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What is 'Sovereign Risk'

Sovereign risk is the risk that a foreign central bank will alter its foreign exchange regulations, significantly reducing or completely nullifying the value of its foreign exchange contracts. It also includes the risk that a foreign nation will either fail to meet debt repayments or not honor sovereign debt payments.

BREAKING DOWN 'Sovereign Risk'

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.

The Origins of Sovereign Risk

The 1960s were a time of reduced financial restrictions. Cross-border currency began to change hands as international banks increased lending to developing countries. These loans helped developing countries increase their exports to the developed world, and large amounts of U.S. dollars were deposited across European banks.

Then, the emerging economies were encouraged to borrow the dollars that were sitting in the European banks to fund additional economic growth. However, most of the developing countries did not obtain the level of economic growth that the banks expected, thus making it impossible to repay the U.S. dollar-denominated debt borrowings. The lack of repayment caused these emerging economies to refinance their sovereign loans continuously, increasing interest rates.

Many of these developing countries owed more in interest and principal than their entire gross domestic products (GDPs) were worth. This led to domestic currency devaluation and decreased imports to the developed world, increasing inflation.

There are signs of similar sovereign risk in the 21st century. Greece, for example, with its high levels of debt, is dragging down the economy of the European Union, and therefore, the world.

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