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Compare what happens when a sovereign defaults on foreign currency obligations versus local currency ones.

FRM® Part II · Credit Risk Measurement and Management · Country Risk: Determinants, Measures, and Implications · FRM2.CR.8.c

The idea

A sovereign can default on debt in its own currency or in a foreign currency, and the two are not the same. Foreign currency debt must be repaid in a currency the government cannot print, so default is a real possibility when reserves and export earnings run short. Local currency debt can always be serviced in nominal terms by creating money, so formal default is rarer. The cost shows up as inflation and depreciation, a hidden default that erodes the real value of local holders' claims. For this reason a sovereign's local currency rating is typically equal to or above its foreign currency rating, and the local currency default spread is smaller. Estimate a local currency spread as the local government bond yield minus a local currency risk-free rate, not minus the dollar risk-free rate. Mixing currencies is the usual error.

Formulas

Local currency risk-free rate

local risk-free rate = (1 + rUSD) × (1 + local inflation) ÷ (1 + US inflation) − 1

rUSD
the US dollar risk-free rate
local inflation
expected inflation in the local economy
US inflation
expected inflation in the United States

Converts the dollar rate using the inflation differential. Adding the inflation rate to the dollar rate is the shortcut that goes wrong.

Local currency default spread

local default spread = local bond yield − local risk-free rate

local bond yield
the yield on the sovereign's local currency bond
local risk-free rate
a risk-free rate in the same currency and maturity

Subtracting the dollar risk-free rate mixes currencies and counts inflation as default risk.

A practice question

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

Why is formal default on local currency government debt generally less likely than default on foreign currency debt?

  1. Local currency bonds are guaranteed by the IMF. The IMF lends to governments in difficulty but does not guarantee their bonds, local or foreign.Why not: The IMF does not guarantee a government's local currency bonds; this is an invented protection.
  2. Local currency debt is always senior to foreign currency debt in law.Why not: Seniority is not what separates the two; the difference is the ability to create the currency of payment.
  3. The government can create its own currency to pay local currency obligations, but it cannot print foreign currency. - correct
  4. Local currency debt is always shorter in maturity so it never falls due in a crisis.Why not: Maturities vary, and short maturities tend to raise rollover risk rather than remove default risk.

A sovereign can always meet nominal local currency obligations by money creation, though at the price of inflation. Foreign currency must be earned or borrowed, which makes default more likely.

A harder one

A government funds a large deficit by having the central bank print money. Inflation reaches 40 percent a year. All local currency bonds continue to receive their contractual coupons and principal in full. Which statement is the most accurate?

  1. There is no loss, because nominal payments are made in full.Why not: Ignores the erosion of real purchasing power, which is the way local currency default usually happens.
  2. This is a formal default, because inflation above 10 percent triggers a credit event.Why not: Credit events are defined by missed or restructured payments; inflation alone does not trigger one.
  3. Foreign currency bondholders gain, because inflation reduces the government's real debt burden on all debt. Inflation erodes only claims fixed in the local currency, so foreign currency debt is unaffected by it.Why not: Inflation reduces the real value of local currency debt; foreign currency debt is not eroded and depreciation makes it heavier.
  4. Local holders suffer large real losses through inflation and currency depreciation, a de facto default that a payment-based default definition does not record. - correct

Money creation lets the sovereign pay in nominal terms while real value is eroded. The loss falls on holders of local currency claims and is not recorded as a formal default.

The hardest tier

A sovereign's 10-year local currency government bond yields 17.5 percent. The US dollar risk-free rate is 4.0 percent, expected inflation is 12 percent in the local economy and 2 percent in the United States. The local currency risk-free rate is (1.04 x 1.12 / 1.02) - 1. Which is closest to the local currency default spread?

  1. 3.3 percent - correct
  2. 13.5 percentWhy not: Subtracts the dollar risk-free rate from the local yield, mixing currencies and counting inflation as default risk.
  3. 5.5 percentWhy not: Subtracts expected local inflation as if it were the local risk-free rate.
  4. 1.5 percentWhy not: Builds the local risk-free rate as 4.0 + 12.0 = 16.0, adding rather than taking the inflation differential.

Local risk-free rate = 1.04 x 1.12 / 1.02 - 1 = 14.20%. Local currency default spread = 17.50% - 14.20% = 3.30%. The spread must be measured against a risk-free rate in the same currency.

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