## ppea2020010 - EXECUTIVE SUMMARY

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### Framework and purpose
- Provides a framework for public lenders and borrowers to assess collateralized financing practices from a development perspective, in response to a request from the G20 IFA Working Group.
- Describes main dimensions of collateralized debt instruments, pros and cons, technical and macroeconomic considerations, and a decision process to ensure consistency with the G20’s Operational Guidelines for Sustainable Financing.
- Prepared by an IMF team led by Mark Flanagan (SPR), with inputs from Rodrigo Garcia-Verdu (SPR); Yan Liu and Wolfgang Bergthaler (LEG); and a World Bank team led by Doerte Doemeland, consisting of Diego Rivetti, Andre Proite (all EMFMD), with inputs from Susan Maslen, Ximena Talero (all LEG) and Daniel Villar (CROCR). Approved by Jeromin Zettelmeyer (IMF) and Marcelo Estevão (World Bank). January 24, 2020.

### Key findings and judgments
- Collateralization may permit market access and transactions that otherwise would not occur, but can entail significant pitfalls; whether benefits outweigh drawbacks requires case-by-case assessment and depends inter alia on the institutions and legal processes of the borrowing country.
- Collateralized finance is more likely to lead to beneficial outcomes if:
  - (i) the transaction produces assets or revenue streams that can be used for repayment (as opposed to financing consumption or the general fiscal deficit);
  - (ii) the reduced risk resulting from collateralization is reflected in improved financial terms;
  - (iii) a rigorous debt sustainability assessment is passed;
  - (iv) there is full, public transparency on all contractual terms;
  - (v) collateralization respects and complies with any applicable Negative Pledge Clauses (NPCs).
- Transparent non-recourse project finance can generally meet these tests.
- Collateralized financing could be harmful in two key circumstances:
  - When a transaction does not produce an asset or revenue stream that can be used for repayment, and the volume of the transaction raises broader financing or debt distress concerns.
  - When the transaction does not involve adequate transparency and disclosure, impeding future creditors’ ability to correctly assess risks and lend sustainably.

### Relationship to IMF–World Bank Multi-Pronged Approach (MPA)
- The note contributes to the MPA pillars on transparency, capacity building, analytical tools, and IFI policies for sustainable lending.
- Aims to encourage greater transparency, build capacity for analysis of collateralized transactions, and inform policy reviews including the IMF’s Debt Limits Policy (DLP) and World Bank’s Sustainable Development Financing Policy (SDFP).

### Observations on prevalence and patterns
- Dealogic data (which captures syndicated sovereign commercial borrowing and bonds but excludes collateralized lending by export credit agencies) suggests a slight increase in collateralized lending since 2007 from a relatively low level.
- Reliance on collateralized syndicated bonds and loans is concentrated:
  - most borrowers do not use collateralized syndicated debt finance;
  - the share of collateralized syndicated finance in total syndicated finance exceeds 25 percent in 20 percent of countries and 50 percent in about 10 percent of countries.
- Collateralization by public sector borrowers tends to be higher in times of stress, or in lending to countries with a risky borrower profile (e.g., due to their high debt or inherent volatility).
- Use of collateralization is higher among non-investment grade and non-rated countries than among investment grade countries.
- Low-income countries classified as commodity producers (and their resource-producing state enterprises) tend to use collateralized debt instruments heavily at times.

### Definitions and acceptable collateral
- Collateralized: creditor has rights over an asset or revenue stream that would allow it, if the borrower defaults, to rely on that asset or revenue stream to secure repayment; legally entails granting liens over specific existing assets or future receivables or arrangements with equivalent effect.
- Future receivables can be financial amounts (e.g., US$) or physical amounts (e.g., barrels of crude oil).
- Any asset identifiable, isolable, attributable a value, or providing predictable cash flow can serve as collateral.
- Acceptable collateral examples: cash; stocks and negotiable bonds; irrevocable letters of credit; certificates of deposit; assignment of receivables (export earnings, electricity generation charges, road tolls, telecom receipts); physical assets (buildings, ports, industrial plants).

