Sovereign Credit Rating, Sovereign Debt and Sovereign Default

What is a Sovereign Credit Rating?

A sovereign credit rating is an assessment of a country’s creditworthiness. It shows the level of risk associated with lending to a particular country since it is applied to all bonds issued by the government.

When evaluating a country’s creditworthiness, credit rating agencies consider various factors such as the political environment, economic status, and creditworthiness to assign an appropriate credit rating.

Obtaining a good credit rating is vital for a country that wants to access funding for development projects in the international bond market. Also, countries with a good credit rating can attract foreign direct investments.

The three influential rating agencies include Moody’s Services, Fitch Ratings, and Standard & Poor’s. Although there are other smaller credit rating agencies, the three agencies exert the greatest influence over market decision-makers.

Sovereign Credit Ratings Explained

Sovereign credit ratings are essential for countries that want to access funds in the international bond market. Usually, a credit rating agency will evaluate a country’s economic and political environment at the government’s request and assign a rating stretching from AAA grade to grade D.

By allowing external credit rating agencies to review its economy, a country shows that it is willing to make its financial information public to investors. A country with high credit ratings can easily access funds from the international bond market and secure foreign direct investment.

A low sovereign credit rating means that a country faces a high risk of default and may have experienced difficulties in paying back debts. The level of sovereign credit risk depends on various factors, including a country’s debt service ratio, import ratio, growth of domestic money supply, etc.

Since sovereign credit ratings were introduced in the early 1900s, several countries have defaulted on their international bonds. For example, during the great depression, 21 nations defaulted on their debt obligations in the global bond market. Over the years, more than 70 nations have defaulted on either their domestic or foreign debts.

Determinants of Sovereign Credit Ratings

Credit rating agencies use both qualitative and quantitative techniques to determine the sovereign credit rating. A 1996 paper published by Richard Cantor and Frank Packer titled “Determinants and Impacts of Sovereign Credit Ratings” outlined various factors that explain the difference in credit ratings assigned by the various rating agencies. The factors include:

Per capita income

Per capita income estimates the income earned per person in a specific area. It is calculated by taking the total revenue earned by individuals in a given area divided by the number of people residing in that area. A high per capita income increases the potential tax base of the government, which subsequently increases the government’s ability to repay its debts.

GDP growth

The GDP growth rate of a country refers to the percentage growth in a country’s GDP from one quarter to another as the economy navigates a business cycle. Strong GDP growth means that a country will be able to meet its debt obligations since the growth in GDP results in higher tax revenues for the government.

However, if the growth rate is negative, the economy is experiencing a contraction, and the country may fail to honour its debt obligation if the situation continues.

Rate of inflation

Sovereign debts are susceptible to changes in the inflation rate, and an increase in inflation will affect a country’s ability to finance its debt. A high inflation rate points to structural problems in a country’s finances, and it is likely to cause political instability as the public becomes dissatisfied with the increasing inflation.

External debt

Some countries rely heavily on external debts to finance their development and infrastructure projects. Increasing debt levels translate to a higher risk of default, affecting its ability to access funding from international lenders. This burden increases if the foreign currency debts exceed the foreign currency income earned by a country in exports.

Economic development

Credit rating agencies consider the level of development when determining the sovereign credit rating. Usually, once a country has reached a certain level of development or per capita income, it is considered less likely to default on its debt obligations. For example, economically developed nations are considered less likely to default than developing countries.

History of defaults

A country that defaulted on its debt obligations in the past is considered to have a high sovereign credit risk by rating agencies. It means that countries with a record of defaults receive low ratings, making them less attractive to investors looking for low-risk investments.

What is Sovereign Risk?

Sovereign risk is a country’s probability of missing a debt obligation in its present economic status. Sovereign risks come in many forms and pose a considerable challenge to the banking system and a country’s financial stability in general.

Strong central banks will impose foreign exchange regulations to reduce the value of a foreign exchange contract, thus minimising the risk of default. Key factors that influence a country’s sovereign risk include natural disasters, political instability, and refusal to comply with the previous payment agreement.

Understanding Sovereign Risk

One of the problems associated with lending is ensuring that both parties to the contract adhere to the loan’s terms and conditions. Generally, it is difficult to ensure that the borrower abides by the terms set out in the bond contract to timely principal and interest payments.

Legal obligations are enforceable in a court, and those who cannot meet their debt obligations may file for bankruptcy. However, repaying the debt is, in large part, voluntary but is encouraged to avoid indirect penalties imposed on countries that do not honour their loan obligations.

Furthermore, no systematic procedure is similar to bankruptcy, by which a country owing a large amount of debt can adopt to discharge its obligations. As a result, a sovereign risk arises when a country is not in a position to service its foreign debt.

Sources of a Sovereign Risk

Sovereign risk arises from several sources. Foreign exchange traders face sovereign risk when a foreign country breaks up from its currency union. For example, foreign currency devaluation can affect the currency trade and alter currency benefits to traders.

Another potential source of sovereign risk is when the government lacks sufficient resources when its bonds are due to mature, rendering it unable to honour foreign debt obligations. The sovereign risk may also result from the collapse of the economic environment due to increasing inflation, making it difficult for the government to honour maturing debt obligations.

Sovereign Risk and Banks’ Funding

Although fluctuating interest rates make financial institutions contend with market risk on sovereign debt, sovereign risk leads to far-reaching implications for the banking system. The challenges are more pronounced if the involved banks are domiciled in a financially-distressed country. Failure to service a foreign debt contract means deterioration of the creditworthiness of the sovereign entity.

Increased sovereign risk increases banks’ funding costs and impairs their market access. Banks cannot cushion themselves against sovereign risk by changing their operations because of the critical role that government securities play in the financial system.

