Eastern Europe: Risk Perceptions versus Economic Fundamentals

Friday, 02 September 2011 13:33
By John Howell & Company

Investors are struggling to value the debt of European countries given uncertainty about contagion and economic growth potential.  Today, the challenge for investors is to compare countries across Europe based on their fundamental economic strengths and weaknesses and identify the core factors that drive economic resilience. In particular, they struggle to apply appropriate risk premia to government bonds of core eurozone, eurozone periphery, and Eastern Europe, as the rule of thumb that developing countries should pay higher risk premia not longer holds true. This raises serious questions about debt pricing in Eastern Europe. Eastern Europe: Risk Perceptions versus Economic Fundamentals addresses this question by analysing Eastern European countries and identifying those that have disparities between economic fundamentals and market risk perceptions, as reflected in their sovereign debt yields and CDS spreads. It also provides insight into the fundamental economic strengths of individual countries and the region as a whole in a wider European perspective. The following Eastern European countries are covered:
  • Bulgaria;
  • Czech Republic;
  • Estonia;
  • Hungary;
  • Latvia;
  • Lithuania;
  • Poland;
  • Romania;
  • Slovakia; and
  • Slovenia.

This analysis is driven by our unique proprietary model, Quantitative Country Analytics (QCA). QCA is the most in-depth tool for comparative, comprehensive economic analysis among those available on the market at the moment. It currently covers 174 countries in the world with equal depth. QCA's single score is driven by 17 critical factors, characterising the economic, political and socio-demographic situation in a country, which in turn create three pillars: external adjustment capacity, institutional robustness and medium-term growth potential. The 17 factors are composed of 62 sub-factors. This enables us to rank countries' relative risk and attractiveness based on both their overall score and their pillar scores.

QCA enables investment managers to improve risk adjusted returns by identifying mispricing of assets based on country risk and growth prospects.  Our extensive back-testing has shown that QCA-driven portfolios consistently outperform the market by avoiding risk and identifying underappreciated opportunities. Use of QCA facilitates profitable risk taking and helps demonstrate a sophisticated and prudential approach to risk taking to investors, shareholders and regulators.

Published September 2011
ISBN 978-1-907720-27-7
57 pages

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For full contents in PDF format,  click here
For the FREE Introduction, click here

Analytical approach

Measuring economic fundamentals in a consistent manner across countries and time can be a challenging exercise. Alternative studies on country risk pricing often use country credit ratings as a proxy for economic fundamentals. Credit ratings have not always been a timely or indeed accurate reflection of risk.  The commercial and operating models of the three key credit rating agencies leaves their analysis prone to distortion.   Moreover, research suggests that 80 percent of the variation in ratings can be explained by GDP per capita. We use JH&Co’s proprietary methodology, Quantitative Country Assessment, which is more effective at consistent comparison of economic fundamentals.

Quantitative Country Assessment (QCA) is a quantitatively driven analytical scoring system that measures a country’s ability to withstand external shock and recover through adopting a new growth model. QCA uses over 100 quantitative inputs sourced from official public such as the World Bank and IMF. It measures 17 critical factors, which in turn create three pillars. The 17 factors are made of 62 sub-factors. The average of these scores creates one country score, enabling us to rank countries based on their relative attractiveness. The pillars are:
1.    External adjustment capacity: a country’s ability to withstand an external financial shock.
2.    Institutional robustness:  measures the robustness of the country’s institutions to implement policy, including fiscal, banking sector institutions and governance by looking at whether governments have a track record of delivering good policy.
3.    Medium-term growth potential: the ability of the economy to grow and achieve a new growth path if necessary.

QCA is successful because it is:
  • Effective - backtesting of QCA’s predictive qualities shows that it adds considerable value to government bond portfolio construction and emerging market equity portfolios.  QCA is also a good predictor of changes in country credit ratings.
  • Rigorous – QCA has over 100 data inputs per country.  Its complex algorithms and recursive interaction distils the various data points into critical factor scores.
  • Transparent and decomposable – QCA’s country score can be decomposed into three pillars, 17 factors and 62 sub factors
  • Broad based and comparable – QCA covers 174 countries and its decomposable scores allow comparing across the full range of different QCA scores.
QCA was created in 2007 at the request of some of our sovereign wealth and private equity clients who wanted a quantitatively driven rigorous medium-term country analysis that allowed them to rank countries.  It forms the basis of the advice we give to our investor clients and allows them to make more informed decisions.  It is also used in the macroeconomic and policy advice we give our government clients.

Since numerous research studies have shown that most of the variation in markets’ risk perceptions (measured through either yields, yield spreads or CDS) are explained by short-term economic indicators, such as GDP growth, current account balance, fiscal deficit, inflation rate etc. In Part I of the report, Risk pricing versus fundamentals, we use Pillars I & II as reflecting a short- to medium-term measure of countries’ economic fundamentals. In Part II, East European Fundamentals in Detail, Pillar III is added and captures medium- to long-term resilience of the economies.


