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Tuesday, July 11, 2006

Stabilizing Debt Payments with Bonds Linked to GDP

This Financial Times Commentary by Stephany Griffith-Jones and Robert Shiller argues for the creation of GDP linked bonds as a means of stabilizing debt-service payments over the business cycle:

A bond that insures against instability, by Stephany Griffith-Jones and Robert Shiller, Commentary, Financial Times: There has been increasing interest in creating bonds linked to the growth of a countries’ gross domestic product. At the spring meetings of the International Monetary Fund and the World Bank, both potential issuers and investors expressed a clear appetite for such bonds. The servicing of these GDP-linked bonds would be higher in times of rapid growth and lower when growth was slow or negative.

GDP-linked bonds would have important advantages ... for borrowers and investors, as well as significant externalities for the international financial system. For borrowers, issuing such bonds would help stabilise public spending throughout the cycle as governments would service more debt when they could better afford to, and less in more difficult times. It would also significantly reduce the likelihood of costly and disruptive defaults and debt crises. ... A temporary reduction of a country’s debt service when the economy deteriorates would facilitate more rapid recovery.

For investors, defaults are costly as they result in expensive renegotiation and sometimes in very large losses. As GDP-linked bonds would help reduce the probability of default, effective total payments will tend to be higher than with conventional bonds. ...

For international institutions, there would be benefits from the decreased likelihood of debt crises. Reduced risk of crisis contagion would also benefit other countries. These externalities and the fact that financial innovations are difficult to introduce may justify some initial public action (for example, from the World Bank) to help develop this market instrument. The World Bank could, for instance, make loans whose servicing would be linked to GDP. ...

GDP-linked bonds should be a core element of government financing both for developed and creditworthy developing countries. Both of these could start today. ... The issuance of even small quantities of these bonds by creditworthy emerging economies would help set in motion an important process of financial development. ...

GDP-linked bonds could take a couple of forms. Simplest is a perpetual bond that pays a share, say a trillionth, of GDP, at regular intervals to the bond holders. Creating such a form would be analogous to listing a country on a market as if it were a stock... Another form that may be easier to introduce is a conventional bond that pays a coupon tied by a formula to growth rates of GDP, but guarantees a minimum level of debt servicing...

Investors’ experience with Argentine GDP-warrants, issued as part of their debt restructuring, has been very positive... The time seems ideal for one or more creditworthy countries to start issuing GDP-linked bonds... Any country whose growth slows significantly would be thankful afterwards that they bought the insurance such bonds represent...

    Posted by on Tuesday, July 11, 2006 at 12:03 AM in Economics, Financial System, International Finance, Policy | Permalink  TrackBack (0)  Comments (9)


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