Description
Macro-Financial dimensions of sovereign risk and propose a conceptual framework that captures risks other than just the default risk. Morphed under a multi-dimensional notion of sovereign risk, we argue that the existing empirical methodologies to measure sovereign risk cover only partial aspects of sovereign risk and fail to capture its macro-financial dimensions.
ADBI Working Paper Series
Sovereign Risk: A Macro-Financial
Perspective
Udaibir S. Das,
Maria A. Oliva, and
Takahiro Tsuda
No. 383
October 2012
Asian Development Bank Institute
The Working Paper series is a continuation of the formerly named Discussion Paper series; the
numbering of the papers continued without interruption or change. ADBI’s working papers
reflect initial ideas on a topic and are posted online for discussion. ADBI encourages readers to
post their comments on the main page for each working paper (given in the citation below).
Some working papers may develop into other forms of publication.
Suggested citation:
Das, U. S., M. A. Oliva, and T. Tsuda. 2012. Sovereign Risk: A Macro-Financial Perspective
.
ADBI Working Paper 383. Tokyo: Asian Development Bank Institute. Available:http://www.adbi.org/working-paper/2012/10/02/5241.sovereign.risk.macrofinancial.perspective/
Please contact the authors for information about this paper.
Email: [email protected]; [email protected]; [email protected]
Udaibir S. Das, Maria A. Oliva, and Takahiro Tsuda are assistant director and division
chief, senior economist, and financial sector expert, respectively, at the Monetary and
Capital Markets Department of the International Monetary Fund.
This paper builds on the conference presentation and speaking notes of Udaibir S. Das.
We are thankful to Anastasia Guscina and Bruno Momont for reviewing this conference
paper, to Gabriel Presciuttini and Kay Chang for excellent research support, and to
Vincenzo Guzzo for his valuable insights.
The views expressed in this paper are the views of the author and do not necessarily
reflect the views or policies of ADBI, the ADB, its Board of Directors, or the governments
they represent. ADBI does not guarantee the accuracy of the data included in this paper
and accepts no responsibility for any consequences of their use. Terminology used may
not necessarily be consistent with ADB official terms.
Asian Development Bank Institute
Kasumigaseki Building 8F
3-2-5 Kasumigaseki, Chiyoda-ku
Tokyo 100-6008, J apan
Tel: +81-3-3593-5500
Fax: +81-3-3593-5571
URL: www.adbi.org
E-mail: [email protected]
©2012 Asian Development Bank Institute
ADBI Working Paper 383 Das, Oliva, and Tsuda
Abstract
We examine some of the macro-financial dimensions of sovereign risk and propose a
conceptual framework that captures risks other than just the default risk. Morphed under a
multi-dimensional notion of sovereign risk, we argue that the existing empirical methodologies
to measure sovereign risk cover only partial aspects of sovereign risk and fail to capture its
macro-financial dimensions. We highlight a menu of tools that could be used to tackle the
broader notion of sovereign risk, and suggest that authorities should actively use them to
manage the macro-financial dimensions of sovereign risk before those risks feed into the real
economy.
