Sovereign Risk Chapter 16

Financial Institutions Management, 3/e By Anthony Saunders

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Introduction

In 1970s:
Expansion of loans to Eastern bloc, Latin America and other LDCs.

Beginning of 1980s:
Poland and Eastern bloc repayment problems. Debt moratoria announced by Brazil and Mexico.

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Introduction (continued)

Late 1980s and early 1990s:

Expanding investments in emerging markets. Peso devaluation.

More recently:
Asian crises. MYRAs Brady Bonds.
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Credit Risk versus 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.

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Sovereign Risk

Debt repudiation
Since WW II, only China, Cuba and North Korea have repudiated debt.

Rescheduling
Most common form of sovereign risk. South Korea, 1998.

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Country Risk Evaluation

Outside evaluation models:

The Euromoney Index Institutional Investor Index

Internal Evaluation Models

Statistical models: country risk-scoring models based on economic 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 and nonreschedulers may be required.

Political risk factors

Strikes, corruption, elections, revolution.

Portfolio aspects

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Problems with Statistical CRA Models (continued)

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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*Mechanisms for Dealing with Sovereign Risk Exposure

Debt-equity swaps
Example:
Citibank sells $100 million Chilean loan to Salomon Brothers for $91 million. Salomon (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
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*Other Mechanisms
Loan sales Debt for debt swaps (Brady bonds)

Transform LDC loan into marketable liquid instrument. Usually senior to remaining loans of that country.

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