What Happens When A Country Declares Bankruptcy?

David McDonald

David McDonald

David is a 19-year-old Canadian student currently attending the University of Guelph. He currently studies Public Management and economics with hopes of one day becoming an accomplished journalist. David enjoys reporting on global events and actively try to make a difference in the world.
David McDonald

Introduction To Global Bankruptcy

According to an article from USA Today, there are at least seven countries that could potentially go bankrupt in the near future.

Belarus, Jamaica, Argentina, Belize, Venezuela, Greece, and Ukraine. The aim of this article is to find out what causes a country to go bankrupt and ultimately, what happens when a nation declares bankruptcy?

Why Do Countries Go Bankrupt?

There are a number of economic forces that can implode any nation’s economy, but a poor monetary policy must reign above many other factors when determining the financial position of any nation.

All seven national economies listed above instill relatively little confidence among investors. However, Jamaica’s credit rating was upgraded by Moody’s this year, and Argentina’s and Belize’s credit ratings remained stable. The remaining four countries, on the other hand, were downgraded.

A country’s history of fiscal responsibility, including past defaults, and current compliance with IMF debt repayment plans, are major contributors to Moody’s evaluations.

Extremely high debt levels, which while not always a feature of unhealthy economies, can also contribute to a country’s poor credit rating. The debt of four of the seven countries was equal to more than 75% of GDP. In Jamaica and Greece, debt was well over 100% of GDP.

Political conflicts have also weakened some of these economies, which in turn has introduced more uncertainty and increased risk. Ukraine’s conflict with Russia over its annexation of Crimea, for example, and the resulting U.S. and European sanctions, have contributed to the country’s downgrade in March.

Borrowing funds in the international bond market is often far more costly for countries with poor credit ratings. Investors require greater returns on what they perceive to be riskier investments and charge higher interest rates as a result. For example, a 10-year U.S. Treasury Note has an annual yield of just 2.16%. By contrast, a comparable bond recently issued by Jamaica pays out 6.44% a year. Yields on 10-year Greek government bonds reached 29% in early 2012, just before the country defaulted.

Foreign investment is vital for most countries, particularly developing nations. To promote interest among investors, countries use a range of strategies. Often, these countries issue bonds in other, safer currencies in order to be more competitive in the international bond markets. Nations such as Argentina, Jamaica, Belize, and Ukraine have all issued bonds in other nations’ currencies. Inflation rates for common currencies such as the dollar, yen, and euro are typically far lower and more stable than the currencies of the issuing countries. This means that investors do not need to worry as much about their investment losing value.

What Happens When A Country Declares Bankruptcy?

When a country actually goes bankrupt, the International Monetary Fund is a good place to go. When the Greece economy crashed in 2009, they went to the IMF, the European Central Bank and the European Commission, who collectively, issued the first of two international bailouts for Greece, which would eventually total more than €240 billion.

The bailouts came with conditions. Lenders imposed harsh austerity terms, requiring deep budget cuts and steep tax increases. They also required Greece to overhaul its economy by streamlining the government, ending tax evasion and making Greece an easier place to do business.

When a country fails to pay its creditors on time, it is said to go into “default”, the national equivalent of going bankrupt. But sovereign defaults are quite different from business bankruptcies as it is far harder for creditors to repossess the assets of a sovereign entity than to repossess the assets of a company.

In the first instance, to curry favour in international markets, defaulting countries tend to restructure their debt rather than simply refusing to pay anything at all. But these so-called “haircuts”, where the original value of a bond is reduced, can be much more painful for the holders of government bonds than a simple clip of the scissors.

After its $81 billion default in 2001, Argentina offered to pay its creditors a third of what it owed—93% of the debt was eventually swapped for performing securities in 2005 and 2010. But the remainder, which is held by vulture funds and other investors, is still in dispute.

These “holdouts” are waiting for $1.3 billion plus interest. And when Greece defaulted in 2012, bondholders were forced to take hits as high as 50%. In less severe cases, countries may choose to restructure their debt by requesting more time to pay. This has the effect of reducing the present value of the bond—so it isn’t entirely pain-free for investors.

Defaults can also be very painful for the offending country, particularly if they are unexpected and disorderly. Domestic savers and investors, anticipating a fall in the value of the local currency, will scramble to withdraw their money from bank accounts and move it out of the country.

To avoid bank-runs and precipitous currency depreciation, the government may shut down banks and impose capital controls. As punishment for default, capital markets will either impose punitive borrowing rates or refuse to lend at all. And credit-rating agencies will no doubt warn against investing in the country. But as history shows, in most countries yield-hungry lenders will eventually start lending again so long as they are adequately rewarded for the risk they are taking on.

Moreover, credit-default swaps—financial instruments which act as a form of insurance against sovereign and corporate defaults—allow bondholders to hedge their risk. But not all defaults are the same: Argentina defaulted again this year by refusing to pay $1.3 billion plus interest to the “holdouts” from 2001.

Critically, there is no international law or court for settling sovereign defaults, which helps explain why they are so varied in length and severity. More international regulation has been proposed—including powers to prevent minority holders from hijacking the process—but such conditions ultimately remain up to the issuing country.

Facebook Comments

Write a Comment