Sovereign Risk as a Predominant Feature in the Modern World - Essay Example

? SOVEREIGN RISK Discussion Sovereign countries advance and receive loans for diverse reasons ranging from infrastructural development, on humanitarian basis as well as for general economic development. The global financial institutions such as the World Bank offer the credit facilities to nations through which many countries have been in a position to realize development and to facilitate the development projects, which are rather challenging for the sovereign countries to realize without the loan facilities. Countries as economic agents enter into agreements through consenting to the terms guiding loan services from the allocating institution. However, during hard economic times such as caused by unfavorable economic patterns or even during times of political crisis, countries have the capacity to hesitate to honor terms of loans acquired (International monetary fund, 2011, para 1-7). Sovereign countries have no capacity to go broke but have the ability to assert their independence where without their consent; they cannot be sued for failure to consent to the terms of loans acquired. Therefore, the probability that a country or a state managed agency would fail to comply and go as per the loan agreement during such instances as difficult financial times or during political crisis is what is referred to as the sovereign risk. This probability differs from a country to another due to the government and economic frameworks guiding the economic performance of the countries. Besides the government’s capacity to borrow on behave of a country, corporate within a country as well as foreign investors have the capacity to borrow credit facilities from the local financial institutions as well as across the countries. The governments rely on the financial assets as well as government bonds to offset the acquired debts. Therefore, any factor that has the capacity to influence the government’s or corporate ability to honor and observe the agreements assented to while borrowing the credit facilities have the capacity of rising the tendency of the country to deliberately overlook the repayment of the borrowed finances. Some other circumstances are explained in the probability that countries engaged in forex trade may be forced by circumstances to pay debts accrued with the uncertainties that characterize the market. Speculations on which way the currencies would be going makes countries hesitant to repay debts in the speculation that they pay the debts at the most favorable exchange rates to them. Countries therefore reason just as economic agents and will evaluate the likelihood of the trading foreign currency to rise or to fall in value before making economic decisions. When the countries speculate that foreign currency is about to rise, they invest higher in buying the currency in order to realize higher returns when they sell the currency at the higher prices likely to be in future. This has direct implications to the willingness and ability of a country to honor agreements consented to while accepting credit facilities from other countries or financial institutions (Anon, 2005-2013, para 1-5; Du and Schreger, 2013, p. 1-2). In the forex trade, sovereign risk is experienced when countries changes the rules that bound them while contracting with foreign investors. It therefore implies that the countries first dishonor the written agreements before they change the rules of the contracts. Equally, private investors always run at a risk when advancing credit services to sovereign countries because in the event that the countries fail to honor the agreements, the investor lacks ways and the right to sue a sovereign country. This therefore lenders the investor to who a country owes a debt vulnerable to loosing the debts because of sovereign risk. Moreover, the risk of the investor loosing on the agreement is heightened by the reason that countries will request for the loan because they are in a financial crises which is one basic reason for the occurrence of the sovereign risk. Strained government finances are major causes of the sovereign risk, which would be explained by macroeconomic factors and volatility factors regarding a country’s currency in comparison to the foregoing international market rates. The overall economic performance of a country is dependent on the performance of macroeconomic factors and the instability of these factors is a major cause to the sovereign risk. At its extremity, sovereign risk is catastrophic to foreign asset trade and hence requires regulatory tools to be devised in order to avert the adverse effects of the risk to be felt by other countries, which participate in the trade. The occurrence of financial crises in a country or at the global front have been claimed to have adverse effects to the likelihood that a sovereign nation will honor the terms of agreements in loans acquired. Other factors as seen to have effects on a country’s ability and willingness to repay loans from local as well as international financial institutions are the political factors. Political stability is credited to influence economic performance of any country. In the event of crisis within a country, most of the government resources are directed to the service of the citizens to meet the rising costs of administration and to offer humanitarian aid. This therefore constricts the ability of the government to honor