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Confidential

Sovereign Strategy
A Framework for Analysis

Kaushik Rudra
February 2002

The Framework for Analysis

Framework for Analysis


A combination of top down and bottom up analysis Fundamental, credit, political and technical analysis Globally unified view disseminated via a total rate of return Model Portfolio Inter- and intra-country relative value ideas disseminated via a relative value portfolio

Top Down Analysis


Global themes G7 themes (US/EU/Japan) Emerging market themes (e.g. Argentina) Crossover market themes Exogenous shock (September 11) Global liquidity conditions Asset class valuation Relative richness or cheapness of EM asset class versus High Grade and High Yield Strong emphasis on global political analysis Geopolitical events analysis
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Bottom Up Analysis
Question 1: Capacity to Service Debt?

Fundamental analysis Real sector analysis Public sector financing analysis External financing analysis Debt dynamics exercise External support (private and public sector) Reform and privatization effort Multilateral support Geopolitical and strategic considerations Access to foreign capital (direct & portfolio)

Capacity to Service Debt


Macroeconomic Fundamentals
Income levels (GDP/capita) Income distribution Unemployment GDP composition Dependence on commodity prices Share of exports Growth trends & prospects Sources of growth Domestic savings/investment rate Export potential FDI inflows
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Capacity to Service Debt


Economic Policy
Fiscal policy Tax Policy Monetary policy Exchange rate policy Interest rate policy Credit policy Commitment to market reforms Support from multilateral organizations

Capacity to Service Debt


Fiscal and Monetary Policy
Effectiveness impact on growth, inflation, FX rate Purpose of government spending Ability to raise taxes Economys sensitivity to interest rates Commitment to price stability Key indicators Budget deficit/GDP Primary deficit/GDP Public debt/GDP Level of real interest rates Inflation trend
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Capacity to Service Debt


Currency Regime
FX free-floating; pegged against a currency basket; currency board Will the Central Bank use reserves to defend FX? Contagion Risk of devaluation Impact on countrys ability to service foreign debt Reserves coverage (Reserves/Imports)

Capacity to Service Debt


Commitment to Market Reforms
Privatization Pace, scale, price Ability to attract strategic investors Trade liberalization Banking sector restructuring Labor reforms Public support Legal/regulatory framework

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Capacity to Service Debt


Support from Multilateral Organizations
Official lending: IMF, World Bank, EBRD, etc. Often covers a substantial portion of funding needs IMF program in place Availability of contingency funds Signaling mechanism for private lenders Track record

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Capacity to Service Debt


Balance of Payments
Typical EMG economy Current account deficit (trade deficit; interest payments on external debt) Dependency on foreign capital inflows Large current account deficit May exert pressure on FX Not necessarily negative Differentiating factor Funding sources FDIs - long-term investments into real economy Portfolio flows short-term; subject to changes in investor sentiment
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Capacity to Service Debt


Balance of Payments
Trade Balance Exports Growth catalyst Competitiveness Imports Consumption vs Capital Services Balance Tourism, Transportation, Interest Payments Capital Account Direct and Portfolio investment External Debt
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Capacity to Service Debt


eg. Bulgaria Estimating Financing Gap/Surplus
Bulgaria Financing Equation (US$ million)(1,2)
Financing Requirements 2000 Current Account Amortizations Multilateral Bilateral Private Sector & Other 676 547 209 195 143 2001F 725 792 338 278 176 2002F 670 806 319 159 328 Capital Account Direct Investments Portfolio Investments Disbursements Multilateral IMF(3) World Bank(4) Other Bilateral Private Sector & Other(5) Total Financing Sources 2000 823 1,002 -179 951 449 274 71 104 142 360 1,774 2001F 350 500 -150 1,121 381 66 150 165 120 620 1,471 2002F 500 600 -100 1,080 450 150 150 150 130 500 1,580

