Defaulting on debt: How can it affect the economy of a stable country?

A failure to honour debt obligations would have serious consequences on a country’s economy and could cause a ripple effect across global financial markets

By Laila Eid | @Laila Eid | 7 June 2023

6 June _ Defaulting on debt_ what does it mean for the economy of a stable country_
  • Throughout history, countries have faced the challenge of managing their internal and external debt

  • The US, Spain and Argentina are examples of countries with historical cases of debt default

  • The debt coverage ratio is used to measure a country’s ability to cover its debt obligations

Overview of historical examples of debt default

When a country defaults on its debt, it means that it has failed to fulfil its contractual obligations to repay borrowed funds. This can occur when a country lacks sufficient resources, faces a severe economic downturn, experiences political instability, or encounters a combination of these factors.

Throughout history, countries have faced the daunting challenge of managing their debts. Defaulting on debt has had profound consequences on economies and financial systems worldwide. Let’s have a look at some examples.

In the 1840s, the United States was undergoing rapid industrialization and infrastructure development. The government inflated its debts by issuing bonds to finance ambitious projects such as the construction of canals and railroads. However, realizing the need for fiscal prudence, the government deliberately defaulted its debt, reducing its overall burden and managing its financial obligations more effectively.

Spain's history of debt defaults stretches back centuries, making it a compelling case study. In 1557, Spain became the first country to default on its debt, setting a precedent for future debt challenges. Since then, Spain has faced approximately 15 instances of default, exemplifying the cyclical nature of debt struggles that countries can experience.

Argentina is another country that has had a turbulent relationship with debt. The country's default in 2001 was one of the largest in history, involving a debt burden of over $100 billion. The consequences of Argentina's default included a severe economic contraction, a sharp depreciation of the currency, and a prolonged period of social and political unrest.

Mexico, which defaulted on its external debt in 1982, and Russia, which experienced a debt crisis in 1998, are other historical examples that demonstrate the pervasive nature of debt problems and their potential global consequences.

Understanding the debt coverage ratio

The debt coverage ratio is a financial metric that measures a borrower's ability to meet its debt obligations. It compares a country's operating income including taxes and non-debt-related expenditures to its debt service costs such as interest payments and principal repayments.

A higher ratio indicates a better ability to cover debts and suggests a lower default risk. However, this metric has its limitations and cannot provide a comprehensive assessment of a country's overall financial health.

To understand the ratio better, this is the formula for calculating the debt coverage ratio:

Debt Coverage Ratio = Operating Income / Debt Service Costs

For example, if a country has an operating income of $1 billion and its debt service costs amount to $500 million, the debt coverage ratio would be 2 ($1 billion / $500 million). This indicates that the country's operating income is twice the amount required to cover its debt obligations, reflecting a relatively strong ability to service its debt.

Possible consequences of defaulting on debt

No country is immune to the risks associated with debt default, and failure to honour debt obligations could have far-reaching consequences for the economy of a stable country.

Firstly, it severely damages a nation's creditworthiness and credibility in the global financial markets. As a result, borrowing costs increase, making it more expensive for the country to access capital for investment and growth. Investors lose confidence leading to capital flight, currency depreciation and potential financial instability. This could severely jeopardize long-term economic prospects.

Furthermore, defaulting on debt creates a negative feedback loop. Domestic businesses and consumers face reduced access to credit hindering investment, consumption, and economic growth. Governments are compelled to implement strict measures including spending cuts and tax increases to restore fiscal stability. These measures, while necessary, can lead to social unrest, a decline in living standards, and increased inequality.

A stable country defaulting on its debt would not only damage its own economy but also have wider implications for global markets. Thus, it is crucial for governments to implement prudent fiscal policies, exercise responsible borrowing practices and proactively address debt challenges to maintain stability and protect the overall economy.

As a conclusion, defaulting on debt is a serious concern for any country, regardless of its current stability. The historical examples demonstrate the profound consequences that such events can have on economies and financial systems.