Setting the stage
Debt crises are extreme events that have been increasing both in number and intensity. A Bank of Canada database reveals that up to 55% of the world sovereigns had been in default at some point since 1975 on hundreds of billions of US dollars (Beers and Nadeau 2014). IMF lending has been on the rise. The average programme during 1992–2012 was about 3% of the recipient’s GDP, programmes for Latin American crisis countries were 6%, and for the Eurozone Crisis they reached 18%. In this context debt restructuring has been “far more common [...] than many observers choose to remember” (Reinhart et al. 2015).
Theory is ambiguous on the benefits of debt relief. There are seminal contributions arguing about welfare benefits of debt forgiveness in situations of debt overhang, with both creditors and debtors gaining from a partial debt write-down, while other studies show that restructuring causes reputational damage and triggers sanctions and output losses. However, consensus among academics and policymakers is unambiguous on this: coordination between creditors and debtor is a major hurdle in sovereign debt restructuring. When defaults occur it takes on average almost eight years to resolve. The delays destroy value for both creditors and debtor, and the burden is distributed arbitrarily through ad hoc negotiations.
Enter contingent debt
Introducing distress contingencies into sovereign debt contracts has the potential of forestalling defaults and avoiding delays when a crisis occurs. In a recent paper (Consiglio and Zenios 2015), we suggest and analyse sovereign contingent debt with payment standstill.
Sovereign contingent convertible debt (S-CoCo) is a sovereign debt instrument with a built-in trigger to allow standstill of payments, activated when an indicator breaches a threshold – invoking a precautionary credit line from the IMF – and making the triggered bond senior to subsequently issued debt.
An appropriate trigger could be a moving average on CDS spreads. CDS spreads aggregate the views of multiple market participants about a sovereign. They are accurate, timely, and comprehensive so that the trigger can be implemented in a predictable way.
Contingent capital was suggested as a remedy in dealing with ‘too big to save’ banks. The market is small but sizeable and rapidly growing. Seventy billion dollars were issued during 2009-2013 and issuance picked up in 2014 with a total of 187 instruments for $208 billion. Contingent capital is also used by insurance and re-insurance firms for protection against catastrophic events, in manufacturing as a source of capital during business cycle downturns, by rated firms as part of capital management, and as supplementary liability insurance by service firms. ‘Shared responsibility’ mortgages with reduced payments under certain circumstances have also been suggested (Turner and Lund 2015). The French Aid Agency used maturity extension contingent debt for some African countries in 2009 and suggestions for using contingent debt by sovereigns were made by Weber et al. (2011), Barkbu et al. (2012) and and Brooke et al. (2013).
Sovereign contingent convertible debt is a contingent legal contract that forces the counterparties to ‘bet on the future’. Its core is the contingent standstill. It limits debt repayment, thus avoiding default with its adverse effects, and since triggering is automatic, delays are avoided.
The standstill contingency provides risk sharing between debtor and creditors that is priced ex ante. Creditors face the prospect of not paid on time, and receive a discount for this. The sovereign pays upfront for the option of a future standstill. It does not just benefit from the borrowed money and leave future problems to the next government. Justification is found in the literature on neglected risks (Gennaioli et al. 2012); investors neglect certain unlikely risks, financial intermediaries provide securities exposed to these neglected risks, and because the risks are neglected, security issuance is excessive. By pricing the contingent standstill we price debt restructuring risk, and neglected risks are not so neglected any more. Therefore, sovereign contingent convertible debt is a contingent contract and a financial innovation to price neglected risks.
Illustration with Eurozone Crisis countries
We use a 30-day moving average on Eurozone CDS spreads with a 400bp threshold to illustrate how the use sovereign contingent convertible debt would have provided early responses to the crises. Raw data are shown in Figure 1, and Table 1 reports trigger timing and dates of signing the international assistance programmes. For Greece, Portugal, and Spain the response would have been accelerated by several months. Greece would have received relief through payment standstill in spring 2010 and not with the private sector involvement PSI at the end of 2011. Cyprus was an extreme case (21 months) of government procrastination that created a ‘perfect crisis’ and depositor bail-in (Zenios 2015).
Figure 1. The 5-year CDS spread on Eurozone crisis countries and the trigger threshold
Table 1. Date of example sovereign contingent convertible debt trigger and of signing an assistance programme
|Country||Trigger||Signed programme||Early response|
|Greece||24 April 2010||5 Sept. 2010||4 months|
|Portugal||16 Nov. 2010||20 May 2011||6 months|
|Ireland||1 Oct. 2010||16 Dec. 2010||2.5 months|
|Spain||27 March 2012||Dec. 2012||9 months|
|Cyprus||11 July 2011||15 May 2013||21 months|
Pricing and incentives
What are the incentives for a sovereign who issues sovereign contingent convertible debt not to provoke a standstill? The suggested design creates both financial and political disincentives.
Financial (dis)incentives are coming from the ex ante pricing of standstill risk as the sovereign has to offer a discount to investors. Figure 2 shows discounts for a three-year standstill at different thresholds. Discounts increase non-linearly as the threshold is approached, and since sovereign contingent convertible debt with a triggered standstill are senior to subsequently issued debt the higher rates are transmitted to new bonds. This is a disincentive to provoking a standstill. A sovereign that needs market access to roll-over debt – or pay salaries and pensions – cannot trigger the standstill with impunity.
What about a sovereign that can meet its financing needs by running a primary surplus? The disincentives are now political. Extensive literature explains why sovereigns pay even if they have immunity, the main argument hinging on reputation risks. This argument does not necessarily apply when any standstill is contractually prescribed. That is why we stipulate a precautionary credit line from IMF with associated conditionality when a standstill is activated. One could think of other pre-designed terms, such as earmarking some tax proceeds for resuming payments, or, for Eurozone countries, budget approval by the Commission during a standstill. These are unattractive options for a sovereign. A government that brings public finances to the point of triggering a standstill runs the risk of being voted out, in a way similar to financial institutions ousting the Board if banking contingent capital is converted.
