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What Happens When a Country Defaults?

A Look at What Happens When a Country Can’t Pay the Bills

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Consumer defaults are a fairly common occurrence. Creditors begin to send letters and make phone calls, and if nothing happens, assets can sometimes get repossessed. But what happens when an entire country defaults on its debts? In reality, most countries have defaulted at least once in their lifetime, even though it may not be common knowledge among its citizens.

From France in 1558 to Argentina in 2001, hundreds of countries have either defaulted on their debt or restructured it throughout history. The result of these countries defaulting has varied from a non-event (due to a technical default) to a significant drop in their economy with profound long-term effects that are still ongoing to this day.

Famous Sovereign Defaults

Philip II of Spain made the first major sovereign default in 1557, when his country defaulted no less than four times, due to military costs and the declining value of gold. The reason? It turns out that the king was paying some 50% annual interest on his new loans prior to the default. Since then, the country has defaulted 15 times between 1557 and 1939!

A more recent example is Argentina, which defaulted on its debt in late 2001 on $132 billion in loans. The amount represented one-seventh of all the money borrowed by the third world at the time. After a period of uncertainty, the country opted to devalue its currency and was eventually able to recover with GDP growth of around 90% over the nine year since.

What Happens after a Default?

Company defaults tend to be sharply different than businesses or individuals. Instead of going out of business, countries are faced with a number of options and often simple restructure their debt instead of not paying it at all. Normally, this happens by either extending the debt's due date or devaluing their currency to make it more affordable.

In the aftermath, many countries undergo a rough period of austerity followed by a period of resumed (and sometimes rapid) growth. For instance, if a country devalues its currency to pay its debt, the lower currency valuation makes their products cheaper for export and helps its manufacturing industry, which ultimately helps jumpstart its economy.

Lenders also eventually borrow again to even the most un-creditworthy countries because they generally don't lose everything - like in a business or personal bankruptcy. Rather, countries tend to restructure debt (albeit in unfavorable terms) and will always have assets to recover down the road. After all, a country can't exactly close its doors forever.

Predicting Sovereign Defaults

Predicting sovereign defaults is notoriously difficult, even when things appear to be bleak for a country. For instance, analysts have warned about Japan's public debt for at least 12 years, but it still stands at 230% of GDP with a lower interest rate than when it was first downgraded in 1998. In fact, many countries that have defaulted have done so at less than 60% debt to GDP!

Governments tend to default for a variety of different reasons, ranging from a simple reversal of global capital flows to weak revenues. But many sovereign defaults are precipitated by a banking crisis. Studies have shown that public debt grows around two-thirds in the years after a crisis, while a crisis in a rich country can rapidly change capital flows in peripheral countries.

Key Takeaway Points

  • Most countries have defaulted at least once in their lifetime, with some countries having defaulted more than 10 times since the 1500s.
  • Instead of going out of business, countries are faced with a number of options and often simple restructure their debt instead of not paying it at all.
  • Governments tend to default for a variety of different reasons, ranging from a simple reversal of global capital flows to weak revenues.

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