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Country Credit: History lessons

Since our Country Credit survey was launched a quarter-century ago, bankers, analysts and portfolio managers have benefited from better information and more-sophisticated technology. Still, assessing sovereign risk hasn't gotten any easier to do well.

When Institutional Investor published its first ranking of country creditworthiness, risk assessment was a relatively young science. Its practitioners relied on scant economic data from international agencies and secretive finance ministries. Ideology and firmly held assumptions played a part in lenders' decisions: Indeed, reading the magazine's introductory essay in 1979, you might have thought bankers didn't pay much attention to numbers. New Zealand and Venezuela, for example, both earned high marks, apparently on the strength of time-honored beliefs about their stability, despite their then-troubled economies and questionable fiscal practices.

In many ways, of course, the world was a very different place 25 years ago -- geopolitically and economically. II's original survey covered only 93 countries; now it includes 173. The U.S. held the top spot in the rankings, with a credit rating of 9.89 out of a possible 10; today it is No. 3, scoring 93.7 out of a possible 100, after Switzerland (95.2) and Luxembourg (93.9). Germany (sans its Eastern half) was then the powerhouse of Europe and second behind the U.S. Today it is in ninth place, just ahead of Canada, which has fallen to tenth from fifth. Perhaps the most dramatic fall from grace has been in Japan, which has sunk to No. 22 from fourth place in 1979 to trail the much smaller economies of Ireland, Spain, Italy, and Portugal.

Yet a longer look at 1979 and 2004 reveals similarities, too. Then, as now, oil prices were ratcheting upward as a result of upheaval in the Middle East, where religious fundamentalists had just overthrown Muhammad Reza Shah Pahlavi of Iran. In November 1979, Iranian militants took Americans hostage in Tehran, beginning a 444-day crisis that did lasting political damage. The U.S. was beginning to get nervous about Central America, where a Socialist revolution against Nicaraguan President Anastasio Somoza Debayle would usher in a decade of bloody civil wars. And at home, newly appointed Federal Reserve Board Chairman Paul Volcker was just beginning to ratchet up interest rates, in part to shore up a weak dollar. Inflation jitters were rampant.

II's most recent country risk survey suggests that risk analysts see many of the same challenges -- rising oil prices, Middle Eastern political and religious strife and higher interest rates -- threatening an otherwise brighter world-investment environment. Overall country ratings hit 42.7 on a scale of 100, up 1.1 points over the 41.6 measured six months ago and a substantial gain from the 39.6 recorded in September 2003. (Excluding Tonga, the only new country added to this edition of the survey, the global average rose even more, to 42.9.) The three top gainers over six months each rose by 6.0 points: Higher oil prices helped Iran climb to 42.0; a stabilizing Bosnia & Herzegovina rose to 28.2; and its neighbor Serbia & Montenegro, flush with foreign exchange reserves, hit 24.9. Two Caribbean countries were among the nations that suffered the biggest six-month declines in their scores: The Dominican Republic fell by 7.0 points, to 26.3, as it struggled with heavy debt and economic crisis; and Grenada, with a mixed economic picture and high debt, dropped by 5.2 points, to 37.6, after gaining 8.9 six months ago. Sovereign credit analysts marked down Kiribati's score by 4.3 points, to 19.5, citing its dependence on foreign aid.

How does today's global credit quality compare with that of 1979? The overall country rating was then a more optimistic 55.4 (rebased from the original ten-point scale), possibly an indication of how sketchy analysts' knowledge of risk was at the time and of how much the world has changed.

In the intervening quarter-century, international lending has taken on a very different character. Back in 1979 the bulk of sovereign borrowing came from other national treasuries or from private sector banks; now, with a switch from credit to capital markets, nonbank institutions, from pension plans to hedge funds, buy increasing amounts of country debt. Accordingly, in II's inaugural credit risk ranking, we polled bankers; these days we also include money managers and securities firms. The fall of Communism, the emergence of more market-based economies around the world and the globalization of business have all whetted investors' appetite for foreign paper. The Washington, D.C.­based Institute of International Finance projects that nonbank institutions will supply $50.5 billion of private net capital to emerging markets this year, or 64.4 percent of the total, about twice the net financing that commercial banks will provide.

