I. PROPOSED ACTION PLAN……………………………..2

II. INTRODUCTION………………………………………….3-22

III. TABLES…………………………………………………….23

IV. INVESTMENT GUIDELINES……………………………24-26

V. APPENDICES……………………………………………...27-47

• APPENDIX A: METHODOLOGY…………………………….…28-34

• APPENDIX B: TRANSFER RISK RATINGS (TRR) DEFINITIONS ….35

• APPENDIX C: COUNTRY LIMIT APPROVAL FORM……………..36

• APPENDIX D: COUNTRY RATING SYSTEMS………………..…..37-47

INVESTMENT GUIDELINESFOR

SFG CROSS-BORDER TRANSACTIONS

2

THE FOLLOWING ACTIONS ARE RECOMMENDED TO MANAGEMENT:

I. PROPOSED ACTION PLAN

n To Approve Aggregate Exposure Limit For All SFG Cross-BorderTransactions Equal To 400% of SFG’s Capital.

n To Approve Investment Guidelines For SFG Cross-BorderTransactions:

• To Establish A Country Risk Committee (CRC)

• To Approve Rating Systems And Methodology

• To Approve Exposure Limits For Individual And Groups Of Rating Categories

• To Approve Maximum Exposure Limits By Regional Configuration

n To Approve Preliminary Country Rating Assignments & ExposureLimits For 78 Countries.

n To Brief Staff on New Guidelines & Their Implications.

3

SFG welcomes new opportunities for debt and equity financing in developing countries followingthe dissipation of bipolar international relations and the global adoption of economicliberalization. At the same time, the company faces the challenge of saturating domestic markets,especially in the infrastructure sector.1 Mindful of these shifts, a decision was made to gradually,but decisively increase SFG’s investments abroad.

This decision, which will secure the company’s role in the market as well as its long-term growthand profitability, has certain implications for the way in which we do business and for the way inwhich we assess risk. The expertise of our outstanding dealmakers to accurately measure theproject or credit risks of new operations will continue to be a necessary, but it will no longer be asufficient condition for prudent business decisions. Instead, we must also consider the risk that isrelated to the extraterritoriality of a growing number of our deals. This risk is generally describedas country or sovereign risk.

The World Bank and Risk.World Bank experience in the area of project finance is a case in point. In 1992, an internalWorld Bank task force revealed that 30% of all projects of the World Bank were in serioustrouble, creating many white elephants.2 One of the major reasons for this high failure rate lay inbad project design, but there were several other factors that were found to be responsible: (i)unfavorable economic conditions in developing countries during the 1980s; (ii) project designsthat overlooked adverse macroeconomic or sectoral policies in borrowing countries; (iii) overlyoptimistic IRRs; and (iv) the proclivity of Bank management for loan volume over projectquality.

This two-sigma performance of the World Bank will be unacceptable to SFG in view of thecommitment of the GE-family to become a six-sigma company by the year 2000. This isespecially important, because SFG -- unlike the World Bank -- is not a preferred creditor. TheWorld Bank lends to governments only. The repayment performance of governments to the

1 S&P warns, however, that pressures on the profitability of projects in the U.S. electric utility industry, forexample, because of rising competition and price declines, are part of a global pattern. New increments ofcapacity bid at prices well below recent plant additions, for example, are squeezing profit margins in emergingmarkets and leave highly leveraged projects most vulnerable. In fact, in October 1996, the auction of a Chileanelectricity generator failed because bid prices were far too low according to the government. However, the low bidprices were the result of growing concern by investors that briskly rising demand was exceeded by more rapidlyincreasing supply of electricity driving prices and operating margins down. Wall Street Journal, October 16,1996.2This study became known as the Wapenhans Report after its main author Willi Wapenhans. Subsequently, theother development banks conducted similar studies and came to comparable results.

II. INTRODUCTION

A. BACKGROUND

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World Bank, in turn, is unrelated to the success of individual projects that were originallyfinanced with these resources. At the same time, the World Bank’s main concern is not timely,but rather ultimate payment. World Bank-delinquent countries are cut off from access to officialor capital market financing. By contrast, any failure of SFG-funded projects, or non-(timely)payment by borrowers has an immediate effect on our asset quality, and hence on our incomestatement.

Risk Assessment and Management.In dealing with this risk, our task breaks down into two components: First, country risk analysisor assessment, and second country risk management. The objective of country risk assessment isnot to avoid risk, but to manage it prudently.

SFG’s country risk assessment will be based on a clearly defined methodology of quantitativeand qualitative factors to evaluate the economic, political, and social risk climate in countries ona comparative basis.

Country risk management will have several functions: (1) It will monitor the risk profile of SFG’scross-border assets on a continuous basis limiting the exposure of the company to any onespecific risk. (2) It will assure that risk and reward are commensurate3. (3) It will assist indeveloping mechanisms to insulate individual operations from country risk. (4) It will focus theattention of dealmakers on those foreign markets which already have an acceptable risk milieu.

Country risk management will be driven by SFG’s net income targets, its appetite for risk, bybusiness opportunities and by the overriding determination to protect the Aaa-rating of GECapital at all times.

Foreign-currency transfer risk.This is the essential concern to foreign investors and the probability of its occurrence can bemeasured with some degree of reliability. Transfer risk is the risk that economic, financial,political, or social factors or force majeure may interfere with the ability and/or willingness of acountry and of its economic agents to honor their financial or contractual obligations to non-resident owners of debt or equity in a timely manner.4

3The risk/reward relationship is very important. During the lending-boom of the 1970s, commercial banksignored that relationship. In fact, between 1976 and 1980 the interest rate spreads between loans to Argentina,Mexico, and Uruguay, on the one hand, and the LIBOR-rate, on the other, actually declined. This seemed tosuggest that default probabilities for these countries were diminishing during those years, when, of course, thecontrary was the case. See S. Edwards, “LDC’s Foreign Borrowing and Default Risk: An Empirical Investigation,1976 -1980,” American Economic Review (September 1984). The surge in liquidity in 1996 and 1997 has led to aworrisome narrowing of spreads, ignoring credit fundamentals once again.4Some analysts argue that, in reality, everything narrows down to willingness. A government -- in their view -- isalways able to allow free transfer of foreign exchange in order to honor the country’s obligations abroad (this is amodified version of the “countries don’t go bankrupt” credo of former Citibank CEO Walter Wriston). There issome validity to that argument (as there was to Wriston’s). In some sense, it is the pain threshold of a governmentthat determines whether it will impose the necessary sacrifices on its population to achieve a more manageable

B. WHAT IS COUNTRY RISK?

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These obligations may comprise of payments for goods and especially for factor services, such asinterest payments on foreign-currency denominated debt to non-residents (bonds, loans, or tradefinance), and repatriation of dividends or profits to foreign owners. But these obligations mayalso consist of the principal payments on debt or the (implicit or explicit) guarantee to foreigninvestors not to hinder them in their exit strategy (divestment). The risk may be immediate(short-term or liquidity risk) or it may materialize over time because of the underlying structuralweaknesses (medium- to long-term). In the worst-case-scenario, it is this risk that makes an assetilliquid, non-performing or a write-off.

Volatility risk.This is the risk that the market value of a given investment might fluctuate. Currency movementsor stock market oscillations may materially affect the market value of a cross-border investment,but they will not -- per se -- make the asset illiquid. Investments in emerging markets arefrequently fraught with this risk5, which evades firm and predictable measurement. Volatility riskwith regard to currency movements may be successfully hedged by investors, but volatility risk isalso of concern to investors of stocks and securities. It may even affect the viability of a project,for example by leading to higher raw material costs.

Subnational risk.In addition to transfer risk, volatility risk and domestic-currency risk, country risk may exist incases, where local or regional units of government are empowered to delay, discontinue orretroactively change the conditions of transactions (in the private or public sector). This risk isaugmented today by the devolution of power in many nation-states6, and it is often referred to ascontract frustration.

While volatility risk is concentrated in emerging markets, subnational risk can be foundeverywhere. Examples are: (i) Contract challenges in Illinois on solid waste facilities; (ii) the

external balance, or whether it prefers to default instead, because it regards these sacrifices as politicallyunsustainable or undesirable. See also, M. Yassukovich, “The Growing Political Threat to International Lending”in: Euromoney, April 1976, p.12, who stated “The history of international lending is littered with the wreckageof borrowers who were theoretically able to take the necessary measures to satisfy their international creditors butdid not, for purely political reasons.”5Stock markets in the emerging markets have grown significantly since the early 1980s. Markets in Mexico,Philippines, and Chile grew by a factor of 30, 20, and 11 respectively between 1986 and 1993, while thecombined market capitalization of all developed markets (as defined by IFC) grew by a factor of 2 during thatperiod. Most of the increase in emerging stock markets was due to an increase in prices rather than new listings.There are some exceptional cases in emerging markets, where market capitalization measured as a percentage ofGDP is equal to or larger than that in the U.S. or Japan (see Chile, Hong Kong, Malaysia and Singapore). In mostcases, volatility in the emerging stock markets is high because of the following: (i) lack of market breadth (lowmarket capitalization, few listings); (ii) lack of transparency (low information, reporting and disclosurestandards); (iii) lack of liquidity and of frequency in trading. In addition, some markets may suffer fromspeculative bubbles were asset prices are artificially high because of price expectation, and not because of animprovement in the underlying financial fundamentals, see: Emerging Stock Markets Factbook 1996 (IFC);Robert A. Feldman and Namohan S. Kumar, Emerging Equity Markets: Growth, Benefits, and Policy Concerns(Washington DC, The World Bank Research Observer, The World Bank, August 1995) pp. 181-200.6see, Kenichi Ohmae for an interesting study of this process; Kenichi Ohmae, The End of the Nation State, TheRise of Regional Economies (New York: 1995).

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shutdown of the Australian-operated Bougainville copper mine in 1989 by secessionist rebels inPapua New Guinea armed with spears, bows and arrows (it has not been reopened since); (iii)the potential for such action by aborigines against a U.S.-operated copper mine in Irian Jaya(Indonesia); (iv) the uncertain credit culture of Chinese provinces; or, of course (v) the shutdownof the Dhabol power project by the government of the Indian state of Maharashtra in July 1995.

The long list of countries that defaulted since the beginning of the 19th century (see Table i, Part-III) demonstrates that country risk is real, heavily concentrated, and regionally correlated.Countries have defaulted against a broad spectrum of financial instruments, such as bonds, bankloans and supplier credits. Foreign exchange crises are not a thing of the past, but resulted inbond defaults as recently as 1992. In fact, the severe political and economic crisis in Bulgaria, in1996/97, has brought the country to the brink of default on its Brady bonds.

The Mexican peso crisis of December 1994, which was so costly to many investors7, would haveresulted in mega-defaults by Mexico and Argentina had it not been for the intervention by theUnited States and multilateral organizations.

In summer 1996, Latin America -- once again -- cast doubt on its willingness to honor externalobligations, when the Latin American parliament (admittedly, not a very powerful institution)asked the UN General Assembly to seek a ruling from the World Court to declare a large portionof Latin America’s debt illegal because of usury.8

SFG will excel in its foreign operations if we have the built-in capacity to anticipate and topreempt as many of these events as possible.

Historic Overview.Since the beginning of the 19th century, major sovereign defaults were concentrated in fourseparate decades (the 1820s, 1870s, 1930s, and the 1980s). In addition, there were two minordebt crises in the 1890s and around World War I, as well as one near-crisis in 1994/95. Theapparent infrequency of international debt crises is not a function of good credit culture amongsovereign nations, but rather the result of a cessation of cross-border lending for long periodsbetween crises. By the same token, each crisis was preceded by a renewed surge of cross-borderfinancing.

The 19th Century: Oops.During the 19th century, investment banking and trade finance developed as two new bankingactivities. By 1822, British investment houses were floating bonds in London on behalf of former

7These losses were caused by volatility risk. The losses were the result of a sudden depreciation of the Mexicanpeso and the crash of the local stock exchange which diminished the market value of many investments.Subsequently, the severity of the crisis led to insolvency of numerous Mexican private sectorborrowers/companies.8It is claimed that this resolution had the support of Argentine President Menem and President Cardoso ofBrazil. Latin American Weekly Report, September 5, 1996 p. 403

C. HOW IMMINENT IS TRANSFER RISK ?

7

Spanish colonies -- countries with great political instability. The terms of these bonds indeedbordered on usury. It probably came as no surprise to lenders that 13 Latin American countriesplus Greece defaulted on those bonds by the end of the 1820s. These 14 countries remained indefault for a combined 333 years, or an average duration of 23.8 years.

During the 1860s and 1870s, there was a second wave of bond issuance’s of “developing”countries, floated mainly in the London and Paris markets. Lending was indiscriminate and asL.H. Jenks remarked in 1927 “any country which claimed sovereignty over a bit of the earth’ssurface and a fraction of its inhabitants could find a financial agent in London and purchasers forbonds”9. Irresponsible fiscal behavior in the unstable political environment of the borrowingcountries triggered 13 defaults by the end of the 1870s. Ten of the 13 countries were in LatinAmerica, six of them had defaulted 40 years earlier. All countries remained in default for acombined 172 years, or an average duration of 13.2 years.

