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The tyranny of benchmarks

Global investors are assumed to differentiate between economies using economic fundamentals. This column uses returns on sovereign CDS contracts for 18 emerging markets and ten advanced countries to argue that fundamentals do not drive these decisions. Instead, most of the variation across sovereigns reflects whether or not the country is designated as an 'emerging market'. Investment strategies tend simply to replicate benchmark portfolios.

Economists are predisposed to believe that investors are guided predominantly by economic fundamentals. During the 'taper tantrum' of the summer of 2013, for example, market analysts identified five of the worst hit economies as the 'fragile five'.1 They attributed their fragility to specific economic fundamentals, such as current account deficits and high debt-to-GDP ratios.  

The literature on investing in emerging markets divides economic fundamentals into two groups: push factors and pull factors. Push factors relate to economic or financial developments in the global economy as a whole, or in the advanced economies, especially the US. Pull factors relate to country-specific economic fundamentals in emerging markets. In the typical analysis there is a tug-of-war between them. Their relative strengths decide whether we see capital inflows or outflows.

Fratzscher (2012), for example, found that global push factors drove capital flows in 2008, and that country-specific pull factors drove such flows in 2009-2010. Forbes and Warnock (2012) identified unusually large capital inflows and outflows in a large sample of emerging markets. They found a global risk factor to be the most important variable to explain these flows, and domestic factors to be less important. Puy (2015) looked at mutual fund flows, and found that push effects from advanced economies exposed developing countries to sudden stops and surges.

Sovereign risk in CDS spreads

In recent work, we consider the role of economic fundamentals in investment decisions by focusing on sovereign risk in emerging markets (Amstad et al. 2016). Instead of looking at capital flows, we look instead at risk premia. Their role is important, because they determine the cost at which a country can raise funds abroad. Remolona et al. (2008) chose to analyse sovereign CDS spreads rather than EMBI spreads, since the CDS market is more liquid than the underlying bond markets. They found that country-specific fundamentals drove individual default probabilities, while the risk aversion of global investors drove time variation in risk premia. Longstaff et al. (2011, hereafter LPPS) also looked at sovereign CDS spreads and found that “the majority of sovereign credit risk can be linked to global factors”. The risk premia they found in CDS spreads seemed to be largely a compensation for bearing the risk of these global factors.

The old normal and the new

Like LPPS, when analysing returns on sovereign CDS contracts, we emphasise the role of risk premia. We consider CDS returns for 18 emerging markets and 10 advanced countries, for 11 years of monthly data from January 2004 to December 2014. Statistical tests on the movements of CDS returns suggest a break at the onset of the Global Crisis in October 2008. This leads us to consider two sub-periods separately, which we call the 'old normal' before the outbreak of the crisis, and a 'new normal' afterwards.

For each sub-period we extract principal components, which provide us with a conveniently small number of otherwise unobservable global risk factors. We consider these factors to be the driving forces of risk premia. In the old normal, the first risk factor alone explains about half of the variation in CDS returns, consistent with LPPS. In the new normal, this factor becomes even more dominant, explaining more than three-fifths of the variation in returns. There is also a second risk factor, which explains more than 15% of the variation in returns in the old normal, but less than 9% in the new normal (Figure 1).

Figure 1 Principal components of changes in sovereign CDS spreads

Source: Amstad et al. (2016).

Explaining the factor loadings

To understand the role of economic fundamentals, we analyse the way the different countries load on the global risk factors. In both the old normal and new normal, we attempt to explain the cross-sectional variation of these loadings in terms of such fundamentals as debt-to-GDP ratios, fiscal balances, current-account balances, sovereign credit ratings, Institutional Investor ratings, trade openness, GDP growth and depth of the domestic bond market.

What’s the first factor?

To our surprise, we find that that these commonly cited economic fundamentals have little or no influence on the country loadings on the first risk factor. Instead the most important explanatory variable for the differences in loadings is whether or not a country is an emerging market. The behaviour of the first factor over time suggests that it reflects the time-varying risk appetites of benchmark-driven global investors. These investors do not seem to differentiate meaningfully between emerging markets, although they differentiate between emerging markets and advanced economies. The factor rises sharply during times of stress, causing all sovereign spreads to widen.