The need for more-sophisticated and comprehensive risk analysis has grown along with that demand. II's original intent in launching the rankings was simply to act as a clearinghouse for country credit information. At the time agencies like the World Bank and the International Monetary Fund -- not to mention borrowing governments themselves -- held their data close to the vest. "We didn't know how indebted these countries were; we just had to guesstimate," recalls one Canadian banker whose employer got back 10 cents on the dollar for loans to such emerging markets as Bolivia, Côte d'Ivoire, Cuba and Sudan in the early 1980s.

"Countries don't go out of business," then­Citigroup chairman Walter Wriston famously declared in 1982, shortly after Mexico asked its creditors for a payment moratorium. That reassurance rang hollow during the subsequent Latin American debt crisis, when U.S. commercial banks' exposure in the region had several, including Citi itself, tottering. The debacle taught financiers of all stripes that a borrower's transparency -- and methodical monitoring of country risk -- are necessary for sound cross-border lending.

By the end of the decade, many lenders hewed to what became known as the Washington Consensus, which promotes deregulated financial markets, privatization and trade liberalization as critical steps for economic development. Not that adherence to these prescriptions and a greater insistence on transparency entirely averted disaster. They certainly didn't prevent the Asian financial crisis of 1997­'98, the collapse of the ruble and Russia's subsequent default in 1998 or Argentina's fiery meltdown in 2001. Indeed, critics contend that policies insisted on by the IMF and the U.S. Treasury in many cases exacerbated the difficulties of these countries.

"The data that countries provide makes it easier to make a proper assessment of country risk," says Christine Shields, London-based head of country risk and emerging markets for Royal Bank of Scotland. "The problem is that the past doesn't repeat itself. Crises are never exactly the same."

Consider September 11, 2001, when the U.S. and the world learned in the most brutal way that cataclysms can strike unexpected targets in unimagined forms. As Roger Donnelly, chief economist at the Australian government's Export Finance and Insurance Corp., says: "The next financial crisis is always inherently different from the last. Policymakers and people involved in trade, finance and investment are like generals fighting the last war. The financial onslaught always catches us unawares and unprepared."

Sure enough, after the Berlin Wall and the Soviet Union crumbled, investors raced to participate in what they believed would be an unprecedented boom -- only to learn that capitalism and creditworthiness don't necessarily go hand in hand. (In fact, the former Soviet Union ranked 17th out of 93 countries in II's 1979 tally; today Russia ranks 58th out of 173, much further down that ladder. China and several countries of the former East Bloc have also seen their rankings fall as they embrace free markets.) These days the Washington Consensus is criticized for discounting the weakness of emerging-markets economies that fail to build solid legal and regulatory foundations. Detractors also warn of the dangers inherent in dealing with corrupt regimes, no matter what formal economic model its leaders espouse. Other skeptics charge that World Bank and IMF policies aren't flexible enough to cope with the wide variety of economic conditions in different countries.

Sometimes waves of Western money simply overwhelm an economic system with a weak foundation. Consider the 1997­'98 Asian currency crisis: Double-digit GDP growth had brought foreign investment pouring into the region -- until devaluation of the Thai baht and currency speculation led to the wholesale collapse of speculative real estate and equity markets. The crisis spread, abetted by information technology that sped data and capital across borders in seconds. The regional disaster, which threatened to topple banks, stock markets and even whole economies, spread to Latin America and Russia, as volatile "hot money" fled to safer venues.

Like the risk analysts whose opinions it reflects, II's Country Credit report has correctly waved a cautionary yellow flag at certain times in its history -- while clearly failing to signal other approaching disasters. Between September 1995 and September 1997, Thailand's score fell from 63.8 points to 59.9 points, a significant decline indicating that trouble was brewing well before the financial crisis hit. Over the same period declines in scores for Hong Kong, Malaysia, South Korea and Taiwan suggested that much of Asia was vulnerable to an economic shock. But then again, Mexico's rating rose steadily from 45.2 in early 1993 to 46.1 in September 1994, the eve of the country's December peso crisis, before plummeting to 41.8 in September 1995.