The 20th Century: More of the Same.During the 1920s, broadly-held bonds were the only vehicle available for cross-border financing.Therefore, governments of creditor countries showed little interest in resolving the crisis thaterupted in the 1930s. Some 27 countries defaulted between 1928 and 1939, six of them twice.Sixteen countries were in Latin America, 9 in Europe, and one each in Asia and Africa. Allcountries remained in default for a combined 305 years, or an average duration of 11.3 years. By1937, 70% of all sovereign debt issued in the U.S. between 1926 and 1937 had been defaultedon. This compares to a default rate of “only” 30% of U.S. corporate debt issued during the sametime period.10

The lending-boom of the 1970s was spearheaded by commercial banks. Therefore, the heart ofthe economies of creditor countries, i.e. the solvency of their financial systems, was at stakewhen emerging markets defaulted during the 1980s. U.S. government intervention wasindispensable and forthcoming while not necessarily expeditious. During the 1980s, 45 countriesdefaulted, 7 more than once. Twenty countries were in Africa, 18 in Latin America, three inEastern Europe, two in Asia and two in the Middle East. All countries remained in default for acombined 360 years, or an average duration of 8 years.

Finally, during 1989 to 1994, the surge of new capital flows to emerging markets waspredominantly in equity investments. Countries with a successful history of economicliberalization experienced large inflows of non-debt creating foreign direct investments. Others -- almost irrespective of their economic performance -- were flooded with portfolio investments.Thus, the 1994 Mexican peso-crisis had an immediate affect on the performance and viability ofU.S. mutual funds, pension funds and life insurances. Multilateral and U.S. government aid wasswift and generous to avoid serious ripple effects.

Approaching the 21st Century: More to Come.

9quoted in: Marylin J. Seiber, International Borrowing by Developing Countries (New York: Pergamon Press,1982) p. 2110Richard Cantor and Frank Packer, “Sovereign Credit Ratings” in: Current Issues in Economics and Finance(New York: The Federal Reserve Bank of New York, June 1995) p. 2

8

Portfolio investments are often described -- even prior to the Mexico crisis -- as hot money,because they are highly sensitive to interest-rate movements in the United States and to interest-rate differentials.11 In 1994, rising rates in the U.S. may have contributed to a loss in internationalreserves of over $20 billion in Mexico as well as a net-outflow from emerging-market mutualfunds.12

Free movement of capital and the advance of technology limit the choice and effectiveness ofpolicy tools available to governments in emerging markets to steer the magnitude and suddennessof in- and outflows of capital. This policy predicament for emerging markets could be comparedto a hypothetical situation of mutually exclusive policy objectives, in which the U.S. were forcedby the United Nations to abolish all border controls and simultaneously attempted to stem theflow of immigration.

When the push and pull for capital inflows is excessive, this may lead to an undesirableappreciation of local exchange rates. Subsequently, it makes countries vulnerable to shocks.Abrupt outflows of portfolio investments and other short-term funding from a country, forexample, create a phenomenon similar to a run on a bank. 13 We should expect a series of suchlocalized liquidity crises in emerging market countries over the next decade.

11This causality is supported by historic evidence. It is further corroborated by various research papers, see:Guillermo Calvo, Leonardo Leiderman and Carmen M Reinhardt, “Capital Inflows and Real Exchange RateAppreciation in Latin America” (Washington, DC: International Monetary Fund, Staff Papers Vol. 40, March1993) pp. 108-151. The authors maintain that the renewal of capital flows to Latin America in the early 1990swas partly the result of falling interest rates in the U.S. and that the reversal of those conditions could lead tofuture capital outflows, ibid. p. 108-109. Of course, that did occur in the case of Mexico in 1994; Punam Chuhan,Stijn Claessens and Nlandu Mamingi, “Equity and Bond Flows to Asia and Latin America” (Washington DC:Policy Research Working Papers, The World Bank, July 1993). The authors point at econometric evidence thatsuggests that about half of the increase in capital flows to Latin America during 1989-92 can be explained by adrop in U.S. interest rates and the slowdown of U.S. economic activity. The authors also claim that capital flowsto Asia are less affected by such global factors and that country-specific factors are three to four times moreimportant in Asia. Finally, the authors found evidence that equity flows are more sensitive to U.S. interest ratesand U.S. industrial activity than bond flows. p. 3-4; Eduardo Fernandez-Arias “The New Wave of Private CapitalFlows: Push or Pull?” (Washington DC: Policy Research Working Paper, The World Bank, June 1994). Theauthor also establishes the link between falling interest rates in the U.S. and the surge of capital inflows in theemerging markets during the early 1990s. He also suggests that these capital inflows would be unsustainable ifglobal interest rates were to return to higher levels. However, he feels that a gradual increase in those rates willresult in lower inflows or to moderate outflows of capital from the emerging markets, rather than sudden andmassive outflows that would destabilize the capital accounts of those countries. p. 35-36. One might argue that hewas disproved in the latter by the Mexican situation.12see, Helmut Reisen, “The Management of Capital Flows: Lessons from Latin America and Asia” in: SecuringStability and Growth in Latin America (OECD 1996) p. 17813It should be noted at this point that the IMF has commented on the difficulty to distinguish between short- andlong-term capital in measuring volatility, see: Peter Clark, Leonardo Bartolini, Tamim Bayoumi, and StevenSymansky, “Exchange Rates and Economic Fundamentals: A Framework for Analysis” (Washington DC,International Monetary Fund, Occasional Paper 115, 1994). “An alternative approach is ... to differentiatebetween persistent transfers of long-term capital and more reversible short-term funds. The long-term flows aretaken to ... be sustainable over time, while the short-term capital transactions are taken as volatile flows that aretransitory and reversible. In practice, however, it is difficult to differentiate these flows. The reason is that thisdistinction lies in the motives of the investor, which are imperfectly correlated with any objective characteristics.”p.14

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The potential for such crisis, for example, rose measurably during the last few years in Thailand,one of the most creditworthy countries of the emerging markets. Between 1990 and 1995,Thailand experienced a considerable build-up of foreign-currency short-term debt -- especially inthe banking sector (Thailand’s public sector has been running surpluses for several years). Thisinflow was partly generated by investment opportunities in Thailand, but largely stimulated bybanks who took advantage of the existing spread between local and international interest rates,to borrow abroad and to on-lend in Thailand with considerable margins.

Thus, by yearend 1995, Thailand’s foreign-currency short-term debt had risen to $44 billion or51.2% of the total debt stock, up from $9.9 billion or 33.8% of total debt in 1990. This increasedexposure to short-term debt heightened the vulnerability of the country to sudden external orinternal shocks, such as rising interest rates in the United States or a crisis of government inThailand -- such as a coup -- that could undermine investors’ confidence and might lead to areversal or curtailment of these flows. A shortfall in capital inflows -- under such circumstances -- would then require an immediate reduction in domestic absorption, most probably through cutsin investments leading to declining economic growth.

In 1996, the Thai government responded to this situation with tighter fiscal and monetarypolicies and with disincentives for foreign borrowing. As a result, economic growth slowedconsiderably, which exposed weaknesses in the property and financial services sectors of thecountry. The Moody’s downgrade of Thailand’s short-term rating in September of 1996 was,therefore, quickly followed by a downgrade of the country’s long-term credit rating in April1997.

The Thai case disproves the often-held view that foreign exchange crises can only be caused bypoor public sector management.14 It is conceptually irrelevant whether the foreign exchangerequirements of a country are a reflection of excessive public or private sector borrowing.15 Infact, during the resolution of the 1980s debt crisis, governments of many borrowing countriesassumed all external debt of their private sectors in order to arrive at comprehensive settlementswith their creditors. This assumption of debt was also an official recognition of transfer risk assystem risk.

Lessons from History.In comparing the debt crises of the 1930s and the 1980s with the near-crisis of 1994/1995 (seeTable iii, Part-III), we find some stunning similarities: (i) Each crisis was preceded by a lengthylending-boom. (ii) During lending-booms investors were seeking higher yields in emergingmarkets because of a low-interest rate environment in the U.S. (iii) Each lending-boom washeaded by a new set of inexperienced market participants, from capital markets to loan

14Although this is historically how it has happened, simply because of the traditionally dominant role of the statein many economies.15Moreover, while governments can control their own destiny through fiscal prudence, they have a limited rangeof policy tools to restrain the appetite of the private sector for borrowing abroad in a world without capitalcontrols.

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syndications to institutional investors.16 (iv) In each lending-boom investors disregardedexposure risks. (v) Each lending-bust was triggered by a sudden rise in U.S. interest rates andpoor economic fundamentals in the borrowing countries to sustain this shock. (vi) In eachlending-bust investors claimed insufficient information.

This leads us to two conclusions: First, the myth of the greedy investor is dead. The behavior oflarge investors seems driven largely by an implied and relatively inelastic target-return on theiroverall portfolio. They invest in emerging markets only when and if low rates in the domesticmarket do not allow for that overall return. However, their risk aversiveness leads them to exitemerging markets as soon as they are able to meet the target at home, although they could bettertheir investment performance by staying in the emerging markets during times of U.S. rateincreases (under this assumption interest rates in the emerging markets would rise at the sameclip as in the U.S. Thus, the spread between rates would remain the same, but the overall returnwould be higher -- ceteris paribus).

This approach to portfolio management by institutional investors is both logical and flawed. Ifthe implied target return on investments during a “normal” interest-rate environment in theUnited States fairly represents the risk appetite of the investor, then it follows that a shift of theportfolio to cross-border transactions to meet that target rate during a low-interest rateenvironment in the U.S., raises the risk profile of the portfolio without raising the targeted return(everything else being equal). At that point, the portfolio composition exceeds the natural riskappetite of the investor.17

The second conclusion is: The fiction of capital markets that are perpetually open to refinancing,has been thoroughly discredited by reality. All markets were essentially closed to Latin Americaduring the 1980s, and Mexico had virtually no market access in late 1994 to refinance itstesobonos.

There are many private sector borrowers, especially in emerging markets, that -- on a stand alonebasis -- have greater financial strength than their governments. Yet, in almost all cases, thecreditworthiness of a private sector entity in foreign-currency obligations is constrained by therisk-level that is assumed for the country as a whole.18 That is so, because in times of economicdistress and foreign exchange shortage or for any arbitrary reason, it is within the sovereigncontrol of any government to ration the available foreign exchange through such means asregulations of foreign-exchange deposits, foreign-exchange controls, or even through suchdrastic measures as expropriation. In other words, transfer risk is system risk.

16 The Institute of International Finance stated on September 12, 1996: ”Competitive pressures and market trendscan sometimes drive flows, especially as new market entrants with little experience in high risks are attracted tohigh yields.”17S.R. Ghosh disagrees, see S.R. Ghosh, “Reverse Linkages - The Effects of Developing Countries on IndustrialCountries: A Conceptual Framework” (unpublished, World Bank, International Economics Department, 1995)18This is often referred to as the “sovereign ceiling” by the rating agencies.

D. HOW DOES TRANSER RISK AFFECT THE PRIVATE SECTOR?

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Forex Controls and the Private Sector: The Experience.There is a slew of cases in which the abstract transfer risk has resulted in actual losses for privatesector agents. Some of these cases have been tried in U.S. courts. 19

In 1982, Mexico implemented foreign-exchange controls forcing domestic banks to redeemoutstanding dollar-denominated CDs to residents and non-residents in pesos rather than dollarsand at an officially determined rate. This forced conversion represents a default on the originalobligation (see Callejo v. Bancomer, and Braka v. Bancomer).

In 1983, a Citibank branch in Manila refused to remit foreign exchange for repayment ofprincipal on all foreign-currency obligations because of foreign-exchange controls by thePhilippine Central Bank that prohibited such remittance (see Wells Fargo v. Citibank).

In 1982, the Argentine Central Bank was unable to deliver U.S. dollars to Argentine borrowerswho had obligations in that currency. In lieu of hard-currency payments, foreign creditors weregiven the option to accept bonds and promissory notes issued by the Central Bank (so-calledbonods) maturing in 1986 and 1987. In 1986, the Central Bank defaulted on these bonds (seeWeltover v. Republic of Argentina).

In 1985, Peru’s President, Alan García, limited all debt-service payments of the country (privateand public sector) to 10% of export receipts. In 1986, he decreed that foreign companies couldnot repatriate profits for two years.

The foreign exchange crisis in Venezuela and the implementation of forex controls at the end ofJune 1994 led to a one-month disruption of all foreign-exchange transactions betweenVenezuelan borrowers (other than PdVSA) and their creditors. This disruption caused a numberof defaults, among them the local telephone company CANTV -- majority-owned by the privatesector (and 40%-owned by a GTE-led syndicate). In August 1995, CANTV restructured $525million of its $1 billion debt, only to be on the brink of default again three months later, becauseprocessing of forex requests by the Venezuelan government was slow.

In an ironic and frivolous twist, a Venezuelan congressional commission, headed by the VicePresident of the Chamber of Deputies, was reported to have come to New York in earlySeptember of 1996 to investigate its claims that at least $15 billion of Venezuela’s rescheduled$27 billion in commercial bank debt had been transferred from the private to the public sector inviolation of the Venezuelan constitution, various public credit and public finance laws, and U.S.antitrust laws. The commission is allegedly preparing a court case against Chase Manhattan,which presided over the debt negotiations with Venezuela during the 1980s as the chair of thesteering committee of commercial banks.20

In October 1996, the economic outlook for Thailand had deteriorated and the government wasunder political pressure that led to a call for new elections. Meanwhile, the Thai stock market fell

19Mostly, however, without success, since the courts either applied the Foreign Sovereign Immunities Act or theAct of State Doctrine.20Latin American Weekly Report, September 5, 1996, p.403

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by 6%. The Thai government considered -- and ultimately rejected -- an idea of introducingmeasures aimed at temporarily preventing foreign investors from selling shares.21

These examples underline the clear link that exists between the public and the private sector incross-border transactions.

