Evaluating Sovereign Risk: Debt and Capital Markets. Derrill Allatt, Managing Partner, NewstatePartners, LLP The panel will address the current state of sovereign capital markets, the realities of issuing government debt, and the future state of financing government expenditure.

1. Current Perspectives on Sovereign Debt 2010 ICGFM Miami Conference

2. Key Challenges Facing Debt Management 2 Part 1

3. Determining Sustainable Level of Debt Several debt measures are utilised by debt managers and international investors to evaluate the sustainability of debt in a given country Debt-to-GDP The public-sector-debt-ratio provides the clearest picture of a country’s public sector debt stock as a percentage of annual production. Generally a level over 60% is considered high. Those countries with higher credit worthiness are able to borrow more without affecting their sovereign ratings as can be seen by the parabolic relationship between Debt-to-GDP and credit rating Interest-to-Revenues The ratio of public sector interest-to-general government revenues is the most commonly used measure of interest affordability as it provides an indication of the interest burden on annual fiscal resources. One government may have a high level of debt, however, through heavy concessional borrowing, might face a lower level of interest than another government with a lowerlevel of debt A ratio above 15% of revenues is generally considered high External Short-Term Debt-to-Reserves A metric of short-term external financing constraints, this ratio describes short-term debt (current-year amortisations, money market instruments, currency and deposits) as a percentage of central bank international reserves 2009 Public Sector Debt-to-GDP vs.. Credit Rating Interest-to-Revenues vs.. Credit Ratings Part 1: Key Challenges Facing Debt Managers Jamaica Greece Iceland Israel Philippines Ghana Bolivia Russia Chile AAA AA A BBB BB B CCC Jamaica Source: IIMF; S&P, Moodys; Fitch Pakistan Costa Rica Iceland Israel Bolivia AAA AA A BBB BB B CCC 3

4. Credit Ratings and Debt Sustainability S&P, Moody’s and Fitch all factor debt sustainability into their determination of credit ratings. These ratings then affect a Government’s ability to borrow externally. Additionally, ratings may serve as country ceilings, which affect the borrowing cost of private enterprises operating within a rated country The level of a country’s indebtedness is a major factor affecting its credit rating. While countries with historically strong sovereign credit worthiness, like Japan and Spain, may be given more flexibility in sustaining more debt, emerging market nations have traditionally been perceived as riskier. Recent events have called into question the debt sustainability of those historically AA- and AAA-rated nations like Greece, Spain and Portugal, which have faced downgrades in recent months IFR; Bloomberg, all figures as of 04 May 2010 Aggregated Sovereign Credit Rating vs.. Borrowing Spread Pakistan, 651bps Greece, 643 bps Ukraine, 551 bps Iceland, 375 bps Portugal, 275 bps Romania, 233 bps Philippines, 168 bps AA A BBB BB B CCC Part 1: Key Challenges Facing Debt Managers 4

5. Managing Rollover Risk Many governments worldwide (particularly within Europe) face large rollover requirements as a percentage of GDP in 2010before any allowance for financing budgetary deficits Debt rollover ratios exceed 20% of GDP for Belgium and Italy. Spain, for instance, must issue EUR 225bn this year in order to rollover its outstanding debts falling due in 2010, even though Spain has a debt-to-GDP of only 54% compared with 125% for Greece and 76% for Portugal. In addition to the need to refinance maturing debt, many European and other governments will need to increase their borrowings to finance their budgetary deficits. S&P has projected that European governments will be forced to borrow a record €1,446b in 2010 due to deteriorating public finances. IMF, S&P Advanced European Market Debt-Rollover Ratios EMEA Debt-Rollover Ratios Part 1: Key Challenges Facing Debt Managers 5

7. Decreased customs duties caused by a decline in global trade

8. Higher than anticipated expenditures caused by financial crisis response measures such as bank takeovers and deposit guarantees

