An Analysis of Transfer Risk in Comparison to Sovereign Risk

Master's Thesis, 2006

86 Pages, Grade: 1,6


Table of Contents

Table Of Figures

Table Of Tables

1 Introduction

2 Types of Risk in International Capital Transactions
2.1 Default Risk
2.1.1 Corporate Default Risk
2.1.2 Sovereign Default Risk
2.2 Country Risk
2.2.1 Political Country Risk
2.2.2 Economic Country Risk
2.2.3 Social Country Risk
2.3 Rating Implications
2.3.1 Historical Application of the Sovereign Ceiling
2.3.2 Local versus Foreign Currency Ratings
2.3.3 Transfer and Convertibility Risk Ratings

3 Determinants of Transfer Risk
3.1 Political Determinants
3.2 Corporate Determinants

4 Empirical Examples of Transfer Risk Determinants
4.1 Influence of Monetary Unions
4.1.1 European (Economic and) Monetary Union
4.1.2 Central African Economic and Monetary Community
4.1.3 Common Monetary Area
4.1.4 Adoption of a foreign currency and currency board
4.2 Sovereign Crises with and without Transfer Events
4.2.1 Venezuela (1994)
4.2.2 Dominican Republic (2005)

5 External Assessments of Transfer Risk
5.1 Assessment by Political Risk Insurers
5.2 Regulatory Assessment of Transfer Risk

6 Quantifying Transfer Risk
6.1 Monte Carlo Simulation
6.2 Merton Approach

7 Summary

8 Conclusion & Trends


Appendix I

Table Of Figures

Figure 1: Two-stage-process of international lending

Figure 2: Schematic illustration of the different types of risk

Figure 3: Differences between the latest local and foreign currency ratings of all rated sovereigns

Figure 4: Distribution trend of differences between local and foreign currency sovereign ratings rated in specific years

Figure 5: Countries of the European Monetary Union

Figure 6: Monetary unions in Africa

Figure 7: Venezuela’s twelve month inflation rates in the 1990s

Figure 8: Development of the Venezuelan Peso from 2002 to 2006

Figure 9: Relation between short term external debt and the transfer event probability (ceteris paribus)

Table Of Tables

Table 1: Standard & Poor’s Sovereign Rating Methodology

Table 2: Comparison of Sovereign Foreign Currency Ratings and the Transfer & Convertibility Assessment of the Country

Table 3: Merton approach calculations

1 Introduction

In international lending the borrower has to go through a two-stage process to honour its debt (figure 1). The first stage is to earn enough domestic currency to provide the debt service. The second stage is to convert that domestic currency into foreign currency used to denominate its debt and to transfer this foreign currency to the creditor. It is this second stage that gives rise to transfer risk.[1] In this thesis transfer risk is defined as the inconvertibility and the non-transferability of foreign currency.

illustration not visible in this excerpt

Figure 1: Two-stage-process of international lending

Transfer risk is the risk that a non-sovereign entity, which is able and willing to service its foreign currency obligations cannot obtain or transfer the money to the receiver abroad. This transfer inability is caused by the imposition of restrictions on convertibility or capital transfers by the government. Transfer risk applies to all types of international investments.

Transfer risk is a substantial part of credit risk, whenever a bank extends credit across international borders and the extension of credit is denominated in a currency external to the one of the country of residence of the obligor. In these circumstances and the absence of the ability to earn foreign currency abroad, an obligor has to obtain the foreign currency needed to service its obligation from the national central bank. Where a country is beset by political, economic, or social turmoil leading to shortages of foreign currencies at the central bank, the borrower may be unable to obtain or transfer the foreign currency and thus default on the obligation to the lending bank or, alternatively, request a restructuring of the debt.[2]

The New Basel Capital Accord requires the consideration of transfer risk as one minimum criterion on risk assessment of a borrower:

The risk assessment of a company has to include “the risk characteristics of the country it is operating in, and the impact on the borrower’s ability to repay, (including transfer risk) where the borrower is located in another country and may not be able to obtain foreign currency to service its debt obligations.”[3]

Financial institutions are exposed to transfer risk and have to consider the risk in their rating systems, when they provide foreign currency loans to non-resident companies or foreign sovereigns, especially when these debtors are residing in emerging markets or developing countries.

