What is an Economic Default? We talk about the nature, types and instances of economic default for nation states. In simpler terms, an economic default is a country’s inability to return its loan to its providers. In financial terms, it is an inability to meet the legal obligations of returning the taken money or loan amount on its maturity. It means that the debtors have been passed behind the payment deadline on a debt whose payment was due.
There are two types of a Default. These are debt services default and technical default respectively. Debt service default occurs when the borrower has not made a scheduled payment of interest or principal. Technical default occurs when an affirmative or a negative covenant is violated. The affirmative covenants are clauses in debt contracts that require firms to maintain certain levels of capital. Negative covenants are clauses in debt contracts that limit or prohibit corporate actions (e.g. sale of assets, payment of dividends) that could impair the position of creditors. Negative covenants may be continuous or incurrence-based. Violations of negative covenants are rare compared to violations of affirmative covenants.
With most debt (including corporate debt, mortgages and bank loans) a covenant is included in the debt contract which states that the total amount owed becomes immediately payable on the first instance of a default of payment. However, it changes completely in case of a nation state or a sovereign’s default.
What is a Sovereign Default?
A sovereign default is the failure or refusal of the government of a sovereign state to pay back its debt in full when due. Cessation of due payments (or receivables) may either be accompanied by that government’s formal declaration that it will not pay (or only partially pay) its debts (repudiation), or it may be unannounced. A credit rating agency will take into account in its grading capital, interest, extraneous and procedural defaults, and failures to abide by the terms of bonds or other debt instruments.
Sovereign borrowers such as nation-states generally are not subject to bankruptcy courts in their own jurisdiction, and thus may be able to default without legal consequences. One example is Greece, which defaulted on an IMF loan in 2015. In such cases, the defaulting country and the creditor are more likely to renegotiate the interest rate, length of the loan, or the principal payments. In the 1998 Russian financial crisis, Russia defaulted on its internal debt, but did not default on its external Eurobonds. As part of the Argentine economic crisis in 2002, Argentina defaulted on $1 billion of debt owed to the World Bank.
Common Reasons of Economic Default
Some of the common reasons of an economic default identified by economic experts include:
- A reversal of global capital flows
- Unwise lending
- Fraudulent lending
- Excessive foreign debts
- A poor credit history
- Unproductive lending
- Rollover risk
- Weak revenues
- Rising interest rates
A significant factor in sovereign default is the presence of significant debts owed to foreign investors such as banks who are unable to obtain timely payment via political support from governments, supranational courts or negotiation.
Examples of Economic Default
A failure of a nation to meet bond repayments has been seen on many occasions. Medieval England lived through multiple defaults on debt, Philip II of Spain defaulted on debt four times – in 1557, 1560, 1575 and 1596. This sovereign default threw the German banking houses into chaos and ended the reign of the Fuggers as Spanish financiers. Genoese bankers provided the unwieldy Habsburg system with fluid credit and a dependably regular income. In return the less dependable shipments of American silver were rapidly transferred from Seville to Genoa, to provide capital for further military ventures.
In the 1820s, several Latin American countries that had recently entered the bond market in London defaulted. These same countries frequently defaulted during the nineteenth century, but the situation was typically rapidly resolved with a renegotiation of loans, including the writing off of some debts.
A failure to meet payments became common again in the late 1920s and 1930s. As protectionism by wealthy nations rose and international trade fell, especially after the banking crisis of 1929, countries possessing debts denominated in other currencies found it increasingly difficult to meet terms agreed under more favorable economic conditions.
A number of states in the U.S. defaulted in the mid-19th century. The most recent U.S. state to default was Arkansas, which defaulted in 1933.
More recently Greece became the first developed country to default to the International Monetary Fund. In June 2015 Greece defaulted on a $1.7 billion payment to the IMF.
What happens in case of an economic default?
According to Investopedia, when a borrower defaults on a loan, the consequences can include:
- Negative remarks on a borrower’s credit report and a lower credit score, a numerical measure of a borrower’s creditworthiness
- Reduced likelihood of obtaining credit in the future
- Higher interest rates on any new debt
What Happens When A Country Defaults?
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.
List of 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
Also Read: How huge is Chinese Economy?
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.