Cross-Border Exposures and Country Risk: Assessment and Monitoring

Cross-border exposures and country risk

Cross-border exposures and country risk Assessment and monitoring Thomas E Krayenbuehl

WO O DH EA D PU B LI SH I NG LI M ITE D Cambridge England

Published by Woodhead Publishing Limited, Abington Hall, Abington Cambridge CB1 6AH, England www.woodhead-publishing.com First published in 1985 by Woodhead-Faulkner as Country risk. This edition published 2001, Woodhead Publishing Ltd # 2001, Woodhead Publishing Ltd The author has asserted his moral rights. This book contains information obtained from authentic and highly regarded sources. Reprinted material is quoted with permission, and sources are indicated. Reasonable efforts have been made to publish reliable data and information, but the author and the publisher cannot assume responsibility for the validity of all materials. Neither the author nor the publisher, nor anyone else associated with this publication, shall be liable for any loss, damage or liability directly or indirectly caused or alleged to be caused by this book. Neither this book nor any part may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, microfilming and recording, or by any information storage or retrieval system, without permission in writing from the publisher. The consent of Woodhead Publishing Limited does not extend to copying for general distribution, for promotion, for creating new works, or for resale. Specific permission must be obtained in writing from Woodhead Publishing Limited for such copying. Trademark notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation, without intent to infringe. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library. ISBN 1 85573 512 1 Cover design by The ColourStudio Typeset by BookEns Ltd, Royston, Herts Printed by Victoire Press Ltd, Cambridge, England

To my wife

Contents Preface 1

2

3

ix

Overview

1

Introduction

1

The debt crisis of the 1980s

1

The Brady Plan

4

The Tequila crisis

5

The transition countries

7

The Asian crisis

8

The latest problems

12

Heavily indebted poor countries

13

Recent developments in cross-border financing

14

Conclusions

22

References

23

The need for capital

24

Introduction

24

The borrowers

25

Gross domestic investment

27

Capital needs

28

Domestic funds

30

Cross-border funds

32

Conclusions

39

References

40

Risks in cross-border exposures and their assessment

42

Introduction

42

Transfer risk

43

Political risk

74

Relating transfer and political risk

90

vii

CONTENTS

4

5

6

References

92

Monitoring of cross-border exposures and hedging of country risk

94

Introduction

94

The establishment of country limits

95

Monitoring cross-border exposures

107

The change of country risk quality and its consequences

111

Hedging of country risk

114

The case of contagion

118

Outsourcing risk assessment

119

The rating agencies

125

Conclusions

130

References

131

Responsibilities

132

Introduction

132

The International Monetary Fund (IMF)

133

The World Bank Group

149

The regional multilateral financial institutions

157

The industrialized countries

158

The developing countries

159

The regulators

163

The rating agencies

165

Conclusions

166

References

167

Conclusions

170

Annex 1

Glossary

177

Annex 2

Articles of Agreement of the International Monetary Fund, Article IV

179

Annex 3

Selected sovereign ratings for foreign currencies of developing countries

182

Annex 4.1

Country risk rating by the International Country Risk Guide

184

Annex 4.2

Country risk rating by the Institutional Investor

188

Annex 4.3

Country risk rating by Euromoney

192

Annex 5

Alternative exchange rate regimes

198

Index

viii

201

Preface Several times in recent years the international financial system has come under strain. It has therefore become an important topic of discussion not only within the international financial community, but also in government circles, the Bretton Woods Institutions in Washington and various `think tanks'. Many questions have been asked on how the now familiar developments came about and how efficient and meaningful have been the reactions of the different participants and players. Analysis has shown that most crises had their origin in the risks that are built into cross-border exposures. While, fortunately, no great crash occurred, each crisis brought significant losses in asset values which had to be registered by investors and lenders. Furthermore, borrowers were faced each time with substantially increased borrowing costs and a drying out of the liquidity in cross-border financing. It must also be acknowledged that the international safety network established by the International Monetary Fund (IMF), the major central banks and the Bank for International Settlement had to be activated more than once in recent years. Working together with the governments of the major nations and those of the debtor nations as well as with the market participants, these institutions put into operation a very effective crisis management system. The international financial system would not have been able to survive on its own. It is also dangerously naõÈ ve to think that in the future such situations will always be managed in a fairly smooth way or will no longer happen as the system has matured enough to overcome such crises. The latter part of the year 2000 again showed how fast situations can deteriorate and how a crisis can develop to such an extent that the support of the international safety net is needed in order to avert the worst. The generally positive economic situation in most of the major economic areas in 1999 and 2000 had helped many developing countries to hide some of their basic economic problems. Nevertheless, in the autumn of the year 2000, Argentina became more and more a topic of discussion in the international financial community as the De la Rua administration seemed to be incapable of overcoming its domestic economic and political difficulties. This led again to an increasing awareness of the risks involved in cross-border exposures. Standard & Poor's conclusion was to downgrade Argentina. At the time of writing, Argentina is negotiating an IMF led support package to assure its international funding needs for the year 2001. It is expecting a rescue package

ix

PREFACE

of up to US$25 billion. Such financial help will obviously be accompanied by a tough IMF programme, which means drastic internal economic adjustments with the accompanying political dynamite. Another Latin American country that is also going through major difficulties is Peru, which was also downgraded by Standard & Poor's in November 2000. It is worthwhile in this context at least to note that the new president of Peru, Mr Paniagua, mused about `adjusting' debt payments to Peru's `economic and social capacity'. Later, the government officially had to reassure the international financial community that it will honour its debt service obligations. Another country that had ± almost overnight ± to be rescued in early December 2000 was Turkey. Here it was the financial system that came under pressure as foreign investors left the country having become nervous because of the Argentinian difficulties. The stock exchange collapsed on 29 November, the so-called Black Wednesday. This led to a liquidity crisis in the banking system as several banks had underwritten very speculative assets to survive in the dangerous environment of volatile markets and high inflation. The Turkish central bank had to support the domestic financial system with repo transactions that led to overnight interest rates of up to 400%. Furthermore, it had to defend the lira with huge amounts to keep its depreciation within the planned 1% per month. It is estimated that over US$6 billion left the country within a fortnight. In record time the IMF arranged for a cash infusion of US$7.5 billion to avert the crisis spreading. In this case it helped that Turkey had already announced a substantial economic reform programme. The question of what more can be done in the future to avoid such crises was asked most vigorously after the Asian crisis and is still very topical today. It must be asked by all participants in active crossborder transactions, be they investors, lenders or borrowers. This book intends to provide some answers to this question and to provide a better understanding of the problem and what can be undertaken, especially by the private sector, to better manage cross-border exposures. Borrowers of cross-border funds came to realize that under certain circumstances that are still difficult to quantify, their creditworthiness had suddenly gone. Today it is clear that there is a relationship between the intensity of the country risk of a specific country and the creditworthiness of the borrowers of that country. Investors have seen the value of their cross-border assets change far more than they were accustomed to in domestic markets. The reasons for this are the additional influence and the perception of country risk. Furthermore, in the area of portfolio investments there is the phenomenon of contagion between seemingly unrelated markets. This is also dealt with in the book. Lenders have at last learned in the Latin American debt crisis of the early 1980s that country risk is a significant factor that influences the quality of their cross-border exposures.

x

PREFACE

The aim of this book is firstly to offer guidance to international investors and lending officers on how to assess and monitor country risk. It may also help students of international finance to become acquainted with the subject. As the reader progresses, he or she will realize how complex the notion of country risk is. There is an almost endless number of factors that constitute and influence a specific country risk. From them must be selected the prime movers for change in the quality and intensity of country risk. The geopolitical situation has evolved over the last ten years in such a way that nearly all countries today have similar economic structures and political systems. We obviously acknowledge the still substantial differences in the development of these structures. However, this allows for the risk in cross-border exposures to be analysed along similar indicators. The large number of factors and indicators, and their mutual interdependence, as well as the relatively small number of countries of similar standing have so far prevented the construction of a convincing computer model to assess the behaviour of country risk which would produce better results than simpler assessment methods. Improvements in the quality and the timeliness of data availability allows for a more efficient assessment of country risk than before. Still, those data need interpretation. This requires not only a talent for logical deduction but also flair and intuition. The last two cannot be learned from a book. They can be learned only either by living on the spot or as a result of frequent visits to the country in question. Such visits provide experiences that go far beyond those of a sales manager who calls on a client in a foreign country. However, even then, slightly biased information and perspectives are still difficult to avoid. The assessment of country risk is a fascinating and demanding task and has to be standardized when evaluating risks in cross-border exposures. It will promote the realism necessary for a good relationship between risk and reward in cross-border exposures. Assessment of country risk will make it possible to determine the quality of a country's creditworthiness but will not indicate the magnitude of advisable cross-border exposures. This will have to be done through monitoring, which has to be based on a conscious decision by the investor and/or lender of his or her risk appetite and risk absorption capabilities. Once this decision is made, the monitoring itself will be to a large extent an administrative task. Indications are also given in this book about how such monitoring might be organized and what kind of hedging techniques exist today to hedge against country risk. Good assessment as well as correct monitoring and meaningful hedging of country risk are the twin activities that make cross-border lending and investment successful. Besides looking at the specifics of cross-border exposures and country risk management, it is useful

xi

PREFACE

to look at some related themes. One is the need for capital in the developing world and the other is the responsibilities of the major players financing the developing countries. Most of the population of our planet lives in the developing countries. Our globalized information and media industry has brought the American dream of a better life into nearly every hut in the world together with the many frustrations of being so far away from this dream. To minimize the social conflict potential arising from this frustration, which is evident not only in the populations of many developing countries, and also to reduce the ever growing gulf between the rich and poor countries, sustainable economic development in the developing world is the only answer. The amount of capital needed to bring about this economic development is enormous as is demonstrated in this book. It might even be too big to be realistically mobilized. It therefore seems important also to show the responsibilities of the major players that have to accompany such a sustainable development and help to fulfil the need for capital. While the multilateral financial institutions and official government aid from the developed world can act as a catalyst in this process, it is the world trade regime, the developing countries and the private sector who are really challenged by this process. It is hoped that this book can not only help the private sector to better evaluate the risks in crossborder exposures, but also incline it to be more open to engaging in cross-border exposures as it will have a better understanding of the risks and rewards associated with those exposures. As private capital will always flow where it finds the best risk±reward relationship, it is up to each developing country to create a political and economic environment that is conducive to attracting cross-border funds in the worldwide scramble for capital. The world trade regime under the leadership of the richest nations should try to become more equitable for the developing countries and accept division of labour for agricultural products as well as for industrial products. The problem of cross-border exposures and country risk in the 1980s under the impression of the Latin American debt crisis has been mentioned. Since then much has been learned by all players in the international financial markets in respect of cross-border exposures and country risk. Dramatic changes in the geopolitical picture in the 1990s also had an impact on the issues discussed in this book. The initial overview outlines the current situation and later chapters allow the reader to review the theme from many different aspects and will hopefully lead to a better understanding of the risk, and also the opportunities, associated with cross-border exposures. Thomas E Krayenbuehl

xii

1 Overview INTRODUCTION The Latin American debt crisis of the early 1980s seems to be a phenomenon of the past. Since the early 1990s cross-border financing and investments have accelerated dramatically between the industrialized world and the developing countries. But not only have we seen an explosion in absolute numbers but also a substantial growth in the number of countries and participants involved. The disintegration of the former Soviet empire in the late 1980s created many new countries. The development of the international financial markets in the 1990s added many more participants to cross-border financing and investments than were present in the 1970s and the early 1980s. In late 1994 and early 1995 Mexico's troubles at the end of the presidential sextenium of President Salinas de Gortari brought about the first international financial crisis of the 1990s. And then in 1997 the Asian crisis broke out, suddenly putting some question marks over the until then seemingly impeccable performance of the South East Asian economies, the so-called Tigers. Furthermore in 1998 Russia sent shock waves into the emerging markets through its default on its domestic rouble-denominated debt of about US$40 billion. Finally, in 1999 Brazil was once again the centre of negative speculation and after a long resistance had to devalue its currency with substantial hardship to its industry and service sectors which had borrowed heavily in foreign currency. It is therefore important to review and analyse these developments in more detail before entering the core of this book, the risks in cross-border financing.

THE DEBT CRISIS OF THE 1980s The Latin American debt crisis, which started with the stoppage of cross-border payments by the Mexican government and Mexican borrowers in August 1982, also marked the end of the heyday of syndicated loans to Latin America. With the exception of Colombia, all major countries in Latin America followed in the greatest debt rescheduling ever undertaken as funds dried up and refinancing was no longer possible. Exposures were mainly to international banks, multilateral financial institutions or governments. While multilateral financial institutions were in a privileged situation,

1

CROSS-BORDER EXPOSURES AND COUNTRY RISK

banks and governments had to start a painful rescheduling exercise, which usually covered first the debt due within the following year. This was later to be changed and so-called MYRA, multi-year rescheduling agreements, were introduced. This dramatic deterioration of a very substantial part of the assets of many major US banks made the international financial community tremble. Latin American countries in general, however, continued to honour their short term trade-related debt as well as their very small exposures to the international capital markets. In addition all countries in payment difficulties renegotiated their debts with the Paris Club, i.e. their obligations towards the Export Credit Agencies (ECAs), the export credit agencies of the Organization for Economic Cooperation and Development (OECD) countries. Besides the Latin American countries, which together had accumulated by far the largest cross-border debt, a few countries in Eastern Europe, such as Poland, Romania and the former Yugoslavia, as well as a number of countries in Africa, Asia and the Far East, the most important being Algeria, Morocco, the Islamic Republic of Iran, Nigeria, the Philippines and later South Africa, also had to renegotiate and reschedule their debt. The group of creditors in these debt negotiations, mostly banks and governments of the industrialized world, was limited in number and fairly homogeneous. Also the debtors represented a fairly small number of counterparties. The developing countries themselves were mostly the debtors, because they had either contracted the debt in the first place or had issued guarantees at the time to state agencies or government-controlled companies. It has to be remembered that in the late 1970s and early 1980s governments in many developing countries still had control over a vast part of the economy. In addition to the debt contracted directly or through guarantees, governments had to take substantial foreign currency debt over from the private sector when the crisis broke out. This was because it was the governments who, due to the lack of freely convertible currencies in their reserves, had pushed the private sector into a situation where it could no longer honour its foreign currency debt. However, it has to be added that some private sector companies also suffered substantially in their creditworthiness due to the upheaval on the exterior front of their countries and had therefore to enter into separate bilateral debt restructuring agreements with their creditors. While for many years there was hope that the developing countries and especially the Latin American countries would if given enough time eventually repay their debt in full, more and more economists and politicians started to doubt that such a `happy end' to the debt crisis of the early 1980s would be possible. Furthermore many of the stronger banks started to sell and/or trade their Latin American loans at a substantial discount acknowledging thereby that the quality of these loans was impaired. Another factor was the failure of the developing countries to address the debt crisis in the early 1980s through specific plans. In this context we might mention the AUSTRAL Plan in Argentina, the

2

OVERVIEW

CRUZADO Plan in Brazil and the APRA Plan in Peru.1 Therefore the economies of nearly all the countries that had rescheduled their debt continued to have a lacklustre performance and minimal foreign investment was forthcoming. Ways were sought to overcome this lack of investment and to alleviate the debt burden through new instruments. Chile created in 1984 the debt/equity swap concept. Through this mechanism no new financing was undertaken, but debt was neutralized by swapping it into local equity. Many countries adopted this kind of mechanism and used it often with great success in the privatization process. Another initiative was the Bolivian buyback scheme which it launched in 1987 after having reached a rescheduling agreement of its official debt and the realization that its debt overhang was too substantial. The buyback was offered to the private creditors, i.e. the commercial banks, at 11% and was successful in the amount of US$340 million or about 40% of its debt to private creditors. Bolivia, however, was a special case and no other country followed with a buyback.2 At the International Monetary Fund (IMF) meeting of 1985 the then Secretary of the US Treasury, James Baker, launched the first initiative to get the flow of funds to developing countries started again through involuntary lending, but unfortunately to no avail. He had proposed to lend an additional US$29 billion to the developing countries, namely US$20 billion by the banking community and US$9 billion from government sources. This lending would have had to be done in exchange for economic reforms. While banks in many industrialized countries had since 1982 made provisions against their LDC (less developed countries) debt, most US and Japanese banks still carried their loans at book value on their books. The highly publicized move by Citibank in 1987 to set aside reserves for 25% of its LDC loan portfolio was the clear and open acknowledgement that the leader of the rescheduling exercises of the 1980s thought that the debt of many developing countries was impaired. Many other financial institutions followed this move and opened the way to the acceptance of some kind of debt forgiveness. This provisioning move by the banking community gave a big boost to secondary market trading of LDC loans. At the same time the IMF, under the guidance of its then chief economist, Jacob Frenkel,3 undertook analytical work trying to find a pattern of economic adjustment that would accomplish the three objectives of reducing macroeconomic instability, restoring growth without a significant increase in consumption and reducing the degree of debt overhang. This study concluded that debt reduction would be beneficial both for the debtors and the creditors.

3

CROSS-BORDER EXPOSURES AND COUNTRY RISK

THE BRADY PLAN The pressure to come up with an innovative product which would be acceptable to the debtors and the creditors was on. In February 1988 Mexico and JP Morgan created the Aztec bonds, which repackaged Mexican rescheduled sovereign debt into a 20-year floating rate bond. The bond was substantially over-collateralized by the sovereign debt and the capital was further guaranteed by US Treasury zero coupon bonds. The success of the bond issue was, however, disappointing. Nevertheless, it led to a new political initiative. In 1989 the Secretary of the US Treasury Nicholas Brady proposed a new plan to overcome the debt crisis of the 1980s. This plan looked for an exchange of bank debt into long term securities for which the repayment of the capital would be assured through a collateral in the form of a zero coupon US Treasury or comparable bond. Such an exchange would have to be accompanied by a reduction of the debt servicing obligation. In order to qualify for such a debt exchange the countries had to accept an IMF-sanctioned structural reform plan. This meant that the debtor countries had to make dramatic changes in their economic policies. They had to liberalize their economy, reduce the state sector, enhance domestic savings; in short they had to apply sound economic policies which would allow good long term growth. In addition the countries had to have a clean position with the Paris Club, i.e. restructuring agreements had to be in place. Mexico, under its young President Carlos Salinas de Gortari, was the first country to restructure its debt under a Brady Plan. After seven years of unsatisfactory and frustrating debt negotiations the Brady Plan brought for the first time a new element of realism into the discussions as it acknowledged that the originally contracted debt was no longer worth its original value. The Brady Plan also acknowledged the existence of country risk as creditors were to lose out on their capital, or to receive a reduced nonmarket rate-related debt servicing cash flow and had to extend the maturity of their exposure way above the original intention. On the other hand the repayment of the debt was guaranteed by high quality treasury bonds. The Brady Plan did further liquefy the bank debt as it was repackaged into securities. The securities created found their way into the hands of institutional investors very fast and in substantial amounts. Nearly overnight a securities market was created for a new asset class, the emerging market debt security. As more and more countries took advantage of a Brady-type restructuring of their debt, this new market expanded dramatically. The market price for these securities incorporated for the first time not only the expectations of interest development and the evaluation of the creditworthiness of the issuer, but also the country risk associated with the country. As the borrower was the country itself, credit and country risk were combined in the so-called sovereign risk. During pre-Brady times the volume of impaired loan trading had continuously

4

OVERVIEW

developed among banks and with some sophisticated investors, but the market was cumbersome due to the substantial loan documentation. Furthermore, price volatility was often haphazard and sometimes difficult to explain. This all changed with the introduction of the Brady bonds. In the final restructuring negotiations of its bank debt each country created a different set of Brady bonds according to its debt servicing capabilities. However, the menu of alternatives was fairly similar and nearly every country issued par and discount bonds. Par bonds are bonds which pay a below market fixed interest rate, but the underlying bank debt is exchanged at 100% of its face value. Discount bonds are floating rate bonds with market rate interest plus a spread of 13/16%, but the bank debt is only exchanged at 60 to 70% of face value. Both bonds have a long term maturity of 25 to 30 years, are registered bonds and are listed on the Luxembourg stock exchange. The bonds are collateralized by 30-year zero coupon US Treasury bonds or similar bonds from another G7 country for their capital and a rolling interest period of 12 to 18 months. In addition to these two major categories of bonds, a variety of other bonds were created covering new money, past due interest or had a special mechanism regarding interest calculation (e.g. front-loaded interest reduction bonds (FLIRB)) or other features. Oil countries like Mexico, Venezuela and Nigeria attached to some of their bonds value recovery rights or warrants which allowed bond holders to recover a portion of the debt and the debt service if the oil price helped the economy to recover above the original estimates. The Brady exchange had other important repercussions on the future of cross-border funding as the countries which had obtained a Brady debt exchange had to go through a structural adjustment programme and were modernizing their economies. This made them attractive to the international financial investor. It allowed also for the opening of the international capital markets to the private sector. By 1993 the flow of funds had reached nearly US$44 billion. In addition portfolio equity investments started to flow, reaching a first peak in 1993 with US$45 billion. By that time euphoria had invaded the emerging markets especially in Latin America and the notion of country risk was nearly forgotten.

THE TEQUILA CRISIS However, by 1993 a Latin American economy, that of Mexico, had already started to show serious imbalances in its current account as the trade balance worsened and the debt service increased substantially. The current account deficit reached 7% of GDP in 1993 and 1994. The capital account, especially in 1993, was still very positive as high amounts of foreign portfolio investment attracted by

5

CROSS-BORDER EXPOSURES AND COUNTRY RISK

high interest rates and a strong stock exchange flowed into the country. The turn in Mexico's fortunes came late in 1994 when the refinancing of the short term debt became more and more difficult and the pressure on the peso increased continuously. By that time international investors were also scared by the social unrest in Chiapas, the assassination of the presidential candidate and Secretary General of the PRI as well as the kidnapping of one of the owners of Banamex, the largest Mexican bank. In order to stop the loss of reserves Mexico had after an unsuccessful devaluation to float the peso in December 1994 and the famous Tequila crisis unfolded leaving many foreign investors with burnt fingers.4 A massive rescue action to restore market confidence organized by the US government together with the IMF saved Mexico from another rescheduling exercise as this crisis was analysed more as one of liquidity and not of solvency. Country risk had once again brought substantial losses to cross-border exposures, this time mainly to international investors, but also to the Mexican domestic industry that had borrowed substantial amounts of foreign currencies. Country risk also therefore became an issue for domestic companies that had borrowed foreign currencies because of their comparatively low interest rates and their easy availability. They now faced a huge bill as their debt servicing in foreign currencies became unbearably high in the local currency. Hedging products were at that time only barely available. In the aftermath of the Tequila crisis, the Mexican banking system became technically bankrupt under the weight of its non-performing assets and only the strong support of the government through the Fundo Bancario de ProteccioÁn al Ahorro (FOBAPROA) mechanism and the pressure applied on the shareholders to recapitalize their banks prevented a full collapse. This incident showed dramatically the importance of a sound banking system for a country's economic well-being, something that can only be achieved with adequate capital ratios and an efficient banking supervision. The privatization of the Mexican banking system not only cost the new owners substantial additional amounts of money over time, but also the Mexican government had to pay the hard way for its failure to create an effective supervisory framework when it had started the privatization process. However, only by the end of 1998 was it politically possible to try to finalize this rescue operation of the banks through the FOBAPROA process. The opening of the political climate in Mexico under President Zedillo had allowed the opposition parties to question the 1995 action of the government and block it for years. While the democratization process was welcomed, it led to a prolonged stalemate in the vital process of the recovery of the Mexican banking system. By 1999 the system still showed strains of the 1994/95 Tequila crisis and the rescue process had to be discussed again. It was probably also for that reason that by the year 2000 nearly all Mexican banks had to look for foreign partners to assure their long term viability.

6

OVERVIEW

The Tequila crisis sent shock waves through all of Latin America and put especially Argentina and Brazil under pressure. Both countries managed the storm by applying sensible policies, but had also to pay the price with a sharp recession in 1995. In addition Argentina had to reform its banking system which showed substantial weaknesses during the Tequila crisis. Another Latin American country that went through a banking crisis at the time was Venezuela. While this crisis of 1994 came about through bad and fraudulent management, it was also made possible due to weak regulatory supervision. The takeover of Banco Latino and its liquidation as well as the intervention at Banco de Venezuela and Banco Consolidado did cost Venezuela at the end of the day about 18% of its GDP. A further Latin American banking crisis took place in Ecuador in 1999, when the country defaulted on its Brady bonds. This incident showed that even Brady bonds have a substantial country risk ingredient. The bail-out of the banking sector due to economic difficulties but also lax banking supervision will cost Ecuador, a rather poor country, eventually up to 13% of its GDP. Despite all the upheavals and crises most Latin American countries nevertheless managed by the mid-1990s to regain the trust of the international investors. They started to exchange the Brady bonds, i.e. collateralized bonds, against new long term bonds without any collateral. Mexico was again the forerunner in these Brady exchange exercises. The countries that were able to make these exchanges could liquefy the pledged treasury bonds which had by then substantially appreciated in value. All Latin American countries took advantage of the improved capital market environment and tried with varied success to lower the cost of their international stock of debt. The latest example at the time of writing is the Brady bond exchange by Brazil in August 2000. It was the largest emerging market debt exchange thus far as Brazil swapped US$5.22 billion of old Brady bonds into US$5.16 billion of new global bonds. This exchange will save Brazil US$983 million in debt service payments over the next ten years.

THE TRANSITION COUNTRIES Another major region of the globe that went through dramatic changes in the late 1980s and the early 1990s was the former Comecon bloc. The falling apart of the political system in Eastern Europe and the dissolution of the Soviet Union created a new challenging situation for cross-border financing. Out of the seven former Comecon countries and former Yugoslavia a new group of 26 countries emerged over time, the vast majority within one year. All these countries were faced with the need for liberalization, privatization and stabilization of their economies. These 26 countries are called economies in transition and their progress is regularly measured by the European Bank for

7

CROSS-BORDER EXPOSURES AND COUNTRY RISK

Reconstruction and Development (EBRD) through transition indicators. Until the end of 1996 the region as a whole had seen seven years of continuous economic decline and only in 1997 was economic growth for the first time positive for this region. Today, however, it is necessary to apply a much more differentiated perspective, because the differences between countries are becoming more and more relevant. We have a first league of transition countries, namely the Czech Republic, Estonia, Hungary, Poland and Slovenia, where the situation has developed in a favourable way. In most other countries the picture is much less clear. The first league countries are also those that are currently in negotiations with the European Union for adhesion. The transition countries have, besides their economic transition, also undergone substantial political change, moving to the democratic political system of Western thinking but still, however, with a big difference in degree. All transition countries have joined the Bretton Woods Institutions (BWI) and therefore furnish today statistical material of equal quality and compilation to the rest of the world. Several transition countries have been involved since 1989 in multilateral debt relief agreements with commercial banks, namely Albania, Bosnia and Herzegovina, Bulgaria, Poland and the Russian Federation. Only the agreement with the Russian Federation which was made before the 1998 crisis offered a lower interest rate and an extension of the terms. All other agreements asked for some kind of capital reduction, normally higher than the one granted to Latin American countries. Country risk associated with a loss of income on the original terms of the contracted debt once again became real.

THE ASIAN CRISIS The eruption of the Asian financial crisis in the second half of 1997 through the devaluation of the Thai baht came as an unforeseen shock to many holders of cross-border exposures. While the crisis had its origins in Thailand it spread very fast to other countries in the region such as Indonesia, Korea, Malaysia and the Philippines. It was driven by the exposures from the private sector and had its origin in developments that had started many months, if not years, earlier. The pegging of the Thai currency to the US dollar at 25 to 27 bahts for over 12 years had led to a feeling of confidence in the local currency. This only changed when the Japanese yen started to depreciate in 1997 against the US dollar, making exports from Thailand to Japan and the USA much more vulnerable. It should not be forgotten in this context that it was mainly Japanese companies that had made huge investments in Thailand over many years to take advantage of the low labour cost and the stable economic situation. These companies as well as local companies and operators who had undertaken substantial foreign currency borrowing which added up to nearly US$20 billion of short term debt by mid-1997 started to lose confidence in the local currency. Suddenly, hedging of the local currency and large repayments of

8

OVERVIEW

US dollar loans were the order of the day for the local community. The Thai currency crisis started to unfold. It was further accentuated by an intensive international speculation against the Thai baht which added additional pressure on the currency. The Central Bank of Thailand, which had significant foreign currency reserves at the beginning of the crisis, was confronted with huge demands for its reserves. The only way to preserve at least part of them was to devalue the currency on 2 July 1997 and let it float. By the end of 1997 the Thai baht had depreciated by 93%. As mentioned before, the origins of the crisis date further back, because the vulnerability had been built up over several years. The very successful Tiger economies with their strong growth rates in the 1980s and the 1990s needed substantial investments which even surpassed their local savings rates, which were by all international standards exceptionally high. Furthermore these economies also started to develop fairly big current account deficits to support the economic expansion. Problems started to arise when it became clear that a large part of the funds was not only used to support export-led growth but seemed to be misallocated into low productivity sectors. In Thailand as well as Indonesia the capital inflows supported speculative real estate developments which led to a glut in this market after the boom, the typical bubble effect. In Korea the industrial conglomerates were pushing for investments to be built up in their capital-intensive industry in order to further and better compete with their Japanese competitors. However, they often produced with these investments low returning assets as well as over-capacity. Besides such misallocation of funds for investment the financing of these investments was often anything but conservative. The high international liquidity and low short term rates induced many borrowers to revert to short term financing through foreign currency loans either through direct borrowing or the local banking community. Such loans were also used to fund assets denominated in local currency and producing only local currency. They produced, therefore, not only a foreign currency mismatch but also often a maturity mismatch. While banks often hedged their exposure, their clients left their position open as they were accustomed to a stable foreign currency regime. As the exchange relation of the Korean won appreciated against the Japanese yen Korean businesses started to lose some of their competitiveness and had to lower their prices, thus weakening their earnings situation and credit quality. Other factors have also contributed to the fast spreading of the crisis in the East Asian region which over the last 20 years had become used only to flattering remarks because of its outstanding economic record. The local financial services industry had not been able to meet the challenges of the rapid expansion of credit demand. The supervision of the financial services industry was furthermore relatively lax and the disclosure standards inadequate. Capital adequacy requirements were less stringent than the ones proposed by the Bank for International Settlements (BIS). Insider lending

9

CROSS-BORDER EXPOSURES AND COUNTRY RISK

and close connections between the borrower and the local banks were tolerated. Unreasonable incentives often produced questionable and weak assets. For example, Korean conglomerates could through their shareholdings in banks influence the lending to their associated companies without the necessary due diligence applied elsewhere. The corporate sector in addition lacked the corporate governance ethic that has become standard in other parts of the world. This made it difficult for the banks to obtain adequate information to make a correct credit judgement. Credit assessments were based on the static balance sheet and profit and loss approach and not on the much needed forward looking cash flow analysis. The lack of corporate governance and reporting transparency in the accounts of the firms in the East Asian region has been known for many years. When the financial service industry was opened up in some countries and the International Banking Facility was opened in Thailand, it was not followed up by an efficient local supervisory concept and an effective local regulatory environment. Reporting requirements for such important items as non-performing loans, for example, were inconsistent and much too lenient. It has to be added, however, that there existed also a lack of due diligence by the international banking and investment community. Many extended loans to or made investments in East Asia by what is now known as name lending, or by believing in the concept of too big to fail or even supposing that the government would bail out the foreign providers of cross-border finance in times of crisis. International investors are supposedly supervised by well instructed authorities and claim to have excellent management. The internationally available statistical data on the macroeconomic situation of the different countries in the region had greatly improved since the Tequila crisis. This therefore made it possible to have a timely and correct assessment of the situation. However, the figures were not checked out by many banks and investors with the necessary critical spirit. This could certainly have prevented some of the troubles. Finally, we also have to note that as the vulnerability of their countries' economies built up, the policy responses by the governments of the region to a potential loss of confidence by the international financial community were not adequate. The governments did not realize early enough that a crisis was coming and that the need to act was imperative. The response came only very slowly. It was obviously difficult for these countries that were for years admired for their success to suddenly realize that they had a major problem and that their traditional consensus building decision making process was probably too complicated to reach the necessary decisions in time. As the World Bank summarizes in its 1999 Global Development Finance Report, `the root causes of the mounting vulnerability of East Asian economies were financial sector weaknesses and poor corporate governance, macroeconomic conditions and policy response and a lack of due diligence by external creditors'.5

10

OVERVIEW

The Asian crisis imposed substantial costs on the four economies most affected by it, namely Thailand, Indonesia, Malaysia and Korea. Malaysia tried quite successfully to redress its situation by undertaking some specific unorthodox measurements such as the control of capital movements. GDP did fall in 1998 by 8.35% in Thailand, 13.2% in Indonesia, 6.4% in Malaysia and 5.8% in Korea. However, all four countries bounced back to a positive growth in 1999 which was estimated for Thailand and Malaysia to be 3.2%, for Indonesia 0.9% and for Korea 6.5%. This turnaround in economic activity shows how fast things can also change for the better. The current account in all these countries did show a dramatic improvement in 1998 after the negative situation in previous years. The biggest fall-out for the countries was the extreme growth of the non-performing assets in the domestic banking sector, which would have made nearly all the banks in these countries technically bankrupt if Western banking standards had been applied. While some financial institutions were let go, many weaker ones were consolidated into stronger or at least better positioned ones. All banking systems were recapitalized either by the respective governments or at their request by the owners and shareholders. In Indonesia, the Indonesian Bank Restructuring Agency (IBRA) was created. By 1999 it had accumulated assets of $108.37 billion of which it can probably only recoup 27%.6 Korea created the Financial Supervisory Commission (FSC) to modernize and restructure the banking system. Furthermore it established the Korea Asset Management Company (KAMCO) which bought impaired loans from the banking community to improve the banks' balance sheets. In Malaysia the Central Bank did the restructuring of its banking system by asking the 58 financial services companies to restructure into 6 so-called anchor institutions. It will, nevertheless, take many good banking years before the banking systems will all reach an acceptable soundness. In financial crises of the past, the cross-border exposure of lenders was hit most. In the Asian crisis lenders such as internationally operating banks had to agree to maintain trade lines in Korea and did some general restructuring in Indonesia. In Malaysia capital flow controls immobilized the assets of many investors. Banks as well as many investors did incur heavy losses due to country risk deterioration. Furthermore, some significant credit losses occurred, because the local devaluations wiped out the foreign exchange accrual power of many companies and banks to serve their foreign currency debt. Nevertheless, in the Asian crisis the domestic economies had to carry the major part of the cost and not the foreigners. While the restructuring of the economies is still far from being achieved, the stock markets in all countries have recovered to their pre-crisis level, offering again many interesting opportunities to the smart investor. As economic growth has resumed in these countries it is to be hoped that the turnaround will not weaken their restructuring efforts, which are needed to bring long term prosperity.

11

CROSS-BORDER EXPOSURES AND COUNTRY RISK

THE LATEST PROBLEMS The Russian debt default in 1998 and the Brazilian devaluation in 1999 are the latest examples at the time of writing of country risk deterioration again inflicting substantial losses on the commercial banking community. But this time the institutional investors also suffered heavy losses on their bond and equity portfolios. And last but not least many companies and financial institutions of the different affected countries also suffered heavy losses, because they were not aware of or willing to see what kinds of risks exist in cross-border financing. The year 1998 therefore became a very special one in relation to the awareness of country risk. The Russian political and economic convulsions cast a shadow over all the emerging markets and put them out of favour with the international financial community. In some places this resulted in a panic withdrawal of funds. Brazil was the hardest hit and lost on some days in the autumn of 1998 over US$1 billion of its reserves. Brazil was a natural target as its budget and current account deficit suddenly seemed to be out of proportion and doubts lingered about the effective and speedy implementation of the intended adjustment programme. A support package had to be drawn up for Brazil under the auspices of the IMF in order to avert a deepening of the crisis and a further loss of confidence in the emerging markets. Brazil had, nevertheless, to devalue its currency in 1999 to redress the cross-border foreign currency flow and improve its trade balance. Despite the actions undertaken by the multilateral financial institutions and the major governments the international capital markets for emerging markets closed more or less in the middle of 1998 and remained so for the rest of that year. Since then a much more cautious approach towards emerging market borrowers has been observed as the country risk is now also an important factor in investors' decisions. In 1997 and 1998 several large bridge loans were made into the emerging markets, many in connection with the privatization process and all with the intention of a take-out through an international capital markets transaction at a later stage. However, these take-out transactions could not be made and the bridge loans therefore remained on the books of the banks. Such large exposures put a lot of pressure on the country limits of the involved banks, therefore diminishing even further the flow of funds to the emerging markets. It is, nevertheless, interesting to note that investors were willing only 20 months after the turning point of the Brazilian crisis to exchange US$5 billion of collateralized bonds into a similar amount of 40-year uncollateralized bonds with a 7.88% yield above 30-year US Treasury bonds. This 7.88% can be considered the country risk premium. It is worth discussing in more detail here the Russian situation of 1998 and 1999 as it has been handled in a much less orthodox way than the Latin American crisis of the 1980s or the Asian meltdown of 1997/98. Russia obtained and is still obtaining a somewhat more favourable treatment than all other countries in debt servicing difficulties because of its former standing as a world power.

12

OVERVIEW

It is the sixth most populous country, a nuclear superpower and commands a seat as a permanent member of the United Nations security council. This situation allowed Russia to be continuously supported by the IMF with admittedly some relatively short dry periods in order to put the country under some pressure. Nobody dared, however, to openly clash with Russia. Russia has only remained current on its outstanding Eurobonds in order seemingly not to impair its standing on the international capital markets. On all other fronts, the foreign private sector creditors, which hold most of the debt of the former Soviet Union, the multilaterals, the Western governments, the holders of Minfins (domestic dollar-denominated debt issued by the Ministry of Finance) and also a large part of the Russian population with pension and salary claims had to accept delays in payments or partial payments. The debt to the private sector was rescheduled in bonds called PRINs ( for principal) and IANs (for overdue interest) and the maturities of the Paris Club were stretched. As Russia and its institutions have so many different creditors and only Eurobond holders have so far been correctly served, the fair treatment of all creditors is becoming more and more of an issue. The private sector creditors in particular would like to exchange the PRINs and IANs into Eurobonds to have an instrument of better liquidity. In addition a change of creditor from the Vnesheconombank to the Russian central government is sought in order to profit from the higher standing of the sovereign and its wider appeal in the market. However, as the available foreign exchange in Russia is limited and never enough to service regularly a much expanded Eurobond debt basis, Western governments would be most unhappy to see such a development and have their own outstandings even further impaired. In such a situation it is always astonishing to see how skilful the Russian negotiators are. They are able to obtain refinancing from the IMF despite obviously lying to the Fund about their reserve position. They wrestle generous concessions from the Paris Club for the current payments and postpone the real problems into the future. They will try to coerce the private sector creditors into a debt reduction exercise for exchange of their debt instruments into more liquid ones. While all this is going on, everybody is aware that Russia will never be able to repay its debt unless it really becomes serious about restructuring its economy and with it also limiting the capital flight. Russia shows to the world of its creditors that its special situation dating back from the Cold War still allows it to obtain concessions that no other country would dream of. Therefore the Russian country risk follows patterns that are very different from the traditional notion of country risk.

HEAVILY INDEBTED POOR COUNTRIES When discussing the debt problems of the developing world we have to mention as a special group the so-called heavily indebted poor countries (HIPC). This group consists of 41 countries which have an

13

CROSS-BORDER EXPOSURES AND COUNTRY RISK

unsustainable debt position. The debt stock of these countries is well over 300% of their exports while the threshold of 200% already indicates a debt overhang. The HIPC have been less in the news than the big developing countries as most of their debt is either public or publicly guaranteed while the private sector is only marginally involved. The private sector in these countries has a lot of difficulty in obtaining external financing. There were initiatives in the 1970s by the United Nations Conference on Trade and Development (UNCTAD) to alleviate the debt burden of these countries by the cancellation of the official development assistance debt.7 It took a long time for the creditor countries to agree that the regular rescheduling of debt was an expensive exercise and only led to a continuous increase of the stock of debt and made the problem therefore only worse. In 1994 the Paris Club finally adopted the concept of reduction of debt. To become eligible for a debt relief operation under the Paris Club and the HIPC initiative, countries have to live up to stringent conditions, the most complex one being a debt sustainability analysis jointly undertaken by the World Bank and the IMF. The HIPC initiative started at the Birmingham summit of the G8 countries in May 1998. However, the process is quite cumbersome and therefore only very few countries have so far negotiated their benefits from the plan. The 41 HIPC have a total stock of debt of about US$250 billion and are collectively therefore only a small participant in the world of cross-border exposures.

RECENT DEVELOPMENTS IN CROSS-BORDER FINANCING Since the debt crisis of the 1980s there have been several political and economic developments in different countries and regions that have led to substantial changes in risk intensity of cross-border financing, be it investments or cross-border loans. The most recent history has therefore again shown that there exist in cross-border transactions specific risks that have little to do with the credit quality of the underlying assets nor are these risks embedded in pure market risks. These specific risks in cross-border transactions are commonly called country risks. As long as the holders of cross-border claims or assets were mainly banks and multinational companies in addition to governments and multilateral financial institutions, the circle of participants was relatively limited. This has, however, changed as will be shown below. The substantial economic growth of the developing world over recent years went along with a huge demand for capital and funds. The improving situation in many developing and transition countries made funding through a wider spectrum of sources not only possible, but also interesting and advisable. The net long term resources flow increased from US$98.5 billion in 1990 to US$343.7 billion in 1997 and fell back to an estimated US$290.7 billion in 1999 (Table 1.1). The continuous

14

Table 1.1 Net long term resource flows to developing countries, 1990±99 (billions of US dollars) Type of flow Net long term resource flows Official flows Private flows International capital markets Debt flows Commercial banks Bonds Others Equity flows Foreign direct investment

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999a

98.5 55.9 42.6 18.5 15.7 3.2 1.2 11.3 2.8 24.1

124.0 62.3 61.6 26.4 18.8 5.0 10.9 2.8 7.6 35.3

153.7 54.0 99.7 52.2 38.1 16.4 11.1 10.7 14.1 47.5

219.2 53.4 165.8 99.8 48.8 3.5 36.6 8.7 51.0 66.0

220.4 45.9 174.5 85.7 50.5 8.8 38.2 3.5 35.2 88.8

257.2 53.9 203.3 98.3 62.2 30.4 30.8 1.0 36.1 105.0

313.1 31.0 282.1 151.3 102.1 37.5 62.4 2.2 49.2 130.8

343.7 39.9 303.9 133.9 103.4 51.6 48.9 3.0 30.2 170.3

318.3 50.6 267.7 96.8 81.2 44.6 39.7 -3.1 15.6 170.9

290.7 52.0 238.7 46.7 19.1 (11.4) 25.0 5.5 27.6 192.0

(a) Preliminary figures. Note: Net long term resource flows are defined as net liability transactions or original maturity of greater than one year. Although the Republic of Korea is a high income country, it is included in the developing country aggregate since it is a borrower of the World Bank. Source: World Bank Debtor Reporting System, in Global Development Finance, (Analysis and Summary Tables) World Bank, 2000, p. 39.

OVERVIEW

15

CROSS-BORDER EXPOSURES AND COUNTRY RISK

growth shows not only the substantial need for funds and the opportunity for investments but also the increased level of comfort for the international banking, business and investor communities to undertake cross-border exposures. Table 1.1 shows a few interesting aspects of the long term flow of funds to the developing world.

Foreign direct investment Foreign direct investment (FDI) is the only source that increased every year over recent years, because the developing countries are becoming a more and more interesting market for the multinational companies. These companies took the opportunities that were presented to them by the liberalization of the rules for foreign direct investments in many countries in the late 1980s and early 1990s. In addition, the privatization process presented new, interesting opportunities. FDI has, therefore, become the most important source of the net long term resources flow to the developing world. It is furthermore interesting to observe that FDI inflows are positively related to GDP growth. Sustained growth improves the attraction for FDI substantially (Fig. 1.1). The important position of FDI in the transfer of resources to the developing world is encouraging as these investments tend to stay in the countries once they are made. They are normally actively managed, often ask for additional funds because of their success and are not meant to be repatriated within a

Figure 1.1 FDI inflows are positively correlated with GDP growth. (Source: World Bank Debtor Reporting System and World Bank data, from Global Development Finance, World Bank, 1998, p. 23.)

16

OVERVIEW

few years. They furthermore contribute to technology transfer and enhance the globalization of business. FDI generates the funds most needed by developing countries. Unfortunately, FDI is still regarded in many developing countries with suspicion or even aversion.

International debt market Besides the FDI the second most important net flow of long term private resources to the developing countries comes from the international debt market. This resource came traditionally from the commercial banks and has in recent years been substantially complemented by the bond markets. Table 1.1 shows how in the early 1990s these two sources of funds were still of limited value as the restructuring exercises of the 1980s led commercial banks and investors to adopt a very cautious approach towards long term lending to the developing countries. However, the improved economic picture opened up these two sources in a very dramatic way, moving from a transfer of US$15.7 billion in 1990 to over US$100 billion in 1997. The crisis of 1998 brought a substantial reduction to less than US$20 billion in 1999. The changing importance of bank loans versus bonds as debt instruments depends on the pricing of these funds and their availability. Pricing and availability are the typical factors that determine the choice of instrument in the much less mature environment of the emerging markets. Therefore it is their individual volatility that has to be watched. Bank loans are, under normal circumstances, always available. Their limitations are the country lines of the banking community which are based on a good understanding of the economic and political environment of the developing world as well as on the risk appetite of the specific institution. Availability of funds in the international bond market depends, however, very much on the market outlook and the expectations of investors as well as their country risk perception. The availability of funds through the international capital markets is therefore more irregular. The prices in the secondary markets normally give an indication of the interest of the international investor community in emerging markets securities. The prices are, however, often distorted by the limited liquidity of the issues. Bonds are interesting sources of cross-border funds because they tend to provide longer term money to the developing countries than bank loans. Only the classical project financing of banks extends longer maturities. Pricing in the bank market and in the bond market differs. The bank market is less volatile in its pricing and has often been cheaper than the bond market for the same maturity.

17

CROSS-BORDER EXPOSURES AND COUNTRY RISK

Short term funds Besides the longer term funds provided by the international banking community, an even more important source of funds from banks is short term funds, namely funds with a maturity of less than one year. As these funds basically support international trade, they have grown continuously as world trade has expanded. The lending of short term funds for the financing of trade is a very effective tool for the lender because he knows that such financing is self-liquidating and has therefore a relatively low risk profile. Furthermore, trade is the lifeline for every country as it provides the needed food and/or energy. Trade finance exposures are nearly always honoured by developing countries. Very few exceptions have occurred, even in the most difficult times over the past 20 years. Table 1.2 shows that recently the East Asia and Pacific regions had percentage-wise a much larger increase by far in short term debt than the other regions. This is not only due to the substantial GDP growth in the region, but also because borrowers in these countries used the short term funds not only for trade financing but also for working capital purposes and general balance sheet needs. The high world liquidity had made these internationally available funds relatively cheap. Special mention has to be made of the inter-bank lines that also played an important role in the recent build-up of short term debt. While considered short term credit lines and extended easily in times of abundant liquidity, they became the focus of attention in the recent problems in Korea, Indonesia and Brazil. They had to be rolled over for various periods of time to give the countries the necessary breathing spaces.8 Therefore the Asian upheaval in late 1997, and earlier the Tequila crisis in 1995, clearly show how dangerous it can be for developing countries and their firms to rely on foreign short term capital for uses other than trade financing. Table 1.2 Developing countries' short term debt stocks, 1980±99 (billions of US dollars) Region All developing countries East Asia and the Pacific Europe and Central Asia Latin America and the Caribbean Middle East and North Africa South Asia Sub-Saharan Africa

1980

1990

1998

1999

145.7 25.2 17.1 68.6 21.1 2.5 11.2

244.6 49.2 40.9 77.4 43.9 12.4 20.9

411.9 119.1 78.6 123.5 41.0 7.2 42.5

402.3 106.1 78.6 122.6 41.8 8.5 44.7

Source: Global Development Finance, Analysis and Summary Tables, World Bank, 2000, pp. 238±50.

18

OVERVIEW

Portfolio equity flow The last source of private sector long term funds as defined by the World Bank is the portfolio equity flow. This flow of resources also began in the early 1990s. The attractive valuations encouraged investors to look at the stock markets of the developing countries. Dedicated country funds were created and started to make equity investments in the emerging markets. Furthermore, the quality of many local stock markets improved substantially through tougher rules and better supervision as well as increased transparency. These developments induced institutional and other sophisticated investors to invest in this new asset class which was by now called emerging markets. With the growing interest and the relatively small liquidity of most stocks, prices increased strongly. The share of the emerging markets' market capitalization as a percentage of world market capitalization has been changing over the years and is currently in the range of 8 to 9 per cent. In monetary terms the capitalization rose from US$500 billion in 1990 to over US$3000 billion in 1999 (Fig. 1.2). During the same time the number of listed companies on the emerging stock markets increased from 8 920 to 26 314. Excluding India, which is a special case, the increase was from 6 485 companies to 20 451.9 These are very important developments. While some markets limit foreign ownership in domestic companies, many have no such restriction, therefore opening up a rich source of investment opportunities. A good number of the more important companies from the developing countries tapped the international capital markets through the issuance of American depository receipts (ADRs) or global depository receipts (GDRs). Such investment instruments are usually more easily tradable than the local ones. Furthermore, the cost of trading is mostly lower and the companies issuing such shares have higher accounting standards. It has, however, to be remembered that all those portfolio equity investments in the emerging markets bear not only credit and market risks, but

Figure 1.2 Emerging markets' share of world market capitalization, 1990±99. (Source: Emerging Stock Markets Factbook 2000, Standard & Poor's, 2000, p. 19.)

