CHAPTER 14Sovereign Risk

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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

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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

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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)

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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

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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 riskCh 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

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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

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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 Index2012 placed Norway at least chance of

default and Somalia at highestU.S. not the lowest risk

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Web Resources

To learn more about the Economist Intelligence Unit’s country ratings, visit:The Economist www.economist.com

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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

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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 = σ2ER

– Domestic money supply growth = ΔM/M Discriminant function: p=f(DSR,IR, INVR,…)

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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

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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

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Using Market Data to Measure Risk

Secondary market for LDC debt– Sellers and buyers

Market segments– Sovereign bonds– Performing LDC loans– Nonperforming LDC loans

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Pertinent WebsitesBank for International www.bis.org

Settlements Heritage Foundation www.heritage.orgInstitutional www.institutionalinvestor.com

InvestorInternational Monetary

Fund www.imf.org The Economist www.economist.com Transparency www.transparency.org

International World Bank www.worldbank.org

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*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

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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 (net cost)

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*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

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