The past two weeks has seen a lot of activity in the credit markets, especially with respect to sovereign credit risk. Naturally, the logical way to view this is via credit spreads and price/liquidity characteristics of credit default swaps (CDS). To that end, Tim Backshall of Credit Derivatives Research posted a couple of great – and interesting – charts over at Scribd which I’m including here.
The first is a BRICs/PIIGS ratio. This looks at risk premia in the CDS market as a ratio of BRICs (Brazil, Russia, India, China) CDS spreads over PIIGS (Portugal, Iceland, Italy, Greece, Spain) CDS spreads:
The second shows a spread between BRICs and PIIGS. The spread is simply a difference in the risk premia between the two groups:
What these two charts are showing is there is risk compression between the two groups of countries. BRICs are becoming less risky meanwhile the PIIGS are getting more risky. With the discussion of the strength seen in the BRICs and the credit risk showing up in the PIIGS, the charts make sense.
But I also want to look at this from a currency perspective because risk in investing isn’t linear and a lot of the time, it’s tangential. So risks to currencies may manifest in credit and vice versa. So I went ahead and prepared two charts to look at the relative performance of the currencies. The first is a time series chart back to 2000. I had to use the Euro as the proxy for the PIIGS and I created an equal-weighted index of the BICs (I couldn’t find daily currency data on Russian rubles in a pinch – no pun intended):
You can see the dollar has been weakening against the euro for some time now, while the BICs have been rangebound, largely because of China’s currency pegs at various points in time in the series. So there’s a distortion in the data created by that practice. I also looked at the correlation between the two:
The real driver of the strength in the euro is the economy and credit ratings in Germany and France. So you really have a situation where two relatively strong economies – and one (Germany) with tremendous fiscal discipline – “carrying the load” as it were for the other weaker economies of the PIIGS. The one question (and tail event) that sticks out in my mind is for a reconstitution of the Euro. What if France & Germany don’t want to pull the weight for their Eurozone partners and leave the rest of the continent in the lurch? With fiscal policies running out of control across developed economies, fiscal conservatives on the continent could demand to leave the monetary union.
The other event to look out for (and might have a higher probability occurring) is China removing their peg they put in place during the credit episodes we saw late last year. As a currency basket, the BRICs want to trade higher, so in the meantime, the best way to get exposure there is going long three of the four. Unless you were willing to deal with a potential updraft in the Renminbi if/when China loosens the choke collar on its currency. You might be better off watching paint dry than waiting for that to occur, but the irrefutable fact is that the Chinese economy has weathered current events better than everyone else thus far.
Another question that rattles around in my mind: in the case of sovereigns we may not frame the credit risk so much as an occurrence of a default event, but a devaluation event. Because in theory, governments don’t have to default on debt. They can request outside assistance (World Bank, IMF), they can raise taxes, or they can print more money and devalue currency. This may be something for others to weigh in on regarding what to be on the watch for. I don’t have the historic data to know whether or not what central banks/governments tend to do in situations like we’re seeing in the PIIGS and Dubai.