The Cycle behind Sovereign Debt Disasters

In theory, sovereign debt can be a healthy part of a growing economy. Governments can borrow from creditors to fund trade deficits, importing goods from other countries so their citizens can buy the products and enjoy the benefits.

While that may be the idea, the results of such borrowing are generally disastrous, warns research by Stanford’s Peter M. DeMarzo, Chicago Booth’s Zhiguo He, and Copenhagen Business School’s Fabrice Tourre. There is no default plan for a sovereign borrower the way there is for, say, a corporate one—and borrower countries have proven unable or unwilling to commit to anything like one. Without the disciplining force of covenants, which are common in private-sector borrowing, the system doesn’t wholly account for the risks associated with economic booms and busts, which works against strategic, responsible borrowing.

The trio’s work on sovereign debt risks rests on a foundation of work by DeMarzo and He on private-sector debt, in which they describe the tendencies of corporations to borrow without restraint when they do not pledge collateral to specific lenders. As uncollateralized borrowers tend to issue debt in good times and bad, lenders demand ever-higher borrowing costs over time, erasing the benefits to the borrower company and increasing default risk. Collateral adds discipline to the process. In another study, DeMarzo argues that sovereign borrowers should pledge assets to creditors as collateral in the event of default. This latest research, with He and Tourre, suggests that such collateralization could crystallize the consequences of default and break the debt cycle that is so costly to so many citizens.

Seeking to better understand what causes sovereign debt defaults, the researchers created a model and tested it under different circumstances. They find that debt can spark a dangerous boom-and-bust cycle that is perhaps familiar to individuals and households caught in a similar spiral. A debt ratchet, or a destructive risk that afflicts even the most careful borrowers, is key to this process. When debt levels rise relative to economic growth, a country’s solvency falters. At that point, the country needs to either refinance or borrow more to meet its obligations, which only worsens its solvency, sparking greater demand for refinancing or borrowing. The cycle continues until investors either refuse to buy more debt or demand higher interest, which can result in a default or a crisis.