Sovereign risk: Causes and Consequences of Default Risk
Several factors have been found to influence the likelihood of sovereign default. Historical data suggest that the risk premium on foreign debt (over the return on U.S. Treasury bonds or British consols) increases with the size of a country’s trade deficit and budget deficit. In addition, internal political considerations play a role: those countries that respond to a crisis by raising taxes or cutting spending are less likely to default. Severe external shocks have been found to precipitate default (Diaz-Alejandro 1983). In addition, the debt-to-export ratio and deteriorating terms of trade appear to influence the likelihood of sovereign default. In general, a country’s internal and external circumstances play a role in sovereign risk.
The tangible consequences of sovereign default have proven difficult to uncover. The economists Lindert and Morton (1989) examined data on the 10 leading debtor countries from 1850 to 1970 and found that, on average, foreign lending earned a higher return than domestic lending in the United States and the United Kingdom. Eichengreen and Portes (1989) examined data on bond issues in the 1920s and found that for bonds issued in London, foreign lending earned a higher return than on contemporaneous British consols. For loans originating in the United States, overseas lending earned a return only slightly lower than that on U.S. Treasury securities. Actual yields on foreign lending compensated British and U.S. investors for suspension of payments and write-downs of principal.
When countries default, have they been denied access to international capital markets? Here the evidence is somewhat mixed. Countries that did not default in the 1930s appear not have gained wider access to international capital in the 1930s, or following WorldWar I. Indeed, default of some countries led to a shrinking of global capital flows to all, as the international capital market virtually shut down. A review of historical evidence suggests that there is little, if any, evidence to suggest that the volume of foreign funds a sovereign could borrow was adversely affected by a record of prior default (Eichengreen 1991).
Why do lenders keep lending to countries that have a history of default? Lenders are often uncertain about the characteristics of borrowers.Consequently, new information about borrowers can have a large impact on lending. In the case of countries, a credible change in policy regimemay negate the influence of a history of default. If a country changes its regime to focus on economic stability and soundmonetary and fiscal policies, history suggests that lenders will be willing to extend further credit.