In April, the World Bank invited several leading experts to explore prospects for a new global financial architecture for debt. Speakers discussed lessons from past restructuring efforts, the role of the private sector and the increased need for debt transparency. Zainab Haruna from Nigeria started the conversation by explaining how government debt can affect the lives of ordinary people.
Angolan Finance Minister Vera Daves spoke with World Bank Group Ex-President David Malpass on how the economic fallout from COVID-19 and Russia-Ukraine has impacted their country’s revenue and debt. Kevin Watkins, CEO of Save the Children, and K.Y. Amoako, President of the African Center for Economic Transformation, described how unsustainable debt can slow countries’ progress and divert resources that could otherwise be used to invest in health, education and more.
Citi’s Julie Monaco and World Bank Chief Economist Carmen Reinhart both referred to the debt crises of the 1980s and 1990s and the lessons this challenging era can offer.
Last year, Sri Lanka defaulted on its external debt (excluding debt to multilateral organizations such as the World Bank) and in July 2022 saw the resignation of an Executive President for the first time in Sri Lanka’s history. The country faced a shortage of fuel, cooking gas, medicines and many essential goods.
At the same time, the country faced a massive political crisis that sparked island-wide protests that led to the resignation of Mahinda Rajapaksa as prime minister in May last year. Two months later, President Gotabaya Rajapaksa Mahinda’s brother also had to resign.
The island nation has defaulted on its $51 billion foreign debt for the first time since gaining independence in 1948 as it grapples with its worst economic crisis. The South Asian country was grappling with soaring inflation of 17.5%, a 12-hour power outage, and dwindling foreign reserves.
While many experts have pointed out that excessive government spending, tax cuts and the first and second waves of COVID-19 worsened the country’s economic crisis, others believe Sri Lanka’s close ties with China have fueled the country’s debt crisis. However, Sri Lanka is not the first country to default on its debts. Over the past century, several countries have defaulted on one or more occasions. According to the World Economic Forum, 147 countries have ‘sovereign defaulted’ on their debt since 1960.
What is the sovereign default?
Sovereign bankruptcy is the failure of a national government to repay its debts. Governments are typically reluctant to default because it is likely to lock the country out of debt markets for years to come and make borrowing more expensive, at least for a period when it becomes possible again. Lenders have limited recourse in the event of a sovereign debt default, as no international court can force a country to pay, although it can claim the defaulted borrower’s assets abroad. Countries borrowing in their own currency can always print more as an alternative to sovereign default. and may also avoid doing so by generating more tax revenue.
Private investors investing in the sovereign debt of other countries closely study the economy, public finances and politics of a bond-issuing country to assess and assess its risk of default. Other countries and multinational lenders such as the International Monetary Fund (IMF) and the World Bank lend to states to achieve policy goals ranging from improving the borrowing country’s governance to boosting the lender’s exports, and may be able to insist on their repayment even if the borrower defaults on other debts.
Government bonds issued in local currency may also attract private foreign investors, but are often primarily bought by the country’s banks and private individuals. A default by a sovereign in its own currency is easier to avoid and can be more politically painful than a default on external debt. Because a national bankruptcy entails a number of costs and economic risks, it is usually used as a last resort. Severe economic downturns, financial crises and political unrest can trigger a national bankruptcy. For example, Russia’s default in June 2022 was the result of economic sanctions imposed on the country for its invasion of Ukraine, including a freeze on Russia’s foreign exchange reserves abroad.
Types of sovereign default
Experts say, a nation may have momentarily defaulted if it temporarily delays interest payments on a small number of its bonds for administrative reasons unrelated to its capacity or willingness to repay debt, as the US Treasury once did in the 1970s. So long as the repayment snag is quickly ironed out, such a ‘default’ is unlikely to have any long-term consequences, or to be widely viewed as one. For instance, amid one of the US government’s recurring episodes of debt ceiling brinkmanship, the United States continues to be among the highest-rated sovereigns in the world, despite Standard & Poor’s downgrading its long-term rating for US national debt from AAA to AA+ in 2011.
