What is Sovereign Risk?

Sovereign Risk is the risk that the country will default on its financial obligations. Rating agencies are responsible for conducting sovereign risk ratings and looking at several factors when rating countries. The ratio used for sovereign risk includes GDP, inflation, current account balance, fiscal balance, debt to GDP, among others.

Example of Sovereign Risk:

There are two types of sovereign debt: issued in a foreign currency (such as the USD) and the type issued in the country’s currency. We will consider each in turn:

Foreign Currency Defaults

Debt issued in a foreign currency is attractive to global banks and other international lenders. However, the risk for the issuing country is that it cannot repay the debt by simply printing more money. To illustrate, the United States government can repay the debt it has issued in USD by printing more USD. This is referred to as increasing the money supply, and it may lead to inflation. A country such as Argentina, however, cannot do this. There have been many defaults on sovereign debt over the last 200 years.

Local Currency Defaults

Some countries have defaulted on debt issued in their own currency and on debt denominated in foreign currency. Two examples of this include the defaults of Brazil and Russia in 1990 and 1998 (respectively). Research from Moody indicates that countries are increasingly defaulting on both types of debt simultaneously. Why would countries default on debt denominated in their currencies when they could simply print more money?

Why is Sovereign Risk important?

Sovereign risk is a compelling argument for making risk management a state responsibility and transferring liability. Financial protection will aid governments in mobilising resources in the immediate aftermath of a disaster while also mitigating the disaster’s long-term fiscal impact.