Due to higher debt and an increase in borrowing costs on hard currency debt, S&P Global Ratings expects sovereigns will default more frequently on foreign currency debt over the next 10 years than they did in the past.  Our study found that, over the past 20 years, most defaulted sovereigns' public finances weakened considerably in the years leading up to credit events. For most lower-rated sovereigns, fiscal and debt imbalances induced capital flight that intensified balance-of-payment pressures, falling foreign exchange reserves, and a loss of market access. Moreover, in those sovereigns where fiscal dominance constrained central bank independence, deteriorating public finances frequently led to monetization of budget deficits, exchange-rate and balance sheet shocks, inflationary pressures, and weaker growth.

Over 2017-2023, rated sovereigns defaulted just as frequently as they did over the preceding 16 years (see chart 1 and table 1).  This trend also reflects our increasing coverage of sovereigns in developing countries, which are characterized by lower average incomes, less liquid domestic markets, and more modest savings rates, compared with developed countries. Commercial lenders have also increased their lending to these geographies at significantly higher interest rates. Overall, sovereigns' creditworthiness weakened globally over the past 10 years.

Chart 1

Table 1

Absolute certainty doesn't exist.  No single measure consistently serves as a reliable early indicator of sovereign foreign currency defaults. Instead, defaults reflect a multitude of interrelated factors that are tied to a government's willingness and ability to repay commercial debt obligations. As part of this report, we identified the early warning signs of sovereign foreign currency defaults and assessed the economic implications of defaults. To assess the common characteristics and leading indicators of defaults, we analyzed Z-scores for a sample of 25 rated sovereigns that have defaulted on foreign currency obligations since 2000. Z-scores show how far specific variables for defaulting sovereigns deviate from the global average. Where sovereigns defaulted multiple times, we focused on the most recent default.

We observed that defaulted sovereigns' fiscal and government debt indicators deteriorated far more substantially than the global average over the three years leading up to the default.  For developing sovereigns that have defaulted since 2017, government borrowing was the key growth and intermediation impulse. This stands in contrast to the private lending impulse that drove boom-and-bust shocks in more advanced economies in the aftermath of the global financial crisis in 2008. Because of this, fiscal deterioration occurred significantly earlier for the sample of developing sovereigns. Importantly, these sovereigns' interest payments tended to approach, and in many instances considerably exceeded, almost 20% of general government revenue on average in the year prior to the default. Additionally, they faced debt increases as financing needs rose sharply, with their fiscal and public debt metrics differing by at least one standard deviation from those of global peers (see chart 2). Collectively, these trends reflected a combination of currency depreciation, higher domestic yields to counter inflationary pressure, policy-induced fiscal slippage, the recognition of contingent liabilities, and declining government revenue linked to volatile commodity earnings.

Chart 2

While our findings suggest that institutional, fiscal, and debt factors are the main contributors to sovereign foreign currency defaults, the effects of external variables are also relevant.  Developing economies typically aim to attract non-resident capital inflows to bridge the gap between their large investment requirements and more modest domestic savings capacity. Over the past decade, most of this external financing has come in the form of public debt, as opposed to private equity. However, poor policy credibility and predictability, an absence of central bank independence, and a reliance on external financing due to shallow local capital markets, have often resulted in large external imbalances. Specifically, the deficit on the net international investment position worsened by over 30 percentage points of GDP in our sample in the three years prior to the default, to the point where total external liabilities exceeded assets by almost 110% of GDP (see chart 3). These factors quickly create liquidity challenges as access to financing dries up and capital flight accelerates. In many cases, this constitutes the tipping point where liquidity and solvency constraints become problematic for a government.

