International trade and capital flows - Country risk soverei...

Learning Outcomes

This article examines international trade and capital flows in the context of country risk, sovereign debt, and external imbalances, including:

• Identifying the key economic, political, and institutional drivers of country risk in cross-border trade and investment.
• Distinguishing between different forms of external borrowing and explaining why foreign‑currency, short‑term, and non‑resident‑held debt heighten vulnerability.
• Evaluating sovereign debt sustainability using debt‑to‑GDP, debt‑to‑exports, interest‑to‑revenue, and related indicators, with emphasis on fiscal space.
• Interpreting current account trends, capital flow composition, reserve adequacy, and the international investment position to judge external balance strength.
• Recognizing early‑warning signals of external and sovereign crises, such as reserve loss, rapid buildup of short‑term external debt, and reliance on volatile portfolio inflows.
• Linking trade patterns, capital flow patterns, and exchange‑rate regimes to default risk, devaluation pressure, and contagion across countries.
• Assessing the effectiveness and trade‑offs of policy tools—interest rate adjustments, exchange‑rate flexibility, capital controls, and fiscal consolidation—in reducing external vulnerability.
• Applying these analytical frameworks to structured exam questions and case‑style vignettes that test integrated understanding of country risk and external sustainability.
• Using market‑based measures such as sovereign spreads and country risk premia to complement rating‑based assessments of sovereign creditworthiness.

CFA Level 2 Syllabus

For the CFA Level 2 exam, you are required to understand the drivers, risks, and consequences of cross‑border trade and capital flows and their interaction with sovereign credit risk, with a focus on the following syllabus points:

• Identifying and assessing the main components of country risk.
• Evaluating the sustainability of sovereign debt in an international context.
• Explaining the causes and indicators of external imbalances and crisis risk.
• Describing the interaction of trade, capital flows, and sovereign creditworthiness.
• Applying frameworks for analyzing a country’s vulnerability to external shocks.
• Interpreting current account, capital/financial account, and international investment position data in investment analysis.
• Understanding how country risk premia and sovereign spreads affect the cost of capital for sovereigns and corporates.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

Background: An analyst is assessing the Republic of Lydora, a small open economy with a managed‑float exchange‑rate regime. Selected data are shown below (all ratios are as a % of GDP unless stated):

• Real GDP growth has slowed from 4% to 1.5% over three years.
• Fiscal balance moved from −2% to −6%.
• Current account moved from −3% to −7%.
• Net FDI inflows are stable at 2%.
• Portfolio and bank inflows rose from 1% to 6% but have recently turned to small net outflows.
• Gross external debt rose from 40% to 70%:
  • Share of short‑term external debt increased from 25% to 45%.
  • Share of foreign‑currency‑denominated debt is 70%; almost all short‑term debt is in foreign currency.
• Official foreign exchange reserves fell from covering 6 months of imports to 3 months of imports.
• The share of government bonds held by non‑residents increased from 30% to 55%.
• Sovereign USD bond spread over US Treasuries widened from 150 bps to 450 bps.

1. Which development most directly increases Lydora’s near‑term risk of an external financing crisis?
   1. Slower real GDP growth and a larger fiscal deficit.
   2. Widening current account deficit financed by higher FDI inflows.
   3. Rising share of short‑term, foreign‑currency‑denominated external debt.
   4. Increase in non‑resident holdings of long‑term local‑currency government bonds.
2. Which single indicator best captures Lydora’s liquidity to meet external obligations over the next year?
   1. Gross government debt‑to‑GDP.
   2. Ratio of official foreign exchange reserves to short‑term external debt.
   3. Current account deficit‑to‑GDP.
   4. Interest payments‑to‑government revenue.
3. The widening sovereign spread from 150 bps to 450 bps most likely reflects:
   1. Higher long‑term trend growth and improved creditworthiness.
   2. Increased perceived probability of sovereign default and/or currency crisis.
   3. Reduced global risk aversion and search for yield.
   4. Declining country risk premium embedded in Lydora’s bonds.
4. If global risk appetite falls further and capital outflows accelerate, which policy response is most consistent with reducing external vulnerability over the medium term, rather than just delaying adjustment?
   1. Defending the currency at all costs using reserves and very high interest rates.
   2. Allowing some exchange‑rate depreciation while tightening fiscal policy and lengthening debt maturities.
   3. Imposing a full moratorium on all external debt payments.
   4. Forcing domestic banks to roll over all maturing external liabilities indefinitely.

