Sovereign 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

15-3 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

15-4 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

15-5 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

15-6 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

15-7 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.

15-9  To learn more about the Economist Intelligence Unit’s country ratings, visit: The Economist Web Resources

15-10 Country Risk Evaluation  Internal Evaluation Models Statistical models:  Country risk-scoring models based on primarily economic ratios.

15-11 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

15-13 Problems 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.

15-14 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

15-15 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 Heritage Foundation Institutional Investor IMF The Economist Transparency International World Bank

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.

15-18 *MYRAs  Aspects of MYRAs: Fee charged by bank for restructuring Interest rate charged Grace period Maturity of loan Option features  Concessionality

15-19 *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.