Sovereign Risk Report:Brexit Contagion Risk Sends Sovereign Credit Risk Through The Roof

　　Shockwaves coursed through global markets in the wake of the United Kingdom’s vote toleave the European Union (EU). The potential for a prolonged period of political uncertaintyin the region led to a broad rise in market-based measures of credit risk. European SovereignEDFTM(Expected Default Frequency)1metrics, which measure the probability of default overthe next five years, rose on average from 0.35% to 0.41% since the beginning of this year.However, over the past week that measure declined to 0.36% prior to the referendum,suggesting that market participants expected the UK to vote to stay in the EU. Investorsentiment proved to be wrong this time around. On June 24, the chairwoman of the UKElectoral Commission, Jenny Watson announced that the voters chose to leave the EU.The reaction from Sovereign EDF measure has been overwhelmingly negative since then.Specifically, the UK’s probability of default measure, which declined over the past weekfrom 0.08% to 0.06%, jumped sharply to 0.09% as of June 24(see Exhibit 1). The rise inthe country’s Sovereign EDF measure is driven by investors’ fear of a rise in unemployment,continued currency weakness, political turbulence, and the lengthy EU separation process.The aftermath of the referendum has already created dramatic effects. David Cameron, theUK’s prime minister who backed a “remain” vote, said that he would resign. The LondonStock Exchange tumbled 1.4% (see Exhibit 2). The British pound plunged to $1.35, its lowestsince 1985, before recovering to $1.367. If the pound continues to weaken, the Bank ofEngland may be forced to raise interest rates. The central bank’s next policy meeting isscheduled for July 14. As shown on Exhibit 3, changes in the probability of default in theUK have been highly correlated with changes in the probability of default of the country’sthree largest banks2since 2013(correlation 0.65over this period). Moreover, the rise in thecountry’s EDF measure has historically led the rise in the credit risk of its banks. On Friday,the average probability of default for the UK banks has also risen from 0.95% to 1.11%.