Some Basics on Sovereign Debt and Default

This 14-minute podcast was released Oct. 4, 2018.

Economist Paulina Restrepo-Echavarria in studio with Kristie Engemann

St. Louis Fed economist Paulina Restrepo-Echavarria (right) explains why governments borrow, what happens when a country defaults on its debt and how a country gets out of a debt crisis. Gaining a better understanding of why sovereign default happens and what makes a country more prone to risk leads to a better understanding of how interest rates behave, she said.

Transcript:

Kristie Engemann: Welcome to Timely Topics, the St. Louis Fed’s podcast series. I’m Kristie Engemann, your host for this podcast. With me is Paulina Restrepo-Echavarria, an economist in the Research division. One of Paulina’s areas of interest is international macroeconomics. In this segment, she will be talking about some issues related to sovereign debt and countries defaulting on their debt. Welcome, Paulina. Thanks for being here.

Paulina Restrepo-Echavarria: Thank you for having me.

Engemann: Could you first explain what is sovereign debt, and why do countries borrow or issue debt?

Restrepo-Echavarria: Sovereign debt is those loans that are made by a government. That’s it. There’s not much to it. Why do governments borrow? Because they want to smooth consumption. If, let’s say, they don’t have such a large income today, but they expect that income to be high tomorrow, they want to be able to consume as much today as they will tomorrow. So, countries would like to borrow today to be able to consume a little bit more, and then tomorrow, when they have a larger income, they can repay that debt, in principle.

Engemann: Countries issue bonds of different maturities. Some are shorter term, and some are longer term. Why would they issue those multiple types like that?

Restrepo-Echavarria: Because they wouldn’t like all their debt to expire at the same time. When they issue bonds of different maturities, they’re guaranteeing that they’re smoothing out, as well, the repaying of this debt.

Engemann: Emerging markets sometimes issue bonds that are denominated in foreign currencies, such as the U.S. dollar. Do you know what percentage of emerging market debt is dollar-denominated, and why is that important?

Restrepo-Echavarria: I don’t know exactly what is the percentage, but it’s a very large percentage. I guess the majority of the debt, if we think about specifically Latin America, for example, it’s issued in dollars. It’s very important because that means that exchange rates matter, and not only exchange rates, but you need to be liquid in dollars in order to be able to repay your debt that is issued in dollars. And, how does a country collect dollars? They collect dollars through imports and exports. So, they need to have kind of the right balance of imports and exports to have all the dollars that they need incoming into their country in order to repay their debt, and the other thing that comes into play is exchange rates because, if you have large swings in your exchange rates and you owe debt in dollars, then this can imply that you owe more or less, in your local currency. And, this is going to be important in terms of how much actual debt you’re going to have to repay.

Engemann: Regarding emerging markets that have debt denominated in U.S. dollars, what happens when the dollar rises?

Restrepo-Echavarria: If you think from the perspective of a small country, imagine that we’re talking about pesos. So, think about $1, and that $1 is equivalent to 1,000 pesos, for example. In that situation, imagine that, all of a sudden, your exchange rate is such that now you have $1 being worth 3,000 pesos instead of the 1,000 pesos. In that case, what’s going to happen is that your currency is losing value against the dollar. That’s going to change the amount of dollars that you’re going to have to pay when you repay your debt. If you had a debt that was very small in your own currency, all of a sudden, it’s going to triple and is going to be much more expensive for you. So, that’s a problem. That’s what matters when you transform it into your local currency, and the exchange rate is what makes it much higher or much lower.

Engemann: How important is the U.S. central bank to these emerging markets that have dollar-denominated debt? Do they pay attention to U.S. monetary policy?

Restrepo-Echavarria: They pay a lot of attention to the interest rate because they believe that this is actually going to move flows in some sense. So, this is going to kind of cause flights out of their country and this is going to affect the exchange rate, and if the exchange rate is affected, then the amount of the debt they owe is affected as well. So, they do pay quite a bit of attention, and especially those that do inflation targeting, which means that they have a specific level of inflation that they want to maintain in their country. The amount of currency, both in dollars and in local currency, that they have domestically matters a lot to be able to hit that target. So, they care a lot.

