## pp032317state-contingent-debt-instruments-for-sovereigns

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### EXECUTIVE SUMMARY — Background and rationale
- SCDIs (sovereign state-contingent debt instruments) link debt service to a measure of the sovereign’s capacity to pay to increase fiscal space and allow greater policy flexibility in bad times.
- Potential benefits:
  - Broaden sovereign investor base, open investor risk diversification, enhance international financial system resilience.
  - If SCDI issuance accounted for a large share of public debt, could significantly reduce incidence and cost of sovereign debt crises.
- Key complications to mitigate:
  - Novelty and liquidity premia in early markets.
  - Adverse selection and moral hazard.
  - Undesirable pricing effects on conventional debt.
  - Pro-cyclical investor demand and migration of excessive risk to the private sector.
  - Adverse political economy incentives.
- Three benchmark SCDI designs discussed: “Linkers”, “Floaters”, and “Extendibles”.
- Official sector roles proposed:
  - Tailored country advice, technical assistance for statistical and debt management capacity.
  - Support for model contracts, incorporate SCDIs into DSAs and fiscal rules.
  - More ambitious options: official underwriting/guarantees, official test issuance, or coordinated issuance by several sovereigns.

### The economic case for SCDIs — illustrative analytic findings
- Continuous-adjustment SCDIs (e.g., GDP-linked bonds): can reduce variance of unexpected changes in the debt-to-GDP ratio.
- Discrete-adjustment SCDIs (e.g., extendible bonds, event-triggered deferrals): can stabilize gross financing needs (GFNs).
- SCDIs especially helpful where:
  - initial debt is high;
  - growth and primary deficit are volatile;
  - interest-rate–growth differential variance is high;
  - exposure to large one-off shocks is significant;
  - near-term debt service or refinancing risk is substantial.

### Simulations and quantitative results (Box 2)
- Assumptions: GDP-linked bonds with principal and coupon linked to nominal GDP; high return volatility premium of "around 200 bps"; GDP-linked bonds transfer all downside risk to investors; novelty/liquidity premia abstracted.
- If GDP-linked bonds made up 20 percent of the debt stock, the sovereign’s debt limit would increase by:
  - "around 15 percentage points of GDP for advanced economies"
  - "8 percentage points for emerging markets"
- All-debt-as-GDP-linked parallel exercise:
  - Debt limit increased by "15–70 percent of GDP in a representative advanced economy", depending on growth uncertainty assumptions.
- Text Table: Debt Limits with Various Instrument Designs (percent of GDP)
  - All countries:
    - Baseline debt limit: 52
    - Debt limit - 100% local currency: 78
    - Debt limit - 100% local currency; 20% GDP linked: 80
    - Debt limit - 100% local currency; 50% GDP linked: 84
  - Advanced economies:
    - Baseline debt limit: 137
    - Debt limit - 100% local currency: 137
    - Debt limit - 100% local currency; 20% GDP linked: 152
    - Debt limit - 100% local currency; 50% GDP linked: 175
  - Emerging markets:
    - Baseline debt limit: 58
    - Debt limit - 100% local currency: 98
    - Debt limit - 100% local currency; 20% GDP linked: 106
    - Debt limit - 100% local currency; 50% GDP linked: 120
  - Low income countries:
    - Baseline debt limit: 40
    - Debt limit - 100% local currency: 54
    - Debt limit - 100% local currency; 20% GDP linked: 54
    - Debt limit - 100% local currency; 50% GDP linked: 52
- Table 1 — Volatility Risk Premium estimates (CAPM, estimated premium in bps)
  - All Countries / S&P500 / 17
  - All Countries / MSCI World bond index / 36
  - G20 / Global equities / 27
  - G20 / US equities / 24
  - United States / US equities / 150

### Past experience and market feedback — lessons learned
- Issuance in normal times: sporadic; many SCDIs appear as targeted, non-tradeable instruments or as features in restructurings.
- Key lessons:
  - Confidence in integrity, availability, and timeliness of data is essential.
  - Simple and consistent instrument design improves acceptability.
  - Political economy challenges can impede adoption; loss aversion among issuers is common.
- Market feedback — sovereigns:
  - Most surveyed sovereigns consider current instruments adequate; none had near-term plans to issue SCDIs; some see medium-term roles.
  - Debt management offices more skeptical; central banks more open.
- Market feedback — investors:
  - Heterogeneous views; some openness if design is simple and standardized.
  - Preferences and concerns:
    - Fixed income investors favor GDP- or commodity-linked bond-style instruments over one-off adjustments.
    - Reinsurers favor disaster-linked extendibles.
    - Demand for upside features and common use of floors; some investors expect sovereigns to retain some upside via caps.
    - Data integrity and legal/regulatory clarity are critical.
  - Risk premia on SCDIs could be "20–30 bps" over comparable conventional bonds (investor responses).

### Deficiencies of the existing toolkit and additional SCDI benefits
- Deficiencies:
  - Self-insurance (reserves) inefficient and politically vulnerable.
  - Conventional debt does not mitigate solvency effects of large macro shocks.
  - Commodity hedges and catastrophe insurance: short horizon, expensive, counterparty risk.
  - Official liquidity support: may be slow or inaccessible for smaller economies.
- Additional benefits of SCDIs:
  - Increased diversification: nominal GDP-linked bonds preserve absolute purchasing power and align returns with real economy.
  - More resilient financial system: facilitate market-based expectations, encourage investor monitoring of fundamentals.
  - Reduction in probability of sovereign debt crises: easing payments in stress can lower default probability; staff simulations show significant potential gains at scale.

### Conditions for an SCDI market to emerge
- Preconditions:
  - Scope for diversification of risks: SCDI returns should correlate with investor liabilities or be uncorrelated with investor assets.
  - Divergent issuer and investor expectations on the state variable path and risks makes trades more likely.
  - Differential tolerance of risk: appeal to investors who can withstand short-term return fluctuations.
- Potential complications and mitigants:
  - (i) Novelty and liquidity premia: standardization, robust contract design, coordinated issuance reduce premia.
  - (ii) Adverse selection and moral hazard: issuer retains some conventional debt "skin in the game"; use exogenous, independently verifiable state variables; caps/floors.
  - (iii) Political economy incentives: delegate issuance to independent debt managers; external verification and penalties for manipulation.
  - (iv) Adverse effects on conventional debt: limit SCDI share (e.g., "10–25 percent of total debt"); avoid seniority over other debt.
  - (v) Risk migration and amplification: regulatory frameworks and design features (caps/floors) to limit investor losses; monitor private-sector concentration.

### Recommended sequencing and overall judgment (paragraph 13)
- Gradual, incremental issuance appropriate for countries with right characteristics; avoid rapid, large-volume issuance due to moral hazard and market effects.
- Recommended approach:
  - Start issuance incrementally—“perhaps starting in good times.”
  - Carefully integrate SCDIs into debt markets and sovereign portfolios.
  - Initial designs should include limits on upside and downside sharing.
- Optimal steady-state share of SCDIs varies by country and instrument type.

### SCDIs in restructurings — experience and design lessons
- SCDIs common in restructurings (Brady deals, Argentina 2005/2010, Greece 2012, Ukraine 2015, Grenada 2015).
- Key lessons:
  - State variable selection must be closely tied to repayment capacity and credible/understood by investors.
  - Indexation lags and persistent state variables are problematic (Argentina GDP warrants example).
  - Complexity raises volatile pricing, low liquidity, and high premia.
  - Upside instruments help bridge expectation gaps between debtors and creditors.
- Table 3 — Selected restructuring examples and design details (selected figures preserved)
  - Argentina (2005 & 2010) — Pays out 5% of real GDP in excess of reference; Total payments capped at 48% of notional principal; Haircut: 29.8%/ 76.8%; Period covered: 20 years.
  - Greece (2012) — Pays out 1.5 times real GDP growth in excess of reference growth; Annual cap at 1%; Haircut: 53.5%/ 64.6%; Period covered: 27 years.
  - Ukraine (2015) — Pays out 15% of real GDP growth between 3-4% and 40% in excess of 4%; No payments unless nominal GDP > USD 125.4bn; Annual cap 1% of GDP from 2021-2025; Haircut: 20%/ 28%; Period covered: 20 years.
  - Grenada (2015) — CBI revenue-linked payments: Pays out 25% of CBI proceeds between US$15mn-50mn and 35% above US$50mn; Discounted value capped at 35% of outstanding principal; Haircut: 50% (of which 25% upfront)/ 54%; Period covered: 15 years.
  - Grenada hurricane clause — 6 month deferral if modelled loss > USD 15mn & < USD 30mn; 12 month deferral if modelled loss > USD 30mn; Trigger can be used up to 3 times; Period covered: 13 years.

