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IF Insights: The renaissance of state contingent debt instruments

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While SCDIs can be powerful tools for speeding up debt restructurings and providing much-needed economic relief, they are not without their challenges

In recent years, the global debt landscape has been increasingly characterised by defaults and restructuring needs, particularly in emerging markets. This has led to the re-emergence of State Contingent Debt Instruments (SCDIs), a tool designed to facilitate complex debt negotiations by providing flexibility and risk-sharing mechanisms between sovereign borrowers and investors.

This analysis explores the renewed interest in SCDIs, evaluates their benefits and challenges, and considers the broader implications of their use in debt restructuring, drawing on recent examples from countries like Ukraine, Sri Lanka, and Zambia.

What Are State Contingent Debt Instruments?

State Contingent Debt Instruments (SCDIs) are a type of bond that links debt repayment conditions to specific economic or fiscal metrics. Unlike conventional bonds that offer a fixed interest rate and principal repayment schedule, SCDIs offer flexibility by tying repayments to variables like GDP growth, revenue from natural resources, or other economic performance indicators. SCDIs aim to balance the risk and reward for both borrowers and investors, offering potential gains when a country outperforms and relief when it underperforms.

The resurgence of SCDIs comes at a time when numerous countries are struggling with unsustainable debt burdens, worsened by global economic pressures, political instability, and the impact of COVID-19. The recent cases of Zambia, Ukraine, and Sri Lanka demonstrate both the potential of these instruments and the challenges they present.

Flexibility And Alignment With Economic Performance

SCDIs offer several advantages that make them an appealing tool for managing sovereign debt. Their primary advantage lies in their ability to align debt repayment obligations with a country’s economic performance. When a country’s economic conditions are favourable, payments can increase, thus rewarding investors for their risk.

Conversely, in times of economic distress, payments decrease, reducing pressure on the borrower. This flexibility can make SCDIs particularly useful for countries facing uncertain economic futures.

For instance, Zambia’s restructuring process incorporated SCDIs linked to the country’s economic performance, specifically its debt-carrying capacity, exports, and fiscal revenues. According to Zambia’s Ministry of Finance, these instruments provided immediate repayment relief while creating a conducive environment for economic development. This approach allowed Zambia to allocate resources toward essential public goods and services while meeting its debt obligations.

Ukraine also leveraged SCDIs during its wartime debt rework in August 2023, integrating GDP-linked bonds that incentivised investors with potential payouts if the economy grew faster than anticipated.

By using these flexible instruments, Ukraine managed to swiftly re-engage with bondholders, effectively bridging the gap between market expectations and economic realities. However, it should be noted that wartime economic forecasts are inherently unpredictable, which brings significant risks for both investors and the issuing country.

Complexity And Investor Reluctance

While SCDIs can be powerful tools for speeding up debt restructurings and providing much-needed economic relief, they are not without their challenges. The complexity of these instruments often makes them difficult for both issuers and investors to navigate. Investors may be deterred by the complicated nature of SCDIs, which can lead to increased borrowing costs for the issuing country.

One major issue with SCDIs is the potential for investor reluctance, especially regarding pricing and trading on secondary markets. History provides several cautionary tales. Argentina’s use of GDP-linked warrants in 2005 led to significant legal disputes, as hedge funds accused Buenos Aires of manipulating economic data to minimise payouts.

Similarly, Ukraine faced billions of dollars in obligations for GDP warrants that lacked a cap on investor payouts, creating substantial fiscal challenges. According to a report from the Bank for International Settlements (BIS), contingent instruments issued by Argentina, Greece, and Ukraine carried a “high and persistent” premium, ranging between 4.24% to 12.5% above standard bond yields, highlighting the risks perceived by investors.

A History Of Mixed Success

The concept of SCDIs is not new. Latin American countries first used these instruments in the form of Brady bonds during the late 1980s to manage the regional debt crisis. Since then, various countries have experimented with SCDIs, with mixed success.

Argentina’s GDP-linked warrants and Greece’s 2012 debt restructuring both included contingent instruments. While these instruments provided a reprieve from crippling debt obligations, they also introduced new complications in the form of legal disputes and elevated borrowing costs.

The mixed success of these historical examples reveals the importance of sound design and clear criteria for contingent debt instruments. The experiences of Argentina and Greece underscore the risks of flawed structuring, which can lead to disputes, market distrust, and adverse economic outcomes.

This historical context provides crucial lessons for countries like Sri Lanka and Zambia, which are looking to utilise SCDIs more robustly and transparently.

Sri Lanka’s Experiment With Macro-Linked Bonds

Sri Lanka’s recent decision to incorporate macro-linked bonds into its debt restructuring strategy is noteworthy. These bonds link debt repayments to performance indicators such as GDP growth, which allows the country to adjust both principal and interest payments based on economic performance.

Such an approach provides the Sri Lankan government with “breathing space” during periods of economic stress. This approach is still evolving, and its long-term success will largely depend on how well Sri Lanka’s economic growth aligns with IMF forecasts and how transparent the process is.

However, concerns have already been raised regarding the stronger-than-expected growth forecasts released by the Sri Lankan government. Analysts have questioned whether these optimistic projections could lead to an overestimation of the country’s ability to meet its repayment obligations, potentially resulting in fiscal strain if economic growth does not materialise as predicted.

Role Of International Institutions And Market Benchmarks

International financial institutions play a pivotal role in the success of SCDIs. The Global Sovereign Debt Roundtable—which brings together representatives from borrowing countries, private lenders, the World Bank, and the G20—has highlighted the potential of SCDIs to address the rising number of sovereign debt defaults. By fostering dialogue between all stakeholders, the Roundtable aims to create a framework that can make these complex instruments more accessible and beneficial.

One of the significant challenges that new SCDIs must overcome is ensuring their eligibility for inclusion in major financial benchmarks like JPMorgan’s Emerging Market Bond Index (EMBI). Instruments that fail to qualify for these benchmarks may struggle to attract investor interest, thereby driving up borrowing costs.

Zambia’s recently issued SCDI, linked to its debt carrying capacity, exports, and fiscal revenues, aims to meet benchmark eligibility to keep borrowing costs manageable. By relying on IMF assessments instead of government statistics, Zambia hopes to mitigate some of the risks associated with data manipulation, as seen in previous examples like Argentina.

While SCDIs offer an enticing option for countries in distress, they are also a double-edged sword. The experiences of Argentina and Ukraine serve as cautionary tales, highlighting the risks of flawed design, legal disputes, and increased borrowing costs.

For SCDIs to truly be effective, they must be well-designed, transparent, and aligned with internationally recognised benchmarks. The role of international financial institutions in fostering a supportive framework for SCDIs cannot be overstated, as their involvement will be critical in ensuring that these instruments serve both issuers and investors effectively.

As more countries turn to SCDIs to navigate their debt challenges, it will be crucial to learn from past experiences and refine the structure of these instruments. If successful, Sri Lanka’s experiment with macro-linked bonds could set a new standard for how countries approach sovereign debt restructuring in the 21st century. The future of SCDIs hinges on finding the right balance between risk and reward, ensuring that they provide the necessary relief to borrowers while maintaining the confidence of investors.

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