FRM Part I · FRM Exam Part I · Country Risk: Determinants, Measures, and Implications
A country's government borrows heavily in foreign currency while its tax revenues are in local currency, and the currency depreciates sharply by 30%. Which statement best describes the effect on the sovereign's default risk?
Default risk rises. With foreign-currency debt and local-currency tax revenue, depreciation increases the local-currency cost of servicing the debt while revenue does not rise to match, worsening the debt burden. Any export benefit is slower and uncertain, so it does not offset the immediate mismatch.
- ADefault risk falls, because depreciation boosts exports immediately enough to offset the debt
- BDefault risk is unchanged, because the foreign-currency debt amount is fixed
- CDefault risk rises, because the local-currency cost of servicing foreign-currency debt increasesCorrect
- DDefault risk falls, because a lower currency reduces inflation
Explanation
Foreign-currency debt is fixed in foreign units, so after a 30% depreciation more local currency is required to service it while local tax revenues do not rise correspondingly. This currency mismatch raises the debt burden relative to revenue. The export boost is gradual and uncertain, and the nominal debt is fixed in foreign terms but not in local terms.
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