Macro Vision June 13, 2017 Country risk: how far can it reach? The global environment has been favorable to emerging markets, despite the recent drop in commodity prices. Better global growth and lower external risks have been reflected in more benign asset prices over the past year. Foreign investors risk perception, as measured by the CDS (credit default swap), has declined in several emerging economies. In Brazil, it was no different: the country-risk premium fell from 500 bps in January 2016 to a level close to 250 bps in June this year. In addition to the benign evolution of the international scenario, the probability of approval of reforms, especially in the fiscal area, played a key role in explaining this movement. Maintaining the Brazilian risk premium at lower levels requires the continuity of the reforms, as well as a continuing benign international scenario. The benign international scenario has led to an increased risk appetite from foreign investors, despite the recent correction in commodity prices. Global indicators remain favorable, with growth in the U.S. and Europe surprising positively. Risks, in turn, seem contained. China s economic slowdown in the second half of the year will probably be gradual and not impact global markets significantly as it did in the 2013-2016 period. This is because the economy is now at in more comfortable cyclical position, with a more balanced housing sector (low inventories and sales surpassing new construction), exports trending upward and the decrease in public investment being offset by the recovery in the private sector. In the U.S., the protectionist agenda appears to have lost steam. Finally, in Europe, the political landscape seems more symmetrical. The risk of a Europopulist government still seems high in Italy, but has been avoided in France, which, along with Germany, will likely reinforce its support for the Eurozone even in Italy, Eurosceptic candidates performed poorly in recent regional elections. As a result, emerging economies assets performed well over the past year. Country risk premium (as measured by CDS 1 ) has retreated and currencies have appreciated against the dollar. Brazilian assets have shown a similar behavior. Between January 2016 and June 2017, country risk as measured by CDS fell by almost half, reaching levels close to 200 bps in early May. The Brazilian currency strengthened, appreciating from 4.00 reais per dollar in early 2016 to close to 3.25 reais per dollar in May 2017. 1 The CDS (credit default swap) is a bilateral contract that allows an investor to purchase protection against a credit event of the issuer of a particular asset. The greater the likelihood of an issuer s credit event (default), the higher the CDS premium, which serves as a measure of the respective entity s credit risk. Please refer to the last page of this report for important disclosures, analyst and additional information. Itaú Unibanco or its subsidiaries may do or seek to do business with companies covered in this research report. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the single factor in making their investment decision.
5-year CDS Macro Vision June 13, 2017 106 104 102 100 98 96 94 92 More appreciated emerging market currencies than in the beginning of 2016 Index number: jan/2016 = 100 Latin America Asia Central Europe and Africa 90 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 4,20 4,00 3,80 3,60 3,40 3,20 Lower country risk premium and more appreciated BRL BRL (lhs.) CDS (rhs) 530 480 430 380 330 280 230 3,00 180 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 We show below that the drop in Brazil risk premium is due both to the more benign international scenario and to the probability of approval of reforms, which has increased over the past year. We have also mapped the interval within which the Brazilian CDS will likely fluctuate over the coming years, under different domestic and international scenarios. Comparing country risk premium with the sovereign rating We have collected the sovereign rating 2 (by Standard & Poor s) and the five-year CDS for 65 countries at three different points in time: early 2016, April 2016 and May 2017. Based on these data, we have built three curves that relate sovereign ratings to CDS. 950 850 750 650 550 450 350 250 150 50 845 629 S&P Rating vs. CDS 673 537 May/2017 April/2016 January/2016 428 514 341 399 420 272 330 343 217 273 280 229 226 187 186 154 127 B- B B+ BB- BB BB+ BBB- S&P Rating Source: Bloomberg, S&P Ratings, Itaú 550 500 450 400 350 300 250 Brazil: 5-year CDS Jan/16 CDS=500 Apr/16 CDS=350 May/17 CDS=225 200 Apr-15 Sep-15 Feb-16 Jul-16 Dec-16 May-17 Fonte: Bloomberg, Itaú 2 The sovereign rating is the rating assigned by a rating agency to a country issuing debt, according to the agency s assessment of that country s ability to honor its debt. Naturally, countries with lower ratings have higher CDS, as there is increased probability of an event of default. Page 2
Macro Vision June 13, 2017 Over time, the curve has shifted downward. Shifts of the curve as a whole indicate changes in the international scenario that uniformly affect all countries with the same rating. More specifically, downward shifts of the curve indicate a more benign international scenario. For example, countries with BB sovereign rating (Brazil s current rating) had an average CDS of 341 bps in January 2016. In May 2017, the CDS of countries with the same BB rating was, on average, 150 bps lower than that level in January 2016 (at 186 bps). The improvement in the international scenario is also seen when we compare the VIX volatility index at the three different points in time. In January 2016, this index was around 25 points, having decreased to 15 points in April 2016 and then reached levels close to historical lows in May 2017 (10 points). In addition to the international improvement, the probability of approval of reforms played a fundamental role in the drop of the Brazilian CDS. In January 2016, Brazil risk premium was approximately 500 bps, which indicates that, at market prices, Brazil was seen as a B+ country. By April 2016, if the risk perception had only dropped in line with the international scenario, Brazil's CDS would probably be around 420 bps. However, at that moment, the country risk was at 350 