Policy Brief On Domestic Debt Restructuring

Recent discussions on sovereign debt crises in low- and middle-income countries (LMICs), arising from their inability to service debt denominated in hard currencies (especially the dollar), have tended to focus on what are seen as excessively high levels of aggregate-domestic and foreign currency-ypublic debt. This raises three questions. First, what is the rationale for making domestic debt restructuring (DDR) part of the adjustment imposed on countries facing external debt stress or defaulting on external debt? Second, is it legitimate to make the restructuring of domestic debt a part of the process of resolution of what is essentially a crisis resulting from the inability to service foreign debt? Third, what are the economic and welfare consequences of DDR, and would it help to resolve the original problem of the foreign debt crisis? The obvious difference between domestic and external debt-that the former can be serviced with domestic currency the availability of which the government and the central bank control, while the latter has to be paid for in foreign currency that has to be earned with foreign revenues or new foreign borrowing which the government cannot control- has been ignored. Even if DDR releases domestic resources and increases fiscal space, there is no reason that it would automatically resolve the stress created by unserviceable foreign debt. Moreover, domestic lenders to sovereigns include domestic banks and ordinary citizens whose savings are invested in government securities (considered riskless) through institutions such as pension funds, insurance companies and mutual funds. Restructuring of domestic debt therefore adversely affects domestic banks and ordinary savers, and has destabilising consequences for the domestic economy. This brief considers the ways in which debt stress stemming from domestic and external debt can be separated and recommends the alternative policy measures needed to address external debt stress.