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(1)City University of New York (CUNY). CUNY Academic Works Dissertations, Theses, and Capstone Projects. CUNY Graduate Center. 1985. Analyzing Country Risk: Estimating the Probability of External Debt Repudiation in the Post-Oil-Embargo Decade Thomas Joseph Webster Graduate Center, City University of New York. How does access to this work benefit you? Let us know! More information about this work at: https://academicworks.cuny.edu/gc_etds/1756 Discover additional works at: https://academicworks.cuny.edu This work is made publicly available by the City University of New York (CUNY). Contact: [email protected].

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(4) 8601701. W e b s te r, T h o m as J .. ANALYZING C OUNTRY RISK: ESTIMATING THE PROBABILITY OF EXTERNAL DEBT REPUDIATION IN THE POST-OIL-EMBARGO DECADE. City U niversity o f New York. University Microfilms International. Ph.D.. 300 N. Zeeb Road, Ann Arbor, Ml 48106. Copyright 1985 by Webster, Thomas J. All Rights Reserved. 1985.

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(8) ANALYZING COUNTRY RISK: Estimating the Probability of External Debt Repudiation in the Post-Oil-Embargo Decade by Thomas J. Webster. A dissertation submitted to the Graduate Faculty in Economics in partial fulfillment of the requirements for the degree of Doctor of Philosophy, The City University of New York..

(9) C O P Y R I G H T BY THOM A S JOS E P H W E B S T E R 1985.

(10) This manuscript has been read and accepted for the Graduate Faculty in Economics in satisfaction of the dissertation requirement for the degree of Doctor of Philosophy.. [signature] date. Professor Michael Edelstein Chairman of Examining Committee. [signature] date. Professor Michael Grossman Executive Officer. Economics. Professor Michael Edelstein Professor Michael Grossman Professor Salih Neftci. Supervisory Committee. The City University of New York.

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(12) ABSTRACT ANALYZING COUNTRY RISK: Estimating the Probability of External Debt Repudiation in the Post-Oil-Embargo Decade by Thomas J. Webster. Advisor:. Professor Michael Edelstein. This dissertation examines the use of logit analysis a. tool. for assessing the likelihood that a. cannot,. economic,. the. as or. a. result. financial. into two parts.. topic. of. of. adverse. political,. disruptions.. The. social,. discussion. assessing the likelihood. of. debt. international bank lending activities by U.S.. banks, deot. is. Part one is devoted to a review of servicing. difficulties by borrower nations by first tracing the of. risk. or will not, adhere to the terms of its foreign debt. obligations. divided. sovereign. as. growth. commercial. followed by a general discussion of the international crisis and a brief survey of some of. approaches. employed. assess. overseas. survey. of. by many international. lending risk.. a variety. the. of. social,. conventional. institutions. Part one continues with economic,. and. to a. political. considerations. incorporated into the risk evaluation process. and. with a discussion of how. concludes. integrated. into. the. microeconomics of. lending.. v. these. factors. international. are bank.

(13) Part two of this study discusses specifically the use of logit. analysis as a tool for evaluating country. alternative. sub-set data specifications.. review. the. of. econometric. major. techniques. empirical for. under. It begins with. studies. predicting. risk. on. the. the. use. incidence. a of of. foreign debt repudiations followed by an investigation of the rescheduling "shock" expand. in. process 1973-74.. subsequent. to. the. first. oil. price. The analysis attempts to improve. upon the work of others by specifically addressing. and a. variety of empirical and theoretical deficiencies present. in. earlier. of. studies.. The paper concludes with a discussion. the possible presence of dynamic elements in the rescheduling process. which. may. ultimately. help to. predictive performance of the logit model.. improve. upon. the.

(14) ACKNOWLEDGEMENTS In any e n d e a v o r of this n a t u r e it is e x t r e m e l y d i f f i c u l t to m e n t i o n final. everyone. result.. There. who. had. are. always. who st a n d out a b o v e the my gratitude. a hand. rest.. to P r o f essor. paper,. not. examination office. with. of. to. Michael. the. mention. whom. I have. appreciation econo m e t r i c s . gratitude. bringing. about. individuals, first. l ik e. the. h o wever,. to e x p r e s s. E d e l s t e i n for his v a l u a b l e. the m o s t. his. numerous. I would also. few. I would. a d v i c e a n d g u i d a n c e in s o m e o f this. a. in. crucial. tireless. drafts. which. and. aspects. of. expeditious. flowed. into. his. l i k e to t h a n k p r o f e s s o r S a l i h N e f t c i. acquired. a. deeper. understanding. and. for t h e s u b t l e t i e s of t h e o r e t i c a l a n d a p p l i e d Finally,. to P r o f e s s o r. I would. l ike to exp r e s s m y h e a r t f e l t. Michael. Gross ma n whose support. confidence saw me through these. last. and. f e w y e a r s of g r a d u a t e. s t u d y and w i t h o u t w h o s e t u t e l a g e n o n e of this w o u l d h a v e b een possible.. In c l o s i n g. all. f a c u l t y and s t u d e n t s at the G r a d u a t e C e n t e r. of. making. the the. enjoyable.. last. few. I would. years. be. remiss. among. my. if I d i d n o t. most. fruitful. thank for and.

(15) Table of Contents. Page. Abstract....................... v. Acknowledgements......................................... vi i List of Tables.............................................ix List of Appendices......................................... x Preface.................................................... 1 PART I: An Overview............... 5 Chapter 1.................................................. 5 Introduction......... 5 Historical Background....................................9 The LDC Debt Crisis.................................... 13 Recent Concern About the Risk of Overseas Lending...... 18 Chapter 2 ................................................. 22 Distinguishing Aspects of International BankLending....22 The Nature of Country Risk............................. 23 The International Credit Market and Credit Rationing....26 Conventional Approaches to Assessing Country Risk...... 38 Chapter 3..................................................41 Assessing Country Risk................................. 41 Economic Indicators.....................................42 Commerical Indicators...................................45 Political and Social Indicators........................ 48 Illustrative Methods for Comparing Country Risk........ 53 The Linkage Between Risk Assessment and A Bank's Loan Portfolio...................................... 57 Long-Term Risk Assessment.............................. 58 Minimizing Country Risk................................ 60 PART II: The Application of Logit Analysis to the Assessment of Country Risk............................. 64 Chapter 4..................................................64 Introduction............................................64 Review of Principal Studies............................ 67 Chapter 5..................................................64 A Logit Model of Debt Rescheduling: An Empirical Investigation........................................64 The Model...............................................86 Data.................. 93 A Note on the Selection of the "Critical Value"........ 98 Results................................................3.02 All Debtors............................................103 Large Debtors versus Small Debtors.................... 110 Large Debtors/Small Debtors - Latin America........... 121 viii.

(16) Chapter 6................ Sunmary and Conclusions. 127 127. Footnotes......... 141. Bibliography...... ,...... . .. 243. List of Tables Table 1.. Table 2. Table 3. Table 4. Table 5. Table 6. Table 7. Table 8. Table 9. Table 10. Table 11. Table 12.. Table 13. Table 14. Table 15. Table 16. Table 17. Table 18. Table 19.. Page. Exposure of U.S. Banks in Eastern Europe and Non-Oil Developing Countries Relative to Capital..................... 202 Exposure as a Percentage of Capital, Major Banks, end-19b2............................... 203 Debt Ratios for All Developing Countries and Ten Largest Debtors........................... 204 Total External Debt Ten Largest Debtors....... 205 Indicators of External Debt, Non-Oil Developing Countries, 1973-82............................ 206 Impact of Higher Oil Prices on Debt of Non-Oil Developing Countries.................. 207 Impact of Exogenous Shocks on External Debt of Non-Oil Developing Countries............... 208 Financial Rescue Packages for Argentina, Brazil, Mexico, and Yugoslavia........................ 209 Matrix for Establishing Country Exposure Guidelines.................................... 210 Frank and Cline: Type I and Type II Errors Based Upon Discriminant Analysis Estimates.... 211 Feder and Just: Type I and Type II Errors Based Upon Logit Analysis Estimates........... 212 Saini and Bates: Type I and Type II Errors Based Upon Discriminant and Logit Analysis Estimates..................................... 213 Estimates of Cline's Logit Model of Debt Resched uling.................................. 215 Estimates of Cline's Logit Model of Debt Rescheduling: Large Debtor Sample............ 2.16 Debt Rescheduling Cases....................... 217 Countries Included in the Logit Analysis of Debt Rescheduling............................. 218 Estimates of the Logit Model of Debt Rescheduling: All Debtors................... 219 Correlation Matrix of the Explanatory Variables: All Debtors (DSR)................. 220 Correlation Matirx of the Explanatory Variables: All Debtors (NDX)................. 221 ix.

