Sovereign risk

Sovereign risk: Sanctions and Reputation

Sovereign risk: Causes and Consequences of Default Risk

Sovereign risk refers to circumstances in which governments default on loan contracts with foreigners, seize foreign assets located within their borders, or otherwise prevent domestic holders of foreign capital from meeting obligations. Because there is no supranational authority that can enforce contracts across borders, when sovereigns choose not to honor contracts with foreign investors, those investors have little recourse to recoup their losses. Consequently relationships between foreign investors and sovereigns are dictated primarily by the sovereign’s willingness to pay rather than its ability to pay.

Foreign governments could become better credit risks by waiving sovereign immunity. The legal doctrine of sovereign immunity can be interpreted as exempting the property of foreign governments from the jurisdiction of domestic courts. Historically, this doctrine has sometimes constrained the ability of creditors to sanction foreign governments that have defaulted. The doctrine has evolved over time to grant creditors some recourse against defaulting sovereigns, however.

History is replete with instances of sovereign default. During the 19th and 20th centuries, in many instances the repayments of loans to sovereigns were far from what was called for in contractual obligations. In the 1820s, for example, Latin America experienced a wave of defaults among its newly independent countries. Many Latin American countries defaulted again in the 1870s, as did Egypt and Turkey. In the 1930s, most sovereign debtors suspended interest payments in the wake of the global depression.

See also asymmetric information; contagion; currency crisis; international financial architecture; Latin American debt crisis; original sin; peso problem; spillovers

FURTHER READING

• Bulow, J., and K. Rogoff. 1989. ‘‘Sovereign Debt: Is to Forgive to Forget?’’ American Economic Review 79: 43 50. Shows how lending must be supported by direct sanctions available to creditors, and not by reputation for repayment.
•  Cole, H., and P. Kehoe. 1997. ‘‘Reviving Reputation Models of International Debt.’’ Federal Reserve Bank of Minneapolis Quarterly Review 21: 21 30. If a country is involved in relationships with creditors that provide enduring benefits, reputation alone may be enough to support lending arrangements.
• Diaz Alejandro, C. 1983. ‘‘Stories of the 1930s for the 1980s.’’ In Financial Policies and the World Capital Market, edited by Pedro Aspe Armella, Rudiger Dorn busch, and Maurice Obstfeld. Chicago: University of Chicago Press, 5 40.
•  Eaton, J., and M. Gersovitz. 1981. ‘‘Debt with Potential Repudiation: Theoretical and Empirical Analysis.’’ Re view of Economic Studies 48: 289 309. Analyzes borrow ing in the absence of explicit penalties for nonpayment.
•  Eichengreen, B. 1991. ‘‘Historical Research on Interna tional Lending and Debt.’’ Journal of Economic Perspec tives 2: 149 69.
• Eichengreen, B., and R. Portes. 1989. ‘‘After the Deluge: Default, Negotiation, and Readjustment during the Interwar Years.’’ In The International Debt Crisis in Historical Perspective, edited by B. Eichengreen, and P. Lindert. Cambridge: MIT Press, 12 37.
• Lindert, P., and P. Morton. 1989. ‘‘How Sovereign Debt HasWorked.’’ InDeveloping CountryDebt and Economic Performance, vol. 1, The International Financial System, edited by J. Sachs.Chicago:University ofChicago Press, 39 106. Historical analysis of the effect of sovereign default on interest rates.
• Ozler, S. 1993. ‘‘Have Commercial Banks Ignored His tory?’’ American Economic Review 83: 608 20. In vestigates how past defaults affected loan terms for de veloping countries during the 1970s. The paper finds evidence that lenders did take default history into ac count when issuing loans in the 1970s. Countries with a poor record of debt repayment faced higher commercial bank lending rates in the 1970s.

KEITH SILL