Chart 3

Sovereign defaults have significant implications for economic growth, inflation, exchange rates, and the solvency of a sovereign's financial sector.  This creates feedback loops, which intensify as default events approach, and worsens public finances and liquidity conditions further. Poverty is also a factor: Across our sample, GDP per capita in defaulted sovereigns is 2.8 times lower than the global average, while economies typically entered recession in the year prior to the default and in the year of the default (see chart 4). At the same time, inflation rose to double digits. This was driven partly by severe currency depreciation and often connected to monetary authorities' low, or worsening, credibility as central banks' direct deficit financing often rises ahead of defaults.

Chart 4

13 Lessons From Sovereign Defaults

1 - Political considerations often supersede macroeconomic drivers of defaults

Unlike corporate bankruptcies, most sovereign defaults are not a mechanical function of macroeconomic data but a fundamental policy choice. Worsening political outcomes can therefore be predictive of defaults. For example, the defaults of Belarus and Russia in 2022 resulted from Western sanctions, which rendered both countries incapable of repaying their foreign obligations, even though they had ample foreign exchange reserves. Ukraine also opted to defer debt service payments on its Eurobonds in 2022, citing war-induced macroeconomic and fiscal stress.

2 - Sovereigns may choose to enter restructuring programs or outright debt defaults, despite sufficient resources to make payments

The more government revenue is needed to repay debt, the more significant the resulting policy trade-offs become. This could incentivize governments to prioritize recurrent and capital expenditure to boost the economy, rather than redirect much needed resources toward repaying debt. For example, Argentina postponed the payment of the U.S.-dollar-denominated principal and interest on local-law debt in 2020, citing stressed fiscal needs and resources during the COVID-19 crisis. This happened despite the country's access to $41.9 billion in gross foreign exchange reserves (see chart 5).

Chart 5

3 - The amount of time it takes to resolve defaults through resuming repayments, restructuring, or distressed exchanges depends on several factors

These include the depth and severity of political, fiscal, and external challenges, as well as the decision to enter into a broad restructuring process, such as the ongoing G20 Common Framework featuring Sri Lanka, Zambia, Ghana, and Ethiopia. Since the 1980s, the duration of sovereigns remaining in selective default has increased significantly (see chart 6). We also found that the long-term macroeconomic consequences are more severe for sovereigns that remain in default for multiple years, increasing the probability of further defaults down the line.

Chart 6

4 - Interest costs tend to rise rapidly from a high base in the three years before the default

Interest to general government revenue averaged 17.0% for the defaulted sovereigns in our sample over those three years, compared with 8.4% for the global average (see chart 7). In general, interest burdens climb for sovereigns with higher foreign currency-denominated debt stocks that experience currency pressures, such as Lebanon--with 72% of total government debt denominated in foreign currencies--and Zambia with 59%. In other cases, the interest burden intensifies from inflationary pressures, resulting in higher policy rates and nominal yields on domestic securities.

Chart 7

5 - Debt-servicing costs fell on average for the sample in the default year

This was partly due to higher inflation stemming from currency weakness, which resulted in negative real effective interest rates that eased the interest burden on local currency-denominated debt if the proportion of foreign exchange-denominated debt was relatively low. In addition, debt moratoriums offering temporary suspensions on official external interest payments can provide debt relief in the default year, as was the case with Ethiopia prior to suspending its commercial payments in 2023.

6 - The pace of debt accumulation tends to exceed headline fiscal deficits

In the three years prior to the default, the change in net general government debt averaged 11.1% in our sample (compared with 2.6% for the global average), against headline fiscal deficits of 6.3% (2.0%) (see chart 8). The reported deficit did not include the effect of exchange rate movements, the recognition of off-balance sheet items or other contingent liabilities, and other quasi-fiscal factors. In the year of the default, headline fiscal deficits declined for the defaulted sample, reflecting financing pressures and the associated reduction in spending. Yet this might have masked the true fiscal stance as sovereigns accumulated arrears to local suppliers and contractors, which might not have been recorded in headline deficits or public debt stocks. Therefore, it is important to differ between fiscal finances that are reported on a cash basis (and show all funds disbursed for expenses) and those that are reported on a commitment basis (and show all spending undertaken and due to be paid).

