Sovereign Default

What Is Sovereign Default?

Sovereign default is the failure by a government to repay its national debts. Countries are typically hesitant to default on their national debt since doing so will make borrowing funds in the future more difficult and more expensive. However, sovereign nations are not subject to normal bankruptcy laws and always have the power to escape responsibility for their debts, often without legal consequences.

Nations that maintain their own currency and whose debt is denominated in that currency will have the option to effectively default by inflating their currency and printing more money to cover the outstanding portion.

Key Takeaways

  • Sovereign default is the same as a default on debt by a private individual or business, but by a national government that fails to repay its interest or principal due.
  • Sovereign default may result in a government facing higher interest rates and a lower credit rating among lenders, making it more difficult to borrow in the future.
  • Sovereign debt is debt created when a country borrows money and creates bonds in a currency other than its own.
  • Sovereign debt is at higher risk for sovereign default because the government cannot inflate or print its way out of the debt.
  • Sovereigns that borrow in terms of their own currency may have the option of printing more money and "inflating" their way out of debt.

Sovereign Debt Overview

Understanding Sovereign Default

Investors in sovereign debt closely study the financial status and political temperament of sovereign borrowers in order to determine the risk of sovereign default. Sovereign defaults are relatively rare and are often precipitated by an economic crisis affecting the defaulting nation. Economic downturns, political upheaval, and excessive public spending and debt can all be warning signs that lead to sovereign default. 

If potential lenders or bond purchasers begin to suspect that a government may fail to pay back its debt, they will sometimes demand a higher interest rate as compensation for the risk of default. This creates what is sometimes referred to as a sovereign debt crisis, which sees a dramatic rise in the interest rate faced by a government due to fear that it will fail to honor its debt. Governments that rely on financing through short-term bonds may be especially vulnerable to a sovereign debt crisis since short-term bonds already face a difficult conflict of maturity mismatch between short-term bond financing and the long-term asset value of a country’s tax base.

In the event of a country’s default, or an increase in the risk of default, a country’s sovereign credit rating will likely suffer. Credit rating agencies will take into account the country’s interest expense, extraneous and procedural defaults, and its previous failures to abide by the terms of bonds or other debt instruments.

Perhaps the biggest concern about a sovereign default, however, is the impact on the broader economy. In the United States, for instance, the interest rates on many mortgages, car loans, and student loans are pegged to U.S. Treasury rates. If borrowers were to experience dramatically higher payments as the result of a U.S. debt default, the result would be substantially less disposable income to spend on goods and services, which could ultimately lead to a recession.

A number of countries have excellent records of paying on sovereign debt obligations and have never formally defaulted. These nations include Canada (although provinces have), Denmark (1813 state bankruptcy, however), Belgium, Finland (which actually paid its WWI debt to the U.S.), Mauritius, New Zealand, Norway, and Switzerland. The United States is famous for never having defaulted on its debt, except that it has. In 1862, the government defaulted on demand notes, in 1933 it defaulted on gold bonds. It also effectively defaulted in 1968 by refusing to redeem silver certificates and did so yet again in 1971 when it went off the gold standard.

Causes of Sovereign Default

Sovereign default is rare and often happens in response to an economic crisis in the defaulting country. Some of the precipitating factors for sovereign default can include an economic downtown, sustained political upheaval, and excessive government spending supported by unsustainable public debt. As bond purchasers and lenders watch developments like these, they may decide that the nation may fail to pay its debt The resulting debt crisis can cause interest rates to skyrocket, exacerbating the crisis. This is especially problematic for governments that rely on short-term borrowing. Eventually, the cycle of distrust and its impact ends when the government fails to service a particular debt.

Impact of Sovereign Default

The causes of sovereign default are actually very similar to the impact of sovereign default. Once some precipitating cause like political upheaval or a recession starts the process toward a default, the impact on the economy and the public begins. Lenders may impose austerity measures, often resulting in job losses and recession, while a rise in interest rates will make everyone's debt more expensive. And, while there may be more exports and tourism because reduced price of the potential defaulting country's currency, those who live in that currency will find that everything is more expensive, especially if it comes from offshore. Eventually, these impacts can combine to create a severe recession, leaving long-term impacts on the national economy of the defaulting nation.

Implicit Sovereign Default

There have been several government defaults over the past few decades, particularly by countries that borrow in a foreign currency. When such a default occurs, the government’s bond yields rise precipitously, creating a ripple effect throughout the domestic, and often the global, economy.

Inflation has sometimes helped countries escape the true burden of their debt. When a country issues its own currency and borrows money in that currency, it has the option of simply creating more currency to repay its debt. Most often, this is carried out through the operation of a government’s central bank, which buys and holds (or continuously rolls over) newly-issued government debt in return for newly created money that the government can then spend. This practice is known as monetizing the debt and is similar to the currently widespread monetary policy known as quantitative easing (QE). 

Other times, when faced with extreme debt, some governments have devalued their currency, which they do by printing more money to apply toward their own debts. In the past, this was also accomplished by ending or altering the convertibility of their currencies into precious metals or metal-backed foreign currency at fixed rates.

