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Paper No. 45

Introducing GS-ESS:

A New Framework for Assessing Fair Value

in Emerging Markets Hard-Currency Debt

Spreads in hard currency sovereign debt experienced significant volatility in the past

3 years, often deviating from a countrys true ability to pay. This situation will likely

persist in the future, creating attractive investment opportunities.

GS-ESS can help identify those opportunities by modeling a sovereigns fair value

spread as a function of solvency and liquidity variables.

of diagnostic and statistical tests. We found that an investor using GS-ESS would

have outperformed the EMBI global by an average annualized return of 386bp over

the period December 1997 to April 2000.

sovereign debt. Of course, our forecasts regarding a specific countrys market may

often differ depending on our macroeconomic views.

Rumi Masih, and Daniel Tenengauzer

June 2000

Important disclosures appear on the back cover of this publication.

Goldman Sachs Economic Research Group

In New York

In London

Linda Britten, E.D. & Global Economics Mgr, Support & Systems

Carlos Teixeira, Associate Economist

Philippa Knight, Research Assistant

In Toronto

Zaki Wahhaj, Research Assistant

In Hong Kong

Sun Bae Kim, M.D. & Director of Asia Pacific Economic Research

In Paris

Dominic Wilson, International Economist

In Frankfurt

In Tokyo

In Singapore

Yuriko Tanaka, V.P. & Associate Economist

Takuji Okubo, Associate Economist

Tomohiro Ohta, Research Assistant

Goldman Sachs Research personnel may be contacted by electronic mail through the Internet at firstname.lastname@gs.com

Main Points

We introduce Goldman Sachs Equilibrium Sovereign Spread (GSESS), our preferred model of long-run equilibrium sovereign spreads

in emerging market economies. In the same spirit as GSDEEMER

and GS-DERBY, GS-ESS develops a systematic guide to valuing

emerging market sovereign spreads over the long run.

emerging market economies as small borrowers in imperfect

international capital markets. We see a countrys fair value spread as

a function of the probability that it will default on its external

obligations. This probability is a function of variables related to the

countrys solvency, liquidity, debt-service track record, and also to

global financial conditions.

emerging market economies from 1996 onwards. The sample

incorporates countries from Latin America, Asia, Emerging Europe,

the Middle East and Africa. For each country, we selected one

benchmark bond, typically between 10 and 20 years maturity.

Our results indicate that out of the 15 countries considered, 2 are now

trading rich to fair value, 12 are undervalued, and one country close

enough to equilibrium to be considered fairly valued. Of the liquid

credits, Venezuela is the most undervalued and Indonesia is the most

overvalued.

statistical tests. In addition, we found a strong long-run relationship

between GS-DERBY and GS-ESS, which confirms that both

measures are consistent estimators of credit risk. Using statistical

techniques, we compared the forecasting ability of GS-ESS against

simpler alternatives and found that in all cases GS-ESS forecasts were

either better or no worse than those from alternative models.

assessed the performance of a portfolio constructed following the

buy and sell signals generated by GS-ESS. Such a portfolio would

have delivered an average annualized return of 11.3% over the period

covering Dec-1997 to Apr-2000, exceeding the average returns on the

EMBI Global index by over 386bps. The GS-ESS based portfolio

also delivers returns that are substantially less volatile than those of

the market neutral portfolios when allowing for both long and shorts.

This results in GS-ESS being associated with a Sharpe ratio that is

more than double that of either of the two other indices.

models, and use it to supplement the views from our country

economists regarding opportunities in sovereign debt. We plan to

update GS-ESS at least on a weekly basis, as we do with

GSDEEMER, GS-DERBY and GS-WATCH, and eventually shift to

a real time platform.

Introduction

The number and value of bonds issued by emerging markets have surged

dramatically over the course of the previous decade. So much so, it is

now one of the fastest growing sources of external development financing

being only second to FDI. In addition, their terms have improved due to

increased investor participation in emerging-market securities, as well as

better long-term economic prospects in a number of countries. However,

emerging-market sovereign spreads also have undergone marked

turbulence, in light of the plethora of financial crises experienced by the

emerging countries since the Mexican crisis in 1994-95. These large

movements have created attractive opportunities over time, both for

buyers as well as for sellers of emerging-market bonds, where price

movements do not often reflect changes in the countries ability to pay.

In this paper we introduce Goldman Sachs Equilibrium Sovereign Spread

(GS-ESS), which represents our preferred model for long-run equilibrium

sovereign spreads in emerging market economies. In the same spirit as

GSDEEMER for the case of real exchange rates and GS-DERBY in the

case of local currency bonds, GS-ESS develops a systematic guide to

valuing emerging market sovereign spreads over the long run.

Empirical studies in the area of emerging spreads, in contrast to studies on

financial crises, have been limited both in scope and in country coverage.

Most studies have focused on identifying the key variables that influence

spreads and justifying their role in a theoretical context. Even those

studies that have offered some empirical support for their theoretical

postulates have not tried to use the model as a means of valuation or

prediction. In light of this, our effort contributes in two innovative ways

(i) first, we perform an empirical analysis of the determination of

sovereign spreads in emerging-market economies; and (ii) second, we

construct a model that provides a valuation tool for the same spreads.

We also tested GS-ESS against other models commonly used to forecast

spreads. We find that from a statistical point of view, GS-ESS performs

better. We believe that this is due to the appropriate combination of

theoretical and state-of-the-art econometric approaches. We also examine

the forecasting ability of GS-ESS and show how it performs within an

asset allocation framework. Here again we find the returns delivered by

GS-ESS to be superior to those that a neutral investor (i.e., one holding

the market) would obtain. Specifically, we find that an investor using

GS-ESS to guide investment decisions would have outperformed the

market by an average annualized return of 386 basis points over the

period December 1997 to April 2000.

Theoretical Determinants of

Sovereign Spreads

specification of the determinants of the probability of default, and tie the

probability of default to a spread. In general, the probability of default is

modeled as a function of macroeconomic fundamentals. For example,

assuming a risk-neutral lender, and following the conventional model of

risk-premium, Edwards (1986) obtains the following linear model for

spread determination

logSPREADt = + i X i + t

where = log(1 + i*) and i* is the risk-free world interest rate, the Xis are

the fundamental determinants of the probability of default, the s are the

GS-ESS: Equilibrium Sovereign Spreads

error term.

Many variables have been suggested by theoretical studies as potential

members in the set of Xis. These include variables that measure the

domestic and external economic performance of a country and exogenous

shocks that affect the liquidity and solvency of the sovereign. Because

the number of potential variables is so large, it is important to formalize a

simple model of an indebted small open economy to guide the search.

