BlackRock Investment InstItute

Willingness to PayBSRI QuaRteRly update

OctOBeR 2013

[ 2 ] W i l l i n g n e s s t o P ay

BlackRock Investment InstItutethe BlackRock Investment Institute leverages the firm’s expertise across asset classes, client groups and regions. the Institute’s goal is to produce information that makes BlackRock’s portfolio managers better investors and helps deliver positive investment results for clients.

executIve dIRectORlee Kempler

chIef StRategISt ewen cameron Watt

executIve edItORJack Reerink

Willingness to pay the latest quarterly update of the BlackRock Sovereign Risk Index (BSRI) highlights the united States and select emerging markets among the 48 countries we track. try our interactive BSRI to view individual country scores, compare two countries and sort rankings by index components.

Our main headlines for the quarter ended 30 September:

`` growing signs of political dysfunction in the United states have dented its Willingness to pay score (which measures a government’s perceived effectiveness, among other things). yet the country’s overall BSRI score has been on a gradual uptrend since mid-2011 thanks to narrowing budget deficits and healthier banks.

`` Willingness to pay has always been the achilles’ heel of the emerging world. this summer’s emerging market rout put the spotlight on countries dependent on external funding. We take stock of the BSRI component scores of the ‘fragile five:’ Brazil, india, indonesia, south africa and turkey.

drawing on a pool of financial data, surveys and political insights, the BSRI provides investors with a framework for tracking sovereign credit risk. the index uses more than 30 quantitative measures, complemented by qualitative insights from third-party sources.

the index breaks down the data into four main categories that each count toward a country’s final BSRI score and ranking: fiscal Space (40%), Willingness to pay (30%), external finance position (20%) and financial Sector health (10%).

`� fiscal Space includes metrics such as debt to gross domestic product (gdp), the debt’s term structure, tax revenues and dependency ratios.

`� Willingness to pay measures a government’s perceived effectiveness and stability, and factors such as perceived corruption.

`� external finance position includes exposure to foreign currency debt and the state of the current account balance.

`� financial Sector health gauges the banking system’s strength.

for full descriptions, see Introducing the BlackRock Sovereign Risk Index of June 2011. the BSRI’s inputs are updated at irregular intervals, meaning some changes may only reflect the timing of data releases. Small changes in scores can spur big changes in rankings, as many issuers are bunched together in the index. the BSRI is not meant to forecast the creditworthiness of countries.

Benjamin BrodskyBlackRock Model-Based Fixed Income Team

Garth FlanneryBlackRock Model-Based Fixed Income Team

sami mesrourBlackRock Model-Based Fixed Income Team

ewen cameron WattChief Investment Strategist, BlackRock Investment Institute

the opinions expressed are as of October 2013 and may change as subsequent conditions vary.

B s R i Q U a R t e R ly U P d at e [ 3 ]

us BuDGet Battlesthe United states is once again stumbling toward a fiscal crisis. after squabbling over a temporary budget caused a partial government shutdown in early October, an ugly battle loomed over raising the statutory debt limit. the country faced a technical default if no deal was reached before the uS treasury exhausted its borrowing capacity.

logic and past experience suggest Washington ultimately will raise the debt ceiling, likely through an 11th-hour Band-aid deal. the question is how dramatic the political theatre will be – and how much pain it may inflict on investors. Rising political dysfunction is reflected in a decline in the uS Willingness to pay score over the past year. See the chart on the right.

yet the overall uS BSRI score has been edging up since 2011. One key reason: the uS fiscal Space improved as projected budget deficits shrunk. the economic recovery has boosted tax revenues, while spending has been falling as stimulus measures fade and mandatory (sequester) spending cuts kick in.

