Key risk indicators (KRIs) or early warning indicators (EWIs) tell you whether a risk is becoming more likely to crystallise, and whether you might want to do something about that. It is important to get the right indicators, the ones that really tell you something might be about to happen.
For investors in bonds issued by developing countries, they need to assess the country’s ability to pay, and then its willingness to do so. When you buy a bond, you want to get your money back and also receive all the interest due. That is the limit to the upside unless you trade bonds and manage to buy them for less than their face value. Necessarily, you have to focus on limiting the downside.
For ability to pay, the ratio of government debt to Gross Domestic Product is a good indicator if you use its level, and where it’s heading. On average, an emerging country’s debt to GDP ratio is around 50%. That tells you one thing. Which way it is moving and how fast, tells you another. For example, Mexico’s debt to GDP is around 50% and stable; Brazil’s is 84% and rising fast. Whose bonds would you rather buy?
Willingness to pay may depend on who else has claims on a government’s money. This could be other creditors, or vested interests such as government pensioners, or the armed forces, or big infrastructure projects that are way over budget. It’s a lot harder to find KRIs for this without good information on the ground, but it can be the difference between making money and losing it. For example, Mexico has just cancelled a big airport project, whereas Brazil has failed to sort out a pension time bomb…
Sources: The Economist magazine