Country Risk Analysis

A Handbook

Ronald L. Solberg

• Publisher: Routledge
• Year: 2002
• ISBN:
  9781134898411
• Edition: 1
• Topic: Betriebswirtschaft
• Subtopic: Business allgemein

Country-Risk Analysis is a comprehensive, practical guide to the management of international risk and cross-border lending. The last fifteen years of international commercial bank lending have witnessed a classical boom-and-bust cycle. Yet it is only recently that a formalized approach to country risk assessment has been implemented in the major international banks.

Ron Solberg's volume provides a state-of-the-art review of the country risk techniques that have evolved in the context of dramatic changes in developing countries' debt service capacity and in international lending itself. It deals comprehensively with sovereign credit decision making, portfolio management, lending behaviour and financial innovations.

1 Managing the risks of international lending

Ronald L.Solberg

INTRODUCTION

This chapter presents an overview of country-risk analysis and its role in decisions regarding a bank’s portfolio of international assets. It reviews the historical development of country-risk analysis, outlines the range of potential loan outcomes and their respective costs, defines the scope and objectives of sovereign risk assessment and presents other risks in international lending. It concludes with recommendations for the management of international risk.

A BRIEF HISTORY OF COUNTRY RISK ANALYSIS

The practice of country-risk analysis dates back to the origins of crossborder lending. Numerous early examples of ‘sovereign’ defaults span a period beginning with the borrowing of the city-states in the eastern Mediterranean in the fourth century BC.¹ England, France, Spain and Portugal each defaulted at least once to various external creditors during the period from the fourteenth through the sixteenth centuries, as did many of the colonies in the Americas in the nineteenth century.

Creditors suffered losses due to insufficient information on the debtor’s financial position or an inaccurate assessment of the borrower’s ability or willingness to repay. Often the country’s inability to repay resulted from a combination of country-specific factors, such as fiscal mismanagement, poor harvests or unproductive expenditures relating to war. At other times, adverse global conditions, including weak growth in important export markets, declining terms of trade or a speculative lending cycle were the contributing cause. A country’s unwillingness to repay could be interrelated with these economic events resulting in contractual non-compliance. Domestic or regional political instability, resulting in either a regime change or impediments to appropriate economic policy, were other hazards of sovereign willingness to pay.

During these earlier centuries, the analysis of risks relating to foreign lending was more an art than a science and certainly in some measure continues to be so today. Lending criteria were determined by individual financial houses and merchant bankers as ersatz country-risk analysts. This practice continued until the late twentieth century when another wave of international lending after the oil shock of the early 1970s prompted the creation of new international-risk departments within banks and multinational corporations.

Compared to the heuristic approach to country-risk analysis used by the early twentieth-century bankers and their predecessors, more analytical methods were developed beginning in the 1970s.² The computer revolution resulted in the greater use of quantitative methods, allowing a more sophisticated approach. Despite the increased availability of such quantitative techniques, however, most analysis within commercial banks continued to emphasize a more qualitative, albeit analytical, approach.³

Detailed individual country reports, using an established data-reporting format which presented historical and prospective trends in the supply and demand of the national-income accounts, the balance of payments, external debt and international reserve stocks, were commonplace. Some banks, devoting more resources to sovereign analysis, complemented this country-specific approach with cross-sectional or portfolio analysis. Weighted and unweighted checklists and various multivariate statistical techniques were used to create a composite country ‘score’ or risk rating which could be used to rank countries according to their creditworthiness at any point in time. These two techniques used together provided both a cardinal and ordinal measure of country risk, expressed either as a timeseries or at a single point in time.

In the late 1970s, the civil war in Lebanon, revolutions in Iran and Nicaragua and the invasion of Afghanistan highlighted the need to emphasize political as well as economic factors in a country-risk assessment. Thus, in the early 1980s, the political-risk analyst joined the economists on the country-risk team in a growing number of international companies.⁴ The invasion of Kuwait underlines the ongoing importance of political-risk analysis.

While the analysis of country risk improved during the 1970s and early 1980s, it continued to suffer from some critical problems. Improvements in methodology were slow to be applied in many institutions which lent or invested money in developing countries. Comprehensive data, especially on the external assets and liabilities of debtor countries, was also incomplete.

Perhaps the most acute problem was that many lending decisions during the 1970s were made without full consideration of country-risk issues. Much of the cross-border lending during the 1970s was driven by the desire to ‘book international assets’. A dearth of credit demand in many developed economies during the concerted 1974–5 recession, meant that many banks looked abroad for the first time to enhance balance-sheet growth and profitability. The loan spreads and related fees on balance-of-payments loans to oil-importing developing countries offered banks the opportunity to enhance profitability. Many times, an aggressive marketing strategy sustained by excess bank liquidity (resulting from the wealth transfer from oil-importing nations to OPEC) overrode country-risk considerations.

