## 4. Commitment Flexibility in Bond Contracts

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---

### I. Introduction — four claims
- Emerging markets commonly exhibit a high degree of volatility and a transitional character (economic, political, social, demographic).
- Volatility and transition create an acute trade-off between commitment and flexibility in policymaking — commitment attracts investment but may be not credible; flexibility allows response to shocks but can be abused.
- Rigid commitment with no flexibility is practically infeasible; flexibility is viable only within an institutional framework that limits discretion. Transition is from transaction-specific commitments to institutional commitments.
- Policy implication: neat, single-front solutions are rare; progress requires complementary, interlocking reforms and institutions. Inertia in reform sometimes reflects complexity rather than failure.

### II. Emerging markets and the policymaking dilemma
- Volatility sources: natural disasters, external price shocks, domestic policy instability.
- Key distinction: whether volatility is uncontrollable or a consequence of policy frameworks; perceived arbitrariness in policymaking undermines investor confidence.
- Empirical notes cited:
  - World Bank (2002): outside East Asia and Pacific, no regional grouping grew systematically faster than “advanced” economies in last two decades.
  - Klingen, Weder, and Zettelmeyer (2004): average return to private investment in emerging markets over past decades has been no higher than the risk free rate.
- Commitment-flexibility dynamic:
  - Transactional commitments: specific contract-based commitments used early to signal credibility.
  - Institutional commitments: broader frameworks and institutions that allow disciplined discretion.
  - As hard rules are relaxed, substitution by clearly articulated objectives and tactics is required (Bernanke and others, 1999).

### III. World Bank guarantees — transactional hard commitments
- Mechanism:
  - World Bank guarantees repayment to private lenders; government counter-guarantees the Bank.
  - Guarantee types: “partial credit guarantee” (sovereign borrowing) and “partial risk guarantee” (private entity loans where government contractual commitments to project are counter-guaranteed).
- Role and evolution:
  - Revival began June 1990 (Hungary) and expanded via World Bank policy changes in 1994 and 1998.
  - Guarantees provide the hardest repayment commitment possible and were used to establish borrower track records.
- Empirical patterns:
  - First 1990s guarantee: Hungary at Moody’s Baa2 (one notch above investment grade Baa3).
  - Early 1990s: three guarantees to China were at higher ratings (China A3 entries shown).
  - By mid-1990s, guaranteed sovereigns included Jordan, Philippines, Pakistan at Ba3; average rating of guaranteed sovereigns declined subsequently.
  - Recent guaranteed projects include IDA-only countries: Côte d’Ivoire, Bangladesh, Mozambique.
- Interpretation:
  - Guarantees helped several emerging economies enter international capital markets in the 1990s.
  - As countries acquired track records, the need to “import” credibility via guarantees diminished.
  - Graduation from guarantees does not mean countries cease to be emerging markets; guarantees remain relevant mainly for low-income countries.

### IV. Exchange rate regimes — commitment vs flexibility at macro scale
- Pegged exchange rates:
  - Pegging limits monetary discretion and signals commitment to low inflation, but limits flexibility to respond to shocks.
  - Pegs are highly persistent (Husain, Mody, and Rogoff 2004); in low-institution settings a peg can be a clearer signal than central bank independence (Broz 2002).
- Intermediate regimes:
  - Intermediate regimes attempt to combine commitment and flexibility; economists are divided on their sustainability (Williamson 2000 vs Eichengreen 1994; Obstfeld and Rogoff 1995).
  - De facto regimes show that the middle ground retained substantial share of regimes (Figure 2 referenced).
- Empirical performance (Figure 3 highlights):
  - Developing countries with limited capital market interactions: harder commitment (fixed/close to fixed) → lower inflation without growth sacrifice.
  - Emerging markets with significant capital market exposure: harder commitment → lower inflation on average, but pegged regimes associated with higher likelihood of financial crises.
  - Advanced economies: greater flexibility associated with higher growth and lower (though not always statistically significant) inflation; crises are rarer.
- Transition trend:
  - A small group of emerging markets (e.g., Chile, Mexico, Brazil) is moving toward greater exchange-rate flexibility while building complementary institutions that anchor credibility.

