External Debt

Emerging Markets

EM Spread
Fundamental Model
Deciphering the key drivers

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Global Research

We identify four country-specific and

three global drivers of EM spreads
Continued US recovery is expected to
benefit EM in general, defying the
excess fear about the US tightening
Turkish spreads appear cheap while
Philippines looks rich

A quantitative drill-down of
fundamentals
The sell-offs in EM external debt (EXD) in the second half
of 2013 and early-2014 invite a deep look at the underlying
reasons. Why did the fragile five suffer while the CEE
happy family escaped unscraped? Would a growing US
economy benefit or harm EM in general? At this juncture
which countries spreads look cheap and which look rich?
To answer these questions, we investigate what economic
and financial variables are the most important drivers of EM
EXD and CDS spreads. We find real effective exchange rate
(REER), import cover, current account plus FDI as % of
GDP, and net public external debt as % of GDP to be most
critical country-specific drivers. We also identify VIX, UST
volatility (MOVE) and UST 10y yield as the most influential
global drivers. Our study confirms the long-run negative
relationship between UST 10y yield and EM EXD spreads.
However, sharp spikes in volatilities, such as the run-ups in
UST volatility last summer, could widen EM spreads
dramatically and thus distort this negative relationship.

16 April 2014
Victor Fu
EM Strategist
HSBC Securities (USA) Inc.
+1 212 525 4219
victor.w.fu@us.hsbc.com

View HSBC Global Research at: http://www.research.hsbc.com

Issuer of report: HSBC Securities (USA) Inc

Disclaimer & Disclosures

This report must be read with the
disclosures and the analyst certifications
in the Disclosure appendix, and with the
Disclaimer, which forms part of it

We econometrically study the effect of US economic growth

on the health of EM external sectors. We conclude that most
EM countries are likely to benefit from continued US growth.
We conduct a rich-cheap analysis of EM spreads using an
econometric technique called cointegration. Our analysis
shows Turkish spreads offer value while Philippines appears
rich. Russia and Brazil also look cheap, however for Russia
we believe caution is warranted given the tension in Ukraine
and Russias worsening long-term fundamentals. For Brazil,
the cointegration relationship is invalid, implying some other
variables may have helped drive the spreads wider.

VOTE HSBC in the 2014 Institutional Investor LatAm survey

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External Debt
Emerging Markets
16 April 2014

Show me the drivers

Motivation of the model
The motivation of this model is to uncover the
drivers of the ebbs and flows of EM EXD and
CDS spreads. 2013 witnessed a U-turn in
investor appetite for EM EXD, an unpleasant turn
likely brought by the US Feds QE tapering
announcement in May. Since then investors have
been pulling money out of this asset class, as
evidenced by a -5.3% total return registered for
EM EXD in 2013. The losses in 2013 were across
the board, but more skewed to the fragile five
Turkey, Indonesia, Brazil, South Africa and India,
whose EXD indices returned -12.6% to -4.3%.
Yet, there were also country indices that showed
positive returns, such as 3.5% for Hungary. Two
questions that could naturally come to the readers
mind would be: 1) what were the driving variables
that caused the across-the-board poor performance
of EM EXD in 2013? 2) What drivers
differentiated the performances of individual
country indices, e.g., Turkey vs. Hungary?
For the first question, one commonly perceived
driver was the widening of US Treasury (UST)
yields, with the UST 10y yield rising from
c1.6% in early May to above 3% at the end of
2013. However, history shows that higher US 10y
yield usually has resulted in tighter EM EXD
spreads (see Figure 1). This long-term negative
relationship broke down between May and
September of 2013 with mounting uncertainty
about the timing of the QE tapering. In fact, this

conundrum can be explained by a large spike in

UST volatility during the same period, as can be
seen in the later shown positive sensitivities of
EM spreads to MOVE index. As the tapering
uncertainty settled in late 2013, this negative
relationship got restored.
Figure 1. EXD spread negatively correlated to UST 10y yield
6
5.5
5
4.5
4
3.5
3
2.5
2
1.5
1

1000
900
800
700
600
500
400
300
200
100
06

07
08
09
10
EMBIG spread (bp)

11
12
13
14
UST 10y yield (%, RHS)

Source: Thomson Reuters Datastream

The answer to the second question comes from

country-specific fundamental variables
including current account balance, which has
become a household buzzword among EM
investors since the tapering talk surfaced, and
which has differentiated the fragile five from
countries like South Korea, Hungary, etc..
In this report, we strive to provide an in-depth
analysis of these two questions. We conduct our
analysis for 11 countries Brazil, Colombia,
Mexico, Peru, Hungary, Poland, Russia, South
Africa, Turkey, Indonesia and Philippines. We

Special thanks to Dilip Shahani, Head of Asia-Pacific Research, Gordian Kemen, Head of LatAm FI Research, and Di Luo, CEEMEA FI Strategist, for their valuable comments

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External Debt
Emerging Markets
16 April 2014

choose these countries because they all have a

relatively large and liquid pool of hard currency
bonds and we believe these EXD markets are
efficient, i.e., prices reflect all relevant
information. We exclude high-beta credits like
Argentina, Venezuela and Ukraine as these
markets are often driven by hard-to-measure
factors such as political noise. We use a linear
regression model on about 10 years of data to
study that, in addition to UST yields and country
current account balance, what other systematic
and idiosyncratic variables would drive the
evolution of EM EXD and CDS spreads. We then
investigate the sensitivities of EM spreads with
respect to these drivers. We believe these
sensitivity statistics would provide a quantitative
link between portfolio allocation and the
economic dynamics of EM countries and US.
Furthermore, we econometrically conduct a richcheap analysis of EM spreads.

