Chapter 16

Sovereign Risk

K. R. Stanton 2006 The McGraw-Hill Companies, Inc., All

Introduction
In

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

Beginning

16-2

of 1980s:

Poland and Eastern bloc repayment problems.

Debt moratoria announced by Brazil and
Mexico.
Increased loan loss reserves
Citicorp set aside additional $3 billion in
reserves for example

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Introduction (continued)
Late

1980s and early 1990s:

Expanding investments in emerging markets.

Peso devaluation and subsequent restructuring

U.S. loan guarantees under Clinton Administration

More

16-3

recently:

Asian and Russian crises.

MYRAs

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Were Lessons Learnt?

16-4

U.S.

FIs limited exposure to in 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

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Credit Risk versus Sovereign Risk

16-5

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

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Sovereign Risk
Debt

16-6

repudiation

An outright cancellation of all a borrowers

current and future foreign debt and equity
obligations.
Recent steps to forgive debts of most severe
cases conditional on reforms targeted to
improve poverty problems

Rescheduling

Changing the contractual terms of a loan, such

as its maturity and interest payments.
Most common form of sovereign risk. through
moratorium

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Debt Rescheduling
More

16-7

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
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Country Risk Evaluation (pg442)

Outside

evaluation models:

The Euromoney Index

The Economist Intelligence Unit ratings

16-8

Highest risk in countries such as Venezuela, Nigeria,

Pakistan, Indonesia.

Institutional Investor Index

2003 placed Switzerland at least chance of default

and Somalia as highest.

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Country Risk Evaluation

Internal

Evaluation Models see from pg 446

Statistical models:

Country risk-scoring models based on primarily

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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16-10

Problems with Statistical CRA Models

16-11

Measurements

of key variables.
Population groups

Finer distinction than reschedulers and

nonreschedulers may be required.

Political

Strikes, corruption, elections, revolution.

Portfolio

risk factors
aspects

Many large banks with LDC exposures diversify

across countries
Diversification of risks not necessarily captured
in CRA models

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Problems with Statistical CRA Models

(continued)
Incentive

Borrowers and Lenders:

aspects of rescheduling: pg453

Benefits
Costs

Stability

Model likely to require frequent updating.

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16-12

Using Market Data to Measure Risk

Secondary

Sellers and buyers

Market

market for LDC debt:

segments

Brady Bonds
Sovereign Bonds
Performing LDC loans
Nonperforming LDC loans

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16-13

16-14

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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