IMF Survey: Why are you raising this issue now?
Borensztein: Considerable effort has been put into strengthening the international financial architecture at various levels. One of the most notable parts of this has been the initiative to address how to handle defaults by sovereign countries. At the same time, work is under way throughout the IMF to determine how to anticipate and prevent crises better, on the one hand, and to take measures to resolve them, on the other. Part of crisis prevention has to do with the policies adopted by countries, but another important aspect might have to do with the way international financial markets work. So this idea would help change the structure of a country’s debt in a way that would reduce the probability of crisis. These bonds would give countries a structure to their payment obligations that would make default less likely.
IMF Survey: How do they do that?
Borensztein: The payments on the bonds would not be a fixed amount but would depend on how the country’s economy is doing. Our basic model would be one in which the coupon payment of the bond is a fixed rate plus something that depends on the growth rate of the economy. When the country is doing well, it will pay a higher coupon rate; when the country is not doing so well, it will pay a lower coupon rate. This would make it much easier for the country to keep its fiscal accounts in order and make external debt payments. The country would be less likely to default and creditors would recognize that.
IMF Survey: In terms of the overall architecture, how important is this?
Mauro: At present, people are very interested in preventing crises—more like wearing seat belts rather than just fixing the damage after the accident happens. This instrument won’t be foolproof, but it will make it a little bit easier for a country to avoid getting into a debt crisis. Ultimately, pursuing the right policies is what keeps you out of trouble.
IMF Survey: It sounds good in theory, but isn’t it the reverse of normal practice? Don’t bond market investors expect a higher return when things are getting worse?
Borensztein: When things are getting worse, investors see the probability of default rising, so they demand a higher premium. Now, in this case, even though things are getting worse, the risk of default would be at least reduced by the easier debt payments. The main objective of designing this kind of instrument is precisely to reduce the probability of default. In addition, fiscal policy would have to adjust less in bad economic times.
IMF Survey: So, an investor is trading something for a bit more certainty. But, for this to work, wouldn’t the GDP-indexed bonds have to be widely used?
Borensztein: There are two kinds of issue. One is how the market price of this bond, if it existed, would relate to those of other bonds if the market were well developed, liquid, and so forth. In our view, the premium attached to these bonds wouldn’t be large because investors can diversify. They can spread GDP risk across countries.
The other issue is that there is no such market now. If you try to start a new financial market, maybe there won’t be sufficient liquidity and maybe the instrument will be seen as a little bit exotic. In these instances, the borrower will be paying a premium for investors to hold a bond that they cannot easily sell or that they cannot, perhaps, easily understand.
It would take time and, maybe, official intervention to start markets of this kind, but in the end they are not that complicated. We have floating rate bonds. Every country has bonds that are indexed, say, to LIBOR [London interbank offered rate]. In this case, instead of LIBOR, you would have the growth rate of GDP. People know about GDP and track it very closely if they are investing in a country. Assuming there are no problems with the GDP data, it’s a matter of seeing how to start such a market on a sufficiently large scale for it to make a difference for the country.
IMF Survey: How would indexation work in terms of the GDP data? In some countries, GDP is revised several times.
Mauro: It really depends on how the indexation clause is written. To make things simple, you look at GDP when the contract is signed; then, if this is a 10-year bond, what ultimately matters is the level of GDP 10 years from now. So what really determines the return and what really matters to investors should be the average growth rate of the country over the 10-year life of the bond. Revisions would be pretty small in comparison.
IMF Survey: But if a country announced its GDP growth rate and then later had to revise it after making a coupon payment, wouldn’t that affect future coupon payments?
Mauro: What would really matter to investors is having some clear and previously agreed way of establishing when such revisions stop being relevant for the coupon payments. As long as there is no intentional bias in the revisions or their timing, this is not a big issue. The real issue is guaranteeing the integrity of the process and making sure that the information is out there and easily available and, especially, that nobody’s trading on inside information.
Borensztein: The market’s going to form an expectation and the bond price will change, as happens when a company announces sales estimates and then revises them. The key point is ensuring that the way the information is disseminated does not give rise to doubts about the integrity of the market.
IMF Survey: Why should the IMF be involved?
