Abstract

Most proposals for reform of the international financial architecture have taken the set of available financial instruments as given. This section asks whether greater use of underutilized instruments could be beneficial in providing countries with insurance and reducing the likelihood of crises. Debt sustainability hinges on developments in real variables, such as exports and GDP. Adverse shocks to these variables often prompt debt crises.1 For some countries, such shocks routinely take the form of adverse developments in commodity prices, natural disasters, or declines in imports by trading partners. For others, changes in economic growth are more difficult to relate to specific events or sectors of the economy.

Most proposals for reform of the international financial architecture have taken the set of available financial instruments as given. This section asks whether greater use of underutilized instruments could be beneficial in providing countries with insurance and reducing the likelihood of crises. Debt sustainability hinges on developments in real variables, such as exports and GDP. Adverse shocks to these variables often prompt debt crises.1 For some countries, such shocks routinely take the form of adverse developments in commodity prices, natural disasters, or declines in imports by trading partners. For others, changes in economic growth are more difficult to relate to specific events or sectors of the economy.

Debt indexed to real variables has been proposed as a way of mitigating changes in debt sustainability that might result from real shocks (Box 6). This section explores the role of debt (or insurance) contracts indexed to real variables, which include

  • variables that are largely outside the control of the country’s authorities and in many cases can be measured in a relatively straightforward manner—such as commodity prices, natural disasters, or imports by a country’s main trading partners; and

  • broader measures of economic activity that are partly within the control of the country’s authorities and are typically measured by the country’s own statistical agencies—such as the country’s own exports or GDP.

The relative merits of indexing to variables in these two groups will depend on individual country characteristics such as the sources of shocks, the reliability of the statistical information, and the perceived credibility of the authorities. In fact, while indexation to broader measures such as GDP would likely provide greater insurance benefits, potential investors might be concerned about the authorities’ incentives to tamper with GDP data or even undertake less-growth-oriented policies, as suggested by some studies (e.g., Krugman, 1988). As indexation to variables outside the control of the authorities has been extensively treated in many previous studies, this section provides more detailed information about indexation to variables partly within the control of the authorities, whose properties and challenges are relatively underexplored.

Benefits of Indexation to Real Variables

Indexing bond repayments to real variables such as GDP or exports, or some of their key determinants (such as natural disasters, commodity prices, or trading partners’ total output or imports), would tend to promote debt sustainability (or raise the level of sustainable debt) by stabilizing variables such as the debt-to-GDP ratio—thereby providing a number of benefits to borrowing countries:

  • If the economy falls onto a path of persistent weak growth, the smaller increases in the debt-to-GDP ratio resulting from indexation would reduce the likelihood of default and debt crises.

  • Governments would find it easier to maintain a smooth path for tax rates and essential public services despite fluctuations in economic growth. The need to pay higher interest rates in years of rapid growth might even make it more difficult for governments to boost noninterest spending unsustainably during times of economic boom.

  • By acting as an “automatic-stabilizer,” real indexation would reduce pressures on governments to engage in procyclical fiscal policy. Emerging markets are often forced to tighten fiscal policies during economic downturns in an attempt to maintain credibility and access to international financial markets, as suggested by the sudden stops literature (Calvo, 2003 s).2 But real indexation may be helpful more generally to governments that are seeking to stabilize the debt-to-GDP ratio, whether because of legal or constitutional constraints, agreements such as the Stability and Growth Pact, or inability to borrow beyond a certain level.

Proposals for Indexation to Real Variables

A first wave of interest in indexing debt to GDP, exports, or key commodity prices emerged in the aftermath of the debt crisis of the 1980s. Bailey (1983) suggested the conversion of debt into proportional claims on exports. Lessard and Williamson (1985) made the case for real indexation of debt claims. Krugman (1988) and Froot, Scharfstein, and Stein (1989) considered the relative merits of indexing debt to variables out of the debtor country’s control (such as commodity prices) versus variables partially under the country’s control (exports or GDP). At the time, a majority view within the academic community seemed, on balance, to emphasize the moral hazard costs rather than the insurance benefits of indexing to exports or GDP. The decline in commodity prices was fresh in people’s minds as one of the causes of the debt crisis and—with commodities still representing a significant share of production and exports for some of the countries most affected—indexing to commodity prices seemed like a better idea.

A second wave of interest originated from Shiller’s (1993, 2003) proposal to create “macro markets” for GDP-linked securities. In Shiller’s proposal, these were to be perpetual claims on a fraction of a country’s GDP. Barro (1995) shows that bonds ought to be indexed to consumption and government expenditure in a model of optimal debt management where the government seeks to smooth tax rates over time. But he suggests GDP-indexed bonds as a more realistic alternative with fewer problems related to moral hazard and measurement. This section analyzes a possibility related to Shiller’s proposal: a bond whose coupon payments are indexed to GDP growth is equivalent to a plain vanilla bond combined with a security whose payoff depends on deviations of the issuing country’s growth rate from a baseline. While Shiller security markets would have to be set up from scratch, the possibility analyzed in this section might be easier to implement: it would require introducing an indexation clause in otherwise standard sovereign bonds.

