Sovereign debt defaults are relatively infrequent. But countries can and periodically default on their sovereign debt. This happens when a government is eitherunable or unwillingto repay its creditors because of one or more reasons including high debt.
Determining what constitutes a sovereign default isn't a simple matter. A payment error can constitute a technical default without lasting consequence, while a debt restructuring inflicting steep losses on bondholders may make legal default unnecessary.
Key Takeaways
- A sovereign debt default is the failure of a government to honor some or all of its debts.
- Common causes of sovereign defaults include economic stagnation, political instability, and financial mismanagement.
- Determining when a default has occurred can be difficult; a debt restructuring that preempts one can still inflict losses on creditors.
- Countries that default can often borrow again quickly, but defaults can inflict severe economic costs in the short run.
What Is Sovereign Debt Default?
Sovereign debt is a form of government debt. It is issued by a nation's government when it wants to borrow money from other countries or investors. Money is borrowed in order to finance public projects, pay bills, or make investments.
Like individual and corporate borrowers, there is a chance that governments won't be able to repay their debts. This is called sovereign debt default. Most countries don't intend for this to happen because it means they may have trouble borrowing in the future. In other cases, it becomes much more expensive for defaulting governments to assume debt—the same way a consumer with a low credit score may experience.
Sovereign debt default can happen unintentionally because of uncontrollable factors, In certain instances, a government may choose not to repay its debt. There are a number of reasons why a country would default on its debt, including high debt levels, economic stagnation, political instability, and even a banking crisis.
Argentina, Lebanon, and Ukraine are among some of the countries that have defaulted on their sovereign debt.
Factors Affecting Sovereign Debt Default
As noted above, there are a number of different factors that can lead to and increase the chance of sovereign debt default. We've listed some of the most common ones below.
- Persistent Economic Stagnation: This undermines a country's ability to service its debt and leaves its economy more vulnerable to shocks such as a recession or a pandemic. It also erodes the confidence of foreign and domestic creditors, making it more difficult and costly to refinance debt. Chronic stagnation was the primary cause of sovereign debt defaults by Russia and Ukraine in 1998, Argentina in 2001, and Venezuela in 2017.
- Debt Levels: High debt accumulated amid trade and budget deficits can also make the repayment burden unsustainable. Examples include Greece in 2012 and Lebanon in 2020.
- Political Climate: Political instability and financial mismanagement have become increasingly frequent catalysts of sovereign default. They were the primary factor in defaults by Argentina in 2014 and 2019, Ukraine in 2015, and Ecuador in 2008 and 2020.
- Financial Instability: Recessions, banking or currency crises, and country breakups are all shocks that can increase default risk. Many defaults stem from a combination of misfortune and mismanagement. The Eurozone currency union proved a major factor in the European debt crisis because countries using the euro lacked the discretion to devalue their currency in response to mounting debt and the loss of international competitiveness.
Undemocratic and corrupt governments looting a country can eventually leave it without the means to service debt, leading to a default. Democracies, however, are not immune. Frequent leadership turnover and a presidential system of government that is distinct from a parliamentary one have been associated with a higher incidence of sovereign debt defaults.
Credit rating agency Fitch downgraded the U.S. from a AAA rating to AA+ in August 2023. It cited several key issues for the move, including the potential for fiscal instability within the next three years due to the political climate. It also suggested that the tax cuts and increased government spending are leading to higher debt levels.
Types of Sovereign Debt Defaults
Technical Default
A technical default does not constitute a default under the definition used by rating agencies or credit default swap contracts. Consider what happened in the U.S. in 1979.
The U.S. Treasury briefly missed $122 million of interest and redemption payments to retail holders of government debt because of technical back office problems. The payments were made within weeks and the delay had no appreciable effect on U.S. status as a highly-rated sovereign borrower.
In this case, there was a short-term payment snag. It came without any long-term consequences. Administrative errors like the one that tripped up the U.S. Treasury in 1979 and minor debt covenant violations fit the bill.
Contractual Default
Unlike a technical default, a contractual default does qualify as a default under rating agencies and credit default swap contract definitions. This type of sovereign debt default presumes the failure to honor debt obligations beyond the 30-day maximum grace period found in bond contracts.
An alternative might be a debt restructuring that avoids a contractual default but still leaves bondholders with substantial losses on the debt principal held, amounting to a substantive default even if no technical default occurs.
One common restructuring tactic is for a distressed sovereign debtor to propose an exchange of old bonds for new ones of lower value it would be willing to service while paying nothing to holdout creditors who reject the offer. While some holdout creditors successfully argued in U.S. courts their contractual rights were violated, others failed to make a similar case in different circ*mstances. Creditor participation in debt restructuring exchanges has averaged 95% since 1997.
Consequences of Sovereign Debt Default
Intuition suggests that countries that default on sovereign debt might have trouble borrowing again and are likely to have to pay a higher interest rate if they get the chance. In particular, higher levels of loss appear to lead to longer periods of market exclusion and penalty rates when the exclusion ends.
But not everyone agrees. Empirical surveys, in contrast, found that defaulting sovereigns tend to regain market access quickly and don't pay a penalty rate. Put simply, these surveys imply that investors tend to forgive and forget.
A sovereign debt default can also impose wide and severe economic costs, lowering output for years. It can also provide overdue relief for borrowers struggling to service unsustainable debt. The relief tends to come in the form of reduced debt service costs following a restructuring rather than a big reduction in the principal owed.
Which Country Defaults the Most?
Venezuela defaulted on its sovereign debt 11 times. Portugal, Italy, Ireland, Greece, and Spain, sometimes referred to collectively as the PIIGS, are often pointed to as having a high risk of sovereign debt. But if you look closely, these five countries have a mixed historical record on a longer time horizon. Ireland has never defaulted, and Italy only did so once during World War II. Spain, however, has defaulted six times.
What Happens if the U.S. Defaults?
The U.S. came close to defaulting in June 2023. However, President Biden raised the debt ceiling with new legislation. Given the political climate and rising national debt, Fitch Ratings downgraded the U.S. from a AAA rating to AA+ in August 2023.
Has the U.S. Ever Defaulted?
No. The U.S. has never defaulted on its debt, but it has come close in 2011 and 2013. But because it has never happened the full extent of the repercussions is unknown.
The Bottom Line
Countries defaulting on their debts is rare. But it does happen. The most common causes of sovereign defaults include economic stagnation, political instability, and financial mismanagement.
When countries do default they are often permitted to borrow again quickly, but defaults can inflict severe economic costs in the short run.
