IMF warns domestic debt restructurings give modest relief but deepen recessions

The International Monetary Fund’s Fiscal Affairs Department has released a new working paper, “Tread with Care: Benefits and Costs of Domestic Debt Restructurings” (WP/25/179), authored by Jean-Marc Atsebi and Jeta Menkulasi. Building on work by the IMF, the Bank for International Settlements, and leading academic research institutes, the study turns its lens on a subject often overshadowed by external debt crises: the restructuring of obligations governed by domestic law. By analyzing 142 emerging markets and developing economies between 1987 and 2021, the authors offer a comprehensive account of when domestic debt restructurings (DDRs) occur, what they achieve, and the steep trade-offs they impose on economies.

Rising Reliance on Domestic Debt

Over the past four decades, domestic debt has shifted from being a marginal financing option to a central pillar of sovereign borrowing in many emerging and low-income countries. This reliance surged in the 1990s as governments deepened local markets and reduced dependence on foreign creditors. During the COVID-19 pandemic, the trend accelerated when many countries lost access to international markets and had little choice but to issue debt domestically. According to IMF estimates, global public debt is expected to surpass $100 trillion, equivalent to 93 percent of world GDP, by 2024 and could reach 100 percent by 2030. In this landscape, DDRs are likely to become more frequent. Yet the paper highlights an uncomfortable reality: they deliver only modest fiscal relief while inflicting lasting economic pain.

Small Fiscal Gains, Large Economic Losses

The authors’ calculations show that DDRs reduce public debt by an average of 7.9 percentage points of GDP over a five-year horizon. This is far less than the 20-point debt reduction typically secured in external debt restructurings with either private or official creditors. Interest payments also fall, by about a quarter of a percentage point of GDP, but again, the relief is smaller than in external deals. On the economic side, the costs are heavy. Five years after a DDR, GDP remains nearly 4 points below its pre-crisis path, while credit to the private sector shrinks by close to 2 points of GDP. By contrast, external restructurings often prove less damaging, and in some cases, with official creditors, they even boost growth over the medium term. The contrast highlights the structural dilemma of DDRs: they help governments balance books but do so by undermining domestic growth engines.

Design Choices Define Outcomes

Not all DDRs are created equal, and their design determines how severe the consequences will be. Face-value reductions deliver the deepest debt relief but trigger the sharpest recessions and longest credit crunches. Maturity extensions ease repayment burdens more gently, achieving moderate relief with smaller economic losses. Coupon reductions effectively lower interest bills but often stress banks and lead to credit contractions. Post-default restructurings, typically carried out under duress, are the messiest and most disruptive. The paper also finds that restructuring bank loans is more damaging than restructuring bonds, since banks are usually the main creditors and their impaired balance sheets transmit shocks across the economy. The evidence underscores that governments cannot treat DDRs as uniform; each design choice carries trade-offs that policymakers must weigh carefully.

Unequal Burdens Across Economies

The costs and benefits of DDRs differ sharply between low-income countries (LICs) and emerging markets (EMs). LICs, with less developed financial systems, tend to secure greater debt relief with relatively moderate economic pain. For these economies, GDP declines are smaller and credit contractions shorter-lived, reflecting weaker transmission channels between government defaults and private financial systems. EMs, on the other hand, face harsher outcomes: deeper and longer recessions, tighter credit conditions, and smaller fiscal gains. The degree of sovereign-bank nexus, how much banks rely on government debt, also matters. Where banks are heavily exposed, DDRs cause sharp declines in both GDP and lending, amplifying the economic fallout.

Buffers and Safeguards Can Soften the Blow

Despite the sobering evidence, the study points to measures that can cushion the damage. Countries with large foreign reserves emerge stronger, as these buffers provide liquidity to stabilize markets and protect currencies during turbulent periods. IMF-supported programs also make a difference, offering not just financial support but also credibility and a framework for fiscal adjustment. Under such programs, the paper finds, DDRs deliver more meaningful debt relief with fewer negative economic side effects. In contrast, restructurings carried out in isolation, especially in countries with shallow reserves, often fail to provide significant fiscal relief while inflicting severe economic contractions. The message is clear: DDRs may be unavoidable in certain circumstances, but their success hinges on careful design, adequate buffers, and international support.

The IMF paper closes with a warning as sharp as its title. Domestic debt restructurings are neither cure-alls nor outright disasters; they are complex and risky instruments that can restore sustainability but also easily backfire. Unlike external deals, they strike at the very institutions, banks, pension funds, and domestic investors that anchor financial stability and support economic growth. For low-income countries, the trade-off may tilt in favor of DDRs, but for emerging markets with deeper financial systems, the risks are far higher. The ultimate decision will always depend on country-specific circumstances, yet the evidence leaves no doubt: governments that choose this path must tread with care.