The external rating agencies incorporate transfer risk in their foreign currency credit rating, which is defined as the obligor's overall capacity to meet its obligations in foreign currency. In former times, sovereign default and sovereign intervention risk were assumed to be equivalent. This implied that the foreign currency credit ratings of private sector entities could not be higher than that of the sovereign. The rating of the sovereign was the sovereign ceiling for all rated non-sovereign entities of the country.

Especially in the 1970s and 1980s transfer risk was mainly borne by banks, which were the only creditors for foreign sovereigns. At this time it was very common for defaulting sovereigns to restrict the convertibility of foreign currency for the citizens of the country. This made the maximum amount of foreign currency available for the amortization of the sovereign’s foreign debt.

In the last decade more and more publicly traded debt is available for private investors. The issuance of corporate and sovereign bonds in local and foreign currency increased strongly during the last ten years. Furthermore, banks granted more credit to foreign entities. This led to a considerable rise of transfer risk exposure. The arising question is: “Can banks grant credit to creditworthy companies in not creditworthy highly indebted countries?”

Another development in the last decade was that international trade, investment and commerce have become much more important. Economies have become more open to trade and integrated into global production networks. Although, a government in financial distress has (often) the possibility to enact foreign exchange restrictions, it will only do so, if it considers the costs of a moratorium less than the costs of defaulting on its own debt. Due to globalisation the cost-benefit-ratio has shifted against the imposition of exchange controls that impede the servicing of private sector foreign currency obligations. The costs of imposing wide-ranging exchange controls are a loss of reputation, trade losses, commercial and legal sanctions, lack of international credit and lower foreign investment and hence reduced long-run growth perspectives.[4]

Additionally, the role of the private sector has grown substantially in many countries. There are now very large and important companies, which rely on access to international capital markets, and whose default would cause significant damage to the overall economic situation of the country. Ultimately, the possible short-term positive effects of capital controls will not last for a long time, whereas the damage influences the capital markets for many years.

The historical experience of sovereign defaults and near-default events since the mid-1990s provides some support for the view that governments are less likely than in the past to impose foreign exchange controls and private sector moratoria in order to prevent a sovereign default. Reality shows that of the thirteen emerging market sovereign crises[5] since the Mexican crisis in 1994/95 ten resulted in a default on some class of sovereign debt, but only Russia imposed a formal 90-day moratorium on repayments on private sector external debt. In the Argentina crisis the government enacted exchange controls and was – for a few months – very selective in granting permission to the private sector to transfer foreign currency to creditors abroad.[6]

Although the probability of the occurrence of a transfer event is decreasing the importance of a measurement of risk inherent in a country’s cash flows is increasing due to globalisation and the internationalisation of the value chain.

To underline the importance of transfer risk Deutsche Bank has recently introduced a special rating tool only to assess the risk of a transfer event. This tool determines the possibility whether a debtor cannot service its debt-obligations due to political or supervisory restrictions.[7]

The importance of transfer risk in these days can be derived from an announcement of Standard & Poor’s in November 2005, in which they upgraded the ratings of 25 non-sovereign entities due to a review of the transfer and convertibility risk of the countries of domicile. The cross-border transfer and convertibility risk was reassessed and resulted in rating upgrades of one to three notches for companies in Latin America and Asia. Especially the companies which have an investment grade rating now have obtained a lot of new advantages as a broader investor base, more liquidity sources and cheaper financing costs.

The new assessment of the transfer and convertibility risk by Standard & Poor’s is as relevant as the traditional sovereign ceiling for non-sovereign ratings. The rating agency determines their ratings for non-sovereign entities usually as the lower of issuer’s local currency rating and the transfer and convertibility risk evaluation of the country of domicile.[8]

In this thesis, for the measurement of the different types of risk (sovereign risk, transfer risk, etc.) the assessments of the international rating agencies are used. Actually, ratings are not always the most exact measure of risks, but they are a good guideline. The big advantage is that ratings are relatively stable compared to the very volatile credit spreads or CDS spreads, which are also influenced by exogenous factors like a changing risk awareness of investors. Furthermore, ratings are often used by market participants to estimate the risk inherent in a cross-border investment.