19

CROSS-BORDER EXPOSURES AND COUNTRY RISK

also country risk. Nevertheless the emerging markets attracted substantial funds in the 1990s because the investors felt that the return outweighed the risks (Fig. 1.3). Equity investments as well as investments in local fixed income instruments can, however, have an unpleasant impact on a country's external accounts in times of loss of confidence. As they are normally tradable instruments, they are liquid investments and therefore very sensitive to market sentiments, expectations and perceptions. Furthermore, many developing countries allow a relatively free flow of cross-border funds. This leads to the by now well known in- and outflow of capital in very short time periods with all its consequences on the reserve position of the country involved. It is therefore not surprising that the yearly variations in these portfolio investment flows are not following a trend, but are going up and down according to investors' market expectations and country risk perceptions. Money internationally raised through initial public offerings (IPOs) and/or through secondary rights issues is certainly beneficial to the capital accounts of the countries involved as it creates a net inflow. However, the instruments created follow in the secondary market the market behaviour of international investors and can lead in a deteriorating country risk situation to an additional outflow of capital, thereby presenting a real danger to the capital account of the country in question.

Official development finance Official development finance is the oldest and probably most reliable source of net long term funds for developing countries. It presents another very different picture as shown in Table 1.1 under the caption `Official flows.' Official development finance was responsible for close to 60% of the long

Figure 1.3 S&P/IFCG regional price indexes vs US S&P 500, 1990±99 (monthly, end 1989=100). (Source: Emerging Stock Market Factbook 2000, Standard & Poor's 2000, p. 53.)

20

Table 1.3 Net official long term flows to developing countries, 1990±99 (billions of US dollars)

Official development finance Concessional finance Grants Loans Bilateral Multilaterial Non-concessional finance Bilateral Multilateral Memo items Use of IMF credit Technical cooperation grants

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999a

56.0 43.8 28.2 15.6 9.6 6.0 12.2 2.9 9.3

62.3 50.8 35.1 15.7 9.3 6.4 11.5 3.9 7.6

54.0 44.0 30.5 13.5 7.0 6.5 10.0 4.5 5.5

53.4 41.6 28.4 13.2 6.7 6.5 11.8 3.4 8.4

45.9 46.2 32.7 13.5 5.7 7.8 (0.3) (2.6) 2.3

53.9 45.2 32.7 12.5 5.3 7.2 8.7 5.0 3.7

31.0 39.4 28.0 11.4 3.2 8.2 (8.5) (12.7) 4.2

39.9 33.6 26.0 7.6 0.2 7.4 6.3 (7.1) 13.4

50.4 37.3 27.1 10.2 3.3 6.9 13.1 (5.7) 18.8

52.0 39.4 26.4 13.0 5.7 7.3 12.6 (0.1) 12.7

± 14.2

3.2 15.5

1.2 17.6

1.7 18.2

1.6 16.8

16.8 20.1

1.0 18.5

14.7 15.5

19.2 16.1

-12.8 15.9

(a) Estimated figures. Note: Although the Republic of Korea is a high income country, it is included in the developing country aggregate since it is a borrower of the World Bank. Source: World Bank Reporting System, from Global Development Finance, (Analysis and Summary Tables) World Bank 2000, pp. 60 and 71.

OVERVIEW

21

CROSS-BORDER EXPOSURES AND COUNTRY RISK

term funds provided in 1990 to the developing world, but this source has declined to a contribution in 1999 of only 18%. The yearly amounts, while varying, show over the recorded period a decline in nominal and even more decline in real terms. This is due to the rethinking about official aid in the industrial world in view of the dramatic political and economic changes that have taken place in the developing world over the last ten years. But it is also a consequence of the mounting budget constraints in many industrialized countries. Furthermore, the effectiveness of official aid has become an interesting topic of discussion for politicians in the industrialized world. Unfortunately, these discussions have often resulted in a reduction of such aid. In addition, aid funds are increasingly channelled through nongovernmental organizations (NGOs).10 Table 1.3 gives a more detailed account of how official development finance is composed. Concessionary finance represents by far the largest part of official finance but remains under constant political scrutiny in the industrial world. The nonconcessionary finance is becoming less important as many countries have started to go to the international capital markets to fund themselves. It is, however, interesting to note that nonconcessionary financing through the multilateral financial institutions has increased mainly through the activities of the World Bank and the Inter American Development Bank as well as the other regional multilateral financial institutions.

CONCLUSIONS As we have seen, country risk is a risk phenomenon which is found in all cross-border financial transactions. It does not exist in domestic financial transactions. Later chapters will go into more detail in analysing the different risk components that exist in cross-border transactions and give a more detailed account of country risk. It is, however, necessary to state here that the existence of country risk in all cross-border financial transactions means that whoever is at the origin of such transactions is bound to be confronted with this additional risk. Chapter 4 will show how this risk can be hedged. It is more or less difficult depending on the type of transaction. Only multilateral institutions and governments can have a different approach towards country risk, because they are guided not only by global economics but also by political motivation and have a much bigger influence over their exposure than the private sector. While in the 1980s bank lending was mostly associated with country risk the substantial expansion of portfolio investments in bonds and equities of emerging market borrowers and issuers as well as the continuous flow of foreign direct investment have made country risk a risk with which many more professionals in the field of finance have to be familiar. This much broader awareness of country risk needed by the lender and investor community finds its counterweight in the concern of the emerging

22

OVERVIEW

economies that not enough in depth knowledge of their economic and political situation is acquired to judge their situation in a fair and individually independent manner. They are worried about contagion, be it by other countries or market sentiment. Globalization has also affected country risk as no country is any longer immune to what is happening in other parts of the world. In this respect contagion has become an issue in the appraisal of country risk. But also lenders and portfolio investors seem to depend more on each other as their interests have become interdependent. The absence of portfolio investors for whatever reason in cross-border financial transactions often also leads today to much reduced lending activity. On the other side we find that an increased attractiveness can quickly lead to increased competition by the major participants in providing cross-border funds. Only foreign direct investment seems to follow a somewhat different pattern as it is guided by parameters such as the quality and importance of a marketplace, which are only of secondary importance to lenders and portfolio investors. Cross-border transactions and exposures are today incurred by governments, financial institutions, portfolio investors and corporations. They are undertaken under all kinds of assumptions and intentions. They all have country risk attached to them. Guidance is given in the remainder of this book on how to cope with this risk.

REFERENCES 1

Sebastian Edwards, Crisis and Reform in Latin America: From despair to hope, a World Bank Book, fourth edition, Oxford University Press, 1997, pp. 33ff.

2

Ibid., p. 74.

3

Jacob A Frenkel, Michael P Dooley and Peter Wickham, Analytical Issues in Debt, IMF, 1989.

4

Edwards, Crisis and Reform in Latin America, pp. 295ff.

5

Global Development Finance, Analysis and Summary Tables, World Bank, Washington, April 1999, p. 35.

6

Asian Wall Street Journal, 26 November 1999, p. 3.

7

`Debt situation of the developing countries as of mid-1998', report by the Secretary General of the United Nations, September 1998.

8

Global Development Finance, p. 51.

9

IMF, International Capital Markets, IMF, September 2000, pp. 130±2.

10 Standard & Poor's, Emerging Stock Markets Factbook 2000, May 2000, p. 23.

23

2 The need for capital

INTRODUCTION In the overview we saw how cross-border exposures to the developing world have grown over time and how the changes in risks influenced the different sources of funds. Besides the need to increase the size of the economies of the different developing countries at the individual business level there is a tremendous need to improve and enhance public services and infrastructure in all their aspects in the developing world. Public services and infrastructure in this context mean education, health care and internal and external security, but also the whole infrastructure for transportation, communication and energy. In addition, ecological considerations start to add new needs for funds in the private and public sector. The reasons for these needs are known, but in the developing world they will increase in the next 20 years at an accelerating rate. This acceleration is primarily due to demographic changes. We still not only have continuous population growth in nearly all developing countries ± fortunately in most places with a decreasing trend in the growth ± but also a fast growing adult population. This older population of over 18 years has a much higher demand for most public services and infrastructure than the children. As it is essential to alleviate the disparities of income and to raise the masses from their alarming poverty levels, we need continuous economic growth in the third world. Such economic growth evidentially has implications for the development of public services and the related need to develop the infrastructure. In addition all observers of the developing world know that its much overused infrastructure is fast ageing since, because of a lack of public funds and general negligence, it has never been adequately maintained. An example in this context is Russia.1 It is estimated that it should spend US$7 billion a year for the next 15 years to repair and replace ageing power stations. In 1999 it spent just US$1 billion. In telecommunications Russia would need US$6.5 billion to reduce the waiting list for telephones and US$15.5 billion to change its old lines to digital and upgrade its long-distance system. Russia currently spends US$500 million.

24

THE NEED FOR CAPITAL

This analysis is concerned only with the simpler concept of the economic development of third world countries rather than with the sustainable development concept of the OECD. This sustainability of development has become a key priority of the OECD.2 However, there does not yet exist in the developing world an efficient institutional framework and a widespread political will to fully alter economic development into sustainable development. The need to obtain short term economic gains is so important that possible negative long term effects are ignored. The Development Assistance Committee has drawn some lessons from this fact.3 The developing world has a very great need for capital to be able to fulfil the aspirations of its population not only on the individual business level but also in relation to public service and infrastructure. It is interesting to note ± as shown in the World Development Report ± that investments, which normally further economic growth, do not alone guarantee GDP growth.4 Nevertheless, investments are clearly needed for an economy to grow and to assure its continuous development for the benefit of its population. One of the crucial questions here is, how much capital is needed for the economic development of the developing world and who will provide it in the future? The World Bank publishes in its World Development Indicators a wealth of interesting data that can provide the necessary information about the size of those needs and where the money has been coming from.5 We will consider here only the capital expenditures that are needed to maintain or allow for continuous development. Such capital has to be provided long term. Current expenditures, such as those that are needed for running the administration, or education and health care systems, are disregarded, because they should not be financed through long term debt and even less through cross-border financing but through the domestic budget process. Despite this it is well known that some governments continue to finance their budget deficit through long term government debt and sometimes even cross-border financing is arranged to cover shortfalls in government revenues.

THE BORROWERS In looking at the borrowers for public service and infrastructure projects we can distinguish between central borrowers and local borrowers as well as between public and private borrowers. These different types of borrower have different appeals to the providers of funds. Traditionally, public sector and infrastructure were the preserve of the central government in developing countries as only the central government was able to mobilize the necessary resources to finance such projects. The central government collected the taxes, did the borrowing and was the recipient of aid. However, the

25

CROSS-BORDER EXPOSURES AND COUNTRY RISK

experience of the developed world, where local governments and municipalities have successfully taken over the management of parts of the public sector and the infrastructure, has shown to the developing world that pushing decision making to the sub-national level increases efficiency and makes economic sense. At the national level allocation of funds for public sector and infrastructure often leads to arbitrary allocation of projects whereas local government can set priorities in a much easier way. To delegate part of the public sector and infrastructure tasks to the sub-national level demands also the allocation of government revenue to that level, if possible in a most direct way. The central government's share of public investment is normally below 50% in countries with a GDP per head of more than $5000.6 Another distinction to be drawn is between public and private borrowers for the public service and infrastructure projects. This distinction is especially important when the need to mobilize crossborder funds is essential. The International Finance Corporation has been at the forefront in backing up private participation in infrastructure (PPI).7 To open these traditionally public sectors to the private sector has been a complex and highly politicized process. It is therefore not surprising that relatively few developing countries have created an institutional framework for private competitive infrastructure. The benefits from privatization and competition are clear, as shown in Fig. 2.1.8 Early PPI was mostly in the area of building new assets such as power generation stations or cellular phone systems. However, starting with the privatization of some telecommunication and airline companies, privatization has in many countries allowed the private sector to move into the power sector, into ports, water distribution and sewage systems, and transportation as well as telecommunication and other areas of public service and infrastructure. In order to achieve a successful private participation in public sector and infrastructure projects that will also generate the

Figure 2.1 Benefits from privatization and competition.

26

THE NEED FOR CAPITAL

necessary funds for its realization, several conditions have to be fulfilled. Governments have to be fully committed to the participation of the private sector in the infrastructure. Transparent and clear rules and regulations have to be established. They should not prevent technological progress, something which is especially important in high tech infrastructure such as telecommunication. For example, licences for fixed lines suddenly became expensive when mobile communications started to serve the same purpose at a much reduced cost. Without the necessary flexibility in the rules and regulations of the sector concerned then economic justification for investments in development can change and its effectiveness for the private sector can be lost. It is interesting to note that in most developing countries it was not only international investors but also domestic ones that actively participated in the privatization process. As time goes by this will allow projects to obtain more and more funding from domestic resources, as locals feel comfortable with these investments.

GROSS DOMESTIC INVESTMENT The World Bank data is historical and not always complete. Furthermore, the World Bank does not make any forecast of forthcoming needs. Here the gross domestic investment figure will be used as the closest from which to make an estimate of the capital needs for the development of public service and infrastructure in the developing world. Gross domestic investment is defined by the World Bank as the `addition to the fixed assets of the economy plus changes in the level of inventories'.9 The addition to fixed assets covers the additional assets invested in the infrastructure, but also expenditure made for machinery, office buildings and residential construction. The data from the World Bank is therefore a larger figure than the more restrictive capital needs for public service and infrastructure to be covered here first. In the context of cross-border financing the capital needs for public service and infrastructure have a specific significance in respect to country risk. Such capital has always to be provided long term and the financed investments rarely produce any foreign exchange. Tenor and limitation of foreign exchange generation have a strong influence on country risk considerations as these two factors normally influence country risk intensity and therefore limit the availability of funds when they move in the negative direction. The World Development Indicators give us information about the relationship between gross domestic investment and GDP. At the time of writing, the latest figures available are for the year 1998.10 See Table 2.1.

27

CROSS-BORDER EXPOSURES AND COUNTRY RISK

Table 2.1 The relationship between gross domestic investment and GDP Range/area Low income (excluding China and India) Middle income Lower middle income Upper middle income Low and middle income East Asia and Pacific Europe and Central Asia Latin America and Carib. Middle East and N Africa South Asia Sub-Saharan Africa High income Europe EMU

Gross domestic investment in % of GDP (1998) 29 17 22 20 23 24 28 22 22 22 23 17 21 19

If we look at the range, the average gross domestic investment lies in the developing countries between 17% and 29% of GDP. Looking at the regional level there is a high of 28% for the East Asian and Pacific region and a low of 17% for the Sub-Saharan region. These figures pretty much match the fact that there are much higher growth rates in the East Asian economies than in most other parts of the world. It should be noted that the figure for East Asia would have been much higher had it not been for the recent Asian crisis whose major impact was felt in 1998. A well travelled observer would remark that public service and infrastructure is in many aspects in most developing countries still very inadequate, which means that the above mentioned levels of domestic investment do not yet provide enough funds to secure a well functioning public service and an adequate infrastructure. It would be a fallacy to think that developing countries can live and develop with a level of gross domestic investment similar to the industrialized world, as these countries have already built up an adequate public service and infrastructure over a long period of time. Fig. 2.2 from the World Development Indicators shows the amounts that were spent from 1980 to 1997 on gross domestic investments.11

CAPITAL NEEDS Currently there is about US$1.4 trillion of gross domestic investment per year in the developing world. It is obviously difficult to estimate how much of this investment was spent on public service and infrastructure. About 70% thereof are domestic private investments and about 10% foreign

28

THE NEED FOR CAPITAL

Figure 2.2 Regional trends in gross domestic investment, 1995 (billions of US dollars). (Source: World Development Indicators 1999, p. 227. From World Bank data files.) direct investments.12 This would mean that only 20% goes into the public sector. However, part of the infrastructure and public service has been privatized in many countries and therefore some of its funding is included in the private investments. However, what is known is that in general not enough money was spent on public service and infrastructure in the past. As the need to develop public service and infrastructure will grow in order to enable countries to achieve a satisfactory growth rate, it can be assumed that at least 500 billion US dollars will soon have to be spent in this area per year. Such an amount of capital would allow infrastructure to keep in line with economic growth and hopefully also improve it from the current unsatisfactory levels. To mobilize such huge amounts of funds all potential sources will have to be tapped. Most of it will have to come from domestic savings. In the Organization for Economic Cooperation and Development (OECD) area there is a high correlation between domestic rates of investment and domestic rates of saving. These findings go back to 1980 when Martin Feldstein and Charles Horioka proved the case.13 It means that higher domestic investments will automatically increase the domestic savings rate and therefore make investment easier to finance. It also points in the direction of limited international integration of financial markets at the time these observations were made. However, such correlation is not found in the developing world, where different sources of funds have to be tapped, especially cross-border funds.14 The World Bank is right to forecast that the well run developing countries that offer a solid return on their investment will have the opportunity to supplement their domestic savings with resources from all over the globe.15 The largest source of funds is, and will be for some time to come, the pool of pension funds around the globe. This pool is still growing. It is, however, estimated that

29

CROSS-BORDER EXPOSURES AND COUNTRY RISK

by the year 2025 this pool of funds will no longer grow because of the ageing of the population in the industrialized world.16 From a country risk point of view domestic funds are the ideal source to finance infrastructure, because neither the borrower nor its home country have to incur a foreign exchange risk. Our discussion in this book of the issues and problems involved in cross-border funding will focus on ways and means of mobilizing cross-border funds to help develop public service and infrastructure in the developing world.

DOMESTIC FUNDS

First, it is worth taking a short look at domestic fundraising for infrastructure before turning to the cross-border aspects. Domestic fundraising has to rely on the savings of the country in question as the major source. The World Development Indicators give some indications about gross domestic savings in the developing world.17 They are calculated as the difference between GDP and total consumption.18 Table 2.2 shows gross domestic savings broken down in the same way as for gross domestic investment in Table 2.1. Table 2.2 Gross domestic savings in the developing world as a percentage of GDP Range/area Low income Middle income Lower middle income Higher middle income Low and middle income East Asia and Pacific Europe and Central Asia Latin America and Carib. Middle East and N Africa South Asia Sub-Saharan Africa High Income Europe EMU

30

Gross domestic savings as % of GDP (1998) 31.1 21.5 19.1 22.7 24.5 38.6 20.3 19.0 18.2 19.5 14.9 22.3 23.4

THE NEED FOR CAPITAL

In order to mobilize domestic savings the country in question needs a resilient banking system. It is unfortunate that the multilateral financial institutions such as the IMF and the World Bank were for a very long time not conscious enough of this fact and did not push through the necessary reforms. Therefore, the needed banking reforms in most developing countries have been carried out in a very haphazard way and savings have not been collected consistently and effectively. Since the Tequila and Asian crises (see Chapter 1), the IMF and the World Bank have clearly realized the importance of an efficient local banking system. They have therefore been making big efforts in recent years to improve the banking systems in the developing world. Besides the normally available short term capital market with a tenor of up to one year, countries need a long term domestic capital market, which allows the financing of public service and infrastructure projects with their tenor of seven years or more. This is, unfortunately, rarely the case in the developing countries. In this context it is interesting to note that Brazil, one of the largest developing countries, intended in late 2000 to lengthen the maturity of its domestic debt to an average tenor of 29 months. Even after doing this 40% of the debt will still be due within one year. However, with this action it is hoped that the Brazilian domestic capital market will slowly accept longer maturities. Furthermore, some of the richer transition countries, such as the Czech Republic, Poland and Hungary, already have fairly well functioning domestic capital markets with tenors of up to ten years. The domestic capital market is an important player and therefore an additional major source of long term domestic funds is the pension systems that function on an accrual basis. Quite a few countries such as Chile, Mexico and Argentina have started with such systems. They will in the coming years be able to contribute substantially to the funding needs of the domestic infrastructure and public service. Domestic savings, however, are also the major source for financing development at the individual business level. In the domestic financial markets there is therefore a competitive environment between the two major users of domestic savings, individual businesses and the public service and infrastructure. As we know that domestic savings in the developing world have no correlation with domestic investments there will continue to be a shortfall in funds from domestic savings and therefore developing countries have to turn to outside sources of funds. In his recent, very readable book Hernando de Soto shows us that there exists much more capital in the developing world than is commonly assumed, but it is all tied up in the extra legal system. Therefore he advocates a property recording and implementation system that allows this capital to become a creator of wealth. `The challenge these [developing] countries face is not whether they should produce or receive more money but whether they can understand the legal institutions and summon the political will necessary to build a property system that is easily accessible to the poor.'19

31

CROSS-BORDER EXPOSURES AND COUNTRY RISK

CROSS-BORDER FUNDS Developing countries have always received cross-border funds for their development as we have seen. The aggregate net resource flows and net long term transfers to developing countries follow the pattern shown in Fig. 2.3.20 The quantitative flow of these funds depends on the perception by the international financial community of the country risk of the country in question and often the region, as well as on governmental policies in the industrialized countries. As the need for capital is particularly important for the development of infrastructure and of the public service sector, it is interesting to discuss this area in more detail. The funds needed form part of the aggregate net transfer as indicated in Fig. 2.3, and this also includes the transfer of funds to individual businesses. Cross-border funds have, therefore, to be shared between the potential users. The international financial markets feel in general more comfortable with the private sector, shorter tenors, equity and portfolio investments than when lending long term to the public sector and to infrastructure projects. Therefore the financing of public service and infrastructure through cross-border funds will have to rely substantially on official flows, including government guaranteed lending as well as foreign direct investments in the privatized sector of public services such as telecommunication, energy and water distribution.

Loan disbursements

Principal repayments

Debt service (LTDS)

Net resource flows on debt

Foreign direct investment (FDI), portfolio equity flows, and official grants

Aggregate net resource flows

Interest payments

Net transfer on debt

Aggregate net transfers

Figure 2.3 Aggregate net resource flows and net long term transfers to developing countries.

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THE NEED FOR CAPITAL

Official cross-border financing A short account of official development finance was given in Chapter 1. This section will go into more detail about the flow of official cross-border financing. The official flow of funds to support infrastructure and public service in the developing world comes from several sources and basically in two forms, by direct funding or by extending guarantees to the providers of funds. Official development finance falls into three categories. The first category, namely the support of industry and employment in the industrialized world, has existed since 1919 when the United Kingdom created the Export Credit Guarantee Department (ECGD). The Export Credit Agencies (ECAs) are discussed below. The second category came with the establishment of the international financial institutions starting with the Bretton Woods Institutions after World War II and later the founding of the regional development banks. These institutions were created to enhance economic and social development in the developing world through balancing short term shortages and through the extensions of longer term credits. The third category is what can be labelled aid. These kinds of funds flowing cross-border are only partly going into the support of infrastructure, but much is in the form of help to alleviate specific problems. Into this category fall not only the support programmes of different agencies of the United Nations, but also the donor clubs for several countries. While there exist many sources of official cross-border funding the total amount provided relative to the needs is small. Table 2.3 shows net official cross-border financing in 1998 using the World Development Indicators.21 The funds provided by the IMF are excluded as these funds are basically to aid balance of payments and are not supposed to be used to finance the development of infrastructure and public service. The figures do not correspond with Tables 1.1 and 1.3 as we were unable to reconcile them fully. Table 2.3 Net official financial flow to developing countries (low and medium income) in US$ billions Private export credits supported by ECAs World Bank IDA IBRD Regional development banks Concessional Non-concessional Official development assistance and aid by DCA (Development Assistance Committee) members Bilateral grants Bilateral loans Total United Nations Agencies

1 873 4 816 6 831 1 728 7 193 32 396 2 729 57 566 2 565

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CROSS-BORDER EXPOSURES AND COUNTRY RISK

The figures in Table 2.3 give a rough indication of what has been available to developing countries from the official sector. It is obvious that only a relatively small part of these funds went into infrastructure and/or public service. The total funds available, therefore, can only provide a small part of the need for capital in the developing world. However, the importance of the official sector lies in its catalytic or moral support function for the providing of private funds. The following section looks at some of the origins of these official funds and at the ECAs, the oldest form of support from the industrialized world for the import of goods to the developing countries.

Export credit financing Imports by developing countries have a long tradition of relying substantially on credits from the supplier or its banks as capital has always been in relatively short supply in the developing world. While imports of raw materials and commodities as well as consumer goods are mainly financed by short term trade credits from the supplier or with the support of its banks, the import of capital goods demands much longer periods for payment. Exporters and banks were not willing and sometimes also not able to extend repayment for such tenors. To continue to be able to export capital goods and to accept such longer tenors for payment the exporters sought help from their governments as these were interested in helping their export industries and supporting employment. Thus the instrument of the export credit was created. The Export Insurance Department (EID) of the Japanese Ministry of International Trade and Industry (MITI) was established in 1930 and the Export±Import Bank of the United States was chartered in 1934.22 In most European countries institutions were also established at that time to support export credits. The ECAs are organized in many different ways. They can be a government department like the ECGD in the United Kingdom (www.ecgd.gov.uk) or a government agency like the Swedish Export Guarantee Board (EKN) (www.ekn.sd). They can also be a wholly government owned but substantially independent institution like the Export Development Corporation of Canada (EDC) (www.edc.ca). Another model was chosen by Germany, which has HERMES (www.hermes.de), a semi-private credit guarantee organization which does a substantial amount of business on its own account but also conducts export credit business on behalf of the German government.23 In October 1999 the Japanese government consolidated its two export supporting and development helping organizations, the Export±Import Bank of Japan (JEXIM) and the Overseas Economic Cooperation Fund, Japan (OECF) into the Japan Bank for International Cooperation (JBIC) (www.jbic.go.jp). The export credit is today broadly defined as an insurance, guarantee or financing arrangement which enables a foreign buyer of exported goods and/or services to defer payment over a period of time which is

34

THE NEED FOR CAPITAL

considered short term for up to two years, medium term for two to five years and long term for over five years.24 Since the 1930s the export credit and the export credit agencies have undergone substantial developments and changes. As WS Tambe and NS Zhu show in their paper, there was a period of rapid growth of the export credit from the Second World War until the beginning of 1982 when the debt crisis broke out.25 Net export credits grew from US$2.2 billion in 1970 to close to US$13 billion in 1981. After that ECAs had to cope with many rescheduling exercises and lost substantial amounts of money which had to be funded by taxpayers. They have become less of a political tool but much more professional and try today to balance carefully the needs of their export industries with the necessary acceptance of country risk. They are no longer an instrument to be lobbied by the domestic export industry or by the proponents of foreign aid. They provide today an insurance or guarantee against political and sovereign risk to the exporter for his supplier credit or to the bank that has extended a buyer's credit. In addition they sometimes also cover the transfer risk of private sector companies. Besides having an insurance or guarantee function some ECAs themselves extend credit or financing as well as interest rate support or even aid financing. In such functions they compete with the private sector banking system. Export credit support became in the 1970s more and more a political tool for countries to push their export industries. Furthermore, the developing countries played exporters from different countries against each other in order to realize their huge infrastructure projects in the energy, communication and transportation sector on the best possible financial terms. Thus rates declined and tenors grew longer and longer. The discussion and information forum of the Bern Union created in the 1930s by the ECGD and the private credit insurers from France, Spain and Italy was no longer able to monitor the risk situation at the different ECAs. ECAs became uneasy about the developments in respect to tenor and rates in their export markets. Within the OECD a group of experts on export credit was therefore created in 1963, which formulated guidelines for the exchange of information and mutual consultation. However, it took many more years until the `Arrangement on Guidelines for Officially Supported Export Credit' was accepted by a larger number of OECD countries in 1978.26 This arrangement is still a `gentlemen's agreement' among currently 23 OECD countries and not an OECD Act. It has, however, been adopted into European Union law. Since 1978 the Agreement has been modified several times through different packages, the Helsinki package in 1991, the Schaerer package in 1994, the Ex Ante Guidance on Tied Aid in 1996 and the Knaepen package in 1997. The major provisions currently are that a cash down-payment of a minimum of 15% of the export contract at or before the starting point of the credit is needed.27 The maximum tenor of the

35

CROSS-BORDER EXPOSURES AND COUNTRY RISK

credit varies according to the classification of the country. It should not exceed five years or with a prior notification eight and a half years. Only poorer development countries can obtain a tenor of ten years. An exception of twelve years is made for power plants other than nuclear power plants. The Agreement also regulates the minimum interest rate that should be applied. It has to be based on the relevant commercial interest reference rate (CIRR), which is the domestic rate for first class borrowers of the currency used, based on the funding cost of fixed interest rate finance over a period of no less than five years. On top of that interest rate a premium has to be applied taking into account the country risk. In addition the OECD established in 1998 a Project Financing Understanding that complements the Arrangement and is currently in place for a three-year trial period.28 This understanding takes into account the particularities of project financing and allows, for example, for some additional flexibility for the repayment of principal and the maximum repayment terms. Export credit financing has today become a much more predictable financing tool for the coverage of longer term cross-border financing. The different OECD countries have different set-ups, but on the major aspects such as tenor and price there are much more similarities than in the past. The agencies now have to cover their costs in the longer term and are, therefore, no longer cheap providers of funds. Because of this export credits no longer play the important role they did in the 1970s. International capital markets are today willing to underwrite sovereign risks which are similar to the risks the ECAs have been taking, sometimes at even lower costs. Furthermore ECAs have given themselves limitations in the amounts they are willing to underwrite, because country risk evaluation has also become an essential tool for them.

The multilateral financial institutions The multilateral financial institutions have also played a major role in providing funds for development. Some of these institutions have a worldwide approach, the best known being the World Bank Group with its agencies and associated companies such as the International Finance Corporation. Others have a regional approach such as the Inter-American Bank for Development which covers Latin America, the Asian Development Bank which looks after the developing countries in Asia, the African Development Bank which has the same task in Africa and the European Bank for Reconstruction and Development which covers the countries of the former Soviet bloc. In addition there is the Corporation Andina de Fomento, that sees its priorities in the

36

THE NEED FOR CAPITAL

Andean region of Latin America. According to Global Development Finance these multilateral institutions provided in 1998 a net flow of about US$26 billion and in 1999 of about US$20 billion.29 This figure is bigger than previously quoted under `official cross-border financing' because it includes all recipients of funds and not only the low and medium income developing countries. The activities of the multilateral financial institutions, which are owned by the industrialized countries as well as the developing countries, have come under criticism from several quarters and specifically the United States Congress, which questions their effectiveness to contribute to the economic development of the third world. While in the environment of the early twenty-first century such criticism might be warranted and a deeper review of the activities of the multilateral financial institutions is not only in the interest of the industrialized world but also in the interest of the developing countries, it should not be forgotten that these institutions have always been dominated by the governments of the industrialized world. Therefore their behaviour has in the past also reflected the development policies of the industrialized world. In the context of cross-border financing the activities of the multilateral institutions are significant in different ways. First of all they are a source of funds that exists in good and bad times. During the various debt crises of the last 20 years the multilateral institutions continued to provide funds, never exited the market and helped many countries to overcome their difficulties. The lending of these institutions is a positive factor for the private sector when it evaluates its lending and investment policies. However, the total amount of funds provided by the multilateral financial institutions is inadequate in relation to the continuously growing needs. Their responsibilities are examined in more detail in Chapter 5.

Official development assistance and official aid The high income countries of the OECD have created the Development Assistance Committee (DAC) which coordinates the flow of aid resources to the developing countries, the so-called `Official Development Assistance' (ODA). It also coordinates the same type of resources flow to the transition economies of the former Soviet bloc, which it calls `Official Aid'. The DCA has three main criteria for ODA.30 The resources have to come from the official sector and have to promote economic development and welfare. They are provided on concessional terms with a 25% grant element on the loans. ODA follows political criteria and not economic ones. It is not therefore concerned with country risk in the traditional sense, but takes into account western democratic values. The ODA element is therefore not discussed further here as a source of capital, because country risk is not

37

CROSS-BORDER EXPOSURES AND COUNTRY RISK

applicable. It has, however, to be acknowledged that ODA is an important financial contributor to the development of the developing world.

Private capital As will be clear by now, the various traditional sources that are providing funds for development, namely domestic savings, the ECAs, the multilateral financial institutions and the aid programmes, are not at all sufficient to cover the needs of the developing world to fund its economic development. Therefore cross-border private financial flows have to help to bridge the gap through foreign direct investments, equity portfolio investments, bond issues or bank lending. According to the World Development Indicators, net private financial flows to the developing world, including the transition economies, amounted in 1998 to about US$180 billion,31 being by far the most important provider of capital to the developing world. Private players are very much dependent in their decision making on their evaluation of the country risk in question. They are more likely in the first place to support the private sector in the countries concerned and therefore are rather hesitant to finance public service and infrastructure projects. To confirm this behaviour we have only to look back over the past few years and analyse the emerging capital markets' activities. The various crises in the emerging markets since 1994 which were covered in Chapter 1 have led to a change of attitude amongst international investors towards the developing world. The enthusiasm of the late 1980s and the early 1990s, which saw the emergence of specially dedicated emerging market funds and the introduction of emerging market securities as a special asset class, has more or less vanished. The Brady bonds, which for many years constituted a major part of the emerging capital market environment, were not a source of new funds, but replaced repackaged bank debt, at longer tenors and different prices. By the end of the year 2000 they had largely been exchanged into normal bonds. These exchanges did not bring new money to the developing world. The asset class of the emerging market bonds is today more and more incorporated in the high yield asset class and has lost its importance of a few years ago. While the private equity movement has brought new money to private corporations in the developing world, the exit strategies for these private equity investments were overshadowed by the new economy of the beginning of this century with its many then attractive looking internet-related Initial Public Offerings (IPOs). This fact has made it much tougher for private corporations in the developing world to attract new capital. The competition for capital is again on and the emerging market paper continues to be an esoteric piece in the investment puzzle. Investors' support and enthusiasm for raising the needed funds for the developing countries is no longer there. Only foreign direct investment will continue to increase as many countries are an attractive market for the multinational corporations of this world.

38

THE NEED FOR CAPITAL

For the sake of completeness we have to add to the providers of private funds the non-governmental organizations (NGOs). Their funds are not provided on economic terms and are therefore not of particular interest in the context of country risk. Nevertheless, it is interesting to note that in 1998 they provided US$6.9 billion.32

CONCLUSIONS We have seen that there is a tremendous amount of capital needed to support the development of the developing world and the transition economies. Of this a substantial part has to go to support public service and infrastructure as the basic elements for all economic development. The amount needed is currently estimated at over US$500 billion. Because of the long term nature of these two elements, they are more difficult to finance. The domestic sources of funds have to be better mobilized so that the collection of these funds is more efficient and the best possible use is made of them. The importance of a sound local banking system, the existence of a domestic capital market and a well functioning pensions scheme cannot be overestimated. The developing countries have therefore to make much bigger efforts not only to improve their banking systems, but also to create effective domestic capital markets and to develop their pension schemes so they can provide long term funds for development. It is still up to the specific country to provide the largest part of the funds it needs for its development. However, the official aid programmes will continue to be a substantial contributor of resources especially for the poorer countries. Their programmes are established according to the political agenda of the different donor countries. The multilateral financial institutions play an important role in shaping the development policies of the industrialized world. Their financial contribution to the development process of about US$20 billion per year is significant as it often acts as a catalyst for additional investments and loans from the private sector. ECAs have lost their importance in the transfer of resources as the total funds available are relatively minor and their costs are no longer as competitive as in the past. The NGOs as providers of funds have become more important over time and will continue to increase their importance not only as providers of funds, but also as voices in the discussion process about sustainable development. By far the largest provider of cross-border funds today is the private sector. Its position has become more important over the past decade as many developing countries have privatized at least part of their public service and many infrastructure projects. Such an importance also means responsibility. The decision process of the private sector is very dependent on the evaluation of the risks in its cross-border exposure. We will therefore now turn to the evaluation and assessment process of these risks.

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CROSS-BORDER EXPOSURES AND COUNTRY RISK

REFERENCES 1

The Economist, 2 September 2000, p. 62.

2

`Framework to measure sustainable development', an OECD expert workshop, OECD, Paris, September 1999.

3

See also Donor Support for Institutional Capacity Development in Environment: Lessons learned, OECD Publication, 1999.

4

`Entering the 21st century', World Development Report 1999/2000. Published for the World Bank by Oxford University Press, August 1999, p. 15.

5

World Development Indicators 2000, World Bank, March 2000.

6

World Development Report, p. 132.

7

An extensive report is given in Financing Private Infrastructure, World Bank, 1996.

8

Ibid., p. 10.

9

World Development Indicators 2000, p. 217.

10 Ibid., p. 216. 11 World Development Indicators 1999, World Bank, March 1999, p. 227. 12 Ibid., p. 272. 13 Martin Feldstein and Charles Horioka, `Domestic saving and international capital flows', Economic Journal, 1980, 90 (June) pp. 314±29. 14 Vamvakidis Athanasios and Wacziarg Romain, `Developing countries and the Feldstein± Horioka puzzle', IMF Working Paper, January 1998. 15 World Development Report, p. 35. 16 Ibid. 17 World Development Indicators 2000, p. 170. 18 Ibid., p. 171. 19 Hernando de Soto, The Mystery of Capital, Basic Books, New York, 2000, p. 66. 20 Global Development Finance, Analysis and Summary Tables, World Bank, Washington, April 2000, p. xxi. 21 World Development Indicators 2000, pp. 338, 352. 22 Waman S Tambe and Ning S Zhu, `Export credits: review and prospects', CFS Discussion Paper Series, World Bank, March 1993, p. 1. 23 Ibid., p. 3. 24 Export Credit Financing Systems in OECD Member and Non-Member Countries, 1999 supplement, OECD, Paris, 1999, Introduction, p. 1. 25 Tambe and Zhu, `Export credits'.

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THE NEED FOR CAPITAL

26

The 1998 version of the Arrangement can be found under Annex I of Export Credit Financing Systems in OECD Member and Non-Member Countries.

27 Ibid., pp. 10±25. 28 Ibid. The Understanding is to be found under Annex II of the Agreement. 29 Global Development Finance, p. 239. 30 World Development Indicators 2000, p. 339. 31 Ibid., p. 338. 32 Ibid.

41

3 Risks in cross-border exposures and their assessment

INTRODUCTION The risks involved in cross-border exposures can be summarized under the term of `country risk'. Traditionally, country risk consisted of two major risks, the transfer risk and the political risk. While these are still the bases for our consideration, additional aspects have to be included because crossborder financing has moved away from lending to sovereigns or sovereign-like institutions which were in the 1970s and early 1980s the normal recipients of cross-border funds. As was seen in Chapter 1, the private sector in the developing world has become a huge and diversified borrower of crossborder funds as well as an important issuer of equity in the international capital markets. We further have to acknowledge that besides the traditional financial products for the emerging markets all the new types of securities and derivative instruments, that have so dramatically changed the international capital markets over the last twenty years, have found their way into the emerging markets. Furthermore, there exists a much bigger need for cross-border funds to develop the economies of the third world than seems available today. Country risk can lead in extremis to a complete loss for the lender or investor. The worst losses suffered from country risk in the last sixty years came about through the nationalization of industries and/or economic sectors without (or with inadequate) compensation or when countries repudiated their debt. Due to the integration of the world at large, countries can no longer operate only on their own agenda. The worst case scenario today is therefore more that of a substantial loss of value of an asset due to an unpleasant restructuring or rescheduling of a cross-border exposure.1 As all assets have a market value today we regularly find a loss of value due to changed market conditions. We are all familiar with credit risks, counter-party risks, and market risks as well as liquidity risks. Most

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important internationally operating institutions control these risks in a fairly sophisticated way. In the world of cross-border financing these risks are in addition influenced by the country risk, the topic of this book. The country risk which is a basic risk that is specific to all cross-border exposures will therefore be investigated in more detail. Country risk can be broken down into its two major parts, transfer risk and political risk. Transfer risk depends on the capability to honour one's debt whereas political risk involves the will to honour one's obligations. These risks do interrelate. They probably do not depend completely on each other, but very often influence each other. This is especially the case if one of the two risks is worsening. The other risk is then frequently drawn along in this deterioration. An example is the situation where the economy of a country has substantially suffered ± e.g. from changes in international commodity prices such as oil or copper ± which then can lead to enhanced political instability due to economic difficulties and therefore increase the political risk. Transfer risk on the other hand can also be very much influenced by political developments such as the election of a radical leader or the sudden introduction of capital transfer controls for political reasons. The interrelation of the transfer and political risks which form the country risk is difficult to quantify. In the overall assessment of country risk, the interrelation of the two risks will become manifest through their respective weighting. In the analysis of country risk the two elements should be dealt with individually. It is therefore advisable to evaluate each risk separately in order to find out its characteristics. We will start with the transfer risk.

TRANSFER RISK The economic part ± i.e. the capability to incur foreign debt and to honour this debt financially ± is in today's relatively stable geopolitical environment the major factor in the evaluation of country risk. This evaluation is called the transfer risk assessment. The amount on which the transfer risk of a country is based is the sum of all actual and contingent cross-border liabilities of the country concerned as well as of all its institutions, corporations and individuals. It is the stock of debt of the country in question. These cross-border liabilities, be they private or public, are denominated in the most actively traded convertible currencies ± such as the US dollar, the Euro or the currencies of the European Union, the Japanese yen or the Swiss franc. The capabilities of a country to honour its external obligations are in direct relation to its foreign currency earning power as well as to the state of its economy. Through the foreign currency earning power the necessary foreign exchange has to be

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accumulated so that not only the servicing of a country's debt as a sovereign borrower is assured, but also the servicing of the cross-border liabilities of the private sector operating within its borders. This latter obligation is a kind of contingent liability of the sovereign in relation to the private sector. The strength of its external economic sector signals to a country and its economic entities the capability to incur cross-border liabilities. Transfer risk is structured around the relation between a country's current cross-border liabilities and its need to incur new debt as well as its ability or inability to earn the necessary foreign exchange to service those liabilities and/or to obtain new cross-border financing. The intensity of the transfer risk is demonstrated in the quality of the current account balance and the balance of capital movements of a country as well as their projections. Commercial or financial debt obligations, be they from a loan, a trade transaction, a bond issue or any other financial product, have to be serviced by future cash flows or new financing. This ability is called credit risk. A similar future obligation exists if in addition the debt is incurred crossborder. Such cross-border liabilities of a country and its debtors must be paid off through future foreign exchange earnings or additional capital imports. The commercial debt obligation brings with it the credit risk whereas the additional cross-border aspect brings with it the country risk. As countries are sovereign entities, they have the authority to allocate their available foreign exchange to whatever debtor they feel obligated to. This freedom of allocation of foreign exchange cannot be legally contested as it is possible with the servicing of a commercial debt. In order to do this allocation in an internationally accepted just and effective way, countries need to have a sophisticated foreign currency management. The basis of this is an extensive and accurate knowledge of the country's foreign currency liabilities and assets as well as the debt profile of the exposure. In addition, countries should have ethical standards which hinder corruption and assure an equitable servicing of the debt. To evaluate transfer risk, countries have to be examined in view of their economic situation, their production potential, their foreign trade, their price stability and their resources. In a modern expression this is called `international competitiveness'. These are the major factors that enable a country's capability to honour its debt to be established. Some countries have additional capabilities, e.g. a substantial income from their service sector or from their citizens working abroad. These aspects are all measurable factors. They even lend themselves to projections into the future. Let us now look at the different factors that influence the flow of foreign exchange across borders and at those that determine the capability of a country to obtain foreign currency funds. We will then define

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the notion of external debt and evaluate the different indicators to measure transfer risk. Finally we will discuss the assessment of transfer risk.

Factors influencing cross-border foreign exchange flows The factors that influence cross-border foreign exchange flows are either within a country's own control or are outside of it. They can increase the inflow or outflow of foreign exchange or both. A country's foreign exchange inflow usually does not match its foreign exchange outflow. A positive or negative gap always exists. This gap will show up in the balance of payments either as a surplus or a shortfall which will have to be compensated by a capital transfer. For country risk assessment purposes a potential shortfall is of concern. The ease or difficulty of making up that shortfall influences the transfer risk intensity of the country in question. Let us look at some of the factors that influence the cross-border flow of foreign exchange.

Economic policies Economic policies have a major bearing on a country's economic strength and on its external accounts. They also influence the perception of a country's attractiveness. They fix the way in which a national economy is managed. They are primarily responsible for the healthy or unhealthy economic development of a country and the creation or destruction of wealth for its population. They influence the division of the economy into the state and the private sector. They create or eliminate incentives for efficiency in all sectors of the economy. They are responsible for the state of public finances and influence inflation. Sound economic policies create a favourable economic climate for a country. They induce investments and help to develop an efficient production structure which enhances a country's international competitiveness.

Inflation Inflation is one factor which can have a significant influence on the foreign exchange operations of a country. We are referring here principally to home-grown inflation. Such inflation has its origin in the economic policies of the country in question. The main cause of inflation is normally an excessively expansionary budget and monetary policy. An above average inflation differential to the

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major trading partners hampers the international competitiveness of the terms of trade since it means higher labour costs and higher costs for nationally bought products. Countries can mitigate this deterioration of the terms of trade by reverting to a floating rate regime for their currency or by making a competitive devaluation in order to save the export capabilities. In the 1970s and early 1980s inflation was still a problem in many countries. Some politicians even considered it necessary for economic growth. Today inflationary environments have become more the exception than the rule. Politicians all over the world have recognized that inflation destroys value and hurts mostly the poorer part of the population which forms normally their largest political constituency. Inflation, however, can also be imported. Changes in prices of commodities, e.g. oil, and goods and services imports, are then the reason. In this case normally a large number of countries is simultaneously affected and therefore inflation differentials between the countries tend not to become substantial and are more manageable.

Exchange rate policy There are several exchange rate policies from which governments can choose. The most widely accepted and supported policy is the free floating of the exchange rate where the market decides on the rate of exchange. Under such a regime the foreign currency reserves of the country are protected as the government does not have to support its currency with its reserves. Sometimes governments lean towards a smoothing out of the volatility of their exchange rate by using their reserves. This procedure is then called dirty floating. The opposite regime is the fixed exchange rate regime whereby a country fixes the exchange rate of its currency directly to the US dollar or another freely convertible currency or within a specific band. Unless a country uses a currency board regime, under a fixed exchange rate regime it has to support its currency with its reserves when it comes under pressure or has to introduce controls to regulate the in- and outflow of currencies. Controls of capital movements are never appreciated by cross-border providers of funds. These controls can, however, have a beneficial result for the country without hindering long term investments, as the Chilean encaje regime has shown over many years. An intermediate type of regime is the crawling peg regime whereby a country continuously devalues its currency because of significant inflation differentials with its major trading partners in order to remain competitive. Under this system the government is also supporting its currency which can mean substantial risks in times of crisis. Therefore, the floating rate foreign exchange regime has over the last twenty years become the most widely accepted and also has many friends in the developing world. It can lead, however, to tremendous short term volatility in the international value of the currency in times of crisis as was the case during the Asian

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crisis. However, most of the East Asian currencies have since recovered much of the lost ground as confidence in the value of their currency has returned.

Degree of central bank autonomy The independence of the central bank is considered a very important factor for a country to obtain price stability, i.e. low inflation. The most cherished institution in this respect was the German Bundesbank until the introduction of the Euro at the beginning of 1999. There are, however, still arguments that too rigid a pursuit of price stability can hinder economic growth. Economic growth is, as we all recognize, essential for development. This is even more the case in the developing world with the need to alleviate social disparities and to reduce poverty. Therefore quite a few developing countries still use the central bank as a tool to help achieve the goals of their economic policies, thereby severely limiting its independence. It is, nevertheless, gratifying to note in this context that the use of the central bank as a printing press to solve budgetary problems is no longer considered a viable alternative to an economic adjustment programme.

Use of cross-border funds A factor often neglected in evaluating transfer risks is the actual use that is made of the funds that a country and its institutions borrow from abroad. This neglect is obviously especially forthcoming with sovereign borrowings as these funds tend to disappear in the huge basin of government funds. The utilization of borrowed funds by private entities is normally much more easily identified as current standards in lending and in capital market transactions always ask for the purpose of the taking up of funds. Private borrowers of cross-border funds should normally show a good capability of earning foreign exchange. Sovereign borrowing in international markets, on the other side, has become more and more a support function for the domestic budgets or for the balance of payment. Furthermore, many public activities which had a clear usage for their borrowed funds have been privatized over the last ten years. A newer development is that countries take in funds for specific political or economic programmes from the multilateral financial institutions. The borrowing to cover budget deficits has an even more limited appeal to foreign lenders and investors when it is used to maintain the welfare state, to keep up subsidies for food or to support dying industries, rather than for the building of a sensible infrastructure for a growing economy.

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CROSS-BORDER EXPOSURES AND COUNTRY RISK

The use of cross-border funds can and should, whenever possible, create a new potential for foreign exchange earnings through increased exports and/or import substitution. It should not have only the opposite effect by expanding the need for foreign exchange through increased foreign debt. A careful analysis has thus to be made of the use of imported funds in order to find out where the borrowed funds are going. It goes much beyond what is done for credit risk evaluation and is often much more difficult to pin down. This analysis is as important for the private sector as it is for the public sector. It is understood that it is not always an easy undertaking especially in respect of the public sector. Studying the budget as well as the accounts of the central government of the country that is evaluated can be helpful in this context. Through a responsible policy of usage of cross-border funds for itself and the private sector the borrowing country can influence its standing with foreign investors and lenders and consequently its ability to obtain foreign exchange.

