How a Country's Debt Crisis Can Affect Economies Around the World (2024)

Whether in the private sector or government, a debt crisis in one country can and frequently does spread economic pain to other countries.

This can happen through a tightening of financial conditions such as a spike in interest rates, a slowdown in trade and economic growth, or merely a steep decline in consumer confidence.

This is especially true if the country in crisis is large and intricately linked to the global economy.

What Is a Debt Crisis?

A debt crisis occurs when a country can't pay creditors what it owes them for the money that the government has borrowed. Countries may borrow funds for a variety of reasons—to undertake projects or spend on national programs—when tax revenues from citizens and businesses fail to provide the money they need.

When the amounts borrowed grow beyond a nation's ability to service them, lenders may charge higher interest rates to lend it more. This leads to higher borrowing costs and at a certain point, a debt burden can become untenable. At this stage, default can become a possibility. With or without defaults, the burden of massive debt can have disastrous effects on nations.

What Are the Effects of a Debt Crisis?

A debt crisis can lead to steep losses for banks, both domestic and international, potentially undermining the stability of financial systems in both the crisis-hit country and others.

This can affect economic growth and create turmoil in global financial markets. If a country's debt crisis is severe enough, it could result in a sharp economic slowdown at home that impedes economic growth elsewhere in the world.

Debt defaults can hit individual citizens within a country and across borders especially hard. Specific effects can include:

• Rising costs of food and other goods and services due to inflation as a government prints money to support its expenditures.
• Higher interest rates on mortgages, credit card debt, car loans, and more.
• The loss of jobs and growing unemployment as companies and the government slash their spending.
• A descent into poverty for millions of people.
• A plunge in economic activity and the potential for a recession.
• Cuts to a nation's all-important services, such as healthcare, public safety, social services, and education.

Global Financial Crisis

The 2007-08 global financial crisis showed how a debt crisis can spread like an epidemic and hurt economies worldwide.

Though other countries participated in similarly risky behavior—particularly in Europe—the global financial crisis was essentially made in the U.S., with risky lending in the subprime mortgage market and extremely leveraged derivatives trading on Wall Street.

Because the U.S. has the world's dominant economy and financial system, and because so many economies around the globe depend on the health of the U.S. economy, the fallout was widespread and severe, causing market slumps worldwide and a global economic recession.

Fear of a complete economic collapse made consumers unwilling to buy and banks unwilling to lend, accelerating a downward economic spiral in the U.S. that quickly spilled over to other economies.

Asian Financial Debt Crisis

The case of Thailand and the Asian financial crisis shows that even a debt crisis in a smaller country that is closely linked to the global economy can wreak havoc in other nations.

This crisis was triggered when Thailand’s financial imbalances—quickly rising external debt and a reliance on short-term inflows of foreign capital—caused the government to devalue its currency, the baht.

The result was a collapse in the currency, which left Thailand unable to pay many of its foreign creditors.

The problem quickly spread to other Asian countries, especially Indonesia and South Korea. Other regional currencies fell due to expectations that Thailand's export competitors would also be forced to devalue their currencies.

This would make it more difficult for borrowers of foreign capital to pay back their debt. Interest rates surged as nations tried to slow the outflows of capital, bringing economic growth to a halt.

In 1998, real per capita gross domestic product fell by 16% in Indonesia, 12% in Thailand, and 8% in South Korea.

Latin American Debt Crisis

The Latin American debt crisis of 1982 to 1989 occurred as a result of the huge rate of borrowing by various countries and their inability to continue to make payments on their debt.

In 1970, total debt owed by countries in Latin America stood at $29 billion. By 1982, it was $327 billion. In 1981, there was a worldwide recession, banks raised loan rates, and debt burdens became unbearable.

In 1982, Mexico announced that it could not service its debt. Sixteen other Latin American countries followed suit. As a result, banks cut off all lending and deep recessions occurred.

Threat to U.S. Financial System

U.S. banks that leant heavily to Latin American countries beginning in the 1970s were at risk. By extension, the safety and stability of the U.S. financial system was threatened. As a result, financial regulations were eased in an attempt to aid the banks. But this allowed them to ignore the consequences of their lending and may have encouraged unwise risk-taking in the years ahead.

The U.S. became international lender of last resort. It established a program involving commercial banks, central banks, and the International Monetary Fund (IMF) that could help Latin American countries restructure their loans and obtain lending sufficient to pay their loans' interest (not the principal).

Countries in trouble were supposed to take steps toward economic reform and to generate exports so that revenues received could be used to pay their debts.

Unfortunately, events did not go as planned. Latin American governments cut spending in ways that weakened their economies and caused high unemployment, drops in per capita income, and stagnant economic growth.

Ultimately, from 1989 to 1994, private lenders had to forgive $61 billion in loans (about one third of the total outstanding debt). As part of that deal, eighteen Latin American countries agreed to undertake domestic economic reforms that would make them capable of paying off their remaining debt.

The Bottom Line

One country's debt crisis can have a domino effect, causing a range of catastrophic results for other countries and their people.

Countries in or approaching a debt crisis potentially must seek to restructure their debt so that they can continue to make payments, arrange for emergency funding, and undertake domestic reforms that can increase revenue. They must support broad and healthy economic activities to protect the financial well-being of their citizens.