Academic journal article Multinational Business Review

Effects on Debt Service Capacity Indicators' Volatitlity on Sovereigns' Debt Service Capacity

Academic journal article Multinational Business Review

Effects on Debt Service Capacity Indicators' Volatitlity on Sovereigns' Debt Service Capacity

Article excerpt

This paper examines the effects of the volatility of sovereignst debt service capacity (DSC) indicators on the borrowing countries' DSC by using several theories and techniques in corporate finance study. Evidence has been found that sovereign DSC behavior is different from DSC behavior of corporations. This is probably because the major concern of a sovereign is the reputation of the nation so that a stable source of future international loans can be maintained. However, among medium-income countries, DSC indicators' volatility does affect a sovereign's DSC. This is probably because the governments in those countries are politically vulnerable and winning the voters become more important than maintaining the reputation abroad.

1. INTRODUCTION

The study of sovereigns' debt service capacity (DSC hereafter) is important for at least the following two reasons.

Firstly, international lending is an important business for many banks. Almost half of the total earnings of the twelve largest U.S. banks is derived from international lending, especially lending to developing countries. The sovereign debt crisis of early 1980s and the recent Asian financial crisis have made lenders become more cautious when dealing with international sovereign borrowers. The assessment of a country's risk has been a big concern for both the lending institutions and the borrowing countries in the international credit market.

Secondly, a sovereign's DSC determines not only whether a country is able to get loans at a reasonable cost but also whether the nation is able to attract other types of capital.

To measure country risk, several models were built by using DSC indicators (which are usually macroeconomic indicators of the borrowing countries) as the measurement of country risk. When these indicators exceed the benchmarks set previously, we will take that as a warning signal.

DSC problems can have several forms, such as default, request of debt forgiveness, negotiation of rearrangement of interest and principle repayment. In this study, DSC problems are mainly referred to debt default.

These models have been useful in predicting DSC of the borrowing countries. However, one possible problem of this approach is that these models were built only by analyzing the different levels of these indicators while effects of the volatility of these indicators are neglected. In corporate DSC analyses, many researchers have reported that firms with stable earnings have a higher debt service capacity. Consequently, in estimating a firm's debt service capacity, pro forma financial statements are often developed to analyze the possible variance of future cash flows of a leveraged firm.

What are the effects of volatility of DSC indicators on a sovereign nation's DSC? Very few studies have been conducted to examine the effects of volatility of DSC indicators on a sovereign nation's DSC. This study intends to fill this gap.

2. DIFFERENCES BETWEEN SOVEREIGN DEBT AND CORPORATE DEBT

Comparing with sovereign debt, corporate debt is much more extensively studied. Consequently, in studying sovereign debt, researchers often imitate the theories and the methods used in corporate finance study. For example, Pettis ( 1994) suggests that sovereign debt lending can be visualized as such that creditors "write" the sovereign debtors put options on the debt service ratio. If debt service ratio exceeds a preset level, the borrower would "exercise" the put and moratorium takes place. Let us call this theory the Sovereign Debt Option Hypothesis (SDOH).

Obviously, SDOH is derived from the Option Pricing Theory (OPT) developed by Black and Scholes (1972). This theory was later extended by Black and Scholes (1973) to describe the relationship between debtor holders and equity holders of a leveraged firm. From the perspective of the debt holders, when they lend money to a firm, they "write" a put option to the equity holders. …

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