COUNTRY RISK ANALYSIS

Republic of Solvencia
and the International Capital Markets

SOLVENCIA’s Eurobond Request

[Link]

Author: Dr. Michel Henry BOUCHET, Distinguished Finance Professor, Global

Finance SKEMA

Book: “Country risk in an age of Globalization”: MH Bouchet, C Fishkin, A

Goguel. Palgrave-MacMillan 2018
[Link]
Globalization/dp/3319897519/ref=sr_1_1?s=english-books&ie=UTF8&qid=1536225444&sr=1-
1&keywords=country+risk+in+an+age+of+globalization

Country Risk Mooc : [Link]

Latest update: Fall 2018

© SKEMA 2018- CCMP-2008 Country Risk Analysis : Solvencia & Casino Bank- Bouchet Michel-H, Global
Finance Center
 SOLVENCIA
&

Country Risk Case Study

© CCMP-2008 Country Risk Analysis : Solvencia & Casino Bank- Bouchet Michel-H, CERAM Global Finance
Center
 TABLE of Contents

1. Country risk case study: Solvencia and Casino Bank

2. Case Presentation and Introduction- Pedagogical support note

3. Excel spreadsheet

4. Glossary: Global finance, debt restructuring, international bond issue

and country risk

5. Case correction 1: Final Country Risk Report

6. Case Correction 2: Excel spreadsheets, ratio calculations, liquidity and

solvency indicators, graphs

© Skema 2018- CCMP – 2008- Solvencia : Country Risk case study – Michel Henry Bouchet - Global
Finance
 Republic of Solvencia and Global Capital Markets:
Eurobond Request to Casino Bank
Fall 2018

Introduction

It was 9 o’clock yesterday morning, when your secretary passed an important message
from Solvencia’s Finance Minister, requesting an urgent meeting next week in Monaco. It
was not too difficult for you to guess the purpose of the meeting given the country’s plan to
launch €800 million Eurobond on international capital markets, taking advantage of ultra-low
rates of interest currently! Mr. Solvent, the finance minister, wants to get your assessment
regarding market conditions for the bond floating, in order to compare your assessment with
your competitors’ offers in London, Zurich, and New York. The prospects of tighter monetary
policy and higher interest rates in the OECD, coupled with market nervousness regarding
developing countries’ rising debt, however, make the request a formidable challenge!

Solvencia’s medium-term external borrowing requirements are well known to the

international financial community. This request thus does not come as a surprise. You are a
young but promising investment banker and you knew that Solvencia was about to approach
investment banks in Europe. Your institution, Casino Bank, is a reputed player. Competition
is fiercer than ever for bond syndication and placement. At stake is a substantial fee (and for
you, a substantial bonus!). But rumours regarding Solvencia’s liquidity difficulties also come
and go in the markets. The country is facing economic overheating, large external financing
requirements, and upcoming financial problems, reportedly. Governance is also a thorny
issue.

Republic of Solvencia: Political Background

Solvencia is a country of roughly 9 million people. Its GDP per capita of around
US$8000 (in purchasing power parity) in 2018 corresponds to a middle-income developing
country. (Solvencia’s GDP per capita thus fits in a group of countries like Belize, el Salvador,
Jamaica, and Paraguay, on the base of the UNDP HDI Index method). Solvencia's long
struggle for independence ended in the mid-1970s. Gradual political reforms in the 1990s
resulted in the establishment of a bicameral legislature in 2012. However, the political
climate remains volatile. Political upheaval leads frequently to mass demonstrations
followed by harsh repression. Since 2008, however, Solvencia was affected by the spill-over
effect of the global financial crisis! In addition, Solvencia’s governance improvement was
questioned by strong pressure from the IFIs, notably the IMF and the World Bank. Rating
agencies stressed that weak governance was a key impediment to sustainable development
and to resumption of market access and development aid. Rating agencies are watching and
stand ready to change their risk assessment of Solvencia. Moody’s country rating currently is
“Baa3” while Fitch rating stands at “BBB“. Things do not seem to improve at the right pace,
nevertheless. You get conflicting signals regarding Solvencial’s commitment to structural
economic and institutional reforms.

© Skema 2018- CCMP – 2008- Solvencia : Country Risk case study – Michel Henry Bouchet - Global
Finance
 Solvencia’s overall economic conditions and policy outlook

Solvencia faces the challenges typical of developing countries – weak productivity, low
competitiveness, and dependence on volatile commodity prices. In 2008-09, Solvencia
experienced severe financial turbulences with large budget and current account deficits,
following years of economic overheating characterized by high inflation. The spill-over effect
of the global financial crisis was an aggravating variable. In addition, a severe drought
depressed activity in the key agricultural sector and contributed to a protracted recession
along with acute social problems. A sticky exchange rate in the initial period resulted in a
sharp decline in external competitiveness, along with booming imports, little export
dynamism, and a drop in official reserve assets, particularly in 2008, due to over-valued
exchange rate. In 2010-11, Solvencia’s government adopted an IMF-sponsored program and
it implemented severe adjustment measures culminating with a sharp growth decline.
Declining imports shifted the trade balance to a modest surplus, the first time in the decade.

20%
Real GDP and inflation growth rates
GDP deflator % change

Real GDP Growth rate (in Local

15%
Currency)

10%

5%

0%
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

-5%

Clearly, Solvencia’s government could postpone the economic adjustment for a while;
it could not avoid it. The finance minister had to negotiate a structural adjustment program
under the auspices of the IMF and the World Bank. The shock therapy was abrupt and it
included the usual market-driven stabilization policy measures aimed at reducing domestic
demand and restoring competitiveness: currency devaluation, cuts in public expenditures,
openness to foreign direct investment, stimulation of private investment, and privatization.
The monetary policy framework was strengthened and an inflation targeting system was
introduced. A late but substantial real devaluation in 2009-2010 boosted exports and the
trade balance benefited from shrinking imports, though at the cost of an anaemic growth
rate in 2011-12. One clear positive result has been to keep inflation under control. Overall,
as much shock as therapy was provided.

In particular, notable progress was being made in areas such as trade liberalization and
privatization. The trade openness ratio reached a level higher than 50% in 2012. The main
challenge, clearly, was to further improve the competitiveness and flexibility of the
economy. Solvencia’s five-year plan (covering the period 2011-2015) was drawn up with
these challenges in mind and with a view to articulate a strategy to accelerate the structural
transformation of the economy towards one based on more skill-intensive sectors. Priorities
included addressing financial sector weaknesses, liberalizing the capital account, improving

© Skema 2018- CCMP – 2008- Solvencia : Country Risk case study – Michel Henry Bouchet - Global
Finance
the regulatory framework and tackling labour market rigidities. The most notable result was
a modest trade surplus in 2011-13 and the emergence of a budget surplus in 2013. But
despite progress in raising living standards, unemployment remained stubbornly high.
Official data shows that the unemployment rate remains broadly unchanged. However,
unofficial estimates suggest that the rate is much higher and unabated. Underemployment is
also a problem, particularly for the young population.

Following structural adjustment programs supported by the IMF, the World Bank, and
the Paris Club, the currency is now fully convertible for current account transactions, and
reforms of the financial sector have been implemented. The devaluation paved the way for
the well-known “J-curve”, i.e., growing imports since 2013, due to unfavourable elasticities!
On the positive side, exports increased and FDI picked up until 2014. Solvencia reported
large foreign exchange inflows from the sale of a mobile telephone license and partial
privatization of the state-owned telecommunications company SolvaPhone. Growth
resumption only emerged gradually after several years of severe decline of real GDP.
Favourable rainfall and export diversification led to reasonable growth thanks to good
harvest conditions and improving terms of trade. Since 2015, however, Solvencia
experienced again rising inflation, showing that stabilization was again off track. Economic
growth recovery seems to be driven by large bank loans supported by global accommodative
liquidity and low real rate policy of central banking authorities.

Inflation and Budget Deficit

Inflation in Solvencia looks like a rollercoaster for the past decade (Exhibit 1). After
double digit inflation that reached an unsustainable peak in 2008-2010, the government was
able to drag down the inflation level to more reasonable levels in 2011-2013. However, rising
budget deficit and an accommodative monetary policy stimulated a rising inflation during
the 2014-2018 period. Growing inflationary expectations stem from unchecked private and
public demand. At the peak of the crisis, in 2009-10, the government budget deficit reached
unsustainable levels. Solvencia returned to a similar situation in 2017-2018, illustrating the
cost of populist policy measures taken by the government.

Solvencia: Budget Gap 2005-2018

40000
Revenues Expenditures
35000

30000

25000

20000

15000

10000

5000

0
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

The structural adjustment program increased social and political volatility. Dynamic
privatization and severe cuts in government spending produced street demonstrations and

© Skema 2018- CCMP – 2008- Solvencia : Country Risk case study – Michel Henry Bouchet - Global
Finance
political protests. But the result of economic adjustment could be seen in the 2011-2014
period, when Solvencia managed to stabilize its current account, improving its
reserves/external debt ratio, and attracting significant foreign direct investment capital
flows. The government also successfully stabilized inflation, while managing a better budget
situation.

Solvencia’s Balance of Payment Position

The current account during the period 2007-2010 was driven by the negative pattern of
trade balance. Solvencia’s trade balance became increasingly negative, mainly due to
excessive growth in imports. In addition to the rise in oil prices, imports were boosted by
strong demand for capital and related goods reflecting investment expenditure related to
the industrial modernization program. In 2011-2013, trade balance generated a short-lived
surplus, thanks to significant improvement in external competitiveness. But starting in 2014,
trade balance returned to negative territory, as a result of declining export competitiveness.
The drop in global oil prices since mid-2014 has been welcome news for Solvencia! Oil is the
largest part of the country’s imported commodities. The rise in the oil price in the global
market, to around $105/barrel in 2012-13, was an important factor in the worsening trade
deficit, though unchecked domestic consumption stems from the accommodative monetary
and fiscal policy. The drop in oil prices between mid-2014 and mid-2018 tended to alleviate
the pressure.