Once the unsustainability of the 1970s ‘recycling’ process became apparent in the early 1980s, the pressures which non-performing assets placed on bank profitability often resulted in the sharp reduction in voluntary commercial-bank long-term lending to developing countries, followed by the reduction or elimination of country-risk departments. Nevertheless, in many institutions, country-risk practitioners continued to analyze the hazards of selective new cross-border lending, to judge the appropriateness of new money requirements associated with sovereign debt reschedulings and to recommend portfolio adjustments using debt-debt, debt-equity swaps and other financial-product innovations.

Thus, the analyst’s role in decision-making has increased during the 1980s and into the 1990s, despite the fact that voluntary bank lending to many developing countries remains limited. Driven by continued globalization of business and the closer integration of countries through trade and investment, cross-border lending can be expected to rebound again. As debt-troubled countries selectively emerge from past difficulties, the role of country-risk analysis will further grow in importance. Lessons from the past two decades will help guide more effective lending, investment decisions and cross-border asset management into the twenty-first century.

UNCERTAINTIES, OUTCOMES AND COSTS

When a creditor extends a loan to a debtor, the range of possible outcomes is known, although their respective a priori probabilities of occurrence are not known. Because these probabilities are unknown, uncertainty exists surrounding the act of lending money. Thus, the decision to lend is subject to the risk of an unprofitable outcome. The objective of the country-risk analyst is to assess both the risks inherent in the proposed loan or asset exposure and their effect on the overall risk of the existing portfolio of cross-border assets, were this asset to be added. Along with data on the asset’s expected return and its covariance with portfolio return, this assessment ‘risk-adjusts’ the considered asset’s return, given the range of possible outcomes. This analysis will determine whether the international loan is an acceptable addition to that portfolio.

The array of outcomes for a bank’s international loan is either full contractual payment, voluntary refinancing, involuntary refinancing (or rescheduling), default or repudiation.⁵

Rational creditors disburse loan funds on the presumption that full contractual payment of interest, fees and the original principal will be made according to the legal terms and covenants of the loan agreement. If we assume that the marginal expected rate of return on the loan, including its fees and spread (i.e. the difference between the loan’s rate of interest and a risk-free rate of return), reflects the movement of the asset’s return relative to the average market return (i.e. ‘beta’), then the creditors have entered into an acceptable contract. Market risk has been accounted for in the loan spread.

Due to unanticipated events, a debtor may face a temporal mismatch of its asset and liability flows. This may force the debtor to fall behind in scheduled debt-service payments, accumulate arrears and request a loan renegotiation with the lenders. If the lenders, in reassessing the debtor’s ultimate repayment prospects, conclude that the debtor is solvent but temporarily illiquid, and if the creditors can reset the terms and conditions of the additional loan without coercion on the part of the debtor, then the voluntary refinancing represents little, if any, loss.

When a new loan is disbursed or an existing loan is rescheduled with the implicit or explicit threat of default and/or if events make it impossible to reset the terms and conditions of the contract, then the loan represents an involuntary refinancing or rescheduling and signals some measure of loss. The decline in the loan’s present value results from the risk premium (i.e. loan spread) no longer being sufficient to account for the higher level of perceived risk and the elongation of principal repayments. There is also an immediate opportunity cost to the lenders because these funds cannot be lent voluntarily to another, more promising borrower. Moreover, the increased staff time required to renegotiate and monitor the impaired asset represents an additional cost to the creditors.

A debt refinancing or rescheduling may not improve the ultimate repayment prospects of the loan when the debtor’s ‘illiquidity’ (i.e. a shortfall of foreign-exchange receipts, international reserves and external credit access relative to foreign-exchange expenditure, liabilities and obligations) reflects an even more serious underlying problem. When the debtor’s gross liabilities exceed its gross assets, the debtor is insolvent and defaults on the loan.⁶ The cost to the creditors includes both the loss of anticipated interest income and the partial or complete loss of principal.

Debtor’s de jure repudiation of the financial obligation can occur whether or not the debtor is solvent or liquid. The cost to the creditors is similar to that of default, depending upon whether repudiation occurs with or without partial compensation. Compared to that in domestic lending, legal redress and the enforceability of loan covenants are less effective in cross-border lending.

COUNTRY-RISK ANALYSIS: SCOPE AND OBJECTIVES

The portfolio manager of international assets in a bank or multinational company attempts to minimize risk by diversification given a targeted average rate of return. The ex post performance (i.e. outcome) of an asset selection (e.g. international loan) will determine the profitability of the investment decision. This decision requires information on the asset’s expected return, its volatility or risk, and the asset’s covariance of risk relative to the investor’s current asset mix to build an efficient, low-risk, portfolio.