Terms of trade and services The development of the terms of trade and services, i.e. a country's position as a contributor to and user of cross-border trade and services, has a most significant influence on a country's foreign exchange operations. In this respect it is again economic policies that have the biggest impact. They influence the relation between self-sufficiency and domestic demand, but also determine the dynamism of an economy. Both have an influence on the terms of trade and services. They either bring necessary structural changes to a country's economy or prevent such changes and therefore determine its international competitiveness. Through customs levies and excise taxes economic policies do manipulate the cost of products and services for the `benefit' of the domestic economy. The General Agreement on Tariffs and Trade (GATT) and General Agreement on Trade in Services (GATS) have substantially contributed over the last fifty years to a worldwide reduction of customs tariffs. They have liberated the international trade in goods and services from many distorting and protective measures. However, we still find many trade barriers, either quantitative or qualitative, that impair a country's ability to earn foreign exchange. Furthermore, trade wars are still erupting from time to time between the major economic blocs and/or different nations or even within economic blocs, one of the more recent examples being the rows in Mercosur between Argentina and Brazil after the Brazilian crisis. The litigation procedures of the World Trade Organization (WTO) are today the most commonly used to solve such differences. As was said above, economic policies obviously influence exchange rate policy and inflation, both of which have an impact on the terms of trade and services. Last but not least, terms of trade are also influenced by the educational standards, the ingenuity, the adaptability and the dynamism of a country's population.

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Natural resources Natural resources are an important factor in many countries' potential for economic development. They can help reduce imports or be the source of substantial export earnings. They are, however, sensitive to international price movements. Unfortunately, an abundance of natural resources often leads to their exploitation for short term benefits only or even to their squandering without being used to develop additional economic activities for the long term benefit of the population of the country in question. A look at many oil producing countries sadly confirms this. On the other hand countries with little or no natural resources such as Japan and Korea, but also many European countries, have demonstrated how economic wealth can be accumulated through ingenuity and hard work. When analysing the potential of a country's natural resources it is important to evaluate the national policies for their depletion and have as well a view on the development of commodity prices. As price fluctuations of commodities are common, price changes can be substantial and obviously affect the foreign exchange operations of a country. They can wreck a national budget that depends on levies from its natural resources. For example the Mexican budget had to be adjusted several times in 1998 for these reasons as the price of oil fell dramatically. Efforts have often been made to stabilize prices and eliminate excessively wide fluctuations through buffer stocks and cartels. But these ideas, which can certainly help the producers, are difficult to implement. Only in the case of oil has a cartel worked in favour of the producers for several years, i.e. the Organization of Petroleum Exporting Countries (OPEC). It has certainly had beneficial effects for some countries, but raised unrealizable expectations in others and created grave economic problems in many. In addition, this cartel was one of the major causes of the disruption of the world economy in the late 1970s. In the mid-1980s it started to disintegrate, but still continues as an association. The International Monetary Fund (IMF) created a special facility for countries that are adversely affected by movements of commodity prices.

Financial markets The international financial markets do influence cross-border foreign exchange operations. They fix the interest rates which determine the cost of funds. Interest rates fluctuate and depend very much on the economic developments in the major OECD countries, especially the United States of America. Developing countries pay a premium on international market rates depending on their standing which is basically the perception of their country risk intensity. Interest costs have become for many developing countries a substantial factor in their cross-border foreign exchange flow. These

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countries' finances are therefore very sensitive to interest fluctuations. The international consensus on promoting economic growth with low inflation has fortunately led to a more stable interest environment and eliminated some of the volatility that was still prevalent in the early 1980s.

Natural catastrophes Natural catastrophes normally only have a major bearing on smaller and less developed countries. One recent exception was the earthquake in Turkey in August 1999 which will cost the country probably 2±3% of its GDP. Natural catastrophes mostly affect the agricultural sector with the destruction of harvest and land, but can also damage substantial parts of the infrastructure. The loss of part of the food basis leads obviously to additional imports and therefore to a loss of foreign exchange. Bangladesh has often been in such a situation. While natural catastrophes are quite unpredictable, their effects are fortunately often reduced through international aid programmes. It is foreseeable that the destruction of the ecological balance occurring in many countries will lead to unmanageable problems for them in the future as natural catastrophes will occur more frequently. One has therefore to expect new risks in this direction which are for the time being difficult to evaluate.

Factors influencing the capability to obtain foreign currency funds All the factors so far enumerated that influence the cross-border flow of foreign currencies obviously also have an influence on a country's and its institutions' capabilities to borrow foreign currency funds. These funds can basically be obtained in the international financial markets through loans, bonds and equity placements or through direct foreign investments. In addition, governments and the multilateral financial institutions are also providers of funds.

Credit risk and due diligence The credit risk of a country is the same as the country risk and is called sovereign risk. All other institutions, corporate customers or individuals depend in addition on the quality of their credit risk to obtain foreign currency funds. Financial institutions and investors have developed sophisticated systems to evaluate credit risks. The quality of the credit risk has to be lower for cross-border funds than for domestic currencies, as the former transactions have in addition a country risk. The addition

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of the credit and the country risks should correspond to the same degree of risk as would be found in a purely domestic transaction which means that the credit risk of a cross-border transaction has to be substantially lower to meet the domestic credit risk qualifications. Cross-border credit risk evaluation is normally more time consuming due to different accounting standards. It is more complex in its structure and more difficult to monitor. Such credits therefore are typically credits of a substantial size and lend themselves to risk sharing. Financial institutions are preferred credit risks in the emerging markets, because they operate in a regulatory environment and are therefore considered better credit risks. One often finds the feeling that they carry an implicit governmental protection umbrella. This assumption, however, can lead to a fallacy. Similar difficulties in evaluating the credit risk are faced in the due diligence process for a capital market transaction. Furthermore, companies have in this case often to adjust their accounting to at least internationally accepted accounting standards, the IAS norms. The cost of placing an emerging market transaction for a private borrower or issuer in the international capital markets is normally higher than for a similar name from an OECD country. In order to issue equity in the international financial markets, companies have also to comply with the regulations of the respective stock markets. Besides the sovereigns, traditionally only the largest and strongest private corporations from emerging market countries have the capabilities to obtain crossborder funding through debt or equity. The new economy is also changing that and allows start-ups to tap international equity markets. A factor often neglected in the appraisal of the credit quality of a borrower of cross-border funds is the borrower's capability to earn foreign exchange on its own and its exposure to the domestic conditions. But it is important in relation to the country risk which is always attached to the credit risk in cross-border financing. A borrower with a strong diversified export business to customers in the highly industrialized countries certainly has a better capability to service its foreign currency exposure than a local provider of electricity. As there are also countryspecific domestic factors that can have an influence on a potential default of a borrower of crossborder funds, it is advisable to incorporate them in the credit review. An example in this connection might be the regulatory constraints in the telecommunication sector on raising tariffs to cover costs due to inflation. The traditional trade financing among banks is the most typical case where a specific foreign exchange flow is directly connected to the exposure and the exposure therefore liquidates itself at maturity. Exposures from trade financing have traditionally had a much lower, close to zero, default rate due to transfer risk than other types of lending. A new factor that emerged during the Asian crisis was the interrelationship between the market risk and credit risk of emerging market derivative counterparties. In many cases market volatility increased exposures to local counterparties while at the same time the credit quality of the local counterparty deteriorated.2

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Market conditions and liquidity Market conditions are a factor outside of the control of most countries. They are, nevertheless, an important factor in several respects for countries to be able to raise cross-border funds. Market liquidity is influenced by market conditions. As financial market conditions have to be taken globally into account, all major capital markets are involved. They tend to depend on each other. Of all the markets the situation of the Euromarket is the most significant since it is still the major provider of funds and, therefore, of liquidity for cross-border financing. By the same token the situation on Wall Street influences the issuance of equity and the valuations of companies. Abundant liquidity usually leads to easier market conditions. This was, as is known today, one of the reasons leading to the substantial build-up of debt by the developing countries at the end of the 1970s. The recycling of Petrodollars was then the name of the game. But not only is liquidity an important factor for market conditions but also the maturity of exposures. Shorter tenors are in general easier to finance than longer ones. They tend to be placed in the bank market whereas longer tenors are placed in the capital markets. Liquidity as well as available tenor in cross-border fundraising are also influenced by perception and not only on fundamental analysis. This leads to the often quoted `herd' instinct. Investors continue to buy as long as they feel others are doing the same and reverse their behaviour as soon as they see others are selling. This situation is more prevalent in the capital markets than in the bank market where country risk analysis has become an accepted indispensable tool. The Mexican crisis of 1994 dried up the market for funds for many other Latin American counterparties. The Asian crisis of 1997 took the liquidity for emerging markets out of the international markets within weeks and not only for the countries concerned, but for all emerging markets. The effect of worldwide contagion then became reality for the first time. The Russian and Brazilian crises prolonged the contagion effect, so that the flow of cross-border financing to the emerging markets was substantially reduced. In addition, more attractive investment opportunities in the new economy diverted funds from the higher perceived risks in the emerging markets.

Concessional funds Concessional funds can only be obtained by the poorest developing countries. They are concessional because they bear an interest rate below market rate and/or have a maturity much longer than any available in the international financial markets. Major suppliers of concessional funds are governments and supranational bodies. Concessional funds are either negotiated bilaterally between governments or are available after a credit and project assessment by one of the supranational bodies

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such as the International Development Agency (IDA). In the 1960s and 1970s, electorates in most industrialized countries were convinced that concessional funds had to be made available for the developing world. Today the situation has changed under the budgetary constraints everywhere, but also by frustration over what has been achieved by these funds. There still exist donor clubs for several countries; the largest amounts have been made available to India.

Other factors A few other factors are worth mentioning in connection with a country's ability to obtain foreign currency funds. The size of a country influences lenders and investors in their perception of country risk. The larger a country and its economy, often the higher is its capability to obtain cross-border funds ± according to the opinion that size is an insurance against the perils of foreign exchange operations. Russia is the most recent example of how wrong such an assumption can turn out to be. The same fallacy is true regarding GNP per head. Richer countries seem to have easier access to cross-border funds than poorer ones. This judgement is obviously not based on an analytical evaluation and therefore neglects the fact that transfer risk is basically a risk of debt service capabilities and not of substance. Similar thinking was to be found many years ago in the analysis of credit risk. In its current evaluation standards credit risk quality is strongly influenced by future cash flow considerations and to a much lesser extent by the strength of the current balance sheet of the borrower. The same holds true for the transfer risk where the forward looking approach with respect to the potential of foreign exchange earnings becomes more and more important for the appraisal process. Looking especially at short term developments a factor often taken into account is payment delays. In bond issues from emerging market borrowers such payment delays usually get substantial publicity and are therefore widely known. Financial institutions are accustomed to monitoring payment delays. If they have a regular flow of business to developing countries they will certainly monitor this aspect carefully. The delay can, however, be due to creditworthiness and/or transfer risk deterioration. The latter is of particular importance in the context of this book.

The external debt We have analysed the different factors that influence the foreign exchange earnings potential of a country as well as its capabilities to incur foreign debt. In order to measure the potential and capability we need indicators. In addition we need a yardstick to measure them against. The

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yardstick is the total of all financial cross-border liabilities of a country or, in short, the external debt. In order to obtain a meaningful result from which to make the necessary deductions we must also know the structure of the debt. Its four major elements are the total amount, the maturity profile, the currencies involved and the interest rates. The total amount of external debt should include the public sector cross-border debt, which is not only the direct and the guaranteed debt of the central government, but also the debt of the states, regional and local governments as well as the non-guaranteed cross-border obligations of all public sector entities. In addition the foreign debt of the private sector has to be added to obtain a complete picture. The computation has also to include the contingent liabilities. The maturity profile, i.e. the schedule of repayments for all parts of the external debt, should be known. The maturity profile should be structured in such a way that it is clearly evident when each instalment is becoming due. Short term debt up to one year should be identified as well as longer term debt, usually structured according to the year when it becomes due. This also has to include the interest becoming due in the specific year. The maturity profile has, therefore, to incorporate the repayment schedule of each cross-border liability. A breakdown along currency lines is interesting because of its relation to the country's export profile. It can indicate potential cross-currency risks or a substantial matching of foreign currency debt and export income. The modern currency hedging techniques, however, allow borrowers to hedge their cross-currency risks. Interest rates and interest calculations are another parameter of the external debt that has to be known. It allows the country's sensibility towards movements of interest rates to be measured and gives an indication of the annual interest bill. As interest rate hedging is available to many emerging market participants the effective interest bill is often difficult to establish. Interest payments for one year added to the repayments due in that specific period gives us the so-called debt service for that year. In addition to this breakdown, it is of interest to distinguish the different creditors of a country. There are usually four major categories in developing countries: governments and their different export credit agencies; multilateral financial institutions such as the International Monetary Fund and World Bank; the international banking community; and investors, namely individuals and corporations. The importance of these four categories as providers of funds has changed substantially over the last ten years. One might think that in view of the importance of country risk it should be fairly easy to obtain the necessary figures for the total external debt of a country, its structure and its debt service. This is, unfortunately, not the case; no country or institution publishes the external debt in such detail

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as outlined above. Therefore, every in depth analysis has to rely on many estimates. However, it is customary today to use the definition of the World Bank as outlined in the Country Tables in Global Development Finance. The short term debt as included in the stock of debt is an estimate by the World Bank. These Tables are published on a yearly basis. Figure 3.1 is based on the Tables.3 As countries have not only external debts but also external assets, such as the reserves of the central bank, these assets must be taken into consideration. The private sector can be in the same situation of having assets abroad. However, the private sector's assets abroad are much more difficult to assess, as they are often out of the reach of a lender or investor and therefore cannot play a role in the defining of the external debt of a country. The private assets abroad, the most notorious being the famous flight capital, are nevertheless important and have played a significant role when a country becomes an attractive investment opportunity. The assets abroad of legal entities such as corporations and financial institutions are, however, often known and are best netted on an individual basis and taken into consideration for the credit analysis. The reserve position of a country is always known and of particular importance because it gives an indication of the international liquidity of the country in question. Several countries publish this on a monthly or even shorter interval. One has to be aware of how a country informs about its reserve position. In addition its composition should be known, as the reserves sometimes also contain non-convertible currencies. Furthermore, it is of interest to know if any of the reserves are pledged against a short term bridge financing. Ascertaining the pledged amount of reserves is usually very difficult unless it is public knowledge.

Figure 3.1 Debt stock and its components.

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In connection with the establishment of the external debt profile of a specific country, it is further important to know if there exist any open credit lines not yet used. For example, every member country of the IMF has several regular quotas on which it can draw. These quotas enable it to take care of short term balance of payment difficulties. They have been increased regularly with the general adjustment of the quotas. The Bank for International Settlement in Basle publishes figures for open credit lines to developing countries supplied by the private banking systems of the 14 reporting industrialized countries on a regular basis. On the one hand, open credit lines enable a country to manage its short term liquidity better, but on the other hand they usually lead to an increased total external debt at a later stage. The last point to be raised under the heading of external debt is the cross-border liabilities that are only contingent, and some of which are not even on a contractual basis. These liabilities can play a very damaging role in times of turmoil and are even often a factor in building up trouble. They are what has been called `hot money'. They are the foreign portfolio investments which consist of all the investments in local securities that have been made by foreign investors. Foreign investors in this context also include domestic investors who use money domiciled abroad to invest in their country. Foreigners are attracted to emerging markets for different reasons, such as high interest rates, undervalued equities or exciting stock exchange performances. They were encouraged in their speculative behaviour in 1994 by their rescue in the Mexican debacle, but suffered a lot when the Russians let them down in 1998. However, the classical foreign direct investment (FDI) has, in contrast, mostly beneficial results. Its inflows and outflows are in many developing countries still very much controlled by the authorities. Remittances such as dividends or royalties from FDIs have never been a factor that led to difficulties in the external accounts of a country.

Indicators to measure transfer risk Having analysed the factors that influence the foreign exchange operations and foreign debt situation, with some additional observations regarding external debt, we should now try to find which indicators can measure the intensity of transfer risk. Transfer risk obviously increases if the availability of foreign exchange and foreign borrowing for a country and its private sector is deteriorating and improves if availability is increasing. Such a change in the quality of transfer risk can be due to short term changes in one or several of the factors enumerated before. In this case liquidity problems would be involved. However, a change can also be the result of circumstances that have evolved over many years, so that the solvency of a country is changing. Many indicators are

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available to help us in the evaluation. The best known and most pertinent are the following: debt service ratio, debt/GNP ratio, interest service ratio, liquidity ratios, reserves/imports, liquidity gap ratio, current account balance/GNP ratio, growth of export ratio and compressibility ratio.

Debt service ratio This indicator measures the payments for servicing the external debt over a certain period of time in relation to the total foreign exchange income out of exports of goods and services including workers' remittances during the same period of time. The payment for servicing the external debt consists of interest payments as well as the principal due measured for debt with maturity over one year. The foreign exchange income is computed in its totality and comprises income from exports and services as well as income from workers' remittances. The debt service ratio is usually measured for a period of one year. As there will be inaccuracies in the different parameters measured, the development of the debt service ratio has to be compared over several years. This way it will show the trend. It is expressed as a percentage figure: Interest and principal on external debt with maturity Debt service ratio =

over one year over period N __________________________________________ Income from goods and services (including workers' remittances) over period N

The debt service ratio is also forecasted for future periods. While the outflow of funds can often be compiled with good accuracy, the income side is subject to many assumptions and will always be an estimate. The lower the debt service ratio, the better is the capability of a country to honour its debt. A debt service ratio of 10% is considered very good. Above 25% is viewed as a fairly difficult situation in the context of transfer risk, because it often leaves the country with not enough foreign exchange to cover the necessary daily imports. As the debt service ratio is a relation between three numbers, its status depends on the development of each of the three. Greater volatility is found in the repayment of principal and foreign exchange income from exports than in interest payments, which are more stable. As an example, an improvement in the debt service ratio normally has its origins in a substantially reduced principal because of the maturity profile or in a changing foreign exchange income rather than in a change in the level of interest payments.

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Debt service ratios for certain major developing countries between 1980 and 1998 are shown in Table 3.1.4 The major drawback of the debt service ratio is that it assumes that the country in question can repay its debt out of its own resources. As we saw in the previous chapter, this is in general not possible since developing countries need a continuous import of capital goods to grow and to maintain current export performance. A 10% debt service ratio is considered good because such a ratio leaves ample room for expenditure on necessary imports. It would, nevertheless, be fairly unwise to assume that the transfer risk is only minimal because of a 10% debt service ratio, as that ratio gives no indication if a country runs a positive current account or not. The debt service ratio measures solvency more than liquidity. A better ratio would be one that measures the result of the current account balance against the amounts needed for interest and principal payments. This would clearly show the difficult situation of many countries in managing their external debt, as the ratios would often be negative. Even if only the necessary payments for interest are taken into account, the situation is still alarming, because every country with an external debt but not a positive current account balance cannot match its interest payments. With the exception of some special situations, mainly due to huge natural resources, it is difficult for developing countries to achieve a better situation. The debt service ratio is, nevertheless, a very well known and widely accepted ratio. Comparing it over a certain period of years as in Table 3.1 gives an indication of the development of a country's transfer risk. But it is important to bear in mind that short term external debt is always excluded. The Asian crisis, for example, had its origins in the nonmanageability of short term indebtedness, while the debt service ratio was fully acceptable. As the debt service ratio is a relatively crude measurement with various shortcomings, a direct translation of the debt service ratio into a specific transfer risk intensity should not be made. Such reasoning could lead to a very superficial assessment of a country's situation. Table 3.1 Debt service ratios for some major developing countries (%)

Brazil Mexico South Korea India Nigeria China

58

1980

1990

1995

1998

63.3 44.4 20.2 9.3 4.1 n.a.

22.2 20.7 10.8 32.7 22.6 11.7

36.8 27.8 7.9 28.1 13.8 9.9

74.1 20.8 12.9 20.6 11.2 8.6

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The debt service ratio therefore has several drawbacks. Various suggestions have been proposed to overcome them. One is to average out interest payments and principal due by adding the two over several years and then dividing the total by the number of years used. Such a method focuses even more on the solvency aspect of a country, therefore neglecting the liquidity problems that can suddenly erupt due to a high debt service obligation in one year. The same can also be applied to the denominator which measures exports where a prognosis has to be made. The averaging out of projected exports should probably be done only over a fairly short period, e.g. three years, in order to give a useful indication. Another drawback of the debt service ratio is that it neglects the extent to which imports can be compressed to compensate for foreign exchange shortages. While this is obviously often done in times of difficulty, it is not easy to assess the extent to which such compressions are done or are possible. Finally, the traditional debt service ratio omits the income from currency reserves as well as from foreign investments. Such income is, however, only of minor importance for many LDCs. While the debt service ratio is no perfect indicator to measure a country's ability to service its external debt, it is, nevertheless, the most widely used. It is found in the Country Tables published by the World Bank in Global Development Finance, together with other major indicators which are dealt with below. It is a useful indicator that can help to assess transfer risk. It should always be used in its original form in order not to lead to confusion when debt service ratios of different countries are compared.

Debt/GNP ratio This ratio assumes that the relation between total foreign debt and gross national product has an influence on transfer risk. In the Country Tables the debt now includes an estimate of the short term debt. As they often also exclude short term debt up to one year, it is important to make sure that comparable figures are used. The ratio is measured as a percentage.

Debt/GNP ratio =

external public and private debt __________________________ GNP

Table 3.2 shows some examples.5 The higher the ratio, the higher the risk involved. A ratio below 15% is considered very acceptable, while a ratio over 30% is viewed as a very difficult situation.

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Table 3.2 Examples of debt/GNP ratios (%)

Brazil India Thailand

1980

1990

1998

31.5 11.0 25.9

26.5 26.3 33.4

30.6 23.0 76.5

Table 3.2 shows the substantial increase in the ratio of Thailand between 1990 and 1998 which was due to significantly increased short term debt. This development then led to the Asian crisis as we saw in Chapter 1. The statement that this ratio is a measurement for a country's transfer risk intensity has to be qualified. The same percentage can mean very different transfer risk situations. First of all, the components of the GNP must be known and analysed. A highly export-oriented country has a different potential to incur external debt than a country that creates its GNP internally. The first earns relatively more foreign exchange to service its level of debt than the second. A country with a substantial public sector offers better control over inflow and outflow of its foreign exchange, but the flexibility of its economy and its ability to adjust to a changing situation are hampered. The latter capability is much in need today and a big public sector is currently considered more of a liability than an asset. Therefore the public sector is largely in decline nearly everywhere. The size of the GNP involved can also be of importance, because a large GNP tends to appeal more to lenders and investors than a smaller one. The debt/GNP ratio is again a ratio that looks more at the solvency of a country than at its liquidity. It certainly cannot be used as an early warning indicator to spot liquidity problems but is useful in assessing the overall creditworthiness of a country that uses the international financial markets.

Interest service ratio This is derived from the debt service ratio and corresponds to the following equation:

Interest service ratio =

Interest payment over period N __________________________ Exports of goods and all services (including workers' remittances) over period N

The period N is usually one year and the following always assumes a one-year period. In contrast to the debt service ratio, the interest service ratio focuses more on the liquidity aspects of the external debt exposure. It also excludes short term external debt under one year. It is by definition always

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lower in percentage than the debt service ratio. The difference between the two ratios shows the percentage of exports of goods and services needed each year to service the principal. It is therefore interesting to look at the differences between the two. Table 3.3 shows a comparison of these differences for five countries.6 An increasing interest service ratio shows that more and more of the exports of goods and services are needed just to service interest payments on the foreign debt. The change in the difference between the two ratios, however, gives some indication about the development of the structure of the external debt. A decreasing difference indicates that the country was in a position to repay part of its external debt or to stretch it and, therefore, to obtain a better maturity profile of its debt. The interest service ratio is a good complement to the debt service ratio. However, it does not take into account the debt repayment that is due within the same period as the interest payments. The interest service ratio was excellent in East Asia, but the repayment needs on the short term debt suddenly went out of control as the assumed automatic rollovers were no longer feasible.

Liquidity ratios Until the late 1970s the concern of lenders was mainly with the solvency of a country, and the inclination was therefore to look only at the medium term situation. The rescheduling wave that started in late 1981 dramatically showed the importance of liquidity for a country's performance in Table 3.3 Comparison of debt service and interest service ratios (%)

Argentina Brazil India Korea Thailand

Debt service ratio Interest service ratio Difference Debt service ratio Interest service ratio Difference Debt service ratio Interest service ratio Difference Debt service ratio Interest service ratio Difference Debt service ratio Interest service ratio Difference

1980

1990

1998

37.3 20.8 16.5 66.3 33.9 32.4 9.3 4.2 5.1 20.2 13.0 7.2 18.9 9.5 9.4

37.1 16.5 20.6 22.2 6.1 16.1 32.7 19.2 13.5 10.8 3.4 7.4 16.9 6.5 10.4

58.2 24.2 34.0 74.1 19.3 54.8 20.6 8.7 11.9 12.9 5.1 7.8 19.2 7.9 11.3

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international financial markets. In the 1990s liquidity became even more important as the investor community joined the financial institutions, the traditional providers of funds, in the market. The goals of the investors were often very different from those of the other providers of funds. They were, for example, particularly keen on buying short term investment instruments in order to profit from substantial interest differentials between those high yield bonds denominated in some emerging market currencies and the much lower level interest of the traditional fixed rate securities denominated in US dollars. In addition some countries even guaranteed the rate of their local currency to the dollar. As this was done to bolster the credibility of the local currency it was a very dangerous exercise. It was the major reason for the Mexican crisis of 1994. Another example came along a few years later. The big worldwide liquidity pool with its low interest level attracted Asian borrowers. It pushed short term exposures of some Asian countries in a few years to such dangerously high levels that they brought about the 1997 Asian crisis. Another example of liquidity problems came from the international investors' interest in emerging countries' stock markets, as they often had much lower valuations than those of the developed world. This new phenomenon of the sudden appeal of emerging stock markets in the 1990s confronted many countries in their short term liquidity management with substantial new problems. Speculation in emerging stock markets provoked substantial price swings. These large price changes led to comparable big in- and outflows of convertible currency. The management of international liquidity became much more difficult. While the incoming flow of all these investment funds was always welcomed, the sudden outflow often confronted the countries with unforeseen liquidity problems. In traditional commercial bankers' language liquidity ratios would be called the `acid test' or the `quick ratio'. The difficulty with these ratios is that, by the time they are statistically established, the problem is already serious. Nevertheless every effort should be made to gain a better knowledge of the dimensions of the short term indebtedness and its influence on foreign exchange liquidity in the developing world. It is noticeable today that countries which are favoured by the international investor tend to boost their foreign exchange reserves to much higher levels than was the case some years ago. This cushion has merits. It is certainly very worthwhile to look at some of the liquidity ratios that can be measured, such as the reserves/import ratio as well as the liquidity gap ratio.

Reserves/imports This ratio relates a country's foreign currency reserves to its imports. It measures the country's ability to pay for its imports with current liquid assets. It is normally expressed in how many months of import are covered by the available reserves, i.e. the reserves cover three months of imports. The

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reserves of a country are the officially published reserves at the current market rate. Thanks to the great efforts of the IMF, many countries today publish their reserves at short intervals and in a timely manner. Such timely publication gives the international financial community a good early warning instrument as imports are the largest regular user of reserves. Unless a country shows extreme seasonal volatility in its imports they can be estimated by using an average of the past six months. As long as the reserves cover more than five months' average of imports, liquidity can be considered highly sufficient for the country's external trade, whereas one month's average means a critical situation that needs careful watching. Countries with low coverage of import requirements often have standby arrangements with the international financial community that allow them to overcome a sudden liquidity gap. The reserve/import ratio clearly focuses on the short end of the country's external liabilities. However, it omits interest and principal payments which are part of the everyday need to service the external debt. This is a drawback since imports can always be compressed, whereas debt service such as interest payments and principal due are fixed regarding rate, amount and payment day and can only be altered through negotiations. It is also a questionable rate for smaller countries that have an atypical export/import structure. Nevertheless, it is easily calculated and normally available in time.

Liquidity gap ratio This ratio is designed to evaluate how a country can manage its short term financial requirements. The liquidity measured is the one that is needed to cover the liabilities of the coming year. It consists of the one-year short term debt liability minus the balance on the current account. Such a calculation leads either to a surplus or a gap in the liquidity. The latter is true if the total figure is positive. This gap can in normal times be reduced through taking up deposits and can therefore be adjusted by the potentially obtainable amount of deposits. The thus estimated liquidity gap is then measured against projected foreign exchange income from exports, services and unilateral transfers for the coming year in order to evaluate the seriousness of the gap. Under normal market conditions it can be assumed that a liquidity gap of 20% can be covered through additional short term borrowings. The reasoning behind this ratio is that, bearing in mind changing market conditions, it will always be possible to fund a liquidity gap of a certain size as a measure to overcome short term foreign exchange liquidity problems. To take an analogy from the credit sector, under normal circumstances a borrower who represents an average credit risk usually has the possibility of taking up some additional loans. The higher the percentage of the liquidity gap ratio, the more difficult it will be for the country concerned

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to manage its short term financial requirements successfully. The various crises of the 1990s, unfortunately, have shown that this can become a desperate exercise because markets for short term funds for the developing world can dry up. Other indicators relating to the liquidity of a country can be added to the one above. But they are sometimes even more difficult to interpret. Changes in the level of reserves are certainly a sign of a change in the liquidity situation of a country. In the case of the losses seen in 1998 in Brazil, it obviously meant a deterioration of the transfer risk, whereas a strong increase does not automatically improve the transfer risk as it can also mean speculation due to interest differentials which might later lead to a significant outflow and upheaval. Late payment experience is also a measure for changes in transfer risk intensity. Late payments obviously occur more often in the private sector. Regarding the public sector they have to be analysed in order to find out if they are really transfer risk related. A clear sign of a tighter liquidity or even problems in the external accounts is the utilization of the help of the International Monetary Fund. This usually indicates a substantial deterioration of a country's financial situation, because it now depends on outside official help, the IMF credits. It will, on the other hand, have to adhere to the conditions imposed by the IMF, which should over time improve the health of the patient.

Current account balance/GNP ratio This ratio reveals more about the medium term performance of a country's external situation. Averages for at least three years, such as the current, preceding and following ones should therefore be taken. The equation would read as follows: x(n71) xn x(n+1) ______ + ____ + _______ Ratio = y(n71) yn y(n+1) ______________________________ 3 x = current account balance y = gross national product n = current year For the current and the forthcoming years it would clearly be necessary to depend on estimates. This adds a certain inexactitude which is, however, largely discounted through the averaging. While a

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positive ratio is a sign of at least a balanced situation, a negative ratio forces the country in question to obtain outside funds or use its reserves to close the gap. A minus 5% ratio indicates an already fairly difficult situation, depending on the use of the funds. Milan N. Brahmbhatt shows how current-account forecasting can be done.7

Growth-of-export ratio Because transfer risk is in direct relation to availability of the necessary foreign exchange, the growth rate of the factor normally most important for such availability, namely exports, should be considered. A developing economy which is able to enjoy continuous growth in exports is internationally competitive. It can be assumed that such an economy has the capability of adjusting to a changing environment. However, the composition of the exports has to be analysed as exports of commodities follow principles of behaviour different from those of finished products. Furthermore, the exports have to add value and not be subsidized. In addition, as the value normally has to be taken in US dollars this can distort the picture over time. In order to have an acceptable ratio an average of several years should again be taken. Some examples of major developing countries and their yearly growth of export rates, using US dollar FOB figures, show that most developing countries have made a big effort to expand their exports. Table 3.4 excludes services, which can make an important contribution.8 Countries with ratios of over 10% of real export growth per year can be considered good performers in international markets. When export performance is being assessed, a country's export structure must not be neglected. A diversified structure that grows is always better than reliance on a few commodities. The Mexican figures are particularly interesting because they show that after the debt crisis of the 1980s and particularly in the 1990s Mexico achieved a substantial growth in non-oil Table 3.4 The yearly growth of export rates in some developing countries (%, billions of US dollars) 1993±97 Brazil China India Korea Mexico Nigeria Thailand

144.3 235.2 168.7 172.6 194.5 152.4 153.5

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exports. From a review of a country's export structure, a so-called commodity reliance factor can be constructed, which will indicate to what extent the country in question is dependent on one or very few commodities. A fairly high dependence on one commodity would obviously mean an additional risk or sometimes also an opportunity. Other strong dependencies can come from the service sector like tourism, e.g. in Egypt, or the remittances of foreign workers can play an important role, e.g. in Pakistan. While these are not measured in this ratio, they have to be considered if they play an important role in a country's external balance.

Compressibility ratio This ratio assumes that imports can always be compressed to a certain extent in order to save foreign exchange. The import side is, therefore, analysed and divided into different groups such as food, energy, raw materials, investment goods, consumer goods and luxury goods. While the basic needs are difficult to compress, it can usually be done with investment, consumer and luxury goods. Many developing countries do this for luxury goods already by taxing them heavily. It is hard for an outsider to measure the compressibility ratio, but in most cases it can be assumed that a country in difficulty can compress its imports by about 25% without too much harm. It probably cannot sustain such a compression over a longer period of time since shortages in some sectors will certainly develop and add a counter-productive effect or even lead to increased smuggling. For example, the absence of spare parts can become a heavy burden for the productive sector of an economy.

Assessment of transfer risk The assessment of transfer risk does not leave a wide choice of possibilities as the relationship between the risk and the factors influencing it is quite clear. We start with the traditional method that takes into account the factors and ratios described above. They are mostly of a quantitative nature, but still also leave room for qualitative elements. The factors that influence the flow of foreign exchange are only seldom quantifiable, whereas the indicators are much more easily so. Furthermore, the goals of the transfer risk assessment must be spelled out. Should they, for example, focus on an early warning system that looks at the short term capabilities of a country to service its debt? This is perhaps needed in developing a short term trading strategy for an investment bank or to reassure an exporter of consumer goods. Or the goal could be to obtain through the assessment an

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indication of the general development of a country's situation. Such an assessment might be more appropriate if a direct foreign investment is being considered. In the first instance the focus is more on liquidity, while the second goal looks more at solvency. The assessment of transfer risk can be carried out by constructing an index through which the country is rated. Normally a scale of 1±100 is used. Within this scale the very low transfer risk reaches a high number of points, whereas the extremely high transfer risk countries are on the low end of the numbers. To each factor or indicator used, a specific weight and points are attributed. Within the range of the weight or points, the better performer obtains a higher result than the medium or low performer. Regarding, e.g., inflation the scheme in Table 3.5 could be used. Through the addition of each individual factor or indicator, the position of a country within the global group of countries is obtained. If it is decided to limit the assessment to the computation of statistics and, therefore, to a purely quantitative approach, the assessment can be done by anybody who has access to the right statistical data. The important work then lies in the elaboration of only the best mix of data and its corresponding weighting, to structure the index according to the chosen goal. It is, however, preferable that the transfer risk assessment also contains a qualitative part. This is because some elements, e.g. policies regarding the management of the economy, cannot be measured in a quantitative way, but are nonetheless very important for the economic well-being of a country. Furthermore, the time lag between assessment and availability of statistical data often calls for a qualitative assessment. The use of only statistical data gives in addition a fairly simple view of transfer risk. However, a purely qualitative approach to assessing transfer risk is not desirable either. Statistical data are available in one form or another and generally are constantly improved and issued more regularly. They should therefore be used to improve the quality of the assessment of transfer risk. In constructing an index it should be borne in mind that only readily available data that are consistent from country to country should be used in order to obtain comparable transfer risk intensity. Such standard sources are the International Monetary Fund, the World Bank or the Bank for Table 3.5 Transfer risk ± factor inflation Most recent year Below 5% 5 ± 10% 10 ± 20% 20 ± 40% above 40%

Weight 5% of total 10 8 5 2 0

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International Settlements. As early as 1981 John K. Thompson proposed nine indicators.9 Four of these indicators focus mainly on exports which means that a weight of 45% is assigned to indicators relating to debt service capability (see Table 3.6). The used system should certainly cover the solvency and liquidity aspects which are dealt with below.

The solvency aspect It is advisable to deal first with the solvency aspect. It is the assessment of the transfer risk that has its origin in a change of a country's solvency, i.e. the long term situation. As rescheduling of a country's debt is a clear indicator of a substantial worsening of solvency, academic research has focused on the prediction of rescheduling as a form of increased transfer risk. Unfortunately, with the exception of some of the findings of logit analysis, it has not been conclusive enough to determine clearly which factors or indicators must be weighted at a certain rate to obtain the curve of transfer risk development and to forecast the date of rescheduling. It has, however, been proven that certain behaviour on the part of a country often leads more rapidly to solvency problems. Such behaviour includes excessive borrowing to finance consumption, excessive credit creation, excessive debt accumulation and weak export growth. These factors are clear early warning indicators to be Table 3.6 Indicators used in structural index Indicator 1

2 3 4 5 6 7 8 9

Weight in %

Percentage change in consumer price (a) most recent year (b) five-year range (c) most recent year/five-year average Percentage change in money supply (M1) 1 year/percentage change in real GDP (five-year average) Change in central bank financing of government/monetary base (most recent year) Purchasing parity Growth of exports (a) most recent year (b) five-year average Exports/GDP (most recent year) Debt/exports (most recent year) Savings/GDP (four-year average) Growth of real per capita GDP (five-year average)

Note: GDP (gross domestic product) = GNP minus transactions with other countries.

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5 5 5 10 5 5 10 10 10 15 10 10 ___ 100

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watched. While the timing of a rescheduling is clear, the reality has also shown that reschedulings are done in very different ways and values for impaired assets vary widely. The incidence of rescheduling has therefore no direct relation with the amount of change in the value of assets. It has not been possible so far to construct a model incorporating the forecasting of worrying behaviour, because it seems that deteriorating or improving creditworthiness is not only the result of a change in key economic indicators but also ± and very often ± the result of an expression of political will by a government, as well as the result of a judgement by the international financial markets. Furthermore, the number of developing countries is too small and too diverse to make it possible to find enough similarities that would enable the construction of a convincing model to forecast future reschedulings. We will talk more about this when we analyse the political risk. This statement should, however, not discourage us from trying, through a system of assessment criteria, to measure the fever of the patient. It will be up to the institution and investor concerned to first determine the major criteria relevant to their commitment to the borrower and the country in question and then build a model upon this. For lenders and long term investors, a combination of both the qualitative and quantitative approaches seems to be the most suitable and also the most widely used method to measure transfer risk, with a clear selection of the factors and indicators. While through the qualitative approach the management of the economy and related policies can be assessed, the quantitative part of the appraisal would look at the economic indicators. Since the different risk factors are then evaluated, not only is their selection important, but also the weight assigned to each. The larger the number of factors used, the more difficult will be the weighting, because each factor will contribute an ever smaller percentage to the total and, therefore, the influence of each will decrease. It is suggested that the total number of factors or indicators be divided into three groups, each having a large part of the weighting. Each of the major groups would focus on one particular aspect that is relevant to the development of the country's transfer risk. The three major groups would consist of the indicators relating to the debt service capability, the management of the economy, and those relating to the economy in general of the country in question. How these three groups are balanced against each other, is again a matter of judgement of the evaluator of the transfer risk. Debt service capability, which is in essence the capability of earning the necessary foreign exchange to service the debt, must in any transfer risk rating system assume the major weight. The choice of the group of indicators relating to debt service capability depends on the ratios available, but should in any case include the debt service ratio, the debt/GNP ratio, and the interest service ratio. It would be very valuable to also incorporate a prognosis component in these indicators.

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The second group of indicators would deal with the management of the economy. This part of the assessment is normally done on a qualitative basis by judging parameters such as monetary policy, development policy or currency parity policy. The overall weight of management of the economy needs to be increased if a forward looking aspect of the assessment is incorporated. This is especially valuable if a country is being evaluated that was in difficulties on its external accounts and has therefore changed its economic policies. The third major group has to deal with the indicators relating to the country's economy as a whole. Such indicators are very much of a quantitative nature and would include, for example, GNP per head of population, the consumer price index, GNP growth and natural resources. These indicators are of higher importance when the solvency of a country in the longer term context is being considered. They are, however, in the current fast changing environment of less significance than the two previously mentioned ones. To make them more relevant, these indicators should always take into account estimates made for the coming years. A weighting of 50% for the debt service capability indicators, 35% for the management of the economy and 15% for the economy in general would give a balanced view of the solvency aspect of the transfer risk. An example is shown in Table 3.7. Table 3.7 Indicators and weighting of indicators to measure transfer risk Indicator Debt service Debt service ratio average current and next year Interest service ratio average current and next year Debt/GNP ratio change over the last three years Management of the economy Management of the economy Rate of inflation last/current and following year GNP growth average over the last three years Export growth average of the last three years Economy of the country Size of the economy (big, medium, small) GNP income per capita Diversification of the economy

Weight in % 20 15 15 __ 50 10 10 5 10 __ 35 5 5 ___5 15 ___ 100

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The transfer risk in relation to the solvency of a country should be reviewed at least once a year. The best time is when most statistical data for the previous year are available which is usually in early autumn. However, this should not exclude a more regular review which is warranted when there is a change in government or when external factors appear which suddenly affect a country or when a substantial change in exposure to a specific country is being contemplated.

The liquidity aspect The difficulty of refinancing short term debt in the Asian crisis of 1997 showed once again the importance of the liquidity aspect in evaluating transfer risk. The vast amount of currently outstanding debt in the international capital markets from borrowers of emerging countries makes it imperative that enough liquidity exists in the marketplace for such securities. To improve the quality of liquidity a better analysis of the transfer risk is needed and with it a constant adaptation of the valuations. Such valuations or market prices are, as mentioned above, still influenced more by the perception of the liquidity than its actual situation. They mean losses or gains on the market price of the securities. This can be qualified as transfer risk volatility. While the liquidity in the securities of a specific country has an influence on its ability to manage its liquidity it has no direct influence on the country's liquidity situation. The liquidity situation is influenced by the short term performance of the country on its external balance and by the management of its foreign exchange situation. It can also be influenced by seasonal factors. In addition, the perception in international markets of the attractiveness of a country is also important. It can have a strong influence on its liquidity situation by adding international reserves through inflows into the domestic debt market or withdrawing international reserves through the reverse mechanism. The correct evaluation of the liquidity aspects of transfer risk is quite difficult as the data are often just not supplied quickly enough. Short term debt data are rarely available in time. A reasonably accurate measurement of the liquidity aspects can enhance the early warning system for the transfer risk of a specific country. Information that is usually available in good time includes the changes in the international reserves, the reserves/import ratio and the use of IMF credits or quotas. The perception of a country in international financial markets can in addition be measured by the development of the spreads on its outstanding debt. The IIF Research Paper No 97±1 of December 1997 gives an interesting analysis of the spreads and the related transfer risk in emerging market lending.10 It shows that spreads improve more than a country's performance would warrant in good times.

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To give some guidance a liquidity index could contain as its major elements the liquidity gap ratio, the reserves/imports ratio and late payment experience, as well as a qualitative judgement of the market acceptability of the country in question by looking at the spread development. A comparison of the liquidity indexes constructed by John K Thompson in 1981 and l'Anson, Fight and Vandenbroucke in 1999 (see Tables 3.8 and 3.9) shows that the difference is more in degree than substance, because they both address the concerns of lenders more than those of investors.11 In order to keep on top of the liquidity aspects a very regular evaluation of the different factors is a necessity. For the sophisticated investor such measuring is a daily activity whereas for the lender it is in most cases an additional tool that complements solvency monitoring. Due to the difficulty of its measuring and the different goals for its use a relatively wide practice exists in the establishing of liquidity measurements. Each category of provider of cross-border financing should, therefore, establish its own measurements in order to satisfy the quality of its transfer risk monitoring. The assessment of transfer risk by trying to evaluate both the solvency aspect and the liquidity aspect is today the most widely used method. Financial institutions commonly rely on this for their transfer risk assessment in cross-border lending activities. However, other methods such as spread analysis Table 3.8 Indicators used in liquidity index Indicator 1 2 3 4 5

Reserves/imports Debt service/exports Large reserve losses Late payment experience IMF credit/quota

Weight in % 40 20 10 10 20 ___ 100

Source: John K Thompson, Euromoney, July 1981. Table 3.9 Short term model structure Factors and categories 1 2 3 4

Import coverage Liquidity gap ratio (% of exports) Payment delays Politics/external relations

Weight in % 25 25 25 25 ___ 100

Source: Kenneth l'Anson, Andrew Fight and Patrick Vandenbroucke, Bank and Country Risk Analysis, Euromoney ± dc gardner workbooks, p. 8.

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and statistical methods have been used and can certainly give interesting results for more specific aspects of transfer risk or specific needs of a provider of cross-border funds.

Spread analysis Spread analysis is a tool that is very much used to analyse the creditworthiness of borrowers in the bond market and to find inconsistencies and arbitrage possibilities. The spread is not that which was fixed when the debt was incurred, but the spread at the current market price. Spread analysis is a good tool if the sample used is large and homogeneous enough to make sensible comparisons. In relation to cross-border financing this method is justified by the reasoning that the largest part of such cross-border financing is incurred in international financial markets, which price the remuneration normally by a spread over a benchmark such as LIBOR or PRIME. The prices made in these markets ± which are basically the spreads and fees ± are, it is argued, very good risk indicators as they show, through their differentiation, the acceptability of a risk by a large number of market participants. In addition, the development of a spread for a specific borrower gives an indication of the changes in its creditworthiness. This latter reasoning has to be qualified, because the development of the spread in cross-border securities not only depends on the creditworthiness of the borrower, but also on the perception of the country risk involved and obviously also on the development of the market in general. As the concern here is with the evaluation of transfer risk, the changes of spreads can only be considered as an indication of the change of the transfer risk in relation to other transfer risks. Furthermore, in order to use spread analysis, compatibility has to be found in the credit and capital market transactions that are to be analysed. The transactions must have similar types of borrower which restricts the comparison of private borrowers and limits the analyses essentially to sovereign borrowers. It should be asked in this context if the same ratings given to different borrowers from the developing countries form a homogeneous enough asset class to which spread analysis can be applied. It certainly has been common in the world of Brady bonds, where comparisons between different countries and different regions are made and are then related to the US Treasury bonds of similar tenor. Spread analysis is certainly an interesting tool for the decision making process of investors in emerging market bonds and helps in the short term management of an exposure. It is less obvious for the loan market as this market uses more tailor-made products with specific tenors. Here the more differentiated analyses of the transfer risk along the solvency and liquidity lines mentioned above is better suited. The same holds true for long term investments such as foreign direct investments.

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Statistical techniques In connection with trying to forecast sovereign debt rescheduling, several statistical methods have been used to construct a model. The previous edition of this book described in detail the concept of logit analysis as a possible statistical technique.12 Robert B Avery and Eric O'N Fisher give a good account of some of the more recent developments.13 The forecasting of sovereign debt rescheduling has lost some of its importance as it has been realized that it does not follow statistically measurable patterns. In today's globalized world sovereign debt rescheduling only occurs if the IMF and the major industrialized countries no longer find it possible to bail out the country in difficulties. The constant monitoring of the economies of all countries by the IMF has made sovereign debt rescheduling basically a political and no longer an economic event. The most recent case at the time of writing was the rescheduling of the former Soviet Union debt by Russia with the London Club in 1999 and 2000. Furthermore, for the investor or the lender with a cross-border exposure the forecasting of a sovereign debt rescheduling also has only a limited interest, because it is much more important to him or her to be able to constantly follow the development of the transfer risk intensity for which pure statistical tools are not yet the most promising experience. For the lender or investor the market price for his or her assets is the important guide mark. Rescheduling of the debt of various Latin American countries in the 1980s was done along similar lines and produced similar assets. The price of these rescheduled assets, however, started immediately to diverge and found very different individual price levels. It is not the rescheduling that is the decisive factor for the risk intensity of a cross-border exposure, but the quality of the country risk. The interested reader is invited to look up the above quoted sources to become more familiar with the statistical tools.

POLITICAL RISK The political risk ± the political element or the will to honour one's obligation ± is the other major risk element that constitutes country risk. Geopolitical development over the last ten years has substantially changed the importance of political risk in the evaluation of country risk. Individualistic behaviour by a country, i.e. out-of-the-way behaviour, has become much less frequent as nearly all nations try to live up to being good citizens in the world community of nations. Furthermore, every developing country has realized that it depends on the international financial markets for its long term survival and therefore has to live up to certain standards of behaviour. The original forms of political risk looked at four major types of loss as the consequence of a deteriorating political risk. For these types of loss insurance coverage was developed by the Overseas

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Private Investment Corporation (OPIC ± an agency of the US federal government) and the Multilateral Investment Guarantee Agency (MIGA) of the World Bank. These losses are inconvertibility, expropriation or nationalization, war damage and civil strife damage.14 For more see Chapter 4. While these losses still occur as a consequence of political risk, this analysis of political risk looks to the development of political aspects that change the intensity of country risk. Political aspects in this definition influence the political, but also the economic behaviour of nations and give political risk its importance. A distinction also has to be made between `political instability' and `political risk'. The former is not the political risk per se; it can exist whenever we have a certain intensity of political risk, but does not have to endanger our business interests. Political instability is usually not measured and is, to some extent, subjective. But it always influences the perception of political risk and is a factor in its determination. We are interested in finding out what the political risk and its components are, and then will try to assess the political risk. To do this we need some sort of system by which the use of political `intelligence' can identify the degree of political risk. We therefore have to find out what political factors determine the political risk intensity. While the importance of the different factors may vary there are a number of factors that should always be taken into account.