BeHind tHe WasHington dRaMaUs BlackRock sovereign Risk index, 2009-2013

BSR

I SCO

RE

Debt CeilingStandoff

FiscalCliff

-0.5

-0.25

0

0.25

0.5

0.75

1

Fiscal Space

Sovereign Risk Index

Willingness to Pay

20132012201120102009

Source: BlackRock Investment Institute, October 2013.

a WoRld oF soVeReign RisKBsRi Country Rankings by Quintile, september 2013

Source: BlackRock Investment Institute, October 2013.

1 Norway2 Singapore3 Switzerland4 Sweden5 finland6 germany7 taiwan8 australia9 canada

10 New Zealand

top ten

11 chile12 denmark13 South Korea14 Netherlands15 uSa16 austria17 Malaysia18 peru19 china20 czech Republic

11-20

21 philippines22 Russia23 Israel24 united Kingdom25 poland26 thailand27 Brazil28 Slovakia

21-28

29 colombia30 france31 Mexico32 Belgium33 Japan34 turkey35 Indonesia36 South africa37 croatia38 Slovenia

29-38

39 India40 hungary41 Spain42 Ireland43 argentina44 Italy45 portugal46 egypt47 venezuela48 greece

Bottom ten

Click for interactive charts

[ 4 ] W i l l i n g n e s s t o P ay

tHe FRaGIle FIve

emerging markets were battered after the uS federal Reserve flagged it may reduce, or ‘taper,’ its bond purchases. the prospect of tighter liquidity raised fears of a funding crisis. a new moniker started making the rounds for those countries in the crosshairs: the ‘fragile five:’ Brazil, india, indonesia, south africa and turkey.

four of the five are flashing red in the BSRI, with overall scores below -0.25. See the chart on the left. the BSRI’s components show the fragile five cannot be painted with a broad brush. disparities between countries are growing rapidly, as detailed in What’s Developing in april 2013.

india’s and south africa’s fiscal Space scores drag down their overall rankings. Both countries are expected to run large budget deficits in 2014. Other members of the fragile five are in better fiscal health.

Most emerging market countries suffer from poor Willingness to pay scores, as detailed in Maturities Matter in april 2013. One notable move this quarter: indonesia’s Willingness to pay score rose (albeit from a low base) as Jakarta’s reformist governor (and Metallica fan) Joko Widodo jumped to the head of opinion polls ahead of next year’s presidential election.

the fragile five’s banks are generally in good shape, as indicated by the countries’ financial Sector health scores. south africa is a standout in this area.

take tHat to tHe Bank another reason behind the uS improvement: better banks. the uS financial Sector health score has jumped since 2011, in contrast to eurozone countries such as Italy and Spain. See the chart on the right. uS banks recorded net profits of $42 billion in the second quarter, according to deutsche Bank. this dwarfed the combined $16 billion profit by european banks for all of 2012. Reasons:

`` uS banks were at the epicentre of the 2008 crisis and took their medicine early, with writedowns of more than $1.1 trillion, deutsche Bank data show. Stress tests and large capital injections also helped restore confidence.

`` the uS economy has grown steadily since 2010, whereas europe is still clawing its way out of a double-dip recession. this affects demand for credit. Bank lending to non-financial corporations has grown at a 5% annualised clip in the united States since 2011 – but has contracted at a similar pace in the eurozone, according to deutsche Bank.

`` uS property prices are rising, while housing bubbles are still deflating in countries such as spain.

european regulators will start asset quality reviews of european banks in early 2014. tougher rules will likely force many to raise capital. the european central Bank’s long-term refinancing operations (ltROs) have been lifesavers for many european banks, and may be extended. UK banks are faring better, albeit from a low base. this is reflected in a sharp rise in the uK’s financial Sector health score.

BanKing is BaCKFinancial sector Health scores 2011 vs. 2013

BSRI SCORE

30 September 201330 September 2011

-0.8 -0.4 0 0.4 0.8

Italy

Spain

France

UK

Switzerland

Japan

Germany

Australia

Canada

US

Source: BlackRock Investment Institute, October 2013.