(17) Table Table Table Table Table Table Table Table Table Table Table Table Table Table Table Table Table. Table. Table Table Table. 20. Final Estimates of Logit Models IA and IB 222 21. Model IA Errors............................... 223 22. Model.IB Errors............................... 224 23. Final Estimates of Logit Models IAA and IBB....225 24. Final Estimates of Logit Models IAAA and IBBB..226 25. Final Estimates of Logit Models IIA and IIB Large Debtors................................. 227 26. Final Estimates of Logit Models IIIA and IIIB Snail Debtors................................. 228 27. Final Estimates of Logit Models IIAA and IIBB..229 28. Correlation Matrices of Significant Variables in Models IIAA and IIBB with Variable III 230 29. Final Estimates of Logit Models IIAAA and IIBBB......................................... 231 30. Correlation Matrices of Significant Variables in Models IIAAA and IIBBB with Variable III 232 31. Final Estimates of Logit Models IIIAAA and IIIBBB................... 233 32. Final Estimates of Logit Models IVA abd IVB Large Debtors - Latin America............. ....234 33. Final Estimates of Logit Models VA and VB Small Debtors - Latin America................. 235 34. Correlation Matrix of Significant Variables in Models IVA and IVB with Variable III....... 236 35. Summary Results............................... 237 36. Comparison of Type I and Type II Errors Among Models IA, IB, and IIA with Cline's Model's C, D, and L ........................... 238 37. Probability Intervals Associated with the Minimum Total Errors Rule for Predicting Debt Reschedulings............................ 239 38. Predicted Probabilities............. 240 39. Parameter Estimates of Equation 6.9 Sixteen Largest Debtors ■,..i 241 40. Final Parameter Estimates of Equation 6.9.... .242. List of Appendices Appendix I.. Structured Qualitative CountryEvaluation: Thailand................................. Appendix II. Selected Economic Indicators.............. Appendix III. Business International Checklist Appendix IV. Commercial Bank Checklist................ Appendix V. Diagrams.................................. Appendix VI. Tables..................................... x. 157 174 188 194 199 202.

(18) PREFACE Between working. for. States.. Chicago. where A. 1974. 19bl I. I. first. had. the. opportunity. years. in. is. the. later I held the. economist. banks. of these banks. was a loan officer. with. commercial banks.. Starting. position. system. international. New. financial. community.. in. U.S.. an. York since. banking. with the OPEC oil embargo in late. assumed ever increasing. the. of. the period. the subsequent quadrupling of oil prices the. banking. in. located. one of the largest. Coincidentally,. of. International. has been one of monumental change in the. industry. and. The. few. international based. and. two of the largest money center. United. Division.. 1974. 1973. commercial. importance. in. This has also. the. been. a. learning period for the major western banks, and has not been without its share of growing pains. Today crossroad. outstanding fundamental. the international financial community stands at a Massive loans. and. overseas. exposure. in. the. repayment problems are. reevaluation. of. the. enterprise in international lending.. basic. form. of. prompting. tenets. of. a. free. Not the least of these. concerns,. and one which has haunted commercial bankers since. the. 1970's,. late. is the evaluation of country risk. relates to present and future lending decisions.. as. it. This paper. is an attempt to focus on this issue and hopefully to provide.

(19) a. clearer. understanding. of. the issues. involved. and. the. dilensna currently facing economic policy makers. This. paper. considerations. will. examine a few. of. the. multitude. facing analysts when examining the. that a particular sovereign risk cannot, or will its. overseas obligations.. focus. on. default been. In particular,. liklihood. not,. honor. this paper. the use of logit analysis as a tool for. risk,. will. assessing. in spite of the fact that this technique. shown to suffer from a combination of. of. has. theoretical. practical. shortcomings.. Part one of this paper is. primarily. to a review of the general topic of assessing. and. devoted the. liklihood of debt servicing difficulties of borrower nations. Chapter. one. activities. discusses the growth of. by U.S.. involvement this. international. lending. commercial banks as veil as its. present. in the international debt crisis.. chapter. will. examine the genesis. of. In addition, the. prevailing. international debt crisis as well as its potential impact not only but. on the commercial banking its. takes. macroeconomic implications as. a. closer look at the subject. lending per se. working. system in the United. In particular,. definition. "country. risk". rescheduling. of. what. is. of. well.. Chapter. international. two bank. this chapter will provide a commonly. referred. and provides a theoretical paradigm. process.. States. to of. The chapter will close with a. as the. brief. discussion of seme of the conventional approaches employed by many. commercial. developing. a. banks. framework. to. assess. within. 2. country. which. to. risk. thereby. ascertain. the.

(20) likelihood lay. the. of a debt repudiation.. Chapter three will. foundation for the actual process of. then. country. risk. evaluation by first discussing a variety of social, economic, and. political. considerations,. considerations overseas. into. the microeconomics of. lending.. comprehensive. The. but. and then to integrate. discussion. these. commercial. is. by. no. is intended to provide a flavor. bank means. for. the. actual considerations employed in the lending process. Part. two. analysis. as. a. Specifically, which. is. in. the. this. tool logit. study discusses the. in the. evaluation. analysis. is an. use. of. of. logit. country. risk.. econometric. used for predicting the probability. valued event; default.". of. of. technique a. binary. in this case the incidence of "default" or "no. Chapter four reviews sane of the principal studies use. incidence. of econometric techniques. of. foreign. debt. reschedulings. employed since the early 1970's. empirical. investigation. for. of. predicting that. have. This. framework. under. purpose. of. performance international. analysis. debt reschedulings. will utilize the. alternative. which. data. logit. of. have price. analysis. specifications.. The. this procedure is to investigate the. predictive. of. the. the logit model in the light structural. of. major. shifts which have occurred in. advent of the developments of the early 1970's. number. been. Chapter five constitutes an. occurred since the OPEC oil embargo and subsequent oil "shocks.". the. the. After this a. innovations will be introduced in an. attempt. to. improve upon the model's descriptive and predictive accuracy. Chapter. six. will. summarize the results. 3. of. the. empirical.

(21) investigations presented in chapter five followed oy a discussion the. of. the possible presence of dynamic elements. rescheduling process which may improve upon the. predictive. orief. performance.. Chapter six will close. brief concluding remarks.. 4. in. model's. with. some.

(22) PART I: AN OVERVIEW. Chapter 1. Introduction During. the. course of the last two decades the. banking. industry in the United States has undergone many changes. these. the. most. significant. has. been. the. broadening. participation of large money center and regional in. overseas. foreign. activities.. In 1965,. U.S.. for example,. banking presence was represented by 13. operating. 211. billion.. By 1971,. overseas. overseas branches with assets. branches. there were 91 U.S. with. combined. billion.. Six. with. overseas branches and assets. 738. the. large. of. totalling. $9.1 583 $67.1. years later the number of oanks stood at 130, of. $259.0. billion,. four times the total overseas assets of. figure. equalled 22 percent of domestic bank assets and times. U.S. banks. only. almost. three. banks. oanks operating. assets. Of. the total equity capital. December. 3i,. 1983,. regional. commercial. billion,. more. of. total assets of U.S.. U.S.. 1971.. This over. banks.. By. money center. and. banks ballooned to a phenominal. $376.3. than 400 percent of the figure recorded just (1) eighteen years earlier. Several factors contributed to this trade, rapid. expansion.. The. tremendous. growth. of. international. full convertibility of most major currencies, and the overseas expansion of major U.S.. corporations in. 1960's which generated the need for a U.S.. 5. banking. the. presence.

