What Is Sovereign Debt and What Are Its Unique Features?

What is Sovereign Debt?

Sovereign debt is issued by a country's government to borrow money. Sovereign debt is also known as government debt, public debt, and national debt.

Governments borrow for a variety of reasons, from financing public investments to boosting employment. The level of sovereign debt and its interest rates will also reflect the saving preferences of a country's businesses and residents, as well as the demand from foreign investors.

Key Takeaways

  • Sovereign debt is debt issued by the government of an independent political entity, usually in the form of securities.
  • Sovereign debt presents some unique risks not present in other types of lending.
  • Several private agencies often rate the creditworthiness of sovereign borrowers and the securities they issue.
  • Countries with stable economies and political systems are typically viewed as better credit risks, allowing them to borrow on more favorable terms.

Sovereign Debt Varieties

Governments take on sovereign debt by issuing bonds, bills or other debt securities, or by taking out loans from other countries and multilateral organizations like the International Monetary Fund.

Sovereign debt may be owed to foreigners or to the country's own citizens, and can be denominated in the domestic currency as well as foreign ones.

Short-term U.S. government and foreign debt securities maturing within months are known as Treasury bills or simply bills, while a sovereign or private debt security with a duration measured in years is called a bond.

Unique Features of Sovereign Debt

Although lenders always take on default risk, sovereign borrowing has a number of distinct characteristics.

Notably, unlike private borrowers, governments can raise tax revenue, and most also issue their own currency. Less reassuringly, governments can also be overthrown by regimes that refuse to honor their debt obligations, or incur economic sanctions that may cause their debt to lose value.

In contrast with a private debtor, sovereign borrowers in default are rarely subject to legal enforcement, and creditors often find it difficult, though not impossible, to target the defaulted sovereign's assets.

In a default, the creditors' main leverage lies in the resulting loss of international capital markets access for the defaulting sovereign, and its likely need to negotiate a debt settlement to be able to borrow again. Some academic studies have found prior defaults have little or no effect on future lending terms, while one concluded that higher losses in sovereign debt restructurings were associated with more prolonged periods of market exclusion and higher borrowing costs.

Some sovereign debt securities have linked coupon payments to the rate of the issuing country's economic growth, though such GDP-linked bond issues are relatively rare.

Who Gets the Risk-Free Rate

By virtue of its status as the world's largest economy, the U.S. has long been seen as the world's safest credit risk. The country has never defaulted on its debt, and it remains the issuer of the world's reserve currency. The rate on the three-month U.S. Treasury bill has traditionally served as a benchmark "risk-free" interest rate.

The U.S. lost its traditional top spot in private agencies' sovereign credit ratings in 2011 when Standard and Poor's downgraded its credit from AAA to AA+ amid Congressional delay in raising the U.S. debt ceiling. Similar concerns resurfaced ahead of another debt ceiling increase in 2021. Fitch has maintained a negative outlook on its AAA rating for U.S. sovereign debt since July 2020.

Congress increased the U.S. debt ceiling in December 2021 by $2.5 trillion, enough to enable borrowing into 2023. As of December 2021, Standard and Poor's assigned AAA sovereign credit ratings to Australia, Canada, Denmark, Germany, Luxembourg, Netherlands, Norway, Singapore, Sweden, and Switzerland. The U.S. was rated AA+ alongside Austria, Finland, Hong Kong, and New Zealand.

The Limits of Sovereignty

Sovereign countries may choose to pool some sovereign powers as in a currency union, like the eurozone, wherein all members use a currency issued by a supranational authority. The shared currency can facilitate trade flows and economic integration.

Those benefits come at a cost, however, especially if different members of a currency union face varying economic circumstances. That was the situation faced by the eurozone in 2011-2013, when its economically weakest members were priced out of public debt markets, leaving them without the traditional policy tools of deficit spending and currency devaluation amid an economic downturn. The European sovereign debt crisis abated once European Union institutions including the European Central Bank guaranteed and restructured those member states' sovereign debt.

A Change of Prescriptions

Traditionally, advice for sovereigns facing a possible default included austerity policies aimed at controlling spending and economic liberalization initiatives promoting growth. Economists Carmen Reinhart and Kenneth Rogoff published research suggesting higher levels of sovereign debt were associated with slower economic growth.

Critics have challenged that study's data, and note public-sector austerity frequently leads to economic slumps.

The experiences of Japan since the 1980s and the U.S. more recently have also cast doubt on the debt-to-GDP ratio as a debt sustainability measure. In both instances, large increases in the ratio were not associated with meaningful increases in interest rates on sovereign debt.

Modern Monetary Theory (MMT) suggests a sovereign currency issuers' borrowing capacity is limited mainly by the rate of inflation it's willing to tolerate. In this model, taxes are raised to cool inflation rather than to offset government spending.

Article Sources
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