Sovereign default

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A sovereign default is the failure or refusal of the government of a sovereign state to pay back its debt in full when due. Cessation of due payments (or receivables) may either be accompanied by that government's formal declaration that it will not pay (or only partially pay) its debts (repudiation), or it may be unannounced. A credit rating agency will take into account in its gradings capital, interest, extraneous and procedural defaults, and failures to abide by the terms of bonds or other debt instruments.

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Countries have at times escaped some of the real burden of their debt through inflation. This is not "default" in the usual sense because the debt is honored, albeit with currency of lesser real value. Sometimes governments devalue their currency. This can be done by printing more money to apply toward their own debts, or by ending or altering the convertibility of their currencies into precious metals or foreign currency at fixed rates. Harder to quantify than an interest or capital default, this often is defined as an extraneous or procedural default (breach) of terms of the contracts or other instruments.

If potential lenders or bond purchasers begin to suspect that a government may fail to pay back its debt, they may demand a high interest rate in compensation for the risk of default. A dramatic rise in the interest rate faced by a government due to fear that it will fail to honor its debt is sometimes called a sovereign debt crisis. Governments may be especially vulnerable to a sovereign debt crisis when they rely on financing through short-term bonds, since this creates a maturity mismatch between their short-term bond financing and the long-term asset value of their tax base.

They may also be vulnerable to a sovereign debt crisis due to currency mismatch: if few bonds in their own currency are accepted abroad, and so the country issues mainly foreign currency-denominated bonds, a decrease in the value of their own currency can make it prohibitively expensive to pay back those bonds (see original sin). [1]

Since a sovereign government, by definition, controls its own affairs, it cannot be obliged to pay back its debt. [2] Nonetheless, governments may face severe pressure from lending countries. In a few extreme cases, a major creditor nation, before the establishment of the UN Charter Article 2 (4) prohibiting use of force by states, made threats of war or waged war against a debtor nation for failing to pay back debt to seize assets to enforce its creditor's rights. For example, in 1882, the United Kingdom invaded Egypt. Other examples are the United States' "gunboat diplomacy" in Venezuela in the mid-1890s and the United States occupation of Haiti beginning in 1915. [3] Today, a government that defaults may be widely excluded from further credit; some of its overseas assets may be seized; [3] and it may face political pressure from its own domestic bondholders to pay back its debt. Therefore, governments rarely default on the entire value of their debt. Instead, they often enter into negotiations with their bondholders to agree on a delay (debt restructuring) or partial reduction of their debt (a 'haircut or write-off'). Some economists have argued that, in the case of acute insolvency crises, it can be advisable for regulators and supranational lenders to preemptively engineer the orderly restructuring of a nation's public debt – also called "orderly default" or "controlled default". [4] [5] In the case of Greece, these economists generally believe that a delay in organising an orderly default would hurt the rest of Europe even more. [6]

The International Monetary Fund often lends for sovereign debt restructuring. To ensure that funds will be available to pay the remaining part of the sovereign debt, it has made such loans conditional on action such as reducing corruption, imposing austerity measures such as reducing non-profitable public sector services, raising the tax take (revenue) or more rarely suggesting other forms of revenue raising such as nationalization of inept or corrupt but lucrative economic sectors. A recent example is the Greek bailout agreement of May 2010. After the 2008 financial crisis, in order to avoid a sovereign default, Spain and Portugal, among other countries, turned their trade and current account deficits into surpluses. [7]

Causes

According to financial historian Edward Chancellor, past instances of sovereign default have tended to occur under some or all of the following circumstances: [8]

A significant factor in sovereign default is the presence of significant debts owed to foreign investors such as banks who are unable to obtain timely payment via political support from governments, supranational courts or negotiation; the enforcement of creditors' rights against sovereign states is frequently difficult. Such willful defaults (the equivalent of strategic bankruptcy by a company or strategic default by a mortgager, except without the possibility of the exercise of normal creditors' rights such as asset seizure and sale) can be considered a variety of sovereign theft; this is similar to expropriation (including inadequate repayment for the exercise of eminent domain). [9] [10] Some[ who? ] also believe that sovereign default is a dark side of globalization and capitalism. [11]

Insolvency/over-indebtedness of the state

If a state, for economic reasons, defaults on its treasury obligations, or is no longer able or willing to handle its debt, liabilities, or to pay the interest on this debt, it faces sovereign default. To declare insolvency, it is sufficient if the state is only able (or willing [9] ) to pay part of its due interest or to clear off only part of the debt.