For emerging market economies, the case for contingent debt contracts has received new impetus after the financial and debt crises of the 1990s. Caballero (2003) recommends that countries issue bonds with contingencies to commodity prices and other external variables of relevance to them (e.g., Chile should issue bonds indexed to the price of copper). Haldane (1999) argues that emerging markets would benefit from indexing debt to commodity prices. Daniel (2001) argues that many governments would benefit from hedging oil price risk through existing financial instruments and markets, and that international institutions should encourage them to explore this possibility. Drèze (2000a) suggests the use of GDP-indexed bonds as part of a strategy to restructure the debt of the poorest countries. Varsavsky and Braun (2002) make the case for restructuring Argentina’s debt into GDP-indexed bonds.

Related proposals have also been made for advanced countries. Some investment banks in Sweden proposed to introduce GDP-indexed bonds in the mid-1990s. The idea received some support in official circles, but fell by the wayside partly because the National Debt Office at the time was focused on promoting greater use of inflation-indexed bonds (Englund, Becker, and Paalzow, 1997). Obstfeld and Peri (1998) suggest that individual governments in the European Union should issue perpetual euro-denominated liabilities indexed to domestic nominal per capita GDP growth. They argue that nominal rather than real indexing would protect securities holders against inflation. Drèze (2000b) makes a similar proposal for the EMU countries.

This section focuses on the insurance benefits of real indexation for the borrowing countries and their citizens. Yet, real indexation can be viewed more generally as a desirable vehicle for international risk-sharing and as a way of avoiding the disruptions arising from formal default. It thus has a number of potential benefits for international investors:

  • International investors would also benefit from a lower frequency of formal default, which often results in costly litigation/renegotiation and is thus disruptive even to large private financial institutions that might be considered risk neutral.

  • Citizens of lending countries would appreciate the ability to invest in assets whose return is linked to other countries’ fortunes. As countries’ incomes are far from being perfectly correlated, this would provide a welcome diversification opportunity.

  • Finally, for the case of GDP indexation, financial market participants might be interested in the opportunity to take a position on countries’ future growth prospects. This is already possible to some extent through countries’ stock markets, but these are often not representative of the economy as a whole, especially in emerging market countries.

Real Variables Beyond the Control of the Country’s Authorities

Some shocks that have a major economic impact are largely beyond the control of the country’s authorities. For the vast majority of countries, fluctuations in world commodity prices are essentially given. Of course, countries may wish to diversify their production, export, and revenue structures, but this takes time and may not always be desirable. Similarly, there is little countries can do to avoid natural disasters, though investments in preparedness and relocation of activities to less disaster-prone areas help mitigate the consequences of disasters. Finally, except for a few very large economies, countries typically must take as given the economic performance of their trading partners.

Bonds whose repayments are linked to such variables are worth considering. Bonds whose repayments are indexed to commodity prices have been used, although rarely, since the 1800s. Insurance against natural disasters (including through catastrophe bonds—whose repayment is waived in the event of a catastrophe) is a much more recent innovation that is already widespread in the private sector, but has only been used by a handful of sovereigns. Bonds whose repayment is linked to trading partners’ performance have not been previously used (or advocated), but their use would seem to be desirable.

Commodity Price Shocks

Shocks to commodity prices have important effects on debt sustainability for several countries where commodities are a sizable share of exports and GDP, and export taxes are a substantial share of total revenues. Shocks to prices of key imports, notably oil, are perhaps even more important for many developing countries, though insuring against these shocks has received less attention than shocks to exports. A number of studies suggest that changes in commodity prices (or, more generally, terms-of-trade shocks) can have a large impact on revenues and economic growth, though the exact magnitude of the estimated impact differs considerably across studies.3

Most advanced countries have well-diversified production and export structures. The percentage share of the top export in total exports of goods amounts to more than one-third only for Iceland (fish) and Norway (oil) (Table 4).4 Even for advanced countries for which commodities are often considered significant, such as Australia, the share of the top three exports in total exports is no more than a quarter.

Table 4.

Percentage Share of the Top Three Exports in Total Exports, 1990–9

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Source: UNCTAD (2001).Note: Within each group, countries are ranked by the total share of the top three exports. Ten countries with the highest export shares are reported. The country group averages refer to the whole sample.

For several developing countries and a few emerging markets, a single product or a few products constitute an overwhelming portion of total exports. Of the 27 emerging market countries for which data are available, 6 have more than 25 percent of exports in one commodity: Chile (copper, 27 percent), Colombia (oil, 29 percent), Egypt (oil, 27 percent), Kenya (tea, 28 percent), Venezuela (oil, 80 percent), and Zimbabwe (tobacco, 34 percent). However, of the emerging market countries with the largest bond market capitalization (Argentina, Brazil, Korea, Mexico, and Russia—on the basis of the EMBIG weights for 2000–03), only Russia’s share of the top three exports is above one quarter.

As might be expected, the importance of commodity price shocks for economic performance differs considerably across countries. Collier and Dehn (2001) report that large adverse shocks to commodity prices are significantly associated with a decline in output growth for commodity-producing countries, though not for other countries. For the typical commodity producer, the worst shocks—in the lowest 2.5 percent of the shock distribution—are associated with a 7 percent output decline in the year of the shock and a cumulative 14 percent decline in the year of the shock and the following three years.5 Shocks to commodity prices have widely different effects on tax revenues depending on the country under consideration. For example, changes in oil prices of reasonable magnitudes affect the revenues of oil-producing countries by several percentage points of GDP (IMF, 2000b).