What have lenders learned from such financial disasters? Participants in II's latest survey rate a country's debt profile and the stability of its banking/financial system as the first and third most important variables, respectively, in assessing sovereign credit quality (for a complete list of ten factors, see our Web site,

"These kinds of crises over the past ten years have made it very clear that the health of a country's banking system is absolutely crucial if a country is to avoid a financial crisis," says Yusuke Horiguchi, chief economist at the IIF and an IMF veteran. "They have also taught us that countries should not get heavily indebted. As a result, countries and investors and institutions are all looking at bank balance sheets and external debt levels as key factors in assessing whether countries are headed for trouble."

The emerging-markets crash of the mid- to late '90s also served as a reminder that "politics matters," says Victoria Marklew, senior international economist at Northern Trust Co. in Chicago. "What came home during the Asian crisis is that there are big differences between a democracy and a one-man dictatorship, as you had in Indonesia. And in the integration of Russia and Eastern Europe into global markets, people concentrated on whether countries could make their payments. In doing so they overlooked high levels of corruption and the lack of respect for the rule of law. You can get some very nasty shocks that way." Respondents to our Country Credit survey ranked a country's political system and its governance as the fourth and fifth most important elements in evaluating risk.

Chastened financiers have adopted a number of technical reforms in managing country risk. Private sector institutions now use "collective-action clauses" in bond contracts that limit the ability of dissident creditors to block widely supported debt restructurings (55.1 percent of respondents to II's survey said they support these clauses, versus just 10.3 percent who oppose them; the rest had no opinion or didn't respond). And the IMF has installed an early-warning system. "The IMF is keeping an eye on mismatches and not allowing banks to borrow willy-nilly internationally and lend in domestic currency -- as they did in Asia -- which can sow the seeds of a domestic crisis," says Australia's Donnelly.

Of course, today's risk assessors have much more information at their fingertips than their predecessors did a quarter-century ago. Credit ratings agencies evaluate the risks in scores of countries around the world, and numerous other information sources -- both public and private -- offer near-instantaneous analysis of local events. By using the Internet, says Cathy Hepworth, a principal and emerging-markets portfolio manager at Prudential Financial, "I can look at a country's real-time foreign exchange reserves or assess the health of the banking system using the central bank's information about capital adequacy and asset quality."

If anything, then, today's investors may be warier than they were 25 years ago. Nevertheless, II's most recent country risk survey suggests that the world investment climate is rebounding after the global recession brought on by a "perfect storm" at the start of the decade: the destruction of the Internet bubble, ballooning budget deficits and the economic strains of war and terrorism. The gain in the overall country rating, to 42.9 (excluding Tonga), is consistent with other indicators: the World Bank, for example, reports that net total capital flowing to developing countries reached $228 billion in 2003, up 19 percent from $191 billion in 2002. Of that amount, $200 billion came from private sources -- the highest level since 1998.

Despite a brightening economic picture worldwide, investors are not uncorking the champagne quite yet. Investors and analysts told II that their five biggest concerns are: rising U.S. interest rates (38.5 percent), global terrorism (23.1 percent), oil prices (15.4 percent), a possible slowdown in China (9.0 percent) and inflation (6.4 percent).

Countries such as Brazil (see box, page 117) and Turkey, among other nations heavily indebted to foreign creditors, have performed much better in the past year but could take a body blow from precipitously rising interest rates. Both countries were among those most frequently cited in the survey as likely to exhibit higher credit risk in the next 12 months. (For more information on investors' views on future sovereign credit quality, see our Web site, www. "Turkey is like Brazil, where there is a lot of short-term debt, and rollover risk is very high," says RBS's Shields. "For both countries the next crisis is just around the corner."