Introduction

International trade and cross‑border capital flows provide opportunities for economic growth, diversification, and risk sharing. However, they also create vulnerabilities, particularly in the form of country risk, unsustainable sovereign debt, and external imbalances. For the CFA exam, you must be able to assess the drivers and consequences of these vulnerabilities and recognize warning signs of a potential external crisis.

At the macro level, a country’s external balance is summarized in its balance of payments: the current account, the capital and financial account, and the change in official reserves. Persistent imbalances in these flows, especially when financed by unstable types of capital, can undermine a sovereign’s ability to service its debt and maintain a stable exchange rate.

Key Term: country risk
The risk of loss for investors due to adverse shifts in a nation’s economic, political, or institutional environment that affect the repayment of cross‑border obligations.

Key Term: sovereign debt
Debt issued or guaranteed by a national government, including both domestic and external obligations.

Key Term: external imbalances
Persistent mismatches in a country’s cross‑border flows of goods, services, income, and capital, typically captured by the current account and capital/financial account positions.

Key Term: debt sustainability
The ability of a sovereign to service its debt obligations over the medium‑to‑long term without accumulating arrears, restructuring, or generating economic instability.

Key Term: current account
The component of the balance of payments that records trade in goods and services, net income from abroad, and net transfers.

Key Term: financial account
The balance of payments account that records cross‑border transactions in financial assets, including direct investment, portfolio investment, and other investment (such as bank loans and deposits).

International investors assess how trade patterns, capital flows, and policy frameworks interact to influence country risk. The same indicators that macroeconomists use—current account balances, external debt structure, foreign exchange reserves, and the international investment position—also feed directly into sovereign credit analysis and pricing in bond and CDS markets.

COUNTRY RISK IN INTERNATIONAL TRADE AND CAPITAL FLOWS

Country risk emerges when cross‑border transactions expose lenders and investors to uncertain economic or political developments in the destination economy. These risks increase when international capital flows are large relative to the size of a country's financial system or when policy credibility is questioned.

Key Sources of Country Risk

Country risk is multidimensional. For exam purposes, it is useful to group drivers into:

• Political and institutional factors

  • Unstable governments, frequent policy reversals, or weak rule of law.
  • Corruption, expropriation risk, and poor protection of property rights.
  • Weak regulatory and supervisory frameworks for banks and capital markets.

  Strong institutions and effective prudential supervision of banks reduce the likelihood that external shocks translate into economy‑wide crises.

• Macroeconomic mismanagement

  • Persistently large fiscal deficits financed by debt issuance.
  • Pro‑cyclical fiscal and credit policies that fuel booms and deepen busts.
  • Very high inflation or deflation, reflecting weak monetary policy credibility.
  • An overvalued real exchange rate that undermines competitiveness.

• External financing structure

  • Excessive external borrowing (public or private), especially when:
    • Denominated in foreign currency.
    • Short‑term in maturity.
    • Held by non‑resident investors.

Key Term: short-term external debt
External debt with an original maturity of one year or less, owed by residents to non‑residents.

• Exchange‑rate regime and buffers
  • Fixed or tightly managed exchange rates may anchor inflation expectations but become fragile when not backed by adequate foreign exchange reserves.
  • Limited reserve buffers constrain the ability to smooth external shocks.

Key Term: foreign exchange reserves
External assets held by a country’s monetary authority (typically in foreign currencies and gold) that can be used to finance balance‑of‑payments needs and intervene in currency markets.

