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The risk management of asset and liabilities by developing countries

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The risk management of assets and liabilities by developing countries.

Greater access to the international financial markets has bestowed many

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benefits on developing countries, but it has also exposed them to the vicissitudes of these markets. In addition to the macroeconomic challenges posed by large, potentially volatile flows, the sizable external foreign currency debt of many developing countries makes them vulnerable to swings in international exchange rates and interest rates and, often, they are tempted to speculative currency attacks.

Indeed, prudent macroeconomic policies have at times been compromised by the fiscal consequences of losses associated with these exposures.

Most recent of such policies is the one embarked upon by Russia.Russia had defaulted on domestic debt, devalued the rubble and frozen payments on some previous Soviet-era commercial debt. The U.S and a few European banks, which lost some $10 billion to the debt default alone, vowed never to go near Russia again. Yet, it is striking to learn through Business Week magazine that due to a change in macro-economic policies, Russia has been able to have some their defaulted debts forgiven.

Now many of the same banks that vowed not to do business in Russia are hailing the administration of this country’s first step toward a return to international bond markets in the form of a massive issue of restructured commercial debt. These financial pundits are hoping for an unprecedented economic rebound. The main economic and financial initiative that has encouraged investors is that Russia has the best performing fixed income market in the world for this year as well as last year. J.P. Morgan’s Emerging Markets Benchmark Index reported this performance. Other areas of policy changes involved the devaluation of the rubble at a time when oil prices have surged. Russia has also recently restructured $32 billion in soviet- era commercial debt. Banks wrote off $10.6 billion and Russia issued two new trenches i.e. an $18.2 billion30-year issue and a $2.8 billion10-year issue for the balance.

As other defaulted nations looked on, they find themselves in not so fortunate a position, and as the struggle for finding economic policies that will woo their creditors continues, they find themselves in unfortunate uncompromising positions. According to Newsweek, exposure of developing countries to currency risk can be broadly gauged by the amount of external public debt they have incurred. In 1996, the outstanding stock of sovereign debt issued or guaranteed by developing countries amounted to $1.5 trillion, or 25 percent of their total GNP and to 300 percent of their foreign currency reserves. Roughly one-half of their external debt was exposed to foreign interest rate risk: one-fifth of this was short term (maturities of less than one year), and two-fifths of the remaining long-term debt was at variable rates.

During the past two decades, a number of emerging markets specifically from the developing countries have been hurt by adverse movements in exchange rates and international interest rates. In the early 1980s, the debt-servicing burdens of some countries in Africa, Southeast Asia, and Latin America were severely affected by the dollar’s appreciation, a worldwide increase in interest rates, and a decline in commodity prices. Several Asian countries saw significant increases in their debt burdens in the early 1990s because of their large, unhedged exposures to Japanese yen. A third of the increase in the dollar value of Indonesia’s external debt between 1993 and 1995, for example, was attributable to cross-currency movements, particularly the steep appreciation of the yen. At the time, 37 percent of Indonesia’s external debt was denominated in yen, while about 90 percent of its export revenues were denominated in dollars. (The depreciation of the yen in 1996 offset some of the losses incurred by these countries.)

A report by the Organization for Economic Cooperation and Development claimed that maturity profile of public debt contributes as much as the total volume of the debt to a country’s vulnerability to external shocks, such as that experienced by Mexico. Mexico’s public debt was relatively low by Organization for Economic Cooperation and Development (OECD) standards, -51 percent of GDP, compared with an average of 71 percent for the OECD countries. The Mexican crisis underscored the difficulty and cost of refinancing a substantial volume of foreign currency debt maturing in turbulent foreign exchange markets. The Mexican economy’s vulnerability to a financial crisis was exacerbated by the fact that Mexico’s foreign exchange reserves totaled $6.3 billion at the end of 1994 and that tesobonos (short-term securities indexed to the dollar) worth $29 billion were due to mature in 1995.

