Spin, bluster and BS

What is ‘Sovereign Risk’

Sovereign risk is the risk that a central bank will impose foreign exchange regulations that will significantly reduce or negate the value of its forex contracts. It also includes the risk that a foreign nation will either fail to meet debt repayments or not honor sovereign debt payments.

Sovereign Risk does not consider the bottom line of business

“sovereign risk” should not be applied to any risk to business profitability resulting from government policy changes.

What is ‘Sovereign Risk’

Sovereign risk is the risk that a central bank will impose foreign exchange regulations that will significantly reduce or negate the value of its forex contracts. It also includes the risk that a foreign nation will either fail to meet debt repayments or not honor sovereign debt payments.

Sovereign is one of many risks that an investor faces when holding forex contracts. These risks also include interest rate risk, price risk and liquidity risk.

Sovereign risk comes in many forms, although anyone who faces sovereign risk is exposed to a foreign country in some way. Foreign exchange traders and investors face the risk that a foreign central bank will change its monetary policy so that it affects currency trades. If, for example, a country decides to change its policy from one of a pegged currency to one of a currency float, it will alter the benefits to currency traders. Sovereign risk is also made up of political risk that arises when a foreign nation refuses to comply with a previous payment agreement, as is the case with sovereign debt.

Sovereign risk also impacts personal investors. There is always risk to owning a financial security if the issuer resides in a foreign country. For example, an American investor faces sovereign risk when he invests in a South American-based company. A situation can arise if that South American country decides to nationalize the business or the entire industry, thus making the investment worthless.

Government policy must not be dictated by any corporations profitability

Mining is a very profitable business rather than sovereign risk, just as the mining and carbon taxes were business risks. It is stretching things to use the label “sovereign risk” every time a policy change affects a company’s bottom line, share price or even its viability.

Mining companies have frequently indicated they would cease to mine in Australia and would move elsewhere if it became too costly to do business here. But the fact that they have remained here indicates that a wide range of policy changes federally and in different states through time cannot be judged as a sovereign risk to their activity.

It’s misguided to apply the term “sovereign risk” to any risk to business profitability resulting from a change of government policy on the Renewable Energy Target, writes Margaret McKenzie.

There is no doubt that getting rid of the RET or lowering targets is a disastrous risk to renewable energy investors who have been left high and dry. A report from the Climate Council suggests that there has been a 70 per cent drop in renewable energy investment since 2013 (a period of time which includes the election of the Abbott Government and the repeal of the carbon tax).

But this is a business rather than sovereign risk, just as the mining and carbon taxes were business risks. It is stretching things to use the label “sovereign risk” every time a policy change affects a company’s bottom line, share price or even its viability.

Traditionally the term sovereign risk has been used to refer to national economic crises in (usually) less developed countries. These are crises involving catastrophic declines in exchange rates as a result of national debt and often dependency on a single export, frequently a natural resource.

This is the situation where international firms lose the value of their investments or are deterred from doing business in that country. It has not traditionally been about domestic firms or industries located within their own country.

However “sovereign risk” has recently been applied to any risk to business profitability resulting from government policy changes. The Abbott Government has applied the term selectively, labelling only some policy changes it disagrees with as creating sovereign risk. Companies have come to do the same.

Was the carbon tax a sovereign risk for miners?

Mining companies have frequently indicated they would cease to mine in Australia and would move elsewhere if it became too costly to do business here. But the fact that they have remained here indicates that a wide range of policy changes federally and in different states through time cannot be judged as a sovereign risk to their activity.

These are multinationals which mine in many jurisdictions including in sub-Saharan Africa, so it is evident that resource extraction is simply located where the natural resources are available. Mining decisions appear not to be very sensitive to policy changes by governments.

Mining companies with activities in Australia did not relocate their activities to African countries when the mining tax was introduced, but rather worked with the Gillard and other governments to ensure it was ineffectual. This is consistent with global tax avoidance strategies by large companies which are largely untouched by formal tax rates in natural resource extracting countries in particular. Norway, another rich resource exporter, has double the effective corporate tax rate of Australia yet its production does not relocate.

The carbon tax too appears to have had little effect on the level of activity of mining companies, and energy companies appear to have responded by moves toward cleaner energy generation. Resource exhaustion, serious declines in world prices, or expectations of falling demand are more likely to offer genuine reasons for miners to exit.

Would getting rid of RET be a sovereign risk for investors?

No. Again, this decision would undoubtedly hurt investors, but this is simply a reality of doing business.

In the long term, one way or another, renewable energy will become viable and perhaps there will be no choice but to utilise it. The adjustment to this reality will impart much greater business risk than fiddling with the RET. It is a question of whether the government wants to assist with smoothing the process or to exacerbate it.

Margaret McKenzie is a lecturer in economics at Deakin University.

Probability that the government of a country (or an agency backed by the government) will refuse to comply with the terms of a loan agreement during economically difficult or politically volatile times. Although sovereign nations don’t “go broke,” they can assert their independence in any manner they choose, and cannot be sued without their assent. Sovereign risk was a significant factor during 1970s after the oil shock when Argentina and Mexico almost defaulted on their loans which had to be rescheduled.

Read more: http://www.businessdictionary.com/definition/sovereign-risk.html

What is and isn’t a ‘sovereign risk’

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Widespread violent protests in Greece in response to austerity measures showed the world what a real sovereign risk looks like.
Joanna/Flickr, CC BY

Margaret McKenzie, Deakin University

The use of the term “sovereign risk” by Trade Minister Andrew Robb to describe the federal budget stalling in the senate shows just how fast and loosely the term has come to be used.

