Sovereign Default: Putting the United States’ Debt-Ceiling Debate in Context Why Self Help Is the Only Option

Posted in: International Law

The United States is not the only country that has recently made headlines over its possible sovereign default—that is, its possible default on its obligations to bondholders worldwide.  Recently, Greece, Ireland, and Portugal, to name a few, have also been on the brink of default—and have been rescued by the International Monetary Fund (IMF) and others.

So why is the United States different?  And why has this potential sovereign default, in particular, been seen as riskier in many respects than others?  Why has it been seen as so very urgent for Congress and President Obama to ensure that a solution was found?

There are a few answers to these questions:  First, the options available to the United States are different from those available to other countries.  Second, as a result of that different set of options, the situation is more critical to global markets.  Third, for the situation to be corrected, Congress must engage in “self help,” as the United States has no knight in shining armor ready to come to the rescue if it is unable to meet its current obligations to its creditors, which include countries like China.  For other countries, solutions may be easier to come by because their governments can rely on various helping hands, but for the United States it may not be so easy.

In this column, I will explain how sovereign default or distress is typically handled; why the United States’ situation is different; and why, as a result, there has been such a great need for Congress and President Obama to resolve this issue.

Notably, the United States’ status is especially crucial, since it serves as an important backstop for other sovereign borrowers—especially through its role as a shareholder and contributor to the IMF.

Defining “Sovereign Borrowing”

When countries need to borrow money, they may do so in one of two ways. First, developing countries may receive loans for specific purposes.  For instance, the World Bank may provide loans to governments so that they can build bridges, hospitals, or schools.  Second, governments may sell debt instruments, such as bonds, to investors; these bonds, like commercial bonds, come with obligations that are placed upon the borrower:  commitments that payments will be made, with interest, at specified intervals.

The U.S. Treasury’s website is quite clear about how the U.S. government borrows money:  Rather than getting a bank loan, it “issues debt.” This means that the government sells Treasury marketable securities such as Treasury bills, notes, bonds and Treasury inflation-protected securities (TIPS) to other federal government agencies, individuals, businesses, and state and local governments from within the United States, as well as to people, businesses, and governments from other countries.

The Treasury is also very clear about the procedures for debt issuance—and its explanation reads as if it were taken straight from today’s headlines:

  • The U.S. Treasury issues or creates the debt.
  • The Bureau of the Public Debt manages the government’s debt. That means it keeps records, takes care of selling the debt, and handles paying back people who loaned the government money.
  • The U.S. Treasury and the Bureau of the Public Debt do not decide how the money is spent. The legislative branch of government (Congress) decides how the money is spent. There is a maximum amount of debt the government can have. This is known as the “debt ceiling.” To raise that amount, the U.S. Treasury must get Congress to approve a new and higher limit.

The Treasury website does not, however, go into detail as to what happens if the Treasury does not have congressional authorization to raise the debt-ceiling limit, or if the U.S. government finds itself to be in default on existing debt obligations.

Why, for Many Countries, Sovereign Default Is Not the End of the World

The phrase “sovereign default” refers to a situation where a government is unable to repay its creditors when certain bond obligations become due.  In many cases, a country (for example, recently, Ireland or Greece) can stave off actual default by seeking a bailout or rescue package from other countries, the IMF, and even private-sector creditors.

If potential lenders or bond purchasers begin to suspect that a government may fail to pay back its debt, they may demand a higher interest rate in the future as compensation for assuming a higher risk of default.

A sovereign government cannot be forced to honor its debt obligations.  Instead, it may choose to default in severe economic circumstances.  But if it does, consequences will follow:  It may be excluded from receiving further credit—either by international financial institutions or by investors; creditors may even seize some of its overseas assets; and its own banks and companies may suffer when the cost of credit becomes higher.

There are various options for distressed or defaulting sovereigns.  Governments can ask for additional credit, funds, and support from their allies, and thereby receive grants, subsidies, loans, and guarantees (from wealthier cosigners).  Greece, for example, called the EU and the IMF for help.

As it turns out, governments rarely default on their entire debt.  Rather, they typically enter into negotiations with their bondholders, hoping to reach an agreement under which they can postpone or reduce their debt payments. This kind of debt restructuring is often called “taking a haircut,” due to a reduction in the amount the sovereign owes.

If a sovereign restructures with its creditors, this may result in various new terms including combinations of reduced principal (which refers to reducing the sovereign’s overall debt obligations), extension of maturity dates, and a reduction of interest rates.  For some sovereigns, part of a rescue package might be the addition of new debt in a different currency.  The nature of the restructure or rescue may vary depending on whether the sovereign is defaulting on outright loans, or on sovereign bonds.

Of course, governments often will have to make huge cuts in their own budgets before they can receive aid.  Such cuts are often referred to as austerity measures.  For countries that have already defaulted, austerity measures are commonly an important facet of their ability to emerge from default.