(23) abroad.. Moreover,. institution enabled funds. developed. reserve. the U.S.. requirements. Additionally, affected. by. restricted. in the. period. in the form of the. a. new. financial. Euromarket. the. without being subject and. interest. Restraint. which. domestic ceilings.. banks. were. Program. that. from. their. As a result, banks were encouraged to fund lending from external sources.. banks without foreign branches, "a. rate. the making of foreign loans directly. overseas. called. to. period 1965 to 1974 U.S.. Voluntary Credit. domestic offices.. that. this. foreign branches of commercial banks to raise needed outside. their. during. window. on. the Eurodollar. This. or at least market,". meant. what. were. was at. a. disadvantage in competing for international business. Beginning in 1974,. international banking took on a. character with new dimensions. at. new. The quadrupling of oil prices. the end of 1973 and early 1974 resulted in massive. trade. and payments surplusses for oil-exporting countries while the major. oil-importing. countries suffered severe reversals. their. international. payments. accounts.. Commercial. played a key role in the process of financial between. in. banks. intermediation. the surplus and the deficit nations.. As a. result,. international lending expanded by an impressive 44 percent in the short period between year-end 1974 and 1976. With in. the explosion of international banking. activities. the past two decades and consequent large scale. lending,. however,. the. international. overseas. financial system. has. become vulnerable to the potential impact of outright default or serious disruption of external debt servicing. obligations.

(24) by,. especially,. East. European. and non-oil-producing. less. developed countries (NOLDC's).. This vulnerability stems not. only. large. from. the. outstanding. fact. that. a. debt is owed to private. proportion commercial. of. this. banks,. but. also because the amounts owed are rather substantial relative to. bank. capital.. commercial regards. of. the. pivotal. banks play in national economies,. to the domestic monetization. outstanding small. Because. role. especially. process,. and. loans are highly leveraged against a. capital. significant. relatively. debt. 1 illustrates the trend in U.S.. as. because. repudiations (2 ) jeopardize international economic stability. Table. base,. which. could. bank lending. in. the period 1977-82.. Since 1977 the ratio of bank exposure to. capital. from 131.6 percent to 155.0. has. 1982. has. risen. in. Of the nine largest U.S. commercial banks this figure grown from 188.2 percent to 221.2 percent,. ought. although. it. to be kept in mind that in spite of these figures this. represents. only a modest portion of total bank. example,. in. accounted. for 282.8 percent of capital of the. U.S.. percent. spite. catniercial. of. the. fact. banks in 1982, (3). that. loans.. For. outstanding nine. loans largest. this was only 14 percent of. total bank assets. As present. a. further illustration of the severity. situation. consider. table 2. exposure. of the eighteen largest U.S.. American. countries,. problems. since. 1982.. which. of. the. highlights. the. banks to. five. Latin. all of which experienced debt servicing For. 7. Citibank,. BankAmerica,. Chase.

(25) Manhattan, Manufacturers Hanover Trust, Chemical, and Crocker National exposure to these five countries alone was in excess of 150 percent of total bank capital. What. are the implications of these developments to. the. U.S.. banking system? As of mid-1982 the ten largest debtor (4) nations owed U.S. commercial banks a total of §221 billion.. The top five (Mexico, Brazil, Argintina, Chile, and. Venezuela) alone owed $56 billion to the sixteen largest U.S. commercial. banks. leveraged. against. (including. shareholder's. reserves banks. (with. capital in excess. total. bank. capital. equity,. of of. $1. billion). $36. billion. subordinated. against possible loan loses).. notes,. and. On this basis these. generated total net profits of roughly $4 billion. billion. pretax).. repudiation repayments. of. In. a worst case. scenario. a. just a single year's interest and. could amount to some $17 billion.. ($7. unilateral principal. After. wiping. out profits this would mean that $10 billion would have to be absorbed This. loss. from bank capital, of. capital. i.e.. a 28. percent. would force banks. to. reduction.. reduce. their. outstanding loans by roughly $200 billion in order to conform to the 5 percent ratio of capital to loans adopted for banks in mid-1983 by bank regulators. translate. into. This, of course, would. a severe contraction of the. domestic. supply necessitating massive federal intervention. and Wojtyla have noted:. 8. large. money. As Michas.

(26) "In a crisis the Fed could pump in reserves, but reserves aren't bank capital, so the Fed or the Congress would have to inject government capital into the banks. Would all the banks be saved or would there be mass mergers, such as are going on in the oil industry with the top 16 (30?) banks reduced to just three or four?"(5) Even. under the worst of circumstances this body of debt. would unlikely oecome worthless overnight.. Nevertheless, in. light. of recent overseas lending activity can there. doubt. as. to. why the Federal. Reserve,. indeed. be. the. any. entire. international financial community is deeply worried about the prevailing external debt situation? for. instance,. repeatedly deficit. Can there be any doubt,. why Federal Reserve Chairman Paul Volcker has. urged Congress to lessen the size of the. in. order. to relieve the pressure. on. the. federal overall. interest rate structure there by reducing the burden of. debt. servicing by the non-oil producing less developed countries?. Historical Background On. October. 19-20,. the. Organization. of. Petroleum. (6 ). Exporting. Countries (OPEC). imposed an embargo on exports. of oil to the United States and the Netherlands following the onset. the. month.. This was followed shortly thereafter by a rise in the. posted. price. of. of. the third Arab-Israeli war earlier in. petroleum. from $3,011 to $5,119. increase of almost 70 percent. market. per. barrel,. In subsequent years the spot. price of Saudi Arabian light crude rose from. roughly. $2.70 per barrel in 1973 to around 11.50 per barrel in By. year-end. 1983. the. price. approximately $30 per barrel.. 9. an. of crude. oil. had. 1976.. risen. to. These price hikes, or "shocks".

(27) as. they. were popularly dubbed by the press,. were. to. have. profound social, political, and economic consequences. For. many Americans the embargo and subsequent oil price. increases are remembered for the irritations of long lines at gasoline stations and for relatively minor reductions in real living. standards.. particularly these. For. the rest. of. the. world,. however,. the non-oil-producing less developed countries,. events were to foreshadow a profound change. countries economic and political fortunes. early. and. economic another. mid-1970's. represented. a. in. those. The events of the. transfer. of. current. resources from one sector of the global economy unparalleled in history.. A cursory examination. to of. (7) sectoral current account balances magnitude. of. the transfer.. serves to illustrate the. In 1973 the. Organization ' for. Economic Cooperation and Development (OECD), the. world's. combined. most. current. economically account. advanced. a consortium of. nations,. surplus totalling. $9.9. ran. billion,. while the NOLDC's exhibited a deficit of $6.2 billion. on the other hand, $7.7. billion.. a. OPEC,. ran a combined current account surplus of. One. year. later. the. OECD. countries. were. sporting a combined deficit of $27.5 billion (a turnaround of $37.4 oillion), billion side,. (or. while the NOLDC's deficit increased to $23.3. a worsening of $17.1 billion).. On. the. other. the current account surplus of OPEC expanded to. $59.5. billion (or an increase of nearly $52 billion). The. first. major. concern of. the. petroleum. importing. countries during the initial stages of the oil price increase was. how. to ameliorate the impact of these. 10. developments. on.