debt repayments over the period and as such explaining the likelihood of the sovereign risk. Such factors lowers the likelihood that such a country would be sued for failure to comply and honor the debt agreements and therefore, this has been used by countries to default or delay debt repayment. The onset of global financial crises has brought about great changes in countries where countries have opted to undertake policy reconstruction in a bid to have policies designed which will help the countries avert the resultant effects of the outcomes of the sovereign risk. Fiscal tightening as a policy mechanism has been widely adopted even where the private sector is weak. However, there is always the risk that the strains, because of foreign funding, have the capacity to spill to the private sector affecting the private credit markets. The resultant effect of the sovereign risk is that the public indebtedness rises, which on effect is disastrous to an economy by raising the financial costs of the private sector. Low public spending is blamed to lead to the contraction of the economy and thus analysts reason that upfront fiscal retrenchment may be instrumental in addressing the issues. The analysis of the sovereign risk shows that it leads to two possible outcomes; there may be the indeterminacy and or a belief-driven equilibrium. More specifically, the failure to monitor and address the issue may lead to a spillover of the private borrowing costs. A shift in the expectation implies that the projected government deficit may rise, the public dept premium rises and the spill be felt by the private sector borrowing through the sovereign risk channel. Higher private funding reveals that the economy has a slowed activity. However, under normal circumstance the central bank has the capacity to avert the effect of the sovereign risk by lowering the policy rates appropriately. In instances where the sovereign risk raises too high, pro-cyclical public spending (fiscal tightening) would result to determinacy. Under certain factors, the operative capacity of the central bank regarding such an issue as the sovereign risk differs. For instance, while unconstrained, the sovereign risk channel is not fully operative while in otherwise, the spending multiplier is reduced by the central bank while in the constrained state (Corsetti et al, 2012, p. 1-4). This paper therefore is based on the analysis of three countries, which have had past literature to analyze the sovereign risk as pertains to the above-discussed factors. It shall therefore contain a thorough analysis of the countries literature concerning the theme besides analyzing the status of the countries sovereign risk. Moreover, this paper will discuss intensively the factors that constitute and explain the theory of sovereign risk. Sovereign risk as a concept emanates from the understanding of sovereign states and the practice of borrowing or credit services. However, the disparity notable between countries and financial institutions is through the methods of guaranteeing as well as monitoring and ensuring compliance to the contracts assented to by the parties involved. The willingness to pay as well as the determinants that a borrower honors the consent to repay the debts varies. Some of the factors reflect the role played by the macro-economic factors, political factors, ability to generate receipts of tax as well as the overall availability of stock within the country (Canuto et al, 2004, p. 4). The discussion of the topic would not be successful without understanding that the risk emanates from the foreign debt. Literature shows that there is a rise in the global sovereign debt issuance where for instance, the Euro zone recorded an approximate rise to over 50% in sovereign debt issuance for the year 2011. Moreover, the sovereign risk is in the rise over the recent years in global perspective. Countries are thus recording rising trends in delaying or defaulting the repayment and the failure to observe loan conditions with the financial institutions responsible. The sovereign risks exhibit traits of correlation with the spreads having similar components, which affect them. There is therefore notable rise in troubled countries, which burden the financial institutions with holding their sovereign debts. Thus, higher exposure of financial institutions within a country to sovereign debt is a common feature in the current global financial performance. Moreover, there are also more cross boarders concentrations in existence now (Patel, 2012, p. 4-9). The measurement of the sovereign risk is through the analysis of the interconnections that are observable between the balance sheets from the sovereign state as well as the co-operates, banks as well as the nonbanking institution as and the households. Besides, the literature shows that managing the sovereign risks would require effective policy frameworks, which would address the issues more holistically (Gapen et al, 2005, p. 4). Traditional fiscal and monetary policies have been seen to be relatively ineffective in addressing the current trends regarding the sovereign risks. Macro financial aspects regarding the negative effects of the sovereign risks and the associated stability in financial status are said to offer critical policy mix to the traditional fiscal and monetary policies, which together would result to effective addressing of the status of the sovereign risks. Other proposals from analysts