佐川直弘 in Forex Basic Knowledge

Sovereign Risk Explained: Basics & Countermeasures

1 What is sovereign risk?
2 Impact of Sovereign Risk
3 Measures Against Sovereign Risk
4 Addressing Subsovereign Risk
5 Summary
6 Reference Sites

What is sovereign risk?

Definition and meaning of sovereign risk

Sovereign risk refers to the possibility that a country cannot meet its debt obligations on time. It is not limited to purely economic problems; it can arise from various factors such as political instability and deteriorating social conditions. Sovereign risk is an important indicator for measuring a country’s creditworthiness and has a significant impact on financial markets and the global economy.

Specifically, it can lead to rising yields on government bonds, falling currency values, and reduced foreign investment. It can also negatively affect corporate overseas expansion and trade transactions, becoming a factor that hampers overall economic growth.

Understanding sovereign risk is crucial not only for investors and businesses but also for policymakers. By accurately assessing the risk and implementing appropriate measures, economic losses can be minimized. Moreover, sovereign risk also indicates the need for international cooperation and support. By collaborating and providing assistance to countries facing economic difficulties, the international community can help reduce sovereign risk. Therefore, sovereign risk is a complex risk that must be understood from various perspectives, including economic, political, and social aspects.

Differences between sovereign risk and country risk

Country risk is a broader concept that includes sovereign risk. Country risk encompasses various risks such as political risk, economic risk, and currency risk. Sovereign risk can be seen as a part of country risk. Country risk is a comprehensive assessment of all risks that should be considered when investing in a particular country.

Political risk refers to the possibility that investment is harmed by political factors such as instability, civil war, or terrorism. Economic risk refers to the possibility that investment is harmed by economic factors such as sluggish growth, inflation, or fiscal deficits. Currency risk refers to the possibility that investment is harmed by fluctuations in exchange rates.

Sovereign risk is one of these country risk elements, specifically focused on the risk that the government cannot meet its debt obligations. Therefore, when evaluating country risk, it is necessary to consider not only sovereign risk but also other risk factors comprehensively. For example, even in a politically stable country, if the economic situation deteriorates, country risk increases. Conversely, even in an economically stable country, if political conditions become unstable, country risk rises.

Factors that cause sovereign risk to materialize

Expanding fiscal deficits, slowing economic growth, and political turmoil are factors that increase sovereign risk. Additionally, external shocks such as surging oil prices or global financial crises can also bring sovereign risk to the fore. These factors are interrelated and can compound, potentially amplifying sovereign risk.

When fiscal deficits expand, the government must increase debt, raising concerns about repayment capacity. When economic growth slows, tax revenue falls and the burden of debt repayment increases. Political turmoil can undermine policy stability and erode investor confidence. External shocks can severely damage the economy and reduce debt repayment capacity.

In addition to these factors, high inflation rates, large current account deficits, and low foreign exchange reserves also increase sovereign risk. Changes in demographic composition, resource depletion, and climate change can also affect sovereign risk from a long‑term perspective. Therefore, when evaluating sovereign risk, it is important to consider these factors comprehensively and forecast future risks.

Impact of Sovereign Risk

When sovereign risk materializes, the price of that country’s bonds falls and yields rise.

Additionally, exchange rates may decline. These movements can spill over into other financial markets such as equities. Falling bond prices can worsen the financial condition of institutions holding those bonds and threaten the stability of the financial system. Rising yields increase corporate borrowing costs and may curb investment. A drop in exchange rates can raise import prices, trigger inflation, and reduce overseas earnings for companies. Turmoil in the equity market can erode investor sentiment and dampen consumption. These effects on financial markets can also harm the real economy, slowing economic growth. If sovereign risk escalates, raising capital from international markets becomes difficult, potentially leading to an economic crisis. Thus, sovereign risk is a highly significant risk that can profoundly affect both financial markets and the real economy.