### Benchmark instruments and standardization — three designs
- Rationale: standardization across a subset of state variables/triggers important to achieve liquidity and scale.
- (i) “Linker”
  - Currency: Local currency
  - State variable examples: Level of nominal GDP; level of commodity price index
  - Adjustment: Principal linked to GDP; coupon fixed percentage of principal; principal may be floored.
  - Tenor: >=5 years, including perpetuity bond
  - Purpose: Stabilizes debt/GDP over cycle and tail events; supports counter-cyclical policy; reduces default risk
  - Limitations: Equity-like features; data integrity concerns for nominal GDP in EMs/LICs; caps/floors recommended.
  - Text table: Real GDP vs. Deflator during Bad Times (group averages)
    - Advanced Economies: Real GDP -6.4% ; GDP deflator -0.4% ; CPI 3.8%
    - Emerging Markets: Real GDP -4.5% ; GDP deflator 16.1% ; CPI 15.4%
    - Low Income Countries: Real GDP -5.6% ; GDP deflator 16.5% ; CPI 15.1%
- (ii) “Floater”
  - Currency: Local or foreign currency
  - State variable examples: Real GDP growth rate; commodity price change; trading partners’ real GDP growth
  - Adjustment: Coupon linked to growth of GDP with a floor of zero; principal fixed; coupon may be capped.
  - Tenor: >=5 years
  - Purpose: Provides debt service relief during recessions; does not assure stable debt ratio.
  - Protections: Coupon floor likely needed; ceiling may limit coupon surges.
  - Suitability: Particularly suitable for EMs and LICs where interest payments are a larger share of revenues.
- (iii) “Extendible”
  - Currency: Local or foreign currency
  - State variable examples: Discrete triggers tied to large adverse movements in external demand, commodity prices, exports, market indices, or natural/public health disasters
  - Adjustment: Pre-defined maturity extension by 1–3 years; possible coupon increase.
  - Tenor: Varies with trigger/extension.
  - Purpose: Provides liquidity support during distress; no direct impact on debt level.
  - Target investors: Insurers/reinsurers and investors tolerant of illiquidity; useful where triggers are independently verifiable.

### Box 6 — State variables/triggers outside government control (selected)
- Commodity prices:
  - Exogenous, easily observed, high correlation with GDP in commodity exporters (median correlation 0.85 across 13 major oil exporters).
  - Example extendible trigger: 20 percent oil price decline over 6 months (10th percentile of price changes).
- Natural disasters:
  - Discrete; suitable for extendible design using external damage estimates (e.g., CCRIF modelled damage used by Grenada).
- Merchandise exports:
  - Externally observable via importers’ data; AFD uses extension if goods exports fall below 95 percent of 5-year average.
  - Merchandise trade represents at least 75 percent of exports for over 2/3 of IMF membership.
- External demand (trading partner GDP):
  - For G20, median correlation of real GDP growth with trading partner-weighted real GDP growth is 0.765; median correlation for nominal GDP growth is 0.66.
- Domestic/global financial market shocks:
  - Triggers could use spreads (e.g., 600 bps spread indicator in IMF DSA); risk of exacerbating market volatility noted.

### Robust institutions, contract design, and regulation
- Institutional prerequisites:
  - Independent statistical agencies to mitigate data integrity concerns.
  - Strengthened debt management capacity for transparency and complexity handling.
- Contract design elements:
  - Clear payout methodology, lags (London termsheet suggests about six months), caps on upside payments, and floors for downside protection.
  - Seniority issues: avoid de facto seniority via CAC pools; consider enhanced CACs with sub-aggregation under single-limb CACs.
- Regulatory and market treatment:
  - Banking regulation likely to classify SCDIs as debt and require mark-to-market; capital charges for market risk could apply.
  - Insurers/pension funds may face fewer constraints and could be natural holders.
  - Regulatory treatment could include base capital charge plus counter-cyclical requirement tied to correlation with other balance-sheet items.
  - Credit rating agencies typically evaluate sovereign credit risk; most well-designed SCDIs should be ratable or fall under sovereign rating (example: U.K. inflation-linked Gilts).
  - Market indices: existing indices require minimum issuance and liquidity; large-scale issuance could prompt index and mandate changes.

### Market prospects, official-sector actions, and pathways to market development
- Near-term market prospects:
  - Sporadic issuance likely to continue over next 5–10 years; sporadic issuance alone unlikely to create self-sustaining liquid markets.
- Official-sector actions proposed:
  - Develop commonly agreed model contracts and “how-to-issue” guidance for benchmark SCDIs.
  - Provide technical assistance to sovereigns (debt managers, statistical agencies).
  - Issue guidance on SCDI use in restructurings and adjust DSAs and fiscal rules to account for state-dependent costs.
  - Leverage MDBs and official creditor balance sheets to underwrite or guarantee SCDIs; expand state-contingent features in official lending (e.g., AFD model).
- Market kick-start options:
  - Lead issuance by a major sovereign or institution to set benchmarks and lower premia.
  - Coordinated issuance by several sovereigns to overcome first-mover problems.
- Near-term actionable items:
  - Detailed discussions on regulatory treatment (capital charges, risk-weights, fiscal rules).
  - Continue technical work on floater and extendible contractual features; build on London termsheet for linker design.
  - Engage debt managers and market participants; staff to use June 2017 Debt Managers Forum for consultations.
  - Staff developed an Excel tool to illustrate benchmark impacts on debt levels and GFNs; proposed publication alongside the Board paper.

### Country groups, issuer suitability, and natural investor groups (high-level)
- Country-group distinctions affect SCDI suitability:
  - Commodity exporters and small states: high growth/primary balance volatility; suitable for commodity-linked bonds and extendibles with externally verifiable triggers.
  - EMs with deepened local currency markets: lower debt-to-GDP volatility; local currency GDP-linked bonds to non-residents may be useful.
  - Other EMs without established LCY markets: foreign-currency SCDIs (extendibles or growth-indexed FX bonds) may help.
  - LICs with shallow LCY markets: initial inclusion of state-contingent features in official lending may be more feasible.
- Selected quantitative group metrics (simple averages preserved exactly as presented)
  - AEs72 (45.8)114.53.92.7...
  - Euro-area members81 (10.5)115.04.42.7...
  - Small open economies42 (2.0)53.83.92.8...
  - Reserve currency issuers116 (33.2)214.32.22.5...
  - EMDCs50 (12.1)1010.27.24.113.555
  - Commodity exporters35 (1.0)69.815.57.311.335
  - Small States61 (<0.1)138.95.25.86.663
  - Local Currency issuers52 (9.3)135.54.42.412.816
  - Other EMs54 (1.3)107.95.82.122.060
  - Other LICs48 (0.5)914.75.83.113.971
- Stress statistic:
  - Median currency depreciation around sovereign stress episodes: 32 percent in emerging and low-income countries, compared to 2 percent in advanced economies.
- Natural investor groups identified:
  - “Natural hedge” investors: pension funds (assets: US$38 trillion) relative to global public debt US$58 trillion (end-2016).
  - Portfolio diversification investors: large mutual funds, sovereign wealth funds, reinsurers.
  - Islamic finance investors: Islamic finance sector ~ US$2 trillion; sovereign Sukuks ~ US$110 billion; quasi-sovereign Sukuks ~ US$50 billion (International Islamic Financial Market, 2016).
  - Insurers/reinsurers (insurance-linked securities market size: US$25.9 billion at end-2015).
  - Official sector lenders (Paris Club claims > US$300bn).