The large foreign currency exposure of emerging markets can be explained by a number of factors, including low domestic saving rates; the lack of domestic borrowing instruments; and the high proportion of official financing (multilateral and bilateral), which tends to be denominated in donor countries’ currencies. Governments also issue debt in foreign currencies to signal their commitment to a policy of stable exchange rates or prices; the credibility of their policies is enhanced by raising the cost of reneging on their commitments as seen in many third world countries. Alternatively, policymakers may signal a commitment to stable prices by issuing inflation-indexed bonds. These bonds tend to serve the interest of the country and sometimes the returns are not encouraging to the foreign investors or lendor. At times the terms even tend to serve the interest of the administration and not the population affiliated membership countries.

More recently, as emerging markets have regained access to international debt markets, the choice of currencies and maturity structures of their external borrowings have often been driven by a desire to reap the immediate fiscal benefits of borrowing in currencies with low coupon rates. The administration of these developing countries often underestimate the risks associated with unstable foreign currency borrowing for several reasons. First, the capacity of governments to generate foreign currency revenues to repay their obligations is generally limited, (especially if the country lacks natural resources), as government assets will consist predominantly of the discounted value of future taxes denominated in local currency. Second, it is unlikely that the costs in terms of output, welfare, and reputation that a developing country may incur in the event of an adverse external shock is fully taken into account in emerging markets’ external borrowing strategies. Although the likelihood of crises is small except in the case of natural disasters, the potential disruption to an economy is substantial as seen in many unstable third world regimes. A net foreign exchange exposure accelerates the economic impact of external shocks and limits the financial policy options available during a financial crisis. For example, a country with a large net foreign currency obligation would have difficulty pursuing an aggressive monetary policy during a financial crisis because it might cause a sharp decline in the domestic currency, which ultimately limits investment at home as well as abroad. A depreciation of the currency could worsen the country’s indebtedness and risk profile and solidify the financial crisis. In the event of a real exchange rate shock, a government may be faced simultaneously with the escalation of its external debt-servicing costs and a decline in the foreign currency value of its revenues. In addition to the potential capital losses that a government may incur on its debt portfolio, its ability to access international markets to refinance its maturing debt is likely to be hindered.

Taking the above mentioned issues into consideration it will be advantageous for the lender as well as the borrower, which often is a sovereign nation to be knowledgeable on the risks involved, and commitment by parties in order to understand their obligations, since both could end up as losers.On the other hand the O.E.C.D also believes that risks associated with a large net currency exposure and the existence of deep and liquid domestic capital markets are the main reasons why the governments of most industrial countries have limited their issuance of foreign currency debt. These Governments have established well-documented legal clauses in their contracts. Such clauses are supported by policies enacted by the lawmakers of the land. According to the IMF’s Monetary and Exchange Affairs Department, large advanced economies such as, Germany, Japan, and the United States do not issue foreign currency debt, while France and the United Kingdom issue only a small fraction of their debt in ecus. In Canada, foreign currency debt represents about 3 percent of total public debt (reflecting debt accumulated in the past and debt issues to finance foreign exchange reserves), and the budget deficit is funded entirely in domestic currency. In recent years, a number of small advanced economies, including Belgium, Denmark, and New Zealand, have stopped issuing foreign currency debt, except to replenish their foreign currency reserves. In Ireland, gross foreign currency borrowing is limited to the level of maturing foreign currency debt. Spain and Sweden issue foreign currency debt but hedge their currency risk through swaps or swap options.

In developing countries, however, governments often need to access international debt markets to offset a shortage of local savings, lengthen the maturity of their debt, diversify their interest rate risk exposure across various asset markets, accumulate foreign exchange reserves, or develop instruments that would allow domestic private entities to issue abroad. The foreign currency can be swapped into the domestic currency, or, when this is difficult, into a currency that is closely co-related to the domestic currency and for which liquid optional markets exist. Issuing currency-hedged foreign debt would prevent a borrowing strategy targeted solely at reducing interest rates and softening internal budget constraints.