What’s the second factor?

We find that, in the old normal, the only fundamental that matters for the is replaced by institutional investor rating. The second risk factor played a supporting role, reduced in the new normal. The factor seems to represent safe-haven behaviour or, in other words, the risk appetites of conservative investors (Figures 2 and 3).

Figure 2 Loadings on the first global risk factor 

Source: Amstad et al. (2016).

Figure 3 Loadings on the second global risk factor

Source: Amstad et al. (2016).

Source: Amstad et al. (2016).

It's not a tug-of-war, it's a division of labour

While much of the research on investing in emerging markets assumes a tug-of-war between push and pull factors, the picture we find is a division of labour between global risk factors and country-specific factors. The global factors drove what happened over time, while the country-specific variables drove what happened across countries.

While the movements in global risk factors determine whether CDS spreads rise or fall over time, the extent to which these spreads rise or fall depends on the country. This is broadly similar to the conclusion of Eichengreen and Gupta (2014), although they examined only the taper tantrum. They found that equity prices, exchange rates and foreign reserves tended to move together across countries, but the magnitudes of the movements depended on the size of the domestic financial market.

It’s the benchmark, stupid!

In the end, we find that CDS returns in the new normal move over time largely to reflect the movements of a single global risk factor, with the variation across sovereigns for the most part reflecting the designation of 'emerging market'. There seems to be no 'fragile five' – there are only emerging markets. While the emerging markets designation may summarise many relevant features of sovereign borrowers, it lacks the granularity that we would expect if investors were to use it for risk assessment.

The importance of the emerging markets designation in the new normal suggests that index-tracking behaviour by investors has become a powerful force in global bond markets. Haldane (2014) has argued that, in the world of international finance, the subprime crisis and the regulations that followed have made asset managers more important than banks. Miyajima and Shim (2014) showed that even actively managed emerging-market bond funds followed their benchmark portfolios closely. When global investors invest in emerging markets, instead of picking and choosing based on country-specific fundamentals, for the most part they appear to simply replicate their benchmark portfolios, the constituents of which hardly change over time.


Amstad, M, E Remolona, and J Shek (2016), "How do global investors differentiate between sovereign risks? The new normal versus the old," Journal of International Money and Finance, 66(C): 32-48.

Eichengreen, B and P Gupta (2014), "Tapering talk: The impact of expectations of reduced Federal Reserve security purchases on emerging markets", Policy Research Working Paper 6794, World Bank.

Forbes, K and F Warnock (2012), "Capital flow waves: Surges, stops, flight and retrenchment", Journal of International Economics 88: 235-251.

Fratzscher, M (2012), "Capital flows, push versus pull factors and the global financial crisis", Journal of International Economics: 341-356.

Haldane, A (2014), "The age of asset management?", speech at the London Business School, 4 April.

Longstaff, F A, J Pan, L H Pedersen, K J Singleton (2011), "How sovereign is sovereign credit risk?" American Economic Journal: Macroeconomics 3(2): 75-103.

Lord, James (2013), "EM currencies: The fragile five", FX Pulse, Morgan Stanley Research, August.

Miyajima, K and I Shim (2014), "Asset managers in emerging market economies", BIS Quarterly Review (September).

Puy, D (2015), "Mutual fund flows and the geography of contagion", Journal of International Money and Finance 60: 73-93.

Remolona, E, M Scatigna and E Wu (2008), "The dynamic pricing of sovereign risk in emerging markets: fundamentals and risk aversion", Journal of Fixed Income (Spring).


[1] The term 'fragile five' refers to Brazil, India, Indonesia, Turkey and South Africa. The term was coined by Morgan Stanley in a research note (Lord 2013). Not to be outdone, another analyst proposed a grouping called the 'sorry six,' which would include Russia as the sixth country.

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