The Economics of Sovereign Defaults

Why does a country default? What happens when a country defaults on its loans? This paper from Richmond Fed answers a few of these questions in simple English. It is in a way a like a literature survey.

First what is a sovereign default? The authors say:

There are different definitions of a sovereign default. First, from a legal point of view, a default event is an episode in which a scheduled debt service is not paid beyond a grace period specified in the debt contract.

Second, credit-rating agencies consider a “technical” default an episode in which the sovereign makes a restructuring offer that contains terms less favorable than the original debt.

Why does a government need to borrow? Simple, when its expenses are more than the revenues, in order to finance the public goods and pay its salaries, the government borrows from the creditors in forms of loans or by issuing bonds. Here, they are similar to private agents:  

Like private agents (households and corporations), governments can borrow to finance long-lived investments. Furthermore, in the same way households borrow to preserve living standards through periods of temporary hardship, governments borrow if they do not want to decrease expenditures when tax revenues are low.

However, there is difference between government defaulting and any private agent defaulting:

It is easier for households and firms to post appropriable collateral in order to improve borrowing conditions. If a private agent defaults, the government forces him to hand over the assets posted as collateral. On the other hand, a sovereign cannot commit to hand over its assets if it defaults, and in general there is no authority that can force it to do so……..Thus, sovereign debt is typically unsecured.

While for households and firms an important part of the costs of debt repudiation is determined by bankruptcy law, there is no international legal framework that imposes costs on a defaulting sovereign. 

Politico-economic factors affect the issuance of government debt. For example, a politician who cares mostly about the period during which he will be in office may not fully internalize the costs of issuing debt. Moreover, governments can borrow strategically to bind the hands of future governments with different preferences. Such strategic behavior would be more important in economies where policymakers’ interests are more polarized.

Why govts default?

1. When current resources to pay are very low.
2. When borrowing costs i.e. interest rates become high.

The importance of external factors for the borrowing cost of developing countries is suggested by empirical studies that  find that the interest rates paid by these countries have tended to move in the same direction as U.S. interest rates.

 3. Political angle

Apart from this, the paper has tabulated all sovereign defaults from 1824 onwards. They basically pick it from one of the numerous papers they have reviewed.

In one of the tables it tells how much the creditors recovered on neogotiations after the default. Like for the much known Russian default in 1998 (which lead to famous LTCM collapse) the creditors recovered 38-45% on average (basically a government takes many kinds of loans each with different of profie) of the total credit given. In Argentina crisis, sovereign paid 58% of domestic and just 27% of International borrowing.

A nice simple paper worth reading.

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2 Responses to “The Economics of Sovereign Defaults”

  1. paid survey Says:

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  2. Paradox of Rich to Poor Capital Flows « Mostly Economics Says:

    […] inflows. Nice insight and a nice twist on the head. I had covered the topic of sovereign defaults earlier as well, but that discussed whys and hows. This paper provides an extension of the […]

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