State-Contingent Debt Instruments for sovereigns
State-contingent debt instruments (SCDIs) can help better manage public debt in a world of macroeconomic uncertainty. SCDIs link a sovereign’s debt service payments to its capacity to pay, where the latter is linked to real world variables or events. For example, instruments can be linked to a country’s GDP, to commodity prices, or to natural disasters such as hurricanes or earthquakes. This means that when times are bad – such as during an economic downturn or following a natural disaster – there is an automatic reduction in the sovereign’s debt service burden. This reduction helps preserve the sovereign’s policy space to undertake countercyclical and stabilization policies, and can serve as a useful complement the traditional government policy toolkit. Where the size of the debt burden reduction is large relative to capacity to pay, SCDIs may also help avert the need for a costly debt restructuring that may have otherwise been necessary.
Being a novel financial instrument, SCDIs can also pose some complications. For instance, there may be a high novelty or liquidity premium demanded by investors in the early stages of market development. Adverse selection and moral hazard risks that arise in any insurance-like product would need to be mitigated. It is also important to consider undesirable pricing effects on conventional debt, or the possibility of excessive risk migration to private sector balance sheets. These complications are also mentioned by market participants, thus underline the importance of careful instrument design, and robust institutions, contracts and regulation.
Against this backdrop, the IMF’s work proposes three benchmark designs for SCDIs for issuers and investors to consider. These include “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 the state variable), and “extendibles” (bonds whose maturity is pushed out if a pre-defined trigger is breached). Guidance is available on calibrating these designs, as well as the appropriate choice of state variables or triggers.