### Classification dimensions for collateralized transactions
- Economic nature of the collateral:
  - Existing or future asset (stock) versus future flow or stream (future receipts/receivables).
- Relationship between collateral and the original transaction:
  - Related collateral (financing used to purchase/construct an asset; that asset or its future receipts secure the debt).
  - Unrelated collateral (e.g., a budget loan collateralized with oil receivables).
- On-balance-sheet (direct) versus off-balance-sheet (indirect) borrowing:
  - Direct: government or public enterprise pledges specified assets/receipts as collateral for debt incurred by that entity.
  - Indirect: collateral assigned to a special purpose vehicle (SPV) which grants collateral to creditors; SPV-issued securities holders have no claim against the government or public enterprise (subject to case-by-case legal assessment and GFSM 2014 classification).
- Marketable versus non-marketable instruments:
  - Marketable instruments (notes, commercial paper, bonds) can be traded on secondary markets, tend to face stricter oversight and may generate better borrowing terms; diffuse ownership can complicate restructurings.
  - Non-marketable instruments are illiquid and typically subject to different oversight and terms.

### Typical groupings and examples (high-level)
- Collateralized trade financing: generally non-marketable, indirect, uses related collateral.
- Collateralized project financing: generally non-marketable, indirect; can use related or unrelated collateral.
- Other secured transactions: repo-style sovereign borrowing involves sale and repurchase of securities with securities provided as collateral; economically similar to collateralized loans because risks and rewards of ownership remain with the original owner.

### Decision process and institutional needs (summary)
- The note lays out the needed institutions and legal framework in borrowers and a decision process for public lenders and borrowers (general government entities, state enterprises, agencies acting on their behalf) to determine whether to engage in collateralized transactions.
- Emphasizes case-by-case assessment, full transparency, rigorous debt sustainability analysis, and compliance with legal constraints (e.g., NPCs and GFSM 2014 classification of SPVs).

### Pros and cons for lenders (section 10)
- Pros:
  - Collateral can increase the security of repayment and reduce the need to monitor the borrower (and the associated costs).
  - Collateralization can in principle allow lending in risky situations that would not otherwise be financed.
- Cons:
  - Collateralized creditors have a prior claim that legally or de facto subordinates other creditors, increasing the likelihood that unsecured creditors bear the full cost of arrears, default, or restructuring.
  - Failure by a borrower to disclose collateral affects future lenders since outstanding senior debt alters pricing of unsecured debt.
  - If collateral is difficult to enforce, expected recovery is unclear and burden-sharing in restructurings can become a source of friction.
  - Potential negative side effects for the borrower could undermine a longer-term development relationship, which lenders need to internalize.

### Pros and cons for borrowers (section 10)
- Pros:
  - Collateral can increase market access, reduce borrowing costs, or both.
- Cons:
  - Collateral can raise the risk of debt distress by:
    - (i) reducing budget flexibility through earmarking resources;
    - (ii) making it easier to overborrow in the absence of strong debt management;
    - (iii) impairing access to non-secured financing, particularly after bad shocks.
  - Collateral can complicate debt restructuring and increase the probability of arrears to unsecured creditors.
  - Improper disclosure can lead to problems with other lenders (e.g., NPCs, unmet information undertakings, permitted lien provisions) and additional risk premia on non-secured loans.
  - Complex collateralization structures can raise costs and contribute to transparency problems.