In the following chapter of this thesis the different types of risk occurring in international borrowing are described. It is differentiated between corporate credit risk and sovereign credit risk. Credit risk is the probability of default in a given time period. Another type of risk to be classified is the country risk, which is further divided into the very important political country risk, the economic country risk and the social country risk. The last part of chapter 2 deals with the rating implications of transfer risk by explaining and analyzing the differences between foreign currency and local currency ratings.

Chapter 3 more closely examines the determinants of transfer risk. The political and corporate determinants of transfer risk are assessed. It will be shown, which factors increase the risk of a transfer event and which factors can be used to reduce the risk of a transfer event. An interesting topic of the political determinants of transfer risk is the influence of monetary unions, which is described in chapter 4. Several monetary unions (in Africa and in Europe) will be analysed. And some empirical examples of transfer events in the recent years will be presented.

The 5th chapter is reserved for the description of external assessments of transfer risk. I will refer to a political risk insurance company, which has decades of experience in evaluating transfer risk, and present the regulatory approach of the U.S. banking supervision.

A more quantitative approach to assess the risk of a transfer event is shown in chapter 6. The focus will be on a Monte Carlo simulation and a Merton approach. The second approach tries to transfer Merton’s corporate credit default model with all its underlying assumptions to a transfer event model.

The last two chapters summarize the results of this thesis and a conclusion will be drawn.

2 Types of Risk in International Capital Transactions

In this chapter the different types of risks in international capital transactions are described.

illustration not visible in this excerpt

Figure 2: Schematic illustration of the different types of risk

Although country risk and sovereign risk are often used interchangeably, this is not the. The sovereign risk is an assessment of the risk that the government of a sovereign nation will not honour its debt obligations. Country risk is a broader concept that relates to the risk to cross-border foreign currency lending and investment. This risk arises from events in a particular country, which are outside the control of the private sector. Country and sovereign risks are highly correlated as the government is the key actor in both. But the risk of a transfer event, which is a political country risk, primarily applies to the private sector and may occur even when the sovereign continues to honour its foreign debt obligations.[9]

The first part of the chapter describes the differences between corporate default risks and sovereign default risks. The country risk plays a major role in the evaluation of risk in international capital transactions and will be divided into three sub-types. These sub-types are political, economic and social country risks.

And in the third part of the chapter the rating implications of the different types of risk will be shown. It is differentiated between local currency ratings and foreign currency ratings as well as between the historical sovereign ceiling and the current transfer and convertibility risk assessment.

2.1 Default Risk

Default risk is the probability of default of a corporate or sovereign entity. Although the result of the default risk evaluation is a probability of default the parameters, which influences this risk, defer between corporate and sovereign borrowers. These different input parameters of the risk analysis are shown on the following pages.

2.1.1 Corporate Default Risk

Every company has its own creditworthiness depending on its liable capital, its future growth perspectives, and its management’s ability. These factors are some of many elements, which are included in a corporate credit rating. External corporate ratings are published by rating agencies (e. g. Standard & Poor’s, Moody’s Investors Service Inc. (Moody’s) or Fitch Ratings (Fitch) and estimate the company’s probability of default within one year.

These ratings consider the free cash flows of the company as well as its debt servicing. For the local currency rating – apart from currency risk – no difference is made between debt in local currency and debt in foreign currency.

In general, the corporate credit rating is based on a quantitative and a qualitative part. The quantitative elements include the latest balance sheet and the profit and loss account as well as those of the two previous years to calculate certain trends. This is the objective part of the rating, as the ratios and developments are calculated automatically. The qualitative elements of a corporate credit rating are an assessment of the management, the quality of the disclosed information, the risk management of the company, the future development and practicability of the future plans. The rating is also influenced by letters of comfort of a parent company or a government.

