Total sovereign domestic debt rose 46% in 20 years
The International Monetary Fund (IMF) sees restructuring of domestic debts playing a big role in the resolution of future debt crises by countries following the rise to 46 percent from 31 percent of total sovereign domestic debt for emerging market developing economies (EMDEs) over the past two decades.
In a paper titled, ‘Sovereign Domestic Debt restructuring: Handle with care,’ the IMF stated that domestic debt restructuring is a tool that can be used by sovereigns facing fiscal and economic stress which should be well designed to avoid doing more harm than good. It also noted that sovereign domestic debt restructuring should be part of a broader policy package that effectively addresses the underlying problems and debt vulnerabilities.
With rising debt vulnerabilities and growing stocks of sovereign domestic debt in emerging and developing economies, the questions of when and how to restructure such debt are now more acute than ever. Also, much of the Fund’s and academic work on sovereign debt problems has focused on the implications of restructuring sovereign external debt, by altering the terms of the debt such as the amount owed or the repayment period through negotiations with different types of external creditors, till date, the paper noted.
The IMF paper stated that domestic debt restructuring may be easier to accomplish, on one hand, but it noted that fiscal authorities may simply elect to alter the terms of debt contracts through changing domestic law. This may avoid some costly consequences associated with external debt restructurings, such as the loss of access to external debt markets. On the other hand, it noted that domestic debt is often held predominantly by domestic creditors who will suffer losses. Through this channel, the IMF says, sovereign debt distress can easily be spread to domestic banks, pension funds, households and other parts of the domestic economy and can add to the economic malaise that made the debt restructuring necessary in the first place.
“The decision to restructure domestic debt or not is always the sovereign’s prerogative and entails the responsibility to limit the damage and help mitigate the effects of a restructuring on the domestic economy. For example, to avoid compromising the viability of the domestic financial system, the government may be required to recapitalize some banks or replenish pension savings. Similarly, ensuring the continued effective functioning of the central bank may require fiscal support.
“The net benefit calculation will determine whether or not the domestic debt should be part of a restructuring, together with external debt, or on a standalone basis,” it asserted.
The Fund further said domestic debt restructuring should be designed to anticipate, minimize and manage its impact on the domestic financial system as:
The authorities need to put in place measures that mitigate losses for banks, non-bank institutional investors, and households and that minimize spillovers. For example, the impact on banks can be limited by extending the maturities and/or lowering the interest rate rather than reducing the nominal amount of the outstanding claims. Losses should be recognized early and may need to be paired with a strategy to restore banks’ capital buffers.
System-wide emergency support that allows institutions to convert illiquid assets into cash may be needed to ensure the functioning of the banking system and shore up confidence. In some cases, temporary measures to slow panic-driven deposit withdrawals and capital outflows might have to be considered.
To garner broad creditor participation in the restructuring and reduce the likelihood of costly litigation, the process of restructuring has to be perceived as fair and transparent while the IMF further noted that the scope of claims for inclusion in any domestic debt restructuring would be dependent on the amount of debt relief needed to restore the debt sustainability and benefit that can be obtained from various types of claims. It also noted that casting the net wide and relying on voluntary mechanisms may help boost participation in the restructuring by lowering the relief sought from each creditor group.