Optimal State Contingent Sovereign Debt Instruments

IMF Working Papers, September 10, 2021

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The optimal sovereign lending contract is state-contingent when a government can default.
The result is obtained as the endogenous solution to a contracting problem under time-inconsistency when a government cannot credibly commit to honor debt service obligations in all possible states of nature.
Rational investors optimally offer state-contingent debt instruments (SCDIs) that include additional financing when the default constraint is binding, keeping the debtor engaged in the contractual relationship and avoiding asset loss.
The debtor benefits because the contract implies net-positive financing when facing a large shock, increasing concurrent welfare, while maintaining access to financing in the future for consumption smoothing at the same terms as with precommitment.

SCDIs are appropriate for countries subject to large shocks that can be observed and verified by all parties involved, such as natural disasters or global pandemics.
SCDIs require maintaining debt at a low level compared to the precommitment case, and also a fiscal consolidation when triggered to contain the increase in debt.

Extension of the time inconsistency problem to add the taxation of capital returns shows that the optimal physical capital investment is also state-contingent.

Subject: Consumption, Debt default, Debt service, Expenditure, External debt, National accounts, Public debt
Keywords: Consumption, consumption path, debt contract, Debt default, Debt service, debtor benefit, Global, natural disasters, physical capital capital investment, sovereign default, state-contingent debt, time inconsistency problem