SOVEREIGN DEBT CRISES

 

 

Summary Of The Article

• Sovereign debt crises occur when countries default on their loans, akin to individuals or companies defaulting on loans.
• Countries resort to borrowing, both domestically and internationally, to meet financial needs and fund development projects.
• Types of domestic debt include loans from local banks and issuance of bonds or savings certificates by the government.
• External debt is often acquired in foreign currency, typically through international development banks, foreign exchange bonds, or loans from institutions like the IMF.
• Sovereign default occurs when a country fails to adhere to terms of loan agreements, leading to consequences such as credit rating downgrades.
• Reasons for default include non-payment of loan installments, rapid decline in foreign exchange reserves, heavy debt burdens, economic stagnation, political instability, and financial mismanagement.
• History showcases instances of defaulted countries, including economically strong ones like the US in the past.
• Consequences of default include lower credit ratings, difficulties in obtaining future loans, increased interest rates, currency depreciation, hyperinflation, banking crises, and socioeconomic challenges like poverty and unemployment.

Navigating Economic Turbulence

Friends, Welcome to Historical Horizons. Suppose you want to buy a house and decide to take a loan from a bank for this purpose. The bank gives you a loan in easy monthly installments of 20 years from which you buy a house. But after some time you are unable to make the payments due to your poor financial situation, in such a situation you will be declared bankrupt or in economic terms you will default. As a result, the law enforcement agencies will come into action and eventually your house bought with the loan will be auctioned and the bank will use the money to settle its loan. After that, the next time you try to get a loan, the bank will either not approve the loan or the loan will be given on tough conditions and at very high interest rate because of your history and poor credit quality.

Similarly, if a company defaults on its loans, its rating falls, along with its stock value. In this situation, it becomes very difficult for the company to expand its work or take on new business by taking loans in the future. In the same way countries or governments also need loans to run their economic system. Developing countries often have to resort to external debt to meet their financial needs. Friends, in this article we will try to understand why a country needs to borrow, what is default and under what circumstances countries default what are the consequences of default.

Types of Domestic Debts

Like personal and business loans, some countries also borrow from internal or external sources for running the financial system or for major development projects. Local banks can also be a source of domestic loans. Apart from this, the government can also raise capital by issuing bonds or savings certificates in the local currency.

Bonds or Savings Certificates are issued by the government for a specified period and the government pays regular interest to the purchaser of the certificate, while the original value is returned to the investor at the end of the certificate's maturity. One of the advantages of this local currency debt is that if a government has trouble paying back the bonds when they mature, it can easily print more money to payback the required amount by doing so, however, the local currency depreciates sharply, which may cause investors to suffer losses.

That is, for example, if an investor is earning 5% per annum on a government certificate, but the currency depreciates by 10% in a year due to inflation, that investor will in real terms loses 5% of its investment. But local currency alone is not enough to run the economic system of countries. Almost every country import various goods from other countries to meet its needs which requires foreign currency especially dollars. Economically weak countries have to resort to external debt to meet the shortage of dollars. In order to complete mega-projects that require imports of goods or external services large international development banks such as the World Bank or the Asian Development Bank provide loans to smaller countries also, one type of borrowing in foreign currency can be foreign exchange bonds.

To raise capital in dollars or other currencies, a government issues bonds or certificates in international market, called the foreign exchange bonds. One of its advantages is the access to capital in foreign currency for the government and on the other hand it is an alternative arrangement for foreign investors who are reluctant to invest in local currency. Moreover, the International Monetary Fund (IMF) also provides financial assistance in the form of loans to countries suffering from financial crisis. A financial crisis may be due to difficulties in repaying loans taken for development projects reducing current account deficits or other international payments.

Sovereign Default

Whatever the loan is, it is repaid under a contract on certain terms which are very important for the borrower to adhere to. If the borrowing country violates one or more terms of the loan agreement, it is called sovereign default or commonly bankruptcy. 

Reasons for Default

Generally, the main cause of sovereign default is non-payment or late payment of loan instalment. In addition non-payment of interest or principal of foreign exchange bonds is also called default. Rapid decline in foreign exchange reserves and heavy debt burden, huge current account deficit, means the difference between outflows and inflows. economic stagnation and political instability are the main reasons for a country to default.