Key Term: reserve adequacy
The degree to which a country’s foreign exchange reserves are sufficient to cover short‑term external financing needs, often assessed relative to imports, short‑term external debt, or broad money.

• Policy unpredictability and capital controls
  • Sudden changes to tax, regulatory, or ownership rules affecting foreign investors.
  • Introduction of unanticipated capital controls or payment restrictions.

Key Term: capital controls
Restrictions imposed by a government on the flow of foreign capital into or out of the country, aimed at managing exchange rates, limiting volatility, or reducing vulnerability to external shocks.

Country risk can also be quantified using country risk ratings and market‑based indicators such as sovereign bond spreads and CDS prices.

Key Term: sovereign spread
The yield difference between a sovereign’s bond (often in a reserve currency such as USD) and a comparable‑maturity benchmark (such as a US Treasury), reflecting credit, liquidity, and country risk.

Key Term: country risk premium
The additional expected return investors demand for holding assets exposed to a specific country’s economic, political, and currency risks, over and above the risk‑free rate and global market risk.

Rising sovereign spreads and country risk premia signal deteriorating perceptions of country risk, often well before rating downgrades.

Worked Example 1.1

A country with high short-term external debt and a fixed exchange-rate regime begins to see rapid capital outflows and declining reserves. What is the likely risk outcome?

Answer:
With large short‑term debt and a rigid currency regime, the country is highly exposed to a loss of confidence. As outflows accelerate and reserves diminish, the sovereign may be forced into a disorderly devaluation or payment restrictions, sharply increasing default and crisis risk to cross‑border investors. In practice, analysts would focus on the ratio of short‑term external debt to reserves and the speed of reserve loss to judge how long the peg can be defended.

SOVEREIGN DEBT SUSTAINABILITY

Sovereign debt sustainability depends on the government's capacity to generate enough primary fiscal surpluses and external earnings to meet debt service, in the face of interest payments and currency volatility. Conceptually, the government’s intertemporal budget constraint requires that the present value of future primary surpluses equals the existing stock of debt.

Key questions for an analyst:

• Is debt solvent in the long run (i.e., does debt/GDP stabilize or fall under plausible assumptions)?
• Is the sovereign liquid in the short run (i.e., can it roll over maturing debt and service interest without resorting to arrears or monetization)?

Assessing Debt Sustainability

Common indicators include:

• Debt-to-GDP and debt-to-exports ratios

  • High and rising ratios indicate stress, especially when not matched by higher revenue capacity or export earnings.
  • Export‑based metrics are particularly relevant for countries whose debt service relies heavily on foreign‑currency income.

• Interest burden relative to fiscal revenue

  • Interest payments divided by government revenue measures how much of the budget is pre‑empted by debt service.
  • A high ratio signals limited fiscal space for discretionary spending or counter‑cyclical policy.

Key Term: fiscal space
The capacity of a government to raise spending or cut taxes without endangering debt sustainability or market confidence.

• Primary balance trends

  • The primary balance excludes interest payments from the fiscal balance and shows how much adjustment is being made to stabilize debt.

  Key Term: primary balance
  The government fiscal balance excluding interest payments on outstanding debt; a primary surplus helps stabilize or reduce the debt ratio.

  Roughly:

  $$\Delta d \approx (r - g)\,d_{t-1} - pb$$

  where:

  • $d$ = debt‑to‑GDP ratio
  • $r$ = effective interest rate on debt
  • $g$ = nominal GDP growth rate
  • $pb$ = primary balance as % of GDP (surplus is positive)

  If $r > g$ and the primary balance is in deficit, the debt ratio tends to rise.

• Currency composition

  • Debt in foreign currency is riskier, especially for countries with volatile exchange rates or limited reserves. Depreciation raises the domestic currency value of foreign‑currency debt, potentially causing a self‑reinforcing debt spiral.

