Discussion Paper Series 2018-E-1

Does Sovereign Risk in Local and Foreign Currency Differ?

Marlene Amstad, Frank Packer, Jimmy Shek

Historically, sovereign debt in local currency has been considered safer than debt in foreign currency. The literature offers scant theoretical or empirical guidance as to why such a gap has existed or why it appears to have slowly and steadily diminished for all regions over the past two decades, as expressed in the credit ratings widely used by global investors and regulators to assess credit risk. We suggest and empirically test five hypotheses. We find the assessed differences between local and foreign currency credit risk to not be driven by changes in inflation. The banking sector's vulnerability to sovereign debt problems is a significant determinant of the gap, but does not account for the declining spread over time. Instead, the surge in global reserves, and to lesser extent the declining dependence on foreign currency borrowing overseas (decline of original sin), as well as lower global volatility, appear to have diminished the gap. In case of a trend reversal of these variables, there could be a widening of the gap going forward.

Keywords: Sovereign risk; local currency debt; foreign currency debt; credit ratings

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

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