Balance of services, income and transfers showed a rising surplus starting in 2012-14,
backed up by a substantial real depreciation of the exchange rate. No doubt that tourism, a
major cash inflow source for Solvencia, benefitted from the large currency depreciation.
Meanwhile, continued growth in the level of remittances has kept the transfers surplus
steady. This constant inflow from one million expatriates (most of whom live in Europe) has
been one of the main factors that has helped shrink the trade deficit in recent years.
The current account balance reached an unprecedented deficit of $ 7,2 billion in 2009,
the equivalent of 14% of GDP, partly as a result of the global financial crisis and also of travel
warning issued by the US and EU governments as a response to political instability and social
upheaval. A couple of bomb threats in the country’s capital city, Solven City, did not improve
the investment climate. But the main culprit for the rise in the deficit has been a

© Skema 2018- CCMP – 2008- Solvencia : Country Risk case study – Michel Henry Bouchet - Global
Finance
combination of flat exports and booming imports. Since 2015, a large current account deficit
surfaced again.
Debt is still a major financing source for Solvencia’s current account deficit. During
2003-2007, commercial banks and capital markets were a primary source of external
financing. The bond market was tapped in 2005 and 2006. The financial crisis led to a sharp
reduction in international bank lending that was somewhat offset by official creditors, both
bilateral and multilateral. The country had to use significant amount of official reserves to
finance its external financing requirements. In 2019-20, bond issuing is to be the new ball
game in Solven City.

The Eurobond Project Request: To float or not to float?

Solvencia, clearly, is not back on track. There is still a long way to go before domestic
and foreign investors recover confidence. Rating agencies are prudent. Corruption and
governance remain a genuine problem. Budget deficit is looming again. Long-term
challenges include: servicing the external debt in view of the interest rate hike by the US Fed
in 2018 and probably 2019; modernizing the industrial sector; preparing the economy for
freer trade with the EU and US; and improving education and attracting foreign investment
(i.e., non-debt creating flows) to boost living standards and job prospects for Solvencia's
youth. Two populist political parties call for debt default or debt restructuring!

Floating a Eurobond issue for Solvencia can be a major coup for your bank, but it can
also become a nightmare should you be unable to place the paper in the market. Getting
stuck with illiquid bond paper would be costly for your bank’s portfolio, and for your so far
promising career! Maturity, pricing, coupon and fees are one thing. Capital adequacy ratios,
loan-loss provisions and default probability are another. As you have identified several
conflicting risk indicators in Solvencia’s economic and political situation, the first thing you
need to do is to get the “story” of Solvencia right, i.e., you need to do some basic number
crunching, particularly liquidity and solvency ratios.

Before calculating the key ratios, however, you need to understand where does the
country come from regarding its growth track, what went wrong in the 2003-2018 period,
and why. You also need to understand the way the IMF’s stabilization program achieved a
turnaround in Solvencia’s economy and whether this improvement is lasting or fragile. You
need to check if the country is not falling back today in the same pitfalls as in 2007-2010.
Then you must look at the scope for a resumption of sustainable development over the
course of 2019 and beyond. The bond issue is a Yes/No decision though you can add a
number of strings & whistles (issue tranches, collateral, currency switching, zero coupon
bond, gradual repayment versus bullet payment, fixed/floating rate, conversion features…).
Last but not least, you will call Solvencia’s finance minister who is waiting in his Monaco
junior suite.

© Skema 2018- CCMP – 2008- Solvencia : Country Risk case study – Michel Henry Bouchet - Global
Finance
 COUNTRY RISK ANALYSIS
Republic of Solvencia and the International Capital
Markets

MICHEL HENRY BOUCHET

FALL 2018

Annex

Background Information for Solvencia’s Eurobond Request to

CASINO BANK

For further information:

[Link]

© SKEMA 2018- CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – - 1
Global Finance Center
 Annex

Background Information for Solvencia’s Eurobond Request

to CASINO BANK

1. What is country risk all about?

2. What is a Eurobond ?

3. What are the key sources of country risk information a risk analyst can rely on ?

4. What are the key conditions that investment banks will/should consider before exploring the
launching of a bond issue?

5. What are the key steps of a bond syndication process?

6. What are the underlying elements of a bond spread?

7. What are the main sources of country risk information a risk analyst can/should rely on?

8. What are the main risk parameters of sovereign risk?

9. What is the so-called “J-Curve impact” regarding the short-term balance of payment consequence
of a currency devaluation?

10. How can a country manage to finance its current account deficit? In the capital account, what is
the difference between non-debt creating flows and other capital flows?

11. What are the key liquidity and solvency ratios that any country risk analyst must consider?

12. What is The Paris Club? Methods and purposes?

13. What is the London Club? What is the IIF’s role regarding country risk analysis

© SKEMA 2018- CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – - 2
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 1. What is country risk all about? (Source: Country risk in an age of Globalization, Palgrave-
MacMillan, 2018: Bouchet, Fishkin, Goguel)

Risk is a multi-faceted issue. It has to do with uncertainty, i.e., a deficit of information. Risk
stems from a situation of uncertainty regarding the near or long term, where information about
the situation’s outcome is insufficient, lacking or simply wrong

Country risk analysis involves the assessment of a private or public foreign entity’s ability and
willingness to service its external obligations in full and in time (contractual, debt servicing, import
payments, legal commitment…). It incorporates a forward-looking estimate of default probability.

Country risk includes several parameters:

¾ Economic risk

¾ Financial risk

¾ Foreign exchange risk

¾ Political risk

¾ Cultural environment risk

¾ Legal and contractual risk (repudiation, confiscation, bribes...)

¾ Regional contamination risk (spill-over effect), and

¾ Systemic risk (global crisis)

2. What is a Eurobond?

First of all, the prefix “Euro” has nothing to do with the € currency in the European economic
community. A Eurobond is a bond issued and traded outside the country whose currency it is
denominated in, and outside a single country’s banking regulations. For instance, a Dollar-
denominated bond issued on the London market is a Euro-dollar bond. This type of bonds is usually
underwritten by a multinational syndicate of investment banks, therefore it can simultaneously be
floated in various capital markets.

Eurobonds have a number of salient features.

x They are usually issued in bearer form, with yearly coupon payment.
x This type of bond also doesn’t follow country issued domestic bond regulation (NY,
London legislations).
x Another feature of Eurobonds, which give advantage to borrower, are less restrictive
covenants and call provision features, even for short term bonds.

There are several types of Eurobond instruments. Most commonly issued bonds are in the form
of long term bonds as well as medium term notes, commercial papers and floating rate notes (FRN).
As a result of this variety type of instruments, the term of Eurobond itself has got a new label, which
is “International Securities”. The most commonly currency used in Eurobond issuance is US$,
accounted approximately 50% of total current outstanding Eurobonds.

© SKEMA 2018- CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – - 3
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 Eurobonds also have secondary market trading, hence market liquidity. Usually, the market
makers in Eurobond secondary market are the underwriters who sell the Eurobond in primary
market. Since 1969, International Securities Market Association (ISMA) has performed a central role
by providing global framework of industry-driven rules and recommendations which regulate and
guide trading and settlement in this market.

3. What are the main underlying risks of a Eurobond issue:

Interest rate risk: The major risk faced by investor in bond market is interest rate risk. The change
in current interest rate will affect the bond price, hence it will affect value of the investment. The
sensitivity of the change in bond prices due to change in interest rate depend on various
characteristics of issuance, such as coupon rate and the maturity period. The higher the coupon rate
and the shorter maturities of the bond, the less sensitive price change due to change on the interest
rate. But, this type of risk is not faced by held to maturity-investor, i.e., an investor who buys the
bond and holds it until the last day. The issuer of the bond, especially floating-bonds issuer, also
faces significant interest rate risk. Since the change of current interest rate will affect the benchmark
rate, and finally will change the coupon rate that the issuer has to pay.

Exchange Rate Risk: currency mismatch: This type of risk is also a major risk faced by issuer and
investor of Eurobond. Exchange rate risk refer to change in the exchange rate of issuer’s and
investor’s currency to Eurobond denominated currency, that will affect return of the investor or the
issuer’s cost of borrowing. For example, imagine that a company in Japan which the revenue mainly
generated in Yen, issued a Eurobond denominated in US$, and one of the investor of the Eurobond is
a European investor. Therefore a change in exchange rate between US$/Yen and €/US$ will affect
the cost of borrowing of the issuer and the rate of return for the investors.

Country Risk: This type of risk is also involved in Eurobond issuance. Country risk refers to any
risk that exists with regard to transnational business, which will not exist in domestic transactions.
Therefore, based on this definition, sources of country risk could be varying. But basically, any
difference in economic structure, political or any other aspects between investor and borrower in a
transnational transaction can be a source of country risk. Related with Eurobond issuance, the
probability of issuer cannot pay the principal or interest from the Eurobond due to specific problem
in country’s issuer is a major risk for Eurobond’s investor. Therefore, country risk analysis is an
important pre-cautionary action before investing in Eurobond.

Default Risk: or often called credit risk is the risk that the issuer of Eurobonds be unable to pay
timely coupon and principal payment, in full and on time! The rating agencies such as Moody’s, Fitch
and Standard and Poor are the major agencies that measure the default risk of issuer.

Liquidity Risk: The risk stemming from the lack of marketability of the Eurobond that cannot be
bought or sold quickly enough to prevent or minimize a loss. The primary measure of this type of risk
is the bid-ask spread quoted by the market. The wider the spread, the higher the liquidity risk faced
by the investors.

“Risk of Risk”: The risk faced by investors given the misunderstanding of the risk of the securities
that they have invested. The main source of this risk is low understanding of the investors related
with the risk-return characteristic of the issued securities, this could happen if the features of
Eurobonds becoming more innovative and complex. In addition, unrealistic hypotheses (bell-shaped

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 curve, thin tails, and Gaussian probability distribution) might add a model risk to a market risk! See
Mandelbrot for further analysis of that biased assessment of market finance risk.

