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The following is a report of key recommendations from the Roundtable on Country Risk in the Post-Asia Crisis Era: Identifying Risks, Strategies, and Policy Implications, sponsored by the Council on Foreign Relations. |
Roundtable on Country Risk in the Post-Asia Crisis Era:
Identifying Risks, Strategies, and Policy Implications
Key Recommendations from Working Group Discussions 10/99-9/00
I. EXECUTIVE SUMMARY
In the three years since the July 2, 1997 devaluation of the Thai baht, countless analyses have addressed the causes of and remedies for the Asian financial crisis, and many efforts have focused on reducing the risks for both investors and countries. Under the auspices of the Council on Foreign Relations, leading members of the investor and policy-making communities have conducted two annual series of Country Risk Roundtable discussions, focusing on the country analysis and sovereign debt restructuring processes. The purpose of the discussions has been to identify ways to improve the identification and management of risks related to countries in the global financial system. Country risk analysis and the debt restructuring process are critical to the stability and viability of the global financial system, as evidenced by the key questions posed by Roundtable participants:
The recommendations set forth below are intended to provide a summary of the most important observations and suggestions made by individuals participating in the Roundtable discussions, and do not imply the endorsement of participating organizations or the Council. Participants and observers included leading country risk practitioners (from rating agencies and other country risk services, commercial banks, and the investor community), as well as government officials and analysts (from the International Financial Institutions, the U.S. and other creditor governments, and borrowing country governments). Since the purpose of the Roundtable discussions has been to provide a forum for a wide-ranging exploration of issues and solutions, no effort was made to reach consensus on the wording of specific recommendations.
Key findings and recommendations, detailed in the report, are summarized below:
II. RECOMMENDATION ONE: Formulate “Principles” for Sovereign Bond Restructurings
Bonds have replaced loans as a major source of capital for many countries, resulting in an exponential increase in the number and types of investors. However, the recent turmoil in international markets, coupled with a series of sovereign bond restructurings, has caused many of these investors to reduce or eliminate their emerging market bond exposures. In order to renew the confidence of these investors and reduce the systemic retrenchment of capital from these markets, there needs to be a clearer delineation of principles outlining the sovereign restructuring process. Included in this report is a proposed list of principles put together by creditors involved in recent sovereign restructurings, in consultation with officials from the IMF, BIS, and major creditor and debtor governments.
The following Principles are designed to be "best practices" for the conduct of private creditors and the Sovereign in connection with a Sovereign debt restructuring. It is recognized that the effectiveness of these Principles will depend on the support of the official community, particularly the IMF. The support of the IMF will be needed in providing private creditors with the IMF’s analysis and views regarding the financial difficulties and economic prospects of the sovereign, including the sustainable debt capacity. Moreover, whether the IMF decides to extend financing to a sovereign in default will depend on whether the sovereign is negotiating in good faith with its private creditors. Accordingly, to the extent that the major private creditors of a sovereign choose to act upon the principles set forth below, the sovereign’s willingness to negotiate within the framework established by these principles will be of relevance to the IMF when it makes its judgement to provide financing.
III. RECOMMENDATION TWO: Further Define and Activate Accountabilities for Key Parties in the Global Financial System
We are in the midst of a major debate on how to stabilize the global financial system, with much of the criticism vented at the International Financial Institutions (IFIs), most notably the IMF. However, other parties also bear key responsibility - member governments, their regulatory structures, and investors themselves. And, very importantly, there are severe constraints on what the IFIs can realistically deliver in terms of independent, timely analysis, given their membership and governance structure. Yet the availability of independent, timely analysis is critical to the stability and integrity of the global financial system.
Below are recommendations on how to define and activate accountabilities for the major parties of the global financial system. Specific steps and incentives are identified, with the objective of identifying the means for building upon the successes to-date in setting standards and improving data disclosure. Most of the suggested mechanisms are based on best practices in corporate finance, such as the establishment of a check-and balance function with third party auditors as a means to strengthen the integrity of data disclosures, and depoliticize the current process for standard setting and data disclosure. Also, just as the accounting profession sets accounting rules, the country risk profession should be an integral actor in the definition of data needs and an intrinsic part of the data audit process.
A) DEBTOR GOVERNMENTACCOUNTABILITY: Debtor governments (not the IMF) bear direct, primary responsibility for providing timely, accurate, and comprehensive disclosures on national accounts, the balance of payments, and material policy changes potentially affecting the economy and business environment of individual countries.
Just as with individual companies, the building blocks for financial stability must begin with a strong foundation in the integrity and credibility of each individual country and the integrity of its reporting. The primary objective of comprehensive, real time disclosure programs, built on a more explicit country accountability basis, is to develop a functional and solid system that facilitates transparent, candid and timely communication between government policy makers, investors, and analysts. This will serve to establish and maintain market confidence, thereby stabilizing market conditions, enabling coordinated and effective policy responses, and reducing the probability of investor panic, massive capital reversals, and costly financial crisis.
The current system of data disclosure has inadvertently created systemic vulnerabilities that undermine the objective of strengthening country accountability and investor access. A new initiative in data disclosure -- that is perceived as building the basis for an independent and credible global system of debtor government disclosure -- is sorely needed on an urgent basis, and critical to the stability of the global financial system. The reasons are three-fold:
The current system lacks a structure for reinforcing country accountability and does not facilitate direct, cost-effective communication between governments and investors. While the principle of “transparency” and disclosure is widely supported today, the actual system itself places the onus on the IMF to define and implement disclosure programs. Despite its critical role on many fronts, the IMF cannot, by virtue of its shareholders and innately political decision-making process, play a completely neutral expert role in identifying and disclosing risks on a timely basis to the larger public. Examples abound on how countries have become entangled in the innately political decision making process within the IMF. Furthermore, it is not constructive for the IMF, given its critical role in stabilizing the global financial system, to become tarnished as the “scapegoat” for country failures or mistakes.
