Good to Know: Sovereign debt

Sovereign borrowing is central to what governments do – but increasingly costly, even for wealthy democracies.

In late November 2024, as French Prime Minister Michel Barnier struggled to build legislative support for an austerity budget, news outlets reported that France’s borrowing costs had surpassed Greece’s. Within days, Barnier had been voted out. And Moody’s (an agency that rates the riskiness of government debt) downgraded France’s credit rating, expressing concerns that the next government would struggle to stabilize French fiscal policy.

On Dec. 9, 2024, a large investment fund announced it would cut its holdings of long-term U.S. government bonds, citing concerns about the sustainability of fiscal policy in the second Trump administration. And in its quarterly review of financial markets, the Bank for International Settlements warned that high levels of sovereign debt were “one of the biggest threats, if not the biggest threat going forward” for the global economy.

And earlier this week, the U.K.’s sovereign borrowing costs climbed to their highest level since the 2008 global financial crisis. Investors cited worries about whether the country’s Labour government would be able to meet its budget targets, especially as economic growth stagnates. 

Why does a country’s sovereign debt – the money its government has borrowed – matter? News stories like these tell us sovereign bond investors – that is, creditors who lend money to governments – are adjusting their portfolios in response to political developments and economic outcomes. Why do these shifts matter?

Sovereign borrowing is ubiquitous

Nearly all governments borrow money. That’s because a government’s spending desires may not coincide with actual revenue flows – and the cash from taking on debt can smooth fiscal operations. This is especially true during economic downturns, when governments are reluctant to impose greater tax burdens on their citizens and firms. 

In tough times – like the pandemic, or the 2008 financial crisis – many governments borrow funds to keep the economy ticking. Economists have long theorized that debt-funded stimulus doesn’t work, however, because citizens will anticipate that this debt ultimately must be repaid, via future tax increases. Whether this theory – what economists now call “Ricardian equivalence” – holds in practice depends on assumptions about how individuals and firms behave.

Borrowing also allows governments to access new resources today, avoiding tax increases (an alternative means of financing expenditures). Governments borrow to finance long-term infrastructure, fund climate transition or mitigation, or even simply to support fiscal budgets. Some of these funds may be used to roll over past debt that has come due, or to boost political support in advance of elections (part of the “political business cycle”). 

Governments borrow in different ways

Lending to sovereign governments is different from lending to a corporation or an individual. For one, it’s very difficult to directly compel governments to repay in the case of default. While most governments repay their debts most of the time – they want to retain access to borrowing in the future – default has been a persistent feature of the global financial system for centuries. When a government is on the brink of default, there is no global bankruptcy court to handle the mess. Investors therefore pay close attention to assessing default risk, relying on macroeconomic indicators, political institutions, and events.

Potential sources of sovereign credit include private investors (who purchase government bonds), commercial banks, multilateral development banks (including the World Bank, the African Development Bank, and the Asian Infrastructure and Investment Bank), and other governments (bilateral official loans). Still other sovereign credit flows from commodity trading and mining companies, such as Glencore and Trafigura, whose loans to governments are tied to resource revenues. And the lines between these creditors can become blurred: China’s rise as the most prominent official bilateral creditor involves loans made by its policy banks, such as China Development Bank, as well as state-owned commercial banks. 

So how do governments decide how much to borrow, and from whom? These decisions partly reflect the country’s level of economic development and its existing debt burden. Private creditors often view low-income, highly indebted countries as too risky. These countries tend to access credit from multilateral official lenders (such as the World Bank or the Inter-American Development Bank, whose mandates include the provision of concessional lending. Lower-income countries also turn to loans from other governments, in bilateral deals that are driven in part by diplomatic and strategic considerations.

Investors pay attention to default risk

Middle- and high-income countries often issue sovereign bonds, which are subsequently bought and sold in highly liquid, secondary markets. So reports about France’s higher borrowing costs are references to the higher risk premiums on French (versus other countries’) bonds on these secondary markets. Investors are making decisions on the basis of perceived default risk: How likely is it that the government will not repay these bonds when they come due? 

