Sovereign Default Risk

After completing this reading, you should be able to:

• Identify and explain the different sources of country risk.
• Evaluate the methods for measuring country risk and discuss the limitations of using those methods.
• Compare and contrast foreign currency defaults and local currency defaults.
• Explain the consequences of a country’s default.
• Discuss measures of sovereign default risk and describe components of a sovereign rating.
• Describe the shortcomings of the sovereign rating systems of rating agencies.
• Compare the use of credit ratings, market-based credit default spreads, and CDS spreads in predicting default.

Factors Determining Sovereign Default Risk

Governments, individuals, and firms default on debt for analogous reasons—it typically occurs when they borrow beyond their means in favorable economic conditions and subsequently struggle to meet debt obligations during downturns. To evaluate sovereign default risk, the following variables must be considered.

Degree of Indebtedness

The primary step in assessing default risk involves examining a sovereign entity’s debt in comparison to its GDP. A high level of indebtedness relative to GDP may suggest a higher risk, but it isn’t a definitive measure of default risk. Countries with considerable debt can either be high-risk or be perceived as creditworthy. This highlights that indebtedness requires context and cannot be solely relied on for predicting default.

Pensions and Social Service Commitments

Government commitments to pensions and healthcare also compete for limited revenues. These promises increase the government’s financial burden and can heighten default risk, especially when commitments are substantial relative to the government’s ability to fulfill them.

Revenue Inflows to Government

Predictably, government revenues are predominantly derived from tax collections, dependent on the tax system and base. A country’s capacity to generate revenue to meet debt obligations can influence the default risk. Access to a larger, stable tax base can reduce the risk by providing consistent revenue streams.

Stability of Revenues

Stable revenue streams mitigate default risk as governments must meet fixed debt obligations regardless of economic cycles. Economic diversification typically promotes revenue stability, whereas reliance on a few sectors can result in volatile revenue streams and increased default risk. The tax system type also affects revenue stability; income taxes can produce more erratic revenues compared to consumption-based taxes like sales or value-added taxes.

Political Risk

The decision to default is not merely economic but also political. Governments that are less susceptible to public dissent or regimes that are more autocratic may be more prone to default. Central bank autonomy and the nation’s monetary policies further influence default risk assessments.

Implicit Backing from Other Entities

Perceptions of sovereign default risk can be influenced by the belief that other, more robust entities might provide support during crises, as seen with European Union member states. However, such support is not always guaranteed and may sometimes lead to misplaced expectations among investors.

In summary, assessing sovereign default risk requires a comprehensive analysis that goes beyond financial metrics. Understanding the broader economic environment, political structures, and the interplay of various risk factors is critical.

Evaluation of Methods for Measuring Country Risk

Evaluating country risk involves examining multiple methods that rating agencies deploy in assessing sovereign creditworthiness. Sovereign credit ratings stem from a template adapted from corporate rating methodologies, with each agency applying its unique system while adhering to common principles. Here’s a breakdown of how these agencies approach sovereign ratings.

Ratings Measure

• Purpose: Ratings focus on a sovereign’s creditworthiness in relation to private creditors, not official creditors like the World Bank or IMF.
• Probability vs. Severity: Different agencies emphasize various aspects—while S&P’s ratings primarily capture the likelihood of default, Moody’s ratings account for both the likelihood and the expected severity (recovery rate).
• Definition of Default: Default can be either an outright failure to pay or a restructuring of the debt that disadvantages the creditors across all rating agencies.

Determinants of Ratings

• Incorporated Factors: Standard & Poor’s uses political, economic, and institutional variables, similar to Moody’s and Fitch.
• Rating Components: The components under examination range from political stability and legitimacy to economic growth prospects, government debt, monetary flexibility, and external liquidity.

Rating Process

• Committee Decision: An analyst compiles a draft rating recommendation, which a committee analyzes. The committee votes on the rating after deliberation, ensuring a group consensus.

Local vs. Foreign Currency Ratings

• Differential Basis: Agencies distinguish between local and foreign currency ratings. The differentiation is based on a country’s monetary policy independence—the more independent the monetary policy (e.g., free-floating exchange rates), the greater the potential divergence between local and foreign currency ratings.

Ratings Review and Updates

• Agencies regularly review and update sovereign ratings, which can be prompted by significant news events like political upheavals.

Effectiveness of Sovereign Ratings

• Correlation to Defaults: Agencies argue that a meaningful correlation exists between sovereign ratings and actual defaults. Investment-grade sovereign bonds exhibit fewer defaults than speculative-grade bonds.
• Ratings Transition Matrix: Ratings can change, with matrices showing the probability of a rating’s change over specific periods.