Both the IMF and the World Bank have long provided facilities specifically designed to help countries adjust to large terms-of-trade shocks. The IMF has used a number of facilities including the Compensatory Financing Facility (CFF), established in the 1960s to assist countries experiencing either a sudden shortfall in export earnings or an increase in cereal import costs caused by fluctuating world commodity prices. Yet, limits to administrative capacity imply that only a few large terms-of-trade shocks will lead to loans in the context of programs supported by the IFIs. More important, with shocks to commodity prices being highly persistent (Cashin, Liang, and McDermott, 2000), these loans facilitate adjustment to adverse shocks and the resulting lower income levels, but they are not designed to provide insurance or maintain income levels through state-contingent transfers.

Countries seem to be reluctant to insure themselves against commodity risks through financial instruments. Until the 1980s, government and multilateral interventions aimed at price stabilization in commodity markets were commonplace. A consensus among academics and policymakers seems to have emerged since then for a shift away from market intervention and toward management of commodity risks through financial instruments (see, e.g., Claessens and Duncan, 1993; Dehn, Gilbert, and Varángis, forthcoming).6 In the context of that shift, researchers in academia and international institutions, notably the World Bank, spurred a debate on the merits of commodity-price-linked bonds. Such bonds could be viewed as a way for countries to hedge against changes in commodity prices even in cases where futures or forwards of a sufficiently long maturity are either absent or too costly. Nevertheless, commodity-price-linked bonds have been used only in a limited number of instances.

Recent efforts to provide sovereigns with market-based insurance against commodity fluctuations do not appear to be attracting much interest. Since September 1999, the World Bank has offered risk management products linked to IBRD loan exposures, including swaps that seek to hedge against fluctuations in interest rates, currencies, and commodity prices. However, swaps that hedge against commodity price fluctuations have not been used by World Bank clients to date. Nor do sovereigns make much use of hedging opportunities even where active and liquid markets exist for futures and forwards on commodities with maturities extending beyond a few years, as is the case for oil (Daniel, 2001).

Sovereigns’ reluctance to use financial instruments to hedge against commodity price fluctuations is not fully understood, though it may be related to the following factors:

  • Insurance—even if incomplete—is already provided, to some extent, by the IFIs.

  • Prices obtained by some countries for the particular quality of the commodities they produce may not be closely correlated with those observed on international exchanges.

  • Regarding commodity-price-linked bonds more specifically, international investors often express a preference for separating exposure to country risks (through standard bonds) from exposure to commodity price risks (through existing markets for commodity price forwards and futures).

  • Without hedging, the borrowing country does not need to share its gains on the upside; and it may force its lenders (through default) to share the downside.

  • It may be politically difficult to pay for hedging, especially in the event that—with hindsight—this turns out to have been the wrong decision. This factor is not unique to sovereigns and may be one of the reasons why hedging remains more limited than might be expected even in the corporate world.7

Countries wishing to reduce volatility resulting from commodity price shocks could of course consider taking steps to diversify their economies. However, this process may take many years and some countries may even judge that their comparative advantage really lies in a few products. Hedging against commodity price fluctuations through financial instruments, including commodity-price-linked bonds, would therefore seem desirable for several countries.

Natural Disasters

Natural disasters take a massive human and economic toll on virtually all countries. Their impact relative to the size of the economy tends to be higher, the lower the degree of economic development and the smaller the size of the country under consideration. This is confirmed by considering the top five most devastating disasters, ranked by the direct loss of capital stock in percent of GDP, for various groups of countries: advanced, emerging market, developing, and small (Table 5).8 For advanced countries, the direct loss of capital stock attributable to specific natural disasters usually does not exceed a few percentage points of GDP. For emerging markets, this direct impact can occasionally be equivalent to more than 10 percentage points of GDP. For small developing countries, especially small islands, the impact can occasionally be equivalent to more than a year’s worth of output. The impact on the fiscal deficit and the trade deficit can also be equivalent to several percentage points of GDP (Freeman, Keen, and Mani, 2003). In many instances, the impact on the GDP growth rate is not commensurate with the direct loss in the capital stock, suggesting that indexation to GDP in these cases would not provide sufficient insurance.

Table 5.

Top Five Natural Disasters by Percent of GDP Lost

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Source: Emergency database (EM-DAT), compiled by Office of Foreign Disaster Assistance (OFDA) and Centre for Research on Epidemiology of Disasters (CRED).Note: The definition of advanced countries follows that of the IMF’s World Economic Outlook. The set of emerging market countries is the union of those defined as such by the International Finance Corporation, Global Stock Market Factbook 2002, and the JPMorgan Emerging Market Bond Index Global. Small countries are defined as those with GDP below $5 billion in 2002. The remaining countries are included in the set of developing countries. Direct economic loss is calculated using CRED’s measure of direct damage to physical infrastructure as a result of the natural disaster.

