What Happens When a Country Defaults?

Would it be a surprise if I said that since 1960, 147 governments defaulted? Is it a big deal? Yes and no. What happens when a country defaults? When a person or business defaults, their assets are frozen and they have to settle an agreement with their lenders to repay over a certain time. When a country defaults, it doesn’t stop all economic activity. Yes, there are certain consequences with its lenders and maybe it affects other countries. However, most of the time, it doesn’t become a global crisis. We’ll take a look at the reasons countries default and the consequences of a default. Currently, Russia is very close to being unable to pay its debts. To better understand what could happen, we will take a look at similar occurrences in the past.

Reasons for a Default

What Happens When a Country Defaults

What happens when a country defaults? And what are the reasons a country would default? That seems like a pretty crazy thing right?

But there are some governments that refuse or are unable to pay a debt they owe. To be frank, it wouldn’t surprise me to hear that the United States defaulted.

They’re racking up debt faster than you can say pay me back. And inflation isn’t helping by any means either.

Government

What happens when a country defaults? A default occurs when the government in power of a country is unable or unwilling to pay its debts on time. Every repayment has a capital and/or interest component.

A technical default happens when the country misses its payment date for whichever reason. In most cases, they have a 30-day grace period, such as with bond repayments. It has happened to the US in 1979 when due to a technical issue.

In other cases, the government is to blame. Not every leader has the benefit of their citizens at heart. Let’s take Venezuela as an example. Just recently, in 2017, the country defaulted on its debt obligations. The corrupt political party in power refused to pay their bondholders. This is due to major financial mismanagement and years of political instability. 

What Happens When a Country Defaults and Economics

Other reasons include economic factors. The country may be in a period of chronic economic stagnation. What does this mean? The country’s yearly output either decreases or barely increases. There aren’t any new industries developing, unemployment remains high and there aren’t any economic booms. The banks aren’t willing to lend money at reasonable rates to be reinvested into the economy. Finally, the country may run constant budget deficits. The number of resources imported constantly surpasses those exported.

When a country defaults, the repercussions may not be limited internally. The consequences may affect others.

What Happens When a Country Defaults: Consequences

Initially, the consequences of a default are negative. In the country manages the default efficiently, the consequences can become positive. 

Negative Consequences

The immediate consequences of a default are negative. Foreign investors are at risk of losing their capital. The country’s credit rating immediately becomes poor and any bonds have the junk bond status.

If the country ever wants to borrow funds from foreign investors, it will be much more difficult and most likely with higher interest rates.

Thankfully, some countries eventually forget and forgive. However, the longer it takes to repay a missing debt payment, the longer the market exclusion will last.

This can cause even lower output and further economic stagnation. However, there is a good chance the economy will recover if the government and its financial institutions handle the crisis with care.

Positive Consequences

What happens when a country defaults? When a country defaults, it gives borrowers a break from having to pay the unsustainable debt. This gives the country enough time to restructure its debt and figure out an agreement with its creditors.

The easiest way to reboot an economy is to devalue its currency. The aim is to increase its exports since the products are effectively cheaper. The trade surplus will lead to more jobs created and a period of rapid growth. However, there may be austere measures in place such as spending cuts and/or tax increases.

Iceland is an excellent example of an economy that recovered without a bailout and came out stronger than before. Now, we will take a deeper look at different countries and the aftermath of their economy after a default.

History of Countries Defaulting

What Happens When a Country Defaults

What happens when a country defaults? Let’s look at Iceland as our first example.

In most cases, defaults happen in less developed economies and tend to have negative effects. Not in Iceland’s case. In 2007, the country fell into an economic meltdown.

Thankfully, unlike other EU members, it has its own currency and effectively has more control over economical repercussions.

So what happened? Long story short, Icelandic banks offered competitive interest rates to foreign borrowers. Its 3 biggest banks eventually became 10 times bigger than the Icelandic economy.

Banks went on a foreign overvalued assets spending spree. When the Lehman Brothers went bankrupt during the 2008 financial crisis, it resulted in a domino effect eventually reaching Iceland. Most countries bailed out their banks, unlike Iceland.

Domestic funds were protected, but foreign investors lost their money. This resulted in a lot of Icelandic Krona leaving the country and its currency devaluating.

How did Iceland bounce back? Icelandic received a few billion dollars from the IMF that it reinvested domestically. They imposed certain laws to prevent further Krona from leaving the country. Exports also became cheaper and the economy became stronger.

All the positive consequences from above became reality in Iceland. The government also wrote off household debt, leaving consumers with a clean slate to spend within the country. If Iceland was part of the Euro currency, things would have been very different.

Greece

Greece

Despite also being part of the EU, Greece suffered a different fate than Iceland. Instead of missing a payment to its creditors, Greece defaulted on its International Monetary Fund loan.

This was the first time that a developed nation missed a payment to the IMF. After the 2008 crisis, it had a hard time getting back on its feet.

Greek industries lost their competitiveness to surrounding nations. Furthermore, the Greek government didn’t crack down on tax evasion and lost a lot of its revenue.

There was a total lack of competence in the Greek government to reinforce the economy and abide by EU laws. Instead, they needed a bailout. The country plunged into a recession, unemployment increased and the government relied on other EU member countries for help. Don’t be like Greece, be like Iceland.

Ecuador

Let’s move back into the positive section of what happens when a country defaults one last time. Defaults are common in Central and South America. For Ecuador, it happened before.

However, there is some positive this time. The economy was already in a turmoil pre-pandemic. In the spring of 2021, a new president came into power, Guillermo Lasso.

Lasso, former banker, made sure Ecuadorians were vaccinated at the same rate as most Europeans, revamped the oil industry and is gaining the confidence of many Ecuadorian industries and investors. He eliminated many duties and import restrictions and began economic reforms.

This sent Ecuadorian bonds on a record year and the best among all countries. It is a rarity to have a clean and positively focused government in that part of the world. Good things may continue to come in Ecuador.

Other South American countries such as Venezuela and Argentina have been plagued with defaults. Their governments aren’t as focused on the well-being of their citizens and lack the discipline to create a better environment for everyone.

Russia Default

What Happens When a Country Defaults

The last time Russia defaulted, was in 1998. It effectively devalued its Ruble and got out of trouble. Many countries suffered in the process.

Today, Russia is unable to pay its debt obligations in USD or Euros. Instead, it insists on paying with a very weak Ruble which is against its contractual obligations.

On top of the war which created shortages of oil, gas and other resources, this will create more problems mainly for Russia.

Many Russian assets outside the country’s borders are frozen due to its war with Ukraine. Russia is threatening legal action if it is forced to default. The issue will not likely be resolved anytime soon.

Russia doesn’t have much debt since it is trying to distance itself from other global markets. Its debt to GDP ratio is only 17%, much lower than most nations. If Russia does default, there won’t be any major global repercussions, thankfully.

Debt to GDP ratio: Divide a nation’s debt by its GDP

Now You Know What Happens When a Country Defaults

What happens when a country defaults? To conclude, defaults aren’t rare. The amount is the most important part of the equation. Japan’s record 254% ($9T USD) debt to GDP ratio is much more concerning than Russia’s 17% ($75B).

As long as countries pay their obligations, we are fine. Unfortunately, debt doesn’t cancel out between countries. We saw two examples of countries defaulting and coming back stronger than before (Iceland and Ecuador).

However, the political and economical climate isn’t the same in every country. It takes willingness and discipline from citizens and political parties to make things work.

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