Literature review
There is a large body of literature studying the
drivers of EM EXD/CDS spreads. The drivers
investigated can be categorized into two groups
country-specific macroeconomic variables and
common factors.

Country-specific drivers
Country-specific economic variables, such as
external debt-to-GDP ratio and foreign
reserves, are deemed critical drivers of EM
sovereign spreads in many studies. Reinhart et
al (2003) shows that a countrys debt payment
history and debt-to-GNP thresholds play a key
role in the variations of the countrys sovereign
spreads. Fovero and Giavazzi (2005) discovers
that Brazilian sovereign bond spreads were
strongly correlated with exchange rates and
interest rates. Remolona et al (2008) decomposes
CDS spreads into expected losses from default
and risk premia required by investors as
compensation for default risk. The paper finds

that country-specific fundamentals primarily drive

sovereign risk. Bellas et al (2010) concludes that
in the long term, fundamental variables, such as
external debt-to-GDP, interest payments-toreserves, trade openness, etc., are significant
determinants of EM sovereign bond spreads.

Common drivers
Global market variables, e.g., VIX, UST yields,
drive EM EXD/CDS spreads, according to many
studies. Pan and Singleton (2008) suggest that a
substantial portion of the co-movement of the CDS
spreads of Mexico, Turkey and Korea during some
sub-periods of 2001-2006 was induced by changes
in investors risk appetite measured by VIX rather
than by reassessment of the fundamental strengths
of those countries. Longstaff et al (2007) finds that a
large sample of CDS spreads for developed and EM
countries were more influenced by US equity and
high-yield bond markets, and global risk premia
than by the local economic factors. Levy-Yeyati and
Williams (2010) asserts that UST curve steepening
represents an import risk factor for EM spreads.

Driver selection
We identified REER, import cover, current
account plus FDI as % of GDP, and net public
external debt as % of GDP as the most
significant country-specific drivers of EM EXD
spreads. For common drivers, we found VIX,
UST option volatility (measured by the MOVE
index), and UST 10y yield to be most
influential. Initially we also included in our study
variables like fiscal balance as % of GDP, trade
openness, and foreign reserves as % of M2, which
were utilized in some of the literature. But these
variables turned out to perform poorly in terms of
explaining the movements of EM EXD/CDS
spreads the beta coefficients in the regression
have varied signs among countries and the pvalues are mostly insignificant. We describe the
retained country drivers in order of explanatory
power as follows.

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External Debt
Emerging Markets
16 April 2014

REER: This is to measure a countrys

international competitiveness. An external debt
crisis usually comes with or follows a currency
crisis. An overvalued REER is likely to cause
imports to grow faster than exports, resulting in a
large and persistent current account deficit, which
has to be funded by external financing. When the
external financing environment tightens, an
overvalued REER could trigger a sharp sell-off in
the nominal exchange rate. This in turn would
raise the concern about the countrys external debt
serviceability and thus induce a rush-out from the
hard currency bond market by investors.
Therefore, REER should be one of the most
influential fundamental factors for EXD/CDS
spreads. A vivid example is the most recent bout
of EM stress with pressure concentrated on
currencies like TRY, ZAR, BRL, coupled with
widening spreads (see Figure 2). Our study also
reveals that real and nominal exchange rates are
highly correlated historically for most of the EM.
Figure 2. Turkey 5y CDS moves in tandem with TRY
2.5

400

2.3

350

2.1

300

1.9

250

1.7

200

1.5

150

1.3
Apr-10

Apr-11
TRY

100
Apr-12
Apr-13
Apr-14
TR 5y CDS (bp, RHS)

Source: Bloomberg

determinants of crisis incidence in more than half of

the 83 papers they surveyed.
Current account balance plus FDI as % of
GDP: The importance of this metric in assessing
the health of a sovereigns creditworthiness is
needless to say just based on its frequent
appearance of the word current account in
headline news since the Fed unveiled the tapering
plan in May 2013. A current account deficit needs
to be financed externally. Hence we net it with
FDI to measure the sustainability of the deficit as
FDI is deemed a more stable type of financing
than portfolio inflows.
Net public external debt as % of GDP: This
metric is computed as (public external debt
foreign reserves) / GDP. It measures not only a
countrys leverage ratio but also the ability to
sustain that level of leverage. Hence this metric is
directly relevant to the valuation of a countrys
external debt.
For common drivers, in addition to the two
widely studied variables VIX and UST 10y
yield, we also include MOVE as we believe UST
volatility is an important source of the variation in
EM spread (see Figure 3), particularly in case
where global liquidity could become tighter.
Figure 3. EM IG spread has responded to MOVE spikes
300