JEL Classification: F30, F34, E43
ADBI Working Paper 383 Das, Oliva, and Tsuda
Contents
1. Introduction ...................................................................................................................... 3
2. Moving to a Macro-Financial Perspective of Sovereign Risk ............................................ 4
2.1 Pre-crisis Debt Outlook and Medium-term Macro Projections ............................... 4
2.2 From narrow Debt Sustainability to a Broader Macro-financial Perspective .......... 5
2.3 Defining Sovereign Risk ....................................................................................... 7
2.4 Sovereign Risk as a Composite of Risks: Conceptual Framework ........................ 8
3. Amplification and Manifestation of Sovereign and Financial Stability Risk ...................... 10
3.1 Sovereign-Bank Inter-linkages: Concepts and Channels .................................... 10
3.2 Investors’ Perspective: Investor Base and Capital Flows .................................... 13
4. Measuring Sovereign Risk ............................................................................................. 16
5. The Policy Response ..................................................................................................... 18
5.1 The Multiple Equilibrium Risk: Tilting the Balance to the Good Equilibrium ........ 18
5.2 Managing Risk through a Crisis—Crisis Prevention ............................................ 19
5.3 Managing Risk through a Crisis—Debt Management Policy ............................... 22
6. Conclusions—Challenges Ahead and Open Questions .................................................. 23
References ................................................................................................................................ 25
Annex: Guiding Principles for Managing Sovereign Risk and High Levels of Public Debt
(Stockholm Principles) ............................................................................................................... 27
Framework and operations ............................................................................................. 27
Communication .............................................................................................................. 28
Risk management .......................................................................................................... 28
ADBI Working Paper 383 Das, Oliva, and Tsuda
3
1. INTRODUCTION
High level of indebtedness in advanced economies is not a new phenomenon. In fact, at the
onset of the current Global Financial Crisis (GFC) in 2007, most advanced economies had
significantly high debt levels, way in excess of the commonly accepted 60% threshold. Yet,
these high debt levels did not trigger fundamental debt sustainability concerns and investor
nervousness. Growth projections conveyed a very solid medium-term economic outlook. Most
early warning and risk indicators did not predict that the following years would be radically
different from a sovereign credit risk angle. What influenced such a benign outlook and why did
various actively used models not identify “sovereign risk” until after it got amplified and led to a
disruption in global sovereign debt markets? Did the policymakers have the right set of tools to
act preventively and fix the system before concerns relating to sovereign credit risk fed into the
real economy?
The complex network of direct and indirect interconnections between the balance sheets of a
sovereign with those of the corporate, households, and banks and non-banking institutions
calls for a broader approach towards identifying and measuring sovereign risk. At the same
time, there is no silver bullet in managing sovereign risk. A full policy menu is needed that goes
beyond the traditional monetary and fiscal policy mix and explicitly takes into account the
macro-financial aspects of sovereign credit risk that propagate and magnify its negative
effects, particularly those relating to financial stability. Perhaps, a new office of a Sovereign
Risk Officer (SRO) could be set up whose main tasks would be the review and the assessment
of risks affecting a sovereign’s credit standing and to advise the pertinent policymakers on
remedial measures. The SRO is similar to the Chief Risk Officer found in many financial firms,
where (s)he is usually responsible for the three categories of risks: market risk, credit risk, and
operational risks.
In Section 1 below we discuss the holistic concept of sovereign credit risk that incorporates the
macro-financial aspects. Section 2 discusses the financial stability dimension of sovereign risk
and the related transmission channels. Section 3 discusses the existing measures being used
to capture sovereign risk and their limitations. Section 4 looks at policy responses, and Section
5 concludes by highlighting challenges ahead and points at some open questions and issues
for further examination.
ADBI Working Paper 383 Das, Oliva, and Tsuda
4
2. MOVING TO A MACRO-FINANCIAL PERSPECTIVE OF
SOVEREIGN RISK
A key legacy of the GFC is the realization that sovereign risk is far more than just a pure fiscal
risk. The analysis of sovereign risk needs to go well beyond the traditional debt sustainability
approach to encompass the complex net of macro-financial interactions (Figure 1).
Figure 1: Debt Sustainability and Macro-Financial Perspective
MACRO-FINANCIAL
PERSPECTIVE
Capital
Market
Infrastructure
Regulatory
Framework
Contingent
Liabilities
ALM
Approach
Investor
Base
DEBT
SUSTAINABILITY
Primary
Expenditure
Interest
Rate
Tax
Revenue
Debt
Stock
Economic
Growth
Source: IMF staff.
2.1 Pre-crisis Debt Outlook and Medium-term Macro Projections
The sole focus on sovereign solvency risks in the early 2000s missed the importance of the
direct and contingent intertwining of cross-sectoral balance sheets with that of the sovereign.
This aspect has played a crucial role in a number of country cases caught in the direct
headwind of the GFC. At the onset of the crisis, debt sustainability in advanced economies
was not an issue despite their sovereign debt levels being well above 60% of GDP in a number
of cases (Figure 2). On average, the euro area’s sovereign debt hovered around 69% of
gross domestic product (GDP) in 2000–07. 2007 outstanding public debt levels of Italy,
Greece, and Belgium were projected to be 105%, 85%, and 79% of GDP, respectively.
