Sovereign Default

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21 Aug, 2024

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Sovereign default refers to the inability of a country's government to pay back the principal and interest of its foreign debt on time. It plays an important role in gauging the turbulent situations of a country, like political instability, a struggling economy, overspending, poor investments, or overleverage.

It may lead to high inflation and reduced government spending, resulting in many individuals and firms going bankrupt. The Coronavirus of 2020 resulted in large-scale sovereign defaults across nations globally. It leads to a slowdown in economic growth, leading to unending foreign debts taken by such countries facing sovereign defaults.

Sovereign Default Meaning

Sovereign default is the refusal of payment of foreign debt to foreign lenders by a country due to inflation, wars, or economic issues.
It started to be termed as sovereign debt when King Edward 3 of England defaulted in payments to its lenders to fund his 100 years of war with France.
Although there are many causes of default in payments, it happens mainly due to endogenous and exogenous factors, wars, economic turmoil, inflation, and pandemics like coronavirus.
It has many severe consequences on the creditors and defaulting nations, including - loss of principal amount and interest rate to the creditor and slowing down the economy.

Sovereign Default Explained

Sovereign default is the default on foreign debt by a country taking a loan from foreign institutions and foreign countries due to endogenous and exogenous factors. It concerns sovereign debts which have been owed by any nation's government or United Kingdom government-issued gold. Many countries that need to raise money to pay off their debt issue sovereign debt bonds. Many weaker nations with poor credit ratings are looking to borrow money from the World Bank, like institutions issuing sovereign debt.

To drive their nation's economic growth, governments enhance their sovereign debt. The money obtained from issuing sovereign debts is utilized in developing infrastructure projects. Sovereign bonds are issued for capital raising by a nation's government. The risky or weak nations denominate their sovereign bonds in terms of the most stable currencies. Exchange-traded funds (ETFs) are the simplest way to invest in foreign sovereign bonds.

Moreover, foreign debt taken by any sovereign nation happens to be of last resort due to its huge interest and costs of bearing and repaying the loan. Major causes for sovereign debts include wars, political instability, inflation, and economic turmoil.

The default also comes in two forms, namely:

#1 - Technically Default

It occurred due to some technicality of repayment, as happened with the United States in the 1970s, but was quickly solved without any consequences.

#2 - Contractual Default

It is the willing default made by the borrowing nations due to many factors like inflation. In such cases, the defaulting nation issues fresh bonds to the creditors in place of previous highly discounted bonds, as done recently in Greece during its European sovereign debt crisis. A similar thing happened in the Russian sovereign default and Sri Lanka sovereign default. In the total sovereign default list, 147 countries have already defaulted.

History

Edward 3 of England, the ruler for fifty years, started the great war of a hundred years. During the war, the treasury of King Edward was emptied. As a result, he decided to take loans from the banking families of Florence. These loans provided to him were of quite high interest. Nevertheless, King Edward never became the king of France and the loans he took never got paid. These loans were later termed sovereign debts or sovereign debt. And if any sovereign country defaults on its foreign debt like King Edward, they are referred to as sovereign defaults.

Causes

The causes of sovereign defaults can be categorized into–

#1 - Endogenous

Endogenous events can be categorized as the ones which led to defaults rather than the primary cause of economic downfall. It can be further divided into supply shocks and domestic aggregate demand. Research shows that almost one-third of endogenous factors, especially supply shocks, were responsible for global sovereign defaults. Endogenous crises, especially aggregate demand shocks, trigger defaults, leading to short-run contractions. On the other hand, aggregate supply shocks cause long-term losses.

#2 - Exogenous

Under this category, defaults happen due to external factors outside the country's domestic business cycle. Moreover, exogenous factors comprise:

Terms of trade shocks
Contagion
Legal events
Moratoria received from creditor nations
Political events

Almost two-thirds of defaults in sovereign were caused by exogenous factors. It is the most relevant of all causes of defaults. This is because defaults arising out of external trade shocks have severe and long-lasting effects, and political effects are less front-loaded than the other factors.

Other factors can be represented as:

Change in governments
Availability of less liquidity
Insolvency
Boom and bust
Interest rates increasing
Exchange rate Devaluation
Inflation
Pandemic like coronavirus
Excessive printing of money
Bad economic policy
Ascending debts of the government
Wars
Natural calamity

Examples

Let us discuss a few examples to understand the topic.

Example #1

In August 1997, Thailand underwent severe sovereign default. As a result, the Thai baht fell in value, leading to almost sixty-five percent of the Thai companies starting to face a liquidity crunch, and the remaining twenty-five percent became insolvent.

Example #2

Likewise, in the 1997-1998 period, Indonesia faced a severe liquidity crunch where almost eighty percent of their companies underwent liquidity crunch. Moreover, sixty-five percent of the firms became insolvent due to the maximum depreciation of the Indonesian currency – the rupiah. It happened because the majority of the Indonesian banks and firms had foreign debts as they were offered to them at lower interest.

As soon as the rupiah began depreciating, Indonesian firms and banks undertook hedging activities to keep their hedge positions open. As a consequence, inflation reached a record level of 50%, and corporate debt measured in rupiah rose disproportionately, leading to debt defaults on a mass scale. Therefore, the government had to close 16 banks that went insolvent.

Consequences

One hundred forty-seven nations have defaulted on debt payments since 1960. Then, the defaults lead to certain sovereign default consequences as listed below:

Creditors lose their principal amount given to the borrowing nation.
Defaulting nations have to restructure their debt in their favor from the creditors.
It slows down the economy.
Cut in government spending.
Foreign investors may shy away from investing.
A defaulting nation may not be able to get fresh money from foreign bond markets.
Downgrading of credit rating of a nation by foreign rating agencies.

Frequently Asked Questions (FAQs)

1. What are actions to avoid sovereign default?

The best way to avoid sovereign debts is to work on trade and current account deficits so as to make them into surplus. Nations might also conduct bond exchanges by changing old, heavily discounted bonds with newer bonds of lower value.

2. What happens if a country suffers from sovereign default?

The most direct result of a country suffering from sovereign default is the slowdown of a nation's economy. The slowdown may again trigger the government to increase its borrowing from foreign investors for a long time. It may also cause the nations to get lesser investments from foreign investors.

3. What happens if the U.S. goes into sovereign default?

Sovereign default is the inability or refusal to pay the foreign debt by a borrowing country on time to foreign creditors. It happens more often in those countries during economic turmoil, political crisis, liquidation, and insolvency. In this case, creditors lose their money. If the United States government defaults, it will increase the prices and inflation. The stock markets would be negatively impacted as a result of down gradation of the U.S. credit rating.