Fear of further fundamentalist militancy in the Middle East manifests itself throughout the survey and in interviews -- most clearly when investors named Saudi Arabia, which ranks 55th overall in this edition, as second among countries most likely to present higher credit risk. Although the kingdom is under intense pressure to bow to local demands for the creation of a conservative Muslim state, a European investment manager sees reason to think that won't happen. "I agree that the potential for political instability is high in Saudi Arabia," this investor says, "but the probability of it happening is less enormous because the Saudi state has the mechanism to clamp down on dissent."

Oil instability cuts two ways. In mid-August oil prices broke $48 per barrel, their highest levels ever in nominal terms (although still lagging in real terms behind 1979 prices, which would be comparable to about $77 per barrel today). That helped send the U.S. Dow Jones industrial average skidding to its 2004 low. Yet higher crude oil prices are boosting the economic fortunes of a string of oil-producing nations, from impoverished Chad in Africa -- whose credit rating rose by 5.8 points in the past year, to 20.2, its highest level ever -- to Venezuela, whose rating also gained 5.8 points in the past 12 months, even before Marxist president Hugo Chávez survived a recall election last month.

Russia is a shining example of the power of higher oil prices, advancing by a handsome 8.4 points in the past year (the fifth-biggest rise in our poll) and by 4.2 points in the six months since March. In Russia's case, stronger oil exports have been accompanied by rising current-account balances and better fiscal management (see box, page 112). Yet investors remain circumspect in the wake of a run on Russian banks in July after a

money-laundering scandal at one institution prompted the government to shut it down and force the sale of another lender. And ongoing controversy over the fate of oil giant Yukos Oil Co., whose former CEO was jailed on tax evasion charges and whose assets have been frozen, bears watching. "What makes us all insecure about Russia is that companies are not treated in the same manner," says a German economist.

Iran, which showed one of the most dramatic improvements in the past six months, with a rise of 6.0 points, is another oil-powered case in point. Though it is patria non grata with the U.S., which still does not trade with Tehran, the country's rise to No. 74 in the rankings from No. 80 just six months ago is unsettling to some who worry about its nuclear ambitions. However, Conrad Schuller, chief economist at Erste Bank in Vienna, thinks analysts should focus elsewhere. "As long as the U.S. is not able to prove that Iran wants to develop nuclear weapons, the risk of a military involvement of the U.S. is very low," he says. But "the internal political developments in Iran -- the reformists have lost the last elections and conservatives have regained control over Parliament -- are much more important."

Even as rising oil prices enrich producers, they threaten to slow one of the world's growth locomotives: China. Its GDP is expected to expand by 8 percent in 2004, down from 9 percent but nothing to sneeze at. Still, China's rapid industrialization makes it particularly vulnerable to higher oil prices. Higher U.S. interest rates would give its economy a double whammy. The question of whether China will manage a soft or hard landing is on virtually every global investor's lips (see box, page 115).

Truly fearsome for the world would be the combination of an abrupt Chinese deceleration and a severe economic setback in the U.S. If high oil prices, rising interest rates and another terrorist attack were to come all at once, another crisis might erupt. That's a worst-case scenario -- the kind that risk managers, for more than a quarter-century, have been paid to consider.

Associate Editor Donovan Hervig compiled the statistics for this feature.

How the ratings are compiled

The country-by-country credit ratings developed by Institutional Investor are based on information provided by senior economists and sovereign-risk analysts at leading global banks and money management and securities firms. They have graded each country on a scale of zero to 100, with 100 representing those countries that have the least chance of default. We also asked respondents to rank ten political, economic and financial indicators in order of their importance for each region. In this edition of the survey, we have regrouped certain countries into new regional categories to better reflect current economic and political ties. Among the changes, we put North African countries with the Middle East instead of with the rest of Africa; shifted Turkey from the Middle East to Eastern Europe/Central Asia; took Mexico out of the North America region and placed it with Latin America; and split Asia-Pacific into Asia-Pacific/Far East and Asia-Pacific/South & East. To make comparisons easier, historical regional averages cited in this edition have been recalculated using the new regional compositions. Also beginning with this edition, we added Tonga to the list of rated countries. Names of respondents are kept strictly confidential. In previous years, survey participants were not permitted to rate their home countries; this restriction was eliminated starting with the March 2004 survey. Participants' responses were adjusted according to an II formula that more heavily weights those institutions with worldwide exposure and sophisticated country-analysis systems.