Such a model suggests that variables reflecting the economys ability to

generate foreign exchange (the external transfer problem) and the

governments ability to generate enough domestic resources to purchase

the foreign exchange required for servicing its external obligations (the

internal transfer problem) should be considered. Economy-wide and

public sector flow and present-value budget constraints provide a natural

set of variables indicative of the solvency and liquidity of the sovereign

(see Appendix 1 for further detailed analysis of a theoretical model).

Based on such a model, we obtained an initial set of 15 candidate

variables and classified them into four distinct groups:

(i) Solvency variables

These variables relate to the countrys ability to pay in the long run. If

one thinks of a sovereign as facing external and internal constraints, it is

immediately clear that real GDP growth, fiscal and current account

balances, and stocks of public and external debts should be part of this

group. In general, we would expect the higher the real GDP growth,

fiscal and current account balances, and the lower the initial stocks of

debt, the lower the probability of default.

(ii) Liquidity variables

A government may be solvent, but it may be unable to secure the local

currency or foreign exchange, or both to make the transfer (coupon or

principal). The risk that a country may face liquidity problems and be

forced to default on its debt in spite of being solvent should also be part of

a general model of equilibrium spreads as long as investors demand a

compensation for that risk.

In this category, we have included a variety of variables that reflect the

countrys ability to generate the local currency counterpart or the foreign

exchange, the cushion it enjoys in case it is unable to generate it, and

proxies for the probability of suffering a currency crisis.

In general, the higher the amount of required debt servicing, the higher

the likelihood of facing liquidity difficulties. Similarly, the lower the

amount of international reserves, the higher the likelihood of default if

the country were to face a reduction in foreign exchange inflows (either

due to weak export performance or reduced capital inflows).

On the domestic cash front, the lower the tax revenue (or primary fiscal

balance), the higher the probability of default. Finally, real exchange

rate overvaluation tends to be associated with currency crises, which

often lead to debt servicing difficulties because a weaker currency raises

the cost of servicing debt. Sachs (1985) and Cline (1983) argue that

inappropriate exchange rate policies resulting in persistent overvaluation

were amongst the most important causes of the debt crises as well as

enormous capital flight in Latin American emerging countries. For these

GS-ESS: Equilibrium Sovereign Spreads

one of the explanatory variables in our GS-ESS model.

(iii) External shocks

A third group of variables relates to those that capture external shocks to

the economy. A number of studies (see Barr and Pesaran [1997]; Calvo,

Leiderman and Reinhart [1993]; and Dooley, Fernandez-Arias and Kletzer

[1996]) have emphasized the crucial role played by external liquidity as

measured by international interest rates in determining international

capital flows to emerging market economies.

More generally, there is ample empirical evidence that emphasizes the

importance of changes in external liquidity conditions on widening

spreads in emerging markets. A higher global interest rate not only

increases the cost of all new borrowing, but also the cost of servicing

outstanding debt. Eichengreen and Mody (1998) is one such study that

illustrates the vulnerability of Emerging Debt Market (EDM) spreads to

global financial conditions. Tight liquidity conditions in industrialized

countries have been identified as a prime determinant of the 1994-1995

financial crisis in Mexico. More generally, in extreme conditions

emerging markets may experience credit rationing, meaning that they are

unable to obtain external financing irrespective of how high local interest

rates are.

Another external variable that can potentially influence a countrys ability

to service external debt is the terms of trade (TOT), or the relative price

of a countrys exports to its imports. In particular, a drop in the price of a

countrys exports will have a negative impact on the countrys ability to

generate foreign exchange to service external debt. Hence, a negative

TOT shock will typically be associated with an increase in the probability

of default.

The LDC crisis of the 1980s is a recent example of how high interest

rates, credit rationing and a deterioration in the terms of trade can lead

to default in external debt. The combination of an unprecedented

increase in interest rates required by Federal Reserve Chairman Paul

Volcker to lower inflation in the United States in 1979-80 led to a surge

in scheduled interest payments by emerging economies, as a large share

of bank syndicated loans were on a LIBOR floater basis. At the same

time, emerging economies experienced a significant drop in the terms of

trade, while bank lending evaporated. This meant that even solvent

emerging economies defaulted on their sovereign debt, because they

needed to make the external transfer (interest plus principal) precisely at

the time when their foreign revenue plunged and financing dried up.

The consequence was a decade of default, recession and inflation

culminating in the broad bank debt workout that created the Brady

bonds.

(iv) Dummy variables

Regional and/or country-specific dummy variables are often included in

theoretical models of spread determination. A dummy variable is one

that takes a value of 1 if a group of individuals (or countries) share a

certain characteristic and 0 otherwise. For example, we could create a

Latin America dummy variable. For each country, that variable would

GS-ESS: Equilibrium Sovereign Spreads

distinguishing experience with debt default), and zero otherwise. In a

regression context, dummy variables may be useful in cases where the

data suggest that coefficients (either intercepts or slopes) should differ

across groups of countries. For example, in the context of GS-ESS, we

may want to allow a different intercept for countries that have defaulted in

the past. Countries that have historically defaulted on debt would have

spreads that are different than countries that did not. Therefore, we try a

more broadly defined dummy variable that captures the history of default

of a particular country. This could be applicable for countries prone to

political instability where political crises reduce willingness to pay, thus

leading to default.

Our Preferred Empirical

Specification

described in the theoretical appraisal of the previous section. We made

the final selection of variables by considering several factors relating to

model parsimony in light of the limited observation span we had, and

whether the coefficients were associated with theoretically expected signs

and were statistically significant.

An exhaustive list of these variables, along with the problems that arose

in estimation, is provided in Appendix 2. We also applied several

recently developed econometric techniques that allow us to distinguish

those variables which form a long-run relationship among themselves and

with sovereign spreads. The model can specified as (dropping the time

subscripts):

DEF)

spread on the benchmark bond for the country in question. The sample is

restricted to those countries that issue long-term bonds. For the purposes

of the sample we only included bonds that were issued at least 20 months

ago. There are 15 countries in this sample that we use for estimation. The

explanatory variables comprise a set of economic fundamentals, a

variable for global liquidity and a dummy variable capturing the impact

on bond spreads to those countries that have defaulted. We briefly

describe the explanatory variables below.

1. Long-run Real GDP Growth (GROWTH): Refers to monthly

estimates of real GDP year-on-year growth, interpolated from

quarterly (where available) or annual figures. As this variable tends

to exhibit a fair degree of volatility in emerging markets, we use an

estimate of permanent or trend growth at the model fitting stage. To

derive this estimate we use a statistical technique known as

exponential smoothing. Other things remaining constant, the higher

the growth, the stronger the countries fiscal position; therefore, the

easier it becomes for the country to transfer the necessary resources

for external debt payments. Hence, this variable should be associated

with a negative sign.