### Design issues (paragraph 11, A)
- Incentives:
  - Lenders and borrowers need to be alert to negative incentives and work to avoid them.
  - Lenders should consider whether collateral encourages overborrowing.
  - Related collateral may give the borrower weaker incentives to make a project succeed than unrelated collateral.
  - Weak linkage between project revenues and collateral increases the incentive for lenders to over-collateralize and reduces incentive to monitor project returns.
- Enforceability of collateral:
  - Collateral is valuable only if enforceable.
  - Borrowers must weigh improved terms against potential political impact of losing collateral.
  - Enforceability depends on collateral type and governing law/location of the asset.
  - Generally, large escrow accounts in the lender’s jurisdiction are most readily enforceable, followed by assets located outside the borrower’s jurisdiction; movable assets (e.g., oil cargoes) can be subject to enforcement; assets within the borrower’s jurisdiction are typically harder to enforce.
- Transparency:
  - Proper disclosure is vital to achieve sustainable financing and to prevent corruption (e.g., effective “privatization” of assets on highly advantageous terms to the lender).
  - Reporting arrangements are a key responsibility of the borrower; SOEs using collateralized borrowing need appropriate reporting regimes to government debt management authorities.
  - Lenders also have responsibility to promote disclosure; while some details may be confidential for commercial reasons, all lenders have a collective interest to ensure a minimum set of information is public, including asset, amount, nature of security.
- Complexity:
  - Avoid complex forms of collateralized lending; greater complexity makes it harder to assess all-in costs, increases transaction costs and legal risks, and contributes to non-transparency and corruption.
  - Additional costs can include export credit premia, remuneration of financial intermediaries, legal fees, and non-monetary “costs” (e.g., lender step-in rights).
  - Loans combining infrastructure development with resource collateral and repayment in resources-to-be-developed are highly undesirable.
- Better terms/value:
  - Granting collateral should be reflected in better terms for the borrower.
  - Borrowers must judge whether the transaction provides value and fits their overall debt management strategy, especially when collateral is partially enforceable or over-collateralization occurs.
  - Public lenders can aid by providing quotes both with and without collateral; borrowers can seek comparable transactions in other countries.

### Evaluating macroeconomic and financing implications (paragraph 12)
- Project returns:
  - Project viability needs careful assessment under a reasonable range of assumptions.
  - If a project generates a new and sufficiently large revenue flow, using that asset/flow as collateral should not impair repayment capacity to other creditors.
- Impact on other creditors and future financing:
  - Collateralization can enable borrowers to bridge financial distress, benefiting both borrower and existing creditors.
  - Sizeable borrowing can impair the value of unsecured loans and reduce access to conventional unsecured funding or increase its cost due to senior debt overhang.
  - Impact is amplified if existing lenders have negative pledge or permitted lien clauses and receive security to cure breaches, or if borrowing damages the borrower’s capital markets reputation.
- Impact on the risk of debt distress:
  - Sustainable lending requires evaluating debt distress risks and how a transaction affects repayment capacity.
  - Transactions creating related assets or revenues generally help repayment capacity.
  - Significant and sustained collateralized borrowing with unrelated collateral tends to raise liquidity crisis risk by subordinating unsecured creditors and depleting collateral stock.
  - Transaction setup matters: requiring physical commodity units for fixed dollar payments can force diversion of production to lenders during shocks, leaving little for other creditors; fixing repayment in physical units shifts price risk to the lender but protects against other sovereign distress risks.

### Considerations for securing beneficial development outcomes (paragraphs 13–16)
- Collateralized financing can be beneficial under a range of circumstances, requiring case-by-case assessment and institutional/legal processes for execution.
- From a development perspective, beneficial outcomes are more likely if:
  - (i) it produces related assets or revenue streams usable for repayment;
  - (ii) reduced risk is reflected in improved financial terms;
  - (iii) a rigorous debt sustainability assessment is passed;
  - (iv) there is full, public transparency on contractual terms;
  - (v) collateralization complies with applicable NPCs.
- Types of transactions:
  - Project-finance related collateralization can be designed to be beneficial with careful project design, full disclosure, fair value, and simplicity.
  - Collateralization involving unrelated assets/revenues undertaken at large scale to finance consumption is likely problematic: increases liquidity crisis risk, is hard to reverse, and creates debt resolution complications even if technical design is sound.
  - Many transaction types are intermediate and could be beneficial or harmful depending on design.