In 2007, financial markets were stable and the projected medium-term macroeconomic outlook
of these highly-indebted economies suggested nothing but stability and solid growth. For
ADBI Working Paper 383 Das, Oliva, and Tsuda
5
instance, for the euro area, the World Economic Outlook (WEO) growth projections made in
2007 for the period 2007–11 averaged 4.2%, and showed a path of smooth debt consolidation.
The 2007 housing market downturn in the Unites States (US) and the subsequent GFC,
however, led to significant downward revisions of the projected debt consolidation trend and
the macroeconomic outlook (Figure 3). In 2011, the euro area’s stock of sovereign debt surged
by 40 percentage points relative to the 2007 levels, and nominal GDP growth rates cut back to
1.5%.
Figure 2: Public Debt to GDP Ratio
0
30
60
90
120
150
180
Greece Ireland Portugal Spain Italy Belgium France UK US
2007 2011
(In percent of GDP)
Source : IMF, Fiscal Monitor (September
2011).
Figure 3: 2011 GDP Growth
Projections
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
Greece Ireland Portugal Spain Italy Belgium France UK USA
Projection in 2007
Projection in 2011
(WEO projections made in 2007 and 2011)
Source: IMF, World Economic Outlook.
The shift in confidence and market expectations in future events, not purely macro fiscal
variables, thus played a key role in determining the public debt trajectory going forward.
1
2.2 From narrow Debt Sustainability to a Broader Macro-financial
Perspective
The
continuous revisions of some advanced economies’ sovereign debt ratios and growth
projections validated the market perception that advance economy sovereigns are no longer
risk free. Stronger inter-linkages between sovereigns’ and banks’ balance sheets, combined
with the deterioration of fiscal and real sector outlooks, contributed to further exacerbation of
the perception of sovereign credit risk among advanced economies.
Often, sovereign risk is referred to as risk to debt sustainability of a country, i.e., the probability
that debt ratios may cross a certain threshold.
2
1
See Reinhart and Rogoff (2009) for more discussion.
Under this purely macro-fiscal approach,
2
Aizenman et al. (2011) look at the past and current fiscal space (defined in terms of levels of debt and deficits
relative to tax revenues) to measure sovereign risk in a number of European countries that are currently facing
pressures. Gray et al. (2008) propose extending the notion of debt sustainability to control for the risks associated
ADBI Working Paper 383 Das, Oliva, and Tsuda
6
sovereign risk is defined as solvency risk measured in terms of primary expenditure, stock of
nominal debt, and tax revenue. In a debt sustainability analysis approach, which examines the
net present value of future debt flows, market and investor factors enter into the equation only
through the discount variable. The qualitative aspects of the composition of the debt stock,
through which market expectations operate, are mostly neglected.
Reliance on a fiscal approach to sovereign risk, while important, becomes too narrow to
address the macro-financial stability challenges that sovereigns confront. It is now well
accepted that, with the evolution and deepening of global and domestic capital markets, and
the entwining of the sovereign and financial sectors’ balance sheets in developed markets, the
notion of sovereign risk has to inevitably expand to cover a much larger set of risk factors.
3
Inadequate policy responses in preventing and managing a sovereign credit crisis in a timely
manner can be explained by misperceptions about the nature of sovereign risk. The excessive
focus on traditional macro-fiscal risk indicators and a poor understanding of the financial
stability and capital market implications for the sovereign balance sheet may contribute to the
mispricing of sovereign assets pre-crisis. Weak macro-prudential and regulatory framework
and sovereign debt management practices also lay the ground for a faster, broader, and more
amplified spread of market anxiety.
To
cite a few, the sovereign risk analysis needs to capture risks deriving from the debt structure
and its composition, the existing capital market infrastructure, the regulatory framework, the
composition of the investor base of the country (beyond the share of non-resident to resident
debt holders), and the funding conditions of systemically important corporations and financial
firms, among others.
with sovereign assets and liabilities. Under the contingent claims approach, Gray et al. (2007) link sovereign
credit risk to the probability the asset value falls below the distress barrier (i.e., the present value of promised
payments.). Garcia and Rigobon (2004) extend the debt accumulation equation to incorporate the stochastic
features of key macroeconomic variables (e.g., the real interest rate, GDP, exchange rate, and inflation) and
define credit risk as the probability the debt will reach a threshold in a certain period of time.