A few countries are routinely affected by the same type of natural disaster: a few small islands are repeatedly hit by cyclones; other countries are particularly prone to earthquakes, or floods (Table 6). However, perhaps a majority of countries that are prone to natural disasters are affected by a variety of disasters, rather than a single type of event. This makes it even more difficult in these countries to estimate the likelihood of disasters and to obtain insurance contracts (or bond indexation clauses) than in countries where disasters always tend to be of the same type.

Table 6.

Small Countries: Types of Disasters, 1975–2002

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Source: Center for Research on Epidemiology of Disasters (CRED) and Office of Foreign Disaster Assistance (OFDA), EM-DAT.Note: Small countries are defined as those with GDP below $5 billion in 2002. Disasters in EM-DAT are defined as those natural disasters that have caused 10 or more fatalities, affected 100 or more people, led to an appeal for international assistance, or resulted in a declaration of a state of emergency. The data are based on reports sent to CRED and compiled by external organizations such as the various UN organizations, country governments, aid-disbursing agencies, and reinsurance companies.

Most natural disasters have a temporary impact on the fiscal deficit and the economy’s growth rate. In the aftermath of a disaster, spending jumps to alleviate humanitarian emergencies and to begin reconstructing infrastructure. As far as the real economy is concerned, for most large disasters considered in Table 4, growth in the year of the disaster declined by a few percentage points but soon returned to its long-run trend, typically within one or two years following the disaster. Caselli and Malhotra (2004) find that, in most instances, natural disasters have no permanent impact on a country’s long-run growth path, though they have a permanent effect on the level of income. From the narrow perspective of debt sustainability, most natural disasters may be viewed as creating repayment difficulties in the aftermath of the disaster, but not as affecting the country’s ability or willingness to meet its external obligations on a permanent basis.

This set of facts has implications for whether countries are likely to be interested in insuring themselves against natural disasters, and for the types of insurance contracts that can be more efficient. Larger, more advanced economies are typically able to cope with natural disasters on their own, by letting the debt-to-GDP ratio rise in the aftermath of the disaster and gradually reducing it over a number of years, through slightly higher taxes or lower spending on other items. For emerging market countries, and especially developing countries, it is often difficult to muster sufficient funds from the private capital markets to cope with disasters. In many instances, the international community has therefore appropriately stepped in with aid and new lending. For its part, the IMF provides emergency assistance to countries that have experienced a natural disaster or are emerging from conflict.9 At the same time, some natural disasters, even if seriously damaging, fail to capture international attention. And even when aid is provided by the international community, it is insufficient to prevent declines in income levels, and lending merely helps smooth the adjustment to a lower income level. Thus, disaster-prone countries might be expected to have a strong interest in obtaining insurance from the private sector. Both the World Bank and the Inter-American Development Bank have advocated greater use of insurance against natural disasters for some countries, and have sought to help country clients obtain such insurance from the markets (Gilbert and Kreimer, 1999; Inter-American Development Bank, 2002).

Despite the existence of markets for insurance against natural disasters, at present only a handful of countries use them. Insurance is available both directly from insurance companies and through innovative financial instruments such as catastrophe bonds, which waive some or all of the principal and interest repayments in the event of a prespecified catastrophe, or weather derivatives, which provide payouts in the event of temperatures or rainfall above or below prespecified trigger levels over a certain period. Sovereigns rarely opt for disaster insurance, even for their own property (Freeman, Keen, and Mani, 2003). Sovereigns rarely issue catastrophe bonds, though it is somewhat more common for private companies to do so.

The possible reasons for why countries do not often insure themselves against natural disasters include the following:

  • In the case of small and poor countries, insurance companies may consider the size of the potential market too limited for them to incur the cost of estimating the likelihood of disasters.

  • Insurance premiums may be high because of potential moral hazard: contracts normally provide for payoffs based upon actual losses rather than the intensity of the natural phenomenon, which could be measured, say, by the number of points on the Richter scale in the case of earthquakes. This tends to reduce countries’ incentives to invest in preventive measures aimed at reducing the physical destruction that would result from disasters.

  • Countries may expect the international community to step in with generous aid and financial support in response to disasters.

The international community could help countries meet a number of prerequisites to obtain insurance contracts against natural disasters from the private sector at a reasonable premium. These include historical data on previous events; appropriate infrastructure, such as weather stations, necessary for contracts based on specific measurements, such as rainfall or temperatures; and historical correlations of actual losses with the scale of events. Technical assistance in these areas, especially to small countries, might also be helpful.

Countries that are prone to natural disasters could be encouraged to consider insurance through the private markets. To mitigate possible disincentives, the international community could emphasize its readiness to step in with help even for countries that have obtained insurance from the private sector. One possibility might be for the international community to commit to providing emergency assistance, perhaps on a concessional basis, to countries deemed to have undertaken appropriate measures to mitigate the impact of possible disasters (Freeman, Keen, and Mani, 2003).

Changes in Total Imports by Main Trading Partners

As noted above, many countries would not derive major insurance benefits from instruments hedging specific risks, such as natural disasters or changes in commodity prices. For these countries, especially highly open economies, changes in total imports or output by main trading partners might constitute an important determinant of economic performance. It is therefore worth considering whether it would be desirable to let a country’s bond repayments depend on an index of total imports by the country’s main trading partners.

