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 country’s 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:

• Interest Rates Rise

  The most immediate impact is that borrowing cost rises for the nation in the international bond market. If the government itself is borrowing at a higher rate, then the corporates also have to borrow at increased rates. As a result, interest rates rise and the price of bonds that were issued earlier collapse even further. Trade and commerce is negatively affected since banks are skeptical of lending money at high rates to borrowers.

• Exchange Rate

  International investors become wary that the defaulting country will continue to print money till it reaches hyperinflation. As a result, they want to exit the defaulting nation. As a result, the exchange rates in the international market plummet as everyone tries to sell their local currency holdings and buy a more stable foreign currency. If a country is not too dependent on international investment, then the effect of exchange rate may be marginal. However, countries which default on their debt tend to have massive foreign investments.

• Bank Runs

  Just like investors want to move their money out of the country, local people want to move their money out of the banks. They are fearful that the government will forcibly take possession of their bank deposits to repay the international debt. Since everybody tries to withdraw money at the same time, bank runs become the norm. Many people are not able to recover their deposits and as a result the crisis becomes even more severe and more bank runs follow.

• Stock Market Crash

  Needless to say, the above-mentioned factors negatively affect the economy. As a result of the stock market also takes a beating. Once again the cycle of negativity feeds off itself. The stock market crash perpetuates itself. It is not uncommon for stock markets to have 40% to 50% of their market capitalization wiped off during a sovereign debt default.

• Trade Embargo

  Foreign creditors are often influential in their home country. Hence after default, they convince their countries to impose trade embargos on the defaulting nations. These embargos block the inflow and outflow of essential commodities into a nation thereby choking its economy. Since most countries import oil to meet their energy needs, such trade embargos can be disastrous. In the absence of oil and energy, the productivity of an economy takes a severe beating.

• Rising Unemployment

  Private firms and the government both feel the negative effects of the economic climate. The government is not able to borrow and tax revenues are also at all-time lows. Hence, they are not able to pay salaries to the workers on time. Also, since there is a negative sentiment in the economy, people stop consuming products. As a result, the GDP comes down and accentuates the unemployment cycle.