Borrowing Strategy: The Role of GDP-Linked Bonds

1. Borrowing Strategy: The Role of GDP-Linked Bonds John Williamson Peterson Institute for International Economics

2. What is a GDP-Linked Bond? A bond that promises to pay a return (in addition to amortization) that varies with the behavior of GDP Two versions: Value of the instrument depends on the value of GDP (Shiller) Return varies with the growth rate of real GDP (Borensztein and Mauro)

3. Outline of Lecture The Operation of a GDP-Linked Bond The Advantages of GDP-Linked Bonds The Problems of GDP-Linked Bonds The Differences Between the Two Versions of GDP-Linked Bonds GDP-Linked Bonds and Borrowing Strategy Obstacles to First Issue of GDP-Linked Bonds

4. The Operation of a GDP-Linked Bond Instrument for raising new money, not for reconstructing existing debt (cf Argentina, Brady agreements of Costa Rica, Bulgaria, and Bosnia/Herzegovina) Example: Instrument that would yield 7% when growth is equal to past average/expected future of 3%, +/- 1% for every deviation of 1% in growth (subject to maxima/minima?) Issue price (thus insurance premium) determined by market Presumption that expected cost would not be greatly different to that of conventional bonds in mature market (diversification) Although ex post the cost might turn out to be considerably different Possible to denominate in foreign or domestic currency Not callable Need for new asset class because of equity-like features (but clearly not equity, no ownership rights).

5. Advantages and Costs to Borrowers Debt service (and foreign payments if money were borrowed abroad) would vary with ability to pay Cyclically stabilizing impact over the cycle (especially for emerging markets subject to sudden stops, also for European countries subject to the Stability and Growth Pact) Less pressure to expand public spending in times of abundance Reduced probability of default crises (once a large part of debt is in this form) Costs: more complex; might cost more. (But note that the advantages are long-term and the potential costs are short-term, which suggests a political economy problem)

6. Advantages and Costs to Lenders Attractiveness of the instrument to lenders who wish to be sharia-compliant (if there are no maxima or minima) Some lenders will believe in their ability to out-perform the market in forecasting GDP Default is costly to lenders, and would be less likely If these attractions are insufficient, then one expects a positive insurance premium to emerge. Cost: greater risk than a plain-vanilla bond, though risks can be reduced through diversification.

7. Problems of GDP-Linked Bonds Complexity Verifiability of GDP data Perverse incentives: To repress growth? To misreport growth? To omit to revise GDP (�the Greek problem�)? Role of financial markets in imposing discipline Lags and fiscal stabilization properties Initial illiquidity.

8. Differences Between the Two Versions Indexation against inflation Automatic with Shiller bond Need for deliberate formula (e.g. indexation of principal) with Borensztein/Mauro variant Sensitivity of yield to variations in growth In earlier example, 2% sustained decrease in growth (with constant prices) reduces yield of $100 Shiller bond by $0.14�in second year� (from $7.21 to $7.14) and of $100 Borensztein/Mauro bond by $2 � already in first year�(from $7 to $5) I.e. much greater impact on yield of latter.

9. GDP-Linked Bonds and Borrowing Strategy Dangers of short-term bonds, mismatches Domestic issue does not preclude foreign borrowing And foreign issue does not preclude domestic currency denomination Thus GDP-linked bonds could be issued (by sovereign) either domestically or abroad, in either domestic or foreign currency Naturally suitable for long-term instruments Advantage of issuing in domestic currency is avoidance of mismatch.

10. First Issue Money made by Wall Street on restructured Argentine bonds has whetted the appetite But few instances of GDP-linked bonds Does this show that there is no potential demand for such instruments? Or is this a case where there are obstacles to innovation? In several other cases (e.g. syndicated bank loans, inflation-indexed bonds, collective action clauses) financial innovation has lagged the development of the idea.

11. Obstacles to First Issue Critical Mass. Default risk will be significantly reduced only when the proportion of debt composed of GDP-linked bonds is substantial. Premium. No individual borrower wants to bear the costs of pioneering a new instrument, given that there is no reward because replication is easy and cheap. Diversification. Possible only with many issuers of a standard security, but no borrower takes account of the benefit of assisting others to issue similar instruments.

12. Conclusions GDP-linked bonds may not be bonds But if most of the debt of sovereign borrowers took this form, the economies of emerging markets would be much less subject to shocks Could also be attractive to lenders Optimal form would be Borensztein/Mauro coupon, perhaps with indexed principal But a public initiative may be required to launch such an instrument.