Coping with Sovereign Risk Since 1991

Histories

This blog article is based on Country Risk – The Bane of Foreign Investors (Springer, 2020) by Norbert Gaillard.

Both the number and percentage of countries in default reached record highs during the globalization years (1991–2016). In 1994, 114 sovereign debtors – accounting for 54% of all countries in the world – had failed to repay debt to their public or private creditors. This figure fell 10 percentage points by 2016, but it remained higher than any year during 1960–1981. Yet unlike what occurred in the 1930s and 1980s, no massive wave of sovereign bond or bank defaults was observed during 1991–2016. The explanation for this paradox involves (a) official creditors and China agreeing to restructure more sovereign debts and (b) private creditors managing to cut their losses by exploiting the new international financial architecture and a more secure legal environment.

How Official Creditors and China Absorbed Losses

In 1996, the international financial community launched the Heavily Indebted Poor Country (HIPC) Initiative in order to reduce the external debt of low-income economies. The Paris Club – as well as multilateral, non–Paris Club official bilateral, and private commercial creditors – all participated in this program. The initiative’s eligibility criteria required that candidate countries have: an unsustainable debt burden (even after obtaining traditional debt relief); a track record of sound policies through IMF- and World Bank-supported programs; cleared any arrears with the IMF, the World Bank, and the African Development Bank (AfDB); and prepared a credible “poverty reduction strategy” (see IMF 2019, pp. 7–8).

In 2005, the Multilateral Debt Relief Initiative (MDRI) complemented the HIPC Initiative. Under the MDRI, several agencies – including the IMF, the International Development Association (IDA), the African Development Fund (AfDF), and later the Inter-American Development Bank (IaDB) – committed to alleviating the debt burden of low-income economies. By the end of 2017, the total costs of debt relief to creditors under the HIPC Initiative and the MDRI were estimated at $76 billion and $43 billion, respectively (IMF 2019, pp. 12–14).

In addition to these specific programs, the Paris Club continued to reschedule and cancel the external debt of low- and middle-income economies. For all types of treatments, the Paris Club signed 248 agreements involving 79 countries during 1991–2016.

The high proportion of defaulting sovereign debt issuers in the 1991–2016 period was driven also by the many debt restructurings and write-offs negotiated by China and its state-owned banks, especially since 2000. This pattern reflects both the weak credit rating system used by Beijing and the poor credit position of its debtors – an interpretation supported by the massive defaults in 2016 of Angola, Cuba, and Venezuela on their debt to China.

How Private Creditors Limited Losses

Several of the sovereign debt crises that arose during 1991–2016 involved major, “systemic” economies. In the context of financial globalization, these shocks threatened not only private creditors but also the international financial community as a whole. In order to prevent a systemic crisis, policy makers instigated a new international financial architecture that proved to be a boon for private creditors.

This new architecture was shaped around the IMF. It became manifest in 1994 when that Washington-based institution – supported by the US Treasury and the World Bank – intervened to stop capital outflows from Mexico, thereby preventing a default and, quite possibly, a serious international financial crisis. These same players were at work in 1997 to resolve the East Asian crisis. In the following years, other bailouts were secured for major emerging countries (e.g., Brazil, Colombia, Turkey) so that they could remain solvent.

These last-resort loan interventions reduced the number of governments in default on their bond debt and cut the percentage of distressed debt owed to private creditors (i.e., among the total sovereign debt in default) from 65% in 1992 to 22% in 2011. Nonetheless, IMF economists admitted that such bailouts were likely to encourage both debtor and creditor moral hazard. Debtor moral hazard was identified in the loans to Argentina in 2000–2001 (Jeanne and Zettelmeyer 2005, pp. 79–80), and creditor moral hazard seems to account for the massive private capital inflows to Russia before its bankruptcy in 1998 (Mussa 1999, pp. 228–229).

The IMF conditionality required that distressed countries accept restrictions minimizing the problems associated with debtor moral hazard. However, a side effect of both financial globalization and the new international financial architecture is that creditor moral hazard remains a fundamental challenge for policy makers.

