Developing nations face new debt peril as IMF flags local market vulnerabilities

A groundbreaking IMF paper, prepared jointly by economists from the International Monetary Fund, the World Bank, and the Paris School of Economics, sheds light on a new and unsettling reality: debt crises in developing countries are no longer confined to foreign creditors. Increasingly, governments are being forced to renegotiate debts owed to their own citizens, banks, and pension funds. Drawing on recent cases in Ghana, Sri Lanka, Suriname, and Zambia, the study offers the most detailed account yet of how domestic debt crises emerge, how they are being managed, and what lessons they hold for countries facing fiscal distress in a world of tighter financial conditions.

From External Defaults to Domestic Distress

For decades, debt distress was synonymous with defaults on loans from foreign creditors. That pattern is shifting. As developing nations deepened their local financial markets over the past two decades, they issued more debt in domestic currency to reduce exposure to exchange-rate shocks. However, the very success of this strategy has now become a new source of vulnerability. Local banks, pension funds, and insurance firms have become major financiers of their governments, and when fiscal positions weaken, these domestic institutions are directly at risk.

The IMF paper explains that in the aftermath of the pandemic and global interest rate hikes, many developing economies found themselves unable to roll over domestic debt without crippling their financial sectors. Governments faced a grim choice: restructure what they owe at home, or face a full-blown financial meltdown. The report notes that this type of crisis is not merely financial; it strikes at the heart of public trust, as citizens watch the value of their savings, pensions, and investments decline.

Ghana’s Painful Precedent

Among the case studies, Ghana’s 2023 domestic debt exchange stands out as the most consequential. Confronted with a fiscal crisis, inflation above 40 percent, and a collapsing currency, Ghana’s government restructured roughly 130 billion cedis, about 10 percent of GDP, through a voluntary bond exchange that extended maturities and slashed interest rates. Officials promised to protect pensioners and small investors, but the shock to the financial system was severe. Local banks suffered capital losses, credit growth stalled, and the central bank was forced to inject liquidity to stabilize markets.

The IMF economists describe Ghana’s effort as “necessary but painful,” a difficult balancing act between restoring solvency and preserving confidence. The operation offered temporary breathing space, yet exposed the fragility of a financial system heavily dependent on government securities. Ghana’s experience, the authors conclude, will likely serve as a model, and a cautionary tale, for other countries contemplating domestic debt restructuring in the years ahead.

Balancing Relief with Stability

The paper contrasts Ghana’s experience with that of Jamaica, which successfully restructured its domestic debt twice, in 2010 and 2013, without destabilizing its financial sector. Jamaica’s success, the authors argue, lay in early recognition of unsustainability, open dialogue with creditors, and credible government communication. In contrast, countries that delayed decisive action, such as Sri Lanka and Suriname, faced deeper recessions and prolonged uncertainty.

The report distills several lessons: act early, communicate clearly, and protect the financial system. Domestic debt restructuring, it warns, must always be coupled with safeguards such as liquidity facilities, bank recapitalization mechanisms, and depositor protections. Otherwise, attempts to fix public finances can inadvertently trigger a banking crisis. The paper’s data show that in economies where domestic banks hold more than half of government debt, a poorly managed restructuring can lead to sharp contractions in lending, a fall in GDP, and loss of investor confidence.

A Social and Political Tightrope

Beyond economics, the paper underlines the political and human dimensions of domestic debt restructuring. Citizens are far more sensitive to domestic losses than to external defaults. In several countries, including Ghana and Sri Lanka, street protests erupted as pensioners and civil servants feared losing their life savings. The IMF authors acknowledge that domestic debt operations are politically explosive, testing the limits of social tolerance and the legitimacy of governments. They recommend that policymakers pair fiscal measures with social protection programs and transparent explanations to sustain public support. “The success of a domestic debt restructuring,” the paper notes, “depends not only on its design but on the public’s belief in its fairness.”

Building a Framework for the Future

In its concluding chapters, the paper calls for a new international framework for domestic debt restructuring. It urges that the G20 Common Framework for Debt Treatments explicitly include domestic debt, recognizing that local and foreign creditors are increasingly intertwined. The IMF and World Bank also recommend stronger legal systems, robust financial market infrastructure, and pre-established crisis management tools to support orderly operations. Preparing in advance, the authors say, is far less costly than improvising during a collapse.

Ultimately, the paper argues that domestic debt restructuring is here to stay. As global interest rates remain elevated and fiscal space narrows, more developing countries will be forced to turn inward to restore solvency. But doing so without undermining financial confidence will require delicate political leadership and precise technical execution. The report closes with a stark warning: the next wave of debt crises will be fought not in foreign courts, but in domestic markets, among a nation’s own savers, banks, and pensioners. How these crises are managed will determine whether developing economies emerge more resilient or face a prolonged erosion of financial and social stability.