What is a Sovereign Default?
A Sovereign Default is the inability of a government to repay its debts to its creditors.
Like individuals and businesses, governments of countries borrow money to fund their activities. As such, if they are unable to repay these loans within the agreed upon timeframe and any grace period, the government will default on these loans just like any individual or business.
Who are the Creditors of the Government?
If governments can borrow money just like individuals and businesses, who loans this money to the government?
Individuals, businesses, and other governments invest in the sovereign debt offered by the government borrower. These financial products, short-term and long-term government bonds, are available to investors in the public financial markets.
Investors analyze the current finances of the government to understand if the government can comfortably afford the new debt to be issued. And investors assess the probability of future political crises or economic downturns that could cause the government to have trouble servicing the debt. Investors also study the credit history of the government and its past ability to repay other debts.
If investors determine that the government can comfortably repay the debt, the interest rate will be lower, as it is a lower-risk investment.
If investors determine that the government may have trouble repaying the debt or that the government’s finances may not be strong in the future, the interest rate will be higher, as it is a higher-risk investment.
Government Bonds
This government bond investment analysis is actually normally performed by credit ratings agencies such as Fitch and Moody’s who designate a credit rating to the bonds.
Rating agencies assess the government’s current and projected finances, the nation’s political and economic stability, as well as any past defaults to deliver a credit rating to the bond.
A good credit rating means a financially-strong government. This a low-risk investment with a low interest rate.
A poor credit rating means a financially-weak government. This a high-risk investment with a high interest rate.
As the government finances change over time, credit ratings agencies may upgrade or downgrade their credit ratings accordingly.
Credit Ratings and Interest Rates
A good credit rating is vital for a good economy because it affects the entire country’s economy. The interest rate, derived from the credit rating, is the benchmark from which all other national interest rates are established.
The government bond is normally the lowest-risk investment product on the market. Thus, interest rates on mortgages and business loans are set higher than this sovereign debt interest rate since mortgages and businesses are higher-risk investments than government bonds. Investors expect higher returns from these higher-risk asset classes.
The lower the interest rate on government debt such as U.S. Treasury Bills or Government of Canada Bonds, the lower the rate on other non-government loans, which means that individuals and businesses who borrow money to buy homes or fund businesses enjoy lower interest expenses. The overall economy benefits from these lower expenses.
The higher the interest rate on government debt, the higher the rate on other non-government loans, which means that individuals and businesses who borrow money to buy homes or fund businesses have higher interest expenses. The overall economy suffers from these higher expenses as individuals and businesses have less discretionary income to spend on goods and services in the economy. This can lead to a recession.
This applies to all types of loans including mortgage loans, credit card loans, student loans, business loans, and personal loans.
Effects of a Sovereign Default
Sovereign defaults are relatively rare as normal default and bankruptcy laws don’t apply to governments.
For example, if the loan is denominated in the same currency that the government borrower controls, the government can simply print more money through its central bank to pay the debt. Of course, this has negative consequences as it devalues the currency, which increases the risk profile of the debt, and therefore increases the interest rate.
And investors are very aware that a financial sleight of hand was implemented to avoid defaulting on the debt. Fewer investors would want to invest in the debt; and for the investors that do invest in the debt, they will seek higher interest rates for their troubles. As explained above, this higher interest on the government debt will negatively affect the interest rates of the government borrower nation’s economy as a whole.
The rare instances of sovereign default are caused by unexpected political or economic crises.
An unexpected political or economic crises will cause investors to expect higher interest rates to accommodate the new higher risk. This increases the interest expenses across the government borrower’s economy, which can quickly lead to a recession as individuals and businesses suffer from higher expenses.
Business owners and managers can no longer invest in their businesses and have to lay off employees and reduce production levels. This reduces revenue and profits in the economy.
The currency value declines which causes the cost of imports to rise as more units of currency have to go to pay for the same unit of import. The cost of living increases, and households with now-lower income due to higher unemployment rates, struggle to pay higher bills.
Historically, many countries have defaulted on their debt including the United States, which defaulted on gold bonds in 1933. However, there are a few developed nations that have never defaulted on debt in their history. These include Norway, Switzerland, and Canada.
Greece Sovereign Default
The most famous example of a sovereign default was Greece in 2015 when it became the first developed nation to fail to make a loan repayment on time to the International Monetary Fund (IMF).
Greece had a Debt-to-GDP ratio of 160% at the time. The IMF loan to Greece was denominated in Euros, a currency Greece obviously did not control. As such, Greece could not simply print Euros to pay off its debt.
In addition to the 2008 global financial crisis, out-of-control Greek government spending and excessive borrowing had led to the dire Greek financial crisis. Its creditors in the European Union imposed austerity measures on the country, which forced the government to curtail its spending within strict budget restrictions in order to improve the Greek government’s finances.
Insurance Protection against a Sovereign Default
Institutional investors make up the bulk of sovereign debt holders. In order to protect themselves against sovereign default, they purchase credit default swaps (CDS).
A credit default swap is an insurance product, a financial derivative, that offers protection to a lender against the default of a borrower.
In real estate investing, you have mortgage insurance. In government bonds, you have credit default swaps.
As with any insurance policy, the investor makes periodic insurance premium payments to the insurer that provides the CDS. If the government defaults on its debt, the insurer assumes the default risk and pays off the investor to cover his losses.
The insurer is normally an investment firm looking to benefit from insurance premium payments in the hope that the government borrower never defaults and the investment firm never has to make the payment to the sovereign debt investor.