In recent years sovereign credit risk has been firmly in the spotlight for politicians, economists, multi-national corporations, investors and all those concerned with the health of global markets and economies. The ability of central banks to manage their countries’ finances is inextricably linked to their ability to borrow in the global financial markets. Simply put, weakness in a sovereign’s credit profile and a corresponding decrease in a country’s ability to service its debt can translate into poor performance in its equity markets and slack economic growth.
Given the importance of understanding sovereign risk to international finance, market participants use various metrics to track and understand the relative creditworthiness of sovereigns, such as the government debt/gross domestic product (GDP) ratio, sovereign long-term debt ratings constructed by credit ratings agencies, the yields on a country’s 10-year bonds and the spreads on its five-year credit default swap (CDS) contracts, among other measures.
In this article, we focus on an approach to tracking sovereign credit risk which draws on a pool of financial data, surveys and political insights. We believe it provides a useful framework for assessing sovereign risk which might be applied by finance professionals in a variety of functions, whether institutional investors in the global sovereign debt markets, strategy teams considering moving operations into a new territory, treasury practitioners with responsibility for understanding and articulating a firm’s sovereign credit exposure through trade finance to counterparties in a foreign country, or members of an institution’s benefits department considering adding specific country or regional exposure to a pension plan.
Sovereign Debt: No Longer Risk Free?
Over the past few years, global capital markets have become attuned to the idea that sovereign debt is not risk-free. While in reality sovereigns never were devoid of credit risk, the probability of capital erosion through default, inflation or devaluation has certainly increased since the great recession began. Far from being a problem particular to emerging markets, the developed world is actually at the centre of the debate on debt sustainability. Along with traditional interest rate and liquidity premia, compensation for credit risk is now being built more explicitly into the yields of all countries, irrespective of their historical default experience or share of global production.
For investors who try to earn a modest premium above inflation by investing in global sovereign debt markets, a credit event can be catastrophic. Quantifying the appropriate compensation for this risk has not been an easy task, given the lack of recent historical experience. The nature of market-value weighted indices, which outweigh large issuers of liabilities, has also impeded price discovery in traded debt markets.
Some market participants have gravitated toward simple measures of credit quality, such as the government debt/GDP ratio, to guide their investment decisions. However, these measures only tell part of the story; there are other factors, such as reserve-currency status or trend growth rates, which are equally important in assessing the vulnerability of debt to a credit event.
Recognising the importance of this source of volatility for investors, we outline an approach below that ranks sovereign debt issuers according to the relative likelihood of default, devaluation or above-trend inflation. It attempts to intelligently summarise and combine the most important factors that go into the analysis of debt sustainability, using a transparent and disciplined methodology.
We believe that any discussion around sovereign credit risk should go beyond the standard ‘debt/GDP’ metric, drawing on a body of research and pool of data that incorporates a much more intensive view of the factors affecting credit quality. This article discusses a comprehensive approach to sovereign credit risk and outlines factors that we have selected as of most importance when considering this area.
Assessing the Risks: Which Factors Matter?
Global debt markets have been vividly reminded recently of how rapidly a nation’s access to the capital markets can change, and how violently a country can transition from risk-free to risky status, as the ownership base switches from newly unwilling holders to opportunistic buyers. Because this transition can occur so quickly, an awareness of the factors that might cause a sovereign to approach a tipping point is critical for understanding the risks inherent in sovereign debt.
One popular and readily accessible indicator used to assess a country’s likelihood of paying back its outstanding obligations in full and on time is the debt-to-GDP ratio. The debt-to-GDP figure conveniently frames the outstanding debt burden of a government in relation to the annual income generated by the country. The logic supporting this indicator is straightforward: a higher debt burden implies high costs of servicing that debt, suggesting that a large share of income over a long period of time may need to be devoted to paying down that debt.
There are, however, many other factors that can influence a country’s likelihood of paying its real obligations in a timely fashion. For example, the term structure and maturity profile of debt may be far more important than its aggregate size. If a government has sufficient time to decide how to restructure its debt or establish measures to cut costs, it is significantly less likely to be forced into making a difficult decision. The world’s largest developed nations may actually enjoy the relative luxury of re-tooling the productive capacities of their economies while holding relatively high debt-to-GDP ratios. The UK, for example, possesses the ability to engage in recovery and austerity efforts at least in part because it has a long debt term structure. In contrast, one need only consider how quickly the Greek debt crisis spiralled out of control to see what can happen when a country does not have that luxury.
