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VI. What Drives Uruguayan Sovereign Spreads? The Role of Global Factors and Regional Spillovers

Author(s):
R. Gelos, Alejandro Lopez Mejia, and Marco Piñón-Farah
Published Date:
July 2008
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Author(s)
Gustavo Adler and Stephanie Eble 

This chapter examines the determinants of Uruguayan sovereign spreads. In particular, it analyzes to what extent sovereign spreads have been driven by economic fundamentals or by external factors. It also assesses the relationship between the spreads of Uruguay and those of other emerging market economies—including neighboring countries—and the change in such a relationship since the 2002 crisis.

The evidence suggests that, although fundamentals explain part of the variance of sovereign spreads, external factors also play an important role. Moreover, there is evidence of external factors becoming more important since the 2002–03 financial crisis. In particular, during the late 1990s Uruguay was perceived as a safe haven in the region and displayed lower sovereign spreads that were largely insulated from regional and emerging market economy shocks, but since the crisis, its spreads have remained at the level of and co-moved closely with those of neighboring countries. Furthermore, econometric estimates point to heightened financial spillovers from other emerging market economies and a change in investors’ perception of Uruguay’s vulnerability to financial shocks emanating from other emerging market economies. This structural break seems to be associated with the loss of investment grade1 as evidenced by the decoupling of Uruguayan and Chilean spreads (an investment-grade economy) and a stronger co-movement with non-investment-grade spreads.

Recent important achievements have gone a long way in reducing vulnerabilities, although further efforts are needed. Rapidly improving fundamentals—supported by prudent policies and a benign external environment—have reduced external vulnerabilities and allowed for subsequent credit rating upgrades. However, Uruguay has not yet regained its safe haven status in the region or delinked its fortunes from those of other emerging market economies. Continuing to strengthen the macroeconomic framework, implementing pending structural reforms, and regaining investment grade status will be key to insulate Uruguay from a possible deterioration in global conditions and from future regional shocks.

Stylized Facts

During the late 1990s, Uruguay’s sovereign spreads were largely insulated from financial shocks in other emerging market economies. They remained significantly below those of neighboring countries—averaging about 500 basis points (bps) less than the Latin American Emerging Markets Bond Index (EMBI) during 1998–2001—and were only weakly correlated with them. This is likely to have reflected Uruguay’s investment grade and the general perception of Uruguay as a safe haven for investment in the region (Figure 6.1). A similar pattern is found when Uruguay’s sovereign spreads are compared with the global EMBI.

Figure 6.1.Uruguay, Latin America and Global Emerging Markets Bond Index (EMBI) Spreads, 1996–20061

(In basis points (bps))

Sources: JPMorgan Chase & Co.; and República AFAP.

1For Uruguay, the Uruguayan Bond Index (UBI) is reported; for Latin American and global emerging markets, the JPMorgan EMBI spread is reported.

In 2002–03, Uruguay’s sovereign spreads spiked in the midst of the financial crisis rooted in the withdrawal of Argentine deposits from the Uruguayan banking system. A severe contraction of the economy, a depreciation of the peso, and a marked increase in public debt led to debt sustainability concerns and to sharp increases in sovereign spreads to above 2,000 bps. With the voluntary debt restructuring—which did not imply any hair cut, but a small NPV (net present value) reduction—some measure of market confidence was rapidly restored. Still, sovereign spreads remained significantly above precrisis levels, reflecting continued concerns about Uruguay’s repayment capacity and the loss of investment-grade rating. Since then, however, spreads have continued a sharp downward trend, reaching precrisis levels by end-2005. This has allowed the government to tap markets at very favorable rates and to improve the profile of public debt significantly.

The marked fall in sovereign spreads has been accompanied by significant improvements in country fundamentals. Strong fiscal consolidation, high output growth, and the recovery of the real exchange rate from its postcrisis lows have contributed to a sharp reduction of public debt as a share of GDP, alleviating solvency concerns. In addition, liquidity indicators have improved substantially, with reserve coverage of short-term external debt and foreign currency deposits well above precrisis levels, partly reflecting a sharp reduction in short-term debt and a marked increase in reserve holdings (Figure 6.2). Furthermore, the recovery of the financial system has reduced contingent fiscal liabilities.

Figure 6.2.Country Fundamentals and External Factors, 1996–2006

Sources: Bloomberg; Central Bank of Uruguay; and IMF.