As the international derivative markets have grown in sophistication, the possibilities of hedging the risks associated with borrowing in foreign currencies have greatly expanded. Borrowers can respond to opportunities to exploit market niches and expand their investor base without incurring exchange rate risk. Similarly, they can use the interest rate swap market to manage the maturity structure of their external debt. The amount that can be hedged is limited, however, because counter-parties are usually subject to a ceiling on total exposure to any individual country. However the developing countries have limited possibilities of exploiting market niches, moreover to expand their investor base. These countries seem to be at financial risks all the time,regardless of the attractive opportunities. They just cannot seem to meet their financial obligations but they continue to take lengthy financial risks in the form of loans from the World Bank, the I.M.F and other expatriate organizations. Since it would seem that they do not fully understand the risks involved, they are often faced with harsh and depressing financial repayment obligations.

Many underdeveloped countries that have borrowed heavily in foreign currencies are now faced with important policy challenges, such as on how to manage their currencies, interest rates, and maturity risks associated with their debts. However in order to implement policies that will help fulfil their obligation to external creditors, it requires management by non-political and non bi-partisan sections of their community. This is not an easy task for administrations whose goal is earn the highest return from their resources, and satisfy their domestic demands.

In addition of self-centered objectives, management of the risks associated with external exposures requires significant technical expertise, sophisticated information technology, and strictly controlled internal management procedures, with disciplined enforcement of internal trading and exposure limits. These requirements are difficult to satisfy in the best of circumstances; they are particularly difficult in emerging market countries. Some emerging markets have found it hard to attract qualified and experienced staff, build adequate information and control systems, and develop the administrative controls necessary to manage overall exposures since they start out without the necessary financial tools to support these initiatives.

Also, the influence of a country’s external position on its creditworthiness is measured in terms of the scale of its existing obligations. According to the World Bank “the scale of a country’s external payment obligation is measured by the ratio of its external debt to GDP”.As is the case with high inflation /high debt countries, credit rating agencies tend to rate them differently than low debt countries. The country’s capacity to service it’s external obligations is assumed to be reflected in the growth rate of its exports, its current account position, the ratio of its non-gold international reserves to imports and its real exchange. In many instances the developing countries have low ratings in all of these areas. Since they will not qualify in these areas it is incumbent upon them to manage the other areas of ratings.

These areas are the internal economic, political and social factors that also influence their credit ratings. In addition to these areas of management, the O.E.C.D recommends that:

– Management should be shielded from political interference to ensure transparency and accountability.

– Debt management should be entrusted to portfolio managers with knowledge and experience in risk-management techniques, with the performance of these managers measured against a set of criteria defined by the ministry of finance.

– Finally, sufficient resources should be allocated to hiring high-quality staff and acquiring sophisticated support systems.

– For countries that have been experiencing a high rate of inflation, a sharp reduction in inflation would significantly improve the country’s rating.

Quite often the strategy of these underdeveloped countries is to implement policies to feed, clothe and house themselves at the expense of the lenders or investors instead of pursuing economic polices such as those implemented by Russia. Their main focus should be to improve the country’s current account balance along with the implementation of a program for revival of growth through economic recovery programs.

References

Agnor, PierreR.and Hoffmaister, Alex W (1995) Money, Wages, and inflation in developing countries.I.M.F report.

Belton, Catherine (10/2000): Russia-all is forgiven. Business Week, October 9th.2000.

Dubash, Navriz Dr. (2000) The right conditions, the World Bank structural adjustment program. World Bank Report, March 2000.

J.P.Morgan (2000): Emerging benchmark index. September 2000.

Organization for Economic Corporation and Development. (1995): The use of economic instruments for financial management in developing countries.O.E.C.D reports 1995.

Cite this The risk management of asset and liabilities by developing countries

The risk management of asset and liabilities by developing countries. (2018, Jun 24). Retrieved from https://graduateway.com/the-risk-management-of-asset-and-liabilities-by-developing-countries/

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