By Sanjaya Ariyawansa
Debt restructuring has become a vital tool for numerous developing economies grappling with financial distress. Over time, many countries have faced the need to restructure their debt multiple times, as previous efforts failed to deliver long-term fiscal sustainability. Between 1975 and 2020, 59% of countries that underwent debt restructuring had to do so repeatedly, with Argentina and Greece among the most notable examples.
This recurrence often stems from persistent governance failures, weak economic policies, and external shocks. To avert such recurring crises, restructuring strategies must evolve beyond mere financial adjustments and focus on fortifying governance and aligning debt servicing with the economic realities faced by these nations.
As the shortcomings of conventional restructuring methods become evident, new approaches are needed to address the root causes of debt instability. This article examines how two innovative financial instruments—Governance-Linked Bonds (GLBs) and Macro-Linked Bonds (MLBs)—can address the structural weaknesses that have historically undermined debt sustainability. By tying debt obligations to governance reforms and macroeconomic performance, these instruments offer countries a way to enhance fiscal stability while promoting sound governance. As countries like Sri Lanka, Ghana, Zambia, Argentina, and Greece continue to deal with the fallout from debt crises, GLBs and MLBs present a new, promising approach to managing debt in a more sustainable and accountable manner.
Governance: A Central Factor in Debt Crises
The importance of governance in debt management cannot be overstated, as it lies at the heart of a country’s ability to implement sustainable fiscal policies. Governance is pivotal in the success or failure of debt management. Countries with weak institutions, lack of transparency, and poor accountability frequently struggle to implement effective fiscal policies, resulting in unsustainable debt levels and financial instability. Poor governance fosters fiscal mismanagement and corruption, making it difficult for governments to control debt. This challenge is especially evident in countries that have endured debt crises, such as Ghana, Zambia, and Sri Lanka.
Sri Lanka’s case is particularly instructive. The country defaulted on its external debt in April 2022, following years of fiscal mismanagement compounded by policy errors, and external shocks like the COVID-19 pandemic. By mid-2024, Sri Lanka’s external debt had ballooned to $37.5 billion. While debt restructuring efforts, including haircuts and maturity extensions, have provided some relief, underlying governance issues and inefficient fiscal policies persist. This makes clear the necessity for more innovative 2 financial tools like GLBs, which directly connect debt servicing with governance reforms, incentivising improvements where they are most needed.
Governance-Linked Bonds: Incentivising Reforms
Governance-Linked Bonds (GLBs), a novel concept first introduced by Verite Research, provide a structured solution to the governance problems that exacerbate fiscal instability, offering a tangible way to incentivise reforms. Governance-Linked Bonds are designed to link debt servicing costs to the implementation of governance reforms.
These bonds allow debtor countries to reduce their debt payments if they meet specific governance benchmarks, such as improving tax collection, enhancing public procurement transparency, or reinforcing anti-corruption measures. The premise is that better governance leads to more effective debt management, thus reducing the likelihood of future debt crises. The potential benefits of GLBs are clear. For debtor nations, these bonds offer fiscal space to implement crucial reforms without the immediate burden of full debt repayments. For creditors, GLBs reduce the risks associated with lending to countries with weak governance by tying debt relief to demonstrable improvements in governance, thereby increasing repayment capacity. In this way, GLBs form a direct bridge between governance and fiscal stability, but they are not without challenges.
Establishing clear, measurable benchmarks is critical, and investors will require confidence that reforms are achievable. The challenges of implementing GLBs naturally lead to a discussion of another instrument, Macro-Linked Bonds (MLBs), which address the broader economic factors that impact debt sustainability.
Macro-Linked Bonds: Aligning Debt with Economic Performance
While GLBs address governance improvements, Macro-Linked Bonds (MLBs) tackle the macroeconomic side of debt management. MLBs adjust debt service payments based on the debtor country’s economic performance, typically linked to indicators such as GDP growth, inflation rates, or export revenues. This counter-cyclical feature provides debtor nations with greater flexibility in managing their debt, allowing payments to decrease during economic downturns and increase when economic growth resumes. By tying debt obligations to economic performance, MLBs complement GLBs in creating a more holistic approach to debt restructuring. MLBs have been deployed in various countries to mitigate risks associated with economic volatility. In Argentina, GDP-linked warrants were issued during the 2005 debt restructuring, tying debt payments to GDP growth. This arrangement provided Argentina with a buffer during economic downturns, helping stabilise its fiscal position. Similarly, Greece and Ukraine have experimented with GDP-linked bonds as part of their restructuring efforts.
For Sri Lanka, Ghana, or Zambia, where export performance and sector-specific revenues (such as tourism) are critical to the economy, MLBs could potentially be customised to include a broader range of macroeconomic indicators. These instruments, however, must be carefully designed to balance the risks and returns for investors, much like GLBs.
A New Path for Sovereign Debt Restructuring
As global debt challenges intensify, there is an urgent need for innovative solutions that extend beyond traditional restructuring methods. Governance-Linked Bonds (GLBs) and Macro-Linked Bonds (MLBs) offer countries tools to align debt relief with governance reforms and economic performance, fostering a more sustainable debt management path.
The integration of governance reforms with fiscal obligations through GLBs, combined with the macroeconomic flexibility offered by MLBs, provides a comprehensive strategy for addressing the root causes of debt distress. For countries like Ghana, Zambia, and Sri Lanka, which have endured repeated debt crises due to governance and macroeconomic challenges, these instruments provide a framework for addressing the root causes of fiscal instability. By linking debt relief to governance progress and aligning debt payments with economic performance, GLBs and MLBs offer a promising way to break the cycle of debt distress and promote long-term fiscal stability. However, the successful implementation of these instruments will require careful design, transparent frameworks, and the political will to execute the necessary reforms.
Investors must be willing to accept these bonds, and governments must commit to achieving the reforms that trigger debt relief. In conclusion, Governance-Linked Bonds and Macro-Linked Bonds represent a critical innovation in the evolving landscape of sovereign debt restructuring, offering countries a new path to financial stability, governance reform, and long-term economic resilience.
Sanjaya Ariyawansa is the Senior Economist at the Ceylon Chamber of Commerce.