Figure 2. Discounts on sovereign contingent convertible debt increase non-linearly as the threshold is approached
Incentives for investors come from the price discount and the reduced likelihood of outright default. Figure 3 illustrates the distribution of losses for both types of instruments. For plain bond we assume that spreads of 500bp signal nominal value haircut 50%, while sovereign contingent convertible debt triggers a 3-year standstill at spreads 200bp. Sovereign contingent convertible debt has higher probability of smaller losses due to standstill, whereas plain bonds suffer from rare extreme losses due to default.
Figure 3. Sovereign contingent convertible debt has smaller tail risk compared to plain bonds
Why sovereign contingent convertible debt?
We summarise the advantages from the use of sovereign contingent convertible debt.
- Overall, it has the potential for improving financial stability.
The full paper discusses in depth based on literature for bank coco (Flannery 2014). Some of the arguments we make are also made by Brooke et al. (2013).
- It forestalls default during a crisis – payment standstill gives the sovereign space to put public finances in order.
- It reduces defaults – payment schedule is altered with a contractually specified standstill which is not a default event.
- Market discipline the debtor – with risk sharing between creditors and debtor, the interest charged on sovereign contingent convertible debt increases as a crisis zone is approached, and because triggered bonds are senior the increase is transmitted to standard bonds.
- Limit creditor moral hazard – short-term creditors risk a standstill in the same way that long-term creditors may witness a default. Flight to short-term debt is arrested, and creditors cannot count on taxpayers to carry all the cost.
- Countercyclical fiscal policy – the standstill lowers primary surplus needs and creates fiscal space to spur growth.
- Automatic stabilisers – when capital inflows stop so do outflows for debt payments.
- Speedy response to crises – in the same way bank coco bypass ‘regulatory forbearance’ so sovereign contingent convertible debt deals with the ‘pathological procrastination’ of sovereigns in trouble and the international organisations that come to the rescue.
Restoring debt sustainability for Greece
Greece is a good candidate for S-CoCo financing. In a previous column we discussed debt rescheduling that would render Greek debt sustainable (Consiglio and Zenios 2015). Using the same problem setting, we show improved risk profile when debt is in S-CoCo.
The frontier of the expected cost of Greece debt against tail risk is obtained using a risk management optimisation model (see Figure 4). The same figure also shows the frontier when using sovereign contingent convertible debt with zero discount (i.e., priced as a straight bond) which gives the best possible improvement. Two intermediate frontiers show improvements with S-CoCo priced at a discount. Note that with 5% discount the expected cost of debt financing decreases from €280 billion to €260 billion with an increase in tail risk by €3 billion. The risk profiles with S-CoCO are roughly the same with those obtained using debt rescheduling from our August column. Greece could benefit by the same order of magnitude from a standstill as with rescheduling. However, with S-CoCo the standstill would have been embedded in the contract.
Figure 4 Greece risk profiles without and with sovereign contingent convertible debt financing at discount 0%, 5%, 10%
- S-CoCo bring market discipline and create the right incentives to debtor and creditors.
- S-CoCo would have provided early responses for Eurozone crisis countries.
- S-CoCo would have provided debt relief for Greece much before the PSI.
- Risk management optimization using S-CoCo improves the debt risk profile.
We have provided evidence on the merits of sovereign contingent debt. To become a significant source of capital for sovereigns a solid investor base is needed. Understanding their merits and developing pricing models can encourage investor participation and develop market depth, volume, and liquidity.
Caveat emptor. While sovereign contingent debt creates the right incentives for fiscal discipline it does not substitute for prudent management of public finances.
Barkbu, B, B Eichengreen, and A Mody (2012), “Financial crises and the multilateral response: What the historical record shows”, Journal of International Economics, 88:422–435, November.
Beers, D T and J-S Nadeau (2014), “Introducing a new database of sovereign defaults”, Technical Report No. 101, Bank of Canada, February.
Brooke, M, R Mendes, A Pienkowski, and E Santor (2013). Sovereign default and state-contingent debt. Financial Stability Paper No. 27, Bank of England.
Consiglio A and S A Zenios (2015), “The case for contingent convertible debt for sovereigns”, The Wharton Financial Institutions Center Working Paper WP 15-13, Nov. 2015. Available at SSRN: http://ssrn.com/abstract=2694973
Consiglio A and S A Zenios (2015), “Greek debt sustainability: The devil is in the tails”, VoxEU.org , 12 August.
Flannery, M J J (2014), “Contingent capital instruments for large financial institutions: A review of the literature”, Annual Review of Financial Economics, 6(1):225–240.
Gennaioli, N, A Shleifer, and R Vishny (2012), “Neglected risks, financial innovation, and financial fragility”, Journal of Financial Economics, 104:452–468, June.
Mody, A (2013), “Sovereign debt and its restructuring framework in the Eurozone”, Oxford Review of Economic Policy, 29:715–744, December.
Reinhart, C M, V Reinhart, and K Rogoff (2015), “Dealing with debt”, Journal of International Economics, 96:S43–S55, July 2015.
Turner A and S Lund (2015), “The Debt Dilemma”, projectsyndicate.org, 17 April.
Weber, A A, J Ulbrich, and K Wendorff (2011), “Safeguarding financial market stability, strengthening investor responsibility, protecting taxpayers”, Frankfurt Allgemeine Zeitung, March 2011.
Zenios, S A (2015), “Fairness and reflexivity in the Cyprus bail-in”, Empirica, published online 4 September.