Sovereign Debt

Sovereign Debt Definition

Sovereign debt refers to the amount of money borrowed by a country’s central government. It is primarily achieved by selling government bonds and securities. Treasury notesTreasury NotesTreasury Notes are government-issued instruments with a fixed rate of interest and maturity date. As a result, it is the most preferred option because it is issued by the government (therefore, there is no risk of default) and also gives a guaranteed amount as a return, allowing the investor to plan accordingly.read more, bonds and bills are some examples of sovereign debt issued by the United States.

Explanation

Whenever a country needs money to finance its growth initiatives, it can do so by two modes.

  1. By raising taxes
  2. By issuing government bonds

By raising taxes, the central government tends to burden the citizens of the country. Hence, it is usually considered better to issue debt rather than increasing taxes. Like any bond, sovereign bonds carry an interest for the borrowing duration while the principal amount is paid at maturity. They are believed to be virtually risk-free.

How does Sovereign Debt Work?

Sovereign debt is issued in two ways; one when raised domestically and the other by borrowing from international organisations like the World Bank. We will go through it one by one.

Sovereign Debt

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Source: Sovereign Debt (wallstreetmojo.com)

#1 – Domestic Debt

To fund development initiatives of their nation, governments issue bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more which are purchased by the domestic lenders. Examples of domestic lenders are commercial banks and financial entities. The lenders are rewarded with interest.

#2 – International Debt

Most times, International lenders lend to the countries that cannot raise money domestically. In this case, the lenders could be a foreign government, private entities or financial bodies like the World Bank. In default, lenders renegotiate the payback terms, and such countries often face issues while raising debts in the future.

Greek Sovereign Debt Crisis

Greece is probably the first name that comes to the mind whenever we think of the sovereign debt crisis in Europe. Following the financial crisis of 2007-08, Greece owed more than 300 billion dollars to the European Union. After it admitted default, 320 billion Euros were loaned to Greece by the European authorities with the restructuring extending beyond 2060. This crisis threatened entire Europe and will continue to do so till the situation is resolved.

Sovereign Debt to GDP Ratio

Advantages

We are listing out some advantages of sovereign debts below.

Disadvantages

The disadvantages of sovereign debts are as follows.

Limitations

The first limitation comes in the form of virtually risk-free nature of sovereign debt which is not always true. Second, these debts are not the only way of raising money to funds projects. It can also be done by increasing taxes and decreasing spending or by injecting more money into the system.

Key Takeaways

This has been a guide to what is sovereign debt, and its definition. Here we discuss its types and how does sovereign debt work along with limitations, advantages, and disadvantages. You can learn more about financing from the following articles –