Sovereign Risk: Meaning, Indicators, How It is Measured

What’s it: Sovereign risk is credit risk attached to the sovereign debt where the government in a country will not pay its debt. It may be because the government doesn’t have the ability or will to do so. Long story short, it is the default risk on sovereign debt.

One of the main indicators is the sovereign rating issued by international rating agencies such as Standard and Poor’s, Moody’s, and Fitch Ratings. The highest rating is AAA (equivalent to Aaa by Moody’s), indicating high credit quality and the lowest default risk. Examples of AAA-rated countries are Singapore, Sweden, Switzerland, Australia, and Canada.

In general, countries rated BBB- or higher are considered investment-worthy. Meanwhile, bonds issued by countries with a BB + rating and below are speculative or junk bonds.

Why is sovereign risk important?

Sovereign risk has broad implications for the economy. It can lead to changes in taxes, subsidies, or regulations, exposing many businesses’ performance.

For example, the sovereign crisis in European Union countries such as Greece and Spain forced the governments in these countries to adopt austerity policies. To reduce the pressure on accumulated debt, they cut government spending programs, carried out privatizations, and raised taxes. These policies cause aggregate demand to fall in the short run, forcing many businesses to lower their production levels and weaken the economy.

The central bank also controls capital outflows to mitigate the bank run, a massive withdrawal of funds from the banking system. A bank run can lead to a crisis in the financial system.

When governments print money to pay debts, it leads to hyperinflation. It destroys the purchasing power of the domestic currency. People became distrustful of the domestic currency. They sell it and exchange it for a more stable currency like the US dollar. As a result, the domestic exchange rate against the US dollar falls.

Furthermore, sovereign risk is contagious. When one country experiences a sovereign crisis, it can spread to other countries. Contagion is high because many countries are connected to one another, both through financial transactions and transactions for goods and services.

The high level of sovereign risk also makes it difficult for interest rates in the economy to fall. Investors ask for a higher premium to compensate for this risk. That makes investment costs more expensive for businesses. Households also have to pay high-interest rates when they apply for loans.

Measuring sovereign risk

The measure of sovereign risk is reflected in the sovereign rating given by global rating agencies such as Moody’s, Standard and Poor (S&P), and Fitch Ratings.

The sovereign rating represents the chance for default of a country. The better the rating, the smaller the sovereign risk and the lower the risk of default. Below is a list of credit ratings from the highest (AAA) to lowest.

BBB- to AAA ratings fall into the investment-grade category, indicating sufficient capacity to meet payment obligations. Meanwhile, the ratings below (ranging from BB + to C) are in the speculative category, and D defaults.

Rating agencies assess risk using several indicators. They evaluate the country’s solvency and liquidity, the country’s political stability, and so on. The following are some of the variables for measuring sovereign risk:

• Institutional effectiveness
• Economic structure and prospects
• External liquidity and international investment position
• Fiscal performance and flexibility
• Monetary flexibility

Institutional effectiveness

Rating agencies assess how government institutions and policy-making affect economic fundamentals, promote balanced economic growth, and respond to economic or political shocks. They also consider transparency and accountability and the historical track record of sovereign debt payments.

Economic structure and economic prospects

Rating agencies measure the diversity and resilience of a country’s economy. Does the country rely on commodity output, manufacturing, or the service sector as the basis for economic growth?

Apart from that, the income level is another measure. Among the indicators are GDP per capita and its growth rate, which indicates the country’s prosperity and indirectly reflects the current and future potential tax and debt payment bases.

External liquidity and international investment position

The assessment includes several aspects, such as the status of a country’s currency in international transactions, the economy’s ability to generate foreign currency, and the position of assets and liabilities in foreign and local currencies. Among indicators are current account balance to GDP, trade balance to GDP, net foreign direct investment to GDP,

Fiscal performance and flexibility

Fiscal assessments reflect the views of rating agencies on the sustainability of fiscal budgets and their debt burden. They consider:

• Fiscal flexibility
• Long-term fiscal trends and vulnerabilities
• Debt structure
• Access to finance
• Potential risks arising from contingent liabilities

Some of the sovereign indicators considered are the change in net debt to GDP, primary balance to GDP, debt to GDP, and debt to revenues.

Monetary flexibility

Monetary valuations consider the rating agency’s views on the monetary authority’s ability to fulfill its mandate while maintaining a balanced economy and mitigating economic shocks. The analysis includes an assessment of the exchange rate regime and the credibility of monetary policy.

The exchange rate regime affects the government’s ability to coordinate monetary policy with fiscal policy to support sustainable economic growth.

Meanwhile, to measure monetary policy’s credibility, they look at the inflation trend during the economic cycle. The effectiveness of the monetary mechanism on the real economy is also a consideration. Another factor is the depth and diversification of the financial system and capital markets.