Chart 8

7 - Defaulters' public indebtedness rose higher and faster than the global average and peaked in the year of the default

In the default year, 80% of our sample's debt-to-GDP ratio exceeded global averages (98% versus 51%, see chart 9). However, defaulters with higher debt ratios often have weak domestic capital markets, which are unable to provide long-term, market-based funding at a relatively low cost. Indeed, banks' total assets averaged 93% of GDP for the defaulted sample in the default year, compared with 222% globally. Sovereigns with lower debt-to-GDP ratios, such as Cameroon and Ethiopia, do not necessarily boast higher fiscal flexibility. Rather, their lower debt burdens are reflective of broader financing challenges and a history of debt relief.

Chart 9

8 - High amounts of foreign currency-denominated debt raises sovereigns' susceptibility to external shocks, particularly currency depreciation

Our sample shows that the proportion of external debt exceeded 50% for most sovereigns that eventually defaulted (see chart 10). Feedback loops emerge as fiscal dynamics deteriorate and can cause further pressures on governments' liquidity position. However, fiscal problems can materialize irrespective of currency issues, as was the case in El Salvador, Ecuador, Belize, Barbados, and Grenada, which have fixed exchange-rate regimes. In such economies, overvalued currencies affected competitiveness in ways that dented economic growth and fiscal revenues.

Chart 10

9 - Sovereigns with high and rising net external liability (NEL) positions are more likely to default, while net external creditors rarely default--although Argentina is a prominent exception

A NEL position implies that the liabilities of total public and private sectors to non-residents exceed the assets invested by residents abroad. Data shows that NEL positions average almost 110% of GDP for defaulting sovereigns in the default year, versus 16% for their global counterparts (see chart 11). Given the external imbalances, most sovereigns facing foreign currency default also have gross external financing needs that significantly exceed their current account receipts and usable foreign exchange reserves, including Cyprus, Grenada, and Greece.

Chart 11

10 - Current account deficits are a common denominator for most defaulting sovereigns

Current account deficits signal a relative shortfall in domestic investments compared with domestic savings, thereby requiring external financing to fund local investments. External imbalances start to build when non-resident investors choose to repatriate their equity investments or divest from government securities--for example, due to political turmoil, deteriorating macroeconomic fundamentals, or bleak investment prospects. Two-thirds of the sample posted three consecutive years of current account deficits in the run-up to the default (averaging 7.6% of GDP, versus the global average of 1.2%), with only Indonesia registering current account surpluses during this period.

11 - Exchange-rate pressures appear to peak in the year prior to the default

Other than political and macroeconomic pressures, currency movements can be tied to pressure on managed exchange rate regimes. This was the case in Lebanon, where the Lebanese pound depreciated 73% against the U.S. dollar after the country could not sustain its pegged exchange rate regime (see chart 12). Exceptions to this trend include sovereigns with pegs to the U.S. dollar (Belize, Barbados, and Grenada), those that use the U.S. dollar as their own currency (El Salvador and Ecuador), and those in monetary unions (Greece and Cyprus). In these cases, balance-of-payments crises developed independently of exchange rate movements, particularly when current account deficits and external liability positions were large and widened significantly.

Chart 12

12 - Economic growth and real growth per capita are typically negative in at least one of the three years preceding the default

However, the length of the economic contraction varies by sovereign: Cyprus, Greece, Paraguay, and Venezuela experienced prolonged contractions in all three years before the default, while Ethiopia, Mozambique, and Seychelles maintained strong positive growth. Additionally, GDP per capita indicators were on average 2.8 times lower than the global average. The only exceptions were Cyprus ($27,671) and Greece ($21,831), which defaulted at higher-than-average income levels (see chart 13).

