Fiscal Policy and Workouts from Debt Crises

Much of the discussion of the risks of sovereign debt crises has focused on the issue of currency risk. This has led to the recommendation that countries should borrow in their local currency. Yet in the drive to develop local markets, many countries are running up domestic debt burdens. Although domestic debt has the advantage over foreign debt that it is not subject to a currency mismatch, countries are still forced to use scarce budget resources to repay the debt, and if the debt gets overly large, a country can run the risk of a debt crisis. There are many reasons that some countries have begun to accumulate large domestic debt burdens including financing external debt buybacks, sterilizing capital inflows, or financing domestic programs. In Indonesia’s case, a costly bailout of the banking system following the 1997 crisis left Indonesia saddled with a domestic debt burden.