Financial Crisis Remedy? Modeling Sovereign Contingent Liabilities for Latin American Countries

Abstract

This thesis analyzes the potential benefits for Latin American countries to issue sovereign contingent liabilities in a world of macroeconomic uncertainty. Two main instruments are analyzed: GDP-Linked Bonds and Sovereign Contingent Convertible bonds (Sov-Cocos). Both instruments provide protection against liquidity crises by linking debt service payments to variables that are correlated with a country’s economic health and ability to pay. GDP-Linked bonds have started to become more widely adopted in the case of governments dealing with macroeconomic crises while Contingent Convertibles have recently gained popularity in the region in the form of convertible debt for financial institutions, particularly as more Latin American governments have implemented Basel III capital requirements. This study aims to quantify the impact of raising capital with these financial instruments for Latin American countries by analyzing the comparative performance of GDP-Linked bonds and Sov-Cocos into two main segments. First, this study performs a historical pro-forma analysis that projects the economic performance under a contingent portfolio for various Latin American countries during the 2008 Financial Crisis and the 2020 COVID pandemic, and then contrasts it with actual historical economic performance. Secondly, this study runs stochastic simulations 10 years into the future and contrasts GDP growth as well as recession events likelihood between a non-contingent debt portfolio versus a GDP-linked bonds portfolio or a Sovereign Contingent Convertibles bonds portfolio. Such results can thus serve as a key reference to analyze the benefits of sovereign contingent liabilities and foresee the challenges that Latin American countries can anticipate upon their implementation.