Expropriations: Will it Happen Again?During the lending-booms of the 1920s, 1970s and early 1990s, the chief vehicles of fundingchanged from bonds to syndicated loans to portfolio investments. The tremendous growth ofproject financing during the last few years has already led some observers to describe the secondhalf of the 1990s as the beginning of “The decade of the Big Deal”22. The funding frenzy at theend of the 20th century includes a broad range of instruments -- including direct investments.23

The topic of expropriation, which is a transfer risk in our definition, maybe obsolete in today’sworld without ideological conflict. Looking back, the history of foreign ownership during thepost-World War II period can be broken down into four eras: (i) 1945-1966: Multinationalcompanies are on the go. (ii) 1967-1977: Nationalist backlashes and the height of expropriations;(iii) 1978-1983: Receding hostilities; and (iv) 1984-1996: The age of privatization and the questfor foreign capital.

Between 1960 and 1985, there were 598 separate acts of expropriation of foreign owners, 62%of them were concentrated in 28 different countries affecting 1,404 different firms (see Table iv,Part-III).24 Most expropriations took place in Africa, but there were also 13 countries in theMiddle East, Latin America and Asia that nationalized foreign companies. The majority ofcountries had relatively recent experiences with colonialism and their strategic industries wereoften owned by foreigners. This relationship was the main cause for rising nationalism in thosecountries that culminated in massive expropriations. Soon, few assets were held by foreigners

21Financial Times, October 9, 1996.22Financial Times, September 13, 1996. Worldwide, FDI has risen from $222 billion in 1994 to $325 billion in1995. FDI inflows to the emerging markets increased from $80 billion in 1994 to $97 billion in 1995. in:Financial Flows and the Developing Countries (A World Bank Quarterly, August 1996). Recent estimatessuggest that infrastructure projects in Latin America will require $50 billion annually of financing for theremainder of the decade. Similarly, the World Bank expects Asia’s needs to stand at approximately $150 billionper year.23Helmut Reisen points out in his article that FDI rose from 15% of gross capital flows each to Latin America andAsia during 1978-82 to 33.5% and 37.1%, respectively during 1990-93. But he also notes some fundamentaldifferences. FDI in Latin America was overwhelmingly the result of debt/equity swaps and privatizations, while itlargely amounted to the acquisition of or setting up of new enterprises in Asia. The former is less likely togenerate additional investments than the latter, and the latter is more likely to be skewed towards exportproduction than the former. Portfolio investments in Latin America during the 1990-93 period came to 68.1% ofgross capital inflows, compared to only 14.2% in Asia. However, 3/4 of portfolio investments in Latin Americawere borrowings in international capital markets, only 1/4 was equity-related. See, Helmut Reisen, “TheManagement of Capital Flows: Lessons from Latin America and Asia” in: Securing Stability and Growth in LatinAmerica (OECD 1996)24Charles R. Kennedy, Jr. “Relations between transnational corporations and Governments of host countries: alook to the future” in: Transnational Corporations, vol.1, no. 1 (February 1992) pp. 67-91.

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which -- at least in part -- explains why there was an ebbing of nationalizations during 1978-1983. The nationalized assets were largely transferred to the state.

In more recent years, the tide has turned and many state enterprises in the emerging markets havecome on the international auction block. One might, therefore, conclude that the world has beencured of the scourge of expropriation. Two words of caution: (i) Only death is irreversible; (ii)The growing foreign ownership of vital industries, the banking sector and natural resources is notwithout controversy in the developing countries, and might at some point -- especially during aprolonged economic downturn -- lead to a backlash and xenophobic behavior that could promotea reversal of ownership.25

Déjà Vu -- All Over Again?Direct investors are a relatively new, and inexperienced breed in cross-border transactions oftoday’s magnitude. Competition among investors’ consortia is heating up, and quickly words ofcaution are brushed aside. This time -- so the story goes -- it will be different. It can be for thosewho optimize their return and minimize their risk.

It is important, then, to assess the potential benefit that the company may reap from the proposedinvestment guidelines and the devised ensemble of exposure limits (see below). For this purpose,we simulated a SFG cross-border portfolio with a face value of $1 billion in a selected group ofcountries using our guidelines and subsequently (and retroactively) assessed the trading value ofthat book by using secondary market prices for bank loans in 1989. Then, we compared theperformance of the SFG portfolio with the actual performance of a $1 billion portfolio ofcommercial banks.

The 1989 scenario was chosen because it represented the height of the debt crisis of the 1980’s(stress scenario). For simplicity, it was also assumed that SFG cross-border investments were tobe exclusively in debt instruments. The trading values of the portfolios were determined by using

25As a matter of fact, this reaction is not unique to emerging markets. During the election campaign in NewZealand in October 1996, Mr. Winston Peters, the leader of a small, but increasingly influential party, broadlyattacked foreign ownership of the country’s airline, its banks, its forests, and foreign control over the telephonesystem and the railroad. “We were” , he was quoted, “a great country once, when we owned it all ourselves”.The Wall Street Journal, October 9, 1996. His message was attractive enough to harvest 13% of the vote in theOctober elections against the background of an extraordinarily successful government policy of opening theeconomy which had returned the country to strong economic growth. Mr. Peters’s party is now a coalition partnerin the new government. Mr. Peters himself is Treasurer and Deputy Prime Minister. There have also beennumerous dire outlooks on America’s economic future with differing degrees of xenophobia: S. Schlosstein, TheEnd of the American Century (New York, 1989), Donald L. Barlett and James B. Steele, America: What WentWrong? (Kansas City, 1992), D. Calleo, Beyond American Hegemony (New York, 1987), and R. Rosecrance(ed.), America as an Ordinary Power (Ithaca, N.Y., 1976). Finally, in 1968, French publicist and politician Jean-Jacques Servan-Schreiber wrote his famous book “The American Challenge”, in which he predicted -- incorrectly-- that there would be three economic superpowers by the middle of the 1980s: The U.S., the USSR, and U.S.companies in Europe.

E. SIMULATED CASE STUDY

14

secondary market prices for bank loans.26 Finally, the composition of our country sample wasentirely driven by data availability for the prices of these instruments.

The SFG portfolio was simulated by assuming the maximum exposure limit for each country inthe sample based on our preliminary ratings assigned to these countries. Of course, using 1997ratings introduces an unavoidable element of hindsight to our 1989 simulation. On the otherhand, we allowed no discretion for portfolio composition. By meeting all individual countrylimits, however, we were in breach of some of the aggregate exposure limits for combined riskclasses. Therefore, we had to reduce each country’s exposure by the percentage by which eachcombined risk group exceeded its limits. The result represented a SFG portfolio in accordancewith all guidelines (Table 1).

Table 1Stress Scenario: 1989 (Peak of Debt Crisis)

The result of the above simulation can be summarized as follows:

(i) The value of the commercial bank portfolio of $1 billion at par was equal to only $289million at the peak of the debt crisis in 1989. Commercial banks did not invest evenly in all 12

26 The impact of asset deterioration on the balance sheets of commercial banks was difficult to measure, until asecondary market for bank loans developed in the mid-1980s. The market served a multiple purpose. (i) it allowedbanks to restructure their existing portfolios, for example, by reducing specific country concentrations. (ii) somebanks, particularly the smaller ones, decided to cut their losses. They sold their entire portfolios of internationaltransactions to larger banks, because they had neither time, nor expertise, nor resources to endure the protracteddebt-workout. (iii) some banks saw arbitrage potential in the secondary market by actively trading bank loans. (iv)the secondary-market price for a country’s outstanding bank loans became a market measure for that country’scredit risk. In the 1980s, few emerging countries had credit ratings from Moody’s or Standard & Poors, becausethese ratings were attached exclusively to bond issuances, and few emerging markets had had access tointernational capital markets since the disastrous bond defaults of the 1930s. In 1989, secondary-market prices foremerging market bank loans reached an all-time low. At the time, the crisis had lasted already seven years.Several attempts to resolve it had failed, such as the so-called Baker Plan, named after the former U.S. Secretaryof the Treasury. Also, the economic conditions had worsened in many emerging markets.

Country SecondaryMarket Prices

for Bank LoansPer US$ 1

CommercialBank Portfolio

at Par(US$ MM)

Commercial BankPortfolio at

Market(US$ MM)

SimulatedSFG Portfolio

at Par (US$ MM)

Simulated SFGPortfolio at

Market(US$ MM)

Colombia 0.594 17.6 10.4 230.8 137.1Philippines 0.474 41.2 19.5 230.8 109.4Uruguay 0.558 8.9 5.0 125.6 70.1Mexico 0.398 264.2 105.2 125.6 50.0Venezuela 0.372 96.2 35.8 107.7 40.1Brazil 0.303 246.5 74.7 53.8 16.3Argentina 0.162 127.0 20.6 35.9 5.8Costa Rica 0.151 6.2 0.9 35.9 5.4Ecuador 0.140 23.2 3.2 18.0 2.5Bolivia 0.111 4.1 0.4 18.0 2.0Peru 0.048 136.1 6.5 18.0 0.8Nigeria 0.240 28.8 6.5 0.0 0.0Average Value 0.296Portfolio Value 1,000.0 289.2 1,000.0 439.5

15

countries, but had disproportionately high investments in countries whose debt had asecondary market value below the simple average. Commercial banks had disregarded creditfundamentals.

(ii) The value of a SFG portfolio, would also have been severely impaired in 1989, with SFG

assets at a trading value of $439.5 million. This condition could only have been avoided --prior to the crisis -- by refraining from investments in emerging markets all together.

(iii) However, a simulated SFG portfolio would have clearly outperformed the commercial

banks’ by nearly 52% in 1989, using the proposed guidelines and assuming 1997 creditratings. SFG would have invested less in less creditworthy countries (with low secondarymarket prices for their bank debt) due to our exposure limits, and we would have protectedour portfolio from over-concentration in a set of countries with low credit ratings because ofthe aggregate exposure limits for combined risk categories.

The above can be summarized as follows: SFG has decided to increase its cross-border businessto take advantage of growing opportunities abroad. Country risk is real, imminent, and applicableto SFG. It has historic precedent and it affects all investors, whether in equity or debt, whether inthe private sector or in the public sector. The two-sigma performance of the World Bank will beunacceptable to any GE Capital unit. Country risk assessment and management will enhance theperformance of SFG. This enhanced performance can be quantified in dollars and cents throughsimulation.

Investment guidelines (Part-IV) provide a manual to SFG in its management of cross-bordertransactions in order to minimize the risk of these activities and to optimize the company’s returnon its investments. The main building blocks of these guidelines are:

• An aggregate cross-border exposure limit for SFG.• A methodology to assess and to rate specific country risk.• A rating scale.• Specific exposure limits for individual and combined country risk categories.• Process.

How to arrive at the limit for aggregate cross-border exposure ?GECC is the largest diversified noncaptive finance company in the U.S. Therefore, it seems mostappropriate to design investment guidelines for SFG that recognize the company’s role as asegment of the financial services industry, while keeping in mind that it is an integral part of theGE-family.

A comprehensive study of the U.S. commercial banking sector gave useful insights in the degreeof cross-border risk, that this sector is willing to accept. The capital/assets relationship at the

F. THE GUIDELINES

16

seven money center banks and at the 10 next largest banks is very similar to that of SFG, whichsupports the comparison (total capital amounted to 7.7% of total assets for the money centerbanks, stood at 9.6% for the 10 next largest banks at year-end 1995 and was 8.4% for SFG atyear-end 1996.).

It is, therefore, recommended that SFG -- not unlike most commercial banks -- adopt an overalldollar limit for all cross-border exposure. This limit should be set annually and it will bedetermined by relating cross-border transactions to the company’s capital base. At the end of1995, actual exposures to cross-border transactions amounted to 260% of capital for the sevenmoney center banks and to 96% of capital for the 10 next largest banks (the limits are likely to behigher, but they are strictly confidential; also bank exposures are measured as a percentage overtheir entire capital base, while the proposed SFG exposures are measured as a percentage as ofSFG capital only).

On a stand-alone basis, it seems prudent that SFG’s aggregate cross-border exposure should belimited to 150-200% of its capital (exposure is defined as commitments plus outstandings).However, SFG has the mandate to undertake a disproportionate share of GECC’s internationalbusiness. Therefore, it is proposed that SFG be also allotted a disproportionate aggregateexposure limit of cross-border transactions equal to 400% of its own capital. Such limit wouldamount to only 23% of capital of GECC (of course there are cross-border exposures of otherbusiness units of GECC). The exposure -- well diversified -- would protect the company’s equitywhile allowing for an aggressive overall growth strategy. This overall limit of cross-borderexposure also takes into account the Aaa-ratings of GECC and GE as the lenders of last resort toSFG.

Country Exposure Limits.Table 2 shows, how the U.S. money center banks have drastically reduced cross-borderexposures to some of the emerging markets since the early 1980s (they have also raised theircapital base dramatically since then). This is in response to the debt crisis and the subsequentdefault of 45 countries, and it supports a judicious approach to country exposure in emergingmarkets.

17

* Gordon W. Smith, John T. Cuddington, International Debt and the Developing Countries(Washington DC: The World Bank: 1985) p.131

** Federal Financial Institutions Examination Council, Statistical Release, April 1996; Moody’sInvestors Service.

It is, therefore, recommended that SFG adopt dollar limits for individual country exposures.These limits will be set and revised every six months. The limits are determined by: (i) assessingand rating a country’s credit risk (the grade will be translated into a country exposure limit equalto a certain percentage of SFG’s capital) and (ii) its market potential. In case of a downwardrevision of a country’s credit rating, SFG management will develop a plan to sell down thecompany’s investments in that country in order to stay within the limits of the lower ratingcategory.

In this context, the question had to be answered, whether the limits should be designed todistinguish between various investment vehicles, such as debt and equity.

After careful consideration, this idea was rejected for the following reasons: 1) Simplicity. Thesetting of country limits adds a new element to overall credit analysis. Consistent application ofthese limits could be complicated by a multi-layer system. 2) Country risk analysis -- as we defineit -- primarily assesses the likelihood of a transfer risk to occur. Should the risk materialize, allinvestments are theoretically affected. The difference between equity, quasi-equity, bonds, loansand other instruments is likely to be relevant in the mop-up operations of a transfer risk crisis.

