Contingent Sovereign Debt’s Emergency Appeal
After months of public and private sector consultations the IMF completed a policy paper at the request of the G-20 on promoting use of state contingent debt instruments (SCDIs) adjusted to continuous economic indicators like GDP or singular events such as natural disasters. They are recognized for countercyclical and risk-sharing features, and recent development institution focus has been on commodity hedging for low-income countries. Recently in Argentina’s and Ukraine’s restructurings growth-linked warrants were offered, but the concept has yet to gain widespread acceptance even in current global low-yield conditions inviting alternatives. As an automatic stabilizer they “preserve space” in bad times , but other tools are available to serve this purpose including foreign reserve accumulation, fiscal rules, commercial insurance, and central bank swap lines. However these backstops all have downsides and are not as accessible as well-designed long-term SCDIs in principle, which also increase securities diversification and the global financial system “safety net,” according to the Fund. Previous simulations show that introduction of GDP-tied bonds can raise the national debt limit before crisis by dozens of points as a fraction of output. The natural investor base would not be commercial banks or other mark-to-market buyers, but so called real money participants that can balance country welfare with asset returns. They nonetheless demand high novelty yields to compensate for liquidity and performance doubts, which would be magnified with data frequency and reporting gaps. For troubled countries the advance cost could spike, and until a track record develops moral hazard could argue that officials will not be as motivated to tackle macro and structural economic weakness. For issuers the operation must be the responsibility of independent debt managers to avoid political considerations and short-term time horizons, and to prepare in the context of asset class trends and sentiment swings. These combined factors argue for gradual testing within strictly-defined gain and loss boundaries, with ratings agencies brought in at an early stage, the study believes.
Official lenders like France’s development agency already provide counter-cyclical facilities to poor countries, and both advanced and emerging economies have adopted inflation-adjusted obligations and contingency features have entered sovereign debt rescheduling since the 1990s Brady Plan. Value recovery rights were in a dozen transactions, with half in detachable form, but the experience has often been indexation lags and undue complexity impeding further adaptation. Nonetheless investors surveyed were open to fresh pilots, on the assumption that pricing may be up to 50 basis points over conventional offerings at the outset. Legal and regulatory treatment should be equal to other instruments, and standard contracts and benchmark issues are preferred, with jurisdiction choices London and New York. Commodity exporters, small states, and emerging markets with shallow local bond activity are potential priority initial borrowers. Pension funds controlling $40 trillion are natural takers but may be confined to hard currency investment-grade exposure. The Islamic finance sector, currently with over $150 billion in sovereign and quasi-sovereign sukuks outstanding, would also be a likely target along with insurers and reinsurers. The document proposes three design versions, one with an automatic maturity extension trigger upon adverse statistics or events. It suggests that official creditors could add guarantees or otherwise work to galvanize multiple attempts through balance sheet and technical support, but concludes urgency is lacking.
