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Murthy Karanam asked: What happens when a country defaults on sovereign debt? Have IMF/World Bank bailouts so far helped or exacerbated the financial condition of the recipient countries?

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  • Rajeesh Kumar replies: A sovereign default occurs when a country fails to pay back its loan to domestic or international creditors. The International Monetary Fund (IMF) defines default as a breach of contract or broken promise. The most immediate impact of sovereign default is that borrowing cost rises for the government in the domestic and international bond market. The higher interest will impact the entire economy of the country, including the value of currency, banking system, stock market, corporate borrowing, etc. The default also leads to a loss of reputation, which makes it harder for the government to borrow money in the future. According to the Bank of Canada and Bank of England sovereign debt database, since 1960, 147 governments have defaulted on their obligations. Sri Lanka is the latest addition to this list.

    When a country defaults on its sovereign debt, it usually approaches the IMF for assistance in the form of bailout packages. For instance, during the Eurozone sovereign debt crisis, Greece approached the IMF for a $145 billion finance package in 2010. Recently, Sri Lanka requested a bailout package worth $4 billion from the IMF. During the COVID-19 pandemic, more than half of the IMF's 189 members approached the organisation for emergency loans and bailouts. This shows that the IMF is still the lender of last resort for many countries.

    There is generally no consensus about the effectiveness of the IMF bailout packages. While the supporters of the IMF bailout argue that it has short and long-term positive impacts on the performance of the current account and the balance of payment and inflation, the opponents believe that the IMF bailout has a negative effect on the economic performance of the recipient countries. In fact, during a sovereign debt crisis, the effectiveness of a bailout depends on several other factors such as the country’s macroeconomic fundamentals, political stability, the gravity of external debt, etc. For instance, while the case of the Latin American economic crisis in the mid-1990s shows that conditionalities and austerity measures attached to the IMF bailout packages damaged economic development, the example of the Asian financial crisis reveals how the IMF helped the countries to return to the path of recovery and growth.

    Posted on 18 July 2022

    Views expressed are of the expert and do not necessarily reflect the views of the Manohar Parrikar IDSA or the Government of India.