For a company which intends to issue bonds a minimum of two external ratings is required. If a company wants to obtain credit from a bank the bank’s risk management will rate the corporate entity and no external ratings are necessary.

The result of every corporate rating is a probability of default. This default is defined in the Basel II framework in the following way:

“A default is considered to have occurred with regard to a particular obligor when one or more of the following events have taken place:

- it is determined that the obligor is unlikely to pay its debt obligations (principal, interest, or fees) in full;
- a credit loss event associated with any obligation of the obligor, such as a charge-off, specific provision, or distressed restructuring involving the forgiveness or postponement of principal, interest, or fees;
- the obligor is past due more than 90 days on any credit obligation; or
- the obligor has filed for bankruptcy or similar protection from creditors.”[10]

2.1.2 Sovereign Default Risk

A sovereign has to maintain and strengthen the political and economic stability of a country. But due to macroeconomic occurrences or highly leveraged public finances and losses in the balance of payment it is also endangered by bankruptcy.

But sovereign ratings are not "country ratings". This is an important and often misunderstood distinction. Sovereign credit ratings assess the ability and willingness of a government to make timely payments to their debt obligations. The sovereign ratings estimate the potential occurrence of a sovereign default. Sovereign ratings address the credit risks of national governments, but not the specific default risks of any other issuers in this specific country. Most frequently the credit ratings of non-sovereign issuers are lower than the one assigned to the sovereign of the country of domicile.

Among others Mellios and Paget-Blanc found out, that as little as six variables have a very significant impact on sovereign ratings. They showed that the per capita income, the government income and the changes in the real exchange rate have a positive effect on the ratings, while the inflation rate has a negative impact. The default history of a country and the corruption index, which is a political variable, play a crucial role for the sovereign rating, too.[11] The yearly published Transparency International Corruption Perceptions Index can be used as a guideline for corruption, defined as the abuse of public office for private gain. It measures the degree to which corruption is perceived to exist among a country's public officials and politicians. This index is based on 16 surveys from 10 independent institutions, which gathered the opinions of business-people and country analysts.[12]

Standard & Poor’s summarizes that their primary focus is on the “government’s economic strategy, particularly its fiscal and monetary policies, as well as on its plans for privatization, other microeconomic reforms, and additional factors likely to support or erode incentives for timely debt service.”[13]

In the following table Standard & Poor’s sovereign rating methodology is shown in detail:

Abbildung in dieser Leseprobe nicht enthalten

Table 1: Standard & Poor’s Sovereign Rating Methodology[14]

Since sovereign bond issuances are increasing, the number of rated sovereigns has grown dramatically. In 1985, only 17 countries had obtained credit agency bond ratings required for borrowing on international capital markets. Most of these countries were industrialised countries and rated AAA. The other countries relied on bank debt or private placements.

Defaults by rated sovereign issuers of bank and bond debt are not uncommon. In the last years Argentina, the Russian Federation, the Dominican Republic, Pakistan, Uruguay, Indonesia, Paraguay, and Suriname defaulted on their local or foreign currency debt.[15]

Some decades earlier Walter Wriston (1982), the former chief executive officer (CEO) of Citibank, announced that a "country does not go bankrupt", because it always owns more than it owes. Actually countries cannot be closed like a company due to overwhelming financial burdens, but for the investors it makes no difference either way, because they don’t get the invested money back.

Although, sovereign defaults are possible nowadays, there are considerable attempts by the debtor countries to redeem their reputations and most governments remain extremely reluctant to dishonour their debts. Indeed, it appears that the economic costs of a default are increasing. This is not because the material penalties have become bigger. It is still not possible to seize the assets of sovereigns in the case of default. The reason is that the globalisation of production, trade and finance increases the advantages of pursuing a liberal economic strategy and raises the opportunity costs of pursuing an autarkic strategy.[16] A more detailed analysis of the impacts and costs of a transfer event can be found in chapter 3.

