Intro: Default risk refers to the probability that a government defaults on external debt (typically dollars) due to an inability or unwillingness to pay. Below gives the main factors that determine the risk of government default.
Government Dollar Debt Relative to Dollar Assets: In order to determine default risk, the government’s debt load is the first place to start. The higher amount of debt relative to the government’s capacity to repay it, the greater the risk of default. While government debt is often measured relative to GDP, capacity to repay will ultimately depend on the availability of dollars to the government, which depends on the amount of export revenues, foreign reserves, and even to some extent private sector net foreign assets. While reserves and export receipts may not go to the government directly in the absence of state owned enterprise revenues, the higher they are the more likely that the government will be able to somehow acquire them to repay bondholders.
Maturity of the Debt, Liquidity Risk: The proportion of debt that is short term in nature is a crucial factor as to likelihood of the government meeting its obligations. Countries with a high level of short-term debt may find it difficult to roll over their bonds in times of global risk aversion, forcing them to default or require a bailout due to a lack of dollar liquidity.
Private Sector External Debt: While we are interested in government debt rather than private debt, a large stock of private sector debt can increase default risk as the government may be forces to bail out the private sector debtors during times of stress. This is particularly problematic if the debt is held by major state-owned enterprises or the financial sector.
As we saw in the Global Financial Crisis, default risk in South Korea spiked due to the high level of short term debt in the banking system, which required the government to burn through large amounts of reserves to prevent defaults (not in the form of bailouts but in the form of defending the currency in order to prevent currency mismatches in the sector from resulting in a banking crisis). This in turn increased the risk of the government itself defaulting.
Net International Investment Position and Balance of Payments: The NIIP measures the net foreign assets (bonds, stocks, cash, loans etc) of a country (both government and privately held) and is essentially the stock of balance of payment flows over time. Countries with large NIIP surpluses have more external assets than they have external liabilities.
If we break down the NIIP into the government and the private sectors, a government that has more liquid assets than liabilities will of course face little default risk. However, all else equal, even a country with a NIIP surplus due to positive private sector net assets would have lower default risk.
Indeed, a positive private sector NIIP will reduce the likelihood of a default in the event that foreign investors sell their emerging market bonds. The reason being that emerging market governments can implement policies (exchange rate controls usually) in order to gain partial access to these dollars during times of crisis. Thought another way, it reduces the downside pressure on the currency, which otherwise increases the local currency value of net external debts.
Composition of Bondholders: Generally speaking, a country with a large proportion of dollar bonds held by foreign investors is likely to have a higher risk premium as foreign investors are much more likely to sell compared to local investors in times of crisis. Also, the lack of ability of the emerging market government to prevent bondholders from selling via policy prescriptions also means they require a higher risk premium.
Domestic Government Debt: If the government has a large amount of debt this will increase default risk even if it is largely denominated in local currency terms. The reason being that the larger amount of tax revenues that are required to pay local currency bondholders, the more difficult it may be for the government to pay external bondholders as growth will tend to be undermined.
Willingness To Pay (Political Risk): Willingness to pay depends on numerous domestic and political dynamics such as whether the government is ideologically against neoliberalism, is populist in nature, has a history of defaulting, or has a high degree of policy uncertainty.