What Happens When Countries Do Not Pay Back Their Debt?
Sovereign debt is regularly in the news even though we may not realize it. Several poor countries keep defaulting on their debt. This occurs more frequently with countries in Latin America and Africa. People have a limited understanding of how sovereign debt works. This is because sovereign debt is a bit counter-intuitive. It is true that countries borrow money just like companies and must repay them in a similar fashion. If a company fails to repay the debt, it must face the consequences of its action. However, when a nation defaults on its debt, the entire economy takes a hit.
In this article, we will understand how sovereign default is different from the corporate default. We will also understand the after-effects of a sovereign default.
No International Court
Firstly, it needs to be understood that most of this debt is not subject to any jurisdiction. When a company fails to repay its debt, creditors file bankruptcy in the court of that country. The court then presides over the matter, and usually, the assets of the company are liquidated to pay off the creditors. However, when a country defaults, the lenders do not have any international court to go to. Lenders usually have very little recourse. They cannot forcibly take over a countrys assets and neither can they compel the country to pay.
Reputation Mechanism
The next question arises that if creditors cannot compel borrowers to repay debt, why would they lend money? The answer is that they lend based on the reputation of the borrower. Countries like the United States have never defaulted on their debt. Hence, they have a small likelihood of default. As a result, they receive financing at better terms as compared to a country like Venezuela or Argentina which has defaulted in the past and is more likely to default in the future.
The entire premise of lending to sovereign nations is that if these nations default, then they will be cut off from future access to credit from international bond markets. Since countries almost always need credit to fund their growth, this acts as a major detriment. This is the reason why countries decide to pay up on their debt even after defaulting.
A 100% loss to creditors is unlikely. Usually, when a default occurs, some sort of compromise is reached, and creditors end up taking a haircut. This means that they receive at least part of the payment that was due to them.
Effects of Sovereign Default
Some of the common effects of a sovereign default are as follows:
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