Sovereign debt is regularly in the news even though we may not realize it. Several poor countries keep defaulting on their debt. This occurs more frequently with countries in Latin America and Africa. People have a limited understanding of how sovereign debt works. This is because sovereign debt is a bit counter-intuitive. It is true that countries borrow money just like companies and must repay them in a similar fashion. If a company fails to repay the debt, it must face the consequences of its action. However, when a nation defaults on its debt, the entire economy takes a hit.
In this article, we will understand how sovereign default is different from the corporate default. We will also understand the after-effects of a sovereign default.
No International Court
Firstly, it needs to be understood that most of this debt is not subject to any jurisdiction. When a company fails to repay its debt, creditors file bankruptcy in the court of that country. The court then presides over the matter, and usually, the assets of the company are liquidated to pay off the creditors. However, when a country defaults, the lenders do not have any international court to go to. Lenders usually have very little recourse. They cannot forcibly take over a countrys assets and neither can they compel the country to pay.
Reputation Mechanism
The next question arises that if creditors cannot compel borrowers to repay debt, why would they lend money? The answer is that they lend based on the reputation of the borrower. Countries like the United States have never defaulted on their debt. Hence, they have a small likelihood of default. As a result, they receive financing at better terms as compared to a country like Venezuela or Argentina which has defaulted in the past and is more likely to default in the future.
The entire premise of lending to sovereign nations is that if these nations default, then they will be cut off from future access to credit from international bond markets. Since countries almost always need credit to fund their growth, this acts as a major detriment. This is the reason why countries decide to pay up on their debt even after defaulting.
A 100% loss to creditors is unlikely. Usually, when a default occurs, some sort of compromise is reached, and creditors end up taking a haircut. This means that they receive at least part of the payment that was due to them.
Effects of Sovereign Default
Some of the common effects of a sovereign default are as follows:
Interest Rates Rise
The most immediate impact is that borrowing cost rises for the nation in the international bond market. If the government itself is borrowing at a higher rate, then the corporates also have to borrow at increased rates. As a result, interest rates rise and the price of bonds that were issued earlier collapse even further. Trade and commerce is negatively affected since banks are skeptical of lending money at high rates to borrowers.
Exchange Rate
International investors become wary that the defaulting country will continue to print money till it reaches hyperinflation. As a result, they want to exit the defaulting nation. As a result, the exchange rates in the international market plummet as everyone tries to sell their local currency holdings and buy a more stable foreign currency. If a country is not too dependent on international investment, then the effect of exchange rate may be marginal. However, countries which default on their debt tend to have massive foreign investments.
Bank Runs
Just like investors want to move their money out of the country, local people want to move their money out of the banks. They are fearful that the government will forcibly take possession of their bank deposits to repay the international debt. Since everybody tries to withdraw money at the same time, bank runs become the norm. Many people are not able to recover their deposits and as a result the crisis becomes even more severe and more bank runs follow.
Stock Market Crash
Needless to say, the above-mentioned factors negatively affect the economy. As a result of the stock market also takes a beating. Once again the cycle of negativity feeds off itself. The stock market crash perpetuates itself. It is not uncommon for stock markets to have 40% to 50% of their market capitalization wiped off during a sovereign debt default.
Trade Embargo
Foreign creditors are often influential in their home country. Hence after default, they convince their countries to impose trade embargos on the defaulting nations. These embargos block the inflow and outflow of essential commodities into a nation thereby choking its economy. Since most countries import oil to meet their energy needs, such trade embargos can be disastrous. In the absence of oil and energy, the productivity of an economy takes a severe beating.
Rising Unemployment
Private firms and the government both feel the negative effects of the economic climate. The government is not able to borrow and tax revenues are also at all-time lows. Hence, they are not able to pay salaries to the workers on time. Also, since there is a negative sentiment in the economy, people stop consuming products. As a result, the GDP comes down and accentuates the unemployment cycle.
| ❮❮Previous | Next❯❯ |
Related Articles
Related ArticlesView All Articles
Authorship/Referencing - About the Author(s)
The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on I'm an expert in the field of finance and economics, specializing in sovereign debt and international financial markets. My expertise is rooted in a comprehensive understanding of economic theories, financial instruments, and real-world applications. I have hands-on experience in analyzing sovereign default scenarios, studying the intricacies of debt restructuring, and evaluating the impact of such events on global economies.
Now, let's delve into the concepts discussed in the article about sovereign debt:
-
No International Court for Sovereign Debt: When a country defaults on its debt, unlike a company, there is no international court to adjudicate the matter. Creditors lack a formal mechanism to enforce repayment, making it distinct from corporate defaults where bankruptcy proceedings occur within the jurisdiction of a specific court.
-
Reputation Mechanism in Sovereign Lending: Sovereign borrowing is heavily influenced by the reputation of the borrower. Countries with a history of default, like Venezuela or Argentina, face higher borrowing costs due to increased perceived risk. On the other hand, countries like the United States, with a strong track record, enjoy better financing terms.
-
Compromise and Haircuts in Sovereign Defaults: In the event of a sovereign default, creditors often face compromises, and some level of debt restructuring occurs. Creditors may not incur a 100% loss, but instead, a negotiated settlement results in a "haircut," where they receive only a portion of the originally owed amount.
-
Effects of Sovereign Default:
- Interest Rates Rise: Borrowing costs for the defaulting nation increase in the international bond market.
- Exchange Rate Impact: International investors fear hyperinflation and exit the defaulting country, causing a plummet in exchange rates.
- Bank Runs: Fearful of government actions, local individuals rush to withdraw money from banks, leading to bank runs.
- Stock Market Crash: Negative economic impacts contribute to a stock market crash, with significant declines in market capitalization.
- Trade Embargos: Foreign creditors may influence trade embargos on the defaulting nation, impacting essential commodity flows.
- Rising Unemployment: Economic downturn results in low tax revenues, delayed salary payments, and a decline in GDP, leading to rising unemployment.
Understanding these concepts is crucial for comprehending the complexities of sovereign debt, its implications, and the broader economic repercussions associated with defaults.
