RBS 2012 Annual Report Download - page 255

RBS GROUP 2012
253
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, expropriation or nationalisation); and 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 environment*
Country risk, notably in the eurozone, remained elevated in 2012,
particularly in the first half of the year. Economic growth projections were
lowered, predominantly for Europe, but also for a number of major
emerging markets. However, important first steps towards achieving
longer-term stabilisation in the eurozone led to some notable easing of
crisis risks. Growth data from major non-European economies, such as
China, were more encouraging towards the end of the year. The ability of
policymakers to tackle fiscal challenges and restore confidence and
growth in both the US and Europe will be a key factor in determining the
pace of recovery.
Eurozone risks
Eurozone risks continued to dominate, as concerns about the impact of
banking sector problems on government balance sheets led to further
capital flight from periphery countries and a rise in sovereign bond yields
until August, particularly for Spain. To break the feedback loop between
banks and their sovereigns, eurozone leaders agreed at their June
summit that the European Stability Mechanism (ESM), the eurozone’s
permanent crisis fund, could lend to banks directly once a single
eurozone-wide banking regulator had been established. They also
approved the provision by the ESM of significant financial support to
Spain to recapitalise its banks.
In the second half of the year, the ESM became fully operational and the
European Central Bank (ECB) announced a major new facility, Outright
Monetary Transactions. This facility allows secondary market purchases
by the ECB of bonds issued by eurozone sovereigns that are subject to a
European Union (EU)/International Monetary Fund (IMF) support
programme. Following these steps, sovereign bond yields fell markedly.
Meanwhile, in Greece, private sector claims on the government were
restructured in early 2012, but political risks remained acute as two
successive parliamentary elections eventually resulted in a narrow victory
for the pro-bailout New Democracy party. As the electoral process
delayed policy implementation and the recession, contrary to earlier
expectations, deepened further, additional reforms became necessary
and the European Commission, the IMF and the ECB (known collectively
as the Troika) further eased Greece’s targets.
Elsewhere, Ireland continued to make progress towards targets set out in
its Troika programme, notably allowing the government to resume a
degree of market financing. Talks with the European authorities on ways
to relieve the government of some of the costs of past banking sector
support continued, resulting in a favourable restructuring of the Anglo
Irish promissory note in early 2013, reducing related fiscal costs
somewhat. Notwithstanding these developments, Irish growth remained
very weak and reliant on external demand. Portugal also made progress
in a number of areas, though had greater structural constraints to
address to boost longer-term growth prospects. Towards the end of the
year, Cyprus also entered negotiations with the EU and IMF on a support
programme. The eurozone as a whole entered recession in the second
half of the year, although divergence within the currency union continued,
with the core considerably stronger than the periphery.
Emerging markets
Emerging markets performed better on the whole. In developing Asia, the
economies of China and India both continued to slow from a strong base,
but risks remained held in check by healthy external balance sheets.
Emerging countries in Europe started to be affected by very weak growth
in the eurozone, with the most export-focused economies being worst hit.
However, countries that took significant action in the wake of the financial
crisis to stabilise their banking sectors, saw an easing of risk. Turkey was
upgraded by one rating agency to investment grade.
General political instability seen in the Middle East and North Africa in
2011 moderated in 2012 in most countries except Syria, although
transition to democratic rule was only partial in some cases. Excluding
Bahrain, Gulf Cooperation Council countries were generally more stable,
underpinned by high oil prices.
Latin America continued to be characterised by greater stability, due to
generally healthier sovereign balance sheets. However, growth prospects
deteriorated because of weaker external demand, notably in the region’s
largest economy, Brazil.
Outlook
Overall, the outlook for 2013 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 on whether growth headwinds in larger advanced
economies, particularly the US and Japan, persist. Emerging market
balance sheet risks remain lower, despite structural and political
constraints, but it is expected that these economies will continue to be
affected by events elsewhere through financial markets and trade
channels.
*unaudited
Business review Risk and balance sheet management continued