CFA Level I Exam · Credit Analysis for Government Issuers

Sovereign Credit Risk and Credit Ratings Explained

Updated 7 October 2026 · Fact-checked

Sovereign credit analysis asks whether a government can pay (ability) and will pay (willingness) its debt. Ratings agencies score both. Foreign currency debt is usually rated lower than local currency debt, because a government can print its own currency but not foreign currency. To solve questions, separate the two tests, then the two currencies.

Understand Sovereign Credit Risk and Credit Ratings

A sovereign issuer is a national government borrowing in its own name. Sovereign credit risk is the risk that the government fails to pay interest or principal on time and in full. Unlike a company, a government cannot be forced into liquidation, and creditors have few legal tools. This is why the analysis looks at behavior and politics as well as numbers.

Analysts split the question in two. Ability to pay is about economic and fiscal capacity: the size and growth of the economy, tax base, government debt burden, budget deficits, debt affordability, external position, monetary flexibility and institutional strength. Willingness to pay is about intent: a government may be able to pay yet choose not to, because paying is politically costly. Creditors cannot easily sue a sovereign, so willingness matters a lot. Signs include the track record on past debt, quality of institutions, rule of law, political stability and the government's attitude to creditors.

Currency matters too. A government borrowing in its local currency can usually meet payments by raising taxes or by creating money through its central bank. So default risk is lower, but it is not zero. The cost may be inflation, and some countries cannot print the currency they borrow in. Borrowing in foreign currency is harder: the government must earn or obtain that currency through exports, reserves or borrowing. So the same government is typically rated higher on local currency debt than on foreign currency debt. The difference between the two ratings is the currency rating gap (a rating differential). Where a country uses a currency it does not control, for example a monetary union member, it has less flexibility in local currency too.

Rating agencies publish an issuer rating, split into local currency and foreign currency ratings. Investment grade runs from AAA down to BBB- on the S&P and Fitch scales (Aaa to Baa3 at Moody's). Ratings are opinions with limits: they lag markets, can change suddenly, and may differ between agencies. Market credit spreads often move before ratings do.

Key formulas to remember

Two-part test of sovereign credit risk: Sovereign credit assessment considers both ability to pay and willingness to pay.; This is a framework, not an equation. Weakness in either part raises risk. Low risk needs a strong economy and fiscal position and a record of honoring debt.
Currency rating rule: Local currency rating ≥ foreign currency rating (typically); Typical, not guaranteed. The gap shrinks when the country has flexible, credible monetary policy and large foreign reserves, or when the currency is not its own.
Debt burden ratio: Government debt-to-GDP = government debt ÷ GDP; Higher ratio means a heavier burden and weaker ability to pay, all else equal.

How to solve Sovereign Credit Risk and Credit Ratings questions

Use this order for any question on sovereign credit analysis or sovereign ratings.

1Identify what is asked: ability to pay, willingness to pay, or the currency of the debt.
2If it is about capacity, list the economic and fiscal factors: growth, debt burden, deficits, external position, tax base.
3If it is about intent, look for institutions, political stability, rule of law and the default or restructuring record.
4Check the currency of the debt. Foreign currency adds exchange and reserve constraints; local currency adds monetary flexibility.
5Decide the direction: stronger factors mean lower risk and a higher rating, weaker factors the opposite.
6Remove options that mix up ability with willingness or reverse the local and foreign currency order.
7Pick the option that fits the facts given in the stem.

Quickest way: Ability, Willingness, Currency

When to use it: For most single-concept MCQs with about 90 seconds per question.

Label the clue in the stem as ability (numbers and economy) or willingness (politics, institutions, history).
Ask which currency the bond is in.
Default expectation: local currency rating is equal to or above foreign currency rating.
Eliminate options that say a government cannot be hurt by lack of willingness, or that call ratings a guarantee.
Choose the remaining option.

