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FRM Part II · FRM Exam Part II · Country Risk: Determinants, Measures, and Implications

A credit officer compares two sovereigns with identical debt-to-GDP ratios of 80%. Country A has most of its debt denominated in foreign currency and a floating exchange rate; Country B has most debt in local currency. After a sharp 30% depreciation of each currency, which conclusion is most appropriate?

Country A faces the larger rise in default risk. Its foreign-currency debt becomes more expensive in local-currency terms after depreciation while its revenues stay in local currency, so the debt burden increases. Country B's local-currency debt is not revalued this way, despite identical headline debt-to-GDP.

  1. ABoth sovereigns are affected equally because debt-to-GDP is identical
  2. BCountry B's debt burden rises more because local-currency debt is revalued
  3. CCountry A's debt burden rises materially in local terms, raising its default risk more than Country B'sCorrect
  4. DNeither is affected because depreciation improves fiscal balances automatically

Explanation

Foreign-currency debt grows in local-currency terms when the currency depreciates, while revenues are mostly in local currency. This currency mismatch raises Country A's effective debt burden and default risk. Country B's local-currency debt is not revalued by the depreciation.

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