Due to the small number of sovereign defaults in comparison to corporate defaults, the rating of sovereigns “depends more on the art of political economy than on the science of econometrics.”[17]

2.2 Country Risk

In the 1970s, 1980s, and 1990s sovereign risk was the most important risk in international lending. The ability or willingness of a sovereign government to honour its cross-border foreign currency debt was the only factor, which had to be analyzed. Sovereign obligations represented the predominant form of international banks' foreign currency exposures to emerging market countries. This risk concept provided a reasonable framework for the Latin American debt crisis of the 1980s and also the Mexican debt crisis of 1994/95. The Asian crisis 1997/98 demonstrated that country risk analysis needs to be extended to incorporate the non-payment of foreign currency obligations by private sector counterparties[18].

The broader understanding of country risk encompasses all of the uncertainties arising from the political, economic, and social conditions in a country. Country risk incorporates the possibility of deteriorating economic conditions, political and social upheaval, expropriation of assets, government repudiation of external indebtedness, foreign exchange controls, and currency depreciation.[19]

Until the middle of the 1990s banks may have treated all sovereign and non-sovereign exposures in one country as having the same risk as the sovereign. However, not later than the Asian crisis, banks have to identify individual foreign counterparties that are more exposed to local country

- political conditions,
- economic conditions and
- social conditions

than others.[20] This differentiation shows also the structure of this chapter. Most of the emphasis is put on the political risk, which includes transfer risk. But economic risk is also an important factor, and social risk will be shown at a glance.

2.2.1 Political Country Risk

Political country risk is a change in political institutions and politically driven regulations stemming from a change in government control. The political country risk covers the potential for political interference, internal and external conflicts, terrorism, legal system as well as expropriation risk.

The political interference has a high impact on the political country risk. It covers the risk of a government induced transfer event. Claessens & Embrechts define transfer risk as “the risk that the government will impose restrictions on the transfer of funds by debtors in the country in question to foreign creditors, either for financial or other reasons. This risk is almost exclusively related to foreign currency exposure.”[21]

The Committee of European Banking Supervisors defines transfer risk as “the risk that a borrower will be unable to obtain the necessary foreign currency to repay its obligations, even if it has the necessary local currency”[22].

In summary, a transfer event is defined as the following situation:

Debtors, who are able and willing to ensure timely payments of foreign currency debt service, are unable to secure or transfer foreign exchange to service their external obligations, because transfer or convertibility restrictions are imposed by the government or the central bank through a law or regulation, which has the force of a law.

Transfer risk and convertibility risk are often used synonymously; although convertibility risk is slightly different. It describes the risk one step before transfer risk comes into place. Convertibility risk is the risk of a domestic entity to be unable to convert local currency into a foreign currency, due to exchange restrictions imposed by the government or the central bank. This makes it impossible for the domestic entity to stay current on its foreign currency obligations. In this sense transfer risk is the risk that the domestic entity has the foreign currency available, but cannot transfer it to its creditor abroad, due to restrictions imposed by the government or the central bank. But as both risks have the same determinants, derive from political risk, are often defined as one risk and the difference is minor, in this thesis both risks are referred to as ‘transfer risk’.

One result of transfer restrictions is the inability of domestic companies to service their own foreign debt. Although the companies are economically healthy and have enough domestic liquidity, they are not able to transfer the money and default on their foreign currency debt. This default can lead to a bankruptcy of the company, which has further negative consequences for the whole economy, e.g. an increasing unemployment rate and less tax revenues for the government. These negative consequences are included in the costs of a transfer event.

The more direct sovereign interventions are possible or to be expected, the more political country risk influences the investments in a country. These sovereign interventions might include exchange controls, frozen bank deposits, required repatriation of all foreign exchange receipts held abroad and different exchange rates for different types of transactions.[23]

In monetary unions like the European Monetary Union or the Economic and Monetary Community of Central Africa (CEMAC) the risk of a political interference in the financial system is reduced broadly because the sovereigns have transferred the right to impose transfer restrictions to the multinational central bank. A more detailed discussion on the transfer risk topic in this context is found in chapter 4.