Total

1,223

1,517

1,476

Source: Lehman Brothers, Bulgarian National Bank, IMF (1) Assumes no change in reserves, no capital flight and no errors and omissions (2) Excludes short-term debt, which we assume will get rolled over (3) Includes a one year IMF program (US$150 million) in 2002 (4) Assumes disbursement of US$150 million in 2002. According to the new CAS drawn up by the world bank, Bulgaria will receive between US$250 750 million between 2002 04 (5) Includes euro-denominated (300 million) eurobond in 2002

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Capacity to Service Debt


What determines the scale of FDIs?
Stable political regime Natural wealth export potential Sizable home market Low labor costs Geographic location/cultural ties Developed infrastructure Stable legal/regulatory framework

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Capacity to Service Debt


External Debt Profile
Level of external debt debt/GDP; debt/exports Debt service ratio debt service/imports Maturity profile/amortization schedule ability to refinance Composition (public/private) probability of debt restructuring Level of international reserves

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Capacity to Service Debt


Sovereign Credit Ratings
Moodys & S&P Issuer rating = Foreign currency rating Domestic currency rating Domestic currency debt typically rated higher for EMG countries Government can print money/raise taxes Rating differential wider for lower-rated countries Sovereign ceiling Governments ability to introduce FX & capital controls

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Bottom Up Analysis
Question 2: Willingness to Service Debt?

Political analysis Lehman Brothers analysis Eurasia Group analysis Strong in-field contacts Eurasias approach to political risk analysis is very different from the traditional Street approach Scientific rigor, quantitative approach to political science Mapping of economics (LB) with politics (EG)

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Willingness of Service Debt


Political Stability
Stable, transparent government Political continuity Election years Western orientation Degree of consensus and public support Presence of domestic/external conflicts Regional developments/relations with neighbors Level of integration with the global economy Too big to fail?

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Bottom Up Analysis
Question 3: Will the Credit Outperform?

Answers to questions 1 and 2plus Technical considerations Holders of debt Relative allocation of debt Index considerations Other considerations Buybacks Debt restructuring Issuance/supply

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Will the Credit Outperform


Technical Factors
Risk appetite for the asset class Correlation with the market and the risk of contagion Type of investors Inclusion in the index Short/long positions New supply/debt exchange Market and asset liquidity

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Investment Outperformance Through Exposure to Sovereign Markets

Importance of the Asset Class


Contagion and Crossover
Why Invest in Sovereign Markets?

Current Yield/Total Return Enhancement

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Fixed Income Asset Classes


Summary Indicators (Jan 1993 Jun 2001)

16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0%


USAGG USGOV USTRY USCOV USHLD GOGLB GOGLBX GOG6 EMAGG

Returns

Std Dev

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Importance of the Asset Class: Contagion and Crossover


Why Invest in Sovereign Markets?

Current Yield/Total Return Enhancement Diversification

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Fixed Income Asset Classes


Cross-correlation Matrix
January 1993 June 2001
USAGG USAGG USGOV USCOR USHLD GOGLB GOG6 EMAGG 100% 98% 97% 41% 51% 25% 20% 100% 93% 30% 54% 28% 13% 100% 54% 47% 22% 30% 100% 15% 1% 52% 100% 95% -3% 100% -9% 100% USGOV USCOR USHLD GOGLB GOG6 EMAGG

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Efficient Frontier Argument


Portfolio Returns are a Weighted Average of Returns

Portfolio Return = X1*R1+X2*R2, where X1 and X2 are the percentage of the portfolio in the two indices; R1 and R2 are the average returns for the respective indices
Portfolio Volatility is not a Weighted Average of Volatility

Portfolio Volatility = [(X1^2)*(s1^2)+ (X2^2)*(s2^2) + 2X1X2*(1,2)(s1)(s2)]^(1/2), where (1,2) is the correlation between the returns of the two indices

