Does sovereign risk in local and foreign currency differ?

Summary

Focus

The paper investigates whether the credit risk of sovereign debt differs depending on whether or not it is issued in the countries' own currency. It also asks if the gap between local and foreign currency sovereign risk has changed over time and, if so, what the drivers might be.

Contribution

Analysts routinely assume sovereign debt is safer when issued in the borrowing country's local currency rather than a foreign currency. However, few have studied this risk gap systematically and the literature offers little guidance about why such a gap should exist. We document both the existence of a gap and the fact that it has steadily diminished over the past two decades. We then examine five hypotheses for how the gap might be related to observable factors. We are the first to propose and test these hypotheses.

Findings

We document that sovereign risk tends to be less when bonds are issued in local rather than foreign currency, but that the gap has narrowed considerably over time. We find that the gap narrows when foreign exchange reserves are higher, foreign borrowing is lower, banks hold more government debt, and global volatility is less. At the same time, we find no support for the view that debt in local currency is safer because of sovereigns' willingness to inflate away their local debt.

The main reason for the trend decline in the gap is the surge in foreign exchange reserves, which makes foreign currency debt less risky. Additional reasons are that governments depend less than before on borrowing in foreign currency overseas, and that global volatility has declined. The risk gap between local and foreign currency sovereign debt might widen again if reserves and the ability to borrow in local currency diminished, while global volatility increased.

Abstract

Historically, sovereign debt in local currency has been considered safer than debt in foreign currency. Yet the literature offers scant theoretical or empirical guidance as to why such a gap exists, or why it appears to have slowly and steadily diminished for all regions over the past two decades, as expressed in the ratings widely used by global investors and regulators to assess credit risk. We suggest and empirically test five hypotheses. We find that differences in inflation do not explain the assessed gaps between local and foreign currency credit risk. The banking sector's vulnerability to sovereign debt problems is a significant determinant of the spread, but does not account for its decline over time. Instead, the surge in global reserves, and to lesser extent the reduced reliance on overseas foreign currency borrowing (ie the decline of original sin), as well as lower global volatility, appear to have lessened the gap. But if these variables were to go into reverse, the gap could again widen.

JEL classification: F31, F33, F34, F41, H63

Keywords: sovereign risk, local currency debt, foreign currency debt, credit ratings