700

250

600

200

500

150

400

Import cover (in months): This is a measure of a

countrys ability to provide USD, particularly in case
of a stress. Studies have showed that measures of
reserves, e.g., import cover, M2-to-reserves, are
important leading indicators of financial crises.
Frankel and Sarvelos (2011), for instance, states that
measures of reserves and the real exchange rate are
the top two most statistically significant

300

100

200

50

100

0
06

07

08
09
10
11
EMBIG spread (bp)

Source: Bloomberg, Thomson Reuters Datastream

12
13
14
MOVE (RHS)

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Econometric study
Data
We collect JPMorgan EM Global Diversified
country index stripped spreads from Datastream
and 5y CDS spreads from Bloomberg for the
selected 11 countries. We take the monthly
averages of the daily spread data, which go back
to June 2004 (Indonesia and Philippines CDS
spreads start from October 2004). VIX, MOVE
and UST 10y yield are downloaded from
Bloomberg and monthly averaged. For countryspecific variables, we obtain the raw data from
Datastream and the websites of various central
banks or ministries of finance, and then do the
calculation when needed. REER and import cover
data come at a monthly frequency. Current
account, FDI and external debt stock data arrive
quarterly for most of the countries and are
interpolated to a monthly frequency.
Table 1 shows a snapshot of country-specific
variables readings as of 31 March 2014 vs. YE
2012 (for REER it is the return since YE 2012). It
can be seen that most countries have experienced
a depreciation in REER with an average loss of
6.2%. Note that some REERs, e.g., for Brazil, had
enjoyed a decent rally over the past two months.
Given REERs highest sensitivity to external
shocks among the chosen fundamental indicators,
the across-the-board depreciation could largely
explain the pressure seen on EM EXD over the
past year. For the other three variables, we see an
average decrease of 0.3 months in import cover
and of 0.1% in current account + FDI as % of
GDP, as well as an average improvement of 0.1%
in net public external debt as % of GDP. Among
the 11 countries, six, six, and seven saw a better
reading in the above three variables, respectively.
These statistics demonstrate that EM long-term
external sector fundamentals in general have been
pretty much intact compared to YE 2012,
implying the bouts of the broad sell-offs in EM

EXD over the past year might have been more

driven by the fear about the QE tapering and the
painful short-term adjustments in EM currencies
than the worsening of the long-term EM
fundamentals. That said, country divergence in
the long-term fundamentals does exit, e.g.,
Hungary has improved all the three long-term
variables remarkably while Russia has shown an
apparent worsening in those variables. Out of the
fragile fives, South Africas long-term
fundamentals appear to be most resilient.
Table 1. EM country-specific variable data snapshot
REER
Import cover
CA+FDI % GDP Net EXD % GDP
Country Return since YE12 Current YE12 Current YE12 Current YE12
BR
1.15%
18.91 20.36
-0.79 0.49 -14.61 -14.07
CO
-10.93%
8.87 7.61
1.00 0.96
2.14 2.41
HU
-0.99%
5.31 5.20
3.60 3.16 16.25 23.36
ID
-3.19%
6.68 7.06
-1.64 -1.18
2.77 1.52
MX
0.05%
5.68 5.29
1.10 -1.83 -3.12 -3.03
PE
-5.00%
18.70 18.68
-0.06 2.62 -19.33 -18.87
PH
-11.51%
15.15 16.19
3.18 2.98 -13.97 -13.90
PL
-0.09%
6.13 6.43
-1.35 -2.71
9.95 9.56
RU
-7.99%
16.05 17.39
0.99 3.72 -3.37 -9.31
TR
-13.16%
5.09 5.09
-6.03 -4.99
1.06 0.47
ZA
-16.54%
5.74 5.72
-4.37 -6.45
6.23 6.74
Source: Bloomberg, Thomson Reuters Datastream.

Methodology
To study what factors drive EM EXD and CDS
spreads, we run a linear regression model of each
countrys EXD and CDS spreads on a list of
global and country-specific variables, which
include those discussed in the section of Driver
Selection as well as additional candidate variables
such as fiscal balance as % of GDP, trade
openness, and foreign reserves as % of M2. But
these additional variables are later discarded due
to their poor explanatory power. We therefore
have totally 22 models for 11 countries. The insample data span from Jun 2004 (October 2004
for Indonesia and Philippines CDS spreads) to
November 2013. All the variables but REER
are first differenced (REER return series is
used) before they are fed into the regression
model since the levels of these variables are
found to be nonstationary (or a random walk in
plain English) by an Augmented Dickey-Fuller
(ADF) test (see Appendix 1). Econometric theory