Building a Framework to Assess Relative Sovereign Risk
There is considerable benefit, when comparing the creditworthiness of differing countries, in pulling together a wide variety of relevant factors in a systematic, transparent way. Once the factors are identified it then is important to think in terms of broad conceptual categories into which all the key factors can be placed. These categories are designed to address several of the most critical questions with respect to debt sustainability:
- Fiscal space: This category assesses if the fiscal dynamics of a particular country are on a sustainable path. It estimates how close a country is to breaking through a level of debt that will cause it to default (i.e. the concept of proximity to distress), and how large an adjustment is necessary in order to achieve an appropriate debt/GDP level in the future (i.e. the concept of distance from stability).
- External finance position: The factors in this category measure how leveraged a country might be to macroeconomic trade and policy shocks outside of its control.
- Financial sector health: This category considers the degree to which a country’s financial sector poses a threat to its creditworthiness were the sector were to be nationalised, and estimates the likelihood that the financial sector may require nationalisation.
- Willingness to pay: In this category we group factors which gauge if a country displays qualitative cultural and institutional traits that suggest both ability and willingness to pay off real debts.
The set of factors we include in this approach are listed in Table 1, where we place each driver into a category and provide a short description of its assessed importance in evaluating sovereign credit risk.
Developing a Sovereign Risk Index
Using this framework we have found it possible to construct an overall index score for specific countries, which can be used as a comprehensive approach to relative sovereign credit quality that we believe correlates with and compares well with other existing traditional approaches.
There are certainly a number of challenges that arise in conducting this exercise. For example, how should we best set weights on factors without a reliable historical guide to their importance? One difficulty in setting empirical factor weights is, of course, that the default/inflation/devaluation experience for developed market countries is extremely limited, and we recognise is not likely to be reflective of the risks going forward. In addition, the quality of specific data sets can cause problems in developing a robust empirical approach. For instance emerging market data becomes more questionable running back into the early 1990s and 1980s.
Table 1: Key Drivers of Credit Quality
This basic measure of fiscal capacity is one of the core drivers of the ability to pay. Assuming a roughly constant tax share, the growth rate of the real income of a country is an important factor in determining the relative difficulty of paying or defaulting (through restructuring, repudiation, dramatic devaluation or above-trend inflation). We use net debt, and estimate the figure from a variety of sources.
|Per capita GDP||
Higher absolute levels of per capita income are generally associated with higher levels of sustainable debt, as the economic and institutional context for borrowing improves further up the income scale. Richer countries tend to have better gearing ratios between capital and labour than poorer countries, leading to more stable economies with better income-generating capacity. We benchmark per capita GDP in purchasing power parity terms as a percentage of the US income level.
|Proportion of domestically-held debt||
Who owns the debt can be a crucial consideration because it can skew incentives to pay. As an extreme example, if 95% of a country’s debt is owed to foreigners, the state may be incentivised to default because its constituency isn’t directly hurt if it does so.
|Term structure of debt||
If a government has sufficient time to decide how to restructure its debt, retool its economy or establish measures to cut costs, it is significantly less likely to be forced into making a difficult decision. A positive debt maturity structure helps lower the likelihood that a liquidity crisis becomes a solvency crisis. We analyse this likelihood by looking at total debt maturing within two years as a proportion of GDP.
Since debts are nominal, higher nominal income makes paying off those debts relatively easier. A growing population also means relatively more ease in creating nominal income. Higher population growth rates are also associated with higher levels of capital productivity. We use the age dependency ratio (the number of non-workers such as children and retirees in a country as a proportion of that country’s working age population, aged 15-64) in the year 2030 as a measure of the working age population dynamic of a nation over time.
|Growth and inflation volatility||
All things being equal, an unstable income stream for a government should mean a higher likelihood of defaulting. Stable growth histories with low volatility of inflation suggest that a country will have the ability, year-in and year-out, to service its loan payments and gradually move towards a sustainable debt level. This is the public sector equivalent of a bank lending to a customer with steady job income.
A country’s tax take is also important; we argue that for a given level of debt, more tax income is better. At same time, we don’t use this metric exclusively, as taxes that are too high might mean less flexibility for the economy and a reduced ability to raise taxes going forward.
|Depth of funding capacity||
As with a favourable debt maturity schedule, easy access to funding markets helps ensure that liquidity crises are less likely. We use the access to capital markets component of the Euromoney Country Risk (ECR) ranking.