These assessments depend on economics as well as on politics – including whether the borrowing country is democratic or autocratic; whether its government is left- or right-leaning; and whether there’s an election on the horizon. Investors also get input from ratings agencies like Moody’s and Standard & Poor’s, who perform their own analyses of the creditworthiness of government bonds. And it’s worth noting that investors also rely on cognitive shortcuts when pricing sovereign risk. For instance, how risky are other countries in the same geographic region? Do key market actors categorize that country as an “emerging” market, or as a riskier “frontier” market?

More borrowing options

During the last 15 years, low- and middle-income countries enjoyed expanded access to sovereign finance. For many lower-income countries, debt relief in the early 2000s opened up space for new borrowing, as creditors worried less about existing debt burdens. And, as private investors faced a low-return environment after the 2008 financial crisis, they were increasingly tolerant of economic and political risk in emerging and frontier market countries. Governments were able not only to issue bonds, but also often to borrow in their own currencies (rather than in dollars or euros), something that most investors had previously considered too risky. 

New funding sources also emerged. China’s government began to focus on outward lending – even prior to the 2013 announcement of the Belt and Road Initiative – as a means of addressing excess capacity in their domestic economy. Other new bilateral creditors, including Brazil, India and Saudi Arabia, soon followed. 

Different creditors have different objectives, and this also means that the cost of finance varies across lending instruments. A recent fine-grained analysis of sovereign borrowing in Africa (between 2000 and 2020) found that, on average, governments paid 6% in annual interest for dollar-denominated government bonds; 3% on loans from China; and a mere 1% for World Bank loans. These findings demonstrate significant variations across time, countries, and creditors in the cost of borrowing. 

And more choices for governments

As a result, governments in lower-income countries made varying choices, within the constraints of their economic fundamentals (those with the weakest economies had less access to private bond markets, for instance). Much of what drove a government’s choices about how to borrow related to the country’s internal politics. Governments that were less inclined to share information about their fiscal positions, for instance, seemed to prefer borrowing from bilateral official lenders (including, but not limited to, China) rather than multilateral development banks. Still other governments elected to pay the higher financing costs associated with sovereign bond issues, because these loans came with fewer rules regarding the use of borrowed funds – and suggested to local audiences that the government was competent enough to participate in the global economy.

During the last few years, however, the downsides of this expanded set of borrowing options have become more evident. The lingering costs of dealing with the covid-19 crisis, the rise in the cost of imported commodities like food and fuel, and the increased risk aversion among private market investors have put pressure on the ability of emerging market countries to service their debt. Many countries now spend more on interest payments on existing debt – often taken on at commercial rather than concessional interest rates – than they spend on education or health care. This comes at a time when lower-income countries also need new financing to deal with climate change-related mitigation and adaptation.

Sovereign debt crises have become more complicated

As many as 50 lower-income countries (according to the International Monetary Fund) – are at high or moderate risk of debt default. When countries find themselves in or at the brink of default – as Chad, Ethiopia, Ghana, Sri Lanka, and Zambia have – the process of negotiating with creditors has been slow. The more diverse set of creditors in recent years has given governments more options for borrowing, but also makes resolution of debt difficulties more complicated, more contentious, and often delayed. With delay comes austerity, political instability, and permanent effects on growth and development.

For lower-income countries, the G-20 created the Common Framework for Debt Treatments in 2021. The idea was to specify a process by which a country on the brink of (or after) default would negotiate with its various creditors. The framework specified how the International Monetary Fund and the World Bank would be involved in assessing debt sustainability; when various types of creditors would be involved in negotiations; and how creditors would be treated comparably. While the Framework has been used in a few cases, it has operated slowly. Newer bilateral creditors like China have sometimes complained about its principles, while private investors note that they are not involved until late in the process. 