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External Debt
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16 April 2014

says that if the variables included in a linear

regression model are nonstationary, the residuals
may be nonstationary, which would render the
ordinary least square (OLS) estimator inconsistent
(this means the estimated coefficients are not
reliable and do not converge to the true
coefficients even when the data sample size goes
to infinity). If on the other hand the residuals are
stationary but serially correlated, the OLS
estimator would be inefficient and result in
distorted coefficient standard errors and RSquared (see, e.g., Davidson and MacKinnon
2004, Tsay 2010, etc).
The regression results are promising. Table 2 and
3 show the statistics of the regressions using EXD
indices and 5y CDS spreads, respectively, as
dependent variables. The green color code means the
p-value is significant at 95% level while the light
blue at 90%. An empty cell in a column indicates the
variable is excluded due to the insensible sign of the

coefficient. Notice that the models for most of the

countries have a R-Squared (R2 in the tables) of
more than 50%, indicating a nice fit, while DurbinWatson (DW in the tables) statistics unveil that in
most of the models residuals are uncorrelated,
confirming the validity of the p-value and R-Squared
statistics. It is obvious that among country-specific
variables, REER is most significant, followed by
import cover, while the rest two show a lower degree
of significance, which could be due to the nature of
low data frequency. As for global variables, VIX is
shown to be most influential on EM spreads,
followed by UST volatility. Interestingly, UST 10y
yield is not as significant as commonly perceived.
As expected, it has a negative relationship with EXD
spread for all the countries but Indonesia
(coefficient: 8.59, p-value: 0.56) with an average
coefficient of -25.33. However, its relationship with
5y CDS spread is unpredictable with the
coefficients sign varying for different countries.

Table 2. EXD index spread regression coefficients and statistics

Country REER p-value Import p-value CA+FDI p-value EXD % p-value
cover
% GDP
GDP

VIX p-value MOVE p-value

BR
CO
MX
PE
HU
PL
RU
TR
ZA
ID
PH

2.94
4.65
2.47
3.34
0.99
1.68
2.54
3.76
4.09
6.96
3.42

-3.23
-1.53
-4.62
-0.90
-14.23
-2.68
-0.22
-3.43
-2.09
-3.33
-1.06

0.00
0.08
0.00
0.63
0.00
0.01
0.88
0.00
0.01
0.00
0.27

-3.00
-31.89
-6.63
-7.34
-24.48
-14.72
-15.53
-33.28
-9.97
-24.96
-1.61

0.36
0.00
0.59
0.09
0.11
0.06
0.00
0.00
0.30
0.01
0.85

-9.89
-7.27
-1.94
-11.47

0.16
0.27
0.83
0.13

-3.50
-2.68
-13.28
-2.83
-17.48
-4.24

0.40
0.73
0.06
0.54
0.34
0.33

3.54
10.23
2.85
2.44
3.13
1.54
5.80
17.00

0.28
0.09
0.38
0.41
0.22
0.54
0.05
0.00

1.24
10.77

0.91
0.00

0.00
0.00
0.00
0.00
0.14
0.00
0.00
0.00
0.00
0.00
0.00

0.29
0.17
0.08
0.51
0.68
0.60
0.77
0.34
0.31
0.07
0.32

0.04
0.32
0.47
0.01
0.00
0.00
0.00
0.05
0.14
0.77
0.06

UST p-value
10y
-10.98
-9.66
-9.06
-21.72
-55.25
-16.28
-62.16
-18.72
-6.42

0.17
0.32
0.16
0.04
0.00
0.03
0.00
0.05
0.56

-43.02

0.00

R2

DW

0.69
0.66
0.73
0.58
0.46
0.55
0.62
0.69
0.61
0.65
0.61

1.71
1.92
1.77
2.08
1.84
1.90
1.60
1.86
1.65
1.95
1.94

R2

DW

0.58
0.62
0.76
0.51
0.55
0.63
0.67
0.66
0.60
0.69
0.59

1.51
1.70
1.67
1.75
1.78
1.65
1.77
2.15
1.79
2.11
1.90

Source: HSBC

Table 3. 5y CDS spread regression coefficients and statistics

Country REER p-value Import p-value CA+FDI p-value EXD % p-value
cover
% GDP
GDP

VIX p-value MOVE p-value

BR
CO
MX
PE
HU
PL
RU
TR
ZA
ID
PH

2.99
3.72
2.54
3.53
1.00
0.93
2.17
3.83
2.67
6.20
3.95

-4.28
-2.40
-5.20
-3.01
-14.90
-7.55
-6.41
-3.35
-3.09
-2.72
-0.99

Source: HSBC

0.00
0.00
0.00
0.10
0.00
0.00
0.00
0.00
0.00
0.01
0.33

-0.92
-31.18
-17.78
-6.08
-12.01
-17.32
-8.63
-32.63
-1.66
-25.20
-9.29

0.83
0.00
0.16
0.13
0.38
0.01
0.07
0.09
0.85
0.01
0.28

-8.56
-12.08
-3.54
-14.55

0.34
0.06
0.72
0.05

3.40
12.78
12.68
2.11

0.44
0.02
0.00
0.44

-7.79

0.04

-9.44

0.24

11.03
4.61

0.00
0.60

-26.21
-6.46

0.13
0.15

5.54
4.99

0.60
0.20

0.00
0.00
0.00
0.00
0.17
0.01
0.00
0.00
0.00
0.00
0.00

UST p-value
10y

0.23
0.22
0.23
0.25
0.81
0.13

0.20
0.18
0.06
0.16
0.00 -44.56
0.28 -14.37

0.00
0.04

0.46
0.35
0.49
0.37

0.01
0.03
0.04
0.04 -3.26

0.75

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External Debt
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16 April 2014