FlasHing Red BsRi scores for ‘Fragile Five’, september 2013

BR in id Za tR

100% sovereign Risk Index

40% Fiscal space

proximity to distress

distance from Stability

30% Willingness to Pay

20% external Finance Position

external debt position

external debt term Structure

current account position

10% Financial sector Health

Bank Stability

capital adequacy

credit Bubble Risk

Banking System vs. economy

BSRI score of more than 0.25 BSRI score of less than -0.25

BSRI score between 0.25 and -0.25

Source: BlackRock Investment Institute, October 2013.

B s R i Q U a R t e R ly U P d at e [ 5 ]

WHo’s UP and WHo’s doWn BlackRock sovereign Risk index Rankings, september 2013

-1.5

-1

-0.5

0

0.5

1

1.5

2

Nor

way

Sin

gapo

reS

wit

zerl

and

Sw

eden

Finl

and

Ger

man

yTa

iwan

Aus

tral

iaC

anad

aN

ew Z

eala

ndC

hile

Den

mar

kS

outh

Kor

eaN

ethe

rlan

dsU

nite

d S

tate

sA

ustr

iaM

alay

sia

Per

uC

hina

Cze

ch R

epub

licP

hilip

pine

sR

ussi

aIs

rael

Uni

ted

Kin

gdom

Pol

and

Thai

land

Bra

zil

Slo

vaki

aC

olom

bia

Fran

ceM

exic

oB

elgi

umJa

pan

Turk

eyIn

done

sia

Sou

th A

fric

aC

roat

iaS

love

nia

Indi

aH

unga

ryS

pain

Irel

and

Arg

enti

naIt

aly

Por

tuga

lE

gypt

Vene

zuel

aG

reec

e

BSR

I SCO

RE

FinlandUp threenotches

to 5th

Canada  Down twonotches to 9th

Philippines  Up twonotches to 21st

France  Up onenotch to 30th 

TaiwanDown two

notchesto 7th

BelgiumDown two

notchesto 32nd

Sources: BlackRock Investment Institute, Bloomberg, IMF, World Bank, central banks, Eurostat, BIS, Consensus Economics, UN, Moody’s, Standard and Poor’s, Fitch, PRS Group, Economist Intelligence Unit and www.euromoneycountryrisk.com.

Click for interactive charts

In a BetteR Placelarge current account deficits have dominated investor worries about the fragile five – and all are flashing red on this metric. yet their overall external finance position is stronger than in previous periods of financial stress, such as the 1990s asian crisis. Reasons:

`` they have lower overall debt levels relative to their economies. india’s ratio of external debt to gdp stands at 21% today, compared with 34% two decades ago, Reserve Bank of India data show.

`` Many emerging market economies are much better equipped to defend their currencies after building huge foreign reserve kitties, as discussed in Emerging Risks in July 2013.

`` the term structure of most countries’ external debt has improved. this has resulted in less short-term debt (which can be hard to refinance in a crisis).

`` indonesia’s short-term external debt amounted to 188% of its foreign exchange reserves in 1997, World Bank data show. the ratio had dropped to around 35% by 2011.

QuaRteRlY moveRs Willingness to pay was the driver behind most of the BSRI ranking changes in the third quarter. an important caveat: absolute scores are more important than quarterly changes, which accentuate moves when countries’ scores are closely bunched together. this was illustrated by Belgium’s and Canada’s moves in the third quarter.

`` Finland jumped three notches in the rankings to fifth place. Increased political stability helped, as prime Minister Jyrki Katainen put a stop to speculation his own party was considering a change in leadership.

`` the Philippines rose to 21st place, helped by a World Bank upgrade of its government effectiveness score and a drop in perceived corruption.

`` a slight uptick in the Willingness to pay score also lifted France (to 30th place).

`` taiwan fell to seventh place as a wave of ministerial resignations this year have shaken president Ma ying-jeou’s administration.

FoR MoRe inFoRMation

blackrock.com

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