## sdnea2020006

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---

### Executive findings
- COVID-19 may cause a series of costly and inefficient sovereign debt restructurings with protracted negotiations and potential relapses into default.
- State-contingent debt instruments (SCDIs) tie restructured debt payments to future outcomes linked to a state variable (for example, GDP or commodity prices) and can:
  - Reduce conflicts over current valuations.
  - Facilitate more sustainable agreements by providing payments that are higher in good states than in bad states.
- Uptake of SCDIs has been limited because fixed-income investors steeply discount “equity-like” instruments due to nonstandard designs, illiquidity, and idiosyncratic risk profiles.
- SCDIs can target specialized situations (for example, restructurings of state-owned enterprises and public-private partnerships) and be redesigned to increase uptake through standardization and improved contract terms.
- Official sector promotion—endorsement of standardized termsheets, enhanced data provisioning, and recognition of SCDIs in debt sustainability analyses—could be catalytic.
- Opportunity to consider symmetric exchange bonds with payouts that vary in both good and bad times, especially when linked to variables outside sovereign control (for example, commodity prices).
- Restructurings present an opportunity to introduce disaster clauses granting temporary debt relief after natural disasters and to study clauses addressing liquidity crises tied to future official sector debt suspensions.

### Definition, classification, and central policy questions
- Definition:
  - SCDIs: sovereign instruments that (1) bear contractual debt service obligations linked to a predefined state variable (for example, GDP, exports, or commodity prices) and (2) provide additional creditor compensation in good times and/or debtor relief in bad times (for example, interest forbearance, maturity extensions, or principal forgiveness).
- Classification (historical structures):
  - VRIs (Value Recovery Instruments): provide only upside payouts (call-options/warrants tied to a state variable).
  - Downside-protection instruments: function like insurance contracts that provide relief after large negative shocks (natural disasters, etc.).
- Four central policy questions:
  1. How can VRIs help facilitate rapid and orderly sovereign debt restructurings, and how should they be structured?
  2. How can SCDIs that offer downside protection be used during restructurings to embed longer-term resilience?
  3. Might SCDIs be useful to avoid a wave of defaults from a global liquidity shock, and how to design triggers?
  4. Is there scope to introduce SCDIs in restructurings that offer “symmetric” payouts to ensure sustainability in both good and bad states?

### Value Recovery Instruments (VRIs): use cases, benefits, and historical experience
- Use cases and mechanics:
  - VRIs have been used in some restructurings to increase upside payouts and boost private creditor participation (example: GDP-linked warrants, GLWs).
  - VRIs function as call options on a better economic outlook, allowing creditors to share upside when variables exceed thresholds.
- Benefits:
  - Bridge the “expectation gap” between creditors and debtors on future prospects.
  - Link to debt sustainability metrics to promote risk sharing and reduce repeat defaults and debt overhang.
- Historical use:
  - Deployed only on a few occasions among more than 50 external sovereign debt restructurings since 1990.
  - Early use in Brady-era restructurings; GLWs featured in Argentina (2005 and 2010), Greece (2012), Ukraine (2015). Argentina and Ecuador restructurings in 2020 did not include VRIs.

### Implementation constraints on VRIs (three major barriers)
- Investor preferences:
  - Majority of Eurobond investors are institutional investors and fixed-income mutual funds preferring “plain vanilla” securities; exotic VRIs attract boutique investors or macro hedge funds demanding higher returns.
- Valuation uncertainty and illiquidity:
  - Difficult pricing; viewed as exotic derivatives with limited secondary market liquidity.
  - Illiquidity generates wide bid-ask spreads—up to 25 percent of mid-value for low-priced options.
  - Lack of standardization and low initial market value reduce demand.
- Measurement issues, data reliability, and incomplete contracts:
  - Nonstandard contract designs and unclear payout calculations have tarnished VRIs’ reputation (examples: Mexico 1977–80, Bulgaria GLWs, Argentina GDP/CPI reporting problems).
  - Investors may refuse VRIs for countries with poor data reliability or institutional independence.

### Potential approaches to increase VRI uptake and effectiveness
- Target VRIs to SOE and PPP restructurings where equity-like instruments are more comparable to corporate restructurings.
- Improve contract design through standardization to promote liquidity and avoid measurement ambiguities, lagging indicators, and uncapped payouts.
- Official sector catalytic actions:
  - Endorse standardized termsheets.
  - Enhance data provisioning.
  - Recognize SCDIs’ benefits in Debt Sustainability Analysis (DSA).

### Recommended VRI design features
- Choice of state variable:
  - Prefer variables closely tied to repayment capacity and free of data-manipulation concerns.
  - Avoid indexation lags and highly persistent variables that erode countercyclicality.
  - Scope for SCDIs linked to state variables outside government control.
  - Link to coupon payments rather than principal to smooth payments and reduce refinancing risk.
- Payout structure:
  - Ensure upside payouts do not preclude sovereign buffer rebuilding.
  - Consider floors and caps on upside payments; avoid GLWs “far out of the money.”
  - Instruments without caps can carry tail risk (example: Ukraine 2015).
  - For downside protection instruments, weigh theoretical procyclicality for creditors versus governments’ need to redirect funds.
- Detachability:
  - VRIs have tended to be detachable so restructured bonds remain fixed-income instruments.
  - Bond-index inclusion may be affected by index compilers’ classification.

### Standardization versus bespoke instruments
- Tradeoff:
  - Standardization promotes secondary market liquidity, familiarity, and pricing and may aid index inclusion.
  - Bespoke VRIs better reflect country-specific repayment capacity but create nonstandard payout formulas and impair liquidity.
- Resolution depends on international community interest in deeper markets for these instruments.

### Valuation and fiscal cost considerations
- VRIs are typically heavily discounted; on average they could be more expensive than enriching offers by reducing outright haircuts.
- Examples:
  - Argentina’s 2005 GLWs were costly for the issuer.
  - Ukraine’s 2015 GLWs could pay out significantly more than initial creditor haircut.
- Immediate benefit of lower haircuts must be reconciled with potentially large fiscal payouts later.

### Box 1 — Market Valuation of GDP-Linked Warrants: Argentina, Greece, and Ukraine
- GLW market attributes:
  - Prices initially low and highly volatile with large bid-ask spreads.
  - Example: bid-ask spread for Greek and Argentine GLWs were 22 and 33 percent to their respective mid prices on July 1, 2020.
- Argentina:
  - GLWs compensated investors for steep NPV haircuts of 77 percent in 2005.
  - Market initially valued GLWs at about 2 cents on the dollar.
  - GLW payments based on GDP level rather than GDP growth; rapid growth after exchange resulted in high payments representing more than 30 percent of total servicing of interest on public sector debt in 2012.
  - Price later collapsed with GDP drop.
- Greece:
  - GLWs part of 2012 exchange with NPV haircuts of 65 percent.
  - Price slumped to 0.25 cents on the dollar early post-restructuring.
- Ukraine:
  - 2015 restructuring: 20 percent NPV reduction equal to US$3.6 billion; creditors received GLWs in US$3.6 billion notional linked to level and growth rate of GDP.
  - Under a 4 percent growth scenario, GLWs deliver an internal rate of return of 3 percent on initial write-down.
  - Under a 5 percent growth scenario, the rate of return jumps to more than 13 percent, implying substantial fiscal costs of more than 55 basis points of GDP per year.
- Conclusion: Initial undervaluation by investors required sovereigns to promise better terms, raising probability of costly GLW payments; unclear whether VRIs succeeded in expanding investor participation while delivering fair ex post risk sharing.

