I'm trying to understand this r/explainlikeimfive analogy. I rectified typos, and simplified some names and numbers.

  1. Won't Cal demand his principal back at some time in the future?

  2. Similarly, won't countries' sovereign debts demand their principal?

  3. For example, China holds much US treasuries and US sovereign debt. If China thinks COVID-2019 will cripple the US and wants to park its money else where, won't China demand all of its principal from the US so that it can buy Australia or New Zealand sovereign debt instead?

'Country A owes \$10 to country B, and has agreed to pay 2% interest annually. Call this Debt X.

Country B owes \$15 to country A, and has agreed to pay 1% interest annually. This is Debt Y.

Investor A is willing to purchase Debt X for \$12, because he values the steady rate of return, and believes country A is very likely to pay its debts. He isn't as sure about Debt Y, but he is willing to pay \$16 for it. Investor B thinks that investor A is going to change his mind about Debt Y and value it more highly, so he is willing to pay \$17 for it today.

Debt is traded constantly and it's valued differently. Just because 2 countries owe each other similar amounts of money, doesn't mean the value cancels out in any meaningful way.

Think of debt this way. You and your three brothers all own a house together. Each year you take up a collection of \$1000 a head for \$~4k annual upkeep on the house. One year, a tree falls on the roof, and the house needs another \$4000 bucks. Everyone could just chip in 1k each, but one brother is having a tough year, so instead, you loan the house \$4k, with the expectation that it will pay you 1% interest a year.

Your brothers agree, and over the years, this comes up a few more times. You even use debt to finance installing a new hottub. You now own \$20k in debt from the house, 1 brother owns \$5k, and for some weird reason, your neighbor Cal wants to purchase the debt from you. (He really thinks your household is trustworthy, and wants somewhere to park \$20k for 1% interest).

Now C owns \$20k of debt from your house, so C owns 80% of all your house's debt. Would you say C owns your house now? Well of course not, your house is likely worth many times more what C has claim to. If someone in your house is super worried about the situation, they could take up a collection in the house to buy the debt back from C, but it's not a popular idea, because most people can think of better things to do with their money than pay off C so they don't have to make the small yearly interest payments.


1 Answer 1

  1. The principal has to be repaid eventually, but with majority of formal debt instruments such as government bonds the creditor can’t just demand repayment whenever he wants. Most debt instruments specify the date, and if not date, then conditions when and how the principal is being paid back.

For example, a standard 10 year bond will pay its principal in 10 years not a day earlier, unless you convince the debtor to voluntarily agree to pay it sooner).

  1. The above works for sovereign countries too. A 10 year government bond will have on it printed that principal is paid back exactly after 10 years.

Now this is outside economics, but technically sovereign nations are in state of anarchy. So I can imagine one country could just decide to say to another — pay now or we will invade you/nuke you etc! But aside some military intervention, you can't legally force the country to pay.

In fact any government can, in principle, default on its debts anytime it wants. The only constraint on sovereign default is that if you constantly default on your debt, nobody will want to lend you money in the future, or if only at punitively high interest. Hence on sovereign level, governments as debtors have much better bargaining power than just individuals.

Government can be forced to pay its debt only through military action, or in some cases by diplomatic pressure (for example EU could threaten Greece by revoking its euro-zone or EU membership, US could threaten countries by economic sanctions etc.). Aside from that, there is nothing other country can do to get its money back if debtor nation says no.

  1. Based on 1, and 2 you probably already know the answer. No that’s not possible. China could patiently wait for bonds to expire and then not buy new US bonds, but instead buy Australian or New Zealand bonds. Of course, since US government issues a lot of debt, bonds expire probably every month and are replaced by new ones, so China could start to refuse to buy new US bonds sooner than later.

Also, usually when people want to get rid of a debt, they won’t wait for maturity and for repayment of the principal. They will take the bond to bond market and sell it at market price to get money now. That creates a trouble for country because now it has to set lower price or higher interest on its newly issued bonds due to increased supply, but whether this becomes a problem depends on plethora of factors unrelated to the original debtor and creditor countries, such as how big is the demand for the debtors bonds etc.


Your Answer

By clicking “Post Your Answer”, you agree to our terms of service and acknowledge you have read our privacy policy.