*STATE-CONTINGENT DEBT INSTRUMENTS FOR SOVEREIGNS — International Monetary Fund. March 23, 2017.*

### EXECUTIVE SUMMARY

### EXECUTIVE SUMMARY

### Background
- The case for sovereign state-contingent debt instruments (SCDIs) as a countercyclical and risk-sharing tool has long been recognized, but take-up has been limited.
- Earlier staff work advocated growth-indexed bonds in emerging markets and contingent financial instruments in low-income countries.
- Renewed interest among academics, policymakers, and market participants prompted staff analysis of conceptual and practical issues to accelerate development of self-sustaining markets in SCDIs.
- The analysis benefitted from broad consultations with private market participants and policymakers.

### The economic case for SCDIs
- Primary rationale:
  - By linking debt service to a measure of the sovereign’s capacity to pay, SCDIs can increase fiscal space and allow greater policy flexibility in bad times.
  - SCDIs can broaden the sovereign’s investor base, open opportunities for investor risk diversification, and enhance international financial system resilience.
  - If SCDI issuance accounted for a large share of public debt, it could significantly reduce the incidence and cost of sovereign debt crises.
- Potential complications to be mitigated:
  - A high novelty and liquidity premium demanded by investors in early 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.
  - Adverse political economy incentives.
- Illustrative analytic findings (Box 1 referenced):
  - Continuous-adjustment SCDIs (e.g., GDP-linked bonds) can reduce variance of unexpected changes in the debt-to-GDP ratio.
  - Discrete-adjustment SCDIs (e.g., extendible bonds or event-triggered deferrals) can stabilize gross financing needs (GFNs).
  - SCDIs are likely most helpful where: initial debt is high; growth and primary deficit are volatile; interest-rate–growth differential variance is high; exposure to large one-off shocks is significant; and near-term debt service or refinancing risk is substantial.

### Past experience of SCDIs and market feedback
- Issuance in normal times has been sporadic; SCDIs have been more common as features in recent restructurings.
- Key lessons from past experience:
  - Confidence in the integrity, availability, and timeliness of data is essential.
  - Simple and consistent instrument design improves acceptability.
  - Political economy challenges can impede adoption.
- Market feedback highlights a first-mover problem:
  - Most surveyed sovereigns consider their current menu of instruments adequate and have no near-term plans to issue SCDIs.
  - Some sovereigns see a role for SCDIs with positive medium-term prospects.
  - Investors’ views are varied but show some openness, with concerns about technical complexity.

### Considerations for market development
- Staff analysis suggests that careful instrument design, robust institutions, contracts, and regulation can help overcome key complications.
- Three potential benchmark SCDI designs discussed:
  - “Linkers”: bonds with principal (and coupon) linked to the level of a state variable.
  - “Floaters”: variable rate bonds with fixed principal and coupon linked to changes in a state variable.
  - “Extendibles”: bonds that push out maturity if a pre-defined trigger is breached.
- Design features to manage upside/downside sharing:
  - Use of “caps” to adjust the level of upside shared with investors.
  - Use of “floors” to adjust the level of protection sought by investors.
- State-variable/trigger considerations:
  - Prefer variables closely tied to government repayment capacity but exogenous (i.e., cannot be manipulated by the issuer sovereign).

### Ways forward (policy options and role of the official sector)
- Without intervention, sporadic issuance—either to meet tailored preferences or during restructurings—is likely to continue and will not lead to self-sustaining, liquid markets over the medium-term.
- The official sector could play an important role in spurring market development:
  - IFIs, including the Fund, can provide tailored country advice to improve sovereign capacity to issue SCDIs.
    - Guidance on benefits and costs of SCDIs.
    - Technical assistance for statistical agencies and debt management offices.
  - Support development of commonly agreed model contracts.
  - Better account for SCDIs in debt sustainability analyses and supranational fiscal rules.
  - More ambitious official interventions:
    - Official creditors could underwrite or guarantee SCDIs, or introduce state-contingent features into their lending.
    - A major sovereign or regional institution could undertake a ‘test issuance’ of an SCDI to lead the market.
    - Several sovereigns could coordinate and issue SCDIs simultaneously to overcome first-mover issues.

*STATE-CONTINGENT DEBT INSTRUMENTS FOR SOVEREIGNS — EXECUTIVE SUMMARY. International Monetary Fund. March 23, 2017.*

### 9.      However, for most sovereigns, the existing toolkit has deficiencies. For instance:

### pp032317state-contingent-debt-instruments-for-sovereigns - 9.      However, for most sovereigns, the existing toolkit has deficiencies. For instance:

### Deficiencies of the existing toolkit
- Self-insurance:
  - Can be inefficient and is vulnerable to political cycles.
  - "Excessive reserve accumulation represents an expensive and globally inefficient way to meet a country’s insurance needs (see Mateos y Lago and others 2009)."
  - Short-term political horizons mean buffers can get spent in good times and fiscal rules can be broken or manipulated, especially where discretion exists.
- Conventional debt instruments:
  - Not designed to mitigate the solvency effects of large negative macroeconomic shocks.
  - Long-term debt guards against refinancing risks but not against the impact on repayment capacity of, for example, "a sharp adverse macroeconomic shock."
  - Generalized shocks are "by far, the most frequent and the second most-costly (after banking crises)."
  - SCDIs are designed to help insulate solvency indicators such as the debt-to-GDP ratio from such shocks.
- Commodity hedges and natural catastrophe insurance:
  - Typically available over a short horizon, can be expensive, and exposes the sovereign to counterparty risk.
  - By embedding insurance within a financing (cash) instrument, SCDIs can potentially help sovereigns tap a broader investor base with longer horizons and avoid counterparty risk.
  - "The 'bundling' of the insurance and financing elements in SCDIs can help issuers arbitrage across (re)insurance and capital markets" and better integrate risk management.
- Official liquidity support:
  - May not be available or accessible on a timely basis for smaller economies; multilateral financing can take time to arrange.
  - Well-designed SCDIs can provide (some) immediate relief in bad times and can facilitate requests for Fund financing support.

### Additional benefits of SCDIs (paragraph 10)
- Increased diversification opportunities:
  - "Nominal GDP-linked bonds may be appealing to savers that seek to preserve both absolute and relative purchasing power."
  - The inflation component preserves absolute purchasing power; the real GDP component aligns returns with the 'average' earner.
  - May reduce funding reliance on domestic (or currency union) banks and weaken sovereign-bank linkages.
- More resilient domestic and international financial system:
  - Facilitate discovery of market-based macroeconomic expectations (e.g., real GDP growth).
  - Variable nominal returns encourage investors to monitor macro outlook and sovereign fundamentals, promoting more accurate pricing of sovereign risk and potentially reducing over-borrowing.
  - Can reduce official-sector support needs and associated moral hazard, complementing Global Financial Safety Net (GFSN) initiatives.
- Reduction in probability of sovereign debt crises:
  - By easing debt payments in stress, SCDIs can reduce likelihood of sovereign debt crises, especially if SCDI issuance becomes a substantial portion of the sovereign’s debt stock.
  - Research and "Staff’s own preliminary simulations" suggest large-scale SCDI issuance can reduce default probability and credit risk premia (see Box 2).

### Box 2 — Simulations and quantitative results
- Simulations with GDP-linked bonds (principal and coupon both linked to nominal GDP), using Ostry and others (2010) methodology:
  - If GDP-linked bonds made up 20 percent of the debt stock, the sovereign’s debt limit would increase by:
    - "around 15 percentage points of GDP for advanced economies"
    - "8 percentage points for emerging markets"
  - "LICs would benefit significantly from moving to local currency denominated debt, there would be little benefit from GDP-linked bonds of this design"
  - A parallel exercise with all debt held as GDP-linked debt showed the debt limit increased by "15–70 percent of GDP in a representative advanced economy", depending on growth uncertainty assumptions.
  - Simulations point to diminishing marginal benefits from increasing GDP-linked debt share above a certain level (Annex I).
  - Simulations assume a high return volatility premium of "around 200 bps" and that GDP-linked bonds transfer all downside risk to investors.
  - Caution: results abstract from novelty/liquidity premia and are sensitive to assumptions about the return volatility premium.

