The case of Greece has put the subject of sovereign default back in the news. What does it mean when a country is in default? What are the implications? Many people have asked me about this, so I think a little clarification is in order:
- Countries do not default. Their governments do . Argentina’s government may default even though many Argentine companies and families continue to pay their debts. When the media talks about the possible default of Greece, Argentina, etc., it is referring to the default of their governments, and more specifically that they cease to pay their overdue sovereign debt or interest owed.
- What is a country’s public debt backed by? Nothing. It is a usually debt with no real security behind it. It is highly improbable that a judge from the country in default would give you a public building in compensation for non-payment. If the deadbeat government has assets abroad, a judge from another country will most likely seize those assets in response to the demand from lenders. This happened in 2012 with the training ship of the Argentine Navy, which was in Ghana. Many central banks have their reserves in London or the United States (Fort Worth) and those assets can be seized.
- Practically the only consequence of default, which is not a minor one, is that the government loses its access to the debt markets. It can no longer finance by issuing bonds in foreign countries. This forces it to either have zero public deficit or create money (and inflation) to pay for the deficit. Obviously it will not be able to (or want to) face impending debt maturities, since most or all of the public debt (of any country) is refinanced, i.e., it is repaid with what you were just loaned. And since they won’t give you a loan, you won’t be able to repay it.
- Another, even harsher consequence is that in the event of default, businesses and families cannot opt for foreign financing, because if they won’t give loans to the government nor will they provide them to companies. When a country defaults, its economy is closed off and depends entirely on itself. The role of the central bank becomes absolutely critical to ensure cash flow, albeit with the temptation to create money and cause inflation. If the country’s banks depend heavily on external financing, you’re in trouble, because suddenly they run out of money and so does the economy.
- And the currency will clearly devalue, due the lack of confidence generated by the government. But this is not bad for the economy, because it will lead the nation’s companies to export more and consumers to import less, which is good for the economy.
- Lastly: risk premium skyrockets. This makes the country’s assets (companies, buildings, etc.,) drop considerably in value and become easily affordable to outsiders (although this is not necessarily bad; in fact, it ends up being a good thing).
This process almost inevitably increases poverty among the population, not to mention economic stagnation. It does happen from time to time. The most recent example is Venezuela.