Another factor that strengthened creditors’ position was the enhanced legal and contractual protection of their rights. Thus, for example, the Foreign Sovereign Immunities Act of 1976 and the US Supreme Court’s statement that the issuance of debt was a commercial act (see Republic of Argentina v. Weltover, 1992) virtually consecrated the restrictive theory of sovereign immunity. This new paradigm spurred the insertion of clauses favorable to creditors in sovereign bond contracts. So starting in the 1990s, contracts were more likely to include a waiver of the sovereign’s immunity from suit and execution. Other clauses (e.g., “consent to jurisdiction” and governing law clauses) were inserted to facilitate the enforcement of sovereign debt contracts (Weidemaier 2014).

Such enforcement became uncertain when creditors doubted their status or disagreed over how best to cope with a distressed sovereign debtor. The fear of legal subordination in favor of another creditor led to a proliferation of pari passu clauses. By the same token, the need to expedite debt restructuring deals favored the insertion of so-called collective action clauses (e.g., collective modification provisions and collective acceleration provisions).

Despite these protections, bondholders have suffered some setbacks in the recent years. For instance, they were forced to accept haircuts exceeding 50% after the debt restructurings of Argentina and Greece in 2005 and 2012, respectively (Gaillard 2014, pp. x, 11). Bondholders have also encountered some coordination problems. The successful strategies followed by certain holdout creditors (e.g., the lawsuits brought by Elliott Management against Argentina) suggest that a creditor’s most dangerous opponent might well be another creditor.

Country Risk

References

Gaillard, N. (2014), When Sovereigns Go Bankrupt – A Study on Sovereign Risk, Springer, Cham.

International Monetary Fund (2019), Heavily Indebted Poor Countries (HIPC) Initiative and Multilateral Debt Relief Initiative (MDRI) – Statistical Update, IMF Policy Paper, August, Washington, DC.

Jeanne, O. and Zettelmeyer, J. (2005), “The Mussa Theorem (and Other Results on IMF-Induced Moral Hazard),” IMF Staff Papers, Vol. 52, IMF Conference in Honor of Michael Mussa.

Mussa, M. (1999), “Reforming the International Financial Architecture: Limiting Moral Hazard and Containing Real Hazard,” in Gruen, D. and Gower, L. (Eds.), Capital Flows and the International Financial System, Reserve Bank of Australia, Sydney.

Weidemaier, W. M. C. (2014), “Sovereign Immunity and Sovereign Debt,” University of Illinois Law Review, Vol. 2014 (1).

The Dynamics of Free Trade and FDI during the Globalization Era

Histories, Read

Multilateralism waned, but the process of trade liberalization continued.

This blog article is a short excerpt from Country Risk – The Bane of Foreign Investors (Springer, 2020) by Norbert Gaillard.

International trade went through unexpected and paradoxical changes during the globalization era (1991–2016). Multilateralism waned, but the process of trade liberalization continued. For instance, the average tariff rate for the Group of Twenty (G20) fell from 13% during 1991–1994 to 5% during 2013–2016.1 How can this evolution be explained?

After the General Agreement on Tariffs and Trade (GATT) was superseded by the World Trade Organization (WTO) in 1995, several challenges arose that rendered multilateral trade talks increasingly complex and lengthy. First, under the WTO regime, tariff rates and market-opening commitments are binding, which deters members from further liberalizing their trade policy. Second, the WTO’s admission of China in 2001 stirred mistrust among other WTO members, whatever their income level. Third, as industrialized countries had reduced their tariffs substantially during the previous GATT rounds, they had little maneuvering room left to obtain trade liberalization in emerging countries – with regard to financial services, for example. Fourth, the sustained growth of international trade in the 1990s and 2000s called into question the relevance of new multilateral talks.

In this context, it is not surprising that the Doha Round, launched in 2001, failed to achieve any trade liberalization agreements (see Cohn 2007). However, some minor progress was observed with the Nairobi Package of 2015, which removed subsidies for farm exports. In fact, other means were employed to effect trade liberalization during 1991–2016: unilateral actions, regional trade agreements (RTAs), and international investment agreements (IIAs).