The recommended approach noted here differs markedly in that it suggests that more direct accountability of each government for its data disclosure is fundamental to establishing and maintaining both data integrity and market confidence. The foundations of the global financial system would be strengthened on two pivotal fronts:
Suggested next action steps for debtor governments, that will build on progress made to-date, include the following:
1)As a confidence building measure, debtor governments of both industrial and developing countries should provide more explicit and concrete evidence of their commitment to adhere with the above principles of full and open disclosure, by means of signing a public statement to that effect, with a detailed program fully disclosing how their respective country program will be effectively implemented. The statement should include an explicit commitment to:
2) Each debtor government should establish a detailed operation for the “Disclosure Programs” in conjunction with support and guidelines provided by the IFIs and the investor community at large. Critical aspects of the “Disclosure Programs” include the following:
4) Annual third party audits of the Program should be conducted by independent parties, as with company financial statements, as a critical function in maintaining market confidence in the integrity of each country’s disclosure program. In the event a country is undergoing financial or economic stress that may potentially result in debt service difficulties, such independent audits may be conducted at more frequent intervals, as requested by any one of the involved parties (i.e., the debtor government, the creditors and investors, the IFIs).
5) While improvements have been made to most countries’ disclosure, further enhancements need to be made on an urgent basis, with input from market participants and IFIs in conjunction with the above “Disclosure Programs." Priority needs to be given in the following two areas:
The creation of more meaningful incentives for compliance with data and information disclosure is critical to operationalizing these country disclosure programs. All parties to the credit provision process must collaborate to safeguard the principles of full and accurate disclosure, and to insure that these principles are upheld in practice at all times, thereby maintaining the credibility of the global financial system. Examples of specific incentive mechanisms that are needed as foundations to this process are provided below:
1)MARKET - ACCESS: The establishment of market-based incentives is critical to the successful implementation of the objectives set forth above. For example:
B) IFI ACCOUNTABILITY: International Financial Institutions (IFIs), and their member countries bear direct responsibility for upholding the above principles of full, immediate disclosure of all pertinent debtor government information.
The IMF bears, consistent with its mandate, primary responsibility for surveillance and the effective provision of early warning systems that serve to minimize the threat of financial crisis. In addition, the World Bank, BIS, and other international organizations have privileged access to a wide range of fundamental data and analyses that are critical to improving overall analytical quality, as well as the risk management and early warning systems employed by private sector creditors.
Suggested next steps for the IFIs to implement that would build upon the progress made to date include the following:
C) REGULATOR ACCOUNTABILITY: Regulators from creditor countries, debtor countries, the BIS, and supporting IFIs bear direct responsibility for the open and timely evaluation of regulatory developments, banking systems, and risks resulting from market movements, such as reversals in capital movements or instrument risk.
The primary forums for stabilizing the global financial system are managed through regulatory interventions initiated by governmental and official multilateral working groups. The development of regulatory frameworks is considered the foundation to insuring a stable global financial system.
Suggested next steps for regulators and supporting organizations, such as the IFIs and related working groups, to implement include the following:
D) PRIVATE SECTOR ACCOUNTABILITY: Investors and creditors inherently bear the direct responsibility for developing their internal risk management systems that integrate assessments of macro risks, and for communicating information and data needs to governments and IFIs. Also, analytical services (such as the rating agencies) can serve a constructive role by immediately notifying debtor governments of any market developments or market perceptions that may result in adverse market conditions for that country. More timely and open notification to debtor governments of investor concerns and exposures would serve to avert or minimize market reversals by alerting governments in a timely fashion, providing a “window” for preemptive policy actions or needed explanations.
A more systematic means for identifying the risks posed by capital flows themselves is urgently needed. The interests of investors and creditors in reducing systemic financial risks are served by supporting the development of more “transparent” analysis of market risk, by providing information as needed on market exposures and market dynamics. Post-Asia crisis, there is widespread recognition of the risk capital markets themselves can potentially create for countries and the global financial system itself.
Some progress has been made in areas such as liquidity analysis, and working groups including IOSCO (International Organization of Securities Commissions) and the Financial Stability Forum are presently developing new proposals for exposure reporting of financial institutions and market analysis. However, these efforts have not to date provided policymakers and investors with easily accessible, quality data, or the comprehensive analysis of a country’s vulnerability to shifts in capital flows and the multiplier effects of financial meltdown from countries and individual institutions. Much more needs to be done in identifying credible mechanisms to track market exposures and identify potential vulnerabilities, in both domestic and international markets.
Suggested next steps that involve enhancing private sector accountability include the following:
IV. RECOMMENDATION THREE: Expand the Current Approach to Improving Data and Transparency
The extensive measures undertaken by the IMF and others in this area of improving data and transparency are clearly important, but have proved insufficient to date for meeting the needs of the wider investment community for quality, timely and comprehensive analysis. If we are to expect investors to identify risks, then the official sector must assure them that they have the full set of data and information required for that task. The remaining problems are manifold:
Tremendous efforts have been made in this area of improving data quality and availability, but despite the dedication of major resources, major gaps of material import continue to exist. (Note: The Financial Stability Forum summaries the progress to date, including the Compendium of 12 Key Standards, at www.fsforum.org. Also, see various IMF web-sites.) These outstanding problems, however, cannot be fixed without addressing how to create new mechanisms and incentives that will facilitate the development of cost-effective and useful data and information.
OUTSTANDING GAPS IN DATA AND INFORMATION: The following list summarizes the ongoing problems in the provision of adequate country data and information:
1) NEED FOR STANDARDIZED REPORTING BASED ON INTERNATIONAL DATA DEFINITIONS: Despite extensive efforts and initiatives, continued problems with data continue to impair the quality of country risk analysis. While there is much public acclaim for the successes made to date, behind the scenes policymakers, analysts, and investors express their frustration at continuing problems of major proportion. As one rating agency analyst commented, “… one of the foremost requirements is that external debt data should be available on a full debtor/creditor/instrument and maturity basis. This requirement is rarely met in developed or developing countries.” Even when disclosure standards are agreed to, a key ongoing obstacle is the “politicization” of data disclosure; one analyst from a major commercial bank characterized the problem as follows: “Governments need to provide the broadest scope of data, and not pick and choose to make themselves look good.”
