Sovereign Default
What is Sovereign Default?
A sovereign default is a government's failure to pay interest or principal on its debt as promised, or a forced restructuring that pays creditors less.
A government cannot be liquidated the way a firm can, and creditors have little power to seize its assets, so repayment rests on the value of continued market access and on the damage a default does to domestic banks, trade credit and reputation. Default becomes tempting when the primary surplus needed to service the debt is larger than the government can politically deliver, which is most likely when the interest rate on the debt exceeds the growth rate of the economy so the debt ratio climbs on its own. Debt issued in a country's own currency is a different case: the central bank can always create the money to make the payment, so the risk shows up as inflation and currency depreciation rather than as a missed coupon. Most defaults are therefore on foreign-currency debt, and they usually take the form of a negotiated restructuring, with maturities stretched and face value written down, rather than a flat refusal to pay. Markets normally price the event well in advance, and it is the resulting loss of rollover finance, not the stock of debt by itself, that forces the actual missed payment.
Sovereign Default: a worked example
A government owes $200 billion at an average interest rate of 6 percent, so interest costs $12 billion a year. It collects $60 billion of revenue and spends $55 billion excluding interest, a primary surplus of $5 billion, which still leaves an overall deficit of 5 - 12 = -$7 billion that must be borrowed. A shock pushes the yield on new issues to 18 percent, and with $40 billion of debt maturing this year the cost of refinancing that slice rises from 0.06 × 40 = $2.4 billion to 0.18 × 40 = $7.2 billion, adding $4.8 billion to the interest bill in one year. If creditors accept a restructuring that halves the face value, debt falls to $100 billion and interest at 6 percent falls to $6 billion, close to what the $5 billion primary surplus can cover. That gap between $12 billion and $6 billion is what the government and its creditors are really bargaining over.
The mistake students make with sovereign default
Students assume a heavily indebted country that borrows in its own currency can be forced into default. It cannot be forced in the same way, because it can create the money to pay, and the constraint appears as inflation and a falling exchange rate instead. The default risk bond markets price is overwhelmingly about foreign-currency debt, debt written under foreign law, and members of a currency union that gave up their own central bank. A second error is treating default as permanent exclusion from borrowing; countries typically regain market access within a few years of completing a restructuring.
Sovereign Default questions
Can a country that prints its own currency default?
It can choose to, and a few have, but it is never forced to in the way a foreign-currency borrower is, because it can always create the money needed to make a nominal payment. The real constraint shows up as inflation and currency depreciation, which impose losses on bondholders through purchasing power rather than through a missed payment. This is why the same government's local-currency and foreign-currency bonds can carry different credit ratings.
What is a haircut in a debt restructuring?
A haircut is the loss creditors take, measured as the fall in the present value of what they will now receive against what they were promised. It can come from cutting face value, cutting the coupon, or stretching maturities, and all three reduce present value even when the headline reduction in face value is small. Haircuts in sovereign restructurings have ranged from under 20 percent to more than 70 percent.
Why do sovereign defaults hurt the domestic economy so much?
Domestic banks usually hold large amounts of their own government's bonds, so a writedown damages bank capital and shrinks lending at the same time the government is cutting spending. Trade credit and foreign investment dry up, and the currency typically falls, raising the local-currency cost of imports. Those output costs are one reason governments delay default well past the point at which the debt is clearly unpayable.
Formula / Example
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