GDP-linked bond
Encyclopedia
In finance, a GDP-linked bond is a debt security in which the authorized issuer (a country) promises to pay a return, in addition to amortization
, that varies with the behavior of Gross Domestic Product
(GDP). This type of security
can be thought as a “stock on a country” in the sense that is has “equity
-like” features. It pays more/less when the performance of the country is better/worse than expected. Nevertheless, it is substantially different to a stock because it there are no ownership-rights over the country.
GDP-linked bonds are a form of floating-rate bond with a coupon that is associated with the growth rate
of a country, just as other floating-rate bonds are linked to interest rates, such as LIBOR or federal funds rate
, or inflation
rates, which is the case of inflation-indexed bonds.
features. The existence of this type of debt can reduce the probability of default
because they tend to keep the debt/GDP ratios within a narrower range than fixed income
bonds.
GDP-linked bonds also act as automatic stabilizers and reduce the temptation for policymakers to spend too much in periods of high growth. In this sense this type of bonds may be especially useful for developing countries where the presence of weaker institutions makes it easier for governants to implement more volatile of policies. Moreover, this type of bonds allow governments to implement less volatile tax policies, since there is no need to increase taxes during times of poor economic performance because it is precisely during these times when debt repayments are lower. If we believe that agents prefer to smooth consumption across time and across states of nature then it is worth it to do so. Hence using GDP-linked bonds may be welfare
improving.
Furthermore, emerging markets
are usually forced to actually undertake more austere measures in times of crises
than their developed counterparts, and it is common to see that emerging markets reduce public expenditures in times of crises with the purpose of reassuring international investors. This means that countries cut their expenditures when they need it the most.
In terms of social policy
it has been mentioned that GDP-linked bonds disproportionately benefit the poor because using them reduces the need to cut social benefits when economic performance is low, given that the debt repayments are lower.
Finally, even if this type of bonds were initially thought in the context of emerging markets, they also constitute an interesting idea for developed countries.
problems, in good times countries have to pay more to their debt
holders, so citizens can potentially complain arguing that the governors contracted debt to favor the lenders.
Another reason to worry about the charasteristics of these bonds is that they may create perverse incentives (moral hazard
) to misreport growth, not revise GDP figures or even worse to repress growth.
Another problem that this type of bond is facing with their implementation is that there is not a sufficient amount of first movers that are ready to issue and invest in this type of security. The market has not developed in part because there are few incentive
s to be the first to move. Being one of the initiators in this type of markets implies taking some risk and most of the agents are not willing to do it. A critical mass
is required to reduce the risk to the issuer. Also, a greater amount of countries issuing these types of securities is required so that investor
s are able to diversify. Given this facts there is scope for public intervention, for example, an initiative from multilateral institutions could play the role of the first mover and coordinate issuances of GDP-linked bonds from different countries.
An additional critique that has been exposed is that there are other debt instruments that could be superior in the task of insuring risk
for consumers
. That is, for example, the case of CPI-indexed local currency bonds. Crises
are generally accompanied by large exchange rate
depreciations that are driven by the fall in domestic consumption. This fall in consumption decelerates the CPI growth and in turn bonds linked to it pay less during crisis. Given that economic agents are more interested in consumption smoothing
than in the stabilization of output, CPI-indexed local currency bonds can provide a better insurance against shocks than GDP-linked bonds.
The first pure GDP-linked bonds were issued by Costa Rica, Bulgaria and Bosnia Herzegovina, also in the context of the Brady restructuring agreements, in the 1990s.
Finally, Argentina issued a GDP-linked bond in 2002, as part of a debt-restructuring of its 2001 default.
Borensztein and Mauro: The return varies with the growth rate of real GDP
Amortization
Amortization is the process of decreasing, or accounting for, an amount over a period. The word comes from Middle English amortisen to kill, alienate in mortmain, from Anglo-French amorteser, alteration of amortir, from Vulgar Latin admortire to kill, from Latin ad- + mort-, mors death.When used...
, that varies with the behavior of Gross Domestic Product
Gross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....
