State Contingent Debt Instruments For Sovereigns

Background. The case for sovereign state-contingent debt instruments (SCDIs) as a countercyclical and risk-sharing tool has been around for some time and remains appealing; but take-up has been limited. Earlier staff work had advocated the use of growth-indexed bonds in emerging markets and contingent financial instruments in low-income countries. In light of recent renewed interest among academics, policymakers, and market participants—staff has analyzed the conceptual and practical issues SCDIs raise with a view to accelerate the development of self-sustaining markets in these instruments. The analysis has benefited from broad consultations with both private market participants and policymakers. The economic case for SCDIs. By linking debt service to a measure of the sovereign’s capacity to pay, SCDIs can increase fiscal space, and thus allow greater policy flexibility in bad times. They can also broaden the sovereign’s investor base, open opportunities for risk diversification for investors, and enhance the resilience of the international financial system. Should SCDI issuance rise to account for a large share of public debt, it could also significantly reduce the incidence and cost of sovereign debt crises. Some potential complications require mitigation: a high novelty and liquidity premium demanded by investors in the early stage of market development; adverse selection and moral hazard risks; undesirable pricing effects on conventional debt; pro-cyclical investor demand; migration of excessive risk to the private sector; and adverse political economy incentives.

These annexes accompany the IMF Policy Paper State Contingent Debt Instruments for Sovereigns

This paper shows that the optimal sovereign lending contract is state-contingent when a government can default. It provides a theoretical basis for the specification of optimal state-contingent debt instruments (SCDIs) in countries subject to large shocks that can be observed and verified by all parties involved, such as natural disasters or global pandemics. The result is obtained as the endogenous solution to a contracting problem under time-inconsistency when a government cannot credibly commit to honor debt service obligations in all possible states of nature. It is shown that rational investors optimally offer SCDIs that include additional financing when the default constraint is binding, keeping the debtor engaged in the contractual relationship and avoiding asset loss. The debtor benefits because the contract implies net-positive financing when facing a large shock, increasing concurrent welfare, while maintaining access to financing in the future for consumption smoothing at the same terms as with precommitment. SCDIs require maintaining debt at a low level compared to the precommitment case, and also a fiscal consolidation when triggered to contain the increase in debt. Extension of the time inconsistency problem to add the taxation of capital returns shows that the optimal physical capital investment is also state-contingent.

State-contingent debt instruments such as GDP-linked warrants have garnered attention as a potential tool to help debt-stressed economies smooth repayments over business cycles, yet very few studies of the empirical properties of these instruments exist. This paper develops a general f ramework to estimate the time-varying risk premium of a state-contingent sovereign debt instrument. Our estimation framework applied to GDP-linked warrants issued by Argentina, Greece, and Ukraine reveals three stylized facts: (i) the risk premium in state-contingent instruments is high and persistent; (ii) the risk premium exhibits a pro-cyclical pattern; and (iii) the liquidity premium is higher and more volatile than that for plain-vanilla government bonds issued by the same sovereign. We then present a model in which investors fear ambiguity and that can account for the cyclical properties of the risk premium.

The COVID-19 crisis may lead to a series of costly and inefficient sovereign debt restructurings. Any such restructurings will likely take place during a period of great economic uncertainty, which may lead to protracted negotiations between creditors and debtors over recovery values, and potentially even relapses into default post-restructuring. State-contingent debt instruments (SCDIs) could play an important role in improving the outcomes of these restructurings.

This paper studies state-contingent debt as an alternative refinancing instrument for advanced economies. In times of high sovereign indebtedness, increasing yields impose eminent debt roll-over risks. We analyze the welfare implications of two state-contingent debt instruments: puttable and GDP-to-debt-indexed bonds, both temporary in nature and intended to improve deleveraging feasibility. In return for an insurance premium, puttable bonds offer protection against sovereign default, thereby internalizing the implicit risk-sharing mechanism inherited by the ECB's "Outright Monetary Transactions" program. Similar to GDP-linked debt, bonds indexed to a country's GDP-to-debt ratio, henceforth "GDR bonds," allow for consumption smoothing via state-contingent interest payments. In contrast to GDP-linked debt, GDR bonds permit competitive risk-return profiles even in the face of pessimistic growth outlooks. We find that, in the presence of default costs, state-contingent bonds allow for substantial welfare improvements relative to standard sovereign debt. For risk-averse consumers, the counter-cyclical fiscal leeway created by GDR bonds dominates the interest savings provided by puttable bonds. We verify this preference order by calibrating our model to the five Eurozone countries most heavily affected by the debt crisis: Portugal, Ireland, Italy, Greece, and Spain. We discuss implied deleveraging incentives, limited commitment, and practical implementation issues for GDR bonds.

This paper surveys the literature on sovereign debt from the perspective of understanding how sovereign debt differs from privately issue debt, and why sovereign debt is deemed safe in some countries but risky in others. The answers relate to the unique power of the sovereign. One the one hand, a sovereign has the power to tax, making debt relatively safe; on the other, it also has control over its territory and most of its assets, making debt enforcement difficult. The paper discusses debt contracts and the sovereign debt market, sovereign debt restructurings, and the empirical and theoretical literatures on the costs and causes of defaults. It describes the adverse impact of sovereign default risk on the issuing countries and what explains this impact. The survey concludes with a discussion of policy options to reduce sovereign risk, including fiscal frameworks that act as commitment devices, state-contingent debt, and independent and credible monetary policy.

The euro-area sovereign debt crisis is receding. Europe is on a recovery path, growth is broad-based and unemployment is falling. One after the other, countries hit hardest by the crisis are exiting their adjustment programmes. However, debt remains high in most countries and future debt crises should not be ruled out. While the memories are fresh, it is a good time to think about insurance against future shocks. Such insurance schemes must involve risk sharing with the markets. They weaken the bank-sovereign doom loop from the sovereigns' side, and not just from the banks' side as pursued by the banking union, and make for a more resilient euro area.The promotion of the banking union and the establishment of a European Monetary Fund are institution-based solutions to crises. Banking union provides the safety regulations that will make banking institutions more resilient, while the EMF is a 'fire brigade' to be called on in emergencies. What has not been tapped are the markets, whose tolerant behaviour to sovereign demands encouraged the built up of debt, while their finicky response exacerbated the crisis.Taking ongoing G20 discussions on sovereign contingent debt as the point of departure, we argue that these instruments could provide market-based insurance to protect the euro area from future debt crises. Risk-sharing with the markets is a constructive way forward in the context of the Franco-German debate on risk-sharing among states versus system-wide risk reduction. The financial innovation of contingent debt is a practical euro-area reform that would not introduce risk-sharing between states or require institutional reforms or Treaty changes. However, coordination would be needed.

Addresses approaches to sovereign debt crises and the role of private creditors in risk-sharing and resolution of sovereign debt crises.

Addresses approaches to sovereign debt crises and the role of private creditors in risk-sharing and resolution of sovereign debt crises.