CHAPTER 14
Sovereign Risk
Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved
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
Ch 14-2
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
Ch 14-3
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)
Ch 14-4
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
Ch 14-5
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
Ch 14-6
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
Ch 14-7
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
Ch 14-8
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
Ch 14-9
Web Resources
 To learn more about the Economist
Intelligence Unit’s country ratings, visit:
The Economist www.economist.com
Ch 14-10
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
Ch 14-11
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,…)
Ch 14-12
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
Ch 14-13
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
Ch 14-14
Using Market Data to Measure Risk
 Secondary market for LDC debt
– Sellers and buyers
 Market segments
– Sovereign bonds
– Performing LDC loans
– Nonperforming LDC loans
Ch 14-15
Pertinent Websites
Bank for International
Settlements
Heritage Foundation
Institutional
Investor
International Monetary
Fund
The Economist
Transparency
International
World Bank
www.bis.org
www.heritage.org
www.institutionalinvestor.com
www.imf.org
www.economist.com
www.transparency.org
www.worldbank.org
Ch 14-16
*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
Ch 14-17
*MYRAs
 Aspects of MYRAs:
–
–
–
–
–
Fee charged by bank for restructuring
Interest rate charged
Grace period
Maturity of loan
Option features
 Concessionality (net cost)
Ch 14-18
*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
Ch 14-19