Hence, crisis resolution has moved slowly in places like Ghana and Zambia. For countries with greater levels of indebtedness to China, negotiations with the International Monetary Fund (as well as with other bilateral creditors) have moved even more slowly. While traditional Western creditors are sometimes prepared to write down debts to bring a country’s debt burden back to sustainable levels, China’s approach has been different, offering instead financial bailouts or extensions of loan maturities. China’s reluctance – largely for domestic political reasons – to share in principal reductions adds complexity and further delays to debt negotiations.

For wealthy democracies, the possibility of debt default remains very small. What is more likely, however, is that investors will increasingly worry about the longer-term sustainability of persistent fiscal deficits (driven by spending as well as tax cuts). These worries will shrink the willingness of investors to hold government bonds issued by these countries, pushing down the prices and increasing the costs paid in debt markets. In places like France, the U.K., and the United States, the ripple effects could potentially crowd out both current and future government spending on crucial public goods. 

Layna Mosley is professor of politics and international affairs at Princeton University, and director of the Princeton Sovereign Finance Lab.

B. Peter Rosendorff is professor of politics at New York University and research director of the Princeton Sovereign Finance Lab.

Related Good Authority posts:

• Erik Voeten and Layna Mosley, “What can be done about the unfolding sovereign debt crisis?” This Good Authority podcast from February 2024 discusses the ramifications of greater global debt – and the difficult decisions debtor nations face. 
• Cameron Ballard-Rosa, Layna Mosley, and Rachel Wellhausen, “This is what will happen if financial markets panic about Trump.” From March 2017, when global markets and investors were nervous about the incoming Trump administration.
• Layna Mosley and Rosendorff, “Sri Lanka can’t count on China to solve its debt problems.” From September 2022, when Sri Lanka defaulted on its external debt payments.
• Cristina Bodea and Raymond Hicks, “Trump is again criticizing the Fed. Could that hurt the U.S. credit rating?” From March 2019, when President Trump blamed Federal Reserve Chair Jerome H. Powell and the central bank for the U.S. economy’s slowing growth.
• Stephen B. Kaplan, “China is investing seriously in Latin America. Should you worry?” From January 2018, as China’s Belt and Road Initiative (BRI) explored new infrastructure investment opportunities in Latin America.
• Raj M. Desai and James Raymond Vreeland, “What the new bank of BRICS is all about.” From July 2014, explaining why Brazil, Russia, India, China, and South Africa – the BRICS countries – decided to establish a new development bank outside the Bretton Woods system.
• Layna Mosley, “From AAA to AA+: Markets, governments and the downgrade.” From August 2011, explaining the Standard and Poor’s decision to downgrade the U.S. credit rating. 

Further reading and resources:

• Cameron Ballard-Rosa, Layna Mosley, and Rachel Wellhausen, “Contingent Advantage? Sovereign Borrowing, Democratic Institutions, and Global Capital Cycles,” British Journal of Political Science 51(1), 2021, pp. 353-373.
• Cameron Ballard-Rosa, Layna Mosley, and Rachel Wellhausen, “Coming to Terms: The Politics of Sovereign Bond Denomination,” International Organization (Winter 2022), pp. 32-69.
• Muyang Chen, The Latecomer’s Rise: Policy Banks and the Globalization of China’s Development Finance (Cornell University Press, 2024).
• Layna Mosley and B. Peter Rosendoff, “Government Choices of Debt Instruments,” International Studies Quarterly, Vol. 67, Issue 2, June 2023.
• Bradley C. Parks, Ammar A. Malik, Brooke Escobar, Sheng Zhang, Rory Fedorochko, Kyra Solomon, Fei Wang, Lydia Vlasto, Katherine Walsh, and Seth Goodman, “Belt and Road Reboot: Beijing’s Bid to De-Risk Its Global Infrastructure Initiative,“ AidData Research Laboratory at William & Mary, November 2023.
• Alexandra Zeitz, The Financial Statecraft of Borrowers (Oxford University Press, 2024).

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