Reasons for this include:[ citation needed ]

Sovereign default caused by insolvency historically has always appeared at the end of long years or decades of budget emergency (overspending [12] ), in which the state has spent more money than it received. This budget balance/margin was covered through new indebtedness with national and foreign citizens, banks and states.

Illiquidity

There is an important distinction between illiquidity and insolvency.[ citation needed ] If a country is temporarily unable to meet pending interest or principle payments because it can not liquify sufficient assets, it is "in default because of illiquidity". In this concept the default can be solved as soon as the assets that are "only temporarily illiquid" become liquid (again), which makes illiquidity a temporary state – in contrast to insolvency. The weakness of this concept is that is practically impossible to prove that an asset is only temporarily illiquid.

Change of government

While normally the change of government does not change the responsibility of the state to handle treasury obligations created by earlier governments, nevertheless it can be observed that in revolutionary situations and after a regime change the new government may question the legitimacy of the earlier one, and thus default on those treasury obligations considered odious debt.

Important examples are:

Demise of the state

With the demise of a state, its obligations are turned over to one or several successor states. For example, when the Soviet Union dissolved, successor states such as Estonia, Russia, Georgia, Ukraine, etc. came into being. The Soviet state ceased to exist, but its debt could be inherited by successor states. [14]

Lost wars significantly accelerate sovereign default. Nevertheless, especially after World War II the government debt has increased significantly in many countries even during long lasting times of peace. While in the beginning debt was quite small, due to compound interest and continued overspending, [12] it has increased substantially.

Approaches to debt repayment

There are two different theories as to why sovereign countries repay their debt.

Reputation approach

The reputation approach stipulates that countries value the access to international capital markets because it allows them to smooth consumption in the face of volatile output and/or fluctuating investment opportunities. This approach assumes no outside factors such as legal or military action because the debtor is a sovereign country. Debtor countries with poor reputations will lack access to these capital markets. [15]

Punishment approach

The punishment approach stipulates that the debtor will be punished in some form, whether it be by legal action and/or military force. The creditor will use legal and/or military threats to see their investment returned. The punishment may prevent debtors from being able to borrow in their own currency. [15]

Consequences

Creditors of the state as well the economy and the citizens of the state are affected by the sovereign default.

Consequences for creditors

The immediate cost to creditors is the loss of principal and interest owed on their loans to the defaulting country.

In this case very often there are international negotiations that end in a partial debt cancellation (London Agreement on German External Debts 1953) or debt restructuring (e.g. Brady Bonds in the 1980s). This kind of agreement assures the partial repayment when a renunciation / surrender of a big part of the debt is accepted by the creditor. In the case of the Argentine economic crisis (1999–2002) some creditors elected to accept the renunciation (loss, or "haircut") of up to 75% of the outstanding debts, while others ( "holdouts") elected instead to await a change of government (2015) for offers of better compensation.

For the purpose of debts regulation debts can be distinguished by nationality of creditor (national or international), or by the currency of the debts (own currency or foreign currency) as well as whether the foreign creditors are private or state owned. States are frequently more willing to cancel debts owed to foreign private creditors, unless those creditors have means of retaliation against the state. [9]

Consequences for the state

When a state defaults on a debt, the state disposes of (or ignores, depending on the viewpoint) its financial obligations/debts towards certain creditors.[ citation needed ] The immediate effect for the state is a reduction in its total debt and a reduction in payments on the interest of that debt.[ citation needed ][ dubious – discuss ] On the other hand, a default can damage the reputation of the state among creditors, which can restrict the ability of the state to obtain credit from the capital market. [9] In some cases foreign lenders may attempt to undermine the monetary sovereignty of the debtor state or even declare war (see above).

Consequences for the citizens

If the individual citizen or corporate citizen is a creditor of the state (e.g. government bonds), then a default by the state can mean a devaluation of their monetary wealth.

