With Zambia defaulting on its debt obligations, we should brace ourselves for very hard times ahead.
What we need to bear in mind is that sovereign default is just like a default on debt by a private individual or business, but by a national government that fails to repay its interest or principal due.
This default may result in a government facing higher interest rates and a lower credit rating among lenders, making it more difficult to borrow.
And we hope this government will not be tempted to do crazy things with its domestic borrowing
and resort to printing more money and “inflating” their way out of debt.
This defaulting will have very serious consequences for our economy. If potential lenders or bond purchasers begin to suspect that a government may fail to pay back its debt, they will sometimes demand a higher interest rate as compensation for the risk of default. This is sometimes referred to as a sovereign debt crisis, which is a dramatic rise in the interest rate faced by a government due to fear that it will fail to honour its debt.
In the event of a country’s default, or an increase in the risk of default, a country’s sovereign credit rating will likely suffer. A credit rating agency will take into account the country’s interest expense, extraneous and procedural defaults, and failures to abide by the terms of bonds.
If borrowers were to experience dramatically higher payments as the result of a debt default, the result would be substantially less disposable income to spend on goods and services, which could ultimately lead to a recession.
When default occurs, the government’s bond yields rise precipitously, creating a ripple effect throughout the domestic economy.
Inflation has sometimes helped countries to escape the true burden of their debt. When a country issues its own currency and borrows money in that currency, it has the option of simply creating more currency to repay its debt. Most often, this is carried out through the operation of a government’s central bank, which buys and holds (or continuously rolls over) newly-issued government debt in return for newly created money that the government can then spend. This practice is known as monetizing the debt and is similar to the currently widespread monetary policy known as quantitative easing.
Other times, when faced with extreme debt, some governments have devalued their currency, which they do by printing more money to apply toward their own debts. In the past, this was also accomplished by ending or altering the convertibility of their currencies into precious metals or metal-backed foreign currency at fixed rates.
These practices represent an implicit default on sovereign debt in that they result in the government’s debt being nominally repaid in terms of money that has lost much of its purchasing power. Like a formal default, they may result in rising interest rates for the sovereign and reduced willingness by lenders to buy or hold the country’s debt.