Russia gathers strength

President Vladimir Putin has brought a measure of order and focus to Russian economic policy where predecessor Boris Yeltsin seemed to jump from strategy to strategy. Christian Thomsen, director of country risk at Charlotte, North Carolina­based Wachovia Securities, compares Putin to the disciplined "ant," where Yeltsin was more akin to a "grasshopper." Surging oil prices, of course, have helped a lot, but the recently re-elected Putin is also husbanding the windfall. Russia boasted massive foreign exchange reserves and current-account surpluses, estimated at $80 billion and $40 billion, respectively, in May, and Moody's Investors Service last year awarded the country its first investment-grade rating for sovereign debt. With a fiscal surplus of 2 percent of GDP -- itself growing at a roughly 7 percent annualized rate -- Russia has been paying down its $100 billion sovereign debt.

The result: Russia continues to rise in Institutional Investor's Country Credit survey. Since our poll six months ago, it improved by 4.2 points, to 53.5, moving up one notch in our global ranking, to 58th. Over a one-year period, Russia has been the world's fifth-biggest gainer, adding 8.4 points. Two years after the 1991 breakup of the Soviet Union, and again in 1998 during Russia's massive default, the country's score fell below 20 points.

In contrast with those dark days, investors today can't seem to get enough Russian debt. In early July the cash-strapped German government repackaged and sold about E5 billion ($6 billion) of the E14 billion in Russian Paris Club debt it then held. News of the huge offering, dubbed Aries, initially caused prices of outstanding Russian bonds to drop. But they quickly rebounded as investors drove the Aries deal price to a premium.

"Russia has clearly come a long way," says one analyst.

Indeed, respondents to II's Country Credit poll listed Russia as the country most likely to see its credit quality improve in the next 12 months.

For all these encouraging developments, Russia hasn't lost its ability to surprise analysts -- sometimes unpleasantly. The government's confrontation with oil giant Yukos Oil Co. and the jailing of its politically outspoken former CEO Mikhail Khodorkovsky on allegations of tax evasion have raised troubling questions about Putin's commitment to corporate and democratic freedoms. And an early summer depositor run on several banks was a reminder of how little faith Russian citizens place in government and financial institutions. Is the Yukos affair an aberration? "Only time will tell whether the actions of the Putin administration were meant to set an example or will set a precedent," says Paul Koenekoop, director of country risk at ING Group in Amsterdam. -- Donovan Hervig

Beijing's smooth downshift

Economists and business leaders the world over have been watching the superheated Chinese economy with trepidation, fearful that a bubble might be developing whose popping could wreck havoc globally. But if our voters are right, a now-slowing China is likely to have a nice soft landing.

The world's fastest-growing economy will downshift, without crashing, thanks to "the cooling measures the Chinese government implemented in a timely manner," says Masashi Shimizu, senior risk and credit analyst for the international credit department at Nippon Life Insurance Co. Other analysts agree: China's rating gained a solid 2.3 points since our survey six months ago and 5.8 points from a year ago. It held steady at No. 38 in our latest rankings, unchanged from March but up from No. 42 last September.

Just a few months ago, analysts were not so sanguine. The first quarter's annualized 9.8 percent GDP growth rate, on top of last year's 9.1 percent gain, suggested that the Chinese economy was in danger of overheating. Energy and raw materials were beginning to run short. Inflation, just 1.2 percent in 2003, jumped to 2.8 percent in the first quarter and hit 5 percent in June. But even before inflation surged, the People's Bank of China ordered banks to boost their reserves and cut lending, and Beijing canceled a number of big public works projects.

