Mak­ing the case for sov­er­eign GDP-linked bonds

The crises that erupted in coun­tries like Ire­land and Greece a decade ago would not have been so se­vere had their debt been linked to their eco­nomic per­for­mance. And the same is true to­day: In­vestors around the world will con­tinue to ac­cept the risk, give

Financial Nigeria Magazine - - Contents -

The time has come for na­tional gov­ern­ments around the world to start is­su­ing their debt in a new form, linked to their coun­tries’ re­sources. GDP linked bonds, with coupons and prin­ci­pal that rise and fall in pro­por­tion to the is­su­ing coun­try’s GDP, prom­ise to solve many fun­da­men­tal prob­lems that gov­ern­ments face when their coun­tries’ economies fal­ter. And, once GDP-linked bonds are is­sued by a va­ri­ety of coun­tries, in­vestors will be at­tracted by the prospect of high re­turns when some of these coun­tries do very well.

This new debt in­stru­ment is es­pe­cially ex­cit­ing be­cause of its mon­u­men­tal size. Although is­sues may start out small, they will be very im­por­tant from the out­set. The cap­i­tal­ized value of to­tal global GDP is worth far more than the world’s stock mar­kets, and could be val­ued to­day in the quadrillions of US dol­lars.

Now an au­thor­i­ta­tive open-source on­line hand­book just pub­lished by the Cen­tre for Eco­nomic Pol­icy Re­search, Sov­er­eign GDPLinked Bonds: Ra­tio­nale and De­sign, ex­plains how gov­ern­ments can do this. I coedited the book with Jonathan D. Ostry of the In­ter­na­tional Mone­tary Fund, and James Ben­ford and Mark Joy of the Bank of Eng­land. The book draws on work com­mis­sioned by the re­cent Chi­nese and Ger­man pres­i­den­cies of the G20, with the col­lab­o­ra­tion of 20 lead­ing econ­o­mists, lawyers, and in­vestors. Its pub­li­ca­tion car­ries en­dorse­ments from Andy Hal­dane, Ex­ec­u­tive Di­rec­tor of Fi­nan­cial Sta­bil­ity of the Bank of Eng­land, and Mau­rice Ob­st­feld, Eco­nomic Coun­sel­lor and Re­search Di­rec­tor at the In­ter­na­tional Mone­tary Fund.

I have been ad­vo­cat­ing some­thing like GDP-linked bonds for 25 years. In my 1993 book Macro Mar­kets, I de­scribed the world’s GDPs as the “mother of all mar­kets” and em­pha­sized a form of debt that I called “per­pet­ual claims.” But I did not work out a real plan of im­ple­men­ta­tion and ad­vo­cacy. Sov­er­eign GDP-Linked Bonds does just that.

The ba­sic idea is sim­ple enough. Gov­ern­ments is­sue GDP-linked bonds to raise funds, just as cor­po­ra­tions is­sue shares. By is­su­ing such bonds, gov­ern­ments pledge to pay in pro­por­tion to the re­sources they have, mea­sured by their coun­tries’ GDP. The price-to-GDP ra­tio of GDP-linked bonds is es­sen­tially anal­o­gous to the priceto-earn­ings ra­tio of cor­po­rate shares. The dif­fer­ence is that GDP is an or­der of mag­ni­tude larger than cor­po­rate prof­its rep­re­sented by the stock mar­ket.

As Sov­er­eign GDP-Linked Bonds ar­gues, the is­suance of GDP-linked bonds will cre­ate “fis­cal space” – a cush­ion for ex­i­gen­cies – for some coun­tries. When gov­ern­ment debt pay­ments are fixed in cur­rency terms, as they typ­i­cally are to­day, coun­tries get into trou­ble. In a fi­nan­cial cri­sis, they be­come over-lever­aged, un­able to bor­row more, and forced to take dras­tic ac­tion that may im­pede re­cov­ery from the cri­sis. Tax­pay­ers, rather than will­ing in­vestors, are forced to be­come the fi­nal bear­ers of risk.

