Sovereign debt refers to the debt incurred by a government of a sovereign nation. This type of debt is also known as government debt, national debt, public debt, or country debt. It encompasses all of a country’s debt obligations to both domestic and international creditors.
Governments are evaluated based on their sovereign debt, with sovereign credit ratings providing investors with insight into the country’s financial stability. These ratings significantly influence the ease or difficulty with which a government can secure funding for its operations.
Why do sovereigns borrow?
Governments often borrow funds to help finance expenditures that exceed their desired levels of revenue from general taxation.
When tax revenues decline, as often happens during a recession, governments may borrow money to maintain their existing spending commitments. This approach helps ensure the continuity of public services like schools and hospitals, preventing the need for spending cuts during an already weak economy—an action that could worsen the situation. This practice is referred to as “tax smoothing.”
During a recession, governments may increase spending or reduce taxes to stimulate growth. This “fiscal stimulus” is financed by issuing sovereign debt.
One reason governments borrow money is to invest in the future. For example, they may take on large sums of debt to fund the construction of major infrastructure projects such as highways, power plants, or subway systems. These projects often require substantial up-front costs, which can be spread out over many years to make repayment more manageable. The goal is that these investments will boost long-term economic growth, thereby justifying the need for borrowing.
Additionally, governments can invest in human capital, which includes areas such as education and healthcare. Again, the expectation is that the long-term benefits of these investments will outweigh the costs associated with borrowing.
Who do Governments borrow from?
Sovereigns can borrow money from their own country or from other countries.
Domestic borrowing, which comes from local banks or directly from households, can be a steady and reliable source of funding. However, there is often a limited amount of money available, and loans usually have short repayment periods.
Governments also borrow money from international capital markets. They can borrow larger amounts and for longer periods. However, these markets can be unpredictable, especially for lower-income countries. It can be risky to think that these lenders will always be willing to provide money.
Many private sector entities also lend to governments. For example, asset managers like pension funds often hold a lot of government debt, as they need safe long-term assets to cover their long-term liabilities.
Banks also buy a significant amount of government debt, especially from local governments. However, this close relationship between banks and governments has caused issues in the past. For example, during the euro area sovereign debt crisis from 2010 to 2012, struggling banks cut back on lending to governments, which increased borrowing costs. This created a cycle that worsened economic problems and strained the banking system. Today, both banks and governments better understand these risks.
Finally, governments can borrow from other governments or international organizations. Often this form of lending is not motivated primarily by commercial objectives . One government might lend to another to strengthen bilateral ties.
The World Bank or African Development Bank might lend money to a country to help build a sanitation system, fund vaccinations, or reform the power sector. And the IMF can provide financing if a country finds itself facing balance of payments difficulties.
What happens when Sovereign states can’t pay?
Sovereign states, like individuals and companies, can face challenges in paying back their debts. This may happen if they borrow too much or take on risky loans. It can also occur because of unexpected events, such as a severe economic downturn or a natural disaster.
When this happens, a country must restructure its debt. However, unlike individuals and companies, countries do not have bankruptcy courts to enforce solutions between themselves and their creditors. Instead, they must negotiate: creditors want to recover as much of their money as they can, while the country aims to return to normal financial status without incurring too many costs.
Debt restructurings can harm both the country and the creditors, which is why they are relatively rare. Some notable examples include Russia in 1998, Argentina in 2005, Greece in 2012, and Ukraine in 2015. The process is usually less costly if an agreement is reached before a country defaults, which occurs when it misses a debt payment. These early restructurings are typically resolved more quickly and have smaller negative effects on the economy and financial system. When a country defaults, the restructuring process can take much longer and be more expensive.
Sovereign borrowing is important for the global economy. It helps governments support their economies during tough times and invest in projects that boost productivity and growth. However, risks such as overborrowing and potential default remain a concern even today.