Sovereign and Country Risk Analysis
JAKARTA 27 – 28 MARCH 2019
© 2019 Moody’s Analytics, Inc. and/or its licensors and affiliates. 1 Sovereign and Country Risk Analysis
Barney Helman, Director, Senior Trainer March, 2019 Indonesia Eximbank Jakarta
Course Objectives
To provide a structured framework and tools necessary to better: » Understand sovereign analysis » Consider country risk » Grasp the importance of support for Government Related Issuers.
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1 Seminar Agenda
Session Topics One Overview: Sovereign Defaults and Country Risk Two Sovereign Ratings Three Sovereign Analysis: Analytical Framework and Rating Methodology Four Country Risk Framework Five Quantitative Metrics: metric details and other considerations, and alternatives Six Other Issues, including Country risk Seven Government Related Issuers and the Sovereign Ceiling, and a Comprehensive Exercise
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Moody’s Corporation
» Credit Ratings » Credit Research & Risk Measurement – Corporate » Economic & Consumer Credit Analytics – Financial Institutions » Enterprise Risk Solutions – Structured » Structured Analytics & Valuations – Municipal/Public » Professional Services » Credit Research » Learning Solutions
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» Start / finish » Breaks » Lunch » Restrooms » Telephones » Binder » Memory Stick
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Seminar Methodology
Informal Working in Groups
Seminar Please Ask! Methodology AHA!s
Not a Lecture
» Review » Parking Lot » Personal Objectives
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3 Sovereign and Country Risk Analysis Meet your Instructor…
Barney Helman Director – Senior Trainer Moody’s Analytics Learning Solutions » Education and Experience… It’s a long story
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Self-Introduction…for 70?
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4 Introduction and Overview
What is Government Debt?
» Limited to financial liabilities » Evaluated in nominal terms except inflation-linked obligations which need to be revalued » All other financial obligations that can accrue in the future, whether contractual or not, are excluded » “Stock-flow adjustments” also affect debt but are not captured in fiscal balance » For example, proceeds of disposal of financial assets are typically not counted as revenue but represent an alternative to borrowing » “General Government Debt” includes all levels of government but we recognize that in some countries transfers between different levels may be minimal, e.g. USA » Inclusion of government-owned entities depends on accounting rules
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5 Sovereign Debt
» Used to generate funding for general government operations » Nominal value of financial liabilities, primarily in the form of borrowings, across all levels of government expressed on a gross basis – Includes other government levels (local and regional) in order to account for the potentially high links of balance sheets and fiscal accounts » Most countries issue a combination of bonds, bills and notes » Debt structure based on market conditions and government policy » In the vast majority of the world’s debt capital markets national governments are the largest borrowers
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Opinions about Sovereign Risk Vary over Time
"The budget should be balanced, the Treasury should be refilled, public debt should be reduced, the arrogance of officialdom should be tempered and controlled, and the assistance to foreign lands should be curtailed lest [the state] become bankrupt…
People must again learn to work, instead of living on public assistance.“ Ovid 55 A.D.
“…because countries don’t go bust” Walter Wriston 1982
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6 What do you worry about with Sovereign Debt?
Ability to pay, based on assessing risks » Economic » Institutional » Political » Susceptibility to Event Risk But also willingness to pay and history of payment
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Sovereign Debt
» Unlike natural persons, sovereign debt does not “die” but continues from generation to generation » Public international law doctrine of “state succession” – a government automatically inherits the debts of its predecessor governments, regardless of how dissimilar the forms of government may be – Aristotle, Book III, Politics “…whether it is right or wrong for a state to repudiate public obligations when it changes its constitution…” – “International law sharply distinguishes the succession of states, which may create a discontinuity of statehood, from a succession of governments, which leaves statehood unaffected” Restatement (Third) of the Foreign Relations Law of the United States » Sovereign debt is congenital (passes through generations), adhesive (remain glued to the territory, no limited liability) and ineradicable (the debt remains long after anyone can recall why it was raised in the first place)
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7 Distinguishing Characteristics of Sovereign Debt
» Sovereign’s ability to modify taxation in order to generate revenue » Freedom from a higher authority to compel debt resolution » High probability of survival even after an event of default
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Sovereignty
Over time has lain with villages, towns, cities, tribes, even empires Now resides with the nation state Freedom from a higher authority New limitations: » Economic cooperation, integration, interdependence
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8 What Makes a Country Rich / Creditworthy?
» Are they the same things? » Does this mean that a country won’t default? » What information would you want in order to make an assessment? » Where would you get that information? » What would cause a country to default on its debt?
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Sovereign Defaults
9 Moody’s Definition of Default
» a missed or delayed disbursement of a contractually-obligated interest or principal payment » a distressed exchange whereby – an obligor offers creditors a new or restructured debt, or a new package of securities, cash or assets that amount to a diminished financial obligation relative to the original obligation – the exchange has the effect of allowing the obligor to avoid a bankruptcy or payment default » a change in the payment terms of a credit agreement or indenture imposed by the sovereign that results in a diminished financial obligation – forced currency re-denomination – forced change in some other aspect of the original promise, such as indexation or maturity.
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Sovereign Default Definition
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10 Sovereign Defaults
Do defaults matter? » To them? » To markets? » To rating agencies?
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Post-default Sovereign Access
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11 Post-default Sovereign Access
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Post-default Sovereign Access
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12 Post-default Sovereign Access
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The Causes of Sovereign Defaults
» The primary causes of the 20 sovereign defaults from 1997-2010 can be grouped into four categories: – High debt burden (35% of studied cases): unsustainable fiscal policies, deterioration in debt affordability. E.g. Pakistan (1999); Belize (2006); Greece (2012) – Political/institutional weakness (35%): governance instability, unwillingness to pay. E.g. Venezuela (1998); Russia (1998) – Banking crisis (15%): large contingent liabilities, capital outflows and foreign currency crises. E.g. Ecuador (1999) – Chronic economic stagnation (15%): loss of investor confidence, capital outflows, even with low debt-to-GDP levels. E.g. Ukraine (1998 and 2000); Argentina (2001)
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13 The Causes of Sovereign Defaults
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Learning From Past Defaults
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14 Debt GDP Changes
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Debt GDP Changes
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15 Sovereign Contingent Liabilities
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Sovereign Contingent Liabilities
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16 Sovereign Contingent Liabilities
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Moody’s Ratings
17 Moody’s Corporation
» Founded in 1900 » First ratings in 1909: Railroad bonds » First sovereign ratings in 1917 » Approximately 7,000 employees in 29 countries » One of three global rating agencies » Ratings include approximately 125 sovereigns
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What does a Moody’s Rating Represent?
» An Independent Opinion ...on the future ability of an issuer to make timely payments on its financial commitments » A measure of Relative Credit Risk ...based on fundamental credit assessment » A statement of Expected Loss
A forward-looking through-the-cycle opinion/ prediction about relative creditworthiness
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18 What is a Credit Rating?
Moody’s opinion of the expected loss to the holder of a debt security. Investors want to know how much money they might lose when holding a particular security. Expected Loss = (Probability of Default) x (Severity of Loss Given Default)
» An issuer-level characteristic » An issue-level characteristic » Measured by corporate » Measured by recovery rates default rates
Opinion is quantified in the rating scale Two broad objectives: accuracy and stability
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What is the Objective of a Moody’s Rating?
Objective of Moody’s corporate bond rating system: “.. to be an accurate and stable measure of relative credit risk, correlated with subsequent default and loss experience.”
Rating accuracy: correlation between ratings and default Rating stability: frequency and magnitude of rating changes.
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19 What is Credit Risk and How is it Measured?
Credit Risk
Borrower Risks Transaction Risks
What is the % you How much exposure do Who are you expect to lose, given you expect to have Time to repayment? lending to? seniority, collateral and should the borrower other loss mitigation? default?
Probability of Default Loss Given Default Maturity Exposure at Default (PD) (LGD) (M) (EAD)
Expected Loss (EL) = PD x LGD x EAD
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Moody’s Sovereign Ratings Characteristics of ratings – Moody’s seeks to rate “through the cycle” » Ratings are monitored continuously but are assigned using a “through the cycle” approach
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20 What is a Government Bond Rating?