1 Gross international reserves over short-term external debt and foreign currency deposits.

2 As percent of GDP.

At the same time, Uruguay has benefited from a very benign global environment. Global financial conditions have improved markedly since 2002, up until end-2006. Long-term U.S. interest rates have declined significantly, financial market volatility—a proxy for liquidity conditions—has reached historical lows, and U.S. corporate high-yield spreads have also fallen.2 Reflecting this favorable environment, emerging market sovereign spreads have followed a steady downward trend across the board, reaching historical lows in 2006.3

However, in contrast with the 1990s, since the crisis, Uruguayan spreads have remained close to and have displayed high correlation with neighboring countries’ spreads. In particular since 2002, Uruguayan spreads have remained at about the level of and closely co-moved with the Latin American EMBI. Sovereign spread correlations across countries have generally increased—pointing to common factors—but Uruguay has been particularly affected (Figure 6.3). Although daily correlation with neighboring countries was low before the crisis, Uruguayan cross-border correlations increased after the crisis to the levels displayed by other countries in the region (Table 6.1).4 Notably, correlations with the Latin American EMBI and the global EMBI have tripled. Interestingly, whereas the correlations between Uruguayan and other non-investment-grade Latin American countries’ spreads have increased, the correlation with Chile (an investment-grade economy) has declined.

Figure 6.3.Selected Country Spreads and Latin American Emerging Markets Bond Index (EMBI) Spread, Pre–and Post–Uruguayan Crisis1

(In basis points)

Sources: JPMorgan Chase & Co.; and República AFAP.

1Argentina is excluded, because most of Uruguay’s postcrisis period coincides with the Argentine debt-restructuring process.

Table 6.1.Sovereign Spread Correlation, Pre- and Postcrisis(First differences)
Precrisis (January 1999–April 2002)ArgentinaBrazilChileColombiaEMBILatin AmericaMexicoPeruUruguay
Argentina1.000.320.020.130.280.310.230.190.08
Brazil1.000.080.430.810.750.620.470.18
Chile1.000.180.120.110.240.120.21
Colombia1.000.420.360.470.320.26
EMBI1.000.960.730.490.21
Latin America1.000.550.400.18
Mexico1.000.380.30
Peru1.000.14
Uruguay1.00
Argentina11.000.710.080.260.820.890.390.360.26
Postcrisis (June 2003–December 2006)
Argentina1.000.050.000.070.350.440.070.050.06
Brazil1.000.210.670.820.860.590.630.55
Chile1.000.240.280.250.330.230.14
Colombia1.000.780.740.650.700.59
EMBI1.000.950.750.690.63
Latin America1.000.720.680.58
Mexico1.000.610.51
Peru1.000.52
Uruguay1.00
Argentina1.000.620.060.530.690.720.500.450.36
Source: IMF staff calculations based on data from JPMorgan Chase & Co. and República AFAP.

Excluding period between default and debt restructuring (Dec. 2001–May 2005).

Source: IMF staff calculations based on data from JPMorgan Chase & Co. and República AFAP.

Excluding period between default and debt restructuring (Dec. 2001–May 2005).

Furthermore, there is evidence of heightened financial spillover risks following the crisis. Before the crisis, Uruguayan spreads were relatively insulated from shocks in other countries in the region, as confirmed by Granger causality tests between Uruguayan and Latin American spreads based on daily data (Table 6.2). With exception of Argentina—with which Uruguay had strong trade and financial links—changes in neighboring countries’ spreads did not spill over to Uruguay (see Eble, 2006). Most notably, the Brazilian and Latin American EMBIs had no significant effect on Uruguayan spreads.5After the crisis, however, financial spillovers from the region and other emerging market economies seem to have increased. All pairwise tests show significant causality, pointing to tighter regional and global linkages.6 It is worth noting, however, that the spike of Argentine spreads, relative to other spreads in the region, during 2007 did not spill over to Uruguayan spreads, suggesting that a process of decoupling from this close neighbor—possibly associated with declining financial and trade links—may be under way, although it is premature to draw conclusions.

