Chapter 10 Sovereign Risk

Overview This chapter explores the risks FIs face when dealing with foreign governments. We compare and contrast credit and sovereign risk. We examine the concept of debt repudiation and debt rescheduling. We learn about techniques for evaluating a country’s risk profile and ratios that can estimate the financial health of an economy. We examine secondary markets for bonds issued by developing countries and the techniques available to address defaults. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Introduction Increased lending activities to less developed countries (LDCs) in the 1970s resulted in large losses in the 1980s: Debt repayment problems in 1980s: Poland and other Eastern European countries. Debt moratoria in 1982: Mexico and Brazil. Late 1980s / early 1990s, new large lending wave by US banks in form of debt and equity claims, followed by devaluation of Mexican peso. Emerging Asian markets faltered in 1997. These examples highlight the importance of country risk or sovereign risk assessment. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Credit Risk versus Sovereign Risk Credit risk is dependent on the ability and willingness of the borrower to repay the loan. Governments can impose restrictions on debt repayments to outside creditors: Loan may be forced into default even though borrower had a strong credit rating when loan was originated. Legal remedies are very limited. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Credit Risk versus Sovereign Risk Sovereign risk is dependent on both: The willingness and the ability of the borrower to repay the loan, The probability that the Government of the country in which a foreign borrower operates will allow the repayment of foreign debt. Lending decisions to parties in foreign countries require two steps: Credit quality assessment of borrower, Sovereign risk quality assessment of country. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Debt Repudiation versus Debt Rescheduling Outright cancellation of current and future debt obligations by a borrower. Examples: China (1949), Cuba (1961), North Korea (1964). 1996: World Bank, IMF and major governments around the world forgave the debt of the world’s poorest, most heavily indebted countries (HIPCs). Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Debt Repudiation versus Debt Rescheduling Changing the contractual terms of a loan, such as its maturity and interest payments. Most common form of sovereign risk event. Example: debt moratoria. Payment delays can refer to either: Principal repayment, or Interest payments. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Debt Repudiation versus Debt Rescheduling Pre–Second World War: debt problems predominantly met with debt repudiation. Post–Second World War: debt problems predominantly met with debt rescheduling. Potential reasons: Post-war financing was mainly through bank loans rather than foreign bonds (major financing method pre-war). Rescheduling for loans is easier and cheaper due to lower number of FIs participating in negotiations, FI cohesiveness in loan renegotiations, Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Debt Repudiation versus Debt Rescheduling Potential reasons (continued): Many loan contracts contain ‘cross-default provisions’, Public policy goals of some Governments aim to avoid large FI failures (especially in developed countries), Perception of higher social cost on bank loan defaults compared to defaults on bonds. Specialness of banks argues for rescheduling, but there are incentives to default again if bailouts are automatic.

Country Risk Evaluation Outside Evaluation Models – The Euromoney Index: Published in 1979. Originally based on spread in Euromarket of the required interest rate in a country’s debt over LIBOR. More recently, replaced by index based on: Large number of economic and political factors, Subjective weighting (relative importance). Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Country Risk Evaluation Outside Evaluation Models – The Economist Intelligence Unit (EIU): Rating through combination of economic and political risk. Maximum 100 point scale. The higher the number, the worse the sovereign risk rating. See: www.economist.com Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Country Risk Evaluation Outside Evaluation Models – The Economist Intelligence Unit (EIU): Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Country Risk Evaluation Outside Evaluation Models – The Institutional Investor Index: Published bi-annually. Based on surveys of loan officers of multinational banks. Subjective scoring system based on 100. The higher the score, the better the risk rating. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Country Risk Evaluation Internal Evaluation Models – Statistical Models: Most common form of country risk assessment: scoring models based on economical factors. Commonly used economic ratios: Debt service ratio (DSR): (Interest + amortisation on debt) / exports, Import ratio (IR): Total imports / total foreign exchange reserves Investment ratio (INVR): Real investment / GDP Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Country Risk Evaluation Internal Evaluation Models – Statistical Models: Commonly used economic ratios (continued): Variance of export revenue (VAREX): σ2ER Domestic money supply growth (MG): ∆M / M Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Country Risk Evaluation Internal Evaluation Models – Statistical Models: Expected relationships among five key economic variables and probability for rescheduling: p = f (DSR, IR, INVR, VAREX, MG, …) + + + or - + + Countries placed into one of two categories: P1 = bad (reschedulers) P2 = good = (non-reschedulers) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Country Risk Evaluation Problems with Statistical CRA Models: Measurements of key variables. Population groups Finer distinction than reschedulers and non-reschedulers may be required. Political risk factors: Strikes, corruption, elections, revolution. Portfolio aspects: systematic versus unsystematic risk. Incentive aspects of rescheduling: Cost and benefits for borrowers and lenders. Stability: model likely to require frequent updating. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Using Market Data to Measure Risk: The Secondary Market for LDC Debt Market Structure: Secondary market has enhanced liquidity of LDC loans. Sellers: Large FIs willing to accept write-downs of loans, Small FIs wishing to disengage from LDC loan market, FIs willing to swap LDC debt to rearrange portfolios. Buyers: Wealthy investors, hedge funds, FIs and corporations: speculation FIs trying to rearrange LDC portfolios. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Using Market Data to Measure Risk: The Secondary Market for LDC Debt Brady bond: issued by an LDC that is swapped for an outstanding loan by that LDC. Sovereign bonds. Performing loans. Non-performing loans. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

LDC Market Prices and Country Risk Analysis Repayment problems are likely to be predicted by combining LDC debt prices with key variables. Most significant variables affecting LDC loan sale prices (P) from 1985 to 1988: Debt service ratios Import ratio Accumulated debt in arrears Amount of loan loss provisions against LDC loans. Approach subject to same criticisms as traditional statistical models. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Mechanisms for Dealing With Sovereign Risk Exposure Debt-for-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. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Mechanisms for Dealing with Sovereign Risk Exposure Multi-Year Restructuring of Loans (MYRAs): Aspects of MYRAs: Restructuring fee charged by bank Interest rate charged on new loan Grace period Maturity of loan Option and guarantee features Concessionality: the amount a bank gives up in PV terms as a result of a MYRA. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Mechanisms for Dealing With Sovereign Risk Exposure Loan Sales: Benefits: Removal of loans from balance sheet. Sale at loss or reduced price indicates strength of balance sheet. Loss = tax write-off. Costs: Loss. Bond for Loan Swaps (Brady Bonds): Transform LDC loan into marketable liquid instrument. Usually senior to remaining loans of that country. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher