Sovereign default facts for kids

Kids Encyclopedia Facts

A sovereign default happens when a country's government fails to pay back its money loans. This means the government can't or won't pay its debts when they are due. Sometimes, the government officially says it won't pay. Other times, it just stops paying without an announcement. When this happens, groups that rate how good countries are at paying debts will lower the country's score.

Sometimes, countries try to make their debt easier to pay by causing inflation. This means money becomes worth less. So, even if they pay back the same amount, the money they pay is not as valuable as it used to be. Governments might also make their money worth less compared to other currencies. This is not a "default" in the usual sense, but it still helps them with their debt.

If people who lend money start to worry that a government might not pay them back, they will ask for higher interest rates. This extra cost is like a fee for the risk of not getting paid. When interest rates go up a lot because lenders are scared, it's called a sovereign debt crisis. Countries can be in trouble if they borrow money for short periods but need to pay it back over a long time.

They can also face problems if they borrow money in foreign currencies. If their own money loses value, it becomes very expensive to pay back those foreign loans.

A country's government is in charge of its own land and people. So, it cannot be forced to pay its debts. However, other countries that lent money can put a lot of pressure on them. In the past, some powerful countries even threatened war or went to war to get their money back. For example, in 1882, the United Kingdom invaded Egypt over debt. Today, a country that defaults might not be able to borrow money again for a long time. Other countries might even try to take some of its assets located overseas. Also, people within the country who lent money might pressure their government to pay.

Because of these problems, governments rarely refuse to pay all their debt. Instead, they often talk with the people they owe money to. They try to agree on a plan to pay later (debt restructuring) or pay back only a smaller part of the debt (called a 'haircut'). Some experts think that during big money problems, it's better for countries to plan a controlled way to deal with their debt. This is sometimes called an "orderly default."

The International Monetary Fund (IMF) often helps countries with their debt problems. To make sure the country can pay back some of its debt, the IMF might ask the country to make changes. These changes could include reducing corruption, cutting down on government spending, or collecting more taxes. A recent example is the Greek bailout agreement of May 2010. After the 2008 financial crisis, countries like Spain and Portugal changed their economies to avoid defaulting on their debts.

Why Countries Default
How Countries Deal with Debt
- Reputation Matters
- Fear of Punishment
What Happens After a Default
Past Examples of Default
See also

Why Countries Default

Financial experts have noticed that countries often default on their debts when certain things happen:

Money stops flowing into the country from other parts of the world.
Lenders give out money without being careful.
Too much debt is owed to foreign countries.
The country has a history of not paying its debts.
Money borrowed is not used for things that help the economy grow.
It's hard to get new loans to pay off old ones.
The government doesn't collect enough money (revenue).
Interest rates on loans start to go up.

A big reason for default is when a country owes a lot of money to foreign banks or investors. It becomes very hard for these lenders to get their money back. This is because it's difficult to force a country to pay. Some people think that a country choosing not to pay its debts is like a form of theft.

When a Country Can't Pay

If a country cannot or will not pay its debts for economic reasons, it faces sovereign default. This happens even if the country can only pay a small part of what it owes.

Reasons for this include:

The government has borrowed a lot of money.
Fewer people are working, which means less tax revenue for the government.
People are unhappy about government cuts to services meant to pay back debt.

Historically, countries that default because they can't pay have usually spent more money than they received for many years. They covered this gap by borrowing more money from their own citizens, banks, and other countries.

Temporary Money Problems

There's a difference between being unable to pay for a short time (illiquidity) and being unable to pay at all (insolvency). If a country can't make payments right now because it can't quickly turn its assets into cash, it's "illiquid." This problem might be solved once its assets become cash again. However, it's hard to prove if an asset is only temporarily hard to sell.

When Governments Change

Usually, a new government still has to pay the debts of the old government. But sometimes, after a big change like a revolution, the new government might say the old government's debts are not valid. This is called "odious debt."

Some famous examples are:

France not paying debts after the French Revolution.
Denmark not paying bonds from Holstein in 1850.
The Soviet government not paying the debts of the Russian Empire in 1917.
The United States not paying the debts of the Confederate States of America after the Civil War.

When a Country Disappears

If a country no longer exists, its debts usually go to the new countries that take its place. For example, when the Soviet Union broke up, its debts were inherited by the new countries like Russia and Ukraine.

Wars can make countries default faster. But even in peacetime, many countries have seen their government debt grow a lot. This is because of compound interest and continued spending more than they earn.

How Countries Deal with Debt

There are two main ideas about why countries pay their debts.

Reputation Matters

One idea is that countries want to be able to borrow money from other countries in the future. This helps them manage their economy when things change. If a country doesn't pay its debts, it gets a bad reputation and won't be able to borrow easily again.

Fear of Punishment

Another idea is that countries pay their debts because they are afraid of what will happen if they don't. Lenders might use legal action or even military force to get their money back. This punishment could stop the country from borrowing money in its own currency.

What Happens After a Default

When a country defaults, it affects the people who lent money, the country's economy, and its citizens.

For Those Who Lent Money

The first thing that happens is that lenders lose some or all of the money they are owed.

Often, there are international talks to agree on a plan. This might mean canceling part of the debt or changing the payment plan. For example, in the Argentine economic crisis (1999–2002), some lenders agreed to lose up to 75% of their money. Others waited for a new government to offer a better deal.

Debts can be different depending on who lent the money (people in the country or foreign lenders) and what currency the debt is in. Countries are often more willing to cancel debts owed to foreign private lenders, unless those lenders can cause problems for the country.

For the Country Itself

When a country defaults, it gets rid of some of its financial obligations. This means it has less debt and pays less interest. However, defaulting can hurt the country's reputation with lenders. This makes it harder for the country to borrow money in the future. In some cases, foreign lenders might try to control the country's money system or even declare war.

For the Citizens

If citizens or businesses in the country lent money to their government (for example, by buying government bonds), a default means their money might become worth less.

Also, other problems can happen in a country after a default:

A banking crisis, because banks lose money on loans they gave to the government.
An economic crisis, because people buy less, and investors take their money out of the country.
A currency crisis, because foreign investors avoid the country's economy.

Citizens might also feel the effects through high unemployment and fewer government services. However, a country that controls its own money can take steps to fix things and help its economy grow again.

Past Examples of Default

Countries failing to pay their debts has happened many times throughout history.

Medieval England defaulted on debt several times.
Philip II of Spain defaulted four times between 1557 and 1596. This caused problems for German banks.
In the 1820s, several Latin American countries that had just started borrowing money in London defaulted. They often defaulted throughout the 1800s, but usually, new agreements were made quickly.

Defaults became common again in the late 1920s and 1930s. As countries protected their own businesses more and international trade dropped, it became very hard for countries to pay debts in other currencies. For example, in 1932, Chile's payments were more than its total exports.

Several states in the U.S. defaulted in the mid-1800s. The most recent U.S. territory to default was Puerto Rico in 2017.

More recently, Greece was the first developed country to default on a payment to the International Monetary Fund. In June 2015, Greece defaulted on a $1.7 billion payment.