- Text Table: Debt Limits with Various Instrument Designs (percent of GDP)
  - All countries:
    - Baseline debt limit: 52
    - Debt limit - 100% local currency: 78
    - Debt limit - 100% local currency; 20% GDP linked: 80
    - Debt limit - 100% local currency; 50% GDP linked: 84
  - Advanced economies:
    - Baseline debt limit: 137
    - Debt limit - 100% local currency: 137
    - Debt limit - 100% local currency; 20% GDP linked: 152
    - Debt limit - 100% local currency; 50% GDP linked: 175
  - Emerging markets:
    - Baseline debt limit: 58
    - Debt limit - 100% local currency: 98
    - Debt limit - 100% local currency; 20% GDP linked: 106
    - Debt limit - 100% local currency; 50% GDP linked: 120
  - Low income countries:
    - Baseline debt limit: 40
    - Debt limit - 100% local currency: 54
    - Debt limit - 100% local currency; 20% GDP linked: 54
    - Debt limit - 100% local currency; 50% GDP linked: 52

- Table 1 — Estimates of the Volatility Risk Premium on GDP-linked Bonds (CAPM)
  - Coverage / Benchmark portfolio / Estimated premium (bps) / Source
    - All Countries / S&P500 / 17 / Staff estimates
    - All Countries / MSCI World bond index / 36 / Staff estimates
    - G20 / Global equities / 27 / Staff calculation using Bowman and Naylor (2016) estimates
    - G20 / US equities / 24 / Staff calculation using Bowman and Naylor (2016) estimates
    - United States / US equities / 150 / Kamstra and Shiller (2009)

### Conditions for an SCDI market to emerge (paragraph 11)
- There must be opportunities for ongoing mutually beneficial exchanges between issuers and investors.
- Sub-conditions increasing likelihood of exchange:
  - Scope for diversification of risks:
    - SCDI return should have (i) high correlation with investor liabilities; and/or (ii) low correlation with investor assets.
    - GDP-linked bonds may be a natural liability hedge for domestic institutions and individuals.
    - Asset return correlations between foreign GDP and established market benchmarks have been estimated to be relatively modest, suggesting prospects for satisfying (ii).
  - Divergent issuer and investor expectations on the state variable path and risks:
    - Trades more likely if expected payout on SCDI (adjusted for full range of risks) is lower for the sovereign than for investors.
    - Sovereign pessimism in boom periods or concern about tail risks can make issuance more attractive.
  - Differential tolerance of risk:
    - Investors with greater tolerance for bearing risk (less risk averse) are more willing to hold SCDIs at acceptable prices.
    - SCDIs most naturally appeal to investors who can withstand short-term return fluctuations rather than mark-to-market investors with strict mandates.
    - SCDIs can be viable even with exposure to global shocks if those with the 'deepest pockets' bear the risk.

### Potential complications (paragraph 12 and following)
- (i) Novelty and liquidity premia:
  - High novelty, liquidity, and model risk premia demanded by investors, especially if design is complex.
  - Liquidity premia expected to be high initially; may fall with supply but not disappear.
  - Model uncertainty premia may be large if there are questions about data integrity (e.g., nominal GDP data).
  - Standardization, robust contract design, and coordinated issuance by multiple sovereigns can reduce these premia over time.
- (ii) Adverse selection and moral hazard:
  - Adverse selection: investors may suspect that worse-off countries will be most eager to issue, leading to high compensation demands; issuers that would benefit most may not issue.
  - Moral hazard: paying high debt service in good times and receiving automatic relief in bad times can reduce incentives to avoid vulnerabilities.
    - Mitigants: SCDIs not replacing conventional debt entirely (issuer retains "skin in the game"); political incentives to avoid bad states; use of exogenous, independently verifiable state variables; caps and floors on relief; nominal GDP-linked bonds reduce scope to 'inflate away' real debt value.
- (iii) Undesirable political economy incentives:
  - Myopia of issuers: short-horizon policymakers may undervalue long-term benefits; possible mitigation by delegating issuance decisions to independent debt managers with long-term mandates.
  - Incentives for data manipulation: authorities may have incentives to misreport cyclical revenues or state variables; external verification, penalties, use of proxy indicators, and caps/floors can attenuate risks; consistent manipulation would be difficult to sustain in repeated games.
- (iv) Adverse effects on conventional debt markets:
  - Pricing impact: SCDIs could reduce default risk premium on conventional debt, but could also erode liquidity of existing instruments or be perceived as more senior; risk mitigants include limiting SCDI share (e.g., "10–25 percent of total debt") and avoiding seniority over other debt.
  - Decline in supply of 'safer' conventional assets: fixed-rate bonds serve as store of wealth and collateral; proponents do not expect SCDIs to fully replace conventional debt; SCDIs with floors and from "safe haven" issuers may still provide safe asset functions.
- (v) Risk migration and amplification:
  - Excessive risk migration to private sector: tail events could impose losses on domestic private investors ill-suited to bear them, causing pro-cyclical deleveraging and potential fiscal costs for sovereigns.
    - Less concerning when SCDI volumes are small relative to private balance sheets or held largely by international investors.
    - Importance of regulatory frameworks and design features (caps/floors) to limit investor losses.
  - Pro-cyclical investor demand: if investor expectations are highly pro-cyclical, demand for SCDIs could rise in good times and fall in bad times, amplifying boom-bust cycles.
    - Countervailing factors: longer maturities than business cycle, predictable business cycle behavior, investor focus beyond short-term cyclical variations, improved projection accuracy due to SCDI markets, and debt managers adhering to issuance calendars.

*Source: https://www.imf.org/-/media/files/publications/pp/pp032317state-contingent-debt-instruments-for-sovereigns.pdf*

### 13.      Overall, the balance of benefits and risk is likely to support a gradual approach to SCDI

### 13. Overall, the balance of benefits and risk is likely to support a gradual approach to SCDI issuance for some countries with the right characteristics

### Summary judgement and recommended sequencing
- Gradual, incremental issuance of state-contingent debt instruments (SCDIs) is likely appropriate for countries with the right characteristics; rapid, large-volume issuance could exacerbate moral hazard, affect conventional debt markets, and lead to excessive risk migration to the private sector.
- Recommended approach for supportive countries:
  - Start issuance incrementally—“perhaps starting in good times.”
  - Carefully integrate SCDIs into debt markets and sovereign portfolios.
  - Initial designs should include limits on upside and downside risk-sharing.
- The optimal steady-state share of SCDIs in a sovereign debt portfolio will vary with country characteristics and instrument types.

### Review of past experience and market feedback
- Purpose of section: summarize practical experience with SCDIs (including in restructurings) and present market participant feedback to identify impediments to market development.
- SCDI issuance in normal times:
  - Sovereigns have primarily used non-debt contingent instruments in normal times.
  - Sovereign debt managers in established markets have used interest and exchange rate hedges; markets for these instruments are well developed and similar to private-sector instruments.
  - Advanced economy sovereign debt largely denominated in local currency and fixed rates; the risks hedged by contingent instruments are often small relative to GDP risk.
  - Emerging markets and low-income countries used contingent financial instruments more sporadically, focused on commodity hedges and disaster risk insurance.
  - Standardized derivative products (such as commodity hedges) were generally only available at short tenors; customized derivatives or insurance products (such as catastrophe insurance) have proven expensive.
  - Novelty premium example: “In some cases, the novelty premium has accounted for as much as 1/3 of the total insurance premium (IMF, 2011).”

