Sovereign Default

What is Sovereign Default?

Sovereign default refers to the failure of the government of a sovereign entity to pay back principal and interest payments when they are due. The failure to repay debts owed to creditors may be accompanied by a government’s formal declaration that it will not pay owed debts, or it may sometimes occur without any formal declaration.

Countries and sovereign entities, like individuals and companies, borrow funds in domestic and international bond markets to fund various budget items such as infrastructure programs and healthcare services.

A country may issue bonds to investors with a contractual obligation to pay the principal amount and interest to bondholders. The government guarantees to repay bondholders using tax revenues raised from its citizens.

However, during the debt period, the government may run into cash flow problems due to various factors such as political instability, poor investment, mismanagement of investor’s funds, etc.

Insufficient cash flows impede the government’s ability to pay back debts due on time. Sovereign defaults may result in lower credit ratings and increased interest rates, making it difficult for the sovereign state to borrow additional funds from the international bond market.

Understanding Sovereign Debt

When investing in sovereign debt, bondholders monitor a sovereign entity’s political stability and financial environment to determine the risk of sovereign default. Although sovereign countries are not subject to bankruptcy laws, as is the case with companies and individuals, cases of sovereign default are common and are preceded by an economic crisis.

When it happens, bondholders will be at a loss since countries cannot be subjected to the same legal consequences as companies. Therefore, when bondholders suspect that a government is likely to default on its debt obligations, they may seek a review of the interest rates to compensate for the increased risk of default.

Such a scenario is known as a sovereign debt crisis, which is common in governments that rely on short-term borrowings since it creates a mismatch between the short-term bond and the long-term value of assets financed through debts.

When a country defaults, credit rating agencies will review its financial status and assign it a sovereign credit rating. The rating assigned will depend on various factors such as procedural defaults, failure to abide by the terms and conditions of the debt, and the sovereign entity’s interest expense.

Causes of Sovereign Default

Change of Government

Formal transitions from one elected government to another elected government may not change the treasury obligations created by preceding governments. However, when a regime change occurs due to a military coup or revolutionary situation, the incoming government may question the legitimacy of earlier debts taken by the previous government and discontinue repayment of current debts.

According to international law, such debts may be considered illegitimate, meaning that they are personal debts of the previous regime and not of the state. In this respect, such debts may not be enforceable. For example, when the Soviet government came into power in 1917, all debts incurred by the Russian Empire were considered illegitimate, and the new government discontinued further repayments.

Illiquidity

A country is in default due to illiquidity when it is temporarily unable to meet principal and interest payments because it cannot quickly liquify its asset base.

Illiquidity is considered a temporary setback since the illiquid assets can become liquid again after a specific period. If the assets cannot be sold to raise capital immediately, the state will be unable to raise sufficient cash flows to meet principal and interest payments.

Insolvency

Insolvency is a state where the country is no longer able to honor its debt liabilities, and it faces a sovereign default. A country may declare insolvency for various reasons, including sharp increases in public debt, unrest at austerity measures taken to repay debt, increased unemployment, and increased government regulations on the financial markets.

Sovereign insolvency occurs after years of overspending and emergency budgets, with the deficit being settled using new debts from domestic and international investors.

Consequences of Sovereign Default

When sovereign default occurs, there will be various consequences to creditors and the state.

For Creditors

The immediate impact of sovereign default to creditors is the loss of the principal amount loaned to the government and the interest owed on the debt. The state may resort to either partial cancellation or decide to restructure the debt to more favorable terms.

Partial debt cancellation occurs when the creditor agrees to partial repayment of the total principal amount. On the other hand, debt restructuring involves renegotiating the outstanding debt to increase the payment terms, swap the outstanding debt in exchange for equity in the company, or other terms.

For the State

When a state defaults on its sovereign debt, it disposes of its debt obligations owed to certain creditors. Disposing of the debts reduces the total debt owed by a state to its creditors, and subsequently, the principal and interest repayments.

Still, when a state defaults on its debts, it becomes less attractive to investors, and it will become difficult for the state to access new funds from the international bond market.

More Resources

CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

• Insolvency
• Sovereign Debt
• Credit Rating
• National Debt
• See all fixed income resources