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Moody's Sovereign Risk Report Summary - Brexit Contagion Impact

Core Content

This report by Moody's Analytics analyzes the impact of the UK's Brexit vote on sovereign credit risk across various global regions. It highlights how market participants reacted to the uncertainty and potential economic consequences of the referendum, leading to a significant rise in credit risk measures.

Main Points

Brexit's Immediate Impact

• The UK's vote to leave the EU caused a sharp increase in the Sovereign EDF (Expected Default Frequency) measure, which reflects the probability of default over the next five years.
• The UK's EDF rose from 0.06% to 0.09% on June 24, 2016, following the referendum outcome.
• The rise is attributed to fears of unemployment, currency weakness, political turbulence, and the lengthy separation process from the EU.

Market Reactions

• The British pound fell to $1.35, its lowest since 1985, before recovering slightly.
• The London Stock Exchange dropped by 1.4%.
• The Bank of England may be forced to raise interest rates if the pound continues to weaken.

Correlation with Banks

• The UK's sovereign EDF has historically been highly correlated with the credit risk of its largest banks.
• The average probability of default for UK banks increased from 0.95% to 1.11% following the Brexit vote.

Other European Countries

• Portugal's Sovereign EDF rose from 0.63% to 0.77%, driven by budget deficits, government debt, and a slowing economy.
• Ireland's Sovereign EDF saw one of the largest increases, from 0.19% to 0.27%, due to its close economic ties with the UK.
• France's Sovereign EDF increased from 0.08% to 0.12%, despite the country's economic slowdown, due to fear of contagion.
• Germany's Sovereign EDF increased from 0.03% to 0.06%, reflecting a slowdown in manufacturing activity.

Global Impact

• The average change in Sovereign EDF measures in other regions was similar to Europe, except for Latin America.
• Asia-Pacific countries like New Zealand, Japan, and Australia saw increases in their EDF measures.
• Middle East & Africa countries such as Israel, Qatar, and Bahrain experienced the highest rise in EDF, with an average increase of 4.30%.

Key Information

Exhibits Mentioned

• Exhibit 1: Five-Year Sovereign EDF Measures of Selected European Countries
• Exhibit 2: British Pound & Stock Index
• Exhibit 3: Average 5-Yr CDS-Implied EDF Measure for UK's Banks vs. Its 5-Yr Sovereign EDF Measure
• Exhibit 4: Average Weekly Change in Sovereign EDF Measures by Region

Summary of Key Sovereign EDF Changes

Additional Observations

• The Brexit vote created dramatic effects on the European region, including political instability and economic uncertainty.
• The Markit Eurozone composite PMI fell to 52.8 in June, the lowest since 2014, indicating economic slowdown.
• The UK's Sovereign EDF was highly correlated with the EDF of its largest banks, suggesting systemic risk.
• Investor sentiment was initially wrong, as they expected the UK to remain in the EU, but the outcome led to negative market reactions.

Conclusion

The Brexit referendum significantly increased sovereign credit risk across Europe and other global regions, with the UK experiencing the most dramatic rise in EDF. The impact extended beyond the UK, affecting currency values, stock indices, and economic growth indicators, highlighting the contagion risk and uncertainty that followed the decision.