Sovereign Risk: Assessing Country Debt Repayment Capabilities, Exams of Credit and Risk Management

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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 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

• (^) 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.

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.

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 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 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