10. Some governments are borrowing abroad in order to guarantee that they have adequate forex for their central banks

11. The inability to service or rollover large foreign-denominated debt payments (public sector or otherwise)

13. Contagion Contagion describes the phenomena whereby financial shocks are transmitted from one economy to other interdependent economies. The term came into wide use during the late 1990s when financial crises spread across emerging market economies, affecting nations with healthy fundamentals and sound fiscal, monetary and exchange rate policies Various theories exist to explain why contagion occurs including: real links such as trade, the pass through of higher/lower market interest rates, a herd mentality among investors, and operations of multinational financial institutions spreading economic distress and investors selling debt of one country to fund losses elsewhere in the portfolio The threat of contagion is very real to debt managers as exogenous events can lead to the transmission of higher interest rates, reduced financing options and speculative exchange rate attacks that undermine the external balance and cause any number of other economic distress factors Bloomberg CDS Lockstep Movements Among Emerging Market Peers Part 1: Key Challenges Facing Debt Managers 7

14. Reaching Investment Grade IFR May 8 2010, Moody’s, S&P, Fitch Why are some emerging market countries perceived as less risky than their peers? Part 1: Key Challenges Facing Debt Managers 8

16. Decreasing dependence on commodity exports (Kazakhstan, Trinidad & Tobago)

17. Taking advantage of higher growth to improve fiscal position and to reduce debt (Russia)

18. Implementation of Investor Relations Programmes (IRPs) (Brazil) Because of the recent turmoil surrounding the European sovereign debt crisis, a number of emerging market countries are now being perceived as less risky than advanced country peers. For instance, Chile’s CDS has recently been trading below UK’s. CDS for Brazilian, Mexican and Polish bonds are trading below those of Portugal 9 Part 1: Key Challenges Facing Debt Managers . Source: S&P S&Ps sovereign ratings methodology categories

19. Part 2 Some Solutions and Strategies 10

20. Sources of Funding Bilateral and multilateral borrowing increased dramatically in the sovereign borrowing mix in 2008 and through much of 2009 due to reduced availability of external commercial financing Many Governments have sought IMF assistance in the form of a stand-by-arrangement (SBA) or drawn on the IMF’s Flexible Credit Line Some sovereigns with SBAs and FCLs have already returned to the international capital markets - even before the availability of official sector funding ends as was the case of Hungary in July 2009 and January 2010 Part 2: Some Solutions and Strategies IMF Current IMF Programmes (as of 29 April 2010) 11

22. Extending the country’s yield curve

23. Encouraging greater investor interest (‘placing the country on the map’) in other sectorsDuring 2009, sovereigns out-issued corporates US$129b to US$115b, with the bulk of issuance coming in the second half of the year. Sovereign bond issuance is already up by more than two-thirds in the first quarter of 2010 Thompson Reuters, Development Prospects Group Part 2: Some Solutions and Strategies 12

25. The quality of economic and sovereign credit research and, most importantly, understanding of the country, its economic and political conditions and its creditworthiness

26. Experience in lead managing similar sovereign issues, including for example experience in bringing sub-investment grade sovereign borrowers to market

27. Distribution capability and willingness to support the transaction in the aftermarket

28. Individual character of the team assigned to the transaction; level of senior resources to be allocated, degree of familiarity with the countryPart 2: Some Solutions and Strategies 13

29. Case Study: Russian Federation Situation Overview After recovering from its debt crisis in 1998, the Russian economy sustained ten years of economic growth in excess of 5% through 2008. Oil receipts enabled the Russian authorities to accumulate assets in their National Wealth Fund and Fiscal Reserve Fund, which stood at US$88.8bn and US$40.9bn respectively as of 1 May 2010. These assets were instrumental in propping up the Russian private sector when the global financial crisis caused the Russian economy to contract by 7.9% GDP in 2009. No Russian credits suffered international bond defaults, in part due to well-timed interventions by the Russian authorities Prior to the most recent issues, Russia hadn’t issued in the international capital markets for many years, and its return required the development and implementation of a detailed medium-term external funding strategy that began in mid-2009 in order to obtain the lowest pricing possible Issuance Strategy The Russian Federation returned to the capital markets in order to provide corporate and sovereign-related entities with new sovereign benchmarks that would enable them to tighten their own credit spreads. Russia sought to raise US$5.5bn from five and 10-year issuances The Russian authorities took a hard-line on the pricing of the new bonds. Issuance at the tightest possible spreads was prioritised over achieving a high oversubscription ratio. The book size was deliberately kept under wraps in order to prevent investors from inflating orders Outcome Russia’s five- and ten-year issues were priced in line with official guidance at 125bps and 135bps wide of US Treasuries respectively and the bonds were two times oversubscribed, even in the face of a weak market. The ten-year yield fell inside of the Italian and Spanish sovereign yield curves. The issuance achieved the Ministry’s objectives of repricing the sovereign curve and establishing benchmarks for future supply Russia MoF Part 2: Some Solutions and Strategies 14