The Rating MethodologyIn designing the methodology for SFG’s country risk assessment (Appendices A and D), theissue arose whether SFG should follow a qualitative approach, a quantitative approach, or ascoring system. It was concluded that any country risk assessment needs quantitative analysis,i.e. it needs to collect historic and current data. For this purpose, SFG will establish its own database, because the comparative nature of ratings demands a consistent approach to the datacollected. The evaluation of existing data and information is a qualitative process that isnecessary to make medium-term forecasts and to design risk scenarios.In order to sort the results of the analysis and to allow for inter-country comparability, the end-product of this comprehensive analysis must be converted into a grading (i.e. scoring) system. It

Country June 30, 1981* Dec. 31, 1995**

Argentina 20.6 8.7Brazil 45.5 15.1Chile 12.2 4.8Korea, Rep. of 18.8 11.4Mexico 50.2 14.5Philippines 13.6 2.4Total 160.9 56.9

Table 2Cross-border Exposure of Money Center Banks

as a Percentage of Total Capital

18

is, therefore, a question of presentation not of approach, whether scoring is undertaken at eachstep of the quantitative/qualitative process and channeled into a single rating at the end, orwhether a final rating (or scoring) implicitly incorporates the evaluation of the individualcomponents. It is recommended that SFG adopt the former approach, because it provides moresimplified as well as user-friendly information.

There are five major areas that are universally accepted as determining a country’s transfer risk.Greatest weight (30%) is given to the external economy. Generating foreign exchangedetermines a country’s capacity to pay its bills to non-residents. Of course, the external sectorwill thrive only, if the country has a well-balanced domestic economy and makes adequate use ofpolicy tools (fiscal and monetary policies primarily). Therefore, the second greatest weight isgiven to this category (25%).

Political and social stability allows for consistent policy-making that leads to a favorableenvironment for the domestic and the external economy. A combined 20% weight is anappropriate recognition of these elements. A lagging indicator of transfer risk is the indebtednessof a country (assigned weight 15%). Inconsistent policy-making and the resulting imbalances inthe internal and the external economy of a country lead to increased borrowing and a rising stockof debt, mortgaging the developmental future of the country.

Finally, there are exogenous factors, which are beyond a country’s control and which may affectits credit risk. Therefore, this last risk category was assigned a weight of 10%. For example, theliberalization of capital flows and technological progress have increased the ability of capital tomove quickly in the pursuit of higher yield. An increase in international interest rates has animmediate effect on the level of capital flows to emerging (inherently riskier) markets. It exposesthe vulnerability of those economies in the emerging markets that have the greatest dependenceon the inflow of “hot money”.

The Rating Scale.The proposed SFG rating scale consists of 16 rating categories from GE/I+ (the lowest risk) toGE/VI (the highest risk). It was felt that 16 categories allow for sufficient differentiation of creditrisk, an assumption that is broadly shared by all credit rating agencies. This scale differs,however, from a Moody’s or S&P scale in two ways: 1) It is more compressed at the top,eliminating one rating category. Risk distinctions at the top are so small that a compressed scaleseemed more efficient. 2) The GE-scale is also more compressed at the bottom, because it wasfelt that there was a certain cut-off point, below which SFG investments were just not advisable(countries in default or on the brink of default). Rating agencies find it useful to distinguishbetween the severity of default of different issuers.

As a next step, an exposure limit is assigned to each rating category. These limits are expressedas a percentage of total capital, because equity is the last cushion to absorb a potential shock.The relationship between exposure and capital manifests the capability of the company towithstand a risk event, if it comes to pass. The limit is then translated into US dollars.

19

Clearly, determining the exposure limits is not an exact science, largely because the methodologyof determining the risks is based on analytical judgment. The functionality of the scale as well asthe exposure limits must be monitored continuously and periodic status reports should beprepared to allow for improvements -- where necessary.

However, the proposed limits are good guidelines to direct business and they are based on thefollowing: First, default risk is not linear. The graph below shows the average cumulated defaultrate of corporate issuers over a 15-year period on securities rated by Moody’s by ratingcategories (there is no separate analysis for sovereign defaults, largely because of the small sizeof the sample and the limited time period during which countries have launched bonds).

The bar chart demonstrates that the occurrence of default rises disproportionately as ratingsattached to the issuers decline. This observation was taken into consideration in proposing ourexposure limits. The line graph represents our proposed exposure limits by rating category. Itsslope is roughly the inverse of observed historical defaults (a greater correlation may exist, butdefault studies by Moody’s combine individual rating categories).

The higher the risk, and, in fact, historical occurrence of default, the lower is the proposedexposure limit. Risk in higher-rated categories is small and the distinction between the highly-rated categories is also less significant (our scale allows for a range of 30 percentage points inexposure limits for the top 7 categories). The risk of countries rated in categories below GE/III-rises disproportionately, and the distinctions between certain categories also widen (our scaleallows for a range of 40 percentage points in exposure limits for the lowest 7 categories).

Second, a reality check was made by comparing the proposed exposure limits to actualcommercial bank exposures, especially, in emerging markets (table 2 page 17). The data showthat the proposed exposure limits are quite similar to actual exposures of the seven money centerbanks for countries with the lowest ratings, in this case Brazil and Argentina. Generally, theproposed exposure limits for countries with a better credit rating are more generous than theactual exposures of the seven banks in those countries.

0

1 0

2 0

3 0

4 0

5 0

Aaa Aa A

Baa Ba B

Moody's Ratings

Def

ault

Rat

es(%

)

0

2 0

4 0

6 0

8 0

1 0 0

Our Proposed Rating Scale

SF

G E

xpos

ure

Lim

its(%

)

1 5 Y e a r D e f a u l t R a t e s ( % )

E xpo s u re Lim its (%)

Moody’s Historical Defaults & SFG Exposure Limits

20

This seems to lend support to the proposed distribution of exposure limits, because we areprotected at downside of the scale (according to commercial bank criteria). On the higher end ofthe scale, the argument is inconclusive.

Third, it was also taken into consideration that SFG has a wider range of investment instrumentsat its disposal than a commercial bank, and that it is part of the GE-system with recourse to GECapital and GE.

Table 3 Proposed Exposure Limits Per Rating Category

In order to protect its portfolio from an imprudent concentration of investments in countries withlow credit-worthiness, it is also proposed that SFG adopt the following aggregate exposurelimits for combined risk classes (table 4):

Table 4Aggregate Limits by Combined Risk Classes

Rating Exposure Limitsas % of SFG Equity

(as of 12/31/96)

Exposure Limits*(US$ millions)

GE/I+ 100% $678.8 millionGE/I 100% $678.8 millionGE/I- 95% $644.8 millionGE/II+ 90% $610.9 millionGE/II 85% $576.9 millionGE/II- 80% $543.0 millionGE/III+ 70% $475.1 millionGE/III 65% $441.2 millionGE/III- 60% $407.2 millionGE/IV+ 40% $271.5 millionGE/IV 35% $237.5 millionGE/IV- 30% $203.6 millionGE/V+ 15% $101.8 millionGE/V 10% $67.8 millionGE/V- 5% $33.9 millionGE/VI 0% $0.0 million

Cumulative Limit

GE/IV- and Below 80%GE/IV and Below 140%GE/IV+ and Below 200%GE/III- and Below 300%

21

As a result of these limits, cross-border transactions in speculative-grade countries shouldamount to no more than 200% of the company’s capital. This compares to actual exposures tospeculative grade countries of 80% of total capital observed at the seven money center banks atthe end of 1995 (important: their cumulative exposure limits are likely to be higher, these areactual numbers). This less restrictive limit for SFG is justified by the company’s role withinGECC.

Finally, SFG should also protect its cross-border portfolio by setting aggregate maximum limits(as a percentage of capital) by geographic region (table 5). The following breakdown isproposed:

Table 5Aggregate Limits by Geographic Region

Asia’s limit is the highest, because its creditworthiness is markedly above that of any othergeographic region in the emerging markets. There are a number of successful economies, such asKorea, Malaysia, Singapore, and Thailand in this group. At the same time, the observed orassumed correlation between an economic dislocation in one country and a disruption in another(contagion effect) is much smaller in Asia than in any other region of the emerging markets.

Latin America and Eastern Europe rank about the same. They both have few outstandingperformers (Chile and Colombia in Latin America and the Czech Republic and Slovenia inEastern Europe), but they also have a considerable number of mediocre and some especially poorcredits.

The contagion effect is significant in Latin America (this certainly was the case in 1982, a lot lessso in 1994; however, Argentina would not have been in its predicament without the near-defaultof Mexico and a subsequent drying-up of capital flows to Latin America). The very recentemergence of Eastern Europe as market participants does not allow for a conclusive opinion on apossible contagion effect. Latin America and Eastern Europe are more exposed to unfavorableexternal conditions (such as a high interest rate environment in the U.S.), because of theirrelatively higher dependence on hot money.

Finally, there is little credit experience in the last two regions and overall creditworthiness is low,suggesting greater caution.

Region LimitsAsia 120%Latin America 120%Eastern Europe 120%Middle East/N. Africa 80%Africa 40%

22

The Process.Finally, the guidelines propose procedures that should be adopted. These procedures include theestablishment of a Country Risk Committee (CRC), and a Country Risk Unit (CRU). TheProcess Map below describes the interactions of the various decision makers in the organization.

The Process MapThe Process Map

Country Risk Unit

• Collects Data

• Assesses Risk

• Monitors Exposure

Country Risk Unit

• Collects Data

• Assesses Risk

• Monitors Exposure

• CEO GECC

• President GECC

• EVP Risk Management & Credit Policy

• Any Other Person Designated By CEO

• CEO GECC

• President GECC

• EVP Risk Management & Credit Policy

• Any Other Person Designated By CEO

The BoardThe Board

StaffStaff

Proposes Annual Aggregate Exposure Limits

Proposes & Reviews On 6 Month Cycle Ratings& Exposure Limits For Individual Countries

Subm

its For A

pprovalIndividual C

ountry Ratings

& E

xposure Limits

Subm

its For A

pprovalA

nnual Aggregate Lim

it

Informs & Reviews Adopted Country Ratings & Limits

Submits For Final Approval Aggregate Exposure Limit

Disseminates Decisions

Country Risk Committee• CEO SFG

• Chief Financial Officer

• Chief Credit Officer

• Managing Director Global AssetManagement

• Managing Director Country Risk

• Person(s) designated by CEO ofSFG

Country Risk Committee• CEO SFG

• Chief Financial Officer

• Chief Credit Officer

• Managing Director Global AssetManagement

• Managing Director Country Risk

• Person(s) designated by CEO ofSFG

23

III. TABLES(End of Document)

24

1.1. The purpose of this policy is to establish a framework for country risk management.

1.2. SFG Management is directed to establish a continuous country risk review process thatenables the company to manage its risk exposure to countries and to groups of countriesprudently.

1.3. A Country Risk Committee (CRC) shall be established. The CRC shall assess country riskfor individual countries, and establish country risk ratings in accordance with an establishedmethodology (see Appendix A). The CRC shall also establish cross-border exposure limits.Country ratings and exposure limits shall expire six months after approval and shall be updatedand newly approved at that time.

1.4. The country rating shall be the basis for maximum aggregate cross-border risk permitted fortotal investment exposure to that country. SFG shall not approve transactions for investments ina country for which a rating and exposure limit have not been established.

1.5. The CRC shall be chaired by the CEO of SFG. Committee members shall be the ChiefFinancial Officer, the Chief Credit Officer, the Managing Director Global Asset Management,and the Managing Director Country Risk as well as any other person or persons so designated bythe CEO of SFG. A sixth standing member of the committee shall be determined by the BusinessUnit Leaders, by whichever process they seem fit. Meetings of the CRC may be called by theManaging Director Country Risk or by the CEO of SFG. Meetings require a quorum of four outof six members of the committee, including the CEO of SFG and the Managing Director CountryRisk.

1.6. The Managing Director Country Risk shall submit recommendations of country ratings andlimits to the CRC. The CRC decides on the recommendations by consensus. If consensus cannotbe found, the chair of the CRC shall make a decision supported by at least two members of thecommittee, including either the Chief Credit Officer or the Managing Director Country Risk.

1.7. All decisions of the CRC shall be submitted to the CEO of GECC, to the President ofGECC, to the Executive Vice President, Risk Management and Credit Policy of GECC, as wellas to any other person or persons so designated by the CEO for final approval.

IV. INVESTMENT GUIDELINES

1. POLICY

25

2.1. Established grades and limits shall also be reviewed on an annual basis with the board.Material revisions made in the country risk methodology shall be reported to the board andchange of any kind which would result in limits exceeding previous limits for any country riskgrade by more than 10% must also be reported.

2.2. Annually, the board will approve an overall maximum dollar limit for the stock of totalcross-border transactions in international investments based on Management’s recommendation.This limit shall not include hedging and derivative activities for the company’s treasury orliquidity purposes. The limit shall not exceed 400% of the company’s projected total capital forthat year.

2.3. For each regularly scheduled board meeting, which involves decisions on cross-bordertransactions, management must provide a report that includes individual country ratings andlimits, approved by the CRC and the CEO of GECC, as well as cross-border risk exposures, andinternational investments.

2.4. For each regularly scheduled board meeting, management must provide specific reports onany extraordinary limits approved by the CRC and the CEO of GECC. (Appendix A: 3.9. &3.10.)

2.5. For each regularly scheduled board meeting, management must provide specific reports onany individual transactions approved by the chairman of the CRC that would temporarily breachthe country exposure limits as approved by the CRC and the CEO of GECC. (see Appendix A:6.1.)

