Proactive Resolution of Sovereign and Subnational Debt

Sovereign nations urgently need help in resolving unsustainable debt burdens. The median public debt of the sixty low-income developing countries increased from 33.5% of GDP in 2013 to 47% of GDP in 2017. Eight of these countries are already in debt distress, and sixteen are facing a high risk of debt distress. The World Bank and the IMF also recognize the increasing urgency of subnational debt problems, which refers to the debt of political subdivisions of nations such as states, provinces, and municipalities.

Traditional resolution strategies for government debt are primarily reactive. Reactive strategies are even less effective for government debt than for corporate debt because sovereigns and most subnationals lack systematic legal mechanisms—such as those provided by corporate bankruptcy law—for correcting collective action holdout problems and other market failures that impede debt restructuring.

Informed by proactive strategies that could help systemically important financial firms resolve unsustainable debt, my article ‘Proactive Resolution of Sovereign and Subnational Debt’ examines and assesses the economic and legal viability of proactive strategies for resolving unsustainable governmental debt. Whether addressing firms or governments, the principles should be the same: to convert borderline unsustainable debt into sustainable financing, through pre-planning, or to try to prevent the debt from approaching unsustainability. 

In response to the global financial crisis, systemically important firms are beginning to issue contingent convertible bonds, or CoCos, that convert into equity securities upon the occurrence of pre-specified triggers that indicate the firm is becoming financially troubled. Conversion would reduce the firm’s indebtedness with the intention of making it financially viable again. The possibility that their debt claims could be converted into equity should also motivate investors in CoCos to take on more of a monitoring role by imposing stricter covenants, which could reduce the firm’s risk-taking.

The article examines how governments could issue the equivalent of CoCos. For example, governments cannot feasibly convert their debt into equity. Instead, government CoCos could be designed to convert into debt whose principal and/or interest rate are reduced, or whose maturities are extended, to try to make the debt sustainable.

There are at least two ways to try to prevent government debt from approaching unsustainability. The first is to tie the amounts and/or maturities of payments on the debt to variables that correspond to the government’s ability to pay. These variables could be the government’s GDP or other factors linked to its creditworthiness such as its commodity-export prices. Although the G20 has called for further analysis of GDP-linked bonds, in practice no nation has yet issued them.

The other way to prevent government debt from approaching unsustainability is to limit recourse on the debt to only specified assets or revenue sources of the debtor (‘non-recourse financing’).  The fundamental distinction between non-recourse financing and variable financing is that the former encompasses debt whose payments derive from specific limited sources, whereas the latter encompasses debt with full recourse to the debtor but whose amounts and maturities can change depending on the variables chosen. Non-recourse government financing has significant precedent in some jurisdictions, including the United States. The key is that investors have recourse to a sufficiently reliable and adequate source of repayment such as high-quality financial assets that are expected to convert to cash. In both a sovereign and a subnational context, this might include payments expected to be generated from an income-producing project or rights to the future payment of specified tax revenues.

Non-recourse financing—especially when done through special purpose entities created to engage in the financing—is very common in corporate finance and is widely accepted by investors. It can increase economic efficiency by more precisely allocating risks and rewards between debtors and creditors, thereby reducing information asymmetry.

When misused, however, non-recourse financing can increase information asymmetry, such as by facilitating opaque off-balance-sheet financing. Furthermore, non-recourse government financing can also create risks if the government has little choice but to stand behind that debt. Subnational governments especially may have strong economic and reputational motivations to do that because a default on that debt could signal uncertainty as to whether the subnational will pay its debts generally, thereby jeopardizing the government’s credit rating. Subnational governments may have other reasons, too, to support payment of non-recourse debt, especially if the entity issuing the debt operates as an integral part of the subnational government, such as providing the water supply—essentially a ‘too important to fail’ variant of the corporate notion of too-big-to-fail.

Steven L. Schwarcz is the Stanley A. Star Professor of Law & Business at Duke University School of Law, and Founding Director, Duke Global Capital Markets Center.