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Sovereign Risk and the Price of Oil

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By Dian L. Chu, Economic Forecasts & Opinions

European and U.S. stock markets have taken a hit recently as spooked investors from Shanghai to Sao Paolo were fleeing risky assets amid concern that the financial crisis in Portugal and Greece could spread through the euro zone with vast implications for the fate of the fragile global economic recovery. (Fig. 1)


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Liquidate & Buy Dollar

A steep drop in crude-oil prices triggered declines across the commodities spectrum, as investors nervous about the pace of the economic recovery gravitated back to the dollar. Crude oil tumbled to a seven-week low of $71.19 a barrel last Friday, down 14% since the 2010 high of $83.18 reached on Jan. 6.

Investors' flight for safety drove the U.S. dollar near a nine-month high against the euro. Emerging market currencies also weakened in Asia, while U.S. stocks fell a fourth straight week, the longest streak since July.

A Shift of Sovereign Risk

According to EPFR Global, risk aversion has prompted a withdrawal of $1.6 billion from emerging market equity funds during the week ending Feb. 3, the biggest outflows in 24 weeks, and $516 million has left Asian equities outside of Japan.

The charts from CDR (Credit Derivatives Research) tell the story of this investors' perception. According to CDR, there has been a dramatic shift of risk in developed nations relative to emerging and less-developed nations when comparing three sovereign risk indexes, SovV, EM and CEEMEA. (Fig. 2)


In SovX, the GIPSI (H/T Zero Hedge) - Greece, Italy, Portugal, Spain and Ireland, represent around 65% of the index risk. In EM, Venezuela accounts for 26%, Turkey, Brazil, and Argentina represents 12% respectively of the EM risk. In CEEMEA, Turkey and Russia represent 49% of the index risk (followed by Hungary and Ukraine each at over 8%).

In addition, CDR finds that the sovereign risks of the emerging economies appear to be closely tied to the price of oil:
"It would appear that the CEEMEA and EM sovereign risk indices are threatened more by commodity price pressures than credit risk currently - and given the 'relatively' high price of oil/gas, their risk remains less of a concern than developed nations where the Ponzi appears to be in question."(Fig. 3)
Oil Price - A Key Risk Factor

Emerging market countries, such as Brazil, China or India, are evolving since the early 90s. During this period, the issuance of bonds by these countries has increased significantly reflecting their needs for substantial long term and infrastructure investment.

Among the many determinants of risk bonds, the price of oil is a key factor as it plays a significant role in economic growth, inflation, production costs, trade balances and currency. Nine of the 10 economic recessions in the United States since the end of World War II were preceded by a dramatic increase in the price of oil.

A Sensitivity Issue

Oil prices nowadays are extremely volatile, and sharp fluctuations in oil prices contribute to macroeconomic volatility all over the globe. The impact of this volatility on an economy varies according to a country's relative dependence on oil production and exports.

For oil-exporting countries like Russia and Saudi Arabia, a rise in oil prices caused a perception of risk reduction relative to its obligations. Conversely, an oil-importing country sees its risk index increase due to a barrel price shock.

Financial Crisis 2.0?

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Dian L. Chu, M.B.A., C.P.M. and Chartered Economist, is a market analyst and financial writer regularly contributing to several leading investment websites. Ms. Chu's work is also syndicated to media outlets worldwide. She blogs at Economic (more...)
 
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