(28) economic. growth.. formulation in. Virtually. involved. of policy at this time feared a severe. world economic growth.. (MDC's). all parties. the. in. the. downturn. For the most developed countries. increased petroleum bill could be. financed. in. large measure by reduced consumption of non-essential imports and. the. promulgation. promote exports, United were. of commercial. notably manufactures.. States,. by. designed. In the case of. virtue of the fact that petroleum. denominated in U.S.. eventually. policies. dollars,. the increase. the sales. in. manifested itself as a growing federal. to. prices. budgetary. deficit, an accelerated inflation rate, and domestic economic recession.. For. vexatious.. the. The. compressibility economic NOLDC. NOLDC's. NOLDC's. the. did. problem. not. was. possess. even the. of the MDC's and the prospects of. depression were imminent.. more import. a. severe. To make matters. worse,. exports (typically agricultural and primary. products). (8). were. demand. inelastic.. For. these. countries. the. consequences of widespread unemployment and higher prices for essential imports threatened political instability and social chaos. Within international economic circles the quintessential question. was. revenues. of. for. higher. how. to. channel. to. considerable. petroleum. OPEC back to the NOLDC's to enable them to priced. oil. imports.. "petrodollar" recycling problem. solution. the. the. initial. relatively painless.. This. was. the. pay. so-called. In retrospect the short-run. problem. appears. to. have. been. Most of the oil revenues earned by OPEC. 11.

(29) during. this. period made its way back to the OECD. countries. through the system of international financial intermediation. Flush. with. oil dollars the 'petroleum. enthusiastically Europe,. and. exporting. pumpea these funds back into North America,. Japan by purchasing real and financial. including real estate,. corporate and government. precious metals,. bank deposits,. coffers. major western banks were. of. petrodollars.. countries. the. etc.. assets,. securities,. In no time at all the overflowing. with. Given the worsening state of the world economy. and the magnitude of the dollars involved there was only place for these funds to go —. right back to the NOLDC's.. one As. John Makin poignantly ODserved: "The huge transfer of resources from oil importers to oil exporters was a banker's dream. Overnight it (the first oil price shock) created a whole new category of borrowers and lenders: the oil Duyer and the oil seller. The sellers were not very sophisticated in financial matters - they wanted to put their money in the bank. At first the bank's biggest problem was to recycle the money fast enough - to get it into the hands of borrowers in huge chunks while collecting their fees, which shot up simply as a reflection of the delightful fact that 1 percent of $100 million is ten times larger than 1 percent of $10 million. Jumbo loans are just as easy to make as large loans and yet much more profitable."(9) By. 1977. NOLDC's. the process of recycling petrodollars back following the initial oil price shock. was. to. the. complete. and the major commercial banks were patting themselves on the back. for. having. resolved a major. crisis.. 12. international. financial.

(30) The LDC Debt Crisis The. recycling. present. day,. of. however,. petrodollars has the. continued. crisis is far from. over.. solution to the short-run problem is having serious side. effects.. medium- and countries. In. 1973 total. long-term (LDC's),. foreign. both oil. approximately $135 billion. risen to $211 billion. debt. outstandingand debt of the and. non-oil. to the. long-run. disbursed. less. developed. producing, was. Four years later this figure had. By sane estimates total. outstanding. of the LDC's in 1984 will have reached as high as. billion.. For. a. more. The. detailed profile of the. total. $790 debt. (10) picture consider tables 3 and 4. The growth. single. most. important cause. in total external debt,. for. the. phenominal. particularly of the NOLDC's,. was the sharp increases in oil prices in 1973-74 and again in 1979-80.. Consider, for example, table 5 which illustrates a. variety of external debt indicators for NOLDC's in the period 1973-82. roughly Table prices. As 6. 6. a percentage of total,. oil imports rose. percent in 1973 to around 20 percent in illustrates the hypothetical impact of. on. these. countries. in. terms. of. the. 1980-82.. higher. costs over and above what would have occured. the. of oil risen by no more than the. price index.. U.S.. oil. cumulative. additional price. from. had. wholesale. As indicated by the table the cumulative total. of additional costs incurred amounted to nearly $260. billion. in the decade 1974-84. This figure does not, of course, refer to. the actual rise in foreign debt since there are a variety. 13.

(31) of mitigating and debilitating factors to consider,. such. export. imports,. trends,. policy. measures. interest rate movements,. etc.,. to. reduce. oil. nevertheless it does provide. an. overall sense of the pressures which must have been. by. local. authorities. to. as. increase the. inflow. of. felt. foreign. capital. It set. is clear,. that the surges in oil prices. the stage for the phenominal increase in. over. the. last. ameliorated not. therefore,. decade.. Yet,. this. external. burden. debt. might. over time with no untoward consequences. been for the global recession and skyrocketing. have. had. it. interest. rates of 1980-82. In. addition. outstanding Prior done. there. to. the. dramatic. growth. in. was also a hardening of financing. to 1976 the bulk of developing country at. LDC. debt terms.. financing. was. terms,. i.e.. the official level at relatively soft. below market interest rates with liberal repayment schedules. After. 1976,. borrowings begun. to. increasing from. the. however,. not. only did the terms. begin to harden somewhat out debtor turn towards private financial regularity.. of. official. nations. had. institutions. with. The bulk of private financing. came. large western commercial banks at. interest. rates. which were, more often than not, based upon eitner the London Inter-Bank shorter. Offer. payout. (LIBOR) or (11) periods.. U.S.. prime. Cline has. rate,. with. estimated,. much (12) for. example, that in the period 1961-70 average real interest (13) rates on NOLDC external debt averaged 4.1 percent. This. 14.

(32) rate dropped to an incredible -.8 percent in the period 197180.. In. 1979 and 1980 although nominal rates were very high. (LIBOR averaged 13.2 percent) so too was the rate.. inflation. By 1981-82, however, real interest rates had begun to. explode. as declines in inflation were not similarly. by drops in nominal interest rates. 82. U.S.. rose. to. an. average 14.8. matched. In fact, LIBOR in 1981-. percent,. resulting. in. real. interest rates of 7.5 and 11.0 percent, respectively. It has (14) also been estimated by Cline that this surge in interest rates,. caused. by. expansionary. fiscal and. tight. monetary. policies in the U.S., accounted for approximately $41 billion in. total. excess. interest payments in. the. period. 1981-82. beyond what would have been anticipated on the basis of (15) interest rates over the previous two decades. As. a. nations. consequence. of these. developments. many. real. debtor. found it increasingly more difficult to service. external. obligations.. recession. To make matters worse,. a. its. worldwide. in 1980-82 caused commodity prices to fall thereby. squeezing export earnings of many developing nations.. Export. unit values fell from 100 in 1980 to 94 in 1981 and to 90 in (16) 1982 for non-oil producing developing countries, while import. unit. before. falling back. loss. to. values. NOLDC's in. rose from 100 in 1980 to. 103 in. 1981. The. total. the period 1981-82 as a result of. these. to 100 thefollowing. year.. changes applied on atrade basis has been estimated by Cline (17) at $79 Dill ion. Unfortunately, these developments were not. offset. developing. by growth in volume as real exports countries,. of. non-oil. which averaged 8.1 percent in 1971-80. 15.

(33) and. 9.9. percent. in 1981 before falling to 1.2. percent. in. 1982. As a result of these developments Cline has that. the. increase. ex. ante impact of these exogenous shocks. external debt of NOLDC's by. figures. established. $401. was. billion.. to. These. are summarized in table 7 which also shows that. the. actual. increase in debt amounted to $482 billion.. Although. these. figures. measures. are. not. adjusted. for. policy. promulgated by some countries to reduce the deficits they do, nonetheless, country. debt. suggest may. that the huge increase. be. attributed. to. in. developing. developments. largely. outside the control of the countries themselves. In. addition. to. these exogenous shocks. the. oorrowing. nations themselves share some of the responsibility for their deteriorated deot situation. Brazil,. short-term. In some instances,. notably in. policies of rapid debt accumulation. for. the. purpose of high rates of ecoonomic growth backfired when. the. resulting. legacy. oppresive. burden. economy.. In. exchange. rate. of. huge. in the face of. other. cases,. external a. weakened. Argentina for. policies resulted. debts. in. became. an. international. example,. overvalued. faulty. currencies. which culminated in high imports and poor export performance. In. Venezuela. and Mexico attempts to maintain an. overvalued. currency on a fully convertible basis,. coupled with domestic. interest. capital. rate. policies,. resulted in. flight.. Argentina and Venezuela this outflow of capital is to. have accounted for roughly one-third of total. 16. In. estimated debt,. and.