- Box 3 (2011 IMF review on LICs and contingent instruments):
  - Instruments used with some success: put options for exports (Mexico, Panama’s oil; Ghana’s cocoa); oil call options (Ghana, Panama); oil call and put options (Sri Lanka); maize call options (Malawi).
  - Regional risk pooling example: Caribbean Catastrophic Risk Insurance Facility (CCRIF).
  - Key lessons: well-specified and easily monitorable triggers; sound institutional frameworks; feasible transaction and regulatory costs; technical capacity; consensus-building; IFI support for capacity building (World Bank examples: weather derivatives in Malawi and Ethiopia).
  - These lessons carry over to SCDIs.

- Actual SCDI usage to date:
  - Use has been limited; SCDIs have not been used as a regular instrument of budget financing.
  - Issued SCDIs generally formed only a small part of debt stocks, complemented conventional debt, and were often discontinued after a small number of issuances.
  - Design of issued instruments reflected the risk addressed, investor base, and issuer technical capacity.
  - SCDIs have also appeared in official sector lending (see Box 4).

- Box 4 (State-contingent features in official lending):
  - Agence Française de Développement (AFD): Prêt Très Concessionnel Contracyclique facility
    - Thirty-year loan, a five-year grace period, and a five-year “floating grace period” for principal payments.
    - Debtor can exercise floating grace period if export earnings fall below a predefined threshold; repayments deferred up to five times after threshold is met.
    - Since 2007, AFD has offered 16 such loans, amounting to €344mn, to five low-income countries.
    - Floating grace period has not been triggered in any loans to date.
  - Petrocaribe lending (Venezuela bilateral oil-linked loans):
    - First issued in 2005; Jamaica was the first recipient.
    - Terms linked to prevailing price of oil; payment terms negotiated bilaterally; debtor countries can offer goods and services in lieu of currency.
    - Loans provide flexible financing linked to oil price and exchange rate.

### Selected instrument features and market patterns (examples from Table 2)
- Instruments and attributes (selected highlights from examples):
  - Guaranteed equity bond — UK (2002-2009): continuous adjustment (with principal cap/floor); LCY; tenor 5; equity index payout linked to FTSE 100; non-tradeable (retail).
  - Gold Bond — India (2015-): continuous; LCY; tenor 8 (redeemable at 5); price of Gold; principal linked to price of gold; non-tradeable (retail).
  - Nominal wage linked bond — Uruguay (2014): continuous (with coupon floor); LCY; tenor 30; nominal wage index; principal linked to level of nominal wage index; tradeable.
  - GDP-linked treasury certificates — Portugal (2013-): continuous (with coupon floor); LCY; tenor 5; real GDP growth; coupon linked to GDP growth (in final 2 years only); non-tradeable (retail).
  - Revenue indexed bond — Turkey (2009-12): continuous (with coupon floor); USD/LCY; tenor 3; Government SoE Revenues; coupon linked to income from SoEs; tradeable.
  - Oil-linked bond — Mexico (1977-1980): continuous (with coupon floor); LCY; tenor 3; export price of oil in USD; principal linked to local currency price of oil; tradeable.
  - Petrocaribe loans — 11 Petrocaribe members (2005-): hybrid; USD/LCY; tenor 25; price of oil in USD; down payment share, interest rate, and grace period linked to price of oil & ex. rate; non-tradeable (official).
  - AFD countercyclical loans — 5 countries (2007-): discrete; EUR; tenor 25 (with 5 year grace); export earnings; maturity and grace period extended by up to 5 years; non-tradeable (official).
  - Extendible municipal paper — USA municipalities (2000-): discrete; LCY; tenor 180-270 days; issuer's discretion; 90 day maturity extension if triggered (from 180 to 270 days); tradeable.

### Key takeaways from SCDI experience in normal times (point 15)
- Confidence in data quality is important:
  - Market indices or prices used more often than economic statistics due to greater measurement certainty and lack of subsequent revisions.
- SCDIs need to match investor group interests:
  - Many have been privately placed with targeted investor groups and non-tradeable.
  - Turkey’s revenue-indexed bonds targeted banks preferring Sharia-compliant instruments.
  - U.K., Portugal, India issued non-tradeable SCDIs targeted at retail investors.
  - Uruguay privately placed a nominal wage linked bond with a public social security fund to match long-term liabilities; Uruguay planned a daily accounting unit to track the wage index to attract private pension providers.
- Investors frequently demand floors on payments:
  - Issued SCDIs commonly had continuous adjustment with caps and floors; Turkey, Portugal, India, and Mexico offered guaranteed minimum returns.
  - Activation of triggers that generate losses without floors can disincentivize investor appetite (example: Mexico’s 2015 Multicat bond triggering).
- Loss aversion is an impediment for issuers:
  - Political constraints can make sharing returns in good times difficult to justify to domestic audiences.
  - Mexico 1977 oil-linked bond example: oil prices rose while official exchange rate used to determine payout caused a net loss for investors.
- Institutional support matters:
  - Importance of independent statistical agencies, strong debt management capacity (SCDIs used by sovereigns with well-established debt management offices), and official sector support (e.g., MDBs) to lower issuance costs and encourage repeat use.

### Insights from inflation-linked debt experience (point 16)
- Successful launch of inflation-linked bonds in advanced economies since the 1980s supports several lessons applicable to SCDIs:
  - There was a natural investor base (pension funds with long-term ‘real’ liabilities).
  - Issuers viewed them as potentially lowering cost of borrowing over the longer term.
  - Instruments were issued when inflation uncertainty was high; analogous uncertainty around future growth could be fertile ground for GDP-linked SCDIs.
  - Bonds strengthened issuer incentives to keep inflation low; credible inflation data was key to investor confidence.
  - Emergence of a simple standardized design (the “Canadian-model”) helped boost liquidity, reduce costs, and facilitate issuance.
  - Issuance sometimes took time and required political will (U.S. example).
  - Novelty/liquidity premia fell with scale but did not disappear: estimates suggest U.S. inflation-linked treasury bonds continue to pay a premium of about 40 basis points, even with more than US$1 trillion outstanding.
  - Note on data: EM/AE country lists and data references cited (BIS, OECD, World Bank); “Refers to 2016 data” and “BIS data for 2015” noted where applicable.

### SCDIs in restructuring contexts (points 17–18)
- SCDIs have become common in sovereign debt restructurings:
  - First prominent use: Brady deals (1989–97).
  - Brady instruments often offered contingent upside payments (value recovery rights, VRRs) tied to economic variables but generally did not reduce payments in downside scenarios.
  - Recent restructurings with upside GDP-warrants: Argentina (2005 and 2010), Greece (2012), Ukraine (2015).
  - Grenada (2015) included instruments with both upside and downside features (hurricane clauses discussed in Annex IV).
- Box 5 (Brady deals) highlights:
  - Brady innovations allowed banks to exchange claims for tradable instruments and transfer debt off balance sheets.
  - VRRs linked to terms of trade or economic conditions; oil exporters linked VRRs to oil prices; others to GDP or terms of trade.
  - Brady VRRs typically offered contingent payments only in upside scenarios and often included limits on upside (caps or buyback options).
  - Problems with Brady instruments included data issues (ambiguity over index referenced, treatment of revisions), non-detachability and embedded guarantees raising liquidity premiums, and overly complicated payoff formulas that reduced investor popularity.
  - Many Brady instruments later made significant upside payments; some sovereigns repurchased instruments when upside became clear (e.g., Mexico, Bulgaria), while others made ongoing payments (e.g., Bosnia, Venezuela).
- Divergent debtor-creditor expectations:
  - Upside instruments have helped bridge expectation gaps about economic outlook and the degree of debt relief needed in restructurings by allowing creditors to receive higher payments if optimistic expectations are realized while keeping political costs lower for governments promising payments only in good states.

