What happens when a country defaults on its debts

Last week, Sri Lanka joined the list of countries that defaulted on sovereign debt. The island nation has defaulted on its foreign debt worth $51 billion as it faces its worst economic crisis, for the first time since its independence in 1948. The South Asian country is in the struggling with inflation soaring to 17.5%, a 12-hour power outage, and dwindling foreign exchange reserves.

A statement from the Ministry of Finance said: “It will be the policy of the Sri Lankan government to suspend normal debt servicing…..will apply to amounts of affected debt outstanding on 12 April 2022.”

While many experts have pointed to government overspending, tax cuts and the first and second waves of Covid-19 to deepen the country’s economic crisis, others believe that Sri Lanka’s close relationship with the China fueled the country’s debt crisis.

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

What is sovereign debt default?

Like businesses, countries borrow from domestic and international creditors. Countries issue bonds in exchange for debt. However, due to insufficient cash inflow, the country often fails to repay the principal amount as well as the interest amount of the loan to domestic or international creditors as well as organizations such as the International Monetary Fund (IMF) . This is called sovereign debt default.

Impact of sovereign debt default

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

High interest rates– In the event of a sovereign debt default, countries tend to borrow at higher interest rates, which in turn leads national banks to lend at higher interest rates. This has a negative impact on the country’s trade and exports. Moreover, with less or no confidence among borrowers in the government, they try to withdraw money from banks. This aggravates the economic crisis.

Foreign portfolio investors– Foreign portfolio investors try to sell their local assets in order to exit the failing country, which leads to falling exchange rates in the international market. This has an additional impact on exporting and importing into the country.

Indoor market– Within the domestic market, the default on sovereign debt led to the disappearance of the stock market capitalization of the country’s large companies.

The IMF to the rescue

When a country defaults on its loans, it typically approaches the IMF for assistance in the form of loans and stimulus packages. For example, on April 17, Sri Lanka approached the IMF for the 17th time for a bailout package worth $4 billion. The failed country is also reaching out to its unilateral and bilateral allies to ease the economic crisis.

In addition, the defaulting country can also engage in a debt restructuring plan. This can be done either by extending the repayment date of their debts or by devaluing their currency. Currency devaluation would mean faster debt repayment, cheaper export goods and a restarting of the economy.

Countries that have defaulted on their loan

In 1557, Spain became the first country to default on its loans. Notably, between the 18th century and the 19th century, this European nation had defaulted on its debt 15 times. Argentina defaulted on its loans in 2001 worth $132 billion. Then, the South American country defaulted on its debt again in 2016 and 2020.

Russia defaulted on its loans in 1918 and 1998. After the disintegration of the USSR in 1993, Russia inherited $100 billion in foreign debt at the request of creditors and in return for aid promised financial support, according to the International Monetary Fund. Amid international sanctions imposed on the country over its invasion of Ukraine, experts have pointed out that Russia could 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 for $1.7 billion and €456 million, 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. dollars.