Foreign Currency Defaults vs. Local Currency Defaults

Foreign Currency Defaults

Foreign currency defaults transpire when governments are unable to meet obligations denominated in a currency other than their own. This can occur because sovereign entities typically cannot print foreign currency, which limits their ability to manage such debt during crisis periods. Historical patterns showcase that governments have more often defaulted on foreign debt, particularly due to the incapacity to acquire enough foreign currency to service their debt. Latin American countries have showcased a significant history of foreign currency defaults, largely because of military conflicts and political instability. Moreover, countries are more prone to default on bank loans than on sovereign bonds, and for foreign currency obligations, the focus shifts heavily to bank loans.

The case of foreign currency default is more straightforward to comprehend because the choices for a country to acquire necessary foreign funds are limited and often out of the immediate control of the country’s central bank or government.

Local Currency Defaults

Local currency defaults, however, are more complex. While defaults on foreign currency debts often make headlines, defaults on local currency debt occur as well. Various issuers have defaulted on their local currency debt throughout history, with notable examples including Argentina, Madagascar, Dominica, Mongolia, Ukraine, and Russia. Russia’s default on ruble debt amounted to $39 billion, which is one of the largest local currency defaults in modern times.

The puzzling aspect of local currency defaults lies in the question: why can’t governments simply print more money to meet their domestic obligations? Local currency defaults are counterintuitive because, theoretically, a sovereign can issue more of its currency to obviate these defaults.

However, the following reasons explain why local currency defaults occur:

• Gold Standard Constraints: Historically, currencies that were backed by gold reserves had a limit on the amount of currency that could be printed, constrained by the extent of these gold reserves.
• Shared Currencies: In situations where countries are part of a monetary union or have adopted a foreign currency (dollarization), the ability to print currency is lost. The Greek crisis highlighted such a scenario within the Eurozone.
• Deliberate Policy Choices: Sometimes, governments must deliberate between defaulting or debasing their currency. Default may be chosen as the less costly option, especially if domestic companies have significant foreign currency debt while holding local currency assets. Printing more money could lead to inflation and severe devaluation of the local currency, drastically impacting companies’ balance sheets.

Comparative Analysis: The contrast between foreign and local currency defaults is primarily rooted in the sovereignty over currency issuance. Foreign currency defaults arise due to external constraints, while local currency defaults are a mixture of historical policy remnants, shared currency constraints, and deliberate economic decisions. Both types of defaults can have profound implications, but the triggers and resolution mechanisms differ significantly.

Consequences of a Country’s Default

Economic and Financial Impacts

Sovereign default typically results in a substantial economic downturn. The real GDP tends to fall between 0.5% and 2%, predominantly within the first year after a default. The effect is generally short-lived, but it triggers other longer-lasting consequences for the country’s economy.

Long-Term Sovereign Rating and Borrowing Costs

Post-default, countries face enhanced scrutiny from credit agencies, which typically results in a downgrade of their sovereign credit rating. One study found that, on average, countries that have defaulted once since 1970 were rated one to two notches lower than those without defaults. Additionally, defaulting countries endure higher borrowing costs by 0.5% to 1% on average compared to those countries that have not defaulted.

Reputation Loss

A defaulting country suffers from a loss of reputation in the financial markets, sometimes being perceived as untrustworthy or financially unstable for an extended period. This can curtail their ability to raise funds in the future.

Capital Market Turmoil

A sovereign default causes wider repercussions in capital markets, leading investors to pull back from the equity and bond markets of the defaulting country. This makes it more challenging for local businesses to obtain the necessary funding.

Real Output and Trade Retaliation

Sovereign defaults can inhibit investment activities and provoke trade retaliation, with some studies indicating up to an 8% reduction in bilateral trade following a default. The effects on trade can persist for as long as 15 years, significantly harming export-oriented industries.

Fragile Banking Systems

The banking system of a defaulting country becomes increasingly vulnerable, evidenced by studies reporting that the chance of a banking crisis rises to 14%—an eleven percent increase over countries without a default history.

Political Instability

Political upheaval is another consequence of sovereign defaults. Historical analysis shows a heightened likelihood of change in the leader of a country or the head of financial institutions, with a 45% increased probability of leadership change at the national level and a 64% increase in the likelihood of turnover in financial leadership positions.

The consequences of a sovereign default are not isolated to financial metrics; they reverberate through the economic structure, impacting trade, capital market operation, and the political landscape. The aggregation of these effects starkly highlights the breadth and depth of the challenges faced by countries that default on their debt obligations.

Measures of Sovereign Default Risk and Components of a Sovereign Rating

Sovereign Ratings Review and Updates

Sovereign ratings offer an established approach to measuring a country’s default risk. Ratings are periodically reviewed and updated to reflect current economic and political conditions. Events like political coups or economic disasters can prompt both immediate reviews for the affected country and potential reassessments for neighboring nations due to contagion risk. The ratings process is comprehensive and is intended to give an accurate measure of default risk for bonds or loans issued by the sovereign entity.

