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Global Economics

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.

We applied GS-ESS to 15 emerging market economies and subjected it to a variety


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.

We plan to use GS-ESS as an aid to evaluating fair value for opportunities in


sovereign debt. Of course, our forecasts regarding a specific countrys market may
often differ depending on our macroeconomic views.

Alberto Ades, Federico Kaune, Paulo Leme,


Rumi Masih, and Daniel Tenengauzer
June 2000
Important disclosures appear on the back cover of this publication.

Goldman Sachs Emerging Markets Economic Research


Goldman Sachs Economic Research Group
In New York

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In London

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William Dudley, M.D. & Director of US Economic Research

Gavyn Davies, M.D. & Chief International Economist

Paulo Leme, M.D. of Emerging Markets Economic Research

Jim ONeill, M.D. & Chief Currency Economist

Alberto Ades, M.D. & Emerging Markets Currency Economist

David Walton, M.D. & Co-Director of European Economic Research

Edward McKelvey, V.P. & Senior Economist

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Martin Brookes, E.D. & Senior Global Economist

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Stephen Potter, E.D. & Senior Global Economist

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

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GS-ESS: Equilibrium Sovereign Spreads

June 16, 2000

Goldman Sachs Emerging Markets Economic Research

Main Points

GS-ESS: Equilibrium Sovereign Spreads

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.

We base the valuation framework on a theoretical model that views


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.

To generate the GS-ESS estimates, we assembled monthly data for 15


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.

The results of the model are robust to a variety of diagnostic and


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.

Within a Capital Asset Pricing Model (CAPM) framework, we


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.

We expect GS-ESS to become an integral part of our family of


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.

June 16, 2000

Goldman Sachs Emerging Markets Economic Research

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

Most theoretical models of equilibrium bond spreads start from some


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
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Goldman Sachs Emerging Markets Economic Research

corresponding coefficients, and t is an independently distributed random


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
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Goldman Sachs Emerging Markets Economic Research

reasons, we have included the degree of overvaluation vs. GSDEEMER as


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.

External Shocks and Debt 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
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Goldman Sachs Emerging Markets Economic Research

take a value of 1 if the country belongs to Latin America (a region with a


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

In arriving at the preferred specification, we tried a number of variables


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):

SPREAD = f(GROWTH, TAMRES, TXDY, NBB, XGD, MISAL, LIBOR,


DEF)

The dependent variable (SPREAD) corresponds to the stripped static


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
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Goldman Sachs Emerging Markets Economic Research

are lenient. However, when risk appetite is low or global liquidity


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

GS-ESS: Equilibrium Sovereign Spreads

As GS-ESS is a long-run model, during the interpolation stage we derive


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

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Goldman Sachs Emerging Markets Economic Research

of bond, along with their sample means and standard deviations.


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.

Limitations on data availability dictated our estimation strategy. GS-ESS


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.
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Goldman Sachs Emerging Markets Economic Research

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.

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Goldman Sachs Emerging Markets Economic Research


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

We report Newey-West heteroskedastic robust standard errors. This means that


the errors are corrected for potential biases arising from the possibility that the
error variances across each country may not be all the same.

GS-ESS: Equilibrium Sovereign Spreads

June 16, 2000

Goldman Sachs Emerging Markets Economic Research

there is any cross-sectional correlation of the estimated error terms across


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

We also examine the underlying short-run model by applying a battery of


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

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Goldman Sachs Emerging Markets Economic Research

These speeds of adjustment vary quite considerably across countries, from


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.

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Goldman Sachs Emerging Markets Economic Research

GS-ESS vs. GSDERBY

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.

Table 4: Speeds of Adjustment and GS-ESS Model Diagnostic Tests by Country


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.

To assess the internal consistency of these two models, we postulate that,


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.

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Goldman Sachs Emerging Markets Economic Research

In order to compare the estimates from both models we transformed each


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

In addition to these plots, we also conducted tests of a long-run


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
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Goldman Sachs Emerging Markets Economic Research

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

The specific Diebold-Mariano statistic that we use is based on the root-mean


square error criterion.

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Goldman Sachs Emerging Markets Economic Research

In addition to a test of predictive ability, we also test the significance of


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.

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Goldman Sachs Emerging Markets Economic Research

Does GS-ESS Deliver


Superior Returns Compared
to Alternative Models?

In this section, we examine the returns that an investor using GS-ESS


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.

GS-ESS: Equilibrium Sovereign Spreads

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Goldman Sachs Emerging Markets Economic Research


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

Chart 3: Efficient Frontier, April 6, 2000


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

When solving the risk-return problem faced by asset managers, we


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.

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Goldman Sachs Emerging Markets Economic Research


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

LONG & SHORTS

How Should We Use GS-ESS?

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%

GS-ESS will become an integral part of our family of models, which


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

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Appendix 1

A Simple Model of a Small Open Indebted Economy

In this appendix, we discuss briefly the theoretical model that underlies


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
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Goldman Sachs Emerging Markets Economic Research

budget constraint, and can be presented either in flow or present value


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

Additional Variables in Initial Specification

In arriving at a preferred specification for GS-ESS, we conducted several


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

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Goldman Sachs Emerging Markets Economic Research

5. Public sector debt to GDP ratio


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.

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References:
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Goldman Sachs Emerging Markets Economic Research

References Continued:

Pesaran, M.H. and A. Timmerman (1994), A generalization of the non-parametric Henriksson-Merton test of
market timing, Economics Letters, 44, 1-7.
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systems, Econometrica, 61, 783-820.

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