Sovereign Debt Definition
Sovereign debt refers to the amount of money borrowed by a country’s central government and is primarily achieved by selling government bonds and securities. Whenever a country needs money to finance its growth initiatives, it can only do so by two modes – either by raising taxes or by issuing government bonds. By raising taxes, the central government tends to burden the citizens of the country. Hence, it seems wiser to issue debt rather than raise taxes.
Treasury notes, bonds and bills are some examples of sovereign debt issued by the United States. Like any normal bond, sovereign bonds promise interest over the entire duration with the principal paid at maturity.
How does Sovereign Debt Work?
Sovereign debt is built up in two ways; one when raised domestically and the other by borrowing from international organizations like the world bank. We will go through it one by one.
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#1 – Domestic Debt
To fund development initiatives in the country, governments issue bonds which are then purchased by the domestic lenders, who in turn get rewarded with interest. The best thing about these sovereign bonds is that they are virtually considered risk-free. When in turmoil, countries can raise taxes or simply print more money to pay back their lenders.
#2 – International Debt
International lenders mostly lend to countries that are not able to raise money domestically due to their default history. In the event of default, lenders renegotiate the payback terms. such countries often face issues while raising debt.
Greek Sovereign Debt Crisis
Following the financial crisis of 2007-08, Greece has owed more than 300 billion US dollars to the European Union. After it admitted default, 320 billion Euros have been loaned by European authorities with the restructuring extending beyond 2060. This crisis has threatened the entire eurozone and will continue to do so for some time in the future since it fails to be contained up until now.
Sovereign Debt to GDP Ratio
An important indicator of a country’s economic and political health is its debt-to-GDP ratio. The high debt-to-GDP ratio indicates a higher risk of default. According to a World Bank statistic, a debt-to-GDP ratio exceeding 77% is an indicator of a slowing economy.
Hong Kong, Brunei, Afghanistan, and Russia are some countries with a debt-to-GDP ratio of less than 15% while countries like Greece, Venezuela, and Italy have a debt-to-GDP ratio of more than 100%. This isn’t always bad as more stable economies have a high tolerance for such incidences. For example, the US has a high public debt-to-GDP ratio of 77% but that doesn’t form a part of sovereign debt for the US plus US economy is too strong to be affected by this. In spite of all these things, countries must learn a lesson from the Greek debt crisis and should handle sovereign debt issues with great care since it is capable of sending ripples all over the world.
Advantages of Sovereign Debt
Some of the advantages of sovereign debt are as follows:
- Boosts Growth: Countries meet their deficit by borrowing, which in turn is used to fund developmental projects within the country. In the absence of necessary funding, such initiatives cannot take shape and can hamper a country’s development.
- Can be used to give a Desirable Direction to Economy: Nations do not always want to boost the economy, there is a need for the decelerating economy as well at times. To expand the economy, the central bank of a country aims to put more money into the system by buying back bonds and printing more money. To decelerate, bonds are sold and money is taken out of circulation.
- Reduced Cost of Borrowing: Borrowing in foreign currency is cheaper at times.
- Keeps Deficit under Check: Foreign borrowing keeps a country’s fiscal deficit under check since any adversity can harm their future hopes of generating foreign debt.
- Makes Country Bonds More Attractive: Listing local bonds on foreign indices attracts foreign investment which further helps a developing economy.
- Establishing a Reasonable Level: A reasonable level of sovereign debt leads to a growing and developing the economy. An accelerating economy boosts demand and generates jobs.
Disadvantages of Sovereign Debt
Some of the disadvantages of sovereign debt are as follows:
- Default Risk: This is the most crucial risk involved in the process where the common assumption of sovereign bonds being risk-free goes directly down the drain. Countries that suffer from high inflation and aren’t stable bear the risk of default, to compensate for which, they offer higher interest rates to lure investors.
- Devaluation of Currency: When a country defaults, the natural tendency is to lower the debt load which is often achieved by devaluing the local currency. Currency Devaluation decreases purchasing power.
- Crowding out Effect: Increased borrowing decreases the lending capacity which further leads to decreased spending by businesses. When private-sector spending declines as a result of increased public sector spending, it is known as the crowding-out effect.
Limitations of Sovereign Debt
The first limitation comes in the form of virtually risk-free nature of sovereign debt which is not always true. Second, sovereign debt is not the only way of raising money to funds projects. It can also be done by raising taxes and decreasing spending or simply by injecting more money into the system.
Sovereign debts have guaranteed paybacks unless the countries default which is anyways a rare phenomenon. Their performance is dependent on a country’s eco-political system and stability. A stable economy renders high rating to its sovereign debt which makes it trustworthy for investors. The ease of raising debt in domestic and international markets is an indicator of a country’s economic standing worldwide.
This has been a guide to what is sovereign debt and it’s 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 –