What Happens When A Country Defaults?

Breaking down what to expect from sovereign defaults

By Patrick Donley and Shawn O’Malley, edited by Robert Leonard

WHAT HAPPENS WHEN COUNTRIES DEFAULT?

It’s an interesting and nuanced question but also a timely one.

In 2022, as the global financial system cracks under tremendous strain, it’s quite natural to wonder what exactly happens when a country fails to pay its debts?

Our thinking today is inspired by the excellent writings of our friend, James Lavish.

Breaking it down

The first thing to know is that we must recognize the differences in types of debt.

When corporations issue bonds, they promise to use their positive cash flows to pay their bondholders back. They also back these issuances explicitly with certain assets or, at a minimum, with the implicit guarantee that creditors will have a first claim to their assets over equity shareholders.

In simpler terms, bondholders, who lend a company money, are given priority to be paid back if the business defaults on its obligations.

Sovereign debt

With countries, things are a bit different. Like corporations, they also raise money to pay back debts, though these funds come from taxes rather than from selling goods and services.

This makes recourse far more difficult for bondholders should a sovereign country default on the debts it owes.

Lavish raises a hypothetical where a California pension fund owns the country of Ghana’s debt.

If Ghana is cannot pay them back, the pension fund can’t just travel to Ghana and start claiming things to clear the debt, nor can they sue them in American courts.

Instead, they would collaborate with other creditors to try and restructure the debt so that it’s more manageable for Ghana to pay back — getting paid back something, or at a later date, is way better than never being paid back at all.

But for corporations, there are well-defined bankruptcy courts to settle corporate debt disputes. If Gamestop goes bankrupt, that same pension fund would have the U.S. legal system at its disposal to resolve the default (to whatever extent possible).

What to know

For Ghana, even after a default, there’s still an incentive to work with creditors so that they can restore their international image.

In theory, a country that defaults and can eventually pay down its debts after restructuring will be able to borrow from the international finance community much more easily than one that defaults and slams the door on creditors.

Now, in practice, it’s a bit more complicated.

For example, in the sort of developing countries and fragile economies that are likely to experience a sovereign default, regime change is often a possible risk.

So if an entirely new government forms with a new leader, they may still be able to find creditors even if the last regime fully defaulted and never restructured.

The new regime would also have to decide whether to start from scratch with its own debt issuance or uphold the previous regime’s bonds and work to pay those off.

Generalizations are hard because every situation is so unique. So the short answer is that it depends.

Defaults — explained

Let’s go deeper and try to define what it means to default.

Lavish says we can think of this as a “breach of the debt contract. This is typically the failure to pay scheduled debt service (coupon payments) on time, or within a specified grace period.”

If a country tries to offer debt repayment terms that are less than the original debt, then most investors and credit-ratings agencies would see this as a default.

Types of sovereign debt issuers

Another important distinction to make is between countries that issue debt in their own currency and companies that issue debt in foreign currencies.

For the former, this is almost exclusively true of countries with reserve currencies, chiefly the United States, though to a lesser extent, this is true in places like Japan and Europe as well.

If your debts are issued in your own currency, should it be necessary to do so, a government could work with its central bank to “print” the money needed to rid itself of these debts.

This is not a functional long-term solution, but the possibility does exist, typically at the cost of the currency’s value (aka debasement).

This provides a lifeline that enables a country like the U.S. to “kick the can down the road” for longer and with more credibility than just about anyone else. Hence, the so-called “exorbitant privilege” of having a global reserve currency.

For the latter, that is, countries that must raise debt in a reserve currency like the U.S. dollar, these tend to be developing economies, and they’re much more vulnerable to default in the short term.

They cannot simply print more of their currency to pay back the dollar-based debts.

Since, in simplified terms, if they dramatically increase the supply of their own currency, they will devalue their currency against the dollar.

This makes it harder to secure enough dollars to pay down their debts while also risking enormous inflation — see the Weimar Republic after World War 1 as an example of this dynamic.

Debt spiral

Of course, countries like the U.S. that issue debts in their own currency are not entirely immune from default risk, especially for liabilities that are pegged to inflation, like social security, which makes it challenging to “inflate your way out of the debt.”

Lavish summarizes by describing the steps for a debt spiral: “Increased cost of borrowing (higher interest rates) → debt grows faster than expected → external demand for debt decreases → interest rates increase more → debt spiral → default.”

Sri Lanka and Russia have defaulted on debts this year, with others like Pakistan and Ukraine at high risk.

There is, perhaps, no more prolific of a defaulter than Argentina, though.

History of defaults

Since its independence in 1816 from Spain, the country has defaulted a staggering nine times. This has yielded profound currency devaluations reaching, at times, inflation rates as high as 5,000%.

Per the IMF, in the last two hundred years, the 1830s, 1880, 1930s-40s, and the 1980s stand out as times of extreme sovereign default, where more than half of emerging market countries defaulted in each period.

Advanced economy defaults are less common, though, in recent memory, Greece became the first developed country since the 1960s to default, according to Lavish.

Restructurings

He explains that restructurings can range from just 12 months to over 60 months of negotiations.

In the end, they should result in a new payment schedule with more favorable interest and principal payments at a lower level with the possibility of extended maturities (more time to pay back the debt.)

Investors who hold the debt get a “haircut.” Their investments will lose value in a restructuring since they’re either getting paid back less or over a longer period of time (time value of money).

As we discussed earlier, countries in default are also losers too, since they typically end up paying higher future borrowing costs.

Other creditors will have noticed that they defaulted and will demand greater compensation to take on the risks of lending to them.

In an extreme scenario, Lavish suggests that countries that have recently defaulted may find themselves entirely excluded from capital markets and unable to borrow at all.

This sort of austerity would be incredibly painful for the country’s populace.

Wrapping up

You can read James Lavish’s full post here.

And don’t miss Preston Pysh’s podcast with James Lavish breaking down sovereign default risks globally today.

And this podcast from Bloomberg walks through just how messy sovereign defaults can be.

Let us know, readers — What do you think of sovereign default risks in today’s environment?

SEE YOU NEXT TIME!

All the best,