Sovereign Cocos
IMF Working Papers, April 29, 2022
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- Sovereign Cocos
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Bibliographic details
- Authors: Juan Carlos Hatchondo, Leonardo Martinez, Kursat Onder, Francisco Roch
- Published: April 29, 2022
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9798400207648.001
Summary
- Model of equilibrium sovereign default where the government issues cocos (contingent convertible bonds) that stipulate a suspension of debt payments when the government faces liquidity shocks in the form of an increase of the bondholders' risk aversion.
- Introducing cocos reduces the frequency of defaults triggered by liquidity shocks but increases the overall default frequency.
- By mitigating concerns about liquidity, cocos make indebtedness and default risk more attractive for the government.
- Cocos that stipulate debt forgiveness when the government faces the shock achieve larger welfare gains by reducing default risk.
Key findings
- Cocos that convert to a suspension of debt payments:
- Reduce defaults that are specifically triggered by liquidity shocks (bondholders' risk aversion increases).
- Increase the overall frequency of default because the government chooses higher indebtedness and faces greater default incentives.
- Cocos that stipulate debt forgiveness when the shock occurs:
- Achieve larger welfare gains compared with suspension-type cocos.
- Reduce default risk more effectively than suspension-type cocos.
Policy implications and considerations
- Design of contingent convertible sovereign instruments matters for default outcomes:
- Suspension-triggered cocos can backfire by encouraging higher government indebtedness and raising overall default frequency.
- Forgiveness-triggered cocos can be more effective at lowering default risk and improving welfare.
- Policymakers should weigh liquidity-mitigation benefits against moral hazard and incentives for higher indebtedness when evaluating cocos as a sovereign liability-management tool.
Subjects and keywords (as given)
- Subject: Asset and liability management, Consumption, Contingent convertible capital, Debt default, Debt relief, External debt, Financial sector policy and analysis, National accounts, Return on investment
- Keywords: Consumption, Contingent convertible capital, Debt default, debt payment, Debt relief, default frequency, default risk, Global, government issues coco, haircuts., liquidity shock, maturity extensions, reprofiling, Return on investment, risk-premium shock, Sovereign Cocos
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- Working Paper