BANK 501 - ASSET AND LIABILITY MANAGEMENT

BANK 501- ASSET AND LIABILITY MANAGEMENT WEEK 11 SOVEREIGN RISK Saunders and Cornett (2006) Chp. 28

Introduction • In 1970s: • Expansion of loans to Eastern bloc, Latin America and other LDCs. In the 1970s commercial banks in USA and other countries rapidly expanded their loans to Eastern European, Latin American, and other LDCs. This was largely to meet these countries’ demand for funds and partly to allow commercial banks to recycle petrodollar funds from huge dollar holders such as Saudi Arabia.

Introduction (Con’t) • Beginning of 1980s: • Poland and Eastern bloc repayment problems. • In 1982 Debt moratoria announced by Brazil and Mexico. At the time of debt moratoria the 10 largest US Banks had overall sovereign risk exposure of $56 billion , 80% of which was to Latin America. • This increased the provisions to loan loss reserves of banks (eg. Citicorp set aside additional 3$ billion). Debt Moratoria: Delay in repaying interest and/or principal on debt.

Introduction (continue) • Late 1980s and early 1990s: • Expanding investments in emerging markets. • Mexican Peso devaluation in 1994 caused “banks run” for Mexican debt. USA put together an international aid package for Mexico amounting to $50 billion. USA provided loan guarantees over three years that would amount to $20 billion to help restructure Mexican debt.

More recently: • 1997-2000 Asian and Russian crises. In 1997, the devaluation of Thai baht resulted in contagious devaluation of currencies in Indonesia, Singapore, Malaysia, and South Korea. Eventually it spread to South America and Russia. • Foreign banks’ share of total Asian debt at the end of June 1997, excluding Singapore and Hong Kong, was $389 billion. • The share of this debt was:Japan 32%,Germany 12% USA 8%, Britain 8% France 10%, Other 30%.

These recurring experiences confirm the importance of assessing the country or sovereign risk of a borrowing country before making lending or other investment decisions such as buying foreign bonds or equities. • In this chapter we first define the sovereign, or country risk. Then we look at measures of country risk that FI managers can use as screening devices before making loans or other investment decisions.

MYRA: A multiyear restructuring agreement that is the official terminology for a sovereign loan rescheduling. • Brady Bond: A bond that is swapped for an outstanding loan to a LDC.

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. • Need to assess credit quality and sovereign risk at the same time.

Credit Risk versus 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 it would do for a normal domestic loan. Second, lenders must assess the sovereign risk quality of the country in which the borrower resides. If the sovereign risk is bad the lender should not make the loan.

Debt Repudiation vs Debt Rescheduling • Repudiation: Outright cancellation of all current and future debt obligations by a borrower. The WB, IMF and major governments around the world agreed to forgive the external debt of the world’s poorest, most heavily indebted countries. Since WWII, only China(1949), Cuba (1961) and North Korea (1964) had debt repudiation.

Debt Repudiation vs Debt Rescheduling • Debt rescheduling: Rescheduling has been the most common form of sovereign risk event. Specifically, a 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 (South Korea,1998; Argentina 2001)

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 • Argentina 2001(severe ongoing economic problems at time of writing)

Debt Rescheduling • More likely with debt financing rather than bond financing • Loan syndicates often comprised of same group of FIs • Cross-default provisions • Specialness of banks argues for rescheduling but, incentives to default again if bailouts are automatic

Debt Rescheduling • One of the public policy goals in recent years has been to prevent large FI failures in countries such as the USA, Japan, Germany and UK. Thus government organized rescue packages for LDCs arranged either directly or indirectly via World Bank/IMF guarantees or the Brady Plan are ways of subsidizing large FIs and/or reducing the incentives for LDCs to default on their loans. Rescue packages may however cause a moral hazard problem, and sovereign debt crises may keep reoccurring.

Country Risk Evaluation Outside Evaluation Models There are three country risk assessment services available to outside investors and FIs: • The Euromoney Index • The Economist Intelligence Unit ratings • Institutional Investor Index

The Euromoney Index : This index is based on the spread in the Euromarket 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. Recently this has been replaced by an index based on a large number of economic and political factors. • The Economist Intelligence Unit: This index is similar to the Euromoney Index. It rates the country risk by combined economic and political risk on a 100 point scale. The higher the number the worse the sovereign risk rating of a country.

The Institutional Investor Index: Normally published twice a year, this index is based on surveys of the loan officers of major multinational banks. • Web Resources To learn more about the Economist Intelligence Unit’s country ratings, visit: The Economist www.economist.com

Country Risk Evaluation • Internal Evaluation Models • Statistical models: • Country risk-scoring models based on primarily economic ratios. • The analyst uses past data on rescheduling and nonrescheduling countries to see which variables best discriminate between those countries that rescheduled their debt and those that did not. This helps the analyst identify a set of key variables that best explain rescheduling and a group of weights indicating the relative importance of these variables.

Statistical Models • The first step in this country risk analysis (CRA) is to pick a set of variables that may be important in explaining rescheduling probabilities.

