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Innovative instruments for managing debt burdens

Nearly 85 per cent of major economies’ outstanding bonds have local currency fixed rate debt service obligations (Makoff, 2017). While such a debt structure can help avoid refinancing difficulties, it cannot protect the sovereign against impairments to repayment capacity resulting from adverse macroconomic shocks. Given that such shocks are quite large and common, and recognizing that sovereign debt crises are costly and involve deadweight losses, academics and policymakers have suggested two kinds of financial innovations. One is a swap of a public debt obligation for specified additional public social or environmental expenditure. The other is ‘state-contingent debt instruments’, which include contractual provisions altering the debtor’s obligations contingent on pre-defined events or data outturns, and thus can serve a counter-cyclical and risk-sharing function.

Several types of state-contingent debt instruments (SCDIs) – which tie a sovereign’s net payment obligations to its payment capacity – have been either discussed or implemented in recent years.  SCDIs can take the form of continuous-adjustment instruments like GDP-linked bonds, where the coupon and/ or the principal of sovereign bonds are indexed to the level or growth rate of real or nominal GDP; or extendibles, which automatically extend repayment maturity in the event of a predefined trigger, but leave the level of coupon and principal unchanged.
 
GDP-linked bonds have been discussed at least since the 1980s, with important benefits identified in the literature, including their ability to make balance sheets safer, to provide fiscal space during downturns and to decrease the likelihood of debt distress. However, take-up has been limited thus far, and they have primarily been used in debt restructuring contexts, or in the form of commodity hedges. Several governments have issued GDP warrants, which pay out additional interest if GDP growth is higher than pre-defined levels – for example Argentina in the context of its debt restructuring in 2005, Greece and Ukraine. However, warrants do not provide symmetric adjustments in case of lower-than expected growth.
 
There is also some experience with state-contingent instruments in official lending. The French Development Agency has issued concessional loans in the past that include a maturity extension if export revenues fall below specified levels, and are thus similar in effect to extendibles. To anticipate shocks from natural disasters, Grenada’s 2015 debt rescheduling agreement with the Paris Club and private creditors included a ‘hurricane clause’, which seeks to provide debt relief in the aftermath of a hurricane.  
 
Building on work carried out by the Bank of England and the IMF, the G20 discussed a “Compass for GDP-linked Bonds” that provides an overview of important aspects of this instrument. In this context, a working group including private sector representatives convened to draft a model ‘term sheet’ for a GDP-linked bond. This could be a starting point for further engagement with investor trade bodies such as the International Capital Market Association. 
 
The IMF Executive Board will discuss a paper on SCDIs in April 2017. The paper will focus on the benefits and costs of such instruments for different sovereigns; review past experience with SCDI issuance, both in normal times and in restructurings; survey issuer and investor appetite for different types of SCDIs; and identify the role of other stakeholders in resolving ’first-mover problems’, and tackle legal and regulatory issues. 
 
State-contingent lending instruments and public creditors

In some cases of debt distress following major shocks and crises, public creditors have responded by easing debt repayment obligations (e.g. the grant assistance from the IMF  to the Ebola-affected countries to pay-off future debt service payments totaling around US$100 million). Grenada’s recent debt restructuring also introduced an extra innovative feature, specifically a “hurricane clause”, which allows for a moratorium on debt payments in the event of a natural disaster.

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Recent analyses by the United Nations Development Programme and the French Development Agency (Hurley and Voituriez 2016, Warren-Rodriguez and Conceição, 2015) stress that instead of case-specific and ex-post responses, there is a strong case for increased use of state-contingent lending instruments, which aim to ex-ante and automatically trigger downward adjustments in debt service during shocks. These instruments have the potential to contribute to improve debt sustainability and help countries manage risk and cope with shocks more effectively.
 
One example is counter-cyclical lending contracts (CCLs), which allow debt service to automatically fall or become zero when a major shock occurs (measured in a specific way, e.g. a significant fall in the value of exports or increase in the price of imports). The idea behind CCLs is to ensure that debt service is counter-cyclical. They aim at building flexibility ex-ante for borrowers, and contributing to reduce the risk of a debt crisis and costly ex-post debt restructuring. The benefit for lenders would be preventing any eventual losses on their claims.
 
Since 2007, AFD has extended CCLs to six African countries (Burkina Faso, Madagascar, Mali, Mozambique, Tanzania and Senegal) for various projects in the areas of urban development, electrification, access to water and sanitation, education and vocational training, and food security. The total of CCL lending implemented by AFD as of mid-2016 was around 300 million Euros. A second example is GDP-linked official sector lending. UNDP’s analysis highlights that many of the challenges in extending GDP-linked bonds (e.g. GDP underreporting, moral hazard problems, the absence of fully developed markets where these securities can be traded) are not applicable to external debt with official creditors. For example, as official debt typically involves either two sovereign states, or a sovereign state and an international public financial institution, it does not require the intermediation of financial markets. 
 
GDP-linked official sector lending could make an important difference in developing countries, as external debt with official creditors often constitutes a major source of government finance, especially in low income countries. A case could be made for scaling up these innovative strategies for preserving policy space in bad times, and for public creditors to take a leading role in this regard.