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CFA Level I · CFA Level I Exam · Credit Analysis for Government Issuers

Two sovereigns have similar debt-to-GDP ratios. Sovereign X has a flexible exchange rate, an independent central bank, and a deep domestic investor base. Sovereign Y has a pegged currency, a central bank that finances the budget deficit, and relies heavily on foreign lenders. Which conclusion about their credit profiles is most likely?

Sovereign X is stronger. Its flexible exchange rate, independent central bank and deep domestic investor base lessen vulnerability to external shocks and capital flight, while Y's peg, deficit monetization and foreign funding add risk. Debt-to-GDP alone does not determine creditworthiness.

  1. ASovereign Y is stronger, because a peg lowers borrowing costs and reduces default risk
  2. BSovereign X is stronger, because its monetary framework and funding base lower vulnerability to shocksCorrect
  3. CThe two are equal, because similar debt-to-GDP ratios determine creditworthiness

Explanation

Institutional and monetary factors matter beyond the debt ratio. Central bank independence, exchange rate flexibility and a domestic investor base reduce vulnerability to external shocks and sudden stops. Y's deficit monetization and foreign reliance raise risk.

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