IMF Discussed State-Contingent Debt Instruments

Christine Lagarde, IMF’s Managing Director

May 22, 2017/IMF

On April 13, 2017, the Executive Board of the International Monetary Fund (IMF) discussed the staff paper “State-contingent Debt Instruments for Sovereigns”.

Sovereign state-contingent debt instruments (SCDIs), such as GDP-linked bonds, as a countercyclical and risk-sharing tool remain appealing. Yet, take-up of such instruments has been limited. In view of recent renewed interest among academics, market participants, and policymakers, including the G20, IMF staff analyzed the benefits and challenges associated with SCDIs, possible benchmark designs that could underpin self-sustaining liquid markets, and the case for official sector interventions to support market development. The analysis has benefited from broad consultations with both investors and sovereign debt managers.  

SCDIs have been used sporadically in “normal times”, although they have been a common feature in recent restructurings. The experience thus far highlights, the importance of confidence in the integrity, availability, and timeliness of data; the problems created by complex instrument design; and the need to meet the requirements of a broad range of issuers and investors.

Most surveyed issuers stated that their current menu of instruments was adequate and indicated no immediate plans to issue SCDIs. However, some issuers did see a role for SCDIs in specific contexts (such as small states facing natural disasters, commodity producers), and more positive prospects generally over the medium-term. Investors’ perspectives demonstrated an openness to the idea of SCDIs, while noting that their technical complexity could warrant high novelty and liquidity premiums in the early stage of market development.

Staff’s analysis suggests that careful instrument design, robust institutions, contracts, and regulation could help address the key barriers to SCDI market development. Three potential benchmarks are discussed: “linkers,” bonds with principal (and coupon) linked to the level of a state variable; “floaters,” variable rate bonds with a fixed principal, and coupon linked to changes in a state variable; and “extendibles,” which push out the maturity of a bond if a pre-defined trigger is breached. Each of these designs can be further adapted to adjust the level of upside shared with investors; and triggers can be identified that are closely tied to government repayment capacity, but which cannot be manipulated by the issuer sovereign.

The near future will likely be characterized by tailored issuance of SCDIs—either to meet the preferences of individual sovereigns and investors in normal times, or during restructurings. Without official sector support, it is unlikely that this will lead to self-sustaining and liquid markets, at least over the medium-term. Accordingly, the official sector could play a role in spurring market development, including through supporting contract design and providing demand-driven technical assistance.

Executive Board Assessment

Executive Directors welcomed the opportunity to discuss State‑Contingent Debt Instruments (SCDIs) for sovereigns. They noted that the staff paper provided a comprehensive and balanced analysis of the benefits and costs of such instruments. Directors agreed, in particular, with the emphasis placed on practical design issues.

Directors agreed that, in principle, SCDIs have the potential to broaden the sovereign toolkit for debt management, reduce the probability of sovereign debt crises, make financial systems more resilient, diversify opportunities for investors and debt managers, and strengthen the international financial system.

Nevertheless, Directors underlined practical complications and risks associated with these instruments, including high initial liquidity and novelty premia demanded by investors, adverse selection, moral hazard, weaker incentives for sound fiscal management, and adverse consequences for conventional debt instruments. Many Directors were skeptical of the potential for broader use of SCDIs. They saw limited appetite from issuers and potential investors. They emphasized that any work on these issues should be done within the existing resource allocation to support member countries in their efforts to improve debt management capabilities. Some directors noted that careful instrument design, institutional support and appropriate financial sector regulation could help mitigate the risks associated with SCDIs. These Directors suggested that further analytical work, outreach and practical experience would help clarify the benefits of these instruments, as well as the preferences and constraints of a diverse set of issuers and investors. A few Directors suggested that further exploration of the three benchmark instruments proposed in the paper and other innovations could help fill gaps in the current architecture for debt management and support the gradual development of markets.

Directors stressed that the use of SCDIs cannot be a substitute for sound macroeconomic management, and in particular prudent fiscal policy. A few Directors thought that buffers and existing hedging instruments constituted alternatives to SCDIs. In the event that SCDIs are used, Directors emphasized that there should be no seniority for SCDIs relative to conventional debt instruments. Directors also emphasized the importance of strong financial sector regulation to ensure that investors could deal with risks associated with SCDIs.

Going forward, Directors recommended that the Fund pursue a gradual, targeted and demand‑driven approach. Some Directors felt that further work on SCDIs should not constitute a high priority for the Fund. Many Directors saw the greatest potential for Fund assistance in the development and use of SCDIs for small states and commodity exporters, and in supporting interested member countries through technical assistance. Most Directors saw limited scope for the official sector to play a lead role in fostering large‑scale market development in SCDIs, although some Directors saw a role for multilateral development institutions to assist with tailored issuances for small economies subject to large shocks, including natural disasters.