### V. Bond contracts — contractual commitment and flexibility
- Contract types:
  - Unanimous Action Clauses (UACs): require all bondholders to agree to changes — imply strong issuer commitment.
  - Collective Action Clauses (CACs): allow a qualified majority to change payment terms — provide flexibility for restructuring.
- Credit-quality patterns in contract choice:
  - Low-rated issuers (Institutional Investor Rating 0-35) tended to issue more often under U.K. law (equated here to CACs/flexibility) than U.S. law (equated here to UACs/rigidity).
  - Early 1990s: U.K. law bonds in the low-rated category were more than twice as likely as U.S. law bonds.
  - Over time, the ratio of U.K. law to U.S. law declined even in low-rated categories, coinciding with lower volatility periods.
- Pricing premium for flexibility:
  - Issuers rated 0-35 pay a significant premium for U.K. law (flexibility) over the full 1991–2002 sample (Table 1, Panel A).
  - As issuers’ ratings improve, they shift toward U.S. law bonds; the share of U.K. law remains substantial but the premium declines.
- Market-volatility interaction (EMBI spread variability periods):
  - Period 1 (1991:1-1995:3) — EMBI variability about 2.5 percentage points a day.
  - Period 2 (1995:4-1997:2) — EMBI variability about 1.5 percentage points a day (exuberant period).
  - Period 3 (1997:3-1999:4) — variability rose to above 2.5 percentage points a day (Asian, Russian, Brazilian crises).
  - Period 4 (recent up to end-2000) — lower spread variability, cautious sentiment without systemic crises.
- Volatility-period findings:
  - Premium for lowest-rated issuers remains large across periods, lowest during exuberance.
  - For 36-50 category: premium small/insignificant in period 1; small discount in period 2 (not significant); significant premium in period 3; premium falls in period 4.
- Direct interaction (Panel B, Table 1) — governing law by itself is not significant; interaction with EMBI volatility is crucial:
  - For issuers below 50, when daily volatility is 1 percent, average premium on U.K. law bonds ≈ 31 percent (calculated as 0.15*1+0.16).
  - When volatility rises to 2 percent, premium ≈ 46 percent (0.15*2+0.16).
  - For 36-50 category: 1 percent volatility → no premium/discount; 2 percent volatility → premium ≈ 17 percent.
  - Note: margins of error on point estimates are large because coefficient on governing law itself is not significant at standard levels.
- Recent institutional innovation:
  - Early 2003: Mexico issued a bond under U.S. law with CACs — triggering trend toward greater use of collective action clauses by sovereign issuers.
  - This shift occurred in a relatively calm market and among more creditworthy emerging markets; it could mark a break if flexibility is credibly constrained and backed by institutional progress.
- Contractual heterogeneity:
  - Choi and Gulati (2004) document significant contractual variations even within U.S. law bonds, reflecting credit quality considerations.
  - Standardization efforts should define key areas important for debt valuation but allow adjustable parameters.

### VI. Conclusions — evolution from transactional to institutional commitment
- Transactional commitments (e.g., World Bank guarantees, rigid bond contracts, exchange-rate pegs) are useful substitutes for institutional credibility in early market interactions.
- Evidence:
  - World Bank guarantees facilitated entry to global capital markets in the 1990s; usage shifted toward lower-rated and IDA countries over time.
  - Exchange-rate pegs lower inflation in developing and emerging markets but increase crisis risk for emerging markets; advanced economies benefit from flexibility backed by institutions.
  - Bond contracts: lowest-rated issuers unable to offer hard commitment pay a premium for flexibility; as ratings improve the value of transactional commitment declines.
- Policy implication:
  - Desirable path: move from transaction-specific commitments toward institutional commitments that allow disciplined flexibility.
  - Mexico example: post-1994 crisis reforms, investment-grade rating, retreat from fixed exchange rate, issuance of U.S.-law bonds with CACs and a 20-year domestic peso bond (peso amount 1 billion, just under $100 million at then exchange rate) as evidence of institutional credibility making transactional commitments less necessary.
- Final assessment:
  - Transactional commitments can be valuable up to a point; they are limiting and sometimes untenable.
  - The measured move toward transactional flexibility embedded within stronger institutions appears to be the sustainable route for emerging markets.

*Source — IMF Working Paper, section "4. Commitment Flexibility in Bond Contracts" (content unit _wp04177).*

### References..............................................................................................................

