Poverty-Stricken 254. What Happens When A Country Goes Bankrupt?

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For the first time since independence, Kenya’s government has been unable to pay civil servants on time, besides that the cost of living has been rocketing and the economic situation worsening. This raises the question in people’s minds, is Kenya going to be declared bankrupt? How does a country go broke and what are the ramifications?

Deputy President Rigathi Gachagua, President William Ruto and Prime CS Musalia Mudavadi

A Look at Sri Lanka

Let’s have a look at Sri Lanka.

Sri Lanka was in the midst of a rising financial and humanitarian catastrophe, with predictions that it could be declared bankrupt in 2022 as inflation reached new highs, food prices skyrocket, and the country’s finances dry up. True to this prediction, on 14 April 2022, Fitch Ratings downgraded Sri Lanka to C and said was on track to be downgraded to RD (restricted default) after defaulting on debt for the first time.

The government’s collapse was exacerbated by high government spending and tax cuts depleting state income, massive loan obligations to China, and foreign exchange reserves at their lowest levels in a decade, as well as the immediate impact of the Covid-19 issue and the loss of tourists.

The government was creating money to pay off domestic loans and international obligations, which fuelled inflation. Since the beginning of the pandemic, the World Bank estimated that 5, 00,000 slipped into poverty, equating to five years’ worth of progress in poverty reduction.

Sri Lanka
Sri Lanka protests over the high cost of living

In November 2021, inflation reached a new high of 11.1 percent, making it difficult for people who were previously well-off to feed their families, and basic items were out of reach for many.

The military was given the power to ensure that essential products, including rice and sugar, were supplied at regulated government prices after the president declared Sri Lanka in an economic emergency, although this did little to alleviate people’s suffering.

Let’s understand what will happen if the government, declares bankruptcy.

Governments, in theory, and in an ideal world, pay their obligations with revenue from taxes and investments. However, just as we as individuals frequently spend over our means and turn to credit, governments do similarly by issuing bonds with the promise of repaying the bond’s value plus interest at the maturity rate.

Internal and external debts make up the national debt, commonly referred to as sovereign debt. External debts are foreign-currency-denominated bonds issued by the government and sold to foreign investors. Internal debts are debts owed to those within the country.

Internal debts can be funded by fiscal and monetary policy- by raising taxes and printing more money- but external debts can divert funds away from other revenue-generating activities since they must be paid in foreign currency, which the government does not control.

ALSO, READ List of Governors Who Died In Office from 2013!

“A country never goes bankrupt”

“The country is going bankrupt.” In truth, that is a false assertion. To begin with, when a country fails to repay its debts, it does not go bankrupt; instead, it defaults on the loan. Second, the government, not the country, defaults.

Although it may appear that a country defaulting on its debts is an uncommon occurrence, most countries have defaulted or restructured their debts at some point during their history. Apart from its infamous default of $1.8 billion as the first developed country to default on an International Monetary Fund (IMF) loan in 377 BC, Greece was the first country to default on its debt in 377 BC.

Greece has defaulted on its debt for about half of its history, dating back to its independence in 1829. Spain, on the other side, has defaulted the most times, with 15 defaults between the eighteenth and nineteenth centuries.

Member nations of the IMF frequently seek a bailout from the IMF before defaulting on their loans, as the IMF not only provides financial resources but also technical experience to handle the bailout program. However, bailout money never comes without strings attached, such as austerity (reducing spending), currency depreciation, and trade liberalization, all of which are outlined in the Washington Consensus.

Bankrupt Kenya
From left Kenya’s economic advisor to President David Ndii, National Assembly Majority Leader Kimani Ichungwa and President William Ruto

What causes default?

The inability or reluctance of a country to fulfill its debts results in default. When a country’s ruling party changes, the new government frequently defaults on the debt it inherited from the previous one. There are a variety of reasons why a country defaults on its debt, including a simple reversal of global money, flows, and insufficient revenues. For example, Jamaica’s $7.9 billion loan default in 2010 was caused by government overspending and the decline of the country’s most important industry, tourism.

When a country defaults, what happens next?

The assets are repossessed by creditors in the case of individual or corporate bankruptcy. However, a country’s assets cannot be confiscated by its creditor, and the government cannot be made to pay with money it does not have during a default.

However, there is no certainty that this applies to the country’s assets located outside of the country. When Argentina defaulted in 2012, its navy training ship, which was based in Ghana at the time, was seized.

Prof. Njuguna Ndung’u, Kenya’s Cabinet Secretary nominee for National Treasury and Planning.

The delinquent country’s creditor’s only option is to renegotiate the conditions of the loan. Government bonds will be rescheduled for postponed payment or ‘haircut,’ which means the value of the bonds will be reduced.

After defaulting on an $81 billion loan in 2011, Argentina promised to pay a third of its debt to creditors. In this regard, between 2005 and 2010, 93 percent of the debt was swapped for performing securities, and it wasn’t until 2016 that Argentina returned the vulture fund for 75 percent of the remaining debt.

READ: ‘We Are Broke!’ Treasury CS Njuguna Ndung’u Says Kenya In A Financial Hole

What are the ramifications of going into default?

The creditor’s loss of principle and capital as a result of partial debt cancellation or debt restructuring is the immediate cost of default.

Due to the lower likelihood of retaliation, the government is more likely to eliminate debts owing to foreign private creditors.

Furthermore, government defaults result in soaring inflation, unemployment, and political pressure on the defaulting government, just as they do in any other crisis.

Because domestic banks hold the majority of domestic debt, bank runs occur as a result of a lack of faith in the financial system. Bank runs occur when a large amount of money is taken out of a bank as a result of public panic and lack of faith. Capital controls are in place to prevent this, with the government attempting to limit the amount of money that each depositor can withdraw.

To avoid a banking crisis, Greek banks were closed for nearly 20 days in June 2015, bank transfers to foreign banks were restricted, and cash withdrawals were capped at €50 per day. As aggregate demand diminishes and the foreign market loses faith in the country’s currency, a sovereign debt crisis might lead to economic and currency crises.

A default country’s lack of access to the credit market is another unavoidable consequence. It will be charged a high-interest rate on its loan, or it will not be granted a loan at all. The defaulted country’s credit rating will suffer, preventing foreign investment in the country.

(Source: Letter to the Editor, published by Barry Ipapo)

Barry Ipapo

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Barry Ipapo

Security professional || Law and Governance Enthusiast || Technologist
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