The success of the international company disclosure, implemented by the private sector body IASC (International Accounting Standards Committee) largely sponsored by the accounting profession, stands in stark contrast to that of the current state of country disclosure. Unlike companies, in the case of countries, those being audited –the countries – set the rules through their shareholder organizations such as the IMF and determine compliance. Direct country involvement in setting country disclosure standards, with limited direct involvement of independent country risk experts, has politicized the process, resulting in long delays in reaching agreements on data disclosure standards, as well as arbitrary implementation.
Specific examples given to date by Roundtable participants of ongoing data problem areas in traditional areas of economic and financial analysis include:
2) NEED TO FURTHER DEVELOP NEW DATA AND INFORMATION REPORTING FIELDS: It is widely understood that quality country risk analysis, as well evidenced by the Asian crisis, requires more than the standard assessment of the balance of payments and national accounts. All key parties agree that country analysis must also include a comprehensive assessment of the country’s banking, financial, regulatory, legal and political systems, as well as regional and global interdependencies.
However, the increased interdependence of today’s sovereign economies has magnified multifold the imperative of expanded analysis and data. The globalization of financial, trade, and production across sovereign borders has changed the basic configuration of the global economy itself. And this new global economy, as it emerges, needs to be charted, its workings defined and measured, in as precise and timely ways as possible.
This analytical imperative would be greatly facilitated by the development of new data and information formats (“templates”) on these aspects of countries and their interdependencies, easily accessible in one central Internet site. A partial preliminary list of specific suggestions of the types of data and information that would facilitate more integrated and comprehensive country analysis include:
3) NEED FOR IMPROVED DATA FORMATS: Users will be able to decipher data better if it is provided in formats that facilitate comprehensive analysis. Examples include:
4) NEED FOR IMPROVED DATA DELIVERY MECHANISMS: Users are less apt and able to use data if it is costly and difficult to access. Providers of data should work more closely with users to insure cost-effective delivery systems. Examples of suggested enhancements include:
PROPOSED MECHANISMS AND INCENTIVES FOR IMPROVING THE PROVISION OF DATA AND INFORMATION: Continued problems in attaining the required level of quality, relevancy, and timelines of data and information will persist unless new mechanisms and incentives are aggressively put into place. A preliminary summary of possible measures that could streamline this important process include:
1) NEED FOR “DEPOLITICIZED” GLOBAL DEFINITION PROCESS: Despite extensive effort in data and information enhancements, the significant residual problems of definitions, timeliness, and integrity will not be improved unless there is a less politicized global framework for defining definitions and insuring its quality. This process should be coordinated by a central professional organization (such as a country risk professional association as noted in prior section) with broad responsibility for both identifying a common global framework, as well as defining the priority reporting needs distinctive to individual countries. This central professional organization should actively involve the investor and policymaking communities in defining these reporting definitions and needs, as well as in providing data. As noted, the accounting profession’s successful leadership role in defining and implementing accounting standards can provide helpful guidance for the development of independent professional expertise in further enhancing country disclosures.
2) FURTHER DEFINE COUNTRY AND IFI PROCESS FOR PROVIDING “GLOBAL PUBLIC GOOD”: TIMELY, ACCURATE DATA ON BOP AND GOVERNMENT ACCOUNTS IN EASILY USABLE FORMATS: There needs to be wider recognition in all communities that quality, timely country data and information are “global public goods” that all governments, and their membership organizations, have vested interests in providing to the larger public. While the IMF will need to continue its leadership role given its privileged access to governments and its existing infrastructure, a more open and inclusive process is needed. This new process needs to recognize the huge imperative of improving existing data and information, providing new data and information (as noted in the prior section), as well as the need to meaningfully institutionalize input from the investor and analyst communities. The provision of these improved and new sets of country data and information should be considered “global public goods” that serve to promote informed decision making in both the investor and policy-making communities.
As discussed in the prior section, countries and the IFIs, need to have more user-friendly, timely interactive systems for data and information disclosure. Specifically, further efforts are needed to bring in the private sector and others in defining data and information needs, formats, and web site functionality. Moreover, as indicated in the earlier section, the country risk profession should take the lead role in defining reporting standards, which would then be reflected in the IMF principles of operation, enabling it to simply implement the reporting process, and insulating it from the pressures of shareholder governments. All public groups working on improving the global financial architecture, such as the Financial Stability Forum, need to promote this concept, and work hand-in-hand with the investor and analytic communities to operationalize it.
3) ESTABLISH PENALTIES ON COUNTRIES FOR FALSE, INCOMPLETE, AND UNTIMELY REPORTING TO THE IFIs: The IMF, BIS, and other IFIs could simply implement the standard guidelines developed by the global professional organization mandated to define country-reporting requirements. As noted in several recent cases, the IMF has received faulty and incomplete data from reporting countries, as countries undergoing crisis are often tempted to manipulate their accounts or delay submission of key data. In order to effectively counter this possibility, the IFIs and its member countries need to reinforce the criticality of adherence to these reporting requirements through a myriad of methods, such as direct negotiations, reinforcement in national regulatory regimes (creating “market” rewards for quality disclosures), and tying to IFI and government aid programs and loans. As noted in recommendation two on IFI accountability, harsh penalties should be a certain outcome for any country that deliberately manipulates its reporting.
Other key players in the global financial system can serve as key allies in this process, strengthening incentives and penalties. For example, credit evaluation and news services such as the rating agencies, country risk services, and the financial press can issue “market warnings” whenever country disclosures are incomplete, misleading, or not timely. In particular, country rating agencies can incorporate disclosure requirements into their rating criteria, downgrading country ratings or outlooks if disclosure standards are not met. Creditor and investor organizations can also play important leadership roles in communicating private sector concerns to debtor governments. Further, as detailed earlier, important creditor countries and their membership organizations can play critical roles in convincing other governments of the importance of establishing high disclosure standards, and assisting them in this process.
