What Is Sovereign Default?
Sovereign default is the failure of a national government to repay its debts. A government that defaults is unlikely to have access to the debt markets again for years and any loans it manages to obtain will come at a high expense.
Lenders have limited recourse in the event of a sovereign debt default because no international court can force a country to pay up. Lenders with deep pockets may pursue claims to the defaulted borrower's assets overseas.
Countries borrowing in their own currency have a couple of options for avoiding default: They can print more money, or they can raise money by increasing taxes.
Key Takeaways
- Sovereign default is the failure by a country's government to pay its debt.
- Sovereign default inevitably slows the nation's economic growth and hampers investment from overseas.
- Overwhelming debt is the main cause of sovereign default. That debt may grow out of control due to the costs of war, mismanagement, political corruption, or a prolonged economic downturn.
- Distressed sovereign borrowers often seek to negotiate a debt restructuring, forcing their creditors to write off part of the debt in exchange for reduced debt service payments.
Understanding Sovereign Default
Private investors in the sovereign debt of foreign countries study the economy, public finances, and politics of a country issuing bonds to assess and price its default risk.
Other countries and multinational lenders like the International Monetary Fund (IMF) and the World Bank lend to nations in order to accomplish policy goals such as promoting the lending country's exports. These lenders may be in a position to insist on being repaid even if the borrower defaults on other debts.
Sovereign debt issued in the sovereign's currency may attract private foreign investors as well but is most often purchased by the country's banks and private citizens. A default on a sovereign's obligations in its own currency is easier to avoid and can be more politically painful than a default on foreign debt.
Steep economic downturns, financial crises, and political upheavals can all precipitate a sovereign default. For example, Russia's default on its debt in June 2022 was the result of economic sanctions imposed on the country for its invasion of Ukraine, including the freezing of Russia's foreign currency reserves abroad.
Types of Sovereign Default
If a country briefly delays interest payments for a few of its bonds for reasons not indicative of its ability or willingness to repay debt, as the U.S. Treasury did once in the 1970s, it might have technically defaulted for a time. As long as the repayment snag is quickly ironed out, the event is unlikely to have long-term consequences.
Contractual Default
Unlike a technical default, a contractual default is the real deal, a willful failure to make debt payments.
Governments that are on the brink of default will sometimes negotiate a bonds exchange, replacing their previously issued and often heavily discounted bonds with new ones of lower value.
In effect, the bondholders take a haircut on the money already lent in exchange for the sovereign's pledge to continue making debt payments in a reduced amount. If lenders are convinced such an exchange is their least bad option, they may go along.
This is considered an implicit default because the exchange can only happen if creditors have good reason to doubt the sovereign's ability to honor its obligations on previously issued debt.
For example, during the European sovereign debt crisis, Greece offered several such settlements to bondholders with the support of its European partners.
U.S. Debt
United States Treasury debt serves as the benchmark "risk-free rate" investors use to evaluate the risk in other debt instruments as well as equities. The U.S. remains among the world's most highly rated sovereigns despite two recent slips from the top of the ratings:
- The credit rating agency Standard & Poor's downgraded its long-term rating for U.S. sovereign debt one notch to AA+ from AAA in 2011, during one of the U.S. government's periodic bouts of debt ceiling brinksmanship.
- Fitch Ratings downgraded United States debt to AA+ from AAA in August 2023, citing expected fiscal deterioration over the next three years, a growing government debt burden, and an erosion of government relative to its peers.
On June 27, 2022, Russia failed to meet a deadline for $100 million of interest payments on the country's foreign currency bonds. It was the country's first default since 1998.
Consequences of a Sovereign Default
For the defaulting government and its citizens, the consequences of sovereign debt default will vary depending on such factors as the state of the economy and public finances, the degree of dependence on external financing, and the likelihood that creditors will return in the future.
Credit markets tend to be more welcoming and forgiving of large countries with exploitable natural resources like Russia than small low-income ones. The latter often depend on the IMF and aid donors for credit. Russia defaulted on its bond obligations in 1918 when Lenin's government repudiated the Tsarist Empire's debt, and again on its ruble-denominated obligations in 1998, though it continued to make payments on its foreign debt after a short moratorium.
If a country depends heavily on foreign creditors to finance investment, the consequences of its sovereign default are likely to include slower economic growth, making things harder for its citizens and businesses.
Impact on Foreign Investors
The sovereign debt default will lower the net asset value of any bond mutual funds holding the defaulted debt. In some cases, the default is seen as an opportunity for distressed debt investors who could buy the bonds at steep discounts to face value in the hopes that they might be worth more later following a debt restructuring.
Sovereign debt defaults also create winners and losers in the market for credit default swaps, which are financial contracts that pay off like an insurance policy in the event of a default. Credit default swaps let bondholders hedge credit default risk. and allow speculators to bet that a default will happen.
Real-World Examples of Sovereign Default
Lebanon defaulted on foreign debt for the first time in its history in March 2020, as years of government corruption and wasteful borrowing culminated in a banking and financial crisis amid an economic depression. Lebanon's Gross Domestic Product (GDP) shrank by 58% between 2019 and 2021, according to World Bank estimates.
The Lebanese economy continued to struggle in 2022 even as the country's government reached a preliminary agreement with the IMF on the economic governance reforms required to secure new IMF funding. Lebanon also would be required to negotiate a debt restructuring with private foreign creditors. No firm agreement had been reached by mid-2023.
Russia's Technical Default
In 2022, Russia went through a technical default after it became unable to pay its dollar-denominated foreign currency obligations. Following the invasion of Ukraine, the U.S. and its allies sanctioned the Russian government, effectively cutting the government off from foreign currency and banking networks.
The Russian government argued that the default was effectively created by Western sanctions since the country had plenty of foreign currency in its now-frozen accounts. But the failure to pay caused Moody's to downgrade Russian bonds to junk status, and the country faced its first foreign debt default since 1918.
What Happens When a Sovereign Defaults?
A nation in sovereign default is already in financial trouble, and defaulting on its debts can only make it worse.
One adverse effect of sovereign default is a collapse of the value of the local currency against the U.S. dollar. This creates inflation in countries that are heavily reliant on imports. That can cause extreme distress to the nation's population, adding to the destabilizing factors facing the government.
The nation's only reasonable choice is to attempt to negotiate a restructuring of its debts with its foreign creditors. This will allow it to make some good-faith efforts to repay part of its debts and eventually may open a door to more borrowing or foreign investment.
Why Does Sovereign Default Happen?
It happens to a nation the same way it can happen to an individual consumer. The nation takes on more debt than it can reasonably sustain from month to month. The first hiccup in its economy tips it over the edge into bankruptcy.
Sovereign default tends to follow severe adverse events including war, revolution, corruption, financial mismanagement, or a severe economic downturn.
What Is Sovereign Default Risk?
Sovereign default risk is the likelihood that a nation seeking loans or issuing bonds will default on its repayments of the debt. It is one factor that financial institutions and investors evaluate when considering extending loans or buying bonds issued by a nation.
Most sovereign defaults involve foreign debt, but nations can also default on domestic debt denominated in the national currency.
The Bottom Line
A sovereign default is a nation's failure to repay its debt obligations. It has serious economic consequences for the nation, making it expensive or impossible for it to borrow money in the future.
It also causes domestic turmoil. Many banks, pension funds, and individual investors keep some of their assets in sovereign bonds. The nation's financial failure ripples through its economy.
Moreover, a sovereign default generally causes inflation in the cost of goods domestically. That spreads the suffering through the general population.