These practices represent an implicit default on sovereign debt in that they result in the government’s debt being nominally repaid in terms of money that has lost much of its purchasing power. Like a formal default, these practices may result in rising interest rates for the sovereign debt and reduced willingness by lenders to buy or hold that country’s debt.

Investing in Sovereign Defaults

Investing when a sovereign default is likely or inevitable can be terrifying. Markets are in turmoil and, sometimes, the most secure debt around is no longer reliable. Most investment professionals who survived the 2008 financial crisis have learned to plan for and hedge against financial catastrophes that were once unheard of. There are various ways to mitigate these risks. First, there are credit default swaps, financial derivatives that allow the lender to offset his or her sovereign debt risk with another investor. The investor fearing default then makes regular premium payments (similar to insurance premiums) to maintain the offset instrument. If you do not hold sovereign debt, but wish to profit from the possibility of a sovereign debt, you could be the other side of the credit default swap making income from the premium payments. Of course, by doing so, you assume the default risk that the debt-holder has now offset.

Real-World Example of Sovereign Default

Sovereign default has been around for a very long time. Medieval English defaulted several times, while Spain under Philip II defaulted four times in less than four decades. More recently, the Greek debt crisis in 2009 when the country announced that its actual budget deficit would more than four times the limit permitted by the European Union.

Further, since Greece had adopted the Euro a few years earlier, it could not use the classic printing press technique to inflate its way out of debt. At the time it did so, the EU and important lenders to Greece imposed austerity measures on the country; these measures imposed significant pain on the economy. The EU and the International Monetary Fund came to Greece's aid but also imposed more austerity measures, further dampening economic growth.

With a debt to GDP ratio of 160%, Greece went into a full-blown depression, eventually experiencing unemployment of nearly 28%, political chaos, and a moribund banking system.

Greece's problems spread with several other EU countries undergoing similar difficulties and also turned to the EU for assistance in servicing their debt. Germany led an unsuccessful fight to impose more austerity measures on each of the near-default nations. In the end, virtually the entire Eurozone was in a financial crisis by 2011.

Frequently Asked Questions

What Happens When a Sovereign Defaults?

When a government defaults on its debt, there can be a cascade of effects. First, and possibly worst, the sovereign's currency will be devalued, making it less acceptable to others, making imported goods more expensive, and in general hurting the economy of the defaulting country.

On the other hand, goods and services in the defaulting country become cheaper for visitors using other currencies which may lead to increases in exports and tourism. The defaulting government may restructure its remaining debt and may impose austerity measures including tax cuts and reductions in spending.

Finally, all this financial upheaval may lead to severe political upheaval, as well as in the financial markets of the defaulting country. Worst of all, the financial standing of the defaulting nation will be badly damaged and future debt will be very difficult to obtain.

Why Does Sovereign Default Happen?

Sovereign default happens, at its simplest, when a country fails to pay its debt. Why it fails to do so can be based on several factors. Sometimes, the country's economy suffers a catastrophic downturn leaving the government without tax income to service its debit.

Political upheaval in which the economy suffers and the government may change hands—and even its form entirely—can result in the government being unable or even unwilling to pay the previous government's debt. Financial bubbles or overinflated markets in a particular instrument or commodity, such as housing, can lead to a financial collapse that, in the end, leaves the government unable to service its debts.

Excessive spending and borrowing lead, in the end, to an unsustainable debt load for a country and it simply announces its inability to service its debt of misses a scheduled interest payment.

What Is Sovereign Default risk?

Sovereign debt default risk is the risk that a particular government will fail to either its sovereign or national debt. The national debt is denominated in the home currency, if there is one, while sovereign debt is denominated in another currency, usually that of the purchaser of the debt. The latter has a higher inherent risk of default since the borrower cannot use inflation or a printing press to reduce the debt.

What Happens if the U.S. Can't Pay Its Debt?

If the United States fails to pay its debt, there would likely be a global revaluation of the dollar, significantly reducing its value and thus increasing the cost of imported goods, including oil, for U.S. citizens. It is possible that the Treasury could amend the due dates of any payments, but this would complicate the market for U.S. debt and reduce confidence in it.

In the meantime, any bonds that should have been and weren't would likely disappear from the system which will assume they were paid. Small businesses would not only find goods more expensive but would also find that small business loans suddenly became much more expensive as U.S. debt was downgrading and interest rates went up.

Consumers would be affected by the same downgrade with higher credit card interest rates and tighter markets for credit in general. The stock market would likely be chaotic for several days, with losses in value that could be in the billions of dollars. Finally, those who depend upon payments from the Treasury, such as Social Security and disability income, make a daily living even more difficult for millions of Americans.

Despite a stellar record overall, the United States, as discussed above, has technically defaulted a few times throughout its history. In 1979, for instance, the Treasury temporarily missed interest payments on $122 million of debt because of a clerical error. Even if the government can pay its debts, legislators may not be willing to do so, as periodic clashes over the debt limit remind us.

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