Sovereign Defaults Are More Likely Than Experts Think. The Problem Is Politics.

Though the risk of inflationary spiral has dissipated, we believe that a new specter haunts the world: the specter of sovereign defaults. Sovereign borrowing rose markedly during the pandemic, with the average government debt-to-GDP ratio climbing by 15 percentage points in 2020. High interest rates are now taking their toll.

According to the CFR Sovereign Risk Tracker, which we created in 2017, a record 12 countries today merit the highest risk rating, 10/10—meaning that they have a greater than 50% chance of defaulting in the coming five years. Four of these countries—Belarus, Lebanon, Sri Lanka, and Venezuela—are in actual default. The eight remaining countries at highest risk are Argentina, Egypt, Ghana, Kenya, Pakistan, Russia, Tunisia, and Ukraine.     

In building and refining our tracker over the years, we’ve gained an unexpected insight. Macro indicators that experts typically link to sovereign risk—such as current-account balance, fiscal balance, and reserve adequacy—actually correlate poorly with market-based indicators and with actual default risk. Why is this?

Sovereign default, unlike, say, corporate bankruptcy in a developed country, isn’t a mechanical function of numbers and law. Whereas bad macro numbers may surely make it more difficult for governments to pay their foreign bills, governments can always sell a few lakes or mountains if they wish. Sovereign default, then, is fundamentally a choice. It should not be surprising, therefore, that markets, which are better attuned to political thinking than are spreadsheets, do better at predicting defaults.

Take Russia, for example. Macro indicators suggest a low risk of default. Russia has a current-account surplus of 5% of GDP and a relatively low level of external debt—just 15% of GDP. For comparison, the U.S.’ external debt is 95% of GDP. But in June 2022, Russia defaulted for the first time since 1918, blaming Western sanctions for its inability to pay.

Greece, in contrast, is running a massive current-account deficit of 8%, and sports government debt amounting to 173% of GDP. Its macro indicators therefore suggest that default risk is high, even as credit default swap spreads say that it’s low. This fact suggests a market judgment that the European Central Bank will continue to “do what it takes” to preclude euro zone defaults.

International politics plays an outsize role in sovereign defaults. Sri Lanka, for example, has become heavily indebted to China from the latter’s massive Belt and Road infrastructure financing in the country. Between 2000 and 2020, Sri Lanka borrowed $12 billion from China alone, and was in 2015 obliged to hand China a 99-year lease on a major port—loans for the development of which Sri Lanka could not repay. 

Following Sri Lanka’s default on $78 million in debt interest payments in May 2022, the Export-Import Bank of China refused to cooperate with the Paris Club of official creditors over a restructuring of the country’s debt to 16 nations. The Chinese bank instead secretly negotiated debt treatment terms bilaterally with Sri Lanka. Sri Lanka’s Paris Club creditors, demanding equal treatment with China, reached an agreement with the debtor country a month later.

Pakistan, too, is embroiled in an economic crisis exacerbated by its $99 billion of external public debt. Since 2015, Pakistan’s foreign debt has doubled, owing in part to the China-Pakistan Economic Corridor, an infrastructure project that began in 2015 under China’s Belt and Road Initiative. China lent Pakistan $67 billion between 2000 and 2021, making China Pakistan’s largest bilateral creditor. China has rolled over Pakistan’s debt with the intent to offer short-term relief, but since the maturities of the rolled-over loans are longer, Pakistan’s dependence on China has only deepened.

The International Monetary Fund is increasingly at odds with China and its sovereign borrowers over the former’s obligations to aid the latter before multilateral resources are called upon. After G-20 countries suspended repayment from low-income countries in debt distress in 2020, the G-20 agreed a Common Framework to accelerate sovereign debt restructuring. China, however, continues to challenge these agreements. It maintains that multilateral development banks such as the IMF, which have “preferred creditor status,” should accept loan losses just as sovereign and private creditors do. It seeks commercial returns on its loans, and typically provides relief only in the form of repayment deferral. It will not write off debt. In the case of Zambia, another major Belt and Road borrower, the China Development Bank insisted on being treated as a commercial creditor to minimize losses.

Within the Paris Club itself, backroom political dealing determines debt-relief outcomes. After Egypt backed the first Gulf War, for example, Washington successfully pressed its fellow sovereign creditors to write off much of Egypt’s debt in 1991. The U.S. also successfully pressed for cancellation of Iraqi debt in 2004—the year after the U.S. invasion. Macro indicators capture none of such dynamics.

With so many countries now facing financial distress, and with contention between and among bilateral and multilateral creditors at a post-Cold War high, we think that market commentators are underestimating the scope of likely sovereign defaults in the coming years. Unfortunately, the numbers that we economists love to parse and pore over in search of warnings will be of limited help in identifying these risks. When it comes to sovereign default, it’s politics that rules the day.

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