What is Sovereign Risk?
Sovereign Risk also known as Country Risk is the risk of default in meeting the debt obligation by a Country. It is the broadest measure of credit risk and includes country risk, political risk, and transfer risk. One of the biggest unfortunate aspects of Sovereign risk is that it is contagious in nature which means that what affects one country tends to affect other countries as well due to the globalized interconnected world. It is here to stay due to the inherent linkage between global economies.
Normally Bonds issued by Government are thought of as having no default risk. However, although governments’ guarantees do reduce such risk of holding government bonds, it is not eliminated altogether and governments do, from time to time, default.
Types of Sovereign Risk
Types of Sovereign Risk can take different forms as enumerated below:
- When a government has bonds that are due to mature and they don’t have sufficient receipts to repay the maturing debts and need to re-enter the market to raise further money via Bond Issuance in such cases Sovereign Risk takes the form of Refinancing Risk.
- It also takes the form of a country imposing regulations, restricting the ability of debt issuers in that country to meet their obligations.
How Sovereign Risk is Measured?
There is no formula to calculate Sovereign Risk. Instead, it is measured by Sovereign Risk Rating which measures the Default risk and is usually assigned by Global rating agencies such as Moody’s, Standard and Poor (S&P), Fitch, etc. Such Sovereign ratings assess the Risk by analyzing the ability and willingness of a country to service its debt which includes evaluation of relevant solvency and liquidity factors of the country, the political stability of the country in question as well as any limiting factors such as Financial Network and Social unrest in the country.
Example of Sovereign Risk Calculation
Let’s try to understand this concept of Sovereign risk with a hypothetical calculation example:
Raven working as a Sovereign Risk Analyst with UBS Risk Division is trying to analyze the Risk of five Emerging Nations based on the Debt levels, Legal System Efficiency, Expenditure Management, Fiscal Discipline, Inflation level, and Central Bank Autonomy.
She has used a five-point scale ranging from 0 (Poor) to 5 (excellent) to grade the five Emerging nations on the parameters discussed above to derive the Aggregate Score and based on the Aggregate Score has assigned Sovereign Rating which captures the Sovereign Risk of these Emerging Nations.
Sovereign Score based on assigned grades to each Emerging Nation in each category.
The score for Sovereign Risk of these Emerging Nations is given below.
- It enables easy comparison between different countries and enables an investor to understand and appreciate the risk and reward associated with making an investment in a particular country and industries within. In short, it enables the cross country and across different time frame comparison.
- Ratings based on such risk act as an important benchmark for a country to showcase its competitiveness over other countries to promote itself as an Investment destination in front of Foreign Investors.
- It follows a herd mentality which means that ratings based on Country Risk are usually impacted by converging practice in which if one developing country is downgraded, others were also downgraded due to the interconnected globalized world.
- Country Risk indirectly impacts the ability of the corporate in that country and impacts their ability to raise cheap foreign borrowing which directly impacts their profitability. A high Sovereign Risk is perceived by foreign Investors as Risky and requires higher premium which will increase the cost of borrowing for companies within that country.
- This is normally not clearly exhibited in the Sovereign ratings until its too late (the country might have defaulted). This is due to the inherent vested interest of the government of various countries to ensure their ratings are higher and the Rating Agency incentive to accommodate the countries (which are its clients).
- It is largely based on Historical data points and analyzing the same to inference future events and as such lacks a lot of objectivity.
Sovereign Risk is an important yardstick which is closely followed and taken into consideration while making an investment in any country by foreign Investors and is normally done by evaluation of Country Risk Rating.
Country Risk increases with deteriorating fiscal conditions, political uncertainty, social unrest, deflation, the legal system, and deep recession, etc. Foreign Investors while making an investment in any sovereign should make a thorough analysis of this risk to ensure they are duly compensated for the risk undertaken.
This has been a guide to what is a sovereign risk and its definition. Here we discuss how to calculate and measure Sovereign Risk along with examples, advantages, and disadvantages. You can learn more about Financing from the following articles –