is that countries should adopt and set up special departments in monitoring the sovereign risks and the accompanying outcomes from which their recommendations would be very instrumental in policy frameworks designed to address the issue (Das, Oliva and Tsuda, 2012, p. 367-368). Most developed countries have continuously suffered the effect of sovereign risk associated with the effects of the global financial crises of the early 21st century. However, this paper takes into special consideration sovereign risk in the U.S, China and Japan while analyzing the issue of sovereign risk. A report by the black rock investment institute show that countries continuously perform differently in matters of foreign credit debts and the overall credit risks. For instance, an end year (last quarter) publication of the institute analyzed the performance of the United States as well as Japan concerning fiscal profiles and the public debt. In spite of the country’s worrying performance before the period, the period’s record placed the country in a worse spot than it had earlier been owing to the rise in the overall debt of the country while at the same time the primary balance in GDP (gross domestic product fell). The period saw Japan fall into an acute recession whose effects translated to the country’s probability to avoid repayment of sovereign debt increase as stability was sought to reinstate the country into the right track. Current trends in Japan’s public debt keep escalating and stand the highest in relation to the GDP as per the global analysis. Japan’s status is expected to have the remedy through the adoption of the appropriate fiscal policies, which should work to stimulate the economic performance of the country. Weakening the country’s currency has been postulated to work effectively in addressing the ever-increasing problem of the public debt, which is directly related to the sovereign risk. However, analysts point that a weaker Japanese Yen work to weaken the country’s equities, which equally has adverse effects to the economy. Every country’s willingness to pay the public debts depicts the stability of both the government and country itself. Government as well as the private corporate within a country exhibit high tendencies to honor debts accrued through increased economic performance while in stable circumstances unlike while the country undergoes the pressure of financial crises or political turmoil. Moreover, it serves to reveal the ability of the rule of law of this country to serve as an incentive to investors through creating an enabling environment. The U.S political climate has had notable effects to her willingness and ability to observe the debt agreements within the public domain. The institute is ranking of countries willingness to pay places the US at eleventh position among forty-eight countries. On the other hand, China has had a relatively steady performance in the willingness to pay as regards to public debts, a feature explained by the proper transition of leadership (Reerink, 2013, p. 1-5). Recent research by O’Brien shows that China has been in the recent past subjected to troubling trends among which rising incidences of civil unrest, environmental degradation, unfavorable labor demographic and wage inflation form the bulk. Besides there are other factors such as rising transport costs, failure of the Beijing’s central authority, public debts and the in transparency in sovereign rating of credit are other factors that explain the status of the country concerning sovereign risk. The Chinese economy continues to operate under intense pressure of many non-performing loans within the banking sector, which in turn is attributed and blamed on the government. This is because the government is observed to have no acknowledgement of this fact and as a result fails to put to task policy guidelines to necessitate addressing the rising concern. The majority of the states institutions are seen to operate under large sums of bad debts. Speculative investments as well as the bad debts have characteristically shaped the economy of the sovereign country and are blamed on the poor government fiscal policies. Analysts reason that the poor government fiscal policies applied within the country are responsible for the disproportionate flow of foreign investment in the country, which ultimately result into economic growth, which is not sustainable. The country economic and financial performance rests on very fragile foundations of finances due to the reason of the massive public debts as observed. However, economic evaluation places the economy on a very stable course where the economic performance of China is commendable. Due to the enormous accumulation of the debts, the NRSRO estimates that the sovereign country has an approximate value of debts of $260 billion and which from the report paints a deliberate move by the government to overlook the contract basis of the debts as well as in overlooking the political implication of such decisions. Under quotation of the Chinese debt arrears has equally been blamed on assisting the Chinese government to intentionally avoid repayment of sovereign debt, which is defaulted. However, the Asia region is predominantly known for the practices of quoting false ratings of sovereign credit. In explaining why national rating agencies quote, false-full figures regarding the sovereign credit figures, it is necessary to understand that the sovereign