It was 9 o’clock yesterday morning, when your secretary passed an important telex from Solvency’s Finance Minister, requesting an urgent meeting next week in Monaco. It was not too difficult for you to guess the purpose of the meeting given that it might well stem from the country plan to launch ??500 million – ??700 million Rebound on international capital markets. Mr.. Solvent, the finance minister wants to get your assessment regarding market conditions for the bond floating, in order to compare with your competitors’ offers in London, Zurich and New York.
The US supreme crisis environment and its spill-over effect, and the protracted credit crunch, however, make the request a formidable challenge, indeed! Solvency’s medium-term external borrowing requirements are well known to the international financial community.
This request thus does not come as a surprise. You are a young but promising investment banker and you knew that Solvency was about to approach investment banks in Europe. Your institution, Casino Bank, is a reputed financial institution. Competition is fiercer than ever for bond syndication and placement.
At stake is a substantial fee (and for you, a substantial bonus! . But rumors regarding Solvency’s liquidity difficulties also come and go in the markets. Once again, the country is facing economic overheating, large external financing requirements, and upcoming financial problems, reportedly. Governance is also in question.
Republic of Solvency: Political Background Solvency is a country of roughly 18 million people, and its GAP per capita of around SIS$5000 corresponds to a low-income developing country. (Solvency’s GAP thus fits in the group of countries like Ukraine, Armenia, Angola, Georgia, and the Philippines, n the base of the World Banks Atlas method).
Solvency’s long struggle for independence ended in the mid-sass. Gradual political reforms in the sass resulted in the establishment of a bicameral legislature in 2008. However, the political climate remains volatile. Political upheaval leads frequently to mass demonstrations followed by harsh repression. Since 2009, however, Solvency was affected by the spill-over effect of the global financial crisis! In addition, Solvency’s governance improvement was promoted by strong pressure from the IF’s, notably the MIFF and the World Bank.
Rating agencies stressed that weak governance was a key impediment to sustainable development and to resumption of market access and development aid. Rating agencies are watching and stand ready to change their risk assessment of Solvency. Moody’s country rating currently is “Baa” while Fitch rating stands at “BOB-“.
Things do not seem to improve at the right pace, nevertheless. You get conflicting signals regarding Solvency’s commitment to structural economic and institutional reforms. Seems 2013- CPM – 2008- Solvency : Country risk case study – Michel Henry Solvency General Economic Conditions and Policy Outlook
Solvency faces the challenges typical of developing countries – restraining government spending, reducing constraints on private activity and foreign trade, and achieving sustainable economic growth. In 2006-08, Solvency experienced a severe economic and financial crisis following years of economic overheating characterized by high inflation and large budget and current account deficits. The spill-over effect of the Asian financial crisis was also an aggravating variable. In addition, a severe drought depressed activity in the key agricultural sector and contributed to a protracted recession along with acute social problems.
A sticky exchange rate in the initial period resulted in a sharp decline in external competitiveness, along with booming imports, little export dynamism, and a drop in official reserve assets, particularly in 2007. In 200708, Solvency reached the bottom of the crisis culminating with a severe recession, a large trade deficit, a drop in international reserve assets and rising short-term liabilities! Exhibit 1: Inflation Rate and Real GAP Growth in Solvency 2004-14 35 120% 25 20 15 10 5 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Source: Solvency National Bureau of Statistics
Inflation Rate (LASH) Real GAP Growth (RUSH) Solvency’s government could postpone the economic adjustment for a while; it could not avoid it, however. The finance minister had to negotiate a severe structural adjustment program under the auspices of the MIFF and the World Bank. The shock therapy was abrupt and it included the usual market-driven stabilization policy measures aimed at reducing domestic demand and restoring competitiveness: currency devaluation, cuts in public expenditures, openness to foreign direct investment, stimulation of private investment, and prevarication.
The monetary policy ramekin was strengthened and an inflation targeting system was introduced. Overall, as much shock as therapy was provided. In particular, notable progress was being made in areas such as trade liberalizing and prevarication. The main challenge, clearly, was to further improve the competitiveness and flexibility of the economy. Solvency’s five year plan (covering the period 2009-2013) was drawn up with these challenges in mind and with a view to articulate a strategy to accelerate the structural transformation of the economy towards one based on more skill-intensive sectors.
Priorities included addressing uncial sector weaknesses, liberalizing the capital account, improving the regulatory framework and tackling labor market rigidities. The most notable results were the trade surplus and the emergence off budget surplus in 2010 and 2011. But despite progress in raising living standards, unemployment remains stubbornly high. Official data shows that the unemployment rate remains broadly unchanged. However, unofficial estimates suggest that the rate is much higher and unabated. Underemployment is also a problem, particularly for the young population.
Following structural adjustment programs supported by the MIFF, the World Bank, and he Paris Club, the currency is now fully convertible for current account transactions, and reforms of the financial sector have been implemented. The devaluation paved the way for the well-known “Curve”, I. E. , growing imports in 1999-2008, due to unfavorable elasticity! On the positive side, FED picked up. Solvency reported large foreign exchange inflows from the sale of a mobile telephone license and partial prevarication of the state-owned telecommunications company.
Growth resumption emerged only in 2010-12 after three years of severe decline of real GAP. Favorable rainfall and export diversification led to reasonable growth throughout the period until 2006 thanks to good harvest conditions and improving terms of trade. In 2012, however, Solvency experienced again rising inflation, showing that stabilization might already be off track! Economic growth recovery seems to be driven by large bank loans supported by an accommodative liquidity and low real rate policy of the central banking authorities.