2.6. For each regularly scheduled board meeting, management must provide specific reports onany international investments classified adversely.

3.1. Transfer risk is the risk that economic, financial, political, or social factors or force majeuremight interfere with the ability and/or willingness of a country and of its economic agents tohonor their financial or contractual obligations to non-resident owners of debt or equity in atimely manner. The risk may be a liquidity issue (short-term) or it may materialize over timebecause of underlying structural weaknesses (medium- to long-term). The rating for the medium-to long-term risk determines the allowed aggregate country exposure under the policy.

3.2. Volatility risk is the risk that the market value of a given investment might fluctuate.Currency movements or stock market oscillations may materially affect the market value of across-border investment. The rating for this risk should guide portfolio composition in a givencountry.

3. DEFINITIONS

2. RELATIONS TO THE BOARD

26

3.3. Subnational risk is the risk that local or regional units of government might use their legalempowerment to delay or discontinue transactions (also described as contract frustration). Therating for this risk should guide portfolio composition in a given country.

3.4. A country limit constrains investment exposure on the basis of country of residence of theultimate obligor or guarantor or place of business, and includes all cross-border exposures arisingfrom loans and other credit-related exposures, direct and portfolio investments, legalcommitments and other contingencies, derivative products, and forex transactions.

3.5. Legally binding support such as third party guarantees or insurance, like OPIC, MIGA andthe support mechanisms by G7 ex-import banks shift the risk to the place of domicile of theguarantor. Pledged deposits, cash collateral or other liquid collateral shift the risk to the locus ofthe collateral, if the collateral ensures timeliness and full coverage of the obligation and ifdelivery is enforceable. Implied guarantees do not shift risk.

27

V. APPENDICES

28

1.1. The country risk review process and country risk management is the responsibility of theManaging Director Portfolio Development & Support, the Country Risk Unit, and the CountryRisk Committee. The review process is based on country risk assessment and risk ratings,translated into country exposure limits which are approved by the CRC.

2.1. To set an aggregate ceiling to all of SFG’s cross-border transactions that is prudent relativeto the company’s capital and other factors which have a direct bearing on SFG’s ability and theability of GECC to absorb losses.

2.2. To assure that specific country risk exposure is prudent relative to SFG’s capital and otherfactors which have direct bearing on SFG’s ability and the ability of GECC to absorb losses.

2.3. To review country risk factors and the company’s business strategy for every country inwhich SFG does business or where the company contemplates doing business.

2.4. To establish an early warning system to identity future risks related to SFG cross-bordertransactions in general or in specific countries.

2.5. To assure that risks and rewards are commensurate.

2.6. To establish country ratings so that countries can be directly compared.

2.7. To set country limits that take into account risk ratings, SFG net income targets, its appetitefor risk, business opportunity and the overriding determination to maintain GECC’s Aaa-rating atall times.

3.1. The Country Risk Unit (CRU) independently assesses country risk, prepares country reviewsand, in the context of a consistent country rating methodology, makes country risk ratingrecommendations and proposes country exposure limits to the CRC for all countries in whichSFG has cross-border exposure or is contemplating such exposure.

3.2. Country Reviews, called Bullet Points (BPs), rating recommendations, and exposure limitsare updated on a semi-annual basis or more frequently, if special circumstances warrant suchaction. The CRU shall prepare a schedule of country review presentations to the CRC.

3.3. The CRC will confirm or change all risk ratings recommended by the CRU.

APPENDIX A: METHODOLOGY

1. AUTHORITY

2. OBJECTIVES AND COUNTRY RISK MANAGEMENT

3. COUNTRY RATINGS

29

3.4. Investments cannot be made in a country without a risk rating approved by the CRC.

3.5. The CRU continuously monitors all countries in which SFG has any cross-border exposurein order to assure the accuracy of the ratings at all times. The CRU is responsible to inform theCRC of any observed material deterioration in the credit condition of any country with anexisting rating and exposure limit. In such event, the CRU may recommend to put the country on‘watch list’ in order to indicate the need for a close monitoring of risk related developments inthat country. Alternatively the CRU may propose such action as a change in rating. In this case,SFG management will develop a plan to sell down existing investments in the country in order tocomply with the exposure limits of the lower rating category. The Managing Director PortfolioDevelopment & Support may suspend investment activities in any country at his discretion at anytime subject to a review of the country’s rating.

3.6. Country risk ratings for medium- and long-term transfer risks (TRRs) range from GE/I+(lowest risk) to GE/VI (highest risk) and they measure a country’s ability and willingness to meetits financial and contractual obligations to non-resident investors in a timely manner (or to allowall of its economic agents to do so). Ratings GE/I to GE/V may be modified by a plus (+) or aminus (-) to indicate relative strength within the grade range. Country ratings between GE/I+ andGE/III- are of investment-grade quality, ratings between GE/IV+ and GE/VI are of speculative-grade quality (see individual definitions of rating categories in Appendix B).

3.7. The CRU will also develop country ratings for short-term transfer or liquidity risk (LRRs),for volatility risk (VRRs) and for subnational risk (SRRs). These risk ratings will not determinethe country exposure limit, but they will facilitate the company’s efforts to optimize the quality ofits portfolio composition of cross-border transactions.

3.8. The country risk assessment by the CRU is to be objective and as internally consistent aspossible. Marketing and other business considerations are not allowed to influence the CRUdecision-making process on country ratings.

3.9. However, the CRU may recommend country limits that exceed those established for the riskcategory within which a given country is placed. These extraordinary limits shall be reserved forcountries that are of an unusual strategic importance to SFG. Under no circumstances will theuse of such authority result in an exposure limit that exceeds the maximum country limitapplicable to country’s risk rating category by more than five percentage points of equity.Approval of such extraordinary limits by the CRC must be based on a joint recommendation bythe Managing Director Portfolio Development & Support and Managing Director Country Risk.

3.10. Extraordinary limits, established by the CRC and finally approved by the CEO of GECCshall be reported to the board.

3.11. The assigned aggregate exposure limit is not to exceed 5% of a country’s GDP --regardless of its credit quality. This is to protect SFG from excessive exposure to countries withsmall economies.

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4.1. All country risk ratings are assigned based on a thorough analysis of quantitative andqualitative factors taking into account past and current, as well as expected performance. TRRdecisions -- the basis for establishing country limits -- consider macroeconomic, monetary andfiscal data and policies, balance-of-payments positions and trade patterns, external debt levelsand debt management, the internal and external stability of the country, and a variety of socialfactors. (see Appendix D)

4.2. The short-term transfer-risk (liquidity risk) rating (LRR) analysis will focus on a country’sexpected cashflow position in foreign exchange during the following 12 months rather than onstructural issues. It will incorporate such factors as the international reserve position of thecountry, its b-o-p prospects under certain shock scenarios during that period, access to financialand capital markets, & its relationship to international lenders. There will be 3 rating categories:• Low Liquidity Risk (LL)• Moderate Liquidity Risk (ML)• High Liquidity Risk (HL)

This rating is to guide the company in designing an investment portfolio in a country thatincorporates a consideration of short-term vs. medium- and long-term risks.(see Appendix D)

4.3. The volatility-risk rating (VRR) analysis will focus on elements related to exchange ratefluctuations & stock market oscillations. It evaluates the exchange rate regime, degree ofconvertibility of the local currency, degree of vulnerability to sudden shifts in capital flows, & themarket breadth, transparency & liquidity of the local stock and capital market. There will be 3rating categories:• Low Volatility Risk (LV)• Moderate Volatility Risk (MV)• High Volatility Risk (HV)

This rating is to guide the company in designing an investment portfolio that recognizes mark-to-market changes, avoids the pitfalls of volatility and optimally gains from it. (see Appendix D)

4.4. The subnational risk rating (SRR) analysis will incorporate: constitutional & legalframework of the country as it is related to the degree of self-control of subnational levels ofgovernment; political parameters of regional and local government; and the degree of political,cultural, ethnic, or religious variance within the country. There will be 3 rating categories:• Low Subnational Risk (LS).• Moderate Subnational Risk (MS)• High Subnational Risk (HS)

The ratings will indicate whether SFG ought to give special attention to local issues in itsinvestment decisions in a given country. (see Appendix D)

4. RATING METHODOLOGIES

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5.1. The CRU will prepare country reviews or bullet points (BPs) that are used in thedetermination of country risk. The BPs involve a structured qualitative approach in conjunctionwith the calculation of certain ratios and peer group analyses.

5.2. Each long-format BP will present a brief summary of the country’s geography, demography,historical, economic, and political background. It will then list the strengths and weaknesses ofthe country in four major areas: (i) Macro- and, if relevant, microeconomic issues; (ii) fiscal andmonetary as well as financial sector issues; (iii) debt and financing issues; and (iv) political andsocial issues.

5.3. Each BP will have a statistical annex with the relevant economic and financial data,(historical, current and projected). This information will primarily rely on access to the country’sown data resources, and secondarily on international statistics.

5.4. The chair of the CRC may request a copy of the data base and scoring sheet of the countrythat are not part of the BP, for the purpose of a rating and/or country limit determination.

5.5. The SFG data base will be accessible through a commonly shared drive to all SFGemployees involved in international transactions (read-only). BPs will be made available in thesame fashion after their approval by the CRC. Finally, all approved country ratings and exposurelimits as well as the company’s current position in those countries will be commonly shared.

5.6. A short-format BP may be presented to the CRC in cases were new business opportunitiesor customer requirements emerge suddenly in a country without rating or country limit, requiringthe establishment of these parameters within a short time-frame. The short-format BP will bebased on the most reliable data accessible in that time-frame. A renewal of the country rating andlimit after six months will require a full analysis.

5.7. SFG will adopt the short-format BPs for a period of six months following the approval ofthese guidelines in order to establish and maintain country ratings and exposure limits. Duringthis time, a SFG data base will be established.

6.1. Country limits established by the CRC can be changed at any time by action of thecommittee. Established limits will not exceed the maximum ceiling for cross-border exposure asprovided in these guidelines, including extraordinary limits. However, the CEO of SFG, or inhis/her absence, his/her designee may authorize international transactions that temporarily resultin a country exposure in excess of committee-established limits for short-term transactions or inorder to allow for an orderly disposal of existing assets in the portfolio of that country.

5. REPORTING REQUIREMENTS

6. COUNTRY LIMITS

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6.2. The use of this authority requires the recommendations of the Managing Director PortfolioDevelopment & Support and the Managing Director Country Risk. Under no circumstances willthe use of such authority result in total exposure in excess of the maximum country limitapplicable to the next higher risk rating or ten percentage points of equity above the limit set forthe country’s respective risk category, whichever is lower.

7.1. The following maximum limits for country risk categories are defined as a share of total SFGequity:

7.2. Maximum country limits are based on the country risk ratings, the ability of SFG’s capital toabsorb loss risks, and the ability of GECC to absorb loss risks. Since the ability of SFG andGECC to absorb losses will vary over time, the country risk review process and allowablemaximum country limits need to be reviewed every six months by the CRC.

8.1. The following sub-limits are established as percentages of the maximum country limits.These sub-limits are guidelines only. Their purpose is to allow portfolio management to take intoaccount both the riskiness of a country and the time horizon of exit strategies in place. It seemsadvisable, for example, that at least 50% of investments in a country rated GE/V+ and belowshould have profitable exit strategies in place that could be executed in less than five years.

Rating Exposure Limits as % of EquityGE/I+ 100%GE/I 100%GE/I- 95%GE/II+ 90%GE/II 85%GE/II- 80%GE/III+ 70%GE/III 65%GE/III- 60%GE/IV+ 40%GE/IV 35%GE/IV- 30%GE/V+ 15%GE/V 10%GE/V- 5%GE/VI 0%

7. MAXIMUM COUNTRY LIMITS

8. SUB-LIMITS

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9.1. SFG does not differentiate between different types of investment instruments in determiningthe exposure risk limits.

9.2. The below maximum aggregate exposures relative to capital are suggested as guidance limitson cumulative country exposure for low investment grade and speculative-grade countries.

9.3. The CRC may also set maximum limits for geographic/economic/political blocs with theapproval of the CEO of GECC and by notifying the board of directors. The following maximumaggregate exposure limits relative to capital are suggested as guidance limits for the followingblocs.

10.1. The Country Risk Committee is to assess risk, approve individual country ratings, to setcountry limits and extraordinary limits where justified by business conditions, and to ensure thatconcentration by country, type of risk asset, and group of countries is prudent relative to SFG’scapital, and the ability of SFG and GECC to accept risk. The CRC shall regularly review countryrisk concentrations in the international portfolio as a whole.

10.2. The Country Risk Unit develops an in-depth knowledge of all countries in which SFG doesbusiness and continuously monitors these countries and collects economic and financial data in

Under 1 year 1-3 years 3-5 years Over 5 yearsGE/I+ to GE/II- 100% 100% 100% 100%GE/III+ to GE/III- 100% 100% 90% 80%GE/IV+ to GE/IV- 100% 90% 80% 70%GE/V+ and below 100% 80% 70% 50%

Cumulative Limit

GE/IV- and Below 80%GE/IV and Below 140%GE/IV+ and Below 200%GE/III- and Below 300%

Region LimitsAsia 120%Latin America 120%Eastern Europe 120%Middle East/N. Africa 80%Africa 40%

9. COMBINED EXPOSURE LIMITS

10. GENERAL PROCEDURES

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order to help keep country ratings relevant to current conditions and perceived trends. It isresponsible for the preparation and presentation of country reviews (bullet points) and formaking recommendations to the CRC on risk ratings and country exposure limits.