### Box 1 — Descriptive Statistics of GDP-Linked Warrant Prices (notional = 100, January 2013–July 2020)
- Ukraine:
  - Initial price after offering: 49.6
  - Maximum: 109.43
  - Minimum: 28.69
  - Average: 57.10
- Greece:
  - Initial price after offering: 0.20
  - Maximum: 1.44
  - Minimum: 0.14
  - Average: 0.57
- Argentina:
  - Initial price after offering: 2.0
  - Maximum: 11.94
  - Minimum: 0.55
  - Average: 7.37

### SCDIs to embed longer-term resilience (discrete and continuous adjustment instruments)
- Categories:
  - Continuous adjustment (e.g., GDP-linked bond with payments indexed to nominal GDP).
  - Discrete adjustment (e.g., natural disaster clauses triggering relief, maturity/grace extensions).
- Case for SCDIs:
  - Reduce debt service in bad times and increase resilience to recessions, natural or public disasters.
  - Contingent standstills and maturity extensions can provide liquidity relief and lower risk of liquidity problems becoming full sovereign crises.
- Recent adoptions:
  - Grenada (2015) and Barbados (2018) included natural disaster/hurricane clauses in restructurings.
- Potential triggers and variants:
  - Commodity price–based triggers for commodity exporters.
  - Countercyclical loans (example: Agence Française de Développement).
  - Borrowing spreads of third-party countries as exogenous triggers.
  - Public health disaster clauses modeled on Catastrophe Containment and Relief Trust criteria.
- Market appetite caveat:
  - Market participants may have limited appetite beyond narrow cases, particularly for global shocks.

### Natural disaster clauses: Grenada and Barbados experiences
- Common features:
  - Verifiable trigger assessed by an independent body (CCRIF parametric assessments).
  - Applicability: Grenada included clauses in domestic and external commercial and official creditor contracts; Barbados included clauses in domestic and external commercial debt.
  - Clauses benefit small sovereign issuers with concentrated debt holders; extending to larger countries is more challenging.
  - Size and duration of liquidity relief matter; both countries permit triggers up to a maximum of three separate occasions.
- Grenada design specifics:
  - Deferral of debt service payments up to 12 months if CCRIF payout exceeds US$15 million (Paris Club treated flexibly).
  - Deferred interest capitalized; deferred principal distributed equally until final maturity.
  - Contingent revenue-sharing feature if Citizen-by-Investment proceeds exceeded US$15 million (payments made in 2018 and 2019).
- Barbados design specifics:
  - Capitalization of interest and deferral of scheduled amortization over a two-year period after a major disaster.
  - Trigger for domestic debt: CCRIF payout above US$5 million.
  - External debt links CCRIF payouts with differentiated thresholds by disaster type.
  - Holders of at least 50 percent of aggregate principal can block activation of clause for one external instrument.
  - New external debt instrument traded in secondary market; virtually no trading in domestic market post-restructuring.

### Pandemic and global-crisis extensions: challenges and the World Bank pandemic bond experience
- Potential benefit:
  - Automatic debt standstills under pandemic/global-crisis conditions could help cope with market illiquidity.
- Key challenges:
  - Defining inclusive and unambiguous triggers for systemic/global shocks is difficult.
  - Systemic shocks affect both borrowers and lenders, reducing lender appetite and increasing required risk premia.
  - Market-based pandemic catastrophe structures exhibit trigger complexity, high coupon rates, and limited payout.
- World Bank pandemic bond program (July 2017):
  - Tranches:
    - Class A: US$225 million in bonds and US$50 million in swaps.
    - Class B: US$95 million in bonds and US$55 million in swaps.
  - Coverage:
    - Class A covered flu and coronavirus; Class B covered filovirus, coronavirus, Crimean Congo, Rift Valley, and Lassa Fever.
  - Pricing and principal risk:
    - Class A: coupon = 6M LIBOR + 6.5 percent; could lose up to 16.67 percent of principal.
    - Class B: coupon = 6M LIBOR + 11 percent; could lose all principal.
  - Trigger and payout:
    - Trigger based on outbreak contagion/spread speed crossing borders using WHO data.
    - April 2020 trigger satisfied; maximum amount US$195.84 million for coronavirus paid out.
  - Retrospective assessment:
    - Trigger complexity, high coupon, limited payout, under-reporting of infections, valuation correlation with global markets reduced diversification benefits and investor appetite.
    - Payout timing: trigger met four months after outbreak; payout ≈ 43 percent of principal.
    - World Bank paid premiums of US$107.2 million for maximum payout of US$195.8 million for COVID-19.
    - Decision: World Bank decided not to renew after maturity on July 15, 2020.

### Design alternatives and policy suggestions for crisis-linked SCDIs
- Market-disruption signal clauses:
  - Trigger suspension/extension by a narrowly defined market-breakdown signal (for example, a massive jump in aggregate EM bond yields measured by an index such as EMBIG).
  - Investor implications for liquidity-constrained holders must be explored.
- Clauses tied to official-sector action:
  - Automatic suspension of private sector payments if predefined official creditors (for example, Paris Club or G20) suspend debt service.
  - Creates contractual link from official sector suspension to private sector participation, using official action as credible signal.

### Scope for symmetric SCDIs (upside and downside payoffs)
- Motivations:
  - Symmetric exchange bonds offering both upside to creditors and downside protection may facilitate agreement on a favorable baseline while protecting creditors against global risks.
  - Restructuring contexts reduce first-mover problems and stigma; entire debt stock can be turned over to achieve meaningful coverage.
- Design considerations:
  - State variable should be outside debtor control and well correlated with debt-carrying capacity.
  - Externally measured metrics (exports, trading-partner GDP, commodity prices) can mitigate manipulation concerns but may reduce investor familiarity.
- Reasons for usefulness in restructurings:
  - Debtors’ pessimism vs. creditors’ optimism creates space for upside SCDIs to bridge valuation gaps.
  - Downside-protection SCDIs need to cover a substantial share of debt to affect default probability—achievable during restructuring.

