Why do Countries default? and What are its Impacts?

Why do Countries default? and What are its Impacts?

In this article, we will discuss why countries require loans. Why do countries default on loans? What is default? What are its impacts? And, what are the chances of Pakistan regarding default? Let’s suppose you need to buy or build a house and you take loans from the bank for this purpose. Bank borrows you money in easy installments of 20 years from which you build or buy your house. But after some years you don’t pay your installments because of your financial issues or other issues. In this situation, you will be called bankrupt or in economic terms, you will default.

As a result, the court will proceed with the case and the house will be auctioned and the bank will get its loan. Another impact of this would be that when you will ask for a loan next time either bank will not give you the loan or will give you strict conditions. Similarly, developing countries often have to take to external debt to meet their financial needs.

Types of Domestic Debts

Like individuals and companies, countries need debts from external and internal sources for running the financial system or for mega projects. Domestic debt can be obtained from local banks. Besides, the government can raise capital by issuing bonds and saving certificates in the local currency. Government issues these bonds or certificates for a specific time period and the government keeps paying regular interest to the purchasers. And when the time period becomes over, the government provides returns s the original value to investors.

One of the advantages of this type of debt is that if the government has any kind of trouble paying back the bonds when they mature, it can easily print new money. However, printing new notes devalue the local currency which may cause investors to suffer. For instance, if an investor is earning 5% per annum on a government certificate but the currency depreciates by 10% then that investor will have to suffer from a 5% loss of the investment.

5% on the certificate
10% inflation
Net Value: 5-10+ (-5) = 5% loss

However, for running a country, the local currency is not enough.

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why do countries default?

Foreign Debts

Almost every country imports goods to meet its needs. For this, countries need foreign currency, especially US dollars. To meet the needs of US dollars, countries have to take foreign loans. In order to run countries and the mega projects that require imports of goods or external resources, large international banks such as the World Bank and ADB (Asian Development Bank) provide loans to developing countries.

Also, another type of borrowing foreign currency can be foreign exchange bonds. To raise capital in dollars or other currencies, the government issues bonds or certificates which are called foreign exchange bonds. One of its advantages is the access to capital in foreign currency for the government and on the other hand, it is also an alternative arrangement for foreign investors who are reluctant to invest in local currency.

Moreover, the International Monetary Fund (IMF) also provides financial assistance in the form of loans to developing countries. It also provides the countries that are suffering from financial crises. A financial crisis may be due to difficulties in repaying loans taken for development projects reducing current account deficits or other international payments.

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Sovereign Default

It doesn’t matter how any country gets the loan, what matters is that that country has to fulfill all terms of the agreement. If the borrowing country violates any term of the loan agreement it is called sovereign default or commonly bankruptcy.

Causes of Sovereign Default

The most common reason for sovereign default is missing a payment or delayed payment of a loan installment. Apart from this, non-payment of profit is also called default. A huge decrease in foreign exchange reserves and the burden of heavy loans, heavy current account deficit i.e. more imports and fewer exports, and political instability are fundamental and significant reasons for the country’s default.

Let’s take a brief look at these causes:

1. Low Foreign Exchange Reserves & Heavy Loans

First, the size of any country’s foreign exchange reserves is analyzed with respect to the value of international payments due in the near term and the value of loans and interest. Therefore, the foreign exchange reserves should be sufficient for imports, debt repayments, and the interest on foreign exchange bonds. Otherwise, for the country to default, chances increase.

2. Current Account Deficit

A country has a current account deficit when it sends more money outside the country than it receives i.e. Cash outflow > Cash inflow. A trade deficit is usually the largest component of the current account deficit. A trade deficit means the difference between a country’s earnings from exports and its expenditure on imports i.e. fewer exports and more imports.

Furthermore, the budget deficit is also a major reason for getting loans. Budge deficit refers to expenditure in excess of income. Prolonged, high current account deficit and budget deficit can also lead to bankruptcy or default of a country.

3. Economic Stagnation

It is another reason for the country to default. Persistent economic stagnation weakens the country’s economy which causes difficulty in national income. And consequently, the country cannot pay its loans.

4. Political Instability and Financial Mismanagement

Political instability causes fluctuation in economic policies which makes the difficult for the country to bring money into the country.

These countries have defaulted more than once which include Venezuela, Ecuador, and Argentina. Interestingly many countries of them were from developed countries. In the 1840s, the American economy was also bankrupt. At that time, 19 out of 26 states of the US had declared default on their loans. It was because of the rapid canal system establishment in the USA. It took 80 million dollars and states couldn’t repay their loans.

Apart from this, in 1933, 1979, and 2013, the US government was unable to meet its loans on time. but because the US has the dollar currency which is also a reserve currency. That’s why the US didn’t have to face default.

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Impacts of Default

1. Decrement in Credit Rating and Increment in Interest Rate

The biggest disadvantage of default is that the world’s biggest credit rating companies like Moody’s and Fitch lower the credit rating of default countries. Consequently, these countries face difficulties in the future regarding taking loans and they lose their confidence which may have negative impacts on completing mega projects and in trading for running the country.

Besides, in such situations, the interest rate of local banks also increases due to which there may be a marked decrease in the circulation of money, and people may face serious difficulties in running businesses.

2. Depreciation in Currency and Increment in Inflation

When a country defaults, foreign investors try to sell their assets in that country and get out of the bankrupted country. It causes the exchange rate to fall in the international market and the local currency to devalue. This makes the imports difficult because they become expensive.

Moreover, attempts are also made to make local payments by printing more notes of money. This makes the available money much higher than domestic requirements. Consequently, it makes the situation of hyperinflation. Hyperinflation refers to increasing the prices of goods to another level.

3. Banking Crisis

After default, people get panic and try to withdraw their money from the banks. It causes a serious banking crisis. The government can also close banks to prevent withdrawals or allow a limited number of capital withdrawals. Its practical form was seen in the 1930s when the Great Depression occurred. And, people demanded their gold in return for money.

4. Internal Default, Poverty, and Unemployment

In addition, countries get default on local currency debt. It causes an increase in poverty, unemployment, and crimes.

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Economic Situation of Pakistan

In this century, there is not such an unusual situation to default for any country. World superpowers like USA, Russia, Germany, and Japan have also gone bankrupt in past due to many reasons. A country is in sovereign default only when it cannot make payments in US dollars. In this regard, Pakistan’s data shows that 38% of Pakistan’s debt consists of domestic debts. Although Pakistan currently has a few billion dollars (6.7 billion $ as of Dec 2022) in foreign reserves which seems to be minimal for debt repayment and imports.

Since the Pakistani state has been borrowing from international financial institutions for a long time and it gets loans every time. That is why Pakistan has not gone bankrupt now and hopefully, it will not happen in the future.

Sovereign default can also affect the quality of life. There are solutions to this. By reducing government expenditure, increasing exports and decreasing imports, political stability, and the continuity of economic policies any country can embark on the journey of redevelopment. Else, it depends on our political leaders what they will learn from the current situation and whether in the future, they will try to save Pakistan from default or not.

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