2. Total External Amortizations as a Ratio of Gross International

Reserves (TAMRES): Large scheduled external amortization

payments should be easy to finance when global liquidity conditions

GS-ESS: Equilibrium Sovereign Spreads

conditions are tight, large amortizations may be hard to roll over,

increasing pressures on spreads. In principle, however, a country can

buffer the shock by drawing down its external assets. Hence, the

reason for taking the ratio of external amortizations to reserves. We

expect this variable to enter with a positive coefficient.

3. Total External Debt as a Ratio of GDP (TXDY): The higher the

debt-to-GDP ratio, the bigger the transfer effort the country will need

to make over time to service its obligations. This coefficient should

therefore be associated with a positive sign.

4. Nominal Budget Balance as a Ratio of GDP (NBB): This variable

captures the fiscal conditions in an economy, and in particular, enters

the countrys solvency equation. The weaker the fiscal position, the

higher the likelihood that external shocks may result in default.

Hence, this variable should be associated with a negative sign.

5. Ratio of Exports of Goods and Non-Factor Services to GDP

(XGD): This variable is used as a measure of openness of the

economy. Traditionally, more open economies tend to be associated

with tighter spreads. There is also some empirical evidence to

suggest that more open economies have a better ability to absorb

external shocks than less open economies. Therefore, this variable

should be associated with a negative sign.

6. Real Exchange Rate Misalignment (MISAL): Currency

overvaluation tends to be associated with currency and balance of

payments crises, which often lead to debt servicing difficulties.

Hence, this variable should carry a positive sign.

7. Global Liquidity (LIBOR): We proxy global liquidity conditions by

the GDP-weighted average nominal interest rate in G-7 economies.

An increase in this variable also should increase spreads in emerging

market countries since it would limit the attractiveness of investments

in emerging (relative to developed) economies, and reduce capital

flows to those markets. Hence, it should carry a positive sign.

8. Default History (DEFAULT): Investors may require compensation

for holding bonds of countries that have restructured their debt in the

past because they may take a countrys debt servicing track record as

an indication of the countrys level of commitment (as opposed to

ability) to serve its external obligations. Alternatively, investors may

distinguish between bonds that corresponded to restructured

obligations (Bradies) and those that do not (Euros or Globals). We

tested the two types of dummies but found only the second to be

significant. Hence, we include a dummy variable which takes on the

value of 1 if the bond in question corresponds to restructured debt,

and 0 otherwise. This variable is expected to carry a positive sign.

Data and Econometric

Methodology

monthly data for all explanatory variables, excluding LIBOR and the

dummy, from annualized time series of quarterly or annual data. As new

or revised quarterly data become available the monthly data are revised

and filtered through the interpolation process to arrive at revised monthly

estimates. We do this since using raw monthly data inherently involves

issues of seasonality and volatility that may seriously bias long-run

estimates. Summary statistics of the dependent variable (stripped static

spread) are presented in Table 1, which also shows the country and type

6

Table 1: Descriptive Statistics

Name of

Country

Bond

Argentina

Republic 17

Brazil

Republic 27

Bulgaria

IAB11

China

Republic 08

Colombia

Republic 07

Indonesia

Republic 06

Korea

Republic 08

Malaysia

PETRONAS 09

Mexico

UMS 26

Peru

PEPDI 17

Philippines

Republic 19

Poland

PLPDI 14

Russia

28

South Africa

Republic 09

Venezuela

Republic 27

Total Panel

Start of

Sample

Jan-96

Nov-96

Jan-96

Aug-96

Feb-96

Oct-96

Jan-96

Nov-96

May-96

Dec-96

Jun-97

Jan-96

Nov-96

Oct-96

Jan-96

Total

Observations

50

40

50

43

49

41

50

40

46

39

33

50

40

41

50

822

Mean

Spread

535

633

965

147

401

557

336

289

422

477

443

268

2928

400

658

551

Spread

Standard

Deviation

119

226

390

65

198

427

175

257

102

133

141

180

1553

192

274

432

Notes: 1) All spreads are monthly averages. 2) Unless otherwise noted, all table sources are Goldman Sachs & Co.

Estimates. In some cases, we extrapolated the yields historically using similar bonds.

uses panel techniques to estimate the long-run fair value for bond spreads.

A panel is a dataset that combines time-series information for a crosssection of individuals (or groups). These groups may be firms,

industries, countries or regions. The time-series for such groups may not

all start at the same time.

One advantage of panels is that they provide a richer set of information

through a greater number of observations in cases where either the timeseries or the cross-sectional dimension of the data is limited. In addition,

they allow us to exploit both the time series and cross sectional nature of

the data. The coefficient estimates that we obtain from regressions

conducted using panels provide us with an average set of long-run

coefficient driving spreads for all the countries. We then apply this same

set of long-run coefficients to the different country fundamentals and

arrive at the country specific estimates of the long-run equilibrium

spreads.

Several methods to estimate panel regressions now exist. These include

the mean-group (MG), pooled-mean group (PMG) and dynamic fixedeffects (DFE) estimators. Each of these can be better understood by

considering all models on a continuum to the extent that they impose

commonality or restrictions on the set of long-run elasticities (those that

we eventually use to arrive at the equilibrium GS-ESS fitted values).

The MG estimator simply involves running individual time-series

regressions for each group on an intercept, lagged-dependent and lagged

explanatory variables, solving for the long-run elasticities of each

regression, and then averaging the coefficients across all groups in the

panel. In this respect, the MG estimator does not impose restrictions on

any of the parameters in the model and is the least restrictive panel

estimator. However, as the MG estimator is an unweighted average of the

group coefficients, it is also highly sensitive to outlier elasticity estimates.

GS-ESS: Equilibrium Sovereign Spreads

The DFE estimator, on the other hand, estimates a panel regression but

imposes commonality across all elasticities and variances of each of the

groups, allowing cross-sectional variation only through the intercept term.

The DFE is also sensitive to panels with small groups and seems overly

restrictive.

The PMG estimator, due to Pesaran, Smith and Shin (1999), is an

alternative estimator that involves the same preliminary regressions of the

MG estimator but differs in one important respect. While allowing shortrun specifications and parameters to vary across individual groups, the

PMG estimator restricts the long-run elasticities to be identical across

countries. This seems to be a sensible assumption due to the imposition of

restrictions from economic theory, arbitrage conditions, etc., and

reinforces our view that the long-run impact of fundamentals on spreads

should be the same over countries, in stark contrast to the short-run. Due

to these reasons and the performance of PMG estimates in panel studies

cited in the literature so far, we adopt the PMG estimator to derive our

GS-ESS long-run elasticities.