31. Issuances could be simultaneously placed on domestic and foreign markets allowing for the widest possible investor base

32. Domestic issuance develops the domestic local-currency debt markets

33. Widely available local-currency bonds could pave the way for foreign investors to increasingly invest on local-currency exchanges and in private sector corporates

35. Domestic-currency bonds could be ‘dumped’ rapidly by global investors causing more volatile price movements. More sophisticated investors may be located abroad, leaving domestic holders to bear the brunt of any depreciation in government debt assets

36. In order to have a successful local-currency issuance, capital controls must be limited or scaled back, which is a concern in some economies

37. External issuance of a domestic instrument is more expensive as legal costs, clearing mechanisms, road-shows and investor relations take on global proportionsPart 2: Some Solutions and Strategies 15

39. Provides a channel for interacting with market participants and investors

40. Helps judge the potential timing of issuance in global capital markets, especially in instances of prolonged absences from the markets

41. Contributes to a more positive perception of the country by investors when making decisions to either maintain or increase exposure to the country, even in the face of increasing external payments pressures

42. Increases transparency and engenders credibility and good faith

43. Helps promote the development of domestic capital markets

44. Helps reduce vulnerability to adverse shifts in market sentiment, whether caused by country-specific concerns or by market-induced contagion

45. Corrects inaccurate information and dispels rumours

46. Helps monitor capital flows into the countryPart 2: Some Solutions and Strategies 16

48. Disseminate concise data on macroeconomic and financial policies, as well as information about structural issues

49. Provide a direct channel of communication with government officials and decision-makers

50. Provide clarification and financial updates as necessary

51. Provide detailed information on the sovereign’s macroeconomic position, updated forecasts and insight on financing plans and other forthcoming events

52. Provide forward looking information on medium-term macroeconomic objectives and proposed policy measures, including future financing needs, debt position, amortisation schedules, future debt issuance, etcAn IRP needs to create formal communication channels for two-way exchange of views and information between sovereign debtors and market participants Part 2: Some Solutions and Strategies 17

53. Investor Relations Programme (IRP) (cont) Many sovereigns have been rewarded for the transparency of their investor relations efforts during the implementation of policy reforms. In the cases of Brazil, Turkey, and South Korea, for instance, the proper conveyance of their reform agenda through well established IRPs helped reduce borrowing costs. As can be seen below, the introduction of an IRP lowered the USD yield curve at 5-years by an average of 164bps for the sampled countries Sovereigns with developed programmes have fared better than those without. There is correlation between the rating of a country’s programme and its ability to withstand external shocks As can be seen below, those countries having the higher rated IRPs had lower 5-Year CDS spreads. This is indicative of the benefit of an open and transparent relationship between the sovereign issuer and investors Effect of IRP on Spread to USD Swaps ‘09 IIF Weighted Score vs.. CDS Spread (13 May 2010) Venezuela Pakistan Ukraine Institute for International Finance, Bloomberg Dom. Republic Part 2: Some Solutions and Strategies Philippines Turkey Brazil Peru 18

54. Domestic vs.. External Borrowing Domestic vs.. external debt financing should aim at minimising cost and risks for the overall economy There is no optimal approach for all circumstances as it depends on the availability of financing, economic environment, institutional framework and the degree of development of the domestic financial markets. However, there are a handful of factors that should be reviewed when deciding whether to borrow domestically or externally: Part 2: Some Solutions and Strategies 19

