Sovereign Debt: Overview and Features

What Is Sovereign Debt?

Sovereign debt is issued by a national government and referred to as government debt, public debt, and national debt. Governments borrow for public investments and to boost employment. The level of sovereign debt and its interest rates reflect the saving preferences of a country's businesses and residents and the demand from foreign investors.

Features of Sovereign Debt

Governments acquire sovereign debt by issuing bonds, bills, debt securities, or loans from countries and multilateral organizations like the International Monetary Fund. Sovereign debt may be owed to foreigners or the country's citizens and can be denominated in domestic or foreign currency. Although lenders always take on default risk, sovereign borrowing has several distinct characteristics.

• Unlike private borrowers, governments can raise tax revenue, and most also issue their currency.
• Governments can be overthrown by regimes that refuse to honor their debt obligations or incur economic sanctions that may cause their debt to lose value.
• Sovereign borrowers in default are rarely subject to legal enforcement, and creditors often find it hard to target the defaulted sovereign's assets.
• Some sovereign debt securities have linked coupon payments to a country's economic growth rate, though such GDP-linked bond issues are relatively rare.

Credit Ratings and Default

The U.S. has historically been viewed as the world's safest credit risk. The country has never defaulted on its debt, and it remains the issuer of the world's reserve currency. The three-month U.S. Treasury bill rate has traditionally been a benchmark "risk-free" interest rate.

However, in August 2023, Fitch Ratings downgraded the long-term ratings of the United States to "AA+" from "AAA" based on the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to "AA" and "AAA" peers over the last two decades with repeated debt limit standoffs and untimely resolutions.

As of September 2023, Standard and Poor's assigned AAA sovereign credit ratings to Australia, Canada, Denmark, Germany, Liechtenstein, Luxembourg, Netherlands, Norway, Singapore, Sweden, and Switzerland.

In a default, the creditors' main leverage lies in the resulting loss of international capital markets access for the defaulting sovereign and its likely need to negotiate a debt settlement to be able to borrow again. Some academic studies have found prior defaults have little or no effect on future lending terms. One concluded that higher losses in sovereign debt restructurings were associated with more prolonged periods of market exclusion and higher borrowing costs.

The Limits of Sovereignty

Sovereign countries may pool some sovereign powers, such as in a currency union like the eurozone, wherein all members use a currency issued by a supranational authority. The shared currency can facilitate trade flows and economic integration.

The eurozone was challenged in 2011-2013, when its economically weakest members were priced out of public debt markets, leaving them without the traditional policy tools of deficit spending and currency devaluation amid an economic downturn. The European sovereign debt crisis abated once European Union institutions, including the European Central Bank, guaranteed and restructured those member states' sovereign debt.

Sovereign Debt vs. Economic Growth

Traditionally, advice for sovereigns facing a possible default included austerity policies aimed at controlling spending and economic liberalization initiatives promoting growth. Economists Carmen Reinhart and Kenneth Rogoff published research suggesting higher levels of sovereign debt were associated with slower economic growth.

Critics have challenged the data and note public-sector austerity frequently leads to economic slumps. Experiences in Japan and the U.S. have cast doubt on the debt-to-GDP ratio as a debt sustainability measure. In both instances, increases in the ratio were not associated with meaningful increases in interest rates on sovereign debt.

Modern monetary theory (MMT) suggests a sovereign currency issuer's borrowing capacity is limited mainly by the rate of inflation it's willing to tolerate. In this model, taxes are raised to cool inflation rather than to offset government spending.

The Bottom Line

Sovereign debt is used by a country's government for a variety of reasons, such as to pay for public infrastructure. When a government has more expenses than the money it has raised in taxes, then it turns to debt to finance those expenses.