Could Aspects of Corporate Financial Strategies Help Prevent Sovereign Default?

Some key strategies from corporate finance could potentially help prevent governments from spiraling into financial collapse and destabilizing the global economy.

That’s the conclusion of UConn Business Law Professor Stephen Park and co-author Tim Samples, a professor at the University of Georgia, in their research article titled, “Towards Sovereign Equity,” which is pending publication in the Stanford Journal of Law, Business and Finance in 2016.

“Because the global financial markets are so interconnected, the insolvency of even one country can create a domino effect through the global economy,” Park said. “The whole global financial system can be at risk.”

A perfect example is the Greek economic collapse and debt default this past summer. “Though Greece is a small country, its financial failure had implications far beyond Greece itself,” Park said.

Governments issue and sell bonds in the global financial markets to finance their investments and operations. Many countries struggle with debt, even if not to the potentially catastrophic degree experienced by Greece.

“Public debt is a big issue worldwide,” Park said. “Unless these structural issues are addressed, they are not going to go away. Over the long-term, other sovereigns will undoubtedly default on their debt obligations.”

“Unlike private companies, there is no ‘bankruptcy court’ or proceedings for such situations. If countries are unable to pay their creditors, there is no orderly restructuring process—no Chapter 11 or Chapter 9 for sovereigns—only ad hoc enforcement and negotiation of contractual obligations,” Park continued.

“It is increasingly difficult to resolve disputes, due to the fragmentation of sovereign debt, because so many entities with competing interests hold bonds issued by various governments,” he added.

The basic premise of Park and Samples’ research is that sovereigns don’t have the option to finance through equity, which limits and distorts their financing strategies and exacerbates the unique collective action problems of sovereign finance. In contrast, a corporation like GE or UTC has the option of selling equity stock or bonds that can be converted into equity, which doesn’t have to be periodically repaid upon maturity.

The paper’s overarching topic is the range of intermediate steps that governments can use to incorporate “equity-like” characteristics into their financing strategies. The paper addresses the legal and institutional design of various proposals, including sovereign contingent convertible securities, debt-equity swaps and Robert Shiller’s idea of GDP shares.

In particular, the paper examines at length GDP-linked bonds, whose value is linked or indexed to the real GDP growth of the country. If a country is doing well, it would generate more interest, and if it is struggling, then the payout would be less. “It is a way to create a debt instrument that mimics equity,” Park said. “It is a burden-sharing tactic that requires the investor to have a little ‘skin in the game.'”

In theory, GDP-linked bonds help address the collective action problems in sovereign finance by helping to avert defaults and better align the incentives of sovereigns and their external creditors. In their paper, Park and Samples suggest that GDP-linked bonds may be viewed as a “pre-commitment” device that constrains the ability of sovereign debtors and their external creditors to take advantage of each other when politically or economically opportunistic.

To test these propositions, Park and Samples analyze the small sample of GDP-linked bonds to date, focusing on their use by Argentina, Greece and Ukraine. Based on these cases, they determine that the effectiveness of these equity-like instruments is decidedly mixed. The market for GDP-linked bonds has been hampered by problems and disputes concerning pricing, valuation, and liquidity, among other issues.

In Argentina, for instance, the government had trouble establishing price of the GDP-linked component of its sovereign bonds, and vastly underestimated the costs of GDP-indexing. After issuing GDP-linked bonds for the first time in 2005, the Argentine economy boomed. As a result, Argentina paid investors handsomely on its GDP-linked bonds and many observers feel the country got the short end of the deal, he said.

Their paper suggests reforms to improve the credibility of GDP-linked bonds, and concludes that although there are legal and institutional barriers to introducing equity in sovereign finance, the uniquely chaotic and fragmented nature of the sovereign financial markets makes this kind of financial innovation worth exploring.

“As we see with Ukraine’s embrace of so-called value recovery instruments in its debt restructuring this fall, the market for sovereign equity will continue to develop – but only if governments and investors resolve the shortcomings that have deterred their adoption and hindered their effectiveness,” Park predicted. “We hope to continue gathering more data and participate in future discussions on the legal and institutional design of this market in order to make it viable in the long term.”