countries are managed through pre defined sovereign ceilings. The domestic corporate therefore faces the challenges of quoting rightfully the figures, as the figures given must be correlated to the given sovereign ceiling. There is an openly observable refusal to honor the repayment of its public debt crisis by the government of China especially to the American Bondholders. Moreover, the government of China has constantly published an artificial investment grade. The untrue grade as recorded has also served to help the country in avoiding the sovereign debt. However, the major challenge pointed out in understanding the sovereign risk in China is the correct identification and reaction to the issues of the misquotation, which is blamed to have played a major role in the exacerbation of the sovereign risk (O’Brien, 2008, p. 24-30). An emerging school of thought reasons in different perspectives regarding the sovereign risk as a topic. There are those whose view is that the sovereign risk is because of the failure of government to draft and enforce policy guidelines on penalties to be engaged to ensure that the payments due to the foreigners are done (Broner, Martin, and Ventura, nd, p. 1-2; Broner, Martin, and Ventura, 2006, p. 1-2 ). Japan as a sovereign country has been observed to be the country with the largest public debt in the world despite the fact that it has not had crisis in the sovereign debt. Household assets have been over time deposited within the financial institutions in the country and have been used by these institutions to buy the bonds by the government. However, continued growth of the public debt puts the country into a risk of running beyond the domestic investors’ capacity to absorb these shocks by the sovereign debts. Japan has therefore experienced a relatively more stable and successful sovereign debt management due to its ability to incorporate good policies in managing the structure in buying and sale of government bonds. Nevertheless, critical studies have revealed that the relatively stable performance of the country in the matters of sovereign debt management suffers the risk of dissolubility due to the likelihood of the global economic crisis and the overreliance in foreign investors as against the internal investors. The projection of economic participation for the country show that the likelihood of the domestic participation in the government bonds market is likely to diminish in the end giving priority therefore to the foreign investors. Unlike the case with many advanced countries, Japan has a relatively unclear relationship between the fiscal variables in relation to CDS spreads. However, it is worth noting that Japan’s CDS spreads have a high correlation to global financial markets developments. Nevertheless, it is observed that the Japanese government bonds yields would likely suffer from financial stress spillovers from the global markets, increased volatility in markets and the eventual decline in supply of funds especially from the corporate. However, to reduce the likely outcome of these effects and the likelihood of the sovereign state suffering sovereign risks has been postulated through adoption of sound fiscal policy frameworks. Moreover, deliberate lengthening of the maturity time of the Japan government bonds have the capacity of locking low interest rates while at the same time addressing the overall risks associated with the debt crises (Lam and Tokuoka 2011, p. 1-17). Observers have noted that the US banks are at the higher risks of exposure to sovereign debt risk and hence the need for the banking sector to devise observatory mechanisms to act as cautions to the likelihood of the risky debts. In an interview with the Reuters, Dugan, the currency comptroller pointed that it has been critical that the observers keep a keen eye on the banks and other financial risks in observing the institutions’ exposure to risk of sovereign debts (Wutkowski, 2020, para 1-3). He also ascertained the rising concern in monitoring the sovereign debt risks in the US because of the noted tendency of the regulatory agencies to under report the risk as was observed in risk. The findings that revealed that Greece operated with an underestimation of two thirds of the actual deficit in terms of sovereign debt raised the concerns to have the observers monitor more keenly the performance of the American institutions. The great global crisis, 2008 resulted from the burst of the housing bumble within the US. More specifically, the bubble bust was the accounting and thus, no mechanism would be applied to salvage the effects of the debts until the implications were discoverable through accounting procedures. The US was strategic to leverage the public sector and in the process to control the private sector although the governments across the globe continue to saddle the outcome of the bust and the historical global economic crises. The treasury as well as Federal Reserve has been credited in monitoring and regulating the performance of financial institutions in the US. To counter and monitor the effects of the financial crisis, they printed money to backstop banks and in the process undertook measures to ensure that financial institutions were restricted from increased default in credit repayments. An inflationary measure expectorations lead covering ten years was drafted as shown. (http://image.minyanville.com/assets/FCK_May2009/Image/LISACATCH/HOWARD1.jpg) Before