Hungary and Poland have significant and highly

negative coefficients and Philippines has an
insignificant negative coefficient. On the other hand,
Indonesia has a large positive coefficient of 26.27
with a p-value of 0.06 and other countries
coefficients are mildly positive and insignificant
with an average of 5.67. The less uniform influence
of UST 10y yield on CDS than on EXD could be
because that, while the underlying rates of EM USD
bonds are UST yields and hence a direct link to
UST, EM CDS contracts are often used to express a
directional view in cases of risk shocks, which could
be related to but not limited to changes in US rates
outlook, hence CDS has a more direct link to risk
gauges (VIX and MOVE) than to UST yields.
In terms of sensitivities, among all the
countries Hungary EXD/CDS spread is most
sensitive to REER with one percentage of
appreciation inducing a c14bp rally in the
spread. Countries with a low import cover
show a large sensitivity to this variable, e.g., an
increase of one month in import cover could
tighten the EXD/CDS spread by c33bp for
Turkey. This reminded us of a massive widening
in Turkish spreads in autumn 2013 when CBRT
kept depleting FX reserves rapidly to defend the
currency. Given the high significance and
sensitivity plus the monthly data frequency,
REER and import cover should be followed most
closely, in our view. For global variables, the
country most vulnerable to a spike in VIX is
Indonesia, followed by Colombia and Turkey,
while standing in the opposite are two CEE
countries Hungary and Poland. If there is a large
rise in UST 10y yield, Hungary is shown to
benefit most. However if the UST yield rise
comes very fast, resulting in a spike in UST
implied volatility, Hungarian spreads are also
expected to widen more than peers.
These sensitivity statistics are important to
portfolio allocation and risk management. The
investor can forecast the future changes in a

countrys EXD/CDS spread by plugging

consensus or proprietary estimates of countryspecific and global variables into the model. This
allows portfolio allocation to be done in an
objective way that does not depend on subjective
judgments. Of course, judgments can be applied
on top of the quantitative analysis if deemed
essential. As an application for risk management,
faced with a major risk event, the investor can
assess the potential spread changes in different
possible scenarios of the event.

Long-run anchors and short-run

adjustments
The chosen explanatory variables can serve
different purposes in the model. Among the
global variables, UST 10y yield provides a
long-run global backdrop, VIX serves as a
short-run risk shock in cases of global growth
concerns and various crises (e.g., US subprime
crisis, eurozone debt crisis, etc.), and MOVE
joins VIX but is more specifically related to
shocks to UST rates outlook. EM spreads evolve
based on the long-run anchor of UST 10y yield
while adjusting to the shocks from VIX and
MOVE. On the surface these three variables
should be highly correlated and one could wonder
why all of them are included in the model. Yet a
quick study reveals that the correlations are less
strong than commonly expected and are timevariant. Table 4 shows the averages of the threemonth rolling correlations of UST 10y yield, VIX
and MOVE since 2005 are pretty benign. And
Figure 4 displays the three rolling correlations
series, which are clearly time-variant but meanreverting. The correlation between UST 10y yield
and MOVE has trended higher since mid-2013,
which is expected as US rates outlook has taken
centre stage during the period. This quick study
confirms the merit of keeping all the three global
variables as they allow us to value EM spreads in
different global environments.

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External Debt
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16 April 2014

Table 4. Average rolling correlations (3-month window)

UST 10y & VIX
-0.33

UST 10y & MOVE

VIX & MOVE

0.15

0.17

Source: Bloomberg, HSBC

Figure 4. UST 10y, VIX and MOVE 3m rolling correlations

1
0.8
0.6
0.4
0.2
0
-0.2
-0.4
-0.6
-0.8
-1
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
UST 10y & VIX

UST 10y & MOVE

VIX & MOVE

Source: Bloomberg, HSBC

Likewise, among the country-specific variables,

the low-frequency current account plus FDI as %
of GDP and net public external debt as % of GDP
can serve as a long-run anchor while REER can
provide a short-run adjustment. Import cover can
function in between. Therefore, the sell-off of EM
EXD in the second half of 2013 could be
attributed to the short-run adjustment to the shock
of UST volatility directly, and indirectly to the
rapid REER depreciation, which itself was an
adjustment to the shock of UST volatility and also
rising US rates. And the rally since early February
2014 could be because the market realized that the
short-run adjustments were overdone since EM
long-term external sector fundamentals have
largely remained unchanged compared to
YE2012, as depicted in Table 1.

EM links to the US economy

As a US economic recovery appears to have
gained a firmer footing, it would be important to
get a handle of the impact of US recovery on the
EM economies external sectors. We select the
Conference Board US Leading Index MoM (LEI)
as a proxy of US recovery. To obtain a gauge of

the health of an EM countrys external sector, we

apply a statistical procedure called Principal
Component Analysis (PCA) to derive a single
variable from REER, import cover, current
account plus FDI as % of GDP, and net public
external debt as % of GDP (the sign is flipped to
make the interpretation consistent with other
three). That single variable is termed first
principal component or PC1 and is expected to
explain most of the variations in the four
underlying variables. We then regress each
economys PC1 on US LEI. Table 5 shows that
most countries PC1s respond positively to US
LEI with Mexico topping the list, which is natural
given Mexican economys dependence on the
neighbour. Though the beta coefficients for Peru
and Philippines are slightly negative, the p-value
statistics are highly insignificant. We also can see
that most of the PC1s explain more than 90% of
the variations. This analysis reveals that a
continuation of US recovery will likely benefit
EM external sectors in general. This conclusion
is consistent with the previous finding that
higher US long yields resulting from US
growth should bring down EM EXD spreads in
the long run, echoing that last years market
fear about the US tapering might have been
overplayed.
Table 5. EM fundamental links to US Leading Economic Index
Country
BR
CO
MX
PE
HU
PL
RU
TR
ZA
ID
PH
Source: HSBC

