The Rise of State Contingent Debt Instruments

By Karin Strohecker and Libby George

Introduction

WASHINGTON/LONDON (Reuters) – The recent cascade of countries defaulting on their debt has brought back into vogue complex securities, known as State Contingent Debt Instruments (SCDIs), that aim to speed up restructurings.

SCDIs Explained

Born in the 1980s, these instruments attract investors with new bonds that promise payouts if certain economic or fiscal targets are met. Countries like Ukraine and Sri Lanka have utilized SCDIs to navigate challenging debt negotiations.

Expert Opinions

Pierre Cailleteau, managing director at Lazard’s sovereign advisory group, advocates for the use of SCDIs as a "deal accelerator" when addressing fundamental disagreements on a country’s economic prospects.

However, concerns arise from other experts that SCDIs may lead to higher borrowing costs in the future, as some investors may hesitate to purchase these bonds once they are traded on the market.

Recent Examples

Authorities from Ukraine, Zambia, Sri Lanka, and Suriname have not commented on the topic recently.

At the International Monetary Fund/World Bank autumn meetings, the Global Sovereign Debt Roundtable will discuss SCDIs. Ukraine’s recent debt restructuring, linked to GDP growth, demonstrates the viability of these instruments.

Structural Differences

Unlike traditional "plain vanilla" sovereign bonds that have fixed interest rates, SCDIs can offer variable payments based on economic performance, revenue from natural resources, or tax receipts.

Risks Involved

Investors are wary of economic projections from IMF, with Sergei Strigo of Amundi expressing doubts about SCDIs. Restructuring efforts can be lengthy, as seen in Zambia and Sri Lanka, which continue to navigate the complexities even into their second years post-default.

Historical Context

SCDIs are not a new phenomenon; they were initially used in Brady bonds during the late 1980s Latin American debt crisis. Mixed success is documented, with a report from the Bank for International Settlements showing a significant premium demanded by investors.

Legal Challenges

Past issues like legal disputes over manipulated data and unregulated payouts have hindered the effectiveness of SCDIs. New instruments, such as Zambia's 2024 bond linked to debt capacity, aim to mitigate these risks by using IMF assessments.

Moving Forward

While SCDIs can create uncertainty for governments, they may also provide sophisticated investors with opportunities due to potential mispricing. Sri Lanka's ongoing restructuring, linked to its IMF growth targets, will be a significant case study in the instrument's future viability.

Lazard’s Cailleteau remains optimistic that successful implementation of these instruments could set a new standard for handling sovereign debt issues.