4. What are the key conditions investment banks will/should consider before exploring the
launching of a bond issue:

Basically, the investment banks should carefully consider the risks described above before
deciding to underwrite the Eurobond issuance. Country risk analysis should be the first priority to
evaluate the underlying risk of Eurobond issuance. The country risk analysis involves qualitative as
well as quantitative analysis of political, economy and other aspects of the country’s issuer’s
creditworthiness. Qualitative analysis can be applied for political and governance issues of the
country’s issuer that will impact its ability to fulfill the commitment to pay coupon and principal of
the Eurobonds. On the other hand, Quantitative analysis can be applied to macroeconomic, balance
of payment and other economic features of the country’s issuer. In the case that the Eurobond issuer
is a private entity, microeconomic, sectoral as well as industry specific characteristics are also
important factors in the Eurobond issuance. Finally, combination of all above-mentioned analysis will
give the investment banks a framework and guidance to assess the short and long-term riskiness of
Eurobond issuance.

5. How can a bond issue be syndicated:

Syndication refers to number of banks grouping together to make a loan to one borrower. There
are 2 syndication’s processes, the traditional one called “European issue procedure” which can be
described in seven stages:

1. Preliminary negotiations and preparation

2. Legal clauses (pro rata, negative pledge…)
3. Preplacement
4. Fixing the final terms of the issue ( pricing day)
5. Apportioning securities ( offering day)
6. Placing the issue
7. Closing the issue ( closing day)

The second syndication way is called “Bought deal”: conditions are fixed by the lead manager
and proposed to the issuer. This procedure is more rapid than the European procedure and the
syndicates much smaller.

6. What are the underlying elements of a spread:

In the bond market, the spread reflects the additional required rate of return from the investors
when shifting their investment from a risk-free or less risky instrument to more risky assets.
Therefore, the term of spread reflects the risk premium of the investors. There are several types of
spread definition that investors must know in bond market:

¾ Quality Spread: spread between different qualities of the credit ratings of the
borrower. One can mention the difference between yield on a AAA credit rating
company with the A credit rating company in a similar industry with same maturities.

© SKEMA 2018- CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – - 5
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 ¾ Maturity Spread: difference between yield of a similar credit rating borrower but with
different maturities.
¾ Intra-market Spread: difference between yield of the bonds from different industries
but with similar maturities and credit ratings and trading in same sector of bond
market. One example is comparing yield between AAA ratings of a company in
manufacturing industries with the company which has same credit rating and
maturities but operates in banking industry. Both bonds are traded in same bond
market sector, i.e., corporate bond market
¾ Inter-market Spread: difference between yield on two sectors of bond market, that is,
comparing a bond issued by the government’s treasury which is being traded in
treasury market securities with the bond issued by the corporate with similar
maturities.
¾ Yield Spread: spread within a specific bond market that is attributable to differences
between credit ratings (quality spread), maturities (maturity spread), and sectors
within markets (intra-market spread).

The definition of Eurobond spread which reflects the risk premium can be driven by two factors.
First, if the Eurobond issuer is a government, the country risk analysis of the country’s issuer is an
important factor that determines the risk premium, and therefore the yield of the Eurobond. The
yield of a Eurobond issued of a government, will be determined by the benchmark rate and risk
premium. The benchmark rate is yield from the bond issued by a super-safe government or a country
which holds a AAA credit rating (typically, an OECD country). Regarding current practices, many
Eurobonds issued by a government use yield from the US treasuries which have same maturities as
benchmark rate, because US treasury securities are still considered risk-free instruments.
Second, if the issuer is a private entity, the component of risk premium will be also determined
by the risk analysis of the entity and the industry where it operates. So, total risk premium on the
Eurobond issued by the private entity is the risk premium from country risk analysis where the entity
operates, coupled with the risk premium from the analysis of entity credit riskiness as well as
industry specific analysis where the entity operates.

Graph 1&2: Emerging Market Bonds (JP Morgan EMBI) Spread over US Treasuries

Source: CBonds

© SKEMA 2018- CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – - 6
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 7. What are the key sources of country risk information a risk analyst can rely on:

Currently there are many institutions that provide country risk analysis data. Institutions like
Standard & Poors, Fitch, Moody’s, DAGONG, INCRA, ICRG, Euromoney, Coface and Economist
Intelligence Unit issue regular monthly or quarterly country risk analysis.

Developing a reliable country risk analysis is much easier now compared to many years ago,
given a wide range of publications and data for assessing country risk. An important source of
country risk analysis is balance of payment and macroeconomics data from the country. One can find
this data on the national bureau of statistics and central bank of the respected country. But before
using this data, you have to analysis whether the government of the country tends to manipulate the
data or not. A country with low governance and high corruption tends to manipulate those kinds of
data for their own political purpose. In such a case, it is better to use the data from the international
financial institutions such as IMF, World Bank, and Bank for International Settlements (BIS). An
institution such as IMF, provides comprehensive financial data of a country in the International
Financial Statistics monthly database. The IMF has also another database that can be accessed freely,
which is World Economic Outlook (WEO) database that is updated periodically. The Bank for
International Settlements (BIS) also provides important data such as international bank loans and

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 deposits, the latter being a proxy for assessing capital flight. Useful trade and FDI data can be
obtained from UNCTAD.

Graph 2: Data Sources Diagram for Country Risk Analysis

MAJOR SOURCES OF COUNTRY RISK INTELLIGENCE

DATA
SOURCES

Official sources Private sources

International Export credit Research centers &

Bilateral Multilateral/IFIs
banks agencies/ECAs EI agencies

Paris Club IMF COFACE Thinktanks

World Bank SINOSUR IIE, Brookings, EIU Rating agencies:
Central Banks
BIS
Investment banks Hermes Euromoney, TI, Inst Inv
Government agencies OECD IIF Ducroire Global Finance-Skema Moody’s, S&Ps, Fitch,
CIA UNCTAD & UNDP ECGD AON, OPIC, Control Dagong, Incra
Group

Michel H. Bouchet/SKEMA (c) 2017 5

Political analysis, including governance and corruption issues, also plays an important factor in
country risk analysis. Political analysis includes data on national institutions, governance and
corruption, system of government, relationship between executive and legislative, as well as political
parties and elections. This type of information can be gathered from independence political
observers or institutions. Economist Intelligence Unit (EIU) provides informative sources for this kind
of data, through EIU Country Profile. Governance. The level of corruption can be observed through
Transparency International, the ICRG database, and the World Bank’s governance database.

8. What are the risk parameters of a sovereign borrower?

There are several risk parameters that a country risk analyst must assess in measuring riskiness
of a sovereign borrower. Macroeconomic indicators such as inflation, interest rate, exchange rate
policy, and economic growth as well as independency of the central bank can develop important risk
parameters from the macroeconomics side.

Balance of payment data also can be important risk parameters. This includes trade balance,
current account deficit, capital account, and international reserve data. Various liquidity and
solvency ratios can be developed from balance of payment data to assess country indebtedness and
their ability to fulfill their financial commitment.

9. What is a J-Curve evolution in a current account balance?

The J-curve illustrates the shape of a country’s trade balance following a devaluation. Trade
elasticities are key parameters regarding the lag in the shift from a trade deficit to a sustainable
surplus. A lower exchange rate initially means cheaper exports and more expensive imports, making
the current account worse (a bigger deficit or smaller surplus).. After a while, though, the volume of
© SKEMA 2018- CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – - 8
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 exports will start to rise because of their lower price to foreign buyers, and domestic consumers will
buy fewer of the costlier imports. Eventually, the trade balance will improve on what it was before
the devaluation. If there is a currency appreciation there may be an inverted J-curve.

Following the depreciation/devaluation of the currency, the volume of imports and exports will
remain on certain level due in part to pre-existing contracts for imported goods that have to be
honored. However, the depreciation in the currency will cause the price of imports to rise and
therefore total spending on imports will subsequently increase. This situation, coupled with the
inertia of the external demand for exports and the domestic demand for imports, causes the initial
worsening of the trade balance. But within around 18 months, a depreciation in the exchange rate
can have the desired effect of improving the current account balance. Indeed, demand for exports
gradually picks up while domestic consumers will switch their expenditure to domestic products and
away from expensive imported goods and services. Equally, many foreign consumers may switch to
purchasing cheaper products exported by the country that devaluates its currency, instead of their
own domestically produced goods and services. This is represented on the diagram by the movement
towards a trade surplus.

Picture 3: Evolution of Trade Balance – J Curve.

TIME LAGS, ELASTICITIES AND THE ADJUSTMENT

MECHANISM: “JJ CURVE”

Trade Balance

SURPLUS

Time path of the trade balance adjustment

0 TIME

Devaluation!
DEFICIT

10. How does a country manage to finance its deficit? With sustainable long-term financing
inflows or with volatile short-term finance?

The best way to financing the current account deficit is using sustainable long-term financing
inflows rather than short-term financing. Mainly because long-term financing provides less volatility
on balance of payment and therefore provides policy space for the government to perform
consistent economic policies.

Long term financing in capital account can be separated into two main part, which are non debt-
creating flows and long term debt-creating flows. Non-debt creating flows include portfolio and
Foreign Direct Investment (FDI). This type of financing is the best way to finance current account
deficit, since there is no obligation to pay interest and principal. It provides budget flexibility to the
government to finance the economy. Long-term debt creating flows can be classified into three main
sources,

1. Long-term debt from international financial institutions such as IMF, World Bank,
regional development banks such as Asian Development Bank, or other multilateral
© SKEMA 2018- CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – - 9
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 creditors. Usually, debt from international financial institutions provides cheaper cost of
fund and longer maturities, although with stricter conditionality than private institutions;
2. Long and medium-term loans from official bilateral creditors (i.e., governments of the
Paris Club);
3. Long-term debt from private international institutions such as international commercial
banks, mutual fund, and hedge funds. This type on debt could be a loan or Eurobond
issued by the country’s government.

