Even before the global negative economic shock resulting from the COVID-19 pandemic, a report by the World Bank (2020) noted that total developing country debt in 2018 had increased by 54 percentage points of total developing country GDP since 2010. Post pandemic, new problems emerged. These include the failure of G20’s Debt Service Suspension Initiative (only Chad, Zambia, and Ethiopia have applied for relief) and the reversal of capital flows from lower and idle income countries in the Global South back to high income countries in the Global North. More lower- and middle-income countries have defaulted, even those who haven’t defaulted have, in the face of rising bond yields and capital flow reversals, have tried to stave off default by cutting expenditure on health and education and low carbon transitions. In the face of potential insolvency, this slowdown of investment in the SDGs makes their achievement by 2030 unlikely (World Bank 2024).

The 2022 economic crisis in Sri Lanka is a case in point, a combination of bad policy choices and bad luck. Certainly, the pandemic, the conflict between Russia and Ukraine, and the resulting rise in global commodity prices are all partly to blame and could not have been anticipated. But poor policy choices by a corrupt, authoritarian governing elite also made Sri Lanka uniquely vulnerable.

Sri Lanka’s governing elites are not alone in making these kinds of poor policy choices. Recent examples include the banking crisis in Lebanon and before that the financial crisis in the eurozone in the 2010s was the result of a similar mix of bad policy choices and bad luck, as was the 1990s Asian financial crisis before it (Corsetti et. al. 1998a, 1998b), and the Latin American crisis (Devlin and French-Davis 1995) in the 1980s.

There is evidence that such repeated episodes of crises and subsequent austerity could end up diminishing the capacity of the debtor state to govern effectively (Blouin et al. 2025). The costs of default are primarily borne by domestic citizens. In contrast, domestic elites, who have access to global financial markets, can mitigate these costs even when ordinary citizens can’t. For example, the total savings of Argentinian citizens in foreign bank accounts equalled the total amount of Argentinian external debt in 2001 when it defaulted (Ghosal and Miller 2003). Evidently, the costs associated with sovereign default are unequally distributed within the debtor state (Stuckler and Basu 2014).

The conventional view is that such default costs are necessary to ensure that the debtor state makes policy choices that lower the probability of default in the first place. In doing so, the interest rates at which sovereigns can borrow should become lower (due to lower default risk) leading to ex ante welfare gains as well.

However, as the Argentinian default of 2001 demonstrates, if political power rests in the hands of a domestic elite who can partially insure themselves against the cost of default, then it isn’t clear that costly debt restructuring will lower the probability of default and lead to ex ante welfare gains. Premature capital account liberalization, whereby capital controls are relaxed by lowering the cost of capital flowing in and out of countries, can have the perverse effect of increasing the probability of default (see Ghosal and Miller 2003; Blouin et al. 2025).

Bolton and Skeel (2007) and Guzman and Stiglitz (2016) highlight the problem of inter-creditor inequity between ‘formal creditors’, such as a West European pension fund buying sovereign bonds, and ‘informal creditors’ within the debtor state itself, such as pensioners who have contributed to the state social security fund, or workers who have paid into the public insurance system, whose claims are based on the social contract between the debtor state and its citizens. Yet in a bailout situation, these informal creditors withstand the worst of austerity, including cuts to social security programmes.

Ghosal and Thomas (2023) examine the conditions under which, conditional on an economy-wide negative shock, lowering the costs of sovereign debt restructuring also lowers the interest rate charged ex ante on sovereign debt: these are ex ante and interim efficiency gains. They show, in a simple proof-of-concept theoretical model, that the participation of informal creditors in the decision to restructure debt results in both ex ante and interim efficiency gains, while effectively addressing equity concerns. Their results imply that when informal creditors play a role in debt restructuring:

  • Early warning indicators (based on the experience of domestic citizens reliant on government services and payments) of an impending debt crisis become more salient.
  • Debt restructuring is more likely to be conducted in a timely fashion after informal creditors conclude that the debtor state is not able to service its existing debt liabilities, and the terms of restructuring (the haircut, changes in the duration of debt servicing) are more likely to restore sustainability.
  • Post-debt restructuring will be effective in reducing the need for subsequent debt restructuring.

In 2015, the UNCTAD (2015) published a debt workout roadmap that proposes referendums at key points in the lead-up to a bailout to ensure that the domestic citizens see the options available for debt restructuring and get a chance to vote on them. Ghosal (2025) elaborates further by setting out the elements of  a roadmap that involves informal creditors at each step of a sovereign debt workout.

The motivation behind the UNCTAD roadmap was to prevent the recurrence of what has become a common feature of debt crises: the ‘socialization of losses from private debts and the subsequent emergence of sovereign debt crisis in developing and developed countries’ (UNCTAD 2015: 3). The UNCTAD roadmap aims to enhance ‘coherence, fairness and efficiency of sovereign debt workouts.’ (UNCTAD 2015: 3).

For debt workouts to restore debt sustainability, both ex-ante and interim efficiency must be achieved. This limits the problem of ‘too little too late’ by explicitly accounting for the impact of workouts on informal creditors.

This blog follow’s Prof Sayantan Ghosal’s background note for the United Nations University World Institute for Development Economics Research.

Read the full publication on the UNU-WIDER website. 

First published: 22 April 2025

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Professor Sayantan Ghosal

UNU WIDER project