• Maturity structure and investor base

  • Reliance on short-term or market-based financing increases refinancing and rollover risk.
  • A high share of debt held by non‑residents increases exposure to global risk sentiment.

Key Term: rollover risk
The risk that a borrower will be unable to refinance maturing debt on affordable terms, or at all, leading to liquidity stress or default.

Worked Example 1.2

Country X has a government debt/GDP ratio of 85%, with 65% in foreign currency and low fiscal surpluses. Capital inflows decline sharply after a global shock. What risks emerge?

Answer:
Country X faces repayment pressures as external financing becomes scarce. The high share of foreign‑currency debt means devaluation would raise the local currency value of debt, risking default, especially if export earnings or fiscal surpluses are insufficient to cover higher debt service costs. Rollover risk is high because the country now needs to refinance maturing obligations at higher spreads, and its limited primary surplus offers little buffer.

Worked Example 1.3

You are given the following data for Country Y:

• Debt‑to‑GDP: 70% (up from 55% three years ago).
• Average interest rate on government debt: 6%.
• Nominal GDP growth: 4%.
• Primary fiscal deficit: 1% of GDP.
• Interest payments: 24% of government revenue.

Is debt likely to be on a sustainable path?

Answer:
The effective interest rate (6%) exceeds nominal GDP growth (4%), so the term $(r - g)d$ is positive and tends to push the debt ratio higher. With a primary deficit of 1% of GDP, the government is not offsetting this dynamic. The rising debt‑to‑GDP ratio and a high interest‑to‑revenue ratio (24%) suggest debt is on an unsustainable trajectory absent policy adjustment (higher primary surpluses or lower interest rates). Market participants are likely to demand higher risk premia, further worsening the debt trajectory.

Exam warning

Focus on the structure as well as the level of sovereign debt. Foreign‑currency, short‑term, and non‑resident‑held debt raise vulnerabilities far more than headline debt/GDP alone. Case vignettes often provide a mix of these details; your task is to identify which combination materially increases default risk.

EXTERNAL IMBALANCES AND CRISIS RISK

External imbalances typically manifest as persistent current account deficits financed by capital inflows. By balance‑of‑payments identity:

A country running a current account deficit must either attract net capital inflows (financial account surplus) or draw down reserves. If deficits are large or funded by short‑term portfolio investments, a sudden reversal of flows (a sudden stop) can trigger external financing stress, reserve depletion, or devaluation.

Key Term: sudden stop
An abrupt halt or reversal of capital inflows, often leading to liquidity crises and forced adjustment in a country’s external accounts.

External vulnerability is best assessed by combining flow measures (current account) with stock measures:

• Net external debt.
• Net foreign asset position.

Key Term: international investment position
A stock measure showing a country’s external financial assets and liabilities at a point in time; a negative net position indicates that the country is a net debtor to the rest of the world.

A country with a large negative international investment position and a current account deficit is more exposed than one with a small net liability position and similar current account.

Warning Signs of Emerging Crisis

Key early‑warning indicators include:

• Deteriorating current account financed by unstable flows

  • Large and widening current account deficits not matched by higher productive investment.
  • Financing increasingly reliant on:
    • Short‑term bank lending.
    • Portfolio inflows into local bond and equity markets.
    • “Hot money” carry trades.

• Rapid buildup of short-term external debt

  • Rising share of external debt maturing within one year.
  • Banks and corporates borrowing abroad in foreign currency to fund domestic credit booms.

• Reserve losses and exchange-rate pressures

  • Persistent intervention to support the local currency.
  • Falling reserve/import coverage or reserves/short‑term debt ratios.

• Adverse shifts in the international investment position

  • Increasing net negative position, especially when liabilities are short‑term and in foreign currency while assets are illiquid or low‑yielding.

• Market-based signals

  • Sharp widening of sovereign bond spreads and CDS premia.
  • Downgrades or negative outlooks from rating agencies.

