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David A. Grigorian: The fact of Sovereign domestic debt restructurings

Updated: Sep 22, 2023

Dr. David A. Grigorian is a Senior Fellow at Mossavar-Rahmani Center for Business and Government at Harvard University’s Kennedy School of Government and a 27-year veteran of the IMF and the World Bank. He has published extensively on issues such as sovereign risk, public debt, financial stability, among others, and his research is cited widely.

The fact of Sovereign domestic debt restructurings and the additional measures for a debt restructuring deal

In recent years, sovereign domestic debt restructurings, being vital for development and enabling investment as well as growth, have become more common. Many developing countries are facing the core debt challenges. Meanwhile, several middle-income countries are also facing a high risk of debt distress, and need a path toward meaningful debt restructuring. Based on the article Restructuring Domestic Sovereign Debt: An Analytical Illustration published by Dr. Grigorian, SPCIS has interviewed him to understand the difference between developing and developed countries as well as the key issue of restructuring domestic sovereign debt. Also, SPCIS asked him to shared his views on how to make the Common Framework process more transparent and reduce uncertainty and moral hazard in the context.

Restructuring domestic sovereign debt is a complex undertaking, potentially more complex than restructuring external debt. What makes it so is the fact that domestic debt is largely held by local financial institutions whose core function is to provide credit to local corporations and households. If a debt restructuring impedes the financial institutions’ ability to perform their core function (e.g., by punching a hole in their balance sheet that would render them undercapitalized or insolvent), this could have implications for financial stability and economic growth, the two of course often reinforcing one another. (This link between restructuring and growth exists in the case of an external restructuring too, via the capital flow channel, but it is much weaker). The greater the share of government debt on the financial sector’s balance sheet, the stronger is the potential impact of restructuring on the sector’s financial health and its ability to lend.

Generally speaking, the key issue for any country during the decision-making process is how to design the restructuring so as to minimize its impact on the financial sector’s balance sheet. As discussed in the paper in the context of the “Domestic Debt Restructuring Laffer Curve”, the net savings from a debt restructuring could decline and eventually become negative if the haircut imposed on creditors is too high. Getting a good grasp of the shape of this curve is thus very important in designing a prudent domestic debt restructuring deal.

However, the main difference between developing and developed countries in this context is that the link between the sovereign and financial sectors is much more pronounced in the former case. This is often a function of the underdevelopment of the private sector, which forces the banks to invest more of their funds in government securities rather than lend to the private sector. For nonbank financial institutions, such as pension and insurance companies, the domestic bias—the tendency to invest more domestically rather than abroad, often driven by regulation and/or lack of sophistication—may be a reason why they are more susceptible to restructuring of domestic debt securities than they otherwise may have been if they were allowed to invest more abroad.

Since the approach envisaged under the Common Framework (CF) attempts to bring together a larger and more diverse group of creditors than is typical for a debt restructuring deal, consistent with the Theory of Collective Action (see Mancur Olson, “The Logic of Collective Action,” 1965), additional measures are required to compensate for the added complexity and incentive issues. While the practical aspects of such an approach in the case of the CF are subject to debate, at least theoretically these additional measures may include some forms of coercion, selective incentives, and improved coordination.

Coercion: As commonly observed, a creditor would benefit from a debtor country returning to debt sustainability if it did not have to participate in a debt restructuring. Generally, the way to convince such “free riders” is to make sure they cannot receive the good if they do not contribute. In the context of a debt restructuring, this could be achieved by making sure the claims they hold are made worthless either via reducing the value of the old bond to zero or reducing to zero the probability of the creditor ever recovering it by legal means.

Enticement: The collective action problem could also be solved by giving enough incentives to the unwilling creditor to “join the chorus” by raising the upside to be received by that creditor as a result of a successful restructuring. Creditors need to be convinced that it is in their best interest to restructure the debt so that they can receive a share of a larger future pie in the event of a successful restructuring. One way to do it would be to offer private external creditors contingent instruments as part of the restructuring deal.

Coordination: The degree to which coordination is required in part depends upon the group size, among other factors. A small group, where there are few cross-cutting issues and costs are small, may only require coordination of activities. Larger groups, with greater heterogeneity and relatively high costs, may require much greater coordination. To overcome coordination difficulties in the context of the CF, some actors—in this case, large official creditors, such as the US, China, and/or the Paris Club—may need to step in and take leadership roles. The Global Sovereign Debt Roundtable is a great start in terms of improving coordination, but it does not address the leadership issue.

Assuming these measures address the collective action problem, two other elements may be necessary to complete a restructuring deal: (1) widening the perimeter of the exchange (which in some cases may include restructuring domestic debt) and (2) securing comparability of treatment. The Iraq’s debt restructuring could provide a useful example in this regard.

Contact: Ye Jiewen

Interview: Ye Jiewen



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