Sovereign Debt

What is Sovereign Debt?

Sovereign debt is a central government's debt. It is debt issued by the national government in a foreign currency in order to finance the issuing country's growth and development. The stability of the issuing government can be provided by the country's sovereign credit ratings which help investors weigh risks when assessing sovereign debt investments.

Sovereign debt is also called government debt, public debt, and national debt.

Understanding Sovereign Debt

Sovereign debt can either be internal debt or external debt. If categorized as internal debt, it is debt owed to lenders who are within the country. If categorized as external debt, it is debt owed to lenders in foreign areas. Another way of classifying sovereign debt is by the duration until the repayment of the debt is due. Debt classified as short-term debt typically lasts for less than a year, while debt classified as long-term debt typically lasts for more than ten years.

How Sovereign Debt Works

Sovereign debt is usually created by borrowing government bonds and bills and issuing securities. Countries that are less creditworthy compared to others directly borrow from world organizations like The World Bank and other international financial institutions. An unfavorable change in exchange rates and an overly optimistic valuation of the payback from the projects financed by the debt can make it difficult for countries to repay sovereign debt. The only recourse for the lender, who cannot seize the government's assets, is to renegotiate the terms of the loan. Governments assess the risks involved in taking sovereign debts since countries that default on sovereign debts will have difficulty obtaining loans in the future.

Risks Involved in Sovereign Debt

Although sovereign debt will always involve default risk, lending money to a national government in the country's own currency is referred to as a risk-free investment because, with limits, the debt can be repaid by the borrowing government through raising taxes, reducing spending, or simply printing more money. Aside from issuing sovereign debt, governments can finance their projects by creating money. By doing so, governments are able to remove the need to pay for interest. However, this method only reduces government interest costs and can lead to hyperinflation. Thus, governments still need to fund their projects through the aid of other governments.

Measuring Sovereign Debt

Measuring sovereign debt is done differently per country. The measurement of sovereign debt depends on who is doing the measurement and why they are doing it. For example, a rating done by Standard & Poor's for businesses and investors only measures debt loaned by commercial creditors. This means that it does not include the money borrowed from other governments, the World Bank, and other international financial institutions. At the same time, the European Union (EU) has limits on the total amount a eurozone country is allowed to borrow. This means that the EU has broader restrictions when measuring sovereign debt. As such, the EU includes local government and state debt.

Example of Sovereign Debt

The ratings and performance of sovereign debt depends largely on the issuing country's economic and political systems. For example, Treasury bills issued by the United States government are considered a safe haven during times of turmoil in international markets. This has led to several foreign countries holding a significant portion of U.S. debt, most notably Japan and China. At the opposite end is sovereign debt issued by countries with profligate spending and debt-to-GDP ratio. Greece's debt crisis is an example of problems that can emerge in a nation's economy, if it is unable to service payments related to its debt.