Irwin/McGraw-Hill 1 Sovereign Risk Chapter 16 Financial Institutions Management, 3/e By Anthony Saunders

Irwin/McGraw-Hill 2 Introduction n In 1970s: Expansion of loans to Eastern bloc, Latin America and other LDCs. n Beginning of 1980s: Poland and Eastern bloc repayment problems. Debt moratoria announced by Brazil and Mexico.

Irwin/McGraw-Hill 3 Introduction (continued) n Late 1980s and early 1990s: Expanding investments in emerging markets. Peso devaluation. n More recently: Asian crises. MYRAs Brady Bonds.

Irwin/McGraw-Hill 4 Credit Risk versus Sovereign Risk n 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.

Irwin/McGraw-Hill 5 Sovereign Risk n Debt repudiation Since WW II, only China, Cuba and North Korea have repudiated debt. n Rescheduling Most common form of sovereign risk. South Korea, 1998.

Irwin/McGraw-Hill 6 Country Risk Evaluation n Outside evaluation models: The Euromoney Index Institutional Investor Index n Internal Evaluation Models Statistical models: country risk-scoring models based on economic ratios.

Irwin/McGraw-Hill 7 Statistical Models n 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

Irwin/McGraw-Hill 8 Problems with Statistical CRA Models Measurements of key variables. Population groups »Finer distinction than reschedulers and nonreschedulers may be required. Political risk factors »Strikes, corruption, elections, revolution. Portfolio aspects

Irwin/McGraw-Hill 9 Problems with Statistical CRA Models (continued) n Incentive aspects of rescheduling: Borrowers and Lenders: »Benefits »Costs Stability »Model likely to require frequent updating.

Irwin/McGraw-Hill 10 Using Market Data to Measure Risk n Secondary market for LDC debt: Sellers and buyers n Market segments Brady Bonds Sovereign Bonds Performing LDC loans Nonperforming LDC loans

Irwin/McGraw-Hill 11 Key Variables Affecting LDC Loan Prices n Most significant variables: Debt service ratios Import ratio Accumulated debt arrears Amount of loan loss provisions

Irwin/McGraw-Hill 12 *Mechanisms for Dealing with Sovereign Risk Exposure n Debt-equity swaps Example: »Citibank sells $100 million Chilean loan to Salomon Brothers for $91 million. »Salomon (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.

Irwin/McGraw-Hill 13 *MYRAs n Aspects of MYRAs: Fee charged by bank for restructuring Interest rate charged Grace period Maturity of loan Option features n Concessionality

Irwin/McGraw-Hill 14 *Other Mechanisms n Loan sales n Debt for debt swaps (Brady bonds) Transform LDC loan into marketable liquid instrument. Usually senior to remaining loans of that country.