### Use of standardized “external” state variables and two design options
- Rationale:
  - Major EM recessions over past 20 years often associated with global shocks; external variables are outside debtor control and reduce manipulation concerns.
- Candidate state variables:
  - Global commodity prices:
    - Highly correlated with GDP/revenues in commodity exporters.
    - Deep liquid markets for medium-term oil futures; longer-dated futures thinner.
    - Example: Chad 2018 restructuring linked to oil receipts; provided liquidity relief when oil prices collapsed at COVID-19 onset.
  - Trading-partner GDP:
    - Historical correlation with domestic GDP ≈ 0.5 on average for stressed EMs.
    - Case-by-case assessment required.
  - Merchandise exports (including importer-reported DOTS for unreliable domestic stats).
    - Less useful for service/remittance-reliant countries.
- Design options:
  - “Floater”:
    - Coupon linked to state variable between a floor and cap; scales linearly with the contract state variable.
    - Produces built-in counter-cyclical fiscal costs; interest-rate sensitivity adjustable.
  - “Extendible”:
    - State-variable-triggered contractual maturity extension (example: trade-partner GDP growth < –2 percent triggers a three-year principal payment deferral).
    - Delivers larger near-term liquidity relief than floater design.
- Relative effects:
  - Both designs provide relief for global-factor-driven recessions; extendible delivers larger near-term benefits, floater provides some solvency relief via reduced average interest.

### VRIs in SOE and PPP restructurings
- Context:
  - Direct lending and contingent liabilities from SOEs and PPPs have increased; staff estimates show 14 major LICs’ aggregate debt-to-GDP rose by 14 percentage points while SOE debt more than tripled from 2008 to 2018 (Figure referenced).
- Advantages:
  - SOE/PPP restructurings parallel corporate restructurings, easing debt-to-equity conversions or warrant structures.
  - Investors in SOEs may better value equity-like claims and accept illiquidity.
  - VRIs as debt-to-equity conversions reduce debt overhang and may facilitate ex post investment.
- Limits and risks:
  - Many SOE investors uninterested in SCDIs; development banks or export-import banks may prefer maturity extensions/grace periods.
  - Insider control and political risks can deter equity transfers to external lenders.
  - Strong transparency and public safeguards required to prevent misuse; poor PPP disclosure can enable opportunistic renegotiations.

### Appendix I — design considerations (high-level)
- Balance debtor and creditor interests; avoid excessive upside commitments.
- Choice of state variable: ideal is repayment-capacity-linked, exogenous, and free of manipulation; indexation lags and persistence problematic.
- Payout structure: simple formulas; floors/caps; coupon-linking preferred.
- Detachable vs. integrated: detachable VRIs preserve fixed-income nature but affect index inclusion.
- Valuation approach: discounted present value using Monte Carlo simulations; valuation depends on discount rate and liquidity/premium considerations.

### Appendix II — considerations for official sector creditors using SCDIs
- Examples of official use:
  - Agence Française de Développement’s “floating grace period” loans (never triggered).
  - Petrocaribe loans linked to oil prices.
- How official-sector characteristics attenuate private-use problems:
  - Liquidity: officials can hold exposures long-term and tolerate illiquidity.
  - Pricing-model concern: officials can hold exposure without needing resale pricing consensus.
  - Political economy: VRIs can help buy domestic political support by highlighting potential upside.
  - Size: large official lenders can create critical demand for VRIs that private markets cannot in normal times.
  - Natural hedge: official lenders with offsetting exposures (for example, oil-importing creditor vs oil-exporting borrower) are low-hanging fruit for commodity-related SCDIs.

*Source: Excerpt from IMF staff paper — “THE ROLE OF STATE-CONTINGENT DEBT INSTRUMENTS IN SOVEREIGN DEBT RESTRUCTURINGS” (sdnea2020006)*

### EXECUTIVE SUMMARY __________________________________________________________________________ 5

### EXECUTIVE SUMMARY

### Executive findings
- The COVID-19 crisis may lead to a series of costly and inefficient sovereign debt restructurings occurring during a period of great economic uncertainty, which may lead to protracted negotiations over recovery values and potential relapses into default post-restructuring.
- State-contingent debt instruments (SCDIs) could play an important role in improving the outcomes of these restructurings by tying payments of restructured debt contracts to future outcomes linked to a state variable (for example, GDP or commodity prices).
- SCDIs may reduce conflicts over current valuations and facilitate more sustainable agreements between creditors and debtors by providing payments that are higher in good states of the world than in bad states.
- Uptake of SCDIs has been limited in practice because fixed-income investors have steeply discounted “equity-like” instruments due to nonstandard designs, illiquidity, and idiosyncratic risk profiles, often providing poor value for their cost to borrowers.
- SCDIs can target specialized situations (for example, restructurings of state-owned enterprises and public-private partnerships) and be redesigned to increase uptake through standardization and improved contract terms.
- Official sector promotion—endorsement of standardized termsheets, enhanced data provisioning, and recognition of SCDIs in debt sustainability analyses—could be catalytic in increasing use.
- There is an opportunity to consider exchange bonds with payouts that vary in both good and bad times (“symmetric” instruments), particularly where payouts are linked to a variable outside sovereign control (for example, commodity prices) to avoid measurement and manipulation risks.
- Restructurings present an opportunity to introduce disaster clauses that grant temporary debt relief after natural disasters (used in recent Caribbean restructurings) and to study new clauses to address liquidity crises tied to future official sector debt suspensions.

*Source: EXECUTIVE SUMMARY (sdnea2020006)*

### Introduction — role and definition of SCDIs
- SCDIs are sovereign instruments that (1) bear contractual debt service obligations linked to a predefined state variable (for example, GDP, exports, or commodity prices) and (2) are designed to provide additional creditor compensation in good times and/or provide debtor relief in bad times (for example, interest forbearance, maturity extensions, or principal forgiveness).
- By tying payments to future outcomes, SCDIs may help avoid protracted disputes about current valuations and facilitate quicker agreements, restoring debt sustainability and aiding return to market access.
- Restructurings offer the unique possibility to implement SCDIs across an entire renegotiated debt stock with creditor consent, eliminating the “first-mover” problem that impedes their use in new issuance.

### Classification of SCDIs (historical structures)
- Instruments providing only upside payouts to creditors (Value Recovery Instruments, VRIs): typically structured as call options or warrants tied to a state variable (for example, GDP, exports, commodity prices). Upside payouts usually delayed and instruments can be traded separately from renegotiated debt securities.
- Instruments providing downside protection to borrowers: function like insurance contracts that provide relief after large negative shocks (for example, natural disasters) via interest forbearance, maturity extensions, or principal forgiveness.

### Four central policy questions addressed
1. How can VRIs help facilitate rapid and orderly sovereign debt restructurings, and how should they be structured?
2. How can SCDIs that offer downside protection be used during restructurings to embed longer-term resilience in debt structures?
3. Might SCDIs be useful to avoid a wave of defaults stemming from a global liquidity shock, and how to design triggers?
4. Is there scope to introduce SCDIs in restructurings that offer “symmetric” payouts to ensure sustainability in both good and bad states of the world?