4) ESTABLISH BROADER-BASED REGULATORY INCENTIVES FOR IMPROVED DATA DISCLOSURE. As noted in the earlier section on accountabilities, national and international regulatory authorities can provide powerful mechanisms by informing investors of country disclosure practices, and further by restricting market access to only sovereigns that have sufficient “Disclosure Programs” in place and are committed to improved disclosure requirements within defined time frames. The SEC data requirements for Yankee bond issues have been successful in raising the disclosure standards for emerging market issuers. The expansion of these regulatory requirements to other markets, including home markets, would provide strong market-based positive incentives for the improvement of data. Furthermore, corporates from countries that have not complied with such country disclosure requirements may also be restricted from access to key markets such as the US. Another regulatory venue are capital allocation rules, such as the Basle accord proposals which may link countries’ risk weights to adherence to the IMF’s SDDS (Standard Dissemination Disclosure Standards).
5) ESTABLISH EFFECTIVE SUPPORT AND AUDITING MECHANISMS FOR ALL DATA AND INFORMATION DISCLOSURES. Countries, like companies, need to have effective support mechanisms in the preparation and review of their economic and financial data. This would entail the provision of the following support functions to countries:
V. RECOMMENDATION FOUR: Revamp Current Risk Management Models and Regulatory Approaches with More Robust Qualitative Methods
All parties agree that the Asian crisis has underlined the limitations of commonly used analytic approaches, in particular fixed-income sovereign ratings and Value-At-Risk models, as accurate indicators of financial vulnerability and the potential for crisis. While recent surveys indicate some refinement of these approaches, risk management models in place across the financial sector, including those envisaged in BIS and other regulatory processes, continue to rely principally on these same mechanisms. Recommendations from the IIF and others have underlined the importance of overlaying qualitative analytic methods, such as scenarios and stress testing, systematically on these quantitative approaches and risk judgments. The main obstacles to implementing these recommendations are twofold: 1) need to develop simple ways to integrate these more qualitative models into current decision making structures, interface with rating systems, and regulatory frameworks; and 2) lack of independent, quality research that meets this criteria, and that is easily accessible and affordable for the wider investor community. While there is general agreement in the country risk community on the types of analytical approaches and outstanding problems, significant difficulty still impedes the actual provision of these suggested enhancements in country analyses provided today, as detailed below and in the section on recommended next steps.
OUTSTANDING PROBLEM AREAS: The analytical challenges of country risk analysis in today’s environment are daunting in scope, as outlined in last year’s Roundtable Report (see Attachment) and in the retrospective debate on “lessons learned” from the Asian crisis. A summary of outstanding problem areas that require further improvement include the following:
1) EXPLICIT IDENTIFICATION OF BOP FUNDING GAPS AND POTENTIAL VULNERABILITIES: The standard format for country risk reports has traditionally included historical data and projections on the country’s balance of payments (BOP). However, these formats do not usually explicitly document estimates of the country’s projected funding gap, assumptions on funding sources, or associated vulnerabilities that could potentially result in debt service difficulties. In order to formulate appropriate policies and investment decisions, users of such BOP data and projections need as much clarity as possible (“transparency”) in relating BOP analyses to key conclusions on the potential for debt service difficulties, and key sources of vulnerability. As noted in the prior section on data, a major problem continues to be the lack of standard definitions for existing data, as well as the lack of information and data on key cross-border interdependencies.
2) DEVELOPMENT OF MORE COMPREHENSIVE AND INTEGRATED ANALYSIS OF COUNTRY RISK ISSUES: Traditional formats for analysis have often separated the different analytical disciplines of economics, politics, finance, and industry analysis, with geographic specialties further isolating country assessments from regional and global assessments. However, end users of country risk analysis must be assured that all potential risk factors have been integrated into the final conclusions of each country risk analysis, or are explicitly noted as omissions. This is a formidable challenge in today’s environment of escalating interdependencies, requiring expert evaluations on the country’s regulatory, legal, financial, and political systems, as well as of critical linkages with the global environment. While some progress has been made, further enhancements need to be made in developing explicit methodologies for evaluating domestic and exogenous risk factors, and equally important, coordinating the various areas of expertise. Again, as noted in the prior section on data, a major initiative is needed in this area.
3) MORE SYSTEMATIC ANALYSIS OF MARKET RISK: Post-Asia crisis, there is widespread recognition of the risk capital markets themselves can potentially create for countries and the global financial system itself. Some progress has been made in areas such as liquidity analysis, and working groups are presently developing new proposals for exposure reporting of financial institutions and market analysis. However, these efforts have not to date provided policymakers and investors with easily accessible, quality data, or the comprehensive analysis of a country’s vulnerability to shifts in capital flows and the multiplier effects of financial meltdown from countries and individual institutions. Much more needs to be done in identifying credible mechanisms to track market exposures and identify potential vulnerabilities, in both domestic and international markets.
4) MORE EXPLICIT ANALYSIS AND DOCUMENTATION OF COUNTRY INTERDEPENDENCIES: As noted in the prior section on data, despite the heightened attention given to contagion and cross-border channels of transmission, much remains undone in assuring users of country risk assessments that full consideration of a country’s vulnerabilities to external factors has been fully integrated in the conclusions of the country risk analysis. Greater efforts are required in two areas: the development of cross-border linkage data bases that fully document potential sources of vulnerabilities; and the development of frameworks that integrate the analysis of such data into country risk assessments. Key areas of focus include the following risks: financial cross-border linkages (e.g., suppliers of capital, cross-border currency mismatching, currency vulnerabilities, etc.); trade dependencies (e.g., export and import markets, commodity prices, etc.); vulnerabilities to debt service capacity (including export dependency on imports, and breakdown of debt profile by instrument and supplier country); and the country’s ability to compete globally.
5) INCREASED EMPHASIS ON ANALYSIS OF POLICY DECISIONS: Policy choices are critical to economic growth, and the avoidance of financial crisis. All too often, country analysis has focused on the data, and not the detailed analysis of policy mixes that serve to either preempt crisis or escalate its potential. Country analysis needs to explicitly evaluate the quality of policies, critical tradeoffs between policies, and any uncertainties associated with the implications of policies on growth, interest rates, the health of the banking system, and the overall country economy. And as well evidenced by the Asian crisis, critical policies are not only issued by governments, but also by the International Financial Institutions and their member governments, and require open debates in expert forums that facilitate thorough reviews of implementation procedures and potential ramifications. In short, the assessments of both country and IFI policy risk are intrinsic components of the risk analysis associated with international lending and investment.