Beta to US LEI

p-value

PC1 weight

0.97
0.54
1.13
-0.17
0.34
0.68
0.41
0.42
0.81
0.55
-0.11

0.00
0.04
0.00
0.49
0.05
0.00
0.19
0.10
0.02
0.07
0.62

94.52%
96.13%
96.47%
61.27%
61.04%
83.95%
69.07%
95.09%
95.14%
97.57%
90.15%

abc

External Debt
Emerging Markets
16 April 2014

Rich-cheap analysis

and a synthetic CDX EM IG index spreads.

We use an econometric technique called

cointegration to conduct rich-cheap analysis. If
a set of time series variables are nonstationary but
a linear combination of them is stationary, then
we say these variables are cointegrated. There are
two approaches to the estimation of a
cointegration relationship the Enger-Granger
two-step method (Enger and Granger 1987) and
the Johansen cointegrated vector autoregression
method (Johansen 1988). We adopt the former for
its accessibility to a broader audience.

Despite the long-run equilibrium relationship

between EM and US corporate spreads, the short-run
divergence could be due to fundamental reasons. We
therefore include the four country-specific variables,
along with VIX to control systematic shocks, into
the cointegration study. In the end for EXD we
regress each countrys EXD spread on US corporate
BBB spread, VIX and country-specific variables.
And for CDS we replace country EXD spread and
US corporate BBB spread with country CDS spread
and CDX NA IG spread. All the variables are level
series. Like the first difference regression, the insample data used to fit the cointegration relationships
are from Jun 2004 (October 2004 for Indonesia and
Philippines CDS spreads) to November 2013.

Given a set of variables, the Enger-Granger

method starts with a linear regression of one
variable of the user choice on the others. If the
residual series is tested, e.g., by an ADF test, to be
stationary, then these variables are declared to be
cointegrated, or in plain English, they tend to
move together in the long run, albeit they may
diverge in the short run. If this regression contains
financial market variables, then the short-run
divergence can be used to conduct the rich-cheap
analysis of one financial variable versus the
others. In our study we would like to assess the
value of EM EXD and CDS spreads, the natural
variables to bring into the analysis would be US
corporate BBB index spread and CDX North
America Investment Grade (CDX NA IG) index
spread, as Figure 5 shows that these two variables
have moved in tandem with EM EXD IG index
Figure 5. EM EXD and CDS IG spreads move together with
US counterparts
700
CDX EM IG
EM EXD IG

600

CDX IG NA
US Corp BBB

500
400
300
200
100
0
Apr-07

Apr-08

Apr-09

Apr-10

Apr-11

Source: Thomson Reuters Datastream, Bloomberg, HSBC

Apr-12

Apr-13

Apr-14

The ADF tests of the regression residuals (see

Table 6 in Appendix 1) depict that for most
countries a cointegration exists. The only
exceptions are Brazil for both EXD and CDS and
Mexico for EXD.
Appendex 2 and 3 display the cointegration
residuals for all the countries for EXD and CDS,
respectively. The curves in black are out-ofsample residuals, which are computed based on
the in-sample fitted coefficients and on the
observations after November 2013. Interestingly,
for most countries the residuals appeared to reach
extremely high (cheap) levels in November 2013,
calling for a broad rally ahead, which did happen
after early February 2014. Post the rally, Turkey
and Russia EXD spreads still look cheap while
Philippines and Peru appear rich. For the 5y CDS
spread, Russia and Turkey are on the cheap side
while Philippines and Indonesia are on the
opposite. For Russia, caution is warranted given
the ongoing tension in Ukraine and worsening
domestic fundamentals. Brazil EXD and 5y CDS
spreads both look cheap, however the residuals
are not statistically cointegrated, indicating there
may be omitted variables that have helped drive
the residuals gradually higher in the long run.

abc

External Debt
Emerging Markets
16 April 2014

Appendix 1. Augmented Dickey-Fuller test

Table 6. Country variables and EXD/CDS cointegration residual ADF test p-values
Country
BR
CO
MX
PE
HU
PL
RU
TR
ZA
ID
PH

REER

CA+FDI % GDP

Import cover

EXD % GDP

EXD Cointegration

CDS Cointegration

0.22
0.13
0.05
0.86
0.09
0.03
0.37
0.26
0.19
0.36
0.48

0.89
0.21
0.15
0.23
0.64
0.44
0.72
0.74
0.13
0.78
0.11

0.53
0.24
0.96
0.47
0.64
0.74
0.12
0.20
0.15
0.13
0.95

0.05
0.04
0.34
0.27
0.14
0.79
0.04
0.02
0.78
0.30
0.87

0.35
0.04
0.14
0.00
0.01
0.01
0.00
0.02
0.00
0.00
0.00

0.16
0.02
0.01
0.00
0.01
0.03
0.00
0.00
0.00
0.00
0.00

Source: HSBC

Note: A p-value smaller than 5%/10% shows that the time series is stationary at a 95%/90% confidence
level. We can see that the four country-specific variables are nonstationary in level for most countries.
The first-difference series (return series for REER) are tested to be all stationary with the test results
omitted here.

