: What happens when a country goes bankrupt?

Question

Recently I just read about Sri Lanka going bankrupt so what happens next?

In: 232

Answer 1

When a country spends more than it makes it needs to borrow money, usually from foreign governments and banks, or from its own citizens by selling bonds. This debt has to be repaid over a specified period of time just like any other loan. If the country still does not have enough money to make the scheduled repayments then it ‘defaults’, or goes bankrupt.

When this happens, it can either:

1. Request to borrow additional money from the International Monetary Fund (assuming nobody else wants to keep lending money).
2. ‘Print’ and create more currency and use that to repay its debt.

It’s usually a combination of both options, but the first one is not guaranteed and comes with very strict terms.

The second option, which seems like a simpler solution, creates a big problem. The local debt can be repaid in local currency, but it is usually a small part of the debt. The foreign debt however has to be repaid in foreign currency (FC). And if you exchange a large amount of local currency for FC reserves which are limited, its price will go up due to supply and demand of each. This leads the devaluation of the local currency making it worth less and less the more you buy and requiring the country to print more and more in an endless cycle.

But that’s not the end of it. All this local currency that has been printed to repay local debt and buy foreign currency is now circulating inside the country. Great, right? WRONG. This increase in devaluating currency directly leads to an increase in prices because anything imported becomes more expensive. So now you have a dangerous combination of devaluation and inflation which makes the problem even worse. Argentina is a good example.

So is there any way out of this? Outside of reducing spending, which is easier said than done since most bankrupt countries have a large part of the population living in poverty who need government spending to pay for basic needs, there is one “positive” side-effect.

A devaluating currency means that anything produced inside the country becomes cheaper for the rest of the world. So policies that facilitate exports, attract investors, or even tourism, to take advantage of this can help quite a bit. But inflation always catches up with devaluation so this isn’t a long term solution and you have to be able to attract foreign investments with other incentives than just “things are cheap here.”