## Optimal State Contingent Sovereign Debt Instruments

_IMF Working Papers, September 10, 2021_

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**Canonical URL:** [Optimal State Contingent Sovereign Debt Instruments](https://www.imf.org/en/publications/wp/issues/2021/09/09/optimal-state-contingent-sovereign-debt-instruments-465403)

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## Bibliographic details
- Authors: Alejandro D Guerson
- Published: September 10, 2021
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781513595917.001

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### Central finding
- 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.

### Scope and applicability
- 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.

### Model extensions and additional results
- 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 areas and keywords
- 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

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_Source: https://www.imf.org/en/publications/wp/issues/2021/09/09/optimal-state-contingent-sovereign-debt-instruments-465403_