10

abc

External Debt
Emerging Markets
16 April 2014

Appendix 2. EXD cointegration residual charts

Figure 6. Brazil residuals

Figure 7. Colombia residuals

150

150

100

100

Figure 8. Mexico residuals

80
60
40

50

50

20

-50

-20

-100

-50

-150

-100

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
BR in-sample residual

-40
-60
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Out-of-sample residual

CO in-sample residual

Out-of-sample residual

MX in-sample residual

Figure 9. Peru residuals

Figure 10. Hungary residuals

Figure 11. Poland residuals

100

250

120

80

200

100

60

150

40

100

20

50

-20

-50

-20

-40

-100

-60

-150

-80
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
PE in-sample residual

80
60
40
20

-40
-60
-80

-200
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Out-of-sample residual

HU in-sample residual

-100
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
PL in-sample residual

Out-of-sample residual

Figure 12. Russia residuals

Figure 13. Turkey residuals

250

100

100

200

80

80

60

60

150

40

20

50

-20

20
0
-20

-40

-50

-60

-40

-100

-80

-60

-150

-100
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
RU in-sample residual

-80
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Out-of-sample residual

TR in-sample residual

Out-of-sample residual

Figure 15. Indonesia residuals

Figure 16. Philippines residuals

100

100

80

80

60

60

40

Out-of-sample residual

Figure 14. South Africa residuals

40

100

Out-of-sample residual

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
ZA in-sample residual

Out-of-sample residual

40

20

20

-20

-20

-40
-60

-40

-80

-60

-100

-80
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
ID in-sample residual

Out-of-sample residual

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
PH in-sample residual

Out-of-sample residual

Source for all charts on this page: HSBC

11

abc

External Debt
Emerging Markets
16 April 2014

Appendix 3. CDS cointegration residual charts

Figure 17. Brazil residuals

Figure 18. Colombia residuals

150

150

100

100

50

50

-50

-50

Figure 19. Mexico residuals

100
80
60
40
20
0
-20

-100

-100

-150

-150
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
BR in-sample residual

-40
-60
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Out-of-sample residual

Figure 20. Peru residuals

CO in-sample residual

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Out-of-sample residual

MX in-sample residual

Figure 21. Hungary residuals

Figure 22. Poland residuals

250

120

200

100

150

80

100

60

20

50

40

20

-20

-50

-100

-20

-150

-40

-200

-60

80
60
40

-40
-60
-80
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
PE in-sample residual

-250
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Out-of-sample residual

Figure 23. Russia residuals

HU in-sample residual

-80
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Out-of-sample residual

Figure 24. Turkey residuals

PL in-sample residual

100

100

150

80

80

60

60

40

40

50

20

20

-50

-20

-20

-40

-40

-60

-60

-100
-150

-80

-80

-200

-100

-100
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
RU in-sample residual

Out-of-sample residual

Figure 26. Indonesia residuals

TR in-sample residual

80

60

60

40

40

20

20

-20

-20

-40
-60

-40

-80

-60

-100
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
ID in-sample residual

Out-of-sample residual

Source for all charts on this page: HSBC

12

Out-of-sample residual

Figure 27. Philippines residuals

80

-80
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
PH in-sample residual

Out-of-sample residual

Figure 25. South Africa residuals

200

100

Out-of-sample residual

Out-of-sample residual

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
ZA in-sample residual

Out-of-sample residual

External Debt
Emerging Markets
16 April 2014

abc

References
Bellas, D., M. G. Papaioannou, and I. Petrova, 2010, Determinants of Emerging
Market Sovereign Bond Spreads: Fundamentals vs Financial Stress, IMF
Working Paper, WP/10/281.
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Engle, R. and Granger, C. (1987) Co-integration and Error-correction: Representation, Estimation and
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Favero, C. and Giavazzi, F. (2005) Inflation Targeting and Debt: Lessons from Brazil, in F. Giavazzi, I.
Goldfajn and S. Herrera (eds.), Inflation Targeting, Debt and the Brazilian Experience 1999 to 2003, MIT
Press.
Frankel, J. and Saravelos, G. (2011) Can Leading Indicators Assess Country Vulnerability? Evidence
from the 2008-09 Global Financial Crisis, Harvard Kennedy School.
Johansen, S. (1988) Statistical Analysis of Cointegrating Vectors. Journal of Economic Dynamics and
Control 12:231-54.
Levy-Yeyati, E., and T. Williams, 2010, US Rates and Emerging Markets Spreads,
Universidad Torcuato Di Tella, Business School Working Papers 02/2010.
Longstaff, F., Pan, J., Pedersen, L., and Singleton, K. (2007), How Sovereign is Sovereign Credit Risk?,
unpublished working paper, UCLA Anderson School, MIT Sloan School, NYU Stern School, and
Stanford Graduate School of Business.
Pan, J. and Singleton, K. (2008). Default and Recovery Implicit in the Term Structure of Sovereign CDS
Spreads, Journal of Finance, 63, 2345-2384.
Reinhart, C., Rogoff, K., and Savastano, M. (2003) Debt Intolerance, NBER working paper series.
Remolona, E., Scatigna, M., and Wu, E. (2008) The Dynamic Pricing of Sovereign Risk in Emerging
Markets: Fundamentals and Risk Aversion, unpublished working paper, Bank for International
Settlements and University of New South Wales.
Tsay, R. (2010) Analysis of Financial Time Series, Third Edition, Wiley.