Unilateral tariff cuts by several emerging countries (e.g., China, India, and Indonesia) were part of offshoring-led development strategies designed to attract foreign investments. These countries’ final objectives were to integrate themselves into global value chains, absorb knowledge and technologies, and export an even wider range of products and services.

The signing of RTAs was another feature of globalization. The number of RTAs in force rose by a factor of 5 within 25 years. However, the nature of those agreements changed significantly during that time span. Contrary to what was observed at the dawn of globalization, the bulk of RTAs signed in the 2010s were “deep” agreements. Thus, they transcend traditional tariff cuts to cover multiple policy areas: competition policy, anti-dumping measures, environmental laws, labor market regulations, and so forth (see Mattoo et al. 2017).

The boom in IIAs was certainly the most salient feature of the past three decades. These agreements, which include treaties with investment provisions (TIPs) and bilateral investment treaties (BITs), contributed to reshaping international business relations and increasing the levels of protection enjoyed by foreign investors. A typical IIA’s main provisions include protection against expropriation risk, convertibility risk, and arbitrary or discriminatory measures; they may also ensure “protection and security”, and/or “most favored nation” treatment.2

Several conclusions can be drawn from these trends in international investment rulemaking. First, they reflected the outright triumph of globalization. Second, they enabled developing countries to gain credibility. Vashchilko (2011) shows that risky economies that signed BITs managed thereby to reassure international investors, which stimulated FDI inflows. Third, the growing proportion of BITs involving exclusively low- and middle-income countries evidenced the ongoing enlargement of the group of capital-exporting nations.3 Such evolution went hand in hand with the mutation of capitalism.

The growing geopolitical tensions between China and the United States are likely to undermine such dynamics of free trade and foreign direct investment. In fact, it seems we are entering what I call the “post-globalization era” (Gaillard 2020). Post-globalization involves “a logic of high interdependence in the economic, trade, migration, and technological areas between States (and their companies) whose geopolitical interests are convergent, or at least compatible. This implies the elimination, the reduction, the selection, and/or the control of dependence and interdependence relations.” This new paradigm will oblige policy makers and economic leaders to revise radically their diplomatic, economic, and financial strategies.

1 Author calculations based on the World Bank’s World Development Indicators. The G20 comprises Argentina, Australia, Brazil, Canada, China, the European Union, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, the United Kingdom, and the United States. It accounted for more than 80% of merchandise trade in 2016 (author calculation based on https://data.wto.org).

2 The “protection and security” provisions require that host countries take measures to prevent the destruction of an investor’s property.

3 About 33% of the BITs that entered into force during 2016 did not involve a high-income economy, compared with less than 12% in 1991 (see source).

References

Cohn, T. H. (2007), “The Doha Round: Problems, Challenges, and Prospects,” in Studer, I. and Wise, C. (Eds.), Requiem or Revival? – The Promise of North American Integration, Brookings Institution Press, Washington, DC.

Gaillard, N. (2020), “Le COVID-19, accélérateur de la post-mondialisation,” Politique Etrangère, Vol. 85, No. 3.

Mattoo, A., Mulabdic, A. and Ruta, M. (2017), “Trade Creation and Trade Diversion in Deep Agreements,” World Bank Policy Research, Working Paper 8206.

Vashchilko, T. (2011), Three Essays on Foreign Direct Investment and Bilateral Investment Treaties, Dissertation in Political Science, Pennsylvania State University.

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The Boom of Emerging Sovereign Bond Markets during 1991–2016

Histories

A remarkable feature of the globalization era was the enhanced credit position of many emerging economies.

This blog article is a short excerpt from Country Risk – The Bane of Foreign Investors (Springer, 2020) by Norbert Gaillard.

This development is perhaps best captured by the modest growth of external debt. During 1991–2016, the public and public-guaranteed external debt of 34 major emerging countries increased (on average) by 4% annually.1 This rate was much lower than that observed during the 1960s and 1970s.

