Catastrophic Events and Sovereign Debt Restructurings

Catastrophic events and Sovereign Debt Restructurings FEBRUARY 25, 2022 Fifth Annual Sovereign Debt Restructuring Conference: Whom to Blame for Sovereign Debt Restructurings — Borrowers, Creditors, International Institutions, or Catastrophes?

Thordur Jonasson Monetary and Capital Markets Department Photo by NASA on Unsplash INTERNATIONAL MONETARY FUND

The views expressed herein are those of the author and should not be attributed to the IMF, its Executive Board, or its management

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Outline

• The role of State Contingent Debt Instruments • Catastrophic events as causes of restructurings • Can debt instruments be possible solutions?

• IFI initiatives in this area

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The Role of State Contingent Debt Instruments

• State contingent debt instruments (SCDIs) could help facilitate debt restructurings by giving creditors upside potential on the restructuring terms

• Restructurings also offer a unique opportunity to strengthen resilience of a sovereign’s debt portfolio through the introduction of SCDIs

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Use of Value Recovering Instruments (VRIs)

• The use of VRIs in past debt restructuring cases has been sporadic

• First introduced during the Brady restructurings in 1980s for oil exporting countries, such as Mexico, Venezuela and Nigeria

• More recently, upside GDP-linked-warrants have been featured as part of the financial packages issued to creditors in three major debt restructuring cases: Argentina (2005), Greece (2012), and Ukraine (2015)

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Can SCDIs be Useful as Countercyclical Risk Sharing Tools?

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Contingent debt service standstills and/or maturity extensions can provide liquidity relief for issuers facing severe liquidity shocks triggered by natural and public health disasters

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Can lower the risk of liquidity problems becoming full-blown and costly sovereign debt crises and is, therefore, beneficial to creditors, borrowers and the global financial system more broadly

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Hurricane Clauses •

Grenada (2015) and Barbados (2018) included natural disaster or “hurricane” clauses

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Provide cash flow relief after a natural disaster event when financing needs are greatest and new sources are scarce

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Future restructurings represent opportunities to support their wider usage, along with recent efforts to standardize these clauses

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Clauses in Caribbean Sovereign Debt Country

Haircut Nominal/NPV

Currency

Grenada (2015) Hurricane clause in 2030 bond

50% (of which 25% upfront)/ 54%

Local and Foreign Currency

0%/ 43%

Local Currency

15-35

"Modelled" Natural Disaster Damage

24 month deferral if modelled loss is greater than USD 5mn

Can be triggered a maximum of 3 times

25%/44%

Foreign Currency

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"Modelled" Natural Disaster damage

24 month deferral if modelled loss is greater than USD 5mn

Can be triggered a maximum of 3 times

Downside Barbados (2018) Natural Disaster Clause in a portfolio of domestic currency long-term bonds Barbados (2018) Natural Disaster Clause in 2029 bond

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Period covered (years) 13

Main trigger

Formula for payout/deferral

Caps/Exercise limits

"Modelled" Hurricane damage

6 month deferral if modelled loss is greater than USD 15mn, less than USD30mn

Can be triggered a maximum of 3 times

12 month deferral if modelled loss is greater than USD 30mn

24 month deferral if modelled loss is greater than USD 7.5mn

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Commodity-linked Clauses •

Clauses based on commodity prices could also provide an exogenous trigger (similar to hurricanes) and is relevant for commodity-exporting countries

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Pandemic debt instruments could be designed with public health disaster clauses, where the trigger for such an event could be set similar to those of the window of the Catastrophe Containment and Relief Trust (CCRT)

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Borrowing spreads of third countries could also provide an exogenous trigger, “systemic sudden stop”

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Is there market appetite?

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While attractive in theory, restructuring instruments that provide upside to creditors (such as GDP-linked warrants) have rarely been used in practice

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Fixed income investors have typically steeply discounted these “equity-like” instruments given their non-standard designs, illiquidity and idiosyncratic risk profiles

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Experience indicates market participants may not have appetite for such instruments beyond a narrow set of cases, particularly when shocks are global in nature

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Restructurings present an opportunity for the inclusion of disaster clauses that provide insurance to vulnerable countries that would contribute to a more resilient debt structure

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Use in Official Lending •

No explicit VRIs have been included in official debt relief cases except in Grenada (2015)

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Official creditors provide debt relief in the form of debt standstill, maturity extension, interest reduction, and outright debt forgiveness (such as the Heavily Indebted Poor Countries (HIPC) initiative)

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The absence of VRIs in official debt relief cases reflects the fact that attempts by official creditors to “recover value” in this manner seems contradictory to the stated objectives of such official lending

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Official creditors have only occasionally issued SCDIs during normal times

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IFI Initiatives •

Countercyclical loans issued by the Agence Française de Développement

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World Bank Pandemic Bond Program (2017) used an outbreak trigger when predetermined levels of contagion, speed of virus spread, and after crossing international borders

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Catastrophe Containment and Relief Trust

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Caribbean Catastrophe Risk Insurance Facility

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Consideration on VRI Structures • A VR mechanism should conform with domestic legal system (laws and regulations)

• The design of VRIs should be transparent, with clear objectives, contingencies, and terms

• Critical terms of a VRI structure include, in addition to the contingent arrangement:

• • • • •

Instrument size Coupon used Maturity Cap Possible collateralization of assets

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Considerations •

The infrequent appearance of VRIs in past restructurings reflects challenges, as creditors tend to strongly discount such instruments given their illiquidity and often idiosyncratic risk profiles

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SCDIs are useful to provide downside protection to sovereign debtors against future shocks such as natural or public health disasters

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Linking a bond’s interest rate to a strong proxy for repayment capacity that is outside the control of the issuing sovereign could enhance debt sustainability while also avoiding manipulation risk

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Recent developments by IFsI appear to provide a platform for further development of catastrophe/pandemic lending instruments

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References Anthony, M., Impavido, G., and van Selm, B., 2020, Barbados’ 2018-19 Sovereign Debt Restructuring – A Sea Change?”, IMF Working Paper, WP/20/34 Asonuma, Tamon and Trebesch, Christoph, 2016, “Sovereign Debt Restructurings: Preemptive or Post-Default”, Journal of the European Economic Association, Volume 14, Issue 1, pp. 175-214 Asonuma, T., Xin Li, M., Papaioannou, M., Thomas, S., and Togo, E., 2017, “Sovereign debt restructuring in Grenada: Causes, Processes, Outcomes, and Lessons Learned”, IMF Working Paper, WP/17/171.

International Monetary Fund, 2017, “State-contingent debt instruments for sovereigns”, Board Paper International Monetary Fund, “The Role of State-Contingent Debt Instruments in Sovereign Debt Restructurings”, Staff Discussion Note Moody’s, 2018, “Sovereign -- Global: Sovereign default and recovery rates, 1983-2017”

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