11. What are the key liquidity and solvency ratios that any country risk analyst must consider:

Liquidity Risk ratios:

ƒ Debt Service Ratio (Interest+Principal/Exports of goods and services): This ratio provides a
good indicator to measure how a country can fulfill its debt obligation based on its ability
to provide foreign exchange from export revenues. The higher the ratio, the riskier the
country. The threshold usually used in this ratio is 33%
ƒ Interest Ratio (Interest/Export): Provide an indicator to measure current proportion of total
interest that a country has to pay in its total export revenues. The higher the ratio (above
25%), the riskier the country.
ƒ Current Account Balance/GDP: Provide an indicator to measure whether the country lives
beyond its means or not. The higher the deficit ratio, the riskier the country since it
consumes more than its overall income.
ƒ Reserve/Import ratio: This ratio is an important indicator, especially to measure the ability of a
country to finance their import based on their current reserve. The lower the ratio, the
riskier the country. Usually, if the ratio is below 6 months, it should be a warning indicator
for the country risk analyst.
ƒ Import/GDP ratio: Provide an indicator that show how import-dependent is the country’s
economy. It thus provides a measure of a country’s dependency on foreign trade partners.
ƒ Growth rate of exports/Average external interest rate: This ratio provides an important
indicator to measure the ability of a country to provide timely interest payments for their
external debt with increasing export revenues. It indicates whether the country’s export
growth rate can match the average interest rate on its external debt. It also measures the
effectiveness of the debt-financed investment proceeds. The higher the ratio, the more
dynamic the economy.

Solvency Risk ratios

ƒ Debt/Export ratio: Is an indicator to measure total stock of debt compared to country’s export.
A ratio above 150% should be a warning indicator for a country risk analyst.
ƒ Debt/GDP ratio: Is an indicator to measure indebtedness of a country, with comparing total
debt of a country to total value of the economy, which represented by GDP. A ratio higher
than 100% is a warning sign that a country is highly indebtedness. However much depends
on the structure of the country’s debt that is, its main creditors, the average maturity,
interest rates floating or fixed, and more generally global market access.
ƒ ST Debt/Reserves: Is an indicator to measure the ability of country’s foreign reserves to service
its short-term liabilities. The higher the ratio, the riskier a country.

© SKEMA 2018- CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – - 10
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 12. What is the Paris Club: [Link]

The Paris Club is a confidential ad-hoc forum of debt negotiations between OECD country
creditors and their sovereign debtors. It only deals with official or officially-guaranteed credits
(Coface, Hermes, ECGD, and US Eximbank). The first meeting with a debtor country was in 1956
when Argentina agreed to meet its public creditors in Paris. Since then, the Paris Club or ad hoc
groups of Paris Club creditors have reached >430 agreements concerning 90 debtor countries. Since
1983, the total amount of debt covered in these agreements has been $585 billion.

The Paris Club has remained strictly informal: voluntary gathering of creditor countries willing to
treat in a co-ordinated way the debt due to them by the developing countries. It can be described as
a "non institution". The creditor countries (19 countries including Russia) meet 10 to 11 times a year,
for negotiation sessions or to discuss among themselves the situation of the external debt of debtor
countries or methodological issues on the debt of developing countries. These meetings are held in
Paris. The Chairman is a senior official of the French Treasury. Deputies to the Chairman in the
French Treasury serve as co-president and vice-president. The current Chairman is the head of the
French Government Treasury.

A debtor country comes to the Paris Club for a negotiation when an appropriate programme is
supported by the IMF and shows that the country is not able to meet its debt obligations and thus
needs a new payment arrangement with its external creditors.

13. What is the London Club: [Link]

The London Club is an ad hoc forum for restructuring negotiations formed by private institutions.
Each London Club is formed at the initiative of the debtor country and is dissolved when a
restructuring agreement is signed. Ad hoc London Club "Advisory Committees" are chaired by a
leading financial bank. Recently, Advisory Committees have included representatives from nonbank
creditors (fund managers holding sovereign bonds). The first meeting of London Club took place in
1976 in response to Zaire’s debt payment problem.

The Institute of International Finance, Inc. (IIF), is the global association of financial institutions.
Created in 1983 in response to the international debt crisis, the IIF has evolved to meet the changing
needs of the financial community. Members include most of the world’s largest commercial banks
and investment banks, as well as insurance companies and investment management firms.

Among the Institute’s Associate members are MNCs, trading companies, ECAs, and multilateral
agencies. The Institute has more than 450 members headquartered in more than 70 countries at

© SKEMA 2018- CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – - 11
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 end-2014. It provides members with in-depth country risk analysis of emerging market countries in
Asia, Africa and the Middle East, as well as Eastern Europe and Latin America.

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 INTERNATIONAL FINANCE & COUNTRY RISK ANALYSIS
Republic of Solvencia and the International Capital Markets

Eurobond Request to Casino Bank

[Link]

Case Study Correction

Auteur : Michel Henry BOUCHET, Global Finance Center

Etablissement créateur : SKEMA Business School

© CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – CERAM Business School- Global Finance
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 SOLVENCIA
Eurobond Request to Casino Bank

Case Study Correction

Republic of Solvencia and the International Capital Markets:

Eurobond Request to Casino Bank

© CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – CERAM Business School-
Global Finance Center
 Republic of Solvencia: Eurobond Request to Casino Bank

In The Face of Looming Crisis

ƒ This report is prepared in response to Casino Bank’s Board of Directors’ request to

analyze Republic of Solvencia’s current and future country risk situation, in relation to a
US$500 million sovereign bond issuance.
ƒ Based on our analysis, we believe that Solvencia is on the verge of a looming
economic crisis with a large trade and current account deficit, mounting external financing
requirements, high reliance on short-term floating rate debt, lower debt servicing ability,
hence deteriorating creditworthiness. Therefore, rejecting the request to underwrite the
Solvencia’s Eurobond is the best option for Casino Bank.
ƒ However, we might still underwrite Solvencia’s Eurobond issuance, if the Government
of Solvencia provides its gold reserves as collateral. This arrangement would create a win-win
opportunity for Solvencia and the investor community, while mitigating the risk of
intermediation for Casino Bank.

I- Country Profile and Political Background

Solvencia is a country of roughly 18 million people, with a rising but still low GDP per
capita of around US$1500. It went through a long struggle for independence that ended in
1962. Gradual political reforms in the 1990s resulted in the establishment of a bicameral
legislature in 2002. However, the political climate remains rather volatile, social upheaval leads
to frequent mass demonstrations, and accusations of corruption and unfair privatization
programs, frequently followed by harsh repression.

The opposition movement gained momentum to promote institutional reforms in the

aftermath of the severe economic crisis that hit Solvencia in 2007, paving the way for
IMF/World Bank intervention. The IFIs imposed the implementaion of a structural adjustment
program, including stabilizing the public accounts, controllng domestic consumption and
encouraging exports, shrinking the balance of payments deficit, as well as promoting political
normalization and good governance.

The economic recovery program led to substantial results. Foreign direct investment flows
increased. Euromoney and Institutional Investor improved Solvencia’s country risk ranking in
the mid-2000s. However, recent developments show that Solvencia’s weak governance is a real
impediment to sustainable development. Rating agencies recently downgraded Solvencia’s
country ranking.

Overall, our report concludes that there is no significant improvement in Solvencia’s

commitment to implement deeply rooted institutional reforms and to strengthen its efforts
towards fighting corruption and reaching sustainable development.

II- Background: Economic Crisis in 1999-2009 and Recovery

Solvencia’s economic crisis was caused by several internal structural weaknesses and
external factors. The main problems include exchange rate overvaluation, growing financing
requirements due to a twin budget and external deficit, and excessive debt burden. Deep
domestic imbalances led to a severe financial crisis in 2000 that was triggered by the rise in
international interest rates and the spillover effect from the Asian Crisis.
In the late 1990s, rigid exchange rate management has led to worsening external
competitiveness (combined effect with skyrocketing inflation), and excessive import reliance
which created large trade and current account deficits. Overvalued exchange rate created three

© CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – CERAM Business School- Global Finance 1
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 problems for Solvencia.
1. First, Solvencia lost its external competitiveness, because the rate of currency
depreciation at that time was not enough to match rising domestic prices. Export growth slowed
down while imports increased. Dynamic domestic demand led to a mounting trade deficit.
2. The second problem was triggered by poor external debt management. During the
period of 1999-2001, the period where Solvencia dragged down into the crisis, Solvencia faced
US$ 3.7 billion of maturing external loans, almost three times higher than the amount due
during the period of 1996-1998. This concentration of debt payments and growing current
account deficit led to very large financing requirements that could not be matched by new debt
and foreign investment. Consequently, official reserves dropped by US$ 2.9 billion.
3. Besides structural weaknesses, Solvencia was also hit by external factors which include
the rise in international interest rates and the spillover effect of the Asian Crisis. The rise in
international interest rate has caused increasing interest payments, especially from commercial
banks and private creditors due to floating interest rate contracts. Solvencia had to pay US$ 2.1
billion of interest during 1999-2001, which is more than double the interest payments during
1996-1998. External liquidity deterioration was amplified by the spillover effect from Asian
Crisis, leading to capital flight. Cumulative Errors & Omissions in the capital account reached
US$750 million in the three years 1998, 1999 and 2000.

The impact of the crisis itself was very harsh. Real GDP growth (in Local Currency term)
dropped by 10% and 13% in 2000 and 2001, respectively. Inflation skyrocketed to 115% at the
peak of the crisis in 2000, while the exchange rate depreciation did not keep pace with
domestic prices. Current account deficit thus reached an all time high of US$ 6.3 billion in 2000,
which pushed Solvencia to rely on its official reserves for financing the deficit. Consequently,
international reserve assets dropped by US$840 million during the year 2000.

The liquidity crisis led Solvencia to request a Standby Arrangement (SBA) loan from the
IMF. The IMF intervention was necessary to strengthen the official reserves and to restore the
investors’, creditors’ and trade partners’ confidence in Solvencia. With strong support from the
US Treasury and France’s Direction du Trésor, the IMF provided urgent cash injection of
US$ 500 million in 2000, and this was followed by another US$ 250 million emergency loan in
the following year. The World Bank itself provided a US$650 million structural adjustment loan
in 2001. The Bank’s intention was to enhance the impact of the IMF intervention and to provide
a social safety net to mitigate the severity of the stabilization program. However, the loans
were not a “free lunch”. To be able to withdraw the financing, Solvencia had to implement the
IFIs’ strict conditionality, i.e., a genuine shock therapy.

Devaluation of currency, liberalization of domestic economy, and privatization of state

owned enterprise were the main IMF recipes. Devaluation of currency has helped Solvencia
improve the current account position, through the J-Curve pattern, while liberalization and
privatization aimed to attract foreign investors in Solvencia. As a result, exports jumped in
2002, imports declined and the trade surplus reached US$1 billion, the first surplus after six
years of deficits! All in all, in 2002, the current account position turned to positive territory,
international reserves increased, thus restoring Solvencia’s creditworthiness.

© CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – CERAM Business School- Global Finance 2
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 Exhibit 1: Inflation Rate and Real GDP Growth in Solvencia
2004-14
15000 12,0%

10,0%
10000
8,0%
5000
6,0%

0
4,0%
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
-5000 2,0%
(%)

-10000 0,0%

-2,0%
-15000
-4,0%
-20000
-6,0%

-25000 -8,0%

-30000 -10,0%

Source: Solvencia National Bureau of Statistics

Inflation Rate (LHS) Real GDP Growth (RHS)

III- The Country’s Potential (positive points)

Solvencia offers some positive elements that could lead to economic and investment
opportunities and/or potentials. Amongst are the following:

ƒ Reforms being undertaken: After declaring its independence in 1962 the Republic of
Solvencia has undertaken a path of gradual reforms and development. This improvement gave
birth to more liberal regulations: a bicameral legislature was established in 2002.
ƒ Under the aegis of the IMF and World Bank, Solvencia carried out normalization of
political system and efforts towards improvement of governance starting in 2003.
ƒ International Institutions Monitoring: International community encouraged the
Government to undertake structural economic and institutional reforms in order to overcome
the obstacles to sustainable development and foreign investment inflows. Governance
improvement, however, seems very fragile.
ƒ An open economy: Solvencia’s trade openness ratio is rather large. By reducing
domestic demand and enhancing competitiveness, the country could boost its export potential
and move to sustainable current account surplus. Trade and services sectors can have a
positive impact on the country’s future economic performance, given their linkages with other
economic activities.
ƒ Increase in FDI: As a result of the sale of a mobile telephone license and partial
privatization of the state-owned telecommunication company, Solvencia benefited from large
amount of FDI after 2000. These non-debt creating capital inflows finance the current account,
contribute to economic and employment dynamism, while promoting technology transfers.
ƒ Growing agricultural sector: Agriculture is a very important part of the country’s
economy. While facing structural and institutional problems with modernizing the industry,
favourable climate and good harvesting conditions resulted in the improvement of GDP growth
since the crisis.
ƒ Dynamic (but not sustainable) economic momentum: Solvencia’s robust
economic performance had a positive effect on the public finance sector. The country benefited
from the global economic boom and accrued domestic consumption and investment, hence a
surge in public revenues.
ƒ High potential of human capital: Solvencia enjoys large skilled human capital as
well as young population.

© CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – CERAM Business School- Global Finance 3
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 IV- The Economy after the Crisis: Losing the Growth Momentum (negative points)

After the economic crisis and the implementation of IMF structural economic policy
measures, Solvencia enjoyed moderate but sustainable GDP growth between 5 and 7%, and
moderate inflation. Inflation witnessed a decreasing trend, reaching an average level of 10%
between 2002 and 2006. Foreign investment activities also started to pick up again,
attracting nearly US$10 billion of new FDI into the country between 2001 and 2005, thanks to
the privatization program. Dynamic growth helped increasing government’s revenues, leading
to a comfortable budget surplus between 2001 and 2004.

Exhibit 2: Solvencia Goverment Revenue and Expenditure 2003-2015

400 000 35%

Government Revenue Government Expenditure

30%
350 000 Budget Deficit to GDP

25%
300 000
20%

250 000
15%
(LC Bn)

200 000 10%

5%
150 000

0%
100 000
-5%

50 000
-10%

0 -15%
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Source: National Bureau of Statistics

However, we believe this favorable economic development was mainly driven by

external factors, namely strong growth in the global economy and low interest rate
environment during the period of 2002-2006. The soundness of economic fundamentals and
the commitment to long-term institutional and structural reforms remain questionable. The
latest developments of Solvencia’s economy raise concerns. Economic growth in 2008 is
expected to be only 3 %, or half of the growth seen in 2007. Moreover, inflation rate also
started to pick up again to 22% in 2007 and probably around 30% in 2008, mainly due to
soaring oil prices and increasing domestic consumption. On the investment side, high political
instability, terrorist attacks and harsh repression to demonstration and political protest have
discouraged FDI. In 2006 and 2007, FDI inflows reached barely US$500 million, and dropped
further in 2008.

Moreover, rising government expenditures contributed to a return to budget deficit since

2006, fuelling inflation. After enjoying surplus on the government budget in the period 2001-
2004, government budget returned to negative territory. All in all, Solvencia did not benefit
from buoyant global economic growth and recent sharp trade dynamism due to deteriorating
economic fundamentals.

V- Balance of Payment: Facing New Mounting Current Account Deficit

From a country risk standpoint, Solvencia’s balance of payment exhibits several sources of
concern. As we can notice between 1996 and 2000, a larger and larger current account deficit
occurred mainly due to eroding external competitiveness, spill-over effect caused by the Asian
crisis, and mounting imports due to overvalued exchange rate.
The main reason lying behind the growing trade deficit is not only the surging oil prices
(and oil is the biggest part of Solvencia’s imported commodity), but also unsustainable
© CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – CERAM Business School- Global Finance 4
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 domestic private consumption and government expenditures. Solvencia suffers basically from a
demand-led inflation and a cost-driven deficit.
On the revenue side, income from tourism revenues has been witnessing severe problems
and have decreased due to travel warnings issued by UK, US, and Japan as a response to the
political turmoil, instability, and several bomb threats in the country’s capital, Solven City.
Private remittances also tend to decrease in 2008, in line with the current threat of global
economic recession. This has greatly affected the current account. However, good harvest
condition in recent years and diversifying export structure has improved the export position,
but still not enough to cover the increase in imports and the drop in tourism revenues. All in all,
trade deficit is wider and wider, reaching around $4,5 billion. We expect the current account
deficit to reach US$5 billion in 2016, as much bas in the previous year, equivalent to a record
high 10% of GDP!

4000
Exhibit 3: Solvencia- Current Account ($ million)
3000
2000
1000
0
-1000 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

-2000
-3000
-4000
-5000
-6000
-7000

VI- Twin Deficit Financing: Increase Reliance on External Debt

The country’s external liquidity situation has deteriorated in the 2004-2008 period due to
a combination of factors including the following: shrinking FDI flows, decreasing current
account surplus, and a drop in external financing. Rising capital flight compounded the problem.
In 2008, the current account deficit exploded, probably reaching –US$2.7 billion, compared
with a surplus of around US$2 billion per year in the 2002-2003 period. In addition, the NE&Os
turned to negative territory, a proxy signal for capital flight. Cumulative capital flight amounted
to a record US$1.35 billion! Accordingly, the country’s reserves might drop by US$2 billion in
2008 alone to cover the mounting external financing requirements.

© CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – CERAM Business School- Global Finance 5
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 Exhibit 4: Solvencia's Net Errors & Omissions, and net portfolio investment flows
2003-2015
600

400

200

0
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
(LC Bn)

-200

-400

-600

-800

Portfolio equity investment, net Errors and omissions, net

-1 000

Source: National Bureau of Statistics

Overall, our main concern stems from Solvencia’s protracted disdain for prudent
macroeconomic management. There are converging signals that the country is back to the pre-
crisis situation of excessive spending, growing deficits, and rising inflation. Despite a high level
of international reserves, estimated at still around US$22.6 billion, current trends point again
toward looming liquidity problems.

Solvencia’s major sources of external debt are capital markets and foreign creditors
including principally International Financial Institutions (IMF and World Bank), official bilateral
creditors (i.e. Paris Club) and commercial banks (i.e. London Club). Capital markets (bond
issuance) do not represent a large share of the country’s external indebtedness.
The main risks of the debt structure of Solvencia, in our opinion, are the growing reliance
on commercial bank borrowing, the bunching of principal repayment between 2007 and 2009,
and liquidity tensions. The total proportion of commercial banks borrowing in Solvencia’s total
debt reveals an increasing trend between 1996 and 2008, from 19% to 23% respectively. Since
interest rate from commercial banks loans is usually floating, high reliance on this type of
financing makes Solvencia’s balance of payment very sensitive to future upward changes in
interest rates.

© CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – CERAM Business School- Global Finance 6
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 Exhibit 5: Solvencia - Debt Principal Repayment Due 2010-17

3 000

Large bunching of debt repayments

2 500

(LC Bn) 2 000

1 500

1 000

500

0
2010 2011 2012 2013 2014 2015 2016 2017

Total principal repayments due Source: National Bureau of Statistics

The second risk Solvencia faces is high principal loan repayment in the period 2011-13,
with almost US$ 7.5 billion of loan maturing, even higher than total debt service payment due
during the 1999-2001 economic crisis. This, in our view, is the major challenge to Solvencia’s
economy in the future. Debt servicing concentration raises concerns about Solvencia liquidity
and its ability (and willingness) to keep servicing its external debt while financing imports. The
debt to export ratio will stand at 69% in 2008, compared with 56% in 2006. However,
according to our calculations, the reserves to import ratio will remain at a comfortable 13
month level in 2008, well ahead of the safety threshold, which is normally 6 months.

Exhibit 6: Solvencia's External Solvency Indicators 2003-15

300% 120%

250% 100%

200% 80%
(LC Bn)

150% 60%

100% 40%

50% 20%

0% 0%
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Debt to GDP (LHS) Reserves to External Debt (LHS) Debt to Export (RHS)

Source: National Bureau of Statistics

In order to stem a further reserve decline and to restore the international community’s
confidence in the country’s economy, Solvencia has requested a new loan from IMF in 2007,
amounting to US$ 300 million and another US$ 100 million in 2008. This reveals the fact that
the Government of Solvencia has realized it might face liquidity problems in the near future.
On the other hand, solvency is not (yet) a major risk for the country. So far, the liquidity
© CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – CERAM Business School- Global Finance 7
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 tension does not translate into solvency risk, as the Debt/GDP ratio is comfortable at 40% in
2008, well below critical levels.

