What is default and its impact

What is default and its impact

Subject :Economy

Section: External sector

Context:

S&P on Saturday lowered Russia’s foreign currency ratings to “selective default” on increased risks that Moscow will not be able and willing to honour its commitments to foreign debt holders.

Details:

Russia had made coupon and principal payments on dollar-denominated Eurobonds in rubles which investors may not be able to convert into dollars equivalent to the originally due amounts given the amount of economic sanctions on Russia.

S&P assigns a selective default rating when it believes the debtor has selectively defaulted on a specific issue or class of obligations but will continue to meet its payment obligations on other issues or classes of obligations in a timely manner.

Sovereign debt Default

Sovereign debt is the bonds a Sovereign country sells to the banks in foreign currency to finance its domestic financial requirement.

Sovereign default is the failure by a government to repay its national debts. Sovereign default is the same as a default on debt by a private individual or business, but by a national government that fails to repay its interest or principal due.

Sovereign nations are not subject to normal bankruptcy laws and always have the power to escape responsibility for their debts, often without legal consequences.

Nations that maintain their own currency and whose debt is denominated in that currency will have the option to effectively default by inflating their currency and printing more money to cover the outstanding portion.

Causes:

Sovereign defaults are relatively rare and are often precipitated by an economic crisis affecting the defaulting nation.

• Economic downturns, political upheaval, and excessive public spending and debt  can all be warning signs that lead to sovereign default.
• Higher interest rates and a lower credit rating among lenders, making it more difficult to borrow in the future.
• Large scale short term borrowing- Governments that rely on financing through short-term bonds may be especially vulnerable to a sovereign debt default since short-term bonds already face a difficult conflict of maturity mismatch between short-term bond financing and the long-term asset value of a country’s tax base.

Impact:

• Recession- In the United States, for instance, the interest rates on many mortgages, car loans, and student loans are pegged to U.S. Treasury rates. If borrowers were to experience dramatically higher payments as the result of a U.S. debt default, the result would be substantially less disposable income to spend on goods and services, which could ultimately lead to a recession.
• Stagflation– reduction in output and employment along with high inflation.
• Reduction in investment confidence and rise in unproductive investments.
• Difficult to borrow in future 
• Large scale capital outflows and currency depreciation