Restructuring domestic sovereign debt: Fiscal savings and financial stability considerations

In recent years, sovereign domestic debt restructurings (DDRs), have become more popular and have a greater impact on a growing portion of total public debt. However, this should not be surprising. The total amount of domestic outstanding securities, i.e., sovereign debt securities, is approximately 40 times larger than the volume of $1 trillion in foreign law sovereign debt securities. From 2000 to 2020, domestic debt has increased from 31 percent to 46 percent in emerging markets and developing countries, where it is more likely to be restructured. There is a distinctive feature that distinguishes domestic restructurings from external debt restructurings. This negative externality is that domestic restructurings can impose direct costs on local financial systems, which could reduce the (fiscal savings) for the sovereign from the bond exchange. These costs arise from the strong nexus that exists between the sovereign and financial institutions (especially the banks), which can impact both the income and balance sheets of these institutions during periods of sovereign stress. It is less likely that a domestic restructuring will occur (relatively to an external debt restructuring).

While the degree of this difference varies from country to country, the captive nature domestic investor base gives sovereign authorities leverage over domestic investment and may have helped make the holdout problem less prevalent in DDR cases in recent decades. DDRs are also more flexible than EDRs when it comes to the government's ability to restructure domestic debt through retroactively altering the terms of bond contract contracts. Barbados (2018) and Greece (2012) have taken advantage of this "local law advantage" and included collective action clauses into their domestic law contracts before restructuring their domestic debt.

Laffer Curve: Domestic debt restructuring

It is interesting to note that if the recapitalization or financial stability costs of DDR are an increasing function on haircut imposed upon creditors, there is a maximum haircut value beyond which the gross relief achieved by the sovereign by increasing the haircut is outweighed by recapitalization costs and financial stability cost, rendering marginal net debt relief negative.

The following figure shows a stylized calculation of net debt relief (NDR), accrued to a sovereign in a variety restructuring scenarios. Because banks' asset side can be affected by haircut, both directly and indirectly, it is possible for them to lose their ability to pay. Bank loans are more risky because of the high haircut needed to ensure debt sustainability. Deposit withdrawals by banks (increasing intensity with economic/fiscal stress) may force them to liquidate assets at fire-sale prices. This will further strengthen the positive correlation between bank asset impairment and haircut.

As a result of haircuts, capital shortfall and net credit relief are both affected

Source: Author's simulations.

The chart shows that net debt relief to the sovereign increases when haircuts are below 20 percent and decreases above 20 percent haircuts. It even becomes negative for haircuts below 40 percent. The sovereign should not impose haircuts above 20 percent. This will reduce the NDR accrued and possibly even make it negative. It also exposes the financial sector to greater financial stability risks and imposes increasing costs (beyond what is possible to capture in ex-ante calculations of the capital shortage).

RLC's shape may vary depending on how impaired assets are treated by regulators and the structure of liabilities. The RLC would be shifted downward if the assumption of zero risk weight for government securities was relaxed and weights were adopted to compensate for sovereign exposures that are in distress. The availability of 'bailable' deposits on the liabilities side may reduce the need to intervene (e.g. Cyprus 2013, 2013) and shift the RLC upwards.

Recapitalizing financial institutions and ensuring stability in financing

If sovereign securities make up a significant portion of bank assets, the DDR could have a significant impact on bank balance sheets and ability to provide credit to economy. Capital losses will result in financial institutions when government debt exposures are reduced, unless they have been absorbed through loan-loss provisioning or mark-to-market accounting before the restructuring. This reduction in government debt portfolio value could be caused by changes to the original contractual values of the debt security such as coupon reduction, face-value haircut and maturity extension (with below market coupon rates).

If banks can absorb losses without resorting to recapitalization with public funding, the demand for debt relief from other creditors or fiscal consolidation to restore debt sustainability will be less. The likelihood of a financial crisis being caused by debt restructuring will be reduced. This is important as bank crises and debt restructurings can often lead to larger economic output losses. When a DDR is being designed, it should be taken to ensure financial stability and prevent financial-sector stress from escalating into a crisis. This can be achieved by strengthening crisis management and contingency planning capabilities, as well as recapitalizing the affected institutions.

The design of the restructuring could have implications on financial stability, immediate recapitalization requirements (and thus for NDR). Restructurings that involve coupon reduction or maturity extension will likely have a less direct impact on the balance sheets of domestic financial institutions than those that involve face-value haircuts.

If losses are recognized, a strategy must be developed to restore capital buffers. If the strategy requires public funding to recapitalize, policymakers need to be aware of the potential downsides associated bailouts (e.g. moral hazard). These should be minimized as much as possible.

To ensure normal operation of the central banks' domestic sovereign debt, special attention should be paid to their holdings.

This research is still in development. Any comments or suggestions are welcome. This research is intended to stimulate debate about domestic sovereign debt restructuring issues, and expand the research agenda in this field. This blog is the author's opinion and should not be attributed or endorsed by the IMF, its Executive Board or its management.