Sovereign Equity – A Way Forward on Sovereign Debt?

Sovereign debt markets have been on a rough ride recently. On the heels of Argentina’s 2014 default, a turbulent debt situation in Greece has threatened the integrity of the Eurozone. An ongoing debt crisis in Ukraine has stoked economic anxiety and raised geopolitical blood pressures. Meanwhile, Puerto Rico’s debt crisis poses unique challenges as a quasi-sovereign territory without access to bankruptcy.

These episodes highlight the broad and far-reaching effects of sovereign debt on the global financial system. While sovereignty limits the enforceability of their debt contracts, sovereigns lack a formal bankruptcy system. Nor is there a global sovereign debt regulator. As a result, sovereign debt exists in an awkward legal void, simultaneously unenforceable yet undischargeable.[1] Despite their freedom from international financial regulation, sovereign issuers are also uniquely constrained. Governments—unlike corporations, which can issue equity stock—rely on fixed income debt to externally finance their investments and operations. While investors can own certain government assets, one cannot invest in the equity of a country. This limits and distorts a sovereign’s financing strategies.

The Need for Sovereign Equity

In financial crises, “equity bends while debt breaks”[2]—and sovereign debt is arguably the most fragile of all sources of debt financing.[3] In our article, Towards Corporate Equity in Sovereign Debt Finance, we suggest that the concept of equity in sovereign debt finance, which we refer to as sovereign equity, merits serious consideration. The need for legal innovation in sovereign debt markets is greater than ever. Collective action problems between sovereign debtors and external creditors have persisted for generations, and have only worsened in recent years. Intractable stand-offs between sovereign debtors and holdout creditors have exacerbated the already flawed sovereign debt system.[4] Institutional solutions and piecemeal contractual innovations continue to lag behind problems in sovereign debt.

Sovereign debt contracts incorporating certain characteristics that resemble corporate equity could reduce the probability of sovereign debt crises. Our article analyzes the economic rationales and legal characteristics of several different kinds of financial instruments with varying degrees of equity-like characteristics, including GDP-linked securities, sovereign contingent convertible securities (“cocos”), debt-equity swaps, and Robert Shiller’s provocative concept of GDP shares.[5]

Sovereign Equity in Practice

State contingent debt instruments facilitate risk-sharing between sovereign debtors and creditors by linking payments obligations to macroeconomic variables.[6] To date, the most prevalent are GDP-linked securities, which are indexed or linked to the issuer’s GDP growth.[7] GDP-linked securities adjust coupon payments upwards or downwards based on the debtor’s real GDP growth rate. In theory, GDP-linked securities should mitigate the collective action problems in sovereign finance by helping to avert defaults and better aligning the incentives of sovereigns and their external creditors. When the country performs well economically, investors enjoy greater profits from an equity-like upside. Conversely, when growth stalls, these instruments calm the seas, easing debt-to-GDP ratios and interest payments. Better alignment of incentives may encourage more flexible responses to debt crises by directly linking creditor demands to debtor payment capacity. For example, in the Greek debt crisis, equity-like debt instruments might have mitigated politically-driven demands for austerity by expressly establishing how much and when Greece would be required to repay its official creditors. In addition, the reputational sorting function built into such instruments may encourage fiscal discipline by all but the most recalcitrant of sovereigns.

GDP-linked securities have been used primarily in the restructuring of highly distressed debt held by private creditors, including several Brady Plan exchanges in the 1980s. GDP-linked securities also played a role in the two of the largest sovereign restructurings in modern history: Argentina (2005 and 2010) and Greece (2012). Moral hazard, valuation, pricing, and liquidity issues in these offerings have hindered broader adoption of GDP-linked securities by other countries. To overcome these obstacles, we highlight the need for better practices in contract design and suggest greater involvement by highly-rated, stable sovereign issuers and oversight by international financial institutions in order to promote standardization and market confidence in these new instruments. In the past year alone, the governments of Ukraine[8] and Jamaica,[9] among other countries, have proposed equity-like financing. Our objective is to provide guidance to these policymakers and investors (and their respective legal advisors) as well as others that may follow in the future.

A Way Forward?

Sovereign equity, while nowhere close to equivalent to its corporate counterpart, deserves greater attention. Given the legal vacuum and limited feasibility of institutional solutions to problems in sovereign debt, the concept of sovereign equity can serve as an organizing framework for the development of new kinds of public-private hybrid responses to persistent problems in sovereign debt finance.

ENDNOTES

[1] See Anna Gelpern, A Skeptic’s Case for Sovereign Bankruptcy, 50 Hous. L. Rev. 1095 (2013).

[2] Most Western Economies Sweeten the Cost of Borrowing. That is a Bad Idea, Economist, May 16, 2015.

[3] See Guillermo A. Calvo, Servicing the Public Debt: The Role of Expectations, 78 Am. Econ. Rev. 647 (1988).

[4] Argentina’s default in 2014 is a vivid and sobering example. Years of bitter litigation between relentless holdout creditors (so-called “vulture funds”) and an equally obstinate defendant ended in a default with significant costs to third parties. See Benedict Mander, Cristina Fernández Holds Out for Victory in Debt Battle, Financial Times, Mar. 30, 2015.

[5] See Robert J. Shiller, Give People Shares of GDP, 90 Harv. Bus. Rev. 50 (2012).

[6] See Kenneth A. Froot, David S. Scharfstein & Jeremy C. Stein, LDC Debt: Forgiveness, Indexation, and Investment Incentives, 44 J. Finance 1335 (1989); Paul R. Krugman, Financing vs. Forgiving a Debt Overhang, 29 J. Dev. Econ. 253 (1988).

[7] See, e.g., Eduardo Borensztein & Paolo Mauro, The Case for GDP-Indexed Bonds, 19 Econ. Pol. 165 (2004).

[8] See Lyubov Pronina & Katia Porzecanski, Greece, Argentina Provide Model as Ukraine Considers GDP Linkers, Bloomberg Business, July 15, 2015.

[9] See Katia Porzecanski, Jamaica Weighing Debt-for-Asset Swap Following Defaults, Bloomberg Business, Oct. 31, 2014.

The preceding post comes to us from Stephen Park, Assistant Professor of Business Law at the University of Connecticut School of Business, and Tim Samples, Assistant Professor of Legal Studies at the University of Georgia, Terry College of Business. The post is based on their recent article, entitled “Towards Corporate Equity in Sovereign Debt Finance”, which is available here.

1 Comment

  1. JoePesci

    Having an ‘equity cushion’ would be good, based on the analogy with a business, but this in fact already exists in a way when a country sells equity in a nationalized business to buyers outside the country, since this replaces funding that would have to come from the government. See Mexico’s decision to allow foreign capital to buy into its nationalized oil company Pemex. For how that can go horribly wrong, see Petrobras.

    A more workable idea for a sovereign would be a commodity linked bond. Especially for countries with nationalized commodity businesses with assets overseas. These bonds could be secured by physical commodities which could be placed in trust in a neutral location, or secured by warehouse receipts or other foreign assets, and the bond buyers could hedge the commodity exposure. Consider the Venezuela / China loan–cash now for future oil–that’s a pretty creative workaround.

    I think after the Argentina fiasco we have to think about secured sovereign bonds where the security is in neutral locations, not inside the borrowing country, and is not denominated in the sovereign’s currency, e.g. oil, gold, copper, etc.

    Or as Matt Levine might say: or, you know, you could just not screw up the pari passu clauses in your bond indenture to allow for a proper haircut in any future restructuring.

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