(34) approximately one-fifth in Mexico. In. addition. development labor,. to. short-term. strategies. excessive. policy. errors,. have been myopic.. protection of. long-term. Over pricing. industrialization. of. programs. based upon import substitution, ill-conceived and inefficient government enterprise activities, (18) hindered growth. By. and other distortions have. 1982-83 the situation had deteriorated so badly that. debt servicing problems had become debt. problems. epidemic.. International. were further aggravated oy what. "psychological shifts" in the credit markets. breakdowns. by. a. major country,. Cline. terms. Debt servicing. according. to. Cline,. has. resulted in severely restricting capital flows to most of the rest. of the region,. which. to wit Poland's quasi-default. in. 1981. pushed Romania into a debt rescheduling and other East. European. countries. into. severe. debt. servicing. problems;. Mexico's. debt crisis in August 1982 causing a credit. shock to Latin America resulting in reschedulings by Chile,. Peru,. and. Venezuela,. difficulties by Costa Rica,. along. with. supply Brazil,. debt-servicing. Nicaragua, Bolivia, and Ecuador.. The sharp curtailment of credit to Latin America is evidenced by data on U.S. billion. in. increase. bank loans outstanding which grew from $68.1. June. 1982. to $69.3. of only $1.2 billion,. billion. in. compared with (19). December, $7.3. an. billion. during the same period in 1981. Debt formal. servicing. reschedulings,. commercial. bank. disruptions during. 1982-83,. reached approximately. debt owed by East European. 17. including. two-thirds and. of. developing.

(35) countries,. while. by year-end 1982 no less than 34 countries. were in arrears on their debt.. The amounts of debt formally. rescheduled rose from $2.6 billion in 1981 to $5.5 billion in 1982, and again to roughly $90 billion in 1983. In reached. short,. the. international. financial. crisis. a peak in 1982-83 can be traced to five. causes:. higher. interest. rates. economic. mismanagement,. international servicing. oil and. credit. prices in 1973-74 global. in. fundamental. 1979-80, 1980-82,. high local. and the psychological shift in. market. breakdowns,. recession. and. which. which,. severely. as a. result. the. of. debt. restricted the flow of. new. credit.. Recent Concern About the Risk of Overseas Lending With the rapid rise in international lending and with an unstable international economic environment, lending risk has became the subject of much discussion in recent years.. Much. of the increased attention has focused on the growth of loans to LDC's. of. debt. The magnitude of U.S. bank overseas lending, cases reschedulings,. and. the. greater. possibility. of. outright default have contributed much to the fervor ot these discussions. (2 0 ) Between total. underwent. a. of 32 multilateral debt rescheduling. provided until. 1956 and 1975 eleven countries. about. 1981,. additional. exercises which (21) $7.5 billion in debt relief. From 1976. a mere half-dozen years later, 23. major debt reschedulings. 18. there. involving. were. an. fourteen.

(36) (22). (23). countries, In. and providing $9.7 billion in debt relief.. 1982. alone. operations nations. - Brazil,. each. were. four. major. undertaken involving the world's. Yugoslavia. in. there. Mexico,. and,. financial. rescue. largest. debtor. Argentina,. along. with. Principal rescheduling was the essential element. of. these. four. cases,. and. typically. involved. restructuring on a five-to-eight year basis. Excluding (24) Yugoslavia, $30 billion in external debt was rescheduled, coupled. with. financial which. $39. billion. support (including Yugoslavia),. was. oanks.. an additional. in. the form of new loans. These. rescheduling. rescue. packages. from. also. in. additional. $14.7 billion U.S.. commercial. typically. carried. fees ranging from .5 to 1.5 percentage. points,. with. relatively wide spreads above either LIBOR or the (25) prime rate, usually around 2 percentage points. In l¥77, the. Senate. U.S.. hearings on overseas lending were conducted by Committee. Development.. Concern. of. Banking,. over. Housing,. and. Urban. the impact of overseas. activities upon the stability of the U.S. voiced. of. lending. hanking system was. by the three regulatory authorities charged with. responsibility. of regulating the. Federal. Reserve,. Federal. Deposit. agencies. banking. industry:. the Comptroller of the Currency, Insurance. Corporation.. the The. and. Together. the these. conducted a joint survey of foreign lending by U.S.. commercial banks covering claims on foreign residents held at all domestic and foreign offices of 119 banks with assets $1. billion. or more.. The findings of the survey led. to. of a. proposal by the Comptroller of the Currency to impose a legal. 19.

(37) lending limit on national tanks to foreign governments. proposal. The. expanded and clarified the federal regulation which. prohibited. any. federally chartered bank from. lending. more. than 10 percent of capital to any single forign government. Under the ruling,. national banks were no longer able to. view government and state-controlled agencies as seperate and independent from the central government unless was. able to demonstrate,. first,. that. it. had. resources and income to pay back the loan, the. proceeds. of. have. borrower. independent. and second,. the loan would be used. purpose intended.. the. for. the. that. specific. More recently, the regulatory authorities. explicitly considered the notion of "transfer risk". sovereign country. lending. which. results from the. inability. in. of. a. to. generate sufficient foreign exchange to service (26) its external debt. In the past, commercial bankers have. contended that sovereign lending was without risk due to fact. that. there is no dissolution of the borrower as. otherwise occur under commercial bankruptcy. three. agencies. promulgated a five point. regulation including: exposure, portfolio,. sharing. Together, these program. of. bank. (b) greater public disclosure of a bank's overseas (27) (c) new loan classifications for writting-off. reported. cooperation. might. (a) a stricter examination of country. or provisioning into reserves "bad" loans, of. the. income. from. loan. fees,. (d) a stretch-out and. (e). increased. with foreign bank regulators including a greater. of International Monetary Fund (IMF) information. external debt.. on. This program supplements the system developed. 20.

(38) in. 1978. to. measure. reflected. in. systems.. This. concentration individual. a. and monitor. bank's approach. and. country. exposure. and. risk. exposure. focuses on the degree. diversification. as. of. is. management of. foreign. country. loans. in. bank portfolios and on the quality of information. possessed by a bank in assessing the degree of risk to. it. that portfolio.. Authorities have,. however,. attached shied away. from ratings of risk on a country by country basis since this would. be tantamount to directing or influencing the flow. of. bank credit. At the international level, a number of agencies are now attempting on. to improve international statistical. capital. International major. central. external. movements.. For. Settlements (BIS), banks,. private. example,. information. the. for. through the cooperation of. has developed a reporting. borrowing and. Bank. lending.. Similar. system. on. data. on. Eurodollar credits and loans from public sources have been on stream. for quite a few years.. 21.

(39) Chapter 2 Distinguishing Aspects of International Bank Lending As risk. in domestic lending,. as. namely. international lending involves. is subject to the same basic credit the definition of that risk,. principles. adequate knowledge. — and. understanding of the borrower, including a thorough financial history,. position and prospects, and a clear indication that. the loan will be repaid. The. element. that most distinguishes. from. domestic lending,. risk. (with. all. sovereign risk. able. that. however, is. overseas. lending. is the concept of. country. involved). and. the. presence. of. Even if the foreign customer is financially. to repay a loan,. i.e., there is an acceptable. banking. risk in the sense of prospects of commercial bankruptcy, that customer's of. government may prevent the appropriate conversion. local. loan.. currency into foreign exchange to repay. This. may. result in default on. the. the. national. bank level. rather than the local private level. The most widely accepted definition of sovereign risk is that it is the risk involved when claims are either against a foreign. government itself or is backed by the full faith and. credit of that government. superior. to. management, well. Such risk is usually regarded as. non-sovereign risk because the. has. good or ill, over its existing foreign assets as. as the flows of receipts and payments,. dampening,. government. stimulation. over goods and services exports and imports.. the other hand,. the sovereign entity usually cannot be. 22. or On sued.

