A sovereign debt crisis occurs when a country is unable to pay its dues. It starts when a country cannot get a low-interest rate from its lenders, it eventually leads to debt default as investors become concerned that the country cannot afford to pay the bonds. A sovereign Debt Crisis results in the confidence of lenders decreasing and they require higher yields to offset their risk. This costs a country more so as to refinance its sovereign debt which leads to the sovereign debt crisis. In this article, we will look into the sovereign debt crisis which is important for UPSC examination.

Sovereign Debt Crisis - History

• It was experienced in the 21st century with the Dot.Com Bubble, US subprime crises, and recently the European debt crises.
• Financial institutions became vulnerable to corrections in asset markets due to their stretched leveraging position.
• A turnaround in a small pool (the US subprime market) of the financial system was sufficient to topple the whole structure.
• The crisis included a liquidity shortage among financial institutions as they experienced stiff market conditions.
• Failure by investment bank Lehman Brothers led to a decrease in the confidence of investors.
• The economy of the EU is related to the US economy also entered a downturn on record since the 1930s which caused a decrease in real GDP.

Sovereign Debt Crisis in Various Parts of The World

Debt Crisis in the USA (2008)

• Trouble in the financial market led to issues in the housing sector that aggravated into financial market decline.
• Investors' confidence about the value of structured securities such as Collateral Debt Obligations (CDOs) and Credit Default Swaps (CDSs) that were built off real estate collateral started decreasing.
• Therefore when a liquidity crisis hit the financial institutions that were already reeling due to short-term borrowing were not able to roll over their liabilities at reasonable costs.
• LIBOR, the main index of the rates charged by banks for lending to each other, increased as Banks started doubting the stability of each other.
• Lehman Brothers were declared bankrupt leading to a full-scale crisis in the financial sector.

Debt Crisis in the Eurozone (2011)

• It occurred mainly due to the Stability and Growth Pact (SGP), as part of the Maastricht treaty which resulted in government budget deficits in excess of the values stated.
• Accumulation of unsustainable levels of government debt by various countries of the Eurozone such as Spain, Greece, Ireland, and Portugal, popularly known as the PIGS crisis.
• Greece had the biggest budget deficits of 12.7% in 2009 and one of the highest levels of public debt (160% public debt to GDP ratio in 2012) in the Euro-zone.
• Greece was agreed to a bailout by the EU and the International Monetary Fund (IMF) but with conditions to cut budgetary spending, this resulted in a downward spiral.

Impact on India due to sovereign debt crisis around the world

• Due to closely linked Indian and western markets, there was the slow growth of the economy.
• Withdrawal of investments by foreign portfolio investors fearing the crash of global markets.
• There was a removal of about USD1.3 trillion in market capitalization and a 60 percent decline in the index in equity markets.
• The Indian banking sector was not much impacted by the sub-prime crisis due to its poor exposure to global markets.
• Fiscal consolidation plans by European nations resulted in declines in aid to developing countries.
• Increased unemployment results in fewer remittances to the developing world.
• The decline in demand for Indian exports across sectors such as textiles, leather, handicrafts, auto components, etc.

Measures to Prevent a Sovereign Debt Crisis

• Maintaining debt sustainability and improving measures essential for the assessment of debt sustainability.
• Providing public debt management assistance to developing countries through various international institutions such as IMF, WB, etc.
• Development of a medium-term debt management strategy (MTDS) and conducting debt sustainability analysis.
• Technical assistance to develop the domestic debt markets.
• Responsible sovereign borrowing and lending and following global best practices such as maintaining sub 3% fiscal deficit.
• Improving debt data collection and reporting to ensure transparency to the lenders and ensure accountability.

Conclusion

Slow down in the global economy greatly impacted various countries, especially those with an integrated economy. The Indian economy was not much impacted by such a global economic crisis. However, it is imperative that policymakers must be able to make a robust regulatory framework that integrates a system-wide approach and provides buffers to smooth cyclical volatility.