CHAPTER 14 Sovereign Risk Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved

Introduction  In the1970s: –Expansion of loans to Eastern bloc, Latin America, and other LDCs  Beginning of the 1980s: –Debt moratoria announced by Brazil and Mexico –Increased loan loss reserves –Citicorp set aside additional $3 billion in reserves Ch 14-2

Introduction (continued)  Late 1980s and early 1990s: –Expanding investments in emerging markets –Peso devaluation and subsequent restructuring  More recently: –Asian and Russian crises –Turkey and Argentina Ch 14-3

Introduction (Continued)  Late 2000s, economies faltered –Developed countries faced some of the worst declines in GDP ever experienced –IMF pledged to inject $250 billion  Dubai and Greece crises –Crisis in Greece spread to Portugal, Spain, and Italy  Multiyear restructuring agreements (MYRAs) Ch 14-4

Were Lessons Learned?  U.S. FIs limited exposure to 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 Ch 14-5

Credit Risk vs. 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  Emphasizes the need to assess credit quality and sovereign risk Ch 14-6

Sovereign Risk  Debt repudiation –Since WWII, 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 Ch 14-7

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 Ch 14-8

Country Risk Evaluation  Outside evaluation models: –The Euromoney Index –The Economist Intelligence Unit ratings  Highest risk in countries such as Somalia, Syria, and Sudan. –Institutional Investor Index  2012 placed Norway at least chance of default and Somalia at highest  U.S. not the lowest risk Ch 14-9

Web Resources  To learn more about the Economist Intelligence Unit’s country ratings, visit: The Economist Ch 14-10

Country Risk Evaluation  Internal Evaluation Models –Statistical models  Country risk-scoring models based on primarily economic ratios  The selected variables are tested for predictive power in separating rescheduling countries from non-rescheduling countries using past data Ch 14-11

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 = σ 2 ER –Domestic money supply growth = ΔM/M  Discriminant function: p=f(DSR,IR, INVR,…) Ch 14-12

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 Ch 14-13

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  Rarely address incentive aspects of rescheduling –Borrowers and Lenders  Benefits  Costs –Stability  Model likely to require frequent updating Ch 14-14

Using Market Data to Measure Risk  Secondary market for LDC debt –Sellers and buyers  Market segments –Sovereign bonds –Performing LDC loans –Nonperforming LDC loans Ch 14-15

Pertinent Websites Bank for Internationalwww.bis.orgwww.bis.org Settlements Heritage Foundation Institutional Investor International Monetary Fund The Economist Transparency International World Bank Ch 14-16

*Mechanisms for Dealing with Sovereign Risk Exposure  Debt-equity swaps –Example:  Citigroup sells $100 million Chilean loan to Merrill Lynch for $91 million  Bank of America (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 Ch 14-17

*MYRAs  Aspects of MYRAs: –Fee charged by bank for restructuring –Interest rate charged –Grace period –Maturity of loan –Option features  Concessionality (net cost) Ch 14-18

*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 Ch 14-19