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Efficient Frontier Analysis


As a result:
Correlation Coefficient () -1 0 +1

Increasing Benefit from Diversification

Limited to No Benefit from Diversification

Examples USAGG with EMAGG: = 20%, Limited Benefits GOG6 with EMAGG: = -9%, Significant Benefits
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Efficient Frontier Analysis Examples USAGG


with EMAGG
Efficient Frontier

Lehman US Aggregate with Lehman EMG Aggregate; Monthly (Jan 1993-Jun 2001)
Annualised Return

14% 12% 10% 8% 6% 3%


98% US Aggregate, 2% EMG Aggregate 100% US Aggregate

100% EMG Aggregate

6%

9% 12% Annualised Volatility


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15%

18%

Efficient Frontier Analysis Examples


GOG6 with EMAGG
Efficient Frontier

Lehman Government Global (G6) with Lehman EMG Aggregate; Monthly (Jan 1993-Jun 2001)
Annualised Return

14% 12% 10% 8% 6% 5% 8% 11% Annualised Volatility


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79% Govt. Global (G6), 21% EMG Aggregate 100% Govt. Global (G6)

100% EMG Aggregate

14%

17%

Importance of the Asset Class


Contagion and Crossover
Why Invest in Sovereign Markets?

Current Yield/Total Return Enhancement Diversification The Potential Crossover Stories

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The Crossover Story (Part I)


Korea In Anticipation of an Investment Grade Rating
800 700 600 500 400 300 200 100 6-Oct-98 25-Dec-98 16-Mar-99 5-Jun-99 25-Aug-99 14-Nov-99 2-Feb-00 Republic of Korea '03 Republic of Korea '08
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18-Dec-98: Moodys reviews credit for upgrade 25-Jan-99: S&P upgrades Korea to Investment Grade (BBB-) 12-Feb-99: Moodys upgrades Korea to Investment Grade (Baa3) Dec-99: S&P and Moodys rate Korea solid Investment Grade (Baa2/BBB)

Cashflow Yield Model Spread (bp)

4-Jan-99: S&P changes outlook to Positive

The Crossover Story (Part II)


Mexico In Anticipation of an Investment Grade Rating
1,000 900
Russian Crisis

Cashflow Yield Model Spread (bp)

800 700 600 500 400 300 200 3-Aug-98 17-Nov-98 3-Mar-99

2-Feb-00: Moodys changes outlook to positive (Ba1/Positive) 7-Mar-00: Moodys raises Mexicos rating to Investment Grade (Baa3)

17-Jun-99

2-Oct-99

16-Jan-00

1-May-00

United Mexican States 16

United Mexican States 26


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Importance of the Asset Class


Contagion and Crossover
Why Invest in Sovereign Markets?

Current Yield/Total Return Enhancement Diversification The Potential Crossover Stories Convergence Plays

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Convergence Virtuous Cycle


Improved Credit Outlook

EU Norms & Targets Increased Capital Inflows


Adherence to Reforms

Accession Process on Track

Improved Investor Sentiment

Improved Ratings

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Applying the Approach


View for 2002

Total Return Model Portfolio


Benchmark LB Emerging Markets Index Components of the Model Portfolio EM top down view (regional breakdown) EM bottom up view (country selection) Asset selection Duration view (based on overall country view) US treasury yield curve view (fixed versus floating) Collateralized versus non-collateralized Risk Profile tracking error analysis Yield curve Credit spreads Issuer selection
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Themes for 2002


5 Themes High beta countries will outperform in H102 Commodity and oil prices Demand factors may dominate countries that can sustain low oil prices will outperform Limited financing requirements Watch current account/current account dynamics Argentina: has it completely decoupled? Politics Implication of a war in Iraq and continued conflict in Israel/Palestine

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Themes for 2002


1. Emerging Markets as a Yield Play Emerging Markets remain attractive from a yield standpoint in H1 02 Outlook for EM ex-Argentina still robust (fundamentals strong, financing requirements limited) Assumption: Global growth conditions remain weak in H1 02; pick up in H2 02 Fed bias in Q1 (and probably Q2) towards growth bias will change to inflation in Q2 and beyond Watch for strong economic data as a precursor to a change in bias Current trade: EM cheap (relative to treasury) begins to get reversed Relative yield differential declines as Fed begins to act on inflation H1 02: High beta names (Russia, Brazil etc.) do well
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Themes for 2002


