10:01 pm - Monday December 18, 2017

An analysis of sovereign risk

These days our governments are more in the business of business than governance. Naturally, when they approach markets for funds – through issue of bonds, debentures, stocks and securities, treasury bills and bonds – the investors will need to evaluate them as they do for normal business concerns.

However, the experience has been different.  The investors consider the governments to be supreme and they are expected not to fail in their performance – either in servicing periodic interest / dividends or repayment of principal.

When said governments or their agencies default sovereign risk is said to have occurred. Thus the probability that the government of a country (or an agency backed by the government) refusing to comply with the terms of a contractual obligation is called as sovereign risk. Though technically sovereign entities do not go broke, they can assert their independence in any manner they choose.

Our governments have found new ways to get over their possible default situations – resort to deficit financing, print more money, and simply write off such debts or even go back on such promise (case in point : Old Chinese Railway Bonds issued by erstwhile Imperial Chinese Government).

We all know what would be the implication of deficit financing and printing more money. The country’s currency will go down in value eroding the very value of the investments made by the investor.

When governments have issued bonds that are maturing and when they don’t have sufficient tax receipts on hand to repay all the debt, they may re-enter the market to raise further money via bond issuance. Sovereign risk thus includes refinancing risk when a government is unable to raise sufficient new debt in the market (i.e at reasonable market prices and in sufficient volume) to repay upcoming bond maturities. Sovereign risk can also be used to refer to a country imposing regulations

Some jurisdictions do not permit outsiders to proceed against such sovereign entities in case of default in a court of law. Suppose a sovereign entity defaults in its obligations, the investors cannot proceed against them to recover their investments. They can do so only if such sovereign entities have specifically agreed to in writing. This waiver to claim sovereign status is primary requirement in international loan markets these days.

Sovereign risk was a significant factor during 1970s after the oil shock when Argentina and Mexico almost defaulted on their loans which had to be rescheduled.

I have also lived through such sovereign risks in my career when Indonesia did not permit closure of loss making ventures and business enterprises set up by foreign investors in their jurisdiction in the 1980s. And the investors had to incur more losses.

In terms of the current issues in Europe, the term sovereign risk has been used to widely categorise the large budget deficits and very high government debt levels of a number of countries, especially Greece, Italy, Ireland, Portugal and Spain. These countries, especially Greece, have both very high net debt levels and very high budget deficits, which are adding substantially to their debt burden.

This ongoing accumulation of large deficits and debt is causing many in the market to question whether there is a higher risk that these countries may at some point not be able to repay bonds as they mature. A borrowing country that has higher budget deficit levels over a long period of time accumulates large government debt levels, giving that borrower less financial flexibility to borrow in the future. This makes these two indicators the key ones to watch when assessing sovereign risk.

Credit Rating Agencies such as Moody’s, S&P and Fitch assign sovereign risk rating to each sovereign borrower / country. This is somewhat similar to the well known corporate bond credit ratings.

Sovereign risk ratings are based upon an assessment of both the ability and the willingness of a country to service its debt. These ratings take into account criteria that include the key economic and socio-political attributes of sovereign entities. The assessment considers solvency and liquidity factors in evaluating the economic ability to pay, while political criteria such as development level of government and institutions, the degree of integration into global financial networks, and constraining forces such as social unrest are all important in assessing the willingness to pay.

Sovereign risk ratings are thus based mainly on economic factors, however, a country’s history as a borrower on global markets and political (governance) factors are also important.

The market is heavily influenced by rating agency actions because of their impact on actual investor behaviour, through the need to adhere to risk limits in portfolios, and because of their impact on general market psychology.

Sovereign risk premium is essentially the yield premium that the market demands to hold a government’s debt. Government borrowing rates, or bond yields, are a synthesis of a wide range of factors, including economic factors (inflation expectations, output gap, interest rates, debt to GDP ratio etc), political/social factors, credibility, and transparency and so on.

When market participants take a less favourable view of a nation its bond yields are pushed higher. The increase in borrowing costs may in turn give rise to further deterioration in the country’s finances, thereby creating a negative feedback loop for the country and its ability to borrow funds.

When sovereign risk premiums increase, the market is in effect penalising the issuer of the debt for deteriorating conditions in the factors that go into yield valuations. Essentially, the driver of rates is the economy. But fundamentals can take a backseat when the market demonstrates ‘herd behaviour’ and/or irrationality due to uncertainties and lack of trust in a government to tackle its problems.

Normally sovereign risk is accentuated by deteriorating fiscal conditions, deep recession/depression, wars, social unrest and deflation

While sovereign risk concerns are creating market volatility, they also create opportunities to actively manage portfolios across issuers, currencies and specific stocks.

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