Sovereign Risk: Definition, Types, History, Examples

What Is Sovereign Risk?

Sovereign risk is the chance that a national government's treasury or central bank will default on their sovereign debt, or else implement foreign exchange rules or restrictions that will significantly reduce or negate the worth of its forex contracts.

Sovereign Risk Explained

Sovereign risk is the probability that a foreign nation will either fail to meet debt repayments or not honor sovereign debt payments or obligations. In addition to the risk to bondholders of sovereign debt, sovereign risk is one of many unique risks that an investor faces when holding forex contracts (other such risks including currency exchange risk, interest rate risk, price risk, and liquidity risk).

Sovereign risk comes in many forms, although anyone who faces sovereign risk is exposed to a foreign country in some way. Foreign exchange traders and investors face the risk that a foreign central bank will change its monetary policy so that it affects currency trades. If, for example, a country decides to change its policy from one of a pegged currency to one of a currency float, it will alter the benefits to currency traders. Sovereign risk is also made up of political risk that arises when a foreign nation refuses to comply with a previous payment agreement, as is the case with sovereign debt.

Sovereign risk also impacts personal investors. There is always risk to owning a financial security if the issuer resides in a foreign country. For example, an American investor faces sovereign risk when he invests in a South American-based company. A situation can arise if that South American country decides to nationalize the business or the entire industry, thus making the investment worthless, unless there is reasonable compensation made to the investors.

Ability to Pay

A government's ability to pay is a function of its economic position. A country with strong economic growth, a manageable debt burden, a stable currency, effective tax collection, and favorable demographics will likely have the ability to pay back its debt. This ability will usually be reflected in a high credit rating by the major rating agencies. A country with negative economic growth, a high debt burden, a weak currency, little ability to collect taxes, and unfavorable demographics may be unable to pay back its debt.

Willingness to Pay

A government's willingness to pay back its debt is often a function of its political system or government leadership. A government may decide not to pay back its debt, even if it has the ability to do so. Nonpayment usually occurs following a change of government or in countries with unstable governments. This makes political risk analysis a critical component of investing in sovereign bonds. Rating agencies take into account willingness to pay as well as the ability to pay when evaluating sovereign credit.

History of Sovereign Risk

In the middle ages, kings would often finance wars and armies by borrowing from the country's lordship or citizenry. When wars became protracted, the realm would default on its debt, leaving many lenders out in the cold. Unfortunately, due to the power of the monarchy, creditors had little recourse to recover their debts.

Sovereign risk of this nature became mutualized in the 17th century for the first time with the establishment of the Bank of England (BoE). The BoE was established as a private institution in 1694, with the power to raise money for the government through the issuance of bonds. The original purpose was to help finance the war against France. The BoE also functioned as a deposit-taking commercial bank. In 1844, the Bank Charter Act gave it, for the first time, a monopoly on the issuance of banknotes in England and Wales, thus taking a major step toward being a modern central bank. As a lender to the king, the BoE minimized England's sovereign risk and allowed the nation to borrow at very low interest rates for centuries to come.

Sovereign Risk in the Modern Era

Fast forward to the 1960s were a time of reduced financial restrictions. Cross-border currency began to change hands as international banks increased lending to developing countries. These loans helped developing countries increase their exports to the developed world, and large amounts of U.S. dollars were deposited across European banks.

Emerging economies were encouraged to borrow the dollars sitting in European banks to fund additional economic growth. However, most of the developing nations did not obtain the level of economic growth that the banks expected, making it impossible to repay the U.S. dollar-denominated debt borrowings. The lack of repayment caused these emerging economies to refinance their sovereign loans continuously, increasing interest rates.

Many of these developing countries owed more interest and principal than their entire gross domestic products (GDPs) were worth. This led to domestic currency devaluation and decreased imports to the developed world, increasing inflation.

Example: Greek Sovereign Debt Crisis

There are signs of similar sovereign risk in the 21st century. Greece's economy was suffering under the burden of its high debt levels, leading to the Greek government-debt crisis, which had a ripple effect across the rest of the European Union. International confidence in Greece's ability to repay its sovereign debt dropped, forcing the country to adopt strict austerity measures. The country received two rounds of bailouts, under the express demand that the country would adopt financial reforms and more austerity measures. Greece's debt was, at one point, moved to junk status. Countries receiving bailout funds were required to meet austerity measures designed to slow down the growth of public-sector debt as part of the loan agreements.

The European sovereign debt crisis was a period when several European countries experienced the collapse of financial institutions, high government debt, and rapidly rising bond yield spreads in government securities. The debt crisis began in 2008 with the collapse of Iceland's banking system, then spread primarily to Portugal, Italy, Ireland, Greece, and Spain in 2009. It has led to a loss of confidence in European businesses and economies.

The crisis was eventually controlled by the financial guarantees of European countries, who feared the collapse of the euro and financial contagion, and by the International Monetary Fund (IMF). Rating agencies downgraded several Eurozone countries' debts.