### Institutional, legal, and capacity requirements (paragraphs 16–18)
- Institutional arrangements:
  - Borrowers need internal and external arrangements to ensure proper transaction development and execution, including procedures to:
    - (i) properly review contractual terms for compliance with domestic law and obligations;
    - (ii) match commercial arrangements with legal details and post-financial-closing implementation of covenants;
    - (iii) limit corruption and self-dealing;
    - (iv) enhance transparency and accountability;
    - (v) ensure transaction consistency with overall debt strategy and macroeconomic framework;
    - (vi) ensure supervisory and back-office units have timely and unfettered input on transactions in real-time.
- Legal framework:
  - Borrowers should establish:
    - (i) the nature of assets/future revenues that can be used as security and the nature of projects eligible for collateralized debt (and profitability conditions);
    - (ii) procedures for transfer of receivables and notice requirements for repayment and consequences of non-notice;
    - (iii) responsibilities of the entity managing the secured commodity to the central government;
    - (iv) information disclosure requirements.
- Capacity:
  - Strong government capacity in legal, debt management, fiscal risk management (and debt sustainability analysis), and public investment management is critical.
  - Capacity reduces over-reliance on external advisers; IFI technical assistance can help build capacity.
  - Countries lacking strong institutions and capacity should be cautious about high volumes and complex transactions; appropriate decision-making procedures must be in place.

### Decision making, alternatives, exit strategies, and debt resolution (paragraphs 19–21)
- Vetting process and steps (aligning with G20 Operational Guidelines on Sustainable Financing and G-20 principles):
  - (i) assess how sustainability might be impacted, including stress tests of budget and financing flexibility in shock scenarios;
  - (ii) check proposed terms fairly account for value of the security and that financing reflects project value;
  - (iii) ensure legal and technical dimensions are fully understood;
  - (iv) assess how granting collateral impacts other financing within the country’s debt management strategy and compliance with existing NPCs.
  - Both lenders and borrowers must ensure proper disclosure.
- If due diligence cannot be completed:
  - Consider renegotiating loan terms and/or collateral (e.g., introduce greater risk-sharing); or not proceeding with collateralization.
- Exit strategies and debt resolution complications:
  - Exit strategies: countries with access to comparable alternative funding can pre-pay collateralized loans by issuing unsecured debt; countries could seek voluntary renegotiation offering alternative credit enhancements, such as guarantees.
  - Debt resolution complications: collateral can increase time and cost of crisis resolution. Partially secured creditors retain leverage, and burden-sharing considerations can prolong restructuring negotiations and delay IFI financing, creating macroeconomic drag.
  - Borrowers need legal advice on collateral implications and options in resolution situations.
  - Lenders and borrowers should be pragmatic in resolution situations involving imperfectly enforceable collateral and coordinate through established fora to achieve timely outcomes.

*International Monetary Fund*

### EXECUTIVE SUMMARY

### ppea2020010 - EXECUTIVE SUMMARY

### Framework and purpose
- Provides a framework for public lenders and borrowers to assess collateralized financing practices from a development perspective, in response to a request from the G20 IFA Working Group.
- Describes main dimensions of collateralized debt instruments, pros and cons, technical and macroeconomic considerations, and a decision process to ensure consistency with the G20’s Operational Guidelines for Sustainable Financing.

### Key findings and judgments
- Collateralization may permit market access and transactions that otherwise would not occur, but can entail significant pitfalls; whether benefits outweigh drawbacks requires case-by-case assessment and depends inter alia on the institutions and legal processes of the borrowing country.
- Collateralized finance is more likely to lead to beneficial outcomes if:
  - (i) the transaction produces assets or revenue streams that can be used for repayment (as opposed to financing consumption or the general fiscal deficit);
  - (ii) the reduced risk resulting from collateralization is reflected in improved financial terms;
  - (iii) a rigorous debt sustainability assessment is passed;
  - (iv) there is full, public transparency on all contractual terms;
  - (v) collateralization respects and complies with any applicable Negative Pledge Clauses (NPCs).
- Transparent non-recourse project finance can generally meet these tests.
- Collateralized financing could be harmful in two key circumstances:
  - When a transaction does not produce an asset or revenue stream that can be used for repayment, and the volume of the transaction raises broader financing or debt distress concerns.
  - When the transaction does not involve adequate transparency and disclosure, impeding future creditors’ ability to correctly assess risks and lend sustainably.