(GDP). This type of security
Security
Security is the degree of protection against danger, damage, loss, and crime. Security as a form of protection are structures and processes that provide or improve security as a condition. The Institute for Security and Open Methodologies in the OSSTMM 3 defines security as "a form of protection...
can be thought as a “stock on a country” in the sense that is has “equity
Equity (finance)
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
-like” features. It pays more/less when the performance of the country is better/worse than expected. Nevertheless, it is substantially different to a stock because it there are no ownership-rights over the country.
GDP-linked bonds are a form of floating-rate bond with a coupon that is associated with the growth rate
Economic growth
In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...
of a country, just as other floating-rate bonds are linked to interest rates, such as LIBOR or federal funds rate
Federal funds rate
In the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend...
, or inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
rates, which is the case of inflation-indexed bonds.
Advantages for the issuer
Debt service varies with ability to pay, when a country has poor economic performance it has to pay less debt obligations to the bond holders. This means that this type of security has countercyclicalCountercyclical
Countercyclical is a term used in economics to describe how an economic quantity is related to economic fluctuations. It is the opposite of procyclical. However, it has more than one meaning.-Meaning in policy making:...
features. The existence of this type of debt can reduce the probability of default
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
because they tend to keep the debt/GDP ratios within a narrower range than fixed income
Fixed income
Fixed income refers to any type of investment that is not equity, which obligates the borrower/issuer to make payments on a fixed schedule, even if the number of the payments may be variable....
bonds.
GDP-linked bonds also act as automatic stabilizers and reduce the temptation for policymakers to spend too much in periods of high growth. In this sense this type of bonds may be especially useful for developing countries where the presence of weaker institutions makes it easier for governants to implement more volatile of policies. Moreover, this type of bonds allow governments to implement less volatile tax policies, since there is no need to increase taxes during times of poor economic performance because it is precisely during these times when debt repayments are lower. If we believe that agents prefer to smooth consumption across time and across states of nature then it is worth it to do so. Hence using GDP-linked bonds may be welfare
Welfare
Welfare refers to a broad discourse which may hold certain implications regarding the provision of a minimal level of wellbeing and social support for all citizens without the stigma of charity. This is termed "social solidarity"...
improving.
Furthermore, emerging markets
Emerging markets
Emerging markets are nations with social or business activity in the process of rapid growth and industrialization. Based on data from 2006, there are around 28 emerging markets in the world . The economies of China and India are considered to be the largest...
are usually forced to actually undertake more austere measures in times of crises
Crises
Crises is the eighth record album by Mike Oldfield, released in 1983. Oldfield's well known hit "Moonlight Shadow" appears on the album.- Album analysis :...
than their developed counterparts, and it is common to see that emerging markets reduce public expenditures in times of crises with the purpose of reassuring international investors. This means that countries cut their expenditures when they need it the most.
In terms of social policy
Social policy
Social policy primarily refers to guidelines, principles, legislation and activities that affect the living conditions conducive to human welfare. Thus, social policy is that part of public policy that has to do with social issues...
it has been mentioned that GDP-linked bonds disproportionately benefit the poor because using them reduces the need to cut social benefits when economic performance is low, given that the debt repayments are lower.
Finally, even if this type of bonds were initially thought in the context of emerging markets, they also constitute an interesting idea for developed countries.
Disadvantages
GDP-linked bonds may cause political economyPolitical economy
Political economy originally was the term for studying production, buying, and selling, and their relations with law, custom, and government, as well as with the distribution of national income and wealth, including through the budget process. Political economy originated in moral philosophy...
problems, in good times countries have to pay more to their debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
holders, so citizens can potentially complain arguing that the governors contracted debt to favor the lenders.
Another reason to worry about the charasteristics of these bonds is that they may create perverse incentives (moral hazard
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...
) to misreport growth, not revise GDP figures or even worse to repress growth.
