The Risk Management Of Asset And Liabilities By Developing Countries The risk management of assets and liabilities by developing countries.
Greater access to the international financial markets has bestowed many 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 countrys 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.Morgans 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 …