Impact on Corporate Activities

Companies operating in high-sovereign-risk countries may face higher borrowing costs and increased currency‑fluctuation risk. Additionally, changes in government policy or tightening of regulations can worsen the business environment. Rising financing costs can erode corporate profitability and curb investment. Greater currency‑fluctuation risk can destabilize overseas earnings and make strategic planning difficult.

Policy changes and regulatory tightening can constrain corporate operations and reduce competitiveness. Examples include tax reforms, stricter labor regulations, and the introduction of environmental rules. In high‑sovereign‑risk countries, political instability may also increase, potentially disrupting business operations.

Examples include protests or strikes, government corruption, and deficiencies in the legal system. These factors can disrupt a company’s supply chain and halt production. Therefore, companies operating in high‑sovereign‑risk countries must fully consider these risks and implement appropriate countermeasures.

Impact on Trade

When the creditworthiness of a high‑sovereign‑risk country deteriorates, it may become difficult to obtain trade insurance or premiums may rise. This can constrain a company’s trade activities. Consider utilizing entities such as the Japan External Trade Organization (NEXI). Trade insurance covers risks such as non‑payment of export proceeds and breach of import contracts.

In high‑sovereign‑risk countries, insurers may hesitate to underwrite or raise premiums due to heightened risks. Consequently, companies find it harder to use trade insurance, increasing the risk of conducting trade transactions. Moreover, currency rates are often unstable in such countries, amplifying currency‑fluctuation risk.

As a result, a company’s export competitiveness may decline and import costs may rise. Additionally, governments in high‑sovereign‑risk countries may impose trade restrictions, such as import limits, export controls, or tariff increases. These measures can impede corporate trade activities and disrupt international supply chains.

Measures Against Sovereign Risk

Avoid business expansion that depends on a single country, and reduce the impact of sovereign risk by diversifying investments across multiple countries.

In addition, diversifying across different asset classes is also effective. Risk diversification enhances the overall stability of the portfolio and is a fundamental strategy to minimize losses. If you concentrate investments in a single country, the sovereign risk of that country can materialize and cause a significant blow to the entire portfolio. By diversifying across multiple countries, you spread risk and reduce losses. Diversifying across different asset classes is also effective. For example, spreading investments among stocks, bonds, real estate, commodities, and so on can increase resilience to market fluctuations. Furthermore, avoiding investments in countries with high sovereign risk also contributes to risk reduction. By evaluating sovereign risk and reducing investments in high‑risk countries, you can lower the overall risk of the portfolio. However, it is important to consider not only risk avoidance but also opportunities for return. Balancing risk and return while formulating an appropriate diversification strategy is essential.

Risk‑Hedging Strategies

Using financial instruments such as forward contracts and currency options to hedge against foreign exchange volatility is also effective. Additionally, using trade insurance can reduce risks in trade transactions. A forward contract is an agreement to buy or sell currency at a specific future exchange rate. This prevents losses due to exchange rate fluctuations.

A currency option gives the right to buy or sell a specific currency at a specific price on a specific future date or period. It is more flexible than a forward contract and can hedge against exchange rate fluctuations. Trade insurance covers risks such as non‑collection of export payments and non‑performance of import contracts.

This reduces risks in trade transactions and allows businesses to operate with confidence. Additionally, in dealings with high‑sovereign‑risk countries, using a letter of credit (L/C) is also effective. An L/C is a guarantee by a bank that the importer will pay, thereby reducing the exporter’s risk. Combining these risk‑hedging strategies can increase a company’s resilience to sovereign risk.

Information Gathering and Analysis

It is important to continuously collect and analyze information on sovereign risk using reports from credit rating agencies and economic indicators. Seeking expert advice is also effective. Credit rating agencies evaluate each country’s sovereign risk and publish ratings. These ratings serve as important indicators for investors assessing sovereign risk.

Economic indicators are data that show a country’s economic situation, including GDP growth rate, inflation rate, unemployment rate, fiscal balance, etc. By analyzing these indicators, you can predict trends in sovereign risk. Seeking expert advice is also effective. Economic analysts and financial experts possess deep knowledge and experience regarding sovereign risk and can support appropriate investment decisions.