3
Cottarelli (2011a) defines rollover risks or fiscal sustainability risks as the probability that the move of certain fiscal
indicators into dangerous territory, or other form of shocks, will trigger a negative market response. This concept
relies on three dimensions: (1) basic fiscal variables that are often captured under the basic fiscal solvency
analyses; (2) the composition of sovereign asset and liabilities and its management; (i.e., rollover needs, maturity
structure, and global market risks) and (3) factors affecting long-term fiscal trends. Baldacci et al. (2011)
formulate the fiscal stress index using the notion of crises events that fall into one of four criteria: (i) sovereign
debt default or restructuring; (ii) IMF-program with more than a 100% quota access; (iii) very high inflation; and
(iv) very high sovereign bond yields.
ADBI Working Paper 383 Das, Oliva, and Tsuda
7
2.3 Defining Sovereign Risk
Despite its popular use since 2009, there is little consensus on how best to define sovereign
risk. We propose expanding the concepts advanced in the macro-fiscal and macro-prudential
literature to incorporate the macro-financial risks that sovereigns encounter. Sovereign risk is a
complex combination of risks that feed through a number of channels into the sovereign
balance sheet in a non-monotonic fashion (Figure 4). For instance, credit risk from systemic
financial institutions will channel through the contingent liabilities component of the sovereign
balance sheet, whereas market risk will affect the fiscal revenue and international reserves
components.
Figure 4: Defining Sovereign Risk
Source : IMF staff.
ADBI Working Paper 383 Das, Oliva, and Tsuda
8
Using a balance sheet approach, sovereign risk can be defined as the probability of a
significant deterioration of the sovereign’s balance sheet, either via increased vulnerabilities in
the domestic market (financial sector, sovereign credit market, real sector, the external sector),
and/or vulnerabilities in foreign markets that spillover to the country. More formally:
Sovereign risk =Probability (event) ? Threshold
? Prob ( A L
Threshold
? K
Macro-Financial dimensions of sovereign risk and propose a conceptual framework that captures risks other than just the default risk. Morphed under a multi-dimensional notion of sovereign risk, we argue that the existing empirical methodologies to measure sovereign risk cover only partial aspects of sovereign risk and fail to capture its macro-financial dimensions.
ADBI Working Paper Series
Sovereign Risk: A Macro-Financial
Perspective
Udaibir S. Das,
Maria A. Oliva, and
Takahiro Tsuda
No. 383
October 2012
Asian Development Bank Institute
The Working Paper series is a continuation of the formerly named Discussion Paper series; the
numbering of the papers continued without interruption or change. ADBI’s working papers
reflect initial ideas on a topic and are posted online for discussion. ADBI encourages readers to
post their comments on the main page for each working paper (given in the citation below).
Some working papers may develop into other forms of publication.
Suggested citation:
Das, U. S., M. A. Oliva, and T. Tsuda. 2012. Sovereign Risk: A Macro-Financial Perspective
.
ADBI Working Paper 383. Tokyo: Asian Development Bank Institute. Available:http://www.adbi.org/working-paper/2012/10/02/5241.sovereign.risk.macrofinancial.perspective/
Please contact the authors for information about this paper.
Email: [email protected]; [email protected]; [email protected]
Udaibir S. Das, Maria A. Oliva, and Takahiro Tsuda are assistant director and division
chief, senior economist, and financial sector expert, respectively, at the Monetary and
Capital Markets Department of the International Monetary Fund.
This paper builds on the conference presentation and speaking notes of Udaibir S. Das.
We are thankful to Anastasia Guscina and Bruno Momont for reviewing this conference
paper, to Gabriel Presciuttini and Kay Chang for excellent research support, and to
Vincenzo Guzzo for his valuable insights.
The views expressed in this paper are the views of the author and do not necessarily
reflect the views or policies of ADBI, the ADB, its Board of Directors, or the governments
they represent. ADBI does not guarantee the accuracy of the data included in this paper
and accepts no responsibility for any consequences of their use. Terminology used may
not necessarily be consistent with ADB official terms.