The second factor of political country risk is the probability of internal or external conflicts. This includes political or regional factionalism or armed conflicts, which adversely affect the country. This becomes obvious in the case of Israel, which is a highly developed country with very skilled professionals, but the risk of an escalating conflict between the Israelis and the Palestinians and the Lebanese makes foreign direct investments into this region very risky.

Terrorism is a similar political risk because it can deteriorate the value of an investment within a second due to a terrorist attack. A good example is the airplane industry in North America, which was affected strongly by the airplane attacks in New York and Washington DC on September 11, 2001.

The legal system is also summarized as one point of political country risk. An important point is the degree to which the country’s legal system can be relied upon to fairly protect the interests of foreign creditors and investors. In addition, the adherence to international legal and business practice standards as well as international accounting standards play a role in the assessment of political risk.[24]

The risk of expropriation is a low frequency risk, which can have a very high impact. Although this happens very rarely, the Bolivian government nationalized two Brazilian refineries, which produce more than 70% of the Bolivian natural gas, in May 2006.

To assess political country risk it is necessary to analyse many factors, including the relationships of various groups in a country, the decision-making process in the government and its stability, and the history of the country.

As the political country risk is an interwoven system, one risk has impacts on many other aspects. This includes that a few political country risk factors are also determinants of the transfer risk, which is described in chapter 3.

2.2.2 Economic Country Risk

Economic country risk can have a significant influence because a change in the economic structure or growth rate in a country will affect the expected return of an investment. This risk arises from the potential for disadvantageous changes in fundamental economic policy goals as well as unexpected macroeconomic developments. These changes include fiscal, monetary, international deterioration as well as changes in wealth distribution or creation. A significant change in a country’s comparative advantage like resource depletion, industry decline, or a demographic shift can have negative impact on the country, too. Economic risk can overlap with political risk in some way since both deal with policy, in a way.[25]

A recession in the operating country will end up in lower demand and have a negative influence on the value of the company or increase the probability that the corporate borrower is unable to repay the loan due to reduced sales.

Economic country risk includes inflation risk, which leads to higher costs for the companies and makes the planning process much more difficult. This is especially a tough issue in combination with the political risk of frozen utility tariffs, i.e. the expenses for material rise, but the sale prices are fixed at a low price level.

A consequence of inflation can be a currency depreciation, which compensates the higher costs for domestic material and personnel expenses, but makes the planning process more unpredictable. The exchange rate risk may also devaluate the total value of an investment in a foreign country. A decreasing exchange rate can raise the cost of imported raw material, and especially in a recession the company may often not be able to pass increased costs over directly to the customer, at least not immediately.

Higher interest rates are also an economic country risk because they result in higher borrowing costs in the operating country, which increases the overall costs for the company and reduces the profits and the net present value of the project.

The depth of the local capital market has to be considered. In a country with a very liquid capital market an economic downturn will not stop the trading and emission of securities, which is important for financing and investing money. In addition, the potential drying-up of liquidity in a country or region has to be incorporated in the country risk analysis.

The aim of a country risk analysis is to identify problems earlier and to adjust exposure in a prompter and more systematic way. Rather than monitoring country by country it has turned out to be more effective to become more regional. During the Asian Crisis the regional contagion risk of financial distress has become obvious. The Basel Committee states that the Asian Crisis has “identified a need at some banks to centrally assemble and analyse country risk information.”[26]

Economic country risk can deteriorate the creditworthiness of assets and companies a lot. Although the government is not playing an active role in economic country risk, it is, especially when in financial distress, integrated in a way. When the government is in distress or default, even if there are no direct restrictions enacted, the economic and business conditions are likely to be hostile for most firms and the economy will likely be contracting,

The impact of economic country risk became obvious during the Argentina crisis. Due to the extreme sovereign default scenario nearly every entity (rated by Standard & Poor’s) defaulted on bond, bank, or supplier debt. The economic country risk that occurred was a tremendous devaluation of the currency, a banking system in crisis and a recession, which lasted about five years.[27]

2.2.3 Social Country Risk

The social country risk includes the country’s human resource potential, which is in the best case well educated, fairly young, and healthy. A high percentage of illiterates shows a good potential for future improvements, but is at the moment not advantageous for highly qualified tasks.