Table 6.2.Pairwise Granger Causality Tests1
PrecrisisPostcrisis
Null HypothesisNumber of observationsF-StatisticProbabilityNumber of observationsF-StatisticProbability
Uruguay does not Granger cause Brazil8281.120.3278960.900.407
Brazil does not Granger cause Uruguay1.610.20039.330.000***
Uruguay does not Granger cause Chile7262.560.078*8960.400.671
Chile does not Granger cause Uruguay1.510.2217.320.001***
Uruguay does not Granger cause Colombia8280.470.6248960.150.864
Colombia does not Granger cause Uruguay0.280.75725.230.000***
Uruguay does not Granger cause EMBI8280.960.3848960.060.944
EMBI does not Granger cause Uruguay3.330.036**28.230.000***
Uruguay does not Granger cause Latin America8280.930.3968960.390.680
Latin America does not Granger cause Uruguay1.830.16135.370.000***
Uruguay does not Granger cause Peru8280.930.3968961.400.247
Peru does not Granger cause Uruguay1.210.30019.450.000***
Uruguay does not Granger cause Mexico8281.150.3168960.400.672
Mexico does not Granger cause Uruguay0.290.74718.950.000***
Uruguay does not Granger cause Argentina8280.050.9478960.130.880
Argentina does not Granger cause Uruguay6.110.002***1.240.291
Uruguay does not Granger cause Argentina 26861.700.1833750.400.670
Argentina does not Granger cause Uruguay24.830.008***8.620.000***
Source: IMF staff estimates.Note:

represent significance at the 10 percent, 5 percent, and 1 percent level, respectively.

Pairwise Granger causality test, for spreads first differences (2 lags). The pre- and postcrisis periods cover Jan. 1999–April 2002 and June 2003–December 2006, respectively.

Excluding period of debt restructuring (December 2001–May 2005).

Source: IMF staff estimates.Note:

represent significance at the 10 percent, 5 percent, and 1 percent level, respectively.

Pairwise Granger causality test, for spreads first differences (2 lags). The pre- and postcrisis periods cover Jan. 1999–April 2002 and June 2003–December 2006, respectively.

Excluding period of debt restructuring (December 2001–May 2005).

The heightened financial spillovers seem to be associated with the loss of investment grade. A simple comparison of sovereign spreads among Latin American countries reveals that during the late 1990s—when Uruguay had investment grade—spreads were significantly lower than those of most neighboring countries and close to the ones of Chile—the other investment-grade economy in the region. Furthermore, Uruguayan spreads co-moved with those of Chile during that period. Since the 2002–03 crisis (and the associated loss of investment grade), however, Uruguayan spreads have moved close to those of other non-investment-grade economies (Figures 6.4 and 6.5).7 Since then, Uruguay’s credit rating has been recovering, but it is still below investment grade.8

Figure 6.4.Standard & Poor’s Credit Rating for Selected Latin American Countries, 1996–2006

Source: Standard & Poor’s.

Figure 6.5.Uruguay and Selected Latin American Country Spreads, Pre- and Postcrisis

(In basis points)

Sources: JPMorgan Chase & Co.; and República AFAP.

1 Data for Argentine spreads are reported from July 2005 onward.

What Drives Sovereign Spreads?

A vector error correction (VEC) model is estimated to quantify the contribution of external and domestic factors in driving Uruguay’s sovereign spreads. The conclusions so far have followed from univariate analysis. However, the observed co-movement of spreads may reflect common global factors. A VEC model is estimated to control for these factors. This methodology, previously applied by Arora and Cerisola (2000) and Larzabal, Valdéz, and Laporta (2001), among others, also provides an adequate framework to disentangle short-term from long-term effects, while allowing for country-specific structural breaks.

The data set comprises monthly information for 1996–2006. Following the literature on determinants of sovereign spreads,9 we choose public debt, the fiscal balance, and external debt (all as a share of GDP), reserve coverage (as a share of short-term debt and foreign currency deposits), and the real effective exchange rate to account for country fundamentals. These fundamentals reflect the economy’s repayment capacity and its vulnerability to external shocks. To capture external factors, we use U.S. interest rates, terms of trade, the high-yield spread index, a market volatility measure (the Chicago Board Options Exchange Volatility Index, or VIX), and EMBI spreads. As a measure of sovereign risk, we use the Uruguayan Bond Index (UBI), instead of the EMBI, because of its longer time span.10 Standard unit root tests (Augmented Dickey-Fuller) confirm that all variables are nonstationary, and support the notion of first-order integration (Table 6.3).

