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Contrast defaults by sovereigns on debt in foreign currency with defaults on debt in local currency, and explain what typically causes sovereigns to default.

FRM® Part I · Valuation and Risk Models · Country Risk: Determinants, Measures, and Implications · FRM1.VR.5.c

The idea

A sovereign can default on debt in two different currencies, and the risk differs. Foreign currency debt must be repaid in a currency the government cannot print, so it needs export earnings, reserves or new borrowing. A currency depreciation raises its burden in local terms. Local currency debt can always be paid in nominal terms because the government can create the money. The cost shows up as inflation and depreciation, which cut the real value paid to holders. Local currency defaults are therefore rarer, and ratings on them are usually the same or higher. A government that cannot create the currency, such as a euro area member, faces risk like foreign currency debt. Typical causes of default are heavy and rising debt, large deficits, weak growth, foreign currency or short-term borrowing, and political unwillingness to pay. Separate inability from unwillingness.

A practice question

From the question bank, with the reason each wrong option is wrong.

Why is a sovereign generally less likely to default on debt in its own currency than on debt in a foreign currency?

  1. Local currency debt has priority over foreign currency debt in every bankruptcy proceeding of the sovereignWhy not: Sovereigns have no bankruptcy court, so there is no such ranking.
  2. It can create more of its own currency to pay, though at the cost of inflation and depreciation - correct
  3. Local currency bonds carry lower coupons, so debt service is always smallerWhy not: Coupon levels do not remove default risk and do not guarantee a smaller debt burden.
  4. Foreign currency is cheaper for a government to obtain, so it is easy to payWhy not: Foreign currency must be earned or borrowed; it is harder, not easier, for the government to obtain.

A government controls its own money supply, so it can always pay nominal local currency debt by creating money. The price is inflation or devaluation, which hurts holders in real terms. It cannot create foreign currency, so foreign currency default is more likely.

A harder one

A government holds USD 30 billion of reserves and runs a primary surplus, yet announces that it will not honour bonds held by foreign creditors, arguing that repayment is politically unacceptable. Which feature of sovereign default does this illustrate?

  1. Unwillingness to pay: default can be a decision - correct
  2. Inability to pay caused by a short-term liquidity shortageWhy not: Reserves and a surplus show the government can pay; the default is a decision.
  3. A technical default caused by a payment-system delayWhy not: The government announces a refusal to honour the bonds; this is not an operational delay.
  4. Implicit default through inflation on local currency debtWhy not: The debt is foreign-held and the default is declared outright, not achieved by inflation.

Default has two sources: inability (lack of resources) and unwillingness (a decision that the cost of paying outweighs the cost of defaulting). The reserves and surplus point to the second.

The hardest tier

An investor holds a one-year local currency government bond with a 6% coupon, repaid in full. The government monetizes its deficit and inflation over the year is 15%. The investor's real return is closest to:

  1. -9.0%Why not: Subtracts inflation from the coupon (6% - 15%) instead of deflating the total proceeds.
  2. -15.0%Why not: Looks only at inflation and ignores the 6% coupon.
  3. -9.9%Why not: Multiplies by (1 - 15%) instead of dividing by (1 + 15%).
  4. -7.8% - correct

Real return = 1.06 / 1.15 - 1 = -7.8%. The nominal payment is made in full, so there is no formal default, but inflation delivers a real loss. This is how local currency debt is eroded.

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