CHAPTER 14

Sovereign Risk

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 Introduction
 Sovereign risk
– Risk that repayments from foreign
borrowers may be interrupted because
of interference from foreign
governments
 In the1970s:
– Expansion of loans to Eastern European,
Latin America, and other LDCs

Ch 14-2
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 Introduction (Continued)
 Beginning of the 1980s:
– Debt moratoria announced by Brazil and
Mexico
 Debt moratoria: delay in repaying interest/principal
on debt
– Increased loan loss reserves
– Citicorp set aside an additional $3 billion in
reserves

 Early 2000s
– Concerns over Argentina and Turkey
Ch 14-3
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 Introduction (Concluded)
 Late 2000s, economies plummeted
– Developed countries faced some of the
worst declines in GDP ever experienced
– IMF pledged to inject $250 billion
 Greece debt crisis, 2009-2012
– Crisis in Greece spread to Portugal,
Spain, and Italy
 Multiyear restructuring agreements
(MYRAs)
Ch 14-4
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 Credit Risk vs. Sovereign
Risk
 Governments can impose restrictions
on debt repayments to outside
creditors (i.e., sovereign/country risk)
– 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
risk and sovereign risk
Ch 14-5
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 Debt Repudiation vs. Debt
Rescheduling
 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, involves
declaration of moratorium on current/future debt
obligations
– South Korea, Argentina, and Greece
Ch 14-6
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 Country Risk Evaluation
 Outside evaluation models:

– Euromoney Country Risk (ECR) index

– The Institutional Investor’s Country

– OECD Country Risk Classifications

Ch 14-7
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 Country Risk Evaluation
 Euromoney Country Risk (ECR) index
– An online community of economic and political
experts

– Provide real-time scores in 15 categories that

– Evaluates the investment risk of a country,

Ch 14-8
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 Country Risk Evaluation
 The Institutional Investor’s Country
Credit Ratings

–Normally published twice a year

–Rating is based on surveys of loan

Ch 14-9
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 Country Risk Evaluation
 OECD Country Risk Classifications
– Under Basel III capital regulations country risk is
measured using OECD Country Risk Classifications
(CRC)
– Two basic components:
 The quantitative country risk assessment model (CRAM)

 The qualitative assessment of the CRAM results by

Ch 14-10
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 Country Risk Evaluation
 Internal Evaluation Models
– Statistical models
 Country risk-scoring models based primarily
on economic ratios
 The selected variables are tested for
predictive power in separating rescheduling
countries from non-rescheduling countries
using past data

Ch 14-11
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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 = σ2ER
– Domestic money supply growth = ΔM/M
 Discriminant function:
p = f(DSR, IR, INVR, VAREX, MG,…)
Ch 14-12
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 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
– Index of Economic Freedom or
Corruption Perceptions Index
Ch 14-13
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 Problems with Statistical CRA
Models Continued
 Portfolio aspects
– Many large FIs with sovereign risk exposures
diversify across countries
– Diversification of risks not necessarily captured
in CRA models
 Incentive aspects
– Borrowers and Lenders
 Costs and benefits
 Stability
– Model likely to require continuous updating
Ch 14-14
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 Mechanisms for Dealing with
Sovereign Risk Exposure
 Alternative mechanisms to handle
problem sovereign credits once they
have arisen
– Debt-for-equity swaps
– Multiyear restricting of loans (MYRAs)
– Sale of LDC loans on the secondary
market
– Bond-for-loan swaps

Ch 14-15
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 Debt-for-Equity Swaps

 Debt-for-equity swaps
– Examples:
 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 14-16
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 MYRAs
 Aspects of MYRAs:
– Fee charged by bank for restructuring
– Interest rate charged on new loan is
generally lower than rate on original loan
– Grace period may apply
– Maturity of loan is lengthened
– Option and guarantee features
 Concessions for FI are larger the lower
the PV of restructured loan relative to
original
Ch 14-17
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 Other Mechanisms
 Loan sales
– Removal of loans from balance sheet and
signal that remainder of balance sheet is
sufficiently strong
– Major cost is the loss itself
 Bond-for-loan swaps
– Transform loan into highly marketable and
liquid instrument – a bond!
– Usually possess senior status to remaining
loans
Ch 14-18
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