6) IDENTIFICATION AND TESTING OF ALL MATERIAL ASSUMPTIONS: Very often country assessments and judgments are based on assumptions of critical importance that are not explicitly identified or stated in the written country risk analysis. This impedes the isolation of critical risk factors, and open debate of underlying critical assumptions, which is of particular importance given escalating interdependencies and the need for more coordination among experts. Examples of key assumptions that need to be identified and tested are those relating to exchange rates, political structure, policy options and constraints, the availability of capital, growth rates, interest rates, commodity prices, export markets, and the overall global environment. Further, it is critical that new open expert forums be created for the testing of these and other critical assumptions, which encourage the open exploration of the prevailing “conventional wisdom,” and allow for thoughtful consideration of unconventional, unpopular and minority views.
7) NEED FOR MORE SOPHISTICATED ABBREVIATIONS OF ANALYTICAL CONCLUSIONS (such as ratios, templates, ratings, etc.): Users of country risk analysis require useful abbreviated judgments that can then be utilized in their decision making processes. Much of the recent debate has underlined the misuse of the fixed-income ratings of the global rating agencies, as well as the inadequacies of risk management systems (such as Value-at Risk) in integrating macro and country risk analysis. However, operative substitutes for these existing shorthand risk assessments have not yet been developed and disseminated in meaningful ways. The providers of country risk data and analyses need to work closely with the user communities -- developing new shorthand rankings, ratios, templates, and other abbreviated risk conclusions-- that better meet user decision needs.
8) PROMOTION OF QUALITATIVE ASSESSMENT TECHNIQUES THAT INCORPORATE UNCERTAINTIES AND INTERDEPENDENCIES (such as development of scenarios, threshold stress testing, and mapping sensitivity to changes in key risk variables): The renewed application of quantitative methods in global financial markets has created renewed vulnerabilities in financial markets, as many of these methods do not adequately reflect the uncertainties and risks actually embedded in portfolios and exposures. Specific initiatives are strongly recommended:
RECOMMENDED MECHANISMS AND INCENTIVES FOR DEVELOPING IMPROVED ANALYTICAL APPROACHES: There is an urgent need to create new mechanisms and incentives to meet the analytical objectives stated above. A preliminary list of suggested initiative follows:
Analysts and investors should expand the range and depth of the independent analytical sources they use for analysis. Specific steps include the expanded use of independent analysts such as academics, journalists, consultants and corporate and banking sources to assess private sector health and competitiveness; explicit input from technical experts on global industry issues such as commodities; and stakeholder analysis to assess political systems, including opposition and vested interests. Other specific suggestions on measures to institutionalize such expert forums follow.
VI. RECOMMENDATION FIVE: Modify Current Performance Measures, Regulatory Regimes, and Analytic Input to Facilitate Use of Quality Data and Analysis in Investor Decision Making
With the recent financial crises, the notion that “markets” reward performance has been discredited in the eyes of many. Many analyses of the Asian crisis have acknowledged that inadvertently both regulatory and market factors skewed capital flows, accentuating systemic risk and market herding. Despite this recognition, however, little research has been conducted that identifies how current regulations and market performance benchmarks may serve to unintentionally distort investor decision making, and what changes would realign fundamental analysis as the basis for decision making, so that performance is rewarded with the availability of affordable capital.
In order to better understand market behavior, it is imperative that research be immediately conducted in this area. The workings of externalities such as performance benchmarks and regulatory regimes are insufficiently understood, despite their huge importance for understanding the direction and magnitude of capital flows. The basic theory underlying “free” markets assumes quality analysis of fundamentals, and that superior performance and open, quality information are rewarded with the availability of inexpensive capital.
In reality, however, performance benchmarks often-skew investor decision-making away from fundamental analysis. Two areas are commonly cited:
Regulatory regimes are also widely understood as primary factors in investment decision making, sometimes in unintended ways that create market risks. The most commonly cited recent case, now in the process of revision, is the Basle capital allocation rules. Despite the huge attention given to this issue, however, insufficient research has focused in systematically identifying how such regulations (and any revisions) in fact influence actual decision making processes. The traditional process of asking for private sector response does not accomplish this objective, as firms will posit the answer they perceive to their advantage, rather than share any analysis on how it might alter their capital allocations and decision making processes per say.
The suggested approach is to conduct in-depth confidential interviews with key decision-makers who constitute a representative sampling of key investor and creditor classes, charting the decision-making process and its key determinants, for emerging market investments. The research should be conducted by trusted third parties that can insure confidentiality of participants and individual responses.
VII. NEXT STEPS
The workings of the global financial system have become more complicated and vulnerable in the wake of global interdependence and an expanded investor base. If the global financial system is to be strengthened for the benefit of both investors and countries, the recommendations stated in this report are urgently in need of implementation. Credibility, expertise, and open exchange are essential to the well functioning of the expanded global market and the provision of adequate capital.
Immediate, essential next steps suggested in the report that would serve to advance these underlying preconditions to a well-functioning global financial system include:
1) Official Sector Adoption and Adherence to the Suggested “Principles” (cited in the report Recommendation One), with more open routine and institutionalized broad communication with the wider investor community (especially directly with buy-side): Key IFI and governmental parties worldwide should openly endorse and implement these basic principles which assure investors of their rights to information and organization.
2) Official Sector Implementation of Suggested Measures for Improving Data and Information, and the Ease of Access (for the larger investment community), such as:
3) IFI and Government Funding of Market Risk Research (to be conducted by third parties): Immediate new initiatives are needed to identify cost-effective means for assessing material exposure risk concentrations, or externalities such as regulations or performance benchmarks that may inadvertently result in costly market herding.
Please provide all report comments to Barbara Samuels, Roundtable Project Director, at samuels_barbara@bah.com, or 212-358-9660.
APPENDIX: LIST OF PARTICIPANTS AND OBSERVERS
ROUNDTABLE WORKING GROUPS
1) SOVEREIGN DEBT RESTRUCTURING WORKING GROUP
The Sovereign Debt Principles Working Group consisted of individuals with wide ranging expertise in the global financial system, as well as recent sovereign bond restructurings, from both the investor and policy making communities.
