What Is Sovereign Risk?
Sovereign Risk is the risk of default in meeting the debt obligation by a Country. It is the broadest measure of credit risk. It includes country riskCountry RiskCountry risk denotes the probability of a foreign government (country) defaulting on its financial obligations as a result of economic slowdown or political unrest. Even a little rumour or revelation can make a state less attractive to investors who want to park their hard-earned income in a reliable place., political riskPolitical RiskPolitical risk is defined as a risk that emerges as a result of a change in a country's governing body, posing a risk to investors in financial instruments such as debt funds, mutual funds, and equities., and transfer risk. It may result from government action against foreign investors resulting in financial loss.
One of the most significant unfortunate aspects of Sovereign risk is contagious, which means that what affects one country tends to influence other countries due to the globalized, interconnected world. It is here to stay due to the inherent linkage between global economies. Analysts use different indicators to assess this risk to mitigate or control potential losses from investing in these countries.
Table of contents
- Sovereign risk, or country risk, is the risk that a country will fail to satisfy its debt obligations. It is the most comprehensive credit risk measure, incorporating national, political, and transfer risks.
- There is no way to calculate sovereign risk. Sovereign Risk Rating is used instead, which analyses default risk and is frequently granted by global rating agencies such as Moody’s, Standard and Poor’s (S&P), Fitch, and others.
- Foreign investors actively monitor and analyze sovereign risk when investing in any nation, commonly done through assessing Country Risk Ratings.
Sovereign Risk Explained
Sovereign Risk is an important yardstick that is closely followed and taken into consideration while making an investment in any country by foreign Investors and is typically done by evaluation of sovereign risk management.
This risk increases with deteriorating fiscal conditions, political uncertainty, social unrest, deflation, the legal system, deep recession, etc. Foreign Investors, while investing in any sovereign, should make a thorough analysis of this risk to ensure they are duly compensated for the risk undertaken.
Usually, BondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period. issued by the government are thought of as having no default risk. However, although governments’ guarantees reduce such risk of holding government bondsGovernment BondsA government bond is an investment vehicle that allows investors to lend money to the government in return for a steady interest income., it is not eliminated, and governments do, from time to time, default.
Sovereign risk analysis shows that this risk is typically low, but investors will face losses if bonds are issued from countries undergoing any economic downturn or crisis. Moreover, it affects the forex traders directly, who hold contracts belonging to the nation’s currency undergoing financial crisis.
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 additional money via Bond Issuance in such cases, Sovereign Risk takes the form of Refinancing RiskRefinancing RiskRefinancing risk refers to the risk arising out of the inability of the individual or an organization to refinance its existing debt due to redemption with new debt. It carries the risk of a company failing to meet its debt obligations and is thus, also known as rollover risk..
- It also takes the form of a country imposing regulations, restricting the ability of debt issuers in that country to meet their obligations.
There are various factors that contribute to the risk, as given below:
- Legal framework – If the legal framework of the country is weak leading to problems like inadequate property protection right, corruption or inconsistent rules, this will mean that the foreign investors are at a risk and may feel threatened.
- Economic factors – High inflation, heavy debt, a volatile currency, etc., contribute to default risk. As a result, the country will be in an ongoing crisis, resulting in investor losses.
- Exchange rate fluctuation – This is a ery important factor leading to risk on investment. It impacts the investment value which is denominated in that currency and erodes the return of investors.
- Political problems – Frequent changes in the ruling government, civil unrest, political conflicts can result in an unstable environment that affects the investments made by foreign investors and ultimately discourage them.
How To Measure?
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 solvencySolvencySolvency of a company means its ability to meet the long term financial commitments, continue its operation in the foreseeable future and achieve long term growth. It indicates that the entity will conduct its business with ease. 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.
Let’s try to understand this concept of sovereign risk analysis 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 a sovereign risk 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 management of these Emerging Nations is given below.
Thus, the above example clearly explains the nature of the risk in details and helps in having a good understanding the concept.
Just as every situation has some positive as well as some negative effects, a sovereign risk has them too. Let us first try to understand the various advantages of the same.
- It enables easy comparison between different countries and allows an investor to understand and appreciate the risk and reward associated with investing in a particular country and industry. In short, it enables the cross country and across different time frame comparison.
- Ratings based on such risk act as an essential benchmark for a country to showcase its competitiveness over other countries to promote itself as an Investment destination in front of Foreign Investors.
Thus, the above are some of the benefits of this kind of risk that the country may have.
Now let us look into the details of some disadvantages of this kind of risk that the nation has to tackle.
- It follows a herd mentalityHerd MentalityHerd Mentality is a concept where individuals adopt the ideology of a larger group bypassing personal critics and rationality. , which means that ratings based on this risk are usually impacted by converging practice. If one developing country is downgraded, others were also downgraded due to the interconnected, globalized world.
- This risk indirectly impacts the ability of the corporate in that country and impacts their ability to raise cheap foreign borrowing, which directly affects their profitability. A high Sovereign Risk is perceived by foreign Investors as Risky and requires a higher premium, which will increase the cost of borrowing for companies within that country.
- This usually is not exhibited in the Sovereign ratings until it’s too late (the country might have defaulted). This is due to the inherent vested interestVested InterestVested interest is defined as a financial concept that talks about the legal rights granted to an individual or a business to possess a pre-determined share of an asset in the future. For example, vested interest arises in retirement funds, contingent equity, property distribution, etc. of the government of various countries to ensure their ratings are higher and the Rating Agency’s incentive to accommodate the states (which are its clients).
- It is primarily based on Historical data points and analyzing the same to inference future events and, as such, lacks a lot of objectivity.
Therefore, both the benefits and limitations are detailed above. Foreign investors should study both the sides of investing in a country which may not have a good credit history or is in the mid of some crises or instability so that unnecessary loses can be avoided.
Sovereign Risk Vs Country Risk
The above two terms are often used interchangeably in economics and finance field, but there are some differences between them as follows:
- The former specifically refers to the risk that is associated with the government or the sovereign authority of a nation whereas the latter refers to the risk with any investment in the country.
- The sovereign risk analyst explains the default risk on the debt obligation of the government whereas for the latter, the risk may be financial of non-financial.
- The former is related to financial stability of the government and its creditworthiness in relation to social, political or economic factors whereas the latter refers to governemnt’s credit risk as well as political risk, social risk, legal risk etc.
- The former is only related to assessmemt of the strength of the government whereas the latter is a more comprehensive approach to the various risks associated within a country.
Frequently Asked Questions (FAQs)
QE helps support public debt by decreasing sovereign bond rates because lower yields allow sovereigns to borrow more favorably.
Sovereign risks take many forms, significantly threatening the banking sector and a country’s financial stability. Robust central banks will implement foreign exchange controls to limit the value of a foreign currency contract, reducing the probability of default.
Sovereign risk is described as the risk of not being able to meet obligations based on primary spending, nominal debt stock, and tax revenue. In a debt sustainability analysis approach that calculates the net present value of future loan flows, market and investor factors enter the equation primarily through the discount variable.
Yes, sovereign risk is dynamic and can change over time based on political, economic, and global shifts. A country’s efforts to improve governance, stability, and economic prospects can reduce sovereign risk.
This has been a guide to what is Sovereign Risk. We explain it with example, differences with country risk, how to measure, types, factors & advantages. You can learn more about Financing from the following articles –