Table 6.3.Unit RootTest: Augmented Dickey-Fuller (ADF)
In LevelFirst Difference
t-StatisticProbability1t-StatisticProbability1
PDGDP–1.38360.5888–2.85760.0531
RES–0.08000.9600–11.95000.0034
FBGDP–1.56540.4985–14.15410.0000
REER–1.92920.3186–16.36560.0000
USTBILL–2.83900.0547–3.79680.0035
HY–1.29000.6300–10.93000.0000
VIX–3.15920.0240–10.98670.0000
UBI–2.43570.1337–8.56760.0000
EMBI–1.64150.4580–10.82080.0000
EMBI_LA–2.09500.2500–8.39000.0000
Source: IMF staff estimates.

MacKinnon (1996) one-sided p-values. Null hypothesis is unit root.

PDGDP Public debt as share of GDP (%)RES Gross official reserves as share of short-term debt and foreign currency depositsFBGDP Fiscal balance as percent of GDPREER Real effective exchange rateUSTBILL U.S. treasury bill rateHY Index of high-yield corporate spread (Merrill Lynch)VIX Volatility indexEMBI JPMorgan Global EMBI spreadEMBI_LA JPMorgan Latin America EMBI spread
Source: IMF staff estimates.

MacKinnon (1996) one-sided p-values. Null hypothesis is unit root.

PDGDP Public debt as share of GDP (%)RES Gross official reserves as share of short-term debt and foreign currency depositsFBGDP Fiscal balance as percent of GDPREER Real effective exchange rateUSTBILL U.S. treasury bill rateHY Index of high-yield corporate spread (Merrill Lynch)VIX Volatility indexEMBI JPMorgan Global EMBI spreadEMBI_LA JPMorgan Latin America EMBI spread

A cointegrating relationship is found among the Uruguayan spreads, public debt, reserve coverage, the terms of trade, the VIX, the high-yield index, and the Latin American EMBI.11 From all variables considered that represent country fundamentals, only the public debt-to-GDP ratio and the reserve coverage are significant in the long-run relationship.12 They both display the expected signs. In particular, a 1 percentage point increase in the public debt-to-GDP ratio increases the spread by about 17 bps, whereas a 1 percentage point increase in reserve coverage reduces the spread by about 28 bps (equation 1). Global factors, such as the terms of trade and the VIX, enter in the long-run relationship with the Uruguayan spread, and with the expected sign.13 It is interesting to note that, in this specification without structural break, the effect of the Latin American EMBI spread on the Uruguayan spread is not significantly different from zero. As shown next, this reflects the presence of a structural break.

If a structural break is allowed, the results confirm that the influence of other emerging market economies on Uruguay has increased following the loss of investment grade. Although the Latin American EMBI is not statistically significant by itself when included in the initial specification, evidence of financial spillover is found if a structural break associated with Uruguay’s downgrading to speculative grade is allowed (equation 2). Moreover, estimates show that before the crisis (and after controlling for other global financial factors) the effect of regional shocks on Uruguayan spreads was negative, confirming the notion that Uruguay was perceived as a safe haven within the region.14 After the loss of investment grade, however, the effect of regional shocks on the Uruguayan spread is positive. Similar, and even stronger, results are found if the global EMBI is used (equation 3). Although this may suggest that spillovers may stem from the emerging market asset class as a whole, it should be noted that Latin American countries (mainly Brazil and Mexico and previously Argentina) have a significant weight in the global index.

Although fundamentals explain part of the variance of spreads, global factors have played an important role. Standard variance decomposition analysis identifies some 20 percent of the variance explained by country fundamentals and about 60 percent by external factors.15 Among country fundamentals, public debt is most important in explaining Uruguay’s spreads; among external factors, the VIX and the Latin American EMBI have the largest contributions (Table 6.4).

Table 6.4.Variance Decomposition1
PeriodUBIPDGDPRESTOTVIXHYEMBI_LAEMBI_LA* (1–INVGRADE)
172.302.313.381.3011.760.152.076.73
252.917.243.602.2020.300.052.2811.42
339.1210.424.403.2825.310.052.5814.84
430.7312.075.064.4127.850.092.8316.95
525.8512.895.525.5328.910.153.0418.10
622.9813.345.836.5629.230.193.2018.68
721.2113.616.037.4829.210.213.3118.94
820.0313.806.178.2929.070.213.4019.04
919.1613.956.278.9828.900.223.4519.07
1018.4714.076.369.5728.750.223.4919.06
Source: IMF staff estimates.