The pooled mean group estimator of Pesaran, Smith and Shin (1999) is

applicable to panels where we have cross sectional variation in the shortrun dynamics but long-run commonality in the long-run equilibrium

relationship.

In estimating GS-ESS, it is important to note that a number of the

explanatory variables that we use (such as economic growth) tend to

exhibit relatively high volatility. This is because there is a gap between

the actual and permanent or potential value of these variables. For

valuation purposes, it appears more appropriate to use only the

permanent, or trend component of the fundamental variables. Hence,

while we use the actual data when we run the regressions, we only use the

permanent component of the data at the fitting stage. To do this, we use

an econometric procedure known as the Hodrick-Prescott (HP) filter to

effectively extract the permanent or trend component from the relevant

variables. The variable we apply the HP filter to is GROWTH.

For each country, the complete data set used for the empirical

specification consists of ten variables (the dependent variable, seven

economic fundamentals, global liquidity conditions and the debt

restructuring dummy variable). These data are pooled for all countries in

the sample, and panel PMG estimation is performed on this 15-country

data set.

Table 2: Long-Run Model Estimates

Impact on Spreads

from 1% increase in

Explanatory Variables

Asymptotic

Variable

Coefficient

t-statistic

(in basis points)

Intercept

-2.7

-439.3

Long-Run Real GDP Growth

-5.1

-7

-691.3

Total Amort/Reserves Ratio

162.1

8.3

2

Total External Debt/GDP Ratio

7.5

10.1

7

Nominal Budget Balance

-34.2

-2.0

-34

Total NFGS Exports/GDP Ratio

-2.57

-5.8

-3

FX Real Misalignment

210.4

2.2

2

Long-Run LIBOR

45.3

1.7

45

Debt Restructure Dummy

165.0

5.0

165.1 (if country restructures)

Significant

Conclusion

R-bar Squared

0.55

F-Statistic

58.019

1%

Explanatory variables jointly significant

Breusch-Pagan LM

2.21

No

Residuals are not cross-correlated

Notes: Asymptotic t-statistics are based on robust standard errors. Long-run real GDP growth refers to trend growth. NFGS

refers to exports of non-factor goods and services. This ratio is corrected by transforming exports values by the long-run real

exchange rate as measured by GSDEEMER. The Breusch-Pagan LM test is a test for cross-sectional correlation of residuals,

distributed chi-square with 1 degree of freedom. Source: GS estimates.

GS-ESS Results

Table 2 above presents the results from the panel regression and the PMG

long-run elasticities. The estimated coefficients correspond to the longrun panel model. As indicated, all coefficients are associated with

theoretically expected signs, suggesting that the explanatory variables all

work to influence EM spreads over the long-run as we think they should.

In addition, all variables are statistically significant at the 5% level or

higher, with the exception of LIBOR which is significant at the 7% level.

Even though this variable is not significant at conventional levels, we

refrain from excluding it on the grounds of economic theory.

In the last column of this table, we provide an estimate of how spreads

would change given a 1-percent increase in each of the explanatory

variables. For example, if long-run real GDP growth were to increase by

1%, assuming all else is constant, this would reduce the long-run

equilibrium spread by about 7 basis points. On the other hand, the

marginal impact of a 100 basis points increase in LIBOR is an increase in

1

spreads of about 45 basis points. If the benchmark bond used is one that

corresponds to restructured debt, the spread will be, on average, 165 basis

points wider compared to those that have not been restructured.

In the table, we report additional summary statistics resulting from the

estimation, such as the adjusted coefficient of determination (or R2-bar) of

0.551. This means that over 55% of the variation of sovereign spreads is

explained by the explanatory variables. When interpreting this statistic, it

is important to note that the model is designed to provide the predicted

values for long-run equilibrium spreads. Consequently, we should not

necessarily expect a very high degree of fit because this implies, by

definition, that current spread levels are misaligned to some degree from

their long-run level. We also report an F-test that suggests that the

explanatory variables taken as a group all contribute significantly to

explaining long-run sovereign spreads. Finally, we test to see whether

1

the errors are corrected for potential biases arising from the possibility that the

error variances across each country may not be all the same.

the different countries. This seems to be an assumption of panel

regressions that often does not hold up empirically. The statistic that we

use to test this is based on Breusch and Pagan (1980). The statistic is not

significant, which suggests that our estimates do not suffer from this

typical problem.

Using the set of estimated coefficients, we construct a series of predicted

equilibrium sovereign spreads and the estimated misalignment series as

the difference between the actual and predicted spread. In so doing, we

arrive at country-specific misalignments based on the long-run

explanatory variables. We report the fitted values in Table 3 (below)

under the column headed May-00 GS-ESS, which represents the

equilibrium sovereign spreads for May 2000. Alongside this column is the

misalignment expressed as the basis points deviation of the March 2000

spread from its long-run equilibrium.

The results that we obtained indicate that out of the 15 countries

considered, 2 are now trading rich to fair value, 12 are undervalued, and

only one country is close enough to equilibrium to be considered fairly

valued. Of the liquid credits, Venezuela is the most undervalued and

Indonesia is the most overvalued.

Table 3: Equilibrium Sovereign Spreads

Name of

Bond

Country

May-00

SPREAD

May-00

May-00

Under (-) or

GS-ESS Over (+) Valuation

Argentina

Republic 17

665

455

Brazil

Republic 27

720

473

Bulgaria

IAB11

728

542

China

Republic 08

158

153

Colombia

Republic 07

836

316

Indonesia

Republic 06

578

743

Korea

Republic 08

214

165

Malaysia

09

221

190

Mexico

UMS 16

374

322

Peru

PEPDI 17

575

442

Philippines

Republic 19

600

361

Poland

PLPDI 14

197

302

Russia

28

1150

932

South Africa

Republic 09

388

271

Venezuela

Republic 27

893

363

Notes: All spreads are monthly averages. Source: GS-ESS estimates.

-210

-247

-186

-5

-520

165

-49

-31

-52

-133

-239

105

-218

-117

-530

May-00

Valuation

Cheap

Cheap

Cheap

Fair

Cheap

Expensive

Cheap

Cheap

Cheap

Cheap

Cheap

Expensive

Cheap

Cheap

Cheap

diagnostic tests at an individual country level. These tests are designed to

empirically examine whether the underlying statistical assumptions of the

model hold. The results of these tests are presented in Table 4 (p. 12).

