## BACK TO BASICS

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**Canonical URL:** [BACK TO BASICS](https://www.imf.org/-/media/files/publications/fandd/article/2022/december/back-to-basics.pdf)

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### What Is Sovereign Debt?
- Sovereign debt is the "multitrillion, multinational, multicurrency network of debt obligations" governments issue to finance spending beyond what they raise through taxation.
- It plays a pivotal role in the world economy by allowing governments to keep economies afloat during recessions and to finance investments that lift productivity and growth.
- Risks associated with sovereign debt include overborrowing and potential default.

### Why do sovereigns borrow?
- Governments borrow to spend beyond what they can or want to raise through general taxation.
- Economic motives:
  - Tax smoothing: borrowing when tax revenues are down, such as during a recession, to pay for existing spending commitments and preserve continuity of public services (schools, hospitals).
  - Fiscal stimulus: increasing spending or reducing taxes during a recession to try to boost growth, financed by issuing sovereign debt.
  - Investment in the future: borrowing large sums to build major infrastructure (highway, power plant, subway) or invest in human capital (education, health), spreading repayment over many years with the expectation that long-term benefits justify the borrowing.
- The article notes that these reasons cannot typically explain the high level of debt seen in many countries.

### Who do they borrow from?
- Domestic lenders:
  - Local banks and asset managers or directly from households.
  - Domestic borrowing can be steady and reliable but often limited in amount and short in maturities.
- International capital markets:
  - Provide larger amounts and usually longer maturities, but can be fickle, especially for lower-income countries.
- Private sector lenders:
  - Asset managers (such as pension funds) hold large amounts of government debt as relatively safe long-term assets to match long-term liabilities.
  - Banks hold large amounts of sovereign debt, especially of governments in the countries where they are based.
  - The "bank-sovereign nexus" can create feedback loops: during the 2010–12 euro area sovereign debt crisis troubled banks reduced funding to governments, raising sovereign borrowing costs and leading to a vicious cycle that aggravated the recession and banking problems.
- Other governments and international organizations:
  - Bilateral lending may be motivated by strengthening ties.
  - Development banks (World Bank, African Development Bank) may lend to fund sanitation, vaccinations, or power sector reform.
  - The IMF can provide financing if a country faces balance of payments difficulties.

### How do they borrow?
- Contractual forms:
  - Loans: normally arranged bilaterally or through syndicates, repayment often spread out over several years.
  - Bonds: issued to hundreds or thousands of creditors, with the entire amount normally due at once.
  - Exotic instruments: smaller in scale.
- Trade-offs in debt structure:
  - Currency choice: many governments find it cheaper to borrow in US dollars or euros than in their own currency, but currency depreciation increases the real burden of the debt.
  - Interest rate structure: fixed rates provide stable debt-service costs; variable or inflation-linked debt can be cheaper initially but risky if rates or inflation move unfavorably.
- A prudent public debt structure can help keep sovereign borrowing costs low over the long run.
- Other determinants of creditworthiness and borrowing costs include level of economic development, size of financial markets, record of honoring obligations, vulnerability to external shocks, and global financial conditions.
- Sovereign rating agencies and international institutions, including the IMF, maintain elaborate models to continuously assess sovereign creditworthiness.

### What happens when they can’t pay?
- Sovereigns can struggle to repay because of excessive or risky borrowing or unexpected shocks (deep recession, natural disaster).
- Debt restructuring replaces unilateral repayment: negotiations between creditors (seeking recovery) and sovereigns (seeking to regain "normal" status in financial markets without paying out too much).
- No bankruptcy court exists for sovereigns; restructuring is negotiated.
- Restructurings are often costly for both debtors and creditors, making them relatively rare.
- Preemptive restructurings (reaching agreement before a sovereign defaults by missing a payment) are usually resolved quickly and have smaller spillovers to the economy and financial system.
- Once a sovereign defaults, the subsequent restructuring process can be long and expensive.
- Well-known examples of sovereign restructurings include Russia (1998), Argentina (2005), Greece (2012), and Ukraine (2015).

### Conclusion
- Sovereign borrowing has become larger, more sophisticated, and more international since medieval times.
- It enables countercyclical policy and long-term investment but continues to carry risks of overborrowing and default that persist today.

*S. M. ALI ABBAS is an advisor and ALEX PIENKOWSKI a senior economist in the IMF’s European Department. They are co-editors of Sovereign Debt: A Guide for Economists and Practitioners.*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2022/december/back-to-basics.pdf_