A rating is an opinion of relative creditworthiness » Creditworthiness: a government’s ability and willingness to service its debt fully and on time » Defined as expected loss (EL) – Reflects default probability and loss given default Ratings are based on credit fundamentals » Assessment of economic and political risks » Forward-looking analysis that looks through cycles » Typically, but not always initiated by government » Meetings held with government officials but also research institutes, NGOs, major banks and corporations
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Why are Ratings Important?
» Key determinant of a country’s borrowing costs » Generally sets a ceiling for ratings assigned to domestic entities, therefore affects private financing costs » Some investors have lower bounds for the investment risk they can take » National governments are by far the largest issuers of debt, short-term (bills) and long-term (bonds) » In 2012, global bond markets reached about US$100 trillion – governments account for 44% of total
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21 What are Credit Ratings?
MOODY’S S&P Capacity to repay Long-Term Short-Term Long-Term Short-Term interest and principal
Aaa AAA Highest quality, minimal credit risk Aa1 AA+ Aa2 AA A-1+ High quality, very low credit risk Aa3 Prime-1 AA- Investment A1 A+ Grade A2 A A-1 Upper-medium, low credit risk A3 A- Prime-2 A-2 Baa1 BBB+ Baa2 BBB Medium grade, moderate credit risk, may possess certain speculative characteristics Baa3 Prime-3 BBB- A-3
Ba1 BB+ Substantial credit risk, speculative elements Ba2 BB Ba3 BB- B B1 B+ High credit risk, speculative Speculative B2 Not B Very high credit risk, poor standing Grade B3 Prime B- Caa1 CCC+ Highly speculative, in or very near default Caa2 CCC Caa3 C In default, little recovery prospect Ca CCC- CC C D Ratings are Opinions of relative PD or relative EL
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Moody’s Ratings are not…
» A buy/sell recommendation » A forensic audit » An evaluation of character/competence
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22 Moody’s Ratings Process
Issuer Information
Rating Methodologies Rating Committee
Financial Metrics
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Understanding Moody’s Rating Process
» Preliminary, informal discussions » Issuer meeting and rating analysis » Decision by the rating committee » Publication and distribution of the rating » Monitoring by the lead analyst » Modification of the rating
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23 The Rating Committee Process
Country AnalystCCO
Sovereign Analyst Team MD Lead Back-up Regional Analyst Analyst CCO
Collective experience of seasoned credit professionals
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Non-Participating Sovereign Issuers
Governments of » Bahrain » Cameroon » Cuba » Iraq » Kenya » Morocco » Rwanda
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24 Sovereign Ratings Distribution
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Sovereign Ratings Distribution
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25 Sovereign vs. Corporate Ratings Distribution
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Sovereigns Span the Rating Spectrum (examples of foreign-currency bond ratings)
Aaa Australia, Germany, Luxembourg, US, etc
Aa1, Aa2, Aa3 Hong Kong, Kuwait, Korea
A1, A2, A3 China, Poland, Malaysia, Japan
Baa1, Baa2, Baa3 Thailand, Brazil, India, Indonesia
Ba1, Ba2, Ba3 Croatia, Angola, Bangladesh
B1, B2, B3 Vietnam, Moldova
Caa1 – C Argentina, Mongolia, Jamaica, Ukraine
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26 Sovereign Ratings are more stable
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Rating Migrations
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27 Rating Migrations
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Rating Migrations
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28 Default Rates
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Default Rates: Aspac vs. Global
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29 Average Cumulative Default Rates, 1983-2012 Rating/Year12345678910 Aaa 0.00% 0.02% 0.02% 0.05% 0.09% 0.13% 0.19% 0.19% 0.19% 0.19% Aa1 0.00% 0.00% 0.00% 0.09% 0.14% 0.15% 0.15% 0.15% 0.15% 0.15% Aa2 0.00% 0.02% 0.16% 0.34% 0.52% 0.65% 0.75% 0.86% 0.98% 1.12% Aa3 0.05% 0.15% 0.23% 0.34% 0.48% 0.58% 0.68% 0.76% 0.84% 0.98% A1 0.08% 0.26% 0.54% 0.81% 1.06% 1.30% 1.50% 1.68% 1.88% 2.13% A2 0.07% 0.22% 0.43% 0.66% 0.90% 1.22% 1.65% 2.14% 2.59% 2.99% A3 0.06% 0.22% 0.48% 0.70% 1.04% 1.38% 1.74% 2.16% 2.56% 2.84% Baa1 0.15% 0.38% 0.63% 0.90% 1.23% 1.55% 1.86% 2.08% 2.27% 2.54% Baa2 0.18% 0.49% 0.88% 1.46% 1.97% 2.56% 3.08% 3.56% 4.14% 4.86% Baa3 0.27% 0.79% 1.40% 2.00% 2.82% 3.61% 4.40% 5.37% 6.24% 7.13% Ba1 0.66% 1.92% 3.60% 5.48% 7.26% 9.16% 10.66% 11.75% 12.85% 14.07% Ba2 0.77% 2.17% 3.98% 5.93% 7.68% 9.05% 10.42% 11.97% 13.42% 14.75% Ba3 1.75% 5.07% 9.01% 13.11% 16.36% 19.39% 22.16% 24.99% 27.71% 30.42% B1 2.38% 6.61% 11.18% 15.28% 19.48% 23.63% 28.02% 31.67% 34.86% 37.94% B2 3.67% 9.20% 14.75% 19.83% 24.20% 28.28% 31.94% 35.12% 38.34% 40.97% B3 6.37% 13.85% 21.21% 27.33% 32.73% 37.72% 41.78% 45.33% 47.83% 50.14% Caa1 8.26% 18.32% 27.45% 35.19% 42.34% 47.44% 50.63% 54.34% 59.46% 64.72% Caa2 17.86% 29.47% 38.40% 45.55% 50.93% 55.73% 59.87% 64.16% 68.82% 72.15% Caa3 28.03% 44.11% 53.78% 60.84% 66.55% 68.00% 70.29% 73.24% 75.93% 79.99% Ca-C 41.40% 54.04% 63.02% 69.41% 74.96% 76.78% 78.64% 80.30% 80.30% 80.30% Inv Grade 0.10% 0.29% 0.54% 0.82% 1.13% 1.45% 1.77% 2.10% 2.42% 2.74% Spec Grade 4.72% 9.81% 14.71% 19.03% 22.76% 26.05% 28.96% 31.52% 33.84% 35.97% All rated 1.86% 3.81% 5.65% 7.22% 8.55% 9.68% 10.66% 11.51% 12.26% 12.16%
Source: Moody’s Investors Service, Corporate Default and Recovery Rates, 1920 – 2012, 28 February 2013
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Ratings Defaults: Timing and Ratings
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30 Sovereign Defaults
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Sovereign Defaults
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31 Variability of Default Rates By Rating Category Annual Default Rate 1920 – 2016
Moody’s does not manage its ratings to maintain a specific default or loss range – unlike Basel II & III IRB
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Sovereign Default Cause Categories and Examples 1997-2010
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32 Sovereign Recovery Rates
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Moody’s Ratings are not…
» A buy/sell recommendation » A forensic audit » An evaluation of character/competence
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33 Defaults – Factors for Sovereigns
» The 20 defaults between 1997 and 2010 all had one of: – Negative economic growth – Banking crises – Currency crises – Natural disasters
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Recovery Levels and Defaults— Factors for Sovereigns
» There is a small sample size, but there appears to be a relationship between why a sovereign defaulted and recovery levels.
