Sovereign Debt: The Sword of Damocles Hanging Over the World

Already in the Middle Ages, the debts of the state became one of the biggest headaches for rulers, who borrowed large sums of money to finance, most often, military campaigns and/or wars against unwanted neighbors or other states. But the debt load jeopardized the political or economic survival of the ruler himself. The first real case of a sovereign failing to repay a debt is probably that of Edward III of England, who, during the ten years from 1327 to 1337, borrowed huge sums from Italian bankers to cover the costs of two wars – the first against the Scots and the second, which went down in history as the Hundred Years’ War, against France. It was the protracted second military conflict that triggered a deep financial crisis in England, which led to the insolvency of the crown in 1343-1346. King Edward III, at the pinnacle of power, defaulted on his debts, thus triggering the first sovereign “default” in world history. Over the centuries, the debt of a sovereign has evolved into “sovereign debt,” because, as the form of government changed, countries, in order to cover national expenditures that they were unable to subsidize through tax collection, began to finance themselves by issuing debt obligations, both nationally and internationally, to both public and private creditors.

Since the end of World War II, financing of the global economic recovery has been based on stages of public debt accumulation in both economically developed and developing countries. Between 1950 and 1970, the level of world public debt remained fairly stable due to sustained economic growth in some regions of the world. In 1981, Jonathan Eaton and Mark Gersovitz, in their seminal work “Debt with Potential Repudiation: Theoretical and Empirical Analysis,” outlined the theory that “states take on new debt during periods of economic recession and repay it during periods of economic growth.” This definition assumes that sovereign debt lives in cyclical phases and that possible defaults can only occur in phases of economic growth.

However, it was from 1980 onwards that world public debt began to grow more strongly, as the globalization of trade and financial markets had a negative impact on the accumulation of public debt in various countries. Deteriorating national trade balances, constraints and difficulties in the economic growth of emerging economies, increased reliance on private financing, and high interest rates have led to a deterioration in the public accounts of many countries. The situation did not improve at the beginning of the 21st century, as the cost of raw materials began to rise, leading to further deterioration in the trade balances of importing countries, and the financial crises of the early 2000s exacerbated the deficits of state budgets in many countries.

More recently, inflation and the resulting rise in interest rates by central banks, increased uncertainty in the geopolitical environment, as well as a new surge in raw materials and energy reserves have resulted in additional fiscal and business costs for many countries. The numbers are simply merciless. Global public debt has quadrupled since the early 2000s, and in July 2023, the UN sounded the alarm: from $22 trillion in 2002, it has risen in 20 years to an astronomical $92 trillion at the end of 2022. At the same time, 70% of debt is owed by the most economically developed countries, while at the level of individual nations the United States alone holds 35%, China 15%, and Japan 11%. Germany, France, Italy, and the UK account for about 3% of the world’s debt. At the same time, over the last 10 years, the growth rate of public debt in emerging economies has been twice as high as in developed countries.

China is the nation that has increased its debt the most, given the need to support the incredibly rapid economic development that the Asian giant has been able to achieve over the past two decades. Also, according to the UN report, developing countries are experiencing the greatest difficulty in attracting new financing due to increased restrictions on access to the credit market, higher costs (management costs and interest rates), and devaluation of national currencies against major currencies of international financing.

The reasons for this lie in the very structure of the global credit market, which makes financing for developing countries too expensive: for fifty of the world’s economies, the cost of interest payments exceeds the income earned by these countries by as much as 10%. By comparison, while German and US government bond rates averaged 1.5% and 3.1% respectively between 2022 and 2023, they were already 6.5% for Asia, 7.7% for Latin America, and 11.6% for Africa. Half of developing countries have to allocate at least 7% of their export earnings to repay external debt. And in Africa, the amounts allocated to interest payments on foreign debts exceed national spending on health and education.

Such conditions present governments with an urgent need to choose between allocating funds from the budget either to repay loans or to finance public expenditures. Private creditors hold 62% of the debt of developing countries: 44% in Africa, 63% in Asia, and 74% in Latin America. For most of these countries, the cost of public debt, both in terms of management and interest accrued, may exceed, if it hasn’t already, the amount of all borrowed funds. According to a World Bank (WB) report, developing countries will pay $443.5 billion in 2022 to manage their public debt, a 5% increase over the same cost in 2021. The poorest countries in 2022 paid $88.9 billion just to manage their debt and another $23.6 billion in interest. Debt management costs for the poorest countries are expected to rise by a further 39% by 2023-2024.