So far these measures seem to be working. Steel and real estate prices have stabilized. Investment in construction and factory equipment dropped from a sizzling 43 percent growth rate in the first quarter to 28.6 percent for the first half (the government did not break out second-quarter numbers). GDP growth in the second quarter slowed a bit, to 9.6 percent.

As a result, China is likely to be able to slow its growth rate to its target of an annualized 7 percent by year-end, says Takuya Mishima, chief credit and risk analyst at Mitsubishi Securities Co. in Tokyo. Other analysts agree that the pace of growth is slowing, though most think the economy will still expand by about 8 percent this year.

The measured slowdown thus far has reassured foreign investors and other partners who might in years past have headed for the exits out of fear that Beijing would bungle a measured reduction in growth. Foreign direct investment, which hit a record $53.5 billion last year, reached $33.9 billion in the first half and should easily exceed the 2003 total, while export growth remains robust at $258 billion in the first half, up 35.7 percent over last year. Credit ratings agency Standard & Poor's said in late July that it was considering raising China's sovereign-debt rating above the current triple-B-plus, thanks to the slowdown.

This confidence in Beijing is a measure of how far China has come in the past few years. "All Western countries accept China as a trusted partner," says Shimizu, who predicts that China's sovereign rating will improve to single-A within a year or two.

Even so, the country faces huge challenges in creating a modern state. Opaque government decision making, huge and destabilizing gaps between rich and poor and a creaky banking system plagued by bad loans and scandal are just a few of the problems, say risk analysts. As Mitsubishi's Mishima notes, "You never know when something unexpected, like SARS, might happen."-- Kazuhiko Shimizu

The rewards of EU membership

Joining the European Union in May fulfilled a decade-old ambition for the countries of Central and Eastern Europe. It also did wonders for their creditworthiness.

The eight new EU member states from these regions scored some of the biggest gains in credit ratings in Institutional Investor's rankings, up by 3.2 points on average in the past six months and by 4.3 points over the past year. By contrast, the ratings for the 15 older EU members slipped by 0.6 point on average in the past six months. (The two other new members, the more-developed Mediterranean states of Cyprus and Malta, enjoyed more-modest ratings gains than did those European countries.)

Acceptance into the EU was in many respects symbolic recognition for years of progress in developing vibrant democracies and rapidly growing economies. The countries already enjoyed open access to the EU market and won't see a notable increase in the flow of funds from Brussels. Still, membership carries great significance for most risk assessors. "Actually being an EU member gives some additional assurance. It's like a quality stamp," says Frank Vinke, a senior economist on the country-risk team at ABN Amro in Amsterdam.

Western Europe's renewed growth contributed to its neighbors' improving credit status. Even slight gains in the bigger economies provide impetus to the smaller accession countries, because more than half of the new members' trade is with the rest of the EU. The eight are expected to grow by an average of 4.5 percent this year, more than double the 2.0 percent rate of the older 15, according to EU estimates.

Slovenia leads the accession pack. Its rating rose by 2.7 points in the past six months, to 73.5, keeping it in 27th place overall. That places it just three spots behind Greece, at No. 24 the lowest-ranked of the EU 15. ABN Amro upgraded Slovenia to its country risk-free category following accession because of the country's low debt and high income levels -- per capita GDP stands at 77 percent of the EU average. That category, broadly equivalent to a double-A rating from the ratings agencies, means that the bank will treat exposure in Slovenia the same way it treats its commitments in the Netherlands or other Western European countries.

Tiny Estonia, with the smallest population and GDP of the eight, posted the biggest gain. Its rating jumped by 5.3 points over the past six months, to 65.8, moving it up five places to 37th overall. The Baltic country is forecast to grow by a robust 5.4 percent this year. Just as important, Estonia is considered one of the leading candidates to adopt the euro. The country has pegged its currency, the kroon, to the euro for years, and in June it entered the EU exchange-rate mechanism, a step it hopes will pave the way for adopting the euro in 2007.

