Simply Put: Sovereign Default

Two friends following the news on US debt ceiling talks got into an interesting conversation.

Ram: Did you hear the US Treasury Secretary Janet Yellen warn of the likelihood that US could default on its obligations by June 1?

Veena: Yes, it’s quite crazy the way they push it to the brink so often.

Ram: But I don’t understand how the US can default on its debt when all it has to do is print money and repay?

Veena: Haha ok, haven’t you heard of sovereign defaults?

Ram: No, can you explain?

Veena: It refers to a country failing to repay its bonds. It can be on its international bonds or also on its local currency bonds.

Countries default on international bonds when their forex reserves are drained and they don’t have the dollars/euros/pounds, etc, to repay the bond. This is what happened in the case of Sri Lanka last year. However, while it is rare, sometimes countries have defaulted on local currency bonds also, like Russia did in 1998. The latter represents default by choice and unwillingness to repay.

Ram: Why didn’t Russia just print money and repay?

Veena: When you print money excessively in a highly inflationary economy, it will further add fuel to fire. In the run-up to the Russian default, its local currency (roubles) had a fixed exchange rate to the US dollar. It was enduring near hyperinflation and this was further draining its forex reserves as investors were converting roubles to dollars out of fear that the rouble will be devalued. Further, speculators were also attacking the rouble. This was resulting in its forex reserves getting drained. So, in order to address the currency crisis, Russia devalued the rouble,  defaulted on domestic debt and declared a moratorium on payment to foreign creditors.

In order to defend the rouble in the run-up to the crisis and also to fight inflation, interest rates had been increased to as high as 150 per cent at certain points. The Russian government had run up a huge deficit and it was borrowing money at interest rates above 100 per cent. Printing money to repay the local currency loan would have caused more mayhem, given the already absurd interest rates. Thus it chose to not repay, although it had the ability.

Ram: Sounds crazy.

Veena: So if you understand, defaults can happen in local currency bonds also. While the US case is totally unlike Russia, the default that Janet Yellen is referring to is one of ‘unwillingness’ to repay and not inability. Sure, the US can issue new bonds, the Federal Reserve can print money and buy those bonds and the proceeds can be used to meet the obligations/repay bonds. However, in the current context that is possible only if the rules allow to increase the debt limits. That is, the government needs to tap debt markets to repay some of the bonds coming due as tax and non-tax revenues are insufficient to meet these obligations, given their overall budget. This will require the opposing political parties to come to an understanding and increase the debt limits.

Ram: Hmm ok, should investors worry?

Veena: Not much for now as the risk of default is extremely low. However do note the risk while low, is not zero. So follow the news as taking debt ceiling talks to the brink can roil markets as it did in 2011. Entirely ignoring it may not be wise.

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