GDP Indexed Bonds: fix the fiscal policy issues first

RBI has this working paper kind of series – DRG Series. The recent paper is on GDP indexed bonds and is written by a group of economists.

What is a GDP indexed bond?

The proposal to index government debt to GDP has been receiving interest since the financial and debt crises that engulfed emerging markets in the 1990s. Such an instrument promises to pay an interest / coupon based on the issuing country’s rate of growth. For instance, consider a country with a trend growth rate of 5 per cent a year and an ability to borrow on plain vanilla terms at 9 per cent a year. This country could issue bonds that pay 1 per cent above or below 9 per cent for every one per cent that its growth exceeds or falls short of 5 per cent, ignoring insurance premiums. The coupon yield then varies systematically with the gap between the actual and trend growth. In periods of low growth, the debt payments of a country will reduce with indexation whereas in periods of high growth the debt payments will correspondingly increase with indexation. The ratio of debt to GDP accordingly varies within a narrower range than in the case of standard financing of the debt.

There are advantages and disadvantages for issuing these bonds:

There are gains to both borrowing countries and to investors from the issue of GDP indexed bonds:

For borrowing countries they help in the stabilisation of government spending as they require smaller interest payments in times when growth has slowed down and this frees up resources for government spending at a time when the economy needs these resources.

As the debt service declines when growth slows down, debt that is indexed to GDP also reduces the likelihood of defaults by the government and the possibility of crises. The reduction in defaults due to this instrument also benefits investors who would like to avoid the disruptions in returns arising from default.

Given the advantages of GDP indexed bonds, it is surprising as to why they have not been issued extensively. Some of the issues that have hindered the development of a market for such bonds include the following:

  • Accuracy of GDP data 
  • Market illiquidity
  • Pricing difficulties

Of these, the most important issue has been the difficulty in the pricing of GDP indexed bonds as it is an instrument with a more complicated structure than plain bonds and this paper explores this issue. With regard to the accuracy of GDP data the major concern is about the quality of GDP data and that governments may deliberately misreport growth so as to affect the interest payments on growth indexed bonds. In this context it has been argued that to improve the transparency of the statistics the data should be verified or even provided by an external agency such as an international financial institution.

So the paper looks at all these issues from an Indian perspective.

The effect of GDP-indexed bonds in stabilizing the path of sovereign debt and the obstacles to the introduction of GDP-indexed bonds especially in terms of pricing of such bonds, have also been analyzed.  By making use of the Chamon and Mauro (2006) approach for pricing of the GDP-indexed bonds, the Study attempts to resolve the pricing issue of the GDP-indexed bonds in the Indian context. 

The Study observes that in case of indexation, the price of GDP-indexed bonds could be below par and the probability of default could also increase depending on the joint distribution of the random variables such as growth rate, real effective exchange rate and the primary budget balance of the Government and other inputs to the model.  The Study also recognizes a number of practical issues related with the GDP-indexed bonds that reduces desirability of this instrument in the Indian context. 

The paper is fairly technical. In the end the findings are summarised.  Despite economic benefits political negatives play a major role:

This paper has analysed what GDP indexed bonds achieve, their stabilisation properties, and the obstacles to the introduction of such bonds especially in terms of pricing of such bonds. We do not see the commonly stated obstacles as insurmountable. We, however, believe there are practical issues involved in the issue of such instruments which reduce their desirability in the Indian context. T

The main one in the Indian context is that the introduction of such a financial instrument requires offering a premium to hold it as investors are uncertain about a new instrument. As GDP indexed bonds make a substantial difference only when they have a long term maturity of five years or more it is not easy for an incumbent government to issue such bonds that make life easier for their successors. Moreover when an economy is going through a buoyant growth phase it makes it difficult for a Finance Minister to justify payment of an insurance premium and higher coupons. Such bonds have so far been introduced in the world economy in Costa Rica, Bulgaria, Bosnia and Herzegovina, and Argentina, as part of a debt restructuring programme.

In the end they say though GDP indexed bonds are useful, it makes more sense to get the fiscal basics right.  

GDP indexed bond would be valuable when an economy is unable to credibly commit to sound fiscal policies which then leaves investors less willing to supply capital to an economy. By reducing the risk of repayment such a financial instrument attempts to keep investors confident and keep capital flows to the economy sustainable. However, arguably instituting credible fiscal policy may be more beneficial to handling the risk that is being sought to be addressed. One such institution is the legislation of fiscal rules that have teeth in the form of penalties in case the government does not meet the targets set by such rules. These rules could be in the form of expenditure limiting rules, overall balance rules prescribing limits to fiscal deficits, and public debt rules. In some cases it may even be advisable to institute an independent fiscal authority that has the power to set the permissible change in the public debt which it sets by taking into consideration that budget deficits now would be offset by surpluses in the future. This gives a long term perspective to fiscal policy than that offered by a government which may be out of office tomorrow and is tempted to manipulate the deficit so as to increase its chances of re-election. The members of such an autonomous authority which is established by law would have to be appointed for long and staggered terms in office with a mandate to insure the stability of public finance. They would set limits to public debt not on the basis of rules but on the basis of sustainability of the debt. The decision about the size of government and about taxation would however still be with the executive and legislative branches of government. Such institutions address problems of commitment and play the role of monitoring and signaling government performance on the fiscal front. In emerging markets it may be more sensible to deepen institutions and make policies that are sustainable rather than attempt to address financial market inefficiencies through the use of financial engineering.

Well said. It is ironical that none of the developed economies which had stable fiscal policies and institutions have issued these bonds. There is no point issuing these bonds to lower deficits without doing some major changes on the institution front.

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