### How can Value Recovery Instruments (VRIs) help facilitate rapid and orderly sovereign debt restructurings?
- Use cases and mechanics:
  - VRIs have been used in some recent sovereign debt restructurings to increase upside payouts to creditors and boost private creditor participation.
  - VRIs function as a call option on a better economic outlook, allowing creditors to share upside when variables such as GDP or commodity prices exceed thresholds (example: GDP-linked warrants, GLWs).
- Benefits:
  - VRIs can bridge the “expectation gap” between creditors and debtors about future economic prospects, making creditors more willing to accept conservative non-contingent bonds in the restructuring.
  - Linking VRIs to metrics of debt sustainability promotes risk sharing and reduces the probability of repeat defaults and post-restructuring debt overhang.
- Historical use:
  - VRIs have been deployed only on a few occasions among a total of more than 50 external sovereign debt restructuring cases since 1990.
  - Early use in the Brady restructurings (1980s) included warrants linked to oil prices or GDP/revenues of key SOEs; upside GDP-linked warrants featured in Argentina (2005 and 2010), Greece (2012), and Ukraine (2015). Argentina and Ecuador restructurings in 2020 did not include VRIs.

### Implementation constraints on VRIs (three major barriers)
- Investor preferences:
  - Majority of Eurobond investors are institutional investors and fixed-income mutual funds that prefer “plain vanilla” fixed-income securities with standard terms and liquidity.
  - Exotic instruments like VRIs attract boutique investors or macro hedge funds, who demand higher returns, putting downward pressure on VRI prices.
- Valuation uncertainty and illiquidity:
  - VRIs tied to GDP or commodity exports are difficult to price and viewed as exotic derivatives with limited secondary market liquidity.
  - This illiquidity generates a wide bid-ask spread for these instruments (up to 25 percent of mid-value for low-priced options).
  - Lack of standardization and initial low market value further reduce investor demand.
- Measurement issues, data reliability, and incomplete contracts:
  - Nonstandardized contract designs and unclear payout calculations have led to outcomes that tarnished VRIs’ reputation.
  - Examples of historical design/measurement issues:
    - Mexico’s VRI (1977–80) linked to oil export revenues did not specify a proper exchange rate to calculate payouts, diluting payout.
    - Bulgaria’s GLWs did not specify the exact GDP index, allowing sovereign calculation choices that favored the issuer.
    - Argentina in the early 2010s reported inaccurate GDP and CPI data, raising credibility concerns.
  - For countries with poor track records of data reliability or institutional independence, investors may be unwilling to accept VRIs.

### Potential approaches to increase VRI uptake and effectiveness
- Target VRIs to restructuring of SOEs and PPPs where equity-like instruments are more comparable to corporate restructurings.
- Improve contract design by increasing standardization of terms to promote liquidity and avoid shortcomings such as measurement ambiguities, lagging indicators, and uncapped payouts.
- Official sector actions that could be catalytic:
  - Endorsement of standardized termsheets.
  - Enhanced data provisioning to reduce measurement and credibility concerns.
  - Recognition of SCDIs’ benefits in Debt Sustainability Analysis (DSA).

### Consideration of symmetric instruments and proxies for state variables
- Economic case for symmetric payouts:
  - Post-COVID uncertainty affects both upside and downside; symmetric instruments linking coupons to a state variable (for example, GDP) could ensure debt sustainability across states.
- Data-risk mitigation:
  - Given GDP measurement risks, it may be preferable to link payouts to a proxy state variable outside debtor control (for example, commodity prices, trading partner GDP, or merchandise exports measured from importers’ data) that remains sufficiently correlated with debt-carrying capacity.
- Investor appetite for symmetric solutions needs to be tested.

### Disaster clauses and crisis-contingent clauses
- Natural disaster clauses:
  - Recent Caribbean restructurings included clauses granting temporary debt relief after natural disasters, providing low-cost insurance against exogenous shocks.
  - Restructurings are an opportunity to introduce such clauses across the renegotiated debt stock.
- Crisis clauses for global shocks (for example, pandemics):
  - Constructing “crisis” clauses similar to natural disaster clauses is challenging because (1) triggering events are difficult to define ex ante beyond pandemics and (2) investor appetite may be low as creditors are also liquidity-constrained during global crises.
  - More promising design: contingency clauses that link private sector debt standstills to official sector standstills—widespread official sector standstills could credibly signal seriousness and increase private creditor acceptance given official participation.

*Source: EXECUTIVE SUMMARY (sdnea2020006)*

### 5.      VRIs have rarely been seen in official lending. Based on available information, no explicit

### 5.      VRIs have rarely been seen in official lending. Based on available information, no explicit

### Use of VRIs in official lending
- No explicit VRIs have been included in official debt relief cases.
- Official creditors provide debt relief mainly via debt standstill, maturity extension, interest reduction, and outright debt forgiveness (such as the Heavily Indebted Poor Countries (HIPC) initiative).
- The absence of VRIs in official debt relief reflects that attempts by official creditors to “recover value” in this manner seems contradictory to the stated objectives of such official lending.
- As concessional lenders, official creditors such as bilateral development aid and multilateral development loans do not intend to share the upside of the economic outlook.
- Official creditors have occasionally issued SCDIs during normal times (see Appendix II noted in source).

### Non-state-contingent alternatives to VRIs and associated risks
- Investors may prefer simpler substitutes, such as bonds with stepped-up coupons (where the interest rate begins at a low level but resets higher after a predefined number of years) which are easier to price and have historically been used in many restructurings.
- Such instruments automatically deliver higher payments to creditors after some pre-specified period, thereby mimicking the recovery element of VRIs.
- Risk: If the step-up coupon is set too high, borrowers could be left exposed under adverse macroeconomic outcomes. In case of underperformance of the debtor economy, these instruments may put countries in a position where debt again becomes unsustainable due to the imbedded rising debt servicing cost, as they provide little downside protection to the sovereign.

### Role of VRIs in past restructurings
- The role of VRIs in facilitating previous debt restructuring appears to be limited.
- It is not clear that VRIs have shortened debt negotiations, given the unique nature of each case and the difficulty in calibrating counterfactuals.
- The overall duration of debt negotiations seems primarily dependent on the level of haircuts and creditor/lender dynamics (Appendix IV referenced in source).

### Valuation and fiscal cost considerations
- VRIs are typically heavily discounted by investors for discussed reasons, and on average they could be more expensive than simply enriching the offer by reducing outright haircuts.
- Examples:
  - Argentina’s 2005 GLWs turned out to be costly for the issuer.
  - Ukraine’s 2015 GLWs could end up paying out significantly more than the initial creditor haircut (see Box 1).
- The immediate benefit of low haircuts tied to inclusion of VRIs must be reconciled with potentially large and fiscally burdensome ultimate payouts.

