State-contingent bonds linked to commodities, such as oil, have been on the agenda since the 1970s, with SCDIs discussed more broadly since the emerging market crises of the 1980s and 1990s. More recently SCDIs have received increased attention. SCDIs link debt service to a measure of the sovereign’s capacity to repay. They could help preserve fiscal space in bad times and reduce the number and cost of sovereign debt crises. In the context of risking debt risks and increased volatility, interest in an increased role for SCDIs has continued to develop.
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- The Paris Club launched a “resilience workstream” in 2018, and the finance ministers of the Group of 7 endorsed work towards drafting a term sheet that could be used as a model for “climate resilient instruments” (CRIs) that could be attractive to developing country issuers susceptible to disasters. Such instruments can complement ex-ante financing mechanisms, which enable governments to invest in disaster risk reduction and resilience.
- Following the severe hurricane season in 2017, there has been particular interest in developing CRIs for Caribbean governments. The Caribbean is among the most disaster-prone regions in the world, with average annual damage of about 2.4 per cent of GDP from 1990 to 2014, and extremely severe damage of about 200 per cent of GDP in the worst cases. In May 2018 the Governor of the Eastern Caribbean Central Bank (ECCB) requested the collaboration of the World Bank and the IMF in exploring the potential use of state-contingent instruments.
- A World Bank/IMF technical working group was set up and has focused on two broad designs for CRIs. The first CRI is a form of insurance, which could be purchased to cover a specified amount of debt service payments following disasters, allowing countries to reallocate budgetary funds towards recovery and resilient investments. The second option would build on the “hurricane clauses” introduced in Grenada’s debt restructuring and would embed automatic maturity extensions following disasters directly into debt contracts. In the latter case, the International Capital Markets Association (ICMA) have developed draft “term sheets” and sought feedback in early 2019 from key stakeholders.
- SCDIs have also featured in debt restructurings, where the creditors are in any case facing potential losses on their defaulted credits. Thus, two sovereign debt restructurings in 2018 introduced state-contingent features that will provide downside protection to the issuers. In Chad, the restructuring of debts owed to a private oil trader introduced mechanisms that will accelerate or slow principal repayments depending on the availability of oil receipts. Given Chad’s dependence on oil revenues to pay debt service, this should reduce the likelihood of costly repeat restructurings in coming years. Barbados introduced “hurricane clauses” in its comprehensive debt restructuring of both domestic and external claims, with the domestic exchange completed in November 2018.
- Nonetheless, despite their potential, complications such as novelty and liquidity premia demanded by investors, adverse selection and moral hazard risks, and adverse political economy incentives have hindered wider market development of SCDIs to date. Efforts by public institutions to underwrite or subsidize SCDI issuance, incorporate SCDIs into their own lending portfolios, or to act as market makers for SCDIs issued by sovereigns could help further realize the potential of this market.