But to whom is the risk? Who would bear the cost of the downside? What caused the risk? How big is the risk in the context of the overall costs and benefits of the action?

Traditionally sovereign risk was the risk of less developed country governments defaulting on their foreign currency debt to banks or developed country governments. It could also be taken to include the risk of expropriation and nationalisation of private assets. More recently the term sovereign risk has come up in relation to the risk of default on euro debts held at the European Central Bank by EU members following the GFC.

Stretching it further, sovereign risk has been applied to the consequences for business profits of a change in taxes, subsidies or regulations. This is a narrow focus on the perceived costs to commercial interests of government actions, rather than the question of appropriate policy.

Sovereign risk origins

Removal of the restrictions on cross border currency flows in the late 1960s increased international bank lending to the less developed countries (LDCs).

Due to expanding LDC exports of oil and other resources to the rich countries especially the US, huge amounts of US dollar revenue (petrodollars) were deposited in European banks. LDCs were encouraged to borrow those funds in order to finance economic development. But many LDCs did not get the anticipated economic growth and increased exports that would generate more foreign currency and allow them to repay the mainly US dollar debt.

Foreign debt repayment difficulties resulted in moral hazard whereby higher interest rates increased the risk of default. Unable to repay or even service the foreign debt especially when interest rates rose, LDC governments were forced to refinance (recycling) and many were trapped in ever increasing foreign debt. To boot, often weak neo-colonial LDC state institutions encouraged corruption and capital flight, whereby foreign currency was siphoned out of the country by corrupt elites, Marcos in the Philippines among many.

Some LDCs came to owe more in yearly foreign debt service than their total exports or even GDP were worth. Domestic currency devaluation led to dearer imports for development and high inflation – Keynes’ famous “transfer problem”. Living standards and basic infrastructure and services (education and health) deteriorated in many countries despite continuing massive resource exports, especially for the poorest. While sovereign risk focused on commercial concerns including bank losses, many people in LDCs faced enormous costs in terms of poverty. The risk of nationalisation of foreign assets was added to the sovereign risk of doing business in those countries.

The IMF and the World Bank imposed conditions on the indebted countries in order to meet eligibility for relief, including balanced government budgets, privatisation and deregulation, a form of “austerity” for already poor countries. As increasingly recognised by the institutions themselves, these measures often exacerbated the situation and served to limit economic development. The Asian crisis of the early 1990s was a case in point.

It has taken a long time to write off even some of the foreign debt of the most highly indebted poor countries.

And then there was the GFC

More recently sovereign risk has come to mean the risk which arises when governments engage in expansionary fiscal and/or monetary policy in response to downturns.

Governments increased their budget deficit (fiscal stimulus) and lowered interest rates (expansionary monetary policy, quantitative easing) in response to the GFC. The intent was to expand household and other expenditure in order to drive increased production and thereby reduce unemployment. Lower interest rates were meant to encourage investment and other spending.

But this is opposed by those who argue that borrowing to fund the budget deficit will increase government debt and the costs of debt service. It is this belief which is driving the current austerity budget measures, widely countered by mainstream economists.

These austerity measures are premised on a belief that government spending is wasteful, and cutting government spending and/or increasing taxes is necessary to reduce government borrowing. It ignores that reductions in government spending would raise costs to businesses and increase their risk of bankruptcy, creating more unemployment. It could also threaten productivity in the longer run, as R&D gets less funding.

Note that this time the sovereign debt in question refers in effect to the government’s debt to itself, all denominated in domestic currency. It is not foreign currency debt, which remains small in Australia’s case. To the extent that government debt is internal it can be neutralised through monetary policy, such as buying bonds from the public. The government’s interest bill is notional, as it is with the public.

The austerity argument denies the fact that even very high levels of government debt can disappear because of increased growth in the economy arising from the initial stimulus and other factors. This has occurred many times in many economies – post World War II is the outstanding example. This is one reason why agencies which predict sovereign risk often do it badly, including the credit ratings agencies in the case of the GFC. Moreover the focus on government debt ignores the importance of private risk, arising from private holdings of debt.

Even for those who might argue a case for austerity at high levels of debt, Australia has very low levels of government debt compared to other countries which would preclude the need, as has been widely argued. In other words, this is a poor premise for sovereign risk.

The Euro crisis

In the case of the euro economies the issue is still more complex. Governments are funded from the European Central Bank (ECB), but conduct their own fiscal policies. The ECB sought repayments of euro debt which made it impossible for countries to manage and coordinate their own fiscal and monetary policies. In this case the sovereign risk is viewed as being that borne by the ECB and those dealing in the euro, yet the euro economies bear the cost of central policy failures.

Australia’s situation doesn’t quite fit

Trade Minister Andrew Robb seems to be interpreting sovereign risk as the threat to foreign confidence in doing business with Australia, driven by perceptions of exchange rate uncertainty and potential instability in the Australian economy. This is seen as arising from anything which would prevent the government from implementing its budget measures, willy nilly.

Changes to government regulation which affect the profitability of particular businesses, as in the Renewable Energy Target removal have also entered the broad church of increasing sovereign risk. It may not be wise policy, but to argue that such measures amount to a sovereign risk is drawing a very long bow indeed.

Labelling everything as “sovereign risk” is not a substitute for sensible policy to strengthen Australia’s international position.


This is the fourth piece in our series on the language of economics. Click on the links below to read the others.

Speak well of the bourgeois, and prosper

Unemployed or lazy? Economists know better

The ConversationWhy treasurers should go back to economics school

Margaret McKenzie, Lecturer, School of Accounting, Economics and Finance, Deakin University

This article was originally published on The Conversation. Read the original article.

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