VII- Solvencia’s upcoming challenges for paving the way to sustainable development,
external creditworthiness, and return to market access

Regarding the need for implementing market-based economic policy measures, one
can highlight the following challenges Solvencia must tackle over the 2008-2012 period:

1. Adopting market-based economic policies promoting competitiveness and trade

openness
2. Cutting inefficient public expenditures and stimulating privatization-driven revenues
to balance the budget
3. Focusing on tourism sector, more security and better services
4. Keeping cost-push inflation pressures at bay while maintaining a competitive real
effective exchange rate with a floating exchange rate system, aimed at supporting a
liberalization of the capital account, attracting further FDI and stimulating
productivity growth.
5. Improving the current account balance by encouraging the return of capital flight,
and boosting exports of goods and services.

VIII- Eurobond Project Request: To Float or Not To Float

Before concluding by providing the recommendation whether we should underwrite or

not Solvencia’s Eurobond, there is a three-fold question we have to answer: Is Solvencia’s
economy in the face of new economic problems…? If the answer is positive, how sharp and
long will be these problems…? And will the government be committed to take all the
necessary measures to move the country back to a track of sustainable development?

We believe that Solvencia is on the verge of new economic crisis, starting as early as
2013. The economic and financial tensions might be triggered by populist policy choices and
imprudent financing strategy. We predict Solvencia will face difficulties in servicing its debt,
considering that there will be much larger debt service payment during 2008-2011, high
current account deficit, and dropping reserves to import ratio. The country would then be
vulnerable to exogenous shocks such as soaring oil import prices and rising rates of interest.
This might then push Solvencia into payment arrears and to debt rescheduling. The crisis
could worsen due to bad governance. All of this situation will dampen Solvencia’s economy.
We also observe that the IMF and the World Bank will be very cautious not to extend new
loans to Solvencia without strong reform conditionality, especially after taking into account its
weak governance.

All in all, we stress the need to speed up the pace of structural and institutional
reforms and to implement the following sustainable development priorities:

1. Addressing financial sector weaknesses, liberalizing the capital account, improving the
regulatory framework and tackling labour market rigidities
2. Modernizing the industrial sector
3. Continuing the privatization program given that the state retains a large presence
throughout the economy, including in the state-owned banks.
4. Increasing trade openness and diversifying the export base regarding products and
markets;
5. Enhancing free trade with the EU and the USA
6. Improving living standards and creating jobs for the young generation
7. Articulating a strategy to accelerate the structural transformation of the economy
towards more skill-intensive sectors.
8. Implementing social and institutional reforms while improving governance

© CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – CERAM Business School- Global Finance 8
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 IX- Conclusion and recommendation to Casino Bank’s Risk Committee
In conclusion, we recommend the Board of Directors not to underwrite
Solvencia’s Eurobond. We believe that investment banks will be reluctant to underwrite the
US$500 million bond and that bondholders will show little appetite for a straight bond issue
despite its attractive yield.
From our standpoint, however, there might still exist an opportunity to support the
Eurobond issue while mitigating the risk for Casino Bank. One can request Government of
Solvencia to use the country’s gold reserves to guarantee the Eurobond. Gold reserves will be
held by an independent party, such as the BIS or an escrow account in a reputed financial
institution. With this arrangement, we believe, we can sell the Eurobond of Solvencia in the
capital markets with promising fees for our bank, and favorable risk/return ratio for
international investors.

1. Solvencia’s return to market access is premature given lack of market-based

economic policy commitment and weak governance;
2. Market appetite might be tested with smaller bond (US$200 million) maturing after
the bunching of upcoming debt repayments;
3. Enhancing features will facilitate the success of the bond issue: equity conversion
option, gold collateral, on-going monitoring of the IMF, cross-default clause…

© CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – CERAM Business School- Global Finance 9
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 10
Appendix: Timeline - Solvencia

© CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – CERAM Business School- Global Finance
Economical + Financial
Recession Increase in FDI
crisis + Budget & Current
account deficit + Low
Asian Crisis – Caught Budget and Current account Tourism Low inflation,
by spillovereffect deficit – High inflation emerging increased terms of trade
1995 1996 199 199 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
High inflation Structural Growth in Stable growth
adjustment politics FDI & GDP in FDI
Economic overheating From 2000/2001 and until Moderate growth FDI. Bond
2008 we see a decrease in issuing is the new ballgame.
inflation
Decrease in official reserves Solvencia’s ecomomy as a
whole is improving

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 Annexes

Exhibit 7: Debt Service Ratio and Import Coverage 2003-15

18,00 30,0%

16,00
25,0%
14,00

12,00 20,0%
(Month)

10,00
15,0%
8,00

6,00 10,0%

4,00
5,0%
2,00

0,00 0,0%
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Reserves to Monthly Import Coverage (LHS) Debt Service Ratio (RHS)

Source: National Bureau of Statistics

Graph II: Correlation Between Solvencia's Interest Rate Payment and LIBOR
12%

10%
Solvencia Interest Rate Payment

8%

6%

4%

2%

0%
0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00%
LIBOR

$ LIBOR (six-month, average) Linear ($ LIBOR (six-month, average))

© CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – CERAM Business School- Global Finance 11
Center
 INTERNATIONAL FINANCE & COUNTRY RISK ANALYSIS
Republic of Solvencia and the International Financial Markets

Eurobond Request to Casino Bank

Michel Henry BOUCHET

[Link]
SKEMA Business School

Pedagogical Support Note

Auteur : Michel Henry BOUCHET, Global Finance

Etablissement créateur : SKEMA Business School

© SKEMA 2018 CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – Global Finance Center
 Pedagogical Support Note for Solvencia Case

The Solvencia Case Study combines international finance, capital markets and country risk features
that enable the professor to tackle a wide range of issues. The case can be used in a Country Risk Course, an
International Finance course, and an International business and strategy course, as well as an Investment
Banking course. The case discussion could be presented and dealt with at the end of the first semester,
when the professor has addressed such issues as balance of payments, international finance strategy, risk
management and capital markets.

1. Case Summary
The case study deals with an emerging market country’s request for financial advisory services with
regard to the launching of a €800 million Eurobond issue on international capital markets. The students
must work on the case from the standpoint of an investment banker who has to perform a country risk
assessment. The end-product of the case is an in-depth risk analysis report with a clear-cut recommendation
to the bank’s Risk Committee. The case can combine a written report (group work or personal work) as well
as an oral presentation of the analysis’ salient points.

2. Case material
The case study comprises the following seven elements:
ƒ Pedagogical note
ƒ Case study presentation
ƒ Background information for the students regarding country risk components, eurobond
syndication, and other international finance issues.
ƒ Excel spreadsheet with macroeconomic and balance of payment data, including a number of
“blanks” to be filled in with liquidly and solvency ratios
ƒ Case correction
ƒ Excel spreadsheet correction
ƒ Case presentation with Power point slides

3. Student target audience

The target student audience is mainly Master in International Finance, “Majeure Finance de Marché”
in business schools, Country risk analysis as well as International Finance courses in business schools, IEP
and University.

4. Case Objectives

3.1. General Objective

Country risk is a broad concept that comprises an underlying combination of economics, finance,
geopolitics, sociology, and history issues. As the global market integration increases the risk of crisis
contagion and spill-over, the level of uncertainty and complexity gets larger for the international firm’s
cross-border strategy. Hence country risk analysis has become today an essential component of strategy
decisions regarding export, investment, partnership, mergers, as well as takeovers. The main purpose of this
case study is thus to help the students to understand the framework of country risk analysis based on an
hypothetical emerging country. However, although the country used in this case does not really exist, all the
political, economic and financial background given in this case is typical pattern of a developing country’s
economic and socio-political challenges.
© CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – 2018- Global Finance 2
 3.2. Specific Objectives

x Helping the students to understand the key parameters of country risk, including political,
economic and financial issues of a country’s development process.
x Analysing the balance of payment and it’s large role in country risk analysis.
x Understanding the impact of macroeconomic policies on a country’s external financing
requirements;
x Identifying the key international finance and economic intelligence sources, both official and
private;
x Focusing on the most important liquidity and solvency ratios to gauge a country’s debt serving
capacity and creditworthiness.
x Writing a succinct and well articulated risk strategy note.

5. Responsibility of the professor:

x Present and explain the case to the class
x Briefly describe the bond issuance process and its main risks;
x Identify the key parameters of country risk (economic, financial, socio-political, regional, and
systemic);
x Spell out the main steps in a country risk assessment note;
x Organize the class in various groups to help the students focus on the most important issues
(economic, financial, socio-political, balance of payments, external indebtedness issues, as well as liquidity
and solvency indicators)

6. Responsibility of the students

x Understand the problems in the case study;
x Identify the critical points of analysis and the step by step country risk assessment;
x One week after the case study being distributed, each group shall submit to the professor an
Excel-based quantitative analysis of the case study;
x Two weeks after the case study being distributed, each group shall present its final analysis in a
formal oral group presentation. Each group will get 30 mns to address the Casino Bank’s “Risk Committee”
and provide a clear-cut recommendation regarding Solvencia’s Eurobond request.

7. Problem solving objectives:

The Solvencia-Casino Bank case study leads the students throughout the hypothetical case of an
emerging country with large external financing requirements. The students must assess the country’s
country risk situation from the standpoint of an investment banker, focusing on the economic, financial, and
socio-political components of sovereign risk.
The professor will spell out the major differences between the role of a commercial bank and that of a
merchant or investment bank. The former will lend money and it will mitigate the risk (1) through a
Eurobond syndication including a large number of underwriting banks, and (2) it might securitize the loan to
sell it on the secondary market as a liquid and tradeable financial instruments. The securitization process will
free capital on the bank’s balance sheet and will shift the risk to other economic agents, for instance,
institutional investors. The latter does not lend any money but acts rather as an intermediary providing fee-
based financial advisory services.
The professor will then tackle country risk from the standpoint of uncertainty, i.e., a deficit of
information and economic intelligence, hence the need to identify a wide range of country risk information
sources, both official and private.
Then the professor will aim at focusing the students’ attention on the four main causes of cross-
border investment pitfalls, namely, economic, financial, socio-political, and regional spill-over. He/she will
emphasize the usefulness of in-depth balance of payments analysis to cast light on liquidity and solvency
indicators. Regarding the socio-political analysis that requires qualitative assessment, he/she will illustrate
the usefulness and limits of ratings and rankings (Asian crisis, LTCM, Enron, US subprime crisis...).

© CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – 2018- Global Finance 3
 8. Length and case organization
Typically the case runs over two to three weeks
ƒ Week 1: (1 hour) case presentation by the professor, team work organization
ƒ Week 2: Debriefing: each group submits to the professor an Excel-based quantitative
analysis of the case study, presenting the key liquidity and solvency ratios; (each group will
get 20 mns for a succinct presentation of its calculations)
ƒ Week 3: Debriefing: each group holds an oral presentation of its overall country risk analysis
of Solvencia, in a Board Meeting format, using PPT slides, leading to a class wide debate (20
mns each). Alternatively, the professor will split the class in two groups; one group will
tackle Solvencia’s Eurobond request with a view to turn it down, hence emphasizing the
negative points of the country’s situation, while the other group of students will emphasize
the positive points leading to Casino Bank’s support of the country’s Eurobond request. The
debate will lead to a confrontation of the two stances concerning the bank’s strategy with
regard to the emerging market country.
ƒ An additional step in the case discussion can be to ask students how to structure a €800
Eurobond issue to facilitate the launching of the bond while mitigating the risk from the
bondholders’ side. The students might consider various collateralization options, using the
gold holdings of the country’s central bank, shortening the bond maturity, or including an
equity conversion option into the upcoming privatization program of the country.
ƒ The professor will ask each group to submit a written report to the Bank’s Risk Committee.
The report should be short, well articulated and with a clear-cut conclusion (three pages).
ƒ The professor can then distribute a correction of the case study and to present the salient
features of the correction using Power Point slides.

9. How can the Solvencia case study fit in an International Finance course and a Country risk
assessment training seminar?
The Solvencia case study is useful in that it brings together a wide number of international finance and
economic issues pertaining to country risk analysis and management. The overall objective is to lead the
students from an in-depth analysis of the country’s macroeconomic and financial situation to an investment
strategy which can be a Yes/No decision, or even a Yes/But decision, i.e., using various risk mitigation
instruments.

© CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – 2018- Global Finance 4
 Succinct bibliography:

ENGLISH
1. Bouchet, Fishkin, Goguel: “Managing Country Risk in an Age of Globalization: A Practical Guide to
Overcoming Challenges in a Complex World, Palgrave 2018

[Link]
[Link]
2. Bouchet, Michel Henry, Ephraim Clark, and Bertrand Groslambert. 2003. Country Risk Assessment: A Guide
to Global Investment Strategy. John Willey & Sons: England.

3. Bouchet Michel-Henry: Country risk in the age of Globalization and Donald Trump, World Financial Review,
October 217

4. Bouchet, Michel Henry. 2017. International Finance Lectures Series. SKEMA Business School.

5. Fabozzi, Frank J. 2000. Bond Market Analysis and Strategies: 4th Edition. Prentice Hall: New Jersey.

6. Clark Ephraim, International Finance, 2nd edition, Thomson, 2002.

7. Madura, Jeff. and Fox, Roland, 2013. International Financial Management: 5th Edition. International
Thomson Publishing: Ohio.

8. BIS International Banking and Financial Market Developments, BIS Quarterly Review.

French, and Spanish:

1. Bouchet et alii : « Gestion et Finance Internationales” (Pearson 2004)
2. Bouchet, “La Globalisation, Introduction à l’Economie du Nouveau Monde” (Pearson 2005),
3. Bouchet, “Intelligence Economique et Gestion des risques” (Pearson 2007, with Alice Guilhon)
4. Bouchet : “Riesgo-Pais: un enfoque latino-americano” (ESAN 2007). (with Sarmiento y Lumbreras)

Websites:
1. [Link]
2. [Link]

3. [Link]/education

4. [Link]

5. [Link]/external

6. [Link]

7. [Link]

8. [Link]

9. [Link]

© CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – 2018- Global Finance 5
 Standard Country Risk Assessment Fact Sheet

1. Introduction: Map and graphs

(History, political system, ethnical features, culture and religion)

2. Survey of geographical features, raw material, human and natural resources

UNCTAD: [Link]
UNDP [Link]
World Bank [Link]
CIA [Link]

3. Macro-economic analysis
Sector analysis, macroeconomic adjustment, trade strengths and weaknesses (partner/product composition),
Inflation, savings/investment ratios
GDP growth, underground economy, public sector expenditures…
IMF/WB/regional development banks: IADB/AfDB:AsDB/EBRD
[Link]

4. Balance of payments analysis

Trade balance, current account, reserves, E&O
[Link]
[Link]

5. Debt Flows & Stock Analysis

Debt servicing burden, liquidity and solvency indicators

World Bank/OECD/BIS/IMF
[Link]
Secondary market discounts: Bradynet, EMTA/IFR

6. Legal and regulatory framework conducive to private investment

World Bank Doing Business [Link]
Heritage Foundation: index of Economic Freedom [Link]

7. Ratings
[Link]
[Link]
[Link]
[Link]/ratings
[Link]
[Link]
[Link]
[Link]

© CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – 2018- Global Finance 6
 Main Sources of Country Risk Intelligence –I-

ƒ BERI (Business Environment Risk Index)

ƒ Bradynet Info and data on emerging fixed income markets.
ƒ Credit Risk International
ƒ Davos World Economic Forum
ƒ Dr. Harvey Campbell 's site (Duke University)
ƒ Dr. Nouriel Roubini's web site (NYU)
ƒ Economist Intelligence Unit (London) [Link]
ƒ Euromoney Magazine (Country risk indices).
ƒ Frost & Sullivan
ƒ Global Finance Magazine
ƒ Global Risk Assessment, Inc. - Country Risk Services [Link]
ƒ Harvard Institute for International Development (Boston)
IFC Emerging Stock Market Factbook
ƒ Institute for International Economics (Washington)
ƒ Institute of International Finance Inc. (Washington, D.C.) [Link]
ƒ Institutional Investor Magazine
ƒ ICRG
ƒ International Finance Corporation Data (World Bank: source for emerging markets data)
ƒ International Finance Review (London): secondary market prices & bond issues
ƒ Morgan Stanley Capital International Data
ƒ Oxford Analytica Inc. On-line daily analysis and custom country risk services.
ƒ Political and Economic Risk Consultancy, Ltd.- PERC Gateway to news & country data
ƒ Political Risk Services (country risk indices).
ƒ Rabid Tiger Project Jeff Deutsch's Political Risk Consulting and Related Research
ƒ Transparency International (corruption & governance)
ƒ UNCTAD (trade and FDI data)
ƒ UNDP (HDI, life expectancy, and GDP per capita PPP)
ƒ World Bank Governance indicators

Useful WEBSITES –II-

[Link]
[Link]
[Link]
[Link]
[Link]
(Handbook of Economic Statistics. Washington, DC: Central Intelligence Agency):
[Link]
Web sites of central banks ([Link]
[Link]
[Link]
[Link]
[Link]/education
[Link]
[Link]

© CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – 2018- Global Finance 7
 RATINGS –III-

[Link]
[Link]
[Link]
[Link]/ratings
[Link]
[Link]
[Link]
[Link]
[Link]
[Link]
[Link]

© CCMP – 2008- Solvencia : Country risk case study – Michel Henry Bouchet – 2018- Global Finance 8
 05/09/2018

SKEMA BUSINESS SCHOOL

COUNTRY RISK ANALYSIS
Republic of Solvencia and the International Capital Markets
Eurobond Request to Casino Bank
Michel Henry Bouchet

WHAT IS RISK ABOUT?

▶Risk stems from a situation of uncertainty

regarding the near or long term, where
information about the situation’s outcome is
insufficient, lacking or simply wrong
▶Information availablility is, in itself, a measure of
risk (BOP, debt data, transparency…)
▶Information scarcity then requires taking action
that might produce negative and costly
consequences (investigation time, transaction cost,
delays, wrong decisions…)

1
 05/09/2018

THE « DISCOVERY » OF RISK

Pascal 1654 Fermat 1654 1703

Markowitz 1952 M. Scholes 1997

Michel H. Bouchet/SKEMA (c) 2018
B. Mandelbrot 3

RISK & UNCERTAINTY

▶ Frank Knight: 1921 Risk stems ▶ Harry Markowitz:

from outcomes that are unknown 1959: Risk = probability of
but can be tackled with loss = historical volatility in
probability distribution…. returns as measured by
Uncertainty stems from a deficit standard deviation or Beta.
of information, hence But risk diversification and
randomness of results tolerance also matter!

▶ J M. Keynes: (Treatise on ▶ Ulrich Beck: 2010: « Global

Probability 1921): Non-linear risk society where current
decisions and technological
nature of risks and danger of developments trigger long-
expecting the future as simple term global impact »
projection of the past: Role of (warming, terrorism,
animal spirits in volatility spill- pollution, financial
over and herd behavior. deregulation…)

Michel H. Bouchet/SKEMA (c) 2018 4

2
 05/09/2018

TACKLING COUNTRY RISK

COUNTRY
RY + RISK
▶Country= sovereign debtor, culture, geographical
distance, specific values, legal and regulatory
constraints, socio-political parameters
▶Risk = uncertainty, lack of perfect information in
real time, transfer risk from the private sector, spill-
over effect

COUNTRY RISK

▶Country risk results from a set of complex

and interdependent socio-economic,
financial and political factors, that are
specific for a particular country, but that can
quickly evolve given the country’s global
integration.

3
 05/09/2018

WHAT COUNTRY RISK ISS NOT

▶ Country risk is NOT a monopoly of foreign creditors,

exporters, importers, or investors
▶ Domestic residents (households, investors, corporate
sector) also face country risk from their own country’s
socio-economic situation:
• The country’s goverment can take arbitrary decisions that
will affect the residents’ situation
• The country can be contaminated by negative regional or
global forces
• A deterioration in the risk perception by capital markets
and rating agencies will feedback on domestic residents’
socio-economic environment and well-being.

COUNTRY RISK ANALYSIS

▶Country risk analysis involves the assessment

of a private or public foreign entity’s ability
and willingness to service its external
obligations in full and in time (contractual,
debt servicing, import payments, legal
commitment…).