Regressions of individual countries’ annual output growth on trade-weighted partner growth may help gauge the extent to which indexation to partner growth might stabilize the debt-to-GDP ratio for the various countries (Table 7).10 For many advanced economies, output growth is clearly related to developments in partner countries. The relationship is more tenuous—with lower average R2 coefficients—for emerging market countries and developing countries.11 A possible interpretation of this finding is that advanced countries tend to export services and manufactures with a relatively high technological content, for which demand shocks are more relevant; by contrast, emerging market countries and developing countries tend to export commodities, for which supply shocks are more relevant, and manufactures with lower technological content, for which demand might increase when the advanced economies experience low growth and redirect their demand toward cheaper goods. Developments in trading partners’ output growth are found to be a key determinant of economic growth also over longer time horizons: using five-year panel regressions, Arora and Vamvakidis (2004) find that a 1 percentage point increase in trading partners’ growth raises a country’s growth rate by as much as 0.8 percentage points, with the effect being somewhat stronger in more open economies.

Table 7.

Output Growth and Trading Partners’ Growth, 1970–2002

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Sources: IMF, International Financial Statistics and Direction of Trade Statistics.Note: The regressions use annual data for 1970–2002, when available. Countries with fewer than 20 observations are not considered. The definition of advanced economies is derived from the IMF’s World Economic Outlook. The set of emerging market countries is the union of those defined as such by the International Finance Corporation, Global Stock Market Factbook 2000, and the JPMorgan Emerging Market Bond Index Global. The remaining countries are included in the set of developing countries. The number of countries in each group is reported in parentheses.

In sum, several countries would derive considerable benefits from insurance or indexation to real variables largely beyond the control of the national authorities, such as natural disasters, commodity prices, or trading-partner output growth. Nevertheless, many countries, including several among the main emerging markets, seem unlikely to derive significant benefits from such insurance or indexation.

Real Variables Partially Within the Control of the Country’s Authorities

Indexing to broader indicators of a country’s economic performance would provide a closer match to its ability to repay. The closest indicators would be GDP or exports; related indicators such as industrial production or electricity consumption could also be considered. The macroeconomic benefits that borrowing countries might derive from real indexation can be illustrated by a number of simple numerical examples, which, for the sake of brevity, are presented here for the case of GDP.

A Simple Example

Consider the case of a country whose real GDP has been growing for many years at 3 percent and it is expected to continue doing so. Assume that this country can issue regular, plain vanilla bonds at, say, 7 percent interest. That country could consider issuing a dollar-denominated, floating-rate bond with a coupon rate that varies according to the performance of the domestic economy. Specifically, the coupon rate could equal

coupont=max[r+(gtg¯),0],(1)

where

gt = actual growth rate of GDP,

g¯ = baseline growth rate of GDP,

and

r = 7 percent.

The baseline growth rate of GDP is agreed upon by the contracting parties prior to the bonds’ issue: in this case, 3 percent could be a reasonable baseline. The coupon rate might be expected to include a small insurance premium in addition to the 7 percent charged for plain vanilla bonds, but this insurance premium is set to zero in this example. Yearly coupon payments will be reduced by 1 percentage point for every percentage point by which real GDP growth falls short of its 3 percent trend—but the coupon has a minimum of zero. In years when growth turns out to be 1 percent, the coupon will be 5 percent. In years when growth turns out to be 5 percent, the coupon will be 9 percent.

This exercise and those that follow are based on the relatively simple formula above. Continuity—with small changes in realized growth resulting in small changes in coupon payments—seems desirable to minimize incentives to misreport. The need for symmetry—with the coupon varying in proportion to the gap between actual and baseline GDP growth on both the upside and the downside—may be a more open question. Many institutional bond investors are required to hold assets that pay a positive interest rate, suggesting the need for a zero or positive minimum for the coupon rate. Borrowers might prefer to include a cap on coupon payments, which is omitted in this example. The link from the growth rate to coupon payments could follow more complicated formulas, but simplicity is likely to be crucial in helping sell this type of instrument. Indexation could apply to the principal, but it seems preferable to apply it to the coupon, because this yields interest savings during times of weak economic growth, thereby reducing the need for fiscal policies to be procyclical. At any rate, mutual agreement between borrowers and lenders would seem the most natural way of determining the exact form of the contract.

When GDP growth turns out lower than usual, debt payments due will also be lower than in the absence of indexation, helping maintain the debt-to-GDP ratio at sustainable levels, and avoiding what could be a costly and politically difficult adjustment in the primary balance at a time of weak economic performance. Conversely, when GDP growth turns out higher than usual, the country will pay more than it would have without indexation, thus reducing its debt-to-GDP ratio less than it would have otherwise. In sum, this insurance scheme keeps the debt-to-GDP ratio within a narrower range. For this insurance, the borrowing country will pay a small premium above the interest rate that it would ordinarily be charged.

Using the specific form of the contract in (1), the following example may be considered. Suppose that beginning in 1990, half of the total government debt of Mexico and Argentina consisted of these GDP-indexed bonds. And suppose that the average growth rate over the 20 years prior to the beginning of the contract is chosen as the baseline growth rate. For the purpose of this example, assume that the composition of the debt has no impact on the behavior of any of the other variables in the economy: variables such as the GDP growth rate and the overall deficit behave exactly as they did in 1991–2002. What coupon rates would have been paid on the bonds, and what would have been the interest savings (or extra costs) for these two countries?

