What happens when a country can’t repay its debts and how does it affect the economy?

There are two ways a country can find itself in a situation where it can’t repay it’s debts. Either the Government has been borrowing excessively for it’s fiscal policy and defaults on their short term obligations. The other way is when there is a systematic failure in the country’s banking system which leads to the Government having to bail out the banks. We are going to discuss the aftermath of both these situations.

Firstly the Government of the country will approach/be approached by the world banking institutions, the “lenders of last resorts” such as IMF and the World Bank. Several countries in Asia and Africa will also be negotiating with China’s Asian Infrastructure Investment Bank (AIIB) and Asian Development Bank (ADB). Meanwhile countries in the EU will also be negotiating with the European Central Bank. The indebted country will negotiate for new loans to service their short term obligations they couldn’t cover. Negotiations will be on how the country will restructure their economy to warrant these new loans. This includes providing plans on how the Government will increase their tax revenue and which Government spending will be cut. The IMF will usually propose several reforms for the country.

If the current debt levels are at a very critical level, there might be negotiations on the sales of the country’s national assets. The assets can literally be anything the Government owns from state owned enterprises or even Government owned buildings and properties. The Greece debt crisis resulted in several of their airports being sold to German firms.

After an agreement is met, the Government now has the funds to meet their short term obligations and prevent default. However, the hard work is just about to begin.

Impact on the economy

The first thing that will happen prior to default is foreign investors and investments will rapidly pull out of the country. Usually coupled with other external factors, all of this will cause the currency to weaken drastically, thus causing rapid inflation in the country. Riots and strikes would then follow causing most business activities to come to a standstill, halting the economy.

Asian Financial Crisis, Indonesia 1998

Greece Sovereign Debt Crisis

Most banks will close, either temporarily or even permanently as they cannot cope with the drastic amount of cash withdrawal caused by the panic of the population. Many businesses may not survive and go bankrupt resulting in the overall economy (GDP) to shrink.

Some countries such as present day Venezuela (above) is experiencing an economic crisis at such a critical level, the Government is forced to ration out goods for the people.

If resentment has been rising towards the incumbent head of state, calls for impeachment might occur as the people calls for drastic change on the system. The replacement then will bring messages of optimism and bring about major reforms. Slowly, with large sacrifices from higher tax rates and massive cuts in Government spending, the economy may gradually recover.

Indonesia Democratic Reformations, 1998

Greece’s Syriza Party led by new PM Alexis Tsipras