Next time could be different – Towards risk-informed development finance
25 Jun 2015 by Pedro Conceicao, Director of Strategic Policy, and Alex Warren, independent consultant
In this blog series, our experts share their thoughts on key financing for development issues.
History provides a stark reminder that sovereign debt crises have been and are a regular feature of international development and finance. This was captured, with a touch of irony, by Professors Carmen Reinhart and Kenneth Rogoff in their book: ‘This Time Is Different: Eight Centuries of Financial Folly’. They argued that with every debt crisis we naively behave as if we are confronting it for the first time, and pretend that we have drawn the lessons that will save us from the next crisis. Yet, centuries of continued financial volatility and recurrent debt crises prove to the contrary.
But is this the inevitable reality of international finance? Or can we think of new forms of risk-informed development finance? And can these contribute to reducing the risk of costly and socially taxing sovereign debt restructuring and defaults?
The last two decades have seen growing interest in the adoption of state-contingent finance – i.e. financing modalities where debt service payments are linked to a country’s ability to pay. Informed by the 1980s sovereign debt literature (e.g. Krugman, 1988; Sachs, 1989), as well as by Robert Shiller’s work on Macro Markets, proposals for state-contingent finance argue that these instruments can contribute to greater debt sustainability, by linking countries’ debt service payments to their economic performance, as measured by GDP or export growth. State-contingent financing can be particularly beneficial for developing countries, whose economies tend to be overly exposed and vulnerable to the adverse effects of external shocks, such as those caused by sudden changes in commodity prices, extreme weather events, natural disasters or disease outbreaks – all outside the direct control of policy makers.
Typically, countries face a fixed schedule of payments as they service their debt, paying fixed interest and, depending on the debt contract, also amortizations of principal. When facing a slowdown in economic growth – or in an emergency situation – government revenues typically drop, while demand for social protection goes up, putting governments under fiscal pressure and making it difficult to make fixed debt service payments.
At the extreme, these dynamics may force countries to restructure (that is, lower the amount) or default on (temporarily not pay) their debt. Under a GDP-indexed type of debt instrument, debt service, including interest and potentially amortization payments, would be adjusted to take into account changes in GDP. As a result, debt service payment streams would be more closely aligned with a country’s economic performance, contributing to make debt more sustainable.
In addition to its debt stabilization benefits, state-contingent financing can also make fiscal policy less pro-cyclical (that is, saving more in good times and spend more in bad times), a desirable feature of macroeconomic policy. Thus, by reducing debt payments in times of economic slowdown, this type of financing reduces the pressure to cut back on other budget expenditures, implicitly creating greater fiscal space for expansionary fiscal policies, including those in support of social programmes and anti-crisis measures.
More generally, state-contingent financing can help countries manage risk and deal with shocks more effectively. The importance of building resilience of this kind cannot be overstated, especially as the costs of dealing with protracted crises, such as the Ebola outbreak in 2014, mount. Adopting state-contingent financing debt instruments in developing countries could be a step in the right direction.