10.3. The CRU is further responsible for advising the CRC at all times of any materialdeterioration in the perceived condition of a country in which risk has been assumed, and forsuggesting grade changes, a suspension of activities, and/or a sale of existing assets in thatcountry. The CRU will also advise the CRC of material improvements in countries in order toguide dealmakers to those markets.

10.4. The CRU is also responsible for coordinating the CRC meetings, including liaison withcommittee members, distribution of country risk reports, and for ensuring that all member of thecommittee and relevant users are made aware of the schedule of the countries to be reviewed andgiven an opportunity to state their business requirements.

10.5. The written material for the country risk meeting will consist of three principal documents:the bullet points (with statistical annex); the proposal for a country rating and correspondingexposure limit; and a country limit approval form which is to be signed by the members of theCRC (Appendix C). All documents are to be distributed to the members of the CRC at least 24hours prior to the scheduled meeting.

10.6. To facilitate committee discussion, presentations should be brief, emphasizing the keypoints rather than repeating the contents of the country briefing.

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RATING DEFINITIONGE/I+ Risk is virtually non-existent.GE/I Risk is very remote.GE/I- Risk is negligible.GE/II+ Risk is very minimal.GE/II Risk is minimal.GE/II- Risk is very low.GE/III+ Risk is low.GE/III Risk is very moderate.GE/III- Risk is moderate.GE/IV+ Risk is rising markedly.GE/IV Risk is moderately high.GE/IV- Risk is high.GE/V+ Risk is very high.GE/V Risk is very high and mitigating factors are diminishing.GE/V- Risk is very high and drastic action is required.GE/VI Risk is very high and macroeconomic or political management is

unpredictable.

APPENDIX-B:TRANSFER RISK RATINGS (TRR) DEFINITIONS

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APPENDIX-C:COUNTRY LIMIT APPROVAL FORM

(End of Document)

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1.1. This rating system measures the probability in the medium- to long term that economic,financial, political, or social factors or force majeure might interfere with the ability and/orwillingness of a country and of its economic agents to honor their financial or contractualobligations to non-resident owners of debt or equity in a timely manner.

1.2. The analytical approach to assess that probability takes into consideration a broad range ofquantitative and qualitative data. The proposed methodology will be monitored continuously byregression analyses and other means in order to measure its effectiveness and practicality. Atcurrent, the CRU has chosen 47 preliminary indicators that are arranged in six broad anduniformly-accepted performance-measuring categories:

♦ The Domestic Economy.♦ The External Economy.♦ Debt.♦ Political Stability.♦ Social Conditions.♦ Exogenous Factors.

1.3. Where applicable, the information will be sorted by historical (10 years), current, andprojected (next five years) data and it will be entered into the SFG Risk Grid.

1.4. In a comparative study of countries, the data will then be given a score that ranges from 1point (worst performance) to 18 points (best performance).

1.5. Of course, individual indicators will differ in their relative importance to each other.Therefore, they will be weighted according to the potential impact they have on foreign-currencytransfer risk. The weighting is standardized for all countries and it is based on economic theory,historical experience and -- where available -- on empirical evidence.

1.6. The weighted scores of the 47 indicators are then added, resulting in a combined score. Ofcourse, there is no fool-proof approach to determining the credit risk of a country. Theassessment depends on statistical data and on subjective assumptions. In order to give properweight to the element of judgment, the combined score may be adjusted upwards or downwardsby two points by the Managing Director Country Risk. This so-called gut factor will be visiblebelow the line and it will allow for a comprehensive and analytical look at the country and its risklevel without making it mechanical. The result of this adjustment -- if any -- will be the finalscore.

APPENDIX-D:COUNTRY RATING SYSTEMS

1. COUNTRY RATING SYSTEM FOR MEDIUM- & LONG-TERM TRANSFER RISK

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1.7. The numerical outcome is then translated into the rating grade according to the followingconversion scale: 18-15 points GE/I; 15-12 points GE/II; 12-9 points GE/III; 9-6 points GE/IV;6-3 points GE/V; and 3-1 points GE/VI.

1.8. The sequence, therefore, of this rating process which is the basis for setting the appropriatecountry limits can be summarized as follows:

♦ Collection of information and data, sorted by historical, current, and projected.♦ Entering of data into the risk grid.♦ Scoring data and multiplying score by weight.♦ Adding scores.♦ Adjusting total score by the gut factor (if recommended).♦ Converting score into rating grade (ranging from GE/I+ to GE/VI).

1.9. This process could also be expressed as follows:

FS = ΣΣin wi * ISi +/- GF = TRR

FS = Final Score (1-18 points)w = Weights

IS = Individual Score (1-18 points)GF = Gut Factor (may range from 0 - 2 points)Σi

n wi = 1TRR = Transfer Risk Rating (according to conversion table)

1.10. Listed below are the 47 indicators, their definitions, and their weights.27

1.11.1. Real GDP Growth. Real, i.e. inflation-adjusted growth of a country’s gross domesticproduct is important as an indicator for the country’s development potential. Obviously,sustained growth is an indicator of a sound economy. It must be seen against a number offactors, such as a country’s current stage of development (industrialized countries require lessgrowth than emerging markets that want to catch up) or external debt levels (a country with ahigh debt level needs vigorous growth levels to lower its debt/GDP ratio).(weight 2%)

1.11.2. Real GDP Per Capita Growth. This is a good indicator for a country’s tax base. Thepublic sector may have to draw on that tax base to repay its debt. It is also an important socialindicator, calculating the average wealth of the population.(weight 3%).

27All assigned weights are preliminary and subject to the results of a comprehensive comparative study followingthe completion of the SFG data base.

1.11. THE DOMESTIC ECONOMY (TOTAL WEIGHT 25%)

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1.11.3. Growth in Industrial Production. A time series of this index shows, how thecomposition of GDP of a country might change given the change in volume of production inmanufacturing, mining, construction, and the electricity, gas and water industries. (weight 1%)

1.11.4. Investment/GDP Ratio. This ratio is crucial to projected future growth. Asianeconomies have experienced sustained Investment/GDP ratios of over 30%, Latin America’sratios have been consistently below 20%. This explains some of the difference that exists in theirrespective economic growth rates during the last 20 years.(weight 3%)

1.11.5. Investment Efficiency. This ratio is a three-year moving average of real GDP growthdivided by the average investment ratio for the same period. The higher the ratio the moreefficient was the placement of investments.(weight 1%).

1.11.6. Inflation. Inflation is usually measured by the consumer price index (CPI). Inflationdistorts the efficient allocation of resources and creates poverty. When looking at the data wemust remember that the basket of goods that determines the CPI differs from country-to-countryand should differ between per-capita income levels (poorer countries consume a largerproportion of their national income in food than richer countries, Engel’s law).(weight 2%)

1.11.7. Money Supply (M1). Money supply growth that exceeds real economic growth on aconsistent basis leads to inflation equal to the monetary overhang.(weight 2%)

1.11.8. Domestic Credit Creation. This is the growth of the domestic component of moneysupply (M2 - net foreign assets) adjusted by inflation. This supply is now compared to thedemand for money as expressed by real GDP growth. If the former consistently exceeds thelatter, this leads to a deterioration of the balance of payments of the country because domesticabsorption is raised (therefore, less exports) and domestic purchasing power is increased(therefore, more imports).(weight 1%)

1.11.9. Depth and Strength of the Financial System. This factor takes into consideration thedevelopment of the local banking sector (level of supervision and regulation, credit experiencevs. riding hyper-inflation, overbanked vs. underserviced, competition vs. collusion). It also looksat the local capital (bond & equity) market (benchmarks, market capitalization, existence ofefficient clearing, registration and central deposit systems).(weight 1%)

1.11.10. Real Interest Rates. High real interest rates prohibit economic growth and may lead toan appreciation of the local exchange rate. Negative real interest rates further fuelinflation.(weight 1%)

1.11.11. Labor Costs. This is an important structural factor. It includes such quantitativeelements as wage growth and indirect labor costs, as well as more qualitative elements such aslabor market flexibility (severance pay arrangements, pensions, hiring and firing practices,collective bargaining). Low labor costs may be particularly important in an emerging market witha high birth rate.(weight 2%)

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1.11.12. Labor Productivity. The change in labor productivity is approximated by subtractingthe growth in employment from the growth in output. This ratio is important especially incountries with limited monetary tools. The only way to improve their competitiveness lies inreducing their domestic costs or raising productivity.(weight 1%)

1.11.13. Public Sector Balance. The deficit or surplus position of general government (whichincludes the central government, lower levels of government, and public, non-financial sectorenterprises) is a key variable to risk analysis. High and prolonged public sector deficits -- publicdissavings -- lead to high domestic interest rates which prohibit private sector investments, stunteconomic growth, and negatively affect the current account balance of the country.

These deficits need to be financed through money creation (monetization) which is inflationaryand/or through borrowing (internal and external) which brings about increased debt and risingdebt service burdens and may ultimately lead into a debt trap.

The historical and current data will be evaluated largely on their comparative strength orweakness. Projections will deal with the various structural elements for government to reduceimbalances (broadening tax base, simplifying tax code, reducing tax evasion, reducing transferpayments, strengthening human and physical infrastructure expenditures of the budget).(weight3%)

1.11.14. Monetary and Fiscal Policy Volatility. Volatility in policy-making is intuitively andincreasingly empirically considered a major factor in determining future economic growth. LatinAmerica has experienced high levels of such volatility, while South East Asia has had low policyvolatility during the last 20 years. This has contributed to the existing growth differential of thetwo regions. The volatility is measured by fluctuations of exchange rates, the number of changesin exchange rate regimes, fiscal performance, etc.(weight 2%)

1.12.1. Current Account Balance. This is a key ratio, it is measured as a percentage of GDP. Adeficit on the current account of the balance-of-payments means that domestic savings are notsufficient to cover domestic investments. In other words, a country’s exports of goods andservices are exceeded by its imports. Therefore, a country must draw on foreign savings, i.e. itmust borrow money, attract foreign (non-debt creating) investment or it must draw down on itsinternational reserves. The analysis is to establish whether any imbalances may be cyclical orstructural.(weight 6%)

1.12.2. Ratio of Current Account Balance to Exports. This is a useful ratio because it uses adollar-denominated denominator. The current account/GDP ratio uses GDP which isdenominated in local currency. If the local currency is overvalued the size of a given currentaccount deficit would be underestimated. This ratio avoids that shortfall.(weight 2%)

1.12. EXTERNAL ECONOMY (TOTAL WEIGHT 30%)

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1.12.3. Exports to GDP. This ratio is an index of the openness of the economy. In a time series,it provides a good picture of the allocation of resources towards the tradable sector, and it is anindicator for future debt-servicing capacity.(weight 2%)

1.12.4. Export Quality Index. This includes the following elements (weight 4%):

• Net Unrequited Transfers to Exports. In many emerging markets, large portions of the workforce live abroad and remit parts of their incomes to their countries of origin. These flows arecaptured in the current account as private remittances. Although they have a certain degreeof reliability, they may also mask the underlying vulnerability of the current account balanceshould the flows discontinue for internal or external reasons.

• Manufactured Exports to Total Exports. Manufactured goods are less price-volatile thancommodities. A higher share of manufactured exports to total exports usually indicates amore advanced and less vulnerable economy. By the same token, these exports may containvery little value-added from the emerging market, if they largely consist of re-exports. Re-exports, are also highly correlated to imports so that their impact on the net foreign assetposition of a country is less significant.

• Export Vulnerability Index. This is the share of the three major commodities in totalmerchandise exports. It indicates whether the external balance may be subject to certain priceshocks or substitution effects.

• Diversification of Trade Partners. As far as a country’s exports are income-elastic, i.e. astheir volume depends on economic growth in the importing country, a high concentration ofexport markets may make expected receipts vulnerable to economic downturns in theimporting country/countries.