Engemann: Can a country have too much debt? When does it become a problem, and how do you determine how much debt is too much? Is it in absolute terms, or is it relative to GDP, or is it something else perhaps?

Restrepo-Echavarria: That’s a very difficult question. I don’t think we have an answer to that because, for example, you have countries like the U.S. The U.S. has a debt-to-GDP ratio of 105 percent. Then, you have Japan, which is, like, 200. But then, you have countries in Latin America that have only, like, 40 percent. But, everyone is really scared of these countries in Latin America defaulting on their debt, but no one is freaking out every single day because the U.S. is going to default on their debt or Japan is going to default on their debt. So, it’s something that is actually completely related to the perception of risk of the economy. So, saying that there’s such a thing as there’s too much debt in absolute terms I think is wrong. You can never say that, but there is certainly such thing as too much debt for a country that you know has political risk or issues like that. Venezuela would be a very good example of that. But the absolute number is completely case dependent.

Engemann: What does it mean for a country to go into default, and why is it dangerous to do so?

Restrepo-Echavarria: The term default means that a country ceases their payments on the principal of their debt on the one hand. Alternatively, they can cease the payment on the services of their debt, meaning that they stop paying interest on their debt. A broader definition of default includes the renegotiation of the terms of your debt. So, if, for example, you had issued a bond that had a particular interest rate and you know that you won’t be able to pay it, and you extend the maturity of that bond, and then you change the interest rate that you’re paying for an interest rate that is less favorable for the country, so a higher interest rate. Then this would also be considered a default because they had to forcefully do this change of terms that is not good for the country.

Why is it dangerous? I wouldn’t say it’s dangerous. It’s not good for the country in terms of reputation. I think it’s clear that it’s never good to not pay your debts, especially when you know that it’s a dynamic game. It’s not a static game. You know that in the future you’re going to probably need resources again, and if you are a country that has a reputation of not repaying its debt, then you’re going to have to pay much higher interest rates for that.

Engemann: And why is it important to study sovereign default and for people to understand it?

Restrepo-Echavarria: It matters a lot because this drives prices in financial markets because we know that a lot of the securities that are being traded are government securities. And default affects the sovereign risk, and sovereign risk determines the interest rate that is paid for the securities. So, it affects prices, and it affects financial markets.

Engemann: And you just talked about risk, but how is the sovereign risk assessed, and what is the impact if a country’s credit rating gets downgraded?

Restrepo-Echavarria: There a couple of ways of assessing credit risk. One is directly through prices. So credit spreads would reflect risk. We tend to think as the U.S. as being kind of the country that dictates the risk-free rate. So, take, for example, the interest rate on Treasuries. It might be two-year, five-year, 10-year Treasuries, and then you look at the interest rate at which bonds from an emerging market, for example, are going. And that difference between the interest rate at which they issue versus the one that the U.S. is issuing the same term bond, that’s going to be the spread, and that is pricing in the risk that an emerging market has versus the U.S. So, that’s one way.

A different way is through indicators, which could be credit ratings. Fitch, Moody’s, these agencies rank countries according to their risk exposure. There are other indicators done by other firms, like the Institutional Investor Index, for example. 

What does being downgraded mean? It means that, all of a sudden, you’re just perceived as a much riskier country. When you’re downgraded in your credit rating specifically, so let’s say in the Moody’s credit rating, what’s going to happen is that in a little bit, that’s going to be translated into the spread. Depending on the reason why the downgrade took place or anything, within a month or so, you should start seeing actual interest rate spreads go up as well. 

Engemann: What leads to a country having a sovereign debt crisis, and when that does happen, what happens to the country’s economy?