– Negative growth led sovereign defaults recovered 68% – Banking crisis led sovereign defaults recovered 38% – Currency crisis led sovereign defaults recovered 57% – Natural disaster led sovereign defaults recovered 23% – Overall: about 50%
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34 Median Metrics at Default
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Median Metrics at Default
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35 Median Metrics at Default
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Median Metrics at Default
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36 External Vulnerability Index Measures:
Short-term Debt & CPLTD & Foreign LT Deposits ------Foreign Reserves (Previous year)
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Moody's Market Implied Ratings
37 Bond Market & CDS Implied Ratings
Bond Implied Rating » The Bond Market Implies a rating for an issuer, based on the spreads on an issuer’s bonds Credit Default Swap Implied Rating » The CDS Market Implies a rating for an issuer, based on the spread on an issuer’s 5yr CDS
=> Measures derived from the Bond/Credit Markets
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Derivative – Credit Default Swap (CDS)
Premium Protection Protection Buyer Seller Payment if Default
Payments Protection Buyer pays an annual premium to Reference Protection Seller in return for a payment of Asset entire notional amount if the Reference Asset defaults
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38 Moody’s Ratings versus Market Implied Ratings – Overall
Moody’s Ratings Market Implied Ratings » Driven by committees and » Driven by market observations analysts’ opinions and a model » Stable » Volatile – ~20% change in a year – ~90% change in a year – ~1% rating reversals – ~76% rating reversals » Through-the-cycle views » Point-in-time estimates » Long time horizon » Short time horizon » Assessments of ultimate credit » Reflect credit views plus other loss factors
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Sovereign Market Implied Ratings Gap
Senior Unsecured Bond Bond CDS CDS or Equivalent Implied Implied Implied Implied Country Outlook Rating Rating Gap Rating Gap Australia, Government of STA Aaa Aaa 0 Aa2 -2 China, Government of NEG Aa3 A3 -3 Baa3 -6 Hong Kong Sukuk 2014 Limited NOO Aa1 A2 -4 Hong Kong Sukuk 2015 Limited NOO Aa1 Aa3 -2 India, Government of POS Baa3 Ba1 -1 Indonesia, Government of STA Baa3 Baa2 1 Ba1 -1 Japan, Government of STA A1 Aaa 4 A1 0 Korea, Government of STA Aa2 Aa1 1 A1 -2 Malaysia Sovereign Sukuk Berhad NOO A3 A3 0 Malaysia Sukuk Global Berhad NOO A3 A3 0 Malaysia, Government of STA A3 A3 0 Ba1 -4 Mongolia, Government of NEG B2 Caa1 -2 New Zealand, Government of STA Aaa Aa2 -2 Philippines, Government of STA Baa2 A3 2 Baa2 0 Sri Lanka, Government of NEG B1 B1 0 Thailand, Government of STA Baa1 Baa2 -1 Vietnam, Government of STA B1 Baa3 4 Ba2 2 Moody’s MIR Issuers List, August 11, 2016, Sovereigns, Asian Pacific
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39 MIRs Sovereign:
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Sovereign Spreads
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40 Moody's Methodology
Analytical Framework
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41 Factors
» Economic Strength » Institutional Strength » Fiscal Strength » Susceptibility to Event Risk
Expressed as Very High, High, Moderate, Low, Very Low with +/- modifiers
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42 Moody’s Sovereign Rating Methodology – Economic Strength
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Moody’s Sovereign Rating Methodology – Institutional Strength
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43 Moody’s Sovereign Rating Methodology – Fiscal Strength
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Moody’s Sovereign Rating Methodology – Susceptibility to Event Risk
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44 Sovereign Metrics
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Sovereign Metrics
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45 Sovereign Metrics
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Sovereign Metrics
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46 Economic Strength – Why It Matters
Intrinsic strength is important in determining country’s resilience or shock-absorption capacity Focus on: » Growth potential » Diversification » Competitiveness » Wealth » Scale
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Economic Strength
Growth dynamics » Average real GDP growth in recent past and medium-term outlook » Volatility of recent GDP growth » Competitiveness and innovation Elements that point to long-term resiliency, e.g. investment in human capital, level of innovation, participation in wider economic area » World Economic Forum Global Competitiveness Report & levels of participation in education
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47 Evolution of the State: Breaking down Debt and GDP
» According to the BIS gross debt now 109%/GDP for USA (+20.3% since 2009); in UK debt is 109% (from 72%); France 114% (from 91%); Germany 88% (from 77%); Italy 144% (from 130%); and Japan 228% (from 189%) » Why use GDP as key metric (market value of all final goods and services produced within a country in a given period)?
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GDP
» Chosen measure of a nation’s well-being for over 70 years but has limitations » No account for environmental degradation and excludes unpaid work such as volunteering and housework » “it measures everything...except that which makes life worthwhile.” Robert Kennedy, University of Kansas, 18 March 1968 » Measure of income, not wealth
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48 GDP Data
» Quality of national data is variable – With a lot of institutional interest in Africa, limited and unreliable data should be a concern – Data in Africa tend to be released sporadically and with lags – In 2014 Kenya announced GDP was 20% higher than previously reported; Nigeria 89% – In 2010 Ghana recalculated the size of its GDP, boosting it by 62% – Guinea-Bissau and The Gambia both more than doubled the size of their economies after recalculation – It is not all good news: although ratios such as debt/GDP fall, others such as tax revenues/GDP decline » Not only Africa: Asian official unemployment rates?
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Deficit Reduction Problems
» Deficit reduction is now more difficult in many countries » Demand for public spending has grown faster than the capacity to tax » Politics in many countries have become polarized » Tax administration has become more difficult with avoidance and evasion widespread – Especially a problem in Asia?
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49 Participation in Wider Economic Area – Support Dimension
» EU – EFSF (European Financial Stability Facility—temporary from 2010 and ESM (European Stability Mechanism since 2010) plus OMTs (outright Monetary Transactions from the European Central Banks) » Association of South East Asian Nations (ASEAN) Chiang Mai Initiative Multilateralisation (CMIM) regional emergency reserve pool – Regionally-based support programmes shift from total dependence on IMF (and their conditionality as in 1997) and access less fraught with negative political implications
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Economic Strength
» Scale of the economy » Wealth: GDP per capita gives an indicator of relative wealth (but care needed as this is highly correlated with Factor 2, Institutional Strength) » Consider also if GDP growth, GDP per capita, nominal GDP are being flattered by excessive credit growth » Diversification
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50 Moody’s Sovereign Rating Methodology – Economic Strength
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Sovereign Metrics
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51 Institutional Strength – Why It Matters
About a third of past sovereign defaults have been directly related to: » Institutional and political weaknesses » Political instability » Weak budget management » Governance problems » Political unwillingness to pay
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Institutional Strength
Are institutions conducive to respect of contracts? » Respect of property rights » Efficiency and predictability of government action » Transparency » Consensus on political goals Important to note assessment does not have political bias about the form of sovereign government – both democratic and authoritarian governments have defaulted But mature democracies tend to have stronger rule of law, greater transparency and a longer history of institutional development
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52 Institutional Framework and Effectiveness
World Bank Indicators: » Government Effectiveness » Rule of Law » Control of Corruption
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World Bank Ease of Doing Business Index 2016
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53 Worldwide Governance Indicators: Control of Corruption
http://databank.worldbank.org/data/reports.aspx?Report_Name=WGI-Table&Id=ceea4d8b
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Control of Corruption
http://info.worldbank.org/governance/wgi/#reports
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54 Control of Corruption
http://info.worldbank.org/governance/wgi/#reports
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Regulatory Quality
http://info.worldbank.org/governance/wgi/#reports
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55 Worldwide Governance Indicators: Political Stability
http://databank.worldbank.org/data/reports.aspx?Report_Name=WGI-Table&Id=ceea4d8b
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Political Stability
http://info.worldbank.org/governance/wgi/#reports
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56 Worldwide Governance Indicators: Government Effectiveness
http://databank.worldbank.org/data/reports.aspx?Report_Name=WGI-Table&Id=ceea4d8b
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Government Effectiveness
http://info.worldbank.org/governance/wgi/#reports
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57 Worldwide Governance Indicators: Rule of Law
http://databank.worldbank.org/data/reports.aspx?Report_Name=WGI-Table&Id=ceea4d8b
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Rule of Law
http://info.worldbank.org/governance/wgi/#reports
