Sovereign Debt: Risk management and contingent debt Andrea Consiglio University of Palermo Stavros A. Zenios University of Cyprus Norwegian School of Economics Wharton Financial Institutions Center

Q1 Is debt sustainable with high probability, say 95% Q1 Is debt sustainable with high probability, say 95%? Q2 If debt is unsustainable, what debt restructuring schedule will restore sustainability? Q3 What is the optimal debt financing strategy for the sovereign, with or without restructuring? The devil is in the tails www.voxeu.org, Aug. 2015

Kingdom of Atlantis debt financing It is about tradeoffs and assumptions

Outline The debate on sovereign debt restructuring Risk management for debt restructuring Sovereign contingent debt Optimizing stochastic debt sustainability analysis Case study of Greece

Ex post: Risk management for debt restructuring Q1 and Q2. Need stochastic debt sustainability analysis Incorporating risk measures Systematic synthesis of assumptions Q3. Portfolio optimization.

Ex ante: Sovereign contingent debt A sovereign debt instrument with a built-in trigger to allow standstill of payments when a crisis indicator breaches a threshold

Debate on sovereign debt restructuring

Debate on sovereign debt restructuring IMF 2013 mea culpa on Greece “Debt restructurings have often be too little and too late, failing to re-establish debt sustainability and market access in a durable way” UN General Assembly 2015 Resolution 69/319 on “Basic Principles on Sovereign Debt Restructuring Processes" (136 in favor, 6 against and 41 abstained) IMF 2015 declares Greek debt unsustainable

Debate on sovereign debt restructuring Data: Bank of Canada 2014.

Debate on sovereign debt restructuring Data: Trebesch 2011.

The issues in sovereign debt crises To default or not to default? Eaton-Gersovitz (1981), Krugman (1988), Reinhart-Rogoff (2009), Sturzenegger-Zettelmeyer (2006), Benjamin-Wright (2009), Brunnermeier et al. (2011), De Grauwe (2012) Is to forgive to forget? Bulow-Rogoff (1989), Arsanalp-Blaire (2005) Cruces-Trebesch (2013), B-W (above), Wright (2012) Massive legal problems Krueger (2002), Gianviti et al. (2013), Buchheit et al. (2013), Delays in resolving crisis destroy value

The issues in sovereign debt crises Endogenously determine debt limit and fiscal space Mendoza and Oviedo (2009), Blanchard et al. (1990) Optimal debt financing Barro (many), Bohn (many), Angelettos (2002), Bolder (2011) Tradeoffs Missale (1997) Assumptions Panizza (in half hour)

The issues in sovereign debt crises What happens if problem is infeasible? Synthesis with sufficient granularity for operations Term structure of legacy debt “Need for development of criteria for “optimal” debt restructuring process” (Wright 2012, Harvard Business Law Review) Risk management has not been part of analysis Operational models are missing

Risk management for debt restructuring

Risk management for debt restructuring Debt dynamics Re-finance debt of different maturities Look at debt flows Look at alternative debt structures

Risk management for debt restructuring States and paths determine conditional and unconditional information flow

Risk management for debt restructuring Scenario dependent debt dynamics D is the term structure of debt (multiple issues) r is the term structure of sovereign rates NB can be state-dependent SF can be state-contingent Scenario tree integrates economic and financial risk factors Objective and risk neutral probabilities (Consiglio, Carollo, Zenios, Quantitative Finance, 16:201-212, 2016)

Risk management for debt restructuring Sovereign issues xn(j) nominal value of instrument j at node n

Joint Stock and Flow model

Risk management for debt restructuring: Flow model

Risk measures Worst case Risk neutral Coherent

Risk management for debt restructuring: Stock model Conditional Debt-at-Risk (Rockafellar and Uryasev 2000)

Risk management for debt restructuring: Joint stock and flow model

Risk management for debt restructuring: Joint stock and flow constraints Specifying xn(j) Fixed mix (simple rules) Adaptive fixed mix Stochastic program

Risk management for debt restructuring: Endogeneity 𝐶𝐹 𝑗 𝑛,𝑚 =𝚽 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒𝑠, 𝑖𝑛𝑠𝑡𝑟𝑢𝑚𝑒𝑛𝑡 Risk premium 𝑟= 𝑟 𝑓 +𝛒 𝛒:=𝛒 𝑑 𝑟 𝑛 = 𝑟 𝑓 𝑛 +𝛒( 𝑑 𝑛 ) Term premium

Risk management for debt restructuring: Endogeneity 𝛒:=𝛒 𝑑

The Kingdom of Atlantis

The Kingdom of Atlantis

The Kingdom of Atlantis Constant fixed-mix (benchmark) 13.11% of GDP Adaptive fixed-mix 8.82% of GDP Stochastic program 8.32% of GDP

The Kingdom of Atlantis. Vicious and Virtuous cycles.

Case study of Greece

Case study of Greece: current debt situation

Sovereign contingent debt: From ex post to ex ante solutions

Ex ante: Sovereign contingent debt

Ex ante treatment of sovereign risk Address creditor moral hazard Deal with “neglected risks” Contingent contracts

S-CoCo designs: Trigger 30-day average CDS spread > 300 to 400bp Country Trigger Signed Program Early response Greece 24 April 2010 5 Sept. 2010 4 months Portugal 16 Nov. 2010 20 May 2011 6 months Ireland 1 Oct. 2010 16 Dec. 2010 2,5 months Spain 27 March 2012 Dec. 2012 9 months Cyprus 11 July 2011 15 May 2013 21 months

S-CoCo Pricing

Risk management for debt restructuring with CoCo

Conclusions Ex post risk management for sovereign debt Ex ante deal with uncertainty

References Consiglio, A. and Zenios, S.A. 2016 Risk management optimization for sovereign debt restructuring Journal of Globalization and Development, (Joseph Stiglitz et al., eds.) Consiglio, A. and Zenios, S.A. 2016 Contingent convertible bonds for sovereign debt risk management http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2694973 Consiglio, A., Carollo, A. and Zenios, S.A. A parsimonious model for generating arbitrage free scenario trees Quantitative Finance, 16:201-212, 2016.