The first column of estimates reports an error-correction coefficient based

on individual error-correction models for each country. The errorcorrection coefficient is a measure of how quickly each of the spreads

return to their long-run equilibrium following a shock. Based on this

estimate we can calculate approximate speeds of adjustment for each

countrys spread. This is reported in column 3 in terms of months.

GS-ESS: Equilibrium Sovereign Spreads

10

64 months in the case of Peru which is the slowest to only one month in

the case of Malaysia and the Philippines. The variation of the speeds of

adjustment may in part reflect the volatility in the sample under

consideration as well as some degree of small sample bias. However, at

the very least, they can be used as a guide to relative reversals of

sovereign spreads back to equilibrium.

The next 6 columns report diagnostic tests on the error-correction models,

including estimates of goodness of fit. In summary, most country

regressions in the panel are robust to standard diagnostics. Exceptions are

mis-specification of functional form for Brazil, Korea and Malaysia. This

may involve a search for an alternative functional form which could

improve individual country elasticities. However, whether violation of

functional form for these 3 countries will significantly alter our 15country panel PMG estimates is highly doubtful. The assumption of

normally distributed errors is also violated in the cases of Indonesia and

South Africa. However, in large samples, we do not strictly require

normality as long as errors have the same variances. The test of error

variances being the same is reported in the column headed Hetero and

indicates that none of the countries are significantly affected.

Adjusted R-squared figures vary by country, but overall they suggest that

the explanatory variables explain over half the fluctuations in spreads in a

majority of countries. In the bottom section of the table we report panel

diagnostics testing the existence of a long-run relationship for the

variables using a panel framework. These panel statistics are all fairly

new but provide a sense of how robust our overall functional form is. The

statistics test, in panel form, whether there exists a statistically significant

long-run relationship between spreads and the explanatory variables. We

find overwhelming evidence to support the view that there does exist a

long-run relationship. This is formal statistical evidence to validate

inferences based on our preferred specification and functional form for

GS-ESS.

11

With the introduction of GS-ESS, we now have two valuation models for

bonds in emerging markets: one for local currency bonds (GSDERBY)

and one for hard currency bonds (GS-ESS). Assuming integrated capital

markets, real interest rate parity requires that, in equilibrium, similarmaturity instruments of similar risk should carry the same real yield.

Differences, may arise due to transaction costs, capital account

restrictions, and other barriers to free capital flows. However, we would

expect our models to deliver results that are broadly consistent with each

other. We turn below to a comparison of GSDERBY and GS-ESS.

Error

Speed of

Serial

Functional

Correction

Adjustment

Correlation

Form

Normality

Hetero

Log

Country

Coefficient

(in months)

Ch-SC

CH-FF

CH-NO

CH-HE

RBARSQ

Likelihood

Argentina

-0.33

3

1.89

0.27

0.49

0.15

0.56

-112.9

Brazil

-0.08

12

0.45

4.58

1.39

0.92

0.88

-147.1

Bulgaria

-0.02

42

0.57

2.94

2.49

0.35

0.61

-349.6

China

-0.03

30

2.81

0.28

1.76

1.68

0.41

-156.5

Colombia

-0.13

8

1.57

1.37

0.65

1.35

0.45

-161.9

Indonesia

-0.16

6

0.00

3.33

6.01

2.41

0.38

-221.9

Korea

-0.15

7

1.54

4.55

1.64

0.09

0.91

-53.8

Malaysia

-0.41

2

1.58

5.74

3.54

3.21

0.48

-181.6

Mexico

-0.34

3

0.95

0.08

1.07

1.15

0.59

-198.9

Peru

-0.02

64

2.84

2.80

0.84

0.98

0.65

-169.2

Philippines

-0.57

2

3.26

2.01

1.87

2.86

0.34

-141.5

Poland

-0.05

19

2.08

2.84

1.05

0.55

0.35

-287.8

Russia

-0.17

7

2.95

1.52

1.88

1.19

0.45

-234.6

South Africa

-0.04

24

3.26

3.34

6.41

1.25

0.28

-144.2

Venezuela

-0.34

3

0.25

0.87

0.37

1.36

0.62

-130.4

Panel Diagnostics: Tests for Long-Run Relationship and Cointegration Statistics

Im-Pesaran-Shin Choi-Ahn

Kao

Levin-Lin Sarno-Taylor

DurbinDynamic OLS

Panel ADF

Multivariate

Panel

Panel ADF Panel ADF

Hausman Cointegration

Stationarity Cointegration

(1993)

(1998)

Stationarity

(1997)

(1999)

(1999)

(1992)

Hypothesis being tested

-4.51

0.15

-4.58

-5.23

-3.90

0.09

-4.25

Panel Regression

is Spurious

Reject

Reject

Reject

Reject

Reject

Reject

Reject

Significance

5%

5%

5%

1%

10%

5%

5%

Notes: The error-correction coefficient is significant at least at the 5% level for all countries. Speed of adjustment refers to months for

convergence to equilibrium. All diagnostic statistics are distributed as chi-square. The variety of panel cointegration and augmented

Dickey-Fuller (see Dickey and Fuller (1981)) statistics test whether, in panel form, there exists a statistically significant non-spurious,

long-run equilibrium relationship between spreads and all the explanatory variables in the model. Dynamic OLS cointegration refers

to tests of stationarity on residual from cointegration regression in panel form of GS-ESS specification by the procedure prescribed by

Stock and Watson (1993). Source: GS estimates.

in equilibrium, the interest rate paid by a sovereign should be the same,

whether denominated in local or foreign currency. In making this claim,

we need not make adjustments for expected real depreciation. This is

because the comparison is performed on equilibrium real rates, which in

the cases of GSDERBY and GS-ESS already take the real exchange rate

misalignment into account.

12

of the yields into real yields by deflating local currency (GS-DERBY)

equilibrium levels by domestic inflation rates and by deflating dollardenominated (GS-ESS) bonds by the US inflation rate. Chart 1 below

shows historical real yields from GS-DERBY and GS-ESS. Plots for four

countries from the start of the sample are shown in the figures below. For

all countries, the two yields seem to track each others movements fairly

well. This is surprisingly reassuring given the short sample under

consideration.

