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Innovative instruments for managing debt burdens

State-contingent lending instruments and public creditors

There has been a renewed interest in the role that state-contingent debt instruments (SCDIs) can play in reducing risks to sovereign balance sheets. Such instruments are designed to link a country’s debt obligation to its ability to pay, and can thus provide insurance against risks such as a deep recession, commodity price decline or natural disaster. Instruments include GDP-linked bonds, which would provide stability over the economic cycle; commodity-linked bonds, which could link interest payments to specific commodity prices; and “extendibles,” which would provide an automatic maturity extension if a natural disaster occurs (see here). In response to growing interest, the IMF developed an associated toolkit to simulate debt and financing need impacts under varying SCDI designs.

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Proponents of SCDIs have made a strong case for these instruments over recent decades. Their arguments note that GDP-linked bonds, which link the repayment obligations of a sovereign to economic growth, can stabilize the debt-to-GDP ratio and generate policy space during recessions that can be used to support recovery. Insofar as the debt stabilization benefits of such instruments reduce the probability of sovereign debt crises, the default risk premium on all the sovereign debt should fall. In debt restructurings, SCDIs could provide an important role in facilitating an orderly debt exchange, providing downside insurance to the sovereign while giving upside benefits to the creditors when the recovery is successful.

While the theoretical benefits are clear, critics point out that advocates fail to consider practical complications associated with issuing such instruments in financial markets. The IMF examined these constraints, finding that (i) liquidity and novelty premiums could be high when SCDIs are first issued; (ii) there may also be stigma associated with such “first-movers;” (iii) significant issuance could lead to a reduction in the supply of conventional bonds; (iv) SCDIs could transfer “excessive” risk to the private sector; and (v) issuance could increase the risk of “moral hazard” (meaning the borrower takes excessive risk knowing relief will be provided).

Despite these challenges and constraints, there is scope for greater use of SCDIs, especially by small open economies that are vulnerable to terms-of-trade shocks and natural disasters. Official sector actions could help realize the potential of this market, including through developing model contracts and common standards, providing technical support to debt management and statistic offices, and, more ambitiously, by underwriting or subsidizing their issuance. Public creditors should also consider increasing the use of state-contingent instruments in their own lending, building on existing experience such as countercyclical lending contracts by the Agence Francaise de Développement.