Eliminating exchange-rate risk would be a big plus for the country's credit rating, says Maxine Koster, an economist at Credit Suisse First Boston in Zurich. Euro adoption also would compel the country to conform to the EU Stability Pact's deficit limits, providing some insurance against a dramatic worsening of the country's fiscal position, notwithstanding recent violations of the pact by France and Germany. "They'll have to abide by, or be close to, the rules," Koster says. Joining the EU exchange-rate mechanism "gives them a certain amount of credibility." Slovenia and Lithuania, which saw its rating jump by 3.4 points, to 60.6, also joined the exchange-rate mechanism in June.

Deficit woes limited the ratings improvements of some of the larger accession countries, however. The Czech Republic, where deficit problems contributed to the ouster of Vladimír Spidla as prime minister in July, rose 2.4 points, to 68.6. Hungary, which is struggling to implement an austerity program to rein in its deficit and steady the forint, gained just 1.3 points, to 66.0, the smallest rise among the eight countries. "They're talking in the right direction," Koster says of the government's deficit-cutting plans. "When you see action, you'll start to see the rating go up." Poland has similar deficit problems, but a sharp upturn in growth -- expected to reach 4.6 percent for the year -- helped boost its credit rating by 3.8 points, to 65.1.

Of the EU's other new members, Malta saw its rating rise by 2.2 points, to 71.9, leaving it in 28th place globally, just behind Slovenia. Cyprus slipped three places to 35th, however, apparently reflecting political risk. On the eve of accession, Greek Cypriots voted to reject a United Nations­sponsored peace plan, dashing hopes for an end to the 30-year-old divide caused by Turkey's invasion of the north of the island in 1974. -- Tom Buerkle

Can Lula sustain the gains?

News from Brasilia doesn't get much better than this: After coming into office in January of last year, Luiz Inácio Lula da Silva's left-leaning administration employed sound monetary and fiscal policies that have created a Brazilian resurgence after several years of stagnation. Lula has kept a lid on spending, reduced inflation and cut rates. What's more, Brazil's large and increasingly diversified economy (exporting everything from airplanes to soybeans) has thrived as new markets in China have boomed. Brazil's GDP grew by 5.7 percent in the second quarter of 2004 versus the same period a year earlier, and its primary surplus, excluding interest payments, is running at nearly 4 percent. In Institutional Investor's March 2004 Country Credit poll, the country rose by an impressive 5.6 points, to 42.7, and its global ranking jumped to 68th from 76th. A year before, Brazil's point total was a lowly 36.1.

But credit experts, mindful of the country's economic history, worry that the news may not stay so good. This cautiousness is evident in our latest survey results. Brazil dropped slightly -- by just 0.1 point -- to 42.6 points in the September voting; its ranking slipped back to 73rd. And Brazil was mentioned most frequently by respondents when asked which country was likely to show increased credit risk in the next year.

"Although we are not so concerned about Brazil in the short to medium term, we will be careful in the long term," says Firmino de Sousa, international economist at Mellon Financial Corp. in Pittsburgh.

That said, the Lula administration continues to plug away at economic reforms that are pleasing to overseas investors. A bankruptcy law strengthening creditor protections is expected to be enacted this year, and legislative efforts to formalize the independence of Banco Central do Brasil are also under way. An official split from the government "would give us some comfort," says Lance Connelly, an economist at Northern Trust Co. in Chicago.

As ever, though, there are nagging questions. Higher U.S. interest rates threaten to raise borrowing costs -- which could be damaging to a country with an estimated $215 billion in outstanding foreign debt -- and China's decision to slow economic growth may dampen demand for Brazilian products. And any sharp drop in commodity prices would hurt Brazil. Risk analysts, encouraged by Brazil's accomplishments, nonetheless are watching carefully. "It still has a long way to go, and serious risks remain, but Brazil has improved its credit picture," says Northern Trust's Connelly. -- D.H.

Millennium challenged

In May, Millennium Challenge Corp. announced that 16 struggling countries -- from Armenia in Eastern Europe to Vanuatu in Southern Asia-Pacific -- had passed their initial eligibility tests and could apply for economic aid under the U.S.'s new Millennium Challenge Account program. By the end of this year, the U.S. government expects to begin to distribute to many of these countries a portion of the first $1 billion appropriated by Congress for the program, which President George W. Bush first proposed in 2002.