Is­su­ing GDP-linked bonds is akin to buy­ing in­surance against eco­nomic dis­tress. The crises that erupted in coun­tries like Ire­land and Greece a decade ago would not have been so se­vere had their debt been GDP-linked. And the same is true to­day: In­vestors around the world will con­tinue to ac­cept the risk, given the un­lim­ited up­side to in­vest­ing in en­tire economies. And they can achieve the ne plus ul­tra of di­ver­si­fi­ca­tion by hold­ing GDP linked bonds from around the world.

One may won­der why coun­tries have hardly ever is­sued GDP-linked se­cu­ri­ties. The rea­son is straight­for­ward: fi­nan­cial in­no­va­tion is dif­fi­cult. Fi­nan­cial in­ven­tions are as com­plex as en­gi­neer­ing in­ven­tions, and many de­tails must be worked out to make things work well. We have al­most no ex­am­ples of suc­cess­ful GDP-linked bonds for the same rea­son we did not see lap­top com­put­ers un­til the late 1980s. It takes time and en­ergy to in­no­vate.

The new book takes on the de­sign prob­lem, de­scrib­ing a term sheet for the debt. The an­swers some­times fo­cus on seem­ingly small but im­por­tant ques­tions. For ex­am­ple, how will the mar­ket deal with gov­ern­ments’ sub­se­quent re­vi­sions of their an­nounced GDP sta­tis­tics? What will hap­pen if the gov­ern­ment some­how fails to pro­duce a GDP num­ber on time? What is the se­nior­ity rank­ing of GDP-linked bonds rel­a­tive to other sov­er­eign debt? How should col­lec­tive-ac­tion clauses be writ­ten, and should they ex­tend to the sov­er­eign’s con­ven­tional debt? Should GDP-linked bonds be is­sued in the na­tional cur­rency or in a re­serve cur­rency?

Some worry that gov­ern­ments could ma­nip­u­late their GDP sta­tis­tics so that they will have less to pay. But that is un­likely, be­cause lower GDP would be taken as a sign of the gov­ern­ment’s fail­ure. As Sov­er­eign GDP-Linked Bonds points out, in­fla­tionin­dexed debt is even more vul­ner­a­ble to gov­ern­ment cheat­ing, be­cause the mone­tary in­cen­tive for the gov­ern­ment is to un­der­re­port in­fla­tion, which is in line with keep­ing up ap­pear­ances. And yet in­fla­tion-in­dexed debt has not been plagued by dis­hon­esty.

The global econ­omy is im­prov­ing, but the af­ter­math of the fi­nan­cial cri­sis has left be­hind a moun­tain of gov­ern­ment debt, leav­ing gov­ern­ments less able to rely on fis­cal pol­icy to re­spond to any new cri­sis. It is im­por­tant to be­gin es­tab­lish­ing GDPlinked debt now, along the lines de­scribed in the new book, so that the big­gest risks can be man­aged, and pol­i­cy­mak­ers can fo­cus on main­tain­ing eco­nomic sta­bil­ity.

Debt in­stru­ments sim­i­lar to GDP-linked bonds have been tried, but only when it is al­ready too late: as an emer­gency com­po­nent of a post-de­fault re­struc­tur­ing process. Now, coun­tries that are not in cri­sis have a chance to try the real thing. The big­gest step for­ward will come when ad­vanced coun­tries is­sue GDP-linked bonds in rel­a­tively nor­mal times. That will set the ex­am­ple the rest of the world has been wait­ing for.

Robert J. Shiller, a 2013 No­bel lau­re­ate in eco­nomics, is Pro­fes­sor of Eco­nomics at Yale Uni­ver­sity and the co-cre­ator of the Case-Shiller In­dex of US house prices.

Debt in­stru­ments sim­i­lar to GDP-linked bonds have been tried, but only when it is al­ready too late: as an emer­gency com­po­nent of a post-de­fault re­struc­tur­ing process.

Robert Shiller

Lon­don protest in sol­i­dar­ity with Greece over its debt cri­sis in 2015

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