Participants included: Carl Adams (Merrill Lynch & Co., Inc.); Derrill Alatt (UBS Warburg); Peter Allen (Independent Consultant); Lee Buchheit (Cleary, Gottlieb, Steen & Hamilton); Richard Buckholz (Goldman Sachs Asset Management); Clifford Dammers (IPMA); Wilma Davis (John Hancock Mutual Life Insurance Company); Richard Gitlin (Bingham Dana LLP); Robert Gray (HSBC Corporate Banking); Eric Hermann (FH International Financial Services, Inc.); Gary Kleiman (Kleiman International Consultants, Inc.); Vitaly Lisovenko (Ukraine MOF); Abigail McKenna (Morgan Stanley Investment Management); Ben Miller (HBK Investments); Walter Molano (BCP Securities, LLC); Jay Newman (Elliott Associates, L.P.); Barbara Samuels (Samuels Associates); Sergay Storchak (Vnesheconombank); Tom White (Metropolitan Life Insurance Company); Andrew Yianni (Clifford Chance); and Daniel Zelikow (JP Morgan).
Observers included: Gavin Bingham (BIS); Matthew Fisher (IMF); Daniel Gleizer (Banco Central do Brasil); Sean Hagen (IMF); Ann Misback (Federal Reserve Board); Michael Nelson (Federal Reserve Bank of New York); Anne Salladin (U.S. Department of Treasury); Brad Setser (U.S. Department of Treasury); and David Wall (Bank of England).
2) DATA AND METHODS WORKING GROUP
The Data and Methods Working Group consisted of individuals with extensive
longstanding expertise in country risk analysis, and investors in
emerging markets.
Participants and Observers included: William Bixler (MetLife); Dan Bond (Ambac Assurance); Omar Borla (Fleming); Uwe Bott (GE Capital); Chris Canavan (Goldman Sachs); John Chambers (Standard and Poors); Niles Chura (American Express); John Clark (New York Federal Reserve); Terese Feng (FITCH IBCA); Frank Fernandez (Securites Industry Association); Lacey Gallagher (Credit Suisee First Boston); Dale Grey (World Bank); Gary Kleiman (Kleiman International Consultants, Inc.); Roger Kubarych (Council on Foreign Relations); Karen Morr (CIA); Joydeep Mukherji (Standard and Poors); Jay Newman (Elliot Associates); Martin Parkinson (IMF); David Roberts (Bank of America); Barbara Samuels (Samuels Associates); Sergay Storchak (Vnesheconombank); David Wall (Bank of England); and Neil Wigan (FITCH IBCA). (Please note: Other input was received from confidential interviews with Asian and Latin American central bankers, other government officials, and investors.)
ROUNDTABLE PARTICIPANTS AND OBSERVERS IN GENERAL MEETINGS 10/98 – 8/00
Carl Adams (Merrill Lynch & Co., Inc.); Kamal Ahmad (Morrison & Foerster, LLP); Peter Allen (Consultant to bondholder creditor committees); Andrew Aran (Alliance Capital Management International); Edmar Bacha (BBA Securities Corp.); Leslie Barcus (Citibank); Merli Baroudi (Economist Intelligence Unit); Jim Barrienau (Alliance Capital Management); Javier Baz (TCW); Amar Bhattacharya (The World Bank); Matthew Bishop (The Economist); Craig Blessing (Chase Asset Management); John. Bohn (GlobalNet Venture Partners); Enrique Boilini (Farallon Capital); Dan Bond (Ambac Assurance Co.); Jack Boorman (IMF); Omar Borla (Robert Fleming Incorpoprated); Uwe Bott (G.E. Capital); Robert Broadfoot (Political & Economic Risk Consultancy, Ltd.); Ernest Brown (Morgan Stanley & Co.); Lee C. Buchheit (Cleary, Gottlieb, Steen & Hamilton); Richard Buckholz (Goldman, Sachs Asset Management); Matthew Burrows (U.S. Mission to the United Nations); Chris Canavan (Goldman, Sachs & Co.); John H. Carlson (Fidelity Investments); Michael Cembalest (J.P. Morgan & Co., Inc.); Michael Chamberlain (Emerging Markets Traders Association); John Chambers (Standard & Poor's); Joyce Chang (Chase Securities Inc.); Jonathan Chanis (Caxton Corp.); Bo Yung Chung (Bank of Korea); Dominique Clavel (American International Group, Inc.); William R. Cline (Institute for International Finance, Inc.); Sam Cross (Columbia University); W. Bowman Cutter (E.M. Warburg, Pincus & Co., LLC); Willma Davis (John Hancock Mutual Life Insurance Company); Andres de la Cruz (Cleary, Gottlieb, Steen & Hamilton); Eli Whitney Debevoise II (Arnold & Porter); Robert Dineen (Shearman & Sterling); Rafael Docavo-Malvezzi (Technology Holdings International); Amy Falls (Morgan Stanley & Co.); Therese Feng (FITCH IBCA); Frank Fernandez (Securities Industry Association); Stephen Fidler (The Financial Times); Matthew Fisher (International Monetary Fund); Wayne Forrest (American-Indonesian Chamber of Commerce); Arminio Fraga (Banco Central do Brasil); Stephen Friedman (Marsh & McLennan Companies, Inc.); Lacey Gallagher (Credit Suisse First Boston Corporation); David Garlow (AIG Investment Corporation); Anna Gelpern (U.S. Department of the Treasury); Richard Gitlin (Bingham Dana, LLP); Lawrence Goodman (Global Economic Associates LLC); Mary Goodman (Moore Capital Global Strategies); Dale Gray (World Bank); Francisco Gros (Morgan Stanley Brazil); John (Sean) L. Hagan, Jr. (International Monetary Fund); David D. Hale (Kemper Investment); Hari Hariharan (Santander Investments); Mitchell Hedstrom (Citibank); John Hennessy (Credit Suisse First Boston Corporation); Cathy Hepworth (The Prudential Insurance Co. of America); Eric R. Hermann (FH International Financial Services, Inc.); Christine M. Y. Ho (The G7 Group, Inc.); George Hoguet (State Street Global Advisors); Ann L. Hollick (State Department); Robert Hormats (Goldman, Sachs & Co.); Yasheng Huang (Harvard Business School); Lyric Hughes (China Online, LLC); Chris Hume (Fitch IBCA Limited); Michael Hunter (Dart Management Inc); Shafiq Islam (BRN Associates); Paul Jabber (Gefinor (USA) Inc.); Henry Jackelen (United Nations Capital Development Fund); Dan Jones (Marvin Zonis and Associates, Inc.); David Jones (National Security Council); Rajeev Joshi (CVC Investment Management); Himmat Kalsi (The World Bank); Cem Karacadag (International Monetary Fund); James Kelly (Salomon Smith Barney Inc.); Edward Keon (Prudential Securities); Eung Jin Kim (Bank of Korea); Gary Kleiman (Kleiman International Consultants); Mahesh Kotecha (Structured Credit International Corp.); Roger Kubarych (Council on Foreign Relations); Emilio Lamar (Columbus Advisors); Eugene Lawson (U.S.