Why sovereign default isn't always a disaster - and what would it mean for the US?

On the face of it, a country failing to pay its bills sounds like a resoundingly negative state of affairs. But can sovereign default actually be a good thing?

If you cast your mind back to the 16th century, you may remember that Philip II of Spain was the first serial defaulter in history. The king racked up enormous amounts of debt (he also inherited a sizeable debt) waging ongoing military campaigns and defaulted on short-term loans over the course of roughly 40 years despite riches flowing from silver mines in the New World.

Any similarities to the US and its soaring debt amid increasing defence spending in spite of its economy being boosted by a fresh source of revenue are purely coincidental.

But why am I bringing up a Spanish king who died more than 400 years ago? Because in the face of so many defaults, he managed to earn the nickname Philip the Prudent and oversee the peak of the Spanish Golden Age. Maybe sovereign default actually can be a good thing.

The world has obviously changed substantially and modern governments don’t have the same kind of carte blanche that a monarch like Philip II had (how exactly are lenders going to force the king to repay them?), but does that mean the outcome of a modern sovereign default is as apocalyptic as it sounds?

According to Jay Sivapalan, Head of Australian Fixed Interest at Janus Henderson, the reality is far more nuanced and, in many cases, a default can actually leave a country better off.

“History is littered with lots of examples of defaults by governments for a variety of reasons, and many of those governments and countries have come out on the other side better and stronger,” Sivapalan says. “The way to think about it is on a case-by-case basis.”

Governments aren’t companies

The first thing to note is that governments and companies don’t operate under the same rules and defaulting means something very different. When a business can’t pay its bills, the end result is often that they cease to exist as an entity. That’s not the case with countries - Sri Lanka didn’t just cease to exist when it suspended payments on foreign debt in 2022, for example.

A government also has tools available to avoid insolvency that a business simply doesn’t. It can raise taxes, control banking and insurance regulation to create captive buyers for its bonds, and use trade policy and tariffs as additional levers.

“If they want more revenue, they can just tax the country more. Now, of course, the very adverse byproduct of that is you slow economic growth, you make people unemployed, and you make businesses invest less, which then has a bit of a spiral. But that's what governments can do in the short run,” Sivapalan says.

That flexibility is precisely why he doesn’t see a near-term US default as a realistic prospect, even as bond yields continue to hit multi-decade highs and its debt-to-GDP ratio sits at around 125%.

“It is probably one of those economies that has a maximum number of levers afforded to it, in terms of how they can tax their country, how they can tax foreign trade - which we're seeing through tariffs and so on,” he says, adding that the US has a strong ability to negotiate deals with trading partners that indirectly support demand for its bonds.

“I think the US is a long way from a real threat of a full default.”

Typically, Sivapalan explains, sovereign default is triggered by a sharp rise in debt that becomes genuinely unserviceable, especially in quite a sharp, strong economic downturn, compounded by heavy reliance on external creditors who have no strategic reason to keep lending and plenty of other places to put their money.

Greece in the wake of the GFC is a textbook example: “Economic growth was falling pretty precipitously and they almost fully relied on external investors to provide the debt.”

The upside of default: Currency, competitiveness and a fresh start

So, how does default become a positive? Sivapalan points to a consistent pattern across recent examples such as Sri Lanka, Zambia, Lebanon, Pakistan, Ukraine, Venezuela, Uruguay and Ecuador. In every case except Greece (constrained by its eurozone membership), the local currency fell sharply after default, making the economy suddenly far more competitive on the global stage.

"With the exception of Greece, which is tied into the euro, all the other ones, the currency dropped very quickly, which made them very competitive," Sivapalan says.

“The second one is whether it’s inbound tourism or the export sector or something like that, you’ve got to create external demand for your goods and services that wasn't there prior to defaulting, which then catapults you out.

“Then the domestic consumer can come back in. It’s rarely led by the domestic consumer because they’re either too fearful, there’s a big unemployment story, or they haven’t got the ability to spend.”

Sri Lanka is his standout recent case study. Having built up unsustainable debt partly through defence spending and some mismanagement during the civil war, the country selectively defaulted in 2022 and, within three years, was booming.

“It’s actually been lifted back out from a third world economy to now sort of on path towards the type of classification that a Singapore would have,” Sivapalan adds.

The mechanics of getting there are fairly standard: a selective default or debt haircut, where lenders agree to accept, say, 70 or 80 cents on the dollar rather than risk losing everything, typically paired with IMF support and a period of enforced budget austerity.

“That typically works," Sivapalan says, provided it's paired with genuine structural reform on the revenue side, whether that's reviving tourism, as in Greece, Portugal and Spain, or attracting new industries altogether.

Could it happen to the US and what would it look like?

The prospects of the US actually defaulting are definitely slim, but the growing concerns around bond yields have created some rumblings. Last month, Schroders Head of Fixed Income Kellie Wood told Livewire US sovereign default risk is “back in play”, particularly if growth slips below the interest rate on its debt.

Sivapalan stresses that even when roleplaying the possibility, it is important to remember that a US default is not likely in the near term and it would be “horrific for markets” given the reserve currency status that the US has.

“If the US were to default, it’s because something’s gone horribly wrong. They probably got a big unemployment spike, share markets are down, etc. But their currency would fall precipitously,” he says.

“Let’s say they shaved their debt from 100 cents in the dollar to 70 cents in the dollar. Because the currency has fallen, they become much more competitive in a whole bunch of industries, and then they would be able to climb their way out. Maybe even tourism might spike.”

If their currency dropped 60%, under this “extreme and hypothetical” scenario, Sivapalan says the US would see a huge resurgence in its automotive industry, their digital technologies, and a whole host of other sectors.

“Their services would become a lot cheaper. Keep in mind, US companies earn more than 50% of their revenue from outside the US, so all of a sudden, the corporate profitability will be super strong, and then you'd get the wealth effects coming through. That share market would then go back on a tear, a real strong recovery. So that's how it would play out.”

Obviously, the US is looking to avoid this happening, but the way it appears to be doing so is different to the way many other countries try and get their debt under control. Rather than shrinking its way to solvency through austerity, it's betting on growing its way out of debt by expanding GDP, largely through the AI and technology boom alongside a defence spending push.

“They do have quite a bit of debt, they do have rising interest rates, and they do have a serviceability challenge,” Sivapalan notes.

“The policymakers’ intent at the moment would be: can they grow their economy out of debt and basically make their GDP and economy wider and bigger, and therefore the tax revenue base wider and bigger, so it becomes easier to service the debt.

“Time will tell whether that’s a successful recipe or not, but they've probably got, among all the economies around the world, one of the best chances of pulling it off.”

The catch: It’s ugly before it’s good

None of this means default is painless. Unemployment spikes, falling asset prices and genuine economic hardship mean that for the people living through it, the short-term consequences are typically brutal even if the country as a whole eventually emerges leaner and more competitive.

For investors, Sivapalan's takeaway is less about predicting a US default and more about positioning for a genuinely different rate environment than the one that prevailed for much of the past 15 years.

“The sweet spot for investors is in that four-to-six-year part of the curve where there's plenty priced in from a cash rate perspective, but it’s not fully exposed to that long end of the bond yield.”

However, investors that are in a passive benchmark or just buying an index, this type of environment could make you a “sitting duck”.

“This is the exact type of environment where we need to be thinking away from benchmarks and really playing to a full spectrum of active choices as investors. High yields are fantastic for investors at the end of the day.”