Asian Development Bank Institute
Kasumigaseki Building 8F
3-2-5 Kasumigaseki, Chiyoda-ku
Tokyo 100-6008, J apan
Tel: +81-3-3593-5500
Fax: +81-3-3593-5571
URL: www.adbi.org
E-mail: [email protected]
©2012 Asian Development Bank Institute
ADBI Working Paper 383 Das, Oliva, and Tsuda
Abstract
We examine some of the macro-financial dimensions of sovereign risk and propose a
conceptual framework that captures risks other than just the default risk. Morphed under a
multi-dimensional notion of sovereign risk, we argue that the existing empirical methodologies
to measure sovereign risk cover only partial aspects of sovereign risk and fail to capture its
macro-financial dimensions. We highlight a menu of tools that could be used to tackle the
broader notion of sovereign risk, and suggest that authorities should actively use them to
manage the macro-financial dimensions of sovereign risk before those risks feed into the real
economy.
JEL Classification: F30, F34, E43
ADBI Working Paper 383 Das, Oliva, and Tsuda
Contents
1. Introduction ...................................................................................................................... 3
2. Moving to a Macro-Financial Perspective of Sovereign Risk ............................................ 4
2.1 Pre-crisis Debt Outlook and Medium-term Macro Projections ............................... 4
2.2 From narrow Debt Sustainability to a Broader Macro-financial Perspective .......... 5
2.3 Defining Sovereign Risk ....................................................................................... 7
2.4 Sovereign Risk as a Composite of Risks: Conceptual Framework ........................ 8
3. Amplification and Manifestation of Sovereign and Financial Stability Risk ...................... 10
3.1 Sovereign-Bank Inter-linkages: Concepts and Channels .................................... 10
3.2 Investors’ Perspective: Investor Base and Capital Flows .................................... 13
4. Measuring Sovereign Risk ............................................................................................. 16
5. The Policy Response ..................................................................................................... 18
5.1 The Multiple Equilibrium Risk: Tilting the Balance to the Good Equilibrium ........ 18
5.2 Managing Risk through a Crisis—Crisis Prevention ............................................ 19
5.3 Managing Risk through a Crisis—Debt Management Policy ............................... 22
6. Conclusions—Challenges Ahead and Open Questions .................................................. 23
References ................................................................................................................................ 25
Annex: Guiding Principles for Managing Sovereign Risk and High Levels of Public Debt
(Stockholm Principles) ............................................................................................................... 27
Framework and operations ............................................................................................. 27
Communication .............................................................................................................. 28
Risk management .......................................................................................................... 28
ADBI Working Paper 383 Das, Oliva, and Tsuda
3
1. INTRODUCTION
High level of indebtedness in advanced economies is not a new phenomenon. In fact, at the
onset of the current Global Financial Crisis (GFC) in 2007, most advanced economies had
significantly high debt levels, way in excess of the commonly accepted 60% threshold. Yet,
these high debt levels did not trigger fundamental debt sustainability concerns and investor
nervousness. Growth projections conveyed a very solid medium-term economic outlook. Most
early warning and risk indicators did not predict that the following years would be radically
different from a sovereign credit risk angle. What influenced such a benign outlook and why did
various actively used models not identify “sovereign risk” until after it got amplified and led to a
disruption in global sovereign debt markets? Did the policymakers have the right set of tools to
act preventively and fix the system before concerns relating to sovereign credit risk fed into the
real economy?
The complex network of direct and indirect interconnections between the balance sheets of a
sovereign with those of the corporate, households, and banks and non-banking institutions
calls for a broader approach towards identifying and measuring sovereign risk. At the same
time, there is no silver bullet in managing sovereign risk. A full policy menu is needed that goes
beyond the traditional monetary and fiscal policy mix and explicitly takes into account the
macro-financial aspects of sovereign credit risk that propagate and magnify its negative
effects, particularly those relating to financial stability. Perhaps, a new office of a Sovereign
Risk Officer (SRO) could be set up whose main tasks would be the review and the assessment
of risks affecting a sovereign’s credit standing and to advise the pertinent policymakers on
remedial measures. The SRO is similar to the Chief Risk Officer found in many financial firms,
where (s)he is usually responsible for the three categories of risks: market risk, credit risk, and
operational risks.
