As shown in the preceding chapter, the solvency of the public sector in an emerging or developing economy depends on the perceptions of creditors about the government's ability and willingness to service its debt on market terms. Because judgments about the government's solvency are made in the present on the basis of projections of the resources that will be available to the government for servicing debt in the future, solvency assessments are inherently forward-looking exercises and, as such, are intrinsically uncertain. When a government's expected debt-servicing capacity far exceeds its existing debt obligations, there may be little doubt on the part of creditors about the likelihood of repayment. But when the stock of debt is large relative to the government's projected debt-servicing capacity, lending to the government becomes a risky proposition for creditors. It is therefore useful to investigate how our solvency analysis is affected by the emergence of such credit risk.

This chapter undertakes that task. In the first section, we will examine how our solvency analysis needs to be modified to incorporate credit risk. As we will see, the key point is that in the presence of credit risk, the government's creditors will no longer be willing to lend to the government at the risk-free interest rate – they will demand a higher interest rate to compensate them for the possibility of nonpayment. The difference between this interest rate and the risk-free rate is referred to as the sovereign risk premium.