Notes for Level I CFA® Program

R55 Fundamentals of Credit Analysis

7.2. Sovereign DebtWatch Video Play


Governments issue sovereign debt to finance public projects such as infrastructure, education, airports, and to pay wages to government employees.

Types of debt issued by governments:

  • Local (internal) debt: Issued in the sovereign’s own currency: easier to service as the government can print money or raise taxes.
  • External debt: Not denominated in the sovereign’s currency, but some other currency like the U.S. dollar.

Characteristics of sovereign debt:

  • Historically viewed as risk-free, but that is changing as seen post-2008. Many Eurozone countries such as Greece and Spain were on the verge of default.
  • Best able to service debt if a sovereign runs twin surpluses (current account surplus and budget surplus).
  • Two key issues to consider in sovereign analysis: the government’s ability to pay and willingness to pay.
  • Credit rating agencies distinguish between local currency debt and foreign currency debt. Rating agencies usually assign a higher rating to local currency debt relative to foreign currency debt.

Given below is a framework (adapted from S&P’s methodology) to evaluate sovereign credit and assign sovereign debt ratings:

Framework for sovereign credit analysis
Political and economic profile Flexibility and performance profile
Institutional effectiveness and political risks

  • How were past political, economic, financial crises handled?
  • Is there consistency in policy framework?
  • Is the government corrupt?
  • Is the media biased/compromised?
  • What is the willingness to implement reforms?
External liquidity and international investment position

  • Low external debt → better able to service foreign currency debt.
  • Actively traded currency → less impacted by adverse shifts in global investor portfolios (e.g. U.S. Dollar).
Economic structure and growth prospects

  • How is the income per capita? Higher income per capita means a deeper tax base.
  • Size of public sector to private sector. The public sector should be smaller compared to the private sector.
  • Age of population. Young population –> expanding tax base, and contributes to GDP. Japan has an ageing population that puts pressure on health care and social services.
Fiscal performance, flexibility, and debt burden

  • Decline in government debt/GDP → strong credit.
  • If  \frac{\text{Government interest expense}}{\text{expenditure}}< 5%, then it is good. > 15% is poor.
  • \frac{\text{Net general government debt}}{\text{GDP}}< 30% is good.
Monetary flexibility

  • What is the exchange rate policy (listed in order of maximum independence/effectiveness) – free floating currency, fixed rate or a hard peg?
  • Central bank
  • Is the bank independent or does the government influence its monetary policy?
  • Is controlling inflation (low, stable levels) the objective?
  • How developed is the banking system?