Debt owed by a central government is known as “sovereign debt.” Government debt in foreign currency is issued by a country’s government for economic growth and development.
Sovereign credit ratings, which help investors weigh risks when evaluating sovereign debt investments, can provide investors with reassurance about the stability of the issuing government. There are several other terms for sovereign debt, such as public debt or national debt.
Understanding Sovereign Debt
It is possible for a sovereign to have both internal and external debt. Internal debt refers to the amount owed to financial institutions located within the country’s borders. External debt is debt that is owed to lenders in other countries. The length of time until the debt is due for repayment is another way to categorize sovereign debt. In general, short-term debt is debt that lasts for less than a year; long-term debt is debt that lasts for more than a decade.
How Sovereign Debt Works
Borrowing and issuing government bonds and bills typically results in sovereign debt. Low credit-worthiness nations rely on the World Bank and other multilateral financial institutions for their borrowing. Countries may find it difficult to repay their sovereign debt if the exchange rate has fallen and the payback from the projects financed by the debt is overestimated.
This means that the lender has no other choice but to attempt a renegotiation since it cannot seize the government’s assets. Because countries that default on sovereign debts will have a hard time getting loans in the future, governments assess the risks of taking sovereign debts.
How Sovereign Debt is Measured
Strict criteria must be followed when comparing sovereign debt between countries. The measurement of sovereign debt varies depending on who is doing the measuring and for what purpose.
There are a number of debt rating agencies for businesses and investors, such as Standard & Poor’s Only commercial creditors’ debt is taken into account. In other words, it doesn’t take into account the debt a country has to the IMF or the World Bank.
In addition, only the national debt is taken into account, not the debt owed by individual states or municipalities. As a result, S&P takes into account the potential impact on the country’s ability to honor its sovereign debt.
A country’s debt-to-GDP ratio is restricted by the European Union. So, it’s a roader in terms of dimensions. State and local government debt, as well as future obligations to social security, are included in this figure.
Debt owed by the federal government to itself, known as intragovernmental debt, is part of the U.S. debt and is not included in the total debt. Debt incurred by non-national governments such as municipalities, states, and the like is not included. The majority of states and municipalities are prohibited from running deficits.
Risks Involved in Sovereign Debt
Risk-free investment: lending money to a national government in its own currency is referred to as risk-free investment because the borrowing government can repay the debt by raising taxes or cutting spending or simply printing more money. Sovereign debt will always involve default risk.
In addition to issuing sovereign debt, governments have the option of creating money to fund their projects. Governments can avoid having to pay interest by doing so. Although this method reduces the government’s interest costs, it can lead to hyperinflation. This means that governments will continue to rely on the assistance of other governments to fund their projects.
Measuring Sovereign Debt
Each country’s sovereign debt is measured in a unique way. Sovereign debt measurement is subject to the motives and methods of the individuals performing the measurements. Only commercial creditors’ debt is considered in Standard & Poor’s business and investor ratings.
To put it another way, this does not include money borrowed from other governments or the World Bank. At the same time, the total amount a Eurozone country can borrow is capped by the EU. As a result, when it comes to calculating sovereign debt, the EU has fewer restrictions. Local and state debt are included in the EU’s scope.
Example of Sovereign Debt
Sovereign debt ratings and performance are heavily influenced by the economic and political systems of the countries issuing the debt. International markets can be volatile, and treasury bills issued by the US government are seen as a safe haven.
As a result, several foreign countries, most notably Japan and China, hold significant amounts of US debt. The sovereign debt issued by countries with excessive spending and a high debt-to-GDP ratio is on the other end of the spectrum.
The Greek debt crisis serves as a cautionary tale about the dangers that can arise in a country’s economy if it is unable to pay its debts.