the changes of sovereign bond spread. Stock market capitalization as the percentage of GDP is found to have a strong positive relationship with sovereign bond spread. The results indicate that as the sovereign bond spread gets wider, it stimulates the development of stock market. It also can be interpreted as when the sovereign risk is getting higher, the stock market gets improved. It can be explained by Kim and Wu (2008) that this result might represent signals of market activities shift from or into the stock market. There is not any evidence found that stock market turnover and sovereign bond spread are related. While Kim and Wu (2008) find that long-term local foreign and currency ratings are significantly relate to the turnover ratio. Moreover, neither ratings of local and foreign currency has an effect on the total value of shares traded divided by GDP or market capitalization as the percentage of GDP. However, I find positive relationships as mentioned. This might suggest that in a long-term orientation, differences in currency may affect the relationship between sovereign risk and stock market development. Though short-term ratings and EMBI Global do not measure at the same level considering the maturity of issues, it is found that results of using EMBI Global are generally consistent with the short-term ratings of Kim and Wu (2008).

legal environment are the determinants of banking development.

In the bonds market, it is found that sovereign bond spread has an significant (coefficient -0.0959) influence on international debt issues divided by GDP. No evidence is found that sovereign bond spread can influence private bond capitalization as the percentage of GDP. In contrast, Kim and Wu (2008) find a positive relationship between long-term foreign currency rating and private bond capitalization as the percentage of GDP. Other results of Kim and Wu (2008) show negative relationships between all types of ratings and bonds market development. However, I find that generally a lower sovereign risk will help to improve the development of bonds market, which is inconsistent with the finding of Kim and Wu (2008). This conflict might be the result that the four types of ratings of Standard & Poor’s are inter-related, while sovereign bond spread is a single indicator. For example, improvements in short-term ratings will also lead to upgrades in long-term ratings and changes in long-term ratings will also affect short-term ratings.

5.2 Results of International Capital Flow

The estimations of Model (2) are presented in Table 5. The variations of development measures are explained ranging from 25% to 61%.

Table 5: Panel Data OLS Regression for Capital Flows

FDI Equity Portfolio Bond Portfolio

Intercept 0.1716 7.53E-07 1.64E-08

(0.7754) (0.3816) (0.2557)

Lag 0.0060 1.6590*** -3.93E-02***

(0.1895) (0.0000) (0.0000)

EMBI 0.17870*** 3.84E-08 -1.68E-09*

(0.0000) (0.4576) (0.0583)

GDP _(0.8190) -0.0032 -3.61E-09 _(0.8632) -2.09E-10 _(0.5539)

CPI -0.0028* _(0.0519) -5.35E-10 _(0.7890) 5.24E-11 _(0.1194)

BLR -1.50E-11 -8.65E-16*** -1.66E-18**

(0.6064) (0.0000) (0.0172) VA _(0.1595) 0.1676 4.75E-08 _(0.7747) 1.02E-09 _(0.726) PSNV -0.6521*** -1.35E-07 -3.32E-09 (0.0000) (0.3973) (0.2151) GE _(0.6042) 0.1362 -4.37E-07 _(0.2386) 1.14E-08* _(0.0776) RQ -0.5515** -1.43E-07 -3.12E-09 (0.0109) (0.634) (0.5687) ROL 0.8199*** 4.86E-07 -2.81E-09 (0.0029) (0.2035) (0.6754)

COC -0.0316 -3.87E-09 7.93E-10

(0.9056) (0.9918) (0.8995)

R – Square 0.2564 0.6142 0.3801

The result shows that sovereign bond spreads have a positive effect on the net inflow of foreign direct investment, which can be interpreted as that a wider sovereign bond spread will impetus the net inflow of FDI. This result is consistent with the finding of Kim and Wu (2008). They find that improvements in short-term local and foreign currency ratings dampen the FDI flows. Yet, they also find that improvements in long-term ratings do not have an influence on net inflows of FDI.

In the aspect of portfolio flows, it is found that the sovereign bond spread has a negative influence on the flows of bond investment portfolio. The flows of bond investment portfolio are improved when there is a decrease in sovereign bond spread. No evidence is found that sovereign bond spread can affect the flows of equity investment portfolio. These results indicate that due to a higher sovereign risk, international investors would tend to lessen the weight of bond investment, but the weight on equity investment would not be influenced.

In financial sectors, economic and political control variables are also found to be significant. GDP growth is found to have a positive influence on the stock market variables but have negative effects on both banking sector and bonds market. In emerging markets, high levels of economic growths are associated with more advanced financial systems (Kim and Wu, 2008). As an estimation of inflation, CPI deters the stock market and banking sectors variables, but encourages the bonds market. The findings are consistent with asset pricing literature of Campbell and Ammer (1993). Unexpected associations are found that economic fundamentals deteriorate capital flows, which is consistent with the results of Kim and Wu (2008).

performance. FDI flows show negative responses to political stability and regulatory quality. Lack of public services provision and policy efficiency might be considered by international investors as advantages for profits (Kim and Wu, 2008).

6. Conclusion

stock market and international capital flows. Governance indices are found especially crucial to stock market, bonds market and FDI flows

Concerning issues’ maturity of EMBI Global, the results should be in line with the long-term ratings of Kim and Wu (2008). Except for the contradictions outcomes, results in this paper are not only consistent with findings of long-term ratings but with the short-term ratings as well. As a matter of fact, I find that the results are mainly in line with the short-term ratings, both in financial development and international capital flows. These different findings suggest that the influence of sovereign risk on the development of financial sectors and international capital flows might not involve time period orientation. A suggestion for those international investors who take sovereign risk as a benchmark for their investment is that instead of only concerning either sovereign bond spread or sovereign credit rating, a risk from currency is noteworthy.

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Appendix

Table A: Countries in the Sample

Georgia Gabon Srilanka Ghana Jamaica Kazakhstan

Trinidad Tobago Belize Iraq Vietnam Serbia Indonesia

Tunisia El Salvador Dominican Rep. Egypt Pakistan Uruguay

Ukraine Chile Hungary Lebanon Thailand Cote D’lvoire

Colombia Malaysia Turkey South Africa China Philippines

Panama Poland Russia Ecuador Argentina Peru

Mexico Brazil Morocco Bulgaria Venezuela

Figure 1

Figure 2

Figure 3-2

Table B: Comparison of Results

Long-term Local Long-term Foreign Short-term Local Short-term Foreign EMBI Stock

Traded N.A. N.A. - N.A. +

Turnover + - N.A. N.A. N.A.

MC N.A. N.A. - N.A. +

Banking

Sector - N.A. - N.A. N.A.

Bonds

Market - + - - -

FDI N.A. N.A. - - +

Equity

Portfolio - N.A. + N.A. N.A.

Bond