State Contingent Debt Instruments: A Sustainable Solution for Sovereign Debt Crises
Context:
The recent cascade of countries defaulting on their debt has brought back into vogue complex securities called State Contingent Debt Instruments.
Background
- State Contingent Debt Instruments has helped nations from Ukraine to Sri Lanka resolve difficult debt negotiations.
- Latin America was first to use SCDIs in the form of Brady Bonds in the late 1980s.
Key takeaways
- State Contingent Debt Instruments (SCDIs) are financial instruments whose repayment terms are linked to certain economic variables or outcomes, like GDP growth,
- commodity prices, or revenue collection.
- SCDIs differ from the bulk of sovereign bonds which pay a predetermined amount in interest before a final repayment.
- 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.
Purpose:
- To provide fiscal flexibility to states by reducing debt servicing pressure during economic downturns.
- Helps manage debt burden effectively by aligning repayment with state revenue performance.
Mechanism:
- Unlike traditional fixed debt instruments, SCDIs allow variation in repayment based on the agreed-upon economic indicators.
- When a state faces a downturn, repayments may be reduced; conversely, in a strong economic period, repayments could increase.
Benefits:
- Counter-Cyclical Support: Helps states manage debt better during economic stress by lowering repayment obligations.
- Debt Sustainability: Reduces the likelihood of debt distress, aiding long-term fiscal health.
- Fiscal Stability: Supports better planning and stability by managing repayment according to economic performance.
Recent Example
- Ukraine used SCDIs as part of a package to convince investors in August to swap their defaulted bonds for newer instruments — including a GDP-linked bond, which would pay investors more if the economy grows faster than anticipated.
Complications:
- 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.
IMF Proposals
- 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).
Conclusion
State Contingent Debt Instruments (SCDIs) represent a promising solution for countries grappling with debt crises. By aligning debt repayments with economic performance, SCDIs offer a flexible and sustainable approach to managing sovereign debt. This innovative financial tool not only provides counter-cyclical support during economic downturns but also enhances fiscal stability and debt sustainability. As demonstrated by recent examples in Ukraine and Sri Lanka, SCDIs can play a crucial role in resolving complex debt negotiations and ensuring long-term fiscal health.
