What Happens When a Country Defaults

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? Surprisingly, most countries have defaulted at least once in their lifetime, even though it may not be common knowledge among its citizens or investors.

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

In this article, we will take a look at some famous sovereign defaults, what happened to the countries, and how investors can predict problems in advance.

Famous Sovereign Defaults

Philip II of Spain made the first major sovereign default in 1557 and his country defaulted three more 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 new loans prior to the default. Since then, the country has defaulted 15 times between 1557 and 1939 for various reasons.

Mexico defaulted on its debt following the Peso Crisis in 1994. A 15% devaluation in the peso relative to the U.S. dollar caused foreign investors to rapidly withdraw capital and sell shares. At the same time, the government was forced to buy U.S. dollars with devalued pesos to repay national debts. The country was eventually bailed out with an $80 billion loan from several countries.

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

Country defaults tend to be very different than businesses or individuals. Instead of going out of business, countries are faced with a number of options. Often times, countries simply restructure their debt 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 and make debt repayment easier.

Iceland was a notable exception in 2008 when it let its largest banks collapse without bailing them out with foreign aid. More than 50,000 citizens lost their life savings and international economies were destabilized, but the country quickly recovered and its GDP recovered to a 3% growth rate by 2012. Many economists have pointed to the country as a model for the future.

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 15 years, but it still stands at more than 200% of GDP with a lower interest rate than when it was first downgraded in 1998. By comparison, 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.

International investors should keep these points in mind when analyzing potential investments around the world.