What it means when a country defaults

When a person or business runs into money troubles, there aren't a lot of options.

Creditors may be circling, looking for ways to recoup outstanding debts. Property may be seized or sold to rustle up cash. Formal bankruptcy might be a last resort.

But what happens when it's a country that is in trouble?

Greece is sitting on that financial ledge, and the way out is anything but clear. The Mediterranean nation needs a bailout of 130 billion euros by March 20, not just to pay its ongoing bills and creditors, but to redeem a large amount of bonds that are coming due on that date.

It only gets the money from the International Monetary Fund and its more solvent European neighbours, though, if it agrees to onerous austerity measures that will affect jobs, government services and, probably, pensions.

The negotiations have been long and arduous. But what if, in the end, they don't work out? Above the turmoil looms one possibility that many financial analysts have said is inevitable: default.

What is a default?

There is a lot of lingo around defaults, and whether they might be orderly or disorderly, soft or hard, managed or messy.

But in basic economic terms, a default is not being able to pay either the interest on or the principal of a loan.

"A default is defined as any failure to pay either interest or principal in full and on time," says Avery Shenfeld, chief economist at CIBC World Markets in Toronto.

"In fact, what Greece is negotiating is in the normal sense of the definition already a default because they are negotiating with some of their bondholders a deal in which the bondholders would not be paid in full and on time," he says.

"It's only a technicality that that's not being considered a default because supposedly these private bondholders are voluntarily agreeing to an exchange of their existing bonds to something that is actually worth less."

What happens when a country formally defaults?

Argentina was the last large, Western-style economy to default, in December 2001, on roughly $100 billion in mostly foreign debt. Bank accounts were frozen and the country went through a very difficult period for years.

After protracted negotiations, bondholders settled for 30 cents on the dollar. But Argentina is still not able to borrow easily on international credit markets.

'Most Argentine bondholders did settle for a big loss or haircut eventually.' Grant Amyot

Some Argentine bondholders are still holding out today, says Grant Amyot, a political studies professor at Queen's University in Kingston, Ont.

"More than 10 years later, these are the so-called vulture funds who swoop in and pick up the debt of countries that are seen as bad risks at low prices because after all, the market price of these bonds goes down long before a default.

"But most Argentine bondholders did settle for a big loss or haircut eventually."

Could Greek national assets be seized?

When you default on a personal loan, the bank might come in and seize your car or house. But something similar doesn't happen in the case of a country.

"Governments in other countries could try to seize assets that Greece has outside the country in a retaliatory measure," says Shenfeld, adding, "they may not have much.

"But you can't go and seize the Parthenon as payment."

But if government decides it is not going to pay creditors, then presumably it's not going to go the route of selling assets to try to raise money to pay them, adds Amyot.

Earlier Greek austerity measures included a round of asset sales that was supposed to raise 50 billion euros by selling state-owned companies.

"I think they found they weren't getting a very good price," says Amyot. "It was a bit like a fire sale. To get a good price, they couldn't sell them instantly."

Who decides when a country is in default?

The International Swaps and Derivatives Association in New Yorkdetermines what isadefault, says Amyot, but for the limited purpose of triggering credit default swaps, a kind of insurance that is taken out by lenders.

"Otherwise, there's no official bodyit's just what people decide to call it. In practice, there's no difference between a voluntary haircut and a default where the creditors are given only 30 per cent or something of the face value."

When the ISDA says a "credit event" has taken place, that would trigger payment of default insurance taken out on a country's bonds.

In the current situation, though, the European Parliament has banned credit default swaps on the debt of sovereign nations, effective December 2011.

What would happen to Greek banks?

If the Greek government was to default, anyGreekdebt that itsbanks held would be written down and assessed by accountants at a much lower figure, says Amyot.

"In some cases, if the losses they'd incurred on these defaulted bonds were too great, they could be headed for bankruptcy."

The government might also close some banks for aperiod of time, as Argentina did.

"In order to avoid a run on Greek banks, they'd probably have to close them for a few days," says Amyot.

What currency would it use?

If the Greek default turned out to be disorderly, like Argentina's, Greece might face a backlash from the rest of Europe, says Shenfeld.

"They would potentially think about leaving the euro altogether because their banks would be bust," he says.

"They don't have the ability to print money, to essentially make those banks solvent again, unless they adopt their own currency.

"So the temptation would be at that point to go to your own currency that you can print and use to start to making payments and also refinancing your banking system in the process."

But that new currency, perhaps a new drachma, might not be worth very much.

What fallout could a Greek default have on Canadian banks?

Canadian banks don't hold much in the way of Greek bonds, so little direct impact would be expected.

'Odds are the politicians in Europe are smart enough to prevent a default in Greece from taking down their entire financial system.' Avery Shenfeld

"However, there would be a serious indirect impact on the whole Canadian economy because many European and even some U.S. banks have a significant [number] of Greek bonds," says Amyot.

"If those bonds suddenly become worthless or lose a lot of their value, then those banks could be weakened. Some of them could even fail and Canadian banks do have loans out to them."

Amyot thinks the Canadian banking system is strong enough to handle whatever indirect impact there might be.

"I would say the worst impact on Canada would just be the depressing effect on the whole world economy more than the direct sort of effect on the banking system."

So how worried should we be?

"Odds are the politicians in Europe are smart enough to prevent a default in Greece from taking down their entire financial system," says Shenfeld.

"But it's nevertheless because politics are involved and are always unpredictable [that] we have to have a little bit of caution in investment strategies these days to reflect that uncertainty."

Shenfeld says that what is at stake today is the extent to which those who invested in Greek bondsprimarily Greek and European financial institutionsdon't get paid in full.

"Also at stake is whether those who sold insurance on those bonds have to make up for those losses or pay off those who essentially bet in the financial markets that Greece would default."

Walid Hejazi, an associate professor of international business at the Rotman School of Management at the University of Toronto, says global financial markets would be hurt if a Greek default were to have the predicted impact of hurting the European economy.

And that would take away any gains the stock market has been making, he says. "So it really would impact the average Canadian."

So what happens if these Greek and European financial institutions don't get paid in full?

Most of the financial institutions involved can afford to suffer some losses, says Shenfeld.

Certain Greek banks might need outside financial assistance to stay solvent. But beyond that, there's worry about a precedent that would cause banks to curtail lending to other European countries, such as Italy or Portugal, that are also in a precarious fiscal state.

"The fear is that those other countries would not be able to borrow at an interest rate that will let them bring their deficits down and cure their own ills," says Shenfeld.

What's the better option for Greece?

"The Greek public is losing either way," says Shenfeld.

"They're facing huge austerity and massive shrinkage of their government in order to make interest payments if they don't default, or they're facing having their wages and life savings be slashed in value as Greece suddenly shifts to a new currency that isn't worth what the euro is."