Possible consequences that may befall banks include a sharp increase in credit default swaps (CDS) and an inability to offer a short-term wholesale loan, which drains their deposits. Consequently, banks are forced to depend on the central bank’s liquidity.

The channels through which banks’ funding costs are adversely affected include reduced government funding benefits, lower collateral values, direct losses on foreign investments, and lower bank credit ratings.

In the U.S., the economy is more manageable to avoid a possible sovereign risk from occurring. Despite the turbulence surrounding the country’s fiscal cliff, there’s not been deteriorating creditworthiness that undermines investors’ perceptions.

Because of its low treasury yields, the U.S. does not depend on the bond market to warn of sovereign stress. The federal policy provides short-term fiscal benefits to banks facing sovereign risk from financial losses in foreign country holdings.

Example of a Sovereign Debts Crisis

Greece’s economy gives a glimpse of how a sovereign risk can lead to a crisis. The country’s high debt levels made it a challenge for the government to repay foreign debt.

Following the crisis, Greece adopted stringent austerity measures. It received two rounds of stimulus packages, promising that it would adopt further financial reforms and stricter austerity measures.

Greece’s ability to repay sovereign loans dropped to junk status, with far-reaching impacts affecting the entire European Union. The bailout given to the country was meant to reduce the growth of public sector loans. At that time, many European countries suffered from the collapse of financial institutions, rising bond yields, and high government debts.

The collapse of Iceland’s banking system in 2008 set the stage for the crisis, which later spread to Portugal, Ireland, and finally Spain in 2009. The European countries offered financial bailouts that eventually stopped the situation.

What is Sovereign Default?

Sovereign default refers to the failure of the government of a sovereign entity to pay back principal and interest payments when they are due. The inability to repay debts owed to creditors may be accompanied by a government’s formal declaration that it will not pay owed debts, or it may sometimes occur without any formal declaration.

Like individuals and companies, countries and sovereign entities borrow funds in domestic and international bond markets to fund various budget items such as infrastructure programs and healthcare services.

A country may issue bonds to investors with a contractual obligation to pay bondholders’ principal amount and interest. The government guarantees to repay bondholders using tax revenues raised from its citizens.

However, during the debt period, the government may run into cash flow problems due to various factors such as political instability, poor investment, mismanagement of investors’ funds, etc.

Insufficient cash flows impede the government’s ability to pay back debts due on time. Sovereign defaults may result in lower credit ratings and increased interest rates, making it difficult for the sovereign state to borrow additional funds from the international bond market.

Understanding Sovereign Debt

When investing in sovereign debt, bondholders monitor a sovereign entity’s political stability and financial environment to determine sovereign default risk. Although sovereign countries are not subject to bankruptcy laws, as is the case with companies and individuals, sovereign default issues are common and preceded by an economic crisis.

Bondholders will be at a loss when it happens since countries cannot be subjected to the same legal consequences as companies. Therefore, when bondholders suspect that a government is likely to default on its debt obligations, they may seek a review of the interest rates to compensate for the increased risk of default.

Such a scenario is known as a sovereign debt crisis, common in governments that rely on short-term borrowings since it creates a mismatch between the short-term bond and the long-term value of assets financed through debts.

Credit rating agencies will review its financial status when a country defaults and assign it a sovereign credit rating. The rating given will depend on various factors such as procedural defaults, failure to abide by the terms and conditions of the debt, and the sovereign entity’s interest expense.

Causes of Sovereign Default

Change of Government

Formal transitions from one elected government to another elected government may not change the treasury obligations created by preceding governments. However, when a regime change occurs due to a military coup or revolutionary situation, the incoming government may question the legitimacy of earlier debts taken by the previous government and discontinue repayment of current debts.

According to international law, such debts may be considered illegitimate, meaning that they are personal debts of the previous regime and not of the state. In this respect, such debts may not be enforceable. For example, when the Soviet government came into power in 1917, all debts incurred by the Russian Empire were considered illegitimate, and the new government discontinued further repayments.

Illiquidity

A country is in default due to illiquidity when temporarily unable to meet principal and interest payments because it cannot quickly liquify its asset base.

Illiquidity is considered a temporary setback since the illiquid assets can become liquid again after a specific period. If the assets cannot be sold to raise capital immediately, the state will be unable to increase sufficient cash flows to meet principal and interest payments.

Insolvency

Insolvency is a state where the country can no longer honour its debt liabilities, and it faces a sovereign default. A country may declare insolvency for various reasons, including sharp increases in public debt, unrest at austerity measures taken to repay debt, increased unemployment, and increased government regulations on the financial markets.

Sovereign insolvency occurs after years of overspending and emergency budgets, with the deficit being settled using new debts from domestic and international investors.

Consequences of Sovereign Default

When sovereign default occurs, there will be various consequences to creditors and the state.

For Creditors

The immediate impact of sovereign default on creditors is the loss of the principal amount loaned to the government and the interest owed on the debt. The state may resort to either partial cancellation or decide to restructure the debt to more favourable terms.

Partial debt cancellation occurs when the creditor partially agrees to repay the total principal amount. On the other hand, debt restructuring involves renegotiating the outstanding debt to increase the payment terms, swapping the outstanding debt in exchange for equity in the company, or other terms.

For the State

When a state defaults on its sovereign debt, it disposes of its debt obligations owed to certain creditors. Disposing of the debts reduces the total debt owed by a state to its creditors and, subsequently, the principal and interest repayments.

Still, when a state defaults on its debts, it becomes less attractive to investors, and it will become difficult for the state to access new funds from the international bond market.