In these days of globalisation and robust economic growth in almost every region of the world, it is tempting to believe that nothing can go wrong. But in many respects this is the most dangerous phase of the economic cycle when businesses, whether they be banks, manufacturers or airlines, are so anxious to expand and take part in the boom that the lessons of the past are forgotten. This does not mean that commerce should sit on the sidelines, afraid to invest, but it does mean proceeding with caution and bearing in mind that not just commercial enterprises but whole countries can go bust.
In fact, this year much of the global financial agenda will be concerned with building more financial stability into the worldwide economic system. A series of studies has been commissioned by world financial leaders ready for discussion by President Clinton and other heads of government at July's meeting of the G7 richest industrial countries in Denver. The experts have been asked to look at a number of interrelated issues, including the stability, soundness and safety of the banks and other financial institutions; the robustness of financial market structures; risks to the financial system; and the capacity of global institutions to deal with crises when they arise.
These financial specialists, whose work largely takes place at the Bank for International Settlements in Basle, are not dealing in academic concepts. The last few years have seen emergencies of several kinds. At the end of 1994 a shortage of foreign exchange in Mexico came close to wrecking the economic renaissance of emerging market economies from Latin America to southeast Asia. A year later the collapse of Barings Bank in London came near to closing down derivatives and futures markets from Singapore to New York and destabilised the whole of London's merchant banking community.
These are not isolated incidents. A survey by the international credit ratings agency Standard & Poors has found that over the last two decades 69 sovereign entities defaulted on their foreign currency bonds and bank debt, while a further seven defaulted on local currency debts. This is a worrying trend, especially given that bankers once thought states could not be bankrupted!
Clearly, when sovereign countries experience credit difficulties a range of official mechanisms comes into play. Temporary bridging loans can be arranged by the BIS in Basle; the International Monetary Fund can provide emergency credits in exchange for economic reforms; and, as has become common practice recently in the case of important defaulting countries like Russia, the Paris Club of creditor nations can reschedule and restructure the loans.
But the world has been changing. More open capital markets mean that investors from overseas can considering putting funds into many entities, such as an airline, an airport terminal, or an aerospace supplier. The fact that the company may no longer be state owned provides little comfort; Standard & Poors found that private sector defaults were triggered by sovereign debt problems in 68 per cent of the cases it examined. In many of the countries concerned the problem arose because of scarcity of foreign currency, which led to private sector borrowers defaulting on foreign currency bond repayments of the kind which are used by inward investors to finance their operations.
As private sector investment in the bonds of state entities grows, the risks of default by the private sector are increased. In the past it was almost axiomatic that private sector default would follow that of the sovereign state, such as with Argentina and Brazil before economic reforms. Other countries which have been through this situation include Mexico, the Philippines and Venezuela. However, in the poorer countries of Africa sovereign default has not necessarily been followed by private sector problems, largely because commercial debt is so small.
However, in the late 1990s lending to the private sector has begun to swamp that to sovereign entities as a result of liberalisation and privatisation. As a result, the nature of the potential risk has become rather different. A series of steps has been put in place since the Mexican problems of 1994 and 1995 in an effort to enable all investors, public or private sector, to understand the economic and financial conditions in the nations in which they invest. The IMF has established an Intranet site which provides subscribers with financial and economic data on most emerging market countries. This may eventually develop into a credit rating system similar to that operated by Standard & Poors and others.
Such systems seek to monitor a range of factors in establishing whether a country is credit-worthy or not; these include the size, structure and growth level of the economy and its volatility; exchange rates; inflation; the regulatory environment; taxation; infrastructure; and labour market conditions. Another factor now looked at quite closely is the quality and regulation of the local banking system.
In order to help head off further Mexico-style problems, the global financial community has put certain economies on the 'watch' list, deserving special attention. These include Bulgaria and Romania, where the banking systems and budgets are being rebuilt; Thailand, which has allowed foreign investment to substitute for domestic savings; Turkey, which has failed to come to grips with its inflation problem; and, most recently, Albania, where investment confidence has been battered by the emergence of fraudulent investment schemes. The monitoring process, designed to prevent financial crisis, has become more sophisticated and the mechanisms to improve coordination when problems occur are now being worked upon.
The ratings which agencies attach to debt issues, ranging from triple 'A' to unrated, provide an easy guide to credit quality in any particular country. But they are by no means watertight. As businesses pursue a global agenda, weighing the sovereign and private risks becomes that more critical.
Source: Airline Business