### Recommended VRI design features (see Appendix I in source)
- Choice of state variable:
  - The ideal state variable for a VRI would be closely tied to sovereign repayment capacity, but free of data-manipulation concerns.
  - Indexation lags and links to highly persistent state variables should generally be avoided as they can erode the countercyclical properties of a SCDI.
  - There may be scope for SCDIs linked to state variables outside government control.
  - Linking the state variable to coupon payments rather than the principal smooths payments over time and reduces refinancing risk.
- Payout structure:
  - VRI payouts to creditors under upside scenarios must not be so large as to preclude the sovereign from rebuilding buffers against future idiosyncratic risks.
  - There is a case for floors and caps on upside payments, while avoiding GLWs structured as “far out of the money” options.
  - Instruments without caps can carry tail risk of large and disruptive payouts (example: GDP warrants issued in Ukraine’s 2015 restructuring).
  - For instruments offering downside protection, there is a theoretical risk of procyclicality for creditors in bad states of the world; this risk (1) would be limited if most holders are external or externally funded and (2) must be balanced against governments’ need to divert funds to social welfare or health expenditures.
- Detachability:
  - VRIs have tended to be detachable so that the restructured bond itself remains a fixed-income instrument.
  - If bond index compilers determine that the VRI is more akin to an equity instrument, the bond may not qualify for entry into a bond index.
  - A wider pool of standardized exchange bonds may allow exchange bonds (including the VRI) to be included in indices.

### Standardization versus bespoke instruments
- Tradeoff:
  - Standardized VRIs (common state variable and relatively simple payment structure) promote secondary market liquidity, familiarity, and investor pricing, and may increase likelihood of inclusion in a benchmark index.
  - Bespoke VRIs may better reflect the best measure of repayment capacity for a particular debtor and investor-specific preferences, but can lead to complex and nonstandard payout formulas.
- Resolution of tradeoffs will depend partly on international financial community interest in deeper markets for these instruments.

### VRIs in SOE and PPP restructurings
- Context and trend:
  - Direct lending and contingent liabilities to the sovereign from SOEs and PPP infrastructure projects appear to have become more common in the period leading up to the current crisis.
  - Staff estimates show that 14 major low-income countries’ (LICs) aggregate debt-to-GDP ratio has increased by 14 percentage points while their SOE debt more than tripled from 2008 to 2018 (Figure 1 in source).
  - There has been a dramatic rise in SOE lending to energy producers.
- Advantages in corporate-like restructurings:
  - SOE and PPP debt restructurings can more closely parallel corporate restructurings, facilitating debt-to-equity conversions or warrants where valuations and analyst coverage exist.
  - Investors in SOEs may be more inclined to accept illiquid equity-like claims, having expertise to value underlying cash flows.
  - VRIs structured as debt-to-equity conversions reduce debt overhang and may facilitate ex post investment.
  - VRIs can replace costly procyclical sovereign project guarantees (for example, revenue sharing agreements that delay payouts with upside potential).
- Limits and risks:
  - A significant fraction of SOE investors are not interested in SCDIs; some investments are intermediated by development banks or import-export banks preferring maturity extensions or grace periods.
  - Insider control in SOEs may deter foreign investors from accepting equity stakes; transferring equity to external lenders can entail significant political risks, especially if the lender is a foreign official creditor.
  - Strong transparency requirements and public safeguards are needed to prevent misuse of VRIs; poor disclosure in PPPs may enable opportunistic renegotiations and harm public interest.
  - In absence of contractual transparency, it may be preferable to face liabilities without changing contractual risk allocation.

### Overall assessment and suitability
- VRIs should be considered in deep debt restructurings involving large uncertainty about economic outcomes, but implementation obstacles and past risks have limited effective use.
- If a significant number of restructuring cases emerge in the current environment, it may offer opportunity to mainstream well-designed and standardized VRIs.
- Substantial challenges remain; poorly designed and valued VRIs (becoming a giveaway to creditors) may not yield risk-sharing benefits commensurate with the additional debt burden they create.
- Effectiveness of VRIs to facilitate orderly and rapid debt restructuring should be explored taking account of investor preference, characteristics of debt contracts, and incentive compatibility between debtor and creditor.
- In general, VRIs may be better suited to SOE/PPP restructuring cases, but political and contractual risks merit close attention.

### Box 1 — Market Valuation of GDP-Linked Warrants: Argentina, Greece, and Ukraine (key findings)
- Prices of Argentine, Greek, and Ukrainian GDP-linked warrants (GLWs) were initially low and highly volatile since issuance, with large bid-ask spreads indicating illiquidity.
  - Example: bid-ask spread for Greek and Argentine GLWs were 22 and 33 percent to their respective mid prices on July 1, 2020.
- Argentina:
  - GLWs offered to partially compensate investors for steep NPV haircuts of 77 percent in 2005.
  - Market initially valued GLWs at about 2 cents on the dollar.
  - GLW payments were based on GDP level rather than GDP growth; rapid growth after the exchange resulted in high payments, representing more than 30 percent of the total servicing of interest on public sector debt in 2012.
  - In recent years the price of the warrants collapsed along with the drop in GDP.
- Greece:
  - GLWs issued as part of 2012 debt exchange with steep NPV haircuts of 65 percent.
  - Price slumped to a low of 0.25 cents on the dollar in the first months after restructuring.
  - Triggers for large payouts now unlikely given low nominal GDP and slow GDP growth.
- Ukraine:
  - 2015 restructuring: 20 percent NPV reduction, equal to US$3.6 billion; creditors received GLWs in US$3.6 billion notional value linked to both level and growth rate of Ukraine GDP.
  - Under a 4 percent growth scenario, GLWs would deliver an internal rate of return to investors of 3 percent on their initial write-down.
  - Under a 5 percent growth scenario, the rate of return jumps to more than 13 percent, which would involve substantial fiscal costs of more than 55 basis points of GDP per year.
- Conclusion: Investors seemed to undervalue future benefits of GLWs, as evidenced by initial low market values; to attract investors sovereigns may need to promise better terms, raising probability of costly GLW payments. It remains unclear to what extent VRIs succeeded in bringing in more investors while delivering fair ex post risk sharing.