*Source: pp032317state-contingent-debt-instruments-for-sovereigns - 13. Overall, the balance of benefits and risk is likely to support a gradual approach to SCDI issuance (PDF chapter).*

### 19.      The recent experience with state-contingent instruments in restructurings (Table 3)

### 19.      The recent experience with state-contingent instruments in restructurings (Table 3)

### Key lessons from recent restructurings
- State variable selection
  - Should be closely tied to the repayment capacity of the sovereign and be readily available and well-understood by investors.
  - Example: Grenada introduced its ‘hurricane clause’ because of the clear effect of hurricane damage on fiscal capacity and because there was a credible quantitative metric to determine when the clause should be triggered.
- Indexation lags and persistent state variables
  - Indexation lags, and links to highly persistent state variables are problematic.
  - Example: Argentina’s GDP warrants—link to the level of GDP necessitated ongoing payments for growth in the early years after issuance, which proved politically very difficult; the indexation lag led to high payments even in years when the economy was in recession (BoE, 2016).
- Complexity and market costs
  - Complexity has brought costs in terms of volatile pricing, low liquidity, and high premia.
  - Non-linear payment structures produced volatile pricing; lack of convergence on valuation methods and rarity/tailoring of instruments hindered model development.
  - Low liquidity deterred investors from developing pricing models, particularly when instruments were “out of the money.”
- Sovereign discounting of future payments
  - Governments undergoing restructurings can place a high discount factor on future payments, focusing on immediate debt relief; investors may place more weight on future upside payments or on uncertainty around them, leading sometimes to instruments offering relatively generous upside payments.

### Table 3 — Issuance examples and design details
- Argentina (2005 & 2010) - GDP-linked warrant
  - Haircut: 29.8%/ 76.8%
  - Currency of denomination: Local and Foreign currency
  - Period covered (years): 20
  - Main trigger: Real GDP level
  - Formula for payout/deferral: Pays out 5% of real GDP in excess of reference level
  - Caps/Exercise limits: Total payments capped at 48% of notional principal
- Greece (2012) - GDP-linked warrant
  - Haircut: 53.5%/ 64.6%
  - Currency of denomination: Local Currency
  - Period covered (years): 27
  - Main trigger: Real GDP growth
  - Formula for payout/deferral: Pays out 1.5 times real GDP growth in excess of reference growth rate
  - Caps/Exercise limits: Annual cap at 1%
- Ukraine (2015) - GDP-linked warrant
  - Haircut: 20%/ 28%
  - Currency of denomination: Foreign Currency
  - Period covered (years): 20
  - Main trigger: Real GDP growth, level of GDP in USD
  - Formula for payout/deferral:
    - Pays out 15% of real GDP growth between 3-4%
    - Pays out 40% of real GDP growth in excess of 4%
    - No payments unless nominal GDP is higher than USD 125.4bn
  - Caps/Exercise limits:
    - Annual cap at 1% of GDP from 2021-2025; uncapped from 2026-2040
- Grenada (2015) - CBI revenue-linked payments in 2030 bond
  - Haircut: 50% (of which 25% upfront)/ 54%
  - Currency of denomination: Local and Foreign Currency
  - Period covered (years): 15
  - Main trigger: CBI revenues
  - Formula for payout/deferral:
    - Pays out 25% of CBI proceeds between US$15mn-50mn
    - Pays out 35% of CBI revenues in excess of US$50mn
  - Caps/Exercise limits: Discounted value of total payments capped at 35% of outstanding principal value
  - Note: These refer to revenues from Grenada's 'Citizenship by Investment' program; payments to be discounted back to May 2015 using average yield on the 2030 bond in the year in which they occur.
- Grenada (2015) - Hurricane clause in 2030 bond
  - Haircut: 50% (of which 25% upfront)/ 54%
  - Currency of denomination: Local and Foreign Currency
  - Period covered (years): 13
  - Main trigger: "Modelled" Hurricane damage
  - Formula for payout/deferral:
    - 6 month deferral if modelled loss is greater than USD 15mn, less than USD30mn
    - 12 month deferral if modelled loss is greater than USD 30mn
  - Caps/Exercise limits: Can be triggered a maximum of 3 times
  - Note: The Caribbean Catastrophe Risk Insurance Facility Segregated Portfolio Company (CCRIF SPC) produces modelled estimates of the economic damage caused by natural disasters, which are used to determine insurance payouts.
- Table notes
  - Upside/Downside: indicated for instruments where applicable.
  - Haircut calculations do not account for the value of the state contingent instruments.
  - Sources for Haircut estimates are Trebesch et al. (2014), Zettelmeyer et al (2013) and IMF (2015, 2016).
  - Similar hurricane clauses were included in restructured debts with the Import-Export Bank of Taiwan and the Paris Club.
  - Source: Bloomberg.

### Feedback from potential issuers
- General stance
  - Surveyed issuers were relatively guarded in indicating an interest in issuing SCDIs.
  - In a survey of sovereign issuers, most reported that their current menu of conventional debt instruments was adequate, and none had plans to launch any SCDIs in the near future.
  - Issuers stressed that SCDIs’ risk reduction benefits would need to justify their expected higher cost relative to conventional debt instruments.
- Main obstacles and concerns
  - Lack of a natural investor base for market creation.
  - Design complexity, data quality, and issues with lags could make SCDIs difficult to price.
  - Difficulty in achieving a share of SCDIs in the overall portfolio large enough to deliver meaningful risk reduction; risk of “cannibalizing” the market for conventional debt.
  - Institutional differences: debt management offices tended to be more skeptical; central banks were more open to SCDIs (debt managers focus on immediate cost-risk considerations; central banks on potential macroeconomic and system-wide benefits).
- Survey coverage
  - The list of countries covered by the survey included 20 AEs and 8 EMDCs. Findings corroborated by workshops and surveys conducted in 2016.

### Feedback from investors
- Overall stance
  - Feedback from investors was heterogeneous but suggested relatively greater openness to well-designed SCDIs.
  - Some investors saw SCDIs as means to complete markets, earn higher yields in a low interest rate environment, and gain exposure to otherwise-closed risk segments.
  - Others were deterred by governance issues and other uncertainties.
  - Almost all highlighted the importance of simplicity, standardization of design, and clarity of legal and regulatory treatment for liquidity to emerge.
- Investor-specific preferences and concerns
  - Continuous adjustment vs. one-off instruments
    - Fixed income investors generally favor GDP- or commodity-linked bond-style instruments over one-off-adjustment instruments.
    - Reinsurers expressed strong interest in hurricane clauses for small states vulnerable to natural disasters.
    - Some fixed income investors worried about “coupon irregularity” and would accept principal loss or extended duration instead.
  - One-sided vs. two-sided adjustment and caps/floors
    - Fixed income investors expressed clear demand for instruments offering upside; some asked for a floor for downside adjustment.
    - Some investors supported sovereigns retaining some upside (via caps) to mitigate moral hazard and political economy difficulties.
    - Instruments with substantial downside risk might be treated as equity and require higher yields; reinsurers saw downside-only instruments as consistent with their business models.
  - Data integrity and choice of state variable/trigger
    - Indexing to macro variables like GDP raised concerns about data reliability, statistical transparency, revisions, redefinitions, model risk, and political economy (adverse selection, ex post commitment).
    - Investors suggested a major issuer go first to build confidence; stressed importance of penalties if a data quality test failed.
    - Investors were comfortable with commodity-price links but noted this limits issuer universe.
  - Detachability (derivatives)
    - Views differed on desirability of derivative instruments alongside the bond; some preferred upfront customization options, others thought derivatives markets would follow once bond markets were established.
  - Legal and regulatory treatment
    - Investors did not expect SCDIs to receive more favorable legal or regulatory treatment than conventional debt.
    - Preference for not giving SCDIs seniority relative to other conventional debt instruments.
    - Essential that activation of a state-contingent clause not be treated as a “credit event.”
    - Investors in EM debt preferred denomination/settlement in a major currency and issuance under New York or English Law to mitigate legal risk.
- Risk premia
  - Some respondents believed risk premia on SCDIs could be 20–30 bps over a conventional nominal bond of similar maturity/currency.