Mauro: First, the IMF has privileged access to the governments it talks with on a regular basis. We can sound them out on their interest in this type of bond. Second, we can talk to the investment community, float the idea, see how people react to it, and then, perhaps, stimulate a dialogue. But, more concretely, one of the main objections to this type of idea is that countries themselves come up with the GDP numbers, and there would be an incentive for them to cheat. It’s difficult to guess exactly how big a problem that would be. But there is an effort to improve statistics and the transparency of a number of economic indicators. One could go further and maybe encourage countries to have more independent statistical agencies. One might even think of having some mechanism whereby someone certifies the GDP accounts.
IMF Survey: So there’s no intention that the IMF should be some sort of referee?
Mauro: That’s not the idea. But there is an international effort to improve statistics and their transparency, and the IMF plays a role in that. This falls in the same area.
IMF Survey: But you mention in your paper that an international institution will need to play a catalytic role to get this idea rolling.
Borensztein: Yes, but we don’t know exactly what role. If you look at how new securities and new markets start, it often occurs with the help of some government intervention. One example that’s often studied is the mortgage-backed securities market in the United States. It’s a huge market and it’s a great success. But it really developed with strong government support.
We’re not sure how this new bond market would develop. One scenario is in the context of debt restructuring. Several of the restructurings in Latin America in the 1980s included bonds whose value recovery rights were linked to either GDP or export prices such that, when GDP recovered to a certain value, the return on the bond would also start to be higher. So, there’s a little bit of experience, but it’s not quite the same idea as we are proposing.
If this works, then a country may offer some kind of bond exchange on a relatively large scale. In those cases, the international institutions could provide advice.
IMF Survey: So, initially, you see development of this market as being linked to an initiative by a particular country?
Borensztein: That’s one scenario.
Mauro: An alternative scenario is that a group of countries just decide that this is a good idea. They coordinate their efforts and float these new bonds simultaneously. They could hire a big investment bank to do this in a coordinated way. A coordinated approach is good because, from the point of view of an investor, once you have a lot of countries issuing these bonds, you don’t have to worry so much about the GDP indexation aspect. In those years when GDP does well in one country, it does badly in another country, and the two countries can offset each other. That’s probably the cleaner scenario.
IMF Survey:What has to happen next for this idea to gain ground?
Borensztein: Quite a lot. It’s an idea that has to be discussed in the context of the reform of the international financial architecture. Clearly, attention is focused on what countries, investors, and international organizations should be doing about sovereign debt and emerging market international debt in general.
Our idea fits in with this but needs work. For example, there could be other contingencies. We look at GDP because it’s the broadest base indicator of how a country is doing and would work well in every country. But there could be other ways of doing it that could make investors more comfortable. In the oil-exporting countries, for example, the bonds could be indexed to oil prices. In terms of actual bond issues, there could be different scenarios. In addition to the context of debt restructuring, another scenario could be in the context of a large debt exchange at a time of favorable conditions in international capital markets.
IMF Survey: What is the likelihood of success?
Mauro: As with many instances of financial innovation, it’s hard to predict. Why does the United Kindgom have inflation-indexed bonds and other similar countries don’t? It’s a bit of a random process. If there were both political will and widespread interest in these instruments, it could be done. From a legal standpoint, it’s easy. It’s a matter of inserting an indexation clause into an otherwise standard bond contract. But the idea has been out for several years; it hasn’t happened, so obviously there are some unresolved issues.
Borensztein: Changes happen during crises, which is when people really concentrate on doing things that otherwise wouldn’t happen. Clearly, the attention of all the participants is focused on these issues now. This is, I think, a good time to try to push ideas of this sort. Markets are getting more sophisticated all the time, so you see new kinds of securities out there. Implementing our proposal might be a little hard, but markets are looking for innovations.
For more information, see IMF Policy Discussion Paper 02/10, Reviving the Case for GDP-indexed Bonds, by Eduardo Borensztein and Paolo Mauro. Copies of the paper are available on the IMF’s website (www.imf.org) or may be ordered, for $10.00 each, from IMF Publication Services. See page 362 for ordering details.
Julio R. Prego
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