What Does It Mean To Default?
Let’s start by understanding what it means for an individual or a company to default.
Let’s assume you want to buy a house and decide to borrow money from a bank. The bank issues you the required loan which needs to be repaid back periodically within 20 years. It is worth noting that the legal agreements, including terms and conditions of the loan will be dependent on your credit worthiness and how likely you are to pay the money back. For instance, the bank might require you to pay a portion of the loan along with the interest back to the bank on monthly basis.
Now, assume you pay the payments as per the agreement for first 6 months and then you miss out on the payments due to your bad economical situation.
What Happens Next?
The bank will start chasing you for the money
You might get a letter from the bank, followed up by phone calls leading to visits from the enforcement agencies and finally your property will be repossessed. Once the property is sold, you might also be required to declare bankruptcy. Subsequently, the next time you borrow loan, banks might charge you higher interest due to your poor credit quality.
On the other hand, if a company defaults on its loans then its stock value goes down along with its ratings. Additionally its assets (laptops, offices etc.) might be sold to pay off loan and it will be harder for the company to conduct new business in the future.
So far, everything makes sense. Now let’s move on to country defaulting
Understanding Sovereign Default
Countries (sovereigns) have a complicated economical structure. Their economy is exposed to a wide range of factors; from political risk (corruption index level, autocratic leadership), legal risks (how reliable their legal system is) to economic growth cycles (how dependent their growth on a service or export is and how productive their revenue system is).
Governments require money to pay existing debts and to perform pension and social service commitments. Country’s government has a treasury department which maintains its capital and ensures the country has enough money available.
Believe it or not, some investors prefer to invest in non-democratic countries because their policies are stable and predictable.
Governments can raise capital in various ways; such as from increasing revenue, taxing its people and services, issuing treasury bonds or to borrow money from foreign countries.
Money borrowed from foreign countries is in foreign currency
Let’s Move On To Treasury Bonds And Foreign Debt
Think of governments issuing treasury bonds as borrowing loans from public. Governments pay money back periodically to the bond holder. The money borrowed by issuing bonds is known as local country debt because the bonds are issued in local (domestic) currency. If the government is unstable then you can expect the government to pay higher interest on the treasury bonds.
When countries borrow money from foreign countries, it is known as foreign country debt. If the government has poor rating and is already in high debt then the foreign countries will charge higher interest rate on the borrowed loans.
When countries are unable to pay back on their loans to their creditors then they declare bankruptcy and are then considered defaulted. Most of the sovereign defaults are foreign currency defaults.
Next Steps — What Happens When A Country Defaults?
This section highlights the core of this article. In this section, I will outline the top ten potential consequences of a country defaulting:
- First and foremost, currency of the country can be devalued. This can make it expensive to import products. Additionally, export businesses might suffer due to selling products and services cheaper in short term. For exporters, currency devaluation is a double edge sword; when services and products get cheaper, it increases their demand. Exports become attractive and raises competition in market. As exports are cheaper for foreign countries, they tend to buy more from the defaulted country. Additionally domestic service providers might benefit due to foreign investments and tourism boosts due to foreigners visiting more frequently as it happened after pound devalued in 2016. Hence default has positive effects for the country too.
- Secondly, debt can be restructured such as by extending the loan payment date or by reducing the loan amount or by further devaluing the currency.
- Austerity measures might be followed which includes spending cuts and tax increase.
- Living standards of people can also be impacted. It might start with riots on the streets leading to banking crises. The core reason for banking crises can be that the people might attempt to take all of their money out of the banks due to uncertainty and confusion. The chances of banking crises might increase, as an instance by up to 10% and the government may close down its banks to avoid money withdraw. Occasionally, withdrawal is permitted but capital controls are imposed.
- Countries defaulting on foreign currency debt might also end up defaulting on local currency debt. This means that if you bought treasury bonds and the country defaults on foreign currency debt then you might not receive your bond periodic payments.
- Unlike business or individual bankruptcies, assets of a country are not repossessed. However occasionally military actions are followed when countries default. As an instance, Britain attempted to occupy Egypt when it defaulted in 1880s.
- Turmoil can be experienced in stock market. This can be due to uncertainty in market. No one might willing to buy anything. Many investors might even decide not to do business with the country until the situation is stable.
- Governments may refuse to pay any money or reduce the borrowed money as it happened in Argentina in 2001.
- The country can face loss of reputation, its rating might decline which makes it harder to borrow money in the future.
- GDP can slow down by up to 2% however it is usually for short term only (1–2 years). Cost to borrow money might even increase up to 1%. Due to higher export demands, current account deficit can decrease and this in turn ends up increasing economic growth. Again, there are some positive side effects.
Defaults can be avoided by restructuring debt agreements and to seek help from a guarantor (IMF)
Countries That Have Defaulted In The Past
It is probably worth mentioning that many countries have defaulted in the past.
Furthermore, it is not surprising for a country to default.
This is a list of famous sovereign defaults:
- Venezuela: 2017
- Greece: 2015
- Ecuador: 2008
- Argentina: 2001
- Russia: 1998
- Mexico: 1994
- France: 1958
- Egypt: 1880s
- Spain: 15+ times by 1939
It is not uncommon for a country to default
Why Can’t Countries Reprint More Local Currency?
Someone asked me this question recently. They were wondering why a country simply doesn’t print local currency to pay off local currency debt.
Here’s my take of it. Although there is more to it but this is one side of the coin:
Printing more money might lead to inflation. This is mainly as supply of money increases, costs of products can end up increasing due to their increase in demand. As a consequence, currency can also be devalued which can be often worse than defaulting. Additionally gold standard and the concept of shared currency prevents countries to print money as and when they want — although gold standards and shared currency is not applicable to all countries.
If you want to know more on how to compare countries along with different economical indicators then have a look at my article “How Should I Compare Countries?”.
Sovereign default can be predicted which I will be covering in future.
This article explained what default means and then the article outlined consequences of a country defaulting. Finally a number of countries were mentioned that have defaulted in the past.
This topic is complex in nature as different countries behave differently. Tu is article presents a possible set of scenarios that are worth considering.
The key point to take away is that sovereign default can put a country into a tough situation for short term, can impact its reputation and living standards of its people, but it is not uncommon for countries to default. Currency devaluation can help exporters and makes it cheaper for foreign countries to buy its products and services. It then helps its economy to grow as current account deficit declines. Additionally, many countries have defaulted in the past. – Farhad Malik