The case for GDP-indexed bonds

Abstract

"This paper seeks to revive the case for countries to insure against economic growth slowdowns by issuing bonds indexed to the rate of growth of GDP. We show that GDP-indexed bonds could provide substantial benefits in reducing the likelihood of default crises and allowing countries to avoid pro-cyclical fiscal policies. We simulate the effects of GDP-indexed bonds under different assumptions about fiscal policy reaction functions and their output effects and find that they could substantially reduce the likelihood of debt/GDP paths becoming explosive. The insurance premium would likely be small, because cross-country comovement of GDP growth rates is low and cross-country GDP growth risk is thus largely diversifiable for an investor holding a portfolio of GDP-indexed bonds. Potential obstacles to the emergence of a market for these bonds include the verifiability of GDP data, the trade-off between insurance and moral hazard, and the need for liquidity. Theory and past experience suggest that financial innovation often requires official intervention and its timing and form are difficult to predict. We discuss institutional fixes and suggest an approach for attempting to start up a market." Copyright � CEPR, CES, MSH, 2004..

Sovereign Debt, Volatility and Insurance

“…The volatility created by foreign interest payments for emerging market governments is significant, as suggested by Borensztein and Mauro [2004] most recently. The procyclicity of capital flows and public finance in emerging markets carefully documented by Kaminsky, Reinhart and Vegh [2004] is probably not an efficient outcome.…”

Public Sector Funding and Debt Management : A Case for GDP-Linked Ṣukūk

“…First, GDP-linked bond is shown to improve debt sustainability for sovereigns in times of economic downturn and allows countries to avoid pro-cyclical fiscal policy (Borensztein and Mauro 2004). This is because GDP-linked bond matches the payment obligation to the economic performance.…”

“…Notwithstanding the higher risk that the creditors face with this instrument, as compared to straight bond, these indexed bonds provide opportunity to take advantage of the benefits of investing in growing economies. Furthermore, these bonds are of nature to lower the likelihood of defaults and financial crises that could result in costly litigation and sometimes in outright losses 9 (Borensztein, and Mauro 2002;Miyajima 2006;Griffith-Jones and Sharma 2006).…”

Sovereign Debt, Volatility, and Insurance

“…As long as GDP measurement is clearly defined and not subject to moral hazard, such contracts should be feasible. Borensztein and Mauro [2004] discuss the feasibility of GDP-indexed bonds and report preliminary estimates of their benefits.…”