Effectiveness of Sovereign Ratings

The primary goal of sovereign ratings is to serve as an effective predictor of default risk for sovereign debt. Agencies assert that there is a high degree of correlation between sovereign ratings and actual sovereign defaults, despite occasional discrepancies. Sovereign ratings are continually adjusted based on new information, with both regular scheduled reviews and updates triggered by significant events.

Sovereign Rating Methodology

A sovereign rating encapsulates multiple facets of a country’s economic and political environment, assessing the nation’s creditworthiness to private creditors like bondholders and banks (not to official creditors such as the World Bank or IMF). Agencies typically focus on the likelihood of a default occurring, although some (like Moody’s) also consider the potential severity of a default if it were to take place.

Components of a Sovereign Rating

To assess sovereign ratings, agencies consider factors such as:

Political Risk:

• Institutional stability.
• Popular political engagement.
• Leadership succession.
• Transparency and security issues.

Economic Structure:

• Diversity and market-orientation.
• Income distribution.
• Financial sector health.
• Nonfinancial private sector profitability.

Economic Growth Prospects:

• Investment size and patterns.
• Growth rates.

Fiscal Flexibility:

• Government revenue and expenditure trends.
• Fiscal and monetary compatibility.
• Government Debt Burden
• Debt levels and interest share of revenue.

Offshore and Contingent Liabilities:

• Non-Financial Public Enterprises (NFPEs) status.
• Financial sector robustness.

Monetary Flexibility:

• Inflation and credit control.
• Monetary policy independence.

External Liquidity and Debt:

• Impact of fiscal/monetary policies on external accounts.
• Adequacy of reserves.

External Debt Burden:

• Gross and net external debt profile.

Practical Use and Observations

Market participants widely use sovereign rating information as it provides a convenient shorthand for assessing country risk. The ratings process, by distilling complex economic and political data into comprehensible ratings, aids investors in making informed decisions about the risk associated with different sovereign debts. Regular updates to ratings help keep the assessment of sovereign default risk current, thereby acting as a barometer for investor sentiment and market conditions related to a country’s ability to meet its debt obligations.

Shortcomings of Sovereign Rating Systems

Upward Bias in Ratings

One of the primary criticisms of sovereign rating systems is the tendency for ratings agencies to be overly optimistic. Unlike corporate ratings, where the payment by issuers for their own ratings might lead to an upward bias, this rationale is not as strong for sovereign ratings because the direct revenue from sovereigns is relatively small compared to the reputational stakes involved. Nonetheless, the upward bias persists, which may be due in part to indirect revenue sources or other factors not directly related to payment for ratings.

Herd Behavior among Ratings Agencies

Another concern is that ratings agencies often exhibit herd behavior. When one agency adjusts its rating for a sovereign, the others tend to follow, diminishing the value of having multiple independent ratings assessments. The tendency of agencies to mirror each other reduces the uniqueness and potentially the usefulness of their individual sovereign risk evaluations.

Reactivity and Timeliness

Sovereign ratings have been criticized for being too reactive and not proactive enough. They often incorporate changes with a significant delay, which means that the modifications to ratings can come too late to effectively inform investors and protect them from a crisis. Moreover, during times of market crises, ratings agencies may exacerbate the situation by rapidly downgrading ratings, potentially entering a vicious cycle that worsens the crisis.

Frequency and Rapid Changes in Sovereign Ratings

When a sovereign rating is changed multiple times within a short period, it could indicate that the initial assessment was flawed. Frequent rating revisions can undermine the credibility of the ratings and lead to doubts about the robustness of the agencies’ evaluation processes.

Information and Resource Limitations

Ratings agencies rely heavily on data provided by governments, raising concerns about the quality and comprehensiveness of the information. Variations in the availability and transparency of government data, as well as the limited number of analysts who are tasked with covering a large number of countries, can result in analysts relying on common information instead of conducting detailed, independent research. This can affect the accuracy of sovereign ratings and lead to conformity in assessments.

Revenue Bias and Incentive Problems

Although agencies offer sovereign ratings for free, their revenue model could still create a bias in ratings. When conducting sovereign ratings, the possibility that agencies generate significant revenue from related rating activities (such as rating sub-sovereign issuers) can create an indirect incentive to avoid downgrades in sovereign ratings, as such downgrades would necessitate a series of sub-sovereign rating downgrades as well. This connection could lead to resistance against downgrading sovereign ratings and thereby cause an upward bias.