### _wp04177 - References

### Tables
- 1.   The Price of Flexibility: Implications of Credit Quality and Market Volatility ........ 19

### Figures
- 1. Graduating from World Bank Guarantess ................................................................. 20
- 2. Worldwide Composition of Exchange Regimes........................................................ 21
- 3. Performance of Floating Regimes Relative to Pegs .................................................. 22

*Source: _wp04177 - References..............................................................................................................*

### 4. Commitment Flexibility in Bond Contracts............................................................... 23

### 4. Commitment Flexibility in Bond Contracts

### I. Introduction — four claims
- Emerging markets commonly exhibit a high degree of volatility and a transitional character (economic, political, social, demographic).
- Central theme: volatility and transition create an acute trade-off between commitment and flexibility in policymaking — commitment attracts investment but may be not credible; flexibility allows response to shocks but can be abused.
- Rigid commitment with no flexibility is practically infeasible; flexibility is viable only within an institutional framework that limits discretion. Transition is from transaction-specific commitments to institutional commitments.
- Policy implication: neat, single-front solutions are rare; progress requires complementary, interlocking reforms and institutions. Inertia in reform sometimes reflects complexity rather than failure.

### II. Emerging markets and the policymaking dilemma
- Volatility sources: natural disasters, external price shocks, domestic policy instability.
- Key distinction: whether volatility is uncontrollable or a consequence of policy frameworks; perceived arbitrariness in policymaking undermines investor confidence.
- Empirical notes cited:
  - World Bank (2002): outside East Asia and Pacific, no regional grouping grew systematically faster than “advanced” economies in last two decades.
  - Klingen, Weder, and Zettelmeyer (2004): average return to private investment in emerging markets over past decades has been no higher than the risk free rate.
- Commitment-flexibility dynamic:
  - Transactional commitments: specific contract-based commitments used early to signal credibility.
  - Institutional commitments: broader frameworks and institutions that allow disciplined discretion.
  - As hard rules are relaxed, substitution by clearly articulated objectives and tactics is required (Bernanke and others, 1999).

### III. World Bank guarantees — transactional hard commitments
- Mechanism:
  - World Bank guarantees repayment to private lenders; government counter-guarantees the Bank.
  - Guarantee types: “partial credit guarantee” (sovereign borrowing) and “partial risk guarantee” (private entity loans where government contractual commitments to project are counter-guaranteed).
- Role and evolution:
  - Revival began June 1990 (Hungary) and expanded via World Bank policy changes in 1994 and 1998.
  - Guarantees provide the hardest repayment commitment possible and were used to establish borrower track records.
- Empirical patterns:
  - First 1990s guarantee: Hungary at Moody’s Baa2 (one notch above investment grade Baa3).
  - Early 1990s: three guarantees to China were at higher ratings (China A3 entries shown).
  - By mid-1990s, guaranteed sovereigns included Jordan, Philippines, Pakistan at Ba3; average rating of guaranteed sovereigns declined subsequently.
  - Recent guaranteed projects include IDA-only countries: Côte d’Ivoire, Bangladesh, Mozambique.
- Interpretation:
  - Guarantees helped several emerging economies enter international capital markets in the 1990s.
  - As countries acquired track records, the need to “import” credibility via guarantees diminished.
  - Graduation from guarantees does not mean countries cease to be emerging markets; guarantees remain relevant mainly for low-income countries.

### IV. Exchange rate regimes — commitment vs flexibility at macro scale
- Pegged exchange rates:
  - Pegging limits monetary discretion and signals commitment to low inflation, but limits flexibility to respond to shocks.
  - Pegs are highly persistent (Husain, Mody, and Rogoff 2004); in low-institution settings a peg can be a clearer signal than central bank independence (Broz 2002).
- Intermediate regimes:
  - Intermediate regimes attempt to combine commitment and flexibility; economists are divided on their sustainability (Williamson 2000 vs Eichengreen 1994; Obstfeld and Rogoff 1995).
  - De facto regimes show that the middle ground retained substantial share of regimes (Figure 2 referenced).
- Empirical performance (Figure 3 highlights):
  - Developing countries with limited capital market interactions: harder commitment (fixed/close to fixed) → lower inflation without growth sacrifice.
  - Emerging markets with significant capital market exposure: harder commitment → lower inflation on average, but pegged regimes associated with higher likelihood of financial crises.
  - Advanced economies: greater flexibility associated with higher growth and lower (though not always statistically significant) inflation; crises are rarer.
- Transition trend:
  - A small group of emerging markets (e.g., Chile, Mexico, Brazil) is moving toward greater exchange-rate flexibility while building complementary institutions that anchor credibility.