The IMF’s Important Role in Coping With Sovereign Distress

The IMF is often a critical player in helping countries that are in sovereign distress (that is, on the brink of sovereign default).  In an early response to the recent global economic crisis, the IMF strengthened its lending capacity and approved a major overhaul of the mechanisms for providing financial support in April 2009.  Then, in August 2010, it adopted further reforms.

In its most recent reforms, IMF lending instruments were improved further, to provide flexible crisis-prevention tools to a broad range of member countries with sound fundamentals, policies, and institutional policy frameworks.  For low-income countries, the IMF doubled loan-access limits, and it is boosting its lending to the world’s poorer countries, with interest rates set at zero until 2012.

Frequently, an IMF bailout will be accompanied by a World Bank bailout, or by an aid package from world powers like the United States, Japan, or the European Union.   Iceland, Ireland, Greece, Hungary, and Ukraine are among the countries that have received bailouts from the IMF and the EU over the past three or four years.

Sovereign Default Is Rare, but Not Unheard Of

Sovereign default events are rare.  Since the mid 1990s, only the following Moody’s rated countries have defaulted on their debt obligations: Venezuela, Russia, Ukraine, Pakistan, Ecuador, Peru, Argentina, Moldova, Nicaragua, Uruguay, the Dominican Republic, Belize, and Jamaica.  (A few additional countries have had defaults, but have not had bonds with sovereign ratings.)

Have true defaults hurt these countries?  Probably not as much as you might think.  In a paper for the IMF, economists Eduardo Borensztein and Ugo Panniza found that from 1824 to 2004, Latin America was the geographic region with the highest number of defaults, 126.  Africa came in second, with 63.  In analyzing these cases, Borensztein and Panniza found that sovereign default events do not have a long-term impact on credit ratings or borrowing costs.  They found that the political consequences, to finance ministers and incumbent governments, were more significant.

In sum, then, for most countries with serious debt problems, help is available from the international community.  But for the United States, the situation is very different, as I will explain.

Why the U.S. Is Different:  It’s Always Been the Rescuing Country, Not the Country to Be Rescued

The United States is different because in an event of default, it would need to resort to self help.  It could not borrow from the IMF; it would need to raise its own capital by selling U.S. government debt.

Thus far, the United States has typically been part of mechanisms that provide rescue packages (consisting of loans or renegotiations of the terms on existing bonds) to countries that risk default, or have defaulted. Consider Greece, for instance:  The IMF was part of the effort to bail out Greece, at a cost to the United States.

But who will bail out the IMF if—or when—it needs its own coffers replenished?   The expectation is that the United States would be at the top of the list.  The United States is the largest shareholder and contributor to the IMF.  Thus, if the United States were to borrow from the IMF, it would largely be borrowing from itself.

When Greece was in distress, it could look to Germany, or other European Union countries, for a bailout.  In contrast, the United States’ largest creditor is China, and it is unlikely that China would come to the rescue.  Would China really renegotiate its bond terms with the United States if the United States were in distress?  We don’t know the answer.

If the United States Did Default, What Would Likely Happen?

For the United States, a default would be especially grave, because of the size of the American economy.  One likely casualty would be the U.S. housing market.  U.S. mortgage rates are priced at a margin over U.S. government bond yields. A second set of casualties would be U.S. banks, pension funds, and other domestic investors, which collectively hold most Treasury securities.

Banks are required to invest their own money in certain types of “safe” and risk-free collateral.  Treasury securities have often served as this collateral, because of their “AAA” rating.  Thus, banks, too, would be left exposed—because they use government bonds to meet liquidity requirements, and as collateral for their daily and ongoing borrowing from the Federal Reserve.  What would happen if, overnight, Treasury securities no longer qualified as collateral because of a rating downgrade?   Banks might be hit with capital losses; face higher borrowing costs; and have a new worry, too:  a possible run on bank deposits.

Even worse, the United States’ distress could affect the international market.  U.S. banking liabilities to overseas creditors total $4.9 trillion, with China, Japan, and the UK among the largest of these investors.  If the United States were to be unable to pay foreign creditors, this state of affairs could lead to contagion and larger risk throughout the system.

The United States is typically there to help other countries avert sovereign distress.  The federal government also provides support to, and buttresses, the U.S. and international financial markets by issuing Treasury securities with AAA ratings that serve as guarantees for banks and other investors to use, in order to seek their own loans and credit.

For these reasons, and others, the strength of U.S. public debt underpins many of the world’s financial decisions—both on the credit and the investment sides.  When one sovereign has so much influence, it is hard to imagine any other country or entity’s being able to rescue it from its own problems.  Thus, when the United States needs help, it has only one real option:  It must help itself.