Common mistakes in Sovereign Credit Risk and Credit Ratings

Treating ability and willingness to pay as the same thing.
Both lead to default, so they feel alike.
Fix: Ability is about capacity (economy, finances). Willingness is about intent (politics, institutions, past behavior). A rich country can still be a poor payer.
Assuming foreign currency ratings are higher than local currency ratings.
Foreign currency sounds safer or stronger.
Fix: A government cannot print foreign currency, so foreign currency debt is usually rated the same or lower than local currency debt.
Believing a sovereign can never default on local currency debt.
Students overextend the idea that a government can print money.
Fix: Printing money lowers default risk but can cause high inflation, and some countries have constraints, such as a shared currency. Say risk is typically lower, not zero.
Ignoring willingness because there are no numbers for it.
Quantitative factors feel more testable.
Fix: Remember that creditors have limited legal recourse against a sovereign, so intent and institutions are central to the analysis.
Treating a credit rating as a guarantee or as always current.
Ratings look official and precise.
Fix: Ratings are opinions that can lag markets and differ across agencies. Spreads can signal change before a rating action.

Worked examples

Example 1

A country has low government debt relative to GDP, a strong tax base and fast growth, but its government has repeatedly delayed payments to creditors for political reasons. Which statement is most accurate? A. Ability to pay is weak and willingness is strong. B. Ability to pay is strong but willingness is questionable. C. Both ability and willingness are strong.

Show the solution

Low debt, a strong tax base and fast growth are capacity factors, so ability to pay is strong.
Repeated delays for political reasons point to intent, so willingness is doubtful.
Option A reverses the two. Option C ignores the payment delays.

Answer: B

Example 2

A sovereign issues one bond in its own currency and another in a foreign currency. The country has modest foreign reserves and a credible central bank. Which rating outcome is most likely? A. Foreign currency rating above local currency rating. B. Local currency rating equal to or above foreign currency rating. C. Local currency rating two notches below foreign currency rating.

Show the solution

A government controls its own currency and can raise taxes or create money to pay local currency debt.
Foreign currency must be earned or held in reserves, and reserves here are modest, which adds risk.
So the foreign currency rating is typically equal to or below the local currency rating, which means the local rating is equal to or above the foreign rating. This is option B.
Options A and C both place the local currency rating below the foreign currency rating, which reverses the usual order, so both are wrong.

Answer: B

Exam tips

Sort every stem clue into ability or willingness first. That alone removes one wrong option in many questions.
Expect the local versus foreign currency comparison. Remember local is usually equal or higher.
Watch for absolute words like 'always' and 'never'. Sovereign credit rules are tendencies.
Link this topic to the determinants of sovereign creditworthiness and to sovereign default and restructuring, since questions often blend them.
With no penalty for wrong answers, never leave a question blank. Eliminate one option and guess between the other two.

Practice questions from Credit Analysis for Government Issuers

Sovereign Credit Risk and Credit Ratings in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Sovereign Credit Risk and Credit Ratings: frequently asked questions

What is the difference between ability to pay and willingness to pay for sovereign debt?

Ability to pay is the government's capacity to meet debt service, based on its economy, finances and external position. Willingness to pay is its intent to do so, shaped by politics, institutions and past behavior. A sovereign can be able but unwilling, because creditors have limited legal recourse.

Why is local currency sovereign debt usually rated higher than foreign currency debt?

A government can raise taxes or have its central bank create local currency to meet local debt payments. It cannot create foreign currency, so it must earn it or hold reserves. This makes foreign currency debt riskier in most cases.

How do I assess sovereign credit risk in the CFA Level I exam?

Split the analysis into ability and willingness to pay, then consider the currency of the debt. Use the clues in the question to decide which factors are strong or weak, and pick the option that matches. Avoid absolute statements.

Are sovereign credit ratings reliable?

Ratings are useful opinions but have limits. They can lag market signals, differ between agencies and change quickly. Credit spreads often reflect new information sooner.