Commodity-linked bonds and Africa’s search for innovative financing

An employee weighs a 1kg gold bar at AGR (African Gold Refinery) in Entebbe, Uganda, October 4, 2018. Picture taken October 4, 2018. To match Insight AFRICA-GOLD/REFINERIES     REUTERS/Baz Ratner

Africa needs about $1.3 trillion a year to achieve the goals of the 2030 Agenda of Sustainable Development. These needs include, for example, about $93 billion to $170 billion per year in investments for the promotion of adequate infrastructure, which doesn’t include the financing necessary for addressing the increasingly devastating impacts of climate change. Still, despite efforts to improve upon the mobilization of domestic revenues, Africa faces a huge financing gap to support its development agenda.

Moreover, the devastation caused by the COVID-19 pandemic has highlighted now, more than ever, the need for an adequate, predictable, sustainable, and integrated financing mechanism to build back better. However, Africa does not have the fiscal space as debt levels of countries have risen to unsustainable levels following the pandemic as countries had to borrow more to address mitigating measures against the virus. Indeed, many experts are recommending that countries in debt distress restructure their debt. However, given the uncertainty and economic costs associated with debt restructuring, African countries could search for alternative resource mobilization strategies.

State-contingent debt instruments

Most African countries—because they are major exporters of raw commodities and have limited capacities to effectively mitigate the risks when commodity prices plummet and there are sharp increases in interest rates—are vulnerable to major financial risks linked to commodity price risks. Such conditions lead countries carrying large debts to face the challenges of increased indebtedness and debt servicing difficulties. These difficulties also lead to the deterioration of the balance of payments of the countries as export revenues fall and, consequently, the depreciation of the value of their currencies. Forms of financing that have been in the financial markets of industrial countries and offer considerable potential for risk management for African countries are state-contingent debt instruments (SCDIs), which could facilitate speedier and less-costly debt restructuring as the payments of restructured debt contracts could be linked to future outcomes. SCDIs are contractual debt instruments where payments are linked to a predefined state variable such as GDP, exports, or commodity prices.

Commodity-linked bonds

In particular, commodity-linked bonds (CLBs)—a type of SCDI—present a significant vehicle that Africa could use to mobilize resources for its development given the vast mineral deposits on the continent. There are a number of positive economic implications for Africa regarding the issuance CLBs.

First, CLBs could potentially stabilize the debt of a country. A country’s debt-to-GDP ratio is impacted by two fundamental shocks: i) government spending shocks, emanating from shocks to the structural primary balance and interest payments; and ii) growth shocks, which come from GDP growth. Given that CLBs compensate creditors with returns that vary with the debtor country’s nominal value of commodities, and by extension nominal GDP, CLBs can reduce the risks faced by a country from growth shocks. Hence, commodity-linked bonds provide a form of recession insurance to the issuer-country and reduce the risk that growth shocks will push a sovereign into default.

Second, CLBs, compared with conventional debt, can increase a country’s capacity to maintain higher debt levels without coming under market pressure. This is because a country’s probability of default increases with the rise in the level of debt or need for debt restructuring and consequently the yield demanded by creditors to hold sovereign debt rises. The size of this credit spread will depend on the size of potential shocks to the debt-to-GDP ratio. In other words, the spread will depend on the probability that the shock could push the country into default. Furthermore, the debt-to-GDP ratio is much less volatile for countries with commodity-linked bonds than conventional debt. Therefore, at any given debt level, the probability that a sovereign will breach its debt limit is lower for commodity-linked bonds than that for conventional bonds, implying a lower credit spread at any given debt level. Hence, commodity-linked bonds have the effect of raising the debt ceiling and providing fiscal space for policymakers.

Third, African countries could, through the issuance of bonds linked to their main export, hedge against fluctuations in their export earnings. Notably, the debt crises faced by the African countries in the past were due to falling export revenues coupled with the simultaneous rise in world interest rates and debt-service payments. If African countries’ debt had been issued in the form of CLBs, then their debt-service payments would have declined along with export prices (or export revenues), thus lightening their debt load.

Fourth, by issuing CLBs, African governments that need investment funds could share the appreciating market value of underlying commodities with bondholders in return for a lower coupon rate. CLBs offer an opportunity for African commodity-producing issuers and international commodity organizations to borrow at below-market interest rates. Through this process, countries could place themselves in an advantageous position by being linked to international markets, such as the U.S. commodity markets and eurobond markets.

In conclusion, the issuing of commodity-linked bonds would provide an opportunity for commodity-producing African countries to tie their borrowing needs to an endowed resource. By issuing bonds indexed to their main export commodity, African countries could hedge against fluctuations in their export earnings and at the same time lessen the probability of defaulting on their external debt obligation.

For more on this issue, see my paper, “Commodity-linked bonds as an innovative financing instrument for African countries to build back better.”


  • Acknowledgements and disclosures

    The author thanks Kasirim Nwuke for encouraging him to prepare this note. The views expressed in the note are the author’s only, and should not be attributed to either the United Nations nor the Brookings Institution.