Chart 1: Comparing GS-ESS to GSDERBY Over Time

14

10

ARGENTINA

MEXICO

12

10

7

6

4

3

GS-ESS

GS-DERBY

0

Sep-97

GS-ESS

GS-DERBY

0

Feb-98

Jul-98

Dec-98

May-99

Oct-99

Mar-00

Sep-97

Feb-98

Jul-98

Dec-98

May-99

Oct-99

Mar-00

16

SOUTH AFRICA

POLAND

14

GS-ESS

GS-DERBY

12

10

5

8

4

6

GS-ESS

2

GS-DERBY

1

0

Sep-97

0

Feb-98

Jul-98

Dec-98

May-99

Oct-99

Mar-00

Sep-97

Feb-98

Jul-98

Dec-98

May-99

Oct-99

Mar-00

relationship (or cointegration) between the real equilibrium yields from

GS-DERBY and GS-ESS. In contrast to simple correlation analysis,

cointegration itself is a formal statistical test for a long-run stable

relationship between two or more variables. Results of this exercise

appear in Appendix 2, Table A1. To summarize, we found significant

statistical evidence of cointegration between each and every set of local

and foreign currency real yields, as reported by the two models. This

GS-ESS: Equilibrium Sovereign Spreads

13

implies that even if there are temporary deviations between the real yields

during some periods over the sample, they still establish an equilibrium

relationship over the long run. This also confirms our preceding test

based on a single month in the sample, and reassures us that deviations

are not only transitory, but can be explained readily if we consider factors

not explicitly accounted by the two models.

Does GS-ESS Predict Better than

Alternative Models?

This section is devoted to a formal analysis to assess the ability of GSESS to forecast sovereign spreads on a country by country basis using

statistical methods. In the next section, we address the same question

from a market-oriented perspective, examining the performance of an

investor following the advice of GS-ESS.

To assess the models statistical ability to predict spreads, we use a

measure known as the Diebold-Mariano (1995) statistic. This statistic has

been shown in the literature to be the best measure for accomplishing

such an objective. Briefly, this statistic is designed to compare the

performance of a model against alternative models in terms of forecast

errors. Naturally, the smaller the forecast errors, the better the forecasting

ability. The Diebold-Mariano test can determine whether the forecasting

ability of a model is, in a statistical sense, significantly better, not

significantly different, or significantly worse than alternative models.

We present the results of applying this test to compare GS-ESS to two

alternative models, described as:

1. Model A ("Drifted Random Walk"): assumes a random walk with

a drift term, i.e. the best predictor of next months sovereign spread

will be this months sovereign spread adjusted for a trend.

2. Model B ("Mean-Reversion"): assumes that sovereign spreads for

each country, over the long run, will revert to their own means,

respectively. This is a hypothetical model in our exercise but one that

mimics well technical rules used for trading in many developed and

developing bond markets.

We compare the predictive performance of GS-ESS over the period

2

September 1998 to March 2000. The first two columns in Table 5 (p. 15)

show the Diebold-Mariano test statistics resulting from the statistical

comparison of the forecasting performance of GS-ESS against Models A

and B. A * denotes significance at the 10 per cent level, a ** at the 5 per

cent, and a *** at the 1 per cent. If the statistic is significant and

negative, it implies that GS-ESS is a better predictor of spreads than the

alternative model. If the statistic is not significant, it implies that GS-ESS

is not a statistically inferior predictor of spreads than the alternative

model. If the statistic is significant and positive, it means that the

alternative model is a better predictor of spreads than GS-ESS.

In comparison to Model A, GS-ESS is a significantly superior predictor in

9 countries, and not significantly worse in any. When compared to Model

B, GS-ESS provides a similar display of forecast performance, with the

rival model not significantly better than GS-ESS for any country. These

results are truly exemplary given that GS-ESS uses a panel framework.

Traditionally, panel models are not used for forecasting and models based

on just the time series methods are often the preferred forecasting models

in the literature.

2

square error criterion.

14

the market timing ability of GS-ESS, out-of-sample. We do this in two

ways. First, we use the Pesaran-Timmerman (1992, 1994) test of

independence between forecast and actual spreads. The PT test is

intuitively a test of whether the forecasts generated by GS-ESS are related

to the actual spreads in structure and dynamics, rather than just a better

predictor over a fixed sample of time.

Second, we present the proportion of times GS-ESS correctly indicated

turning points for each countrys spreads. The PT test is presented in the

third column and shows that in all cases the forecasts and actual spreads

are not independent, using appropriate levels of statistical significance. In

terms of market timing, the ability of GS-ESS is also outstanding, with

the turning point of spreads being correctly predicted in over 50% of the

time for a vast number of countries.

These tests provide statistical evidence that, in a vast majority of cases,

GS-ESS provides a superior prediction framework compared to

alternative models often used to predict spreads.

Table 5: Statistics of Comparing Predictive Ability Using Forecasting Sample Sep-98 to Mar-00

GS-ESS vs.

Drifted Random Walk

Diebold-Mariano

GS-ESS vs.

Mean-Reversion

Diebold-Mariano

PesaranTimmerman

Market

Timing

Country

Using RMSE Criterion

Using RMSE Criterion

Out-of-Sample

Sign (%)

Argentina

-1.39*

-2.47**

2.55***

55.1

Brazil

-2.15**

-2.25**

2.64***

51.5

Bulgaria

-2.75*

-2.88***

3.15***

44.8

China

-1.75*

-1.55*

3.55***

69.2

Colombia

-2.12**

-0.05

2.81***

58.7

Indonesia

-2.11**

-1.64

2.64***

62.7

Korea

-1.23

-3.11***

3.23***

59.8

Malaysia

-1.12

-2.25**

3.15***

51.4

Mexico

0.56

0.36

3.29***

45.8

Peru

-0.66

-0.98

2.00***

67.7

Philippines

-2.15*

-0.15

1.75*

56.7

0.55

-3.54***

2.19**

59.4

Poland

Russia

-2.24**

-2.01

1.96*

53.44

South Africa

-0.12

-2.36**

3.22***

51.3

Venezuela

-1.59*

-1.88**

1.81*

71.5

Notes: *, ** and *** denote significance at the 10, 5 and 1 per cent levels, respectively. If the figures are not significant

this implies that we cannot reject, at conventional levels of significance, the hypothesis of equal expected meansquare error - i.e. GS-ESS is not a statistically significantly inferior predictor of the spread than is the alternative

model. If significantly negative, this favors GS-ESS outright against the alternative models. If significantly positive,

this favors the alternative model over GS-ESS. We use GS-ESS as the benchmark model. The DM test is associated

with the null hypothesis of equal forecasting accuracy in forecasting performance. For further details, see F.X.

Diebold and R.S. Mariano (1995). The PT test explicitly tests for independence between forecast and actual values.

Market timing refers to the percentage of times GS-ESS predicted correct turning points out of sample. For details of

the PT test see Pesaran, M.H. and A. Timmerman (1992). Full references are provided in separate reference list.

Source: GS estimates.

