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Sovereign Risk
Chapter 15
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.McGraw-Hill/Irwin
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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.