### Relationship to IMF–World Bank Multi-Pronged Approach (MPA)
- The note contributes to the MPA pillars on transparency, capacity building, analytical tools, and IFI policies for sustainable lending.
- Aims to encourage greater transparency, build capacity for analysis of collateralized transactions, and inform policy reviews including the IMF’s Debt Limits Policy (DLP) and World Bank’s Sustainable Development Financing Policy (SDFP).

### Observations on prevalence and patterns
- Dealogic data (which captures syndicated sovereign commercial borrowing and bonds but excludes collateralized lending by export credit agencies) suggests a slight increase in collateralized lending since 2007 from a relatively low level.
- Reliance on collateralized syndicated bonds and loans is concentrated: most borrowers do not use collateralized syndicated debt finance; the share of collateralized syndicated finance in total syndicated finance exceeds 25 percent in 20 percent of countries and 50 percent in about 10 percent of countries.
- Collateralization by public sector borrowers tends to be higher in times of stress, or in lending to countries with a risky borrower profile (e.g., due to their high debt or inherent volatility).
- Use of collateralization is higher among non-investment grade and non-rated countries than among investment grade countries.
- Low-income countries classified as commodity producers (and their resource-producing state enterprises) tend to use collateralized debt instruments heavily at times.

### Definitions and acceptable collateral
- Collateralized: creditor has rights over an asset or revenue stream that would allow it, if the borrower defaults, to rely on that asset or revenue stream to secure repayment; legally entails granting liens over specific existing assets or future receivables or arrangements with equivalent effect.
- Future receivables can be financial amounts (e.g., US$) or physical amounts (e.g., barrels of crude oil).
- Any asset identifiable, isolable, attributable a value, or providing predictable cash flow can serve as collateral.
- Acceptable collateral examples: cash; stocks and negotiable bonds; irrevocable letters of credit; certificates of deposit; assignment of receivables (export earnings, electricity generation charges, road tolls, telecom receipts); physical assets (buildings, ports, industrial plants).

### Classification dimensions for collateralized transactions
- Economic nature of the collateral:
  - Existing or future asset (stock) versus future flow or stream (future receipts/receivables).
- Relationship between collateral and the original transaction:
  - Related collateral (financing used to purchase/construct an asset; that asset or its future receipts secure the debt).
  - Unrelated collateral (e.g., a budget loan collateralized with oil receivables).
- On-balance-sheet (direct) versus off-balance-sheet (indirect) borrowing:
  - Direct: government or public enterprise pledges specified assets/receipts as collateral for debt incurred by that entity.
  - Indirect: collateral assigned to a special purpose vehicle (SPV) which grants collateral to creditors; SPV-issued securities holders have no claim against the government or public enterprise (subject to case-by-case legal assessment and GFSM 2014 classification).
- Marketable versus non-marketable instruments:
  - Marketable instruments (notes, commercial paper, bonds) can be traded on secondary markets, tend to face stricter oversight and may generate better borrowing terms; diffuse ownership can complicate restructurings.
  - Non-marketable instruments are illiquid and typically subject to different oversight and terms.

### Typical groupings and examples (high-level)
- Collateralized trade financing: generally non-marketable, indirect, uses related collateral.
- Collateralized project financing: generally non-marketable, indirect; can use related or unrelated collateral.
- Other secured transactions: repo-style sovereign borrowing involves sale and repurchase of securities with securities provided as collateral; economically similar to collateralized loans because risks and rewards of ownership remain with the original owner.

### Decision process and institutional needs (summary)
- The note lays out the needed institutions and legal framework in borrowers and a decision process for public lenders and borrowers (general government entities, state enterprises, agencies acting on their behalf) to determine whether to engage in collateralized transactions.
- Emphasizes case-by-case assessment, full transparency, rigorous debt sustainability analysis, and compliance with legal constraints (e.g., NPCs and GFSM 2014 classification of SPVs).