Another problem that this type of bond is facing with their implementation is that there is not a sufficient amount of first movers that are ready to issue and invest in this type of security. The market has not developed in part because there are few incentive
Incentive
In economics and sociology, an incentive is any factor that enables or motivates a particular course of action, or counts as a reason for preferring one choice to the alternatives. It is an expectation that encourages people to behave in a certain way...
s to be the first to move. Being one of the initiators in this type of markets implies taking some risk and most of the agents are not willing to do it. A critical mass
Critical mass
A critical mass is the smallest amount of fissile material needed for a sustained nuclear chain reaction. The critical mass of a fissionable material depends upon its nuclear properties A critical mass is the smallest amount of fissile material needed for a sustained nuclear chain reaction. The...
is required to reduce the risk to the issuer. Also, a greater amount of countries issuing these types of securities is required so that investor
Investor
An investor is a party that makes an investment into one or more categories of assets --- equity, debt securities, real estate, currency, commodity, derivatives such as put and call options, etc...
s are able to diversify. Given this facts there is scope for public intervention, for example, an initiative from multilateral institutions could play the role of the first mover and coordinate issuances of GDP-linked bonds from different countries.
An additional critique that has been exposed is that there are other debt instruments that could be superior in the task of insuring risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
for consumers
Consumer
Consumer is a broad label for any individuals or households that use goods generated within the economy. The concept of a consumer occurs in different contexts, so that the usage and significance of the term may vary.-Economics and marketing:...
. That is, for example, the case of CPI-indexed local currency bonds. Crises
Crises
Crises is the eighth record album by Mike Oldfield, released in 1983. Oldfield's well known hit "Moonlight Shadow" appears on the album.- Album analysis :...
are generally accompanied by large exchange rate
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
depreciations that are driven by the fall in domestic consumption. This fall in consumption decelerates the CPI growth and in turn bonds linked to it pay less during crisis. Given that economic agents are more interested in consumption smoothing
Consumption smoothing
Consumption smoothing is the economic concept used to express the desire of people for having a stable path of consumption.Since Milton Friedman's permanent income theory and Modigliani and Brumberg life-cycle model, the idea that agents prefer a stable path of consumption has been widely accepted...
than in the stabilization of output, CPI-indexed local currency bonds can provide a better insurance against shocks than GDP-linked bonds.
Historical background
Previous to the actual issuance of GDP -linked bonds, there were some financial innovations that lead to the appearance of bonds that had features related to the economic performance of the issuing country. Mexico issued several bonds indexed to oil prices during the 1970s and later on, in the early 1990s, Mexico, Nigeria, Uruguay and Venezuela issued some Brady bonds with Value Recovery Rights (VRR), that were structured to pay higher returns when the price of certain commodities was sufficiently high.The first pure GDP-linked bonds were issued by Costa Rica, Bulgaria and Bosnia Herzegovina, also in the context of the Brady restructuring agreements, in the 1990s.
Finally, Argentina issued a GDP-linked bond in 2002, as part of a debt-restructuring of its 2001 default.
A simple example
Suppose a country has been growing in the last few years at an average rate of 3% and is expected to do so in the coming years. Suppose also that this country can issue debt using a fixed-income bond with a coupon of 7%. This country can issue a GDP-linked bond that pays 7% when output growth at the end of the year is exactly 3% and will pay more or less accordingly to its economic performance. That is, for example, if the country grows 1% instead of 3%, then the GDP-linked bond will pay a coupon of 1% instead of 3%. Conversely, if there is an unusually better economic performance and the country grows 5% instead of 3%, then the GDP-linked bond will pay a coupon of 9%.Categories
Shiller method: The value of the instrument depends on the value of GDPBorensztein and Mauro: The return varies with the growth rate of real GDP
See also
- Bond (finance)Bond (finance)In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
- Common stockCommon stockCommon stock is a form of corporate equity ownership, a type of security. It is called "common" to distinguish it from preferred stock. In the event of bankruptcy, common stock investors receive their funds after preferred stock holders, bondholders, creditors, etc...
- EquityEquity (finance)In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
- Inflation-indexed bonds
- Floating-rate bond