The actual performance of a cross-border sovereign asset will be determined by both systematic risk and non-systematic risk. The latter component is, in turn, comprised of both common factors and country-specific risk.

Systematic risk refers to the asset’s vulnerability to market risk. In the strict capital-asset-pricing model (CAPM) interpretation, it is the relationship in which the asset’s return moves with that of the market’s average return (‘beta’), where the market here means the weighted average returns on all international bank assets. Systematic risk is influenced by the periodicity in the business cycle and fluctuations in the financial markets, including both supply, demand and price shocks. Fluctuations in the value of the US dollar and interest rates are examples of price disturbances, while economic recession and drought represent demand and supply shocks respectively. The transmission of all these environmental factors can occur across country, regional, sectoral or industrial boundaries, thus contributing to market risk and affecting market return. According to CAPM, since market or systematic risk is undiversifiable, it is the only risk factor which is reflected in market spreads.

To the extent that variables contributing to market risk are imperfectly correlated across countries, causing ‘domino effects’, they represent common factors which explain part of an asset’s specific or non-systematic risk. Because an individual asset’s performance is imperfectly correlated with important loan attributes, common factors can be identified which explain a portion of an asset’s specific risk. This covariance of asset returns is determined, in part, by the pervasive but unequal impact which environmental factors can have on financial performance. For example, an unanticipated sharp rise in oil prices or an economic recession can adversely affect the credit quality of many seemingly unrelated loans. Common factors, and their impact on loan groupings, allow the analyst to identify risk concentrations within the portfolio and to address, with an approximate solution, the problem of risk covariance.

Country-specific risk arises from factors unique to the debtor country. The sovereign debtor’s political stability, natural-resource endowment, structural (i.e. supply-side) and development strategies, open-economy demand-management policies and external asset-liability management are important areas of focus to guage this risk.

A bank’s asset portfolio is subject to non-systematic risk (i.e. common and country-specific factors) when its asset composition differs from that of the market portfolio. It is diversifiable since a sufficiently large portfolio can replicate the composition of the market portfolio. In practice, probably all bank portfolios contain specific risk owing to their divergence from the market portfolio. Underweighting a particular asset in a bank’s portfolio can be justified when the risk or expected return of a particular asset is considered unacceptable.

There are several particular problems which characterize international lending. Severe data limitations and potentially restrictive theoretical issues have precluded the application, to date, of CAPM and modern portfolio theory (MPT) to international bank lending. Market data on the ex post performance of loan contracts are unavailable. Hence, constructing the distribution of returns for bank loans, based on historical performance, is impossible. Moreover, any borrower, whether domestic or cross-border, holds privileged information on its ability and willingness to honor the loan contract. While a country’s bankruptcy proceedings and legal codes improve the accountability of the local borrower in honoring the loan contract, this enforceability mechanism is less effective for cross-border debtors.

Borrowers may withhold their true intentions and abilities from the creditors, resulting in asymmetric information. Since the borrower/ lender relationship has game-theoretic aspects, the ex post performance of debtors cannot be guaranteed ex ante, suggesting principal/agent issues. Furthermore, contract enforceability is weakened in international lending, since collateral across borders cannot provide ultimate security owing to diminished legal redress. Inability to positively identify the borrower’s willingness and ability to repay when the loan contract is under consideration means that the bank is faced with the risk of adverse selection. Moral hazard arises because the bank does not know, and cannot ensure, the debtor’s ex post financial performance.

The bank’s elaborate methods to assess counterparty integrity and country creditworthiness are meant to address the risk of adverse selection. Similarly, contract structure and financial-market penalties are meant to promote ‘good faith’ behavior on the part of the debtor, once the lender-borrower relationship has been initiated. However, these problems preclude bank-loan performance from being described by well-defined probability distributions, a key assumption for building an efficient international portfolio.

While these conceptual difficulties limit the use of these techniques, they do not mean that sovereign borrowers are inherently unworthy of cross-border credit. The record of bank cross-border lending to sovereign borrowers suggests that those elem...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Figures
• Tables
• Preface
• Contributors
• Introduction
• 1 Managing the risks of international lending
• 2 The analytics of country reports and checklists
• 3 Current-account forecasting
• 4 External financing and debt analysis
• 5 Empirical models of debt rescheduling with sovereign immunity
• 6 Political-risk analysis for international banks and multinational enterprises
• 7 Systematic risk in international bank lending: Theory and estimation
• 8 The strategy of sovereign-debt renegotiation
• 9 Loan valuation and the secondary market for developing-country debt
• 10 Managing non-performing sovereign assets
• 11 Foreign direct investment: The upstream petroleum industry
• 12 US regulatory supervision of commercial banks with international operations
• 13 The decision-making process: A changing role for country-risk analysis
• 14 Efficient allocation of an international loan portfolio