*Prepared by an IMF team led by Mark Flanagan (SPR), with inputs from Rodrigo Garcia-Verdu (SPR); Yan Liu and Wolfgang Bergthaler (LEG); and a World Bank team led by Doerte Doemeland, consisting of Diego Rivetti, Andre Proite (all EMFMD), with inputs from Susan Maslen, Ximena Talero (all LEG) and Daniel Villar (CROCR). Approved by Jeromin Zettelmeyer (IMF) and Marcelo Estevão (World Bank). January 24, 2020.*

### 10. Collateralized transactions can have pros and cons for both lenders and borrowers:

### 10. Collateralized transactions can have pros and cons for both lenders and borrowers

### Pros and cons for lenders
- Collateral can increase the security of repayment and reduce the need to monitor the borrower (and the associated costs). Collateralization can in principle allow lending in risky situations that would not otherwise be financed.
- However:
  - While the creditor whose loan is secured may benefit, other creditors are legally or de facto subordinated as collateralized creditors have a prior claim on resources that the government could otherwise have used towards meeting the claims of unsecured creditors. The creation of a senior class of debt increases the likelihood that unsecured creditors only will bear the full cost of the debtor incurring arrears, default, or undertaking a debt restructuring.
  - In the event that the borrower does not properly disclose the existence of collateral, even future lenders can be affected, since the level of outstanding senior debt affects the pricing of unsecured debt.
  - If collateral is difficult to enforce, it is no longer obvious what creditors can expect to recover. In such a setting, the presence of collateral could induce additional frictions on how to share the burden of a restructuring across creditors but in this instance burden sharing arrangements can become a source of friction across creditors.
  - A lender also needs to internalize that potential negative side effects for the borrower could undermine a longer-term development relationship.

### Pros and cons for borrowers
- Collateral can increase market access, reduce borrowing costs, or both.
- However, collateral can have negative impacts:
  - The presence of collateral can raise the risk of debt distress through multiple channels: (i) by reducing budget flexibility (through the earmarking resources); (ii) in the absence of strong debt management, by making it easier to overborrow; and (iii) by impairing access to non-secured financing, particularly after bad shocks. These problems can arise even when collateralized borrowing is fully transparent.
  - The presence of collateral can complicate a debt restructuring, including by increasing the probability of arrears to unsecured creditors. The possibility of restructuring debt is an implicit way in which borrowers and lenders share risk. The greater the extent of collateralization, the greater the share of risk born by the borrower (as well as unsecured creditors).
  - Improper disclosure exacerbates these problems, including by leading to problems with other lenders (e.g., in connection with NPCs, unmet information undertakings and permitted lien provisions). It can also lead to additional risk premia on non-secured loans.
  - Complex collateralization structures can both raise costs and contribute to transparency problems.

### Design issues (paragraph 11, A)
- Incentives:
  - Lenders and borrowers need to be alert to negative incentives that such transactions can create for each other, and work to avoid these.
  - A lender needs to consider whether the use of collateral may be contributing to overborrowing (which can affect overall creditworthiness).
  - The lender also needs to be aware that the use of related collateral, while generally desirable, may give the borrower weaker incentives to make a project succeed than unrelated collateral.
  - A borrower needs to internalize that the weaker the link between project revenues and the revenues that serve as collateral, the higher the incentive for the lender to over-collateralize and the lower the lender’s incentives to monitor the economic rate of return of the financed project.
- Enforceability of collateral:
  - Collateral is of little benefit and cannot motivate improved terms and conditions for a public lender unless it is enforceable.
  - A borrower must weigh improved borrowing terms against the potential loss of collateral, which could have significant political impact.
  - Enforceability depends on the type of collateral and the governing law of the jurisdiction in which it is located.
  - Generally speaking, large escrow accounts in the lender’s jurisdiction are the most readily enforceable (but typically cover only a small portion of the loan), followed by assets located outside the borrowers’ jurisdiction (e.g., equity shares in a company). Movable assets (e.g., oil cargoes) can also be subject to enforcement actions. Assets within the borrower's jurisdiction are typically harder to enforce.
- Transparency:
  - Proper disclosure is vital to help public lenders and borrowers achieve sustainable financing practices and to prevent corruption (e.g., the effective “privatization” of assets on highly advantageous terms to the lender).
  - Reporting arrangements are critical and are a key responsibility of the borrower. For SOEs that use collateralized borrowing, appropriate reporting regimes to government debt management authorities need to be in place.
  - Lenders also have a responsibility to promote disclosure; commercial interest may argue for some precise details to be preserved as confidential and kept out of the public domain, but all lenders have a collective interest to ensure that a minimum set of information is made available including asset, amount, nature of security.
- Complexity:
  - Public lenders and borrowers should avoid complex forms of collateralized lending. Greater complexity makes it more difficult to assess all-in costs, especially in countries where capacity is weak.
  - Complexity can translate into higher transaction costs and legal risks, contribute to non-transparency and corruption, and include additional costs such as export credit premia, remuneration of financial intermediaries, legal fees, and non-monetary “costs” (e.g., lender step-in rights and other lender controls over management and disposal of the secured asset).
  - Adding features—e.g., loans combining infrastructure development with resource collateral and repayment in resources-to-be-developed—is highly undesirable.
- Better terms/value:
  - The granting of collateral should be reflected in better terms and conditions for the borrower, reflecting the lower risk of non-collection on the loan.
  - A public borrower must judge whether the transaction as a whole provides value and fits within its overall debt management strategy, especially when collateral is partially enforceable, when there is over-collateralization, or when alternative sources of finance are available.
  - A public lender can help by providing a quote both with and without collateral while the borrower can seek information from other countries’ transactions in similar circumstances.