The Millennium Challenge offers a departure from other U.S. aid programs. For one thing, it's bigger. If fully funded at $5 billion in the next few years, the MCA will be 50 percent larger than existing U.S. core development assistance schemes aimed at stimulating economic growth and reducing poverty. It also links payouts to performance in new ways. To receive aid, these nations, whose annual per-capita GDP must be less than $1,415, are evaluated on 16 criteria intended to reveal whether they govern justly, invest in their citizenry and promote economic freedom. Among the indicators that the government uses is Institutional Investor's Country Credit survey, which, as an assessment of individual sovereign creditworthiness, is considered one measure of economic freedom.

A key advantage of the MCA money, says Steven Radelet, who was part of the Treasury Department team that designed the program, is that it provides what he calls "no-year money." In other words, a country, once it reaches an agreement with the MCC on how the money will be distributed and its impact monitored, doesn't have to spend its windfall under tight deadlines that can sometimes lead to bad decisions. Instead, no time limit is imposed on the country in putting the funds to work, but the effectiveness of the investments is monitored continually by MCC staff. Radelet, now a senior fellow at the Center for Global Development in Washington, D.C., also notes that MCA nations don't have to use U.S. contractors on their projects, which may range from building new roads to constructing irrigation systems. It's expected that much of this work will be subcontracted to local companies, providing an additional economic kick.

As promising as MCA is and as quickly as it's gotten under way -- by Washington standards, anyway -- the account faces its own development challenges. Congress allocated $1 billion to the MCC for fiscal year 2004, ended September, but the House of Representatives cut in half the administration's $2.5 billion request for fiscal year 2005. The Senate could reduce the figure further. As a result, the program looks unlikely to receive the generally envisioned $5 billion requested -- at least not by 2006, as originally planned.

"Many of us think the MCA is a good program with a lot of potential, and we'll fight to keep it going and adequately funded," says Representative James Kolbe, an Arizona Republican who chairs the House Subcommittee on Foreign Operations, Export Financing and Related Programs, which holds jurisdiction over many U.S. aid programs, including MCA.

Some eyebrows were raised about the MCC's policies when it put the former Soviet state of Georgia on the list of eligible countries. "While having reasonable discretion can be a good thing, this seems to be a political play in support of the recently elected president, Mikhail Saakashvili," says Radelet.

Saakashvili succeeded Eduard Shevardnadze, a onetime foreign minister of the Soviet Union who resigned the presidency last November after Georgia's economy collapsed and its government leadership was engulfed in scandal. Radelet says that Georgia did well on only a few of the measures MCC uses in its assessment, suggesting that it was included to encourage economic and political reforms. (The country did improve by 3.1 points in the past six months, to 21.4, in II's current Country Credit survey.)

"We're making a bet on leadership," concedes MCC chief executive officer Paul Applegarth, reached in Cape Verde. "A compact has yet to be formed, and we're keeping a close eye on them in the coming months." Applegarth says that "effecting positive governance changes can give a country as much bang for its buck as giving money."

The upcoming U.S. presidential election has raised questions about the program's long-term viability. Although it enjoys bipartisan support, MCA owes its start to President Bush, who announced the initiative in March 2002 during the International Conference on Financing for Development, in Monterrey, Mexico. Board members of the MCC include Secretary of State Colin Powell, as chair, Treasury Secretary John Snow and former Environmental Protection Agency head and New Jersey governor Christine Todd Whitman. Whether a Democratic administration under John Kerry would push the MCA as vigorously or try a different tack isn't clear.

Of course, the 16 eligible countries just want a chance to obtain and use the money, regardless of who's in the White House. They are now working to achieve their compacts with the MCC. Once those agreements are reached, they will receive their allotments.

In early July, MCC announced that nearly 70 additional candidate countries would undergo review to assess their eligibility to apply. If Congress allocates the money and partisan politics don't intervene, the Millennium account will no doubt become very popular.-- D.H.