Sovereign Debt

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Blog Author :

WallStreetMojo Team

Edited by :

Ashish Kumar Srivastav

Reviewed by :

Dheeraj Vaidya, CFA, FRM

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Sovereign Debt Definition

Sovereign debt refers to the amount of money borrowed by a country’s central government. It is primarily achieved by selling government bonds and securities. Treasury notes, bonds and bills are some examples of sovereign debt issued by the United States.

Table of contents

Explanation

Whenever a country needs money to finance its growth initiatives, it can do so by two modes.

  1. By raising taxes
  2. By issuing government bonds

By raising taxes, the central government tends to burden the citizens of the country. Hence, it is usually considered better to issue debt rather than increasing taxes. Like any bond, sovereign bonds carry an interest for the borrowing duration while the principal amount is paid at maturity. They are believed to be virtually risk-free.

How does Sovereign Debt Work?

Sovereign debt is issued in two ways; one when raised domestically and the other by borrowing from international organisations like the World Bank. We will go through it one by one.

Sovereign Debt

#1 - Domestic Debt

To fund development initiatives of their nation, governments issue bonds which are purchased by the domestic lenders. Examples of domestic lenders are commercial banks and financial entities. The lenders are rewarded with interest.

#2 - International Debt

Most times, International lenders lend to the countries that cannot raise money domestically. In this case, the lenders could be a foreign government, private entities or financial bodies like the World Bank. In default, lenders renegotiate the payback terms, and such countries often face issues while raising debts in the future.

Greek Sovereign Debt Crisis

Greece is probably the first name that comes to the mind whenever we think of the sovereign debt crisis in Europe. Following the financial crisis of 2007-08, Greece owed more than 300 billion dollars to the European Union. After it admitted default, 320 billion Euros were loaned to Greece by the European authorities with the restructuring extending beyond 2060. This crisis threatened entire Europe and will continue to do so till the situation is resolved.

Sovereign Debt to GDP Ratio

  • An essential indicator of a country’s economic and political health is its debt-to-GDP ratio. The high debt-to-GDP ratio indicates a higher risk of default. According to a World Bank statistic, a debt-to-GDP ratio exceeding 77% is an indicator of a slowing economy.
  • Hong Kong, Brunei, Afghanistan, and Russia have a debt-to-GDP ratio of less than 15% while countries like Greece, Venezuela, and Italy have a debt-to-GDP ratio of more than 100%.
  • This isn’t always bad as more stable economies have a high tolerance for such occurrences. For example, the US has a high public debt-to-GDP ratio of 77%. But it doesn’t form a part of the US's sovereign debt as its economy is too strong to be affected by this.
  • Despite, countries must take a lesson from the Greek debt crisis and handle their debts with much care since it can send ripples worldwide.

Advantages

We are listing out some advantages of sovereign debts below.

  • Boosts Growth: Countries meet their deficit by borrowing, which is used to fund the country's developmental projects. In the absence of necessary funding, such initiatives cannot take shape which hampers a country’s development. With more growth comes more jobs.
  • Gives a Desirable Direction to Economy: Sometimes, nations need to decelerate the economy. The deceleration can be used as a tool to reduce the circulation of money in the economy. A simple way of achieving that is by issuing more bonds. As opposed to that, when the government intends to boost the economy, it works towards increasing the circulation of money.
  • Reduces Cost of Borrowing: Borrowing in foreign currency is cheaper at times which works to domestic governments' advantage.
  • Makes Local Bonds More Attractive: Listing local bonds on foreign indices attracts foreign investment which further helps a developing economy.

Disadvantages

The disadvantages of sovereign debts are as follows.

  • Not that risk-free: When countries suffer from high inflation, it raises the risk of default. As a way out, the nations resort to offering higher interests to lure investors. Higher interest results in increasing a country’s expenditure.
  • Devaluation of Currency: When a country defaults, the natural tendency is to lower the debt load, which is often achieved by devaluing the local currency. Currency Devaluation decreases a country’s purchasing power.
  • Crowding out Effect: Increased government borrowing and spending decrease the lending capacity of the private players. This further leads to reduced spending by businesses. When private-sector spending declines due to increased public sector spending, it is known as the crowding-out effect.

Limitations

The first limitation comes in the form of virtually risk-free nature of sovereign debt which is not always true. Second, these debts are not the only way of raising money to funds projects. It can also be done by increasing taxes and decreasing spending or by injecting more money into the system.

Key Takeaways

  • Sovereign debt refers to the amount of money borrowed by a country’s central government.
  • It is primarily achieved by selling government bonds and securities. Treasury notes, bonds and bills are some examples of sovereign debt issued by the United States.
  • A country raises finance either by raising taxes or by issuing government bonds.