Sovereign Default and State-Contingent Debt

20 Pages Posted: 5 Dec 2013

See all articles by Martin Brooke

Martin Brooke

Bank of England - International Economic Analysis Division

Rhys Mendes

Government of Canada - Bank of Canada

Alex Pienkowski

International Monetary Fund

Eric B. Santor

Bank of Canada - International Relations Department

Date Written: November 19, 2013


In recent decades, the common perception had been that sovereign debt crises were unlikely to occur in advanced economies. Events in the euro area over the past few years, however, have undermined this view.

The sovereign debt restructuring in Greece and the events surrounding the IMF-EU support packages for Ireland, Portugal and Cyprus have exposed fault lines in the existing practices for sovereign debt crisis resolution — perhaps most importantly, an overreliance on official sector liquidity support. This paper argues that the current approach is suboptimal for five main reasons: (i) it increases the risk of moral hazard; (ii) it incentivises short-term lending, which can increase the risk of liquidity crises; (iii) it puts an inequitable amount of tax-payer resources at risk; (iv) substantial official sector holdings of an insolvent sovereign’s debt can complicate negotiated debt write-downs; and, (v) it can delay necessary reforms thereby requiring larger policy adjustments to be implemented when action is eventually taken.

In response to these deficiencies, this paper argues that, for reasons of equity and efficiency, private creditors should play a greater role in risk-sharing and helping to resolve sovereign debt crises. We propose the introduction of two complementary types of state-continent bonds — ‘sovereign cocos’ and ‘GDP-linked bonds’.

Sovereign cocos are bonds that would automatically extend in repayment maturity when a country receives official sector emergency liquidity assistance. This predictable and transparent means of bailing-in creditors would increase market discipline on sovereigns to prudently manage their debt, ex-ante, thus reducing the incidence of crises. And, it would reduce the size of official sector support packages once a crisis has hit, as amortising debt would no longer need to be covered by program financing.

GDP-linked bonds are debt instruments that directly link principal and interest payments to the level of a country’s nominal GDP. They provide a natural complement to sovereign cocos. While sovereign cocos are primarily designed to tackle liquidity crises, GDP-linked bonds help reduce the likelihood of solvency crises. This is because GDP-linked bonds provide a form of ‘recession insurance’ that reduces principal and interest payments when a country is hit by a negative growth shock. This helps to both stabilise the debt-to-GDP ratio and increase a sovereign’s capacity to borrow at sustainable interest rates. While all countries might experience some benefit from the use of GDP-linked debt, economies with higher GDP growth volatility (such as emerging market economies) or countries where monetary policy is constrained (such as those in a monetary union) are likely to benefit most.

The promotion of collective action clauses (CACs) by the G10 and the major emerging market economies in the mid-2000s provides evidence that it is possible for the international community to reach agreement on, and implement, changes to the contractual terms of sovereign debt. This experience suggests that it would be possible to implement the two types of state-contingent bonds proposed in this paper.

Suggested Citation

Brooke, Martin and Mendes, Rhys and Pienkowski, Alex and Santor, Eric B., Sovereign Default and State-Contingent Debt (November 19, 2013). Bank of England Financial Stability Paper No. 27, Available at SSRN:

Martin Brooke

Bank of England - International Economic Analysis Division ( email )

Threadneedle Street
London EC2R 8AH
United Kingdom

Rhys Mendes

Government of Canada - Bank of Canada ( email )

234 Wellington Street
Ontario, Ottawa K1A 0G9

Alex Pienkowski (Contact Author)

International Monetary Fund ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Eric B. Santor

Bank of Canada - International Relations Department ( email )

234 Wellington Street
Ottawa, Ontario K1A 0G9

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