Sovereign default and state-contingent debt

Martin Brooke, Rhys Mendes, Alex Pienkowski, Eric Santor

Recent Eurozone events have changed the perception that sovereign debt is a problem of emerging-market economies. This column highlights some major deficiencies of the current framework, and proposes two new and complementary types of state-contingent debt contracts. The first – sovereign cocos – are designed to tackle liquidity crises. The second – GDP-linked bonds – help prevent solvency crises.

For the better part of the past six decades sovereign default has been widely viewed as an emerging-market economy (EME) phenomenon. Recent events, however, have changed this perception. In April 2012 the Greek government restructured €200bn of its sovereign debt, imposing net present value (NPV) losses of 59-65% on its creditors (Zettelmeyer et al., 2013). At the same time, market participants have been pricing in material default probabilities for some advanced economies’ sovereign debt.

Fault lines with the current system

The sovereign-debt restructuring in Greece and the events surrounding the IMF-EU support packages for Ireland, Portugal, and Cyprus have exposed fault lines in the existing practices for sovereign-debt crisis resolution – perhaps most importantly, an over-reliance on official-sector liquidity support. The current approach is sub-optimal for five inter-related reasons:

Creditor and debtor moral-hazard problems can arise if there is an expectation of official sector bailouts. While there are often good reasons for such support, it can have the adverse consequence of encouraging excessive risk taking by the sovereign borrower and its private-sector creditors. The size of IMF support packages has been steadily increasing, leading to greater risks from moral hazard (Figure 1).

If creditors anticipate official sector financial support to a sovereign in times of distress, this can incentivise short-term lending. This is because these creditors have a much higher probability of being paid in full than longer maturity debt holders. But by reducing the average maturity of the sovereign’s debt, this can increase the likelihood of a liquidity crisis occurring.

Since the beginning of the Eurozone crisis, over €600 billion of official sector support has been disbursed or committed (excluding ECB liquidity support to banks). This represents over 6% of the Eurozone’s GDP. These support packages have, therefore, put large amounts of public resources at risk, and raise questions about the fair burden sharing of losses incurred by private-sector creditors.

The experience in the Eurozone has demonstrated that it can be difficult to achieve sustainable debt levels via negotiated debt write-downs with private creditors when a significant proportion of a sovereign’s debt is held by the official sector. This is because sovereign debt held by the official sector often has de-facto senior creditor status, which effectively subordinates existing private-sector debt.

The prospect of generous official sector liquidity support has the potential to delay economically necessary, but politically difficult decisions, in the hope that circumstances might improve. However, an early and perhaps relatively small debt restructuring may be in the best interest of the country, and even creditors.

In response to these deficiencies, we argue that for reasons of equity and efficiency private creditors should play a greater role in risk-sharing and helping to resolve sovereign debt crises. We propose the introduction of two complementary types of state-contingent bonds – ‘sovereign cocos’ and ‘GDP-linked bonds’.

Figure 1. Size of IMF programmes through time

Source: IMF MONA database.

Sovereign cocos

Sovereign cocos are bonds that would extend in repayment maturity when a country receives official sector liquidity assistance. This idea was advocated by Weber et al. (2011) in the context of Eurozone bonds. There are numerous ways in which sovereign cocos could be designed. To stimulate discussion of this contractual innovation, we suggest introducing a sovereign coco with the following features:

An automatic three-year maturity extension when the sovereign receives emergency liquidity assistance from the official sector.

All sovereign bonds and loans would include the clause, except Treasury Bills with original maturity of less than one year.

If a maturity extension is triggered, coupon payments continue at their original level and frequency.

The maturity extension clause can only be activated once.

Sovereign cocos will enhance the discipline on sovereign debtors delivered via changes in funding conditions. Creditors could no longer anticipate full repayment by the official sector in times of crisis. This would reduce the incentive to lend incautiously to sovereigns, helping to mitigate moral hazard. Over the medium term, this should contribute to reducing the incidence of sovereign-debt crises.

Furthermore, by maintaining the exposure of existing creditors rather than transferring it to the official sector, any subsequent debt write-down, if needed, would involve a greater proportion of the sovereign’s pre-crisis creditors. And the burden of such a debt write-down would be more equitably distributed amongst creditors, and would involve smaller haircuts on each bond to restore debt sustainability.

Finally, the activation of sovereign cocos would significantly alter burden-sharing between private creditors and the official sector/taxpayers, reducing the required size of official-sector emergency loans. Official-sector liquidity assistance would not have to cover debt amortisation payments. It would, however, need to provide lending to cover the fiscal deficit and any off-balance sheet liabilities, such as bank recapitalisation.

The benefits are clear in the case of Greece. If the maturity of Greece’s sovereign bonds had been extended ahead of its IMF/EU programme, this would have significantly reduced the size of official sector support from €110 billion, to less than €45 billion. By reducing the size of official sector intervention, sovereign cocos could significantly reduce the risk to global taxpayers and make it easier to negotiate a debt restructuring in the event of insolvency.

