COUNTRY RISK

By:
Saif Ullah
INTRODUCTION

In 1970s:
• Expansion of loans to Eastern bloc, Latin America and
other Less Developed Countries (LDCs).
• In many cases, these loans appear to have been made
with little judgment regarding the credit quality of the
sovereign country in which the borrower resided or
whether that body was a government-sponsored
organization (such as Pemex) or a private corporation.
INTRODUCTION

Beginning of 1980s:
• Debt moratoria announced by Brazil and Mexico.
• Increased loan loss reserves
• Citicorp set aside additional $3 billion in
reserves for example
INTRODUCTION
Late 1980s and early 1990s:
• Expanding investments in emerging markets through
debt and equity arrangements
• With the rising trade deficits and declining foreign
exchange reserves – Countries started to devaluate their
currencies
• Mexico (Peso) devaluation and subsequent restructuring
• To support Restructuring, Clinton administration, along with
the IMF, put together an international aid package for
Mexico amounting to some $50 billion.
 INTRODUCTION
Emerging markets in Asia faltered in 1997 when an economic
and financial crisis in Thailand, produced worldwide reactions.
In early July, the devaluation of the Thai baht resulted in
devaluations of currencies throughout Southeast Asia (including
those of Indonesia, Singapore, Malaysia, and South Korea) and
the devaluations eventually spread to South America and Russia.
Hong Kong’s pegging of its currency to the U.S. dollar forced its
monetary authorities to take precautionary action by increasing
interest rates and to use China’s foreign currency reserves to
stabilize the Hong Kong dollar.
 INTRODUCTION
In November 1997, Chase Manhattan Corp. announced
losses from emerging market securities holdings in the
$150 million to $200 million range. This was followed
by a similar announcement of poor earnings by J. P.
Morgan. In 1999, U.S. banks such as Bank of America,
Republic New York Corp., and Chase Manhattan (now J.
P. Morgan Chase) wrote off hundreds of millions of
dollars in losses as they accepted a payoff of less than
five cents on the dollar for Russian securities.
 INTRODUCTION
• With the Collapse of Asian currencies, financial institutions
in countries such as Japan and Hong Kong failed or were
forced to merge or restructure.
• Investment bank powerhouses such as Yamaichi Securities,
Japan’s fourth largest securities firm, and Peregrine
Investment Holding, Ltd., one of Hong Kong’s largest
investment banks, failed as currency values fell.
• Commercial banks in Japan and Hong Kong that had lent
heavily to other Southeast Asian countries failed.
 INTRODUCTION
• In the early 2000s, concerns were raised about the ability of
Argentina and Turkey to meet their debt obligations and the effects
this would have on other emerging market countries.
• For example, in December 2001, Argentina defaulted on $130 billion
in government-issued debt, and in 2002, passed legislation that led to
defaults on $30 billion of corporate debt owed to foreign creditors.
• The situation continued to deteriorate, and in November 2002
Argentina’s government paid only $79.5 million of an $805 million
repayment due to the World Bank.
• However, as Argentina pulled out of its crisis, it was offering debt
holders only 25 cents on the dollar for their holdings.
 INTRODUCTION
These recurring experiences confirm the importance of
assessing the country or sovereign risk of a borrowing
country before making lending or other invest-ment
decisions such as buying foreign bonds or equities.
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.
 SOVEREIGN RISK
• Making a lending decision to a party residing in a
foreign country is a two-step decision.
• First, lenders must assess the underlying credit quality of
the borrower, as they would do for a normal domestic
loan, including setting an appropriate credit risk premium
or credit limits.
• Second, lenders must assess the sovereign risk quality of
the country in which the borrower resides.
 SOVEREIGN RISK
 The World Bank assesses country risk based on several measures.
 Political economy risk (the risk that powerful interest groups
may undermine reform objectives by blocking
implementation, capturing benefits, or reversing reform
actions),
 Exogenous risks (the risk of shocks to the external
environment, such as a natural disaster or regional economic
crisis that might have a bearing on the vulnerability of the
poor),
 Other country risks (the threat of an increase in political
instability or social tensions that could undermine effective
implementation).
DEBT REPUDIATION VERSUS DEBT
RESCHEDULING
A sovereign country’s (negative)
decisions on its debt obligations or the
obligations of its public and private
organizations may take two forms:
Repudiation
Rescheduling
 DEBT REPUDIATION
Repudiation is an complete cancelation of all a
borrower’s current and future foreign debt and equity
obligations.
Since World War II, only China (1949), Cuba (1961), and
North Korea (1964) have followed this course.
 DEBT RESCHEDULING
Rescheduling has been the most common form of sovereign
risk event. Specifically, a country (or a group of creditors in
that country) declares a moratorium or delay on its current
and future debt obligations and then seeks to ease credit
terms through a rescheduling of the contractual terms, such
as debt maturity and/or interest rates.
Such delays may relate to the principal and/or the interest
on the debt (South Korea in January 1998 and Argentina in
2001 are recent examples of debt rescheduling's).
 DEBT RESCHEDULING
First, there are generally fewer FIs in any international
lending groups compared with thousands of
geographically dispersed bondholders.
The relatively small number of lending parties makes
renegotiation or rescheduling easier and less costly
than when a borrower or a bond trustee has to get
thousands of bondholders to agree to changes in the
contractual terms on a bond.
 DEBT RESCHEDULING
Second, many international loan groups comprise the same
groups of FIs, which adds to FI giants in loan renegotiations
and increases the probability of consensus being reached.
For example, Citigroup was chosen the lead bank negotiator
by other banks in five major loan rescheduling's in the