This positive evolution was driven by the relative efficiency of the macroeconomic policies implemented in these economies. Measures designed to increase domestic savings, attract FDI, boost exports, and curb inflation enabled reductions in payments imbalances and mitigated the problem of “international original sin” (Eichengreen et al. 2005).2

Figure 1 plots the composition of public and public-guaranteed external debt. After accounting for almost a third of lending to emerging economies in the 1990s, bilateral loans saw their share decline dramatically during the subsequent two decades. In the meantime, the percentage of multilateral loans stabilized. Yet the most prominent development was the resumption of sovereign bond markets. During 1991–2016, the volume of bonds issued by major low- and middle-income governments increased by a factor of 11 and their share in total public external debt quadrupled.3

Figure 1 Composition of public and public-guaranteed external debt, 1991–2016

Notes: The data set’s 40 countries have low- and middle-income economies whose total public and public-guaranteed external debt exceeded $10 billion (US) in 2016. Those countries are Angola, Azerbaijan, Bangladesh, Belarus, Brazil, Bulgaria, China, Colombia, Costa Rica, the Dominican Republic, Ecuador, Egypt, Ethiopia, Ghana, India, Indonesia, Jordan, Kazakhstan, Kenya, Lebanon, Mexico, Morocco, Myanmar, Nigeria, Pakistan, Peru, the Philippines, Romania, Russia, Serbia, South Africa, Sri Lanka, Sudan, Tanzania, Thailand, Tunisia, Turkey, Ukraine, Venezuela, and Vietnam. The data set for 1991 excludes Azerbaijan, Belarus, Kazakhstan, Serbia, South Africa, and Ukraine because of insufficient data.

Source: Author calculations based on World Bank’s World Development Indicators.

The boom in sovereign bond markets can trace its roots to the financial disintermediation of the 1980s, but it was catalyzed by the Brady Plan. This initiative – which was launched in 1989 and amounted to transforming commercial bank loans into bonds – resolved the public debt crisis and encouraged an increasing number of emerging countries to tap capital markets. The growth of foreign government bond markets was accompanied by development of a new “business ecosystem” (Buckley 1997, 2006).

The most prominent feature of this trend was the inordinate power of credit rating agencies. Ever since credit ratings were incorporated into regulatory rules and investors’ prudential guidelines, bond issuers have been obliged to obtain a rating – and the higher, the better. Higher ratings corresponded to greater investor confidence and lower borrowing costs. Credit ratings are lagging indicators, not leading indicators (Gaillard 2011, pp. 175–183; Gaillard 2014). Yet a downgrade, a review for possible downgrade, or a negative outlook is likely to exacerbate risk aversion and trigger sell-offs.4

It is noteworthy that S&P and Moody’s methodologies compel borrowers to remain solvent on their bond debt: any missed payment or (even minor) debt restructuring is considered a sovereign default and results in a downgrade to the bottom of the rating scale. In addition, CRAs frequently use the FC sovereign rating as the ceiling for FC ratings of other debt issuers domiciled within that country; hence a reduction in the former rating leads to downgrading the latter.5 This policy – which aims to account for the risk of a government restricting access to foreign exchange – highlights the importance of sovereign ratings for all borrowers.

Major financial institutions took advantage of this propitious environment to expand their operations in emerging financial markets. An illustrative example is that of JP Morgan. In 1991, the New York–based bank created a special “emerging markets” group to provide an array of services to these economies (JP Morgan 1992). Later, it launched a series of indices that track foreign currency–denominated bonds – the Emerging Markets Bond Index (EMBI), the EMBI+, and the EMBI Global – as well as local currency–denominated debt instruments (see JP Morgan 1999). More importantly, JP Morgan was the most active underwriter of emerging government bond issues during 1993–2007 (Flandreau et al. 2009).

Another group of organizations gained ground during the globalization: bondholders’ associations. In addition to the IIF and the International Securities Market Association (ISMA, established in 1969), new organizations – such as the Emerging Markets Traders Association (EMTA) and the Emerging Markets Creditors Association (EMCA) – were set up to monitor sovereign bond market activity and to promote creditors’ rights (see EMTA 2015). The IIF is certainly the most influential among these associations; its members include investment and commercial banks, insurance companies, sovereign wealth funds, asset management firms, hedge funds, and central banks.