In addition, the following scenarios can occur in a debtor state from a sovereign default:

Citizens of a debtor state might feel the impact indirectly through high unemployment and the decrease of state services and benefits. However, a monetarily sovereign state can take steps to minimize negative consequences, rebalance the economy and foster social/economic progress, for example Brazil's Plano Real. [16]

Examples of sovereign default

A failure of a nation to meet bond repayments has been seen on many occasions. Medieval England lived through multiple defaults on debt, [17] Philip II of Spain defaulted on debt four times – in 1557, 1560, 1575 and 1596. This sovereign default threw the German banking houses into chaos and ended the reign of the Fuggers as Spanish financiers. Genoese bankers provided the unwieldy Habsburg system with fluid credit and a dependably regular income. In return the less dependable shipments of American silver were rapidly transferred from Seville to Genoa, to provide capital for further military ventures.

In the 1820s, several Latin American countries that had recently entered the bond market in London defaulted. These same countries frequently defaulted during the nineteenth century, but the situation was typically rapidly resolved with a renegotiation of loans, including the writing off of some debts. [18]

A failure to meet payments became common again in the late 1920s and 1930s. As protectionism by wealthy nations rose and international trade fell, especially after the banking crisis of 1929, countries possessing debts denominated in other currencies found it increasingly difficult to meet terms agreed under more favourable economic conditions. For example, in 1932, Chile's scheduled repayments exceeded the nation's total exports; or, at least, its exports under then-current pricing. Whether reductions in prices – forced sales – would have enabled fulfilling creditors' rights is unknown. [18]

A number of states in the U.S. defaulted in the mid-19th century. [19] The most recent U.S. state to default was Puerto Rico, which defaulted in 2017. [20]

More recently Greece became the first developed country to default to the International Monetary Fund. In June 2015 Greece defaulted on a $1.7 billion payment to the IMF. [21]

See also

Related Research Articles

Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the debtor.

In finance, default is failure to meet the legal obligations of a loan, for example when a home buyer fails to make a mortgage payment, or when a corporation or government fails to pay a bond which has reached maturity. A national or sovereign default is the failure or refusal of a government to repay its national debt.

<span class="mw-page-title-main">Debt</span> Obligation to pay borrowed money

Debt is an obligation that requires one party, the debtor, to pay money borrowed or otherwise withheld from another party, the creditor. Debt may be owed by sovereign state or country, local government, company, or an individual. Commercial debt is generally subject to contractual terms regarding the amount and timing of repayments of principal and interest. Loans, bonds, notes, and mortgages are all types of debt. In financial accounting, debt is a type of financial transaction, as distinct from equity.

Credit risk is the possibility of losing a lender holds due to a risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial. In an efficient market, higher levels of credit risk will be associated with higher borrowing costs. Because of this, measures of borrowing costs such as yield spreads can be used to infer credit risk levels based on assessments by market participants.

<span class="mw-page-title-main">Fractional-reserve banking</span> System of banking

Fractional-reserve banking is the system of banking in all countries worldwide, under which banks that take deposits from the public keep only part of their deposit liabilities in liquid assets as a reserve, typically lending the remainder to borrowers. Bank reserves are held as cash in the bank or as balances in the bank's account at the central bank. Fractional-reserve banking differs from the hypothetical alternative model, full-reserve banking, in which banks would keep all depositor funds on hand as reserves.

<span class="mw-page-title-main">Holdout problem</span> Economic issue of securities

In finance, a holdout problem occurs when a bond issuer is in default or nears default, and launches an exchange offer in an attempt to restructure debt held by existing bond holders. Such exchange offers typically require the consent of holders of some minimum portion of the total outstanding debt, often in excess of 90%, because, unless the terms of the bond provide otherwise, non-consenting bondholders will retain their legal right to demand repayment of their bonds at par. Bondholders who withhold their consent and retain their right to seek the full repayment of original bonds, may disrupt the restructuring process, creating a situation known as the holdout problem.