▶It incorporates a forward-looking estimate of

default probability

4
 05/09/2018

Inflation, twin deficits, weak

Capital controls, debt default,
banking insolvency productivity, rising labor costs,
Sovereign Macro- stock market bubble
&Transfer Economic
Risk Risk Exchange rate imbalances,
deteriorating competitiveness,
Political imported inflation
Bad governance and Exchange
corruption, political turmoil,
Risk COUNTRY rate Risk
strikes, nationalization, RISK
revolution
Correlation Socio-
and Cultural
Systemic Xenophobia, cultural and
Risk
Risk Legal and religious intolerance
Spill-over, commodity price Regulatory
volatility, regional recession,
Risk Contract repudiation,
rating downgrading,
confiscation, opacity,9
competitive devaluations Michel H. Bouchet/SKEMA (c) 2018
bureaucracy

Payment delays, capital controls,

Payment arrears, rescheduling,
customs bribes, exchange rate
refinancing, default and write-off
devaluation
Exporter Creditor
Defective supplies, exchange rate Capital controls, contract
over-valuation, corrupt customs repudiation, bureaucracy,
officers corruption, deficient
infrastructures
Importer COUNTRY FDI
RISK
EXPOSURE
Investment Devaluation, strikes, bad
M&As
fund governance, weak productivity,
nationalization
Drop in commodity prices, Domestic
regional recession, competitive economic
devaluations, debt default, stock agents Inflation, banking crisis, negative
market crisis interest rates, protectionism,
Michel H. Bouchet/SKEMA (c) 2018 10
political turmoil

5
 05/09/2018

LOOKING TOWARD EARLY WARNING SIGNALS OF

UPCOMING FINANCIAL AND SOCIO-POLITICAL CRISIS?

¾IMF reports?
¾Rating agencies?
¾CDS prices?
¾Stock market volatility
¾Spreads and yields
¾Minsky’s speculative bubbles and herd-instinct
¾B. Mandelbrot’s fractal geometry
¾N. Taleb’s Black Swans
¾D. Sornette’s Dragon-Kings (extreme events)
¾Capital Flight?

Michel H. Bouchet/SKEMA (c) 2018 11

COUNTRY RISK ASSESSMENT

Reliable and updated information

Eco
= Economic intelligence
▶ Robust risk analysis

6
 05/09/2018

MAJOR SOURCES OF COUNTRY RISK INTELLIGENCE

DATA
SOURCES

Official Private
sources sources

Research
Multilateral/IFI International Export credit
Bilateral s banks agencies
centers &
agencies

Paris Club
Investment
IMF banks COFACE Thinktanks
Central Banks World Bank IIE, Brookings Rating agencies:
SINOSUR
Government BIS IIF Hermes EIU Moody’s, S&Ps,
agencies OECD Ducroire NGOs
Fitch, Dagong,
CIA UNCTAD & UNDP ECGD Global Finance-
Skema Incra

Michel H. Bouchet/SKEMA (c) 2018 13

FINANCIAL, MACROECONOMIC AND SOCIO-POLITICAL

INFORMATION AND INTELLIGENCE SOURCES

Official sources Private sources

1 . Multilateral sources 1. Insurance agencies (Coface,
▶IMF OPIC)
▶World Bank 2. Research institutes (IIE, IIF)
▶BIS, OECD, UNCAD, UNDP 3. Thinktanks (Cato, Heritage,
▶RDBs Freedom House)
4. Magazines (Euromoney…)
2. Official bilateral sources 5. Academic centers (CforGD,
¾ Country governments (CBs, CIA) Global Finance…)
¾ ECAs (DREE, Hermes, Eximbank,
ECGD) 6. Rating agencies (S&Ps)

Michel H. Bouchet/SKEMA (c) 2018 14

7
 05/09/2018

HOW DOES COUNTRY RISK MATERIALIZE?

1. CREDITOR = Payment arrears, default, rescheduling, write

down and/or write off
2. INVESTOR = Capital control ÎLimitations on dividend
and capital repatriation
Contractual obligations and legal commitment : contract
repudiation, corruption
Public guarantees: unilateral suspension
3. TRADE PARTNER = Supplies and purchases (imports of
goods & services) Î delays, defective merchandise
Sales (exports of goods & services) Î payment arrears

EXTERNAL DEBT ANALYSIS:

THE DUAL FACE OF COUNTRY RISK

▶Liquidity Risk ▶Solvency Risk

▶ Debt Service Ratio: ▶ Debt/Export ratio
▶ (P+I/X) ▶ Debt/GDP ratio
▶ Interest Ratio (I/X) ▶ ST Debt/Reserves
▶ Current account/GDP
▶ Reserve/Import ratio
▶ Import/GDP ratio
▶ Growth rate of exports/
Average external
interest rate
Michel H. Bouchet/SKEMA (c) 2018 16

8
 05/09/2018

M Risk Indicators 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

GDP (in US$ billion)

Real GDP Growth rate (in Local Currency)
GDP Growth rate (in US$)
GDP per capita (US$)
GDP per capita /day
Rate of currency depreciation
Trade Balance (US$ million)
External competitiveness
Trade openness ratio (X+M/GDP)
Buddget Deficit-Surplus /GDP%
Current account/GDP %

N RATIOS 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
O Solvency
Debt/Exports
Debt/GDP
Reserves/External Debt
Short-term Debt/Total Debt

P Liquidity 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Principal Amortization/Exports %
Debt servicing Ratio %
Interest/Exports %
Reserves/Imports GS in %
Reserves/Imports in Months Coverage
Average external interest rate in %

Q Cash-flow ratio 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Numerator:
+ Official reserves assets including Gold+XG&S
+Undisbursed bank credits + Net transfers )
Denominator (debt service + MG&S + ST debt)
Cash flow ratio #REF!

Michel H. Bouchet/SKEMA (c) 2018 17

SOLVENCIA’S MACROECONOMIC TRENDS

Solvencia- GDP and Inflation growth rates 2003-2016
18% GDP
Deflator

13%

8%

3%

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
-2%

9
 05/09/2018

ECONOMIC OVERHEATING AND STOP & GO POLICY

Solvencia's Budget Gap

40000
Revenue Expenses
35000

30000

25000

20000

15000

10000

5000

0
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Michel H. Bouchet/SKEMA (c) 2018 19

SOLVENCIA = LIVING BEYOND ITS MEANS

4000
Exhibit 3: Solvencia- Current Account ($ million)

2000

0
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
-2000

-4000

-6000

-8000

10
 05/09/2018

VOLATILITY OF INTERNATIONAL RESERVE ASSETS

Official Reserves excluding gold

25 000

20 000

15 000

10 000

5 000

0
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Michel H. Bouchet/SKEMA (c) 2018 21

Michel H. Bouchet/SKEMA (c) 2018 22

11
 05/09/2018

DEBT PRINCIPAL REPAYMENT SCHEDULE

SOLVENCIA’S INTEREST PAYMENT SENSITIVITY TO LIBOR

12
 05/09/2018

KEY MARKET-BASED ECONOMIC POLICY MEASURES TO PRESERVE HEALTHY GROWTH

DYNAMISM IN THE 2011-2018 PERIOD

1. Adopting market-based economic policies promoting

competitiveness and trade openness
2. Cutting inefficient public expenditures and stimulating
privatization-driven revenues to balance the budget
3. Focusing on tourism sector, more security and better services
4. Keeping cost-push inflation pressures at bay while maintaining a
competitive real effective exchange rate with a floating exchange
rate system, aimed at supporting a liberalization of the capital
account, attracting further FDI and stimulating productivity growth.
5. Improving the current account balance by encouraging the return
of capital flight, and boosting exports of goods and services.

KEY STRUCTURAL AND INSTITUTIONAL CHALLENGES SOLVENCIA MUST

TACKLE TO RESTORE SUSTAINABLE DEVELOPMENT PATH:

1. Addressing financial sector weaknesses, liberalizing the capital account,

improving the regulatory framework and tackling labour market rigidities
2. Modernizing the industrial sector
3. Continuing the privatization program given that the state retains a large
presence throughout the economy, including in the state-owned banks.
4. Increasing trade openness and diversifying the export base regarding
products and markets;
5. Enhancing free trade with the EU and the USA
6. Improving living standards and creating jobs for the young generation
7. Articulating a strategy to accelerate the structural transformation of the
economy towards more skill-intensive sectors.
8. Implementing social and institutional reforms while improving governance

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 05/09/2018

OVERALL CONCLUSION REGARDING SOLVENCIA’S REQUEST FOR

LAUNCHING A US$500 MILLION EUROBOND ISSUE

1. Solvencia’s return to market access is premature

given lack of market-based economic policy
commitment and weak governance
2. Market appetite might be tested with smaller
bond (US$200-350 million) maturing after the
bunching of upcoming debt repayments
3. Enhancing features will facilitate the success of
the bond issue: equity conversion option, gold
collateral, on-going monitoring of the IMF, cross-
default clause…

Michel H. Bouchet/SKEMA (c) 2018 28

14
 05/10/2018

ITALY
“THE BUDGET BATTLE”

Data: 10y Italian Bond Yield

Source: BLOOMBERG

Friday (28/09)
Announced Deficit/GDP at 2.4% (2019-2021) 10y BTP Yield (3.44%)

Tuesday (2/10)
Announced Deficit/GDP 10y BTP Yield
(3.30%)
2.4% (2019)
2.2% (2020)

Greek bank shares slide on bad debt worries

Piraeus Bank Source: [Link]

1
 05/10/2018

Can Russia stop using the US dollar?

2
 05/10/2018

Surge in bond yields signals fear of Lebanese default

● Yield on dollar-denominated Lebanese bonds jumped to 10.3% since April
● Spread over US Treasuries jumped to 7.3%

3
 05/10/2018

Surge in bond yields signals fear of Lebanese default

● Debt is equal to 153% of the country’s gross domestic product.

● Third-worst figure in the world after Japan and Greece.
● Moody’s is predicting that servicing costs of debt will account for 44% of government revenues this
year.
● The IMF forecasts Lebanon’s current account deficit will come in at around 25.8% of GDP.
● Seven year long war still raging in neighboring Syria, a conflict that has sent an estimated 1m to
1.5m refugees fleeing across the border, a large number in a country with a population of just 4.6M
● Cost of issuing debt goes up which will probably lead to default of the country

Surge in bond yields signals fear of Lebanese default