Governments that are already generally believed to be likely to take that course of action may occasionally negotiate a bonds exchange, exchanging their previously issued and frequently severely discounted bonds for new ones of lower value, in order to prevent this outright default. In exchange for the sovereign’s promise to continue making lower debt payments, the bondholders effectively take a ‘haircut’ (a risk of the underlying asset) on the money they have already lent. Lenders agree that such an exchange is the least terrible choice available to them. This is an implicit default because the exchange can only take place if the sovereign’s ability to honour its commitments to previously issued debt is severely questioned by creditors. With the assistance of its European partners, Greece made a number of similar settlement offers to bondholders during the European sovereign debt crisis.
Consequences of a sovereign default
For the defaulting government and its citizens, the consequences of a sovereign debt default vary depending on factors such as the state of the economy and public finances, the degree of dependence on external financing and the likelihood that creditors will return in the future.
Credit markets tend to be large countries with exploitable natural resources like Russia to be more open and forgiving than small low-income countries, which are often dependent on IMF loans and aid. Meanwhile, Russia defaulted on its loan commitments in 1918, when Lenin’s government rejected the Tsarist Empire’s debt, and again on its ruble-denominated commitments in 1998, although it continued to make payments on its external debt after a brief moratorium. If a country is highly dependent and promotes foreign creditors to finance investments, the consequences of the sovereign default are likely to be slower economic growth, making the situation more difficult for consumers and businesses.
The sovereign debt bankruptcy will also lower the net asset value of all bond mutual funds holding the defaulted debt and its market value will fall. Conversely, a sovereign default could present an opportunity for distressed debt investors, who could buy the bonds at deep discounts to face value in the hope that they might be worth more later after a debt restructuring. Sovereign debt defaults also create winners and losers in the market for credit default swaps, which are financial contracts that pay out like an insurance policy in the event of a default. Credit default swaps allow bondholders to hedge against the risk of default and allow speculators to bet that a default will occur.
Countries that defaulted
In 1557, Spain became the first country to default. Notably, this European country defaulted on its debt 15 times between the 18th and 19th centuries. Argentina defaulted on its $132 billion in loans in 2001. As a result, the South American country defaulted again in 2016 and 2020.
Russia defaulted in 1918 and 1998. After the breakup of the USSR, Russia inherited a $100 billion foreign debt in 1993 at the request of creditors in exchange for promised financial assistance, according to the International Monetary Fund. Amid international sanctions imposed on the country for invading Ukraine, experts have warned that Russia could default on $117 billion worth of loans again.
Ukraine defaulted on its loans in 1998 and 2020. Between 2017 and 2018, the Latin American country of Venezuela defaulted on its $60 billion worth of loans. Greece twice defaulted on its $1.7 billion and €456 million debt in 2015. Ecuador defaulted on payments in 2008 and 2020. Mexico defaulted in 1982 and 1995. In 2010, the African country of Jamaica defaulted on its $7.9 billion debt.
In 2020, amid the pandemic, two Latin American countries, Argentina and Ecuador defaulted. Argentina adopted a take-it-or-leave attitude towards creditors, often leading to public dissent and dramatic breakdowns in negotiation. But in each round of negotiations, the country gave the creditors ground. Argentina started the process with support from the International Monetary Fund (IMF), whose economists backed Argentina’s calls for a generous restructuring.
However, Argentina’s final agreement with creditors included a 45% discount on interest payments and a six-month grace period, in contrast to the government’s original requirement of a 61% discount and a three-year grace period. Argentina also reluctantly agreed to change the collective action clauses in its bonds, a legal innovation aimed at minimizing so-called hold-outs that emerged from the protracted litigation that followed Argentina’s 2001 debt saga.
In contrast, Ecuador emphasized transparency and quiet consensus-building. Unlike Argentina, Ecuador agreed early on to grant bondholders special legal protections in the event of future restructuring. It also secured financial support from the IMF and received an emergency loan to deal with the public health and economic consequences of COVID-19.
In 2022, Belarus was declared bankrupt by Fitch Ratings and jointly announced with Moody’s Investors Service that Russia’s most trusted ally has officially breached the terms of its debt obligations to foreign investors. The eastern European country’s rating was cut to the default of RD by Fitch, below C. The credit checker cited the country’s failure to provide a dollar coupon payment on $600 million in US Dollar-denominated bonds, which is to be paid by 2027.
Moody’s said on July 14 that the incident constituted a default, but left its rating stable at CCC. Back then, the Belarusian Ministry of Finance accused the international rating agency Moody’s of a provocation which, according to Minsk, is intended to affect the Eurobond market.