1 Author calculation based on the World Bank’s World Development Indicators. The countries under consideration are the low- and middle-income economies whose total public and public-guaranteed external debt exceeded $10 billion (US) in 2016. Six countries are excluded because of insufficient data for 1991. The 34 countries included in this data set are: Angola, Bangladesh, Brazil, Bulgaria, China, Colombia, Costa Rica, the Dominican Republic, Ecuador, Egypt, Ethiopia, Ghana, India, Indonesia, Jordan, Kenya, Lebanon, Mexico, Morocco, Myanmar, Nigeria, Pakistan, Peru, the Philippines, Romania, Russia, Sri Lanka, Sudan, Tanzania, Thailand, Tunisia, Turkey, Venezuela, and Vietnam.

2 For example, the so-called BRIC countries (Brazil, Russia, India, and China) were especially successful in cutting the share of their public debt denominated in foreign currency or indexed to a foreign currency.

3 Author calculations based on the World Bank’s World Development Indicators.

4 The pro-cyclical effects of rating downgrades were obvious in November–December 1997 during the East Asian crisis and between December 2009 and April 2010 during the Greek debt crisis.

5 Increased financial globalization prompted Moody’s and S&P to relax their policy on this matter in the 2000s. In 2011, however, very few debt issuers were assigned a FC rating higher than that of their government (see S&P 2011).

References

Buckley, R. P. (1997), “The Facilitation of the Brady Plan: Emerging Markets Debt Trading From 1989 to 1993,” Fordham International Law Journal, Vol. 21 (5).

Buckley, R. P. (2006), “A Force for Globalization: Emerging Markets Debt Trading From 1994 to 1999,” Fordham International Law Journal, Vol. 30 (2).

Eichengreen, B., Hausmann, R. and Panizza, U. (2005), “The Mystery of Original Sin,” in Eichengreen, B. and Hausmann, R. (Eds.), Other People’s Money, Chicago University Press, Chicago.

Emerging Markets Traders Association (2015), EMTA @ 25 (1990-2015).

Flandreau, M., Flores, J. H., Gaillard, N. and Nieto-Parra, S. (2009), “The End of Gatekeeping: Underwriters and the Quality of Sovereign Bond Markets, 1815–2007,” NBER Working Paper No.15128.

Gaillard, N. (2011), A Century of Sovereign Ratings, Springer, New York.

Gaillard, N. (2014), “How and Why Credit Rating Agencies Missed the Eurozone Debt Crisis,” Capital Markets Law Journal, Vol.9 (2).

JP Morgan (1992), 1991 Annual Report, New York.

JP Morgan (1999), “Introducing the J. P. Morgan Emerging Markets Bond Index Global (EMBI Global),” 3 August, New York.

Standard & Poor’s (2011), “Corporate and Government Ratings that Exceed the Sovereign Rating,” 3 June.

Genealogy of Country Risk

Definitions, Histories, Read

It is difficult to determine exactly when the concept of country risk was forged. The expression was used as far back as 1967 by Frederick Dahl – then assistant director of the Division of Examinations at the Board of Governors of the US Federal Reserve System – in a research paper addressing the international operations of American banks.

Frederick Dahl states that “an appraisal of the so-called country risk inherent in any foreign credit is the major distinction between domestic and international lending. Besides assessing the creditworthiness of the individual borrower, the bank has to exercise a judgment on political, economic, and social conditions in the country of the borrower as they are likely to affect foreign exchange availabilities at the time of repayment of the loan.”

It was not until 1975–1977 that the notion of country risk began to permeate the economic literature and media. Between 1970 and 1975, the external public debt of low- and middle-income countries soared by 144%, while the share of that debt financed by Western banks climbed from 7.5% to 25%.

This growing exposure to sovereign debt began to worry the US Office of the Comptroller of the Currency (OCC). By 1977, country risk had become a buzzword among bankers and investors. In its annual report released in June 1977, the Bank for International Settlements explained that “country risks [did] add new dimensions to private banking in many ways”; this international institution added that it was “necessary to appraise a country’s overall economic and political development and to relate the data on the amount and the structure of its external indebtedness to a number of macro-economic figures, such as current and prospective foreign exchange earnings.”