1.12.5. Growth Rates and Composition of Imports. High capital goods imports bode well forfuture growth. Rapid growth of consumer imports may reveal underlying weaknesses. (weight2%)

1.12.6. Current Account Deficit (three-year moving average) to Present-Year ExportGrowth Rate (if applicable). This ratio shows whether the excess of imports over exports inprevious years has been invested into productive activities that in turn were export-oriented andled to a growth in exports large enough to reduce or likely to reduce the current account deficitin the long run.(weight 1%)

1.12.7. Percentage Change in Exports to Percentage Change in Imports. This indicatorshows whether the trade balance of a country is strengthening or weakening. (weight 1%)

1.12.8. Terms-of-Trade. This is the ratio of export prices to import prices and it serves as ameasure of improvement or deterioration of a country’s balance-of-payments position andprospects.(weight 3%)

1.12.9. The Real Effective Exchange Rate. This rate is taken as a measure of the country’srelative competitiveness. It looks at a country’s nominal exchange rate movements and adjustsfor differentials in price increases between a country and its major trading partners to determine

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whether an exchange rate is appreciating (which suggests that its exports are becoming moreexpensive, i.e. less competitive in relative terms) or whether the exchange rate is depreciating(exports are becoming more competitive). (weight 3%)

1.12.10. Quality of Foreign Direct Investment (FDI) and Gross Capital Inflows. FDI is anon-debt creating capital inflow that may help to finance a country’s current account deficitwithout directly affecting its debt profile. However, distinctions must be made. For example, FDIthat is the result of privatization is a one-off investment by foreign investors. Also, privatizationof state assets often takes place in the nontradable sectors. Therefore, this type of FDI might notresult in future export receipts. FDI that is unrelated to privatization, on the other hand, isusually channeled towards export-oriented sectors, strengthens the country’s foreign exchangeearnings capacity, and is more of a vote-of-confidence in the overall political and economicmanagement of the country.(weight 2%)

1.12.11. Short-term Capital Inflows Plus Portfolio Investments to Gross Capital Inflows.This is an indicator of the speculative element of capital inflows, which are confidence-sensitiveand are also highly correlated to the direction of U.S. interest rates.(weight 2%)

1.12.12. International Reserves Coverage of Imports. This indicator tells us, for how longcurrent import levels could be theoretically sustained without international financing. Theshortcoming of this ratio is that the build-up of reserves may be the result of extensive borrowingby the country.(weight 2%)

1.13.1. Foreign-Currency Debt to GDP. This indicator measures a country’s debt stock as itrelates to the size of its economy, and, therefore, to its long-term ability to repay. However, thisratio may be distorted by an overvalued exchange rate (see 1.10.2.).(weight 2%)

1.13.2. Foreign Currency Debt to Exports. This is a key ratio. It shows how much of thecountry’s current receipts, i.e. its receipts from exports of goods and services and net positivetransfers are absorbed by the country’s debt stock.(weight 3%)

1.13.3. Debt Service Ratio. This is an important flow ratio and it expresses annual interest andprincipal payments as a percentage of current receipts. This shows the capacity of the country toservice its obligations in a timely manner.(weight 3%)

1.13.4. Debt Service Ratio Adjusted by Minimum Imports. In a situation of foreign exchangeshortage, a country may act to compress levels of imports in order to save foreign currency.However, there is a minimum level of imports required for any country, including such importitems as fuel and food. This ratio modifies the debt service ratio by subtracting an assumedminimum level of imports (estimated at 60% of a three-year moving average of imports) from thecountry’s current receipts. The ratio then indicates, how much of the residual will be absorbed bydebt service payments.(weight 1%)

1.13. DEBT. (TOTAL WEIGHT 15%)

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1.13.5. Short-term Debt to Total Debt. A high ratio raises the vulnerability for a countrybecause of its continuous need to refinance maturing obligations (principal). There may beoccasional lack of market access, or refinancing may be costly because of a changed interest-rateenvironment etc.(weight 1%)

1.13.6. Public Sector Debt to GDP. This helps to understand the overall indebtedness of thepublic sector in domestic and foreign currency. High domestic debt may affect local interest ratesand a default on such debt may spill over onto the external sector.(weight 1%)

1.13.7. Total Public Sector Debt Service to Government Revenue. This ratio shows howmuch room there is for discretionary spending by government. Less room for such spendingraises the probability of default.(weight 1%)

1.13.8. Default History. Moral hazard has an impact on the creditworthiness of a country.Important quantitative measures are: existing arrears on interest or principal; number ofIMF/World Bank stabilization programs; number of Paris Club defaults/restructuring; number ofLondon Club defaults/restructuring; Brady bond reschedulings; etc.).(weight 2%)

1.13.9. Access to Financing. This measure looks at the size of the economy (a larger economygenerally has more access to capital markets); existing credit lines with commercial banks etc.But the measure also takes into consideration the country’s position with the IMF. Every countryhas a quota with the IMF on which it can draw. The balance of that quota will be factored intothis measure. If a country is currently receiving IMF-financing, the country’s likely compliancewith the conditions for additional tranches is also assessed.(weight 1%)

1.14.1. The System of Government. This measure takes into account the degree of institution-building, the perceived legitimacy of government, good governance, the participatory nature ofthe system, ethnic and religious inclusion, the power of constituencies. This is not a valuejudgment on the form of government, but rather an evaluation of the efficiency, effectiveness andsustainability of the system in place.(weight 8%)

1.14.2. The Rule of Law and Legal Recourse. This measure looks at the legal system in thecountry (constitution, property rights, commercial law, bankruptcy law, unfair practices, anti-trust legislation, etc.). It also evaluates compliance by major political and economic actors andthe degree to which the letter of the law is enforced by an independent judiciary.(weight 4%)

1.14.3. Transparency. The degree to which corruption is affecting commercial and social life asmeasured by Transparency International.(weight 2%)

1.14.4. External stability. This measure assesses the risk of hostile conflict with other countries,but it also takes into consideration the degree of political and economic integration.(weight 1%)

1.14. POLITICAL STABILITY (TOTAL WEIGHT 15%)

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1.15.1. Income Distribution. Income distribution as measured by the GINI-coefficient tells ushow evenly income is distributed. Uneven income distribution reduces the potential benefit ofrising national income on stimulating domestic demand, it might pose a threat to political stabilityor it might put pressure on budgetary expenditures designed to compensate for theunevenness.(weight 3%)

1.15.2. Unemployment & Underemployment. High unemployment obviously leads to politicalas well as economic distortions. Poor macroeconomic management often leads to the formationof a sizable informal sector, i.e. an underground economy that is not captured by officialemployment or national output statistics. It usually produces subsistence-level employment,while it also leads to depressed wages and to a loss of government revenue.(weight 1%).

1.15.3. Overall Social Development Index. This index includes in equal weights: birthrates,levels of urbanization, poverty rates, infant mortality rates, life expectancy rates, and literacyrates.(weight 1%)

1.16.1. Material Increase in International Interest Rates. The actual outbreak of all debtcrises of the 20th century has been -- in part -- attributed to an increase in U.S. interest rates.Portfolio investments in emerging markets seem especially affected by such development (seefootnote 11).(weight 5%)

1.16.2. Economic Activity in Industrialized Countries. An economic slowdown inindustrialized countries leads to capital inflows in the emerging markets and vice versa.However, these effects are partly offset by the impact of slower/faster growth in industrializedcountries on the export performance of emerging markets.(weight 2%)

1.16.3. Force Majeure. Natural disasters, such as earthquakes, floods, or droughts may affectthe production levels of a country.(weight 1%)

1.16.4. Rating Agencies. The opinions of the two major credit rating agencies are a valuableindependent assessment of risk. They are taken into consideration by scoring the averagebetween a long-term foreign currency rating by Moody’s and by S&P.(weight 1%)

1.16.5. Yield Spreads. Market opinion is reflected by a cross-country comparison of yieldspreads on equal or similar instruments.(weight 1%)

1.15. SOCIAL CONDITIONS (TOTAL WEIGHT 5%)

1.16. EXOGENOUS FACTORS (TOTAL WEIGHT 10%)

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2.1. The liquidity risk rating analysis (LRR) will focus on a country’s expected cashflow positionin foreign exchange during the following twelve months rather than on structural issues.Therefore, the analysis will be less complex. It will incorporate the following indicators:

• International Reserves Coverage of Imports. (weight 25%)• Changes in International Reserve Levels. (weight 10%)• Short-term Debt to Total Debt. (weight 10%)• Debt Service Ratio. (weight 20%)• Debt Service Ratio Adjusted by Minimum Imports. (weight 5%)• Late Payments against Bilateral, Multilateral or Commercial Creditors. (weight 10%)• Seeking or Receiving IMF Support. (weight 10%)• Pressure on Local Exchange Rate. (weight 5%)• Pressure on Domestic Financial Markets. (weight 5%)

2.2. Similar to the methodology used for TRRs, the data for each indicator will be collected.Then a score between 1-18 points will be assigned to each indicator. Each score will bemultiplied by the weight allocated for the indicator. The sum of all weighted scores will result inthe final score. There will be no gut-factor allowance. Therefore, the amended TRR formula forliquidity risk ratings is:

FS = ΣΣin wi * ISi = LRR

LRR = Liquidity Risk Rating (according to conversion table, below)

2.3. Total scores will be converted into one of three rating categories:

• Low Liquidity Risk (LL): 18-13 Points• Moderate Liquidity Risk (ML): 12-7 Points• High Liquidity Risk (HL): 6-1 Points

3.1. The volatility risk rating analysis (VRR) will focus on the risk that the market value of agiven investment might fluctuate. Currency movements or stock market oscillations maymaterially affect the market value of a cross-border investment.

3.2. As pointed out on page 5 of the introduction, volatility is traditionally higher in emergingthan in the more developed markets for a variety of reasons. From a technical point of view, thintrading on currency and stock bourses in less developed markets is a major reason for thatvolatility. But more importantly, political stability (or the lack of such) is a driving force behind

2. COUNTRY RATING SYSTEM FOR SHORT-TERM TRANSFER RISK (LIQUIDITY RISK)

3. COUNTRY RATING SYSTEM FOR VOLATILITY RISK

46

wide fluctuations in those markets in emerging countries. The following indicators will be usedto measure this risk:

• Likelihood of Political Shocks. (weight 35%)• Foreign Exchange Rate Volatility (time series). (weight 7.5%)• Number of Switches of Foreign Exchange Rate Mechanisms. (weight 7.5%)• Degree of Rigidity of Existing Foreign Exchange Rate Regime (single-currency fixed

exchange rate, currency-basket pegged exchange rate, currency board, crawling peg,crawling band, dirty float, free float). (weight 7.5%)

• Thinness of Forex Market. (weight 10%)• Stock Market Capitalization. (weight 10%)• Number of Listings on Local Stock Market. (weight 7.5.%)• Transparency of Stock Market (information, reporting and disclosure standards).(weight

7.5%)• Liquidity and Frequency in Trading. (weight 7.5.%)

3.3. Similar to the methodology used for LRRs, the data for each indicator will be collected.Then a score between 1-18 points will be assigned to each indicator. Each score will bemultiplied by the weight allocated for the indicator. The sum of all weighted scores will result inthe final score. There will be no gut-factor allowance. Therefore, the VRR formula for liquidityrisk ratings is:

FS =ΣΣin wi * ISi = VRR

VRR = Volatility Risk Rating (according to conversion table below)

3.4. Total scores will be converted into one of three rating categories:

• Low Volatility Risk (LV): 18-13 Points• Moderate Volatility Risk (MV): 12-7 Points• High Volatility Risk (HV): 6-1 Points

3.5. This rating analysis only provides guidance to the user in determining the degree of volatilityrisk. Negative triggers only protect the potential downside of an investment, but they do notallow for making gains from the upside potential. In order to take advantage of volatility as wellas to avoid its pitfalls, an active trading desk is a prerequisite. Active trading means to profitfrom arbitrage opportunities. The traders watch market movements, have the authority tobuy/sell up to certain limits, and are controlled by an independent back-office.

4.1. The subnational risk rating analysis (SRR) will focus on the risk that local or regional unitsof government are empowered to delay, discontinue or retroactively change the conditions oftransactions. As mentioned also in the introduction, this is a risk that has begun to materializeand distinguish itself from transfer risk in recent years because of the global trend of

4. COUNTRY RATING SYSTEM FOR SUBNATIONAL RISK.

47

decentralization of power. The transfer of authority to subnational levels of government mayinclude all responsibilities other than national defense or monetary and foreign exchange policy.28

The following indicators will be used to measure this risk:

• Degree of Self-Control of Subnational Governments According to the Existing or ExpectedConstitutional and Legal Framework. (weight 25%)

• Depth of Political Elite and Administrative Competence of Lower Levels of Government.(weight 25%)

• Degree of Political, Cultural, Ethnic, or Religious Variance Within a Country. Especially, thedegree to which the overall heterogeneousness of a country may not be evenly distributedover its territory, but rather the result of combining a number of internally homogeneous andorganizationally independent subsets. (weight 25%)

• Historical Experience of Contract Frustration with Subnational Levels of Government.(weight 25%)

4.2. Similar to the methodology used for LRRs and VRRs, the data for each indicator will becollected. Then a score between 1-18 points will be assigned to each indicator. Each score willbe multiplied by the weight allocated for the indicator. The sum of all weighted scores will resultin the final score. There will be no gut-factor allowance. Therefore, the SRR formula for liquidityrisk ratings is:

FS = ΣΣin wi * ISi = SRR

SRR = Subnational Risk Rating (according to conversion table below)

4.3. Total scores will be converted into one of three rating categories:• Low Subnational Risk (LS): 18-13 Points• Moderate Subnational Risk (MS): 12-7 Points• High Subnational Risk (HS): 6-1 Points

4.4. This risk analysis will be able to give guidance only concerning the systemic risk that mayexist in a country. Where material subnational risk has been detected, a comprehensive, case-by-case analysis of the political system is necessary to advise concerning the risk within any specific,administrative subset of that country.

28However, there are cases, in which subnational governments have issued local-currency equivalents. TheArgentine province of Tucuman, for example, has been issuing so-called Tucumani dollars since the mid-1980s.These are really bonds issued by the province in 1 and 5 dollar denominations deriving from the province’sinability to cover its payroll. They function as a currency parallel to the peso and they are traded at face value. Ofcourse, such monetization of the deficit of the province of Tucuman undermines monetary control by the centralgovernment. It is alleged that other provinces in Argentina pursue a similar policy. Reuters, February 13, 1996.