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58 Rule of Law Country Score % Australia 1.56 92% Cambodia (0.69) 25% China 0.42 68% Hong Kong 1.93 99% Indonesia (0.22) 46% Japan 1.79 96% Korea 1.03 80% Malaysia 0.96 77% Mongolia (0.40) 40% New Zealand 1.89 99% Philippines 0.11 58% Singapore 2.25 100% Taiwan 1.41 88% Thailand 0.36 66% UK 1.74 94% US 1.46 90% Vietnam 0.08 55% http://info.worldbank.org/governance/wgi/#reports
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Worldwide Governance Indicators: Voice and Accountability
http://databank.worldbank.org/data/reports.aspx?Report_Name=WGI-Table&Id=ceea4d8b
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59 Voice and Accountability Country Score % Australia 1.36 93% Cambodia (1.09) 19% China (1.58) 5% Hong Kong 0.48 64% Indonesia 0.14 52% Japan 1.02 79% Korea 0.67 69% Malaysia (0.35) 36% Mongolia 0.24 57% New Zealand 1.57 99% Philippines 0.14 52% Singapore (0.14) 43% Taiwan 0.89 73% Thailand (0.90) 12% UK 1.27 92% US 1.08 81% Vietnam (1.33) 11% http://info.worldbank.org/governance/wgi/#reports
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Scales: 2.5 to -2.5
Above 1.5: 3 (Norway, The Netherlands, Sweden) At 1 (ranked 41-46: Guam, American Samoa, Anguilla Aruba, Bermuda, Hungary) At 0 (ranked 108: Bosnia and Herzogovina) At -1 (ranked 167-168: Brunei, Central African Republic) Below -2.0 4 (ranked 206-209: Turkmenistan, Eritrea, North Korea, Burma)
World Governance Indicators 2008, Voice and Accountability
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60 Policy Credibility and Effectiveness
Inflation performance » Price stability helps growth and prosperity and also a factor in competitiveness Inflation volatility » Institutional strength of central bank » High volatility associated with monetary policy uncertainty But consider also track record of default
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Moody’s Sovereign Rating Methodology – Institutional Strength
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61 Sovereign Metrics
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Economic Strength + Institutional Quality
» Indicator of shock-absorption capacity » Much research has shown the factors to be interrelated
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62 Economic Strength and Institutional Strength
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Fiscal Strength – Why It Matters
Historical defaults often associated with: » Slow build-up of debt » Dependence on external creditors » Deterioration in debt affordability
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63 Fiscal Strength
Debt Burden » General Government Debt/GDP » General Government Debt/Revenues Debt Affordability » General Government Interest Payments/Revenue » General Government Interest Payments/GDP
Consider contingent liabilities and financial assets
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Fiscal Strength – Other Considerations
» Debt trend » General Government Foreign Currency Debt/General Government Debt » Other Public Sector Debt » Public Sector Financial Assets or Sovereign Wealth Fund
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64 Moody’s Sovereign Rating Methodology – Fiscal Strength
Sovereign and Country Risk Analysis, 2019 129
Sovereign Metrics
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65 EM External Debt Has Almost Tripled Over Last Decade
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Asia Pacific: China Leads Growth but External Leverage Low
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66 Asia Pacific: Asia Ex-China Experienced the Largest Deterioration in External Vulnerability Metrics
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External Debt is Mostly US Dollar Denominated
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67 EM Sovereign Debt Has Transitioned Towards Local Currency
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Thailand: Private Sector Loans 1980 – 1997
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68 Economic Resiliency and Fiscal Strength
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Event Risk – Why It Matters
A number of defaults have taken place in the past in the aftermath of exogenous shocks » Banking crisis » Foreign exchange crisis » Liquidity crisis
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69 Event Risk
Political Risk » Domestic – World Bank Voice & Accountability Index/GDP per capita » Geopolitical Government Liquidity Risk » Fundamentals: Gross Borrowing Requirements/GDP, Non-Resident Share of General Government Debt » Market Funding Stress: Market Implied Ratings Banking Sector Risk » Strength of Banking System – average Baseline Credit Assessment » Size of Banking System – total domestic bank assets/GDP » Funding Vulnerability - average banking system loan/deposit ratio
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Event Risk
External Vulnerability Risk » Current Account Balance + FDI Inflows/GDP » External Vulnerability Indicator » Net International Investment Position
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70 Moody’s Sovereign Rating Methodology – Susceptibility to Event Risk
Sovereign and Country Risk Analysis, 2019 141
Government Financial Strength and Event Risk
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71 External Vulnerability Index measures:
Short-term Debt & CPLTD & Foreign LT Deposits ------Foreign Reserves (Previous year)
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Moody’s Sovereign Rating Methodology – Susceptibility to Event Risk
Sovereign and Country Risk Analysis, 2019 144
72 Moody’s Sovereign Rating Methodology – Susceptibility to Event Risk
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Adjustments
» Unusual scale » Unusual wealth » Unusual scale » Unusual diversity—commodities » Large stocks of natural resources » Structural shifts
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73 Sovereigns: Impact of Climate Change
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Malaysia
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74 Malaysia
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Malaysia—Key Indicators
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75 Malaysia
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Malaysia
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76 Malaysia
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Malaysia
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77 Malaysia
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Malaysia
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78 Indonesia
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Indonesia
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79 Indonesia
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Indonesia
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80 Indonesia
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Indonesia
Sovereign and Country Risk Analysis, 2019 162
81 Country Risk
Risks and Mitigants
Country » Political » Social » Legal » Regulatory » Environmental » Physical Infrastructure » Sovereign and Country ceilings
Sovereign and Country Risk Analysis, 2019 164
82 Sovereign Ceiling
» Sovereign risk is typically defined as the government or GRI defaulting. » Is that all the risk involved in doing business in that country? » Country risk tries to capture risks beyond that, including: – political instability – conflict risk – regulatory and legal issues, eg contract enforceability – risk of nationalization or expropriation – financial instability or currency redenomination – natural disaster or systemic failure
Sovereign and Country Risk Analysis, 2019 165
Country Risk
» “Country Risk” goes beyond the probability that the sovereign will meet its own debt obligations in full and on time » Numerous “definitions” used » Moody’s Country Ceilings are the closest we get to expressing a view on country risk, though Local Currency ratings incorporate it » Political risk analysis providers and credit rating agencies use different methodologies to assess and rate countries' comparative risks » Credit rating agencies tend to use quantitative econometric models and focus on financial analysis, whereas political risk providers tend to use qualitative methods, focusing on political analysis
Sovereign and Country Risk Analysis, 2019 166
83 Country Risk in Ratings
» Country risk refers to domestic economic and financial risks in a given country that arise from political, institutional, and economic factors » It encompasses the risk arising from sovereign default – referred to as sovereign risk, as well as the risk that the government will interfere with the ability of domiciled borrowers to repay their cross-border debts – often referred to as transfer and convertibility risk » Within the ratings architecture, country ceilings, which represent an upper limit on possible ratings of corporate obligations or structured finance transactions within a sovereign’s jurisdiction, speak directly to the importance of country risk
Sovereign and Country Risk Analysis, 2019 167
Country Risks and Defaults
» Episodes of large-scale corporate and sub-sovereign defaults generally coincide with episodes of sovereign crises » Over 70% of emerging market defaults have occurred during sovereign crises » A detailed survey of the reasons for default of rated issuers suggests that country risk has been twice as important as firm risk in corporate defaults during sovereign events and has remained important outside of sovereign events as well » Economic recessions and currency depreciation have been the major risk factors, followed by political and civil disturbances and bank runs
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84 Impact of Sovereign on Other Sectors
Sovereign crises have been shown to promote financial distress in other sectors through a number of channels – slowing or contracting economic activity – liquidity constraints and higher financing costs resulting from diminished investor confidence and credit availability – capital outflows leading to a foreign exchange and/or a systemic banking crisis – government austerity measures that reduce or delay government payments and may depress the general level of economic activity – unfavourable changes or restrictions to movements in exchange rates, interest rates or price levels – government interference or changes in regulation, and changes in tax policies – increased risks of political uncertainty and civil or labour unrest
Sovereign and Country Risk Analysis, 2019 169
Country Risk Goes Beyond Sovereign Risk
» Other examples of country risk? » What affects both? Macroeconomics. » What do you think the outlook for the next 12-18 months is for sovereigns?
