Sovereign Default: Definition, Causes, Consequences, and Example

What Is Sovereign Default?

Sovereign default is the failure of a national government to repay its debt. Governments are typically hesitant to default, since doing so is likely to bar the country from accessing debt markets again for years, and to make borrowing more expensive, at least for a time, when it once again becomes possible.

Lenders have limited recourse in the event of a sovereign debt default because no international court can force a country to pay up, though they may pursue claims to the defaulted borrower's assets overseas.

Countries borrowing in their own currency can always print more of it as an alternative to a sovereign default, and may also be able to avoid it by raising more tax revenue.

Key Takeaways

  • Sovereign default is the failure by a country's government to pay its debt.
  • Sovereign default may slow economic growth and is likely to bar further government borrowing from overseas investors for years.
  • Wars and revolutions, mismanagement, and political corruption are among the leading causes of sovereign default.
  • Distressed sovereign borrowers often seek to negotiate a debt restructuring forcing their creditors to write off part of the debt in exchange for reduced debt service payments.

Sovereign Debt Overview

Understanding Sovereign Default

Private investors in the sovereign debt of foreign countries closely study the economy, public finances, and politics of a country issuing bonds to assess and price its default risk.

Other countries and multinational lenders like the International Monetary Fund (IMF) and the World Bank lend to sovereigns to accomplish policy goals ranging from improving the borrowing country's governance to promoting the lending country's exports, and may be in a position to insist they are repaid even if the borrower defaults on other debt.

Sovereign debt issued in the sovereign's currency may attract private foreign investors as well, but is often primarily purchased by the country's banks and private citizens. A default on a sovereign's obligations in its own currency is easier to avoid and can be more politically painful than a default on foreign debt.

Because sovereign default has a variety of costs and economic risks, it is usually undertaken as a last resort. Steep economic downturns, financial crises, and political upheavals can all precipitate a sovereign default. For example, Russia's default on its debt in June 2022 was the result of economic sanctions imposed on the country for its invasion of Ukraine, including the freezing of Russia's foreign currency reserves abroad.

Types of Sovereign Default

If a country briefly delays interest payments for a few of its bonds for technical reasons not indicative of its ability or willingness to repay debt, as the U.S. Treasury did once in the 1970s, it might have technically defaulted for a time. So long as the repayment snag is quickly ironed out, such a "default" is unlikely to have any long-term consequences, or to be widely viewed as one.

For example, the U.S. remains among the world's most highly rated sovereigns, though the credit rating agency Standard & Poor's downgraded its long-term rating for U.S. sovereign debt one notch to AA+ from AAA in 2011, during one of the U.S. government's periodic bouts of debt ceiling brinksmanship. Treasury debt still serves as the benchmark "risk-free rate" investors use to price the risk in other debt instruments as well as equities.

In contrast, a "contractual" default is the real deal, a willful failure to make debt payments.

To avoid this outright default, governments already widely seen as likely to take that step will sometimes negotiate a bonds exchange replacing their previously issued and often heavily discounted bonds with new ones of lower value.

In effect, the bondholders take a "haircut" on the funds already lent in exchange for the sovereign's pledge to continue making reduced debt payments. If lenders are convinced such an exchange is their least bad option, they may go along.

This is an implicit default, because the exchange can only happen if creditors seriously doubt the sovereign's willingness to honor its obligations on previously issued debt. During the European sovereign debt crisis, Greece offered several such settlements to bondholders with the support of its European partners.

Consequences of a Sovereign Default

For the defaulting government and its citizens the consequences of sovereign debt default will vary depending on such factors as the state of the economy and public finances, the degree of dependence on external financing, and the likelihood that creditors will return in the future.

Credit markets tend to be more welcoming and forgiving of large countries with exploitable natural resources like Russia than small low-income ones, which is why the latter often depend on the IMF and aid donors for credit. Meanwhile, Russia defaulted on its bond obligations in 1918 when Lenin's government repudiated the Tsarist empire's debt, and again on its ruble-denominated obligations in 1998, though it continued to make payments on its foreign debt after a short moratorium.

If a country depends heavily on foreign creditors to finance investment, the consequences of its sovereign default are likely to include slower economic growth, making things harder for consumers and businesses.

The sovereign debt default will also lower the net asset value of any bond mutual funds holding the defaulted debt as its market value plummets. Conversely, a sovereign default could spell opportunity for distressed debt investors who may buy the bonds at steep discounts to face value in the hopes they might be worth more later following a debt restructuring.

Sovereign debt defaults also create winners and losers in the market for credit default swaps, which are financial contracts that pay off like an insurance policy in the event of a default. Credit default swaps let bondholders hedge credit default risk. and allow speculators to bet a default will happen.

Real-World Example of Sovereign Default

Lebanon defaulted on foreign debt for the first time in its history in March 2020, as years of government corruption and wasteful borrowing culminated in a banking and financial crisis amid economic depression. Lebanon's Gross Domestic Product (GDP) shrank by 58% between 2019 and 2021, according to World Bank estimates.

The Lebanese economy continued to struggle in 2022 even as the country's government reached a preliminary agreement with the IMF on the economic governance reforms required to secure new IMF funding. Another requirement is that Lebanon negotiate a debt restructuring with private foreign creditors. Two years after the default, talks on such a deal had yielded no apparent progress as of mid-2022.

What Happens When a Sovereign Defaults?

When a sovereign defaults on debt economic growth is likely to slow or reverse, while the national currency could lose value against the U.S. dollar, spurring inflation in countries heavily reliant on imports.

The country would likely need to negotiate a debt restructuring with foreign creditors before it could borrow in debt markets again.

Why Does Sovereign Default Happen?

Sovereign default tends to follow severe political or economic problems including war, revolution, corruption and mismanagement, or a financial crisis.

What Is Sovereign Default Risk?

Sovereign default risk represents the likelihood that a particular sovereign will default on its debt. While most debt defaults involve foreign debt, sovereigns may also default on domestic debt denominated in the national currency.

Article Sources
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