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Wednesday, March 23, 2011

What Exactly happens when a nation defaults?

I was reading about Portugal as they brace for government collapse over the impending debt vote.  In brief, the government wants to force more austerity upon its people so it has the fiscal means to keep paying its debts to its loan sharks such as the ECB and IMF while their Parliament is ready to vote against such a proposal.

The rocky downslope Portugal is facing, is no different than Greece or Ireland, nor will Spain be able to avoid the same fate in the near to mid future.   In the case of both Greece and Ireland, they've sold their national sovereignty to the banks.  Ireland's economy is in a depression and Greece is in a more precarious state.

So the question of defaulting needs to be raised- specifically what happens when a nation defaults and why hasn't any country done so since the start of this global financial crisis?

There used to be a time when a nation defaulted, it meant military invasion to force repayment, usually though the robbing of a nation's natural resources.  An example of this was in the 1860s when Mexico defaulted on its debts to France so in 1864, its leader, Napoleon III invaded, toppled the Mexican govt, then put in a puppet leader named Maximillian to rule until he was eventually overthrown by Benito Juarez and the Mexican people, and killed in 1867.

Now in present times, the debtor nation's leaders meet with bank executives and work out a new repayment plan.  It is true that when a nation defaults, it effectively can not borrow for years, and then when eventually able, it will do so at high interest rates.  But overall, it is not the nation or its populace that takes the hard hit in a default--  its the creditors and bond holders.

Most sovereign assets held outside a sovereign debtor’s own jurisdiction are protected by sovereign immunity or other legislation. Protected assets include: Diplomatic missions such as embassies, Payments to and from multilateral organisations such as the IMF, Central bank reserves and Military assets.  And although debt holders may obtain favorable court rulings to collect money owed by a sovereign, actually trying to enforce the ruling to gain assets through litigation ends up being a fruitless and time wasting enterprise.

So it is the creditor and bond holder who gets hurt most in a default.  Currently as nations near default do everything humanly possible to avoid it, it is the populace of those nations who get hurt with the poorest feeling the most dramatic and sustained affects.  Meanwhile, creditors and bond holders, continue receiving 100 cents on the dollar in repayment on debts.

So, why do nations like Greece and Ireland sell their national souls instead of default?

As mentioned earlier, its very hard to get loans and the interest rates will be higher than what they're paying now.  In addition, neither nation has a robust, self-sustaining economy.  Ireland is almost 100% dependent on imports and its exports are very minimal in comparison.  The same holds true with Greece-  both are heavily dependent on trade.

Argentina is a good comparison-  it was going through a bad recession and economic crisis starting in 1999.  By 2002, it decided to default on its debt because it was impossible to maintain payments to the IMF and other creditors/bondholders.  The state had no spare money and the Central Bank's foreign currency reserves were almost depleted.

After the default, for four years, Argentina was a pariah, effectively shut out of the international financial markets.  Even as the economic situation improved, thanks in part to its resources and exporting capabilities,  the amount of the debt was still the largest defaulted debt in history (about $93bill USD), and Argentina was in no position to pay without sacrificing essential parts of its budget.  The government was eventually able to force the creditors to take stiff 'haircuts' on their debts by remaining strong in the face of global banking threats.   Banks eventually started re-lending to Argentina in 2010.

~ Yes, the US should be contemplating 'defaulting' as well...

A national default is no different than a personal bankruptcy-- life is certainly more difficult in the near-term but there's a certain point when debts simply can't be repaid without incredible financial hardships that can lead to nations politically and socially fracturing. And in the long term, with sound leadership (if there is such a thing), the economic health and vitality of the nation (like that of the individual) improves.

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