State-Contingent Debt Instruments for sovereigns

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State-Contingent Debt Instruments for sovereigns

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IMF assessment and objectives

• The IMF examines state-contingent debt instruments (SCDIs) as a useful addition to sovereigns’ policy toolkit.
• Objective: better manage public debt in a world of macroeconomic uncertainty by linking debt service to a sovereign’s capacity to pay, which is tied to real-world variables or events.
• Intended policy benefit: preserve sovereign policy space to undertake countercyclical and stabilization policies when adverse shocks occur, and potentially avert costly debt restructurings when reductions in debt service are large relative to capacity to pay.

How SCDIs work

• SCDIs link a sovereign’s debt service payments to its capacity to pay, where capacity to pay is linked to state variables such as:
  • a country’s GDP,
  • commodity prices, or
  • natural disasters such as hurricanes or earthquakes.
• Mechanism: when adverse events (for example, economic downturns or natural disasters) occur, debt service is automatically reduced, easing fiscal pressure.

Potential benefits

• Automatic reduction in debt service during bad times helps:
  • preserve fiscal policy space for countercyclical and stabilization measures,
  • reduce the likelihood or severity of costly debt restructurings when reductions in debt service are large relative to capacity to pay,
  • serve as a complement to traditional government policy tools.

Complications, constraints, and risks

• Novelty and market development:
  • A high novelty or liquidity premium may be demanded by investors in early market stages.
• Insurance-related risks:
  • Adverse selection and moral hazard risks arise and would need mitigation.
• Market and balance sheet effects:
  • Potential undesirable pricing effects on conventional debt.
  • Possible excessive risk migration to private sector balance sheets.
• Implementation requires careful instrument design, robust institutions, clear contracts, and regulation; these complications are also mentioned by market participants.

IMF guidance and recommended designs

• The IMF proposes three benchmark SCDI designs for issuers and investors:
  • "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.
  • "Extendibles" — bonds whose maturity is pushed out if a pre-defined trigger is breached.
• Guidance is available on calibrating these designs and on the appropriate choice of state variables or triggers.

Content in this bundle

• Managing Sovereign Debt and Debt Markets through a Crisis—Practical Insights and Policy Lessons
  • Managing Sovereign Debt and Debt Markets through a Crisis—Practical Insights and Policy Lessons (Markdown version)
  • Managing Sovereign Debt and Debt Markets through a Crisis—Practical Insights and Policy Lessons (PDF)
• 103111a (PDF)
• Sovereign Debt Structure for Crisis Prevention (PDF)

References

• Debt Limit and the Structure of Public Debt, IMF Working Paper (2017)