2. Commodity prices: A play on global growth Oil prices, commodity prices remain soft to low as long global growth remains weak LB oil forecast for 2002: $17 p/b If V-shaped recovery does not play out, oil prices remain soft for a longer period Russia will be ok strong reserve build up, stabilization fund, changed geopolitical environment Venezuela will be more worrisome Deteriorating fiscal situation, troubling politics

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Themes for 2002


3. Financing Requirements Current Account, Capital Account: will it change in 2002? Major EM Countries Limited gross external financing requirements Multilateral (especial IMF) flushed with liquidity Brazil: Net financing requirement $12 billion, of which public sector will need at most $6 billion Russia: Zero financing requirement (even if oil remains at low levels) Turkey: Moral Hazard at play Argentina: Covered?.but other more important issues to consider Relative to available cash, overall financing requirements seem fairly innocuous
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EMG Bonds
Cash Flow Analysis

Overall Market (projections for 2002): Total Interests plus Principal coming due: $39.6 billion
($ billion)

5.0 4.0 3.0 2.0 1.0 0.0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

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EMG Bonds
Issuance to Redemption Analysis

Overall Market Issuance Requirement ($27.8 billion) compares favorably to projected redemption ($39.6 billion)
Emerging Markets Cash to Supply Dynamic, 2002 (US$ billion)
2002 Financing Requirement (1) US$0.0 billion US$5.0 billion US$3.2 billion US$0.0 billion US$4.0 billion US$1.5 billion US$14.1 billion US$27.8 billion US$40.0 billion +US$12.2 billion Of which: US$ US$0.0 billion US$4.0 billion US$2.5 billion US$0.0 billion US$2.0 billion US$1.5 billion US$8.9 billion US$18.9 billion US$32.0 billion +US$13.1 billion uro(2) US$0.0 billion US$1.0 billion US$0.7 billion US$0.0 billion US$2.0 billion US$0.0 billion US$5.2 billion US$8.9 billion US$8.0 billion US$0.9 billion

Argentina Brazil Mexico Russia Turkey Philippines Others Total Issuance Total Available Funds Differential

Source: Lehman Brothers (1) Need to access international capital markets (2) Total available funds on the euro side under-estimate the total cash available. Index definition used to calculate cash flow

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Themes for 2002


4. Argentina: has it decoupled completely? Recent price action suggests market has decoupled from Argentina Potentially more downside for Argentina Rest of the market: limited contagion fears Only exception: Brazil (potential peso devaluation could put pressure on the real/interest rates/growth debt dynamics) Buy opportunities for the rest of the Market

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Themes for 2002


5. Politics Geopolitical Considerations Security remains of paramount importance Attack on Iraq? Negative for Turkey, Qatar, Egypt etc. Political implications for Russia and Turkey Conflict between Israel and Palestine: broader implication for the region and global politics? Domestic Politics Elections in Brazil Venezuela: The Chavez Drama Nothing significant in Asia and Europe

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An Example of Lehman Analysis


Will Turkey Outperform in 2002? Moral Hazard Trade at Play Debt rollover and domestic financing gap covered Positive implications for currency, deposit composition and debt dynamics It is not about the money, it is all about confidence Currency and deposit switch Debt dynamics Rollover flexibility Confidence and investor sentiment will improve only if authorities undertake credible and strong implementation of the reform agenda

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An Example of Lehman Analysis


Will Turkey Outperform in 2002? Risks on the Horizon Challenging economic environment Challenging global environment Domestic political risks A war with Iraq? Are the spreads too tight? At 200 bps tight to the overall index and 300 bps to Brazil, Turkey offers limited near-term upside Strong performance since beginning of September (has outperformed regional peers incl.. Russia) Although attractive from a diversification standpoint, near-term outperformance is conditional on significant and credible progress on the reform agenda especially banking sector
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