What Is Sovereign Debt?
Sovereign debt is issued by a national government and referred to as government debt, public debt, and national debt. Governments borrow for public investments and to boost employment. The level of sovereign debt and its interest rates reflect the saving preferences of a country's businesses and residents and the demand from foreign investors.
Key Takeaways
- Sovereign debt is debt issued by the government of an independent political entity, usually in the form of securities.
- Several private agencies often rate the creditworthiness of sovereign borrowers and the securities they issue.
- Countries with stable economies and political systems are typically viewed as having better credit, allowing them to borrow on more favorable terms.
Features of Sovereign Debt
Governments acquire sovereign debt by issuing bonds, bills, debt securities, or loans from countries and multilateral organizations like the International Monetary Fund. Sovereign debt may be owed to foreigners or the country's citizens and can be denominated in domestic or foreign currency. Although lenders always take on default risk, sovereign borrowing has several distinct characteristics.
- Unlike private borrowers, governments can raise tax revenue, and most also issue their currency.
- Governments can be overthrown by regimes that refuse to honor their debt obligations or incur economic sanctions that may cause their debt to lose value.
- Sovereign borrowers in default are rarely subject to legal enforcement, and creditors often find it hard to target the defaulted sovereign's assets.
- Some sovereign debt securities have linked coupon payments to a country's economic growth rate, though such GDP-linked bond issues are relatively rare.
Short-term U.S. government and foreign debt securities maturing within months are known as Treasury bills, T-bills, or simply bills. A sovereign or private debt security with a duration measured in years is called a bond.
Credit Ratings and Default
The U.S. has historically been viewed as the world's safest credit risk. The country has never defaulted on its debt, and it remains the issuer of the world's reserve currency. The three-month U.S. Treasury bill rate has traditionally been a benchmark "risk-free" interest rate.
However, in August 2023, Fitch Ratings downgraded the long-term ratings of the United States to "AA+" from "AAA" based on the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to "AA" and "AAA" peers over the last two decades with repeated debt limit standoffs and untimely resolutions.
As of September 2023, Standard and Poor's assigned AAA sovereign credit ratings to Australia, Canada, Denmark, Germany, Liechtenstein, Luxembourg, Netherlands, Norway, Singapore, Sweden, and Switzerland.
In a default, the creditors' main leverage lies in the resulting loss of international capital markets access for the defaulting sovereign and its likely need to negotiate a debt settlement to be able to borrow again. Some academic studies have found prior defaults have little or no effect on future lending terms. One concluded that higher losses in sovereign debt restructurings were associated with more prolonged periods of market exclusion and higher borrowing costs.
The Limits of Sovereignty
Sovereign countries may pool some sovereign powers, such as in a currency union like the eurozone, wherein all members use a currency issued by a supranational authority. The shared currency can facilitate trade flows and economic integration.
The eurozone was challenged in 2011-2013, when its economically weakest members were priced out of public debt markets, leaving them without the traditional policy tools of deficit spending and currency devaluation amid an economic downturn. The European sovereign debt crisis abated once European Union institutions, including the European Central Bank, guaranteed and restructured those member states' sovereign debt.
Sovereign Debt vs. Economic Growth
Traditionally, advice for sovereigns facing a possible default included austerity policies aimed at controlling spending and economic liberalization initiatives promoting growth. Economists Carmen Reinhart and Kenneth Rogoff published research suggesting higher levels of sovereign debt were associated with slower economic growth.
Critics have challenged the data and note public-sector austerity frequently leads to economic slumps. Experiences in Japan and the U.S. have cast doubt on the debt-to-GDP ratio as a debt sustainability measure. In both instances, increases in the ratio were not associated with meaningful increases in interest rates on sovereign debt.
Modern monetary theory (MMT) suggests a sovereign currency issuer's borrowing capacity is limited mainly by the rate of inflation it's willing to tolerate. In this model, taxes are raised to cool inflation rather than to offset government spending.
Who Owns Sovereign Debt?
Sovereign debt is owned by foreign governments and private investors. As sovereign debt is primarily issued via bonds and other debt securities, both individual investors and foreign governments can purchase these government securities.
Who Owes the U.S. the Most Money?
As of September 2023, the countries that hold the most U.S. debt are Japan ($1.1 trillion) and China ($822 billion).
Which Country Has No Debt?
The countries with the lowest national debt in relation to GDP as of 2022 are Brunei Darussalam (2.06%), Kuwait (2.92%), Turkmenistan (5.19%), and Timor-Leste (7.49%).
The Bottom Line
Sovereign debt is used by a country's government for a variety of reasons, such as to pay for public infrastructure. When a government has more expenses than the money it has raised in taxes, then it turns to debt to finance those expenses.