### Box 1 Table 1 — Descriptive Statistics of GDP-Linked Warrant Prices (Referencing the notional of 100, January 2013–July 2020)
- Ukraine
  - Initial price after offering: 49.6
  - Maximum: 109.43
  - Minimum: 28.69
  - Average: 57.10
- Greece
  - Initial price after offering: 0.20
  - Maximum: 1.44
  - Minimum: 0.14
  - Average: 0.57
- Argentina
  - Initial price after offering: 2.0
  - Maximum: 11.94
  - Minimum: 0.55
  - Average: 7.37

### SCDIs to embed longer-term resilience in debt structures (sections 15–18)
- SCDI categories:
  - Continuous adjustment of debt service payments (e.g., GDP-linked bond where payments indexed to nominal GDP).
  - Discrete adjustment instruments (e.g., natural disaster clauses triggering debt service relief after predefined natural disaster events, or maturity/grace period extensions in face of export shocks).
- Case for SCDIs:
  - SCDIs designed to reduce debt service in bad times (recession, natural or public disaster) increase resilience.
  - SCDIs offering contingent debt service standstills and/or maturity extensions can provide liquidity relief for issuers facing severe liquidity shocks and lower the risk of liquidity problems becoming full-blown sovereign debt crises.
- Recent successful adoption:
  - Restructured debt in Grenada (2015) and Barbados (2018) included natural disaster or “hurricane” clauses to provide cash flow relief after natural disaster events.
  - Such clauses enable redirecting funds intended for debt service to immediate needs and reduce economic impact of the disaster.
  - Future restructurings represent opportunities to support wider usage and standardization of these clauses.
- Potential triggers and variants:
  - Commodity price–based triggers could provide exogenous triggers relevant for commodity-exporting countries.
  - Countercyclical loans (example: Agence Française de Développement referenced in source) are a variant.
  - Borrowing spreads of third-party countries could provide an exogenous trigger (e.g., debt service suspension if average spread of other countries increases beyond a threshold).
  - Public health disaster clauses could be modeled similarly to the Catastrophe Containment and Relief Trust (e.g., cumulative GDP/revenue loss caused by a pandemic exceeding a given magnitude).
- Market appetite caveat:
  - Previous experience indicates market participants may not have appetite for such instruments beyond a narrow set of cases, particularly when shocks are global in nature.

*Source: Excerpt from IMF staff paper — “THE ROLE OF STATE-CONTINGENT DEBT INSTRUMENTS IN SOVEREIGN DEBT RESTRUCTURINGS” (sections summarized as provided).*

### 19.      The experience with the use of natural disaster clauses in Grenada and Barbados

### 19.      The experience with the use of natural disaster clauses in Grenada and Barbados

### Key features and outcomes of natural disaster clauses
- Verifiable trigger event assessed by an independent body:
  - Both Barbados and Grenada use Caribbean Catastrophe Risk Insurance Facility (CCRIF) parametric-based assessments to determine when the natural disaster event has been triggered.
- Applicability across debt contracts and creditors:
  - Grenada: natural disaster clauses included in both domestic and external commercial and official creditor debt contracts.
  - Barbados: clauses included in both domestic and external commercial debt contracts.
  - Result: a large portion of the debt stock in both countries now embodies insurance against natural disasters.
- Protection for small sovereign issuers against large idiosyncratic and exogenous shocks:
  - SCDIs with natural disaster clauses have so far been adopted only by small states with relatively concentrated debt holders.
  - Extending use to restructurings involving larger countries may be more challenging where tradeable commercial debt is a large share of the SoDR, because investors value liquidity of restructured instruments and may be reluctant to support SCDIs with “nonstandard” clauses.
- Size and duration of liquidity relief matter:
  - The size and duration of liquidity relief influence how much restructured SCDIs help mitigate the risk of a more costly debt restructuring.
  - Barbados and Grenada permit debt relief to be triggered up to a maximum of three separate occasions.
  - When a significant share of outstanding debt contains SCDIs with natural disaster clauses, liquidity relief can be very substantial.

### Box: Grenada — design and operational details
- Historical context:
  - First debt restructuring of 2004–06 triggered by Hurricane Ivan; another restructuring in 2013–15.
- Natural disaster clause mechanics:
  - Allows deferral of debt service payments on restructured debt for up to 12 months in the event of a qualifying hurricane.
  - Trigger: a CCRIF payout for losses that exceed US$15 million (except for Paris Club debt, where creditors opted for a more flexible trigger).
  - Maximum of three triggers.
  - Deferred interest is capitalized; deferred principal is distributed equally on top of scheduled payments until final maturity.
- Effects and market reaction:
  - Would provide significant cash flow relief and improve risk profile by reducing likelihood of follow-up restructuring.
  - Private creditors noted clauses made new instruments difficult to price and trade.
  - Hurricane provisions remain untested (conditions for trigger not yet met).
- Additional contingent feature in 2015 restructuring:
  - Contingent revenue-sharing if proceeds from Grenada’s Citizen-by-Investment program exceeded a threshold of US$15 million; payments were made in 2018 and 2019.

### Box: Barbados — design and operational details
- Context:
  - 2018–19: Barbados restructured public debt for first time in country’s history; risk from extreme weather events and earthquakes.
- Natural disaster clause mechanics:
  - Most new debt instruments allow capitalization of interest and deferral of scheduled amortization falling due over a two-year period following the occurrence of a major natural disaster.
  - Trigger for new domestic debt: CCRIF payout above US$5 million.
  - New external debt links CCRIF payouts with differentiated thresholds depending on the type of disaster (hurricane, flood, earthquake).
  - For new external debt instrument, holders of at least 50 percent of the aggregate principal amount of the bonds outstanding at the time Barbados elects to defer payments can block activation of the clause.
- Market outcomes:
  - New external debt instrument is traded in the secondary market.
  - Virtually no trading of debt instruments on the domestic market following the restructuring.
  - No new external debt has been issued since the debt restructuring.

### Pandemic and global-crisis extensions: potential and challenges
- Potential benefit:
  - SCDIs that prompt automatic debt standstills under “pandemic” or other global crisis conditions could help developing countries cope with market illiquidity like that experienced during COVID-19.
  - Gelpern, Hagan, and Mazarei (2020) advocated SCDIs with standstill clauses to secure binding standstills during global crises.
- Key implementation challenges:
  - Trigger delineation difficulty:
    - Effective “crisis” clauses must consider a large set of potential catalysts beyond previous episodes; defining inclusive and unambiguous triggers is challenging even for narrower shocks like natural disasters.
    - “Hurricane-linked” clauses are triggered by a modeled loss (minimum insurance claim) after a specified event; absence of parameter coverage or insufficient payout prevents trigger activation.
    - A “crisis” clause would transfer a larger set of risks to investors, who would likely demand higher yields.
  - Systemic nature of global shocks:
    - Global shocks affect both borrowers and lenders, reducing lender appetite.
    - Pandemic shocks subject investors’ portfolios to simultaneous losses, making “pandemic” clauses less appealing and driving up premiums and coupon rates.
  - Pandemic-bond experience underscores problems:
    - Market-based pandemic catastrophe bonds provide high yields but carry trigger complexity, high coupon rates, and limited payout.
    - Example: World Bank pandemic bond program (see Box 3).