(40) due to its immunity to foreign prosecution, that. immunity.. The. principle. of. unless it waives. sovereign. immunity. recognizes the independent integrity of each sovereign state, asserting. that. no one state is superior to any. reflects. general. acceptance in international. sovereign. cannot,. without consent,. other, law. and. that. a. be made a respondent in. the courts of another sovereign. In. this. Sovereign. connection,. the. U.S.. passed. the. Foreign. Immunities Act in 1976 which set the standards. by. which questions of iirmunity are to be resolved as far as this country. is concerned.. inmunity. from. The Act contains a general grant. the jurisdiction of the courts of the. States to each foreign state. arrest,. and. foreign. state's property in the United. exceptions. execution. to. such. is. An immunity from. Act. United. attachment,. also granted with respect States.. represents a codification. to. Among. immunity are cases in which. state engages in a commercial activity.. of. a. a the. foreign. In large degree this. of court-created lawover. the. years rather than the breaking of any new ground.. The Nature of Country Risk Country cannot. or. obligations economic,. risk. will as. is. the risk that. not adhere to the a. result. of. a. particular. terms. adverse. and financial developments.. of. its. political,. country external social,. The term "default" is. widely used in the literature to describe such debt servicing disruptions although this is a somewhat of a misnomer. Eaton (29) and Gersovitz point out, for example, that a loan is not. 23.

(41) legally. in. borrower. default until the lender has declared. that. the. has failed to meet the terms of its obligations,. situation. which. has. sovereign debt.. rarely. been. taken. When arrears have. have usually ensued.. with. occurred,. respect. a to. reschedulings. Such circumstances have,. nonetheless,. been referred to in the literature as "defaults.". In what is. to follow the terms defaults, reschedulings, and repudiations have. been. used. interchangeably,. unless. where. otherwise. obvious from the text. Whether company. or. social,. and. vital the. the a. borrower is a government,. private entity,. such. actions. restrictions,. singly. include. Adverse. or. in. expropriations, of. assets. economic, becomes. or. crucial. importance. to the overseas. legal. inconvertability. of. They can occur the. result. of. it. is. of. operations. of. Thus,. lending. banks to carefully assess the political,. economic. to. nationalization;. usually. political changes.. a. developments. crippling. and. devaluation,. combination and are. economic. commercial. of. political. and rescheduling of external debt.. adverse. and. as. freezing. risks. currency. appraisal. in evaluating the desirability of lending. prospective borrower.. financial. quasi-public. political conditions in the country. element. include. an. a. environment of those countries in. social,. which. they. have outstanding committments. The fundamental concern of every international lender is that. sufficient. countries. in. foreign. exchange. will. be. order to facilitate the orderly. 24. available servicing. to of.

(42) their external debt. those. It is essential, therefore, to consider. factors which bear on a country's ability to meet. external related. obligations. to. the. Such. factors are essentially. availability of. foreign. exchange. possible reduction in foreign exchange expenditure.. its those. or. the. The most. important factors to be considered include: - Revenues derived from exports of goods and services; - Net factor remittances; - Net inflow of capital through direct investment; - External borrowings and foreign aid; - International reserve holdings; - Maneuverability for reduction of imports of goods. and. services. These. factors. will. be developed more fully. in. subsequent. discussions regarding the choice of economic indicators. used. in flagging potential servicing disruptions. When the. extending credit facilities to a foreign. question. country,. frequently arises as to the extent to which. a. bank ought to expose itself in any given country, not only in absolute terms but also in proportion to other countries. this,. concern. standing, and. is not over the countries with a high. credit. nor with those countries where excessive political. commercial. regarded. risks. as. international. so obvious by. that. private. they. are. lenders.. relation. to. Who are they?. each other? finite. How do they measure. Where does the lender. resources. 25. in. order. to. not The. bank lender is rather concerned with the. cases.. his. are. creditworthy. between". place. In. "in-. up. in. desire. to. optimize. his.

(43) international portfolio within the context of maximum return, liquidity,. and security.. lender. concerned,. is. In other words, the international. first,. with the degree. of. exposure. within each country individually, and then» more importantly, the. net placed at risk in that country in relation to. countries. as. influenced by the size of his total. other. portfolio. commitment to foreign credit operations. What. then is exposure?. consists. of. short-term. transactions with banks,. Exposure in a foreign credit. lines. and. country. individual. individuals, private and government. corporations, and governments for letters of credit, stand-by letters. of. credit,. temporary overdrafts.. acceptances. and. advances,. including. It also includes layoffs and. exchange positions and lines.. foreign. Also included are firm unused. commitments and term loans. A commercial bank's exposure in any given country is the result of its cumulative credit decisions, possibly over many years,. and. country. to how. represents. total commitment in. any. A bank's first concern is how to determine. country exposure, much. country. the. is. given limits. while its basic preoccupation is. at risk and the likelihood that. a. with. particular. will experience problems which might jeopardize. the. viability of its commitments.. The International Credit Market and Credit Rationing We. have thus far considered the possibility of. repudiation at the purely microeconomic level,. 26. a. debt. i.e. from the.

(44) point of view of the individual lender. In other words, discussion. has. thus. the. far been centered exclusively. topic. of sane sort of. market. without having. on the. breakdown in the internationalcredit first given form and substance to the. underlying nature of this market. We. know. that a country's decision to. foreign. debt. is. very often the result. inability to earn, amount. of. that. attract through investment,. on. sovereign. its. country's. or borrow an. of foreign exchange consistent with its perceived. actual requirements. a. default. or. As and when such conditions arise then. nation. must. make. certain. policy. decisions.. Either that country must implement domestic measures, such as import. reductions,. political foreign external. which. consequences, exchange debt. may. or. through,. have. economic. or. outflow. of. it must reduce its say,. obligations.. adverse. a. restructuring. In other words,. capable. of. reducing the drain in. through. either internal measures,. its. of. its. a country. financial. is. resources. external measures,. or. a. combination of the two. In. order. determinants following. to. obtain. a clearer. understanding. of. the. of the international credit market consider the. simplistic. short-run model of. a. global. economy. which is characterized by two countries, a net borrower and a net lender, that. and a financial intermediary. It will be assumed (30) exchange rates are fully flexible. A flexible-. exchange-rate which. system. is. a convertible-currency. system. in. the exchange rate is market determined after which. no. "deficit" in the balance of payments is possible.. 27. In. other.

(45) words,. the. current account (defined as exports less imports. plus net tourist expenditures, insurance equal. and shipping receipts,. etc.) must be. identically. to the sign reversed capital account (defined. borrowings from abroad, and. dividends, interest payments,. draw-downs. international. as. net purchases of foreign securities,. of foreign bank accounts) with no change reserve. net. holdings.. A. in. flexible-exchange-rate. system stands in contrast to a fixed-exchange-rate system. in. which the government ouys and sells foreign exchange in order to. maintain. result. international. fluctuate. which. the exchange rate at some fixed. Consider,. illustrate. a. reserve. holdings. therefore,. value.. are. equations. simplified version of. As. likely. a to. (2.1) and (2.2) the. oalance. of. payments accounting identity for the borrower and the lender, respectively.. (2.1). F dR = [X(Y*)-M(Y)-iD] + [B+I(i-i*)-Q]=0. (2.2). F dR*= [X*(Y)-M*(Y*)-iD]+[B*+I(i-i*)-Q]=0. where dR = the change in international reserves; X. =. exports of goods and services as foreign income;. M. = imports of goods and services as a function of home income;. i. =. the real interest country;. D. =. total outstanding external debt;. 28. rate. paid. by. a. function. the. of. borrowing.

(46) iD = total interest payments; Q. =. principal repayments banks;. iD+Q = B=. on borrowings. from. foreign. total debt service payments to foreign banks;. total new public foreign banks;. and. private. borrowings. from. L (=B-Q) = new net lending; F I(i-i*) = new net non-bank borrowings as a function of the difference between interest rates prevailing in the borrower country and the lender country,respectively.(31) For the sake of simplicity it will be assumed that there exists. no. assumption many. net dividend. restrictionson. analysis the. to. foreigners.. This. is at least partially supported by the fact. developing. foreign. payouts. countries. capital. purchases is. have. outflows.. The. imposed. integration. prohibitive. inclusion. of interest bearing securities. of. net. into. the. justified on the grounds that the period. late 1960's and early 1970's witnessed of. an. the global economy as capital. and. Following. Y*. are. from. assumed equations. to. be. exogenously. since. unparalleled flows. increasingly sensitive to interest rate differentials. i*. that. became Both. determined.. (2.1) and (2.2) it can. be. seen,. therefore, that. (2.3). [X(Y*)-M(Y)-iD] = - [X*(Y)-M*(Y*)+iD]. (2.4). F F [B+I(i-i*)-Q] = -[B*+I*(i-i*)-Q*]. Define total investment demand of the borrowing. 29. country.