bps, indicating that, at market prices, Brazil was already seen as a better rating country (BB-). A similar behavior was observed in May 2017: the Brazilian CDS, around 200 bps, indicated that at market prices, Brazil was already seen as a BB country. Curve shifts indicate an improvement in the international scenario. Shifts along the curve, on the other hand, indicate idiosyncratic improvement in the perception of country risk. We may conclude that, between January 2016 and May 2017, in addition to the more benign outlook for emerging countries, the probability of approval of reforms contributed to a drop in Brazil risk premium. How far can the Brazilian CDS reach? We start from the equation below, in which Brazil s country risk is only a function of the average CDS of other 21 countries. The other countries CDS is a proxy for the international factors, while the domestic factors are represented by the error (ε) of the regression (i.e., everything that is not explained by international factors). Brazilian CDS = α 1 + α 2. other countries CDS + ε The following charts show the Z-score of the evolution of the international (other countries CDS) and domestic (ε) factors 3 ; i.e., at each point in time, the Z-score represents the number of standard deviations (s.d.) by which each of the indicators is above (+) or below (-) the historical average. 2.00 1.50 1.00 0.50 0.00-0.50-1.00-1.50-2.00 International factors 2008 Crisis -2.50 05 06 07 08 09 10 11 12 13 14 15 16 17 Z-score of the CDS of other countries Domestic factors 3.00 Z-score of the model error 2.50 2.00 1.50 1.00 Investment grade 0.50 0.00-0.50-1.00-1.50-2.00 05 06 07 08 09 10 11 12 13 14 15 16 17 3 We have calculated the Z-score of the log of the international and domestic factors series; i.e., we have subtracted the historical average and divided by the historical standard deviation. Page 3
International factors Macro Vision June 13, 2017 A few interesting points arise from these charts: Regarding international factors, it should be noted that: There was a pattern change between the 2008 pre-crisis and post-crisis periods. Up to the crisis, the Z-score of international factors remained in negative territory, which indicates that, during this period, the external scenario was more benign than the average of the sample period. It is worth remembering that, between 2005 and 2007, average global growth reached 5% and public indebtedness was much lower (around 65% of GDP). After the crisis, there was a clear change in this trend: the Z-score of international factors began to fluctuate in positive territory, indicating a less-benign international scenario compared to the average of the sample period, in line with the scenario of lower global growth and larger public debts. In the most recent period (2013-2017), the index has remained between 0 and 0.5 s.d. above the historical average. At the margin, however, the international scenario is at its most benign point in the post-crisis period. That is, the Z-score of international factors is close to zero (close to the historical average). Regarding domestic factors, it should be noted that: The Z-score of domestic factors remained below zero only while Brazil held the investment grade rating. That is, Brazil's country-risk premium remained below the historical average only during this period. After the loss of the investment-grade rating, the index has remained between 0 and 1 s.d. above the historical average. More specifically, over the past year, the probability of approval of reforms has led the Z-score of domestic factors from one to close to zero. Based on this information, we have built the table below, which shows the Brazilian 5-year CDS that would be compatible with different external and domestic scenarios. We have restricted the domestic and international factors to the recent fluctuation range. In the first case, from 0 to 1 s.d. in relation to the historical average, and in the second, from 0 to 0.5 s.d. in relation to the historical average. 5-year Brazil CDS compatible with different scenarios Domestic factors 0.00 s.d. 0.25 s.d. 0.50 s.d. 0.75 s.d. 1.00 s.d. 0.00 s.d. 174 210 253 305 368 0.125 s.d. 207 249 301 363 437 0.25 s.d. 246 297 358 431 520 0.50 s.d. 246 297 358 431 520 At the international level, we believe that the scenario will likely remain benign ahead that is, close to the historical average (0 s.d.) or slightly worse (+0.125 s.d.). Global growth will probably remain robust, being only partially offset by the withdrawal of monetary stimuli in developed economies. In the domestic scenario, the 0 to 1 s.d. interval in relation to the historical average reflects the probability of progress in the reforms; zero being the case in which the reforms advance in a similar way to that proposed to Congress, and one being the opposite case. This inference is based on the evolution of the domestic scenario over the past year, as described in the table below. Page 4
Macro Vision June 13, 2017 Domestic factor Domestic scenario description High after losing investment grade +0.86 D.P. Without prospect of reforms Low after losing investment grade +0.17 D.P. Reforms advancing Thus, the analysis of domestic and international factors leads us to believe that the Brazilian CDS can fluctuate between 175 bps and 400 bps. More than the external scenario, it will be crucial to understanding how the political landscape will affect the reforms, especially in the fiscal area, in order to determine the country risk level over the coming years. Conclusion Brazil's country risk, as measured by the 5-year CDS, fell more than 250 bps within a year and a half. In addition to the more favorable global environment, which led to a reduction in the risk premium of different economies around the world, the benign evolution of the domestic scenario, with a greater probability of approval of reforms that help stabilize public debt, was fundamental. Looking ahead, the continuity of the reforms, as well as the continuation of the benign international scenario for risky assets, will be crucial for the maintenance of country risk at low levels. Julia Gottlieb Macro Research Itaú Mario Mesquita Chief Economist Tel: +5511 3708-2696 Click here to visit our digital research library. Page 5
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