Political risk factors Political risk factors can be inherent in, evolve out of, or have their origins outside a particular country. The political risk factors that come from within a country can evolve within the constitutional proceedings or outside that framework. These factors can have a positive or negative influence on the degree of political risk. Political events create not only risks but also opportunities. A specific element in the evaluation of political risk is the importance of the role of the actors, something we find much less pronounced in the evaluation of transfer risk. These actors have to be identified. They can be individuals or groups of individuals, but also neighbouring countries as well as institutions such as the Catholic Church. The more we know about these actors the better we can judge the importance of the different political factors which will be described below. The actors tend to influence substantially or even manage the political factors. The 1990s saw the growing importance of sub-national actors who have eroded the central authority in many developing and also industrialized countries.15 This process is still going on. The major political factors examined below are the constitutional environment, political parties, quality of government, social structures, demographic structure, ethnic and religious differences, corruption, conflicts and discriminating acts.

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Constitutional environment A constitution incorporating the basic principles of Western democratic thinking provides a good framework for political stability. It has, however, to be enforceable and be enforced. Failure, for example, on the part of government to guarantee people's constitutional rights will sow the seeds of resentment and discontent and thus create political instability. Equally, an ambiguous interpretation of a country's constitution by the government must raise doubts about the government's credibility. The most intractable problems in the constitutional environment often lie in the judicial systems. The path of justice is often cumbersome to invoke and very slow in delivering results. Unfortunately the judicial system is in addition in many countries corrupt or corruptible. It is also important to analyse whether the constitution provides the framework within which the government must act ± thus protecting the rights of all citizens; or whether the government uses the constitution as an instrument to achieve its own ends. Referring to the latter it is useful to examine how often a constitution has been revised in a given country. An example is the tendency of some countries' leaders to change the constitution to improve their chances of being reelected for additional terms of office.

Political parties The nature of the political parties and the type of programme they offer have a major bearing on the political risk. Parties can be dominated by strong personalities who are certainly among the important actors mentioned above. The significance of the different political parties has to be analysed. A balanced party system of two to three parties can be a factor of stability, whereas a very fragmented party landscape makes governing difficult. Their significance is also often out of proportion to their size. Small parties regularly hold the balance of power, sometimes in the government as a coalition partner, sometimes on a pure consent basis. The religious parties in Israel or the Greens and the Liberal Party in Germany have played such a role. The one-party system can be a factor of stability or instability, depending on whether the party is system- or personalityoriented. Examples are the longstanding power of the communist parties in a large part of the world during most of the last fifty years or the dominance of the Partido Revolucionar Institucional (PRI) in Mexico or the personality-dominated parties in several developing countries. Today it is generally accepted that a balanced party system that provides a strong government as well as an acceptable opposition provides the best basis for political stability. The proliferation of issues in our current society has seen a growth in the number of parties in many countries which unfortunately has also led to an increased immobilization of the governing process.

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Quality of government This is another important factor in assessing political risk. Can the government act freely or is it blocked by the influence of pressure groups? In this connection it is advisable to check the quality of the bureaucracy of a country, because the bureaucracy is often even more important than the government, especially in the day-to-day running of the country. In many countries the bureaucracy becomes in itself the major actor, largely because of its ability, through its action or its inaction, to affect government policy. Another reason for its importance is the stability of the major part of the administration as it does not normally change when the government changes. Only top echelon members of the administration, who are often political appointees, change fast when there is a change in the political colour of the government. The four-year election cycle in many countries limits the changes a new government can introduce to the way a bureaucracy operates. The time span is just too short and the resistance of the bureaucracy too big to implement effective change. Nevertheless, a change of government always has an influence on the degree of political risk. It is an expression of the will of the people for change. A change of government is not a destabilizing factor per se, but warrants a new appreciation of the political risk. In the worst case a change of government is due to a crisis in government. Such a crisis always increases the political risk in the short term. Government crises are in general resolved by new elections, but sometimes also by a coup d'eÂtat. Two examples from the same region show how government crises are dealt with differently. This was partly the result of different traditions, but also because of the difference in the origins of the crisis the outcome was very different. Between 1994 and 1999 India had several government crises, which it always tried to solve by new elections, therefore bringing the electorate out nearly every other year. Pakistan, on the other hand, resolved its government crisis in 1999 through a coup d'eÂtat by the military under General Musharraf. Government quality is an important factor to watch in the evaluation of the political risk.

Social structures Social structures constitute a major political factor that influences the political stability of a country and through this the political risk. Considerable inequality, either between urban and rural populations or between different layers of the population, is a source of conflict. Social inequalities are frequently linked with government crisis (paralysis), high debt problems, outright instability or violence as well as ethnic, racial or religious problems. Equal distribution of wealth and jobs will go a long way to reducing potential political risk in the social structure of a country. It is, nevertheless,

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interesting to see that the huge inequalities that exist in many countries have not led automatically to bigger and more frequent social conflicts. Populations at large seem to be very willing to accept their poor living conditions. This is obviously also due to the wide ignorance of a substantial part of the population in the developing world due to the low level of literacy. The continuous presence of television in almost every corner of the world has, unfortunately, only a limited impact on these populations. The literacy rate is also part of the social structure. The literacy rate of a country must, however, be taken together with other factors if its significance for political risk reasons is to be evaluated. The following conclusions might be drawn: high literacy rate and

=

discontent ± instability

=

contentment ± stability

=

lack of awareness ± stability

unequal distribution of income or high literacy rate and equal distribution of income but also low literacy rate and unequal distribution of income The World Bank publishes the so-called Gini index which measures the extent to which the distribution of income (or in some cases, consumption expenditure) among individuals or households within an economy deviates from the perfectly equal distribution.16 A Gini index of zero represents the perfect equality, whereas an index of 100% implies maximum inequality.

Demographic structure Urban migration, a phenomenon which is particularly significant in the developing world, creates overcrowding, bad housing and slums as well as other infrastructure problems. All this brings crime, violence and social difficulties, but also malnutrition to these overcrowded centres. There is an obvious danger of political instability here which could lead to increased political risk. In addition, if

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there has been high urban migration there is the danger that the government will concentrate resources in the cities and neglect rural areas where very often the traditional sectors of the economy are concentrated. These deteriorate, which leads to social and political problems and political resentment. Urban migration is so popular in the developing world because opportunities are associated with urban rather than rural areas. Also, a population dependent on industry and services will have quite different political ambitions from those of a large agricultural society which will in turn affect the political risk. Projections show that early in the twenty-first century all the largest cities will be in the developing world, creating huge problems of overcrowding, pollution and massive strains on infrastructure.

Ethnic and religious differences Countries vary substantially in their ethnic and religious composition. The existence of one or more minority, ethnic or religious groups can provide the basis for political instability, particularly if, for example, this group perceives that the government is discriminating against it, or it is excluded from the political process, or is pursuing separate claims. Ethnic and religious differences become especially explosive if they are superposed by differences of wealth. The 1990s will go down in history as a decade where conflicts of an ethnic and religious nature dominated much of international politics, meant substantial internal turmoil, broke up countries such as the former Yugoslavia and introduced the term `ethnic cleansing' to our vocabulary. These unfortunate events show us their importance in evaluating political risk.

Corruption Corruption is yet another factor worth looking at when appraising political risk. It varies substantially from country to country in its significance. It can be part of the way of life. It could therefore even be the deciding factor in the decision making process of the institutions of a specific country. International political pressure, especially from the multilateral financial institutions, tries to fight corruption. Corruption is not a destabilizing political factor per se but its implications on the institutions of the country in question need attention. Corruption is often a means to further enrich just a few. Unfortunately, in many poor countries it is the only way of obtaining a minimum income for an underpaid administration.

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Conflicts Conflicts within a country or from outside the country in question always lead to destabilization and increased political risk. These conflicts can have many different origins. Internal conflicts come mostly from the dissatisfaction of a group of the population with the current political structure. They can lead to violent eruptions such as a revolution or a coup d'eÂtat. In these cases the conflict is usually over within a relatively short time and the political risk can be assessed within a reasonable time frame. The dissatisfaction can, however, also lead to a long period of destabilization and increased political risk, which is the case when a civil war breaks out. Within the same category can be included the ethnic cleansing that has been taking place in too many countries recently, and also the continuous attacks by terrorist groups on the institutions of a specific country. Sometimes the destabilization is actively organized and supported by neighbouring countries without, however, leading to all-out war. When they do occur, wars are not always confined to two countries, but can also develop into multilateral conflicts where several nations are involved. The latest conflict of such dimension was the Gulf War in 1991, which started as an invasion of Kuwait by Iraq, but led quickly to the deployment of a multinational task force to restore order in the region.

Discriminating acts Discriminating acts are sanctions imposed on a specific country by other countries or by international organizations to persuade that country to change its behaviour. Such pressure is mostly executed by economic means such as an embargo or withdrawal of financial support. Unfortunately, the discriminating acts rarely lead to the changes hoped for by the discriminators. The governments under attack can usually rally their population to support them in the difficult times brought upon them by the discriminators. Iraq under Saddam Hussein is certainly an example where the pressure applied did not lead to the changes the international community hoped for. And Serbia, part of the former Yugoslavia, under Slobodan Milosevic is a similar example, where only after years of pressure and dismal economic conditions did the country's population finally opt for change.

Assessment of political risk While the identification of the different political risk factors is relatively easy, their assessment is much more difficult. We do not have any quantitative measurements as in assessing transfer risk.

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In the past, the need and justification for the assessment of political risk was mainly to foresee the risk of expropriation as cross-border investors were wary of such developments. Since then political risk assessment has come a long way as its interdependence with transfer risk has been more and more recognized. Today it is clear that the fever curve of the patient also has to be measured on the political scale to be able to obtain meaningful results in the country risk assessment process. Interestingly enough a change in the political risk often precedes the development of the transfer risk. Assessment of political risk includes not only the task of foreseeing a deteriorating situation, but also that of finding improvements in the risk situation and therefore opportunities. Political risk analysis can usually discover opportunities at an earlier stage than economic indicators do as the latter have to rely on developments over a certain period of time to show changes. When assessing political risk the time element also has to be taken into account, because risk has always to be seen in relation to time. Political risk assessment has to occur within a certain time horizon in order to be pertinent. It cannot limit itself to the assessment of the current situation, i.e. the status quo, but must make assumptions about the future and/or find a specific trend. The factors that are suitable for political risk assessment should always take into account a time period of more than one year in order to obtain the necessary dynamic approach to the assessment. The assessment should, however, refrain from too much guesswork and speculation. The need for political risk analysis and the assessment of the risk depends on the ultimate aim of the provider of cross-border funds. Owing to changes in the geopolitical environment it has lost some of its importance recently. Analysing political risk does, however, remain important as the tenor for providing cross-border funds has continuously been increased. In assessing political risk three basic approaches can be distinguished. First come the qualitative methods. They have names like subjective-individual analysis and subjective-group analysis or the wise men systems.17 The qualitative approach focuses on the experience of experts who have the knowledge and ability to assess the different political risk factors. In addition there are the quantitative approach and the integrated approach. The quantitative method gives a numerical value to the different political factors chosen and then tries to predict the political risk by using a multivariate analysis. The integrated approach combines both methods. The value and acceptance of these three methods differ. Whatever the system used, the assessment has to be systematic in order to be worthwhile. It must take place at regular intervals, using the same

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method each time to be consistent. It is necessary to make an additional assessment after a major political event has occurred, such as a change of government. The approach taken has to be forward looking in order to be able to forecast events that might lead to changes in the risk profile. Assessment of political risk classifies countries according to the following scale: . Extremely high risk. . High risk. . Medium risk. . Low risk. . Very low risk. The classification can differ for a country depending on whether a short term or a longer term approach is taken. For most countries their political risk intensity will be similar to their transfer risk intensity because of the interdependence of the two. Interestingly enough, however, in quite a few cases political risk intensity can be lower than transfer risk while the reverse is today very rare. Quite a few politically stable countries from the developing world have difficulties on their external front. Political risk intensity can also be expressed in numerical terms instead of using a verbal scale. This is done if the quantitative or integrated method is used. What does this scale of political risk intensity mean? In an extremely high risk country, most if not all political factors have been assessed in a negative way. Basically, business is no longer done in a conventional way in such a country. Expropriations and nationalization have probably taken place at a disadvantageous rate for foreign nationals and investors. Repatriation of capital is nearly impossible, and dividends, interest, fees or royalties transmittals are for political reasons severely restricted and controlled. Payments for trade transactions are in doubt. Business with such countries, if done at all, is on a government-to-government basis. Private companies are either locked in due to earlier deals and/or normally abstain from new deals. An example of such a country at the end of the twentieth century would be Afghanistan as well as some African countries. Countries in such a high class of risk are relatively easily identified and have become in today's geopolitical environment very rare. It has to be said that nevertheless on a limited scale business can be very profitable with such countries ± but remains high risk until its completion. On the other end of the scale the very low risk country gives no headache whatsoever to the provider of cross-border funds. These countries usually have a very high rating, and present a very competitive business environment for financial services with low margins.

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The art of assessing political risk is therefore centred on the other three risk qualifications which are what is called the grey area. Analysts are asked to foresee changes in the risk status in these countries in order to optimize potential opportunities and minimize the consequences of evolving risks. In this exercise the different risk factors are weighted in relation to each other. The weighting cannot be done uniformly, but must be tailor-made for the goals of the provider of cross-border funds. While expropriation is an important risk for foreign direct investments it is much less so for the cross-border lender who is, on the other hand, very much concerned with the possibility of the repudiation of debt. The political risk also presents itself differently for a well known consumer product company from the United States than for an investment goods producer from Sweden. Both are nolens volens associated with their countries of origin and their foreign policies. Let us now turn to the three most common methods.

Qualitative methods The qualitative method uses experts to achieve its results. This can be done by choosing an individual expert or a group of experts, often called wise men. Such a method is the most elementary way for a cross-border provider of funds to add the political dimension or the non-financial environment to the evaluation of cross-border risks. It is obviously preferable to have a group of experts rather than just one consultant. A group of experts could, e.g., consist of a team of three members. One member of the team, the country expert, should certainly be a person who has access to first-hand intelligence of the country to be reviewed. Normally such access can only be obtained after years of building up a network of relations. Another team member should be a political analyst who has the necessary expertise in political science and analysis. His or her main task would be to cross-check the assumptions made by the country expert in evaluating the different political risk factors. The third member could be a senior executive with international experience of the institution interested in the political risk assessment. This executive would probably lead the team and be responsible for translating its findings into an appropriate business strategy. The team would take into account the different political risk factors discussed above. It would reach a conclusion with respect to the political risk intensity in a specific country. As country experts normally have an expertise limited to a specific country the team would be composed differently depending on the type of country or region. This method is efficient, as a conclusion can be reached very fast. Its longer term efficiency will depend on the quality of its members and the personalities involved. To use a single person only as an adviser on political risk assessment is a more dangerous method as it depends entirely on the individual quality of the expert. Such experts are usually seasoned

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diplomats, educators, journalists or businesspeople. They often base their information on a fairly limited number of sources and are probably best at the assessment of the actual leadership of a country and in the evaluation of the strengths and weaknesses of the different political groups. They can, however, give additional insights and sometimes have interesting unorthodox opinions. Using a number of experts lends itself to the use of the Delphi technique. This is a systematic method that can also be used to assess the political risk. In order to be effective a number of factors have to be considered. The interested party in the analysis has to enumerate the different political factors that influence and determine the political risk. This list has to be established and used in a consistent way over a certain period of time. A group of experts is then individually asked identical questions on the political factors according to the list and has to rank and weigh the importance of these factors, producing possible future scenarios. The members of the group receive a continuous anonymous feedback of the answers of the other members in order to adapt their own opinion and hopefully reach a consensus. The results are then assembled in a ranking or index of political risk. The quality of such a ranking ± and also its strength or weakness ± obviously depends on the choice of factors. A similar method is the Bayesian decision analysis which also draws on the knowledge of several experts by using statistical techniques. 18 A variant of the Delphi method is the key factor analysis.19

Quantitative method The quantitative method relies on the use of a multivariate analysis, which makes multidimensional decisions possible. The distinguishing feature is that one or several variables are to be the function of other variables. The variables that influence each of the political risk factors must be determined. For example, take the political factor `constitutional environment'. The variables that make this factor a political risk are the quality of political rights as well as the quality of civil rights. Each of these variables can then be measured on a scale. Added together they can form one of the indicators being sought. To make it even more meaningful this indicator can be examined in a dynamic way by screening the development of the two variables over a certain period of time. Thus positive development may be measured on a scale from zero to six and negative from zero to minus six, as indicated in Tables 3.10 and 3.11.

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Table 3.10 Political rights developments, 1995±99 Extraordinary improvement Substantial improvement Good improvement Moderate improvement Small improvement Slight improvement Stable Slight deterioration Small deterioration Moderate deterioration Important deterioration Substantial deterioration Extraordinary deterioration

plus 6 plus 5 plus 4 plus 3 plus 2 plus 1 0 minus minus minus minus minus minus

1 2 3 4 5 6

plus 6 plus 5 plus 4 plus 3 plus 2 plus 1 0 minus minus minus minus minus minus

1 2 3 4 5 6

Table 3.11 Civil rights developments, 1995±99 Extraordinary improvement Substantial improvement Good improvement Moderate improvement Small improvement Slight improvement Stable Slight deterioration Small deterioration Moderate deterioration Important deterioration Substantial deterioration Extraordinary deterioration

The formula could then read as follows: Political rights (1995±99) + Civil rights (1995±99) = Indicator of changing constitutional environment The scale of this indicator would then go from minus 12 to plus 12. The difficulty with the method is to find a uniform appraisal of the changes so that a common level for all countries can be found. Another example might be `social structure' as a political factor. The political risk of this factor lies in the wealth per head, degree of urbanization, income distribution and degree of literacy. The sensitivity of the political risk is a relation of these variables. The higher the degree of literacy and the higher the wealth per head of population, the lower may be the political risk. The same might also be

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true for the reverse; i.e. a low literacy and low per capita income usually produce a fairly low political risk. In order to translate this into an indicator the scale of one to ten is applied to degree of literacy, ten being 100% literacy and one nil. The same goes for GNP per head which is also measured on a scale of one to ten ± assuming, for example, a GNP per head of more than US$10 000 with ten on the scale. By relating these two variables the sensitivity of the political risk can be measured as shown by the following formula:

I1 =

A ____ B

A = Degree of literacy (1±10) B = GNP per head (1±10) I 1 = Indicator sensitivity political risk This can be shown graphically as in Fig. 3.2, assuming that there is a linear dependence between the two factors (which is probably not the case). The formula results are one to ten, one being the most stable situation with the lowest probable risk. Another indicator resulting from concern about political risk emanating from the social structure might incorporate a third variable such as the distribution of wealth. The difficulty lies in relating the three variables, each one being standardized on a one-to-ten scale, in a formula that really indicates the variations in political risk. A multiplication on the indicator `I 1' by the distribution of wealth variable can give such a result, as in the following formula:

I2=

A _____ 6 C B

A = Degree of literacy B = GNP per head C = Distribution of wealth I 2 = Indicator sensitivity political risk In order to arrive at a good assessment of political risk by using this method, a careful selection of political factors is needed. For each one, the variable must be chosen, quantified and brought into a scaling system.

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Figure 3.2 Sensitivity of political risk: two variables. The variables must then be interrelated in the way they influence political risk, which can be through addition, subtraction, multiplication or division. The result of these mathematical calculations gives us one political indicator. In order to assess total political risk, the different indicators will then have to be weighted against each other. The difficult tasks in this multivariate system are to find quantifiable variables for each political factor, and the weighting of the different indicators. As there is no `generally accepted theory of political change, there is no agreement which variables should be quantified and how those variables should be combined'.20 It is therefore advisable to restrict this method to a specific aspect of political risk such as expropriation or nationalization. The method needs and uses many assumptions and is quite difficult to implement. Therefore the reliability of the quantitative method has been debated in the literature and no convincing system has yet been presented. The quantitative method can also lead to the scenario approach. This tries to discover how political risk develops under different assumptions. It is a very interesting approach in so far as it shows that developments are always possible in different directions. The difficulty lies again in finding out which are the probable assumptions.

Integrated method The third method of assessing political risk is the integrated approach, which tries to bring together the subjective and objective approaches, i.e. the qualitative and quantitative elements. This method benefits

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from both aspects and is recommended for political risk analysis. A checklist is put together of the political factors that are relevant for the type of operation of the provider of cross-border funds in question. By using the same checklist for all countries analysed, the goal of judging all countries the same way can be attained. Variables must be attributed to each factor, and are then weighted. For example, the risk factor `constitutional environment' could be evaluated in relation to generally accepted principles of Western democratic thinking, to the constitutional rights of its citizens, to the quality of the country's judicial system. This would then be related to the political risk and given score points as follows: . Very comforting

10

. Improving

8

. Stable

5

. Worsening

3

. Chaotic

0

This factor would then be weighted in the context of all the other political factors evaluated. The total score would then be indexed according to intensity of risk. There is a very good example of a political score sheet shown in Fig. 3.3. For the reader interested in finding out more about political risk in the information age, Jerry Rogers has published a guide to internet research on the topic. 21

Conclusions Political risk assessment is an important factor in assessing country risk. It might be considered less important than the assessment of transfer risk in view of the relatively stable geopolitical environment. Nevertheless, it is important that political risk assessment is carried out in as systematic a way as transfer risk assessment. All providers of cross-border funds should do so for every country in which they have assets and do so on a regular basis. This could be once a year, but certainly after every important political event. It cannot be assumed that the assessment process will act as an early warning system, but political risk analysis often points to potential future changes in the intensity of the country risk. Each provider also has to find out by trial and error which factors best suit its business operations. That test period can take several years, but will help in the end to improve the awareness of the political risk in international transactions.

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Political score sheet A Weights

1. EXTERNAL Current state and past history of relations with neighbour states: Perception of outlook for same: Nearer term: Longer term (5y+) Is country particularly vulnerable because of special attractions for a potential aggressor (see note 1)? Do sufficient internal/external deterrents exist to discourage such aggression (e.g. risk of world confrontation)? Protection afforded by existence of treaties/international groupings.

B Scores out of 5

C Weighted score A×B

4

7 5 5 6

3

WEIGHTED EXTERNAL SCORE (OUT OF 30) = sum of column C divided by 5. 2. INTERNAL Current position and past history of internal political stability: Perception of future internal stability: Nearer term: Longer term: (5y+) Rate each of the following as potentially destabilizing factors (see note 2) Political system: Unevenness of income and wealth distribution: Economic outlook – unemployment, living standards, etc.: Presence of extreme religious, political, racial, or other alienated groups: General fairness and acceptability of legal, judicial and fiscal systems:

9

12 11

9 6 7 9 7

WEIGHTED INTERNAL SCORE (OUT OF 70) = sum of column C divided by 5 TOTAL WEIGHTED SCORE (OUT OF 100) Notes: 1. Smaller or weaker countries, holding key raw materials, or uniquely positioned geographically are in mind here. (Powerful, industrialized nations, though strategically important, will not hold out special attractions). The less attractive to an aggressor the better and, therefore, the higher the score. 2. Responses should reflect the perceptions and attitudes of the local population and the probable effect of their political attitudes.

Figure 3.3 Example of a political score sheet. (Source: Kenneth l'Anson, Andrew Fight and Patrick Vandenbroucke, Country Risk Analysis, euromoney ± dc gardner workbooks, book 3, p. 15.)

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RELATING TRANSFER AND POLITICAL RISK Having shown how to assess both the transfer risk and the political risk, this final section will show how these two risks relate to each other and how this relation impacts on the total intensity of the country risk. Several methods are again used to come up with an answer, taking the liquidity and solvency aspects of the transfer risk into account. Three of these methods are the overall index, the combined index and the matrix solution.

The overall index One way of relating the two types of risk is to combine the different indexes into one super-index. This method assumes that country risk is to a certain extent dependent on the political risk and to another on the transfer risk. The weighting of the two aspects is obviously different for the various types of cross-border exposures. A foreign direct investment will depend more on the political risk, while a trade transaction or a short term bond investment depends more on the transfer risk. In the overall index for cross-border lending political risk is often assigned a 30% weighting. Within the transfer risk, the liquidity part can account for up to 50% of the transfer risk. Such an overall index is easy to understand and has therefore become quite popular. Many financial institutions use an overall index because they combine the country risk assessment with the credit evaluation process. They take the same numerical rating, i.e. one to ten, or an alphabetical rating similar to the rating categories used by the big rating agencies. The disadvantage of an overall index is that a change in the position of a country cannot easily be attributed to one factor or the other, unless the details are reviewed. It cannot be used as an early warning index because there are too many factors that make up the index. On the other hand, it is a fairly easy method that shows in one number where a country stands according to the country risk assessment process and how it relates to other similar countries. It is also the method used by most rating agencies. It is probably an appropriate method when only a restricted number of indicators and factors is used.

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The combined index With the combined index, a separate index is used for political risk and transfer risk. The indexes are divided into score groups, each with a category number. This could mean that an index score of 81 to 100 would correspond to category V. A score of 0 to 20 would fall into category I. The same scoring would be made for the transfer risk index and this index could be further divided into a solvency and a liquidity index. In order to facilitate the reading of the index, letters such as A to E could also be used for political risk intensity. A country would then rate, e.g., A/IV/IV, which would mean a very low political risk as well as a low transfer risk regarding liquidity and solvency. Such a combined index is perhaps cruder than an overall index with a big scale. On the other hand, it gives a better indication of how the different components of country risk relate to each other. If there are big discrepancies between the three figures the situation needs attention, as is the case when all figures point to the high end of the risk profile. Nevertheless, the combined index is a useful one.

The matrix solution The matrix solution sees a relation between political and transfer risk. It further assumes that the importance of both risks is similar in relation to the country risk as a whole (Fig. 3.4). On the ordinate, political risk is listed according to its intensity and on the abscissa the same is done for the transfer risk. Each country therefore needs a score for each of the two components of country risk. Low risk countries will be on the upper left side, while high risk countries will remain on the lower right side. One of the interesting aspects of the matrix method is that it is possible to see, at a quick glance, where countries stand and how countries move on risk intensity. Similar countries are easily compared. The matrix solution is two-dimensional, but easy to read and understand.

Figure 3.4 The matrix solution.

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Providers of cross-border funds will have to choose the solution that is best adapted to their goals.

REFERENCES 1

Ronald L Solberg, `Managing risks of international lending' in Country Risk Analysis, a handbook by Ronald L Solberg, Routledge, London, 1992, p. 13.

2

Basle Committee on Banking Supervision, `Supervisory lessons to be drawn from the Asian crisis', Working Paper No. 2, June 1999, BIS, Basle, p. 19.

3

Global Development Finance, Country Tables, The World Bank, Washington, published annually.

4

Ibid., April 2000, see respective country tables.

5

Ibid.

6

Ibid.

7

Milan N Brahmbhatt, `Current-account forecasting', in Country Risk Analysis, a handbook by Ronald L Solberg, Routledge, London, 1992, pp. 52ff.

8

Global Development Finance, Country Tables, April 2000.

9

John K Thompson in Euromoney, July 1981.

10 William R Cline and Kevin JS Barnes, `Spreads and risk in emerging market lending', IIF Research Paper No. 97±1, Institute of International Finance, Washington, December 1997. 11 Thompson, Euromoney; Kenneth l'Anson, Andrew Fight and Patrick Vandenbroucke, Bank and Country Risk Analysis, Book 4, euromoney-dc gardner workbooks, 1999, p. 8. 12 Thomas E Krayenbuehl, Country Risk, second edition, Woodhead-Faulkner, Cambridge, 1988, pp. 63±6. 13 Robert B Avery and Eric O'N Fisher, `Empirical models of debt-rescheduling with sovereign immunity', in Country Risk Analysis, a handbook by Ronald L Solberg, Routledge, London, 1992, pp. 100ff. 14 Llewellyn D Howell, The Handbook of Country and Political Risk Analysis, second edition, the PRS Group, East Syracuse, New York, 1998, p. 4. 15 Jeffrey D Simon, `Political-risk analysis for international banks and multinational enterprises', in Country Risk Analysis, a handbook by Ronald L Solberg, Routledge, London, 1992, p. 130. 16 World Development Report 2000/2001, the World Bank, Oxford University Press, 2000, pp. 238±9, 287. 17 Simon, `Political-risk analysis', pp. 120±1; l'Anson, Fight and Vandenbroucke, Bank and Country Risk Analysis, p. 13.

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18 Simon, `Political-risk analysis', p. 121. 19 L'Anson, Fight and Vandenbroucke, Bank and Country Risk Analysis, p. 14. 20 Ibid. 21 Jerry Rogers, Global Risk Assessments: Issues, concepts and applications, Book 4, Global Risk Assessment Inc, Riverside CA, USA, 1997, pp. 246ff.

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4 Monitoring of crossborder exposures and hedging of country risk

INTRODUCTION As we have seen, cross-border exposures carry a risk for the lender as well as the investor. It is, therefore, only natural that lenders and investors look for hedging and monitoring techniques to reduce the risk hazard from cross-border exposures. This country risk can take effect in several ways. The worst situation is a complete loss of the asset, which is an exceptional case and has come about in the past in cases of the repudiation of debt by a country or through nationalization of assets without any compensation. The normal pattern of risk appearance is, however, the impairing of the value of the asset from a cross-border exposure through market perception of increased country risk intensity or effective higher country risk by the behaviour of the country in question. There are several ways in which that impairment can become actual, but it is important to look only at impairment that is due to country risk and not at impairment due to other risks such as, e.g., market risks. The most typical impairment is that repatriation of interest, dividends or capital becomes more difficult or even impossible for ever or at least for a certain period of time. Such impairment comes from unilateral political and/or economic actions or behaviour by governments. Another type of impairment comes from negotiated agreements between the government of a country and its creditors to find a new level from where the country can again honour its debt. The many rescheduling exercises of the last twenty years through the Paris and London Clubs have been the most visible instances of this type of impairment. In these cases the normal outcome has been an interest rate reduction, a prolongation of tenor or a reduction of capital. These different elements were negotiated on an either/or or a combined basis. A less quantifiable loss of value is the overreaction when market risks change. In this

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case cross-border exposures of some countries lose much more of their value than the changes of market risk would suppose due to the perception that the change in market conditions affects certain countries disproportionately and therefore their country risk. An example is when interest rates increase and assets from countries with a heavy interest burden lose much more of their value than US Treasury bills. The impairment of the value of assets due to country risk does not usually happen overnight. It is much more often the result of a long process that can even take years. The constant monitoring of country risk is the best way to keep on top of the developments and the changes of risk intensity. Depending on the type of cross-border exposure different monitoring and hedging techniques are used. Considered first below is the traditional situation of financial institutions that have diversified cross-border exposures.

THE ESTABLISHMENT OF COUNTRY LIMITS It has been standard practice for banks to limit their lending exposures through the fixing of credit ceilings for their customers. Such credit ceilings can be structured in different ways. However, they are usually divided into lines of credit for each type of credit and are therefore structured along a product-oriented system. These different credit lines are then consolidated for each borrower in order to monitor the total possible exposure to that specific client. In a further step all credit exposures to borrowers from the same group should be consolidated in order to know the total exposure to that specific group. All exposures to subsidiaries and majority-owned participations have to be added to give a correct picture of a bank's exposure to such a group. The creditworthiness of the group is then the guiding factor for establishing credit lines to the different companies of the group, making exceptions only when specific factors in the credit structure allow for it. Banks diversify and hedge their credit risk by lending to borrowers of different sizes and from different industries as well as from different geographical areas. They compile the risks to the different industries in order to monitor their exposure to a specific industry. This is not only done on a national level, but also on an international level, as many industries today have become global. By watching the trend in the different industrial sectors banks can adapt their portfolio to an adequate industry risk diversification and monitor the quality of the credit portfolio of the different industries. In addition, most banks today rate their credit risks on a scale from, e.g., one to eight and compile

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their portfolio along these lines. By the diversification of the risks taken, by classifying and comparing them as well as managing them in their totality, banks achieve a risk intensity reduction in their credit portfolio. This is called credit portfolio management. The realization that cross-border exposures involve a country risk in addition to the credit risk made it obvious that the former also had to be monitored in order to control the risk of the exposure to a specific country. The international geographical diversification of credit risk creates country risk and therefore asks for the monitoring of country risk. The country limit is the instrument used to monitor and control cross-border exposures in relation to a particular country and to limit the exposure to that particular country. Banking supervisors are, therefore, asking for the establishment of country limits for every country where a specific exposure exists or is contemplated to ensure prudent banking. Not only banks but also investors that have investments in different countries should consider the establishment of country limits for their investments to better monitor their portfolio of country risks. Country risk from cross-border exposure is often of a more complex nature than the exposure to a specific name would suggest. It can consist of risk from direct cross-border exposure and indirect cross-border exposure. It is suggested that both exposures are taken into account when compiling the size of an exposure to a specific country. Country risk from a direct cross-border exposure is primarily the exposure to a customer which has its legal domicile in the same country where it takes up its borrowing. This kind of exposure is associated with the term direct country risk. Not only does all sovereign borrowing fall into this category but it is also the most common cross-border exposure and therefore dominates the monitoring of cross-border exposure and country risk. Nevertheless it is also necessary to discuss here the so-called indirect cross-border exposure or indirect country risk. While investors rarely have to deal with indirect cross-border exposures they are regularly found in bank lending. An indirect cross-border exposure is in most cases a by-product of direct cross-border exposure. It is created when there are parties from more than one country involved in a cross-border transaction. Within the network of multi-location relations there is direct and indirect cross-border exposure. It means that in addition to a direct country risk an indirect country risk is involved. While this may lead statistically to a double counting, the risks are in reality not added together but stand towards each other in an either/or relationship. A few examples might illustrate the situation. The most common transaction involving an indirect country risk is a guarantee transaction, where the lending to a borrower in one country is guaranteed by a guarantor in another country. The guarantee must obviously cover not only the credit risk but also the country

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risk to create an indirect country risk. While from a credit risk point of view the credit risk of the guaranteed might often be neglected as it is possible to rely on the quality of the guarantor, it seems unwise to do the same for the country risk. The quality of the country risk for the country of domicile of the guaranteed can be better than that of the guarantor, whereas for the credit risk the reverse always holds true. In a guarantee transaction the direct country risk lies with the guaranteed and the indirect country risk with the guarantor. Exceptions to this scheme are the cross-border transactions guaranteed by the ECAs. In such a case the funding unit can neglect the direct country risk to the borrower since the transfer risk is excluded from the funding transaction through the guarantor, i.e. the ECA. However, it might be that the lender has a country risk towards the ECA if the ECA is situated in a different country to the lending institution. Another example of indirect country risk is found in the inter-bank market where the lending to the branch of a foreign bank creates an indirect country risk with the head office. The direct country risk is always with the unit taking up the funds because every unit operating in a country is subject to that country's regulation and therefore is part of that country risk. An indirect country risk lies with the country of origin of the head office. This country is involved because through the credit obligation undertaken the bank as a whole is engaged. The importance of such an indirect country risk depends on whether the head office of the institution is in a country of high standing or in one that is considered more risky. Banking supervisors in the main international financial centres try to control country risk exposures of branches from banks located in areas of higher country risk to ascertain their creditworthiness and their prudent monitoring of country risk. Furthermore, banks with international networks tend to notify correspondents that they exclude any liabilities of their head office which could materialize from country risks of their overseas branches, therefore eliminating any indirect country risk. Indirect country risk should be included in a country limit system in order to have a better picture of the total potential of cross-border risk incurred. It is a risk similar to a contingent liability. Its importance depends on the importance of the underlying credit transaction. If the underlying guarantee is the basis for the credit transaction, the indirect country risk has nearly the same status as that of a direct country risk. Another question that is sometimes asked in connection with country risk is whether there exists a country risk arising from the currency used in cross-border transactions and the corresponding

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exposure. A typical case would be a British institution creating a US dollar cross-border exposure to a German institution through an investment or a credit transaction. The argument goes that in such a transaction the United States could block the repayment of the US dollars for one reason or another. Such currency risk from a third party is obviously inherent in many cross-border transactions and has been common when an embargo is declared. Cuba, Libya, Serbia, Iraq and Iran have been targets of such an embargo either by one country or a group of countries. These risks are not viewed as country risk and quite correctly so, because the country risk lies by definition in the relationship between the investor or lender and the country in which it takes its exposure. It is, however, a risk that comes up in the settlement of international transactions and is therefore part of the foreign exchange risk. The multilateral financial institutions play an important role in the international capital markets. They are substantial borrowers and nearly always have the highest possible credit ratings. Their creditworthiness is therefore generally above any doubt. Many are also located in the OECD area which means countries with a low country risk. However, these aspects are not of such great relevance as the multilateral financial institutions generally enjoy the status of extraterritoriality. Lending to or investing in bonds of multilateral financial institutions can constitute a cross-border exposure when the lender or investor resides in a different country from the institution. In view of its extraterritoriality however, it does not involve a country risk, but only a credit risk. It is advisable to check the legal status of the multilateral institution to ascertain the extraterritoriality and to know the responsibilities of the member states in case of economic difficulties. As no specific country risk is incurred, financial institutions might set up special limits for them as they do for specific industries.

Size of country limit The size of a country limit is the total amount that an institution is willing to take as cross-border exposure towards a specific country. The establishment of that amount is, therefore, of crucial importance for the institution involved. So far there exists no generally agreed rule according to which the size of a country limit can be established. Regulators leave it, therefore, up to the management of an institution to fix the country limits. This is very acceptable because it is the management's duty and responsibility to fix the risks it is willing to undertake. The freedom to fix the country limit is in contrast to the legal lending limits that exist for banks in all well regulated banking systems. It also shows that the perception of country risk is one of a generally lower risk intensity

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than the credit risk. Regulators have become more relaxed towards country risk since the debt crisis of the 1980s, because banks all over the world strengthened their capital basis substantially and with it their risk absorption potential. Furthermore they developed country risk evaluation schemes and models better to cope with this risk. In addition, the IMF has made big efforts to manage debt crisis in the less developed countries better since the early 1980s in cooperation with the governments of the developed world. Today, however, the activities of the IMF in the management of debt problems have come under scrutiny and this will be discussed in Chapter 5. While regulators are relatively generous when it comes to the establishment of country limits they are very interested to know the process of the monitoring of country risk in the supervised institutions. Country limits have to be based on the consolidated operations of the institution in question. Most banks use a `top down' approach that treats the country limit as a scarce resource.1 This system probably came from the experiences of the early 1980s. It has certainly helped to make banks more conscious about country risk. Nevertheless a `bottom up' approach also has value. Chapter 3 showed how to assess the country risk and this section therefore concentrates on the need to explore the market potential when fixing country limits. The estimation of the market potential in a specific country has to be part of the marketing plan for that country. Country experts and marketing specialists will have the necessary depth of knowledge to arrive at a good estimate of the potential. The estimation of the market potential is, therefore, a recommendation for all actively operating international institutions when looking at country risk. Whether the goals for the marketing plan go so far as achieving a certain market share or give only some monetary numbers, will depend on the individual institution. Large financial institutions with their specific product lines will tend to opt more for the market share approach whereas smaller financial institutions will see the potential more as an outflow of their risk absorption capabilities.

The policy decision Whatever the reasons for cross-border exposures, the first step should always be an assessment of the business potential of the country the investor or lender is looking at. Purely financial investors, however, will look at the risk reward potential of the specific market. Companies and institutions have then to think about the way in which and to what extent they would like to become involved in cross-border exposures. A multinational company might decide to have cross-border exposures only through the direct holding of equity in foreign countries. Or it might add cross-border exposures through financing of exports or even undertake cross-border inter-company lending to optimize its

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treasury operations. An investment fund dedicated to a region will probably look at the attractiveness of the different stock markets more than at the country risk intensity when it allocates country limits. Again, banks operate in a different environment. They can have an active policy in the sense that a bank aims to obtain a certain percentage of its earnings from cross-border lending and exposures to the emerging markets, or that it wants to limit its international exposure in the more difficult markets to a certain percentage of its balance sheet. However, more passive behaviour is also found that is substantially driven by what kind of business comes under discussion. Looking a bit more specifically at banks, the goal would be to fix an amount of international exposure in relation to the balance sheet, to the equity and/or to the funding possibilities, nationally or internationally, which would allow the opportunities to be estimated and the risks involved to be broadly calculated. Banks have further to bear in mind that cross-border lending often involves a different currency from the one they operate in their domestic activities. Only after the assessment in principle about the international activity and of the potential of crossborder exposures can the more detailed work of establishing country limits be done. It is advisable to formulate the cross-border exposure policy in writing and review it on a regular basis. It can be assumed that the reduction in international lending after the Asian crisis had a lot to do with a candid review along the above mentioned lines of thinking. Prudent cross-border exposure management means the spreading of risks and not just the following up of opportunities. Banks should, therefore, try to diversify their cross-border exposures by analysing the potential in the different sectors of possible cross-border exposures, bearing in mind their customers, the potential in the different geographic regions as well as their business strategy. This task is certainly time consuming and needs a great deal of reflection. However, if it is not done in a serious way and at regular intervals, the institution might find itself in the not too distant future with a cross-border exposure of mixed blessings.

Risk assessment Having assessed the potential for business in a specific country, the risk assessment of that specific country should allow the institution to find the acceptable size of cross-border exposure to that country. This process will force the investor and lender to decide whether it really wants to realize the potential of the market or whether a more restrictive approach seems advisable. The difficult choice

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between high risk/high return and low risk/low return will become evident, but will also present opportunities. The risk assessment and the fixing of the upper limit of the corresponding cross-border exposure is an exercise that has a different outcome for everyone. The only thing that can be said is that similar institutions will probably come to similar conclusions. For every country where a crossborder exposure is contemplated such an upper limit of exposure should be fixed. While the risk assessment looks primarily at the country risk involved, another aspect of the process is to look at the risk absorption potential of the institution. Banks in particular should assess this, because they are very leveraged institutions in comparison with industrial companies. The cross-border exposures of banks to specific countries should be such that they are manageable in relation to their risk absorption potential. Some banks have therefore established a certain percentage of their capital as a ceiling for individual country limits.2 The question of manageability has an absolute side and a relative side. The absolute side of the question would be similar to the lending limits that bank regulators extend to banks, whereas the relative side would be more the institution's self-assessment of its capabilities to carry and manage country risk. An institution that has its major focus of activity towards, e.g., Latin America can probably live with relatively much higher country limits for the Latin American countries than a similar institution for which Latin America is just one of many areas where it supports its clients. As country risk deterioration has seldom led to a complete loss of the value of assets, it is noticeable that the country limit for large countries has been going much higher than the equity of the institution concerned. The risk intensity of the country risk as well as the business potential of the specific country has obviously to be taken into consideration when fixing the limit.

Differing intensity of country risk Different kinds of cross-border exposures carry different country risk intensities. The potential of the products in the different categories of country risk intensity will have to be analysed. Each country offers different opportunities and these opportunities often have a differing intensity of risk. Investors and banks might very well limit their exposures to certain categories of exposure in certain countries. Fund managers will often include derivative lines in addition to lines for investments. Some of the product categories enumerated further down are non-existent in specific countries because the transactions are not allowed and/or there are no counterparties in these categories. Nevertheless it seems correct to use the same structure for all country limits in order to have a certain system for the institution. In this context it might be asked why the intensity of country risk is different for different categories. This has already been alluded to above. Foreign exchange

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regulations, for example, tend to change when the economic situation in a country worsens. The attribution of the necessary foreign exchange to the different sectors of the economy can change in particular. While trade transactions and B-loans might still be honoured, other cross-border exposures might face delays in their settlement. Obligations from issuance of bonds in the international capital markets have tended to be relatively immune to higher country risk. This was certainly true when bonds from emerging countries were a relatively small part of their international exposure. Derivative transactions might be unwound faster than lending exposures, or a securities portfolio might be liquidated just in time, before capital transfer restrictions are enacted. Bank and public sector exposures might be privileged when scarce foreign exchange has to be attributed. Others think, however, that banks are the first to receive orders from governments in financial difficulties to stop paying foreign exchange debts as this segment of the economy is easily controllable. In the private sector one can, e.g., establish third-country guarantees which can reduce country risk, something that is not possible in the public sector. Furthermore, due to their international presence, private multinational corporations might have chances to obtain foreign exchange even in difficult times and governments might be unable to prevent that.

Structure of country limit Banks probably have the most complex cross-border exposures and will therefore also need the most structured type of country limit. As they usually have direct and indirect country risk, the country limit should first be structured according to these two major categories. Cross-border exposure of banks comes from all kinds of transactions. These therefore have to be grouped by similar intensity. Lending would be an important part of the structure. Lending means not only different types of lending but also different kinds of maturity. In a specific phase of the decision process the maturity aspects have to be dealt with, as was seen earlier with the importance of tenor in the assessment of country risk. As it is, however, too cumbersome and too difficult to monitor a country limit that is structured in too many items, a certain simplified structure in rough categories seems to be appropriate.

Direct country risk First, cross-border exposure should be dealt with under what is called direct country risk. Within the overall country limit a specific limit has to be established for the direct country risk. It is usually by

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far the largest part of country limit. Such a limit for the total maximum exposure under the direct country risk to a specific country would in a second step be divided into the different types of exposures and tenor. Too fine a division is not recommended because it would be very difficult to monitor it effectively. A division into about four broad categories of different risk intensity would seem to be adequate. These would be exposures in trade finance, in lending, through derivative exposures and exposures for investments.

Short term trade finance Short term trade finance transactions certainly have to be accounted for separately in the country limit and would constitute one category. They are transactions related to financing of international trade and have to be self-liquidating. They cover not only the financing of imports, but also the prefinancing of exports. Their tenor should on average not exceed one year, but can go up to 18 months. It is therefore normally the shortest type of exposure into a country. Trade-related exposures have also to be accounted for separately, because they are considered as the cross-border exposures with the lowest country risk intensity. They are the life blood of a country and are usually honoured even in the most difficult times.

Lending Lending is the most sensitive category in relation to country risk, because in this category is found the traditional country risk that is not mitigated by any factor and is increasing with the length of its tenor. It might be advisable to subdivide the lending limit in the three major categories of potential counterparties, namely the banks, the private sector and the public sector. In any case it is also important to split lending into the different maturities, such as short term, medium term and long term. Two additional categories can be added in the lending field, namely project financing and the so-called B-loans of multilateral financial institutions. Project financing often has a lower country risk than direct lending, because the repayment of the loan is based on the export of products, mostly commodities generated by the project. Countries in economic difficulties have an interest in keeping up their export potential. They are therefore willing to leave funds generated through such projects with the borrower of funds so that it can maintain the exports. B-loans are a completely different proposition. They derive their lower country risk from the fact that they are granted in connection with an investment and a loan from a multilateral financial institution and are therefore considered to be on a similar country risk level to the exposures to the multilateral financial institutions themselves. B-loans are normally honoured even in times of great economic difficulties and foreign exchange shortages.

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Derivative exposures Derivative exposures also have to be accounted for separately in the country limit, because they are a product line that generally has a lower risk intensity than lending. Furthermore, the exposure in derivative products is usually measured by taking the market risk into consideration and by applying the value at risk method. It has to be added that derivative exposure sub-limits within the country limits are obviously only sensible if the country in question allows such transactions. The losses from derivative exposures during the Asian crisis in 1997/98 showed the importance of accounting for those products separately. The tenor of the derivative exposures has to be divided into those with short term duration up to one year and those that have longer tenors.

Investments This category can again encompass different types of investment. While multinational corporations will make mainly long term investments to participate in the local market, fund managers and financial institutions keep investment instruments for a shorter or longer period depending on their investment strategies. The valuation of these instruments will also differ substantially depending on the holder of the investment and the purpose of the investment. In this category it is certainly also advisable to divide the line for investments according to the intended length of tenor for holding it. Investments for trading purposes have to be separated from those for holding to maturity purposes.

Indirect country risk As was said earlier, in some cases a cross-border exposure also produces an indirect country risk. These indirect country risks are found in the banking sector in particular. They are usually, however, only a fraction of the size of the direct country risk. The most significant indirect country risks come from the inter-bank market in the big funding centres of the world. These tend, however, to be risks from the developed world countries and therefore have a relatively low risk intensity. It is nevertheless necessary to record them under a separate caption in the country limit.

The maturity profile Having structured the country limit into the different categories of direct country risk and indirect country risk, a maturity profile for the different categories also needs to be established. This maturity

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profile is needed because an increase in tenor changes the intensity of country risk. It is a guide for the institution to set limits regarding the tenor of its exposure. The setting of the maturity profile has to be done in a pragmatic way. Normally the tenor is divided into short term, medium term and long term (meaning up to one year), between two and five years and over five years. In addition to this suggested break-up of the maturities, the reporting requirements of the supervisory authorities have to be followed. Such a structure with four to five different categories and three different maturity profiles leads to a country limit broken up into 15 different items. It therefore already involves a fairly substantial exercise in reaching an optimal result. Because there is no standard break-up, each category and maturity has to be established based on a management decision. Further refinements in the country limit structure through additional categories are obviously possible, but substantially increase the task of administering and monitoring because each part has to be handled separately. It should always be borne in mind that the country limit structure is the basis not only for the marketing policy but also for monitoring the country exposure of the institution in that specific country. The tenor of the structure of a country limit is thus not only the outflow of a technical solution but also the expression of the policy adopted by the institution towards that specific country. The country limit structure should, therefore, be understandable and realizable.

