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Sovereign Risk

A country’s probability of missing a debt obligation in its present economic status

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.

 

Sovereign Risk

 

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

 

Summary

  • Sovereign risk is the likelihood that a government will default on its loan obligation by failing to meet its principal payments or interest. 
  • It comes in different forms and may result in losses to investors in addition to negative political consequences.
  • Central banks can reduce the actual and perceived sovereign risk by imposing foreign exchange regulations.

 

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.

There are legal obligations that 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 are encouraged to avoid indirect penalties imposed on countries that do not honor 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 honor foreign debt obligations. Sovereign risk may also result from the collapse of the economic environment due to increasing inflation, making it difficult for the government to honor 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 the funding costs of banks and impairs their market access. Even so, 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 liquidity of the central bank.

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.

 

Sovereign Risk and Banks’ Funding

 

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 with the promise 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, a significant number of 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.

 

More Resources

CFI is the official provider of the global Capital Markets & Securities Analyst (CMSA)® certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

  • Sovereign Debt
  • Securities Lending
  • Bank Credit Analysis
  • Foreign Investment