### Considerations for market development — key requirements (i–iv)
- (i) Identifying natural issuers and investors
  - Match issuers with sustained demand for protection against macro-financial risks to investors willing/able to bear this risk to ensure sufficient ongoing issuance and market scale (ratings, indices).
- (ii) A few simple benchmark instrument designs
  - Menu must be broad enough to cover principal risks (GDP risk, sudden stops, large exogenous terms of trade, natural catastrophe) but simple and immune to manipulation risks and perverse incentives.
  - Liquidity is both a consequence and a driver of scale; advantages to keeping to a few benchmark designs.
  - Potential role for IFIs, including the Fund, to provide guidance.
- (iii) Robust institutions and contracts
  - Strong statistical and debt management institutions needed to secure investor confidence.
  - Robust contracts can address data integrity/manipulation/revision risks, mitigate moral hazard and adverse selection, and consider likely regulatory treatment.
  - Technical support from IFIs could be helpful.
- (iv) Appropriate regulation and market treatment
  - Regulatory treatment needed to reflect risk-mitigation benefits, prevent excessive risk migration to the private sector, and reduce operational load for investors (administrative/financing costs, capital requirements).
  - Credit ratings and index eligibility likely important for market demand.

### Potential issuers and natural investors — issuer types and vulnerabilities
- Advanced economy sovereigns
  - Vulnerable to domestic demand shocks; could benefit from generalized insurance/countercyclical properties of GDP-linked instruments, subject to adverse selection and moral hazard concerns.
  - Euro-area members: relatively elevated debt levels and volatile interest rate-growth differentials; GDP-linked debt could reduce uncertainty around debt/GDP ratios—but adverse selection issues are more acute. Access to larger international investor base and supranational euro area statistical agencies would strengthen case for issuance.
  - Reserve currency issuers: relatively stable interest rate-growth differential and liquid domestic markets; can mimic SCDI effects with policy levers—less compelling case for issuance.
- Small-open economies
  - Generally lower debt levels but some are highly exposed to external shocks and have less access to deep domestic markets; issuing SCDIs to non-residents may provide beneficial insurance against growth or financing shocks.
- Emerging markets and low-income countries
  - Exposed to substantial, largely exogenous shocks; net benefits from SCDIs depend on country characteristics and vulnerability profile.

*Source: STATE-CONTINGENT DEBT INSTRUMENTS FOR SOVEREIGNS (International Monetary Fund).*

### Annex VI provides full details of the countries in each group and a more detailed summary of their characteristics.

### Box 6. Possible SCDI State Variables/Triggers outside Government Control

### Box 6. Possible SCDI State Variables/Triggers outside Government Control

### Overview
- SCDIs are intended to stabilize government solvency or financing in the face of shocks. The most natural state variable would be government expenditures or revenues, but those are under government control and raise moral hazard concerns.
- Where independent statistical authorities underpin data credibility, GDP could serve as a proxy. In some EMDCs lacking such credibility, it may be useful to consider state variables that can be produced without relying on data collected or produced by the issuer’s own authorities.
- There may be a role for the Fund or other international bodies in collecting or compiling statistics used for triggers.

### Possible trigger variables whose construction is outside the control of the issuer
- Commodity prices
  - Easily observed and verifiable; exogenous for smaller exporters and importers, minimizing manipulation or moral hazard.
  - Relevant for countries highly reliant on either exporting or importing commodities.
  - Given high correlation of GDP and commodity prices in many commodity exporters, these bonds could deliver similar benefits to GDP-linked bonds.
  - Example for an extendible design: a maturity extension that triggers upon a 20 percent oil price decline over 6 months (corresponding to the 10th percentile of all price changes).
  - Example statistic: across 13 major oil exporters (Algeria, Angola, Canada, Iran, Kazakhstan, Kuwait, Mexico, Nigeria, Oman, Russia, Saudi Arabia, UAE, and Venezuela), the median correlation between the annual change in the oil price and annual nominal GDP growth since 2000 is 0.85.
- Natural disasters
  - Due to discrete nature, appropriate only for an extendible design.
  - Relief could be tied to occurrence (and intensity) of natural disasters using external estimates of damage.
  - Example: Grenada’s hurricane clause links the state variable (CCRIF damage estimate) to an insurance payout.
  - Summers (2015) proposed a similar approach for pandemics.
- Merchandise exports
  - Easily observed and can be externally calculated when measured from the importers’ side (possibly published by the Fund based on DOTS data).
  - Relevant for small open economies where revenues from merchandise exports represent the principle source of foreign exchange.
  - Extendible design example: trigger upon a drop in merchandise exports revenues below a benchmark. Some AFD official loans extend in maturity if goods exports fall below 95 percent of their average over the past 5 years.
  - Example statistic: Merchandise trade represents at least 75 percent of exports for over 2/3 of the IMF membership.
- External demand (trading partner GDP)
  - Trading partner GDP-index could be provided externally by an independent international organization, such as the Fund.
  - Relevant for economies where services represent a substantial share of exports.
  - Example statistics: For G20 economies, the median correlation of real GDP growth with trading partner-weighted real GDP growth is 0.765, while the equivalent median correlation for nominal GDP growth is 0.66. (Correlations calculated using annual data for the 1999-2015 period, and using trade-weights based on IMF DOTS.)
- Domestic financial market shock
  - Discrete trigger instruments might be linked to domestic bond or CDS spreads.
  - Domestic spreads could be collected from private financial data providers; the incentive to manipulate might be mitigated if a durable increase was required to trigger the instrument.
  - Example: IMF debt sustainability framework for market access countries uses a spread of 600 bps or more relative to market benchmarks as an indicator of high risks.
  - Risk: any financial market-based trigger could risk exacerbating market volatility in stress episodes.
- Global or regional financial market shock
  - SCDIs might be linked to a global or regional index such as EMBI; not prone to manipulation and captures exogenous shocks faced by a group of economies.
  - Risk: may not provide relief against country-specific shocks and may expose investors to maturity extension in several markets simultaneously.

### Extendible instruments (maturity-extension design)
- Definition: “Extendible”: maturity extension linked to a pre-defined trigger. Postpones bond maturity when a pre-defined trigger is breached, but maintains principal and possibly coupon payments unchanged.
- Design variants:
  - Pure option-based structure: sovereign chooses whether or not to extend; provides flexibility but would be expensive due to opportunistic exercise.
  - Automatic trigger: may be overly rigid and trigger when extension not needed/desired.
  - Knock-in option: sovereign has the option to extend once a trigger has been breached; may balance affordability and flexibility.
- Protection
  - By pushing out maturities, an extendible can generate substantial financing for a country facing a liquidity shock.
  - Can prevent liquidity problems from translating into a full-blown/costly debt crisis and help stabilize interest payments at precrisis levels, preventing deterioration of solvency.
  - Particularly useful for economies prone to “sudden stops.”
- Limitations
  - Provide liquidity relief but limited solvency support (no reduction in principal or coupon payments).
  - If sovereign elects a knock-in option, choosing to trigger could adversely affect pricing of conventional bonds if interpreted as signaling solvency risks.
  - Market participants may value extendibles if the alternative is a debt restructuring rather than an official sector bail-out.

### Robust institutions and contract design
- Independent statistical agencies are indispensable to mitigate investor concerns around data integrity and payouts. Strengthening statistical agency capacity and insulating them from political interference may be needed in EMs and LICs.
- Address gaps in debt management capacity given greater complexity and transparency needs implied by SCDIs.
- Careful contract design can reassure investors:
  - Clear methodology to calculate payouts and contingencies where data availability or reliability concerns arise to reduce misreporting incentives.
  - Parameters governing debt service payments: contracts should aim for close to real time adjustments where possible (London termsheet suggests a lag of about six months) and caps on upside payments. Payments floors can limit moral hazard but also limit relief.
  - Seniority relative to conventional debt: ex ante separate CAC pools to ring-fence SCDIs could be perceived as affording de facto seniority and raise inter-creditor equity concerns. Enhanced CACs allowing “sub-aggregation” under single-limb CACs can recognize economic differences between instruments while lessening signaling of seniority.

