Sovereign Defaults – How, Why, Where, and When?
In May 2022, Sri Lanka defaulted on its sovereign debt for the first time in its history. This dark event sparked violent protests, with clashes and widespread arson reported in many parts of the country. At least nine fatalities were reported as a result of the violence, which stemmed from years of anger over excessive borrowing to support state companies with generous social benefits.
As one of the latest in a string of Sovereign Defaults since the start of the Covid-19 pandemic, Sri Lanka’s default is seen by many as a warning to other emerging economies where record-high food costs, inflation, and general shortages could potentially wreak havoc on their economies.
Other countries which have already defaulted on their sovereign debt over the past few years include Lebanon, Argentina, Zambia, Suriname, and Belize.
What is a Sovereign Default?
A Sovereign Default happens when a country’s government fails (or refuses) to pay its debt to its creditors. This puts the country at risk of being cut off from any future financial aid, as creditors have very little recourse over unpaid debt. Although the creditors may be able to seize their debtors’ international assets, no international court can force a country to pay what they owe.
Due to this, the threat of being barred from future international borrowing for several years, along with high borrowing costs when they are finally allowed to access debt again is generally enough to ensure that a Sovereign Default is regarded as an absolute last resort.
Furthermore, a Sovereign Default carries several consequences to the state, as well as its citizens. These include damage to the state’s reputation among creditors, restricting its access to international funding, a currency crisis as investors avoid the country’s national economy, and an economic crisis as investors withdraw their money due to falling internal demand.
Who is at Risk?
Generally developing economies are at the greatest risk of suffering a Sovereign Default. Currently, 135 countries in Africa, Eastern Europe, Asia, and Latin America are considered critically indebted, with 17 countries at risk of defaulting on their Sovereign Debt. These 17 countries – including El Salvador, Zambia, Tunisia, Ghana, Pakistan, Egypt, and Nepal to name a few – owe almost a quarter of a trillion US Dollars combined (237 billion USD) and make up 12% of the world’s population.
South Africa, with a 70,2% debt to GDP ratio, currently occupies 15th place on Visual Capitalist’s list of countries at risk. Although South Africa’s risk of a sovereign default has been downgraded to moderate, we are still ranked in the top 10 African countries at risk of a Sovereign Default.
What causes Sovereign Default?
The simple answer is that governments are spending more than they earn.
This has been exacerbated over the past few years, as during the height of the Covid-19 pandemic governments had to increase their spending on hospitals, vaccines, and economic stimulus. At the same time, their revenue was falling. Many countries – such as Sri Lanka – depend heavily on tourism for revenue, however during the pandemic lockdowns that revenue virtually disappeared.
Another major contributor to Sovereign Defaults is a strong US Dollar. Most of the debt taken on by emerging economies are from foreign sources, which means that they need to be paid back in foreign currency. The stronger the Dollar, the larger the amount becomes that the government must pay back.
Other leading causes of Sovereign Defaults include political instability, wars, mismanagement, political corruption, and revolution. As an example, Russia defaulted on their sovereign debt in June 2022, the first time since doing so in 1918. This was a direct result of the economic sanctions imposed on them over the ongoing war in Ukraine.
Financial mismanagement, political instability, and economic stagnation are more frequently becoming the major catalysts for Sovereign Defaults. These were the primary factors in the Sovereign Defaults of Ukraine in 2015, Ecuador in 2008 and 2020, and Argentina in 2020.
What are the Effects of a Sovereign Default?
A Sovereign Default can have devastating effects on a country’s economy. It imposes severe economic costs and can impede output for years to come. As mentioned earlier, a default can cause a country to be cut off from foreign lending, and high repayments when they are finally allowed to borrow again. As an example, Pakistan is desperately asking for a $6 billion loan from the IMF, however the money is being held back.
If a country is heavily dependent on foreign creditors, the results of a sovereign default would most likely include slower economic growth, which makes it harder for businesses and consumers to keep afloat. But economic ramifications are not the only concern.
We know all too well that people are volatile. What would happen in countries with a history of violent political instability if they were to default? Already we have seen the protest in Sri Lanka turn deadly, but it is only a glimpse of what could happen in countries like Tunisia, El Salvador or Lebanon.
In July 2020, South Africa loaned $4.3 billion from the IMF. In January 2022, the World Bank loaned the country another $750 million. This brought the total government debt to $282.2 billion in May 2022. In 2021 we saw the Zuma riots, triggered by the incarceration of the former president. However, the cause runs much deeper.
Frustration over mounting job losses and economic inequality worsened by the Covid-19 policies pushed people over the edge, resulting in billions in damages and hundreds of lives lost. This could foreshadow what could happen if South Africa was to fall victim to a Sovereign Default. With fuel prices already soaring by 80% and the Rand losing 14% of its value since the start of 2021, the pinch would be felt for years to come should we fail to service our foreign debt.
The Impact of a Sovereign Default.
Argentina suffered a Sovereign Default in 2020, which gives us a great example of how this impacts a country’s economy. In January 2020, the Argentine Peso was at AG$59.76 to the US Dollar. On 27 July 2022, it had fallen to AG$130.88 to the Dollar. This means that any money kept in a FIAT-based investment would be worth a mere 45% of what it was a year and a half ago.
Imagine if your Rand-based investments were to lose more than half its value in 19 months. This is the sad reality of the devastating currency devaluation that could happen because of a Sovereign Default. This is why it is important to diversify your portfolio and move at least a portion of your wealth out of FIAT-based investments.
To illustrate this point and help define the difference between wealth and the amount of money you have, we did an exercise to illustrate exactly how far the value of your money would have fallen had you been invested in an Argentine Peso- based investment.
On January 1st, 2020, AG$1,000,000 would have been worth US$19,648.84 and would have bought you 11,23 ounces of Gold. This was calculated using the AM price fix of Gold on 1 January 2020 and adding a 15% markup. This Gold would now be worth $19,313.91, or AG$2,527,804.54.
On 27 July 2022, AG$1,000,000 was worth only US$7640.58, and would have bought 3,86 ounces of Gold (once again using the AM price fix and adding 15% markup).
This is a difference of more that AG$1,500,000 in the space of 19 months. Although your money would not have increased (due to the markup at purchase), you would have been much better off than you would have been had you kept your money in the bank or in a Peso-based investment.
This also illustrates clearly that your wealth is not measured by how much money you have in the bank. In both cases you would have had AG$1,000,000, but the buying power of that same amount of money has been significantly eroded by the Sovereign Default, as has your wealth.
Guarding Your Wealth with Bullion.
We have always said that buying physical bullion is not about getting rich quick, but rather preserving your wealth during times of economic turmoil and financial instability. South Africa is not out of the woods yet in terms of suffering a Sovereign Default, and when it happens, we could very well see the value of the Rand decrease significantly.
Gerhard Kemp, our newly appointed DCX Chairman, Executive director of M2Resources, and seasoned Gold analyst who has been working on Gold mines and marketing Gold globally for the last 46 years had the following to say: “Gold has given a return of 21% over the last 20 years in Rand terms, thus one of the best performing assets across the board”. Furthermore, the World Gold Council reported that over the last 50 years gold has expanded more than 48 times, with a compound annual growth rate of 8%.
By investing in physical bullion, you are essentially hedging your wealth out of Rands and into a Dollar-based commodity. As we could see in the example above, even if the value of our local currency might suffer a significant devaluation, the wealth you have stored in bullion will endure and continue to grow for decades to come.