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Explained: What Happens When A Country Defaults On Its Debts

Owing to an insufficient cash inflow, the country often fails to pay back to its creditors the principal amount as well as the interest amount of the loan. This is known as sovereign debt default.

Explained: What Happens When A Country Defaults On Its Debts
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Last week, Sri Lanka joined the list of countries that have defaulted on sovereign debt. The island nation defaulted on its foreign debt worth $51 billion as it faces the worst economic crisis, for the first time since its independence in 1948. The South Asian country is grappling with soaring inflation at 17.5 per cent, a 12-hour power cut, and dwindling foreign reserves. 

A statement from the finance ministry said, “it shall be the policy of the Sri Lankan government to suspend normal debt servicing…..shall apply to amounts of affected debts outstanding on April 12, 2022”.

While many experts have pointed out overspending by the government, tax cuts, and the first and second wave of Covid-19 to worsen the country’s economic crisis, others believe that Sri Lanka’s close relations with China fueled the country's debt crisis. 

Nonetheless, Sri Lanka is not the first country to have defaulted on its debts. Over the past century, several countries have defaulted on their debts once or multiple times. According to the World Economic Forum, 147 countries have defaulted on their debts since 1960. 

What Is Sovereign Debt Default?

Just like companies, countries borrow loans from domestic and international creditors. The countries issue bonds in exchange for the debt. However, owing to an insufficient cash inflow, the country often fails to pay back the principal amount as well as the interest amount of the loan to domestic or international creditors as well as organizations like the International Monetary Fund (IMF). This is known as sovereign debt default. 

Impact of Sovereign Debt Default

Two of the major impacts of the sovereign debt default are rising inflation and unemployment. However, sovereign debt default also affects the interest rates, domestic stocks, and exchange rates.

High-interest rates- With sovereign debt default, countries tend to borrow at higher interest rates, which in turn results in domestic banks lending at higher interest rates. This puts a negative impact on the trade and exports of the country. Furthermore, with less or no trust amongst the borrowers in the government, they try to withdraw money from banks. This worsens the economic crisis.  

Foreign Portfolio Investors- Foreign portfolio investors try to sell off their local assets in order to exit the defaulting country leading to plummeting exchange rates in the international market. This further impacts the export and import within the country. 

Domestic Market- Within the domestic market, defaulting on sovereign debt, leads to the wipeout of the market capitalization of major firms within the country.

IMF To The Rescue

When a country defaults on repaying its loans, it usually approaches the IMF for assistance in the form of loans and recovery packages. For example, on April 17, Sri Lanka approached IMF for the 17th time for a bailout package worth $4 billion. The defaulting country also approaches its unilateral and bilateral allies to alleviate the economic crisis. 

Furthermore, the defaulting country can also engage in a debt restructuring plan. This can be done by either extending the date to repay their debts or devaluing their currency. The devaluation of the currency would mean faster repayment of the debts, cheaper export products, and kickstarting the economy. 

Countries That Have Defaulted In Their Loan

In 1557, Spain became the first country to default on its loans. Notably, between the eighteenth century and nineteenth century, this European nation had defaulted on its debt 15 times. Argentina defaulted on its loans in 2001 worth $132 billion. Followed by this, the South American country again defaulted on its debt in 2016 and 2020.

Russia defaulted on its loans in 1918 and 1998. After the disintegration of the USSR, in 1993, Russia inherited an external debt of $100 billion at creditors’ request and in exchange for promised financial assistance, according to the International Monetary Fund. Amidst the international sanctions imposed on the country as it invaded Ukraine, experts have pointed out that Russia can once again default on loans worth $117 billion.

Ukraine defaulted on its loans in 1998 and 2020. Between 2017 and 2018, the Latin American country Venezuela defaulted on its loans worth $60 billion. Greece defaulted on its debt twice in 2015 worth $1.7 billion and 456 million euros, respectively. Ecuador defaulted on its debt in 2008 and 2020. Mexico defaulted on its debt in 1982 and 1995. In 2010, the African country Jamaica defaulted on its debt worth $7.9 billion. 

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