Sovereign RiskSovereign Risk

Chapter 15

© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.McGraw-Hill/Irwin

15-2

Introduction

In 1970s: Expansion of loans to Eastern bloc, Latin

America and other LDCs. Beginning of 1980s:

Debt moratoria announced by Brazil and Mexico.

Increased loan loss reserves Citicorp set aside additional $3 billion in

reserves for example

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Introduction (continued)

Late 1980s and early 1990s: Expanding investments in emerging markets. Peso devaluation and subsequent restructuring

U.S. loan guarantees under Clinton Administration More recently:

Asian and Russian crises. Turkey and Argentina

Argentina’s focus on fiscal surplus • Economic growth in the 2000s and reduction in external

debt.

MYRAs Brady Bonds

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Were Lessons Learned?

U.S. FIs limited exposure to in Asia during mid and late 1990s Not all: Chase Manhattan Corp. emerging

market losses $150 million to $200 million range Poor earnings by J.P. Morgan.

Losses in Russia with payoffs of 5 cents on the dollar

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Credit Risk versus Sovereign Risk

Governments can impose restrictions on debt repayments to outside creditors. Loan may be forced into default even though

borrower had a strong credit rating at origination of loan.

Legal remedies are very limited. Need to assess credit quality and sovereign

risk

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Sovereign Risk

Debt repudiation Since WW II, only China, Cuba and North Korea

have repudiated debt. Recent steps to forgive debts of most severe

cases conditional on reforms targeted to improve poverty problems

Rescheduling Most common form of sovereign risk. South Korea, 1998 Argentina, 2001

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Debt Rescheduling

More likely with international loan financing rather than bond financing

Loan syndicates often comprised of same group of FIs versus large numbers of bondholders facilitates rescheduling

Cross-default provisions Specialness of banks argues for

rescheduling but, creates incentives to default again if bailouts are automatic

15-8

Country Risk Evaluation

Outside evaluation models: The Euromoney Index The Economist Intelligence Unit ratings

Highest risk in countries such as Iraq, Zimbabwe and Myanmar.

Institutional Investor Index 2006 placed Switzerland at least chance of default

and Liberia as highest. U.S. not the lowest risk.

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To learn more about the Economist Intelligence Unit’s country ratings, visit:

The Economist www.economist.com

Web Resources

15-10

Country Risk Evaluation

Internal Evaluation Models Statistical models:

Country risk-scoring models based on primarily economic ratios.

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Statistical Models

Commonly used economic ratios: Debt service ratio: (Interest + amortization on

debt)/Exports Import ratio: Total imports / Total FX reserves Investment ratio: Real investment / GNP Variance of export revenue Domestic money supply growth

15-12

Problems with Statistical CRA Models

Measurements of key variables. Population groups

Finer distinction than reschedulers and nonreschedulers may be required.

Political risk factors may not be captured Strikes, corruption, elections, revolution. Corruption Perceptions Index

15-13Problems with Statistical CRA Models (continued) Portfolio aspects

Many large FIs with LDC exposures diversify across countries

Diversification of risks not necessarily captured in CRA models

Incentive aspects of rescheduling: Borrowers and Lenders:

Benefits Costs

Stability Model likely to require frequent updating.

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Using Market Data to Measure Risk

Secondary market for LDC debt: Sellers and buyers

Market segments Brady Bonds Sovereign Bonds Performing LDC loans Nonperforming LDC loans

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Key Variables Affecting LDC Loan Prices

Most significant variables: Debt service ratios Import ratio Accumulated debt arrears Amount of loan loss provisions

15-16

Pertinent Websites

BIS www.bis.org

Heritage Foundation www.heritage.org

Institutional Investor www.institutionalinvestor.com

IMF www.imf.org

The Economist www.economist.com

Transparency International www.transparency.org

World Bank www.worldbank.org

15-17*Mechanisms for Dealing with Sovereign Risk Exposure

Debt-equity swaps Example:

Citibank sells $100 million Chilean loan to Merrill Lynch for $91 million.

Merrill Lynch (market maker) sells to IBM at $93 million.

Chilean government allows IBM to convert the $100 million face value loan into pesos at a discounted rate to finance investments in Chile.

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*MYRAs

Aspects of MYRAs: Fee charged by bank for restructuring Interest rate charged Grace period Maturity of loan Option features

Concessionality

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*Other Mechanisms

Loan Sales Bond for Loan Swaps (Brady bonds)

Transform LDC loan into marketable liquid instrument.

Usually senior to remaining loans of that country.