Sovereign Default

What Is Sovereign Default?

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

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

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 is sometimes referred to as a sovereign debt crisis, which is 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 create a situation 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. A credit rating agency will take into account the country’s interest expense, extraneous and procedural defaults, and 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, 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 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, Denmark, Belgium, Finland, Malaysia, Mauritius, New Zealand, Norway, Singapore, Switzerland, and England.

Implicit Sovereign Default

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

Inflation has sometimes helped countries to 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, they may result in rising interest rates for the sovereign and reduced willingness by lenders to buy or hold the country’s debt. 

Despite a stellar record overall, the United States 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.