Sovereign Risk

Topics: Foreign exchange reserves, Currency, Foreign exchange market Pages: 5 (1607 words) Published: April 7, 2013
Research Question: Country/Sovereign and Risk Assessments have evolved to become an integral part of international lending. Explain the factors to consider in determining the overall Sovereign/Country risk and why these factors are critical. What is the Bahamas' experience in its Risk Assessments? Financial institutions increasingly conduct business abroad in order to diversify and expand their sources of revenue and profitability. This strategy of international lending exposes the bank to country risk and raises the potential for financial loss. Country risk is a collection of risks which are associated with investing in a foreign country. These risks include political risk, exchange rate risk, economic risk, and sovereign risk (as well as transfer risk). It varies from one country to the next. Some countries have a high enough risk to discourage foreign investment. The United States is generally considered the benchmark for low country risk and most nations can have their risk measured as compared to the U.S. One of the main subsets of country risk is sovereign risk. This is the risk that a foreign central bank will alter its foreign-exchange regulations, thereby significantly reducing the value of foreign exchange contracts. It is the potential loss of the assets that a bank loaned internationally in foreign currency (Khambata, 1996). The existence of such risk means that creditors should take a two-stage decision process when deciding to lend to a firm based in a foreign country. Firstly one should consider the sovereign risk quality of the country and then consider the firm's credit quality (Cooper, 1998). According to the International Monetary Fund (IMF), the term transfer risk, which is also known as direct sovereign intervention risk, is usually only used in a foreign currency context. It refers to the probability that a government with foreign debt servicing difficulties imposes foreign exchange payment restrictions on otherwise solvent companies and individuals in its jurisdiction which eventually forces them to default on their own foreign currency obligations. Indirect sovereign risk is the equivalent of transfer risk in domestic currency obligations. It refers to the probability that a firm defaults on its domestic currency debt as a result of distress or default of its sovereign. Many countries have faced sovereign risk in the 2008 global recession. There are two main factors that are used to assess country risk. The first category is the economic factor. Lenders use economic factors as a guide to determine whether a country is financially able to repay its debts. Some of the economic determinants include the resource base, government policies, the quality of economic management, and financial restrictions. The resource base of a country refers to raw materials, human resources, infrastructure, industry, finances, agricultural output, and any other important aspect of the economy (Khambata). In order for a country to obtain a low country risk, it must be able to use all of its resources efficiently. Long and short term government policies of a nation greatly influence the sovereign risk of a country. These policies help investors to understand how stable a country’s government. The more stable a country is, the lower the risk. The quality of economic management is also important in assessing the sovereign risk of a country. A government must ensure that the economic management relates to the comparative advantage of a country. It must also ensure that the government’s borrowing practices help economic growth. It is also important that the government is willing and able to implement economic reforms. The quality and timeliness of available data is also considered in the sovereign risk. There are also specific economic indicators that international bankers look at. One is the ratio of the current account on the balance of payments accounts to the Gross National Product. This ratio states how large the deficit...
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