15

Superior Returns Compared

to Alternative Models?

would have obtained since September 1997. We address this issue by

asking whether such an investor would have outperformed a neutral

investor holding the market defined as a portfolio constructed with a set

of weights similar to the Global EMBI in emerging sovereign bonds.

To conduct the tests, we proceed as follows. First, we calculate daily

stripped static spreads in each of the 15 emerging market bonds from

September 12, 1997 to April 6, 2000. Using the total return series, we

calculate a variance-covariance matrix of returns using a 60 trading-days

window3. Next, we calculate expected returns for each bond. For each

bond, the expected return over a given horizon would be a function of the

coupon the bond carries and the expected decline/increase of the bond

price over the subsequent 3-month period. In other words, the expected

return is the bond coupon inflated/deflated by the expected pricing

valuation implied by the spread change according to GS-ESS. The price

change implied by the convergence to equilibrium is also a function of the

error correction term (ECT).

The ECT defines the speed of convergence from a given spot level to

equilibrium. Generally speaking, we find that rich bonds have a lower

ECT relative to cheap bonds. Therefore, Brazil and Argentina tend to

have higher ECTs than China and Korea. Of all efficient portfolios, we

chose the one that reflects minimum variance, and yields the lowest cost

of funding.

From looking carefully into the efficient portfolio graphs, we may already

obtain some interesting insights. First, bonds were clearly oversold after

the Russian crisis. According to the model, the minimum variance

portfolio yielded an expected return of about 370bp over the following

three months (see Chart 2 below). Second, after the rally in early January

2000, EDMs were rich against GSS equilibrium. This translated into

negative expected returns for the minimum variance portfolio, or 250bp

expected loss on the overall portfolio (see Chart 3 below).

Using the expected returns that we obtain and the variance-covariance matrix as

inputs, we calculated two sets of efficient portfolios. An efficient portfolio is a

combination of investments that maximizes the expected rate of return on that

portfolio for a given variance of return. To derive such portfolios, we used the

mean-variance model of asset choice. The model has been extensively used in

finance since its inception, more than four decades ago, by Harry Markowitz. In

our calculations, we specifically followed this approach as developed in Huang

and Litzenberger (1988, Chapter 3). The combination of all such portfolios

defines the portfolio frontier, with each point on the curve representing a

particular combination of weights for each of the bonds.

16

Chart 2: Efficient Frontier, September 12, 1998

E xp e c t e d 3 M

3 .8 5%

Expected

ns in im u m

3 .8 4%3M returm

-0.99%

va ria n c e p ortfo lio

3 .8 3%

-1.00%

3 .8 2%-1.01%

-1.02%

3 .8 1%

-1.03%

3 .8 0%

-1.04%

3 .7 9%

-1.05%

minimum

variance portf olio

3 .7 8%

-1.06%

-1.07%

3 .7 7%

-1.08%

3 .7 6%

0.175%

0.175%

0 .78 5 %

0 .7 8 5 %

0.175%

0 .78 5 %

0.175%

0 .7 8 5 %

0.175%

0 .7 85 %

0.175%

0 .7 8 5 %

0.175%

0.175%

0 .78 5 %

0 .7 8 5 % volatility

vo la lit y

Expected

3M returns

-0.99%

-1.00%

-1.01%

-1.02%

minimum

variance portfolio

-1.03%

-1.04%

-1.05%

-1.06%

-1.07%

-1.08%

0.175%

0.175%

0.175%

0.175%

0.175%

0.175%

0.175%

0.175%

volatility

produced two alternative sets of portfolios. In other words, in building

the portfolio solutions for the variance minimization problem, we

restricted our resulting portfolios to two sets of constraints. First, we

allowed investors to trade the bonds actively, i.e., to enter short and long

positions in their books. Second, we inserted constraints to the problem

that would not allow for short positions, i.e., investors would not be able

to borrow bonds, but only to buy and to hold the corresponding weights.

Finally, we compared the performance of portfolios developed according

to a market-neutral portfolio (see Chart 4 below), in situations where (i)

both long and shorts would be allowed and (ii) only longs would be

allowed. In the case where both longs and shorts were allowed, GS-ESS

outperforms the market-neutral portfolio index. In this situation, GS-ESS

would deliver an average annual return of 386bp above returns from the

EMBI Global. If we allow for longs only, GS-ESS outperforms the

market on a risk adjusted basis only. In other words, the Sharpe ratio is

higher for GS-ESS than the market.

GS-ESS also delivers returns that are substantially less volatile than those

of the market neutral portfolio when allowing for both long and shorts.

This outcome results in GS-ESS being associated with a Sharpe ratio that

is more than double that of the market.

17

Chart 4: Portfolio Performances vs. Benchmark Market Weights

140

130

GS-ESS (Long and Short positions)

120

GS-ESS (long positions only)

110

100

EMBI Global

90

80

70

60

Dec-97

Mar-98

Jun-98

Sep-98

Dec-98

Mar-99

Jun-99

LONG ONLY

Sep-99

Dec-99

Mar-00

EMBI Global

Avg. Returns

Std. Dev

Skewness

11.3%

26.79%

(1.11)

7.3%

56.56%

(3.30)

7.5%

76.06%

(1.65)

Sharpe Ratio

42.3%

12.9%

9.8%

include GSDEEMER and GS-SCAD for valuing currencies, GS-DERBY

for valuing local currency bonds, and GS-WATCH for assessing currency

risk. GS-ESS will provide measures of valuation to assess whether, for

example, the yield that sovereign spreads offer is enough to compensate

the investor for the associated risks. GS-ESS can also prove useful in our

sovereign bond yield forecasts, based on a long-run horizon. Going

forward, we plan to update GS-ESS at least on a weekly basis, as we do

with GSDEEMER, GS-DERBY and GS-WATCH, and eventually shift to

a real time platform.

Alberto Ades

Federico Kaune

Paulo Leme

Rumi Masih

Daniel Tenengauzer

June 2000

18

Appendix 1

the econometric estimations. Modeling sovereign risk in a small open

economy (SOE) requires clearly identifying the choices and constraints

that such an economy, and its government, face. From a theoretical

standpoint, it is usually assumed that SOE agents try to maximize welfare

(or the amount consumed at different points in time) subject to a resource

constraint. In such an environment, the typical economic agent will

usually try to smooth its consumption path as much as possible. This will

be achieved by accumulating assets when resources are abundant, and

depleting them in times of scarcity. By opening to international trade, the

SOE can lessen the hardships associated with smoothing consumption in

the face of a volatile income stream.

