Young Investor

What happens when a country defaults

Adarsh Gopalakrishnan | Updated on March 12, 2018

Illustration for BL, Investment page

The US has shown little responsibility in how much it borrows.



It's pretty easy to picture a person or company going broke, but how about a country? Let's start with the basics. You are at the dinner table and your dad is dropping hints about how bad his brother's business is going and how he is having trouble paying his kids fees and making ends meet and keeping the loan sharks at bay. He's sold his house, cars, paintings and bankers circle his defunct plant trying to figure out what they can salvage by selling it.

It's quite easy to extrapolate this painful scenario to companies as well. A company has its assets such as plants, patents among other things which can be sold to pay off debtors.

Governments are people too…

Much like a company or an individual, a state does borrow money from both its own citizens and lenders outside the state such as large banks, pension funds, other governments and institutions such as the International Monetary Fund.

However, unlike an individual or a corporate, a sovereign's assets and obligations are much harder to quantify. Spending on numerous welfare schemes, building infrastructure, salary obligations, medical care, military, government pension schemes are difficult to quantify. To better gauge how sustainable a country's borrowing tendencies are investors use measures such the net-debt GDP ratio or trends in a country's trade surplus or deficit, government revenue growth or lack of it.

The scary part of government borrowings is that a sovereign default can have a fallout on so many aspects. This spills over very quickly into the realm of private and public consumption. In a connected world, perception is everything and the panic that follows can be blind and cause serious damage as we currently are witnessing in the markets.

The past two decades have actually seen major economies getting into a debt crisis, getting pushed to the brink and requiring external assistance to get the house in order.

Precedents

Three big countries have come close to going broke in the last two decades- Mexico in 1994, Russia in 1998 and Greece last year. Here's what happened. Mexico in 1994 fell prey to crisis after an attempted coup and assassination of a presidential hopeful, spooking investors into demanding higher returns for money they lent to the country. Splurging by the government in the years to 1994 led to weakening finances. The story ended with the country's central bank running out of reserves. The US Government along with IMF stepped in to avert an actual default and arrest the slide in the local currency.

A sharp fall in prices of crude oil, Russia's main export, crippled the economy too. Not only did the country default on payments to mining employees, but there were reports of the military going unpaid. This, after the collapse of the Soviet Union, sparked a series of events which led to the Russian government requiring a bail-out by the IMF and the World Bank.

Greece as a member of the European Union has proven to be one of the more challenging cases so far. The country is saddled with economic obligations, which stretch far into the future in the form of pension and salaries for a large government workforce. Various Greek cities have seen wide-scale social unrest in response to its efforts to cut down on spending. Various European states continue to haggle over the size and structure of a bail-out as investor fears over the debt-led contagion spreading to Italy, Spain and Portugal continues to grow.

Takeaway

The government or a sovereign in the modern setting has evolved to become a much larger entity than anyone envisaged a century ago. This is due in part to the need to provide basic services to much larger populations. However, as the Spiderman quote goes “With great power comes great responsibility”. In the government's case, the power is the ability to borrow to their heart's desire and the ability to print paper money whenever the need arises. Keeping both in check is the great responsibility. In the case of most developing countries, both the borrowing and printing abilities are restricted by the lender and global appetite for a certain currency. This is directly related to how responsible a country is perceived as with its finances and obligation. Current fears facing the global economy include the ramifications of Greece dragging down Spain, Portugal and Italy in a global flight of lenders from sovereigns perceived as irresponsible with their books.

However, while global lenders or investors can easily turn their nose up at a small nation, the real problem arises when the crisis involves a nation as large and important as the US. Dollar notes are the currency of choice across the world for transactions and borrowing. The same sovereign has also shown little responsibility in how much they borrow and how many notes they print. With the recent downgrade the question which has the global marketplace scratching its head is: should the currency of an indebted giant be the world's currency of choice?

Published on August 20, 2011

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