Given regime changes and the evolution of institutional depth and quality, it is exceedingly difficult to use the past as a predictor of future actions on the part of a sovereign. However, there is some evidence that past defaulters are more likely to default again when compared to countries with clean payment histories.1 We proxy the historical proclivity towards default using the incidence of lending arrangements with the International Monetary Fund (IMF) since 1984.
|Reserve currency status||
Certain countries, by virtue of their status in world trade, their historical growth performance and the depth of their financial markets, are the natural recipients of capital flows from countries looking to increase their reserves of foreign currency. These countries also tend to act as safe havens when markets experience volatility. This ‘exorbitant privilege’ allows them to more easily finance deficits and debt loads without incurring the discipline of the markets. We endow the US, Japan and the eurozone with varying degrees of this status.
|Interest rate on debt||
The interest rate on debt is a crucial input when calculating the level of government debt at some point in the future. If the growth rate of debt is greater than the growth rate of income (GDP) over a prolonged period of time, a country will need to adjust its spending patterns (primary balance) to achieve stability in debt/GDP at some point in the future.
|External Finance Position|
|External debt/GDP (net of foreign exchange (FX) reserves)||
The currency in which debt is owed can be important for a sovereign, as it may limit options for repayment. If debts are denominated in local currency, a government may have the option to reduce those debts by printing money in moderate amounts. This option is unavailable when the debt is owed in the currency of other countries, which means it must be paid out of FX reserves or current income at spot exchange rates. To the extent that reserves are unavailable and a currency has weakened, a liquidity crisis may ensue. As mentioned in other factor descriptions, liquidity crises have the ability to hasten solvency crises. We also incorporate the term structure of external debt in this analysis, as well as the size of a banking sector’s external liabilities, in proportion to the sector’s frailty. There are instances of quasi-external debt, where debt may be denominated in local currency but the ‘option to print’ assumption doesn’t hold. Eurozone members fit such a profile, where the European Central Bank’s (ECB) activities remain distinct from the wishes of any individual member state. In such cases, we have designated a proportion of domestically-denominated debt as external, trending inversely with the influence the country at hand can be expected to have on the central bank.
|Current account position||
In very general terms, to the extent that a country is a net importer of goods, it will also be a net issuer of liabilities. The bigger the import ratio of a country, the more vendor financing it is likely to require, and therefore the more prone it might be to building up a large debt load. It is also likely that the country will find it more difficult to use import substitution to increase the competitiveness of its economy. We consider the current account position as a proportion of GDP, as well as of exports.
|Financial Sector Health|
|Bank credit quality and size||
A weaker banking sector means a higher probability that the liabilities of the sector will be assumed by the sovereign. This risk transfer from private to public balance sheets can significantly increase the debt burden of a government, particularly if the size of the banking sector is large. We use a variety of third-party bank health measures, a composite capital adequacy ratio (CAR) and a non-performing loan ratio to characterise a country’s banking system in terms of quality.
|Credit bubble risk||
Countries with rapid growth in private debt loads have been shown to be more prone to enter asset price bubbles. Even if a government’s formal liabilities are not large, it may be politically incentivised to step in and bail out an over-stretched domestic private sector. Countries that experience credit bubbles are also more likely to have weaker bank credit quality.
|Willingness to Pay|
These factors are designed to capture the ‘soft’, qualitative aspects of a country’s ability to adequately service its obligations. The factors intend to capture the willingness – as opposed to the ability – of a country to pay, the flexibility of an economy and its capacity for growth, the transparency of data, as well as a country’s fiscal credibility and commitment to responsible borrowing. These factors are collated from a variety of public and private sources and include measures of government effectiveness, legal rights and process, payment delays, repatriation risk, corruption, democratic accountability, government cohesion, government stability and support, and bureaucratic quality.1
1 “The Costs of Sovereign Default,” Eduardo Borensztein and Ugo Panizza, IMF Staff Papers, Vol. 56, No. 4, pp. 683-741, 2009.
Sovereign risk is a key factor for institutions engaged in international investment or trade. For banks and pension funds, which have direct financial exposure to a sovereign, it is critical to understand the latter’s ongoing ability to service its debts. For non-financial institutions engaged in international trade sovereign risk is one of a range of factors which they have to consider, but may arguably be less important than understanding the creditworthiness of a particular counterparty that they are doing business with. However, as just one example, there is a clear relationship between currency movements and the relative risk profile or perceived debt servicing ability of sovereigns and any institution engaged in international trade and with exposure to non-domestic currencies will understand the need to dynamically monitor sovereign credit risk.
Developing a systematic approach using the factors and categories outlined above can help finance professionals to sort through the complexities of evaluating sovereign risk in a more considered way than relying on standalone measures such as the debt/GDP ratio and CDS spreads.
The following is adapted from the BlackRock Investment Institute article: “Introducing the BlackRock Sovereign Risk Index” (June 2012). For the full article please click here.
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