Why and When Do Countries Default?

Though sovereign debt defaults are relatively infrequent, countries can and periodically do default on their sovereign debt. This happens when a country's government is either unable or unwilling to repay creditors. Argentina, Lebanon, and Ukraine are among the countries that have defaulted on their debt in recent years.

The causes of a default can range from high debt burden and economic stagnation to political instability or a banking crisis.

Determining what constitutes a default isn't a simple matter. A payment error can constitute a technical default without lasting consequence, while a debt restructuring inflicting steep losses on bondholders may make legal default unnecessary.

Key Takeaways

  • Sovereign default is a failure of a government to honor some or all of its debt obligations.
  • Common causes of sovereign defaults include economic stagnation, political instability, and financial mismanagement.
  • Determining when a default has occurred can be difficult; a debt restructuring that preempts one can still inflict losses on creditors.
  • Countries that default can often borrow again quickly, but defaults can inflict severe economic costs in the short run.

Factors Affecting Default Risk

Persistent economic stagnation undermines a country's ability to service its debt and leaves its economy more vulnerable to shocks such as a recession or a pandemic. It also erodes the confidence of foreign and domestic creditors, making it more difficult and costly to refinance debt,

According to Moody's, chronic stagnation was the primary cause of sovereign debt defaults by Russia and Ukraine in 1998, Argentina in 2001 and Venezuela in 2017.

High debt accumulated amid trade and budget deficits can also make the repayment burden unsustainable. Examples include Greece in 2012 and Lebanon in 2020.

Political instability and financial mismanagement have become increasingly frequent catalysts of sovereign default. They were the primary factor in defaults by Argentina in 2014 and 2019, Ukraine in 2015 and Ecuador in 2008 and 2020.

Recessions, banking or currency crises, and country breakups are all shocks that can increase default risk. Many defaults stem from a combination of misfortune and mismanagement.

The Eurozone currency union proved a major factor in the European debt crisis, because countries using the euro lacked the discretion to devalue their currency in response to mounting debt and the loss of international competitiveness.

Undemocratic and corrupt governments looting a country can eventually leave it without the means to service debt, leading to a default. Democracies, however, are not immune. Frequent leadership turnover and a presidential system of government as distinct from a parliamentary one have been associated with a higher incidence of sovereign debt defaults.

Why All Defaults Are Not Created Equal

In 1979, the U.S. Treasury briefly missed $122 million of interest and redemption payments to retail holders of government debt because of technical back office problems. The payments were made within weeks and the delay had no appreciable effect on U.S. status as a highly-rated sovereign borrower.

That's an example of what some classify as a technical default: a short-term payment snag with no long-term consequences. Technical default does not constitute default under the definition used by rating agencies or credit default swap contracts. Administrative errors like the one that tripped up the U.S. Treasury in 1979 and minor debt covenant violations fit the bill.

A contractual default, in contrast, would qualify as a default under ratings agency and credit default swap contract definitions. It presumes the failure to honor debt obligations beyond the 30-day maximum grace period found in bond contracts.

An alternative might be a debt restructuring that avoids a contractual default but still leaves bondholders with substantial losses on the debt principal held, amounting to a substantive default even if no technical default occurs.

One common restructuring tactic is for a distressed sovereign debtor to propose an exchange of old bonds for new ones of lower value it would be willing to service, while paying nothing to holdout creditors who reject the offer. While some holdout creditors have successfully argued in U.S. courts their contractual rights were violated, others have failed to make a similar case in different circumstances. Creditor participation in debt restructuring exchanges has averaged 95% since 1997.

The Consequences of Sovereign Default

Intuition suggests countries that default on sovereign debt might have trouble borrowing again and are likely to have to pay a higher interest rate if they get the chance. Empirical surveys, in contrast, have found that defaulting sovereigns tend to regain market access quickly and don't pay a penalty rate. Not everyone agrees that credit investors "forgive and forget." In particular, higher levels of loss appear to lead to longer periods of market exclusion and penalty rates when the exclusion ends.

A sovereign debt default can also impose wide and severe economic costs, lowering output for years after. It can also provide overdue relief for borrowers struggling to service unsustainable debt. The relief tends to come in the form of reduced debt service costs following a restructuring rather than a big reduction in the principal owed.

Article Sources

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  1. Moody's Investor Service. "Sovereign Debt Restructurings: Key Facts From History," Page 12. (Registration required.)

  2. Moody's Investor Service. "Sovereign Debt Restructurings: Key Facts From History," Page 13. (Registration required.)

  3. Moody's Investor Service. "Sovereign Debt Restructurings: Key Facts From History," pp 14-15. (Registration required.)

  4. International Monetary Fund. "IMF 2018 Sovereign Debt Conference - Chapter 7: Sovereign Default," Page 18.

  5. World Bank Blogs. "The Euro Crisis – What Role Did the Common Currency Play?"

  6. Federal Reserve Bank of Richmond. "The Politics of Sovereign Defaults," Page 293.

  7. Congressional Research Service. "Has the U.S. Government Ever 'Defaulted'?" pp. 12-19.

  8. International Monetary Fund. "IMF 2018 Sovereign Debt Conference - Chapter 7: Sovereign Default," pp. 3-4.

  9. International Monetary Fund. "IMF 2018 Sovereign Debt Conference - Chapter 7: Sovereign Default," Page 3.

  10. SSRN. "The Pari Passu Fallacy -- Requiescat in Pace," Page 1.

  11. Moody's Investor Service. "Sovereign Debt Restructurings: Key Facts From History," Page 20. (Registration required.)

  12. American Economic Association. "Sovereign Defaults: The Price of Haircuts," Page 85.

  13. Moody's Investor Service. "Sovereign Debt Restructurings: Key Facts From History," Page 16. (Registration required.)

  14. VoxEU. "The Aftermath of Sovereign Debt Crises."

  15. Moody's Investor Service. "Sovereign Debt Restructurings: Key Facts From History," Page 19. (Registration required.)

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