A creditor or lender is a party that has a claim on the services of a second party. It is a person or institution to whom money is owed. The first party, in general, has provided some property or service to the second party under the assumption that the second party will return an equivalent property and service. The second party is frequently called a debtor or borrower. The first party is called the creditor, which is the lender of property, service, or money.

<span class="mw-page-title-main">Government debt</span> Total amount of debt owed to lenders by a government/state

A country's gross government debt is the financial liabilities of the government sector. Changes in government debt over time reflect primarily borrowing due to past government deficits. A deficit occurs when a government's expenditures exceed revenues. Government debt may be owed to domestic residents, as well as to foreign residents. If owed to foreign residents, that quantity is included in the country's external debt.

<span class="mw-page-title-main">Brady Bonds</span>

Brady bonds are dollar-denominated bonds, issued mostly by Latin American countries in the late 1980s. The bonds were named after U.S. Treasury Secretary Nicholas Brady, who proposed a novel debt-reduction agreement for developing countries.

<span class="mw-page-title-main">Insolvency</span> State of being unable to pay ones debts

In accounting, insolvency is the state of being unable to pay the debts, by a person or company (debtor), at maturity; those in a state of insolvency are said to be insolvent. There are two forms: cash-flow insolvency and balance-sheet insolvency.

In finance, unsecured debt refers to any type of debt or general obligation that is not protected by a guarantor, or collateralized by a lien on specific assets of the borrower in the case of a bankruptcy or liquidation or failure to meet the terms for repayment. Unsecured debts are sometimes called signature debt or personal loans. These differ from secured debt such as a mortgage, which is backed by a piece of real estate.

A currency crisis is a type of financial crisis, and is often associated with a real economic crisis. A currency crisis raises the probability of a banking crisis or a default crisis. During a currency crisis the value of foreign denominated debt will rise drastically relative to the declining value of the home currency. Generally doubt exists as to whether a country's central bank has sufficient foreign exchange reserves to maintain the country's fixed exchange rate, if it has any.

<span class="mw-page-title-main">Vulture fund</span> Fund that invests in distressed assets

A vulture fund is a hedge fund, private-equity fund or distressed debt fund, that invests in debt considered to be very weak or in default, known as distressed securities. Investors in the fund profit by buying debt at a discounted price on a secondary market and then using numerous methods to subsequently sell the debt for a larger amount than the purchasing price. Debtors include companies, countries, and individuals.

<span class="mw-page-title-main">Argentine debt restructuring</span> Process following Argentinas Great Depression

The Argentine debt restructuring is a process of debt restructuring by Argentina that began on January 14, 2005, and allowed it to resume payment on 76% of the US$82 billion in sovereign bonds that defaulted in 2001 at the depth of the worst economic crisis in the nation's history. A second debt restructuring in 2010 brought the percentage of bonds under some form of repayment to 93%, though ongoing disputes with holdouts remained. Bondholders who participated in the restructuring settled for repayments of around 30% of face value and deferred payment terms, as well as warrants that paid investors based on annual economic growth as part of the same offer, and began to be paid punctually; the value of their nearly worthless bonds also began to rise. The remaining 7% of bondholders were later repaid 25% less than they were demanding, after centre-right and US-aligned leader Mauricio Macri came to power in 2015.

A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults. Financial crises directly result in a loss of paper wealth but do not necessarily result in significant changes in the real economy.

Global debt refers to the total amount of money owed by all sectors, including governments, businesses, and households worldwide.

In finance, an asset–liability mismatch occurs when the financial terms of an institution's assets and liabilities do not correspond. Several types of mismatches are possible. An asset-liability mismatch presents a material risk at institutions with significant debt exposure, such as banks or sovereign governments. A significant mismatch may lead to insolvency or illiquidity, which can cause financial failure. Such risks were among the principal causes of economic crises such as the 1980s Latin American Debt Crisis, the 2007 Subprime Mortgage Crisis, the U.S. Savings and Loan Crisis, and the collapse of Silicon Valley Bank in 2023.

<span class="mw-page-title-main">Debt crisis</span> Situation in which a government cannot pay back its debt

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<span class="mw-page-title-main">Causes of the European debt crisis</span>

The European debt crisis is an ongoing financial crisis that has made it difficult or impossible for some countries in the euro area to repay or re-finance their government debt without the assistance of third parties.