SFG

Before 1820’s 1802 Austria, Netherlands. (Bonds)

1820’s 1820 Spain; 1826 Brazil, Chile, Colombia, Ecuador, Greece, Peru, Venezuela; 1828 Argentina,Costa Rica, El Salvador, Guatemala, Honduras, Mexico, Nicaragua. (All Bonds)

1830’sto

1870’s

1833 Mexico; 1837 Portugal, Spain; 1844 Mexico; 1848 Venezuela; 1850 Colombia, Portugal; 1851Spain; 1854 Mexico; 1860 Venezuela; 1865 Venezuela; 1866 Mexico; 1867 Tunisia, Spain; 1868Ecuador. (All Bonds)

1871 - 1880 1872 Dominican Republic; 1873 Honduras, Colombia;1874 Costa Rica, Paraguay; 1875:Liberia, Bolivia; 1876 Egypt, Guatemala, Turkey, Peru, Uruguay; 1880 Chile, Colombia. (All Bonds)

1881-1900 1890 Argentina; 1891 Uruguay; 1892 Dominican Republic, Paraguay, Portugal, Venezuela; 1894Ecuador, Greece, Guatemala, Nicaragua; 1895 Costa Rica, Yugoslavia; 1897 Dominican Republic;1898 Brazil, El Salvador, Venezuela; 1899 Dominican Republic, Guatemala; 1900 Colombia; (AllBonds)

1901-1927 1901 Costa Rica; 1902 Brazil; 1903 Morocco; 1906 Ecuador; 1909 Ecuador; 1911 Nicaragua; 1912Liberia; 1914 Austria, Brazil, Ecuador, Liberia, Mexico; 1915 Nicaragua, Turkey, Uruguay; 1916Bulgaria; 1917 Liberia; 1918 USSR; 1919 Liberia; 1920 Paraguay; 1921 El Salvador, China. (AllBonds)

1928-1939 1928 Mexico; 1929: Ecuador; 1931 Bolivia, Brazil, Chile, Dominican Republic, Turkey, Peru; 1932Austria, Bulgaria, Colombia, Costa Rica, El Salvador, Germany, Greece, Hungary, Liberia,Nicaragua, Panama, Paraguay; 1933 Cuba, Guatemala, Romania, Uruguay, Yugoslavia; 1935Colombia; 1936 Poland; 1937 Brazil; 1938 Austria, El Salvador, Czechoslovakia; 1939 China,Germany. (All Bonds)

1940-1979 1940 Austria, Italy, Poland, Turkey (All Bonds); 1941 Hungary (B); 1942 Japan (B); 1949 Germany(East) (B); 1952 Czechoslovakia (B); 1959 Turkey (S)

Sovereign Defaults On Private Lending 1800-1994Table i

SFG

1940-1979(cont.)

1960 Cuba (B); 1961 Zaire (B), Brazil (S); 1962 Costa Rica (B); 1965 Turkey (S), Zimbabwe (B),Chile (S); 1966 Ghana(s); 1968 Peru (S,L); 1972 Chile (S); 1976 Zaire (S,L); 1977 Sierra Leone(S,L); 1978 Gabon (S), Jamaica (L), Peru (S,L), Iran (L), Turkey (S,L); 1979 Sudan (S,L), Togo(S,L).

1980 - 1989 1980 Bolivia (L), Liberia (S,L), Nicaragua (L), Zimbabwe (B); 1981 Costa Rica (L), Honduras (L),Madagascar (S,L), Senegal (S,L), Poland (B,L), Uganda(S); 1982 Argentina (L), Cuba (L),Dominican Rep. (L), Ecuador (L), Guyana (L), Malawi (L), Mexico (L), Romania (L), Venezuela(L); 1983 Brazil (L), Chile (l), Morocco (L), Niger (L), Nigeria (L), Panama (L), Philippines (L),Uruguay (L), Yugoslavia (L), Zambia (L); 1984 Costa Rica (B), Cote D’Ivore (L), Egypt (L),Mozambique (L), Tanzania (S,L); 1985 Guinea (S,L), South Africa (L), Viet Nam (L); 1986Argentina (B), Congo (L), Gabon (L), Gambia (L), Nigeria (B), Paraguay (L), Uruguay (B); 1987Panama (B); 1988 Angola (S,L), Guatemala (B); 1989 Cameroon (L), Jordan (L), Trinidad &Tobago (L).

1990’s 1990 Albania (L), Iraq (L), Bulgaria (L); 1991 Russia (L); 1992 Iran (L), Yugoslavia (B)

Sovereign Default On Private Lending 1800-1994

B = BondsL = Commercial Bank LoansS = Supplier Credits

Sources: Christian Sutter, Debt Cycles in The World-Economy (Westview Press, 1992)

John H. Purcell, Jeffrey Kaufman, “The Risks of Sovereign Lending; Lessons from History.” (Salomon Brothers, September 1993)

Juan José Fernandez-Ansola and Thomas Laursen “Historical Experience With Bond Financing to Developing Countries”(IMF, March 1995)

Vincent Truglia, “Sovereign Risk: Bank Deposits vs. Bonds” (Moody’s Investors Service, October 1995)

Richard Cantor and Frank Packer “Sovereign Credit Ratings” in: Current Issues in Economics and Finance (FederalReserve Bank of New York, June 1995)

Table (ii)Cumulative Arrears by Sovereign Borrowers on

Concessional Bilateral Official Lending (1990-94)(in USD millions)

Country 1990 1991 1992 1993 1994

Algeria 0 0 1 3 0Angola 41 117 202 339 341Benin 12 9 5 11 11Botswana 1 1 3 3 3Burkina Faso 1 1 1 0 0Cameroon 141 339 250 488 576Cape Verde 0 0 0 4 5Central African Republic 20 35 34 47 23Chad 4 7 10 14 16Comoros 1 1 1 1 0Congo 35 179 258 700 2Côte D'Ivoire 71 89 278 688 86Equatorial Guinea 23 34 46 46 63Ethiopia 7 27 1 1 1Gabon 120 293 343 595 92Ghana 90 50 48 65 61Gambia 0 0 0 1 1Guinea 56 122 9 62 119Guinea-Bissau 21 43 56 65 63Kenya 56 71 96 117 26Lesotho 1 2 3 3 6Liberia 190 232 261 282 320Madagascar 76 135 308 445 961Malawi 19 3 1 3 3Mali 1 19 4 6 9Mauritania 17 42 59 2 2Mauritius 2 5 5 9 15Morocco 1 351 1 1 1Mozambique 7 9 10 15 15Niger 12 18 62 114 6Nigeria 569 159 1,823 4,221 6,708Rwanda 7 10 15 20 31Sao Tome & Principe 10 14 16 24 25Senegal 0 0 63 154 5Seychelles 5 4 4 2 2Sierra Leone 131 155 25 27 13Somalia 100 185 255 336 435Sudan 1,787 2,229 2,293 2,632 3,130Swaziland 0 0 1 2 3Tanzania 318 432 369 450 600Togo 1 15 32 64 138Tunisia 4 26 0 0 0Uganda 39 76 37 41 53Zaire 346 1,295 1,939 2,548 3,511Zambia 107 126 130 96 78Sub-total 4,450 6,960 9,358 14,747 17,559

Cumulative Arrears by Sovereign Borrowers (cont.)

Bangladesh 0 1 1 2 3Cambodia 158 171 167 189 205Indonesia 1 1 1 1 0Laos 1 1 0 0 0Myanmar 397 548 792 1,006 1,333Pakistan 16 10 0 0 0Philippines 333 78 13 6 5Vietnam 201 232 200 81 105Sub-total 1,107 1,042 1,174 1,285 1,651

Bulgaria 3 24 19 115 47Croatia 0 0 0 109 130Kazakhstan 0 0 0 1 10Latvia 0 0 0 2 0Macedonia 0 0 0 81 91Poland 7,489 5,237 2,762 0 0Russian Federation 638 857 1,571 803 1,551Slovenia 0 0 0 82 89Ukraine 0 0 0 0 1Yugoslavia 247 560 852 926 1,604Sub-total 8,377 6,678 5,204 2,119 3,523

Argentina 284 456 397 0 0Bolivia 0 1 1 2 75Brazil 1,138 2,966 2,463 4,389 3,167Colombia 58 67 101 126 144Costa Rica 127 114 35 39 93Dominica 0 0 1 0 0Dominican Republic 623 61 53 33 29Ecuador 7 144 6 78 43El Salvador 1 2 20 0 0Grenada 9 12 12 14 16Guatemala 298 334 363 19 62Guyana 6 6 5 5 6Haiti 26 10 15 18 21Honduras 1 6 4 13 22Jamaica 121 98 97 100 99Nicaragua 414 124 81 53 86Panama 92 18 1 1 1Paraguay 88 128 28 37 27Peru 2,180 522 419 454 414St. Vincent 0 0 1 1 1St. Lucia 1 0 0 0 0Trinidad and Tobago 0 11 2 3 8Venezuela 0 0 41 75 168Sub-total 5,474 5,080 4,146 5,460 4,482

Egypt 1,261 328 309 297 320Iran 35 2 0 0 0Jordan 5 47 7 5 5Lebanon 12 11 8 13 13Syria 200 88 297 338 346Yemen 1 0 7 11 22Sub-total 1,514 476 628 664 706Total 20,922 20,236 20,510 24,275 27,921

Source: World Credit Tables 1996 (EURODAD 1996)

SFG

1930’s 1980’s 1994/95

Lending-BoomCharacteristics

• Low U.S. interest rates;lenders are seeking yieldsabroad 1924-29.

• Emergence of capitalmarkets.

• Banks enter market throughaggressive underwriting andmarketing techniques.

• Banks and investorsdisregard country risk,concentration risk, contagionrisk.

• Low U.S. interest rates andlow real rates make lendingattractive to lenders andborrowers alike. 1976-1981.

• Need to recycle petro-dollars to avoid inflationarypressures.

• Emergence of banksyndication.

• Banks disregard countryrisk, concentration risk,contagion risk.

• Low U.S. interest rates;lenders seeking yieldsabroad; 1989--94.

• Emergence of pension andlife insurance companiesas major investors followingregulatory changes.

• Rise of mutual funds.• Investors disregard

warnings on over-exposureand country risk.

Lending-BustCharacteristics

• U.S. interest rates rising in1928.

• Falling commodity prices;deteriorating terms-of-tradefor borrowers.

• Roll-over of financing(refinancing) dries up.

• Increased protectionism inU.S.

• Abrupt increase in U.S.interest rates.

• Deteriorating terms-of-tradefor emerging markets.

• Refinancing dries up.• Lack of information inside

banks on their ownexposure and across sector.

• Increase in U.S. interestrates in 1994.

• Lack of information.• Refinancing dries up.

AffectedBorrowers

• Global • Emerging Markets • Mexico, Argentina

PreferredInstruments ofCapital Flows

• Bonds • Loans • Trade financing, somebonds, and equity (moreFDI in Asia and EasternEurope, more portfolio inLA).

Resolution ofCrises

• Default.• Borrowers cut off until 1960s.• Borrowers implement import

substitution to reduce Forexneeds.

• Default.• Major Multi-lateral bailout.• Borrowers cut off until late

1980s.• Borrowers implement fiscal

reform to reduce publicsector borrowing needs.

• Major multilateral bailout.• Borrower almost instantly

reinstated, because U.S.interest rates decline again.

• Borrowers implementmonetary reform to sterilizecapital inflows and maintainstable currency.

Sovereign Debt Crises of the 20th CenturyTable iii

SFG Expropriation of Foreign CorporationsThe Major Culprits (1956-1985)

C o u n t r i e s b y R e g i o n Y e a r s N u m b e r o f F i r m s A f f e c t e dA F R I C A D u r i n g T h e P e r io d O f

A lg e r ia 1 9 6 5 - 1 9 7 8 1 0 7A n g o la 1 9 7 5 - 1 9 7 8 1 2 8B e n im 1 9 7 4 1 0C o n g o 1 9 7 0 - 1 9 7 7 3 1E t h io p ia 1 9 7 5 - 1 9 7 8 1 0 5G u in e a 1 9 5 9 - 1 9 7 9 9M a d a g a s c a r 1 9 7 5 - 1 9 7 8 5 0M o r o c c o 1 9 6 5 - 1 9 7 5 3 0M o z a m b iq u e 1 9 7 5 - 1 9 8 0 4 3N ig e r i a 1 9 6 7 - 1 9 7 4 3 5S o m a l ia 1 9 7 0 1 0S u d a n 1 9 7 0 - 1 9 7 8 2 5U g a n d a 1 9 7 0 9T a n z a n ia 1 9 6 3 - 1 9 7 8 1 2 7Z a m b ia 1 9 6 4 - 1 9 8 0 2 1

S u b T o t a l 7 4 0

M I D D L E E A S T

E g y p t 1 9 5 6 - 1 9 6 7 7 0I r a n 1 9 7 9 - 1 9 8 0 5 8I r a q 1 9 6 8 - 1 9 7 7 8L ib y a 1 9 6 9 - 1 9 7 4 3 3Y e m e n 1 9 6 9 - 1 9 7 8 3 0

S u b T o t a l 1 9 9

L A T I N A M E R IC A

C h i le 1 9 7 0 - 1 9 7 3 4 6J a m a ic a 1 9 7 2 - 1 9 7 7 1 2P e r u 1 9 6 8 - 1 9 7 5 4 7T r in id a d & T o b a g o 1 9 6 9 - 1 9 8 1 1 0

S u b T o t a l 1 1 5

A S I A

B u r m a 1 9 6 2 - 1 9 8 3 2 4I n d ia 1 9 6 7 - 1 9 7 5 4 8I n d o n e s ia 1 9 5 7 - 1 9 6 5 2 4S r i L a n k a 1 9 7 1 - 1 9 7 6 2 5 4

S u b T o t a l 3 5 0T O T A L 1 4 0 4

S o u r c e : C h a r le s R . K e n n e d y , J r . , “ R e la t i o n s B e t w e e n T r a n s n a t io n a l C o r p o r a t io n s a n d G o v e r n m e n ts o f H o s t C o u n t r i e s . A L o o k T oT h e F u t u r e ” i n : T r a n s n a t io n a l C o r p o r a t io n , V o l . 1 , N o . 1 F e b r u a r y 1 9 9 2 , p p . 6 7 - 9 1 .

Table iv

COUNTRY LIMIT APPROVAL FORMCOUNTRY LIMIT APPROVAL FORM

NAME OF COUNTRY

TRANSFERRISK RATING

LIQUIDITYRISK RATING

VOLATILITYRISK RATING

SUBNATIONALRISK RATING

EXPOSURELIMIT

Managing DirectorPortfolio Development and Support

Managing DirectorInternational

Managing DirectorCountry Risk

CEO -- SFG

Effective Date Renewal Date

g GE CapitalStructured Finance Group