What is Sovereign Debt? Definition and Examples

Introduction to Sovereign Debt

Sovereign Debt, also known as Government Debt or National Debt, refers to the money borrowed by a country’s government from both domestic and international creditors to finance its spending.

While borrowing can be crucial for funding essential services like healthcare, education, and infrastructure, the effective management of this debt is critical for maintaining a country’s financial health.

Mismanagement of sovereign debt can lead to financial instability, strained public services, difficulties in repaying creditors, and a loss of investor confidence, making them less likely to invest in the future.

In today’s global economy, sovereign debt plays an essential role, helping governments cope with short-term financial needs and invest in long-term projects. However, excessive borrowing or poor debt management can lead to significant risks, including debt crises or defaults. This article will explore why governments borrow, how they do it, who lends to them, and the best practices for managing sovereign debt.

The Center for Economic and Social Rights has the following definition of sovereign debt:

“Sovereign debt, government debt, public debt, or national debt, are all terms to describe the amount that a state owes to others. Borrowing money creates an obligation to allocate resources towards paying (also called servicing) that debt, which also accrues interest.”

“Debt can be domestic (owed to lenders in the country) as well as external (owed to foreign lenders). Lenders can be public (multilateral and bilateral) or private.”

The Meanings of “Sovereign” and “Debt”

Let’s break down the meanings of the words “sovereign” and “debt” when used on their own:

  • Sovereign

The term ‘sovereign’ can mean a monarch or someone with supreme authority. It can also refer to a nation that governs itself independently.

In this article, “sovereign” refers to a country with the power to make decisions, including borrowing money.

  • Debt

‘Debt’ is money borrowed that must be repaid. When a government borrows, this becomes “sovereign debt,” which refers to the funds a nation owes to its creditors, whether they are domestic or international.

Graph showing 15 countries with very high sovereign debts.
Many of the world’s wealthiest countries have very high sovereign debt-to-GDP ratios. Data 2023.

Why Do Governments Borrow?

Governments borrow for several reasons, often because tax revenues fall short of covering their current or planned expenditures.

  • Public Services

Borrowing helps maintain continuity in public services without needing to raise taxes or cut expenditures abruptly.

During economic downturns or recessions, when tax collections tend to decline, borrowing helps ensure that public services like healthcare, education, and infrastructure projects are funded. This strategy, known as “tax smoothing,” prevents the need for sudden budget cuts that could worsen the economic downturn.

  • To Kickstart the Economy

In some cases, governments borrow to stimulate the economy by increasing spending or reducing taxes, hoping to spark economic growth. This “fiscal stimulus” is often employed during recessions to counteract reduced economic activity.

  • Investments in Infrastructure

Additionally, governments may take on debt to finance long-term investments in infrastructure, such as building roads, bridges, or power plants, or in human capital, such as education and healthcare systems.

These investments are meant to boost long-term economic growth, making the borrowing worthwhile.

Regarding infrastructure, the World Bank says the following in one of its blogs:

“Sovereign loans are an important source of financing for countries around the world. Borrowing can enable governments to support key areas for growth and development, such as healthcare, education, infrastructure and the green transition.”

When a another country, the IMF, or the World Bank lends money to a country, we call it a Sovereign Loan.

Who Lends to Sovereigns?

Governments can borrow from a variety of sources, both domestic and international.

  • Sovereign Debt from Domestic Lenders

Domestic lenders may include local banks, households (citizens like you and me), pension funds, and insurance companies.

  • From Foreign Lenders

Internationally, governments can borrow from other governments, multinational institutions like the World Bank, International Monetary Fund (IMF), African Development Bank, Asian Development Bank, the European Investment Bank, and the Inter-American Development Bank, as well as private sector lenders such as asset managers and foreign banks.

Each type of lender comes with its own risks and advantages. Domestic borrowing is often more stable but may be limited in scale and maturity.

International lenders may offer larger amounts and longer repayment periods but can also be more unpredictable.