the September of 2009 (at the green divide), the CDS market would welcome low rates of inflation. In the period, the Federal Reserve undertook deliberate measures to lower the interest rates to levels, which ensured that borrowing dollars was cheaper than the yen. However, the creation of more money would result to high inflation and as a result, analysts points that since the September of 2009, the US treasury has continuously experienced credit swaps and defaults of honoring the credit agreements by the government as well as the corporate. Therefore, the above illustration depicts the point of contrast between the periods before and after the September of 2009 in relation to inflation and the resultant sovereign risk experienced by the Federal Reserve as well as by the treasury (Simons, 2010, para 1-6). In conclusion, sovereign risk has been seen to be a predominant feature in the modern world and especially in the frequencies of financial crisis that constantly shape the global economy. The probability that any sovereign country or corporate fails to honor agreements biding borrowing of finances from other countries or also from the internal financial institutions explains the sovereign risk. Moreover, sovereign risks also emanates from the likelihood of countries to honor agreements that bind the financial markets. In instances where countries speculate either a fall or a rise in a currency value, then there is the likelihood for the countries to deliberately fail to honor and observe the binding contracts in money markets. Countries fail to honor and eventually amend the contracts in manners that would be more favorable to them in terms of gains. Therefore, forex trade in many instances results to sovereign risk when countries fail to adhere to agreement contracts due to the fluctuations of currencies in exchange. Countries are sovereign and as such enjoy the privilege that they cannot be sued to a court of law for the reason of defaulting payment of a debt or for the reason of delay as against the consented contracts. The eventualities that lead to the likelihood of the defaulting of these agreements by sovereign countries may be explained by the occurrence of natural calamities, the political instabilities as well as due to financial crises such as the global crisis experienced in the year 2008. However, it is worth noting different reasons result to the probability that a country defaults payment of a debt. Moreover, modeling the different reasons for cause of defaulting differs from one country to another. This paper has taken a keen interest in analyzing the theme of sovereign risk as regards the three countries; the United States, China as well as Japan. The united states have been revealed as the point at which the bumble that caused the 2008 global finance al crises burst. Concerns in the country as regards the sovereign risk has been in close watch after the budget deficit were noted to be below the actual values. However, greater concern regarding the sovereign country has been the inflationary pressure that has constantly been building up since the Federal Reserve and the treasury adopted policies to create more money to ease the pressure of the increased debts as was during the global economic crisis in the early 21st century. Japan on the other hand has had commendation that it has not had major crisis in sovereign debt despite the fact that it is globally the country with the highest public debt. Government bonds have been very instrumental in regulating and addressing the concerns of rising public debts. However, caution has been postulated due to the likelihood of the sovereign state to suffer sovereign risks in the current trends concerning ever-rising public debts. On the other hand, China has had a relatively steady performance in the willingness to pay as regards to public debts, a feature explained by the proper transition of leadership. Recent research studies shows that China has been in the recent past subjected to troubling trends among which rising incidences of civil unrest, environmental degradation, unfavorable labor demographic and wage inflation form the bulk. Besides there are other factors such as rising transport costs, failure of the Beijing’s central authority, public debts and the in transparency in sovereign rating of credit are other factors that explain the status of the country concerning sovereign risk. Moreover, Chinese economy continues to operate under intense pressure of many non-performing loans within the banking sector. This is because the government is observed to have no acknowledgement of this fact and as a result fails to put to task policy guidelines to necessitate addressing the rising concern. The majority of the states institutions are seen to operate under large sums of bad debts. Speculative investments as well as the bad debts have characteristically shaped the economy of the sovereign country and are blamed on the poor government fiscal policies. Bibliography Anonymous. 2005-2013. Sovereign Risk Explained. [online] Available at: http://www.cris-creditrisk.com/sovereign-risk.php [Accessed on 16 July 2013]. Broner F., Martin A., and Ventura J. 2006. Sovereign risk and secondary markets. NBER working paper series. Cambridge, U.S. Available at: http://www.nber.org/papers/w12783.pdf?new_window=1 [Accessed on 16 July 2013]. Broner F., Martin A., and Ventura J. 2006. 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