Sovereign Default

Failure or refusal of a government to pay it back when it is due

A default is defined as a breach or violation of a contract, or more particularly, failing to fulfill a debt payment. Similarly, Sovereign debt is a failure or refusal of a government to pay it back when it is due.

Sovereign Default

This unwillingness to repay the obligation may be declared with a formal proclamation that it would default on its dues, or it may occur unexpectedly. 

Such defaults are more prevalent when a country is experiencing an economic crisis, political instability, insolvency, illiquidity, etc.

Governments and sovereign bodies, like individuals and businesses, can borrow money. It is mainly used to fund various infrastructure projects, healthcare programs, and other similar endeavors. 

Most of the money is raised by issuing bonds, in which the government is contractually obligated to repay the principal amount plus interest.

The government, however, can often run into poor cash flows due to political instability, insolvency, illiquidity, etc. This impedes the ability of the government to pay back the amount when it is due and thus results in defaults. 

These defaults can often damage the government's reputation and credit ratings, affecting its future borrowing capability.

Unlike normal individuals and corporations, governments and sovereign entities are not bound by common bankruptcy laws. Thus, sovereign defaults are standard, especially when the country faces an economic crisis. 

Default

As a result, bondholders frequently monitor the government's political and economic environment to gauge the danger of sovereign default.

Because legal action cannot be taken if these sovereign entities default, bondholders frequently request higher interest rates to protect themselves from losses.

This may create what is called a sovereign debt crisis, where the government sees a high rise in the interest rate

This is especially dangerous for those countries that rely on financing through short-term bonds as there exists a mismatch between the short-term maturity of the bonds and the long-term assets these bonds finance. 

A default can have a poor impact on a country's economy. It can hamper a country's credit rating, impacting future borrowings and interest rates. Bankruptcy also affects the overall disposable income of the general public and the nation's economic growth. In addition, defaults often lead to recessions in the economy. 

Sovereign debt crisis

A sovereign debt crisis is when a government loses its ability to pay back its dues. 

Such a condition occurs when the government runs a long-term deficit, meaning its expenses exceed revenues. As a result, the government must continue taking on additional loans to finance its debt.

Bar graph

Due to the excessive debt burden, in case of any recession, cash flow problems, or economic crisis, it then becomes likely that the government may default on its dues. Moreover, the additional risk may result in creditors demanding higher interest rates, further increasing the government's burden.

Recently, Sri Lanka has seen a debt crisis where its debt burden has kept rising through the years to finance its deficits.

However, due to depleting forex reserves, it has reached a point where it doesn't have enough funds left to pay back its loans and thus will have to default. 

The Greek debt crisis is also one of the most famous examples of a sovereign debt crisis. Due to growing debt over the years and a lack of foreign investments due to the recessions, Greece could not meet its liabilities.

Example of sovereign default 

The most commonly cited example in recent times of sovereign default has been the case of the Greek debt crisis of 2009. For many years, the Debt to GDP ratio for Greece was more than the average amount.

Bank

Just a few years before the crisis, Greece had adopted the Euro as its national currency. This led to increased labor costs for Greece but no increase in productivity. 

This soon resulted in a trade deficit when a country consumes more than it produces, which requires it to borrow even more.

The Great Recession followed this in 2008, when foreign lending halted, severely impacting peripheral countries like Greece and Portugal as they depended on foreign borrowing for consumption. 

Ultimately Greece reached a debt-to-GDP ratio of 160% and saw political turmoil and unemployment rates of 28%.

Greece couldn't even resort to devaluing its currency, which would have allowed it to settle the remaining large debt. This was because instead of taking loans in its currency, Greece used the Euro as legal tender, on which it had no control over printing. 

Stack of coins

Greece would have had to default due to a lack of cash flow, but the IMF provided it with a rescue credit of 110 billion euros, mainly used to pay down maturing bonds and reduce budget deficits.

Greece was slammed by an even harsher recession in 2011 due to the economy's dismal performance, and it was once again unable to repay its obligations. In the end, many private borrowers opted to accept a 50% haircut (loss) on their obligations. 

Even after renegotiating the debt in more favorable terms and two bailout attempts by the IMF, in 2015, after years of budgetary deficits, political turmoil, and economic hardship due to the obligations imposed by IMF, Greece, burdened by its dues, finally defaulted in paying back IMF and became the first developed country to do so. 

Causes of sovereign default

Government defaults are uncommon because governments are well aware of the economic consequences of defaults. 

This is why sovereign defaults are standard after a country has experienced an economic downturn. However, there are times when the government does not have enough funds and must default on its loans.

Bankruptcy

Insolvency

Insolvency is a situation wherein the government cannot honor its dues, liabilities, or the interest on its loans and thus faces a sovereign default. It usually is reached after years of overspending, where the deficit is often settled by further loans, due to which the debt keeps rising.

Insolvency can also be due to the following factors

  • Increase in public debt
  • A decline in employment and tax revenue
  • Increased government regulations on financial markets

This is what happened in Greece over many years. Years of high expenditure resulted in budgetary deficits, which ultimately required Greece to pay more debt. This continued until it was out of the foreign investment, due to which Greece could not pay the dues back.