Sovereign and Country Risk Analysis, 2019 170
85 Exercise
Given that Sovereign ratings are a function of Economic, Institutional, and Fiscal Strength along with Susceptibility to Event Risk, what… » Do you think is the outlook for sovereigns—in your region and/or globally? » Do you think are the most important factors that may weigh on or boost Sovereign ratings now and for the near future? » Do you think markets agree with your view? Will this affect sovereign’s ability to refinance? » If you already know of Moody’s outlooks, what are your major points of agreement or disagreement? » Work in your group and summarize answers on the flip chart
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Country versus Sovereign Risk
86 Country risk vs. Sovereign risk
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Ceilings—other considerations
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87 Ceilings—other considerations
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Trade Issues
88 World Bank
https://www.worldbank.org/en/results/2018/04/03/stronger-open-trade-policies-enables-economic-growth-for-all
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APAC’s vulnerability to trade and tech tensions
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89 APAC’s vulnerability to trade and tech tensions
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90 Ceilings
Impact of Sovereign Ratings on Corporate Ratings
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91 Definitions
Local-Currency Government Bond Ratings: » Reflect the government’s capacity and willingness to generate local- currency revenue to repay its local-currency bonds on a timely basis. Foreign-Currency Government Bond Ratings: » Reflect the government’s capacity and willingness to mobilize foreign exchange to repay its foreign-currency denominated bonds on a timely basis.
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Definitions
» Foreign Currency Bond Ceiling: Reflect the risk that a government would impose a moratorium should it default. » Foreign Currency Deposit Ceiling: Reflect the risk that a government would freeze foreign-currency deposits to conserve scarce foreign- currency resources during a crisis. » Local Currency Bond Ceiling: Reflect all the risks of a country— including economic, financial, political, and legal—that, taken together, constrain the local currency ratings of domiciled obligors…reflect the risk of a collapse of the domestic payments system. » Local Currency Deposit Ceiling: Reflect the risk that an important bank would default on its local-currency deposits due to limited local- currency resources or a domestic deposit freeze.
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92 Foreign Currency Country Ceilings
Ability of ratings to pierce the FC Country Ceiling » Criteria revised in June 2001, based on default experiences in various countries » General moratorium not always imposed if sovereign defaults » Corporate bond ratings (issued under foreign law) as well as Project Financings can pierce the country ceiling
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Ceilings
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93 Ceilings
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Assessing Asian Country Level Risks 8/18/2017
COUNTRY CEILINGS GOVERNMENT BOND RATINGS FOREIGN CURRENCY LOCAL CURRENCY Bank FOREIGN LOCAL Bonds Deposits Bonds Deposits CURRENCY CURRENCY Australia Aaa Aaa Aaa Aaa Aaa / STA Aaa / STA China Aa3 A1 Aa3 Aa3 A1 / STA A1 / STA Hong Kong Aaa Aa2 Aaa Aaa Aa2/ STA Aa2 / STA India Baa2 Baa3 A1 A1 Baa3 /POS Baa3 / POS Indonesia Baa2 Baa3 A1 A1 Baa3 / POS Baa3 / POS Japan Aaa Aaa Aaa Aaa A1 / STA A1 / STA Korea Aa1 Aa2 Aaa Aa2 Aa2 / STA Aa2 / STA Malaysia A1 A3 A1 A1 A3 / STA A3 / STA Philippines A3 Baa2 A2 A2 Baa2 / STA Baa2 / STA Singapore Aaa Aaa Aaa Aaa Aaa / STA Aaa / STA Taiwan Aa2 Aa3 Aa2 Aa2 Aa3 / STA Aa3 / STA Thailand A2 Baa1 A1 A1 Baa1 / STA Baa1 / STA
Sovereign and Country Risk Analysis, 2019 188
94 Government Risk Isn’t Necessarily the Best
Government Bonds (even those denominated in local currency) are not necessarily the least risky financial asset in a country » Domiciled issuers could, and did, service their FC debt during bond defaults by their sovereigns Many corporate issuers, particularly in emerging market countries, have a lower risk profile than their government
Sovereign and Country Risk Analysis, 2019 189
Ceilings: the Sovereign Architecture
» Private sector ratings for bonds issued in the global capital markets are not constrained by the sovereign rating – the country ceiling is usually higher than the government’s rating » Case-by-case assessment – driven by our analysis of the company’s standalone rating in local currency and the extent to which that company/sector – is affected by “moratorium” risk » Sovereign rating is the “umbrella” – setting the stage and the benchmark for government-related issuers as well as private sector ratings: both banks and corporates
Sovereign and Country Risk Analysis, 2019 190
95 Ratings Above the Sovereign
» Most non-structured locally-domiciled issuers are rated at or below the level of the sovereign because they operate in the same economic and financial environment and are therefore vulnerable to the same broad credit pressures as the sovereign » Sovereigns are often viewed as the lowest risk credit in their local market or currency » In order to be rated above the sovereign, an issuer needs not only to be fundamentally stronger than the sovereign from a credit perspective, but also to demonstrate a degree of insulation from the domestic macroeconomic and financial disruption which generally accompanies a sovereign default
Sovereign and Country Risk Analysis, 2019 191
Ratings Above the Sovereign (continued)
For non-financial corporates, the reference comparison is the gap between the government’s senior unsecured bond rating and the senior unsecured rating of the entity for an investment grade issuer, or the corporate family rating (CFR) for a speculative grade issuer » Revenues are derived from non-government sources or have a substantial international component – Where the reliance on domestic revenue sources is significant, the financial profile must be strong with limited risk of deterioration due to the impact of weak domestic economic fundamentals » Limited reliance on domestic banks or capital markets for funding, usually because the company has substantial free cash flow and flexibility to make adjustments (such as reductions in dividends or capex) to maintain its financial profile in a deteriorating environment
Sovereign and Country Risk Analysis, 2019 192
96 Rating Above the Sovereign (continued)
» Ratings of strong entities are likely to be more than two notches above the sovereign when a substantial majority of revenues, cash flow and assets are derived from foreign sources and there is no reliance on local market funding – At the extreme where virtually all operations are outside the nominal headquarters country, the sovereign rating may have little relevance to the rating of a multi-national company; instead, the ratings of countries where its operations are based will be more relevant » Strong support from a foreign parent may also result in ratings that are well above the sovereign, although timely and reliable support is more likely for a wholly-owned strategic subsidiary than a minority-owned affiliate – Contractual guarantees can result in ratings being equalized with the rating of the guarantor
Sovereign and Country Risk Analysis, 2019 193
Foreign-Currency Bond Ceiling
Not a rating on an issuer or on a debt instrument Represents “convertibility risk” Acts as a “ceiling” on other ratings » Serves to limit ratings on foreign-currency obligations that are subject to “acts of state” » Can be “pierced” under specific conditions » The Foreign-Currency Bond Ceilings reflect the risk that a government would impose a debt moratorium should it default » It is determined by multiplying the implied default risk associated with the government’s foreign-currency government rating by the risk that it would impose a debt moratorium
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97 Ceilings for Foreign Currency Bank Deposits
» Moody’s assigns long-term and short-term ceilings for foreign-currency bank deposits to every country (or distinct monetary area) in which there are rated bank deposits » The ceilings specify the highest ratings that can be assigned to foreign-currency denominated deposit obligations of 1) domestic and foreign branches of banks headquartered in that domicile (even if subsidiaries of foreign banks); and 2) domestic branches of foreign banks
Sovereign and Country Risk Analysis, 2019 195
Country Risk Ceiling
The Country Risk Ceiling broadly refers to risks affecting a given country that arise from political, institutional, financial and economic factors either within that country or externally – include: » political instability » conflict risks » regulatory and legal uncertainty over, for example, the enforceability of contracts » risk of government intervention, such as for example, expropriation or nationalization of local assets » risk of systemic economic disruption, severe financial instability, currency redenomination under adverse circumstances, and natural disasters, etc Sovereign and Country Risk Analysis, 2019 196
98 Local Currency Country Risk Ceilings
» Determine the maximum credit rating achievable in local currency for a debt issuer domiciled in that country or for a structured note whose cash flows are generated from domestic assets or residents » The purpose of the ceilings is to allow debt ratings to capture the risk of operating in a non-neutral (below Aaa) credit environment - ceilings also support the global comparability of ratings » In most countries the starting point for assessment of the ceiling is the rating that would hypothetically be assigned to the government if its balance sheet was pristine