Aggregated structure It can be questioned if it is meaningful to add all the different products into one country limit, because they are measured differently for credit risk purposes. For the credit facilities the notional amounts and the commitments are added. For the derivative exposure the values of the contracts in the money are added. The trading assets such as securities and foreign exchange are measured by an estimation of their value at risk. Longer term investments can follow their own valuation methodology. In a way, therefore, this compares apples and pears, but a similar methodology is used for the different products when the capital at risk in the credit evaluation process is measured. Therefore it seems that it is meaningful to use the aggregated exposure to the specific country and establish country limits or, better perhaps, sub-limits for all the different products. Such an aggregated structure also allows for efficient monitoring. An example of an aggregated country limit structure is found in Table 4.1.

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Table 4.1 Structure of a country limit Country: X

Total limit US$850 million maturities Total

up to 1 year

2 to 5 years

over 5 years

Direct country risk Trade finance

200

200

Financial institutions Private sector Public sector Project finance B-loans

150 150 100 50 20

100 30

50 100 50 20 10

20 50 30 10

Derivative products

50

40

10

Investments trading Investments hold

80 40

80

840

450

Indirect country risk

50

50

Total country limit

890

500

Total direct country risk

20

20

260

130

260

130

Responsibility for fixing the country limit Establishing and structuring a country limit always involves the assessment of the country risk as well as an estimate of the market potential of the specific country for cross-border transactions and exposures. Fixing the size of the country limit and its structure is, therefore, a highly important decision for every institution, because it involves not only the decision about risk taking within a complex structure, but also the commitment of substantial amounts of capital. The responsibility for fixing it has to lie high up in the corporate hierarchy. It is therefore the task of the top management to make those decisions; it would be imprudent to leave it to the lower level of management. Proposals for the limit, however, will have to be prepared at the country desk level and by regional management if such an organizational structure is used. The approval and therefore the fixing of the limit will then be done in the upper echelons of management, like the way by which credit lines are approved. The responsibility for approval is in most banks in the hands of a senior executive-level committee or unit and the country limits and their changes are normally reported to the board of directors. 3 Very often the country risk approval process is even integrated in the credit process.4 Different ways of fixing the country limit are certainly possible; the important thing is that a clear and formal procedure exists for approving and fixing the limits. In

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this context a centralized system surely has some advantages as it allows exposures to be controlled in a fast and accurate way. Most supervisory authorities today not only look at the size of country limits and the respective exposures, but also evaluate the procedure for fixing them. They want to make sure that bank management is fully aware of the risks from doing cross-border business and controls them in an efficient way.

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General aspects The establishment of a country limit is the basis for limiting the total risk of cross-border exposures into a specific country. While the country limit is fixed and reviewed from time to time, the effective exposure can vary substantially at times, depending on the kind of relationship the investor or lender has with that country. The monitoring of the cross-border exposure should enable the lender or investor to make the necessary decisions to seize new opportunities in time and, therefore, to expand the exposure ± but should also enable it to foresee a deteriorating situation and therefore to contain or reduce the exposure. In order to do so, the monitoring should encompass the risk assessment, the country limit proposal and review and the exposure management, as well as making provisions for country risk if necessary. The task of monitoring should be delegated to specialists within the institution. These specialists should not be the same ones that approve the limits. There are different organizational approaches to locating these specialists within an institution's structure. In smaller banks it will be the international division; in larger establishments there are local representatives and country managers, a regional management or a country specialist organization at headquarters to look after the monitoring of country exposures. Often the organization is part of the credit process or the risk organization. The essential thing is that the task of monitoring country risk is clearly assigned within the institution, just as the monitoring of credit risk has always been. In addition, monitoring the country limit can be valid only when it is done on a consolidated basis for the institution in question. It must take into account not only the branches but also all the subsidiaries of the group.

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Choice of a system for the assessment of country risk In monitoring cross-border exposure to a specific country the monitoring of the quality of the country risk in question is one of the major objectives. In monitoring credit risk a whole package of information on the debtor in question is reviewed together with an evaluation of the product line, the industry and the management. In monitoring country risk we must evaluate the intensity of this risk by assessing it at regular intervals. The system chosen should make this possible. In the previous chapter the different methods currently used to assess country risk were explained. Each provider of cross-border funds is in a different situation and therefore there is no one or best system, but each provider has to choose its own method. It is obviously important what system is chosen; but even more important is that the provider adheres to the same system over a certain period of time, in order to achieve consistency of assessment and to find out if the system chosen is relevant for the purpose for which it is used. Financial institutions have to a large extent adopted systems that allow them to reach a rating of the different countries that can parallel the credit rating system. Often this is a scale of one to ten or to eight. By having country rating and credit rating along the same type of numerical scale banks often limit the credit rating to the country ceiling, which means that no counterparty in a specific country can have a better rating than the country in question. This assumption has come under discussion, as we will see later. In the United States there is often a correlation of the banks' country risk ratings to the ICERC (Interagency Country Exposure Review Committee) ratings, as banks have to classify their country exposure according to the ICERC guidelines. The categories of the ICERC ratings are `Strong', `Moderately strong', `Weak', `OTRP' (other transfer risk problems), `Substandard' and `Value impaired'.5 It has to be borne in mind that the ICERC rating only covers transfer risk. Another possibility is the outsourcing of the risk assessment by the providers of cross-border funds to third parties. While such a procedure simplifies the risk assessment process and probably makes it less costly, it gives away one critical core competence for institutions doing international business. The outsourcing of risk assessment can have many aspects as we will see later. Why should an institution choose a sophisticated system when at the end it boils down to a scale of one to ten? The reason to choose a more elaborate system lies in the need to follow the changing intensity of the quality of the risk. If the assessment system has, e.g., a scale of one to a hundred, ten

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units would correspond to one change in the rating. However, it is very important to be able to see how fast or slow the risk intensity moves within this bracket of ten units. Rather than analysing the past, the chosen system should focus on possible developments in the future. In this context the prompt recognition of a change in risk intensity and the correct forecasting of its implication on the perception of that country risk means a lot. It helps to contain the exposure and to avoid new commitments in time. In view of the constantly changing situation in country risk intensity a regular review of the quality of the country has to be made. It is common in the financial services industry to assess countries at yearly intervals. This is acceptable under normal circumstances but has to move to shorter intervals in unstable situations. Political and transfer risk intensity have to be updated using the information that is available at regular intervals. If countries are considered higher risks, the pace of review has to be such that not only new commitments are stopped in time, but also new opportunities are looked into when the risk intensity is decreasing. A change of risk intensity can lead for example to a worsening of the situation in the private sector when local interest rates are increased without yet affecting the public sector. Or a highly inflationary situation can dramatically change the ability of the private sector to service its foreign currency debt while the government is still in a much more comfortable situation. The medium term outlook may be improving due to newly found natural resources while the short term situation is still bleak. In such a situation it is possible, e.g., to change the structure of the limit without changing the total exposure limit to that specific country. The assessment system should allow an institution to make such fine tuning of its country limit. Country limits should not be carved in stone, but reviewed and changed to monitor the quality of exposure and to be able to take advantage of opportunities. It is not the most sophisticated assessment system which will lead to successful cross-border exposure management, but a system that produces the correct fever curve for the country in question. Such a combination of local knowledge and systematic assessment has a lot to offer.

Monitoring of effective exposure While the review of the country limit through the chosen system of country risk assessment gives the financial institution the necessary indications regarding its overall policy towards a country, the daily monitoring of country exposure helps to fine tune cross-border exposures. While in lending, the time frame to make a decision can often be measured in weeks, securities dealing needs a real time up-todate information system to manage a portfolio successfully. Through the constant monitoring of the

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exposure to a specific country, the institution will always be in a position to account for it in the same categories as are identified in its structure of the country limit. This is also important because country exposure tends to be closer to the country limit in higher risk countries than in those of a lower risk level. The constant monitoring of the exposure has as such a double purpose. In the low risk countries the monitoring can help to identify where the institution is still looking for business opportunities. It is, therefore, an instrument for marketing the institution's services towards a specific country. On the other hand, monitoring the country exposure in high risk countries will help to contain the exposure or shift it in the direction the institution desires. Through the monitoring the institution will also be able to maintain the same diversification of risks as it planned when it established the country limits and their structures. A bank must in this context be especially careful not to find itself at the end of the day with fully used limits in countries with a difficult situation and unused country limits in the so-called `premium countries'. A certain portfolio thinking seems warranted for the global country exposure of an institution. Furthermore, it should not suddenly find out that the major part of its commitments are in the longer maturities of the country limit instead of being well spread. Such developments would point towards an unbalanced and probably inefficient monitoring system. The managing of the cross-border exposure within the structure of a country limit is also similar to portfolio management, because each category represents a different asset class and the different asset classes should stand in a specific relation to each other in order to obtain the optimal risk return relation on the portfolio of the country risk exposure in a specific country. As is the case with the measurement of credit exposures, it is obvious that country risk exposures always have to include commitments such as partly used committed credit lines, standby lines, confirmed letters of credit, guarantees and open credit offers. The ability to monitor correctly the country exposures of large providers of cross-border funds such as big internationally operating financial institutions, needs a substantial infrastructure. The current information technology allows the provider to put the data together without too much difficulty and run the system on real time. However, it is not only the data and its availability that are important, but also the procedures that have to be set up to control and monitor the country risk exposure, real and potential, within the authorized limits. The organization of the institution must ensure that every proposed transaction involving a country risk obtains correct country risk clearance and is then monitored accordingly. The system can be run in a very centralized manner as well as in a decentralized way. Sub-limits can be delegated either for specific products or to lending units of the institution.

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Monitoring country risk on an individual country basis is probably the only effective way to control country risks. It does not seem possible to use the academic portfolio management approach to manage the global cross-border exposures of an institution, because too many asset classes would have to be established. Each product group in each country is more or less a different asset class. This would create an unmanageable multiplicity of alternatives. To make portfolio management interesting, commitments to each asset class have to be big enough to make a difference.6 The institution might consider putting together a portfolio of cross-border exposures in a region under the assumption that there is a fixed relation between the product groups of the different countries in this region. Such an exercise is obviously of higher value for investors than lenders, because lenders have not the same freedom in managing their portfolios as investors.

THE CHANGE OF COUNTRY RISK QUALITY AND ITS CONSEQUENCES If an assessment system with periodical reviews is institutionalized, it should give the first indications of a change in the risk quality of a country. If the cross-border exposure is based mainly on tradable instruments, a changing of spreads is always an indication of a change in the risk perception of a country. However, such an indication of change in the perception has to be substantiated to really know if there is also a change in the country risk intensity or only the effects of changes in market risk due to changes in the international interest environment. The same holds true with swings in the stock market valuations. It would be up to the decision making level of the institution to fix at which scoring points, range of scoring or change of scoring points a review of business and marketing policies should be made. A change in a rating scale of one to ten would be much too coarse a move and probably too late a development for an efficient adjustment. This is why a finer scale such as one to one hundred was proposed. Management has to fix the risk tolerance when changes are warranted. The review obviously does not automatically lead to a change of policy, but obliges the different departments and officers concerned with that particular cross-border exposure to reassess the institution's policy towards that country. It is certainly helpful in this context if the institution's management fixes broad policies of action for specific changes in the range of scoring. This could mean that only certain types of cross-border exposures are undertaken at a given score and maturity structures are related to specific scores. It is further important that these policies are well known within the institution and find their way also to the managers in the field. Like this the institution obtains a coherent policy between its system of scoring or assessment and its marketing effort respective to exposure.

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A deteriorating situation In a deteriorating situation it is most important that the holder of cross-border exposures grasps such a development as early as possible. This will give it the largest number of options to contain or reduce the risks. This is psychologically a most difficult moment, because the institution is responding to a situation that is only starting to unfold with no indications of what will be the eventual outcome. Having said that, it is probably a very obvious thing to fix the exposure at the then existing outstanding amount regardless of the authorized country limit. This pulling of the brake has consequences on the business relations in the country concerned and therefore should be the responsibility of persons high up in the corporate hierarchy. It is probably also advisable to communicate the decision in a constructive way to the customers of the institution. After such action a detailed analysis is needed to confirm the perceived deterioration or to conclude that the perception did not match the reality. Depending on the analysis an adjustment in the country limit might be proposed regardless of the exposure. The gap between the exposure and the new limit is now outside the accepted risk tolerance and means have to be found to adjust the exposure as soon as possible to the new limit. As country risk normally degrades over a long period of time, often many months if not years, it is very difficult for country experts to define the correct moment when action is needed. It is clear that when everybody is aware of the deterioration of a specific country risk it is probably too late to try to adjust the exposure to the new risk level. If the deterioration is, however, spotted well in advance, the adjustment process can be carried out in a fairly orderly way. There are several actions that can be undertaken. They are in many ways similar to those undertaken when a domestic creditor faces difficulties. As in such a case, at each stage of risk deterioration specific and different measures will be needed. It should be noted that an investor in securities will certainly act differently from a multinational company or a lender when it realizes the deterioration of country risk. The investor in securities has the advantage that it nearly always has the possibility to exit the investment within days by selling it and taking the loss, whatever it may be. Unfortunately such actions often have a negative impact on all other holders of cross-border exposures to the country in question, including those holders of cross-border exposures that do not have the option of the `easy exit' of selling, because they have business relationships at stake or their reputation as a good corporate citizen. Furthermore, actions that are too drastic might jeopardize the future when the situation is improving again. With the deterioration of a credit risk the situation is different as the creditor in difficulty can and often does go under, whereas when country risk deteriorates it is countries that are involved. They do not disappear, but in many cases stage a comeback after a certain period of time. In the context of a worsening of country risk there is often simultaneously a

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worsening of the credit risk of the private sector. Therefore close cooperation between the country risk and credit risk specialists is needed to coordinate their actions successfully. Only then can damages to the asset quality of the portfolio of cross-border exposures be minimized. In the context of this book, however, the following discussions will be limited to the consequences of a deterioration of country risk. The following measures have therefore to be viewed in the above mentioned context.

Basic steps The basic steps should aim to make clear that the holder of cross-border exposures is separating the credit risk from the country risk. Its action does not intend to hurt the credit relation, but is needed to safeguard it against the deteriorating country risk. Financial institutions will therefore suspend unused credit lines and will have to handle confirmed letters of credit much more carefully, probably on a case by case basis. Confirmed credit lines, however, can only be reduced or cancelled on the dates fixed in the contract. Further steps may be needed because the credit risk has also deteriorated. The maturity structure of the country exposure has to be analysed to see what kinds of steps can be taken to improve it. New business should only be undertaken if the country risk intensity complies with the risk tolerance of the institution. In this connection it should be noted that, whatever their situation, all countries need a minimum of international trade to satisfy their needs in food, energy and medicine and therefore will support imports of those goods under all circumstances. Therefore the financing of that part of international trade might go on even in a deteriorating climate. Pricing of the services provided will have to be reviewed in a deteriorating situation by increasing margins and fees in order to regain an acceptable risk return relationship on the exposure. Unfortunately competition is often too intensive to obtain a better pricing. The reduction of the exposure is therefore normally unavoidable.

Selling of assets Another possibility of reducing exposure when the deterioration of country risk warrants it is the sale of assets of the country in question. Such action is possible only as long as there exists a market for assets of the specific country and if the underlying credit quality of the asset is not impaired. Under normal market conditions such sales are possible for countries that are perceived in the market as carrying a moderate risk. Discounts on the value are, nevertheless, often needed to make the transaction attractive to the buyer. The securities investor will certainly sell assets, remembering the maxim that the first loss is always the smallest.

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An improving situation If the assessment of a specific country risk shows an improvement, the actions to be undertaken move in the opposite direction. It is equally important to recognize such a development in time in order not to miss potential opportunities. To be a latecomer involves no losses, but does bear a certain opportunity cost. It has to be added that an improving environment usually brings immediate pressure on margins and fees. Lock-ins of prices when a country risk improvement is perceived are, therefore, advisable, before everybody in the market realizes the positive development.

HEDGING OF COUNTRY RISK As well as monitoring country risk, providers of cross-border finance should consider hedging that risk. There exist relatively few possibilities to hedge country risk and therefore most providers of crossborder funds accept country risk as a risk they have to take on their own books. This is one of the main reasons why monitoring of country risk is of such importance. The possibility of hedging country risk depends very much on the kinds of cross-border exposures. The biggest efforts have been made to hedge the political risk for investments in the developing world, in order to make such investments more attractive and by the same token hopefully more numerous. Hedging is always costly, and therefore holders of cross-border exposures generally forgo taking out insurance as they deem the cost too high for the risk they have to take on their books. In addition, it is not possible to take up an insurance when the risk is evidently increasing. Several institutions have taken a very active part in the development of investment insurance coverage against political risk. They come from different promoters of international cooperation, most prominently from the World Bank Group.

Multilateral Investment Guarantee Agency (MIGA) The World Bank Group realized after the debt crisis that more had to be done to attract foreign investments, especially in the more difficult developing countries, in order to enhance their respective development. In September 1985 it endorsed the Multilateral Investment Guarantee Agency Convention which stipulated as its core mission such development on the basis of fair and stable standards for the treatment of foreign investment. In April 1988 the Multilateral Investment Guarantee Agency (MIGA) (www.miga.org) was established as a member of the World Bank Group. The importance of MIGA will be reviewed in more detail in Chapter 5. Our concern here is with the hedging programme it offers.

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MIGA may insure eligible investors for qualified investments in developing countries against the following risks: . Transfer restriction, i.e. the inability to convert into foreign local currency earnings for transfer out of the country. . Expropriation, i.e. acts of the host government, including expropriation, nationalization, or confiscation, that reduce or eliminate ownership of the investment. . War and civil disturbance, i.e. acts of war, revolution, insurrection, civil strife, sabotage or terrorism, that cause physical damage to guaranteed assets or interference with business operations. . Breach of contract, i.e. breach of contractual obligations by the host government when the investor cannot enforce an award or judicial decision, recognizing the right to be compensated by the government. The guarantee programme covers more or less what is considered country risk. The guarantees given are for long term exposures, normally of 15 years. The amounts available for each country are limited. Eligible instruments include equity, commercial bank loans, shareholders and loans and loan guarantees technical assistance, and management contracts.7

Overseas Private Investment Corporation (OPIC) OPIC (www.opic.gov) is an agency of the US government. Its mission is `to mobilize and facilitate the participation of United States private capital and skills in the economic and social development of less developed countries and areas, and countries in transition from non-market to market economies, thereby complementing the assistance objectives of the United States'.8 OPIC is an instrument for investment projects with a substantial US participation. OPIC offers, among other services, an insurance programme. OPIC has a similar insurance coverage to MIGA, namely against: . Currency inconvertibility, which is the investor's inability to convert profits, debt service and other investment returns from local currency into US dollars and to transfer US dollars out of the host country. . Expropriation, which is the loss of an investment due to expropriation, nationalization or confiscation by the host government.

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. Political violence, which is the loss of assets or income due to war, revolution, insurrection or politically motivated civil strife, terrorism and sabotage. OPIC has a special programme for financial institutions and insures a wide range of banking services. Furthermore, it also insures capital market transactions such as, e.g., 144A bond issues. The maximum amount to be insured is US$200 million with a maximum tenor of 20 years. OPIC requires a self-insurance of 10% of the eligible investment.9

Other institutions Besides these two major institutions that help cover the country risk there are in other OECD countries government agencies or separate government bodies that have similar aims. One such is the Export Credit Guarantee Department (ECGD) of the British government (www.ecgd.gov.uk). The ECGD has a programme called Overseas Investment Insurance (OII) cover. With this programme the ECGD provides insurance cover for investors or lenders against the main political events such as war, expropriation and restrictions on remittances. In France COFACE (www.coface.fr) has a similar programme. The guarantee programme of the Japan Bank for International Cooperation has similar aims. In addition, several private insurance companies, such as the AIG group, also offer insurance against political risk. They are sometimes able to coinsure with the government-owned institutions thereby increasing the total insurance capacity for large projects. Hedging with these different insurance schemes still represents more the exception than the rule in cross-border exposures. Such hedging is probably most interesting for investments as it gives a long term coverage. However, the premium also runs for many years and therefore the coverage can become quite expensive.

Co-financing Co-financing can be considered in cross-border lending as a tool to reduce the country risk somewhat. Co-financing is an instrument that has been developed by the World Bank Group, but it is also used by other multilateral institutions. Through the co-financing mechanism the lender participates in a project lending that has its origin in a project lending originated by a multilateral

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institution. The lender has the advantage that the project selection as well as the continuous review is done by a multilateral institution with political clout. They are normally in a privileged situation in the developing world and therefore the lender's exposure is in a better asset class than it would be by direct lending. The World Bank, the largest co-financer, had at the end of fiscal year 2000 US$2.2 billion from private sponsors in its co-financing portfolio.10

Refinancing aspects It has already been mentioned that most cross-border exposures are denominated in US dollars, Euros or any other of the major OECD currencies. It is standard banking practice to refinance assets congruently regarding currency and tenor and to have open positions only according to an institution's risk tolerance. Therefore as long as the quality of the cross-border assets is not impaired there is no refinancing risk. If, however, impairment does come about, the situation changes. It normally means that tenors are stretched, which in turn means that the lending institutions might suddenly have an unforeseen maturity structure and potentially a foreign exchange refinancing risk. As this situation normally concerns only one or a few countries the impact should be manageable. Furthermore, in today's global liquidity market this risk can certainly be disregarded for the major lending institutions from the OECD countries, because funds will always be available for them. The matching tenor might not be available and the prices might be higher than originally envisaged, but both aspects should lie within the risk absorption potential of the institution, perhaps just spoiling the profit and loss statement a bit. Besides impairment of the assets there can also be turmoil in the international financial markets. It is true that the custodians of the international financial system will do everything to avert such a crisis. Nevertheless it can still happen. In those circumstances, banks with a large foreign currency asset portfolio can face problems in the refinancing. In an international liquidity crisis they have no lender of last resort for the refinancing of these assets. The central banks function only in the domestic market as lender of last resort. For foreign currencies, central banks have only a limited potential to assist their national banks. It might be argued that the swap market will always function and take care of such a situation or that the non-availability clause of the syndicated loan agreement can be invoked and, therefore, another currency be offered. Under normal circumstances both these arguments have their appeal. However, this problem cannot be completely disregarded, as turmoil in the financial markets can still occur.

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The situation is certainly more acute for banks from countries with a lower rating. They constantly have to monitor their foreign currency refinancing capabilities to prevent being squeezed out of the market at a particular moment. The Korean banks were a recent case in this connection. They had to ask the international banking community to maintain their refinancing lines in the package negotiated during the Asian crisis in order to have enough liquidity in their overseas branches to support their cross-border lending. While it was a refinancing problem for the Korean banks it was a typical case of country risk for their correspondent banks. Refinancing aspects also play a role in leveraged investment portfolios, when country risk suddenly deteriorates. A recent case was apparent during the Tequila crisis. Leveraged investors, who held peso-denominated bonds with a fixed relation to US dollars from the Mexican government and who took advantage of the high Mexican interest rate differentials between the peso and the US dollar, suddenly faced a huge liquidity crisis when it became apparent that the Mexican government was no longer able to honour its obligations. The fast reaction from the US government in conjunction with the IMF was regarded by many observers more as a bail-out of Wall Street investors than a carefully structured operation for the return of Mexico to health. Foreign direct investors, on the other hand, rarely face refinancing risks, because they usually have to refinance themselves long term. In addition their leverage is normally fairly low. Furthermore, they stay in a foreign country for the long term and are accustomed to certain ups and downs. They are, however, very sensitive to political risk and therefore have an interest in the investment protection mechanisms.

THE CASE OF CONTAGION A special aspect of country risk deterioration comes along with the effect that is called contagion. There are several definitions of contagion in the literature. The definition by Sebastian Edwards that restricts contagion to the term `economic contagion' and defines it `as a situation where the extent and magnitude to which a shock is internationally transmitted exceeds what was expected ex ante' seems the most appropriate.11 Contagion became an issue in connection with risks in cross-border exposures only in the mid-1990s when the problems in Mexico affected Argentina and other Latin American countries, and even more significantly when the Asian and Russian crises not only had substantial impacts on the country risk perception in several countries in other continents, but created serious problems in these countries. The affected countries had to change their economic and monetary policies in order to avoid

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being drawn into the crisis or at least to adjust better to the shock coming from another part of the globe. The effects always showed themselves as pressure on the domestic interest rate and on the exchange rate of the currency. It is argued that the much greater capital mobility of the 1990s was one of the major reasons for the spreading of the contagion virus. The holder of cross-border exposures has no direct hedging possibility against contagion. The developing countries can, however, reduce the effects of contagion on their economies by adopting floating rate exchange rate regimes. The holder of cross-border exposures has to be aware of the possibility of contagion and take it into account when assessing a specific country risk. If it wants to do some hedging the best way is probably to spread the cross-border risk over different regions by choosing country exposures in relation to the likelihood of contagion affecting the different countries.12

OUTSOURCING RISK ASSESSMENT The question of outsourcing risk assessment is a valid one. It can be less costly. It can obviously be limited to certain aspects of risk assessment. There are quite a few services available in the field. LD Howell gives in his handbook a comprehensive overview of the different possibilities.13

The BERI ratings and system The oldest service providing country risk information and assessment is that of BERI SA (Business Environment Risk Intelligence). Its first index was constructed by its founder and senior editor Dr FT Haner in the late 1960s and had as its objective the classification of about 50 countries ± giving each one a rating between 1 and 100 ± which would represent the political and economic climate of each country. BERI SA (www.beri.com), which today has its headquarters in Geneva, Switzerland, has substantially expanded its services and perfected its methods and scope of information. The firm has two panels of experts that provide the country ratings and the qualitative observations. While one panel judges the political situation, the other looks after the operating environment. There are two major products that the company sells. The Business Risk Service offers a broad country risk evaluation looking at political and economic factors. The other major product, FORELEND, tries to evaluate the future capacity and willingness of a country to honour its obligations. The Business Risk Service (BRS) is published three times a year in April, August and December for the 50 countries covered by BERI, each with a two-page briefing. The BRS produces a composite score

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rating on a scale of 0 to 100 for each country. It is based on the political risk index (PRI), the operations risk index (ORI) and the remittance and repatriation factor (R-factor). All three components are calculated separately. BERI arrives at the two indexes through the qualitative method, whereas the R-factor is calculated through the quantitative method. BERI uses separate permanent panels for each of the two indexes with more than 100 experts from banking, industry and government. The panel for the PRI focuses on areas of possible political change. It provides ratings on the sociopolitical conditions. The ORI looks at the operating condition in each country which affects the production and profit earning capability in local currency for a foreign company and provides a corresponding rating. The R-factor is calculated by a large computer programme which uses more than 14 000 data cells. The R-factor has four sub-indexes which are simultaneously produced. The R-factor measures the transfer risk to a large extent by using qualitative data. The two risk indexes and the factor are established on a scale of one to a hundred. An addition of the three numbers divided by three gives the primary rating for the country or the Profit Opportunity Recommendation. The other major product is called FORELEND. The FORELEND system evaluates the capacity and willingness of 50 countries to meet their obligations in convertible currency during a five-year period. It is published three times a year. Several quantitative and qualitative measures analyse the economic, financial, monetary and political developments. For the quantitative measures information regularly produced from reliable sources such as the IMF or the World Bank is used. They form a complex set of variables. Out of these variables three ratings and a composite score are produced. The ratings cover the Lender's Risk Quantitative Rating (LRquant), the Lender's Risk Qualitative Rating (LRqual) and the Lender's Risk Environment Rating (LRenvir). The composite score that is based on the three ratings covers the past five years, the present year, the + 1 year and the + 5 years. These ratings and the composite score allow for a comparison between the different countries. The quantitative rating, the LRquant, has a weight of 50% in the overall creditworthiness rating, and is based on four sub-indexes which measure: . Foreign exchange generation (30% of LRquant). . Foreign debt assessment (30% of LRquant). . The reserve position (30% of LRquant). . The budget performance (10% of LRquant). The qualitative rating, the LRqual, which has a weighting of 25% in the overall rating, looks at the competence of the economic management of the country, the structure of foreign debt (short term,

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long term), the regulations regarding foreign currency transfer, the influence of corruption, and the resolution of the government to meet its foreign obligations. Each factor is rated on a scale from one to five and then weighted. The environment rating, the LRenvir, which also has a 25% weighting in the overall rating, reviews the political and social environment prevailing in the country under review, because the environment influences production of goods exported to service the foreign debt. The environment rating is also divided into three sub-indexes, namely the political risk index (40%), the adjusted operations risk index (40%) and the social conditions index (20%). While the first two of these sub-indexes are arrived at through the panel method as mentioned above, the third is measured quantitatively. The three ratings added together then constitute the overall creditworthiness rating or composite score on a scale between 1 and 100. The scale is divided into eight categories of lender ratings, which indicate to the lending institution the quality of the borrower and suggest a certain behaviour. In addition to the statistical data, a two-page analysis is made for each country. It begins with a recommended lender action (RLA). As the analysis covers economic, political and financial developments in a descriptive way and gives the reasoning behind the proposed action for the lender, the reader can draw his or her own conclusions. The services of BERI SA follow the classical assessment of country risk with the BRS and FORELEND products. They are, therefore, a very valuable tool for that purpose. Besides these two best known products, the company provides several additional services and products to help the internationally oriented business to better assess its policies and risks.

The International Country Risk Guide (ICRG) The International Country Risk Guide (ICRG) is another country risk assessment service that was started in 1980 by the editors of the International Reports. Today it is published by the PRS Group (www.prsgroup.com) in East Syracuse, NY, USA. The PRS Group is a division of IBC USA Financial Services Inc, but the ICRG is edited in the United Kingdom. The ICRG covers 140 countries and is published on a monthly basis. For a recent sample see Annex 4.1. The ICRG arrives at its composite scoring by breaking down the total score into three components. It uses a total of 22 variables for the three components. The political risk factor contributes 50% to the composite risk rating. This factor uses 12 variables. The other two risk factors, the financial risk factor and the economic risk factor, each contribute 25% to the composite score. Each of them uses five variables.

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The maximum score for the political risk factor is 100 points and 50 points for each of the other two factors. The composite score factor is an addition of the three risk factors divided by two. The scores range from 0 (highest risk) to 100 (lowest risk). They are, furthermore, classified into the broad categories of very high risk, high risk, moderate risk, low risk and very low risk. In addition the ICRG makes a forecast every month regarding the future risk situation for the periods of one year ahead and five years ahead. By using the same methodology as for the actual situation the forecasts are divided up into worst case forecast, a most probable forecast and a best case forecast. ICRG works with the reasonably possible risk and not with extremes when indicating the score for the worst and best case scenario. The monthly publication of the ICRG is extensive. It begins with a summary of the methodology. It is then structured according to regions with the ratings of the region's countries in front and then, in a narrative version, summaries of some specific countries of that region. A substantial statistical section is attached as an annex and summarizes the different parameters and scores in country lists. The ICRG gives a wealth of information at frequent intervals. It does not use a panel of experts to convert the collected qualitative data into numerical risk assessment, but instead does this in house. Broadly speaking it puts a slightly higher emphasis on the political aspects of country risk than BERI SA. The ICRG is therefore a very valuable tool in country risk assessment. The statistical section, with all the comparative data, allows a relatively easy identification of changes in the intensity of country risk.

The Economist Intelligence Unit (EIU) The Economist Intelligence Unit (www.eiu.com) also maintains a country risk service. The country risk service covers the 100 key emerging and highly indebted countries. A quarterly report is issued for each country covered. Each report rates the country in four generic risk categories, the political risk, the economic policy risk, the economic structure risk and the liquidity risk. These four broad risk categories are aggregated to produce the overall country risk rating and score. The political risk has a 22% weight, the economic policy risk a 28% weight, the economic structure risk a 27% weight and the liquidity risk a 23% weight in the overall risk rating.14 In addition it looks at three specific investment risk categories, the currency risk, the sovereign debt risk and the banking sector risk. The ratings always include the current and the previous rating. The risk rating methodology is explained in more detail in the handbook which accompanies the quarterly reports.

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The EIU uses for its risk methodology the standard country risk assessment process as described earlier, trying to make the best possible mix between the quantitative and qualitative assessment. It analyses in each of its reports about 180 economic variables in depth. For its ratings the EIU uses letters from A to E, A being the lowest and E the highest risk. For the scoring a numerical scale from 0 to 100 is used, 0 being the lowest and 100 the highest risk category. The quarterly report describes each country in detail and also gives the required up-to-date statistical data and sources of the data. The reports cover: . Overall country risk rating. . Political risk outlook. . Economic outlook. . External finance and credit risk. . Specific investment risk ratings. The reports make a forecast for the current year and the coming one. The Country Risk Service (CRS) product is very valuable for country risk assessment, not only because the EIU has a very large database starting from 1980, but also because it is a product that is delivered at regular intervals. It also contains alerts to make the reader aware of deteriorating or improving situations. Furthermore, it is of value not only to the lender, but also to the investor. However, it is obviously not a tailor-made product and is therefore in many ways very standardized. The weighting of the different risks leans strongly towards the transfer risk side of country risk. The EIU distributes the products by using up-to-date technology.

The Institute of International Finance, Inc (IIF) The IIF is also discussed here (www.iif.com) because its economic reports on over 50 emerging economies as well as its other products and services such as the Monthly Economic Review or the Capital Flows to Emerging Market Economies, which is published three times per year, are very helpful in broadening the reader's own view when assessing country risk. The IIF is the only global association of financial institutions. It was created in response to the debt crisis of the 1980s by a group of internationally operating banks. Today its members include most of the world's largest commercial and investment banks as well as a growing number of insurance companies, investment management firms, multinational companies, export credit agencies, and multilateral agencies. The

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economic reports offer an in depth analysis of the economic situation of the country in question and deal also with the domestic capital markets and the country's access to external finance. The IIF makes regular visits to the countries it covers in order to obtain a broader and deeper knowledge of the local situation and to gather information that is of particular interest to the financial community. In addition, an outlook for the coming year as well as extensive statistical material are included. The economic reports do not make any judgements regarding the transfer risk of the country in question, but help the reader to come up with his or her own evaluation of the transfer risk.

Euromoney and Institutional Investor Euromoney (www.euromoney.com) and Institutional Investor (www.iimagazine.com) are two publications widely read by the international financial services community. Both periodicals publish country risk ratings regularly, Euromoney once a year and Institutional Investor twice a year. These ratings are very popular and widely used in the international financial community. The rating process is somewhat different, but the result is similar, namely a list of all the countries rated according to their respective ranks with additional statistical data according to region or to specific aspects of the rating. Euromoney uses nine categories for its weighting of which economic performance and political risk make up 50% of the total score. Euromoney relies on experts in industry to come up with the scoring for these two factors of country risk. The other seven variables cover debt indicators (10%), debt in default or rescheduled (10%), credit rating (10%), access to finance (5%), access to short term finance (5%), access to capital markets (5%) and discount on forfaiting (5%). Euromoney compiles the scores for these factors internally by using publicly available information. Institutional Investor relies for its ratings on a biannual survey of up to 100 internationally operating banks. The banks are asked to rate each country on a scale from 0 to 100. The lowest scores represent the least creditworthy countries and those with the greatest chances of default, whereas the highest ones indicate countries with an excellent creditworthiness. The individual responses are weighted using an Institutional Investor formula that gives more weight to responses from banks with the largest worldwide exposure and the most sophisticated country risk assessment systems. Due to their sources both country risk ratings have a close relation to the mood in the international financial community. They are, therefore, often used for a comparison with an institution's own assessment of country risk. Recent examples can be found in Annex 4.2 and Annex 4.3.

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THE RATING AGENCIES When outsourcing the assessment of country risk the rating agencies are valuable and special providers of information. They certainly have wide experience in assessing credit risk and have for years been giving ratings to bonds and other debt-related securities of borrowers from the emerging markets. As these bonds always involve a country risk their ratings are a combination of the evaluation of country and credit risk. Ratings of bonds from sovereign issuers, however, can be equated with a judgement on country risk, as the credit risk of a sovereign borrower equals its country risk. All rating agencies attempt to measure the default risk and credit loss experience of the rated securities. The ratings do not have any connection with market risks that obviously also affect prices of securities. The rating agencies that evaluate country risk are Standard & Poor's (www.standardpoor.com), Moody's Investor Services (www.moodys.com) and Fitch IBCA (www.fitchibca.com). In May 2000 Fitch IBCA took over Duff & Phelps which was another well known rating agency. It plans to integrate the Duff & Phelps ratings into its own system. All three rating agencies have developed sophisticated rating methodologies for the sovereign credit rating, which take into account a wide number of factors and criteria similar to the ones enumerated earlier. In addition the rating agencies undertake extensive interviews with the political and economic leadership of the countries they cover in order to obtain information which is not publicly available, but helps them in giving the country and its obligations a rating. Cantor and Packer have looked into the relationship between the criteria used by Standard & Poor's and Moody's and the actual rating from the two US rating agencies.15 Their statistical data suggested that both agencies use broadly the same criteria but weight the variables somewhat differently. However, they found it difficult to establish a relationship between a country's economic indicators and its rating as the agencies do not give an indication of the weighting of the different criteria and quite a few of them are not quantifiable. While ratings from the rating agencies are an indispensable tool for the institutional investor in asset allocation and in the evaluation of the risk inherent in debt securities, such as bonds or commercial paper, they are also helpful for all other providers of cross-border funds to obtain a better understanding of the country in question and/or to cross-check their own evaluations. Asset allocation by institutional investors is often guided more by the ratings than by the name of the borrower or the country. The influence of the rating for the allocation of assets should therefore never be underestimated. Today, sovereign borrowers from the emerging markets have to obtain a rating from at least one of the three major rating agencies if they want to have a wider acceptance of their paper with institutional and private investors. As international capital markets for borrowers

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from developing countries have developed substantially over the last fifteen years the sovereign credit ratings have also become important for all other issuers from the same nationality. For the current situation of the ratings of emerging countries by the different rating agencies see Annex 3. Nevertheless, it should be asked whether the rating agencies provide any additional information that is not already known in the market. Do they only compile available information or do they add to the pool of knowledge? It is certainly their intention to go beyond what is known. The competition between the three agencies furthers that aim. They do provide with their reports a useful summary of the situation in the country covered. Their judgement, especially if it is a downgrading, is so important for the country's acceptability in the international capital markets, that they tend to be prudent in their statements. As securities are by definition tradable, it is interesting to see what kind of impact the rating has on pricing. Cantor and Packer have also investigated that question and found that ratings are clearly related to yields.16 Their research on the impact of rating announcements, be it a rating change or an outlook change, is also interesting as it suggests that the market discounts such changes in country risk quality well in advance of the agencies. This means that the market and the rating agencies have similar opinions on country risk, but act at different speeds or in a phased way. Yields start to move before the effective announcement of the rating agencies. There exists, therefore, what is called an announcement window. The yields change during the announcement window, which means a few weeks before the announcement and for a few weeks after it is made, before stabilizing at the new level. For many years it was generally accepted that the rating of a country also establishes the ceiling for the ratings of corporations and local governments. Even the best run corporation could never obtain a better rating for its cross-border exposures than the country where it had its head office. However, the situation has now changed. For some years the rating agencies have been allocating higher than sovereign ratings to certain companies for their foreign currency debt. The reasoning behind this change of opinion is interesting, because it is also of importance for a lender's or investor's own country risk assessment scheme. In the sovereign foreign currency defaults since the mid-1970s about a third of private sector companies with foreign currency exposures were able to continue to service their foreign currency debt.17 Furthermore, there were countries which imposed a default on their private sector for its cross-border exposures, but remained current on their sovereign debt, such as Venezuela between 1994 and 1996. Rating agencies have rightfully pointed out that the case of higher than sovereign ratings for the private sector is more convincing for local currency ratings than for foreign currency ratings. The

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reasoning is that a sovereign that no longer allows a domestic corporation to obtain the foreign exchange it needs to service its cross-border debt will certainly not restrict its access to domestic funds. In some rescheduling exercises the government took over the cross-border debt of its private sector, but asked the private sector to continue to service its foreign currency debt by depositing the corresponding domestic currency with the government or the central bank. In which cases can a higher rating then be justified? As was pointed out earlier, governments in economic difficulties on their foreign currency exposure often impose foreign exchange controls. The private sector then has to follow these controls. However, under certain circumstances it can be possible for the private sector to gain access to foreign currency and service its debt nevertheless. This depends on the one hand on how the government of the country concerned will handle the foreign exchange controls and on the other hand on the specific situation of the company in question. While it will be difficult to make a prognosis of how a specific country will behave in a foreign currency crisis it might be easier to analyse how well a private sector company might handle an imposed regime of foreign currency controls. As a better rating gives access to lower funding costs, private sector companies have an interest in showing to the rating agencies their ability to service foreign currency debt, when their home country is in a difficult situation. A company with strong external resources is a candidate to make a successful case. These external resources can lie in an interesting geographical set-up regarding home and external production or in a strong export basis and a natural hedge between foreign currency exposure and foreign currency income. Another situation where a higher than national rating can be considered is when there is a parent/ subsidiary relationship or a relationship with a strong strategic partner. In this case the history of that relationship may give a clue. A further case is that of a government-owned or controlled company such as Petroleos de Venezuela SA which is considered to be so important for the country that it is above its foreign exchange control measures. Furthermore, this company has lived through over 20 foreign exchange regimes without ever defaulting on its foreign currency obligations. Another special case is Argentina, with its currency board regime. This regime is considered by some observers to be so strong that a differentiation between foreign currency and domestic currency has become questionable for the private sector but still applies for the government. To give a higher rating to a private sector company or even a government-owned company is a difficult decision for rating agencies. They do not therefore take such a decision easily. Investing in securities is often limited by the rating barrier of `investment grade'. This holds true for many institutional investors. Emerging market issuers rarely succeed in overcoming this barrier.

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However, it is clear that a non-investment grade corporate issuer from an industrialized country may have the same grade as an issuer from a developing country but they are not of the same investment quality. This is especially true for a strong corporate issuer in a developing country who gets its relatively low rating only because of country risk consideration. We have seen that country risk does not have the same risk intensity as credit risk. Furthermore, it is to a certain extent mitigated by the financial assistance potentially available from the Bretton Woods Institutions, which is here for the long term. The different rating agencies work with similar symbols for their long term debt ratings. They all distinguish between securities which have an investment grade rating and those that are below investment grade. Most of the securities from the developing world are at the lower end of the investment grade or below investment grade. The symbols used by the rating agencies compare as shown in Table 4.2. Besides the rating the agencies confer on the sovereign they often also express a judgement on the near future of the country in question through their qualified outlook or rating alert. In recent times and especially in connection with the Asian crisis the rating agencies have come under some criticism. One aspect that led to it was that they maintained their ratings for too long and did not adjust them fast enough. While this criticism has some justification, it can be seen from experience that the markets usually adjust the value of securities due to changes in the country risk intensity well in advance of rating changes. Is this because markets are more information sensitive and quicker to act than the rating agencies? This is partially true. The rating of sovereign debt means the judgement of a country's risk intensity and therefore has a heavy political weight. This factor has to be considered. More important, however, is the fact that the sovereign rating concerns the quality of a country's long term obligations and is not a judgement regarding the short term perspective. The perceived short expectations and the concurrent emotions often determine the market price much more than the underlying long term value of securities. Regarding the short term ratings for sovereign debt, rating agencies use a reduced rating scale. They classify most short term debt from non-investment grade countries as speculative or not prime, which should give the necessary warning to investors. Another criticism levelled at the credit rating agencies was that by charging for their services they jeopardize their independence.18 However, as the rating business is competitive and the reputation of the firms is at stake, it is unlikely that the rating agencies are influenced by their clients. The Federal Reserve Bank of New York looked into this question at various times in the mid-1990s and came to the same conclusions. A similar criticism is voiced regarding the accountability of the rating

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Table 4.2 Ratings for sovereign foreign currency long term debt Interpretation

Moody's

Standard & Poor's

FitchIBCA

INVESTMENT GRADE RATINGS Highest quality (best quality, extremely strong, highest credit quality) Aaa AAA AAA High quality (high quality, very strong, very high credit quality) Aa1 AA+ AA+ Aa2 AA AA Aa3 AAAAStrong payment capacity (many favourable investment attributes, strong payment capacity, low expectation of credit risk) A1 A+ A+ A2 A A A3 AAAdequate payment capacity (medium grade obligations, adequate payment capacity, lowest investment grade) Baa1 BBB+ BBB+ Baa2 BBB BBB Baa3 BBBBBBSPECULATIVE GRADE RATINGS Likely to fulfil obligations (future not well assured, less vulnerable than lower grades, speculative) Ba1 BB+ BB+ Ba2 BB BB Ba3 BBBBHigh risk obligations (no desirable investment, more vulnerable than BB, highly speculative) B1 B+ B+ B2 B B B3 BBPoor standing (poor standing, currently vulnerable, high default risk) Caa1 CCC+ CCC+ Caa2 CCC CCC Caa3 CCCCCCHighly vulnerable (speculative in a high degree, default probable) Ca CC CC Extremely poor prospects (default imminent) C C Default (selective default) SD,D DDD,DD,D Note: No country is rated in the ratings in italic. agencies. It is true that they are not accountable for the effects of the rating. However, with each rating they issue they put their professionalism to the judgement of the international financial market and have every interest in performing correctly. Therefore it seems, as was said at the beginning of this section, that the rating agencies perform a very valuable service for the international financial markets and help the many investors to obtain a

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better picture of the risks and especially the country risk associated with cross-border exposure through investments.

CONCLUSIONS This chapter has shown how cross-border exposures should be monitored and what kinds of possibilities exist to hedge them. In order to monitor the exposure correctly it is important to establish a country limit for each country in which an exposure is considered. This limit should be based on a review of the business potential, an assessment of the country risk and an evaluation of the risk absorption potential of the provider of the cross-border funds. As the establishment of a country limit is always an important decision, the decision should be taken at the highest level in the corporation and be in line with the policies established for cross-border exposures. The country limits should cover all the different products that will produce cross-border exposures. The product exposure will be measured in nominal terms or through the value at risk method depending on the structure of the product. Both values will have to be added to form the total limit for exposure. Direct and indirect country risks will have to be taken into consideration on a consolidated basis. For the country limit a maturity profile has to be established as the risk intensity for the longer end is higher than for the short end of the exposure. The exposures have to be monitored on a regular basis, if possible in real time, so that action can immediately be taken when a change in country risk intensity warrants it. For the assessment of the risk the methods outlined in the previous chapter should be applied. The important thing is to have a consistent method of assessment. The sophistication of the assessment method will depend on the size of the exposures, but it is suggested that a method is used that can show the fever curve of the country risk intensity consistently. Changes in country risk intensity have to be watched carefully and the necessary adjustments in the exposures have to be made without delay. It is important that cross-border providers of funds develop in house country risk assessment competencies. Nevertheless, several ways of outsourcing the assessment of country risk were shown. These services help to test an organization's own method but cannot replace it. The institutional investor will rely very much on the ratings of the three rating agencies to compose his or her portfolio of securities and to structure the asset allocation. The hedging of country risk is not a common activity. There are no hedging techniques available in

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today's financial markets to hedge country risk consistently. However, several institutions, mostly promoted by governments as well as by the World Bank Group, offer political risk insurance or transfer risk insurance for cross-border exposures. Industrial investors, as well as financial institutions, rely on such insurance to protect their investment in production or services against political risk. Such insurance is always granted on a long term basis. The monitoring and hedging of country risk are an integral part of the managing of cross-border exposures.

REFERENCES 1

Common Practices for Country Risk Management in U.S. Banks, Interagency Country Exposure Review Committee, Country Risk Management Sub-Group, November 1998, p. 4.

2

Ibid.

3

Ibid., p. 2.

4

Ibid.

5

Ibid., p. 2.

6

David F Swensen, Pioneering Portfolio Management, Free Press, New York, 2000, p. 102.

7

MIGA, Annual Report 1999, pp. 4±5 , Washington, 1999.

8

United States Code Title 22, paragraph 2191, OPIC's authorizing legislation.

9

Overseas Private Investment Corporation, Program Handbook, Washington, March 2000, section: Political Risk Insurance.

10 World Bank, Annual Report FY2000, p. 31. 11 Sebastian Edwards, Contagion, revised edition of 1999 World Economy Lecture, University of California and the National Bureau of Economic Research, p. 5. 12 For more detail see Edwards, ibid. 13 Llewellyn D Howell, The Handbook of Country and Political Risk Analysis (second edition), PRS Group, East Syracuse, New York, 1998. 14 See 13, pp. 103 to 105. 15 Richard Cantor and Frank Packer, `Determinants and impact of sovereign credit ratings', FRBNY Economic Policy Review, October 1996, p. 39. 16 Ibid., p. 43. 17 FitchIBCA, `Corporate finance, corporates', special report, June 1998, p. 1. 18 Financial Times, `Rating agencies: different kind of risk', 8 May 1998.