Key findings
Introduction and overview
Analytical approach: Quantitative Country Assessment as a tool for measuring economic resilience

PART I. Risk pricing versus fundamentals
1.1.    Country risk in Eastern Europe
1.1.1.    Slovakia vs Czech Republic
1.1.2.     Slovakia vs Hungary
1.2.    Eastern Europe in a global context
1.2.1.    Intra-regional risk in Eastern Europe
1.2.2.    Global risk pricing
1.2.3.    Does risk pricing accurately reflect the fundamentals?

PART II. East European fundamentals in detail
2.1. Bird’s eye view on Eastern Europe and comparator regions
2.2. Intra-regional overall economic performance
2.3. External adjustment capacity
2.3.1 Macrofinancial adjustment capacity
2.3.2 Reserves
2.3.3 External indebtedness
2.3.4. Current account
2.3.5. Trade vulnerability
2.4. Robustness of institutions
2.4.1. Monetary policy/inflation
2.4.2. Fiscal policy and debt
2.4.3. Banking sector
2.5. Medium-term growth potential
Actual versus potential growth
I2.5.1. nnovation and technology
2.5.2. Demography and human resources
2.5.3. Business environment
I2.5.4. nfrastructure

Table 1. Selected economic indicators, the Czech Republic and Slovakia, 2007 and 2010
Table 2. Selected economic indicators, Hungary and Slovakia, 2007 and 2010
Table 3. Selected external flexibility-related economic indicators
Table 4. Fiscal stimulus measures in East European EU members, 2009 and 2010, % of GDP relative to 2008 baseline
Table 5. Selected institutional robustness-related indicators, 2007 and 2010.
Table 6. Selected medium-term growth related indicators, 2007 and 2010
Annex 1. QCA factor scores, 2007
Annex 2. QCA factor scores, June 2011

Figure 1. Selected East European countries: yield on Euro-denominated sovereign debt and QCA score as of June 2011
Figure 2. CDS on $-denominated debt vs QCA ext. adjustment capacity and institutional robustness
Figure 3. Evolution of QCA score (average external adjustment capacity and institutional robustness) and yields, Czech Republic and Slovakia, 2007-2011
Figure 4. Hungary vs Slovakia, QCA vs Euro-debt yield, July 2011
Figure 5. Yield on Euro-denominated sovereign debt of selected East European countries, March 2006-February 2011

Figure 6. Yield on US$-denominated sovereign debt in selected regions, 2006-2011
Figure 7. Yield on Euro-denominated sovereign debt in selected regions, 2006-2011
Figure 8. Economic fundamentals vs yield on Euro-denominated sovereign debt, Eastern Europe, core EU and GIPS
Figure 9. Economic fundamentals vs yield on US$-denominated sovereign debt, Eastern Europe, Latin America and Southeast Asia
Figure 10. Overall QCA score: East European EU members, core EU, GIPS, Western Balkans, CIS-3, Latin America, South East Asia, June-2011 QCA scores
Figure 11. Regional comparison by three QCA pillars, June 2011 QCA scores
Figure 12. Overall QCA score, Eastern Europe, Core EU and GIPS, June 2011 QCA scores
Figure 13. Comparison by three QCA pillars, EE, Core EU and GIPS, June 2011 QCA scores
Figure 14. Cross-country comparison, 2007, 2009 and 2011 QCA scores
Figure 15. External adjustment capacity in Eastern Europe, core EU and GIPS, 2007 and 2011 QCA scores
Figure 16. Components of external adjustment capacity by comparator regions, QCA 2011 scores
Figure 17. Evolution of nominal exchange rates versus Euro in Eastern Europe, Jan-2007-Feb-2011, Jul-2007=1.
Figure 18. Robustness of institutions by comparator regions, 2011 QCA score
Figure 19. Robustness of institutions by individual East European countries, June 2011 QCA score
Figure 20. Components of institutional robustness by comparator regions, June 2011 QCA scores
Figure 21. Average inflation in selected regions, end-2003 to end-2010, year-on-year change
Figure 22. Market share of foreign-owned banks (% of total banking system assets, 2006)
Figure 23. Pillar III: Medium-term growth potential, EE, Core EU and GIPS, June 2011 average score
Figure 24. Performance of selected regions on Pillar III factors
Figure 25. Average regional scores on Pillar III: Medium-term growth potential, 2007 and 2011

About John Howell & Co

John Howell and Company Ltd brings together a group of professionals from banking, financial markets, energy, public administration and academia whose record of co-operation goes back to 1993. It provides research and consultancy services to public and private sector clients, offering support at strategic, operational and tactical level in the identification and attainment of business or policy goals. Our activities cover all stages of the policy cycle, from research and planning through development and implementation to monitoring and evaluation.  Our areas of expertise are economics and financial markets, strategic risk, investor relations, regulatory reform and compliance analysis.  By bringing together complementary areas of expertise we help our clients to understand the economic environment they are operate in, understand and mange financial risks and allocate resources where they are most needed.  Our clients include hedge funds, sovereign wealth funds, investment banks, supranational entities and private equity funds.

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