Commonly used economic ratios: • Debt service ratio (DSR): (Interest + amortization on debt)/Exports • The Import ratio (IR): Total imports / Total FX reserves • Investment ratio (INVR): Real investment / GNP • Variance of export revenue (VAREX) • Domestic money supply growth (MG)

Problems with Statistical CRA Models • Measurements of key variables. • Data may be out date due to delays in collection of data and errors in measurement • Population groups • Finer distinction than reschedulers and nonreschedulers may be required. • Political risk factors • The model incorporates only economic variable. Political risk events such as strikes, corruption, elections and revolution are not included in the model. • Portfolio aspects • Unsystematic or country specific risks can be diversified away but systematic risk can not be diversified away with in a multisovereign loan portfolio.

Problems with Statistical CRA Models (continued) • Incentive aspects of rescheduling: What are the incentives or net benefits to an LDC seeking a rescheduling? What are the incentives or net benefits to an FI that grants a rescheduling? That is what determines the demand for rescheduling by LDCs and supply for rescheduling by FIs. Only when the benefits outweigh the costs for both parties does rescheduling occur.

Borrowers • Benefits: • By rescheduling its debt, the borrower lowers the present value of its future payments in hard currencies to outside lenders. This allows it to increase its consumption of foreign imports and/or increase the rate of its domestic investment. • Costs: • By rescheduling now, the borrower may close itself out of the market for loans in the future. As a result, even if the borrower encounters high-growth investment opportunities in the future, it may be difficult or impossible to finance them. • It may also affect borrower’s international trade negatively as it may become difficult to gain access to letters of credit.

Lenders (FIs) • Benefits: • Once a loan has been made, a rescheduling is much better than a borrower default. With a rescheduling, the FI lender may anticipate some present value loss of principal and interest on the loan; with an out right default , the FI stands to lose all of its principal and future interest repayments. • The FI can renegotiate fees and various other collateral. • There may be some tax benefits. • Costs: • Through rescheduling, loans become similar to long term bonds or even equity, and the FI often becomes locked into particular loan portfolio structure. • Those FIs with large amounts of rescheduled loans are subject to greater regulatory attention.

Stability: A final problem with simple statistical CRA models is that of stability. Certain key variables may have explianed rescheduling in the past does not mean that they will perform or predict well in the future. Over time , new variables and incentives affect rescheduling decisions and the relative weights on the key variables change.

Using Market Data to Measure Risk • Secondary market for LDC debt (Sellers and buyers): Since the mid-1980s a secondary market for trading LDC debt has developed among large commercial and investment banks in New York and London. These markets provide quoted prices for LDC loans and other debt instruments that an FI manager can use for CRA. Sellers: Large FIs willing to accept write-downs of loans on their balance sheets; small FIs wishing to disengage themselves from the LDC loan market; FIs willing to to swap one country’s LDC debt for another’s. Buyers: Wealthy investors, hedge funds, FIs, and corporations seeking to engage in debt-for-equity swaps or speculative investments; FIs seeking to rearrange their LDC balance sheets by reorienting their LDC debt concentrations.

Market segments • Brady Bonds: US dollar denominated bond issued by an emerging market, particularly those in Latin America, and collateralized by US Treasury Zero coupon bonds. Brady bonds arouse from an effort in the 1980s to reduce the debt held by less developed countries that were frequently defaulting on loans. The bonds are named for Treasury Secretary Nicholas Brady, who helped international monetary organizations institute the program of debt-reduction. Defaulted loans were converted into bonds with USA zero- coupon Treasury bonds as collateral. The Brady bonds are coupon bearing bonds with a variety of rate options with maturities of between 10 to 30 years.

Sovereign Bonds: Starting from 1996, some LDCs started to buy back or repurchase programs for their Brady bonds. Brady bonds are sovereign bonds. The difference between a Brady bond and a sovereign bond is that a Brady bond’s value partly reflects the value of the US Treasury bond collateral underlying the principal and or interest on the issue. By contrast , sovereign bonds are uncollateralized and their price reflects the credit risk rating of the country issuing the bonds. The benefits to the country is the saving from not having to pledge US Treasury bonds as collateral.

Performing LDC loans Performing loans are original or restructured outstanding sovereign loans on which the sovereign country is currently maintaining promised payments to lenders or debt holders. • Nonperforming LDC loans Nonperforming loans reflect the secondary market prices for the sovereign loans of countries where there are no interest or principal payments currently being made. These are normally traded at very deep discounts from 100 percent.

Key Variables Affecting LDC Loan Prices By combining LDC debt prices with key variables, FI managers can potentially predict future repayment problems. • Most significant variables affecting LDC loan sale prices • Debt service ratios • Import ratio • Accumulated debt arrears • Amount of loan loss provisions

Pertinent Websites BIS www.bis.org Heritage Foundation www.heritage.org Institutional Investor www.institutionalinvestor.com IMF www.imf.org The Economist www.economist.com Wall Street Journal www.wsj.com World Bank www.worldbank.org

*Mechanisms for Dealing with Sovereign Risk Exposure • Debt-equity swaps • Example: • Citibank sells $100 million Chilean loan to Merrill Lynch for $91 million. • Merrill Lynch (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.

*MYRAs • Aspects of MYRAs: • Fee charged by bank for restructuring • Interest rate charged • Grace period • Maturity of loan • Option features • Concessionality

*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.

BANK 501 - ASSET AND LIABILITY MANAGEMENT