Furthermore, reports and analyses from international organizations such as the IMF and World Bank are also useful. These institutions provide detailed analyses of each country’s economic situation and information on sovereign risk. Using this information comprehensively and having accurate knowledge of sovereign risk is the first step in risk management.

Addressing Subsovereign Risk

Subsovereign risk refers to the risk that entities other than the central government, such as local governments and state-owned enterprises, default on their debt.

Even when the central government guarantees it, risk can still exist depending on fiscal conditions. Subsovereign risk, like sovereign risk, can have a significant impact on financial markets and the economy. When local governments or state-owned enterprises default, the region’s economy can stagnate and resident services may deteriorate. Even if the central government guarantees it, if the fiscal condition of local governments or state-owned enterprises worsens, the central government’s fiscal burden may increase, raising sovereign risk. Subsovereign risk varies by country. For example, in countries where local autonomy is advanced or local governments have high fiscal independence, subsovereign risk tends to rise. Likewise, in countries where state-owned enterprises have low managerial efficiency or local government fiscal management is opaque, subsovereign risk may increase.

Concrete Examples of Subsovereign Risk

For example, the Greek crisis highlighted deteriorating fiscal conditions of local governments. Argentina’s local debt default is another instance where subsovereign risk materialized. In Greece, it was discovered that local governments had engaged in financial misreporting, revealing severe fiscal distress. This eroded confidence in Greek sovereign bonds and heightened sovereign risk.

Argentina’s local debt default occurred because local governments could no longer repay their debt. This weakened Argentina’s overall credit and led to an economic crisis. These cases demonstrate that subsovereign risk can spill over into sovereign risk. Moreover, subsovereign risk can arise not only in emerging or developing countries but also in advanced economies.

For instance, local governments in the United States and local authorities in Europe have also seen worsening fiscal conditions and rising default risk. Therefore, subsovereign risk is an important risk factor even from a global perspective.

Measures to Address Subsovereign Risk

To address subsovereign risk, it is essential to conduct a detailed analysis of the financial condition of local governments and state-owned enterprises. One must also consider the central government’s support framework and fiscal health. When analyzing the financial condition of local governments or state-owned enterprises, it is necessary to review information such as revenue, expenditures, and debt balances.

Additionally, it is important to verify the audit status of financial statements and the application of accounting standards. When evaluating the central government’s support system, one must confirm the scale and conditions of fiscal assistance to local governments and state-owned enterprises. The central government’s fiscal condition should also be taken into account.

If the central government’s fiscal condition deteriorates, support for local governments and state-owned enterprises may be reduced. Furthermore, strengthening the governance structures of local governments and state-owned enterprises is crucial to address subsovereign risk. Enhancing management transparency and establishing internal controls to prevent misconduct is necessary.

Summary

Sovereign risk is a significant risk that can have a major impact on international financial markets and corporate activities. It is important to gather the latest information and take appropriate measures to minimize risk. In particular, let’s use trade receivables insurance and overseas business financing insurance, and also take measures against sub‑sovereign risk.

Sovereign risk is not just an economic issue; political, social, and geopolitical factors are also intricately intertwined. Therefore, it is necessary to evaluate risk from multiple perspectives and respond flexibly to changing circumstances. Companies should conduct thorough due diligence and understand the risk when investing in or expanding business in countries with high sovereign risk.

Additionally, by implementing various measures such as risk‑hedging strategies and insurance, risks can be mitigated. Investors should diversify their portfolios while taking sovereign risk into account, thereby spreading risk. It is also important to continuously gather and analyze information on sovereign risk using credit rating agency reports and economic indicators. Governments should curb sovereign risk by maintaining sound fiscal management and promoting economic growth. Strengthening international cooperation and providing assistance to countries in economic crisis also contributes to reducing sovereign risk.