In Section 1 below we discuss the holistic concept of sovereign credit risk that incorporates the
macro-financial aspects. Section 2 discusses the financial stability dimension of sovereign risk
and the related transmission channels. Section 3 discusses the existing measures being used
to capture sovereign risk and their limitations. Section 4 looks at policy responses, and Section
5 concludes by highlighting challenges ahead and points at some open questions and issues
for further examination.
ADBI Working Paper 383 Das, Oliva, and Tsuda
4
2. MOVING TO A MACRO-FINANCIAL PERSPECTIVE OF
SOVEREIGN RISK
A key legacy of the GFC is the realization that sovereign risk is far more than just a pure fiscal
risk. The analysis of sovereign risk needs to go well beyond the traditional debt sustainability
approach to encompass the complex net of macro-financial interactions (Figure 1).
Figure 1: Debt Sustainability and Macro-Financial Perspective
MACRO-FINANCIAL
PERSPECTIVE
Capital
Market
Infrastructure
Regulatory
Framework
Contingent
Liabilities
ALM
Approach
Investor
Base
DEBT
SUSTAINABILITY
Primary
Expenditure
Interest
Rate
Tax
Revenue
Debt
Stock
Economic
Growth
Source: IMF staff.
2.1 Pre-crisis Debt Outlook and Medium-term Macro Projections
The sole focus on sovereign solvency risks in the early 2000s missed the importance of the
direct and contingent intertwining of cross-sectoral balance sheets with that of the sovereign.
This aspect has played a crucial role in a number of country cases caught in the direct
headwind of the GFC. At the onset of the crisis, debt sustainability in advanced economies
was not an issue despite their sovereign debt levels being well above 60% of GDP in a number
of cases (Figure 2). On average, the euro area’s sovereign debt hovered around 69% of
gross domestic product (GDP) in 2000–07. 2007 outstanding public debt levels of Italy,
Greece, and Belgium were projected to be 105%, 85%, and 79% of GDP, respectively.
In 2007, financial markets were stable and the projected medium-term macroeconomic outlook
of these highly-indebted economies suggested nothing but stability and solid growth. For
ADBI Working Paper 383 Das, Oliva, and Tsuda
5
instance, for the euro area, the World Economic Outlook (WEO) growth projections made in
2007 for the period 2007–11 averaged 4.2%, and showed a path of smooth debt consolidation.
The 2007 housing market downturn in the Unites States (US) and the subsequent GFC,
however, led to significant downward revisions of the projected debt consolidation trend and
the macroeconomic outlook (Figure 3). In 2011, the euro area’s stock of sovereign debt surged
by 40 percentage points relative to the 2007 levels, and nominal GDP growth rates cut back to
1.5%.
Figure 2: Public Debt to GDP Ratio
0
30
60
90
120
150
180
Greece Ireland Portugal Spain Italy Belgium France UK US
2007 2011
(In percent of GDP)
Source : IMF, Fiscal Monitor (September
2011).
Figure 3: 2011 GDP Growth
Projections
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
Greece Ireland Portugal Spain Italy Belgium France UK USA
Projection in 2007
Projection in 2011
(WEO projections made in 2007 and 2011)
Source: IMF, World Economic Outlook.
The shift in confidence and market expectations in future events, not purely macro fiscal
variables, thus played a key role in determining the public debt trajectory going forward.
1
2.2 From narrow Debt Sustainability to a Broader Macro-financial
Perspective
The
continuous revisions of some advanced economies’ sovereign debt ratios and growth
projections validated the market perception that advance economy sovereigns are no longer
risk free. Stronger inter-linkages between sovereigns’ and banks’ balance sheets, combined
with the deterioration of fiscal and real sector outlooks, contributed to further exacerbation of
the perception of sovereign credit risk among advanced economies.
Often, sovereign risk is referred to as risk to debt sustainability of a country, i.e., the probability
that debt ratios may cross a certain threshold.
2
1
See Reinhart and Rogoff (2009) for more discussion.
