The debt structures of countries have an important influence on their economic performance and vulnerability to crises. In particular, excessive reliance by emerging market countries on short-term debt and foreign-currency debt exposes them to risks of rollover crises and sharp increases in the debt burden resulting from exchange rate changes. Of course, risky debt structures are often themselves symptoms of underlying institutional and policy weaknesses that need to be convincingly addressed. But beyond this, the paper has argued that there are valuable lessons to be extracted for improving sovereign debt structures from liability structures in the corporate sector. In particular, debt with different degrees of seniority, and instruments with equity-like features, could help to reduce the vulnerabilities inherent in current sovereign debt structures. Three key messages emerge from the analysis:
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First, credibility of fiscal and monetary policies is a central prerequisite to buttress investors’ willingness to hold long-term local-currency bonds. Credibility, in turn, depends on both the quality of institutions and a reputation for sound policymaking. Without supporting reforms, building such a reputation can take many years, but the combination of macroeconomic stabilization with institutional and structural reforms can accelerate this process, as demonstrated by the experience of several emerging market countries, including Chile, Israel, Mexico, and Poland, in the last decade. Soon after bringing their inflation rates into the single digits and undertaking reforms of their monetary and fiscal frameworks, these countries successfully issued unindexed local-currency bonds with medium-term maturities. While initially relying on inflation-indexed bonds, which played a helpful and important role in the transition, most of these countries graduated to routinely issuing nonindexed long-term local-currency debt. This suggests that emerging market countries can improve their debt structures relatively quickly, as long as they show clear commitment to sound policies.
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Second, progress in overcoming the problem of debt dilution in the sovereign context could reduce the cost of borrowing and increase market access for low-debt countries, and help prevent crises that result from overborrowing and risky debt structures in high-debt countries. In the corporate context, debt dilution is addressed through methods that include debt covenants and explicit seniority. This paper has argued for consideration of analogous innovations in the sovereign context, in order to curb incentives for overborrowing, reduce costs of borrowing at low levels of debt, and limit the bias toward risky types of debt, such as short-term debt. This said, measures that reduce the scope for debt dilution are also likely to have some drawbacks: for example, making borrowing harder at high levels of debt may not always be desirable, especially if it exacerbates the risk of liquidity crises. In addition, some open questions remain, including the consequences of explicit legal seniority for crisis resolution and potential legal obstacles to the implementation of first-in-time seniority. While this cautions against making strong policy recommendations at the present time, the possible benefits of explicit seniority in the sovereign context seem to warrant further attention to the issue.
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Third, this paper has argued that instruments with equity-like features, which provide for lower payments in the event of adverse shocks and weak economic performance, could help sovereigns to improve debt sustainability and international risk sharing. Disaster insurance could benefit small countries prone to frequent natural disasters. Indexation to commodity prices might confer benefits for commodity-producing countries. GDP-indexed bonds would likely provide substantial insurance benefits to a broader range of countries, including the advanced economies and the main emerging market countries, though they present greater implementation challenges. In principle, GDP-indexed bonds could be issued relatively quickly, especially by countries with trusted and independent statistical offices. Whether these bonds would attract sufficient investor interest at reasonable cost to borrowing countries remains an open, empirical question. In particular, potential concerns of investors about complexities and difficulties in pricing would need to be addressed. Market acceptance and the requisite liquidity could be sought through international coordination or a large swap, possibly in the context of a restructuring. Countries could seek to ensure the independence of their statistical agencies, and technical assistance efforts could be stepped up in this area. More ambitiously, methods could be sought whereby outside parties could provide an independent view on whether countries’ data are being systematically distorted.
The analysis in this paper suggests that progress in ameliorating debt structures could yield substantial benefits in economic performance and international risk sharing, while reducing the frequency of crises and the damage they entail. While sound policies remain a precondition for securing better sovereign debt structures, renewed attention to innovative structures that may have become possible as a result of the increased sophistication of financial markets could be well rewarded.