Chart 13

13 - Inflation and domestic credit growth take the biggest hit in the default year

About two-thirds of defaulted sovereigns experienced double-digit inflation in the year prior to the default or in the year of the default. This stemmed largely from currency weakness and deficit monetization, which led to hyperinflation episodes in Venezuela (863%), Lebanon (85%), and Suriname (61%) in their respective default years. Private sector lending initially slightly exceeds the global average in the three years prior to the default. Yet a sudden contraction takes place in the default year as consumer and business sentiment declines, while the domestic financial sector becomes increasingly cautious and risk appetite decreases.

Appendix

Related Research

• Sovereign Risk Indicators, Oct. 7, 2024
• Global Credit Conditions Q4 2024: Policy Rates Easing, Conflicts Simmering, Oct. 1, 2024
• Sovereign Ratings List, Sept. 10, 2024
• Sovereign Ratings History, Sept. 10, 2024
• Sovereign Ratings Score Snapshot, Sept. 5, 2024
• Sovereign Debt 2024: Borrowing Will Hit New Post-Pandemic Highs, Feb. 27, 2024

Glossary

Consumer price index (% change).  Average percent change in index of prices of a representative set of consumer goods bought by a typical household on a regular basis.

Exchange rate, year-end (LC/USD).  The official exchange rate of the sovereign's local currency, expressed in local currency units per USD.

General government.  Aggregate of the national, regional, and local government sectors, including social security, and excluding intergovernmental transactions.

Gross debt/GDP (%).  Debt incurred by national, regional, and local governments, either for governmental purposes or for on-lending to a government-owned or private sector entity, as a percent of GDP. Internal holdings, including social security and pension fund investments in government debt, are netted out.

Net debt/GDP (%).  Gross debt minus general government financial assets (cash, deposits, arms-length loans, and minority holdings of traded equities), as a percentage of GDP.

Interest/revenues (%).  Interest payments on general government debt, as a percentage of general government revenues.

General government balance/GDP (%).  General government operating and capital revenue, excluding proceeds from privatization, minus operating and capital and extraordinary expenditures (though generally excluding aid to the financial sector), as a percentage of GDP.

Primary balance/GDP (%).  Surplus (deficit) plus interest payments on general government debt, as a percentage of GDP.

Current account receipts (CAR)/GDP (%).  CAR, which include proceeds from exports of goods and services, factor income (compensation of employees plus investment income) earned by residents from nonresidents, and official and private transfers to residents from nonresidents, as a percentage of GDP.

Current account balance/GDP (%).  Exports of goods and services minus imports of the same plus net factor income plus official and private net transfers, as a percentage of GDP.

Net external liabilities/CAR (%).  Total external debt plus the stock of direct investment (both equity and debt) and portfolio equity investment from abroad minus total external assets, which include official reserves, other public sector foreign assets, financial institutions; deposits with and lending to nonresidents, other private sector deposits with and lending to nonresidents, and the stock of direct and portfolio equity investment placed abroad, as a percentage of CAR. A negative number indicates a net asset position.

Narrow net external debt/CAR (%).  The stock of foreign and local currency public and private sector borrowings from nonresidents (including nonresident deposits in resident banks) minus liquid non-equity external assets, which include official foreign exchange reserves, other liquid public sector foreign assets, and financial institutions' deposits with and lending to nonresidents, as a percentage of CAR. A negative number indicates net external lending.

Usable reserves.  Official foreign exchange reserves (including gold at market price) minus items not readily available for foreign exchange operations and repayment of external debt (such as: (1) reserves pledged as security; (2) mark-to market losses on reserves sold forward; (3) reserves deposited with offshore branches of domestic financial institutions; and (4) the monetary base for sovereigns with a currency board or longstanding fixed peg).

Gross external financing needs (% of CAR plus usable reserves).  Current account payments, plus scheduled principal repayments on external debt, plus the stock of short-term debt (original maturity of less than a year), as a percentage of CAR plus usable foreign exchange reserves.