INTERNATIONAL: Countries can gain by swapping risk

Analysis

The international market for swaps has grown from virtually nothing in 1980. Today, banks and investment companies around the world use swaps to manage their exposure to different types of risk -- currency, interest rate, and equity market -- in order to lower their transaction costs (see JAPAN/ASEAN: Tokyo keeps momentum in cooperation - January 28, 2005). Swaps transfer risk, while leaving the flows of capital largely untouched, thus minimising the need for institutional change when diversifying.

Nobel prize winner Professor Robert C. Merton of Harvard Business School has recently suggested an innovative use for swaps: swapping country risk. In this context, Merton proposes using equity swaps as a means of efficiently managing a country's risk exposure and improving national risk profiles. Swaps can achieve this by reducing countries' dependency on a single industry without siphoning away investment from domestic industries with comparative advantages.

Risk reducing diversification. Suppose, for instance, that country A has a flourishing automotive industry, and a nonexistent electronics industry; while country B has a flourishing electronics industry, and a nonexistent automotive industry. Each government, in the name of improving its risk profile, will seek to diversify its economy, thereby reducing dependence on a single industry. Traditionally, a country would sink billions of dollars into creating a 'national champion' in the other industry. Country A would invest heavily in creating an electronics industry, causing enormous social disruption as people would need to be retrained. Furthermore, as country A has no set of advantages for electronics, developing a robust electronics industry would require extensive protections and subsidies. This method of diversification, rather than reducing risk, carries many risks of its own, and would probably result in billions of dollars misspent.

Country risk swap. However, diversification could be achieved through other means, namely an equity swap:

• Country A would agree to pay returns on a world automotive portfolio -- the industry for which it has an advantage -- in exchange for returns on a world electronics portfolio.
• In so doing, country A would effectively eliminate its exposure to the world automotive market -- over which it has practically no control.
• Concurrently, country A would retain its risk exposure and economic gain related to the local automotive industry -- over which it has control.

Thus, country A can focus on its comparative advantage -- automobiles -- all the while insulating itself from the risk associated with this global industry.

Numerical example. Country A and country B have entered into a swap agreement worth 10 billion dollars, whereby country A agrees to pay returns on a world automotive portfolio, and country B agrees to pay returns on a world electronics portfolio:

• Country A reduces its exposure to the world automotive market by 10 billion dollars and replaces it with a diversifying risk of 10 billion dollars to the electronics market.
• Assume the world automotive market grows by 12% while the world electronics market grows by 10%. The swap generates a cash outflow of 200 million dollars -- (.12-.10)*10 billion dollars -- for country A, as autos outperformed electronics globally. Importantly, a country is expected to pay only in the years when its local industry was also the 'winning' global industry, ie autos over electronics for country A.
• Conversely, if the automotive market grows 8% while the world electronics market grows 10%, country A would be entitled to 200 million dollars.

Comparative advantage. Equity swaps allow each country to diversify risk and improve risk profile without pursuing economic activities inconsistent with its comparative advantage:

• Countries can invest in industries for which they have a comparative advantage without damaging their risk profile.
• Countries can manage their risk characteristics without engaging in disruptive, and potentially wasteful, policies developing non-competitive industries with the single goal of 'risk diversification'. The day before the swap is done, and the day after, workers in each country go to work and perform in the same way; there are no changes required to the domestic financial system and local business practices. Thus, this approach to what might be potentially massive risk transfer is non-invasive of the domestic system.
• By using swaps, instead of physical investment, the country has the flexibility quickly and easily to reverse a decision. Reversibility also makes it more likely that the country will be willing to undertake the proposed large transformation of risk in the first place.

Feasibility/Obstacles. All of the requisites for trading country risk swaps currently exist, so its implementation would be relatively straightforward:

1. Market. An active global swaps market already exists:
   • Swaps are bilateral agreements or contracts, and thus do not require an 'exchange'. New types of swaps can be created and implemented as soon as two consenting parties are willing to enter into a contractual agreement.
   • Thanks to a flourishing market in interest rate and currency swaps, there is a body of law and conventions covering swap contracts that could easily be borrowed for country risk swaps.
   • Under the International Swaps and Derivatives Associations agreements, contract terms are standardised.
2. Settlement. By using a mixture of existing traded indices as the underlying asset being swapped, settlement mechanics should be clear.

3. Credit risk. Countries swapping risk will want to minimise their contract credit risk. This can be achieved via:

   • standard collateral marked to market;
   • the purchase of private sector performance guarantees; or
   • quasi-government institution guarantees.

   Furthermore, credit risk is less of a problem for swaps, as contracts call for payment from the party benefiting economically -- assuming the swap is a 'right way' contract used for hedging. Thus, the country that pays has the ability to pay. Also, there is no exchange of principal amounts between the counterparts; the credit risk is orders of magnitude smaller for the swap than the size of the notational amount of the swap.

   Thus, on 10 billion dollars of risk transfer of auto assets, the only exposure for the counterpart is to the difference in return between autos and electronics for the period between exchange of settlement payments (quarterly, or semi annually or even annually). For example, 12% return on autos minus 8% return on electronics (4% of 10 billion dollars) would create exposure of 400 million dollars. This is not a small sum, but it is far smaller than the exposure on 10 billion dollars of sovereign loans -- 10 billion dollars plus interest accrued.