Restrepo-Echavarria: The question what leads to a country’s debt crisis? Many reasons can lead to that, but basically what happens is that you see that they just default on all of their debt. And, what are the implications? You see exports suddenly spiking up. So, exports increase largely, and the reason for that is that there’s a current account reversal. When you are borrowing money, a lot of money and resources are coming into your country. Your current account is negative, and a negative current account corresponds to large imports. So, it’s equivalent to importing goods. Then, when you default on your sovereign debt, that means that no one is going to lend you anything else. So, you’re excluded from international financial markets, and at that point, you basically have to do anything to save your reputation. You see imports dropping completely. Exports spike up. That corresponds to a positive increase in the current account, which means that resources are flowing out of your country, and this is observed to go together with an output drop, meaning that your GDP is going down at the same time.

So, sovereign debt crises come together with spikes in exports or capital flow reversals, which are called sudden stops; output drops, so drops in GDP; and consumption drops largely as well. These are the features that we would observe.

Engemann: So, you talked about what happens to that particular economy, but does it have spillover effects on the rest of the world when a country can’t repay its debt?

Restrepo-Echavarria: Not necessarily. It depends on the level of integration. So, for example, it’s very different when we think about the situation in Europe. So, the European Union, they share a currency, and we know that in the last crisis that we observed in Europe, there the risk of contagion was much larger because they share a currency and they were defaulting on debt that was made by another of the countries in the Union, so let’s say Germany.

Now, it’s different in the case of a region like Latin America, for example. Latin America doesn’t share a currency, and often times, the business cycles of these countries are not even that correlated. So, when one country defaults, it’s not necessarily the case that others are going to default. Now, sometimes, we do see that these crises happen at the same time. For example, in the 1980s, in 1981, ’82, ’83, we saw all the countries in Latin America defaulting, with the exception of Colombia, and they all defaulted for different reasons. But, they all defaulted within a two-year period. So, this was seen like a general phenomenon when it was not. So, it depends on the circumstances. There can be spillovers, as I said in the case of Europe for example.

And then, the other implication might be, if the country that is lending you the resources and to the one that you’re defaulting, if, for example, they were to have a very large share of their GDP in your country, then that would be a problem. But, you generally don’t see that happening. So, in my perspective, I think, apart from the case of Europe, all of these crises are very contained within countries. 

Engemann: Once a country is in a debt crisis, how does it get out of it?

Restrepo-Echavarria: So, usually, the IMF or the World Bank interfere. They are kind of the lenders of last resort for these countries. Often times, what happens is that there’s a renegotiation of the terms of debt. There’s a haircut. Basically, you negotiate that you don’t have to repay your whole principal with all the interest and so on. And then, the IMF will lend you resources to repay that debt under the new conditions that you have settled. So, usually, that’s how countries get out of it, and that goes together with an IMF plan. The IMF kind of tries to enforce fiscal regimes and so on to try to get you out of the situation.

Engemann: Is there anything else on this topic that you would want to share or that you think is important to convey?

Restrepo-Echavarria: I think that something that might be interesting to people is that, at the end, we never really see countries being excluded from international financial markets. Something that some people can have in mind is, OK, these countries default and then they’re excluded from international financial markets and they lose access for a while and so on. At the end, we don’t see that. We see their reputation being affected. And at the end, it’s all priced in. So, financial markets price all of this in and then it’s all accommodated in some sense. And because it’s a dynamic game, not a static situation, then this is just going to keep on happening. But we do like to understand better why it happens, what makes a country more prone to risk, because that will help us understand also interest rates and how they behave. And, we care about that. 

Engemann: All right. Well, thank you.

For more on Paulina’s research on this topic, go to her website. You can find that by starting out at stlouisfed.org, then clicking on “Research and Data,” and then on “Economists.” To listen to more of our podcasts, go to stlouisfed.org/timelytopics

Additional Resources

On the Economy: Comparing Measures of Sovereign Risk