The collected shortcomings highlight systemic issues with the sovereign rating systems, questioning their reliability as accurate reflectors of sovereign default risk. These criticisms include biases, herd mentality, lack of timeliness, information limitations, and incentives that could potentially influence the objectivity of ratings. These factors can cumulatively impact the trust that investors place in sovereign ratings as measures of default risk.

Comparing Credit Ratings, Market-Based Credit Default Spreads, and CDS Spreads in Predicting Default

Timeliness and Dynamics of CDS Spreads

Credit Default Swaps (CDS) spreads are more timely and dynamic compared to sovereign ratings. They also reflect fundamental changes in the issuing entities immediately. This aspect is critical as evidence shows that changes in CDS spreads precede changes in sovereign bond yields and ratings, suggesting their potential to predict default risk more effectively.

Superiority of Sovereign CDS Spreads

Research indicates that changes in sovereign CDS spreads are more accurate as forward indicators of sovereign default events than sovereign ratings. This is significant because it implies that CDS spreads could be a more reliable tool for gauging impending default risks.

Economic Policy Uncertainty

CDS spreads not only increase with heightened economic policy uncertainty but also tend to track with currency depreciation, offering additional insights into the interplay between policy uncertainty, currency risk, and default risk.

Clustering Effect in the CDS Market

The CDS market exhibits a clustering effect where CDS prices across groups of countries move cohesively. This suggests the presence of broader, systemic factors affecting a set of countries that are captured in the CDS pricing mechanisms.

Functionality of Market-Based Default Spreads

When utilizing market-based default spreads, there must be a reference or default-free security, generally U.S. Treasury bonds for dollar-denominated instruments. Market-default spreads are prompt to adjust to new information and hence can provide earlier warnings of potential default compared to credit ratings.

Comparative Efficacy

Studies have found default spreads to be correlated with sovereign ratings and ultimate default risk. The sovereign bond market often leads rating agencies by reflecting changes in default spreads sooner than changes in ratings. Despite this lead-lag relationship, changes in sovereign ratings themselves still carry informational weight and can impact market prices at the time they occur.

Integration of Ratings and Market Data

While both sovereign ratings and market data are useful, they do not operate in isolation. The sovereign bond market appears to consider ratings and consequent changes when pricing bonds, and vice versa, ratings agencies draw on market data to issue or adjust ratings.

Limitations of Using CDS Prices

While CDS prices convey valuable information regarding shifts in default risk, they are not without limitations. They may be influenced by factors unrelated to default risk, such as counterparty risk, market liquidity, and the narrowness of the CDS market, which can lead to illiquidity problems and pricing anomalies.

In conclusion, CDS spreads appear to be better suited for predicting sovereign default risk compared to traditional credit ratings, given their timely adjustments to new information. However, market-default spreads drawn from government bonds are also useful indicators, often leading to rating changes. While the use of these measures has drawbacks, such as susceptibility to market-specific risks and illiquidity, they provide essential metrics for assessing and predicting default risk.

Practice Question

Country risk, particularly in the context of sovereign default risk, is influenced by a myriad of factors. When evaluating the risk of sovereign default, it is crucial to consider variables beyond just economic metrics. Which of the following options best characterizes the range of factors that analysts should consider?

1. Exclusive focus on a country’s GDP growth rates as the primary indicator of its ability to service debt obligations.
2. Analysis of the political stability and policymaking environment, acknowledging that sovereign decisions are inherently political.
3. Meticulous review solely of a country’s export revenues, assuming it to be the main source of foreign currency for debt servicing.
4. Assessment of external credit ratings without internal review as these ratings are comprehensive reflections of the country’s creditworthiness.

Correct Answer: B.

Analyzing sovereign default risk requires consideration not only of economic factors but also of political ones because decisions regarding default or repayment of sovereign debt are inherently political. Analysts must examine political stability, the policymaking environment, and the country’s institutional framework, among other factors, to form a comprehensive view of the country’s creditworthiness and default risk.

A is incorrect because GDP growth rates, while important, do not offer a complete picture of a country’s ability to service debt. The analysis must consider a broader range of economic, political, and social factors.

C is incorrect because relying solely on export revenues is an incomplete approach. A country’s ability to service its debt is influenced by multiple components of the economy, not just exports.

D is incorrect because while external credit ratings provide valuable insights, they are not a substitute for a thorough internal analysis, which should also consider qualitative factors and potential biases in the external ratings.

Things to Remember

• Evaluating sovereign default risk entails a multifaceted analysis that extends beyond quantitative economic measures to include political risks and policy decisions.
• Political stability, effectiveness of governance, and institutional quality are important determinants of a country’s creditworthiness and susceptibility to default.
• Understanding the context and dynamics of a country’s economic and political environment is essential for assessing sovereign default risk accurately.