In 2023, according to estimates by leading international rating agencies, global public debt will continue to rise and reach $97 trillion, representing a 40% increase from 2019. According to Standard & Poors, Europe and Latin America were the regions that recorded the largest increase in debt due to weak economic growth and fiscal pressures caused by very high inflation. High interest rates have also pushed the cost of financing public debt to levels not seen in a long time, so that even for the most economically developed countries the cost of issuing new debt obligations has doubled. In conditions of high interest rates for emerging economies, the issuance of new foreign currency denominated government debt obligations or repayment of already contracted debt increases credit risk in the short term, which, as a consequence, inevitably leads to a further increase in the cost of financing.

However, in September 2023, ratings agency Fitch said that despite the current global economic and financial conditions, domestic ratings volatility has declined, and they have become more balanced since the COVID-19 pandemic period and the outbreak of the conflict in Ukraine. Moreover, the agency noted that the average volatility of foreign currency-issued sovereign debt ratings was even lower in 2023 than in the longer term. In 2023, Fitch actually upgraded 13 countries and downgraded 11, bringing the number of countries with a positive outlook to 13 and negative to 14, although the agency itself noted that the negative outlook was for countries, including Belgium and Great Britain, with much higher debt – $5 trillion – than for countries with a positive outlook but with debt of “only” $600 billion.

The steady growth of the national debt is not something that can be neglected. While the focus is on the growing risks of sovereign debt default in developing countries, more attention should be paid to the fiscal and budgetary plans of economically more advanced countries to keep their deficit growth under control. According to a Reuters poll of developed countries, the USA, Italy, and the UK will come under scrutiny in the near future due to the uncontrolled growth of their relative public debt. Long-term debt raises the biggest concern, given the national spending plans announced to combat rising inflation.

In general, the entire Europe could be in a very difficult situation. According to a study conducted in March 2023 by Japanese financial company Nomura, while on the one hand, high inflation is now playing in Europe’s favor by “inflating” economic growth, on the other hand, the effect of the European Central Bank’s (ECB) rate hike has not yet been “absorbed” by the market, leaving the costs of managing and paying down the national debts of eurozone countries still low. For this reason, analysts estimate that the risk of default remains low, but the situation could change dramatically, as 10 of the 12 eurozone countries run deficits, putting additional pressure not on national fiscal systems, but on the entire European system.

In recent years, we have become accustomed to hearing the word “default” whenever a state finds itself unable to fulfill its financial obligations, especially to international creditors. While in the Middle Ages monarchs managed to circumvent the danger of financial defaults by conferring noble titles and political offices, in the recent past the main tool for getting out of defaults has been debt restructuring, i.e., issuing new debt on new terms, often more unfavorable, to repay existing debt. Refinancing the government is always considered possible because there is a strong belief that the government simply cannot go bankrupt, since the government, at least in theory, can always sell its infrastructure, industry, or natural resources to cover its debts.

In Global Sovereigns Outlook 2024, Fitch maintains a “neutral” outlook on the likelihood of new sovereign debt defaults, as a possible slowdown in the global economy, and continued fiscal strains on national accounts are “balanced” by a slowdown in inflation, which could lead to financial support associated with lower interest rates from central banks. It is the decline in interest rates that analysts at Germany’s Allianz see as a factor that could drive further issuance of debt obligations by emerging economies in 2024. USB Management analysts even believe that 2024 will be a year of recovery for emerging economies, which, thanks to certain steps their governments are taking, will be able to access new financing from the International Monetary Fund (IMF) and the World Bank (WB), which will make the bonds of these countries very profitable and therefore attractive.

Among developing countries, according to analysts, the ones currently most exposed to the risk of default are Argentina, Belarus, Egypt, Ghana, Kenya, Lebanon, Pakistan, Sri Lanka, Tunisia, Ukraine, and Venezuela. Some analysts include Russia in this group, but the reasons are political rather than economic. In fact, Russia’s debt to international creditors is about 16% of its GDP. By comparison, the foreign debt of Poland, which, according to analysts, has “zero risk of default,” is as much as 55% of its GDP.