Sovereign and Country Risk Analysis, 2019 197
Governments Declared Moratoria in the Past
» In the 1970s and 1980s, most countries that defaulted on foreign- currency debt imposed a moratorium on servicing foreign debt » As a result, foreign-currency ratings of corporations and banks were capped at the government’s foreign-currency bond rating » Moratoria have been used in the past to socialise risk, not to punish domestic borrowers
Sovereign and Country Risk Analysis, 2019 198
99 Determining Moratorium Risk
» Country’s integration with the global economy » Relative cost of moratorium as a policy option » Likelihood that government would “socialise” the cost of the crisis » Historical use of intervention and protectionism
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Debt, Default and Forward-Looking Analysis
100 Linkages Between the Sovereign and Other Sectors (1)
From Corporates and Banks to the Sovereign:
Distress in the Distress for the Loss of exports Loss of tax revenue corporate sector sovereign
Bank support or Bad lending recapitalizations Distress in the Distress for the decisions, fraud, banking sector sovereign contagion, runs Real economy suffers
Sovereign and Country Risk Analysis, 2019 201
Linkages Between the Sovereign and Other Sectors (2)
From the Sovereign to Corporates, Banks, and Other Sectors:
Exchange rate depreciation High interest rates Credit constraints No external market Distress for Sovereign access corporates, crisis banks, utilities, Inflation sub-sovereigns Falling demand Government interference Changes in regulation Civil disturbances/labor strikes
Sovereign and Country Risk Analysis, 2019 202
101 “Doom Loops”
Sovereign and Country Risk Analysis, 2019 203
Key Issues
» Sovereign debt default is not a matter of hard numbers » For sovereign borrower the cost of default is limited (almost) to temporary loss of reputation » Between 1970 and 2008 possible to observe external debt/GDP ratio for 33 instances where default took place – ranges from 12.5% (Russia 1991) to 214.3% Guyana (1982) » But for sovereigns the shift is discontinuous – no “medium” confidence level » Can be triggered not only by economic shock (lowers GDP but also lowers tax revenues) but by interest rate shock (probably bigger threat) » Exacerbated by “automatic stabilisers”
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102 Key Issues
» Debt/GDP ratios are backward looking » Deflation risk » Ageing populations: (in Europe fiscal costs range from 2% - 8% p.a. over next 50 years – 160% - 650% of GDP in NPV terms) » Private sector deleveraging: McKinsey Global Institute research indicates lasts for 6-7 years after crisis impacting credit-reliant sectors (e.g. real estate, construction, domestic trade and financial intermediation) » Gross versus net debt? – Evaluation of net debt would require both identification of assets to be netted and a clear and consistent valuation of them » It’s not GDP but government ability to mobilise revenue that matters » Current fiscal challenges and simultaneous tightening in many countries unprecedented » “Financial repression” – imposing real rates of return that are negative or artificially low, inflation, regulatory incentives to make institutions purchase debt at uneconomic prices
Sovereign and Country Risk Analysis, 2019 205
Legal Redress
» US Sovereign Immunities Act 1976 » UK State Immunity Act 1978 » 157 countries signatories to International Center for Settlement of Investment Disputes (ICSID) Convention – institution of World Bank since 1966 – voluntary arbitration (but binding)
» No bankruptcy framework for sovereigns (despite proposals) » A number of countries have agreed voluntary debt rescheduling – Iraq, Seychelles, Liberia, Jamaica, Panama – Much debt now institutionally held by mark-to-market investors with less resistance to restructure – Sovereign immunity – e.g. “absolute” in Hong Kong, UK excludes commercial activities – NML Capital vs. Argentina, UK Supreme Court, July 2011 [2011] UKSC 31 Sovereign and Country Risk Analysis, 2019 206
103 Investor Protection
» Waiver of sovereign immunity – Does not mean that creditors can collect on their debts; it means only that the creditors can bring a lawsuit » Choice of governing law » Arbitration clauses provide that if a country defaults, creditors may bring the case before an international arbitration panel, which will render a judgment – Arbitration clauses do not solve the enforcement problem because arbitrators have no power to enforce their judgments » Cross-default clause – Such clauses provide that if the sovereign defaults on some of its debt, then that action constitutes a default on other debt even though the sovereign is otherwise current on that debt
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Investor Protection (continued)
» Acceleration clauses – allow the creditor to accelerate all of the future payments owed to it if one of a set of predefined “Events of Default” takes place » Collective Action Clauses (CACs) – permit bondholders to modify the terms of the bond through collective action » Disenfranchisement clauses – provide that a country cannot vote on the basis of its holdings of its own debt and may also apply the prohibition to entities that are controlled or influenced by the debtor » Negative pledge clause – which states that an issuer may not issue security interests to future creditors without securing the current debt on an equal basis
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104 Investor Protection (continued)
» Pari passu clause – bars the sovereign from passing legislation to lower the legal rank of a creditor vis-à-vis some future creditor it is seeking to borrow from » Events of Default – can include the issuer declaring a moratorium on debt payments, the issuer being ejected (or resigning) from membership of the IMF, or a default on some other debt obligation that remains uncured for more than 30 days (a “cross default”) » Sinking fund – invented in the 1700s to smooth out the debtor’s repayment schedule » Tax – reimbursement of any tax that the sovereign imposes on bonds payable to foreign investors » GDP clause
Sovereign and Country Risk Analysis, 2019 209
ICMA
» On 29 August 2014, the International Capital Market Association (ICMA) published a new model pari passu clause and collective action clauses (CACs) for inclusion in sovereign debt contracts – The new standard template clauses will weaken the position of holdout bondholders – The change in model clauses will not apply retroactively to outstanding sovereign debt – The changes have no immediate impact; it will take many years for the new clauses to be gradually adopted in future sovereign bond contracts and likely limit holdout litigation in the future – CACs allow a supermajority of bondholders to agree to changes in the bond payment terms that become legally binding on all bondholders, including those who vote against a restructuring – CACs used in the past have generally required voting series by series - ICMA’s new standard CACs include aggregation mechanisms that allow voting across multiple bond series
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105 What’s Happening Now?
» Almost immediately after ICMA released its proposals sovereigns such as Kazakhstan and Mexico adopted their clauses » But a number of countries have issued debt that did not contain all of the changes, including Mexico, Tunisia, Philippines and Ivory Coast » “Every time I encounter a country in trouble that needs to restructure its debt, I am struck by the fact that their debt often includes clauses that no one has paid any attention to until that point and that suddenly can become a big problem for them,” Peter Doyle, economist and former International Monetary Fund official quoted in the Financial Times, 21 April 2015
Sovereign and Country Risk Analysis, 2019 211
IMF
» Usual practice is to negotiate an agreement to provide financing subject to reduction in debt/GDP (conditionality in lending) » Sovereign may or may not be able to comply – e.g. opposition within Greece raised further doubts » Greece target of 150% was both too high and too low – too high to satisfy investors and too low for political constituents who see austerity measures as too harsh
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106 IMF Programs
» Half of sovereign defaults since 1983 were preceded by an IMF program in the two years prior to default - this share has risen to almost 70% since 2000 » During 1983-2012, the average annual default rate of sovereigns conditional on being in IMF program during the previous two years (3.8%) was almost twice as high as annual default rate of sovereigns without an IMF program (2.1%) symptomatic of underlying credit vulnerabilities in the former group of countries and consistent with their ratings generally being non-investment grade » Bottom line - significant increase in probability of default for governments with IMF program participation
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Issuer-Weighted Cumulative Default Rates 1983-2012
Sovereign and Country Risk Analysis, 2019 214
107 IMF Status
» The IMF’s preferred status is de facto rather than de jure - it is an agreed principle among, rather than a legal requirement on, its members » The preferred status is not mentioned in the IMF’s Articles of Agreement » Four criteria for exceptional access adopted in 2002 – The borrowing country experiences “exceptional balance-of-payments pressures”; – A “rigorous and systematic analysis indicates that there is a high probability that the member’s public debt is sustainable in the medium term”; (an option was introduced to waive this in the case of Greece) – “The member has prospects for gaining or regaining access to private capital markets within the time frame when Fund resources are outstanding”; – The country’s policy program “provides reasonably strong prospects of success”.
