Personal reflections on sovereign debt and sustainability from Seoul

Richard Smith-Morgan, Deputy Chief Risk Officer at UKEF, reflects on a thought-provoking Berne Union country risk specialist meeting, impeccably hosted by KSURE in Seoul, South Korea.

Everyone enjoys a nice ‘goody bag’, don’t they? From Hollywood Premieres to luxury offsites, expectations run right off the scale. We normally plunge our hands in and wrench out our loot. Not me. Not this time. Not when I opened my tin to find an umbrella – the death sentence – a chilling symbol from the ultimate [Korean] TV series.

Joking aside, while the biannual meeting of the country risk specialists may have lacked some of the tension of Squid Game, our hosts, Korea Trade Insurance Corporation [KSURE], did us proud. From the well-chosen, venue – The Westin Josun – and opportunity to network, to the traditional Korean dinner and cable car ride to the top of the Namsan Tower, KSURE excelled.

Sovereign credit concerns

The conference kicked off with an excellent global economic overview from Cedric Chehab from Fitch Solutions, who outlined the key global economic trends and their likely impact on sovereign credit profiles. This led nicely into break-out sessions on East Asia, West Asia (Turkey being a particular area of interest) and importantly, sub-Saharan Africa, where the impact of interest rate rises on already stressed sovereign debt profiles, raises the unwelcome spectre of sovereign debt sustainability. Dhiren Patel, Co-Chief Economist of UK Export Finance (UKEF), developed this theme further in a lively session on debt sustainability, noting Zambia and Sri Lanka as two of the earliest casualties.

Climate change risks

The second day dived straight into the theme of the moment, namely ESG and climate change risk, and their potential effects on credit ratings. To date at least, incorporating the potential consequences of climate change risk – transition risk and physical risk in particular – into specific default probabilities (PDs) and losses given default (LGDs) has been challenging. The ratings agencies, for example, are currently treating these issues as separate, but parallel, descriptors which, while occasionally overlapping, cannot yet be combined in the absence of sufficient empirical data.

Moritz Nebe, from MIGA, opened the session by addressing this issue head-on and discussing the difficulties of incorporating climate risk considerations into political risk insurance ratings (PRIs). After offering a practical framework for the evaluation of climate risk on PRIs, he outlined firstly how acute physical risks may ultimately impact PRIs in terms of the transmission channels through which climate risk drivers might flow. Through some interesting modelling, he demonstrated a clear correlation between physical climate risks and political insurance ratings (PRIs) but at the same time, less robust connections between transition risk indicators and PRIs. He concluded by emphasising the importance of a holistic approach in reviewing climate risk indicators, including, in particular, individual governmental willingness and capacity to intervene.

My presentation followed, in which, perhaps not unexpectedly, I took a more transaction-based, approach, outlining some practical steps for facilitating (the approval of) clean growth transactions. I first outlined the fragile base from which most ECAs are currently operating. ECAs’ de facto already aggressive risk appetites that had already been stretched to the limit through the ravages of a global pandemic are now being battered by the winds of the most significant geopolitical event of the last 75 years. In the context of an increasingly fragile economic backdrop, credit risk managers are faced with the unenviable task of trying to further adjust ECA risk appetites, to ‘facilitate climate change transactions’.

Organisational and cultural change is a critical first step in this process. UKEF, for example, took the decision to create an entirely new department in this respect, importantly, under the direct auspices of the CEO and even more critically perhaps, combined with the organisation’s strategy division. Equally importantly was the rapid development and implementation of awareness and communications channels across the organisation to reinforce the importance of this new approach. Buy-in from all stakeholders – from all staff to the entirety of the board – combined with regular reporting and the development of key metrics (as they become available) – is the third, and final part of this structural change.

Only following the successful implementation of these key structural changes are more tactical transaction and risk appetite-related adjustments possible. Such refinements in risk appetite will clearly be specific to each ECA and to their respective risk appetites. These could include fundamental adjustments to the very types of financing under consideration. Start-up financing, for example, has traditionally at least, been the preserve of the equity markets – and is very relevant given the number of EV battery factory start-ups under consideration across Europe.

Another fundamental adjustment may include an acceptance of higher technology risk (tidal technology and the hydrogen engine, for instance) to more tactical amendments, such as higher debt-equity ratios, extended repayment terms (OECD constraints notwithstanding) and non-deal term-matching, offtake arrangements. I suggest an evolutionary not revolutionary pace to this process.

Jørn Fredsgaard Sørensen, EKF’s Director, Country, Bank & Sector, who kindly (and successfully) agreed to step in as our Chair, concluded the climate change session with some fascinating observations on the effects of climate change on sovereigns, corporates and financial institutions, referencing a number of academic research papers to corroborate his conclusions.

Somewhat contrary to (some of) the prevailing themes of the day, and referencing Deloitte’s study ‘Europe’s Turning Point’ in particular – he concluded that a wide range of scenarios (including the ECB, European Commission and NGFS) indicated ‘limited damage’ to global growth projections, largely in the range of between only one or two percentage points.

Of more concern, however, was the uneven nature of the potential consequences, with poorly rated, emerging market sovereign economies most likely to contract substantially. Sovereigns with greater vulnerability to climate change, he concluded, will face a much higher likelihood of debt default. While better-rated sovereigns would experience more downgrades, better-rated sovereigns by definition, enjoy more intrinsic capacity for downgrade and are therefore better able to weather any climate-related, deterioration. Corporates, while clearly experiencing considerable rating deterioration over a 25-year horizon, particularly under the ‘hot house scenario’ similarly, experience very modest deterioration over a five-year horizon with a BB- (BB minus) entity’s probability of default increasing by a modest 2% only over this period.

The afternoon session focused on modelling and data including a presentation on tail event risk from Steve Capon, of CHUBB, geospatial, big data and machine learning from Mark Rosenberg of GeoQuant, and concluded with a lively panel discussion on the economic consequences of restricted access to basic social and economic fundamentals.

Conference delegates agreed that both the formal and informal elements of these meetings were invaluable and came to the inevitable conclusion that as we head into yet another period of uncertainty, increasing the frequency of these meetings seems more relevant than ever.