Cholesky ordering: TOT VIX HY EMBI_LA EMBI_LA*(1–INVGRADE) PDGDP RES UBI.

Source: IMF staff estimates.

Cholesky ordering: TOT VIX HY EMBI_LA EMBI_LA*(1–INVGRADE) PDGDP RES UBI.

Conclusions

Although country fundamentals have explained part of the variation in sovereign spreads, external factors have played an important role. Moreover, external conditions have become more important following the 2002–03 crisis, and there is evidence of heightened financial spillover from other emerging market economies since then. Furthermore, econometric results suggest that, following the crisis, there has been a change in investors& perception of Uruguay’s linkages with other emerging market economies. Such change seems to be associated with Uruguay’s loss of investment grade during the crisis, as Uruguayan spreads have decoupled from those of Chile and moved closer to those of other non-investment-grade economies in the region.

These results suggest that, although Uruguay has made remarkable strides over the past years, it remains more exposed and vulnerable to global and regional shocks than it was before the crisis. In this context, continuing to strengthen the macroeconomic framework, diversifying trade destinations, further improving the public debt structure, and implementing pending structural reforms are key to regaining investment-grade status and, thus, insulating Uruguay from a possible deterioration in global conditions and from future regional shocks.

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1In the remainder of the paper, credit ratings refer to foreign currency long-term debt.
2Financial market volatility is proxied by the Chicago Board Options Exchange Volatility Index, a popular measure of the implied volatility of Standard & Poor’s 500 index options, which aggregates market expectations of volatility over the next 30-day period. The Merrill Lynch high-yield index is used to measure the average spread of U.S. speculative grade corporate bonds (a proxy for investor risk appetite).
3During the 2007 market turbulence (born in mature economies) emerging market sovereign spreads widened somewhat but remained low relative to historical averages.
4Following Forbes and Rigobon (1999) and Gelos and Sahay (2001), a formal test of increase in correlation, applying the correction for changes in variance, was conducted, confirming the findings. As the variance has fallen in the postcrisis period, the adjustment accentuates the increase in correlations.
5It is also interesting to note the impact of Uruguayan shocks on Chilean spreads (at 10 percent significance level) in the precrisis period and the following reversion in the direction of causality after the crisis.
6Because the table displays pairwise tests, results should be interpreted with caution. Spillover from small countries in the region is likely to reflect aggregate shocks either to all emerging markets or to the region.
7Increased correlation and financial spillovers from non-investment-grade countries may also reflect a change in the investor base for Uruguayan debt instruments because of the fact that some institutional investors (often with buy-and-hold strategies) are not allowed to hold instruments with speculative ratings.
8In June 2007, Standard & Poor’s introduced a new methodology for rating sovereign debt issuers according to the expected recovery rate in the event of a default. Interestingly, Uruguay’s recovery rating (2 = “substantial recovery”) is higher than all graded countries in the region. A higher recovery rating combined with a lower overall rating—vis-à-vis neighboring countries—suggests that Uruguay’s risk premium reflects mainly its vulnerability to external shocks rather than low “willingness to pay” (that is, Uruguay enjoys a good reputation for debt repayment).
9For the most recent work in this topic, see Min (1998); Kamin and von Kleist (1999); Mauro, Sussman, and Yishay (2000); Garcia Herrero and Ortiz (2005); González Rozada and Levy Yeyati (2005); and Rojas and Jaque (2005).
10The UBI is built from spreads of fixed-rate, dollar-denominated euronotes and global bonds issued by the Uruguayan government. UBI spreads are highly correlated with the Uruguayan EMBI spread produced by JPMorgan since the introduction of the latter in 1998.
11Both trace and maximum eigenvalue tests confirm the existence of a unique cointegrating relation.
12External debt is excluded because it is highly collinear with the public debt-to-GDP ratio.
13Unlike previous work that has stressed the effect of U.S. interest rates on emerging market economy spreads, this link is not found for Uruguay.
14These results are consistent with previous work by Larzabal, Valdés, and Laporta (2001) covering the precrisis period that found that changes in the EMBI had a negative impact on Uruguayan spreads.
15Based on equation (2).

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