Mexico (Figure 11, top panel) grew relatively rapidly in the 20 years prior to 1990, by 4.4 percent on average, compared to about 3 percent in 1991–2002. This would have resulted in an average coupon rate of 5.9 percent compared to the expected 7 percent. In good years, Mexico would have paid higher-than-average coupon rates. However, during the Tequila crisis of 1995, when output contracted by more than 6 percent, the coupon rate would have fallen to its minimum of zero. Mexico would have obtained a large reduction in the interest bill, leaving more room to avoid procyclical fiscal measures. Large interest savings would also have applied during the sudden slowdown of 2001–02.

Figure 11.
Figure 11.

Interest Savings over the Economic Cycle

(Interest bill savings as percent of GDP, left scale; Coupon and GDP growth rates in percent, right scale)

Source: IMF, World Economic Outlook.

In Argentina (Figure 11, lower panel), growth over the 20 years prior to 1990 averaged only 0.9 percent per year. In 1991–2002, despite two major crises, the average growth rate rose to 2.3 percent. This would have resulted in coupon rates of 8.8 percent on average. The coupon rate would have fallen sharply in 1995 (Tequila crisis) and again beginning in 1999 (Brazil crisis), though it would have hit the minimum of zero only in 2002. Interestingly, Argentina defaulted on foreign debt in 2002 and actually did not make any interest payments in that year. Argentina would have made roughly no net savings on its interest bill: it would have paid higher-than-average coupon rates in the years of rapid growth (the early 1990s), but would have made sizable savings in its interest bill since 1999.

Avoiding Procyclical Fiscal Policy

The example above illustrates how GDP indexation of bond repayments could reduce the need for countries to engage in procyclical fiscal policy. When GDP growth is below trend, the government will be able to have a lower primary surplus (higher primary spending and lower taxes) with indexation than without it; conversely, when GDP growth is above trend, the government will need to have a higher primary surplus (lower primary spending and higher taxes) than without indexation. Thus GDP indexation of bond repayments tends to make for smoother paths of the primary surplus, taxes, and primary spending, over the cycle. The advantages could be large for both emerging market countries and advanced economies (Box 7).

While this paper focuses on emerging market countries, GDP indexation could also help advanced economies to avoid procyclical fiscal policies, in particular where the government faces constraints on its deficit level. The constraints could arise from legal or constitutional provisions (as for some of the U.S. states) or a concerted policy commitment such as the Stability and Growth Pact of the European Union. To gauge the benefits of GDP-indexed bonds for advanced economies, Borensztein and Mauro (2004) consider what would have happened to the debts, total deficits, and primary deficits of some of the European Monetary Union (EMU) countries had they been subject to a 3 percent of GDP limit on the fiscal deficit beginning in 1980, and then simulate what would have happened to their primary deficits had the debt been indexed to GDP. Adjusting the primary balance to meet the 3 percent total deficit ceiling would have significantly curbed the ability of some of these countries to conduct countercyclical fiscal policy. Growth-indexed debt, however, would have largely offset the impact of the deficit ceiling, helping preserve the countercyclicality of fiscal policy.

Having argued that GDP-indexed bonds might provide substantial insurance benefits, it remains to be shown whether the insurance premium countries might expect to pay would be sufficiently small for the insurance to be attractive to them.

Diversifiability of Growth Across Countries and the Insurance Premium

Pricing financial instruments that do not yet exist is a difficult task, but considerations loosely based on the Capital Asset Pricing Model (CAPM) suggest that the insurance premium on GDP-indexed bonds issued by emerging market countries would likely be small. In fact, income growth rates are not highly correlated with possible measures of a “world market portfolio,” and the CAPM implies that only the systematic portion of risk is reflected in expected returns, because unsystematic risk can be diversified away by investors.12

Benefits of GDP Indexation for Emerging Markets and Advanced Economies

How much additional room would countries have had for countercyclical fiscal policy if their debt had been indexed to GDP at the beginning of the 1990s? To address that question, a simple exercise is conducted for 20 advanced economies and 25 emerging market countries. For each country, it is assumed that, in 1991, the entire debt stock was indexed to GDP; each year, the interest rate on the entire debt under the indexed contract would equal the implied interest rate (from the interest bill and the previous year’s debt stock) observed in the actual data plus an indexation term equal to the difference between actual growth and baseline growth (with a minimum of zero); the baseline growth in the contract was the average growth rate in 1980–2001, which could be viewed as resulting from a mix of adaptive expectations and perfect foresight; and total deficits (and thus the total debt path) and economic growth were exactly as observed during the simulation period. Then it is estimated what the primary balance would have been with indexation in 1992–2001, and the resulting correlation between the primary balance and the GDP growth rate—a summary measure of the government’s ability to conduct countercyclical fiscal policy. (For example, if primary spending is more expansionary during recessions, that correlation will be higher.) This correlation is then compared to the same measure based upon actual data.

The correlation between the primary balance and the GDP growth rate would have been substantially higher with indexation than it was in the actual data, and the increase in correlation would have been slightly more pronounced for emerging market countries than it would for advanced economies (see the table).

