How Countries Deal With Debt

Though it typically only makes headlines when things go wrong, sovereign debt is usually a win-win proposition. The public borrowing lets governments spend more than they raise in revenue, a practice seldom out of fashion. It also offers creditors a yield backed by the government's power to levy taxes.

Too much of this sort of winning can be costly, however. Like households that pile up unsustainable credit card or mortgage debt, overindulging governments may end up needing a debt restructuring.

In such instances, the outcome is often a sovereign default. And while people who can't pay their debts may be sued and forced to give up assets to satisfy the resulting judgement, there is no international debt court to enforce such claims against insolvent sovereign debtors.

Often, the resulting standoff can take years to resolve, further weighing on the defaulting country's economy.

Understanding Sovereign Debt

Sovereign debt is the sum of outstanding bonds and loan obligations of a country's central government. Governments may issue debt to finance essential public investments, to meet the demand from institutional and individual investors for safe assets, or to prolong unsustainable overspending and enable graft. How well the borrowed money is spent has a lot to do with whether it will be repaid.

All debt issued by a country's government is sovereign debt, whether it is a dollar-denominated Senegalese Eurobond purchased by foreign investors or yen-denominated Japanese government bonds once favored by Japan's savers as a hedge against deflation.

The COVID-19 pandemic fueled a global borrowing surge in 2020 that increased sovereign debt by some 14 percentage points to about 102% of worldwide Gross Domestic Product (GDP), according to International Monetary Fund (IMF) data. The sharp rise in commodity prices following Russia's invasion of Ukraine and increasing interest rates amid elevated inflation threatened to further raise sovereign debt and its service costs in 2022, especially for developing countries.

How Sovereign Debt Affects Growth

Economists have long known that higher levels of sovereign debt correlate with slower long-term economic growth. Correlation is not causation, however, and often it is the slower rate of growth that causes sovereign debt to swell as tax collection shortfalls and higher spending on the social safety net expand budget deficits.

In the wake of the 2008 global financial crisis, advocates of public austerity cited research suggesting that a rise in sovereign debt above 90% of GDP marked a tipping point severely undermining the economy's prospects. The study was subsequently shown to have been flawed and its conclusions were challenged.

While higher debt can slow growth and slower growth may cause sovereign debt to rise, the level of debt at which it turns into a problem depends on a country's particulars, including sources of its debt financing and economic growth catalysts.

Japan's sovereign debt reached 257% of GDP in 2021, and its debt-to-GDP ratio has long been the world's highest amid persistent deflation. That mattered little while the country's central bank was buying half of all outstanding government bond debt under its quantitative easing program, at least until the sell-off in government bonds tied to yen depreciation in mid-2022. The long-term decline in Japanese government bond yields amid central bank buying and deflation caused losses for speculators betting on a drop in bond prices as a result of rising debt levels, earning the trade the "widow maker" nickname.

The Home Currency Advantage

Japan and the United States issue all of their debt in a currency they control, making a sovereign debt default especially unlikely. Aside from the economic might and institutional strength of the world's largest and third-largest economies, the Federal Reserve and Japan's central bank have an unlimited supply of U.S. dollars and Japanese yen respectively, which they can spend to buy the bonds issued by their governments.

In contrast, governments of the European Union's member countries borrow in a currency controlled by the European Central Bank (ECB). As a result, decisions on whether to support the prices of Italy's government bonds are made in Frankfurt, not Rome. Some economists point to the arrangement as the primary cause of the European sovereign debt crisis.

Developing countries often have to issue bonds in the currency (primarily U.S. dollars) that they don't manage in order to attract foreign buyers. That raises default risk since the borrower can't meet its obligations simply by issuing additional currency, and their Eurobonds are priced accordingly.

Sovereign debt defaults are far more complicated than corporate or personal bankruptcies, because assets not overseas cannot be seized, nor national economies restructured, through a legal process.

The stakes are higher as well, not only for a variety of private creditors and multilateral lenders with their own interests, but for the population of the defaulted nation as well. Talks on complicated international debt restructurings can take years, while the inability to access international debt markets can cause severe economic stress for developing economies dependent on such funding.

Lebanon's talks with creditors showed little progress more than two years after the country's 2020 debt default as the depressed economy continued to suffer.

Because the costs and risks of sovereign debt defaults are so high, they are usually the last resort for debtor countries. For example, Russia's default on foreign debt in June 2022 was the result of economic sanctions imposed for its invasion of Ukraine, which among other measures barred U.S. citizens from accepting Russian coupon payments made in U.S. dollars.

Wars like Russia's and banking crises like Lebanon's are among the leading causes of sovereign debt defaults, alongside public corruption.

The Bottom Line

Rising levels of sovereign debt around the globe have increased default risks and are likely to slow economic growth in the future. At the same time, they largely reflect pandemic relief spending that helped short-circuit a sharp slump with unpredictable long-term consequences. Slow growth and high debt go hand in hand in part because slow growth increases the likelihood of deficit spending.