1980s, as well as in both the Mexican and South Korean
rescheduling's. J. P. Morgan Chase is the lead bank involved
in the recent loan rescheduling's of Argentina.
 DEBT RESCHEDULING
Thirdly, many international loan contracts contain
cross-default provisions that state that if a country
were to default on just one of its loans, all the other
loans it has outstanding would automatically be put
into default as well. Cross-default clauses prevent a
country from selecting a group of weak lenders for
special default treatment and make the outcome of
any individual loan default decision potentially very
costly for the borrower.
 DEBT RESCHEDULING
Fourthly, behavior of governments and regulators in
lending countries. One of the over-whelming public
policy goals in recent years has been to prevent large
FI failures in countries such as the United States,
Japan, Germany, and the United Kingdom.
COUNTRY RISK EVALUATION
 COUNTRY RISK EVALUATION
• In evaluating sovereign risk, an FI can use alternative
methods, varying from the highly quantitative to the
very qualitative.
• FI may rely on outside evaluation services or develop
its own internal evaluation or sovereign risk models.
 COUNTRY RISK EVALUATION
Outside Evaluation Models
 The Euromoney Index
 The Economist Intelligence Unit
 The Institutional Investor Index
Internal Evaluation Models
 Statistical Models
 Debt Service Ratio (DSR)
 Import Ratio (IR)
 Investment Ratio (INVR)
 Variance of Export Revenue (VAREX)
 Domestic Money Supply Growth (MG)
OUTSIDE EVALUATION MODELS
 THE EUROMONEY INDEX
When originally published in 1979, the Euromoney Index was
based on the spread in the Euromarkets of the required
interest rate on that country’s debt over the London
Interbank Offered Rate ( LIBOR ), adjusted for the
volume and maturity of the issue.
More recently, this has been replaced by an index based on
a large number of economic and political factors weighted
subjectively according to their perceived relative
importance in determining country risk problems.
THE ECONOMIST INTELLIGENCE UNIT
A sister firm to The Economist, the Economist
Intelligence Unit (EIU) rates country risk by combined
economic and political risk on a 100-point (maximum)
scale. The higher the number, the worse the sovereign
risk rating of the country.
 THE INSTITUTIONAL INVESTOR INDEX
Normally published twice a year, this index is based on
surveys of the loan officers of major multinational banks.
These officers give subjective scores regarding the credit
quality of given countries. Originally, the score was based
on 10, but since 1980 it has been based on 100, with a score
of 0 indicating certainty of default and 100 indicating no
possibility of default. The Institutional Investor then
weighs the scores received from the officers surveyed by
the exposure of each bank to the country in question.
INTERNAL EVALUATION MODELS
 STATISTICAL MODELS
The most common approach to evaluating sovereign country risk
among large FIs has been to develop sovereign country risk-
scoring models based on key
economic ratios.
An FI analyst begins by selecting a set of macro- and
microeconomic variables and ratios that might be important in
explaining a country’s probability of rescheduling. Then the
analyst uses past data on rescheduling and non-rescheduling
countries to see which variables best discriminate between
those countries that rescheduled their debt and those that did
not.
 DEBT SERVICE RATIO (DSR)
An LDC’s exports are its primary way of generating dollars and other
hard currencies. The larger the debt repayments in hard currencies are
in relation to export revenues, the greater the probability that the
country will have to reschedule its debt. Thus, there should be a
positive relationship between the size of the debt service ratio
and the probability of rescheduling.
 IMPORT RATIO (IR)
The ratio of a country’s imports to its total foreign
currency reserves
the import ratio and the probability of
rescheduling should be positively related.
 INVESTMENT RATIO (INVR)
The investment ratio measures the degree to which a country is
allocating resources to real investment in factories, machines, and so
on, rather than to consumption. The higher this ratio, the more
productive the economy should be in the future and the lower the
probability that the country would need to reschedule its debt: This
implies a negative relationship between INVR and the probability of
rescheduling.
VARIANCE OF EXPORT REVENUE
(VAREX)
• An LDC’s export revenues may be highly variable as a result of two
risk factors.
• Quantity risk means that the production of the raw commodities the
LDC sells abroad—for example, coffee or sugar—is subject to periodic
gluts and shortages.
• Price risk means that the international dollar prices at which the
LDC can sell its exportable commodities are subject to high volatility
as world demand for and supply of a commodity, such as copper,
vary.
• The more volatile an LDC’s export earnings, the less certain creditors
can be that at any time in the future it will be able to meet its
repayment commitments. That is, there should be a positive
relationship between and the probability of rescheduling
DOMESTIC MONEY SUPPLY GROWTH
(MG)
The faster the domestic growth rate of an LDC’s money
supply, which measures the change in the money
supply (∆M) over its initial level (M), the higher the
domestic inflation rate and the weaker that country’s
currency becomes in domestic and international
markets.
SUMMARY
After selecting the key variables, the FI manager
normally places countries into two groups or
populations:
P 1 Bad (reschedulers)
P 2 Good (nonreschedulers)
 PROBLEMS WITH STATISTICAL CRA
MODELS
1. Measurement of Key Variables – Out of Date Data
2. Population Groups – Diversified Groups (Interest,
Principal, Both)
3. Political Risk Factors – Account fall only corporate only
economic variables
4. Portfolio Aspects – Each country is considered separately
5. Incentive Aspects -identify variables based on rather
loose or often non-existent analyses of the borrower or
lender’s incentives to re-schedule
6. Stability – Model Fitness over time
LDC MARKET PRICES AND COUNTRY
RISK ANALYSIS
LDC MARKET PRICES AND COUNTRY
RISK ANALYSIS