what happens when a country defaults on debt
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For the South Korean film, see Sovereign Default.
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A sovereign default is the failure or refusal of the government of a sovereign state to pay back its debt in full when due. Cessation of due payments (or receivables) may either be accompanied by that government's formal declaration that it will not pay (or only partially pay) its debts (repudiation), or it may be unannounced. A credit rating agency will take into account in its gradings capital, interest, extraneous and procedural defaults, and failures to abide by the terms of bonds or other debt instruments.
Countries have at times escaped some of the real burden of their debt through inflation. This is not "default" in the usual sense because the debt is honored, albeit with currency of lesser real value. Sometimes governments devalue their currency. This can be done by printing more money to apply toward their own debts, or by ending or altering the convertibility of their currencies into precious metals or foreign currency at fixed rates. Harder to quantify than an interest or capital default, this often is defined as an extraneous or procedural default (breach) of terms of the contracts or other instruments.
If potential lenders or bond purchasers begin to suspect that a government may fail to pay back its debt, they may demand a high interest rate in compensation for the risk of default. A dramatic rise in the interest rate faced by a government due to fear that it will fail to honor its debt is sometimes called a sovereign debt crisis. Governments may be especially vulnerable to a sovereign debt crisis when they rely on financing through short-term bonds, since this creates a maturity mismatch between their short-term bond financing and the long-term asset value of their tax base.
They may also be vulnerable to a sovereign debt crisis due to currency mismatch: if few bonds in their own currency are accepted abroad, and so the country issues mainly foreign currency-denominated bonds, a decrease in the value of their own currency can make it prohibitively expensive to pay back those bonds (see original sin).
Since a sovereign government, by definition, controls its own affairs, it cannot be obliged to pay back its debt. Nonetheless, governments may face severe pressure from lending countries. In a few extreme cases, a major creditor nation, before the establishment of the UN Charter Article 2 (4) prohibiting use of force by states, made threats of war or waged war against a debtor nation for failing to pay back debt to seize assets to enforce its creditor's rights. For example, in 1882, the United Kingdom invaded Egypt. Other examples are the United States' "gunboat diplomacy" in Venezuela in the mid-1890s and the United States occupation of Haiti beginning in 1915.
Today a government that defaults may be widely excluded from further credit; some of its overseas assets may be seized; and it may face political pressure from its own domestic bondholders to pay back its debt. Therefore, governments rarely default on the entire value of their debt. Instead, they often enter into negotiations with their bondholders to agree on a delay (debt restructuring) or partial reduction of their debt (a 'haircut or write-off').
Some economists have argued that, in the case of acute insolvency crises, it can be advisable for regulators and supranational lenders to preemptively engineer the orderly restructuring of a nation's public debt – also called "orderly default" or "controlled default". In the case of Greece, these experts generally believe that a delay in organising an orderly default would hurt the rest of Europe even more.
What Happens When Countries Do Not Pay Back Their Debt?
This article explains the difference between corporate default and sovereign default. It also lists the effects that are commonly faced by economies once the government has defaulted on its debt.
Home Library Managerial Economics What Happens When Countries Do Not Pay Back Their Debt?
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 country’s assets and neither can they compel the country to pay.
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.
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.
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.
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.
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.
Source : www.managementstudyguide.com
Why and When Do Countries Default?
Countries can default on their debt. This happens when the government is either unable or unwilling to make good on its fiscal promises.
Why and When Do Countries Default?
By DANIEL KURT Updated August 27, 2021
Reviewed by MICHAEL J BOYLE
Though not common, countries can, and periodically do, default on their sovereign debt. This happens when the government is either unable or unwilling to make good on its fiscal promises to repay its bondholders. Argentina, Russia, and Lebanon are just a few of the governments that have defaulted over the past decades.
Of course, not all defaults are the same. In some cases, the government misses an interest or principal payment. Other times, it merely delays a disbursement. The government can also exchange the original notes for new ones with less favorable terms. Here, the holder either accepts lower returns or takes a “haircut” on the loan – that is, accepts a bond with a much smaller par value.
Sovereign default is a failure of a government to honor some or all of its debt obligations.
While uncommon, countries do default when their national economies weaken, when they issue bond denominated in a foreign currency, or a political unwillingness to service debts.
Countries are often hesitant to default on their debts, since doing so will make borrowing funds in the future difficult and expensive.
Factors Affecting Default Risk
Historically, failure to make good on loans is a bigger problem for countries that borrow in a foreign currency instead of using their own. Many developing countries issue bonds in an alternate currency in order to attract investors – often denominated U.S. dollars – but borrowing in another currency plays a significant role in default risk. The reason is that when a country that borrows foreign currency faces a budgetary shortfall, it does not have the option to print more money.
The nature of a country’s government also plays a major role in credit risk. Research suggests that the presence of checks and balances leads to fiscal policies that maximize social welfare – and honoring debt carried by domestic as well as foreign investors is a component of maximizing social welfare. Conversely, governments that are composed of certain political groups with a disproportionate power level can lead to reckless spending and, eventually, default.
With the ability to print their own money, countries like the United States, Great Britain, and Japan appear immune to a sovereign default, but this is not necessarily the case. Despite a stellar record overall, the United States has technically defaulted a few times throughout its history. In 1979, for instance, the Treasury temporarily missed interest payments on $122 million of debt because of a clerical error. Even if the government can pay its debts, legislators may not be willing to do so, as periodic clashes over the debt limit remind us.
Investors can thus experience a loss on government debt, even if the nation has not officially defaulted. Whenever a country's Treasury must print more money to meet its obligations, the country’s total money supply increases, creating inflationary pressure.
When a country defaults on its debt, the impact on bondholders can be severe. In addition to punishing individual investors, defaulting impacts pension funds and other large investors with substantial holdings. One way that institutional investors can protect themselves against catastrophic losses is through a hedging strategy known as a credit default swap (CDS). With a CDS, the contract seller agrees to pay any remaining principal and interest on a debt should the nation go into default. In exchange, the buyer pays a period protection fee, which is similar to an insurance premium. The protected party agrees to transfer the original bond, which may have some residual value, to its counterpart should a negative credit event occur.
While originally intended as a form of protection or insurance, swaps have also become a common way to speculate on a country's credit risk. Many of those trading CDS, in other words, do not have positions on the underlying bonds that they reference. For example, an investor who thinks the market has overestimated Greece's credit problems could sell a contract and collect premiums and be confident that there is no one to reimburse.
Because credit default swaps are relatively sophisticated instruments and trade over-the-counter (OTC), getting up-to-date market prices is difficult for typical investors. This is one of the reasons only institutional investors use them, as they come with more extensive market knowledge and access to special computer programs that capture transaction data.
Just as an individual who misses payments has a harder time finding affordable loans, countries that default – or risk default, for that matter – experience substantially higher borrowing costs. Ratings agencies such as Moody’s, Standard & Poor’s, and Fitch are responsible for evaluating the credit quality of countries worldwide based on their financial and political outlook. In general, nations with a higher credit rating enjoy lower interest rates and thus cheaper borrowing costs.
When a country does default, it can take years to recover. Argentina, which missed bond payments beginning in 2001, is a perfect example. By 2012, the interest rate on its bonds was still more than 12 percentage points higher than that of U.S. Treasuries. If a country has defaulted even once, it becomes harder to borrow in the future, and so low-income countries are particularly at risk. According to Masood Ahmed, a former senior executive at the IMF and now president of the Center for Global Development, as of Oct. 2018, of the 59 of the countries that the IMF classifies as low-income developing countries, 24 were in a debt crisis or at the edge of one, which is almost 40% and double the number in 2013.
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