Monday, March 19, 2018

What if Country Bonds Were Linked to GDP Growth?

What if countries could have some built-in flexibility in repaying their debts: specifically, what if the repayment of the debt was linked to whether the domestic economy was growing? Thus, the burden of debt payments would fall in a recession, which is when government sees tax revenues fall and social expenditures rise. Imagine, for example, how the the situation of Greece with government debt would have been different if the country's lousy economic performance had automatically restructured its debt burden in away that reduced current payments. Of course, the tradeoff is that when the economy is going well, debt payments are higher--but presumably also easier to bear.

There have been some experiments along these lines in recent decades, but the idea is now gaining substantial interest,  James Benford, Jonathan D. Ostry, and Robert Shiller have edited a 14-paper collection of papers on Sovereign GDP-Linked Bonds: Rationale and Design (March 2018, Centre for  Economic Policy Research, available with free registraton here).

For a taste of the arguments, here are a few thoughts from the opening essay: "Overcoming the obstacles to adoption of GDP-linked debt," by Eduardo Borensztein, Maurice Obstfeld, and Jonathan D. Ostry.  They provide an overview of issues like: Would borrowers have to pay higher interest rates for GDP-linked borrowing? Or would the reduced risk of default counterbalance other risks? What measure of GDP would be used as part of such a debt contract? They write:
"Elevated sovereign debt levels have become a cause for concern for countries across the world. From 2007 to 2016, gross debt levels shot up in advanced economies – from 24 to 89% of GDP in Ireland, from 35 to 99% of GDP in Spain, and from 68 to 128% of GDP in Portugal, for example. The increase was generally more moderate in emerging economies, from 36 to 47% of GDP on average, but the upward trend continues. ...

"GDP-linked bonds tie the value of debt service to the evolution of GDP and thus keep it better aligned with the overall health of the economy. As public sector revenues are closely related to economic performance, linking debt service to economic growth acts as an automatic stabiliser for debt sustainability. ..  While most efforts to reform the international financial architecture over the past 15 years have aimed at facilitating defaults, for example through a sovereign debt restructuring framework (SDRM), the design of a sovereign debt structure that is less prone in the first place to defaults and their associated costs  would be a more straightforward policy initiative. GDP-linked debt is an attractive instrument for this purpose because it can ensure that debt stays in step with the growth of the economy in the long run and can create fiscal space for countercyclical policies during recessions. ...
"The first lesson is to ensure that the payout structure of the instrument reflects the state of the economy and is free from complexities or delays that can make payments stray from their link to the economic situation. To date, GDP-linked debt has been issued primarily in the context of debt restructuring operations, from the Brady bond exchanges that began in 1989 to the more recent cases of Greece and Ukraine. ...  This feature, however, gave rise to structures that were not ideal from the point of view of debt risk management. For example, some specifications provided for large payments if GDP crossed certain arbitrary thresholds or were a function of the distance to GDP from those thresholds. In addition, some payout formulas were sensitive to the exchange rate, failed to take inflation into account, or were affected by revisions of population or national account statistics. All these mechanisms resulted in payments that were  disconnected from the business cycle and the state of public finances, detracting from the value of these GDP-linked instruments for risk management (see Borensztein 2016).
"The second lesson is that the specification of the payout formula can strengthen the integrity of the instruments. GDP statistics are supplied by the sovereign, and there is no realistic alternative to this arrangement. This fact is often held up as an obstacle to wide market acceptance of the instruments. However, the misgivings seem to have been exaggerated, as under-reporting of GDP growth is not a politically attractive idea for a policymaker whose success will be judged on the strength of economic performance. ... 
"[T]he main source of reluctance regarding the use of GDP-linked debt, or insurance instruments more generally, may not stem from markets but from policymakers. Politicians tend to have relatively short horizons, and would not find debt instruments attractive that offer insurance benefits in the medium to long run but are costlier in the short run, as they include an insurance premium driven by the domestic economy’s correlation with the global business cycle. In addition, if the instruments are not well understood, they may be perceived as a bad choice if the economy does well for some time. The value of insurance may come to be appreciated only years later, when the country hits a slowdown or a recession, but by then the politician may be out of office. While this problem is not ever likely to go away completely, multilateral institutions might be able to help by providing studies on the desirability of instruments for managing country risk, and how to support their market development, in analogy to work done earlier in the millennium promoting emerging markets’ domestic-currency sovereign debt markets."
Back in 2015, the Ad Hoc London Term Sheet Working Group decided to produce a hypothetical model example of how a specific contract for GDP-linked government agreement might work, with the ideas that the framework could then be adapted and applied more broadly. This volume has a short and readable overview of the results by two members of the working group, in "A Term Sheet for GDP-linked bonds," by Yannis Manuelides and Peter Crossan. I'll just add that in the introduction to the book, Robert Shiller characterizes the London Term Sheet approach in this way:
"The kind of index-linked bond described in the London Term Sheet in this volume is close to a conventional bond, in that it has a fixed maturity date and a balloon payment at the end. The complexities described in the Term-Sheet are all about inevitable details and questions, such as how the coupon payments should be calculated for a GDP-linked bond that is issued on a specific date within the quarter, when the GDP data are issued only quarterly. The term sheet is focused on a conceptually simple concept for a GDP-linked  bond, as it should be. It includes, as a special case, the even simpler concept – advocated recently by me and my Canadian colleague Mark Kamstra – of a perpetual GDP-linked bond, if one sets the time to maturity to infinity. Perpetual GDP-linked bonds are an analogue of shares in corporations, but with GDP replacing corporate earnings as a source of dividends. However, it seems there are obstacles to perpetual bonds and these obstacles might slow the acceptance of GDP-linkage. The term-sheet here gets the job done with finite maturity, shows how a GDP-linkage can be done in a direct and simple way, and should readily be seen as appealing.
"The London Term Sheet highlighted in this volume describes a bond which is simple and attractive, and the chapters in this volume that spell out other considerations and details of implementation, have the potential to reduce the human impact of risks of economic crisis, both real crises caused by changes in technology and environment, and events better described as financial crises. The time has come for sovereign GDP-linked bonds. With this volume they are ready to go."