Worked Example 1.4

A country runs a 6% of GDP current account deficit for several years, funded primarily by portfolio investment in government bonds. Global conditions tighten, leading to capital outflows. How might this play out?

Answer:
As inflows dry up, the country will be forced to draw down reserves or devalue its currency, making foreign debt harder to repay. Yields on local bonds will rise sharply as investors demand higher compensation or sell existing holdings. If reserves are inadequate or policymakers resist exchange‑rate adjustment, the country may face a sudden stop, forced fiscal consolidation, and possibly sovereign restructuring—a classic external crisis pattern.

Worked Example 1.5

You observe the following external indicators for Country Z:

• Current account deficit: 4% of GDP.
• Net FDI inflows: 3% of GDP (largely into export‑oriented manufacturing).
• Short‑term external debt: 20% of GDP.
• FX reserves: 25% of GDP.
• Ratio of short‑term external debt to reserves: 0.8.
• Net international investment position: −30% of GDP (stable over five years).

How would you characterize Country Z’s external vulnerability?

Answer:
Although the current account is in deficit, most of it is financed by FDI, which is relatively stable and directly supports export capacity. Reserves cover more than 100% of short‑term external debt (ratio 0.8), providing a liquidity buffer. The net international investment position is moderately negative but stable. Overall, near‑term external liquidity risk appears contained, though continued monitoring is warranted if the deficit or short‑term debt share increases.

ANALYSIS TECHNIQUES AND POLICY RESPONSES

Analysts use a range of tools to gauge a country’s external vulnerability. Indicators include reserve adequacy (relative to short-term debt), current account sustainability, and external debt structure. Policymakers facing growing imbalances may employ measures such as raising interest rates, imposing capital controls, or allowing currency adjustment to restore sustainability.

Key analytical ratios

Common ratios you may be asked to calculate or interpret include:

• Reserves to short-term external debt

  • A ratio below 1 (reserves < short‑term debt) is a red flag for liquidity risk.

• Reserves to imports (months of import cover)

  • Lower coverage reduces the ability to maintain essential imports during shocks.

• External debt to exports

  • High ratios indicate greater dependence on export earnings to service foreign‑currency debt.

• Interest payments to exports or to fiscal revenue

  • High ratios signal reduced capacity to meet obligations without cutting essential spending.

These metrics differentiate between solvency (long‑run ability to service debt) and liquidity (short‑run ability to roll over obligations).

Worked Example 1.6

Country M has:

• Short‑term external debt: USD 80 billion.
• Official reserves: USD 60 billion.
• Annual exports: USD 200 billion.
• External public debt: USD 160 billion.

Compute the reserves/short‑term debt and external debt/exports ratios and comment on vulnerability.

Answer:

• Reserves/short‑term debt = 60/80 = 0.75.
• External debt/exports = 160/200 = 0.80 (80%).

Reserves cover only 75% of short‑term debt, indicating significant rollover risk if capital inflows stop. However, the external debt/exports ratio of 80% suggests that, in aggregate, the country’s export earnings are large relative to public external debt. The main concern is short‑term liquidity rather than long‑run solvency. Extending maturities and rebuilding reserves should be policy priorities.

Policy responses: trade-offs and effectiveness

Policymakers have several tools to reduce external vulnerability. For Level 2, you should be able to analyze trade‑offs:

• Exchange-rate policy

  • Allowing the exchange rate to depreciate can:
    • Improve competitiveness and narrow the current account deficit.
    • Raise the domestic value of foreign‑currency debt, worsening debt metrics.
  • Maintaining an overvalued peg may:
    • Reduce inflation temporarily.
    • Deplete reserves and increase the risk of a sharp, disorderly devaluation later.

• Monetary policy

  • Raising interest rates:
    • Supports the currency by attracting capital and reducing outflows.
    • Increases borrowing costs, potentially weakening growth and banking sector balance sheets.

