RBS 2011 Annual Report Download - page 210

208 RBS Group 2011
Risk management: Country risk
Introduction*
Country risk is the risk of material losses arising from significant country-
specific events such as sovereign events (default or restructuring);
economic events (contagion of sovereign default to other parts of the
economy, cyclical economic shock); political events (transfer or
convertibility restrictions and expropriation or nationalisation); and natural
disaster or conflict. Such events have the potential to affect elements of
the Group’s credit portfolio that are directly or indirectly linked to the
country in question and can also give rise to market, liquidity, operational
and franchise risk related losses.
External risk environment*
2011 was another year of heightened country risks. However, trends
were divergent, with conditions deteriorating among vulnerable eurozone
countries facing growth impediments and higher public debt burdens,
while many emerging markets continued to enjoy relative stability, seeing
net inflows of capital for the full year and lower spreads despite some risk
aversion in the second half. In the US, notwithstanding a more
challenging political environment and a sovereign downgrade from a
rating agency, a deal was secured to increase the sovereign debt ceiling,
and yields on government debt remain low.
Eurozone risks
Europe was at the centre of rising global risks, owing to a combination of
slower growth among some of its major economies and a further
deepening of the ongoing sovereign crisis, which in turn harmed financial
sector health. Risks in Greece rose as a deeper than expected
contraction in GDP impacted the fiscal adjustment programme and hit
debt sustainability. Negotiations on a voluntary restructuring of public
debt held by the private sector commenced in the first half and a deal
was eventually reached in February 2012, with more punitive write-offs
for private investors than previously envisaged. This in turn led to an
agreement by eurozone leaders on a further borrowing programme for
the Greek government.
In May 2011, Portugal’s new government agreed a borrowing programme
with the European Union and International Monetary Fund (EU-IMF) after
a sharp deterioration in sovereign liquidity. Ireland's performance under
its EU-IMF programme was good and the announcement of a bank
restructuring deal without defaults on senior debt obligations helped
improve market confidence. This was reflected in a compression in bond
spreads in the second half of the year.
Despite the announcement of significant new support proposals by
eurozone leaders in July 2011, investor worries over risks to their
implementation rose and market conditions worsened markedly as a
result. Risk aversion towards Spanish and Italian assets picked up and
despite a policy response by both countries, yields remained elevated,
prompting the ECB to intervene to support their bonds in secondary
markets for the first time. Contagion affected bank stocks and asset
prices.
*unaudited
Eurozone leaders responded by stepping up anti-crisis efforts, focusing
largely on agreeing fiscal reform, bolstering bank capital and
strengthening capacity to offer financing support to sovereigns losing
market access. The ECB continued to buy sovereign debt in the
secondary market and increased liquidity support to banks with the
introduction of an emergency three-year long-term refinancing operation
in December. This helped ease interbank funding tensions somewhat and
may have contributed to some relief in sovereign debt markets late in the
year, as yields on new issuance by Spain and Italy dropped.
Emerging markets
Emerging markets continued to perform relatively well. In Asia, despite
slowing growth, China and India continued to post strong overall
expansion, while generally large external savings levels reinforced
balance of payments stability. In China specifically, measures to curb
house price growth began to have a more noticeable impact, with real
estate prices falling in many cities. Efforts are underway to address some
bank asset quality concerns linked to rapid lending growth in 2009.
In emerging Europe, Russia experienced some contagion into asset
markets from weaker commodity prospects and a challenging investment
climate, but the sovereign balance sheet remained quite robust. Foreign
exchange debts remained a risk factor in a number of Eastern European
economies. Elsewhere, Turkey’s economy cooled in the second half of
2011, helping to narrow the current account deficit sharply, though
external vulnerabilities persisted.
The Middle East and North Africa witnessed political instability in a
number of the relatively lower-income countries. The path of any
transition has yet to become fully clear in most cases. Excluding Bahrain,
pressures for change were more contained in the Gulf Co-Operation
Council countries.
Latin America remained characterised by relative stability owing to
balance sheet repair by a number of countries following crises in previous
decades. Capital inflows contributed to currency appreciation, but
overheating pressures have so far proven contained, including in Brazil
where credit growth slowed from high levels.
Outlook
Overall, the outlook for 2012 remains challenging with risks likely to
remain elevated but divergent. Much will depend on the success of EU
efforts to contain contagion from the sovereign crisis (where downside
risks are high) and whether growth headwinds in larger advanced
economies persist. Emerging market balance sheet risks remain lower,
despite ongoing structural and political constraints, but these economies
will continue to be affected by events elsewhere through financial
markets and trade channels.
Business review Risk and balance sheet management continued