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5 Responsibilities INTRODUCTION For some time, it has been a concern of politicians in many countries as well as of the international financial community to stabilize the international financial system. Through stabilization it is hoped that crises in the international financial system such as the Latin American debt crisis in the 1980s, followed by the Mexican crisis, the Asian crisis, and the Russian and Brazilian crises, could be avoided or at least substantially defused. This might be achieved through changes in the current system or by more efficient coordination among the participants. These crises are not only a threat to the international financial system but impose enormous costs and hardship on the countries involved. They often destroy within a relatively short period of time economic progress that was achieved over several decades. Financial crises have not to be seen only in economic terms as they often have much bigger social and political consequences. They can lead to a questioning of the democratic system and its institutions as well as of the marketplace. Several institutions and policy groups have issued papers and statements proposing improvements to the international financial architecture. 1 If avoidance of crisis is not possible, at least better management of the system in crisis should be. As a consequence, a clear consensus has emerged for the need to strengthen the system in order to reduce the risks posed by institutional weaknesses and the volatility of the international capital markets.2 The activities of the Bretton Woods Institutions (BWI) in particular have come under scrutiny in this connection. In addition, the development aid programmes of the industrialized nations have been questioned in many countries regarding their effectiveness, efficiency and meaning. And last but not least the world at large has started to realize that the last fifty years of fund transfers from the developed to the developing world have, with a few notable exceptions, not led to a substantially better life for the poorer part of our planet. It is not the purpose of this book to find a solution to the basic problem of a better distribution of wealth among the people of this world. The concern here is with the risks in cross-border exposures and the question to be investigated is how an improved international financial system could help to reduce country risk. This is especially important as much larger cross-border funds are needed to satisfy the capital needs of the developing world.

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In this analysis it becomes clear that the various participants of the international financial community in the international financial system all bear part of the responsibility to improve the system. This book has so far tried to show how the providers of cross-border funds can monitor their cross-border exposures better through an adequate country risk evaluation scheme and system. Good monitoring should enable the providers of such cross-border funds to participate in a sensible way in the international financial system. This chapter now looks into the responsibilities of some of the other participants in the system. These are the multilateral financial institutions, mainly the International Monetary Fund and the World Bank Group, the industrialized countries, the developing countries, the regulators and the rating agencies. All can and do help to reduce and to better understand country risk. These institutions and entities can and indeed already do contribute to the stabilization of the international financial system and to the facilitation of the flow of cross-border funds. However, it is necessary to review these participants in more detail and show where improvements could and should be made.

THE INTERNATIONAL MONETARY FUND (IMF) The International Monetary Fund IMF (www.imf.org) is by far the most important and powerful participant in and regulator of the international financial system.3 It was created in 1944 by the international conference of Bretton Woods, New Hampshire, USA. At the same conference the International Bank for Reconstruction and Development (IBRD) or, in short, the World Bank was also created. This will be discussed below. The statutory purpose of the IMF is: . To promote international monetary cooperation by establishing a permanent institution which creates a system of consultation and collaboration for all monetary problems. . To facilitate the expansion and balanced growth of international trade. . To promote exchange stability. . To establish a multilateral system for the settlement of transactions between member states and to eliminate exchange restrictions. . To make its general resources temporarily available to help member states cope with balance of payments problems under adequate safeguards. . To shorten the duration and lessen the degree of imbalance in the international balances of payments of the member states.4 The IMF keeps its accounts in special drawing rights, the so-called SDRs. The SDRs' valuation is determined by using a basket of currencies. The currencies have the following weights: US dollar

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39%, Deutschmark 21%, Japanese yen 18%, French franc 11% and pound sterling also 11%. Since the introduction of the Euro the weights of the Deutschmark and the French franc have been expressed in Euros. The IMF has over the years become an institution that has taken on the role of a `global central bank'.5 It is active in three areas, namely surveillance of member countries, giving financial assistance and giving technical assistance. Because of the various international financial crises over the last twenty years which were discussed in Chapter 1, the IMF's financial assistance to member states with balance of payments difficulties has probably been its major task and has certainly been the most publicized one. While this task was meant originally to be a case by case activity of a temporary nature to assist member states, the huge structural payment imbalances that have emerged in the international financial crises have obliged the IMF to seek new ways of coping with balance of payments problems. Financial problems and unrest in the developing world in particular have led the IMF to create new programmes of financial assistance with much wider scope than originally foreseen. This has led in turn to the question of adequate resources for the IMF, which became a very important item on the agenda of the executive directors, as the extent of possible financial assistance is naturally in direct relation to the resources of the IMF. Each member of the IMF subscribes a sum of money which is called its `quota'. The IMF relies for its resources primarily on these quotas, which constitute its capital. The quota system also forms the basis for the implementation of many of the IMF's policies. The quota system must thus perform four functions. It determines: . The member states' subscription to the Fund. . Within approximate limits, the voting rights of the members of the Fund. . The borrowing rights from the Fund. . The share of special drawing rights (SDRs) allocations. The quantity and quality of the financial assistance the Fund extends to its members is obviously related to its financial resources.

Resources of the IMF The IMF relies on two major sources of funds: the so-called ordinary resources, which are subscribed to by the Fund members, and the borrowed resources.

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Ordinary resources The ordinary resources are based on the quota system through which the IMF receives the funds it needs. Each member state joining the IMF is assigned a quota according to its economic standing relative to other members. The member state then has to fund its quota. They are expressed in special drawing rights (SDRs). The IMF's Board of Governors reviews the quotas of the member countries at least every five years and, if appropriate, adjusts them in order to take into account changes in the economic situation of the member countries in the various parts of the world as well as the overall financial needs of the Fund. In addition, each member can at any time request an adjustment in its quota. There have so far been 11 reviews of these quotas, the last one being in September 1997 with the resolution adopted in January 1998. Nearly all reviews have brought about an increase in the Fund's own resources by an increase of the monetary equivalent of the quota. The last review was an overall quota increase of 45% which became effective in January 1999. With this latest substantial increase in the quotas the resources of the Fund were brought to approximately SDR210 billion which corresponds to about US$283 billion. This increase was necessary to enable the IMF to play its role more efficiently in line with the size of the world economy. Furthermore, the globalization and liberalization of trade and capital accounts did not only enlarge the world economy but increased substantially the size of potential payment imbalances at member states level. This was clearly demonstrated during the Asian and Russian crises of the late 1990s. The eleventh quota increase has substantially improved the liquidity of the IMF thus reducing its need to revert to borrowed resources. Member countries must pay their quotas within a deadline fixed at each review of the quota. As a rule, 25% of the quota subscription has to be paid in reserve assets as specified by the IMF. These are mostly SDRs or widely usable currencies. The other 75% of the quota subscription is paid in the country's own currency. The IMF has assisted member states that have difficulty in raising the 25% in reserve assets by arranging for them the borrowing of SDRs from an economically stronger member.6 Despite the substantial theoretical resources the IMF has faced a liquidity problem at times as many of the currencies paid in are not freely convertible and cannot be used to help a specific member country with its balance of payments problems. For these reasons the Articles of Agreement stipulate in Section VII that the IMF can revert to borrowed funds.

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Borrowed resources The IMF has in the past ± and will probably also in the future ± resort to borrowed funds. This was done to satisfy increased demand for assistance at times when its own resources were not sufficient. It can be considered a kind of bridge financing for a liquidity gap until an increase in the quotas is approved and paid in. This allows the IMF to continue to keep its manoeuvrability in times of turmoil in the international financial scene. The IMF's borrowing has so far been only from official sources; no borrowing has taken place in international capital markets. The first such borrowing set-up was undertaken under the General Arrangements to Borrow (GAB) which was established in 1962. It has been revised several times and renewed every four to five years, the last time in November 1997. Under this agreement 11 participants (Belgium, Canada, France, the German Bundesbank, Italy, Japan, the Netherlands, the Swedish Riksbank, the Swiss National Bank, the United Kingdom and the United States) make available to the IMF a total of SDR17 billion to forestall or cope with an impairment of the international monetary system or to deal with an exceptional situation that poses a threat to the stability of that system. An additional SDR1.5 billion is made available under an associate agreement with Saudi Arabia (see Table 5.1). The IMF remunerates the GAB participants with 100% of the current SDR interest rate, which is calculated by using the market rate for prime financial instruments in the five major industrial Table 5.1 General Arrangements to Borrow (GAB) Participant Belgium Canada France German Bundesbank Italy Japan Netherlands Swedish Riksbank Swiss National Bank United Kingdom United States Total Associate agreement with Saudi Arabia Total Source: IMF, Annual Report 2000, p. 6.

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Amounts in millions of SDRs 595.0 892.5 1 700.0 2 380.0 1 105.0 2 125.0 850.0 382.5 1 020.0 1 700.0 4 250.0 17 000.0 1 500.0 18 500.0

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countries whose currencies are represented in the SDR basket. All GAB participants have to agree on a call before it can be made. The GAB has so far been activated ten times, the last time in July 1998 for SDR6.3 billion to help Russia to overcome its financial difficulties. The IMF repaid the GAB participants in March 1999 after the eleventh quota increase provided it with additional funds. Probably the most famous use of funds from the GAB was the lending to the United Kingdom and Italy in 1977 under standby credits. After the Mexican crisis of 1994 it was felt that there could be instances where the usable funds of the IMF including the GAB credit lines would not be sufficient to manage a potential crisis in the international financial system. The G7 summit in June 1995 in Halifax made a call to the G10 and other financially strong countries to put together an arrangement that would double the funds available under the GAB. Thus the New Agreement to Borrow (NAB) was set up between the IMF and 25 member countries and institutions which together with the GAB extend to the IMF a total credit line of SDR34 billion. The NAB (see Table 5.2) will run for five years until November 2003 and can be renewed. The NAB has been activated once, in December 1998, to help Brazil restore its reserve assets as the loss of market confidence had led to a substantial outflow of US dollars. A total of SDR9.1 billion was called for funding but actually only SDR2.9 billion was drawn down. The borrowing under the NAB was repaid when the eleventh quota increase came into effect. Because the two borrowing arrangements were in place the Russian and Brazilian crises could be handled swiftly and thus a deeper crisis of the international financial system was averted. During its history, the IMF has resorted to various other borrowings when it felt the need to cope with specific situations. It is in this context that the IMF arranged in 1974 and 1975 two so-called oil facility borrowings amounting to SDR6.9 billion. Through these facilities the IMF obtained funds for the countries that were most affected by the oil price increases. In order to enlarge its general ability to assist countries with balance of payments problems the IMF concluded borrowing arrangements in 1979 to finance the so-called Supplementary Financing Facility (SFF) for an amount of SDR7.8 billion and in 1981 for the Policy of Enlarged Access to Fund Resources (EAR) for SDR9.3 billion. The relatively recent examples of the Brazilian and Russian crises have shown that huge amounts of funds are sometimes needed at short notice to manage a crisis in a big country. The IMF has since the eleventh general review had much more of its own resources at its disposition. Nevertheless, it is certainly prudent to have borrowing structures in place that can be activated at short notice through

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Table 5.2 New Agreement to Borrow (NAB) Participant Australia Austria Belgium Canada Denmark Finland France German Bundesbank Hong Kong monetary authority Italy Japan Korea Kuwait Luxembourg Malaysia Netherlands Norway Saudi Arabia Singapore Spain Swedish Riksbank Swiss National Bank Thailand United Kingdom United States Total

Amounts in millions of SDRs 810.0 412.0 967.0 1 396.0 371.0 340.0 2 577.0 3 557.0 340.0 1 772.0 3 557.0 340.0 345.0 340.0 340.0 1 316.0 383.0 1 780.0 340.0 672.0 859.0 1 557.0 340.0 2 577.0 6 712.0 34 000.0

Source: IMF Annual Report 2000, p. 65. a relatively simple decision process. As globalization and liberalization have brought along much bigger numbers in everything connected with the economies of the world's nations the need for funds to manage today's financial environment in a crisis situation has also ballooned. The Fund's resources will probably, however, always be limited.

Other resources In addition to the funds from the quotas and those obtainable through the GAB and NAB the IMF has resources available from the sale of its gold. They are supplemented by contributions from Fund members in the form of loans or grants. These resources have been put into a trust for which the IMF functions as trustee. They are specifically used to help the poorest nations and are lent at concessional rates.

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How the IMF uses its resources will be the next topic.

Activities of the Fund The IMF's activities today consist as we have seen of financial assistance, surveillance and technical assistance. Of these three activities the financial assistance programmes get the widest publicity. It is certainly in this area that the IMF has a huge responsibility not only for its members but also for the international financial system. It is to be hoped that it will not continue to be the most important activity of the IMF in the future. Nevertheless, the financial assistance programmes are discussed first below.

The IMF financial assistance programmes The IMF extends its financial assistance under different facilities to member countries that have got into difficult economic situations and have balance of payments problems. These facilities are nearly all based on the member's quota or a multiple thereof. The members obtain through these facilities the necessary funds to cope with their problems. They purchase with their own currency reserve assets such as SDRs or widely used foreign currencies from the IMF's own financial resources. The financial assistance is repaid at maturity by the member country by repurchasing its own currency with international reserve assets. This purchase±repurchase mechanism means that the size of the IMF's balance sheet is not influenced, only the composition and quality of its assets. The various facilities structured and extended to its members and their size are in relation to the severity of the member country's problems. The only exception to this mechanism is the Poverty Reduction and Growth Facility (PRGF), formerly known as the Enhanced Structural Adjustment Facility (ESAF), which is separately funded through the trust account.

Regular facilities Regular facilities are available under either a Standby Agreement (SBA) or an Extended Fund Facility (EFF). While the SBA is used to cover temporary or cyclical deficits in the balance of payments of a country, the EFF supports medium term programmes to adjust to macroeconomic and structural problems. They are only available if an understanding (letter of intent) between the IMF and the country in difficulties is reached regarding the economic policies and financial

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adjustment programmes the country intends to realize. The Fund then formalizes its commitment to make specific resources available over a defined period of time on the basis of a certain performance and the completion of periodic programme reviews. The resources are usually made available in tranches of 25% of the quota. The first tranche is released upon the demonstration that the country in question makes a reasonable effort to overcome its economic difficulties. The following tranches are then phased as the performance criteria agreed upon are met. The SBA typically runs over a 12to 18-month period whereas the EFF supports an adjustment programme of generally three years' duration. The amount available under these regular facilities is a maximum of 300% of the quota of which a maximum of 100% of the quota is paid out annually. Under exceptional circumstances these percentages of the quota can, nevertheless, be exceeded. The country taking up these facilities has to repurchase its currency under the SBA within three and a half to five years after the purchase of the reserve currencies and within four and a half to ten years for the EFF.

Special facilities As experience has shown over time, the regular facilities have not always been sufficient or appropriate to help countries with balance of payments problems, in a speedy and efficient way. Some of these problems are of a cyclical nature and, therefore, self-reversing. In such cases a focused facility is more appropriate than the regular facilities. The need for such a facility was recognized early and by 1963 the Fund created the Compensatory Financing Facility (CFF). This is particularly used by primary commodity exporting developing countries which have problems with their exports due to a sudden price or volume change. This facility is also available for balance of payments problems due to fluctuations in the cost of cereal imports. Such funds have recently been used by Azerbaijan, Jordan, Pakistan and Russia. Its terms are the same as for the SBA. In 1969, the IMF created the Buffer Stock Financing Facility (BSFF) to assist members in financing their contribution to IMF-approved international buffer stocks of primary products. The BSFF is structured in the same way as the CFF. For both facilities the access is limited to a percentage of the quota. The BSFF has not been used since 1984. Along similar lines the IMF created in 1974±75 so-called oil facilities for countries in difficulties because of the oil price hike of the 1970s. The last drawdown was made in 1976 and the facility is no longer available.

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In other instances the shortage of foreign exchange was due to a sudden fall in market confidence so large that the regular facilities were no longer big enough. This problem has become ever more acute in recent times due to the much higher and more volatile short term portfolio investments in the developing world. The famous contagion effect (see Chapter 4) should be mentioned in this connection as it can often aggravate the problems. Countries can in such a situation draw on the Supplemental Reserve Facility (SRF) for which no quota exists, but where a range of 300 to 500% of quota is expected. The SRF is structured like the regular facilities with repurchases to be made within one to one and a half years. A surcharge of 300 to 500% is levied to encourage early repayment. Korea in 1997 and Russia and Brazil in 1998 made use of the SRF. Korea has begun to make repurchases according to the one to one and a half year running of the facility. In order to prevent further disruption in the international financial markets and the spreading of a crisis, the IMF created in 1999 the Contingent Credit Lines (CCL). The IMF allows countries that are financially sound and well managed to subscribe to this facility in order to help prevent problems when a sudden loss in market confidence leads to a substantial outflow of reserve assets. The facility is provided for one year and is structured similarly to the SRF. Table 5.3 shows the access of member countries to the different facilities in relation to their quotas. Table 5.3 Access limits, April 1999 (% of member's quota) Facility or policy Standby and extended arrangements1 Annual Cumulative Special facilities Supplemental reserve facility/contingent credit lines Compensatory and contingency financing facility Export earnings shortfall2 Excess cereal import costs2 Contingency financing Optional tranche Buffer stock financing facility Enhanced structural adjustment facility Three-year access Regular Exceptional

Limit 100 300 none 20 10 20 15 25 140 185

(1) Under exceptional circumstances these limits may be exceeded. (2) When a member has a satisfactory balance of payments position except for the effects of an export earnings shortfall or an excess in cereal imports, a limit of 45% of quota applies to either the export earnings shortfall or the excess cereal import cost, with a joint limit of 55%. Source: IMF, Annual Report 1999, p. 99.

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Concessional assistance For many years the IMF has helped low income countries to overcome their external account problems through concessional financing. In 1987 it created for this purpose the Enhanced Structural Adjustment Facility (ESAF). This facility was enlarged and extended in 1994 and further strengthened in 1999 to include specifically the promotion of poverty reduction. It has now been renamed Poverty Reduction and Growth Facility (PRGF). Currently 80 low income countries are eligible for this facility. The facility aims to help strengthen and improve in a sustainable way the balance of payments of these low income countries so that they can achieve continuous economic growth, improve the living standards of their population and thus reduce poverty. This facility is not funded through the General Account of the IMF, but through the trust account and carries an interest rate of 0.5%. The facility is disbursed over a three-year period, has a five and a half years grace period and a ten-year maturity. The facility asks for observance of performance criteria and completion of programme reviews. The latest development to help the poorest nations comes with the HIPC (heavily indebted poor countries) initiative, which was covered in Chapter 1. Only countries that have access to the PRGF facility are included in the HIPC initiative which is a common undertaking of the Paris Club, the multilateral institutions as well as official and bilateral creditors. The IMF has created a special trust fund for this initiative of debt relief. It is estimated that currently 36 IMF member countries might be included in this initiative.

Conditionality The origin of the use of the different facilities of the IMF is normally economic difficulties at the member country level. The reasons for these difficulties vary widely, but always have an impact on the balance of payments of the country in question. They further have a direct relation to the quality or better intensity of the country risk which is the topic of this book. In order to extend its help through the different facilities the IMF has to make sure that the member country undertakes the necessary steps to ameliorate and hopefully eliminate its external economic problems. The mechanism for putting the facilities in place starts with an understanding between the member country and the IMF about an adjustment programme to remedy the difficulties. The commitment by the member country in return for the financial help of the IMF is known as conditionality. This can be a general commitment of the member country or a letter of intent through which it commits itself to a specific behaviour. The latter is needed if the country requests substantial support from the IMF. Through negotiations with the IMF the letter of intent is formulated in such a way that the

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economic problems should be solved in the medium term. It states the policy intentions of the government that will allow it to accomplish the goals of the adjustment programme. It fixes the different criteria to be met before the facilities can be arranged and the performance criteria that have to be satisfied in order to be able to draw down the funds. The performance criteria are indicators that can be measured annually, quarterly or sometimes even monthly. The conditionality is designed to be flexible, taking into account each country's specific situation. The IMF remedies are, nevertheless, still very much oriented to a macroeconomic adjustment programme that should control demand. However, as it has been realized that growth is often essential to regain economic viability, measures to stimulate economic growth are now also designed into the agreements. In addition the social dimensions of the adjustment process are discussed with the member country in order to alleviate possible negative aspects. The IMF adjustment programmes have become a seal of approval by the international financial community for a change for the better in a country with economic difficulties. However, they are also often heavily criticized as being too harsh or not effective enough. This will be considered further with the IMF's responsibilities. The second activity of the IMF is the surveillance of its member countries.

The IMF surveillance One of the central tasks of the IMF under its Articles of Agreement is formulated as its obligations regarding exchange arrangements. The obligations are described in Article IV of the agreement (see Annex 2) and were, in the early stages of the IMF, mainly related to the exchange arrangements then in place. Article IV also stipulates that the international monetary system should provide the framework `that facilitates the exchange of goods, services, and capital among countries, and that sustains sound economic growth'.7 The huge growth over the last fifty years in the worldwide economic situation through liberalization and globalization, and also the many crises in the international financial system, have changed the originally relatively narrow interpretation of these obligations. The IMF realized the importance of this mandate and, based on Article IV, created the consultation mechanism as the pillar of its surveillance activity. The consultation and surveillance process has been developed substantially over the years and enlarged in the last few years. Due to the importance of the surveillance, Article IV has

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become the best known article of the agreement. It stands today for the extensive consultation process between the IMF and its members. In 1996 the Special Data Dissemination Standard (SDDS) was added to the consultation process. The consultation process between the IMF and the member countries allows and obliges the IMF to review with the governments of the member states their economic and financial policies. From these reviews result recommendations on how to correct macroeconomic imbalances, reduce inflation and change policies in such areas as trade and exchange rates. But the reviews are also the basis for institutionalizing other market reforms. Traditionally the process has focused on these matters, as they were considered the decisive factors for financial and economic stability. The fundamental shifts in the global economy to a much larger participation of the private capital markets, to economic and monetary regional integration but also the implementation of current account convertibility and extensive market reforms, have put additional pressure on the surveillance process to make it more transparent and regular. It was further realized that a much greater number of structural and institutional reforms ± the so-called second generation reforms ± were necessary to establish and maintain the confidence of the private sector in a country's economic development. This confidence is crucial to realizing a country's potential for economic growth. The areas of such reforms include strengthening the efficiency of the financial sector, improvements in data collection and dissemination, and better transparency of the government's budget as well as its financial and monetary policies. Furthermore the IMF also felt the need to promote the autonomy and operational independence of the central banks as well as legal reforms and good governance to improve the quality of the private sector.8 The IMF normally conducts its surveillance on an annual basis through bilateral meetings with the authorities and government officials of the member country. A concluding statement or memorandum summarizes the findings for the country reviewed. An extensive report is then prepared for discussion at the executive board level of the IMF. The managing director of the IMF will summarize the views expressed at that meeting and send them to the country as a record of the discussions. If the country in question agrees, the summing up will be released to the public with additional background information. This release is called a Public Information Notice (PIN). In its annual report the IMF publishes the board's review dates of the consultations and indicates for which countries a PIN was issued. Besides the bilateral surveillance the IMF also conducts multilateral surveillance where it discusses the implication of the different countries' policies on the global economic situation and publishes its

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results in the World Economic Review. A similar review is undertaken to review the international financial markets and is published in International Capital Market Development.9 There are three other types of surveillance arrangement the IMF maintains with member countries on a bilateral basis, namely the Precautionary Arrangements, the Informal Staff-Monitored Programmes and the Enhanced Surveillances. The Precautionary Arrangement is entered into when a member country maintains a Standby or Extended Arrangement, but does not intend to draw funds under the agreements. For the member country such an arrangement means an endorsement of its economic and financial policies by the IMF and will thus boost international confidence. The other two arrangements do not include an endorsement by the IMF of the member country's policies, but increase the intensity of the dialogue. Within the context of surveillance the IMF's initiative to improve the economic and financial statistical data of member countries is important. In 1996 the IMF established the Special Data Dissemination Standard (SDDS) which was strengthened in 1999. The SDDS sets a standard of good practice for the release to the public of financial and economic data. As of September 1999 47 countries had subscribed to the SDDS. These are mostly countries that have or seek access to the international financial markets and commit themselves to provide regular and comprehensive data on their performance. Through measures introduced in 1999 to further strengthen the SDDS countries were asked to provide more detailed information on their international reserve position with monthly dissemination of data, encouraging countries to provide even weekly figures. For the external debt a separate category has been introduced that includes quarterly disaggregation by sector and maturity. Within three years countries also have to provide data on their international investment position. Furthermore, IMF staff will monitor the quality and timeliness of the data provided by the countries in relation to their commitments. Hyperlinks are provided between the IMF's Dissemination Standards Bulletin Boards and the national summary data pages on the internet to facilitate monitoring of the data and help meet the needs of the consumer of the data.10 In December 1997 the IMF introduced the General Data Dissemination System for those countries that are not yet able to adhere to the Special Data Dissemination Standard.11 The surveillance activity of the IMF and the introduction of the SDDS has substantially increased the amount of information available on a country's performance. Furthermore, its better quality and timeliness, and also uniformity, allow for a more realistic evaluation of that performance.

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The IMF technical assistance The geopolitical changes resulting from the dismantling of the Soviet empire and the creation of many new nations suddenly created an increased need for technical assistance and training. The third activity of the IMF, technical assistance and training, thus became much more important. Currently the technical assistance and training activity represents about 19% of the administrative expenses of the IMF.12 The major purpose of this activity is to strengthen the human resources and institutional capacity at governmental level to manage the economy of the member country better and more effectively. It should reduce the need for financial assistance through better economic management and improve the dialogue between the IMF and the member country during the surveillance process. In the last few years technical assistance and training programmes have been widely operated in countries emerging from different types of crisis. In these cases comprehensive large scale multiyear programmes of technical assistance were conceived and often co-financed with other donors. For the holder of cross-border exposures it is important to know that the IMF extends such technical assistance and training to those member countries most in need to redress the management of their economies.

Responsibilities of the IMF The activities of the IMF imply a heavy responsibility on it for the smooth functioning of the international financial system. The IMF is the sovereign nations' credit union.13 Through its surveillance and technical assistance programmes the IMF is contributing to the prevention of economic and financial crisis in member countries. The IMF has the responsibility to push member countries to manage their economies better, to increase the quality and efficiency of their institutions and to improve their domestic financial sector. It emphasizes strongly the international implications of domestic economic policy, stresses the regional dimensions of domestic policies and integrates in its surveillance a technical assessment of the vulnerability and risks in the financial sector.14 The surveillance activity has become much more transparent over recent years and today allows participants with cross-border exposures to obtain better and more regular information on the countries where they have exposures. The PINs are available for many countries. It has, however, to be acknowledged that in its surveillance activity the IMF can only use persuasion to change member countries' behaviour. However, as the surveillance process has become much more transparent and public and is backed up by the SDDS, there is a lot of psychological and economic pressure on member state governments to explain their behaviour if they will not follow the IMF recommendation.

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The IMF has added through the Contingent Credit Line (CCL) facility an additional interesting tool to aid its responsibility to prevent crisis, a kind of standby line. Unfortunately, by mid-summer 2000 the CCL had not yet attracted a single applicant. The reasons might be twofold. One is that the line is fairly expensive with an up-front fee and relatively high interest rates. The other more important reason is that member countries are worried that an application for the CCL might be perceived as a sign of weakness. Furthermore the conditionality of the CCL can lead to a suspension of the line and therefore even precipitate a crisis. Only a simultaneous set-up of CCL to a large number of countries would counteract this suspicion. Furthermore, the transparency of the IMF's activities is a disadvantage in respect of the CCL. In the private sector standby lines are usually not known for just that reason. However, the CCL facility goes in the right direction as it rewards developing countries which do a good housekeeping job. Besides the responsibility to prevent a crisis in the international financial system for which the above mentioned instruments are helpful, the IMF is obviously responsible for managing any crisis that does arise. For this exercise it uses the various financial assistance facilities. The size of the assistance packages in the most recent crisis, however, went way above the regular 300% of quota. For South Korea it went up to 1900% of its quota. These huge rescue packages have given rise to much criticism and deepened the discussion on the future of the international financial architecture. It has to be noted here, that the IMF had until the recent quota increase not enough of its own usable resources available to manage a crisis on its own in a speedy and efficient way. It always had to coordinate its efforts with at least the US Treasury. Nevertheless, all major international financial crises since the early 1980s have been successfully managed under the leadership of the IMF. The international financial system was never paralysed and the world economy did not fall into a prolonged recession. Providers of cross-border funds lost substantial amounts in all these crises, but they never lost everything as can be the case in a bankruptcy in the private sector. This should be remembered if a provider of cross-border funds criticizes the crisis management of the IMF. Furthermore many governments and central banks were involved in the crisis discussions as well as the executive directors of the IMF and supported the actions of the IMF. Some criticism might be justified concerning the effects of the crisis management of the IMF on the countries in difficulties. In this respect though, the IMF is the only multilateral institution that could first mobilize the necessary liquidity to overcome the immediate effects of the crisis and afterwards exert the necessary discipline on the member countries to adjust their economies without unacceptable interference in their sovereignty. The IMF certainly does not have

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responsibility for bailing out private providers of cross-border funds in a crisis situation. Through this the IMF would only increase the `moral hazard' which is the implicit protection of private capital in a crisis. However, the IMF has often been instrumental in reducing potential losses in a crisis situation. As private capital flows to the developing world have become more and more important, the IMF also has a responsibility to help sustain and hopefully increase that flow of funds. A stable private sector presence in the developing world is a very productive way to prevent a crisis and therefore creating optimal conditions for it is an important responsibility.15 In this connection the liberalization of capital movements should be mentioned. It seems that the IMF now undertakes to identify the steps individual countries need to take to achieve free movements of capital and helps them to set up a possible timetable.16 A special responsibility of the IMF in connection with country risk questions is its task to help alleviate the debt situation in the heavily indebted poor countries. While the HIPC initiative is in the hands of several institutions and governments, the IMF has the leadership role. For providers of cross-border funds to these countries ± probably only through trade finance ± the HIPC initiative is a positive development in the evaluation of country risk intensity. To sum up the responsibilities of the IMF for country risk purposes it can be said that the IMF provides continuously improving information on member countries' status. It helps member countries to manage their economy better and solve their economic difficulties. Through its activities the IMF stabilizes and often reduces the country risk intensity of cross-border exposures and helps the flow of cross-border funds to the developing world. While the IMF cannot prevent a crisis in the international financial system, it has certainly helped to effectively manage crises that have occurred. Through its surveillance and technical assistance programmes, which have been significantly developed over recent years, it has improved the state of the international financial system by strengthening the members from the developing world. In its efforts to further improve the international financial system the IMF has recently started a new initiative to assess the activities of the so-called offshore financial centres. The purpose is to value the different centres and analyse their influence on the stability of the international financial system.17

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THE WORLD BANK GROUP

Introduction While the IMF is by far the most important watchdog in the international financial system and in many ways its lender of last resort, the twin institute that was also created at the Bretton Woods conference in 1944, the International Bank for Reconstruction and Development (IBRD), has its main responsibility in the development area. The IBRD has developed substantially over the years and is today called with its many affiliates the World Bank Group. It is widely present on the internet through its many websites, the basic one being www.worldbank.org, where a huge amount of information about the World Bank Group is available.18 The World Bank Group's activity should, however, not be in competition with the private sector. In connection with the theme of this book, risks in cross-border exposures, the responsibilities of the World Bank Group will be discussed in this respect. The World Bank Group operates through five closely associated institutions, namely the IBRD, the International Development Association (IDA), the International Finance Corporation (IFC), the Multilateral Investment Guarantee Agency (MIGA) and the International Centre for the Settlement of Investment Disputes (ICSID). The World Bank's main mission is to alleviate poverty and improve living standards in the developing world.19 The way it tries to achieve this goal has changed over the years. The various presidents of the World Bank have all tried with quite different policies to achieve this aim. This with hindsight often led to criticism, because the efficiency of the different programmes was not always evident. Environmental issues, which have only relatively recently become a major issue in economic development policies, have added to the criticism. The world at large has further to accept at the beginning of the twenty-first century that the long held expectations that it will be possible to halve poverty within the next twenty years remain doubtful. Poverty and inequality are on the rise, urban areas account for a rising share of the poor, life expectancy gains of the last few years are again at risk and education for the poor is worsening. Around 30% of the population of the developing world still live on less than US$1 per day.20 The reduction of poverty is a very important factor that contributes to the economic development of a country and this explains its attraction as a destination for private cross-border funds. These crossborder funds, as is clear by now, are essential to further the economic development of the country in

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question. The World Bank Group has the primary responsibility to fight poverty in the developing world and to coordinate its efforts with governments and non-governmental organizations to achieve this aim. Article 1 of the Articles of Agreement of the IBRD lists its purposes in detail. These purposes have been interpreted in different ways during the past fifty years and therefore the core activities of the World Bank Group have undergone changes. For the purposes of this book the current policies of the World Bank Group will be examined, together with their implications for the flow of cross-border funds and how they influence country risk quality as well as country risk perception. Under its current President, James D Wolfensohn, the World Bank Group has undertaken a drastic review of its development policies and tested them in respect of their effectiveness towards the International Development Goals for 2015 adopted internationally in 1996. The Asian and Russian crises acted as a kind of catalyst to the World Bank Group policies. These had to be stretched and the World Bank Group extended its activities to new boundaries in order to meet the emergency needs of the situation.21 The World Bank Group realized that there must be better ways to serve the needs of its clients, the developing member states. After a proposal by the President of the World Bank made in the autumn of 1998 the World Bank Group launched the Comprehensive Development Framework (CDF) in 1999. This process is based on a more integrated approach to development relying on a framework articulated and `owned' by the country itself.22 It suggests a `holistic approach to development that recognizes the importance of macroeconomic fundamentals but gives equal weight to the institutional, structural and social underpinnings of a robust market economy'.23 A further aim of the CDF is to foster partnerships among the participants in the development process by bringing governments, donors, civil society and the private sector as well as other development actors such as the NGOs to the table for discussion. It has been realized that a much larger group of partners is essential to successful development. However, the CDF keeps the country in question in the driving seat by letting it own and direct its development agenda. According to the 1999 annual report, the World Bank and its partners are currently discussing the implementation of a CDF with 12 pilot countries.24 The CDF is an interesting new way for the World Bank Group to look at its development task and its aim to fight poverty. It will, however, show results only in the years to come, when agreement has been reached with the participating countries and sufficient time has elapsed to judge the results.

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The International Bank for Reconstruction and Development (the World Bank) Within the World Bank Group the International Bank for Reconstruction and Development or World Bank is by far the most important institution. Its sources of funds are the paid-in capital and borrowings in the international capital markets as well as retained profits and repayments of its loans. It enjoys a triple A rating, the highest possible. For many years the World Bank was mainly a provider of project loans to the middle income and poorer creditworthy countries for development projects mostly in the infrastructure area. As infrastructure was until recently considered a service publique the borrowers of the World Bank were the governments of the member states, which gave the loans a high credit quality if country risk aspects were excluded. The loans are always long term, namely 12 to 20 years. Through this activity the World Bank provides the developing countries with the long term funds that are not obtainable from any other source and helps to develop the infrastructure they need. Working with governments always has a political aspect and thus the choice of projects to be funded was not always in line with the poverty reduction purpose of the World Bank's goals. Nevertheless, the involvement of the World Bank in lending to projects which were designed to promote the use of resources for productive purposes has had overall a very beneficial effect on the development of the middle and lower income countries and thus helped these countries to obtain funds from other sources. Today this lending is called `Investment Lending'. It is executed through different types of loan and programme. They are called `Adaptable Programme Loans' (APLs), `Emergency Recovery Loans', `Financial Intermediary Loans', `Learning and Innovation Loans', `Sector Investment and Maintenance Loans', `Specific Investment Loans' and `Technical Assistance Loans'. Depending on the year, by far the largest number of loans, between 80 and 90% of total investment lending, are extended under the `Specific Investment Loans' category which covers `the creation of new productive assets or economic, social and institutional infrastructure or their rehabilitation to full capacity'.25 When the World Bank realized that while the lending for specific projects did certainly help to develop specific pockets of the economy of a developing country, it had no adequate tools to help in a crisis situation it started what is now called `Adjustment Lending'. With this type of lending the World Bank extends its activities into an area which is in many ways the primary responsibility of the IMF. However, it accounted for more than half of the total commitments of the World Bank in fiscal year 1999 but was reduced substantially in FY2000.26 The World Bank extends under this heading `Structural Adjustment Loans' (SAL), `Sector Adjustment Loans', `Rehabilitation Loans', `Debt Reduction Loans' and `Special and Sector Structural Adjustment Loans' (SSAL). The SSALs were introduced in 1999 and are fast-disbursing loans. Nearly 100% of adjustment lending has been going into SAL, SSAL and Sector Adjustment Loans. In fiscal year 2000 the World Bank also introduced

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the so-called `Programmatic Structural Adjustment Loans' which support governmental programmes of structural and social reform. The purpose of the adjustment lending is to support economic and financial reforms to bring the country back on track. Furthermore, these loans should also help to mitigate the social cost of the crisis. Through its sector adjustment lending the World Bank has supported substantially the restructuring of the financial sector in many developing countries as the health of this sector is crucial for sustainable development. Recently the major part of the adjustment lending went, however, into so-called multi-sector lending or structural adjustment lending in order to reduce the social impact of a crisis. Many adjustment lending programmes were accompanied by technical assistance as money alone often does not solve the problems. The World Bank has a policy that not more than 25% of its total lending should go into adjustment lending excluding debt and debt reduction service. To achieve its goal of poverty reduction the World Bank Group has initiated the `Programmes of Targeted Intervention' (PTIs) and classifies them as `poverty-targeted intervention' or `povertyfocused adjustment operations'.27 In this area the International Development Association plays an important role. While the World Bank receives a lot of publicity for its activities, it is interesting to note that the core activity of the bank, extending loans for the different purposes described above, has not been very dynamic over the past five years. The figure of outstanding loans has remained more or less stable, namely US$123 billion in FY1995, US$117 billion in FY1999 and US$121 billion in FY2000.28 In order to live up to its responsibility, namely to contribute effectively to the economic development of the developing world and reduce the poverty level in this part of the world, the World Bank would need a larger number of acceptable lending opportunities and substantially larger resources than it has at its disposal today. It could then also make an important contribution to the reduction of country risk in the developing world thus enhancing the potential for an increased flow of much needed private capital. It can even be argued that given its current size, the World Bank is unable to function as a catalyst for the flow of private funds to the developing world. Even with total assets of US$231 billion at the end of FY1999 it is not among the 40 biggest banks in the world.

The International Development Association (IDA) The International Development Association (IDA) was created in 1960. Its members have to be members of the World Bank. For details see www.worldbank.org/ida. It is financially and legally

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independent of the World Bank, but shares the same staff as the World Bank and applies the same criteria as the World Bank for its support of projects. It was created to enable the World Bank Group to arrange concessional lending to fight poverty better. It is funded by contributions from the wealthier members of the World Bank, from transfers of World Bank profits as well as from repayments of earlier loans. The IDA extends interest free loans, so-called credits, with a service charge of 0.75% per annum. The credits are only extended to governments. The maturity of these credits is 30 to 40 years with a grace period of 10 years. The IDA has a key role in the fight against poverty. The eligibility criteria for the IDA's credits are relative poverty and lack of creditworthiness. The eligibility is measured in relation to the GNP per capita. Currently the cut-off point is US$925 per capita and year.29 However, there are some exceptions and in FY1999, 81 countries were eligible for IDA credits. In relation to the question of risks in cross-border exposures, countries that rely on IDA funding are countries that rarely obtain cross-border funds through private sector lending with the exception of some trade finance. However, they are in many cases recipients of foreign direct investments and sometimes also receive equity investment if the local stock market allows for it. The IDA's responsibility in connection with country risk is that it assists the poorest countries in the world, which number over 40% of all countries of the globe, to develop their economy so that they may one day become creditworthy for private sector cross-border loans. Its involvement in the efforts of the World Bank to alleviate poverty is ± if we may use this comparison ± similar to the incubators for the new economy, who provide start-ups with the necessary funds till they can go to the international financial market. This key responsibility of the IDA should not be underestimated.

The International Finance Corporation (IFC) The International Finance Corporation (IFC) was established in 1956. Its members have to be members of the World Bank. Its web page, www.ifc.org, covers its operations extensively. It is the private sector arm of the World Bank. The IFC is funded like the World Bank through capital provided by the members as well as through borrowings in the international financial markets. It also enjoys a triple A rating. The IFC's mission is to promote private sector investment in developing countries which will reduce poverty and improve people's lives. The IFC fulfils its mission in partnership with private investors

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by taking equity participation in private ventures and by providing loans to the private sector in the developing countries. In order to leverage its investment it often asks internationally operating banks to take part in the lending activity by co-financing its own loan through a so-called B-loan. The Bloans provide funds from commercial banks to the customers of the IFC and supplement the A-loans from the IFC which often have a longer maturity than the B-loans. In addition to committing its own resources, the IFC also provides services to companies in the developing countries as well as to the countries themselves. The IFC also mobilizes funds through capital market transactions, often bringing companies from the developing countries to the international capital markets for the first time. It thus helps to satisfy the need for capital from that part of the world by underwriting the issuance of securities. In addition the IFC supports asset management companies in the developing countries as well as private equity funds or companies that target the emerging markets with the aim of developing the capital markets in those countries. Another activity is the risk management service the IFC provides to emerging market clients. These products are offered solely for hedging purposes. The IFC hedges the risk taken, i.e. its own market risk in the international financial markets. Furthermore, it provides technical assistance and advisory services to business and governments. The technical assistance programme and advisory service include the financial sector and the capital market technical assistance, the advisory work in infrastructure as well as help for governments and local businesses in the privatization process. Furthermore, the IFC also advises governments of developing countries on how to reduce barriers to foreign direct investments and on how to benefit best from such investments. These are called Foreign Investment Advisory Services (FIAS). A major effort is made through the FIAS to mobilize investments in the infrastructure area. As these services are costly and cannot always be billed to the recipients the IFC has asked donor countries and institutions to help it. Therefore in this connection the `Technical Assistance Trust Funds Programme' should also be mentioned as the FIAS programme is funded not only by the World Bank Group, but also by donor countries.30 The IFC donor-supported technical assistance programme amounted to US$451 million in 1999 of which US$379 million was provided by non-BWI institutions and mostly OECD countries.31 In its efforts to develop the flow of funds from the industrialized world to the developing world the IFC has always had a particular interest in the development of the local stock exchanges. By providing consistent and reliable information on the local stock markets from the developing countries the IFC promotes capital flows through information flows. In the 1980s it started to create an emerging markets database (EMDB). By selecting a sample of stocks in every country the IFC creates an index of the respective stock market performance that serves as a benchmark. By using the

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same principles in the 51 stock markets the IFC covers today it achieves comparable benchmarks across the different emerging markets which are important for international investors. A detailed description of the IFC indexes can be found on the EMDB website: www.ifc.org/emdb.32 The IFC has over the years been expanding its scope of activities, but its disbursed and outstanding portfolio of US$10 billion by FY1999 is still relatively small. It shows in its relationship to the World Bank's loan portfolio that until recently the private sector played only a minor role in financial terms in the support of the development of the third world by the World Bank Group. However, the World Bank Group was not created originally to build-up the private sector in the developing world, but to help governments to develop their economies. Furthermore, as it should not compete with the efforts of the private sector, it is only natural that its exposure to the private sector is limited. The responsibility of the IFC in relation to cross-border exposures has many aspects and has been evolving over time. Through its investment activity coupled with loans the IFC shows to the private sector its assessment of country risk and encourages banks to participate in its loans through cofinancing. The co-financing mechanism with the IFC umbrella allowed banks to lend to customers in developing countries at a perceived reduced country risk. The customers benefited in addition from longer tenors than those normally provided by private banks. These exposures had a kind of positive catalytic meaning for cross-border exposures to the country in question. The IFC's responsibility is, therefore, to be very selective in its investment choices in order to live up to its image of a highly knowledgeable investor and supporter of the private sector in the developing countries. With its advisory and consultant work the IFC has assumed the responsibility of improving the quality of the private sector as well as its standing within a country's economy. Today's acknowledgement that it will be the private sector that will have to be the `unquestioned engine for the growth in the developing world' underlines the IFC's role and responsibility towards the private sector.33 Through its activity the IFC is improving and will further improve the risks in cross-border exposures taken by the private sector. With the EMDB, the IFC took the responsibility of providing international portfolio investors with consistent and accurate data on the stock markets in the emerging countries enabling them to understand these markets better and hopefully awakening greater interest in these markets.

The Multilateral Investment Guarantee Agency (MIGA) Chapter 4 described the hedging products the Multilateral Investment Guarantee Agency (MIGA) offers to cross-border investors. It is the youngest member of the World Bank Group and began

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operating in 1988. To become a member of MIGA one has also to be a member of the IBRD. MIGA is funded by its member states and currently has an authorized capital of US$2 billion. While the IBRD and IDA extend loans and credits to foster economic development and the IFC undertakes investments as well as loans for the same purpose, MIGA encourages the flow of foreign direct investments to the developing countries by providing guarantees against country risk. It is therefore also part of the World Bank Group's efforts to reduce poverty through economic development. It eliminates to a substantial extent the cross-border exposure on a foreign direct investment. By the end of FY1999 MIGA had entered into 420 guarantee contracts with a cumulative guarantee amount of US$5.5 billion. It is estimated that these contracts enabled an investment volume of US$30.4 billion.34 MIGA currently has one contract under litigation. Besides the guarantee programme MIGA also offers technical assistance and legal services to its developing country members. The purpose of these activities is to prepare developing countries to attract foreign direct investment and retain it successfully. In this connection the investment promotion agencies (IPA) in the different countries play a very important role and their training is therefore a priority for MIGA. It has developed in addition its own internet-based investment promotion network, the IPAnet, giving a wide amount of information and data on 160 countries for the interested global investor. MIGA's work is a further building block of the World Bank Group in its responsibility to reduce country risk intensity, this time for foreign direct investment. Member states that have signed the MIGA convention have to adopt an attitude towards foreign direct investors that is beneficial for foreign investment which should then lead to its increase and thus to further economic development.

The International Centre for Settlement of Investment Disputes (ICSID) As early as 1966 the World Bank Group established facilities for the settlement of investment disputes between member countries and nationals of other member countries. These disputes are settled either by conciliation or arbitration. The World Bank Group offers through ICSID the opportunity to include itself as an arbitrator in international investment contracts as well as bilateral and multilateral investment treaties.35 Since its inception ICSID has registered a total of 65 cases.

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Responsibilities of the World Bank Group The responsibilities of each of the institutions that form the World Bank Group towards the international financial system have been discussed above. We should now take a short look at the relation of the two sister institutions with respect to this. The World Bank Group and the IMF both have major responsibilities within the international financial system. However, they should go in different directions. The two institutions should not start to do similar things as is currently the case. There exists a certain overlap between some facilities of a longer tenor of the IMF and the adjustment lending of the World Bank. The World Bank Group's responsibility should be to focus on the fight against poverty and support all activities in the developing countries towards that aim. This means the support of long term structural reforms and not crisis management. Furthermore, the Comprehensive Development Framework is a good basis for such a cohesive activity. The World Bank Group should certainly not take on activities that the private sector can do as well. Through the fight against poverty the World Bank Group strengthens the economic development of the developing countries and thus adds to the vital strengthening of the weakest members of the international financial system. In relation to the topic of this book, the risk in cross-border exposure, the World Bank Group has helped to reduce country risk through the substantial loans and investments it has made in the developing world. Furthermore, the activities of the IFC and MIGA have helped develop foreign direct investments as well as portfolio investments in the developing countries. In view of the limited resources of the World Bank Group the activity of the Group will have to be more and more directed to the poorer countries of the developing world. The wealth of information produced by the World Bank Group on the developing countries is a very valuable resource for everyone contemplating cross-border exposures. Furthermore, it is relatively easily available. This information dissemination is certainly also a responsibility of the World Bank Group as it has been the most dedicated and therefore also one of the most knowledgeable partners of the developing countries.

THE REGIONAL MULTILATERAL FINANCIAL INSTITUTIONS The various regional multilateral financial institutions have in essence the same responsibilities as the World Bank Group, but focusing on a specific region. They duplicate to a certain extent the work of the World Bank, but have with their specific regional expertise and their smaller organizations the advantage of being closer to their customer and more flexible. The quality of the regional development banks is uneven. They contribute towards development in the region and help with their

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long term funds to support infrastructure developments. They have also started adjustment lending. This is a more problematic activity for the regional development banks as it is more difficult for them than for the World Bank to monitor and especially interfere in the adjustment process. Their presence helps to reduce the country risk intensity in the region.