Correlation Between Primary Balance and Real GDP Growth

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Sources: OECD, Analytical database; and IMF, International Financial Statistics, Government Finance Statistics, and Country Reports.Note: Emerging market countries include Argentina, Brazil, Bulgaria, Chile, China, Colombia, Côte d’Ivoire, Ecuador, Hungary, India, Indonesia, Korea, Lebanon, Malaysia, Mexico, Morocco, Nigeria, Pakistan, Peru, Philippines, Poland, South Africa, Turkey, Uruguay, and Venezuela. Advanced economies include Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Iceland, Ireland, Italy, Japan, Luxembourg, Netherlands, New Zealand, Norway, Spain, Sweden, United Kingdom, and United States.

Simple regressions of individual countries’ GDP growth rates on various proxies for the return on the “world market portfolio” (including world real stock returns, U.S. real stock returns, world GDP growth, and U.S. GDP growth) yield relatively low R2 coefficients.13 For emerging market countries, the highest R2 coefficient is 0.20 (Russia) using world stock returns; beta coefficients range from–0.6 (Bulgaria) to 0.43 (Russia), with an unweighted average of 0.032 (Borensztein and Mauro, 2004). Comovement across countries is somewhat higher for advanced countries, and marginally lower for developing countries.

To illustrate the implications of the equation above for the pricing of GDP-indexed bonds, the following example assumes that the relevant portfolio for investors is the world stock market, the risk-free rate of return is 3 percent, the expected return on the market portfolio is 8 percent and, taking the case of Mexico from the (unreported) individual country regressions, that the β of the country’s growth rate with respect to the return on the world stock market is 0.072. Then, the indexation premium will be (8–3)×0.072, that is, 0.36 percentage point a year—fairly small compared with the spreads often observed in emerging markets. This premium is in excess of the rate that the country pays on plain vanilla bonds, that is, it is in addition to the premium that compensates for default risk. It is likely, however, that default risk would decline significantly if a country were to convert a large portion of its debt into indexed bonds such as these. For simplicity, the above assumes that the default risk is uncorrelated with the GDP growth risk. The appeal of indexed bonds is even greater when this assumption is relaxed, letting default risk rise when growth falls.

Obstacles for Variables Partly Within the Control of the Government

Despite its potential advantages, real indexation has been used in practice only in a limited number of cases (Box 8). If such advantages were really significant, as the analysis above suggests, why has real indexation not been more widespread? Part of the answer, of course, is that creating markets for new financial instruments is never easy, as argued in Section II. However, indexation to real variables that are partly within the control of the government, such as GDP, presents an additional set of practical and conceptual obstacles that are discussed below.

  • Possibility of lower incentives for growth-promoting policies. Bonds indexed to variables that are partly affected by government policies could reduce the authorities’ incentives to pursue growth-promoting policies. The extent to which a government (whether benevolent or kleptocratic) would—for a number of years—pursue less growth-oriented policies with indexed bonds than it would with standard bonds (on which it could default) is an open question, but investors might reasonably be concerned about that possibility.

  • Potential misreporting. When repayments are linked to economic indicators produced by the debtor country, the authorities might be tempted to tamper with the measurement of those indicators. How strong the temptation would be, and whether the authorities would place their reputation (and possibly market access) at stake are also open questions.14 Nevertheless, the potential for misreporting could make investors reluctant to hold instruments of this type. Of course, it is high growth rather than low growth that is typically considered a success and gets politicians reelected, but the incentives might be reversed if the new instruments were to constitute a large fraction of a country’s external debt.

  • Data revisions. Even for advanced countries, revisions compared with initial data releases for variables such as GDP can be substantial. Investors might perceive potential data revisions as an unwelcome source of uncertainty, and might be concerned about the possibility that debtor countries might use the revisions opportunistically to reduce repayments.

  • Lags. The benefits of real indexation in reducing the procyclicality of fiscal policy depend on whether repayments are linked to variables that truly reflect the current state of the economy. Although the state of the economic cycle tends to persist in time and GDP data become available with only a few months’ delay in many countries, debtor countries might be concerned about linking repayments to macroeconomic indicators that, in practice, become available with significant lags.

  • High volatility of returns. While many international investors already invest in emerging market financial instruments with very volatile returns, such as stocks, some bond investors might be reluctant to accept the additional volatility of returns resulting from the variable coupon payments associated with real indexation. Moreover, many institutional investors may be prevented from doing so by the constraints placed on the range of assets that they are allowed to invest in.

  • Complexity and difficulty in pricing. While some financial market players thrive on dealing with and pricing complicated financial instruments, many investors, especially bond investors, are often reluctant to buy instruments that are difficult to understand and price. Indeed, for bond investors in particular, there appears to be a trend away from complex instruments toward simple bonds, as shown by several swaps to retire Brady bonds, and a decline in the prominence of floating-rate bonds. While a generally accepted pricing formula does not seem to be necessary for a market to operate, lack of a well-established pricing model for GDP-indexed bonds might hamper their acceptance by investors. Indeed, if investors were to apply a very high discount rate to future uncertain payments, borrowing countries would find GDP-indexed bonds too costly to be issued.

  • Politicians’ short horizons. As real indexation would have a significant impact only for relatively long-term bonds, politicians currently in power—given their short horizons—might be reluctant to pay an insurance premium today in exchange for benefits that might only be reaped by their successors.