GDP-linked bonds

GDP-linked bonds are debt instruments that directly link principal and interest payments to the level of a country’s nominal GDP. GDP-linked bonds are not a new idea. Shiller (1993, 2003) argues that these bonds would allow households and companies to take an ‘equity stake’ in a country’s economic performance, helping risk diversification and hedging. Others, including Chamon and Mauro (2005) demonstrate how GDP-linked bonds can reduce the credit risk on sovereign debt.

GDP-linked bonds provide a return to creditors that varies in proportion to the debtor country's nominal GDP growth, which means that they can reduce the risks from growth shocks faced by the sovereign. This provides a form of recession insurance to the sovereign, and reduces the risk that growth shocks will push a sovereign into default.

To illustrate this, the left-hand column of Figure 2 shows the variance of changes in debt to GDP of G7 economies over the period 1991-2011. The left-hand bar shows that around half of the variance of the G7 countries’ sovereign debt to GDP ratios can be accounted for by ‘growth shocks’ (including the cyclical component of the primary balance). The right-hand column of the figure shows the reduction in variance that would have been achieved if G7 countries had issued GDP-linked bonds covering the entirety of their debt. In these simulations, GDP-linked bonds reduce the variance of changes in the debt to GDP ratio by over 40%. This reduces the likelihood that recessions will force a country to default on its debt. It also allows greater scope for governments to use counter cyclical fiscal policy to stabilise growth.

While all countries might experience some benefit from the use of GDP-linked debt, economies with higher GDP growth volatility (such as EMEs), or countries where monetary policy is constrained (such as those in a monetary union), are likely to benefit most.

Figure 2. Debt to GDP variance decomposition in G7 countries (1991-2011)

Source: IMF WEO, Consensus Forecasts; authors calculations.

GDP-linked bonds provide a natural complement to sovereign cocos. While sovereign cocos are primarily designed to tackle liquidity crises, GDP-linked bonds help reduce the likelihood of solvency crises. This is because GDP-linked bonds provide a form of recession insurance that reduces principal and interest payments when a country is hit by a negative growth shock. This helps to both stabilise the debt-to-GDP ratio, and increase a sovereign’s capacity to borrow at sustainable interest rates.

International coordination

Allen and Gale (1994) and Borensztein and Mauro (2004) consider a number of reasons why socially beneficial financial instrument innovations may sometimes not be introduced. These include:

The inability to coordinate to reach a critical mass of issuance required to achieve sufficient market liquidity;

Initial uncertainty over how to value these instruments;

High initial costs to designing the instruments and creating a trading platform; and

The need for common standards to minimise operational uncertainty.

One way to overcome some of these first-mover considerations would be for interested sovereigns to coordinate their issuance of sovereign cocos and/or GDP-linked bonds. Such a collective effort would facilitate the development of the market infrastructure and standards to support these instruments.

An example of this type of international coordination was the promotion of Collective Action Clauses (CACs) by the G10 following the Asian Crisis. Prior to 2003, CACs had been common in bonds issued under English Law, but the majority of EME foreign bonds were issued under New York law and did not contain CACs. In early 2003, to help overcome this first-mover problem, G10 economies committed to include CACs in their foreign currency denominated debt. Following this, Mexico issued the first EME sovereign bond which contained a CAC under New York law.

Just as with CACs, progress on implementing these changes to bond contracts would be facilitated by an international agreement, both to issue this debt (thus reducing concerns relating to liquidity and stigma), and to collectively invest in the infrastructure and institutions required to support the debt.

While we recognise the possible risks of introducing these instruments in the present climate, these issues need to be discussed and addressed now in order to build confidence that the next sovereign debt crisis can be resolved in a less costly manner.

The views expressed in this paper are those of the authors, and are not necessarily those of the Bank of England and Bank of Canada.

References

Allen, F and D Gale (1994),“Financial Innovation and Risk Sharing”, MIT Press.

Borensztein, E and P Mauro (2004),“The case for GDP-indexed bonds”, Economic Policy.

Brooke M, R Mendes, A Pienkowski and E Santor (2013), “Sovereign Default and State-Contingent Debt”, Bank of England Working Paper No. 27, and Bank of Canada Discussion paper 2013-3.

Chamon, M and P Mauro (2005), “Pricing Growth-Indexed Bonds”, IMF Working Paper WP/01/92.

Shiller, R (1993), Macro Markets: Creating Institutions for Managing Society's Largest Economic Risks, Oxford University Press.

Shiller, R (2003), The New Financial Order: Risk in the 21st Century, Princeton University Press.

Weber A, J Ulbrich and K Wendorff (2011), “Safeguarding financial market stability, strengthening investor responsibility, protecting taxpayers: A proposal to reinforce the European Stability Mechanism through supplementary bond issuance terms”.

Zettelmeyer J, C Trebesch and M Gulati (2012), “The Greek Debt Restructuring: An Autopsy”, Peterson Institute for International Economics, working paper 13-8.