(47) as. D. F. (2.5). where. D I(i,Y) is. domestic investment as a function. domestic interest rate and national income.. of. the. The hypothesized. first partials are. D. (2 .6). D. F. I <0, I >0, I >0 i y i. Attempting to model the behavior of diverse sovereign nations simultaneously as regards to their attitudes towards capital. inflows. example, or. to. is. problematical.. Sane. foreign. countries,. for. seek to attract foreign capital in order to sustain increase present consumption levels as was. certainly. the case for many NOLDC's following the first and second price greater. shocks.. Increased. consumption may take the form. military outlays (Argentina) or increased. of. imported. commodities (Egypt. countries since the early 1970's, LDC's. and. of. borrowing. for the purpose of fixing the exchange rate to keep down price. oil. Turkey).. the Sane. notably such oil-producing. like Mexico and Indonesia or. non-oil-producing. LDC's. with seemingly tremendous latent potential for rapid economic gorwth. such as Brazil,. sought to attract foreign capital in. order to encourage total investment expenditures. words, theory. it of. In. is quite difficult to formulate a single policy. objectives. 30. of. the. state. other. unified. given. the.

(48) variegation of nations considered in the present study. One. reasonable,. developing total. albeit. limited,. hypothesis. is. that. countries attempt in any given period to maximize. investment subject to the constraints imposed upon. it. by the availability of domestic savings and/or its ability to generate. foreign. exchange.. To. the. extent. that. other. considerations such as the level and composition of household and. government. will. consumption expenditures are. concerned,. merely be assumed that such considerations. are. it. policy. variables which have been built into the "programmed" balance of. payments. determined admittedly large. (see footnote 45) and as such are and. reflected in. feeble argument is. the. exogenously. trade balance.. This. endorsed by the fact that. a. proportion of LDC internal investment is intended as a. foreign exchange saver through import substitution.. It can. easily. income. bedemonstrated from the. standard. national. accounting identities that,. (2.7). (S. D +S -I ) = (X-M-iD) + (G-T) HH B. where S represents household savings, S business savings, HH B and G-T the federal budgetary surplus (or deficit). If we define government savings as -S =G-T, then (2.7) becomes G D (S-I ) = (X-M-iD). (2.8). where S=S HH. +S +S . B G. Equation (2.1) may, therefore, be rewritten. as. 31.

(49) (2 .1)'. D F dR = (S-I ) + (B+I(i-i*)-Q) = 0. We can rearrange (2.1)' to provide a basic description of the (32) so-called "two-gap" model of foreign lending, i.e. that net. foreign. lending is required to bridge the. gap. between. domestic savings and foreign exchange availability to finance domestic investment;. D F L = I -I -S = B-Q. (2.9). The problem,. therefore, is to mazimize (2.5) subject to. (2 .1);. (2.10). D F max I = I(i,Y)+I(i-i*) s.c.. F X(Y*)-M(Y)-iD+B+I(i-i*) -Q =0. Forming the expression. (2.11). D F G = I(i,Y)+I(i-i*)+g[X(Y*)-M(Y)-iD+B F +I(i-i*)-Q]. where g is the lagrangian multiplier, derivatives. with. respect to i and Y,. and taking the partial the. order (necessary) conditions are obtained:. (2.12). D F F G = i +1 +g[-D+I ] = 0 i i i i. 32. following. first.

(50) D G = I +g[-M ] = 0. (2.13). y. y. y. F G = X(Y*) - M(Y) - iD + B + I(i-i*) - Q = 0. (2.14). 9 where. M >0.. The second order (sufficient) conditions for a. y global maximum are:. (2.15). D F F D I + I - I I / M ii ii ii y y. D I iy. -M y. D I yi. D I yy. F I ii. -M. F 1. y Solving. > 0. 0. ii. equations. (2.12). through. (2.14). and. rearranging. yields the demand for net foreign credit as. D F L = M(Y)-X(Y*)-I(i-i*). (2.16). D F D F +i{ ([I +1 ]/I )M +1 }. i Turning. although. current. account. It. y y. i. to the supply side of the international. market,. surplusses. i. are. the. supply of credit is. surplus. of. the. essentially. creditor. channeled through financial. nation,. maximizing. firms.. The. generalized as. 33. profit. the these. intermediaries.. is assumed that these financial institutions are. profit. credit. function. private may. be.

(51) (2.17). where. H = (i+k)L[r(i+k)]-i*A. H. prevailing. is. profit, interest. k. is. the. rate i,. bank's. and A is the. spread. above. availability. the of. foreign credit defined as. (2.18). A = -X(Y*)+M(Y)+iD. In equation (2.16) the extension of net credit by the private bank. is functionally related to perceived risk,. r.. It. is. assumed that the extension of credit is negatively related to risk, and that risk is positively associated with the spread, i.e.. (2.19). L <0, r >0 r k. Maximizing profit with respect to the spread above the market interest rate yields the supply of credit equation. (2.20). S L = -kL r -iL r r k r k. Although thecoefficient of. i in equation (2.17) issign D D F indeterminant, if we assume that I >0 and that I > I iy i i and utilizing thecondition in(2.16) fromwhichit might be. D inferred that I. D. F. ,1 ii. ,1 yy. < 0 , then ii. 34.

(52) D D F D L = [(I +1 )/l ]M i i i y y. (2 .21). D D F +i{M [I (I +1 ) y y ii ii D F D2 F + (I +1 )]/I +1 } < 0 i i yy 11 ii. Furthermore,. if. it is assumed that. compensation. for. r. >0, i.e. that the ki perceived risk must rise at an increasing. rate, then from equation (2.21). S. (2 .22). L i. = - (i+k)L r - r L > 0 r ki k r. From these results,. equations (2.16) and (2.20) are depicted. diagramatically in figure 1, panel A. One. way. repudiation event. to of. interpret the. debt. of. as the consequence of a failure of. the. view. the. international. External debt reschedulings. repudiations may occur when the demand for. able. temporary. i.e. a situation in which there is a. failure to reach an equilibrium.. credit. a. servicing obligations is to. credit market to clear,. or. incidence. international. exceeds the amount which foreign banks are willing or to. supply,. possibly even after an array. of. domestic. austerity measures, devaluations, etc. have been implemented. To. clarify. consider illustrate Unlike until. this. the this. sort of market failure. it is (33). theory of credit rationing. concept. consider panel. A. in. useful. to. In order. to. diagram. 1.. most commodity markets where prices rise continuously equilibrium between supply and demand is. 35. established..

(53) in. credit markets there is an interest ceiling beyond. lenders. are. reason. unwilling to. for. this. information. supply. additional. is usually attributed to. about. borrowers,. which. credit.. the. The. paucity. of. particularly. developing. countries. where up-to-date and accurate data is. notoriously. suspect.. As. a result,. lenders use the interest rate which. borrowers are willing to pay as a proxy for the desperateness of the borrower's situation. potential. borrower. conventional of. the. is (34). norm. willing. desperate. additional funding might,. viewed level. to. pay. rises. situation. in. which. case. Such circumstances might. by foreign creditors as constituting an risk.. some. in fact, dry up altogether thereby. a financial crisis.. of. above. then this would be viewed as evidence. borrower's. hastening. If the interest rate which the. be. unacceptable. Note also in the diagram that. below. some. interest rate, say i', the supply of new credit (SS) is zero, where. i' represents the cost of loanable funds to the lender. (say. LIBOR (35) costs).. plus a minimum spread At. representing. the ceiling rate,. i",. transaction. the supply. of. new. credit, L, becomes totally inelastic. The. demand. conventionally. for as. foreign. credit. (DD). being inversely related to. can. be. the. viewed interest. rate, which in turn reflects the scarcity of domestic capital (36) and foreign exchange. In the diagram equilibrium occurs at i(t) at an amount L(t) of new lending. Consider now the disequilibrium case depicted in panel B of. the same diagram.. In this case we have a contraction in. 36.