An important point (right now also for Germany) are the labour issues, like non-wage labour costs, labour unions, and laws about the working conditions.

Infrastructure challenges like poor transport and high-cost/inefficient port services have to be considered as well as a need to supply own electricity or other basic services (if applicable). Finally, the stability of these infrastructure items in the cases of natural disasters is important.

2.3 Rating Implications

The rating implications of the different types of risks are shown on the historical application of the sovereign ceiling, the difference between the local and foreign currency rating of sovereigns and the currently established assessment of transfer and convertibility risk.

2.3.1 Historical Application of the Sovereign Ceiling

The foreign-currency rating of governments generally served as a ceiling for foreign currency ratings of other domestic non-sovereign entities. This is called the sovereign ceiling. The analytic rationale for this practice is that all domestic issuers are potentially subject to foreign currency transfer risk, i.e. otherwise creditworthy borrowers can stem from the imposition of exchange controls that impede debt service (=political country risk). Another reason found in the literature is that the government and the non-sovereign entity operate in the same macroeconomic environment. An economy wide downturn may lower a company’s growth perspective and increase the default probability of the government (=economic country risk) due to decreased tax income and higher expenses.[28]

The sovereign ceiling was also reinforced by capital market experience over the last several decades. In this context, the ceiling accounts for the fact that a government confronted by an external payments crisis has the power — and often had a strong motivation — to limit foreign currency outflows, including debt payments.[29]

Due to the government’s monetary authority, domestic entities are subject to foreign currency transfer risk. The government measure limits foreign currency debt repayments by domestic issuers. Capital market experience in the 1970s and the 1980s highlighted the importance of transfer risk. In many cases the governments facing external payments crises imposed across-the-board deposit and loan moratoria. Often, there were external payments crisis resulting from external and internal disequilibria, such as an overvalued exchange rate or excessive domestic demand resulting from inappropriate economic policies.

This resulted in a growing current account deficit, and the problem was frequently exacerbated by speculative attacks on the local currency, as well as substantial capital flight. In such situations, there was pressure to make decisions aimed at rationing scarce foreign exchange. These restrictions often incorporated moratoria for foreign exchange payments on debt. This was indeed the case in defaults by Mexico, Brazil, Argentina, Turkey, South Africa, and many others in the 1970s and 1980s, all of which provided the empirical evidence underpinning the sovereign ceiling methodology.[30]

In the sovereign defaults of the 1990s of Pakistan, Ukraine, Russia, and Ecuador, across-the-board-moratoriums were not used to stop payments on loans and bonds. Even in Russia a general long-term debt-moratorium was avoided. This empirical data shows that it is not inevitable that a sovereign external payment crisis goes hand in hand with a blanket debt moratorium on foreign currency borrowers within its jurisdiction. Despite this trend, the rating agency Moody’s announces “Nonetheless, it is still quite plausible that some countries will go the route of imposing a moratorium as happened in the 1980s. To the extent that this still occurs, ratings that had been allowed to pierce the ceiling will have been too high.”[31]

2.3.2 Local versus Foreign Currency Ratings

Traditionally most sovereigns and non-sovereigns had foreign currency ratings. In the last decade an increasing percentage of sovereigns have received local currency ratings as well. This is likely to be the reflection of efforts to increase the investor base for domestic currency bonds.[32] In analogy this applies to obtaining credit in local and foreign currency.