Inflation and Budget Deficit Inflation in Solvency looks like a reallocates for the past decade (Exhibit 1). After bubble digit inflation that reached an unsustainable peak in 2006-07, the government was able to drag down the inflation level to more reasonable levels in 2010-12. However, rising budget deficit and an accommodative monetary policy lead to a rising inflation forecast for the 2013-2015 period. Rising inflationary expectations stem from rechecked private and public demand. At the peak of the crisis, in 2007-08, the government budget deficit reached unsustainable levels (Exhibit 2).
Severe adjustment might have been postponed, but it could not be avoided any longer. This severe economic situation imposed the implementation of a tight tutorial economic adjustment. However, the structural program increased social and political volatility. Dynamic prevarication and severe cuts in government spending produced street demonstrations and political protests. The economy experienced significant contraction in 2008 until end of 2010, when growth recession reached impressive levels.
But the result of economic adjustment could be seen as early as 2011, when the economy started to regain momentum, and when FED reached US$ 3. Billion, the highest level for the past 5 years. The government also successfully cut inflation, while managing a better budget situation. Solvency’s Balance of Payment Position The current account during the period 2003-2008 was driven by the negative pattern of trade balance. Solvency’s trade balance became increasingly negative, mainly due to excessive growth in imports. In addition to the rise in oil prices, imports were boosted by strong demand for capital and related goods reflecting investment expenditure related to the industrial modernization program.
In 2009-2010, trade balance generated a short-lived surplus, thanks to significant improvement in external competitiveness. But starting in 2011, trade balance returned to negative rewriter, as a result of higher oil prices and declining export competitiveness. Oil is the largest part of Solvency’s imported commodities. The rise in the oil price in the global market, to around $105/barrel in 2012-13, has been one important factor in this worsening trade deficit, though unchecked domestic consumption stems from the accommodative monetary and fiscal policy.
Exhibit 3: Solvency- Current Account ($ million) 2000 2003 -2000 Balance of services, income and transfers showed a rising surplus starting in 2009. No doubt that tourism, a major cash inflow source for Solvency, benefited from the large currency depreciation. Meanwhile, continued growth in the level of remittances has kept the transfers surplus steady. This constant inflow from one million expatriates (most of whom live in Europe) has been one of the main factors that has helped shrink the trade deficit in recent years.
The current account balance reached an unprecedented deficit of $ 5,6 billion in 2007, on the eve of the financial crisis, partly as a result of travel warning issued by I-J, US and Japan as a response to political instability and social upheaval. A couple of bomb threats in the country capital city, Solves City, did not improve the investment climate. But the main culprit for the rise in the deficit has been a combination of flat exports and booming imports. Debt is still a major financing source for Solvency’s current account deficit.
During 20032007, commercial banks and capital markets were a primary source of external financing. The bond market was tapped in 2005 and 2006. The financial crisis led to a sharp reduction in international bank lending that was somewhat offset by IF’s. The country had to use significant amount of official reserves to finance its external financing requirements. But starting in end-2013, Solvency might embark n a strategy to get back to market access. Bond issuing is to be the new ball game in Solves City. The Rebound Project Request: To float or not to float ?
Solvency, clearly, is not fully back on track. There is still a long way to go before domestic and foreign investors recover confidence. Rating agencies are prudent. Corruption and governance remain a genuine problem. Budget deficit is looming again. Formidable long-term challenges include: servicing the external debt; modernizing the industrial sector; preparing the economy for freer trade with the EX. and US; and improving education and attracting foreign investment (I. . , non-debt creating flows) to boost living standards and Job prospects for Solvency’s youth.
Floating a Rebound issue for Solvency can be a major coup for your bank, but it can also become a nightmare should you be unable to place the paper in the market. Getting stuck with illiquid bond paper would be costly for your banks portfolio, and for your so far promising career! Maturity, pricing, coupon and fees are one thing.
Capital adequacy ratios, loan-loss provisions and default probability are another. As you have identified several conflicting risk indicators in Solvency’s economic and lattice situation, the first thing you need to do is to get the “story’ of Solvency right, I. E. You need to do some basic number crunching. Before calculating the key ratios, however, you need to understand where does the country come from regarding its growth track, what went wrong in the 2003-2008 period, and why.
You also need to understand the way the Miff’s stabilization program achieved a turnaround in Solvency’s economy and whether this improvement is lasting or fragile. You need to check if the country is not falling back today in the same pitfalls as in the mid-sass. Then you must look at the scope for a resumption of sustainable development over the course of the 2014-2015 period.
To sum up the key steps in your country risk assessment work, you should:
1. Read the case thoroughly while writing down the salient features, both pros and cons, of Solvency’s current economic situation
2. Once you get the story clear and reliable, you will look at the Excel spreadsheet that presents Solvency’s macroeconomic and financial situation over the 1996-2013 period.
Pay close attention to the relation between economic data (GAP, inflation, judged and trade deficit, exchange rate…. And financial data (capital account, external borrowing requirements, international reserve assets, external indebtedness, debt servicing payments… )
3. Then, calculate a range of ratios and risk indicators as wide as possible: GAP growth rate, GAP per capita, liquidity and solvency ratios, debt servicing ratios, trade openness ratios, current account and budget deficits ratios.
4. You will then need to make up your mind regarding the upcoming Rebound issue. What should be the adequate amount of the Rebound floating given Solvency’s rage external borrowing requirements?
Will the country be able to meet its payments given the large amortization payments looming on the horizon? But the key question is whether or not you will recommend the banks key RISC (Risk Strategy committee) to go ahead or not!
5. Write a well articulated and concise 5-page note summarizing the main positive and negative points, before concluding with a clear cut recommendation, while adding an annex with ratios, graphs and tables for the 2014-15 opened. 6. Then you will call Solvency’s finance minister in his Monaco hotel’s “senior suite”.