13

External Debt
Emerging Markets
16 April 2014

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Disclosure appendix
Analyst Certification
The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the
opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their
personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific
recommendation(s) or views contained in this research report: Victor Fu

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Additional disclosures
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This report is dated as at 16 April 2014.

All market data included in this report are dated as at close 14 April 2014, unless otherwise indicated in the report.
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Global Fixed Income Research Team

Steven Major, CFA
Global Head of Fixed Income Research
+44 20 7991 5980
steven.j.major@hsbcib.com

Credit

Rates
EMEA
Bert Lourenco
Head of Rates Research, EMEA
+44 20 7991 1352
bert.lourenco@hsbcib.com
Subhrajit Banerjee
+44 20 7991 6851

subhrajit.banerjee@hsbcib.com

Theologis Chapsalis
+44 20 7992 3706
theologis.chapsalis@hsbcib.com
Wilson Chin, CFA
+44 20 7991 5983

wilson.chin@hsbcib.com

Di Luo
+44 20 7991 6753

di.luo@hsbcib.com

Chris Attfield
+44 20 7991 2133

christopher.attfield@hsbcib.com

Sebastian von Koss

+49 211 910 3391
sebastian.von.koss@hsbc.de
Frank Will
+49 211 910 2157

frank.will@hsbc.de

Asia
Andr de Silva, CFA
Head of Rates Research, Asia-Pacific
+852 2822 2217
andre.de.silva@hsbcib.com
Pin-ru Tan
+852 2822 4665

pinrutan@hsbc.com.hk

Himanshu Malik
+852 3941 7006

himanshu1malik@hsbc.com.hk

Dayeon Hong
+852 3941 7009

dayeonhong@hsbc.com.hk

EMEA
Lior Jassur
Head of Credit Research, EMEA
+44 20 7991 5632
lior.jassur@hsbcib.com
Dominic Kini
+44 20 7991 5599

dominic.kini@hsbcib.com

Laura Maedler
+44 20 7991 1402

laura.maedler@hsbcib.com

Anna Schena
+44 20 7991 5919

anna.schena@hsbcib.com

Pavel Simacek, CFA

+44 20 7992 3714
pavel.simacek@hsbcib.com
Reza-ul Karim
+44 20 7992 3703

reza-ul.karim@hsbcib.com

Raffaele Semonella
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raffaele.semonella@hsbcib.com
Ivan Zubo
+44 20 7991 5975

ivan.zubo@hsbcib.com

Jordan Cant
+44 20 7991 5475

jordan.cant@hsbcib.com

Asia
Dilip Shahani
Head of Global Research, Asia-Pacific
+852 2822 4520
dilipshahani@hsbc.com.hk
Zhiming Zhang
+852 2822 4523

zhimingzhang@hsbc.com.hk

Devendran Mahendran
+852 2822 4521
devendran@hsbc.com.hk
Philip Wickham
+65 6658 0618

philipwickham@hsbc.com.sg

lawrence.j.dyer@us.hsbc.com

Keith Chan
+852 2822 4522

keithkfchan@hsbc.com.hk

jae.yang@us.hsbc.com

Louisa Lam
+852 2822 4527

louisamclam@hsbc.com.hk

bertrand.j.delgado@us.hsbc.com

Yi Hu
+852 2996 6539

yi.hu@hsbc.com.hk

Helen Huang
+852 2996 6585

helendhuang@hsbc.com.hk

Crystal Zhao
+852 2996 6514

crystalmzhao@hsbc.com.hk

Alejandro Mrtinez-Cruz
+52 55 5721 2380
alejandro.martinezcr@hsbc.com.mx

Kelly Fu
+852 3941 7066

kellyyfu@hsbc.com.hk

Aaron T Gifford
+1 212 525 3277

Lan Lan
+852 3941 7186

lanlan@hsbc.com.hk

Christopher Li
+852 2822 3232

christopherbli@hsbc.com.hk

Americas
Larry Dyer
+1 212 525 0924
Jae Yang
+1 212 525 0861
Bertrand Delgado
+1 212 525 0745

Gordian Kemen
Head of Latin America Fixed Income Research
+1 212 525 2593
gordian.x.kemen@us.hsbc.com
Victor Fu
+1 212 525 4219

victor.w.fu@us.hsbc.com

aaron.t.gifford@us.hsbc.com

Americas
Sarah R Leshner
Head of LatAm Corporate Credit Research
+1 212 525 3231
sarah.r.leshner@us.hsbc.com
Sean Glickenhaus
+1 212 525 4131

sean.x.glickenhaus@us.hsbc.com