Sovereign Debt Sustainability with Domestic Debt Markets

Published on: 18/06/26

By: Aitor Erce, 

As governments rely more on domestic debt, this paper examines the implications for sovereign debt sustainability and asks whether the IMF's LIC Debt Sustainability Framework (LIC DSF) remains suited to this changing reality.

  • The paper shows that domestic and external debt influence macroeconomic outcomes through different channels, shaping fiscal and monetary policy trade-offs, debt management strategies, and sovereign default risks.
  • It highlights how governments often treat domestic and external debt differently during crises, with important implications for debt restructuring and crisis resolution.
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The paper argues that the current LIC DSF continues to place disproportionate emphasis on external debt, leaving domestic debt largely as a residual component of the analysis.

This limits the framework's ability to produce realistic macroeconomic projections, assess vulnerabilities accurately, and support effective policymaking.

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The paper proposes reforms to better integrate the domestic–external financing mix into debt sustainability analysis, including improved macroeconomic scenarios and realism checks, revised debt-carrying-capacity assessments, and domestic-debt-specific risk thresholds. It also discusses the implications for future reforms of the G20 Common Framework and for the design of sovereign debt crisis resolution mechanisms.