Indexing government debt repayments to its GDP has for a long time been seen as a possible way of recession-proofing government balance sheets by shifting the burden of adjustment in downturns from taxpayers to investors with deep pockets. When growth is weak, the government's debt servicing costs would decline and its debt-to-GDP ratio would stabilise rather than rise, reducing the need for an immediate fiscal consolidation. When growth is strong, and the government's revenues are high, the return on the GDP-linked bond would increase in line with repayment capacity.
Intermittent groundswells in policy and academic support for GDP-linked bonds over the past half century (Shiller 1993, Obstfeld and Peri 1998, Haldane 1999, Council of Economic Advisors 2004, Borensztein and Mauro 2004, Blanchard et al. 2016) have resulted in some incremental progress towards issuance. GDP-linked ‘warrants’, which contain an element of indexation to GDP – providing holders with a higher coupon if GDP exceeds some threshold level – have been issued by a small number of countries as part of debt restructuring agreements (Costa Rica, Bulgaria, and Bosnia and Herzegovina in the 1980s and 1990s; and since then, Argentina, Greece, and Ukraine). In 2014, Uruguay issued a $1 billion bond with principal and coupon payments indexed to nominal wages. Portugal recently issued small-denomination bonds to domestic savers with additional payouts tied to GDP.
However, no sovereign has yet issued a marketable GDP-linked bond where institutional investors take on both the upside and the downside risk of GDP movements, with returns varying symmetrically, falling with lower GDP and rising with higher GDP.
Drawing among other things on work commissioned by the recent Chinese and German presidencies of the G20, a new VoxEU eBook – edited by James Benford, Jonathan D. Ostry and Robert Shiller, and with a foreword by Andy Haldane and Maurice Obstfeld – explores what has been holding back innovation, weighs up the pros and cons from both the issuer's and investor's perspective, and looks at what an intelligently designed GDP-linked bond that overcomes the perceived impediments to issuance might look like (Benford et al. 2018).
Download the new eBook here:
The first part of the eBook examines the rationale for issuing GDP-linked bonds, weighing up the theoretical pros and cons. Robert Shiller, in his introductory chapter, sets the scene by posing the question: If we acknowledge that, historically, uncertainty about GDP is as important as it has been, then why, globally, is there such limited risk-management of that uncertainty?
By issuing GDP-linked bonds, Eduardo Borensztein, Maurice Obstfeld and Jonathan Ostry, in their chapter, show that countries could achieve a debt structure that is more resilient to economic downturns and more robust to disappointments about long-term growth prospects. For a representative advanced economy, gains in fiscal space could be in the order of 10-60% of GDP (see the chapter by Jonathan Ostry and Jun Kim; see also Ostry and Kim 2018). Of course, an important qualifier is that the ‘GDP risk premium’ – the premium issuers would have to pay to receive the recession insurance GDP-linked bonds would provide them with – would have to be low enough to not put issuers off issuing, but high enough to persuade investors to take on the risk of variable GDP-linked payments (see the chapter by James Benford and Fernando Eguren-Martin). Could a premium be found to satisfy both issuers and investors? Jonathan Ostry and Jun Kim suggest countries with particularly volatile GDP should in principle be willing to pay a premium of up to around 260 basis points to insure against that volatility. For most advanced economies, investors would accept a much smaller premium.
How much GDP-linked debt would countries need to issue to see a meaningful improvement in fiscal space? Alex Pienkowski, in his chapter, suggests that if a representative advanced economy were to have 20% of its total debt stock in GDP linked bonds, this would effectively raise its maximum sustainable debt-to-GDP ratio by around 15 percentage points of GDP, which would be more than enough to accommodate the median fiscal costs of a systemic banking crisis.
The second part of the eBook examines what a GDP-linked bond might look like in practice, moving the debate on, from the theoretical to the operational.
There are a set of key commercial and economic design choices to be weighed up in setting out the operational parameters of such a security (see the chapter by Mark Joy). A suite of different GDP-linked instruments could in principle be designed to secure high prices from different investors with different preferences. However, there are likely to be gains from standardisation and from having a product that has sufficient appeal and depth of liquidity to underpin a well-functioning market.