Under this purely macro-fiscal approach,
2
Aizenman et al. (2011) look at the past and current fiscal space (defined in terms of levels of debt and deficits
relative to tax revenues) to measure sovereign risk in a number of European countries that are currently facing
pressures. Gray et al. (2008) propose extending the notion of debt sustainability to control for the risks associated
ADBI Working Paper 383 Das, Oliva, and Tsuda
6
sovereign risk is defined as solvency risk measured in terms of primary expenditure, stock of
nominal debt, and tax revenue. In a debt sustainability analysis approach, which examines the
net present value of future debt flows, market and investor factors enter into the equation only
through the discount variable. The qualitative aspects of the composition of the debt stock,
through which market expectations operate, are mostly neglected.
Reliance on a fiscal approach to sovereign risk, while important, becomes too narrow to
address the macro-financial stability challenges that sovereigns confront. It is now well
accepted that, with the evolution and deepening of global and domestic capital markets, and
the entwining of the sovereign and financial sectors’ balance sheets in developed markets, the
notion of sovereign risk has to inevitably expand to cover a much larger set of risk factors.
3
Inadequate policy responses in preventing and managing a sovereign credit crisis in a timely
manner can be explained by misperceptions about the nature of sovereign risk. The excessive
focus on traditional macro-fiscal risk indicators and a poor understanding of the financial
stability and capital market implications for the sovereign balance sheet may contribute to the
mispricing of sovereign assets pre-crisis. Weak macro-prudential and regulatory framework
and sovereign debt management practices also lay the ground for a faster, broader, and more
amplified spread of market anxiety.
To
cite a few, the sovereign risk analysis needs to capture risks deriving from the debt structure
and its composition, the existing capital market infrastructure, the regulatory framework, the
composition of the investor base of the country (beyond the share of non-resident to resident
debt holders), and the funding conditions of systemically important corporations and financial
firms, among others.
with sovereign assets and liabilities. Under the contingent claims approach, Gray et al. (2007) link sovereign
credit risk to the probability the asset value falls below the distress barrier (i.e., the present value of promised
payments.). Garcia and Rigobon (2004) extend the debt accumulation equation to incorporate the stochastic
features of key macroeconomic variables (e.g., the real interest rate, GDP, exchange rate, and inflation) and
define credit risk as the probability the debt will reach a threshold in a certain period of time.
3
Cottarelli (2011a) defines rollover risks or fiscal sustainability risks as the probability that the move of certain fiscal
indicators into dangerous territory, or other form of shocks, will trigger a negative market response. This concept
relies on three dimensions: (1) basic fiscal variables that are often captured under the basic fiscal solvency
analyses; (2) the composition of sovereign asset and liabilities and its management; (i.e., rollover needs, maturity
structure, and global market risks) and (3) factors affecting long-term fiscal trends. Baldacci et al. (2011)
formulate the fiscal stress index using the notion of crises events that fall into one of four criteria: (i) sovereign
debt default or restructuring; (ii) IMF-program with more than a 100% quota access; (iii) very high inflation; and
(iv) very high sovereign bond yields.
ADBI Working Paper 383 Das, Oliva, and Tsuda
7
2.3 Defining Sovereign Risk
Despite its popular use since 2009, there is little consensus on how best to define sovereign
risk. We propose expanding the concepts advanced in the macro-fiscal and macro-prudential
literature to incorporate the macro-financial risks that sovereigns encounter. Sovereign risk is a
complex combination of risks that feed through a number of channels into the sovereign
balance sheet in a non-monotonic fashion (Figure 4). For instance, credit risk from systemic
financial institutions will channel through the contingent liabilities component of the sovereign
balance sheet, whereas market risk will affect the fiscal revenue and international reserves
components.
Figure 4: Defining Sovereign Risk
Source : IMF staff.
ADBI Working Paper 383 Das, Oliva, and Tsuda
8
Using a balance sheet approach, sovereign risk can be defined as the probability of a
significant deterioration of the sovereign’s balance sheet, either via increased vulnerabilities in
the domestic market (financial sector, sovereign credit market, real sector, the external sector),
and/or vulnerabilities in foreign markets that spillover to the country. More formally:
Sovereign risk =Probability (event) ? Threshold
? Prob ( A L
Threshold
? K