Sovereign Domestic Debt Restructuring: Handle with Care

IMF Blog, December 1, 2021

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Authors: Peter Breuer, Anna Ilyina, Hoang Pham
Date: December 1, 2021
Core message: Restructuring domestic debt is like surgery — undertaken only if necessary and designed to avoid doing more harm than good.
Context: Rising debt vulnerabilities and growing stocks of sovereign domestic debt in emerging and developing economies make questions of when and how to restructure domestic debt more acute.

Over the past two decades, emerging market developing economies have seen their share of sovereign domestic debt increase from 31 to 46 percent of their total sovereign debt.
The paper draws on the past 40 years of sovereign debt restructurings to derive insights.

Domestic debt restructuring may be easier to accomplish because authorities can alter terms by changing domestic law, potentially avoiding some costly consequences associated with external debt restructurings (for example, loss of access to external debt markets).
Domestic debt is often held predominantly by domestic creditors (banks, pension funds, households, non-bank institutional investors), so losses can propagate domestically and exacerbate the economic malaise that necessitated restructuring.

Central criterion: the net benefit of domestic debt restructuring — do the benefits of a lower debt burden outweigh the fiscal and broader economic costs of achieving that debt relief?
The decision is the sovereign’s prerogative and entails responsibility to limit damage and mitigate effects on the domestic economy.
Potential fiscal support obligations include recapitalizing some banks, replenishing pension savings, and ensuring the continued effective functioning of the central bank.
The net benefit calculation determines whether domestic debt should be included in a restructuring together with external debt, or handled on a standalone basis.

Scope (perimeter) of claims to include depends on:
- the amount of debt relief needed to restore debt sustainability, and
- the net benefit obtainable from each type of claims.
In principle, all the government’s domestic debt liabilities could be included.
Risks:
- Some creditors may use political influence to avoid burden-sharing, shifting adjustment onto others.
Recommendations:
- Cast the net wide and rely on voluntary mechanisms to boost participation by lowering the relief sought from each creditor group.
- Engage creditors constructively and transparently.
- Rely on market-based incentives and present the debt exchange as part of a consistent macroeconomic plan.
- Convincingly explain how the restructuring fits with the broader strategy to address the causes of sovereign debt stress to secure political support.

Design the restructuring to anticipate, minimize, and manage impacts on the domestic financial system.
Measures to protect financial-sector stability:
- Limit bank impact by extending maturities and/or lowering the interest rate rather than reducing the nominal amount of outstanding claims.
- Recognize losses early and pair with a strategy to restore banks’ capital buffers.
- Provide system-wide emergency support that allows institutions to convert illiquid assets into cash to ensure banking-system functioning and shore up confidence.
- Consider temporary measures to slow panic-driven deposit withdrawals and capital outflows where necessary.
Legal and contractual considerations:
- Carefully evaluate potentially adverse consequences of unilaterally amending domestic law.
- Inclusion and use of collective action clauses in domestic debt contracts could increase legal certainty and predictability, and may be superior to retrofitting such mechanisms by law.

Restructuring domestic debt can be a useful tool for sovereigns facing fiscal and economic stress, but must be well-designed to avoid doing more harm than good.
Sovereign domestic debt restructuring should be part of a broader policy package that effectively addresses the underlying problems and debt vulnerabilities.

Sovereign Domestic Debt Restructuring: Handle with Care — Peter Breuer, Anna Ilyina, Hoang Pham, December 1, 2021