### Box: World Bank Pandemic Bond Program — facts and challenges
- Structure and coverage:
  - Launched July 2017 in two tranches:
    - Class A: US$225 million in bonds and US$50 million in swaps.
    - Class B: US$95 million in bonds and US$55 million in swaps.
  - Class A covered the flu and coronavirus; Class B covered filovirus, coronavirus, Crimean Congo, Rift Valley, and Lassa Fever.
  - Coronavirus covered by both tranches; Class A covered coronavirus at a higher level of severity than Class B.
- Pricing and principal risk:
  - Class A offered coupon of 6M LIBOR + 6.5 percent and could lose up to 16.67 percent of its principal.
  - Class B offered coupon of 6M LIBOR + 11 percent and could lose all its principal.
- Trigger and payout:
  - Trigger based on outbreak reaching predetermined contagion and spread speed levels and crossing international borders, using WHO-reported public data.
  - In April 2020, the trigger was satisfied and maximum amount US$195.84 million for coronavirus was paid out.
- Performance and retrospective assessment:
  - Typical challenges: trigger complexity, high coupon rate, and limited payout.
  - Trigger complexity compounded by under-reporting of infections due to limited testing and domestic politics.
  - With COVID-19 onset, valuation became highly correlated with global financial markets, reducing diversification benefits and investor appetite, leading to high coupons and lower issuer incentives to issue.
  - Payout timing and size issues:
    - Trigger met four months after outbreak.
    - Payout constituted about 43 percent of the principal.
    - World Bank’s accumulated payments of premiums since issuance: US$107.2 million for the maximum payout of US$195.8 million for COVID-19.
  - Decision: World Bank decided not to renew after current pandemic bonds and swaps matured on July 15, 2020.

### Design alternatives and policy suggestions for crisis-linked SCDIs
- Consider clauses linked directly to crisis signals rather than precipitating factors:
  - Market-disruption signal clauses:
    - Temporary debt suspension and maturity extension could be triggered by a narrowly defined signal of breakdown in market functioning (for example, a massive and idiosyncratic jump in aggregate emerging market bond yields as measured by a broad EM bond index such as Emerging Market Bond Index Global—EMBIG).
    - Investor interest and implications for investors facing liquidity pressures (such as mutual funds) must be explored.
  - Clauses tied to commensurate official-sector action:
    - Private sector debt service could be suspended automatically if a predefined set of official creditors (for example, the Paris Club or the G20) suspended debt service.
    - This would create a contractual link from official sector suspension to private sector participation without requiring debtor action.
    - While private investors may be reluctant because repayment would depend on reprofiling of other debt classes, official sector suspension could serve as a credible signal and encourage private sector ex ante commitments to liquidity relief.

### Scope for symmetric SCDIs (upside and downside payoffs)
- Motivation for symmetric SCDIs in restructurings:
  - In heightened upside and downside uncertainty, symmetric exchange bonds offering both upside to creditors and downside protection may facilitate agreement on a more favorable baseline while protecting creditors against global risks.
  - Symmetric SCDIs may be politically preferable ex post to debtors if they imply lower upside repayments relative to a more favorable baseline.
- Design considerations and tradeoffs:
  - Choice of state variable must balance being outside debtor control and being well correlated with debt sustainability.
  - Exotic metrics may be less palatable to investors; externally measured metrics (such as exports) should be considered and market appetite investigated.
- Reasons symmetric SCDIs may be especially useful in restructurings (Box 4):
  - Restructuring debtors often have more pessimistic expectations than creditors, opening scope for upside SCDIs to bridge valuation gaps.
  - SCDIs can increase expected returns for creditors without increasing default probability by promising higher payments only in good states.
  - Debtor signaling concerns that deter SCDIs in normal times are reduced in restructuring contexts, since inability to repay is acknowledged.
  - To impact probability of default meaningfully, downside-protection SCDIs typically need to account for a substantial share of the debt stock—achievable in one shot during restructuring.
  - If creditors demand high premiums for state-contingent payouts, debtors may still prefer them when risk premiums on conventional debt are already high, particularly if the contingency reduces default risk.

*International Monetary Fund — Chapter text from "The role of state-contingent debt instruments in sovereign debt restructurings" (content unit sdnea2020006 — section 19).*

### 27.      There may be scope to use standardized “external” state variables that could mitigate

### sdnea2020006 - 27.      There may be scope to use standardized “external” state variables that could mitigate

### Use of standardized “external” state variables
- Staff analysis: major EM recessions over the past 20 years have generally been associated with global shocks.
- Rationale: much of the medium-term uncertainty facing individual sovereigns today stems from global factors; global state variables are outside debtor control, reducing manipulation concerns and increasing creditor attractiveness relative to GDP-linked VRIs.
- Notable candidate state variables:
  - Global commodity prices, for commodity exporters.
    - Commodity prices are highly correlated with GDP and revenues in commodity exporters.
    - Not subject to manipulation concerns (perhaps aside from a few very large producers).
    - Deep and liquid market for medium-term oil futures (longer-dated futures are thinner), aiding pricing and investor natural hedges.
    - Chad’s 2018 restructuring of loans from a commodity trader featured upside and downside elements linked to oil receipts and provided liquidity relief when oil prices collapsed at the beginning of the COVID-19 crisis.
    - Note: These instruments need not be collateralized by the underlying commodity exports, avoiding liquidity risks and debt resolution challenges from large collateralization transactions.
  - Trading partner GDP, for non-commodity-exporting small open economies.
    - Historical correlation in currently stressed EM sovereigns is about 0.5, on average, between trading partner GDP and domestic GDP.
    - Use requires case-by-case assessment that (1) trading partner GDP is sufficiently correlated with domestic GDP and the current account, and (2) political feasibility of linking a country’s obligations to trading partners’ GDP.
  - Merchandise exports, where reliance on manufacturing exports is high.
    - May correlate with debt serviceability, particularly for foreign exchange debt.
    - If domestic trade statistics are unreliable, the state variable could use importer-country reporting for the IMF Direction of Trade Statistics (DOTS).
    - Less useful for countries relying heavily on services exports and remittances.

### Design options: “floater” and “extendible”
- “Floater” design:
  - Coupon rate on the exchange bond linked to the state variable, subject to a floor and cap.
  - Proposed in IMF (2017): bond’s nominal interest rate scales linearly with the contract state variable (between a minimum and a maximum value).
  - Interest-rate sensitivity to growth can be adjusted to investor preferences.
  - Expected growth rate would be near the distribution middle, so coupon expected to both rise and fall with growth, producing built-in counter-cyclical fiscal costs.
- “Extendible” design:
  - State variable triggers contractual maturity extension (similar to Agence France Development countercyclical loans with extendible grace periods).
  - Example trigger: state variable falls below a threshold (say trading partner GDP growth of –2 percent) → principal payments deferred for a prespecified period (say, three years), delivering substantial near-term liquidity relief.
- Relative effects:
  - For recessions driven by common/global factors, both designs could provide substantial liquidity relief; the “extendible” design delivers larger near-term benefits.
  - The “floater” design also provides some solvency relief through reduced average interest payments.
  - Market-based indicators (e.g., global EM spread levels) could be used as state variables.