• Fiscal consolidation

  • Reducing fiscal deficits lowers future borrowing needs and helps stabilize debt/GDP.
  • Front‑loaded consolidation can strain growth and social stability; gradual adjustment may be more sustainable but depends on market tolerance.

• Debt management

  • Lengthening maturities and increasing the share of local‑currency debt reduce rollover and currency risk.
  • Liability management operations (swaps, buybacks, exchanges) can smooth maturity profiles but may involve near‑term costs.

• Capital flow management

  • Well‑designed measures can tilt inflows toward longer maturities or more stable forms (e.g., FDI) and reduce financial stability risks.
  • Poorly designed or abrupt controls can damage investor confidence and encourage evasion.

Key Term: external imbalances
Persistent mismatches between a country’s external spending and income—often reflected in prolonged current account deficits or surpluses—that may necessitate significant exchange‑rate or policy adjustment.

Worked Example 1.7

A commodity‑exporting country faces a sharp fall in export prices, a large current account deficit, and declining reserves. The exchange rate is managed against the USD, and most government debt is in local currency with long maturities; banks and corporates, however, have sizeable short‑term foreign‑currency liabilities.

Which policy mix is most appropriate to reduce crisis risk?

Answer:
The priority is to reduce external pressures while protecting domestic balance sheets. Allowing the exchange rate to depreciate gradually, combined with some monetary tightening and targeted macroprudential measures (e.g., higher reserve requirements on foreign‑currency lending), would help adjust the current account and conserve reserves. Fiscal policy should be re‑anchored with a medium‑term consolidation plan. Because banks and corporates have short‑term foreign‑currency liabilities, extremely sharp depreciation or very large rate hikes could destabilize them, so adjustment needs to be balanced and supported by contingent liquidity facilities.

Revision tip

Always compare external liabilities with available reserves and consider the currency and maturity of debt—not just the total liability level. Exam vignettes often present enough data to compute simple ratios; use them to structure your judgment rather than relying on impressions.

Summary

International trade and capital inflows enable growth but also raise system‑wide risk if unchecked. Persistent current account deficits financed by volatile capital raise the risk of external crisis. Country risk and sovereign creditworthiness must be assessed using both headline ratios and the structure of obligations. Early warning indicators, such as reserve loss or rising short‑term foreign liabilities, help anticipate potential crises. Policy responses involve difficult trade‑offs between short‑term stabilization and long‑term sustainability.

Key Point Checklist

This article has covered the following key knowledge points:

• Country risk increases with political and macroeconomic instability, weak institutions, large external borrowing, and rigid currency regimes without adequate reserves.
• The composition of sovereign debt—foreign‑currency vs local, short‑term vs long‑term, resident vs non‑resident—often matters more than the headline debt/GDP ratio.
• Sovereign debt sustainability analysis relies on indicators such as debt‑to‑GDP, debt‑to‑exports, interest‑to‑revenue, primary balance, and the relationship between growth and interest rates.
• Persistent external imbalances (current account deficits) financed by short‑term or volatile capital flows increase crisis risk, especially when the international investment position is strongly negative.
• Reserve adequacy (relative to imports and short‑term external debt), external debt structure, and capital flow composition are key indicators of external vulnerability.
• Market‑based measures such as sovereign spreads and country risk premia provide timely signals of changing perceptions of country risk.
• Policymakers can respond to rising vulnerabilities with exchange‑rate adjustment, monetary and fiscal policy changes, debt management operations, and carefully designed capital flow measures.
• In exam scenarios, focus on identifying whether vulnerabilities are primarily solvency‑related (long‑run) or liquidity‑related (short‑run), and whether proposed policy responses address the correct margin.

Key Terms and Concepts

• country risk
• sovereign debt
• external imbalances
• debt sustainability
• current account
• financial account
• short-term external debt
• foreign exchange reserves
• reserve adequacy
• capital controls
• sovereign spread
• country risk premium
• fiscal space
• rollover risk
• sudden stop
• international investment position