Sovereign and Country Risk Analysis, 2019 215
IMF Proposals
» IMF is discussing changes to its rules to require countries in difficulty to extend debt maturities as a condition of help » At present, limited to bailout or restructuring based on sustainability analysis » In circumstances where a member has lost market access and the IMF considers the debt to be sustainable, but not with high probability, the IMF would be able to provide financing on the basis of a debt restructuring involving maturity extensions, but no changes to principal or interest » In circumstances where the IMF deems the debt unsustainable, the IMF will pursue an upfront debt reduction » If a maturity extension fails to restore sustainability, the IMF will avoid repeated maturity extensions and pursue debt reduction
Sovereign and Country Risk Analysis, 2019 216
108 IMF (continued)
» The IMF will eliminate the systemic contagion exemption introduced in 2010, which allowed lending when the IMF did not consider the debt sustainable with a high probability but was concerned there would be international spillovers » The IMF will expect official creditors to maintain exposure through extensions of maturities or provisions of new financing » The IMF will also consider avoiding repeated use of maturity extensions not only in large-scale IMF lending programs but in all programs
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Calibrating Sovereign Risk
109 Government Bond Ratings ─ The Ratings Bedrock
Government bond ratings are the bedrock of Moody’s sovereign/country ratings system Foreign- vs. local-currency government ratings » Historically, we rated local-currency bonds slightly higher than foreign- currency bonds – Rationale ─ Governments: can print money; have captive investors; didn’t default on LC » Given developments since the late 1990s, we now usually rate foreign- and local-currency government bonds the same
Sovereign and Country Risk Analysis, 2019 219
Local Currency v Foreign Currency
» Current and capital account openness have increased » Capital markets have liberalised and deepened » Governments’ investor bases have broadened and partially moved offshore » Justifications for distinguishing between LC and FC have weakened » Far more likely now that problems servicing debt in one currency will spill over » Rating gap is now only applied in those cases where there is: – Limited capital mobility – Government which either faces constraints in terms of external liquidity or shows a difference in its ability and willingness to repay LC v FC (or vice versa!) » Even then not automatic – ratings are forward looking
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110 Analysis
Analysis
» Economic Structure and Stability » Political Factors » Macroeconomic Policies » Balance of Payments » International Liquidity » Debt Position
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111 Sovereign Data
» Economic Structure and Performance » Government Finance » External Payments and Debt » Monetary, External Vulnerability and Liquidity
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Why Do Domestic Conditions and Policies Matter for Foreign Currency Ratings?
Financing requirements of the government Medium/long-term prospects affected by policy » Level of investment and export prospects Access to multilateral finance Investor confidence: » Capital flow affected by political situation, assessment of policy environment » Rollover risk
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112 Analysis Behind Sovereign Bond Ratings
Structure of revenues Flexibility in both revenues and expenditures Debt position and debt service » Level of debt » Creditors » Currency composition » Maturity structure – future affordability Vulnerability to exchange rate and interest rate changes
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Debt Position
Total debt of all sectors » Government » Private Sector » Banks – Including not just market debt, but also deposits from nonresidents » Fiscal policy sustainable if the current policy can be continued indefinitely with a stable debt/GDP ratio – If deficits too high, debt expands until no longer financeable – If surpluses too high, economy nationalises – Short run factors may cause deviations
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113 Economic Structure and Stability
» What are the country’s sources of foreign currency earnings? » Which countries are the major customers? » What is the level of investment? » What is the exchange-rate regime? » How deep and diverse are the financial markets? » Can the country’s external position withstand shocks? » How volatile is the economy? Commodity based?
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Political Factors
» Governmental system & stability » Ethnic, religious or regional divisions? » Institutional maturity » Differences in policy stance of parties » Foreign relations/threats » Geopolitical risk and national security » Do any or all of the above constrain policy options?
Sovereign and Country Risk Analysis, 2019 228
114 Macroeconomic Policies
Fiscal policy Monetary policy and inflation Market structure/regulation » Price controls » Subsidies » Labour market Foreign trade policy Structural reforms
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Balance Sheet Structure
“Inverted” debt structures can be dangerous » Foreign currency and short-term borrowings are inverted debt » Servicing costs decline when confidence and asset prices rise » Makes good times better and bad times worse » Can leave a country vulnerable to debt crises
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115 Government Budget and Debt
Budget » Fiscal balance and policy priorities » Structure and flexibility of revenue and expenditure » Off-budget activities Financing flexibility – Depth of local capital markets Debt and debt service » Debt burden » Vulnerability to exchange and interest rates – Currency composition – Maturity structure » If interest rates exceed growth rates country must eventually run a primary surplus or increase base money to achieve fiscal sustainability
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Government Debt
Direct debt » Structure (tenor, rate, currency) » Foreign holders? Contingent liabilities » Guaranteed debt » Government enterprises – Self supporting? Would government bail out? » Banking system » Regional & local governments » Gross/net debt
Sovereign and Country Risk Analysis, 2019 232
116 Macroeconomic Policies
Fiscal policy Monetary policy » Monetary credibility and inflation record » Credit growth » Interest rates Exchange rate regime and policy management
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Economic Structure
Wealth (per-capita GDP) Income distribution Growth and inflation Diversity of output and exports Market orientation » Competition in goods, labour and financial markets – Flexibility of prices, wages and interest rates – External openness Financial market development Investment and savings rates Competitiveness – Unit labour costs – Productivity
Sovereign and Country Risk Analysis, 2019 234
117 Foreign Currency Earnings and Access
Balance of Payments Position and Outlook » Current account balance – Exports and imports of goods, services, transfers, remittances › Sustainability: Cyclical vs. Structural outlook - Product or geographic concentration risks » Capital account balance – Debt vs. non-debt creating flows (FDI) › Sustainability: Cyclical vs. Structural outlook - Implications of a sudden shift in investor confidence
Sovereign and Country Risk Analysis, 2019 235
External Liquidity
International reserves » Adequacy of foreign-currency reserves » Ratio of reserves to imports » External vulnerability indicator – (FX debt coming due within one year + nonresident FX deposits) / international reserves) Net foreign asset position of the banking system Foreign-currency deposits at domestic banks Short-term external liabilities “Dollarisation” ratio?
Sovereign and Country Risk Analysis, 2019 236
118 Banking Crises
Costs have been greater in developing economies (historically as % of GDP) » “No cost” public policy responses usually help restore confidence » Foreign exchange mismatches raise the cost of bail-out The ability to intervene, and intervene quickly, seem to be key factors in restoring confidence
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Example: The Asian financial crisis
» Asset bubble, weak financial institutions, weak institutional structures » Unrealistic currency exchange policies, asset-liability mismatch, and currency mismatch amped up liquidity risk » Short-term dollar funding of long-term local currency assets could not be repaid when exchange rates moved » Domestic credit market collapses created sovereign distress » IMF imposed policies varied, but largely problematic, resulting in contagion » Capital and currency controls and workouts » Improvement in institutional strength—is it enough?