(54) the. supply. of. credit as depicted by a. left-shift. supply curve (S'S')f an expansion in the demand for credit. as. (D'D')r. or. in. the. foreign. depicted by a right-shift in the demand curve (37) both. Under these circumstances at i",. L(d)>L(s),. with. disequilibrium. the. resulting. gap,. G,. representing. in the foreign credit market.. a. The manner in. which the borrowing country is able to rectify this situation is. of. paramount importance from the point of. international lender.. view. of. the. As Cline has pointed out:. "Under normal circumstances the country can take adjustment measures to shift the demand curve for foreign borrowing backward to the left, often with IMF guidance. Indeed, the announcement of an adjustment package (especially one with IMF participation) may serve to shift the supply curve of international loans outward to the right because, other things being equal, it will give foreign lenders more confidence."(3a) Under. more. infeasible through the. extreme to. shift. lending. however,. either the demand curve. curve. to. climate.. of political paroxysms, the right due to a. or. jittery. Under these circumstances. rescheduling becomes an incipient possibility. degree the. SS. it .may to. the. be left. the imposition of domestic austerity measures due to. possibility. supply. circumstances,. to. shift. the. international external. debt. The relative. to which either the DD curve will be left shifted curve right-shifted will depend upon the. position of the parties involved.. 37. or. bargaining.

(55) (39) Conventional Approaches to Assessing Country Risk Even. before. authorities. to. activities,. recent more. large. systematically. closely. U.S.. and. efforts by. U.S.. monitor. commercial. bank. regulatory. overseas. lending. banks were acting themselves. against. overseas risk.. They developed their own individual. systems. for. economic. evaluating. Moreover, banks'. smaller. decisions. formally to protect. more. banks when. conditions in. foreign. countries.. which used to rely on participating in. loan. the. larger. syndications. began to develop their own risk evaluation systems as well. (40) A survey conducted by Eximbank of 37 U.S. banks revealed when. the variety of different types of systeas. assessing. repudiation, exposure. by. country. and. for. i.e.. determining. debt the. rescheduling. extent. of. country. banks in evaluating country risk varied significantly. no systan,. systanatic. strictly. in. 3anks with small international portfolios and evaluated country risk only when a. application necessitated it.. countries.. or. Eximbank found that the analytical approaches used. nature and scope. had. risk,. utilized. procedure The. Most banks, however, employed a. for assessing the creditworthiness. analytical approaches used range. qualitative —. loan. from. involving little or no numerical. of the or. statistical analysis appearing in the final country review — to. those. that are fundamentally quantitative in. character.. Some banks used more than one system. In. general,. four types of country evaluation. 38. systems.

(56) can. be. distinguished:. qualitative, fully. checklist,. qualitative. evaluation. be. and. systam. those. qualitative,. quantitative. is structured. report whose format,. from country to country. to. fully. detail,. structured. econometric. around. a. A. country. and scope may vary. Banks which used this system tended. which were just. beginning. to. do. country. reviews. seeking. to develop a more structured system more suitable to. their. and are therefore using this. systematic. particular. needs.. This. approach. system. is an. while. entirely. subjective approach. In. contrast,. standardized statistical. the. format. structured qualitative system has. and a well. defined. scope,. analysis generally included.. with. a. some. Nearly 75 percent. of. the banks surveyed used a structured qualitative. An. example of this type of country evaluation report from. major New (41) I.. York. commercial bank is. presented in. system. a. Appendix. The checklist system is bothquantitative and subjective in. nature,. strengths. using a scoring technique to scale a with. respect to a set of. predetermined criteria, quantitative judgement. and. or. to. variables.. chosen. country's. indicators. and. The indicators are often. that extent the. scoring. requires. first-hand knowledge of the country.. On. no the. other hand, subjective judgements, especially with respect to political. and social features or likely trends. intimate familiarity with specific countries. each. indicator. each. country using a common set of. may. require. The score for. may be aggregated into a summary rating. 39. subjectively. for. determined.

(57) weights — both. a. the weighted checklist approach.. weighted. system.. Other. checklist. and. a. Some banks use. structured. qualitative. banks combine the weighted checklist with an. experimental. quantitative. indicators. are. subjectively. selected and any built-in bias will affect. the. quality. of. the result,. technique.. The. although these. short-comings. will. apply accross the board to all countries evaluated. The. quantitative. econometric. approach. involves. statistically more sophisticated evaluation techniques. methods include discriminant analysis, linear These. probability. models,. logit. Such. principal components,. and. probit. transforms.. approaches attempt to overcome the shortcomings of the. checklist. system which lie in the subjectivity. selecting. the. evaluation tests. of. involved. in. most significant variables to be used in. process. predictive. Standard econometric. and. the. statistical. accuracy are used to select. the. most. relevant explanatory variables and to predict potential. debt. servicing difficulties. It 26. was found that of the 37 banks surveyed by. used. the. results of country evaluation reports. maximum exposure limits for countries and, set. exposure. ceilings,. however,. were. solely. by the evaluation results.. bank's. marketing. strategy. played. important. roles in the setting of. and. limits.. 40. to. set. in some cases, to. sub-limits for specific loan maturities and. Country. Eximbank. not. categories. determined. Other factors such as competitive. position. country. a. also. exposure.

(58) Chapter 3 Assessing Country Risk Traditionally, involved risk. assessment. of. two important technical steps:. indicators. weighting rank. the. (together. scheme). with. an. country The. risk. selection. implicit. or. and the choice of a formula to. potential country exposure.. has of. explicit grade. or. This chapter discusses the. quantitative and qualitative ingredients generally considered to. be. essential. for. making. relative,. albeit. limited,. comparisons across countries. Economic country's. conditions. alone cannot accurately. ability to service its external debt. Furthermore, conditions. its. therefore, not. also. which. service. such. would not reveal local policy makers' willingness. therefore. realities. a. obligations.. even if this were possible an analysis of. to meet is foreign comnittments. must. mirror. A truly thorough evaluation. consider those. may impinge upon a external. debt.. social. and. country's. The. political. capacity. necessary. to. approach,. is to consider risk evaluation within the context. only. of. economic. developments,. but. of. prevailing. commercial, political, and social circumstances as well. A. carefully. especially the to. conceived. risk. appraisal. if performed on a repetitive basis,. framework, can. provide. analyst with a time series of evaluations against make. strenghts. a considered appraisal of an and. deterioration,. weaknesses. or. turning. By. pointing. points in. 41. individual. a. out. which. country's. improvement,. country's. overall.

(59) position,. this. process can help to focus attention early on. incipient economic,. social,. or political developments which. may serve as a basis for taking early corrective measures. in. order. to. to. reduce. exposure risks or for moving. promptly. capitalize on new opportunities.. Economic Indicators While. taking. indicator point. conceivable. economic. is neither feasible nor necessary from a practical. of view,. significant. it is possible to select a few of. and use them as analytical tools.. ratios are then a. into account every. scored in order to. the. most. Key data and. provide the analyst with. basis of comparison in order to measure relative. economic. stability, strength, and growth. The. main. country's. concern is,. of course,. with. capacity to service its debts.. relevant. economic. balance. of. indicators,. payments,. the. borrowing. The most directly. therefore, debt. the. relate. structure,. to. the. and. the. international liquidity of the country. Most the. country risk analysts start with the appraisal. elements. general. rule,. of the country's balance of balance. of. payments. payments.. (especially. As. of a. current. account) surplusses are healthy in as much as they provide an indication exchange country and. of. with. a country's ability to generate which. to service. outstanding. the. foreign. debt.. If. a. experiences a persistent balance of payments deficit. adverse trends in,. say,. 42. its trade. account,. then. the.

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