FREE ESSAY ON THE RISK MANAGEMENT OF ASSET AND LIABILITIES BY DEVELOPING COUNTRIES

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 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.
Bibliography
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.