Innovative or re-purposed financial instruments represent an opportunity to address some of the obstacles impeding sovereign debt restructurings. The main factors that determine the suitability of different instruments to be employed in the sovereign debt restructuring context pertain to the ease with which they can be priced, the existence of an identifiable investor base given institutional constraints affecting certain investors, and the legal or technical challenges connected to the engineering of the various instruments. Achieving a degree of standardisation would support the diffusion of new instruments in the market.
Financial instruments dealing with legacy debt
There are a series of financial instruments that might help deal with legacy debt and smooth the restructuring process by counterbalancing the uncertainties inherent in evaluations of debt sustainability and future economic prospects. They can help bridge questions on burden sharing and increase creditors’ willingness to reduce the debt burden. These are:
- State-contingent bonds: The coupon on this kind of bond increases or decreases depending on economic variables, such as GDP or government revenue (a more timely indicator). This can compensate for the uncertainty inherent in debt sustainability assessments and, at the same time, supports long term sustainability from the borrowers’ perspective as interest payments decrease in case of deterioration of the economic parameters. While these instruments are widely investible, there are challenges pertaining to the timeliness and measurement of the underlying economic variables.
- Future financing rights: Forgone payments in debt restructurings are compensated through vouchers permitting the purchase of future issuance at a discount. These instruments have the advantage of offsetting the uncertainty inherent in debt sustainability assessments by partially compensating creditors once the borrower regains market access while, simultaneously, incentivising the purchase of the new issuance and thus addressing borrowers’ financing needs. However, they might not be widely investible due to institutional constraints.
- GDP (or commodity-linked) warrants: The pay out of these financial instruments is dependent on an increase in GDP (or key commodity prices) relatively to predetermined levels. Similarly to state-contingent bonds and future financing rights, this sort of instrument redresses uncertainties in the assumptions underlying debt sustainability assessments and addresses inter-creditor equity concerns around taking losses in a restructuring process when future economic scenarios may allow repayment. While the publicity of the documentation concerning GDP enhances transparency, challenges remain as to the timeliness and the measurement of the relevant variables, which may be easier with commodity-linked warrants where prices are timelier.
- Bonds collateralized or asset backed with state assets: The suitability of these financial arrangements in the context of sovereign debt restructurings may be more limited in application. While they allow, analogously to the instruments mentioned above, to address uncertainties and inter-creditor equity concerns and unlock new resources for future debt service, the availability of adequate state assets or cashflows and the enforceability of the arrangements might prove challenging.
Financial instruments addressing financing needs
A series of financial instruments could be employed in debt crisis resolution processes to support new financing flows. These are:
- Bonds with partial risk free collateral or guarantees (e.g., the partial guarantees provided by the World Bank, or the partial collateralisation of Brady-bonds by US treasury bonds): These arrangements involve respectively the provision of a partial guarantee by a risk free entity or the borrower’s purchase of a zero-coupon long dated risk free bond as partial collateral. They support the provision of new finance and are widely investible. However, potential challenges relate to the need to find a pool of capital to provide the partial collateral, or to size constraints of entities acting as guarantors, such as multilateral development banks.
- Fully guaranteed bonds (e.g., US aid bonds): These instruments support the provision of new finance and have the potential to produce scale up effects. However, guarantors can be subject to budget or credit constraints. Furthermore, there is the need to find an investor base outside of Emerging Markets funds that is willing to buy what will be lower yielding debt.
Other financial arrangements might be considered, even though their suitability is more questionable:
- Debtor-in-possession financing: This arrangement consists of the issuance of short-term senior debt to cover the restructuring period. However, there are issues of overlap with lender of last resort functions currently covered by IFIs and ensuring the seniority of claims is likely to encounter legal challenges in the sovereign debt context.
- State-contingent step-down bonds or payment holidays: Coupon payments on these bonds decrease or are suspended if a macroeconomic variable deteriorates compared to a predetermined threshold or if there is a standstill payment to official sector creditors. Similar arrangements have the advantage of ensuring the long term sustainability of the debt profile by providing relief when debt distress is anticipated. If linked with payment holidays offered by the official sector, they also help in addressing inter-creditor equity concerns. However, challenges remain as regards the timeliness and appropriate measurement of underlying variables, meaning the cashflow relief may not come when needed.
- State contingent bonds on other key performance indicators (e.g., climate variables): The coupon payments on these bonds increase or decreases depending on the achievement of certain goals (key performance indicators or KPIs), such as benchmarks concerning climate change mitigation or adaptation policies. While this sort of instrument allows in principle to foster financing flows by unlocking ESG capital as well as to support the achievement of non-economic policy objectives, the measurement of the relevant variables is likely to be challenging, which will make pricing these more difficult.
- Use of proceeds from ESG bonds: The proceeds of these bonds are earmarked for the achievement of ESG goals. While they serve analogous purposes as KPIs contingent bonds, helping to mobilise ESG finance, the concrete enforcement of use of proceeds clauses encounters difficulties.
- Tax free bonds for developed market retail investors: These arrangements involve the provision of tax incentives to retail investors in the developed markets to buy debt issued by emerging market countries. While such instruments would support the provision of new finance, it is unclear whether there is adequate demand.
To conclude, the development of new financial instruments or the re-use and standardisation of existing instruments should be pursued to allow faster debt restructurings, address legacy debt and secure new financing. At the same time, a balance needs to be struck between ensuring that economic growth following a restructuring is able both to benefit borrowers and to enable the compensation of creditors.