Sovereign Default

Sovereign default is a failure in the repayment of a county's government debts. Countries are often hesitant to default on their debts, since doing so will make borrowing funds in the future difficult and expensive. However, sovereign countries are not subject to normal bankruptcy laws and have the potential to escape responsibility for debts without legal consequences.

Sovereign defaults are relatively rare, and are often precipitated by an economic crisis affecting the defaulting nation. Investors in sovereign debt closely study the financial status and political temperament of sovereign borrowers in order to determine the risk of sovereign default.

In the event of a country’s default, a credit rating agency will take into account the country’s interest, extraneous and procedural defaults and failures to abide by the terms of bonds or other debt instruments. Inflation has sometimes helped countries to escape the true burden of their debt. Other times when faced with extreme debt, some governments have devalued their currency, which they do by printing more money to apply toward their own debts, or by ending or altering the convertibility of their currencies into precious metals or foreign currency at fixed rates.

When the United States needs more money, it relies on two primary options. One is to raise taxes and the other is to issue debt. Because raising taxes can be a lengthy and unpopular option, the U.S. Department of Treasury will instead often choose to issue debt in the form of selling U.S. securities. These Treasury securities and bonds act as loans in which the purchaser gets to collect interest until the bond matures and the government pays back the original amount.

If potential lenders or bond purchasers begin to suspect that a government may fail to pay back its debt, they will sometimes demand a high interest rate as compensation for the risk of default. This is sometimes referred to as a sovereign debt crisis, which is a dramatic rise in the interest rate faced by a government due to fear that it will fail to honor its debt. Governments that rely on financing through short-term bonds may be especially vulnerable to a sovereign debt crisis since short-term bonds create a situation of maturity mismatch between short-term bond financing and the long-term asset value of a country’s tax base.

A number of countries have excellent records of paying on sovereign debt obligations and have never defaulted. These nations include Canada, Denmark, Belgium, Finland, Malaysia, Mauritius, New Zealand, Norway, Singapore, Switzerland and England.