[1] Trevino, Lourdes and Thomas, Stephen (2001): Local versus Foreign Currency Ratings: What Determines Sovereign Transfer Risk? In: Journal of Fixed Income 06/2001, p. 65

[2] Federal Deposit and Insurance Corporation (1999): Guide to the ICERC Process

[3] Basel Committee on Banking Supervision (2001): The New Basel Capital Accord, Consultative Document, Basel

[4] Fitch (2004): Country Ceiling Ratings and Rating Above the Sovereign, p. 3

[5] Mexico, Venezuela, Romania, Korea, Indonesia, Russia, Ecuador, Pakistan, Ukraine, Argentina, Uruguay, Moldova, Dominican Republic

[6] Fitch (2004): Country Ceiling Ratings and Rating Above the Sovereign, p. 4

[7] Deutsche Bank (2005): Annual Report 2005, Risikobericht, p. 54 and NN (2004): Die Risikoberichterstattung der Großbanken, in: Zeitschrift für das gesamte Kreditwesen 11 / 2004, p.41 (599)

[8] Standard & Poor’s (2005): Ratings Above The Sovereign: Foreign Currency, Rating Criteria Update, p. 1

[9] Fitch (2004): Country Ceiling Ratings and Rating Above the Sovereign, p. 2

[10] Basel Committee on Banking Supervision (2001): The New Basel Capital Accord, Consultative Document, p. 52

[11] Mellios, Constantin and Paget-Blanc, Eric (2004): Which factors determine sovereign credit ratings? p. 20

[12] Transparency International (2005):­Index_2.810.0.html, May 19, 2006

[13] Standard & Poor’s (2004), Sovereign Credit Ratings: A Primer (RatingsDirect), p. 4

[14] Standard & Poor’s (2004): Sovereign Credit Ratings: A Primer (RatingsDirect), p. 3

[15] Standard & Poor’s (2004): Sovereign Credit Ratings: A Primer (RatingsDirect), p. 1

[16] Fitch (1998): Sovereign Ratings, Rating Methodology (Criteria Report), p. 3

[17] Fitch (1998): Sovereign Ratings, Rating Methodology (Criteria Report), p. 4

[18] Bank for International Settlements (1998): On the Use of Information and Risk Management by International Banks, Basle, p. 1

[19] Federal Deposit and Insurance Corporation (1999): Guide to the ICERC Process, p. 1

[20] Basel Committee on Banking Supervision (1999): Supervisory Lessons to be drawn from the Asian Crisis (Working Papers No. 2), p. 18

[21] Claessens, Stijn and Embrechts, Geert (2002): Basel II, Sovereign Ratings and Transfer Risk External versus Internal Ratings, p. 4

[22] Committee of European Banking Supervisors (2006): European Commission, Internal Market DG, (June 18, 2006)

[23] Standard & Poor’s (2003): The Impact of Sovereign Risk on Russian Corporate Ratings (reprinted from RatingsDirect), p. 1

[24] Comptroller of the Currency Administrator of National Banks (2001): Country Risk Management, Comptroller’s Handbook, p. 12

[25] Meldrum, Duncan H. (2000): Country Risk and Foreign Direct Investment, in Business Economics 01/2000, p. 3

[26] Basel Committee on Banking Supervision (1999): Supervisory Lesson to be drawn from the Asian Crisis, Working Paper No. 2, p. 23

[27] Standard & Poor’s (2002): Local Currency Rating Criteria Update: The Importance of Country Risk for Corporate and Infrastructure Sectors (reprinted from RatingsDirect), p. 2

[28] Durbin, Erik and Ng, David T. (2005): The sovereign ceiling and Emerging Market Corporate Bond Spreads, p. 633

[29] Moody’s (2001): Revised Country Ceiling Policy, Rating Methodology, p. 1

[30] Moody’s (2001): Revised Country Ceiling Policy, Rating Methodology, p. 3

[31] Moody’s (2001): Revised Country Ceiling Policy, Rating Methodology, p. 4

[32] Packer, Frank (2003): Mind the gap: Domestic versus Foreign Currency Sovereign Ratings, BIS Quarterly Review, September 2003, p. 58

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An Analysis of Transfer Risk in Comparison to Sovereign Risk
Frankfurt School of Finance & Management
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Master of Science (MSc) Philipp Hauger (Author), 2006, An Analysis of Transfer Risk in Comparison to Sovereign Risk, Munich, GRIN Verlag,


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