THE INDUSTRIALIZED COUNTRIES The industrialized countries are the most important participants in the international financial system as they control all the major financial markets of the world. They also dominate the Bretton Woods Institutions and are instrumental in their policies. They therefore have the major responsibility for the structure and the functioning of the international financial architecture. They have especially to make sure that in a crisis situation the system functions correctly. It can be said that the different consultation mechanisms through the BWI, the central banks, and also government ministries and agencies that exist today between the countries representing the major economies function well. They also allowed the system to function relatively smoothly during the major emergencies of the late 1990s. Furthermore, the industrialized countries accept the leading role of the IMF in crisis management despite any criticism. The industrialized countries have reached an informal understanding to divide the world into three areas of influence, now known as the G3, representing the US dollar, the Euro and the yen. This means that the United States has the primary responsibility for the management of an economic crisis in the Americas, Japan in Asia and the European Union in the old continent. The actions of these three major players have unfortunately not always lived up to the expectations of the world at large. In this connection a criticism of their actions is that the impact of the global economy on a developing country is effectively driven by the swing among the G3 currencies and therefore often unrelated to the fundamentals of the underlying economy. A better coordination of the G3 currencies is therefore proposed, some even suggesting a system of target zones or reference ranges.36 In order to play their important roles the industrialized countries have to adhere to successful economic policies and not become a problem themselves. This is fortunately currently the case. They have furthermore to be in a position and willing to put substantial additional means at the disposal of a nation or a region in economic difficulties. Obviously there will always be some dispute among the industrialized countries about the best way to solve an emerging crisis. Besides the crisis management which will always get the biggest attention in the media and is certainly an important responsibility of the industrialized countries together with the IMF, the industrialized countries also have a responsibility to help avoid such situations. While a better

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financial architecture for the international financial system can alleviate the repercussions on country risk perception of a crisis, the system in itself does not improve the country risk quality of the developing countries. The real risk in cross-border exposures can only be mitigated if the country risk quality improves, which is usually the case when there is economic growth with political stability. This brings us to the often voiced criticism that the industrialized countries should be fairer partners for the developing countries so that they can achieve the economic development that lies within their potential. In this connection the biggest stumbling block is still the opening of markets of the industrialized countries to all products of the developing world, especially agricultural products. It is one of the important tasks ahead for the World Trade Organization to make the world trading regime more equitable for the developing world. This topic should be high up on the next international trade round. Besides a revision of their trade policies, there are other ways through which the industrialized countries can further economic growth in the poorer part of the world, the most obvious being through maintaining constant economic growth themselves. An example is the long-lasting growth of the United States since the early 1990s, which has certainly had a very beneficial effect on Mexico. The continuous support of the multilateral financial institutions is another responsibility of the industrialized countries as it helps to increase the catalytic mass of long term available funds which is important for the reassurance of cross-border providers of funds. The long term funds from the multilateral financial institutions available through loans, credits or even equity investments furthermore enlarge the development base in a very positive and quite an efficient way. Besides that support it is rewarding to see that nearly all industrialized countries support the third world in some way or another on a bilateral basis, or by being in specific donor clubs, or through the IDA and the HIPC initiative.

THE DEVELOPING COUNTRIES The term developing country is used here for all developing countries as well as the so-called transition countries. There are obviously big differences in development stage, in size and in international importance within this group of countries. However, they all have in common that they need cross-border funds for their development, do not have a top country rating and do not belong to a supportive economic and political association such as the European Union. Within the international financial system the responsibility of the developing countries is of crucial importance because it was their actions that precipitated nearly all the major crises in the system over the last

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thirty years. The most important exception in recent years was the troubles of the Long Term Capital Management hedge fund in 1998. However, this near-collapse was also related to difficulties in the emerging markets as unforeseen price variations in emerging market securities developed into huge losses. It is usually economic problems that lead to difficulties in the developing countries which at a certain moment create such a loss of confidence that a crisis has to break out. Contagion then often spreads the crisis from one country to the whole region. The developing countries' responsibility is therefore to avert a sudden loss of confidence in their financial situation which could bring about the unwarranted disruption in the cross-border flow of funds. The assessment of country risk was discussed in Chapter 3. We therefore know what kinds of indicator lead to an increased country risk or at least to the perception of increased country risk. Developing countries need therefore to be aware of the country risk evaluation process undertaken before committing to cross-border flows of funds and international exposures. As they mostly depend on and certainly need cross-border funds they have to take this into account when formulating and executing their economic policies. They can thus make a substantial contribution to the prevention of a crisis in the international financial system. Political parties in the developing countries have to be much more aware of this than they normally are. The pursuing of sound macroeconomic policies should always be high up on their agenda. Countries that are run by parties without such a commitment will soon face problems in attracting cross-border funds. Sound macroeconomic policies have many aspects. It is clear that they involve responsible fiscal behaviour and keeping a close watch on the government's budget. A professional management of the public and private debt belongs also in this category as it will lead to lower costs, longer tenors and better distribution of maturities on the stock of debt. Furthermore, governments will have to follow their external accounts closely. All this will help them to attain better and hopefully acceptable economic indicators or at least show to the providers of cross-border funds that the government is seriously trying to put and keep its house in good order. The recent crises have shown some particular aspects of the important responsibility of developing countries which will now be described in some detail. The origins of the Mexican, Russian and Brazilian crises have all been very much related to an overvalued exchange rate of their currency and to their currency regime of an adjustable peg system. This regime has its defenders as it helps to manage domestic inflation, but it is utterly unsuited to protecting a country against a financial crisis. An adjustable peg system has to be managed very carefully in order to find the right balance between inflationary pressures and international

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competitiveness. It has thus often led to an overvalued currency with a loss of competitiveness and a surge in imports. Such a situation brings with it a decline in international reserves. The consequence is then that the currency has to be defended, so that the outflow can be reversed. This can usually only be done by higher domestic interest rates which is in most cases the beginning of a vicious circle. Such higher interest rates have a negative effect on the domestic economy as well as on the highly indebted corporations. The economy therefore usually slows down with its repercussion on government finances and on the cost of the floating rate government debt. Furthermore, the nonperforming loans in the banking sector tend to grow, weakening an often already shaky banking system. At this point the speculators will take the floor and the battle between them and the defender of the currency regime starts. The most publicized of these battles was fought when the European Exchange Rate Mechanism, the EMS, broke down with the British, Italian and Spanish devaluations in 1992. This example shows it is not only developing nations that face these challenges. Mexico in 1994, Russia in 1998 and Brazil in 1999 are other examples where the central bank and the government could no longer hold back the currency outflow through the adjustable peg mechanism, but had eventually to let the currency float. There exists therefore a relationship between the exchange rate policy and a currency crisis. There are interesting comments on this subject in the research paper by Sebastian Edwards.37 The choice of an adequate exchange regime is an important responsibility of the developing countries in preventing a financial crisis. The vast majority of countries, covering a high percentage of world trade, have by now chosen the floating rate regime which offers the best mechanism for the prevention of a crisis. Only Hong Kong and Argentina have been able to maintain a currency board for more than five years, which means a fixed rate currency system. Both situations have a specific historical background. In addition, for the last three years Bulgaria has had a currency board through which it ties its currency to the Deutschmark. This has led to a positive stabilization of its economy. The G24, a group of 24 developing countries, has been concerned that the choice of the exchange regime could have an impact of the IMF's financial support at a time of crisis.38 For details of possible foreign exchange regimes see Annex 5. Another area with shortcomings in many developing countries is the situation in the financial services industry. There has therefore been a banking crisis in nearly every major developing and transition country since the Latin debt crisis broke out in the early 1980s. In every banking crisis the origin normally lies in lax lending standards as no professional credit culture exists. Sometimes the lending process is even overshadowed by blatant fraud. Banks have been run for the benefit of the shareholders and not the depositors. Such a situation could develop because most developing

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countries have had a weak system of banking regulation and supervision. Some countries have undertaken a liberalization of their banking system without providing at the same time the necessary regulatory framework. As no adequate regulatory frameworks were in place most governments chose the apparently easy way for the solution of their banking crisis. They bailed their banking system out by refinancing it, by providing guarantees, by purchasing bad loans or bringing the banks under government management. This has not only brought moral hazard as foreign bankers no longer had an incentive to check the creditworthiness of their banking debtors properly but the result of these bail-outs was a tremendous cost to the taxpayers of the countries involved. Low capital adequacy in many countries added to their plight. It is important to point to the responsibility of government to run an efficient banking system with internationally acceptable accounting and disclosure standards. The Bank for International Settlement, the BIS, published in September 1997 the Core Principles for Effective Banking Supervision which were established by the Basle Committee on Banking. In addition the Bretton Woods Institutions have actively been promoting and helping developing nations to improve their banking systems and bringing them up to international standards. It is, therefore, today a matter of implementing the adopted system as the principles are well known and readily available. Countries with an effective banking regulation and supervisory system are well advised to let banks default in order to improve the efficiency of their banking system. The principle `too big to fail' should only be applied in very rare circumstances. Furthermore, the question of deposit insurance is also worth studying as it will exonerate the government from bail-out actions as the smaller depositors will have valid insurance. The promulgation of international financial standards and corporate governance in company law and through the domestic accounting profession can have positive effects. It will make the menu of the local stock market more interesting for foreign investors. Brazil is undertaking an improvement of its corporate governance system to activate the local stock market. The reform will in particular improve the rights of minority shareholders.39 Such a development in a major developing country will certainly have positive repercussions on other countries. However, these standards have to be implemented and enforced to make them useful, e.g. through the local supervisors of the stock exchanges. Good accountancy practice and good corporate governance in the developing countries should also become a better entry to bank credit, as banks are still the largest providers of funds to domestic industry. To have these is certainly an advantage if a company looks for cross-border funds. A related problem is that of the bankruptcy procedure, which has in many countries prevented banks from seizing the assets of borrowers in default. Clear and workable bankruptcy procedures promote trust in an economy.

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A further aspect of the recent crises which could probably be better managed by the developing countries and would help in preventing further crises is the efficient management of short term crossborder funds. The volatility of short term cross-border funds made a substantial contribution each time to the recent crises in the international financial system. Borrowing longer term should not be made more difficult than borrowing short term. Korea made that mistake which led to a ballooning of short term inflows with the reverse effect when the crisis hit in 1997. Longer term cross-border borrowing should not be penalized but supported. Chile at one time introduced a mechanism to tax capital inflow that did not stay long enough in the country. The liberalization of capital flows has obviously made it more difficult to control them. More controls on capital movements are not supported here. However, developing countries should maintain an information system on their external accounts that allows them to see what happens at the short end of their cross-border exposure. And it would be even better if they would make that information publicly available, thus contributing to better transparency. While the G24 recognize this in their communique of April 2000, they also ask all other players in the international financial system to do the same.40 These additional aspects show that developing countries have many ways of enhancing the confidence put into them by the providers of cross-border funds. They should never forget that they are big competitors among themselves in attracting foreign funds.

THE REGULATORS Another group of participants in the international financial markets with specific responsibilities are the regulators. These are the regulators that regulate the financial services industry in the industrialized countries as developing country regulators were discussed in the previous section. They are in the first place the banking supervisory agencies. Their task in preventing a crisis in the financial system is to make their respective banking systems strong enough to withstand such a crisis. This was clearly not the case in 1982. They have to be comfortable with the cross-border exposures of the banks within their territory. The Basle Committee states in this respect in Principle 11 of the Core Principles for Effective Banking Supervision that the supervisors have to be `satisfied that banks have adequate policies and procedures for identifying, monitoring and controlling country risk and transfer risk in their international lending and investment activities, and for maintaining appropriate reserves against such risk.'41 Therefore they need to take a close look at the country risk policies of their constituency and the portfolio of their exposures. The Basle Committee on Banking Supervision has dealt extensively with this problem since the Latin American debt crisis. Its latest Working Paper

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reviewed the situation and dealt with the lessons to be drawn from the Asian crisis.42 All OECD countries today have supervision systems in place that live up to their task of preventing a crisis relatively well. They place the major responsibility for adequate management of country risk on the shoulders of the bank management. Besides looking at the country risk management of their banking communities the Basle Committee has also approached the question of capital adequacy in connection with cross-border exposures and published a consultative paper on this topic in June 1999.43 This paper was issued in the aftermath of the crises of 1997 and 1998 as the supervisors recognized that the banks of the G10 countries, while not directly affected by the crisis, had to deal with risks that have become more complex and challenging. This paper proposes a replacement of the 1988 accord.44 In respect of cross-border exposures some of the proposed changes in relation to the minimum regulatory capital requirements are of interest and if they are implemented will be important not only for the creditor banks but also for the debtors, which means the developing countries and their institutions. The 1988 accord made a distinction in risk weight between sovereign and bank borrowers from OECD countries and all other countries. The group of OECD countries included non-member countries that had special lending agreements with the IMF and had not rescheduled debt within the previous five years. The new proposal would calculate the risk weight for exposure to sovereigns according to the rating of the credit assessment institutions, the rating agencies.45 For claims on banks the current accord asked for a 20% risk weight if they were incorporated in the OECD or a tenor of the claim of less than one year for banks from all other countries. The proposed new accord suggests two options, one using the rating assigned to the sovereign of the country in which the bank has its headquarters, the other to use the rating that was directly assigned to the specific bank. A risk weighting of less than 100% would only be assigned to banks located in countries that follow or are implementing the 25 Core Principles for Effective Banking Supervision. Also for claims on corporates the proposed new accord stipulates some new rules which take into account the credit quality of the corporate borrowers. On cross-border exposures, however, it also puts the ceiling of the country rating on the corporate borrower. Using Standard & Poor's credit rating the new schedule looks as shown in Table 5.4. The new proposal also introduces a weighting of more than 100% for high risks. In general it can be said that the proposed new minimum capital adequacy standards will probably increase the cost for cross-border exposures. Furthermore, if the new rules are accepted, the rating agencies' responsibility will become even more important. The Institute of International Finance has prepared an interesting response to this proposal which can be seen as the position of the international banking community.46 It is argued that leading internationally operating banks all have very robust internal

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Table 5.4 Risk weighting in relation to origin of claim and assessment from rating (%) Claim

Sovereign Banks Corporates

Option 11 Option 22

Assessment AAA to AA-

A+ to A-

BBB+ to BBB-

BB+ to B-

Below B-

Unrated

0 20 20 20

20 50 503 100

50 100 503 100

100 100 1003 100

150 150 150 150

100 100 503 100

(1) Risk weighting based on risk weighting of sovereign in which the bank is incorporated. (2) Risk weighting based on the assessment of the individual bank. (3) Claims on banks of short original maturity, for example less than six months, would receive a weighting that is one category more favourable than the usual risk weight on the bank's claims. Source: `A new capital adequacy framework', Consultative Paper, Basle Committee on Banking Supervision, June 1999, p. 31, see 109.

systems for country risk assessment and monitoring. These systems are preferable for the measuring of country risk intensity to the proposed standard approach relying on the ratings of external rating agencies. The Working Group further argues that as more and more financial institutions today determine the economic capital needed against country risk exposures it would be more preferable to rely on those calculations than to impose regulatory capital which could even lead to a double counting. To obtain the economic capital a bank has to address the risk of the unexpected loss of the principal on a cross-border loan or portfolio of loans. This is a challenging task and therefore we should be cautious about the effectiveness of such calculations as the statistical distribution of sovereign default is not of high quality. Conceptually the argument is nevertheless very valuable.47 For further details, readers should consult the report. While the capital adequacy rules certainly try to hedge the risk in cross-border exposures for banks better, they are a disincentive to longer term lending to the developing countries because they still clearly favour short term inter-bank lending.

THE RATING AGENCIES The functioning and the services of the rating agencies were explained in detail in Chapter 4. Their responsibility in connection with the architecture of the international financial system and also crossborder exposures should now be examined. The rating agencies cover today over 100 sovereigns and therefore have an opinion on the credit standing of most countries that have access to cross-border funds. However, they have only a relatively short experience in rating developing countries as these countries started to use the international capital markets only in the late 1980s and early 1990s. This led

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to some interesting rating changes during the recent Mexican and Asian crises. While in the Mexican crisis of 1994/95 Standard & Poor's downgraded Mexico only one notch from BB+ to BB, the Asian crisis saw substantial downgradings by the three major agencies in very short intervals. For example, S&P downgraded Korea in five steps by 10 notches from AA- on 27 June 1997 to B+ by 22 December 1997. With such dramatic actions the rating agencies certainly do not live up to their responsibilities, as it is inconceivable that the long term quality of cross-border exposures to Korea, an important economy with a substantial position in international trade, can take such a hit in such a short period of time. While rating agencies have long been accustomed to rating corporate bonds on their default probability in an environment with clear bankruptcy procedures, the rating of sovereigns from the developing world is much trickier. The inexperience in rating sovereigns from developing countries and the inconclusive history of sovereign default certainly led to some of the inconsistencies. The recent crises and their solutions have been valuable learning experiences. It is therefore hoped that the rating agencies will in the future become more professional in their analysis of sovereign risk quality. As not only investors rely on their ratings, but more and more financial institutions and their supervisors are looking to them for rating the quality of cross-border assets, they have to be aware of that increased responsibility. Their actions during the Asian crisis unfortunately contributed to the impression of the boom±bust behaviour of the international financial system. It will be up to the rating agencies to further improve their assessment of sovereigns so that their ratings become the true benchmark of the quality grade of country risk.

CONCLUSIONS We have seen that many participants in the international financial system have responsibilities towards that system. These responsibilities have been analysed in terms of their influence on the risks in cross-border exposures. The major financial crises within countries or regions from the developing world were mostly caused by their own actions. Therefore the question of the participants' responsibility has to be more focused on preventing financial crisis in the developing world. In contrast to financial upheaval in the industrialized world, where it is mainly up to the central banks to cope with the problems, financial crisis in the developing world always has an important crossborder aspect and therefore international cooperation is needed to resolve it. The Bretton Woods Institutions, the IMF and the World Bank all play a pivotal role in crisis management in the developing world. While effective and efficient crisis managements are keys to solving turmoil in the international financial system, prevention of the crisis is even more important.

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In the prevention of a cross-border financial crisis the developing countries themselves are the most important actors. It is for them to do their utmost to be good housekeepers and for the rest of the world to reward such behaviour. It has to be acknowledged that this is easier said than done. The various players all have responsibilities in this respect and, as we have seen, could do a better job. The IMF and the World Bank Group need to stick more to their original mandates. With its surveillance task the IMF should not only help the developing countries to manage their economies better, but also allow the rest of the world to receive through the SDDS better information and more transparency on the state of the third world. The World Bank Group should focus its lending and investment programmes on the reduction of poverty through the elimination of structural and sector problems.48 These programmes should have in addition a catalytic effect in attracting cross-border funds. The industrial countries have the responsibility to help formulate and support effective policies for the BWIs. Furthermore, they should be fairer to the developing world in their trade policies and open their markets to the products of the developing world. The regulators and rating agencies are in a position to influence the cross-border flow of funds. They should use that position in a responsible way so that the flow of funds is not unduly hindered, but lives up to realistic criteria of risk perception and intensity.

REFERENCES 1

Among others: `Council of foreign relations: the future international financial architecture', report of an independent task force, 2000, New York; Intergovernmental Group of Twenty-Four on International Monetary Affairs, CommuniqueÂ, 15 April 2000.

2

International Monetary Fund, Annual Report 1999, p. 42.

3

International Monetary Fund's web page was an important source of information for this chapter.

4

IMF, Articles of Agreement, I.

5

David D Hale, `The IMF, now more than ever', Foreign Affairs, November/December 1998, p. 13.

6

IMF, Annual Report 1999, p. 96.

7

Articles of Agreement of the IMF, Article IV, Section 1.

8

IMF, Annual Report 1999, p. 53.

9

Donald J Mathieson and Gary J Schinasi, International Capital Market Development: prospects, and key policy issues, World Economic and Financial Surveys Series, Washington, September 1999.

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10 IMF, Annual Report 1999, p. 44. 11 Report of the Working Group on Country Risk, Institute of International Finance, Washington, September 2000. 12 IMF, Annual Report 2000, p. 101. 13 David Rockefeller, `Why we need the IMF', Wall Street Journal, 1 May 1998. 14 Michael Camdessus, `An agenda for the IMF at the start of the 21st Century', Remarks at the Council on Foreign Relations, New York, 1 February 2000. 15 Ibid., 16 Ibid., 17 Neue ZuÈrcher Zeitung, 2 August 2000, No. 177, p. 17. 18 The World Bank, Annual Report 1999, p. 351. 19 Ibid., p. 96. 20 Ibid., p. 3. 21 Ibid., p. 2. 22 Ibid., p. 4. See also World Bank, Annual Report 2000, p. 15. 23 Ibid., p. 4. 24 Ibid., p. 6. 25 The World Bank, Annual Report 2000, Financial Statements and Appendices, p. 6. 26 Ibid., p. 7. 27 World Bank, Annual Report 1999, pp. 99±100. 28 Ibid., p. 239; Annual Report 2000, p. 23. 29 Annual Report 1999, p. xii. 30 International Finance Corporation, Annual Report 1999, p. 59. 31 Ibid., p. 60. 32 Ibid., p. 57. 33 Ibid., p. 5. 34 MIGA, Annual Report 1999, p. 1. 35 World Bank, Annual Report 1999, p. xiii. 36 `The future international financial architecture', Report of an independent task force, Council of Foreign Relations, New York, 2000, p. 20. 37 Sebastian Edwards (UCLA) and the National Bureau of Economic Research, Exchange Rate Systems in Emerging Economies, third draft, 1 January 2000. 38 Intergovernmental Group of Twenty-Four on International Monetary Affairs, CommuniqueÂ, 15 April 2000, point 17. 39 Financial Times, 28 September 2000, p. 5.

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40 Intergovernmental Group of Twenty-Four on International Monetary Affairs, point 15. 41 Basle Committee on Banking Supervision, Core Principles for Effective Banking Supervision, Basle, September 1997, p. 5. 42 Basle Committee on Banking Supervision, `Supervisory lessons to be drawn from the Asian crisis', Working Paper No. 2, June 1999, BIS, Basle. 43 Basle Committee on Banking Supervision, `A new capital adequacy framework', Consultative Paper, June 1999. 44 Basle Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Standards, Basle, July 1998. 45 Ibid., Annex 2, paras. 3±20. 46 Report of the Working Group on Country Risk. 47 IMF, Annual Report 2000, p. 38. 48 The World Development Report 2000/2001, World Bank, Oxford University Press, 2000, deals exclusively with this topic under the heading `Attacking poverty'.

169

6 Conclusions Cross-border exposures became more and more apparent after the Second World War as through the political process the country map of the world changed significantly and as the integration of the world economy increased its pace. The number of countries increased substantially, first due to the dissolution of the mainly European colonial empires and then through the disintegration of the Soviet bloc in the late 1980s and the early 1990s. While cross-border exposures were extended to many more countries and the number of counterparties expanded, these exposures also increased in size. However, the special risk aspect attached to these cross-border exposures was for many years neglected. It was only the Latin American debt crisis of the early 1980s that awoke the international financial community to this risk. Lenders and investors became fully aware of what has since then been called country risk. Chapter 1 started with the nightmare in the international financial system caused by the Latin American debt crisis. The efforts to overcome the crisis were explained. Subsequent chapters have looked at the developments of cross-border exposures and the risks involved since that event. While it has to be acknowledged that over the last twenty years perception of the risk intensity has fluctuated, the recent upheavals have made it clear to holders of cross-border exposures that country risk is continuously present. It is therefore important to all kinds of holder of cross-border exposures to be aware of country risk, to try to understand it and to manage it in an optimal way. Financial institutions, especially banks but also the export credit agencies, were the first to be hit in an unforeseeable way by country risk when the rescheduling rounds of the 1980s were the order of the day for cross-border exposures to developing countries. Investors in financial instruments, be it bonds or equities from developing countries or their companies, paid dearly for country risk in the various international financial crises of the 1990s. Only the providers of direct foreign investment had the opportunity to weather out their investments, because most countries emerged eventually from their financial and economic difficulties. The need for capital to develop the economies of the developing world is immense. The domestic creation of capital is fortunately quite significant in many developing countries. However, it still falls very short of what should be available. Therefore cross-border funds have to be mobilized to close the gap. The composition of those funds has changed over the years, as well as the recipients of the funds. The privatization process in many countries has opened up important opportunities for the

170

CONCLUSIONS

private sector. This as well as the increased economic attractiveness of several countries has made foreign direct investment over the past few years by far the largest contributor to the external financing of the developing world. It is understandable that the larger countries and those with a higher average income benefited more from the flow of these private funds than the poorer countries. The Bretton Woods Institutions, as well as the governments from the industrial countries, have launched a special initiative to help the very poor nations, the so-called HIPC initiative. Internationally operating commercial banks have in the last few years substantially reduced their direct exposures to the emerging market economies. They felt that the risk reward for such lending no longer met their return on asset criteria. To close that gap bonds issued by emerging market borrowers played an important role. In addition several stock markets in the developing world have at times become interesting investment opportunities for institutional and private investors. While there are today many more providers of cross-border funds to the developing world, the total amounts mobilized are still far away from what is really needed. In addition we have to be conscious of the fact that internationally available capital usually goes to those places where it obtains an adequate return for the risk incurred. Developing countries find themselves therefore in a very competitive situation with other investment opportunities and lending situations. A professional country risk analysis is a must to judge the risk in cross-border exposures fairly. Country risk analysis has to look at the two components of this risk, transfer risk and political risk. The international debt crisis of the 1980s and the various crises of the 1990s have shown to all providers of cross-border funds, be they lenders, investors or governments, the magnitude of transfer risk and its influence on the value of the assets underwritten. The crises have also shown that the international financial system can face serious problems due to a negative development of transfer risk. Several methods have been developed to assess transfer risk by evaluating the capability of a country to generate foreign exchange. As information on economic performance is available only for the past, the assessment of transfer risk has initially to be based mainly on historical figures. Great efforts have been made to improve the quality of data available as well as the timeliness of its publication. Today for most countries we have a very acceptable time span between the accumulation of the information and the release of this information. To further improve the quality of transfer risk assessment, sufficient attention has to be given to the possible future economic performance of a country. The interdependence of every country's economy with the world economy and the variety and complexity of factors influencing its performance have made it difficult to achieve significant academic progress in evaluating transfer risk. A combination of quantitative and qualitative factors geared to the specific characteristics of groups of similar countries as well as the needs of the provider

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of the cross-border funds still seems to be the best way to assess transfer risk. The choice of the number of different factors will be crucial for obtaining good results. Too many factors make the development of the intensity of transfer risk less evident and sometimes tend to balance each other out. Highlighting the difference between liquidity and solvency problems is as important in transfer risk as in credit risk assessment. The political risk is the other component of country risk to be assessed. Political risk is in today's world perhaps less evident than it was as most countries adhere to similar political standards. However, not only are there still continuous political conflicts in several parts of the world, but also there are many unstable regimes. The intensity of political risk can therefore have its origin in the country or from outside influence. As for the transfer risk, assessing political risk means reviewing the different factors that influence it. The choice of the right factors in view of the objective of the assessment for the provider of the funds is again crucial. Very different approaches are possible and in the end it is evident that only a systematic and consistent approach that continues over several years can bring meaningful results. The different approaches to the political risk evaluation were explained and the integrated approach found to be the most valuable. It combines the subjective and objective aspects and has to be oriented towards the needs of the investors and lenders. Assessments of country risk are undertaken not only by the providers of cross-border funds but also by specialized institutions about which information is provided in this book. They undertake country risk assessment in a general way for both transfer and political risks, producing rating tables. With the regular appearance of these ratings at fairly short intervals, a fair view of the development of a specific country risk can be obtained. The development of an international capital market for borrowers from emerging countries has encouraged investors to demand ratings for the securities from emerging market borrowers. Therefore all three major rating agencies have developed their own country risk assessment systems for developing countries. They incorporate them in their review process when they establish a rating. The assessment of the country risk in cross-border exposures is today part of every professional risk assessment. As its aim is more than ever the forecasting of future developments, it will never lend itself to a fully scientific approach but will remain to a certain extent an art. The development of computer models based and checked out on past experiences has brought some insights into the variations in the quantitative factors. However, the many qualitative elements that influence the intensity of country risk and the uniqueness of every country place limitations on a generalized and statistical approach to the assessment of country risk. History rarely repeats itself.

172

CONCLUSIONS

While country risk assessment remains an art in several respects, cross-border exposure monitoring and the hedging of country risk are much more mundane affairs. They are essentially administrative tasks. Monitoring cross-border exposures starts with the choice of an effective assessment system. This should enable the provider of funds not only to limit its exposure but also to follow it up on a continuous basis in order to adjust it whenever a change in the country risk intensity makes it necessary. The overall limitation of the risk taken on cross-border exposure to a specific country is best achieved through the establishment of country limits. It is, however, not sufficient to establish only a numerical figure for country limits. They must be structured according to maturity and the kind of business or products the provider intends to offer or subscribe to. Furthermore, a forward looking approach should be adopted, taking into account the potential size of the exposure an institution is willing to take on its book when fixing the country limit. The country limit must also identify separately the direct and indirect country risk, so as to allow a complete picture of all the risks incurred to be drawn up. While the fixing of the country limit is a business decision that should be taken high up in the hierarchy, the monitoring of the actual exposure will be done in the departments responsible for cross-border exposures. Today's efficient IT systems allow these departments to monitor the exposure in real time even in highly decentralized organizations. The monitoring should be limited to supervision of the exposure, but should also follow up on the assessment of the country risk. It should raise the red flag when needed and give the green light when new opportunities occur. As country risk is a commercial risk it has to be included in the provisioning process of financial institutions. Some cross-border exposures, such as securities, follow, however, the market to market pricing accounting rules and are therefore continuously adjusted to their market value. The hedging of country risk is not a common practice for cross-border exposures. The two parts of country risk have furthermore received different attention with respect to hedging. Political risk has been more the focus of attention for hedging whereas transfer risk is basically considered a commercial risk that is part of the overall risk management of every organization. The Bretton Woods Institutions' efforts to develop foreign direct investment have resulted in the creation of MIGA, which has as its main purpose the coverage of the political risk of foreign direct investments. Its country risk insurance coverage is also available for other cross-border exposures as was explained earlier. Other public institutions have taken on similar tasks. Refinancing cross-border exposures is usually a relatively smooth exercise for financial institutions and leveraged financial investors. The situation can, however, dramatically change if the cross-border assets become impaired. In this case refinancing can still be available but the return on the assets will

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fast deteriorate and even become negative. The profit and loss accounts will have to bear the brunt of such developments. An interesting aspect of country risk is the case of contagion. In this context it means the transmission of an economic shock that has its origin in one country or region and spreads to other countries and regions. Contagion became an issue in the various crises of the 1990s. A good spread of cross-border risks over different countries and regions is probably the best safeguard against contagion. Country risk assessment and the monitoring of cross-border exposures as well as the hedging of those risks are not only an important task for financial institutions, companies and investors, but also for government agencies and institutions in managing their international activities. An institution's country risk assessment system should make a change in risk intensity evident as early as possible. This will allow it to undertake the necessary action in time. Each provider of cross-border funds will have to establish a system that suits its goals best. There is no standard answer. This book is intended to supply the necessary guidance for these organizations to fulfil their tasks. Cross-border exposures have been the origin of many financial crises in the last twenty years. It is therefore only natural that many scholars and experts, and also many affected parties, ask themselves what can be done in the future to reduce the potential for such crisis. And if they continue to occur, can we improve our management of them? It has to be acknowledged that at the beginning of the twenty-first century the wealth on our planet is very unevenly distributed not only in a geographical sense but also among the different layers of our populations. This situation contains an enormous potential for conflict. In the context of this book we can disregard to a certain extent the uneven distribution of wealth in the different layers of the population of a country. The disparities on the geographical scale, however, form a large part of the risk in cross-border exposures. Only accelerated, sustainable economic development in the developing countries will help to reduce these risks. This book has therefore looked at the responsibilities of the different players in the international financial system for reducing the risks in cross-border exposures, and also for managing the current situation better and being ready to diffuse a crisis should it occur. The most important players in the international financial arena of cross-border exposures are the two Bretton Woods Institutions, the IMF and the World Bank Group. They are to the world of economy and finance what the United Nations is to the world of politics. They should facilitate an increased

174

CONCLUSIONS

flow of funds and expertise to the developing world at an acceptable risk level. Both institutions have recently come under a lot of criticism for not following their original assignments, interfering in each other's jobs and being too bureaucratic and not efficient enough. However, we have to accept that without these institutions the various international crises of the last twenty years would not have been resolved with such a low number of casualties. The surveillance programme of the IMF is the basis for better information on the economic performance of the member countries. It is also a tool to help developing countries to manage their economies better and reinforce their institutional network, especially the financial sector and its supervision. This should enhance corporate governance. The financial assistance programmes are flexible enough to take care of countries that face economic difficulties efficiently. The activities of the IMF help the providers of cross-border funds to obtain information so they can judge the country risks they underwrite better. They also know that in a financial crisis the IMF will assist the country in difficulties to overcome them. It is, however, not the task of the IMF to bail out providers of cross-border funds. The World Bank Group is the most important development institution in the world. Its main task is to alleviate poverty and improve living standards in the developing world. With respect to the risks in cross-border exposures the World Bank Group produces a wealth of information that is of interest to the providers of those funds. Through the International Finance Corporation the World Bank Group is an important provider of capital to the private sector and acts as a catalyst in the attraction of foreign private capital to the developing countries. With its co-financing activities it mobilizes loans from international financial institutions at longer terms than these institutions would normally accept. The World Bank furthermore provides a risk umbrella which mitigates substantially the country risk for the provider of such funds. The IMF and the World Bank are both dominated by the industrialized countries. The main beneficiaries of their activities are, however, the rest of the world. The current strong representation on the Executive Board by the industrialized countries should be reviewed in order to give the two institutions better credentials in running their affairs. The developing countries are, as we know by now, at the centre of the risk question in cross-border exposures. They also greatly need to attract cross-border funds to support sustainable economic development. As we have seen, private funds usually go there where they feel comfortable with the relation between risk and return. Unfortunately, developing countries do not all have the best track record in this respect. In order to be able to attract such funds on a continuous basis developing countries have therefore to run their house in a way that satisfies these demands. Even in times of

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CROSS-BORDER EXPOSURES AND COUNTRY RISK

ample liquidity in the international financial markets the rule of an adequate risk/return relationship remains the basis for decisions on cross-border exposures. There is an ongoing tough competition among those who look for funds, so the developing countries have to make every effort to remain attractive to investors. Over the last twenty years the regulators have lived through many difficult situations in respect of country risk. The Basle Committee on Banking Supervision has, therefore, dealt widely with country risk problems. The learning process has been extensive at the supervisors' level and even more at the supervised level. Today the common understanding is that the supervisory bodies have to be satisfied with the quality of country risk assessment and monitoring within their constituency. Furthermore, as for every other risk the regulators also ask for adequate reserve levels against country risk. Country risk assessment and monitoring plays an important role in the allocation of the various resources available to build and expand the economies of the developing countries. Therefore, both the lender or investor and the borrower or recipient of the funds will have to take this into account. The country of destination of cross-border funds will have to direct and adjust its economic policies so that it obtains funds from the international financial community if it needs them. Politicians in all countries that depend upon the inflow of funds must be concerned about the international creditworthiness of their countries. Today, prudent international bankers, multinational companies and internationally active investors, and also governments in the industrialized world, continuously watch the international economic and political environment through their country risk assessment systems and monitor their exposure carefully in order to optimize the risk composition of their crossborder lending or investment. They should in this process never forget that they are a privileged group in today's world and should therefore endeavour to continue to support the efforts of the governments of the developing countries who try to improve their creditworthiness.

176

Annex 1: Glossary Contagion

Contagion is a situation where a financial crisis in one country or region is

internationally transmitted to other parts of the international financial system in a shock of unprecedented extent and magnitude. Country exposure

Country exposure is the total amount of cross-border exposure of a lender and/or

investor in a specific country, directly as well as indirectly. Country limit

Country limit is the numerical amount up to which an institution such as a bank, a

company or an institutional investor is willing to take a cross-border exposure in a particular country. Country rating

Country rating is the result of the individual appraisal of a particular country in

view of its standing to honour its foreign obligations in relation to other countries or groups of countries. Country risk

Country risk is the possibility that a sovereign state or sovereign borrowers of a

particular country may be unable or unwilling, and other borrowers unable, to fulfil their obligations towards a foreign lender and/or investor for reasons beyond the usual risks that arise in relation to all lending and investments. Country risk is composed of transfer and political risk. Cross-border exposure

Cross-border exposure is an exposure that a lender and/or investor resident

in one country has in another country. The cross-border exposure can have its origin in a loan, in a grant, in a portfolio investment or in an investment in a company or other assets. Developing country

Developing countries are all those countries in the context of this book that

need substantial cross-border funds for their development, do not have a top rating from the international rating agencies and do not belong to an economic and political association that can give financial support. The so-called transition countries are for the purpose of this book considered developing countries.

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CROSS-BORDER EXPOSURES AND COUNTRY RISK

Direct country risk

Direct country risk in cross-border exposures is the country risk of the country

where the borrower takes up its liabilities and/or the investment is made. Indirect country risk

Indirect country risk in cross-border exposures is the country risk of the

guarantor or of the main security if the guarantor or security is in a different country from where the borrower has taken up its liabilities or where the investment has been made. This country risk can be qualified as the ultimate country risk. London Club

The London Club is composed of the private holders of cross-border exposures who

negotiate together a restructuring of their exposures to a specific country. The leadership of the London Club is usually assumed by an internationally operating financial institution. Paris Club

The Paris Club is composed of the governments or government agencies that negotiate

together the restructuring of their exposures to a specific country under the leadership of the French Treasury department. Political risk

Political risk is the risk incurred by lenders and/or investors that the repatriation of

their loan and/or investment in a particular country, i.e. capital, dividends, interest, fees or royalties, is restricted by that country for political reasons only. Rescheduling

Rescheduling is a process by which the lender and the borrower agree to new

conditions for an existing loan agreement. Sovereign risk

Sovereign risk arises from the special risk associated with a sovereign loan or bond

issue which is taken up or guaranteed by a government or a government-guaranteed body. The special significance of such a loan or bond issue lies in the risk that it might prove impossible to secure redress through legal action ± i.e. the borrower or issuer might claim immunity from process or might not abide by a judgment. Transfer risk

Transfer risk is the risk that a particular country may impose restrictions on

remittances of capital, dividends, interest, fee or royalties to foreign lenders and/or investors as part of its economic policy.

178

Annex 2: Articles of Agreement of the International Monetary Fund ARTICLE IV: OBLIGATIONS REGARDING EXCHANGE ARRANGEMENTS

Section 1. General obligations of members Recognizing that the essential purpose of the international monetary system is to provide a framework that facilitates the exchange of goods, services, and capital among countries, and that sustains sound economic growth, and that a principal objective is the continuing development of the orderly underlying conditions that are necessary for financial and economic stability, each member undertakes to collaborate with the Fund and other members to assure orderly exchange arrangements and to promote a stable system of exchange rates. In particular, each member shall: (i)

endeavour to direct its economic and financial policies toward the objective of fostering orderly economic growth with reasonable price stability, with due regard to its circumstances;

(ii)

seek to promote stability by fostering orderly underlying economic and financial conditions and a monetary system that does not tend to produce erratic disruptions;

(iii) avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members; and (iv) follow exchange policies compatible with the undertakings under this Section.

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CROSS-BORDER EXPOSURES AND COUNTRY RISK

Section 2. General exchange arrangements (a)

Each member shall notify the Fund, within thirty days after the second amendment of this Agreement, of the exchange arrangements it intends to apply in fulfilment of its obligations under Section 1 of this Article, and shall notify the Fund promptly of any changes in its exchange arrangements.

(b)

Under an international monetary system of the kind prevailing on January 1, 1976, exchange arrangements may include (i) the maintenance by a member of a value for its currency in terms of the special drawing right or another denominator, other than gold, selected by the member, or (ii) cooperative arrangements by which members maintain the value of their currencies in relation to the value of the currency or currencies of other members, or (iii) other exchange arrangements of a member's choice.

(c)

To accord with the development of the international monetary system, the Fund, by an eightyfive percent majority of the total voting power, may make provision for general exchange arrangements without limiting the right of members to have exchange arrangements of their choice consistent with the purposes of the Fund and the obligations under Section 1 of this Article.

Section 3. Surveillance over exchange arrangements (a)

The Fund shall oversee the international monetary system in order to ensure its effective operation, and shall oversee the compliance of each member with its obligations under Section 1 of this Article.

(b)

In order to fulfil its functions under (a) above, the Fund shall exercise firm surveillance over the exchange rate policies of its members, and shall adopt specific principles for the guidance of all members with respect to those policies. Each member shall provide the Fund with the information necessary for such surveillance, and, when requested by the Fund, shall consult with it on the member's exchange rate policies. The principles adopted by the Fund shall be consistent with cooperative arrangements by which members maintain the value of their currencies in relation to the value of the currency or currencies of other members, as well as with other exchange arrangements of a member's choice consistent with the purposes of the Fund and Section 1 of this Article. These principles shall respect the domestic social and political policies of members, and in applying these principles the Fund shall pay due regard to the circumstances of members.

180

ANNEX 2: ARTICLES OF AGREEMENT OF THE INTERNATIONAL MONETARY FUND

Section 4. Par values The Fund may determine, by an eighty-five percent majority of the total voting power, that international economic conditions permit the introduction of a widespread system of exchange arrangements based on stable but adjustable par values. The Fund shall make the determination on the basis of the underlying stability of the world economy, and for this purpose shall take into account price movements and rates of expansion in the economies of members. The determination shall be made in light of the evolution of the international monetary system, with particular reference to sources of liquidity, and, in order to ensure the effective operation of a system of par values, to arrangements under which both members in surplus and members in deficit in their balances of payments take prompt, effective, and symmetrical action to achieve adjustment, as well as to arrangements for intervention and the treatment of imbalances. Upon making such determination, the Fund shall notify members that the provisions of Schedule C apply.

Section 5. Separate currencies within a member's territories (a)

Action by a member with respect to its currency under this Article shall be deemed to apply to the separate currencies of all territories in respect of which the member has accepted the Agreement under Article XXXI, Section 2 (g) unless the member declares that its action relates either to the metropolitan currency alone, or only to one or more specified separate currencies, or to the metropolitan currency and one or more specified separate currencies.

(b)

Action by the Fund under this Article shall be deemed to relate to all currencies of a member referred to in (a) above unless the Fund declares otherwise.

The Articles of Agreement of the International Monetary Fund can be found under www.imf.org.

181

Annex 3: Selected sovereign ratings for foreign currencies of developing countries Argentina Azerbaijan Bahamas Bahrain Barbados Belize Bolivia Brazil Bulgaria Chile China Colombia Costa Rica Croatia Cuba Cyprus Czech Republic Dominican Republic Ecuador Egypt El Salvador Estonia Guatemala Honduras Hong Kong Hungary India Indonesia

182

Standard & Poor's

Moody's

FitchIBCA

BB nr nr nr A± BB BB± B+ B+ A± BBB BB BB BBB± nr A A± B+ B± BBB± BB+ BBB+ nr nr A BBB+ BB SD

B1 nr A3 Ba1 Baa2 Ba2 B1 B2 B2 Baa1 A3 Ba2 Ba1 Baa3 Caa1 A2 Baa1 B1 Caa2 Ba1 Baa3 Baa1 Ba2 B2 A3 Baa1 Ba2 B3

BB B+ nr BBB± nr nr nr BB± B+ A± A± BB+ BB BB+ nr nr BBB+ nr nr BBB± BB+ BBB+ nr nr A+ BBB+ BB+ B±

ANNEX 3: SELECTED SOVEREIGN RATINGS FOR FOREIGN CURRENCIES

Iran Israel Jamaica Jordan Kazakhstan Korea Kuwait Latvia Lebanon Lithuania Malaysia Malta Mexico Moldova Mongolia Morocco Nicaragua Oman Pakistan Panama Papua New Guinea Paraguay Peru Philippines Poland Qatar Romania Russia Saudi Arabia Singapore Slovakia Slovenia South Africa Surinam Taiwan Thailand Trinidad & Tobago Tunisia Turkey Turkmenistan Ukraine United Arab Emirates Uruguay Venezuela Vietnam

Standard & Poor's

Moody's

FitchIBCA

nr A± B BB± BB± BBB A BBB B+ BBB± BBB A BB+ nr B BB nr BBB± B± BB+ B+ B BB BB+ BBB+ BBB B± SD nr AAA BB+ nr BBB± B± AA+ BBB± BBB± BBB B+ nr nr nr BBB± B nr

B2 A2 Ba3 Ba3 B1 Baa2 Baa1 Baa2 B1 Ba1 Baa3 A3 Baa3 B3 nr Ba1 B2 Baa2 Caa1 Baa1 B1 B2 Ba3 Ba1 Baa1 nr B3 B3 Baa3 Aa1 Ba1 A3 Baa3 nr Aa3 Baa3 Baa3 Baa3 B1 B2 Caa1 A2 Baa3 B2 B1

nr A± nr nr BB± BBB+ A± BBB BB± BB+ BBB A BB+ B± nr nr nr nr nr BB+ B+ nr BB BB+ BBB+ nr B± B nr AA+ BB+ A BBB± nr nr BBB± nr BBB± BB± B± nr nr BBB± BB± nr

Note: nr = no rating; SD = selective default. All ratings are at l October 2000. They are available on the web pages of the three companies.