### Evaluating macroeconomic and financing implications (paragraph 12)
- Project returns:
  - Project returns need careful assessment, with project viability evaluated under a reasonable range of possible assumptions about driving factors.
  - If a project results in a new asset which generates a new and sufficiently large flow of revenues, a country’s capacity to repay the loan and other creditors should in principle not be impaired by using the asset or flow of revenues as collateral.
- Impact on other creditors and future financing:
  - Collateralization can enable borrowers to bridge times of financial distress, which is in the interest of both the borrower and existing creditors.
  - When borrowing is sizeable enough (which is case-specific) it can impair the value of existing unsecured loans and reduce access to more conventional unsecured funding and/or increase its cost (i.e., due to an overhang of senior debt).
  - This impact can be increased to the extent that other existing lenders have negative pledge or similar clauses (e.g., permitted lien clauses) and receive security from borrowers pursuant to the clause or in order to cure a breach of the clause, and more broadly to the extent that it damages the borrowers’ reputation with capital markets.
- Impact on the risk of debt distress:
  - Sustainable lending requires careful evaluation of debt distress risks, beginning with an assessment of how the transaction could enhance the borrowers’ repayment capacity.
  - Transactions involving creation of (related) assets or revenue streams will generally help repayment capacity.
  - Significant and sustained collateralized borrowing, using collateral unrelated to the original transaction, tends to raise the risk of a liquidity crisis, because it increasingly subordinates unsecured creditors and depletes the stock of collateral that could be used for additional collateralized lending.
  - Transaction setup matters: requiring physical units of a commodity as collateral for fixed dollar payments can require all physical production to be diverted to lenders when there are large shocks (leaving little left for other creditors). Risks associated with fluctuation in market prices will be borne solely by the debtor. Fixing repayment in terms of physical commodity units would shift these risks to the lender while still protecting the lender against other risks that may induce sovereign debt distress.

### Considerations for securing beneficial development outcomes (paragraphs 13–16)
- Collateralized financing can be beneficial under a range of circumstances, requiring case-by-case assessment. Borrowing countries need to establish institutions and legal processes to support effective assessment and execution.
- From a development perspective, a collateralized transaction is more likely to lead to beneficial development outcomes if:
  - (i) it produces assets or revenue streams that can be used for repayment (i.e. “related assets/revenues”);
  - (ii) the reduced risk resulting from collateralization is reflected in improved financial terms;
  - (iii) a rigorous debt sustainability assessment is passed;
  - (iv) there is full, public transparency on all contractual terms;
  - (v) collateralization respects and complies with any applicable Negative Pledge Clauses (NPCs).
- Types of transactions:
  - Project-finance related collateralization can generally be designed to be beneficial with careful project design, full disclosure, fair value, and simplicity.
  - Collateralization involving unrelated assets or revenues, when undertaken on a large scale to finance government consumption, is likely to be problematic: large-scale transactions of this sort increase the risk of a liquidity crisis, are challenging to reverse, and create debt resolution complications—even if technical design issues are handled well.
  - Many transaction types fall between these extremes and could be either beneficial or harmful depending on design.

