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External Liquidity Index: Flagging countries at risk of external debt/BOP crisis

  • We update our external liquidity scorecard for 66 emerging and frontier markets to assess the risk of a BOP crisis

  • The most vulnerable (excl. those in default) are Ethiopia, Mozambique, Rwanda, Laos, Mongolia, Bolivia and Tunisia

  • The least vulnerable (excl. Russia) are Kuwait, Saudi Arabia, Iraq, Papua New Guinea, Azerbaijan, Peru and Qatar

External Liquidity Index: Flagging countries at risk of external debt/BOP crisis
Tellimer Research
5 November 2022
Published byTellimer Research

Access Tellimer’s complete External Liquidity Index covering 66 countries by subscribing to the Tellimer Data Channel.

Following the release of the IMF’s updated October 2022 WEO Database earlier this month, we have updated our External Liquidity Index to assess the risk of an external debt or balance of payments crisis across a sample of emerging and frontier markets (following last week’s update to our Debt Sustainability Index). We expand the index from 12 to 17 variables by including both FX and total reserves for all reserve-related variables. We also expand the sample to cover all JP Morgan Emerging Market Bond Index (EMBI) constituents (excluding the CFA franc zone countries with pooled reserves), plus several other countries of interest, increasing our sample from 43 to 66 countries.

We score each variable in terms of standard deviations better (worse) than the sample median and take the simple average across variables to arrive at a composite external liquidity index. The resulting output is a quick and dirty way to quantify the risk of an external debt or balance of payments crisis for each country on a relative basis:

Index

Results

After excluding countries that have already defaulted (Sri Lanka, Zambia, and Lebanon), we find that the most vulnerable countries are Ethiopia, Mozambique, Rwanda, Laos, Mongolia, Bolivia and Tunisia. On the other hand, the least vulnerable (excluding Russia) are Kuwait, Saudi Arabia, Iraq, Papua New Guinea, Azerbaijan, Peru and Qatar.

A simple scatter plot shows a negative relationship between the overall external liquidity score and the country risk premium (measured by the Bloomberg EM Sovereign OAS), as we should expect. A linear line of best fit is statistically significant at the 99% confidence level with an R2 of 33%, which rises to 43% with a log-linear line of best fit. Excluding the countries that are in the process of restructuring (Ethiopia, Lebanon, Sri Lanka and Zambia), the relationship is still statistically significant at a 99% confidence level with a smaller R2 of 14% for the linear model and 24% for the log-linear model.

Index vs OAS

The better fit of the log-linear model and the drop in explanatory power when extreme cases are excluded indicate that the model is best at flagging cases of extreme stress (which also holds for our debt sustainability index) and that vulnerability (as measured by spreads) doesn’t change much when liquidity variables weaken from a strong base but increase exponentially as liquidity indicators deteriorate further.

We also backtest our model by regressing the external liquidity score from the May update by the change in spread for each country since the last WEO was published on 19 April (notably this is before the index was expanded from 43 to 66 countries). We find that the external liquidity score explained 36% of the change in spreads over the subsequent 6-month period at a 99% confidence level, with each standard deviation difference in score translating to an 801bps difference in performance. When Sri Lanka and Ethiopia are excluded, however, the R2 drops to 11% and the confidence level to 90%, with each standard deviation difference in score translating to a 471bps difference in performance.

Backtest

Notably, the relationship between the external liquidity index and spreads is much stronger than it is for the debt sustainability index (which had an R2 of 12-31% versus 24-43% for the log-linear external liquidity model). Likewise, the external liquidity score in May was a much better indicator of performance over the next six months, with the debt sustainability index explaining a much smaller proportion of the spread change over that period (16% versus 36% for the external liquidity index) and the relationship breaking down entirely when extreme cases were excluded. This suggests that external liquidity variables are a better predictor of near-term vulnerability (as measured by credit spreads) and asset price performance (as measured by spread changes) than debt sustainability variables.

That said, the two indexes can be combined to identify countries at the greatest risk of debt distress, with the debt sustainability risk proxying for “solvency” risk and the external liquidity index proxying for “liquidity” risk. The chart below displays the 48 countries that have scores for both indexes, with those in the lower left quadrant at the greatest risk of distress.

Scatterplot

More details on our methodology and sources are available here.