State-Contingent Debt Instruments

Project Stream 4 · Caterina Foti

State-contingent debt instruments (SCDIs) are sovereign financial instruments with an adjustable or extendible debt service linked to a contractually defined state variable, for example, GDP growth, exports, natural disasters or the achievement of certain KPIs. Since the idea of SCDIs first materialized in the 1980s as a tool for ex ante debt relief for emerging market and developing countries, they have repeatedly been considered by academics, practitioners and multilateral institutions. Despite compelling arguments, such as countercyclical fiscal space and immediate relief in times of crisis, SCDIs providing debt forgiveness in downside scenarios remain essentially unexplored in practice. The persistent lack of state-contingent debt is perplexing, especially in light of devastating humanitarian implications of protracted debt restructurings and continuously rising debt levels. 

In the current market-based debt architecture, state-contingent contracts are rather considered as a value recovery mechanism in restructuring contexts. Value Recovery Instruments (VRIs) provide bondholders who agree to the proposed restructuring terms with additional payouts if their expectations in the debtor’s recovery exceed the IMF’s conservative growth forecasts. For this reason, several debtors issued detachable GDP-linked warrants in the past, most notably, Argentina in 2005, Greece in 2012, or Ukraine in 2015. These instruments were undervalued at first, but turned out to be very costly. More recently, countries like Suriname, Zambia, and Ukraine included state-contingent Step-Up bonds in their exchange offers to “sweeten” the deal.

In other words, although VRIs and classical SCDIs are based on the same logic—adjustable payments linked to the issuer’s payment capacity—they aim at entirely different things: While classical SCDIs are supposed to insure debtors against sudden shocks or changed circumstances, VRIs insure bondholders against the risk of losing too much value by granting the debtor a haircut. It is against this background that the idea and challenges of SCDIs are assessed from a legal perspective. In the context of RESOLVENCY—aiming to define debt by its limits—, SCDIs could embrace the deliberative paradigm through contractual design (ex ante) as opposed to debt resolution (ex post).