-Russia Business Council); Jonathan Lemco (National Policy Association); Paulo Leme (Goldman, Sachs & Co.); David Levey (Moody's Investment Services); Marc Levinson (Chase Securities); Frank Linden (Merrill Lynch & Co., Inc.); Wayne Lyski (Alliance Capital Management Corporation); Michael Maguire (MBIA); Douglas Makepeace (Sperry Fund Management Corporation); Armando Bravo Martinez (World Policy Institute); Scott McDonald (KRW International); Michael McDonnell (Merrill Lynch & Co., Inc.); Wesley McGrew (U.S. Department of the Treasury); Abigail McKenna (Morgan Stanley Asset Management); Arthur K. McMahon (Comptroller of the Currency Administrator of National Banks); William Milberg (New School University); Benjamin Miller (HBK Investments); Anne Misback (U.S. Federal Reserve); Walter Molano (BCP Securities); John Moore, Jr. (Morgan Stanley & Co., Inc.); Karen Morr (Central Intelligence Agency); Joydeep Mukherji (Standard & Poor's); Brian Murray (AIG Investment Corporation); Leonel Narea (Coutts & Co.); Michael Nelson (Federal Reserve Bank of New York); Jay Newman (Elliot Associates, LP); Mark Niland (Hartford Investment Company); Nancy Northrop (Alliance); Michael F. Oppenheimer (Global Scenarios, LLC); William Overholt (NOMURA Securities International (Hong Kong) Ltd.); Hugh Peyman (Government Research Works); Jorge Pinto Mazal (Consulate General of Mexico); Peter Plaut (Bank of America); Arturo Porzecanski (ABN AMRO Inc.); Susan K. Purcell (Americas Society/Council of the Americas); Nadine Rihani (The First National Bank of Chicago); Bruce Roberts (Central Intelligence Agency); David Roberts (Bank of America Securities, LLC); Rita Rodriguez; Frederick Roggero (United States Air Force); David Rolley (Loomis Sayles & Co., L.P.); Paul Sacks (Multinational Strategies, Inc.); Anne Salladin (U.S. Department of the Treasury); Barbara Samuels II (Samuels Associates); Marco Santamaria (Lehman Brothers); Jaime Sanz (Duff & Phelps); Antranig R. Sarkissian (Citigroup); Brad Setser (U.S. Department of the Treasury); Frances Seymour (World Resources Institute); Eshagh Shaoul (American International Group, Inc.); Harvey Shapiro (Institutional Investor); Roger Shields (MBIA Insurance Corporation); Michael Silva (Federal Reserve Bank of New York); Dorothy Meadow Sobol (Federal Reserve Bank of New York); Francis Stankard (American Express Bank, Ltd.); Joseph Taylor (Merrill Lynch & Co., Inc.); Gabriel Torres (FITCH IBCA); Thomas Trebat (Salomon Smith Barney Inc.); Vincent Truglia (Moody's Investors Service, Inc); Thomas White (Metropolitan Life Insurance Co.); Malcolm H. Wiener (The Villa Candia); Neil Wigan (FITCH IBCA); John Wilton (The World Bank); Robert Windorf (Salomon Smith Barney); Alice Young (Kaye, Scholer, Fierman, Hays & Handler); Daniel Zelikow (JP Morgan); Marvin Zonis (Marvin Zonis & Associates, Inc.); Barry Zubrow (Goldman, Sachs & Co.)
ATTACHMENT: YEAR ONE REPORT FROM CFR ROUNDTABLE ON COUNTRY RISK
Key Recommendations From Discussions 10/98-9/99
In the two years since the July 2, 1997 devaluation of the Thai baht, countless commentaries have addressed the causes of and remedies for the Asian financial crisis. Yet remarkably little attention has focused on the glaring weaknesses of the country analysis process itself: Why did virtually no analyst in either the investor or policy communities foresee the depth or duration of the Asian crisis and its far-reaching consequences for the Asian countries, other emerging markets, and the industrial countries? What can be done to improve our ability to assess vulnerabilities, risks, and channels of contagion, enabling investors and policymakers alike to minimize the economic, political, and social costs of future financial crises?
Leading members of the country risk community conducted a series of Roundtable discussions from the fall of 1998 through the fall of 1999 under the auspices of the Council on Foreign Relations, with the objective of developing recommendations for how to improve the quality of country risk assessments utilized by investors and policymakers. Participants included leading country risk practitioners (from rating agencies and other country risk services, commercial banks, and the investor community), as well as government officials and analysts (from the International Financial Institutions, the U.S. government, and borrowing country governments).
The recommendations set forth below are intended to provide a summary of the most important observations and suggestions made by members of the Roundtable. Since the purpose of the Roundtable was to provide a forum for a wide-ranging exploration of issues and solutions, no effort was made to reach consensus on the wording of specific recommendations. However, members expressed strong general support for the thrust of the conclusions below, and no participant dissented on any major points.
The recommendations are in three principal areas: Analytical Country Risk Methods; Structure of the Country Risk Profession; and the Use of Country Risk Analysis in Decision-Making. The recommendations cut across market and regulatory structures, which suggests the need for a serious collaborative approach in improving analysis and its use in the decision-making process. Roundtable participants urge key decisionmakers in both the private and public sector to consider these recommendations seriously, as the increased use of high-quality, relevant country risk assessments by investors, lenders, and policymakers would decrease excessive market volatility and improve policymaking, serving to minimize the economic and social costs resulting from financial crisis.