56. The preventative approach is suitable in those countries, which are able to anticipate and publicly acknowledge the existence of a liquidity problem before it becomes a solvency problem

57. In outright solvency crises, voluntary debt exchanges are more difficult to achieve

58. A candid dialogue is essential in order to gauge creditor tolerance for an NPV reduction, obtain feedback on how to improve a proposal and generate an atmosphere of trust

60. Identify Creditors

61. Build the case for debt relief

62. Consultation Process

63. Exchange Offer

64. Bring in remaining investorsPart 2: Some Solutions and Strategies 20

65. Case Study: Belize Situation Overview Belize’s public sector debt stock rose rapidly from 2000 to 2005, driven by increased borrowing from private sector sources in order to finance the cost of emergency relief and the reconstruction process following a series of natural disasters in the period from 1998-2002. Repeated refinancing operations in previous years led to a consistent rise in borrowing costs: the effective weighted average interest rate on the external commercial debt stood at approximately 11.25% in mid-2006 In mid-2006, Belize’s public debt burden stood at approximately US$1.1b, which was equal to over 90% of estimated GDP. Interest on the public debt was due to exceed 27% of fiscal revenue in 2006. Servicing the external debt absorbed an average of 46% of Belize’s annual foreign currency earnings from exports of goods and services since 2002. Furthermore, debt service due to external commercial creditors was characterised by spikes caused by bullet maturities, some of which were linked to put options held by creditors Macroeconomic projections, undertaken in conjunction with the IMF, showed that Belize’s debt burden would contribute to acute twin financing shortfalls in the short- to medium-term IMF, Belize MoF Debt Stock Before Restructuring (June 2006) Savings Generated by Debt Exchange Offer Part 2: Some Solutions and Strategies 21

66. Case Study: Belize (cont) Exchange Strategy Belize pursued a strategy based on: The full and early engagement of creditors through open and constructive dialogue A policy of transparency in the dissemination of all economic and financial data and assumptions A willingness to find a solution that would address Belize’s needs in a credible manner but that would also be perceived as fair by creditors The support of the IMF, the IADB, and the CDB Before entering into dialogue with creditors, Belize built a case for debt relief by producing detailed macroeconomic projections that took into account the impact of the authorities’ economic reforms and the financial assistance expected from multilateral and bilateral lenders. The authorities presented creditors with a number of indicative debt restructuring scenarios, all comparable in NPV terms In December 2006, Belize announced the broad terms of its exchange offer and simultaneously suspended interim debt service payments. In order to ensure comparable treatment in NPV terms for all participating creditors, Belize incorporated exchange ratios into the exchange offer. Special legal procedures were put in place to encourage the reconstitution of stripped instruments as well as the use by participating creditors of the collective action clauses (CACs) embedded in some of the affected instruments Outcome Holders of 96.8% of the affected debt tendered their claims. The new debt service profile for the external commercial debt was radically different from the original one. Between 2007 and 2015, Belize will benefit from cash flow savings equal to US$482m. Additionally, consolidation of the country’s external commercial debt into a single benchmark-size (US$547m) instrument encouraged trading in Belizean instruments and broadened the country’s investor base A major economic crisis was averted and Belize now has a debt burden that has proven sustainable. The country’s credibility and standing in the international financial community was preserved: creditors acknowledged that Belize conducted itself in a transparent and responsible manner in very challenging circumstances IMF Part 2: Some Solutions and Strategies 22

68. Will the markets be successfully persuaded that Greece can achieve debt sustainability without a comprehensive or partial debt restructuring?

69. If a restructuring of Greece’s debt becomes inevitable, will the Government have missed out on an opportunity to take a decisive and pre-emptive debt reprofiling action while it still had funds at its disposal?Part 2: Some Solutions and Strategies 23

70. Contact Us For further information, please contact: Derrill Allatt Managing Partner Newstate Partners LLP 33 Cavendish Square London W1G 0PW Phone: +44 (0) 20 7182 4641 E-mail: info@newstatepartners.com Website: www.newstatepartners.com 24