In an ideal world, a SOE would be able to fully insure itself against all

contingencies. In other words, it would enter into a (fully contingent)

contract with another party (a foreign investor) by which it would make

(receive) a transfer of resources whenever income is higher (lower) than

consumption, thus perfectly smoothing its consumption path. Of course,

in such a perfect world, contracts would be fully enforced, with lenders

lending whenever required and borrowers (SOEs) repaying whenever

required.

In reality, however, not all contingencies can be perfectly insured, nor are

all contracts perfectly enforceable. Many contingencies are difficult to

verify by both parties (because they involve private information), or

because of problems regarding the underlying information technology

(monitoring is costly). Contract enforcement problems can be particularly

acute when dealing with sovereign states because of the lack of a

supranational legal authority capable of enforcing those contracts and

because sovereigns possess immunity.

Because such difficulties make the implementation of fully contingent

contracts unfeasible, we usually observe some imperfect form of standard

debt contracts (SDC) instead. In an SDC, either each foreign investor

receives a non-contingent payment (a fixed coupon independent of the

realization of the SOEs income stream), or the SOE defaults. In the later

case, the SOE typically faces some kind of direct or indirect cost (e.g., the

attachment of external assets, costs related to exclusion from international

trade or capital markets, or simply reputation costs). By construction, the

fixed payment required in a SDC will include a risk premium to

compensate the foreign lender for the probability that the SOE may be

unable to pay under some conditions.

Faced with the option of entering into a SDC with an SOE's government,

a foreign investor is likely to focus in two main issues. The first issue is

the SOEs ability to generate enough foreign exchange to service its

external obligations under different conditions. This is usually referred to

as the "external transfer problem." The second is the SOE government's

ability to generate enough domestic resources to purchase the foreign

exchange required for servicing its external obligations. This is usually

referred to as the "internal transfer problem." By focusing on these two

constraints, a potential foreign lender should be better positioned to assess

the ability to pay (but not the willingness to pay) of a SOE.

Formally, these two constraints can be represented as the SOEs intertemporal budget constraint and the SOE government's inter-temporal

GS-ESS: Equilibrium Sovereign Spreads

19

form. The flow budget constraint can help assess any liquidity problems

that an SOE may confront if faced with financial or real shocks. The

present value budget constraints provide the necessary elements to judge

whether the SOE and its government are solvent. The objective of such a

model is to produce a function that relates the SOEs fundamentals to the

risk premium (or probability of default).

The SOEs flow budget constraint can be rearranged to show that, for an

economy to be solvent, the stock of external debt should equal the present

value of trade balances (discounted by a factor that includes the rate of

growth of the economy and the external interest rate) plus the stock of net

worth. Higher rates of output growth, or lower external interest rates,

allow for a lower trade surplus without necessarily increasing the debt-tooutput ratio, and hence are inversely correlated with the countrys risk

premium. Conversely, a lower stock of debt-to-GDP ratio requires lower

trade surpluses for a given rate of interest and output growth.

In the standard SOE model, the government is seen as making transfers to

the private sector and servicing external debt, financed by taxes and

external indebtedness (the governments budget constraint).

The

sustainability of such fiscal policies depends heavily on the behavior of

the economy as a whole, as tax resources vary proportionally with the

economy-wide rate of growth (the internal transfer issue). An equivalent

present value representation of the governments budget constraint shows

that, for a government to be solvent, the stock of public debt should equal

the present value of primary surpluses (discounted by a factor that

includes the rate of growth of the economy and the external interest rate)

plus the stock of public net worth.

Hence, from the functioning of the model that we have described, the

variables that appear as determining the SOE governments ability to pay

include the long-term real GDP growth rate, the external (risk-free)

interest rate, and the debt-to-GDP ratio. In addition, the flow budget

constraints suggest the importance of including the current account and

nominal budget deficits, amortization of external debt, and measures of

external liquidity (such as international reserves). The real exchange rate

also plays a role in affecting the economys ability to pay because it

affects the allocation of resources between the tradable (generator of

foreign exchange) and non-tradable sectors. More sophisticated models,

including those that assume enduring relationships between lenders and

borrowers, do provide an important role to reputation issues including

default history.

Appendix 2

rounds of specification, estimation and out of sample valuation. In this

section, we briefly summarize the variables that were included in the

initial specification, but for various reasons were omitted from the driver

variables included in GS-ESS.

1. Real per capita GDP

2. Inflation rate

3. Short-term debt to reserves ratio

4. Primary budget balance

20

6. Private external debt to GDP ratio

7. Debt service to exports ratio

8. Debt to exports ratio

9. Import cover

10. Current account balance

11. Terms of trade

12. Openness defined as (total exports + total imports)/GDP

13. Dummy for political events (as defined in GS-WATCH)

14. EMBI

15. Several definitions of duration and convexity

16. Several alternative dummy structures

In most cases, we found that these variables were correlated with the

variables included in the final specification for GS-ESS. Including such

variables led to a commonly cited problem in econometric modeling

known as multicolinearity. This problem usually gives rise to incorrect

signs on correlated variables, as well as lack of statistical significance.

Other variables that did not give rise to such problems did not add to the

explanatory or diagnostic power of the preferred model. One should also

take into consideration the nature of the panel, and the potential biases it

may lead to from small samples and parameter instability.

Appendix 2 Table A1:

Tests of Long-Run Equilibrium Relationship between GS-DERBY and GS-ESS Real Yields

Country

Maximum

Eigenvalue

Statistic

Max Eigenvalue

90%

Critical Value

Trace

Statistic

Trace

90%

Critical Value

Significance of

LR Relationship

Argentina

17.81

12.98

24.43

23.08

High

Korea

22.93

12.98

28.48

23.08

High

Mexico

18.61

12.98

26.85

23.08

High

Poland

24.06

12.98

31.27

23.08

High

South Africa

18.75

12.98

23.41

23.08

Moderate

Philippines

20.22

12.98

25.96

23.08

High

Notes: Maximum eigenvalue and trace are statistics testing the null hypothesis that there is no long-run

relationship between the two variables. A statistic higher than the 90% critical values suggests evidence in

favor of a long-run relationship between GS-DERBY and GS-ESS real yields. The final column summarizes

the strength of the statistical significance with high and moderate indicating significance at the 95% and

90% critical values. These tests are based on the procedure prescribed by Soren Johansen (1991),

"Estimation and hypothesis testing of cointegrating vectors in Gaussian vector autoregressive models",

Econometrica, 59, 1551-1580.

21

References:

Barr, D.G. and B. Pesaran (1997), An assessment of the relative importance of real interest rates, inflation, and the

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Dickey, D.A. and W.A. Fuller (1979), Distribution of the estimators for autoregressive time series with a unit root,

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22

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