One plausible design, with standardisation in mind, and with a comprehensive set of legal considerations taken into account as would be expected with any internationally traded security, is put forward in the chapter by Yannis Manuelides and Peter Crossan (‘the London Term Sheet’). How investors might react to such a design is discussed by Christian Kopf, in his chapter, along with a broader discussion of where GDP-linked bonds might fit in an investor's portfolio.
Turning to the role GDP-linked bonds could play in resolving the debt burdens of post-crisis countries, Patrick Honohan, in his chapter, considers what role they, or similar instruments, could play in the euro area, in particular how they could have helped Ireland, and could still help Greece. Mark Walker, in his chapter, explores the hypothetical legal and commercial dynamics of a sovereign debt restructuring in which all of, or a portion of, the debt to be restructured is replaced with new instruments linked to GDP.
Islamic finance, which prohibits charging interest, would appear to offer a natural home for GDP-linked securities, and Arshadur Rahman, in his chapter, explores various Shari'ah-compliant structures.
The final part of the eBook looks at impediments to market development and how these might be overcome.
Uncertainty over pricing is one area that has in the past been seen as holding back issuance, which Joel Bowman and Kevin Lane address, in their chapter, by estimating the ‘GDP risk premium’ using a model that assumes the price would be determined by the amount of systematic risk embedded in the security's returns: the more that domestic GDP co-moves with, say, US stock returns, the higher the price. They find that for G20 countries the premium would be fairly modest, around 30 basis points, and for some countries could be even negative.
Credit ratings, which David Beers looks at in his chapter, could be important for market development since they may determine whether the new instruments are included in the investment guidelines used by many investors. He finds that rating agencies could rate GDP-linked bonds lower than existing sovereign bonds or not at all because of their equity-like characteristics. But he also argues that the new instruments will attract investors unconstrained by current ratings-related rules, and that credit rating agencies should devise new ratings that address GDP-linked bonds’ downside risks and upside potential.
Broadening out the considerations on market development, Starla Griffin, in her chapter, draws lessons from past innovations in sovereign debt, including Brady bonds and inflation-linked bonds. Concluding the eBook, meanwhile, Stephany Griffith-Jones offers thoughts on what options might exist for catalysing market development, where she considers the first-mover problem, scope for internationally coordinated trial issuance, how multilateral and regional development banks could play a role, and what scope there might be for securitisation.
The recent issuance of GDP-linked savings certificates in Portugal and wage-indexed bonds in Uruguay offers evidence that state-contingent debt instruments referencing macroeconomic variables both have appeal and are technically viable. Operationally, GDP-linked bonds are within reach. The main impediment to market development, though, is not operational but rather overcoming the first-mover problem. Trial issuance by a single innovator, or a supportive multilateral development bank, or a coordinated effort among a coalition of willing issuers would be required to overcome that problem. Ahead of that, though, a better understanding of how these instruments might work, and what benefits they could offer, is needed. The eBook seeks to address that need, and lays out a comprehensive assessment of the economic, commercial, legal and operational considerations relevant to any debt manager or investor seeking an informed understanding of GDP-linked bonds, and an actionable course forward.
Benford, J, J D Ostry and R Shiller (2018), Sovereign GDP-Linked Bonds: Rationale and Design, A VoxEU.org eBook, London: CEPR Press.
Blanchard, O, P Mauro and J Acalin (2016), "The case for growth indexed bonds in advanced economies", Peterson Institute Policy Brief PB16–2.
Borensztein, E and P Mauro (2004), "The case for GDP indexed bonds", Economic Policy 19(38): 166-216.
Council of Economic Advisors (2004), "Growth indexed bonds, a primer".
Haldane, A (1999), “Private Sector Involvement in Financial Crisis: Analytics and Public Policy Approaches”, Bank of England Financial Stability Review, November: 184-202.
Obstfeld, M and G Peri (1998), "Regional Non-Adjustment and Fiscal Policy: Lessons for EMU", Economic Policy 13(26): 207-259.
Ostry, J D and J Kim (2018), "Boosting Fiscal Space: The Roles of GDP-Linked Debt and Longer Maturities", IMF Departmental Paper No.18/04.
Shiller, R (1993), Macro markets: creating institutions for managing society’s largest economic risks, Oxford: Clarendon Press.