You’ve heard before: Someone has a credit card or mortgage payment problem and needs to develop a payment plan to avoid bankruptcy. When a country encounters a similar debt problem, what will the entire country do? For some emerging economies, issuing sovereign debt is the only way to raise funds, but things may soon deteriorate. How can countries deal with debt while struggling to grow?
Most countries — from economically developing countries to the richest countries in the world — issue debt to fund their growth. This is similar to how companies obtain loans to finance new projects, or how households obtain loans to buy houses. The biggest difference is size; sovereign debt loans can cover billions of dollars, while personal or business loans can sometimes be quite small.
Sovereign debt is a promise that the government pays to the borrower. It is the value of bonds issued by the government of the country. The biggest difference between government debt and sovereign debt is that government debt is issued in local currency, while sovereign debt is issued in foreign currency. The loan is guaranteed by the issuing country.
Before purchasing government sovereign debt, investors must determine the risk of investment. The debt of some countries such as the United States is generally considered risk-free, while the debt risk of emerging countries or developing countries is even greater. Investors must consider the stability of the government, how the government plans to repay the debt, and the possibility of default by the country. In some respects, this risk analysis is similar to a risk analysis of corporate debt, although sovereign debt investors sometimes face greater risks. Since the economic and political risks of sovereign debt are greater than debts of developed countries, the debt is usually assigned a rating lower than safety AAA and AA, and may be considered lower than investment grade.
Foreign currency debt
Investors prefer to invest in currencies they know and trust, such as the U.S. dollar and the British pound. This is why the governments of advanced economies can issue bonds denominated in their own currencies. The currencies of developing countries tend to have shorter records and may be unstable, which means that there will be much less demand for their currency-denominated debt.
Risk and reputation
In terms of borrowing, developing countries may be at a disadvantage. Like investors with poor credit, developing countries must pay higher interest rates and issue bonds in stronger foreign currencies to offset the additional risks that investors bear. However, most countries will not encounter repayment problems. If inexperienced governments overestimate debt-financed projects, overestimate the revenue that economic growth will generate, structure debt to pay only in the best economic environment, or exchange interest rates that make it too difficult to pay in denominated currencies.
What makes a country issuing sovereign debt want to repay the loan in the first place? After all, if it allows investors to inject money into their economy, wouldn’t they take the risk? Emerging economies want to repay debt because it creates a good reputation that investors can use when evaluating future investment opportunities. Just as young people must build solid credit to build credibility, countries that issue sovereign debt also want to repay their debts so that investors can see that they are capable of repaying any subsequent loans.
Impact of default
Sovereign debt defaults can be more complicated than corporate debt defaults because domestic assets cannot be seized to repay funds. On the contrary, the debt terms will be renegotiated, which usually puts the lender at a disadvantage, if not all losses. Therefore, the impact of default may be more far-reaching, whether it is the impact on the international market or the impact on the country’s population. A government that defaults can easily become a chaotic government, which can be disastrous for other types of investment in the issuing country.
Reasons for debt default
In essence, when a country’s debt exceeds its ability to pay, a default occurs. There are several situations where this can happen:
- During the currency crisis
Due to the rapid changes in the exchange rate, the domestic currency lost its convertibility. It has become too expensive to convert the national currency into the currency that issued the debt.
- The changing economic climate
If the country relies heavily on exports, especially bulk commodities, a significant reduction in foreign demand may result in a shrinking GDP and high repayment costs. If a country issues short-term sovereign debt, it is more susceptible to market sentiment fluctuations.
- Domestic politics
The risk of default is usually related to unstable government structures. A new party that seizes power may be unwilling to fulfill the debt obligations accumulated by previous leaders.
Example of debt default
There are several prominent cases where emerging economies are in trouble with debt issues.
- North Korea (1987)
After the war, North Korea needed a lot of investment to start economic development. In 1980, it defaulted on most of the newly restructured foreign debt, and by 1987 it owed nearly US$3 billion. Industrial mismanagement and large military expenditures have led to a decline in gross national product and the ability to repay outstanding loans.
- Russia (1998)
A large part of Russia’s exports comes from merchandise sales, so it is susceptible to price fluctuations. Russia’s default has triggered negative sentiment throughout the international market, because many people are shocked by the possibility of a major international country’s default. This catastrophic event led to the collapse of long-term capital management.
- Argentina (2002)
Argentina’s economy experienced hyperinflation after it started to grow in the early 1980s, but managed to stabilize the situation by pegging its currency to the U.S. dollar. The recession in the late 1990s forced the government to default on debt in 2002, and then foreign investors stopped investing more money in the Argentine economy.
In recent decades, the increasing integration of global capital markets has allowed emerging economies to reach a more diverse group of investors who use different debt instruments. This provides greater flexibility for emerging economies, but it also increases uncertainty because debt is spread across so many parties. Each party has different goals and risk tolerance, which makes deciding the best course of action in the face of default a complex task.
Investors buying sovereign debt must be firm and flexible. If they demand repayment excessively, they may accelerate the economic collapse; if they do not apply pressure, they may send a signal to other debtor countries that the lender will succumb under pressure. If reorganization is required, the goal of the reorganization should be to preserve the value of the assets held by creditors while helping the issuing country restore economic vitality.
- Repayment incentive
Countries with unsustainable debt levels should be able to choose to contact creditors to discuss repayment options without having to bear any responsibility. This creates transparency and sends a clear signal that the country wants to continue to pay loans.
- Provide restructuring plan
Before proceeding with debt restructuring, debtor countries should review their economic policies to understand what types of adjustments can be made to restore loan payments. This can be difficult if the government is stubborn, because being told what to do may push them to the edge.
- Prudent lending
Although investors may be looking for diversified investments into a new country, this does not mean that the influx of large amounts of cash into international securities will always produce positive results. Before investing money in expensive businesses, transparency and corruption are important factors to check.
- Debt relief
Because of the moral hazard associated with getting debtor countries out of trouble, creditors believe that clearing a country’s debt is absolutely the last thing they want. However, debt-ridden countries, especially those owed to organizations such as the World Bank, can seek to forgive their debts if they can create economic and political stability. A failed country will have a negative impact on neighboring countries.
The existence of international financial markets makes it possible for emerging economies to provide funds for economic growth, but it may also complicate collective agreements between creditors, making it difficult to repay debts. Since there is no strict mechanism to simplify the resolution of the problem, it is important for sovereign debt issuers and investors to reach a consensus-it is better for everyone to reach an agreement instead of letting the debt default.