Lessons Learned from Sovereign Risk

2. 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

3. 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

4. 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)

5. 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

6. 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 risk

7. 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

8. 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

9. 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 Index • 2012 placed Norway at least chance of default and Somalia at highest • U.S. not the lowest risk

10. Web Resources • To learn more about the Economist Intelligence Unit’s country ratings, visit: The Economistwww.economist.com

11. 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

12. 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,…)

13. 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

14. 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

15. Using Market Data to Measure Risk • Secondary market for LDC debt • Sellers and buyers • Market segments • Sovereign bonds • Performing LDC loans • Nonperforming LDC loans

16. Pertinent Websites Bank for International www.bis.org Settlements Heritage Foundation www.heritage.org Institutional www.institutionalinvestor.com Investor International Monetary Fund www.imf.org The Economist www.economist.com Transparency www.transparency.org International World Bank www.worldbank.org

17. *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

18. *MYRAs • Aspects of MYRAs: • Fee charged by bank for restructuring • Interest rate charged • Grace period • Maturity of loan • Option features • Concessionality (net cost)

19. *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