Let's take a brief look at these reasons:

First, the size of a country's foreign exchange reserves are analyzed with respect to the value of international payments due in the near term and the value of loans and interest. Therefore, the foreign exchange reserves should be sufficient to meet the country's requirements for imports debt repayments and interest on foreign exchange bonds, otherwise, there is a clear possibility of the country defaulting A country has a current account deficit when it sends more money abroad than it receives from foreign sources. The trade deficit is usually the largest component of the current account deficit. Trade deficit refers to the difference between a country's earnings from exports and its expenditure on imports. means low exports and high imports A trade deficit occurs when a country spends more on imports than it earns on exports. Apart from this, budget deficit, i.e. expenditure in excess of income, is also a major reason for obtaining loans Prolonged, high current account deficit and budget deficits can also lead to bankruptcy or default of a country. Economic stagnation can also be a reason for default. Persistent economic stagnation weakens a country's economy, making it difficult to increase national income. As a result, the country's ability to repay the debt decreases. This undermines the confidence of domestic and foreign lenders, making it more difficult and expensive to obtain further loans. Due to political instability, the continuity of economic policies in the country is not maintained due to which it becomes very difficult to bring foreign investment in the country. Similarly, financial mismanagement is also a major cause of investor distrust which is highly detrimental to the country's economy. Hence, political instability and financial mismanagement are also important causes of sovereign default.

 History of Defaulted Countries

Friends, in recent history there are many countries that have defaulted on foreign payments. Some of these countries, including Venezuela, Ecuador and Argentina, have defaulted more than once. Interestingly, not all defaulting countries were developing or economically weak countries, but some economically strong countries have also defaulted in the past. America Today, America is considered to be the greatest economic power in the world, but in the 1840s, the American economy was also bankrupt. At that time, 19 out of 26 US states had declared default on their debts. The reason for this default was that efforts were being made to rapidly establish the canal system in America, which had cost 80 million dollar. This amount could not be paid as promised and on time Also, in 1933, 1979 and 2013, the US government was unable to meet its debt or foreign payments on time due to various reasons. But because the currency of the US government is the dollar, which is also the reserve currency of the world the US did not face default like other countries.

Recently the Sri Lankan government has defaulted on its foreign debt payments. Sri Lanka's fragile economy has been suffering from multiple crises for decades. In the past, the Sri Lankan government has sought help from the IMF 16 times to avoid default. However, this time the situation was very different and far more complicated. Government financial mismanagement is believed to be a major reason for Srilanka's default however, global pandemic has worsened the situation in early 2020. The tourism sector accounts for 25% of Sri Lanka's foreign exchange earnings and the global pandemic had badly affected Sri Lanka's tourism industry. Finally in 2022, Sri Lanka was forced to suspend debt payments to foreign creditors for the first time in its history. Iran the new government installed immediately after the 1979 Iranian revolution refused to repay billions of dollars in foreign loans taken out by the previous government and hence, they defaulted on foreign debts. Iceland has a population of just under 400,000 yet Iceland defaulted on over $85 billion in external debt during the 2008 global financial crisis. As a result, Iceland's stock market crashed and the savings of about 15 percent of the country's population, more than fifty thousand citizens, were lost. Lebanon and Greece the governments of Greece in 2012 and Lebanon in 2020 had also defaulted. The reason was huge trade and current account deficits and associated debt burdens. Russia defaulted in 1998, Ukraine in 1998 and 2015, and Venezuela in 2017 due to severe economic stagnation. Argentina in 2001, 2014 and 2019 and Ecuador in 2008 and 2020 defaulted due to political instability and misguided economic policies.

Consequences of Default

The impact of default on a country depends on the reason for the default and the circumstances and resources of the defaulting country.

Let's look at the possible consequences of defaulting. The biggest disadvantage of default is that the world's major credit rating agencies such as Moody's and Fitch lower the credit rating of defaulting countries. As a result, due to the distrust of international institutions for such a country there may be difficulties in financial transactions and obtaining loans in the future, which may have negative effects on the country's trade and the completion of major development projects.

Moreover, in such a situation, the interest rates of local banks also increase, due to which there may be a marked decrease in the circulation of money and people may face serious difficulties in starting new businesses. Friends, when a country defaults, foreign investors try to sell their local assets to get out of the bankrupt or defaulted country, which causes the exchange rate to fall in the international market and the local currency to depreciate. This makes the import of products either expensive or completely eliminated. Moreover, attempts are also made to make local payments by printing currency notes to meet local needs This makes the available money much higher than the domestic production which leads to hyperinflation in that country. Hyperinflation in economic terms refers to rapid, excessive, and out-of-control general price increases.

A default increases uncertainty in any country. As a result, people get panic and try to withdraw all their money from the banks, which can lead to a serious banking crisis. The government can also close its banks to prevent withdrawals or allow a limited number of capital withdrawals A practical example of this is the Great Depression that hit much of the world between in 1930s when people turned to American banks in large numbers and demanded their gold held in exchange for currency, which created a severe banking crisis. In addition, countries defaulting on foreign currency debt may also default on local currency debt. Apart from this, poverty, unemployment and crime can also increase in such countries.

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