### V. Bond contracts — contractual commitment and flexibility
- Contract types:
  - Unanimous Action Clauses (UACs): require all bondholders to agree to changes — imply strong issuer commitment.
  - Collective Action Clauses (CACs): allow a qualified majority to change payment terms — provide flexibility for restructuring.
- Credit-quality patterns in contract choice:
  - Low-rated issuers (Institutional Investor Rating 0-35) tended to issue more often under U.K. law (equated here to CACs/flexibility) than U.S. law (equated here to UACs/rigidity).
  - Early 1990s: U.K. law bonds in the low-rated category were more than twice as likely as U.S. law bonds.
  - Over time, the ratio of U.K. law to U.S. law declined even in low-rated categories, coinciding with lower volatility periods.
- Pricing premium for flexibility:
  - Issuers rated 0-35 pay a significant premium for U.K. law (flexibility) over the full 1991–2002 sample (Table 1, Panel A).
  - As issuers’ ratings improve, they shift toward U.S. law bonds; the share of U.K. law remains substantial but the premium declines.
- Market-volatility interaction:
  - Four sample periods distinguished by EMBI spread variability:
    1. 1991:1-1995:3 — EMBI variability about 2.5 percentage points a day.
    2. 1995:4-1997:2 — variability about 1.5 percentage points a day (exuberant period).
    3. 1997:3-1999:4 — variability rose to above 2.5 percentage points a day (Asian, Russian, Brazilian crises).
    4. Recent up to end-2000 — lower spread variability, cautious sentiment without systemic crises.
  - Findings:
    - Premium for lowest-rated issuers remains large across periods, lowest during exuberance.
    - For 36-50 category: premium small/insignificant in period 1; small discount in period 2 (not significant); significant premium in period 3; premium falls in period 4.
  - Direct interaction (Panel B, Table 1) — governing law by itself is not significant; interaction with EMBI volatility is crucial:
    - For issuers below 50, when daily volatility is 1 percent, average premium on U.K. law bonds ≈ 31 percent (calculated as 0.15*1+0.16).
    - When volatility rises to 2 percent, premium ≈ 46 percent (0.15*2+0.16).
    - For 36-50 category: 1 percent volatility → no premium/discount; 2 percent volatility → premium ≈ 17 percent.
    - Note: margins of error on point estimates are large because coefficient on governing law itself is not significant at standard levels.
- Recent institutional innovation:
  - Early 2003: Mexico issued a bond under U.S. law with CACs — triggering trend toward greater use of collective action clauses by sovereign issuers.
  - This shift occurred in a relatively calm market and among more creditworthy emerging markets; it could mark a break if flexibility is credibly constrained and backed by institutional progress.
- Contractual heterogeneity:
  - Choi and Gulati (2004) document significant contractual variations even within U.S. law bonds, reflecting credit quality considerations. Standardization efforts should define key areas important for debt valuation but allow adjustable parameters.

### VI. Conclusions — evolution from transactional to institutional commitment
- Transactional commitments (e.g., World Bank guarantees, rigid bond contracts, exchange-rate pegs) are useful substitutes for institutional credibility in early market interactions.
- Evidence:
  - World Bank guarantees facilitated entry to global capital markets in the 1990s; usage shifted toward lower-rated and IDA countries over time.
  - Exchange-rate pegs lower inflation in developing and emerging markets but increase crisis risk for emerging markets; advanced economies benefit from flexibility backed by institutions.
  - Bond contracts: lowest-rated issuers unable to offer hard commitment pay a premium for flexibility; as ratings improve the value of transactional commitment declines.
- Policy implication:
  - The desirable path is moving from transaction-specific commitments toward institutional commitments that allow disciplined flexibility.
  - Mexico’s experience is cited: post-1994 crisis reforms, investment-grade rating, retreat from fixed exchange rate, and issuance of U.S.-law bonds with CACs and a 20-year domestic peso bond (peso amount 1 billion, just under $100 million at then exchange rate) as evidence of institutional credibility making transactional commitments less necessary.
- Final assessment:
  - Transactional commitments can be valuable up to a point; they are limiting and sometimes untenable.
  - The measured move toward transactional flexibility embedded within stronger institutions appears to be the sustainable route for emerging markets.

*Italic: Source — IMF Working Paper, section "4. Commitment Flexibility in Bond Contracts" (content unit _wp04177).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2004/_wp04177.pdf_