Market-friendly alternative to domestic debt restructuring

Domestic debt restructuring

A large and growing share of domestic-law public debt within the sovereign liabilities of many low- and middle-income countries in recent years has attracted much-needed attention to the topic. Starting from Reinhart and Rogoff (2008), who brought issues related to the scale and scope of domestic debt¹ to the forefront of economics profession, Erce, Mallucci, and Picarelli (2022) demonstrated that domestic debt defaults and restructurings have been a rather common phenomenon in recent decades, while IMF (2021) and Grigorian (2023) highlighted the range of design and implementation issues needed to be explicitly factored in for a restructuring of domestic debts to succeed and provided a framework for measuring fiscal savings generated by domestic debt restructurings (DDRs).

Recent sovereign debt restructurings in Zambia, Ghana, and Sri Lanka reignited the discussion on the practical (including political economy) issues of the inclusion of domestic debt in the overall restructuring mix. This is in part due to the growing role of domestic debt in total sovereign liabilities and the growing sovereign-bank nexus in some (emerging market and developing economies) EMDEs that may amplify financial stability risks (October 2025 GFSR, Chapter 3).

However, Grigorian (2025) demonstrated that when the costs of recapitalization of domestic financial institutions affected by a DDR and of safeguarding system-wide financial stability are properly accounted for, the net debt relief resulting from the operation is likely to be small, at most in single-digit percentage points of GDP in two of the countries in debt distress analyzed in the paper. If broadly true for other cases, this may result in domestic debt being excluded from the perimeter of future sovereign debt exchanges most of the time (as they may not be worth the trouble of going through), leaving external creditors to shoulder the burden of achieving debt sustainability in full. They could in turn blame the authorities for unfairly shielding their domestic creditors from the burden of providing debt relief, complicating the negotiations and delaying the final settlement.

Is there an alternative to DDRs?

While not restructuring domestic debt may be the rational thing to do in some cases (IMF, 2021, offers a framework for thinking about such decisions), there are other options that policymakers can pursue vis-à-vis domestic debt that will contribute to debt sustainability while signaling burden-sharing, without triggering any financial stability concerns commonly associated with DDRs. In some cases, market-friendly liability management operations (LMOs)—swaps or buyback operations—using domestic debt securities could be the solution, if accompanied by (i) restructuring of external debt, (ii) credible (above-the-line) fiscal consolidation program, and (iii) temporary financial support from International Financial Institutions (IFIs).

Such operations will have the objective of reducing the government’s domestic interest bill in an environment where interest rates remain elevated due to debt distress and sustainability concerns (and may even increase further) but could decline on the back of improving macroeconomic fundamentals and confidence. This could be done in one mega swap (i.e., where all outstanding domestic securities will be eligible for exchange with new securities at lower interest and longer-maturities) or in an iterative fashion (i.e., by taking a portion of domestic debt securities off the market via buybacks to help cool it off and re-issue new securities within a short period of time) until the entire stock of (short-term and expensive) domestic debt is bought back and new debt re-issued.

In addition to lower coupons on newly issued securities, such LMOs could also lock in savings on principal, since the distressed bonds will likely be bought below par, often significantly so. While the difference between the par value and market value of bonds could shrink as the program succeeds in bringing markets to normalcy, the principal savings in aggregate could be significant in some cases. As the buybacks and reissuance continue, benefits from the principal difference will get smaller, while the benefits of the interest/coupon differential will get larger.

The LMOs can also extend the maturity of the stock of debt by issuing new securities with maturities longer than the pool of securities purchased from the market. By lengthening the maturity profile of public debt, LMOs can reduce the impact of debt overhang by reducing the gross financing needs of the budget in the short to medium term. To signal credibility of the macroeconomic adjustment program and to save more on the interest bill, a portion of new debt can be linked/indexed to exchange rate (see the Turkiye’s 2001 swap below), consistent with medium-term foreign exchange (FX) risk and debt management objectives.

Such market-friendly LMOs may avoid a damaging Selective Default (SD) rating classification for sovereign debt, thus allowing central banks to continue conducting Open Market Operations and other transactions using government securities (which they may be bound by their own legislation to avoid in case of SD ratings or their domestic equivalents).

The success of the proposed operation will depend critically on the credibility of the overall adjustment effort. An IMF-supported adjustment/stabilization program, aided by viable fiscal adjustment and a strong reserve position, could help enhance credibility of the overall policy framework and provide a much-needed backstop. The benefits of the proposed operation would be greater the greater confidence-induced decline in interest rates after the announcement of the adjustment program. It is noteworthy that many “sticks” and “carrots” described in IMF (2021) in application to conventional DDRs will work well in the context of LMOs, making them more likely to succeed.

While not necessary, some IFI funding set aside for such operations could markedly increase chances of success. Such funds could be made available by making a potential IMF-supported program disbursement front-loaded to the extent possible, with resources explicitly earmarked for “domestic use.” However, funds needed to make such LMOs successful will be much smaller than funding necessary to secure the financial stability of a typical DDR (a la Jamaica Financial System Support Fund, which housed nearly a $950 million from IFIs). Such a commitment from the IFIs, if accompanied by a credible and strong fiscal consolidation program, could help shorten the time necessary to conduct the LMO and improve the chances of its success.

A practical application

Turkiye’s (2001) domestic debt swap is a good example of how these LMOs could be structured and help reduce debt-related pressures on the budget. In June 2021, Turkiye’s Treasury announced a swap intended to exchange high-cost, short-maturity Turkish lira debt for longer-term and dollar-indexed debt. The transaction was announced on June 12, for delivery of bonds to Central Bank and Auction bids to be submitted by June 15. The deal was closed on June 17, the entire operation lasting less than a week.

As a result of the swap, a total of TL 9.8 quadrillion ($8.4 billion; or roughly 9% of total banking sector assets) in securities with an average maturity of 5.7 months, were exchanged for bonds with average maturity of 39.2 months, significantly reducing the rollover risk of the portfolio. The swap reduced interest expense on domestic debt from above 70% per annum (when interest on six-month T-bills was nearing 80%) to less than 15% per annum. The new securities consisted of a mix of three- and five-year USD-indexed lira bonds (roughly a third of the new stock of bonds), paying a coupon of six-month LIBOR plus a margin of 2.85%, and lira-denominated one- and two-year bonds, paying 55% for first 6 months with subsequent payments of three-month T-bill rate plus 5%.² The authorities used a Dutch Auction to set up a competitive market pricing mechanism for the yield of the newly issued securities.

The operation benefited from the credibility of the IMF-supported program and was tailored to meet the gross financing needs of the budget during the program period. The success of the swap played an important role in stabilizing government finances post-stabilization.