Does Sovereign Risk in Local and Foreign Currency Differ?
38 Pages Posted: 26 Mar 2018
Date Written: March 2018
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.
Keywords: sovereign risk, local currency debt, foreign currency debt, credit ratings
JEL Classification: F31, F33, F34, F41, H63
Suggested Citation: Suggested Citation