- Figure/assumptions (illustrative):
  - It is assumed that the decline in GDP in the country concerned is in line with that of the instrument’s state variable (e.g., trading-partner GDP).
  - It is assumed for illustrative purposes that a three-year maturity extension is triggered by the decline in GDP in 2020.
  - The original bond is assumed to have five-year maturity, interest and discount rate of 5 percent.

### Conclusion: role and limitations of VRIs and SCDIs
- VRIs could facilitate speedier and less-costly restructurings by tying payments to future outcomes, but usefulness limited by diverging creditor/sovereign valuations.
  - Creditors historically discount VRIs due to illiquidity, idiosyncratic risk profiles, and lack of correlation with fixed-income portfolios.
  - VRIs may be more useful in restructuring of SOEs and PPPs, resembling corporate restructurings where VRIs are common.
  - New VRIs should learn from history: choose state variables minimizing measurement issues, avoid lagging indicators, and structure payouts with floors and caps.
- SCDIs (state-contingent disaster instruments) present opportunities:
  - Natural disaster clauses can provide low-cost downside protection against exogenous shocks; included in recent Caribbean SoDRs.
  - Potential to expand to larger countries and broader shock criteria (including public health disasters), though market appetite may be limited.
- Contingency clauses linking private sector debt standstills to official sector standstills are promising:
  - Widespread official sector standstills could credibly signal seriousness and encourage private lenders to commit ex ante given promise of official participation.
- Symmetric payouts and floating-rate fixed-principal instruments:
  - Restructuring exchange bonds with symmetric payouts could share both upside and downside uncertainty; linking coupons to external proxies can avoid debtor manipulation risk.
- Potential to develop liquid SCDI markets during restructurings:
  - First-mover problems in normal times (sovereign stigma; creditor subordination) lessen in restructurings, as stigma is reduced and entire debt stock can turn over.
  - Official sector actions to actualize potential:
    - (i) Endorse standardized SCDI termsheets developed by reputable legal and market professionals (akin to enhanced CACs).
    - (ii) Enhance data provision to facilitate common state variables not subject to manipulation risk.
    - (iii) Explicitly recognize resilience from downside or symmetric SCDIs in debt sustainability assessments.
    - (iv) Incorporate standardized SCDIs in official debt restructurings to signal support for the instrument class.

### Appendix I — design considerations for VRIs
- Balance between debtor and creditor interests: VRIs must offer upside to investors if repayment capacity strengthens, while avoiding excessive upside payments that sovereigns cannot meet.
- Tension between standardization (for liquidity) and tailoring (for country circumstances).
- Choice of state variable:
  - Ideal: closely tied to repayment capacity, exogenous to sovereign, free of data-manipulation concerns—difficult in practice.
  - Indexation lags and highly persistent variables should be avoided because they erode countercyclicality and can lead to politically unpopular lagged payments (Argentina GDP warrant example).
  - Novel external variables (commodity prices, trading-partner outturns, partner-reported exports) can mitigate manipulation concerns but may reduce investor familiarity and liquidity.
- Payout structure:
  - Simple, easy-to-understand formulas preferred by investors; complex nonlinear links have been unpopular.
  - Key considerations:
    - Baseline/central projection of the state variable: conservative baseline may lead to positive payoffs on small upside realizations, undermining conservatism.
    - Need for floor/bounds above baseline to preserve government counter-cyclical policy space.
    - Establishment of a cap to limit excessive upside and keep instrument within fixed-income realm.
  - Floors and caps determine expected payoffs; frequent low-value payments may have similar valuation to infrequent high-value payments—fixed-income investors generally prefer the former.
  - Caution against over-committing payments in good states given remaining idiosyncratic risks.
- Other design choices affecting valuation:
  - (1) Associate state variable with principal (linkers) or coupon rate — coupon-linking preferred for simplicity and cap implementation.
  - (2) Binary vs. continuous payoff valuation — binary payoffs may increase misreporting incentives around triggers.
  - (3) Detachable vs. part of restructured bond — detachable VRIs maintain fixed-income nature of restructured bond but may affect bond-index inclusion.
- Valuation approach:
  - Discounted present value of all possible realizations from Monte Carlo simulations applying the payout formula across paths.
  - Valuation depends on chosen discount rate:
    - Asymmetric VRIs with upside payments imply lower default risk than regular bonds (payments concentrated in good states), suggesting the same bond discount rate would understate VRI value.
    - Creditors argue bespoke nature, reduced liquidity, and valuation difficulties justify a premium on the fair-value discount rate.

*International Monetary Fund — The Role of State-Contingent Debt Instruments in Sovereign Debt Restructurings (selected excerpts)*

### Appendix II. Considerations in the Use of SCDIs by Official

### Appendix II. Considerations in the Use of SCDIs by Official Sector Creditors

### Examples of official use
- Agence Française de Développement’s “floating grace period” loans — allowed for a grace period when export earnings fall below a certain threshold (these have never been triggered).
- Petrocaribe loans — bilateral loans with predetermined flexible financing terms extended by Venezuela to countries to purchase oil produced by PDVSA (Petroleos de Venezuela, S.A.). The terms of the Petrocaribe loans were linked to oil prices.

### How official-sector characteristics can attenuate problems that limit private use of SCDIs
- Liquidity
  - Official sector lenders typically maintain their exposure over the long term, unlike most private investors.
  - Even private investors that plan to follow a “buy and hold” strategy still need to worry about contingencies when they need to close a position.
  - As a result, official borrowers may not be as concerned about an illiquid SCDI.
- Lack of commonly used pricing model
  - Private investors are concerned by the lack of agreement over the pricing/valuation of an SCDI; an investor may be reluctant to pay a perceived fair value for fear future buyers will not value it under the same assumptions.
  - If an official creditor is willing to hold the exposure of the SCDI throughout its term, it only needs to worry about the uncertainty surrounding its own valuation, not of other investors.
- Political economy considerations
  - If an official creditor faces domestic political economy pressures regarding its assistance, a VRI could help buy political support.
  - By pointing out a potential upside to its assistance, it may be easier to build political support at home.
- Size
  - The risk-sharing benefits of SCDIs only materialize if there is a significantly large use of these instruments.
  - Large official sector lenders could create a critical demand for the VRI that would be hard to achieve (outside of a restructuring) among decentralized private lenders.
- Natural hedge
  - Some official lenders may be ideally placed to share risk with borrowers. For example, both an oil importing creditor and an oil-exporting borrower would benefit from sharing the risk of shocks to oil prices.
  - While the same is true for some private investors, the combination of large size and a natural hedge makes official holding of commodity-related instruments one of the lowest hanging fruits for the development of SCDIs/VRIs.

*Appendix II. Considerations in the Use of SCDIs by Official Sector Creditors*

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_Source: https://www.imf.org/-/media/files/publications/sdn/2020/english/sdnea2020006.pdf_