How deep in debt? Measuring sovereign default risk

Sovereign credit risk is when a government is under threat of being unable to meet its loan obligations and going bankrupt. Traditional ways of measuring such risk are fundamentally flawed. Researchers Manish K Singh from IIT Roorkee in India, Marta Gómez-Puig from the University of Barcelona, and Simón Sosvilla-Rivero from the Complutense University of Madrid, Spain propose a new measure of sovereign risk which pays particular attention to euro area (EA) countries. After all, the recent European sovereign debt crisis and the COVID-19 pandemic highlight that these countries need a robust and accurate measure of their own financial health.

Sovereign credit risk indicators are methods of calculating a governments’ ability to repay debt and its risk of bankruptcy. For the euro area (EA) or eurozone – the 20 European Union member states using the euro as a primary currency – choosing an optimal indicator is vital for good governance. This is because the European sovereign debt crisis of 2009–2010 still looms large for many countries, and they must keep track of their financial health to avoid repeating this financial catastrophe. Meanwhile, the COVID-19 pandemic has further increased fiscal deficits and public debt ratios in the euro area, emphasising the need for a robust indicator of sovereign credit risk.

Risk assessment: Breaking from tradition

Traditional indicators of a country’s ability to repay debt have been based on market factors, such as the pricing of credit default swaps (CDS) – a form of insurance against credit risk – and sovereign yields – the interest rate paid by governments to buyers of their bonds. However, measuring these financial factors to determine a country’s credit risk has limitations, including their vulnerability to political interference. For example, financial authorities have banned certain purchases of sovereign CDS and, in times of crisis, central banks have provided support for sovereign bonds.

Since these actions are designed to protect financial products like sovereign bonds in times of instability, their related pricings no longer act as a clear indicator of sovereign credit risk. Similarly, a nation’s credit rating may reflect the highs and lows expected throughout the fluctuations of an economic cycle, meaning that indicators using snapshot credit ratings can under- or overestimate risk.

Traditional measures also fail to differentiate between types of creditors when calculating a government’s risk of bankruptcy. For example, governments will have less flexibility when debts must be paid in a foreign currency or have short-term contracts. In such cases, sovereign countries cannot inflate their currency to ease the burden of debt, and unlike short-term and domestic debt, they cannot trade below their contractual liabilities for a significant period of time. Such an imbalance was demonstrated in the Greek debt restructuring of 2012, in which the losses experienced by creditors depended on their level of seniority.

To address these gaps in traditional indicators, three researchers with a common interest in international finance and macroeconomics have collaborated. Manish K Singh, Assistant Professor at IIT Roorkee in India, Marta Gómez-Puig, Professor at the University of Barcelona, and Simón Sosvilla-Rivero, Full Professor at the Complutense University of Madrid in Spain propose a new framework called the sovereign distance to default (DtD) indicator. Their measure incorporates the seniority structure of creditors and offers a more comprehensive estimation of sovereign credit risk in currency union countries. Their paper is the first to adapt a pre-existing methodology – the Merton model – for the euro area.

Modifying the Merton model

The Merton model for measuring sovereign credit risk uses Contingent Claims Analysis (CCA). Contingent claims are when the amount required for full repayment of a loan depends on broader conditions, such as the value of another asset possessed by a firm. Therefore, CCA measures the volatility of a firm’s assets to determine its ability to repay debt. However, unlike stock prices, which can be measured straightforwardly from market data, a firm’s asset volatility cannot be directly observed.

Various methods are used to derive a firm’s asset values from accessible information. For example, the Merton model assumes that a firm’s assets will follow the ‘Brownian motion’ of small random fluctuations, and then uses available measures from the liabilities side of a firm’s balance sheet – such as the market value of the firm’s equity and debt – to infer the amount of volatility on the asset side. This is the focal point of the newly proposed DtD indicator, which refers to the calculated distance between an entity’s asset values and its contractual obligations. By aggregating this data across firms, DtD can capture the risk of default for entire sectors, or the economy as a whole.

The euro area (EA) has particular features that must be considered in order to accurately measure sovereign credit risk within its remit. For example, EA countries share the same primary currency – the euro – which means that they cannot inflate their own local currency to reduce the burden of repaying their debts. This effectively makes the sovereign debt owed by EA countries a form of ‘foreign currency’ debt.

Meanwhile, unlike countries with greater power invested in their own central banks, EA countries rely upon an external monetary authority, the European Central Bank (ECB). Since the assets and liabilities of the ECB are held independently of member states, no single EA nation can directly alter their debtor relationship with the authority through political means. The ECB is, in other words, just another lender to these countries. Therefore, debt owed to the ECB is of critical importance, while for many other governments, their own monetary authority would form a low-priority creditor.

Not all credit is created equal

Being heavily reliant upon an external monetary authority can lead EA governments to fear and distrust the ECB, since any potential action it might take to address their financial instability will be subject to its own political considerations. Such distrust can lead to a liquidity crisis for these countries, which may cascade into a solvency crisis, and ultimately follow a self-fulfilling prophecy into bankruptcy.

The financial framework of the EA, therefore, introduces certain priorities for sovereign debt, including the creditor’s location and their institutional characteristics. The research team has reviewed historical examples, survey responses, and decisions made by credit rating agencies to identify groups of institutional creditors that are practically – if not formally – superior to other market creditors.

For example, knowing whether creditors are banks, official authorities, or non-banks, in addition to their location, is pivotal for sovereign debtors’ priorities. The researchers use their evidence-backed picture of creditor seniority to calculate the equity of firms and governments, from which DtD is derived. The DtD measure is used to estimate sovereign credit risk in eleven EA countries, and results are compared with those from traditional indicators.

A more accurate indicator

The study’s findings are significant as they propose the DtD indicator, which provides a more accurate assessment of sovereign credit risk than traditional indicators. By incorporating the priority structure of creditors as well as macroeconomic factors, the researchers manage to isolate the variables that are most predictive of financial failure.

This provides EA nations with a new and superior approach to monitoring their risk of bankruptcy. The researchers also highlight the potential for the DtD measure to inform future policy development, suggesting it could be used to design policies that reduce sovereign risk and even extend the framework beyond the sovereign context to incorporate signs of international instability.

Distance to default harnesses the most relevant measures to assess the risk of bankruptcy for credit union countries. As such, DtD offers the most comprehensive and forward-looking measure available to assess sovereign credit risk in the euro area and similar regions. In light of past pandemics and financial crises as well as future threats on the horizon, this measure offers a vital tool to track sovereign credit risk and avoid repeating catastrophe.