It is the ratio of public debt to GDP that is the main indicator used to assess a country’s ability to repay accumulated debt. If we look at global data, we can get an idea of the financial health of each nation: at the end of 2023, Japan was estimated to have a debt-to-GDP ratio of almost 260%, the highest in the world. It is followed by Venezuela at 240%, Sudan at 180%, and Greece at 170%. The top ten countries with the highest debt-to-GDP ratios include two other G7 members: Italy with 140% and the USA with 120%. Other notable European countries include France, Portugal, and Spain – all three have debt-to-GDP ratios of around 110%, Belgium and the UK around 105%. Austria (75%) and Germany (66%), which have always had a more conservative financial policy in the past, are much lower.

However, even this indicator does not fully reflect the magnitude of the national debt problems. The debt-to-GDP ratio in Latin America was estimated to be around 58% at the end of 2023, but if you look at the history of defaults, the black mark for sovereign debt defaults goes to Latin America, with 50 defaults in the last 50 years. After each default, debt restructuring plans were put in place, but the root causes that led to these crises were never addressed, because, in addition to mismanagement of public resources, exogenous factors, such as exchange rate fluctuations against “international” currencies and commodity price shocks, contributed to the destabilization of the region’s economies.

Argentina is in the most difficult position, having experienced a string of nine bankruptcies totaling $132 billion over the past decade, the most recent of which occurred in 2020. By the end of 2019, the country had accumulated $323 billion in debt, much of it owed to the IMF, the Paris Club, and other private investors in Argentine government bonds, before being forced to restructure its debt again in 2020 as a consequence of its inability to make payments on its international obligations. A total of 18 defaults have occurred in 10 developing countries in the past three years, more than in the past 20 years. According to the WB, 60% of low per capita income countries have a high risk of defaulting on their debts or are already in default. Actionaid, an independent international organization dedicated to fighting the causes of poverty, has made the accusation that 50 years of IMF financial aid to African countries has been a complete failure.

Despite “advice” and recommendations from the IMF to get out of poverty, most countries on the African continent suffer from high inflation and ever-increasing debt levels. Of the 35 low-income African countries, 19 are either defaulting or at risk of defaulting on their debt obligations. In December 2023, Ethiopia became the latest country to default as it failed to make a $33 million coupon payment on a $1 billion international bond.

How is it possible that a country that has not paid a $33-million coupon should default, while a country with a debt-to-GDP ratio of over 100 percent and trillions of dollars in debt can continue to issue bonds and not question its ability to repay the borrowed funds?

The UN itself confirms in its July 2023 report that the international financial system is not balanced, and developing countries are at a distinct disadvantage. According to a May 2023 Bloomberg analysis, the volume of bonds denominated in dollars, euros, or yens, issued by developing countries, was equivalent to $210 billion, and the average interest rate on them exceeded 10%. These bonds represented only 15% of the total $1.4 trillion in sovereign bonds. Moreover, the terms of financing are dictated by the same economically more developed countries that directly, like the Paris Club, or through international institutions, like the WB or IMF, regulate the debt market. Analyzing, for example, the voting power of the various countries that comprise the IMF, makes it clear that the G7 countries control more than 40% of the votes.

Also, if you look closely at the IMF’s loan portfolio, the total amount of loans to developing countries as of January 2024 is about $111 billion. As for the Paris Club, participation is much more limited, and of its 22 member countries, only Russia and Brazil are considered developing countries. The absence of China and India is particularly noticeable. According to the latest data, as of the end of 2022, the Paris Club has lent a total of $324 billion to developing countries. One could say that a rather paradoxical situation has emerged: countries that have been “not careful” about borrowing at all over the past 50 years to achieve a high level of economic development are now deciding the fate of the debt of poorer developing countries.

While some of these countries, such as Canada, Belgium, Norway, or England, can boast that they have never defaulted, it is worth considering what might happen if in the future these governments find themselves unable to manage their huge public debts. It is worth remembering that the most indebted country in the world, the United States, despite the claims of its current Treasury Secretary, has declared bankruptcy four times in its history (1862, 1933, 1968, 1971), but, like sovereigns in the Middle Ages, has each time used its dominant position to avoid meeting its financial obligations to creditors.