## What Is Sovereign Debt?

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## Bibliographic details
- Authors: Ali Abbas, ALEX PIENKOWSKI
- Published: December 1, 2022

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### Overview
- Sovereign debt evolved from early royal borrowing (example: Edward III of England borrowing from Florentine banking families) into a "multitrillion, multinational, multicurrency network of debt obligations."
- Sovereign debt allows governments to "keep their economies afloat during recessions and other unexpected shocks and to finance investments that lift productivity and growth."
- Main persistent risks: overborrowing and potential default.

### Why sovereigns borrow
- Governments borrow to spend beyond tax revenues for several motives:
  - "Tax smoothing": borrow when tax revenues are down (such as during a recession) to pay for existing spending commitments and avoid cutting public services.
  - Fiscal stimulus: increase spending or reduce taxes during a recession financed by issuing sovereign debt.
  - Investment in future growth: borrow to fund major infrastructure (highway, power plant, subway) or investments in human capital (education, health) with repayment spread over many years.
- Note: These motives do not fully explain "the high level of debt seen in many countries."

### Who lends to sovereigns
- Domestic lenders:
  - Local banks and asset managers.
  - Households (when governments borrow directly from them).
  - Characteristics: "steady and reliable", limited supply, often shorter maturities.
- International capital markets:
  - Provide larger amounts and usually longer maturities, but "can be fickle, especially for lower-income countries."
- Private sector entities:
  - Asset managers (such as pension funds) "typically hold a large amount of government debt" for safe long-term assets.
  - Banks hold large amounts of sovereign debt, especially from their home country, creating a "bank-sovereign nexus" with systemic risks.
  - Historical example: "2010–12 euro area sovereign debt crisis" where troubled banks reduced funding to governments, raising sovereign borrowing costs and creating a vicious cycle.
- Official lenders:
  - Other governments (sometimes to strengthen bilateral ties).
  - International organizations: World Bank, African Development Bank (project lending), IMF (financing for balance of payments difficulties).

### How sovereigns borrow (instruments and risk trade-offs)
- Common instruments:
  - Loans: bilateral or syndicated, with repayment spread over several years.
  - Bonds: issued to many creditors, typically repaid in a lump sum at maturity.
  - "Many exotic instruments" exist but are "much smaller in scale."
- Key trade-offs in debt composition:
  - Currency choice: borrowing in US dollars or euros can be cheaper but risks increased real debt burden if the sovereign's currency depreciates.
  - Interest rate structure: fixed-rate debt provides stable debt-service costs; variable-rate or inflation-linked debt may be cheaper initially but can introduce volatility if rates or inflation move unfavorably.
- Determinants of borrowing costs beyond debt structure:
  - 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) use "elaborate models" to assess sovereign creditworthiness continuously.

### What happens when sovereigns can't pay (restructuring and defaults)
- Causes of repayment difficulties:
  - Excessive or risky borrowing.
  - Unexpected shocks (deep recession, natural disaster).
- Sovereign debt resolution process:
  - No bankruptcy court for sovereigns; resolution is through negotiation between sovereigns and creditors.
  - Objective tensions: creditors seek maximal recovery; sovereigns seek restoration of normal market access without excessive payments.
- Costs and timing:
  - Restructurings are often costly for both debtors and creditors, making them relatively rare.
  - Preemptive restructurings (reaching agreement before a missed payment) tend to have much smaller costs and spillovers and are usually resolved quickly.
  - Post-default restructurings can be "long and expensive."
- Historical restructuring examples: Russia (1998), Argentina (2005), Greece (2012), and Ukraine (2015).

### Key takeaways
- Sovereign debt is essential for smoothing taxes, financing fiscal stimulus, and funding long-term investments, but it carries risks that depend on volume, currency composition, interest structure, and external vulnerabilities.
- A prudent debt structure can help lower long-term borrowing costs, but many creditworthiness factors lie beyond governments' direct control.
- Early, preemptive restructuring is generally less costly than restructuring after a default.

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## Content in this bundle

- **Back to Basics: What is Sovereign Debt?**
  - [Back to Basics: What is Sovereign Debt? (Markdown version)](/-/media/files/publications/fandd/article/2022/december/back-to-basics.pdf.md){rel="alternate" type="text/markdown"}
  - [Back to Basics: What is Sovereign Debt? (PDF)](/-/media/files/publications/fandd/article/2022/december/back-to-basics.pdf){rel="external" type="application/pdf"}

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_Source: https://www.imf.org/en/publications/fandd/issues/2022/12/basics-what-is-sovereign-debt_