### Regulatory framework and market institutions
- Banking regulation is likely to classify SCDIs as debt (analogous to inflation-linked bonds and CoCos); they would likely be held on trading books and priced mark-to-market.
  - Additional capital charges because of greater ‘market risk’ could disincentivize banks from holding SCDIs.
- Insurers, pension funds, and other asset managers may face fewer constraints; focus is on matching assets and liabilities and SCDIs can aid such matching.
- Regulatory treatment should guard against excessive risk accumulation on private balance sheets, especially when investors take large exposures to their own sovereign or to sovereigns with performance tied to global risk factors.
  - Possible approach: impose a base capital charge plus a counter-cyclical requirement related to correlation between SCDI performance and other balance sheet items during stress.
- Credit rating agencies
  - Typically evaluate sovereign credit risk rather than a specific instrument; bonds of the same currency are generally given the same rating.
  - Agencies may not rate an instrument where debt service obligations are not clearly specified (e.g., S&P requires the obligation to be “credit-based and measurable”).
  - Certain SCDIs, such as longer-term extendibles, may not be ratable; however, most properly designed SCDIs should be eligible for credit ratings or fall under the sovereign’s general rating (example: U.K. inflation-linked bonds receive the same sovereign credit rating as conventional Gilts).
- Market indices
  - SCDIs are unlikely to be eligible for inclusion in most existing major bond indices due to minimum issuance volume and liquidity requirements.
  - Large-scale issuance may prompt market institutions to adapt (investor mandates can change; new or modified indices could be developed; rating agencies could quantify reduction in sovereign credit risks associated with SCDIs).

### The way forward — Pathways to market development
- Absent major international support, some sporadic issuance of SCDIs will likely continue, including:
  - Investor-targeted domestic issuance to meet hedging needs of specific investor groups (e.g., pension funds, retail investors, Islamic finance investors). Example: Uruguay’s wage-indexed bonds.
  - Issuance by countries vulnerable to large exogenous shocks (commodity producers and small states) to guard against commodity price and natural disaster shocks (example: Grenada’s 2015 bonds with hurricane clause).
  - More official bilateral loans with state-contingent features, for example, countercyclical grace periods tied to exports (a model with AFD already exists).
  - Issuance in restructuring contexts: sovereigns restructuring debt may consider SCDIs featuring downside protection; higher likelihood of negotiation success in restructuring contexts.

*International Monetary Fund — Box 6, “Possible SCDI State Variables/Triggers outside Government Control.”*

### 40.      However, such issuances are not very likely to lead to the creation of self-sustaining

### STATE-CONTINGENT DEBT INSTRUMENTS FOR SOVEREIGNS

### Market prospects and limits
- Sporadic issuances of different SCDIs unlikely to create self-sustaining liquid markets over the next 5–10 years.
- Sporadic issuance can build experience and familiarity but should not be expected to translate into scale or standardization in the near term.

### Rationale for official sector support
- SCDIs are not substitutes for prudent macroeconomic policies but can yield system-wide positive externalities:
  - Help complete the sovereign toolkit for preserving policy space.
  - Provide a mechanism for greater risk-sharing and diversification for investors and debt managers.
  - Close financial market and information gaps.
  - Improve the pricing of sovereign risk.
- If risks and costs are mitigated through careful instrument design, robust contracts, and regulation, net positive externalities are likely to remain.

### Practical official-sector actions proposed
- Developing commonly agreed model contracts:
  - Official sector could partner with the private sector to mitigate start-up costs of a contractual framework.
  - Assist market participants in the development of model contracts and/or “how-to-issue” guidance notes around a set of benchmark SCDIs (both in normal times and in restructuring contexts), including for the three benchmark instruments discussed above.
  - Process has begun for GDP-linked bonds and hurricane clauses. (Footnote 38)
- Technical assistance to sovereigns:
  - IFIs, think tanks, and practitioners can discuss and explain features of benchmark SCDIs.
  - The Fund can provide guidance to country authorities considering issuing SCDIs and to staff country teams evaluating the case for issuance. (Footnote 39)
  - Technical assistance can focus on debt managers and statistical agencies to strengthen capacity to handle SCDIs, including provision of reliable and accurate statistics on key state variables used in the benchmarks.
- Guidance on the use of SCDIs in restructurings:
  - Standing guidance on design issues can account for problems experienced with previous instruments.
  - Advice can help sovereigns develop instruments with greater secondary market liquidity and more symmetric structures.
- Treatment in DSAs and fiscal rules:
  - Risk-mitigating features and state-dependent costs of SCDIs could be explicitly modeled for the purpose of the IMF’s DSAs.
  - Modifications would be required to current DSA templates, especially shock scenario modules.
  - Fiscal rules could be adjusted to give credit to sovereigns with higher shares of SCDIs, acknowledging added complexity.

### Leveraging official creditor balance sheets
- Official creditors already provide large ex-post loan, grant, and debt relief financing in bad states; ex-ante commitments could reduce costs and improve planning/transparency of support.
- MDBs could underwrite and guarantee SCDIs:
  - Support issuance where countries cannot afford such instruments on their own.
  - MDB involvement could provide credibility around design and data aspects and reduce risk of payment default, lowering investor premia.
  - Annex VIII discusses experience with MDB sovereign guarantee products.
- Official creditors could expand or introduce state-contingent features in their lending:
  - AFD countercyclical loans (adjustable grace period tied to exports) provide an example.
  - Such initiatives could be broadened to other official bilateral creditors and MDB lending, leveraging MDBs’ ability to diversify risks across many borrowing sovereigns.

### Market kick-start options
- Lead issuance by a large sovereign or institution:
  - A major sovereign issuer could command investor confidence and lower issuance premia.
  - Could help set benchmarks for pricing, rating, and regulatory treatment.
  - Currency-union issuers (or institutions such as the ESM) could issue instruments linked to regional GDP, with underlying risk shared via bilateral agreements (as suggested by Makoff (2017)).
- Coordinated issuance by several sovereigns:
  - Could remove first-mover reticence and reduce novelty and liquidity premia.
  - Applicable in currency unions or coalitions of willing sovereigns seeking mutual benefit in creating self-sustaining SCDI markets.

### Next steps (near term actionable items)
- Conduct detailed discussions with competent authorities on regulatory treatment of SCDIs (e.g., capital charges, risk-weights, fiscal rules).
- Continue technical work on contractual features of the floater and extendible designs in consultation with market participants (building on London termsheet consultations around the linker design).
- Further engagement with debt managers and market participants to develop practical guidance for potential issuers, including in restructuring contexts, and to support a transition to developed SCDI markets.
- Staff intends to use the June 2017 Debt Managers Forum (hosted by the Fund) to initiate in-depth consultations.
- Staff has developed a user-friendly Excel based tool to illustrate benefits of the three SCDI benchmarks in terms of impact on debt levels and gross financing needs; it is proposed that the tool be published alongside the Board paper. (Footnote 39)

### Issues for discussion (enumerated for Directors)
- Do Directors agree that SCDIs can have broad benefits for sovereigns, investors, and the international financial system?
- Do Directors concur with staff’s analysis of the potential complications associated with SCDIs and the extent to which these could be mitigated through careful design and additional measures?
- Do Directors endorse staff’s representation of the experience with state-contingent instruments, including in restructuring cases, and the lessons for market development?
- Do Directors agree with staff’s analysis of potential issuers and investors, and the three benchmark instrument designs around which liquid markets could emerge?
- Do Directors concur with staff’s assessment of the range of official sector support possibilities to promote SCDI market development?
- Should official sector efforts be supported by the Fund, and if so, should efforts concentrate on GDP-/growth-indexed bonds (mainly for advanced and emerging economies) or extendible bonds (mainly for emerging market and low-income countries)?

*STATE-CONTINGENT DEBT INSTRUMENTS FOR SOVEREIGNS — International Monetary Fund*

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_Source: https://www.imf.org/-/media/files/publications/pp/pp032317state-contingent-debt-instruments-for-sovereigns.pdf_