# **1. Introduction**

The focus of interest in emerging market countries’ debt is shifting to government domestic debt. In the past, developing countries suffered numerous foreign exchange crises that were often associated with large foreign debt. Correspondingly, interest in their debt was focused on foreign debt. However, since the mid-1990s, government domestic debt has grown in importance in developing countries, as has researchers’ interest in it.<sup>1</sup> The growth in government domestic debt reflects various factors. The banking crises of the last 15 years led to substantial issuance of government domestic debt, both to recapitalize banks and to fund governments when the supply of foreign loans declined. Since then, governments in both crisis and non-crisis countries have continued to rely increasingly on domestic debt. It is attractive to governments because its costs have fallen compared to the past and relative to foreign debt. These lower costs partly reflect improvements in their macroeconomic situation and the growth of new buyers, domestic and foreign. Governments also may perceive domestic debt as less volatile than foreign debt after the experience with the crises of the last 15 years and matching the currency of their revenues. In addition, the growth of government domestic debt has well-known positive spillovers in the development of private capital markets. Growing academic interest in government domestic debt reflects the possibility that it may reduce some of the problems associated with the crisis-generating cutoffs of international capital flows – “Sudden Stops”—and with borrowing in foreign currency — “Original Sin”.<sup>2</sup> Many authors nonetheless argue that the main risk related to government debt remains its size relative to a country’s GDP and, probably more importantly, the country’s fiscal, financial, and political structure, not the location or currency of debt issue.<sup>3</sup> This paper argues that while the composition of debt, for example, foreign or domestic, may have some importance, it should not be overstated. For example, excessive debt and negative shocks can contribute to a “Sudden Stop” in the demand for government domestic debt as well as for a country’s foreign debt. To some extent, the current attractiveness and low cost of domestic debt may reflect the benign international environment, not fundamental changes. In addition, not only is domestic government debt not a clear solution to the aforementioned problems, it carries its own risks and burdens within the economy through its potential impacts on the financial system. This paper examines these risks and burdens and makes suggestions to reduce them.

> 1 See for example, Borensztein, Chamon, Jeanne, Mauro, and Zettelmeyer. 2004; Borensztein, LevyYeyati, and Panizza, 2006; Cowan, Levy-Yeyati, Panizza, and Struzenegger, 2006, IMF, 2003; Jeanne, 2006, and Mehl and Reynaud, 2005. Christensen, 2005, looks at issues associated with government domestic debt in African countries. Hanson 2003 included a discussion of the growth of holdings of government debt by banks in developing countries in the 1990s. World Bank IMF 2001 and World Bank 2007a, and 2007b discuss ways to develop the government debt market and manage government debt. 2 See for example Calvo, 1998 and Eichengreen and Hausman, 2004.

3 See for example, IMF, 2003 and Gill and Pinto, 2005. Reinhart, Rogoff, and Savastano, 2003 focus more on high foreign debt and raise the issue of the difficulty of reducing it and the problems of serial default. Borensztein, Levy-Yeyati, and Panizza, 2006, recognize the importance of political and fiscal structure in the risks associated with debt, but also raise the importance of the structure of debt.