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119 Restructuring
» Sovereign bond restructurings are generally resolved quickly, without severe creditor coordination problems and involving little litigation » On average restructurings closed 10 months after government had announced intention to restructure and 7 months after start of negotiations with creditors » Of 36 sovereign bond exchanges since 1997, only two have been affected by holdout creditors: Argentina in 2005 and Dominica in 2004. Holdouts did not affect recent large Greek debt exchanges » 53% of sovereigns in sample had a payment default before negotiations, 12% during negotiations, and 35% had no payment default
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Restructuring (continued)
» Creditor participation has averaged 95% in sovereign bond restructuring offers - Argentina had 76% and Dominica 72% immediately after exchange (rose to 93% and 100%, respectively, later on) » About 35% of sovereign debt exchanges relied on using collective action clauses or exit consents included in the bond contracts
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120 Summary of Modern Era Bond Exchanges
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Recovery Levels
» The loss in sovereign restructurings does not seem to correlate well with the size of the debt exchange, but is somewhat correlated with the level of the country’s debt-to-GDP ratio » Losses have depended on a number of factors, including: – the economic conditions at the time of default – the debt maturity structure, the features of the bond contracts – the presence of official debt – the involvement of multinationals – the concentration of debt holders
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121 Recovery Rates
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Recovery Rates
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122 Paris Club
» An informal group of official creditors that has met since 1956 to deal with payment problems of emerging market debtor countries » For countries in crisis, the Paris Club provides rescheduling of sovereign debt owed to official creditors » The Paris Club has a set of rules for the terms of restructuring based on the countries' income and debt level and are known in advance – the scale of debt relief will depend on a case-by-case assessment of the financing need of each program – restructurings are conditional on a proven record of performance under an IMF program – seniority for new lending and for trade finance – sets a cutoff date and the restructuring, as well as any future restructuring, will apply only to debt originally contracted before that date » New lending is therefore senior to old debt
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Modelling Sovereign Risk
Caution! » No quantitative model can capture complexity of sovereign risk » Difficult to predict combination of quantitative and qualitative factors » Interaction of political, economic, financial and social factors » But can provide conceptual framework
Anything that increases the chance of sustained mismatch between earnings and debt servicing undermines creditworthiness. But, if your concern is default, what matters is not expected (average) outcome but expected variance (extreme outcome).
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123 “Impossible Trinity” – Trilemma
» No country can simultaneously have freely flowing capital and control over both the exchange rate and monetary policy: only 2 out of 3 are possible
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Data Reliability
Government financials are not usually audited Accounting issues: » Push spending into the future (e.g. public-private partnerships) » Hidden borrowing (pension liabilities, derivatives) » Accelerated revenue (sell assets or rights to future cashflows) » Spending by non-government entities
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124 Accounting
» “There is virtually no acknowledgement that this crisis is a result of deficient accounting, auditing and financial management practices by governments.” » “For potential investors in the debt of European governments...two questions are in order: “Does the government produce financial statements in line with International Public Sector Accounting Standards...” and “Are those financial statements audited...? If the answer to either question is “No” it would be appropriate to reconsider your appetite for risk.” Ian Ball, Chief Executive, International Federation of Accountants, letters to the Financial Times 29/9/11 and 2/11/11
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Cash v. Accrual Accounting
Does the government even know what its balance sheet looks like? “...they started either with negative equity or with no idea what their equity is, because they do not produce a sensible balance sheet.” Ian Ball, Chief Executive, International Federation of Accountants, letter to the Financial Times, 24/4/09 Under accrual accounting look at total liabilities/GDP not debt/GDP – in the UK the latter is c. 70%, the former c. 170%
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125 Looking Ahead
Outlook for GDP Growth?
Components of GDP » Personal Consumption Expenditure – Goods, durable and non-durable – Services › Wage growth, inflation, deleveraging? » Business Investment – Fixed investment, including equipment and new construction – Change in private inventories › Demand growth, bank funding availability? » Government Expenditure › Fiscal austerity? » Net Exports of Goods and Services › Exchange rate, export markets?
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126 Monetary Flexibility
» Inflation – Would accelerate with looser policy rates » Excess credit – Rate of growth relative to GDP » Real interest rates – Potential for inflationary impact » Exchange rate – Higher import prices will increase inflation » Current account balance – Lower interest rates will make deficit harder to fund
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Fiscal Flexibility
» Debt » Deficit (structurally adjusted)
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127 Joint Default Analysis for Government Related Issuers
Government Related Issuers
Moody’s defines a GRI as entity with: » Full or partial government ownership or control » Special charter » Public policy mandate from national or local government » Does not have taxing authority Examples include utilities, railroads, highway authorities, government-sponsored enterprises (GSEs)
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128 Government Related Issuers Rating Methodology (GRIs)
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Government Related Issuers Rating Methodology (GRIs)
Three Step Process normally: » Baseline Credit Assessment—a standalone assessment – There is no standard set of ratios used as GRIs can vary by industry » Assess of likelihood and ability to support from government » Joint Default Analysis – How likely is the GRI and sovereign to default at same time However, in some case Moody’s assigns a rating without first establishing a Baseline Credit Assessment. » Then the rating is based on notching from sovereign based on support assessment.
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129 Baseline Default Risk
» Takes into account all aspects of entity’s existing or anticipated business model » Includes benefits such as operating subsidies or credit extension » Also includes potential negative factors associated with government relationship » At what point do subsidies become a rescue?
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Joint Default Analysis
Needs four inputs: » Stand-alone rating of issuer (local currency) (baseline default risk) » Supporting government’s rating » Probability of government support » Dependence ratio: If the government defaults, what is the likelihood that this issuer would default at the same time? Most GRIs demonstrate moderate to very high degrees of default dependence
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130 Determining Dependence – Three Broad Factors
Operational and Financial Linkages » Direct and Indirect Government Transfers % GRI Revenue » Government Purchases % GRI Revenue » GRI Payments (Dividends) to Government % Government Revenue Overlapping Revenue Base » GRI: Exports as a % of Revenue » Sovereign Supporting Government: Externally derived revenues % Revenue » Sub-sovereign supporting government: Intergovernmental transfers % Revenue Common Credit Risks » FX Risk in Debt Structure » Shared Industry Exposure » Political Event Risk
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Government Related Issuers Rating Methodology (GRIs)
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131 Support Ranges
Low 0% - 30%
Moderate 31% - 50%
Strong 51% - 70%
High 71% - 90%
Very High 91% - 100%
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Typical Attributes of State Support for GRIs
» Guarantees: explicit, verbal, comfort letters, special legal status » Level of ownership: privatisation plans » Barriers to support: history, political inclinations, governance and business model » Political tolerance for government intervention: political linkages » National importance of issuer » Possible delays in providing support
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132 Government Related Issuers Rating Methodology (GRIs)
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Government Related Issuers Rating Methodology (GRIs)
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133 GRIs in Asia
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GRIs in Asia
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134 GRIs in Asia
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Export-Import Bank as a GRI
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135 Estimate Issuer Ratings
In terms of notching down from the sovereign rating, estimate the ratings of the generic firms below. » State-owned electric utility » State-owned oil refinery » Partially owned State railway
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GRI example: Indonesia
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136 GRI example: Indonesia
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GRI example: Malaysia--Petronas
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137 Questions?
For more information, please contact us
This Course and Materials Public Seminars Tailored Training Solutions Barney Helman Carol Chan Alan Blair 852.3551.3131 [email protected] [email protected] [email protected]
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Sovereign RM Graphic Overview
150 Sovereign Rating Methodology
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Determining the Overall Grid –Indicated Rating
EXHIBIT 3
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151 Sovereign and Country Risk Analysis, 2019 303
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152 Sovereign and Country Risk Analysis, 2019 305
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153 Economic Resiliency
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154 Sovereign and Country Risk Analysis, 2019 309
Government Financial Strength
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155 Sovereign and Country Risk Analysis, 2019 311
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156 Government Rating Range
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World Economic Forum Global Competitiveness Report Details
157 World Economic Forum--Competitiveness
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World Economic Forum--Competitiveness
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158 World Economic Forum--Competitiveness
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World Economic Forum--Competitiveness
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159 World Economic Forum--Competitiveness
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World Economic Forum--Competitiveness
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160 World Economic Forum--Competitiveness
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Indonesia
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