Sovereign Debt

Sovereign debt is issued by national governments. Sovereign credit analysis must assess both the government’s ability to service debt and its willingness to do so. The assessment of willingness is important because bondholders usually have no legal recourse if a national government refuses to pay its debts.

A basic framework for evaluating and assigning a credit rating to sovereign debt includes five key areas:

1. Institutional assessment includes successful policymaking, minimal corruption, checks and balances among institutions, and a culture of honoring debts.
2. Economic assessment includes growth trends, income per capita, and diversity of sources for economic growth.
3. External assessment includes the country’s foreign reserves, its external debt, and the status of its currency in international markets.
4. Fiscal assessment includes the government’s willingness and ability to increase revenue or cut expenditures to ensure debt service, as well as trends in debt as a percentage of GDP.
5. Monetary assessment includes the ability to use monetary policy for domestic economic objectives (this might be lacking with exchange rate targeting or membership in a monetary union) and the credibility and effectiveness of monetary policy.

Credit rating agencies assign each national government two ratings: (1) a local currency debt rating and (2) a foreign currency debt rating. The ratings are assigned separately becausedefaults on foreign currency denominated debt have historically exceeded those on local currency debt. Foreign currency debt typically has a higher default rate and a lower credit rating because the government must purchase foreign currency in the open market to make interest and principal payments, which exposes it to the risk of significant local currency depreciation. In contrast, local currency debt can be repaid by raising taxes, controlling domestic spending, or simply printing more money. Ratings can differ as much as two notches for local and foreign currency bonds.

Sovereign defaults can be caused by events such as war, political instability, severe devaluation of the currency, or large declines in the prices of the country’s export commodities. Access to debt markets can be difficult for sovereigns in bad economic times.