Illiquidity

Illiquidity is when the government can temporarily not pay the principal and interest because it cannot liquidate sufficient assets. If the assets can not be liquidated in time, it becomes tough for a government to get enough cash to meet the debt repayments, which leads to default. 

Liquidity

In contrast to insolvency, illiquidity is only temporary and can be solved as soon as the illiquid assets can be made liquid. 

Change of Government

Ideally, a change in government does not change the debt obligations created by the previous government. However, suppose there is a change in government due to a military coup or a revolutionary situation. In that case, the new government often discontinues the payment of dues as it may question the legitimacy of the loans taken.

According to international law, such loans are considered illegitimate and declared as personal loans of the previous government and thus are often not enforceable. 

For example, the dues incurred by the Russian empire were declared illegitimate when the soviet union came to power in 1917.

Consequences of sovereign default

Any economic crisis or political unrest that leads to default can have devastating economic consequences. Lenders may impose stringent standards, and interest rates may climb, making loans prohibitively expensive for everyone in the economy.

Increase In percentage

This eventually leads to a recession and job loss. In addition, there is a fall in the currency value, making imports very expensive for the country. Overall, these can create a recession and hamper the economy in the long run. Some specific consequences to various stakeholders are as follows:

Impact on creditors

In the event of a default, government creditors are frequently subjected to significant losses and are deprived of the principal and interest due from the government.

Sometimes the government may offer partial debt cancellation when the creditors accept a haircut (loss) on the outstanding debts. For example, this happened in the Greek Debt crisis, where the creditors had to get haircuts of over 50% on their loans.

Otherwise, the debt is often renegotiated, and the debt is restructured to either decrease the payments or swap the income from cash to equity in government companies, etc. 

Impact on the state

While a default may, in the short run, reduce the burden of debt on the government as its payment obligation reduces, it may hamper its reputation in the long run. This results in poor credit rating, which may hinder future loans from capital markets and result in higher interest rates if loans are given. 

Foreign lenders may even question the money sovereignty of the government and can even declare war.

Impact on the citizens

A citizen may face economic hardships and a reduction in wealth if a country defaults on loans. This may be because the government could go into recession or face a banking and currency crisis as investors avoid depositing money and the overall demand falls.

Past Due

The recession can also lead to high unemployment rates and overall political instability.

This could be seen in the case of Greece, where the default and eventual economic crisis led to high unemployment and poverty rates. 

Even when it was bailed out by the IMF, due to the restrictions placed by the IMF, it saw taxes rise and wages decline, which were heavily protested by the public.

Implicit sovereign default

A government can repay its full loan in nominal terms, but in real terms, the repayment is practically a default because the currency loses most of its value.

Such a situation can arise when a country borrows money in its currency. Then it can create and print more of its currency to repay the dues. This is also known as the printing press technique. 

When faced with extreme debt, governments in the past have devalued their currency by printing more money to apply toward their obligations. 

Multiple notes

In addition, the government's central bank buys or retains freshly issued government debt in exchange for newly created money that the government can spend. This is referred to as monetizing debt.

Even if the loan is repaid, such tactics result in an implied default on the national debt because the currency being refunded loses most of its purchasing power. 

Like a formal default, however, such a tactic too can damage the country's reputation, resulting in restrictions in accessing capital markets in the future or excessive interest rates.

Debt repayment

There are two theories as to how countries can be made to repay their debt. 

  • In the reputation approach, countries that default on debts will have a poor reputation and thus will automatically be punished as their access to the capital markets will be limited. 
  • The punishment approach is when creditors may use legal or military threats to get a country to repay its debts. 

Debt restructuring

Debt restructuring

The International Monetary Fund (IMF) often lends money to restructure sovereign debt if a country has a huge debt burden and seems to be defaulting. 

To ensure that there will be enough funds to pay off future debts, the IMD lends based on conditions like reducing corruption, privatizing public sector enterprises, imposing austerity measures, and increasing tax revenues.

An example of this sort of restructuring can be the Greek bailout. Where along with the Eurogroup and the European central bank offered to help Greece out of the crisis on conditions like decreasing expenditure, raising taxes, etc. 

Investing during sovereign defaults

Investing during sovereign defaults can be extremely risky as markets are often volatile, and even the most secured debts can become unreliable as defaults can be likely. Thus it is often wise to hedge against such financial crises through various ways to mitigate the risk.

Risk

Credit Default Swaps (CDS)

A credit default swap is a derivative that allows investors to offset their risk in sovereign debt with another investor. For example, investors can buy a CDS from another investor if they fear a government default and make regular payments in the form of premiums. 

If there is a default by the debtor, the seller of the CDS reimburses the lender in full for the amount defaulted. Thus an investor can be insured against debt defaults while earning more by issuing the CDS and getting regular payments.

FAQs

Key Takeaways

  • Sovereign debt is a failure or refusal of a government to pay back its debt when it is due.
  • The leading causes of default are political instability, insolvency, illiquidity, etc., which causes a cash crunch for the government due to which they cannot pay back loans.
  • Defaults result in losses for lenders, poor credit ratings and a bad reputation for the governments, and overall economic hardship for the ordinary citizen
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Researched and authored by Soumil De | LinkedIn

Reviewed & Edited by Ankit Sinha | LinkedIn

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