Governments are at risk of defaulting on their debts due to overspending and making up the shortfall by issuing government bonds. Factors such as the duration of the bond, risk associated with the government issuing it, economic conditions, and market participants determine the interest rate on government bonds. When governments have too much debt, they impose regulations or use monetary financing to keep interest rates low, which could result in devaluing their national currency. If governments default, they may issue new durations of debt, change terms or convince bondholders to accept smaller repayment. The consequences of a debt default would be particularly severe for the economy.
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Why Governments Are at Risk of Defaulting on Their Debts
Introduction:
Last week, the U.S reached its credit limit of 31.5 trillion dollars, and the government cannot legally borrow any more money. Treasury Secretary Janet Yellen is now warning of a U.S default if a new limit isn’t set soon. But the U.S isn’t the only country in trouble. Today, we’re going to explain why governments are at risk of defaulting on their debts, tell you what this means for the markets, and reveal why the worst is yet to come.
Government Debt:
Most governments make their money from taxes and fees. In theory, this money is supposed to be used for public infrastructure and institutions, such as schools and roads. In practice, this money goes on military spending and buying votes with lots of benefits. Not only that, but most governments spend a lot more money than they bring in from tax and fee revenues. To make up the difference, governments issue debt in the form of bonds.
Types of Bonds:
A Government Bond is basically an IOU. Give me money today, and I’ll pay you back later with interest. The repayment date in question depends on the duration of the bond. Bond durations range from one month to 30 years or more, and bonds are generally considered to be the safest investment you can make. That’s simply because governments make their money by effectively taking it from citizens, which means that you’re guaranteed to get paid back with the interest that’s been promised at the end of the bond term.
Interest Rates:
The interest rates on government bonds depend on factors such as the duration of the bond, the risks associated with the government issuing it, the economic conditions of the country or region where the government is based, and the buying and selling of market participants. Logically, the longer the duration of a bond, the higher the interest rate. That’s because investors need to be compensated for the opportunity cost of not being able to spend that money. Countries considered to be high-risk tend to offer higher interest rates on their bonds, regardless of duration.
Yield Curve Inversion:
When a country’s economy is struggling, interest rates on shorter-term government debt are higher than the interest rates on longer-term government debt. This is called a yield curve inversion, and the economic signal it sends is why it’s associated with a recession. Note that the yield curve is the most inverted it’s been in over 40 years.
The Role of Central Banks:
When governments have too much debt, they often introduce regulations to force domestic investors to buy government bonds to keep interest rates low. In extreme cases, the Central Bank itself will begin actively buying government bonds to keep rates low, called monetary financing. Almost every country has been doing something along these lines for decades because almost every country is up to its eyeballs in debt that it can’t pay back. As such, allowing interest rates to rise would result in a government default and inability to pay the money and interest rates owed to bondholders.
The Risk of Default:
A government default doesn’t happen overnight. What typically happens is that a government starts allocating more and more of its revenue from taxes and fees to paying off bondholders until there’s little to no money left to spend on public infrastructure or institutions. This becomes a sort of death spiral because an inability to spend on public infrastructure and institutions usually means the economy will suffer, which lowers tax revenue. That’s why most governments will simultaneously do what Japan is currently doing, buying up bonds to keep interest rates low.
The Consequences of Default:
Historically, governments sacrifice their national currencies to protect themselves. But it begs the question of what happens when governments default. The answer is that the government may issue new durations of debt, change the terms on existing durations of debt, or convince bondholders to accept a smaller repayment. However, a defaulting country gets downgraded, making it harder to find bond buyers, and interest rates on new bonds soar.
Conclusion:
Governments around the world are in an unsustainable amount of debt. The situation has become so dire that governments are now at risk of defaulting on their debts, which would have dire consequences for the global economy. As investors, it’s essential to stay informed about these issues and be prepared for the worst.
