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Sovereign Risk Chapter 16

Sovereign Risk Chapter 16. Financial Institutions Management, 3/e By Anthony Saunders. Introduction. In 1970s: Expansion of loans to Eastern bloc, Latin America and other LDCs. Beginning of 1980s: Poland and Eastern bloc repayment problems. Debt moratoria announced by Brazil and Mexico.

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Sovereign Risk Chapter 16

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  1. Sovereign RiskChapter 16 Financial Institutions Management, 3/e By Anthony Saunders

  2. Introduction • In 1970s: • Expansion of loans to Eastern bloc, Latin America and other LDCs. • Beginning of 1980s: • Poland and Eastern bloc repayment problems. • Debt moratoria announced by Brazil and Mexico.

  3. Introduction (continued) • Late 1980s and early 1990s: • Expanding investments in emerging markets. • Peso devaluation. • More recently: • Asian crises. • MYRAs • Brady Bonds.

  4. 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.

  5. 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.

  6. Country Risk Evaluation • Outside evaluation models: • The Euromoney Index • Institutional Investor Index • Internal Evaluation Models • Statistical models: country risk-scoring models based on economic ratios.

  7. 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

  8. Problems with Statistical CRA Models • Measurements of key variables. • Population groups • Finer distinction than reschedulers and nonreschedulers may be required. • Political risk factors • Strikes, corruption, elections, revolution. • Portfolio aspects

  9. Problems with Statistical CRA Models (continued) • Incentive aspects of rescheduling: • Borrowers and Lenders: • Benefits • Costs • Stability • Model likely to require frequent updating.

  10. Using Market Data to Measure Risk • Secondary market for LDC debt: • Sellers and buyers • Market segments • Brady Bonds • Sovereign Bonds • Performing LDC loans • Nonperforming LDC loans

  11. Key Variables Affecting LDC Loan Prices • Most significant variables: • Debt service ratios • Import ratio • Accumulated debt arrears • Amount of loan loss provisions

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

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

  14. *Other Mechanisms • Loan sales • Debt for debt swaps (Brady bonds) • Transform LDC loan into marketable liquid instrument. • Usually senior to remaining loans of that country.

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