I. ANALYTICAL COUNTRY RISK METHODS
Analytical capacity in the country risk profession has been outpaced by developments in the global environment, given the unprecedented changes across economies, political structures, and societies, amplified by increased global, regional, and interregional interdependencies. While some improvements have been made to analytical methods and data collection over the last twenty-four months by a number of country risk analysts, the speed and depth of the historic transformations occurring in our global environment underscore the need for further modifications. Following are a number of concrete steps that our group identified to improve the analytics of country risk assessment:
1) All country risk analysts and investors should routinely utilize analytical frameworks that explicitly recognize the increased complexity, interdependency, and uncertainty of the global environment. Specific measures include the following:
2) Country risk services and analysts should expand beyond the traditional focus on country reports to routinely include global, regional, sector, and instrument reports that facilitate more targeted identification of portfolio concentration risk. A more precise identification of risks requires that the International Financial Institutions (IFIs), rating agencies, and other country risk services that routinely prepare reports recognize more macro risks, as well as how those risks relate to different sectors and instruments. Analysts need to focus reports on the following: a) global scenarios that identify key uncertainties, systemic risks, and potential implications for regions and countries; and b) global industry sectors and instruments (such as bonds), identifying risks specific to those instruments and sectors.
3) Primary government providers of data and analysis, such as the IMF, the World Bank, the BIS, and country governments, should collaborate more closely with country risk analysts, investors, and lenders to identify priority gaps. Specific taskforces should be organized around this objective, and should include private sector analysts, with the goal of augmenting the individual analyst’s risk assessment capacity through the improvement of data and analysis from mulitlateral and government sources. Key areas of focus for the Taskgroups include the following risks: currency and maturity mismatching; vulnerabilities in a country’s balance of payments profile, including breakdown on debt profile and debt amortization by instrument; and a country’s economic interdependencies, the health of its private sector and banking system, global competitiveness, political and social cohesiveness, and overall sustainability of policies. Such timely and relevant data and analysis should be made available through expanded web sites.
4) The IMF, the World Bank, and country governments should enhance their communication with investors and creditors, by providing more comprehensive and timely rationales for country policies and performance assessments, and by explaining significant country developments. The use of Internet technology would facilitate the dissemination of and access to information by all groups, improving the investor community’s capacity to analyze and exchange views on key issues. Specific recommendations include the following: a) enabling more user-friendly downloading, graphing, and analytics applications; and b) constructing private Web Intranet sites to facilitate open collaboration and interactive dialogue on data and analyses.
5) Analysts and investors should expand the range and depth of the independent analytical sources they use for analysis. Specific steps include the following: appropriate use of rating agency output, with an understanding of intent and scope; expanded use of other independent analysts—such as academics, journalists, consultants and corporate and banking sources—to assess private sector health and competitiveness; explicit input from technical experts on global industry issues such as commodities; stakeholder analysis to assess political systems, including opposition and vested interests; and full utilization of IMF and World Bank analysts, analyses, and data.
II. THE STRUCTURE OF THE COUNTRY RISK PROFESSION
The structure of the country risk profession has evolved to support securitization, decreasing the individual analyst’s capacity to openly provide independent, long-term assessments of country fundamentals and systemic risks. Profit motives and other vested interests have led to increasingly biased assessments. As a result, even when data is sufficient and warning signals are ample, a correct and timely assessment may not be forthcoming. The result is an amplification of the costs of the crisis. To correct this problem, a number of definite structural and collaborative measures are required:
1) Investors and lenders need access to more independent country risk assessments for their analyses. Independent providers must compete against free sell-side research that is provided as a marketing function to private-sector clients. To encourage the growth of independent country risk services, as well as lower their cost, policymakers should collaborate with the private sector in the following steps:
2) IFIs should focus analytical resources on building the relevant economic and financial databases and overall analyses needed to support the investor and policymaking communities. To accomplish this, the IFIs need to partner with the private sector through ongoing collaborative fora involving country risk analysts in key institutions. These fora should leverage profession-wide expertise in identifying potential risks and preemptive strategies. Immediate next steps for the IFIs include the following:
3) IFIs and country risk service providers should enhance their capacity to provide interdisciplinary analysis on all potential sources of country risk. Further advances need to be made in the establishment of objective criteria and data provisions for evaluating critical aspects of each country (such as systemic and global interdependencies, global competitiveness, policy issues and tradeoffs, strength of the national banking system, adequacy of the country’s regulatory regimes, independence of the legal system, independence of monetary and interest rate policies, resiliency of the political system, etc.).
4) Country risk analysts need to institute a professional group that would serve to establish and disseminate “Best Practices” for the country risk profession. Critical functions would include the following:
III. THE UTILIZATION OF COUNTRY RISK ASSESSMENTS IN DECISION
MAKING
Even when available, quality country risk assessments are often inadequately integrated in decision making processes because of two factors: the large role of externalities influencing market behavior, as well as inadequate interfaces between assessments and decision making processes. To the extent that market behavior is commonly affected by these two factors, they are the potential source of mass-market movements, reversals and systemic risks. Significant action steps are urgently required:
1) Industry leaders and associations should revise performance benchmarks, incentive systems, and accounting regulations as needed to reward fundamental assessments and reduce costly market volatility. Immediate measures include:
2) IFIs and governments need to review how national and international regulatory regimes might better reinforce quality, fundamental long-term assessments. Key next steps include the following:
3) Regulatory authorities, private sector professionals, country risk service providers, and multilaterals should collaborate in enhancing a) the relevancy of the framework utilized in risk management models; and b) the actual usage of assessments in decisionmaking. Immediate implementation of the following is recommended:
The recommendations provided above are to be further developed in a second series of Roundtable discussions to be held at the Council from November 1999 through June 2000. For more information, please contact the Roundtable’s Project Director, Barbara Samuels (telephone 212-358-9660, fax 212-358-9642, samuels_barbara@bah.com).