183

Annex 4.1: Country risk rating by the International Country Risk Guide

COUNTRY Albania Algeria Angola Argentina Armenia Australia Austria Azerbaijan Bahamas Bahrain Bangladesh Belarus Belgium Bolivia Botswana Brazil Brunei Bulgaria Burkina Faso Cameroon Canada Chile China, People's Rep. Colombia Congo, Dem. Republic Congo, Republic Costa Rica CoÃte d'Ivoire Croatia Cuba Cyprus

184

CURRENT RATINGS Political Financial Economic risk risk risk 06/99 06/99 06/99 47.0 39.0 39.0 75.0 59.0 88.0 85.0 56.0 82.0 62.0 58.0 64.0 76.0 69.0 76.0 63.0 75.0 69.0 64.0 58.0 86.0 71.0 61.0 51.0 27.0 41.0 81.0 68.0 66.0 59.0 71.0

35.0 30.5 28.5 32.0 34.0 34.5 42.5 29.5 31.0 43.5 37.5 29.0 38.0 33.5 43.5 25.5 48.0 37.0 31.5 31.5 39.0 37.5 45.5 35.5 22.0 23.0 37.5 30.0 35.5 31.5 43.0

30.1 32.2 20.6 37.8 30.6 37.1 38.8 26.6 34.4 36.9 34.0 24.7 41.1 27.1 41.9 25.1 40.5 36.2 34.5 34.6 39.8 35.2 39.1 27.9 23.5 32.1 34.0 37.6 35.7 30.8 34.6

Year ago 06/98 53.3 58.8 45.3 74.3 79.3 86.0 79.5 73.8 66.5 61.3 82.0 70.0 80.0 68.3 86.3 65.3 59.8 61.8 83.5 79.0 73.5 60.0 45.8 45.8 76.5 65.0 62.0 79.0

COMPOSITE RATINGS One Five Current year year 06/99 forecast forecast 56.0 50.9 44.1 72.4 61.8 79.8 83.2 56.0 73.7 71.2 64.8 58.8 77.5 64.8 80.7 56.8 81.8 71.1 65.0 62.0 82.4 71.9 72.8 57.2 36.3 48.1 76.2 67.8 68.6 60.6 74.3

60.5 53.5 43.0 69.5 60.0 79.5 82.5 57.0 74.5 71.0 62.5 56.0 80.0 68.0 82.5 57.5 79.5 74.5 65.0 63.0 80.0 73.5 72.5 58.0 42.5 51.0 75.5 63.3 69.0 60.5 75.0

68.5 67.0 48.5 76.5 68.0 83.0 85.0 61.5 75.0 70.5 64.5 58.5 81.0 71.5 83.5 70.0 81.0 77.0 66.5 63.0 81.0 75.0 76.5 62.0 55.5 54.5 77.5 64.0 69.0 63.5 76.0

ANNEX 4.1: COUNTRY RISK RATING

COUNTRY Czech Republic Denmark Dominican Republic Ecuador Egypt El Salvador Estonia Ethiopia Finland France Gabon Gambia Germany Ghana Greece Guatemala Guinea Guinea-Bissau Guyana Haiti Honduras Hong Kong Hungary Iceland India Indonesia Iran Iraq Ireland Israel Italy Jamaica Japan Jordan Kazakhstan Kenya Korea, D.P.R. Korea, Republic Kuwait Latvia Lebanon Liberia Libya Lithuania Luxembourg Madagascar

CURRENT RATINGS Political Financial Economic risk risk risk 06/99 06/99 06/99 83.0 89.0 70.0 59.0 65.0 73.0 75.0 59.0 93.0 80.0 63.0 71.0 87.0 65.0 76.0 65.0 57.0 46.0 70.0 45.0 63.0 69.0 82.0 88.0 52.0 44.0 65.0 32.0 87.0 59.0 72.0 74.0 78.0 72.0 71.0 55.0 55.0 74.0 70.0 67.0 57.0 44.0 57.0 65.0 92.0 64.0

38.5 39.5 37.0 26.5 35.0 43.0 36.5 25.0 37.0 37.5 36.5 33.5 39.5 31.5 35.0 37.5 32.5 23.5 27.0 35.0 32.0 44.0 34.5 35.5 38.5 33.5 39.0 25.5 41.5 37.5 40.5 36.5 46.5 36.5 32.5 36.0 18.0 39.0 45.5 39.0 31.0 20.0 37.0 40.0 42.0 33.5

31.3 41.9 37.8 27.3 35.7 38.3 32.6 30.0 43.0 41.0 39.8 32.5 39.3 29.6 36.2 35.3 33.1 25.5 31.6 33.1 29.1 36.4 32.2 41.3 29.6 18.1 27.8 22.3 44.6 34.4 39.5 29.4 37.9 39.2 30.7 34.5 6.6 39.0 34.3 36.9 21.7 23.0 28.2 41.9 45.4 35.0

Year ago 06/98 77.3 87.8 73.8 62.3 70.8 76.0 66.5 88.8 80.8 69.3 72.3 84.0 63.0 77.8 72.0 61.5 41.5 68.3 52.5 65.8 78.3 77.5 85.0 63.3 42.0 68.5 38.8 87.3 69.5 83.8 75.0 78.0 73.8 60.5 38.5 68.3 78.0 55.8 41.5 64.5 92.0 64.8

COMPOSITE RATINGS One Five Current year year 06/99 forecast forecast 76.4 85.2 72.4 56.4 67.8 77.1 72.0 57.0 86.5 79.3 69.6 68.5 82.9 63.0 73.6 68.9 61.3 47.5 64.3 56.5 62.1 74.7 74.3 82.4 60.0 47.8 65.9 39.9 86.6 65.4 76.0 69.9 81.2 73.8 67.1 62.8 39.8 76.0 74.9 71.4 54.8 43.5 61.1 73.5 89.7 66.3

75.0 84.0 71.0 58.0 69.0 77.0 73.5 59.5 83.0 80.5 70.5 71.0 80.5 62.0 76.0 68.0 59.8 52.5 64.0 56.5 60.0 74.0 76.0 82.0 64.0 53.5 68.5 44.0 87.0 65.0 78.5 70.0 83.0 74.0 67.0 63.5 40.5 73.0 72.5 71.5 55.5 44.0 63.5 74.5 90.3 67.5

77.0 85.0 70.5 63.0 68.5 75.5 74.0 63.5 83.0 83.5 70.5 72.5 85.5 64.5 77.5 71.5 62.0 60.5 67.0 59.5 67.5 72.5 77.0 80.0 68.0 63.0 71.5 52.5 84.5 68.0 80.0 75.0 85.5 74.0 67.0 64.5 48.5 78.5 72.0 72.0 57.5 48.0 68.0 74.0 88.5 68.5

185

CROSS-BORDER EXPOSURES AND COUNTRY RISK

COUNTRY Malawi Malaysia Mali Malta Mexico Moldova Mongolia Morocco Mozambique Myanmar Namibia Netherlands New Zealand Nicaragua Niger Nigeria Norway Oman Pakistan Panama Papua New Guinea Paraguay Peru Philippines Poland Portugal Qatar Romania Russian Federation Saudi Arabia Senegal Sierra Leone Singapore Slovak Republic Slovenia Somalia South Africa Spain Sri Lanka Sudan Surinam Sweden Switzerland Syria Taiwan Tanzania Thailand

186

CURRENT RATINGS Political Financial Economic risk risk risk 06/99 06/99 06/99 73.0 66.0 66.0 88.0 68.0 67.0 71.0 70.0 60.0 46.0 77.0 93.0 88.0 61.0 53.0 51.0 86.0 75.0 50.0 77.0 63.0 59.0 61.0 72.0 83.0 90.0 75.0 71.0 49.0 64.0 58.0 35.0 85.0 85.0 81.0 28.0 66.0 76.0 58.0 36.0 62.0 86.0 85.0 68.0 81.0 66.0 67.0

21.5 40.0 33.0 37.5 34.5 20.0 33.0 37.5 30.5 40.0 43.0 38.0 31.0 19.0 30.5 34.5 44.5 39.0 30.0 31.5 34.5 39.5 36.5 36.5 37.5 37.0 27.5 21.5 27.5 43.0 33.0 8.0 45.5 33.0 41.5 22.0 36.0 40.0 34.5 19.0 41.5 34.5 46.0 35.5 45.0 17.0 39.0

29.0 35.0 36.0 35.4 32.2 16.0 28.1 36.2 26.5 26.2 36.8 41.5 37.0 22.6 35.0 31.2 43.9 32.4 29.1 34.5 32.2 30.7 35.4 33.1 34.5 36.1 29.3 19.8 20.9 30.0 36.1 21.5 45.4 31.1 35.1 28.5 31.9 37.6 33.6 29.6 30.5 42.7 42.8 37.0 40.5 32.0 37.3

Year ago 06/98 64.3 69.0 64.8 80.8 67.5 67.3 71.5 57.5 55.0 77.5 87.5 78.8 53.8 54.5 56.8 92.8 76.0 55.5 73.3 68.3 68.5 65.8 68.0 81.0 84.5 69.5 62.3 63.8 73.5 64.5 33.0 89.5 76.8 33.3 70.8 79.3 62.0 41.3 67.3 84.5 87.3 69.0 81.3 60.3 65.0

COMPOSITE RATINGS One Five Current year year 06/99 forecast forecast 61.8 70.5 67.5 80.4 67.4 51.5 66.0 71.8 58.5 56.1 78.4 86.3 78.0 51.3 59.3 58.3 87.2 73.2 54.5 71.5 64.8 64.6 66.4 70.8 77.5 81.6 65.9 56.1 48.7 68.5 63.5 32.3 88.0 74.5 78.8 39.3 66.9 76.8 63.1 42.3 67.0 81.6 86.9 70.3 83.3 57.5 71.7

60.0 69.0 65.3 80.5 65.5 53.0 65.5 72.0 57.3 56.0 77.0 87.5 77.5 49.0 59.5 56.5 86.5 72.0 58.0 71.5 63.5 59.5 64.5 69.0 78.5 80.5 62.5 58.0 48.0 68.0 63.8 35.0 82.5 77.0 77.0 35.0 65.5 78.5 62.5 47.0 69.5 82.5 88.0 70.0 82.0 57.0 67.5

61.5 64.0 68.0 77.5 69.5 59.5 63.5 70.5 58.5 54.5 76.0 86.5 77.5 54.0 63.0 63.5 87.0 71.0 60.5 73.5 68.0 65.0 66.5 70.0 77.0 81.5 65.0 64.0 60.0 72.0 63.5 53.0 78.0 77.0 77.5 46.5 66.0 80.0 65.0 54.5 69.5 82.0 87.0 69.0 80.5 61.0 68.0

ANNEX 4.1: COUNTRY RISK RATING

COUNTRY Togo Trinidad & Tobago Tunisia Turkey Uganda Ukraine United Arab Emirates United Kingdom United States Uruguay Venezuela Vietnam Yemen, Republic Yugoslavia Zambia Zimbabwe

CURRENT RATINGS Political Financial Economic risk risk risk 06/99 06/99 06/99 53.0 73.0 73.0 50.0 53.0 65.0 72.0 87.0 88.0 74.0 62.0 66.0 58.0 20.0 70.0 57.0

33.0 40.0 36.5 31.0 32.0 25.5 42.0 37.0 37.0 35.0 38.0 29.5 32.5 25.5 25.5 22.5

35.5 35.2 34.8 28.4 36.5 23.1 37.5 38.4 41.6 32.9 25.7 27.5 34.1 24.7 28.1 24.1

Year ago 06/98 60.8 79.0 73.3 49.0 63.5 67.0 78.5 81.8 83.0 73.0 66.8 63.5 66.0 39.3 61.8 57.5

COMPOSITE RATINGS One Five Current year year 06/99 forecast forecast 60.8 74.1 72.2 54.7 60.8 56.8 75.8 81.2 83.3 71.0 62.9 61.5 62.3 35.1 61.8 51.8

61.0 73.5 71.0 60.5 62.0 56.0 75.5 80.0 80.0 68.5 61.0 59.5 63.5 42.0 56.5 49.0

63.0 73.0 69.0 69.0 63.0 62.0 75.0 81.0 80.5 72.0 70.0 62.0 69.0 58.5 63.5 55.0

Source: From the International Country Risk Guide, published by PRS Group LLC, East Syracuse, New York, USA.

187

Annex 4.2: Country risk rating by the Institutional Investor (II) Mar 00

Sep 00

Country

1 2 4 7 5 2 8 14 6 12 11 15 18 10 16 9 19 17 20 13 21 22 23 24 31 27 30 26 25 28 33 37 32

1 2 3 4 5 6 7 8 9* 10* 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32* 33*

Switzerland Germany Netherlands Luxembourg France United States Norway Canada United Kingdom Finland Denmark Ireland Singapore Japan Sweden Austria Spain Italy Portugal Belgium Australia Taiwan New Zealand Iceland Bahamas Greece Hong Kong Chile Slovenia United Arab Emirates Hungary Israel Kuwait

188

II credit ranking

6 month change

1 year change

95.6 94.6 94.5 93.9 93.6 91.6 90.1 89.6 89.1 89.1 88.9 88.5 87.8 87.7 87.2 87.1 86.1 84.2 83.6 83.1 82.1 78.9 78.7 73.7 70.7 70.0 68.3 67.2 67.0 66.3 64.9 64.4 64.4

1.8 1.7 2.4 3.4 1.9 ±1.3 0.6 4.5 ±2.0 3.5 2.6 3.7 7.4 0.8 3.3 ±2.3 5.7 2.2 3.9 ±2.5 3.8 2.7 3.2 4.0 10.5 7.5 7.5 4.6 3.9 3.9 5.7 6.8 4.6

2.6 2.6 3.3 3.6 2.2 0.7 2.4 6.1 ±1.1 5.5 3.8 5.1 5.9 1.2 6.0 ±2.3 4.4 2.9 5.2 ±1.8 6.3 3.60 4.7 5.9 10.9 7.0 6.2 5.8 3.1 7.6 8.6 6.2

ANNEX 4.2: COUNTRY RISK RATING

Mar 00

Sep 00

Country

29 35 36 38 34 40 42 41 47 43 39 49 58 46 52 45 44 48 50 51 53 57 56 54 61 59 62 55 68 63 72 60 65 71 64 66 69 70 75 67 76 83 77 74 85 87 73 91 79

34 35 36 37 38 39 40 41 42 43 44 45* 46* 47 48* 49* 50* 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65* 66* 67 68 69 70 71 72 73 74* 75* 76 77 78 79 80 81 82

Malta South Korea Poland Cyprus Czech Republic China Malaysia Saudi Arabia Mexico Qatar Botswana Estonia South Africa Oman Barbados Bahrain Mauritius Tunisia Uruguay Thailand Trinidad & Tobago India Egypt Philippines Slovakia Latvia Costa Rica Morocco Turkey Panama El Salvador Argentina Croatia Brazil Colombia Lithuania Peru Jordan Venezuela Namibia Bulgaria Guatemala Dominican Republic Lebanon Kazakhstan Jamaica Sri Lanka Algeria Paraguay

II credit ranking

6 month change

1 year change

64.3 63.3 62.2 61.1 60.9 60.6 59.5 57.0 56.7 56.2 56.1 55.1 55.1 54.9 54.6 54.6 54.6 54.5 53.5 53.2 52.0 51.5 51.0 49.4 49.1 47.9 47.5 47.3 46.8 46.7 46.3 45.8 45.8 45.0 44.0 43.7 42.3 41.9 37.9 37.4 37.1 37.1 37.0 36.8 34.4 33.8 33.3 33.1 32.5

2.0 4.5 3.7 3.6 1.8 4.0 4.6 1.9 6.9 2.9 ±0.9 5.7 9.9 4.0 6.0 3.1 2.2 4.8 4.4 4.4 4.8 6.2 5.6 2.7 6.2 4.5 4.8 1.7 7.8 4.0 8.0 2.8 4.0 6.5 1.4 2.9 3.5 3.3 3.0 ±2.3 4.6 6.1 5.1 1.8 4.2 4.3 ±2.1 5.4 0.8

2.7 6.5 4.7 3.6 1.8 4.2 7.8 3.0 8.5 4.7 0.1 9.2 9.5 2.9 9.6 3.7 0.7 4.2 6.3 4.9 7.1 7.3 5.6 3.5 7.5 7.1 7.0 3.0 7.9 5.0 10.7 3.4 6.2 8.5 ±0.1 5.4 5.3 4.0 4.1 ±0.6 6.8 9.0 6.1 3.2 4.7 4.9 ±0.4 6.6 1.2

189

CROSS-BORDER EXPOSURES AND COUNTRY RISK

Mar 00

Sep 00

Country

80 78 92 84 82 81 96 86 89 90 88 94 103 106 105 93 95 97 102 116 100 99 101 120 127 134 109 114 107 108 104 111 110 112 113 117 121 98 118 115 123 131 122 136 124 126 129 128 133

83 84 85 86 87 88 89 90**

Libya Seychelles Romania Papua New Guinea Ghana Bolivia Bangladesh Swaziland Vietnam Indonesia Iran Nepal Russia Honduras Grenada Lesotho Kenya CoÃte d'Ivoire Gabon Kyrgyzstan Senegal Syria Uganda Turkmenistan Nicaragua Georgia Tanzania Uzbekistan Burkina Faso Mozambique Malawi Pakistan Ecuador Nigeria Ukraine Togo Myanmar Zimbabwe Benin Cameroon Ethiopia Albania Moldova Burundi Zambia Guinea Belarus Tajikistan Cuba

190

92 93 94 95 96 97 98* 99* 100 101* 102* 103 104 105 106 107 108 109 110 111* 112* 113 114 115 116 117 118 119 120 121 122 123 124* 125* 126 127 128 129 130 131

II credit ranking

6 month change

1 year change

31.5 30.4 30.3 30.2 29.5 28.6 28.4 28.0 28.0 27.4 27.0 26.9 26.7 26.6 25.5 25.0 25.0 24.1 23.8 23.8 23.5 23.1 22.7 21.9 21.8 21.0 20.3 20.2 19.8 19.8 19.6 19.2 18.3 18.1 17.7 17.6 17.4 17.1 17.0 16.3 15.9 15.8 15.8 15.6 15.5 15.1 14.4 14.2 14.1

±0.1 ±1.5 2.8 ±0.7 ±1.5 ±2.5 2.9 ±1.7 ±1.1 ±0.9 ±2.2 0.1 7.1 7.3 6.1 ±1.9 ±1.6 ±1.1 1.6 6.2 0.3 ±0.1 ±0.2 4.8 8.4 9.9 1.2 2.2 0.6 0.6 0.1 0.4 ±0.8 ±0.2 ±0.4 0.2 0.5 ±7.0 ±0.3 ±1.7 0.0 3.2 ±0.2 6.0 0.4 0.7 1.7 1.3 2.0

2.4 0.8 1.6 ±2.0 ±1.2 0.2 1.6 ±2.0 ±0.1 0.3 ±1.0 ±0.4 7.4 7.3 8.8 0.2 ±1.4 1.2 0.7 ±0.7 1.0 9.7 10.2 0.8 1.3 0.7 0.5 0.1 ±0.3 ±4.1 0.2 ±1.0 0.5 ±0.5 ±8.0 ±0.2 ±0.9 ±0.7 3.4 0.6 ±1.2 1.0 2.0

ANNEX 4.2: COUNTRY RISK RATING

Mar 00

Sep 00

119 132 132 133 141 134 138 135 135 136 130 137 142 138 125 139 139 140 140 141 137 142 145 143 143 144 144 145 Global average rating

Country Mali Chad Yugoslavia Iraq Haiti Angola Congo Republic Niger Democratic Republic of Congo Sudan Liberia Afghanistan Sierra Leone North Korea

II credit ranking

6 month change

1 year change

14.0 13.9 12.7 12.6 12.5 11.9 11.1 10.9 8.8 8.7 8.6 6.5 6.4 6.2 43.4

±3.2 1.5 5.4 4.3 2.4 ±0.7 4.0 ±3.7 0.8 0.8 0.2 0.8 ±0.7 ±0.6 2.5

±1.5 4.5 4.9 1.3 0.3 1.8 1.5 1.6 ±0.4 0.7 0.3 ±0.5 1.9

* Order determined by actual results before rounding. ** Actual tie. Source: Institutional Investor magazine, September 2000.

191

Annex 4.3: Country risk rating by Euromoney Total score

Sep Mar Country 00 00 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34

192

1 2 4 3 6 5 11 8 7 12 9 10 14 15 16 13 17 18 20 19 21 22 23 24 25 27 26 29 30 28 33 31 32 38

Weighting:

Luxembourg Switzerland United States Norway Netherlands Denmark Germany France Austria United Kingdom Finland Sweden Japan Singapore Ireland Belgium Canada Australia Spain Italy Iceland New Zealand Portugal Taiwan Greece Hong Kong Cyprus United Arab Emirates Bermuda Kuwait Malta Israel Slovenia Saudi Arabia

Political risk

Economic performance

Debt indicators

100

25

25

10

99.02 96.89 94.25 94.24 92.90 92.77 92.77 92.33 92.29 91.54 91.38 91.12 90.70 90.04 89.71 89.63 89.10 88.01 87.29 87.11 86.72 85.27 83.25 80.65 78.66 77.42 76.62 75.59 73.67 73.28 72.89 72.68 68.93 68.27

24.38 25.00 24.94 23.90 24.66 23.09 24.52 24.34 23.69 24.63 23.52 23.65 23.51 22.39 23.42 23.07 23.75 22.69 23.03 22.61 19.91 21.42 22.21 20.46 20.13 18.22 18.18 18.07 18.67 16.35 18.40 16.56 17.43 16.74

25.00 21.89 19.30 20.42 18.27 19.95 18.27 18.01 18.63 16.92 18.23 18.65 18.41 19.07 16.53 17.84 16.24 16.60 14.93 16.14 18.71 14.54 13.72 14.95 13.35 15.95 13.49 14.59 13.71 15.45 14.20 13.70 12.31 10.85

10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 9.50 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 9.87 10.00 10.00 9.76 9.98 10.00 9.64 9.95 9.74 5.66 9.79

Debt in default or rescheduled

Credit ratings

10

10

10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00

10.00 10.00 10.00 10.00 10.00 9.79 10.00 10.00 10.00 10.00 9.69 9.38 9.58 9.58 9.79 8.75 9.17 9.17 9.38 8.44 8.54 9.38 8.75 8.75 6.25 7.08 7.50 6.88 8.96 6.67 7.08 6.88 7.29 4.38

ANNEX 4.3: COUNTRY RISK RATING Total score

Sep Mar Country 00 00 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81

34 35 40 36 41 42 39 43 44 45 48 49 54 37 47 51 46 75 50 52 55 53 57 60 58 67 59 66 56 65 64 62 69 63 61 70 68 71 76 73 74 78 77 90 85 84 88

Weighting:

Qatar Brunei Korea South Oman Chile Hungary Bahrain Poland Czech Republic Malaysia China Mexico Thailand Bahamas Mauritius South Africa Tunisia Barbados Uruguay Egypt Estonia Morocco Argentina Trinidad & Tobago India Costa Rica Latvia Slovak Republic Philippines Turkey Panama Botswana Brazil El Salvador Lithuania Croatia Colombia Fiji Guatemala Lebanon Jordan Venezuela Dominican Republic Jamaica Bolivia Bulgaria Kazakhstan

Political risk

Economic performance

Debt indicators

100

25

25

10

68.14 66.84 66.28 66.17 65.83 65.24 65.20 63.59 63.14 61.11 59.75 59.68 59.55 59.46 59.08 57.71 57.48 57.32 56.79 56.36 55.69 55.11 54.97 54.18 53.75 53.42 53.11 52.95 52.81 52.74 52.20 51.83 51.31 51.12 50.79 49.67 48.88 47.38 47.31 46.85 46.32 43.85 43.84 42.70 42.52 42.51 42.56

16.10 16.40 17.50 15.57 18.24 17.06 15.22 16.56 17.11 15.86 15.64 15.68 14.89 16.50 14.16 13.85 13.87 15.62 14.19 14.48 13.85 12.76 12.81 14.10 13.79 13.07 12.84 12.86 13.23 14.07 12.02 15.14 12.49 10.98 12.54 11.69 11.26 10.12 9.77 10.33 11.22 10.71 10.25 7.73 8.54 10.46 9.28

12.20 18.44 12.43 10.27 10.39 10.78 10.56 9.92 9.96 10.08 9.46 9.28 8.55 6.03 11.44 9.51 10.00 10.71 9.41 9.21 9.31 9.27 9.58 10.95 7.90 10.88 8.56 8.57 7.61 8.54 9.34 9.93 8.66 9.63 8.28 8.49 7.13 9.18 8.84 7.29 7.96 6.85 8.81 8.76 7.10 6.69 6.65

8.50 10.00 9.05 9.49 8.67 8.35 10.00 9.26 8.94 8.88 9.58 8.81 8.44 10.00 8.90 9.41 8.80 9.43 8.83 9.19 9.61 8.55 7.68 9.10 9.11 9.20 9.62 8.76 8.75 8.74 8.54 9.82 7.51 9.29 9.49 9.14 8.64 9.68 9.33 8.62 7.56 8.72 9.45 8.74 8.08 8.23 9.21

Debt in default or rescheduled

Credit ratings

10

10

10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 9.90 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 9.96 10.00 10.00 7.67 10.00 10.00 10.00 10.00 8.49 10.00 9.19 10.00 10.00 10.00 10.00

5.31 0.00 5.83 5.00 6.88 6.04 3.75 6.25 6.46 5.42 5.83 4.58 4.79 5.31 5.00 4.79 5.21 6.56 4.79 4.79 5.63 4.38 3.13 5.00 3.96 3.54 5.42 4.38 4.38 2.08 4.38 0.00 2.29 4.58 3.96 4.58 3.96 3.75 3.13 2.50 3.44 1.67 1.25 2.19 2.81 1.88 2.29

193

CROSS-BORDER EXPOSURES AND COUNTRY RISK Total score

Sep Mar Country 00 00 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 114 115 116 117 118 119 120 121

86 80 82 79 91 94 125 92 93 116 136 115 87 133 99 72 89 102 120 83 103 107 100 98 118 110 95 96 164 137 101 112 105 134 97 81 131 106 123 114

122 123 124 125 126 127

108 129 119 132 109 147

194

Weighting:

Paraguay Iran Belize Sri Lanka Seychelles Macau Maldives Peru Syria Honduras Dominica Indonesia Vietnam Russia Algeria Ghana Kenya Gambia Macedonia (FYR) Papua New Guinea Azerbaijan Romania Lesotho St Lucia Kyrgyz Republic Equatorial Guinea Bangladesh Senagal Uzbekistan Yemen Uganda Zimbabwe Cape Verde Ukraine Gabon Swaziland Cambodia Nepal CoÃte d'Ivoire St Vincent & the Grenadines Nigeria Pakistan Burkina Faso Turkmenistan Malawi Samoa

Political risk

Economic performance

Debt indicators

Debt in default or rescheduled

Credit ratings

100

25

25

10

10

10

41.31 40.64 40.61 39.81 39.71 39.59 39.22 39.12 38.95 38.77 38.60 38.48 38.36 37.88 37.71 37.64 37.64 37.63 37.37 37.17 36.94 36.62 36.42 35.91 35.76 35.69 34.96 34.28 34.15 33.99 33.73 33.43 33.06 33.06 33.03 32.92 32.90 32.72 32.47 32.14

9.74 8.99 10.81 9.37 9.14 14.15 9.64 10.63 9.67 8.00 7.39 7.98 9.82 8.02 8.27 8.57 7.41 7.85 6.30 8.49 8.42 8.17 8.47 9.98 8.05 4.19 7.73 6.28 6.76 7.57 6.77 4.22 6.33 6.05 6.86 9.09 3.81 6.24 5.84 7.53

7.01 7.09 5.30 5.82 6.32 12.75 8.23 7.50 6.62 7.12 9.98 5.96 6.01 6.65 6.77 6.61 7.37 7.67 7.67 5.33 6.72 5.32 6.74 4.57 8.13 9.88 5.48 7.03 6.35 5.86 6.68 5.04 4.95 5.68 8.42 8.96 9.40 5.38 6.56 4.27

9.45 9.25 8.82 9.08 9.14 0.00 9.03 9.15 7.96 8.13 9.08 6.65 8.64 8.62 7.94 7.92 8.61 9.43 8.18 8.74 9.22 8.89 8.54 8.69 8.59 8.93 9.24 8.22 9.43 8.38 8.95 7.88 8.89 9.26 8.42 0.00 8.80 8.96 7.29 7.70

10.00 10.00 10.00 10.00 10.00 0.00 10.00 1.25 10.00 10.00 10.00 8.65 9.96 8.26 8.90 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 9.95 7.72 10.00 10.00 9.61 8.26 10.00 10.00 10.00 8.70 10.00

1.88 1.25 3.13 0.00 0.00 5.63 0.00 3.33 0.00 1.25 0.00 0.63 1.88 0.42 0.00 0.00 0.00 0.00 0.00 2.29 0.00 0.83 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

32.09 31.99 31.95 31.81 31.66 31.28

4.88 6.36 6.27 5.98 4.99 7.75

6.20 4.87 4.65 5.96 5.55 0.87

8.48 8.61 8.85 7.32 7.73 8.52

10.00 10.00 10.00 10.00 10.00 10.00

0.00 0.94 0.00 0.94 0.00 0.00

ANNEX 4.3: COUNTRY RISK RATING Total score

Sep Mar Country 00 00 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 151 152 153 154 155 156

130 140 139 144 121 155 135 146 127 126 117 153 142 113 145 111 157 141 152 104 150 149 138 122 171 158 154 124 -

157 156 158 159 160 161 162 163 164 165

168 148 128 163 143 176 162 161

166 167 168 169 170 171

159 151 167 166

Weighting:

Ethiopia Belarus Mongolia Armenia Grenada Georgia Solomon Islands Albania Vanuatu Cameroon Madagascar Ecuador Moldova Tanzania Mozambique Togo Bhutan Benin Guyana Mali Chad Mauritania Zambia Guinea Myanmar Nicaragua Sudan Nigeria Micronesia (Fed. States) Central African Republic Djibouti Haiti Tonga Laos Namibia Surinam Sierra Leone Dem. Rep. Of the Congo (Zaire) Eritrea Congo Rwanda Angola Burundi Guinea-Bissau

Political risk

Economic performance

Debt indicators

Debt in default or rescheduled

Credit ratings

100

25

25

10

10

10

30.95 30.74 30.64 30.47 30.41 30.40 30.39 30.38 30.02 29.74 29.48 29.28 29.24 28.89 28.63 28.63 28.53 28.51 28.27 28.15 27.79 27.19 27.04 26.77 26.35 26.34 25.45 25.43 25.24

4.79 5.77 6.10 6.22 8.09 4.19 6.86 5.40 6.19 5.64 3.90 3.90 4.90 4.96 4.60 5.46 6.19 4.00 6.69 4.66 3.04 3.52 3.86 5.02 5.03 4.71 2.41 2.67 13.06

7.62 3.24 3.68 3.44 1.46 6.05 0.79 4.56 0.92 5.52 5.66 5.34 2.42 6.12 5.48 3.61 0.71 3.69 3.79 3.52 3.51 5.33 6.35 3.19 3.24 5.76 3.33 3.17 0.93

7.41 9.82 8.71 8.91 8.71 9.26 9.25 9.49 9.58 7.73 7.87 7.94 8.37 6.63 6.31 7.69 9.22 8.64 6.10 8.02 8.73 5.66 6.57 8.04 7.19 4.29 8.82 8.26 0.00

9.80 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 7.72 9.37 10.00 10.00 8.79 8.84 9.19 10.00 10.00 10.00 9.99 9.82 10.00 9.32 9.62 10.00 8.72 10.00 9.89 10.00

0.00 0.00 1.25 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.94 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1.25 0.00 0.00 0.00

25.13

2.86

4.27

8.11

9.00

0.00

24.63 24.32 24.01 23.99 23.65 23.11 23.06 22.87

3.30 2.71 8.64 6.06 10.29 7.36 2.62 2.35

0.91 0.69 1.06 0.00 7.58 3.22 2.96 2.61

9.17 9.40 0.00 7.04 0.00 0.00 6.62 7.01

10.00 10.00 10.00 10.00 0.00 10.00 9.97 10.00

0.00 0.00 0.00 0.00 0.00 1.25 0.00 0.00

22.18 22.03 21.13 20.97 20.81 20.04

1.33 3.66 1.52 3.30 2.29 4.19

0.64 3.44 0.77 3.29 0.62 2.56

9.31 5.75 9.55 4.44 7.01 2.47

10.00 9.19 8.40 8.42 10.00 9.93

0.00 0.00 0.00 0.00 0.00 0.00

195

CROSS-BORDER EXPOSURES AND COUNTRY RISK Total score

Sep Mar Country 00 00 172 173 174 175 176 177 178 179 180

165 174 169 172 160 173 175

181 182 183 184 185

170 177 178 179 180

Weighting:

New Caledonia Marshall Islands Antigua & Barbuda Libya Tajikistan Sao Tome & Principe Bosnia-Herzegovina Liberia Yugoslavia (Fed. Republic) Somalia Cuba Iraq Korea North Afghanistan

Political risk

Economic performance

Debt indicators

Debt in default or rescheduled

Credit ratings

100

25

25

10

10

10

19.96 19.44 19.43 19.30 17.76 16.67 15.82 15.30 14.81

12.86 12.19 4.61 9.20 3.09 2.41 3.38 3.91 1.99

3.67 1.00 2.87 8.19 4.42 0.65 3.25 0.85 1.73

0.00 0.00 0.00 0.00 8.99 0.00 8.16 0.00 0.00

0.00 0.00 10.00 0.00 0.00 10.00 0.00 10.00 10.00

0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

14.76 10.67 9.04 4.72 2.81

2.29 3.80 2.36 2.98 0.00

0.74 5.81 5.80 0.85 1.56

0.00 0.00 0.00 0.00 0.00

10.00 0.00 0.00 0.00 0.00

0.00 0.00 0.00 0.00 0.00

Methodology To obtain the overall country risk score, Euromoney assigns a weighting to the nine categories listed below. The best underlying value per category achieves the full weighting (25, 10 or 5); the worst scores zero and all other values are calculated relative to these two. The formula used is the following: A± (A / (B7C)) 6 (D7C), where A = category weighting; B = lowest value* in range; C = highest value* in range, D = individual value. * NB for Debt indicators and Debt in default, B and C are reversed in the formula, as the lowest score receives the full weighting and the highest gets zero. . Political risk (25% weighting): the risk of non-payment or non-servicing of payment for goods or services, loans, trade-related finance and dividends, and the non-repatriation of capital. Risk analysts give each country a score between 10 and zero ± the higher, the better. This does not reflect the creditworthiness of individual counterparties. . Economic performance (25%): based (1) on GNP* figures per capita and (2) on results of Euromoney poll of economic projections, where each country's score is obtained from average projections for 1999 and 2000. The sum of these two factors, equally weighted, makes up this column ± the higher the result the better. . *GNP figures were unavailable for the following countries, so GDP data were used instead: Afghanistan, Antigua & Barbuda, Bahamas, Bahrain, Barbados, Bosnia-Herzegovina, Cuba, Cyprus, Djibouti, Iraq, North Korea, Kuwait, Liberia, Libya, Macau, Myanmar, New Caledonia, Oman, Qatar, Singapore, Somalia. . Debt indicators (10%): calculated using these ratios from the World Bank's Global Development Finance 2000: total debt stocks to GNP (A), debt service to exports (B); current account balance to GNP (C). Scores are calculated as follows: A + (B x 2) ± (C x10). The lower this score, the better. Figures are for 1998.

196

ANNEX 4.3: COUNTRY RISK RATING

. Because of lack of consistent economic data for OECD and rich oil-producing countries, these score the full weighting, except where they report debt figures to the IMF. . Developing countries which do not report complete debt data get zero. . Debt in default or rescheduled (10%): scores are based on the ratio of rescheduled debt to debt stocks, taken from the World Bank's Global Development Finance 2000. OECD and developing countries which do not report under the debtor reporting system (DRS) score 10 and zero respectively. . Credit ratings (10%): nominal values are assigned to sovereign ratings from Moody's, S&P and Fitch IBCA. The higher the average value, the better. Where there is no rating, countries score zero. . Access to bank finance (5%): calculated from disbursements of private, long-term, unguaranteed loans as a percentage of GNP. OECD and developing countries not reporting under the DRS score five and zero respectively. Source: the World Bank's Global Development Finance 2000. . Access to short-term finance (5%): takes into account OECD consensus groups (source: ECGD) and short-term cover available from the US Exim Bank and NCM UK. . Access to capital markets (5%): heads of debt syndicate and loan syndications rated each country's accessibility to international markets at the time of the survey. The higher the average rating out of 10, the better. . Discount on forfeiting (5%): reflects the average maximum tenor for forfeiting and the average spread over riskless countries such as the USA. The higher the score, the better. Countries where forfeiting is not available score zero. Data were supplied by Deutsche Bank, Standard Bank and WestLB. Source: Euromoney, September 2000.

197

Annex 5: Alternative exchange rate regimes Regime

Main features

Main benefits

Main shortcomings

1 Free float

± Value of foreign exchange freely determined in the market. Actual and expected changes in demand/supply of assets and goods reflected in exchange rate changes.

± Changes in nominal exchange rate shoulder bulk of adjustment to foreign and domestic shocks. ± High international reserves not required.

± High nominal (and real) exchange rate volatility may distort resource allocation. ± Monetary policy needs to be framed in terms of nominal anchors different from the exchange rate; scope for discretion and inflation bias may be large.

2 Floating with a `feedback rule'

± Indirect intervention (through changes in interest rates, liquidity and other financial instruments) does not result in changes in reserves.

± Same as in a free float, except that higher international reserves may be needed. ± Dampens `excessive' fluctuations of exchange rates.

± Lack of transparency of central bank behaviour may introduce too much uncertainty. ± Effects of intervention may not last and may be destabilizing.

3 `Dirty' or managed float

± Sporadic central bank interventions in foreign exchange market. Modes and frequency of intervention vary, as do the objectives guiding the intervention. ± Active intervention (sterilized and non-sterilized) results in changes in international reserves.

± Same as in a free float except that higher international reserves may be needed. ± Dampens `excessive' fluctuations of exchange rates.

± Lack of transparency of central bank behaviour may introduce too much uncertainty. ± Effects of intervention are typically short-lived (even when intended as a signal) and may be destabilizing.

4 Floating within a band (Target zone)

± The nominal exchange rate is allowed to fluctuate (somewhat freely) within a band. The center of the band is a fixed rate, either in terms of one currency or of a basket of currencies. The width of the band varies (in the ERM it was originally‹ 2.25 (percent). ± Some band systems are the result of cooperative arrangements, others are unilateral.

± System combines the benefits of some flexibility with some credibility. ± Key parameters (bands, mid-point) help guide the public's expectations. ± Changes in the nominal rate within the bands help absorb shocks to fundamentals.

± In some cases (especially when the band is too narrow and when domestic macro policies are not consistent with a `horizontal' band) the system can be destabilizing and prone to speculative attacks. ± Selecting the width of the band is not trivial. ± Systems that allow for the possibility of realignment of the bands and central parity weaken the credibility afforded by the regime.

198

ANNEX 5: ALTERNATIVE EXCHANGE RATE REGIMES

Regime

Main features

Main benefits

Main shortcomings

5 Sliding band

± There is no commitment by the authorities to maintain the central parity `indefinitely'. Instead, it is clear at the outset that the central parity will be adjusted periodically (e.g., due to competitiveness considerations). ± The system is an adaptation of the band regime to the case of high-inflation economies.

± The system allows countries with an ongoing rate of inflation higher than world inflation to adopt a band without having to experience a severe real appreciation.

± The fact that the timing and size of central parity adjustments are unknown, introduces considerable uncertainty, which often leads to high interest rate volatility. ± As in the case of the standard band system, it is difficult to choose the appropriate width for the band.

6 Crawling band

± A band system whereby the central parity crawls over time. ± Different rules can be used to determine the rate of crawl. The two most common are: backwardlooking crawl (e.g., based on past inflation differentials), and forward-looking crawl (e.g., based on the expected, or target, rate of inflation.

± System allows high inflation countries to adopt a band system without having to undertake (large) stepwise adjustments of the central parity.

± Choosing the criteria for setting the rate of crawl entails serious risks. A backward-looking approach can introduce considerable inflationary inertia into the system. A forward-looking approach that sets the `wrong' inflation target can produce overvaluation and give rise to speculative pressures.

7 Crawling peg

± The nominal exchange rate is adjusted periodically according to a set of indicators (usually lagged inflation differentials) and is not allowed to fluctuate beyond a narrow range (say, two percent). ± One variant of the system consists of adjusting the nominal rate by a pre-announced rate set deliberately below ongoing inflation (variant known as a `tablita' regime).

± Allows high-inflation countries to avoid severe real exchange rate overvaluation. ± The `tablita' variant helps to guide the public's expectations, and buys a limited amount of credibility.

± A pure backward-looking crawling peg (where the nominal rate is mechanically adjusted according to past inflation differentials) introduces inflationary inertia and may eventually cause monetary policy to lose its role as nominal anchor. ± Equilibrium changes in the real exchange rate are difficult to accommodate. ± A `tablita' system will not last if fiscal and incomes policies are not supportive.

8 Fixed-butadjustable exchange rate

± The regime optimized by the Bretton Woods system. The nominal exchange rate is fixed, but the central bank is not obliged to maintain the parity indefinitely. No tight contraints are imposed on the monetary and fiscal authorities, who can follow, if they so decide, policies that are inconsistent with preserving the parity. ± Adjustments of the parity (devaluations) are a powerful policy instrument.

± Provides macroeonomic discipline by maintaining (tradable good prices) in line with foreign prices in a context of relatively low uncertainty. ± The built-in `escape clause' (which allows the authorities to devalue in case of need) provides the system with some flexibility.

± Realignments (devaluations) under this system have typically been large and disruptive (introducing uncertainty and inflationary pressures) rather than smooth and orderly events. ± If supplemented by the right institutions (e.g., an independent central bank) the time inconsistency problems embedded in the system could be attenuated.

199

CROSS-BORDER EXPOSURES AND COUNTRY RISK

Regime

Main features

Main benefits

Main shortcomings

9 Currency board

± Strict fixed exchange rate system, with institutional (legal, and even constitutional) constraints on monetary policy and no scope for altering the parity. ± The monetary authority only can issue domestic money when it is fully backed by inflows of foreign exchange.

± The system maximizes credibility and reduces (eliminates) problems of `time inconsistency'.

± The system is long on credibility but short on flexiblity. Large external shocks cannot be accommodated through exchange rate changes but have to be fully absorbed by changes in unemployment and economic activity. ± The central bank loses its role as lender of last resort.

10 Full dollarization

± Generic name given to an extreme form of a currency board system where the country gives up completely its monetary autonomy by adopting another country's currency.

± Credibility is maximized under this regime. Monetary authorities have, in theory, no scope for `surprising' the public.

± As in the currency board, the system is long on credibility but short on flexibility. Adverse external shocks have to be absorbed fully by the real economy. ± The central bank loses its role as lender of last resort. ± A non-trivial shortcoming of this system is that it is usually resisted on political and nationalistic grounds. Another one, is that the rules of the game can be changed under extreme circumstances.

Source: Exchange Rate Systems in Emerging Markets Economies by Sebastian Edwards, University of California and the National Bureau of Economic Research, third draft, 1 January 2000, pp. 59±61.

200

Index adjustment lending 151±2 African Development Bank 36 aggregated country limit structure 105±6 aid 33 alternative exchange rate regimes 199±201 American depository receipts (ADR) 19 APRA Plan 3 Argentina vii±viii, 7, 127 `Arrangement on Guidelines for Officially Supported Export Finance' 35±6 Asian Development Bank 36 Asian financial crisis 8±11, 62 asset allocation 125 AUSTRAL Plan 2 B-loans 103, 154 Banamex 6 Bangladesh 50 Bank for International Settlements 9, 55 banking reforms 31, 39 banking regulation 162±3 Basle Committee on Banking Supervision 162, 163±4, 176 Bayesian decision analysis 84 BERI (Business Environment Risk Intelligence) ratings and system 119±21 Bern Union 35 Bolivia 3 bonds 17 Aztec 4 IANs 13 PRINs 13 borrowers 25±7 Brady bonds 5, 7, 38, 73 Brady Plan 4±5 Brazil 1, 3, 7, 12, 31, 64 breach of contract 115 Bretton Woods Institutions (BWI) 8, 33, 128, 132, 162 bridge loans 12 Buffer Stock Financing Facility 140 Bundesbank 47 Business Risk Service (BRS) 119±20 buyback scheme 3

capital adequacy requirements 9, 164±5 capital controls 46 capital needs 28±30, 39, 170±71 Central Bank of Thailand 9 central banks 47, 117 Chile 3 Citibank 3 co-financing 116±17 COFACE (French insurance organization) 116 combined index 91 commercial banks 17 commercial debt 44 commercial interest reference rate (CIRR) 36 Compensatory Financing Facility 140 Comprehensive Development Framework (CDF) 150 compressibility ratio 66 concessional funds 52±3 conditionality 142±3 conflicts 80 constitutional environment 76 contagion 118±19, 141, 174 Contingent Credit Lines (CCL) 141, 147 Core Principles for Effective Banking Supervision (BIS) 162, 163, 164 Corporation Andina de Formento 36±7 corruption 79 country limit 95±107, 130 country risk 14, 22, 42±3, 50, 160 assessment 172±3 intensity 101±2 quality 111±14 country risk rating 185±8, 189±93, 193±8 Country Risk Service (CRS) 123 crawling peg regimes 46 credit guarantees 96±7 credit risk 44, 50±51 cross-border foreign exchange flows 45±50 cross-border funds 32±9, (use) 47±8 cross-border liabilities 56 CRUZADO Plan 2 currency inconveritibility 115 current account balance/GNP ratio 64±5

201

INDEX

debt exchange 4 debt reduction 3 debt service 54 capability 69, 70 ratio 57±9, 61 debt/equity swap 3 debt/GNP ratio 59 Delphi technique 84 demographic structure 24, 78±9 derivative exposures 104 deteriorating situations 112±13 developing countries x, 2, 159±63, 175±6, (resource flows) 15 Development Assistance Committee (DAC) 25, 37 direct country risk 102±3 direct cross-border exposure 96 dirty floating 46 discriminating acts 80 domestic funds 30±31 economic policies 45 Economist Intelligence Unit (EIU) 122±3 Ecuador 7 effective exposure 109±11 emerging markets 171, (debt securities) 4, (derivative counterparties) 51 Enhanced Structural Adjustment Facility (ESAF) 142 ethnic and religious differences 79 Eurobonds 13 Euromarket 52 Euromoney 124, 193±8 European Bank for Reconstruction and Development (EBRD) 8, 36 European Exchange Rate Mechanism (EMS) 161 European Union 8 Ex Ante Guidance on Tied Aid 35 exchange rates 46±7, 160±61 Export Credit Agencies (ECAs) 33, 34, 35, 36 Export Credit Guarantee Department (ECGD) 33, 116 Export Development Corporation of Canada (EDC) 34 Export Insurance Department (EID) (Japan) 34 Export-Import Bank 34 Export-Import Bank of Japan 34 expropriation 115 Extended Fund Facility (EFF) 139±40 external debt 53±6

202

Federal Reserve Bank of New York 128 financial services industry (in developing countries) 161±2, (regulation) 163 Financial Supervisory Commission (Korea) 11 Fitch IBCA 125 FLIRB (front loaded interest reduction bonds) 5 foreign currency funds 50±53 foreign direct investment (FDI) 16±17, 38, 56, 118 Foreign Investment Advisory Services (FIAS) 154 FORELEND system 120±21 former Comecom block 7±8 Fundo Bancario de ProteccõÁ on al Ahorro (FOBAPROA) 6 G3 158 G10 164 G24161 163 GDP 28, 30 General Agreement on Tariffs and Trade (GATT) 48 General Agreement to Borrow (GAB) 136±7 General Agreement on Trade in Service (GATS) 48 Gini index 78 global depository receipts (GDR) 19 Global Development Finance (World Bank) 10, 16, 37, 55, 59 globalization 23 GNP 70, 86 government policy response 10 government quality 77 gross domestic investment 27±8, 30 growth-of-export ratio 65±6 Gulf War 80 heavily indebted poor countries (HIPC) 142, 148, 171 hedging of country risk 94±131, 173 Helsinki package 35 HERMES (German credit guarantee organisation) 34 Horioka, Charles 29 Howell, L.D. 119

13±14,

IBRD (World Bank) 133, 151±2 ICERC (Interagency Country Exposure Review Committee) ratings 108 IMF (International Monetary Fund) vii-viii, 3, 6, 12, 13, 33, 49, 56, 63, 64, 74, 99, 133±48, 158, 174±5

INDEX

IMF, cont. articles of agreement 180±82 financial assistance programmes 139 impairment 94±5, 117 imports 34, 63 India 77 indirect country risk 104 indirect cross-border exposure 96 Indonesian Bank Restructuring Agency (IBRA) 11 industrialized countries 158±9 inflation 45±6 infrastructure projects 25±6, 29, 30 Initial Public Offerings (IPOs) 20, 38 Institute of International Finance, Inc (IIF) 123±4, 164 Institutional Investor 124, 189±92 Inter-American Bank for Development 22, 36 inter-bank market 97 interest service ratio 60±61 International Banking Facility (Thailand) 10 International Capital Markets 145 International Centre for Settlement of Investment Disputes (ICSID) 156 `international competitiveness' 44±5 International Country Risk Guide (ICRG) 121±2, 185±8 international debt market 17 International Development Association (IDA) 53, 152±3 International Development Goals 150 International Finance Corporation (IFC) 26, 36, 153±5 international financial institutions 33 international financial markets 49±50 international financial system 132 `investment grade' 127±8 investments 104 involuntary lending 3 Japan 8, 9 Japan Bank for International Cooperation (JBIC) 34, 116 JP Morgan 4 key factor analysis 84 Knaepen Package 35 Korea 9, 10, 11, 118, 147, 166 Korea Asset Management Company (KAMCO) 11 late payments

64

Latin America 1±3, 101 LDC (less developed countries) debt 3 lending 103 liquidity 52, 71±3 liquidity gap ratio 63±4 liquidity ratios (Acid test or quick ratio) logit analysis 74 London Club 74, 94

61±2

Malaysia 11 market conditions 52 matrix solution 91 maturity profiles 104±5 Mercosur 48 Mexico 1, 4, 5±7, 49, 62, 65±6, 76, 118, 166 Minfins (domestic dollar-denominated debt issued by Ministry of Finance) 13 monitoring cross border exposures ix, 94±131 Moody's Investor Services 125 multilateral financial institutions 36±7, 39, 98 Multilateral Investment Guarantee Agency (MIGA) 75, 114±15, 155±6 multivariate analysis 84 MYRA (multi-year rescheduling agreements) 2 name lending 10 natural catastrophes 50 natural resources 49 New Agreement to Borrow (NAB) 137, 138 non-governmental organizations (NGOs) 22, 39 non-performing assets 11 OECD 25, 29, 35, 36, 37, 98 official aid 37±8 official cross border financing 33±4 `Official Development Assistance' (ODA) 37±8 official development finance 20±22 offshore financial centres 148 oil 49, 140 Organization of Petroleum Exporting Countries (OPEC) 49 outsourcing risk assessment 119±24 overall index 90 Overseas Economic Cooperation Fund, Japan (OECF) 34 Overseas Investment Insurance (OII) cover 116 Overseas Private Investment Corporation (OPIC) 75±6, 115±16 Pakistan 77 Paris Club 2, 4, 13, 94, 142

203

INDEX

payment delays 53 pension funds 29±30, 31, 39 Peru viii, 3 policy decisions 99±100 Policy of Enlarged Access to Fund Resource (EAR) 137 political instability 75 political parties 76 political risk 42, 43, 74±93, 171, 172 assessment methods 80±88 relating to transfer risk 90±93 political score sheet 88, 89 portfolio equity flow 19±20 poverty 149±50 Poverty Reduction and Growth Facility (PRGF) 139, 142 private capital 38±9 private participation in infrastructure (PPI) 26 privatization 16, 26±7, 29, 32 Programmes of Targeted Intervention (PTIs) 152 project financing 103 project financing understanding 36 Public Information Notice (PIN) 144, 146 public service projects 25±6, 29, 30, 32 rating agencies 125±30, 165±6 refinancing 117±18, 173±4 reforms 144 regional multilateral financial institutions 157±8 regulators 163±6, 176 rescheduling 2, 68±9, 94 reserves 55, 64 reserves/imports ratio 62±3 risk assessment 100±101 Russia 1, 8, 12±13, 24, 53, 74 Schaerer package 35 selling of assets 113 short term funds 18, 163 short term trade finance 103 social structures 77±8 solvency aspect 68±71 sovereign ratings 126±7, 128, 183±4

204

sovereign risk 4, 50 Special Data Dissemination Standard (SDDS) 144, 145 special drawing rights (SDRs) 133±4, 135, 136 Specific Investment Loans (LILs) 151 spread analysis 73 Standard & Poor's 125 Standby Agreement (SBA) 139±40 statistical techniques 74 stock exchanges 154±5 structural reform plans 4 supervision of financial institutions 9±10 Supplemental Reserve Facility (SRF) 141 Supplementary Financing Facility (SFF) 137 sustainable development 25 Swedish Export Guarantee Board (EKN) 34 syndicated loans 1±2 Technical Assistance Trust Funds Programme 154 Tequila Crisis 5±7, 118 terms of trade and services 48 Thailand 8±9, 10, 11 trade wars 48 transfer restriction 115 transfer risk 42, 43±74, 171±2 assessment 66±74 indicators 56±66 relating to political risk 90±93 transitional countries 7±8, 31 Turkey viii, 50 value at risk method 104 Venezuela 7, 127 Vnesheconombank 13 Wall Street 52 war and civil disturbance 115, 116 World Bank Group 10, 16, 22, 27, 29, 36, 114, 149±57, 175 World Development Indicators (World Bank) 25, 27±8, 30, 38 World Economic Review (IMF) 145 World Trade Organization (WTO) 48, 159