Academic journal article
By Tarzi, Shah M
The Journal of Social, Political, and Economic Studies , Vol. 22, No. 4
The methods by which private banks assess the risks involved in lending to the sovereign governments of Less Developed Countries (LDCs) and Developing Nations are examined, and a new typology is suggested whereby bankers might improve their ability to make efficient risk assessments on a comparative basis.
Key Words: International Banking, LDCs, Debt Risk Evaluation
The debt crisis of the 1970s and early 1980s was largely brought under control by the late 1980s. However, a renewed interest in country risk assessment has arisen as a result of the recent Asian crises and the fact that five countries that used to be the biggest debtor states in the previous decades - Argentina, Brazil, Chile, Mexico and Venezuela - are among the leading emerging markets in Latin America. In addition to capital flows to these countries through mutual funds, the central banks of these states have once again been borrowing on the international markets. Similarly, since the reunification of Germany and the collapse of the communist system, Poland and Hungary have been recognized in the international financial markets as states that belong to the emerging markets group. These countries too have accelerated borrowing on the international markets. A preliminary look at some of the causes, and dynamics of the international debt crisis and assessment of sovereign risk is therefore warranted.
In the early 1970s the total debt of developing countries was less than 100 billion dollars. Less than two decades later it had risen to more than a trillion dollars. A complex set of factors motivated banks to loan almost unprecedented sums of money to the developing countries and prompted country borrowers to engage in what may be characterized as a "borrowing frenzy." For multinational banks, lending to developing countries was a natural extension of movements underway in international financial markets. Reduced credit demands, fierce competition in the traditional domestic markets and the development of Eurocurrency deposits provided impetus for banks to lend abroad. Another factor that pushed international banks to lend vast sums of money to leading LDCs includes the desire of many banks to forge long-term relationships with newly industrializing Third World countries. (Mexico, Brazil and Argentina received over half the loans to non-OPEC developing countries.) In addition, banks now used margins over the London Interbank Offered Rate (LIBOR) in the pricing of loans; they reduced some of the interest-rate risk in short term-term deposits to fund medium-term loans, they included cross-default clauses in loan agreements, thus placing all bank claims on an equal footing; and they used the syndication of credits.
A variety of economic, political and legal reasons enticed country borrowers to pursue foreign loans. First, both domestic firms and governments needed access to capital in order to increase income or exports. Second, foreign loans eased adjustment to economic slowdowns or temporary worsening of economic prospects such as, for example, a drop in export income, or, for another example, a drop in oil exports. Country borrowers used foreign loans as the vehicle for solving short-term problems of current account deficits. Third World governments also borrowed for political reasons. Loans enabled them to retain and consolidate power and to ease the political pressure arising from demands to sustain an expected measure of economic welfare for the population. Country borrowers borrow on the basis of their capacity to earn enough from future income and exports to pay out foreign loans.1
Bank lending to developing countries grew at an annual rate of 20 to 25 percent throughout the mid-1970s until the early 1980s. Lenders appeared not to be concerned with the risk associated with international lending. With interest rates below the rate of the debtor's economic growth, banks could lend new money so that country borrowers could repay old loans with a degree of confidence. …