References

Citations

  1. ↑ Eichengreen, B.; Hausmann, R. (2005). Other People's Money: Debt Denomination and Financial Instability in Emerging Economies. Chicago: Univ. of Chicago Press. ISBN   0-226-19455-8.
  2. ↑ Borensztein, E.; Panizza, U. (Nov 10, 2010). "The Costs of Sovereign Default: Theory and Reality". VOXLACEA.
  3. 1 2 Reinhart, Carmen M.; Rogoff, Kenneth S. (2009). This time is different: Eight Centuries of Financial Folly (p. 54ff). Princeton University Press. ISBN   978-0-691-14216-6.
  4. ↑ Firzli, M. Nicolas J. (March 2010). "Greece and the Roots the EU Debt Crisis". The Vienna Review.
  5. ↑ Roubini, Nouriel (June 28, 2010). "Greece's best option is an orderly default". Financial Times.
  6. ↑ Louise Armitstead, "EU accused of 'head in sand' attitude to Greek debt crisis" The Telegraph, 23 June 2011
  7. ↑ Avetian, Samson (2019). Armenia Economy: The Next 25 Years. Yerevan: Antares. pp. 67–72. ISBN   978-9939-76-173-2.
  8. ↑ Reflections on the sovereign debt crisis, Edward Chancellor, GMO White Paper, Juli 2010.
  9. 1 2 3 4 Wright, Mark; Tomz, Mike (2010). "Sovereign Theft: Theory and Evidence about Sovereign Default and Expropriation". In Hogan, William; Sturzenegger, Federico (eds.). The Natural Resources Trap: Private Investment without Public Commitment. Cambridge, Massachusetts: MIT Press. pp. 69–110. Archived from the original (PDF) on 15 April 2012. Retrieved 6 November 2011.
  10. ↑ Hagerty, James R. (17 December 2009). "Is Walking Away From Your Mortgage Immoral?". The Wall Street Journal .
  11. ↑ "Sovereign Default: The dark side of globalization and capitalism". AllISayIs.com. August 2015.
  12. 1 2 Baqir, Reza (30 September 1999). Districts, spillovers, and government overspending (Report). Policy Research Working Paper Series. World Bank. No. 2192.
  13. ↑ Landon-Lane, J., Oosterlinck, K. (2006), "Hope springs eternal: French bondholders and the Soviet Repudiation (1915–1919)", Review of Finance, 10, 4, pp. 507–535.
  14. ↑ "26 years on, Russia set to repay all Soviet Union's foreign debt". The Straits Times. SPH Media Limited. 26 March 2017. Retrieved 8 March 2022.
  15. 1 2 Eaton, Jonathan; Gersovitz, Mark (1981). "Why sovereigns repay debts to external creditors and why it matters". The Review of Economic Studies. 48 (2): 289–309. doi:10.2307/2296886. JSTOR   2296886.
  16. ↑ Lim, Richard (2011-06-20). "Brazil's Battle Against Inflation". Soundsandcolours.com. Archived from the original on 2013-10-16. Retrieved 2013-10-14.
  17. ↑ Bell, Adrian R.; Brooks, Chris; Moore, Tony (12 June 2019). "England's history of defaulting on European lenders shows repercussions of not paying Brexit bill". The Conversation. Retrieved 2020-07-20.
  18. 1 2 Erika Jorgensen and Jeffrey Sachs, "Default and Renegotiation of Latin American Foreign Bonds in the Interwar Period" In: Barry J. Eichengreen and Peter H. Lindert, The International Debt Crisis in Historical Perspective
  19. ↑ Frum, David (2020-04-25). "Why Mitch McConnell Wants States to Go Bankrupt". The Atlantic. Retrieved 2020-05-02.
  20. ↑ Ergungor, O. Emre (2017-10-12). "Judge Approves Deal to Resolve Puerto Rico Bankruptcy".{{cite journal}}: Cite journal requires |journal= (help)
  21. ↑ Liakos, Virginia Harrison and Chris (2015-06-30). "Greece defaults on $1.7 billion IMF payment". CNNMoney. Retrieved 2017-04-26.
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