Sovereign Debt Crisis With Examples

A sovereign debt crisis occurs when a country is unable to pay its bills. But this doesn't happen overnight—there are plenty of warning signs. It usually becomes a crisis when the country's leaders ignore these indicators for political reasons.

The first sign appears when the country finds it cannot get a low interest rate from lenders. Amid concerns the country will go into debt default, investors become concerned that the country cannot afford to pay the bonds.

As lenders start to worry, they require higher and higher yields to offset their risk. The higher the yields, the more it costs the country to refinance its sovereign debt. In time, it cannot afford to keep rolling over debt. Consequently, it defaults. Investors' fears become a self-fulfilling prophecy.

That happened to Greece, Italy, and Spain. It led to the European debt crisis. It also happened when Iceland took over the country's bank debt, causing the value of its currency to plummet. It very nearly occurred in the United States in 2011, as interest rates remained low. But it experienced a debt crisis for very different reasons. Let's look at some of these examples in depth.

Greek Debt Crisis

The debt crisis started in 2009 when Greece announced its actual budget deficit was 12.7% of its gross domestic product, more than quadruple the 3% limit mandated by the European Union. Credit rating agencies lowered Greece's credit ratings and, consequently, drove up interest rates.

Usually, a country would just print more money to pay its debt. But in 2001, Greece had adopted the euro as its currency. For several years, Greece benefited from its euro membership with lower interest rates and foreign direct investment, particularly from German banks. Unfortunately, Greece asked the EU for the funds to pay its loans. In return, the EU imposed austerity measures. Worried investors, mainly German banks, demanded that Greece cut spending to protect their investments.

But these measures lowered economic growth and tax revenues. As interest rates continued to rise, Greece warned in 2010 that it might be forced to default on its debt payments. The EU and the International Monetary Fund agreed to bail out Greece. But they demanded further budget cuts in return. That created a downward spiral.

By 2012, Greece's debt-to-GDP ratio was 160%, one of the highest in the world. It was after bondholders, concerned about losing all their investment, accepted 25 cents on the dollar. Greece landed in a depression-style recession, with the unemployment rate peaking at 27.9% in 2013, political chaos, and a barely functioning banking system.

Eurozone Debt Crisis

The Greek debt crisis soon spread to the rest of the eurozone, since many European banks had invested in Greek businesses and sovereign debt. Other countries, including Ireland, Portugal, and Italy, had also overspent, taking advantage of low interest rates as eurozone members. The 2008 financial crisis hit these countries particularly hard. As a result, they needed bailouts to keep from defaulting on their sovereign debt.

Spain was a little different. The government had been fiscally responsible, but the 2008 financial crisis severely impacted its banks. They had heavily invested in the country's real estate bubble. When prices collapsed, these banks struggled to stay afloat. Spain's federal government bailed them out to keep them functioning. Over time, Spain itself began having trouble refinancing its debt. It eventually turned to the EU for help.

That stressed the structure of the EU itself. Germany and the other leaders struggled to agree on how to resolve the crisis. Germany wanted to enforce austerity, in the belief it would strengthen the weaker EU countries as it had Eastern Germany. But, these same austerity measures made it more difficult for the countries to grow enough to repay the debt, creating a vicious cycle. In fact, much of the eurozone went into recession as a result. The Eurozone Crisis was a global economic threat in 2011.

U.S. Debt Crisis

Many people have warned that the United States will wind up like Greece, unable to pay its bills. But that's not likely to happen for three reasons:

• The U.S. dollar is a world currency, remaining stable even as the United States continues to print money.
• The Federal Reserve can keep interest rates low through quantitative easing.
• The power of the U.S. economy means that U.S. debt is a relatively safe investment.

In 2013, the United States came close to defaulting on its debt due to political reasons. The tea party branch of the Republican Party refused to raise the debt ceiling or fund the government unless Obamacare was defunded. It led to a 16-day government shutdown until pressure increased on Republicans to return to the budget process, raise the debt ceiling, and fund the government. The day the shutdown ended, the U.S. national debt rose above a record $17 trillion, and its debt-to-GDP ratio was more than 100%.

The U.S. debt crisis began in 2010. Democrats, who favored tax increases on the wealthy, and Republicans, who favored spending cuts, fought over ways to curb the debt. In April 2011, Congress delayed approval of the Fiscal Year 2011 budget to force spending cuts. That almost shut down the government in April. In July, Congress stalled on raising the debt ceiling, again to force spending cuts.

Congress finally raised the debt ceiling in August by passing the Budget Control Act, which required Congress to agree on a way to reduce the debt by $1.5 trillion by the end of 2012. When it didn't, it triggered sequestration, a mandatory 10% reduction of the Fiscal Year 2013 Federal budget spending that began in March 2013.

Congress waited until after the results of the 2012 Presidential Campaign to work on resolving their differences. The sequestration, combined with tax hikes, created a fiscal cliff that threatened to trigger a recession in 2013. Uncertainty over the outcome of these negotiations kept businesses from investing and reduced economic growth. Even though there was no real danger of the U.S. not meeting its debt obligations, the U.S. debt crisis hurt economic growth.

Ironically, the crisis didn't worry bond market investors. They continued to demand U.S. Treasuries, which drove interest rates down to record lows in 2012.

Iceland Debt Crisis

In 2009, Iceland's government collapsed as its leaders resigned due to stress created by the country's bankruptcy. Iceland took on $62 billion of bank debt when it nationalized the three largest banks. Iceland's banks had grown to 10 times its GDP. As a result, its currency plummeted 50% the next week and caused inflation to soar.

The banks had made too many foreign investments that went bankrupt in the 2008 financial crisis. Iceland nationalized the banks to prevent their collapse. But this move, in turn, brought about the demise of the government itself.

Fortunately, the focus on tourism, tax increases, and the prohibition of capital flight were some major reasons why Iceland's economy recovered from bankruptcy.