You've heard it before: someone runs into credit card or mortgage payment problems and needs to work out a payment plan to avoid going bankrupt. What does an entire country do when it runs into a similar debt problem? For a number of emerging economies issuing sovereign debt is the only way to raise funds, but things can go sour quickly. How do countries deal with their debt while striving to grow?
Most countries – from those developing their economies to the world's richest nations – issue debt in order to finance their growth. This is similar to how a business will take out a loan to finance a new project, or how a family might take out a loan to buy a home. The big difference is size; sovereign debt loans will likely cover billions of dollars while personal or business loans can at time be fairly small.
Sovereign debt is a promise by a government to pay those who lend it money. It is the value of bonds issued by that country's government. The big difference between government debt and sovereign debt is that government debt is issued in the domestic currency, while sovereign debt is issued in a foreign currency. The loan is guaranteed by the country of issue.
Before buying a government's sovereign debt, investors determine the risk of the investment. The debt of some countries, such as the United States, is generally considered risk free, while the debt of emerging or developing countries carries greater risk. Investors have to consider the government's stability, how the government plans to repay the debt, and the possibility of the country going into default. In some ways, this risk analysis is similar to that performed with corporate debt, though with sovereign debt investors can sometimes be left significantly more exposed. Because the economic and political risks for sovereign debt outweigh debt from developed countries, the debt is often be given a rating below the safe AAA and AA status, and may be considered below investment grade.
Debt Issued in Foreign Currencies
Investors prefer investments in currencies they know and trust, such as the U.S. dollar and pound sterling. This is why the governments of developed economies are able to issue bonds denominated in their own currencies. The currencies of developing countries tend to have a shorter track record and might not be as stable, meaning that there will be far less demand for debt denominated in their currencies.
Risk and Reputation
Developing countries can be at a disadvantage when it comes to borrowing funds. Like investors with poor credit, developing countries must pay higher interest rates and issue debt in foreign stronger currencies to offset the additional risk assumed by the investor. Most countries, however, don't run into repayment problems. Problems can arise when inexperienced governments overvalue the projects to be funded by the debt, overestimate the revenue that will be generated by economic growth, structure their debt in such a way as to make payment only feasible in the best of economic circumstances, or if exchange rates make payment in the denominated currency too difficult.
What makes a country issuing sovereign debt want to pay back its loans in the first place? After all, if it can get investors to pour money into its economy, aren't they taking on the risk? Emerging economies want to repay the debt because it creates a solid reputation that investors can use when evaluating future investment opportunities. Just as teenagers have to build solid credit in order to establish creditworthiness, countries issuing sovereign debt want to repay their debt so that investors can see that they are able to pay off any subsequent loans.
The Impact of Defaulting
Defaulting on sovereign debt can be more complicated than defaults on corporate debt because domestic assets cannot be seized to pay back funds. Rather, the terms of the debt will renegotiated, often leaving the lender in an unfavorable situation, if not an entire loss. The impact of the default can thus be significantly more far-reaching, both in terms of its impact on international markets and of its effect on the country's population. A government in default can easily become a government in chaos, which can be disastrous for other types of investment in the issuing country.
The Causes of Debt Default
Essentially, default will occur when a country's debt obligations surpass its capacity to pay. There are several circumstances in which this can happen:
- During a currency crisis
The domestic currency loses its convertibility due to rapid changes in the exchange rate. It becomes too expensive to convert the domestic currency to the currency in which the debt is issued.
- Changing economic climate
If the country relies heavily on exports, especially in commodities, a significant reduction in foreign demand can shrink GDP and make repayment costly. If a country issues short-term sovereign debt, it is more vulnerable to fluctuations in market sentiment.
- Domestic politics
Default risk is often associated with unstable government structure. A new party that seizes power may be reluctant to satisfy the debt obligations accumulated by the previous leaders.
Debt Default Examples
There have been several prominent cases in which emerging economies got in over their heads when it came to their debt.
- North Korea (1987)
Post-war North Korea required massive investment in order to jump start economic development. In 1980 it defaulted on most of its newly-restructured foreign debt, and owed nearly $3 billion by 1987. Industrial mismanagement and significant military spending led to a decline in GNP and ability to repay outstanding loans.
- Russia (1998)
A large portion of Russian exports came from the sale of commodities, leaving it susceptible to price fluctuations. Russia's default sent a negative sentiment throughout international markets as many became shocked that an international power can default. This catastrophic event resulted in the well documented collapse of long-term capital management.
- Argentina (2002)
Argentina's economy experienced hyperinflation after it began to grow in the early 1980s, but managed to keep things on an even keel by pegging its currency to the U.S. dollar. A recession in the late 1990s pushed the government to default on its debt in 2002, with foreign investors subsequently ceasing to put more money into the Argentine economy.
Investing in Debt
Global capital markets have become increasingly integrated in recent decades, allowing emerging economies access to a more diverse pool of investors using different debt instruments. This gives emerging economies more flexibility, but also adds uncertainty since debt is spread over so many parties. Each party can have a different goal and tolerance for risk, which makes deciding the best course of action in the face of default a complicated task.
Investors purchasing sovereign debt have to be firm yet flexible. If they push too hard on repayment, they might accelerate the economy's collapse; if they don't press hard enough, they might send a signal to other debtor nations that lenders will cave under pressure. If restructuring is required, the goal of the restructure should be to preserve the asset value held by the creditor while helping the issuing country return to economic viability.
- Incentives to repay
Countries with unsustainable levels of debt should be given the option of approaching creditors to discuss repayment options without being taken to task. This creates transparency and gives a clear signal that the country wants to continue loan payments.
- Providing restructuring alternatives
Before moving to debt restructuring, indebted nations should examine their economic policies to see what sorts of adjustments can be made to allow them to resume loan payments. This can be difficult, if the government is headstrong, since being told what to do can push them over the edge.
- Lending prudently
While investors might be on the lookout for diversification into a new country, that doesn't mean that flooding cash into international securities will always have a positive result. Transparency and corruption are important factors to examine before pouring money into expensive endeavors.
- Debt forgiveness
Due to the moral hazard associated with letting debtor countries off the hook, creditors consider wiping a country's debt clean to be the absolute last thing that they want. However, countries saddled with debt, especially if that debt is owed to an organization such as the World Bank, can seek to have their debt forgiven if it will create economic and political stability. A failed state can have a negative effect on surrounding countries.
The existence of international financial markets makes funding economic growth a possibility for emerging economies, but it can also make debt repayment troublesome by making collective agreements between creditors more complex. With no strict mechanism in place to make the resolution of problems streamlined, it is important for both the sovereign debt issuer and investors to come to a mutual understanding – that everyone is better off coming to an agreement instead of letting the debt go into default.