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1. Sovereign risk
1.1 Descriptions of sovereign risks
Sovereign risks are general considered as a kind of country risk. According to Henri L. Beenhakker (2001, p. 51), country risk refers to the possibility that unexpected events within a host country will influence a client firm’s or a government’s ability to repay a loan. It is usually divided into sovereign risk and currency risk. Sovereign risk is also known as political risk, arises because a host government may exercise its sovereign power to unilaterally repudiate foreign obligations, or may prevent local firm from honoring their foreign obligations. The risk may be the result of direct government action or the result of indirect consequences of ineffective government (for example, a government being unable to maintain law and order).
1.2 Indicators of Sovereign risk
1.2.1 Development trend of balance of payments in the nation
The balance of payments (BOP) is the method countries use to monitor all international monetary transactions at a specific period of time. Usually, the BOP is calculated every quarter and every calendar year. All trades conducted by both the private and public sectors are accounted for in the BOP in order to determine how much money is going in and out of a country. If a country has received money, this is known as a credit, and, if a country has paid or given money, the transaction is counted as a debit (investopedia.com 2011). Therefore, in the case of disequilibrium arising when a country buys more goods than it sells (i.e., a current account deficit), the country must finance the difference through borrowing or sale of assets which increase the scale of foreign obligations and in the end, it would enhance the sovereign risk that we have mentioned. For example, in case of Iceland, historically, from 1990 until 2012, Iceland Current Account averaged -20328.8800 Million ISK reaching an all time high of 9701.0000 Million ISK in September of 2002 and a record low of -139040.0000 Million ISK in June of 2008 (tradingeconomics.com 2012). The increase trend of current account deficit from 2003 to 2007 actually provide a very good indicator of the hidden sovereign risks.
Chart 1 The Iceland current account trend from 2002 to 2012
Source: tradingeconomics.com 2012
1.2.2 Magnitude of foreign exchange obligations
The increase of the magnitude of the foreign exchange obligations in general would enhance the political risks of a country, in particular when it is higher than in a country than that in other nations in term of percentage of the GNP. Therefore, the magnitude of foreign exchange obligations could act as a key indicator of sovereign risk.
1.2.3 Political stability
Political stability is one of the key political factors which refer to the regulations and policies set by local and national governments (Lockström 2007, p. 101). Actually, many studies have shown that, political stability and economic performance are to some extent quite interrelated which is within our common understanding. For example, in some African countries where wars are still frequent, the ruling governments could also change, and their inability or unwillingness to repay the international loan could directly lead to the sovereign risks which is not unusual.
1.2.4 Foreign exchange reserve changes
Foreign exchange reserves are stores of international currency held by the central banks of nations around the world. Sufficient foreign exchange reserve would usually play an important role in enhancing the foreign investors’ confidence. For example, according to the news Standard & Poor’s, the credit rating agency, warned recently that it would downgrade India’s sovereign debt rating unless the government moved swiftly to bring the country’s widening fiscal deficit under control. Ms Varma, an economist at Nomura, said: “We believe there is a low likelihood of a rating downgrade actually occurring as we expect the economy to see some cyclical rebound in the near term … and the fiscal deficit should not worsen substantially. The only risk to this view is foreign reserves declining materially (Fontanella-Khan 2012).” Therefore we can see that even Standard & Poor’s, one of the world’s most famous credit rating agency would consider the Foreign exchange reserve as a key indicator of credit rating of the national sovereign debts, it is safe to use Foreign exchange reserve changes as the one of the major indicators of measuring the sovereign risks.