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Sovereign Risk

Chapter 15

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


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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 inreserves 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 duringmid and late 1990s

Not all: Chase Manhattan Corp. emergingmarket losses $150 million to $200 million range

Poor earnings by J.P. Morgan.

Losses in Russia with payoffs of 5 cents onthe dollar


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Credit Risk versus Sovereign Risk

Governments can impose restrictions ondebt repayments to outside creditors.

Loan may be forced into default even thoughborrower had a strong credit rating at originationof loan.

Legal remedies are very limited. Need to assess credit quality andsovereign

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 financingrather than bond financing

Loan syndicates often comprised of samegroup of FIs versus large numbers ofbondholders facilitates rescheduling

Cross-default provisions

Specialness of banks argues for

rescheduling but, creates incentives todefault 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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To learn more about the EconomistIntelligence Units country ratings, visit:

The Economist www.economist.com

Web Resources


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Country Risk Evaluation

Internal Evaluation Models

Statistical models:

Country risk-scoring models based on primarilyeconomic 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 andnonreschedulers may be required.

Political risk factors may not be captured

Strikes, corruption, elections, revolution.

Corruption Perceptions Index


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15-13Problems 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.


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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.orgThe Economist www.economist.com

Transparency International www.transparency.org

World Bank www.worldbank.org


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15-17*Mechanisms for Dealing with Sovereign

Risk Exposure

Debt-equity swaps

Example:

Citibank sells $100 million Chilean loan to MerrillLynch for $91 million.

Merrill Lynch (market maker) sells to IBM at $93million.

Chilean government allows IBM to convert the$100 million face value loan into pesos at adiscounted 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 liquidinstrument.

Usually senior to remaining loans of that

country.

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