Starting in 1977, however, policy makers and academics offered different definitions of country risk. Confusion spread in the following years and remains to this day. The main reason is that country risk experts do not all monitor the same risks; instead, they focus on those risks that impinge on their own respective institutions or clients.

Read more and find all quoted sources in Country Risk: The Bane of Foreign Investors (by Norbert Gaillard, Springer, July 2020).

Vision

History and Future of Ratings

Histories, Read

In the 1980’s we at RATING EVIDENCE GmbH got to know ratings of American agencies. Even back then, these agencies were 80 years old, since they started operating shortly after the turn of the century. For decades, there were comparatively few changes in these agencies, as it was not until the 1980s that computers became available that significantly changed the rules by which ratings could be created and disseminated.

The new information and communication technologies, coupled with advanced data processing, have enabled more data to be considered in the rating than ever before, as well as to deliver results to a wider audience. While US agencies were present in only a few dozen countries in the 1980s, today they are in more than 110 countries.

With the emergence of new financial products, the areas of application of ratings also widened. Today, there is hardly any financial product that would not also be accessible to a rating. Due to the strong regulation of financial products, and in particular due to the different intervention of governments in the financial markets, numerous different rating approaches have developed. It is therefore important to work towards the comparability of ratings in order to provide investors with a better basis for decision-making.

In the future, social credit systems will play an increasingly important role as they imply an even more comprehensive judgment on natural and legal persons.

Vision

History and Future of Ratings

Histories

In the 1980’s we at RATING EVIDENCE GmbH got to know the rating of American agencies. Even back then, these agencies were 80 years old, since they started operating shortly after the turn of the century. For decades, there were comparatively few changes in these agencies, as it was not until the 1980s that computers became available that significantly changed the rules by which ratings could be created and disseminated.

The new information and communication technologies, coupled with advanced data processing, have enabled more data to be considered in the rating than ever before, as well as to deliver results to a wider audience. While US agencies were present in only a few dozen countries in the 1980s, today they are in more than 110 countries.

With the emergence of new financial products, the areas of application of ratings also widened. Today, there is hardly any financial product that would not also be accessible to a rating. Due to the strong regulation of financial products, and in particular due to the different intervention of governments in the financial markets, numerous different rating approaches have developed. It is therefore important to work towards the comparability of ratings in order to provide investors with a better basis for decision-making.

In the future, social credit systems will play an increasingly important role as they imply an even more comprehensive judgment on natural and legal persons.

China’s Social Credit System

Experts, Histories, Systems, Tools

The Social Credit System (SCS) is perhaps the most prominent manifestation of the Chinese government’s intention to reinforce legal, regulatory and policy processes through the application of information technology, writes Rogier Creemers, Van Vollenhoven Institute at Leiden University. Yet its organizational specifics have not yet received academic scrutiny. He published a paper which identifies the objectives, perspectives and mechanisms through which the Chinese government has sought to realise its vision of “social credit”.

Reviewing the system’s historical evolution, institutional structure, central and local implementation, and relationship with the private sector, he describes the SCS as an ecosystem of initiatives broadly sharing a similar underlying logic, than a fully unified and integrated machine for social control. With regards to big data and artificial intelligence notwithstanding, he sees the SCS as a relatively crude tool.

See his video or read his paper here.

For more historic background information: Oliver Everling, Yan Yin and Yusi Ding (Herausgeber, Associate Chief Editor, http://www.cnis.gov.cn/): Domestic and Foreign Credit Theory Studies and Standardization Practices, Technical Book Series on Standardization of Social Credit in China, Chen, Yuzhong, und Qian, Yumin (Chief Editor), compiled by National Technical Working Group on Credit of Standardization Administration of China (http://www.sac.gov.cn/), China Metrology Publishing House, Beijing, 1. Auflage, August 2010, 420 Seiten, ISBN 978-7-5026-3332-5.