Sovereign credit risk is the risk of a government of asovereign state becoming unwilling or unable to meet itsloan orbond obligations leading to asovereign default.Credit rating agencies will take into account the capital, interest, extraneous and procedural defaults, and failures to abide by the terms of bonds or other debt instruments when setting a country's credit rating.
A sovereign cannot be forced to pay its debts even when in asovereign debt crisis but it may be able to use inflation andmoney printing to reduce its debts. The lender may also use its own government to pressure the sovereign through diplomatic and even military means. The United States government for example has theForeign Claims Settlement Commission to help lenders recover debts from sovereigns. The risks for the lender are therefore different to loans to individuals or corporates. This risk can be mitigated bycreditors andstakeholders taking extra precaution when makinginvestments orfinancial transactions with foreign countries.[1]
Five key factors that affect the probability ofsovereign debt leading to sovereign risk are:[2]debt service ratio,import ratio,investment ratio, variance of export revenue, and domesticmoney supply growth. The probability of loss increases with increases in debt service ratio, import ratio, variance of export revenue and/or domestic money supply growth. Frenkel, Karmann, Raahish and Scholtens also argue that the likelihood of rescheduling decreases as investment ratio increases, due to resultanteconomic productivity gains.
However, Saunders argues thatdebt rescheduling can become more likely if the investment ratio rises as the foreign country could become less dependent on its external creditors and so be less concerned about receivingcredit from these countries/investors.[3]
An example of states being unwilling or unable to meet its debt obligations wasCyprus in 2013. Many countries faced sovereign risk in theGreat Recession of the late-2000s.