### Institutional, legal, and capacity requirements (paragraphs 16–18)
- Institutional arrangements:
  - Borrowers need internal and external arrangements to ensure proper transaction development and execution, including procedures that aim at:
    - (i) proper review of contractual terms to ensure compliance with domestic legislation and existing obligations;
    - (ii) matching commercial arrangements with legal details and post-financial-closing implementation of transaction covenants and requirements;
    - (iii) limiting the prospect of corruption and self-dealing;
    - (iv) enhancing transparency and accountability;
    - (v) ensuring consistency of each transaction with a borrower's overall debt strategy and the country’s macroeconomic framework;
    - (vi) ensuring supervisory and back-office units have timely and unfettered review and input on transactions in real-time.
- Legal framework:
  - Borrowers should establish (among other elements):
    - (i) the nature of assets or future revenues that can be used as security and the nature of projects that can be financed through collateralized debt (and the profitability conditions to be set);
    - (ii) the procedures that need to be followed for the transfer of receivables and the notice that needs to be given to the lender that the debt is being repaid and the consequences of not giving those notices;
    - (iii) the responsibilities and obligations of the entity in charge of the management of the commodity—being the secured asset—to the central government;
    - (iv) the requirements for information disclosure.
- Capacity:
  - Strong government capacity in legal, debt management, fiscal risk management (and debt sustainability analysis), and public investment management is critical.
  - Capacity guards against over-reliance on external advice; technical assistance from IFIs can help fill gaps and build capacity over time.
  - Countries without strong institutions and capacity should be particularly careful and generally cautious about higher volumes and complex forms of such transactions. Appropriate decision-making procedures need to be in place for all countries.

### Decision making, alternatives, exit strategies, and debt resolution (paragraphs 19–21)
- Vetting process and steps (aligning with G20 Operational Guidelines on Sustainable Financing and G-20 principles):
  - (i) a careful assessment of how sustainability might be impacted (including stress tests covering how much budget and financing flexibility would be retained in shock scenarios);
  - (ii) a check that the proposed terms and conditions account fairly for the value of the security given, and the amount of financing reflects the value of the project;
  - (iii) a check that the legal and technical dimensions of the proposed structure are fully understood by the parties;
  - (iv) a careful assessment of how the granting of collateral might impact other financing, in the context of the country’s debt management strategy (recognizing also that existing negative pledge clauses of other lenders are complied with).
  - Both lenders and borrowers have a responsibility to ensure proper disclosure.
- If due diligence cannot be completed:
  - Consider renegotiating the terms and conditions of the loan and/or the collateral (e.g., including greater elements of risk-sharing in the financing); or not proceeding with collateralizing the transaction.
- Exit strategies and debt resolution complications:
  - Exit strategies: Countries that retain access to alternative sources of funding at comparable costs can pre-pay collateralized loans by issuing unsecured debt. Countries could also seek voluntary re-negotiation with creditors by offering alternative credit enhancement techniques, such as guarantees.
  - Debt resolution complications: Collateral can raise the time and cost of a debt crisis resolution. Even partially secured creditors retain more leverage, and burden sharing considerations may draw out debt restructuring negotiations, which in turn may delay financing from IFIs. Delays in completing restructurings create macroeconomic drag, which is beneficial neither for the borrower nor for creditors as a whole.
  - Borrowers need to understand from their legal advisors the potential implication of the collateral that they are taking on, and in the event of a resolution situation, their options.
  - Both lenders and borrowers need to be pragmatic in the event of a resolution situation involving collateral that is not perfectly enforceable, and seek ways to coordinate, including through established fora, with a view to achieve a timely outcome.

*International Monetary Fund*

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_Source: https://www.imf.org/-/media/files/publications/pp/2020/english/ppea2020010.pdf_