International lending and sovereign debt
International sovereign debt is the credit extended to governments (the sovereign) by lenders in other countries. For example, the government of Brazil has taken credits from banks from the U.S., Britain, Spain, Japan, and many other countries.
These banks want to lend to the government of Brazil to take advantage of the higher interest rates in Brazil compared to the interest rates in their own countries. They also want to diversify their portfolio of international credits across many different countries. The Brazilian government is interested in borrowing internationally as it can tap a larger pool of funding compared to the domestic financial market in Brazil. It can borrow more and at better interest rates.
And here is a puzzle:
Why would anyone lend to a government in a foreign country? After all, if the government of Brazil refuses to pay its debts, how can some bank in Spain or another country force them? The answer is that they cannot. The bank cannot take the foreign government to court and cannot seize its assets as it would do with a local borrower. In earlier times, countries that refused to pay their debts were sometimes invaded by the creditor countries or suffered trade embargos. Now, thankfully, military invasion over unpaid debts is not a viable option.
So, why do lenders lend and why do governments pay back? The reason is that countries want to preserve their access to international credit. They build reputation by servicing their debts in a timely fashion and this reputation allows them to borrow at lower interest rates the next time they need to do so. If they refuse to pay their debts, then they lose the trust of international lenders and have to pay exceedingly high interest rates to borrow, if they manage to attract any funding at all.
Ability vs willingness to pay
Of course, sometimes countries cannot pay back even if they want to, i.e. one has to differentiate between ability to pay and willingness to pay. The ability may be there but the willingness may be low. For example, the government may be taken over by a regime that is hostile to foreign influences and decides to renegotiate the credit contracts (think Russia after the communist revolution). Or, governments may want to service their debts but they simply cannot do that. The latter case is exemplified by Greece during the recent financial crisis.
Not solvent or illiquid
Also, one has to differentiate between borrowers that are not solvent and those that are not liquid. In the first case, the income of the borrower is not enough to pay back the debt (Greece). In the second case, the income is enough but the borrower does not have enough disposable cash to service their debts right now (the East Asian countries in 1997). It makes sense to give financial help in the second case as we only have a cash-flow problem. In the first case, the only thing that works is debt forgiveness: full or partial.
There are in fact two informal international institutions that deal with debt forgiveness and restructuring: the so-called London Club deals with the restructuring of international credits from private lenders to governments and the Paris Club that deals with lending from official lenders (governments and international organizations) to governments. The rescheduling and forgiveness of the international debts is also heavily influenced by the International Monetary Fund and the World Bank.
These banks want to lend to the government of Brazil to take advantage of the higher interest rates in Brazil compared to the interest rates in their own countries. They also want to diversify their portfolio of international credits across many different countries. The Brazilian government is interested in borrowing internationally as it can tap a larger pool of funding compared to the domestic financial market in Brazil. It can borrow more and at better interest rates.
And here is a puzzle:
Why would anyone lend to a government in a foreign country? After all, if the government of Brazil refuses to pay its debts, how can some bank in Spain or another country force them? The answer is that they cannot. The bank cannot take the foreign government to court and cannot seize its assets as it would do with a local borrower. In earlier times, countries that refused to pay their debts were sometimes invaded by the creditor countries or suffered trade embargos. Now, thankfully, military invasion over unpaid debts is not a viable option.
So, why do lenders lend and why do governments pay back? The reason is that countries want to preserve their access to international credit. They build reputation by servicing their debts in a timely fashion and this reputation allows them to borrow at lower interest rates the next time they need to do so. If they refuse to pay their debts, then they lose the trust of international lenders and have to pay exceedingly high interest rates to borrow, if they manage to attract any funding at all.
Ability vs willingness to pay
Of course, sometimes countries cannot pay back even if they want to, i.e. one has to differentiate between ability to pay and willingness to pay. The ability may be there but the willingness may be low. For example, the government may be taken over by a regime that is hostile to foreign influences and decides to renegotiate the credit contracts (think Russia after the communist revolution). Or, governments may want to service their debts but they simply cannot do that. The latter case is exemplified by Greece during the recent financial crisis.
Not solvent or illiquid
Also, one has to differentiate between borrowers that are not solvent and those that are not liquid. In the first case, the income of the borrower is not enough to pay back the debt (Greece). In the second case, the income is enough but the borrower does not have enough disposable cash to service their debts right now (the East Asian countries in 1997). It makes sense to give financial help in the second case as we only have a cash-flow problem. In the first case, the only thing that works is debt forgiveness: full or partial.
There are in fact two informal international institutions that deal with debt forgiveness and restructuring: the so-called London Club deals with the restructuring of international credits from private lenders to governments and the Paris Club that deals with lending from official lenders (governments and international organizations) to governments. The rescheduling and forgiveness of the international debts is also heavily influenced by the International Monetary Fund and the World Bank.
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