For instance, international capital markets can become volatile, especially for lower-income countries, leading to sharp increases in borrowing costs. If your country’s debt is denominated in US dollars and your local currency devalues, the debt will immediately become larger in real terms.

Governments must carefully choose their lenders to balance the cost of borrowing with the risks involved.

A graph showing ten countries with highest sovereign debt with IMF
The IMF primarily lends to emerging and developing economies. (Data 2024)

Different Types of Sovereign Debt Instruments

There are various ways governments can borrow, with loans and bonds being the most common instruments.

  • Loans and Bonds

Loans are often arranged directly between a government and a lender or group of lenders, while bonds are issued to multiple investors.

These bonds, known as government securities, are sold to raise funds, and the government promises to repay the amount borrowed (plus interest) by a specific date.

Government bonds can have varying maturities. Short-term debt, such as treasury bills, usually matures within a year, while medium-term debt, like treasury notes, has a maturity range of two to ten years.

Long-term bonds, such as treasury bonds, can have maturities extending to 30 years or more. These instruments allow governments to manage their financing needs over time, aligning debt repayments with future revenue streams.

  • Currency Classification

Sovereign debt is also classified by the currency in which it is issued. Governments sometimes borrow in foreign currencies, such as US dollars or euros, when these options offer lower interest rates.

However, as mentioned earlier, this can create additional risk if the local currency depreciates, making it more expensive to repay the debt.

The International Monetary Fund makes the following comment about sovereign debt currencies and risks:

“A prudent public debt structure can help keep sovereign borrowing costs low over the long run.”

“But many other factors also influence a sovereign’s creditworthiness and its borrowing costs, such as its level of economic development, the size of its financial markets, its record of honoring its obligations, and its vulnerability to external shocks, as well as global financial conditions.

Managing Sovereign Debt: Best Practices and Challenges

Effective debt management is critical to maintaining a country’s financial stability. Poorly managed sovereign debt can lead to crises that affect the broader economy and the well-being of citizens.

  • Loan Terms and Strategies

Governments must negotiate favorable loan terms, use debt data to develop sound strategies, and monitor their debt portfolio closely.

Monitoring cash flows—such as interest and principal payments—ensures that debt repayments do not overwhelm a country’s finances.

  • Debt Bunching

Countries must also be cautious about “debt bunching,” where multiple large repayments fall due at the same time, which can create liquidity issues. Spreading out repayments over time can help governments avoid such problems and manage their debt more sustainably.

Many lower- and middle-income countries face challenges in managing their debt portfolios due to limited technical expertise and resources. External assistance from organizations like the World Bank or IMF can help governments improve their debt management practices by providing technical support, guidance, and training.

The Consequences of Overborrowing or Bad Borrowing

While sovereign debt allows governments to invest in their economies, borrowing too much or borrowing under unfavorable conditions can lead to severe consequences.

  • Too Much Sovereign Debt

When a government takes on too much debt or faces unexpected economic shocks, it may struggle to meet its repayment obligations.

This can lead to a debt crisis, where a country defaults on its loans, triggering economic and social hardships.

  • Debt Restructuring

Debt restructuring is one way to address these challenges, involving negotiations between a government and its creditors to adjust repayment terms.

Restructuring can prevent a full-blown crisis, but it can also be a long, expensive process.

Historical examples include countries like Argentina, Greece, and Ukraine, which have all undergone debt restructurings in recent decades.

  • Ensuring Sustainability

To avoid these risks, governments need to maintain prudent borrowing practices, ensuring that their debt remains sustainable over the long term.

This includes avoiding excessive debt accumulation, choosing appropriate lenders and instruments, and developing sound debt management strategies.

Final Thoughts

Sovereign debt is an essential tool for governments to manage their economies, fund critical projects, and respond to economic shocks.

However, it also carries significant risks if not managed carefully. Effective debt management, including careful selection of lenders, monitoring of cash flows, and spreading out repayment schedules, is key to ensuring that sovereign debt remains a tool for growth rather than a source of financial instability.

For countries, particularly those with limited financial resources, mastering these practices is crucial to sustaining their economies and avoiding debt crises.