Chapter 15

Sovereign Risk

McGraw-Hill/Irwin

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

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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
Argentinas 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

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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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Web Resources To learn more about the Economist Intelligence Units country ratings, visit: The Economist www.economist.com

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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

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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

Problems with Statistical CRA Models (continued)

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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

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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

*Mechanisms for Dealing with Sovereign 15-17 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.