  • Inability to recall the bonds. Real indexation is unlikely to be consistent with the callability of bonds. Suppose that a GDP-indexed bond were callable: should GDP growth turn out better than expected, the interest rate faced by the country on standard bonds would presumably fall (because the country would now look more solvent); the borrower would then have an incentive to recall the indexed bonds and issue plain vanilla bonds at a lower interest rate. At present, less than 5 percent of all emerging market bonds are effectively callable. However, the ability to recall a bond is another important form of insurance—in this case, against fluctuations in interest rates. Therefore, the appeal of GDP-indexed bonds may depend on the relative importance of uncertainty over interest rates and uncertainty over GDP growth.

Previous Examples of Indexation to Real Variables

A handful of emerging market countries have already issued bonds with elements of real indexation: Mexico has issued bonds indexed to oil prices; and various Brady bonds issued by Mexico, Nigeria, Uruguay, and Venezuela to commercial banks in exchange for defaulted loans in the early 1990s were issued with value recovery rights (VRRs) that were designed to provide additional payments in the event of an increase in prices of commodities such as oil. However, the indexation formulas were exceedingly complex, and the characteristics of each country’s formulas differed widely. Moreover, there were restrictions on the tradability of the bonds and the detachability of the VRRs (http://www.emta.org/ndevelop/primer.pdf). Loans combined with protection (through swaps) from commodity price fluctuations have also been made available by the World Bank to member countries, beginning in September 1999, though interest has thus far been limited.

Costa Rica, Bulgaria, and Bosnia and Herzegovina have issued bonds containing an element of indexation to GDP. These bonds, which were issued as part of Brady restructuring agreements, contain clauses or warrants (value recovery rights) that increase the payoff to bondholders if GDP (or GDP per capita) of the debtor country rises above a certain level. In the case of Bulgaria, the bonds provided for a GDP “kicker” such that, once real GDP exceeds 125 percent of its 1993 level, creditors will be entitled to an additional 0.5 percent in interest for every 1 percent of real GDP growth in the year prior to interest payment. At the same time, these bonds were callable by the issuer and even at the time of issue it was widely expected that Bulgaria would repay the principal and refinance it, should the kicker appear likely to be triggered by rapid economic growth. Indeed, Bulgaria has already swapped a portion of its indexed bonds for newly issued, nonindexed bonds. In any case, indexed bonds are very much exceptions, and, in the few instances when they have been issued, the indexation clause was set so far “out of the money” that it was unlikely ever to be triggered.

Going beyond sovereigns, one set of bonds (for a few hundred million dollars and a maturity of four to six years) recently restructured by the city of Buenos Aires includes indexation of principal repayments to the city’s revenues. This seems quite close to the notion of equity for a public entity (the proceeds from the right to collect taxes). Indexation to revenues, however, would seem unlikely to gain widespread acceptance, owing to reduced incentives to collect revenues.

Finally, moving away from bonds and toward pure claims to the indexation component, a market for derivatives on indicators of real economic activity has recently been developed. In September 2002, Goldman Sachs and Deutsche Bank successfully completed the first-ever parimutuel auctions of economic derivatives—specifically, options on the U.S. Bureau of Labor Statistics release of change in U.S. Nonfarm Payroll data for September 2002 (www.longitude.com/html/news_oct04_2002.html). In April 2003, the same firms hosted pari-mutuel auctions for three- and six-month options on the European Harmonized Index of Consumer Prices (Risk Magazine, March 2003). (See also Baron and Lange, 2003.)

While there are no precedents of IFIs linking repayments to measures of economic activity, the IFIs have—in exceptional cases—made loan disbursements explicitly conditional on economic activity. The IMF’s Stand-By Arrangement with Mexico in 1986 included a growth contingency such that, should GDP growth fall below a benchmark level, the authorities would be allowed to implement an additional public investment program, financed by additional loans from the World Bank and commercial banks. The growth contingency mechanism was activated in 1988 (Boughton, 2001, pp. 441–50). The use of adjustors—especially for changes in commodity prices—in IMF programs also plays a similar role.

The importance of such obstacles was assessed through a systematic survey of market participants conducted by IMF researchers in collaboration with the Emerging Markets Traders Association (EMTA) and the Emerging Markets Creditors Association (EMCA). Respondents identified liquidity and the potential for mismeasurement of GDP as the key obstacles in using growth-linked instruments. The survey and the results are described in further detail in the appendix.

Steps to Foster Acceptance

Overcoming many of the obstacles that might make it difficult for real indexation to emerge requires credibility, which is ultimately to be provided by the potential issuers. Nevertheless, a number of additional steps could be considered if these bonds are deemed useful:

  • Improving the quality and timeliness of the data. Ensuring that the macroeconomic indicators accurately reflect the state of the economy is crucial for countries to reap the full benefits of real indexation. This is especially important to ensure that indexation acts as an accurate “automatic stabilizer.”

  • Ensuring the integrity of the data. Investors’ main concern may be that errors or revisions could be used opportunistically in order to reduce debt payments. While the existence of substantial markets for CPI-indexed bonds in many countries suggests that data integrity issues are not insurmountable, it may be more difficult to accurately estimate real GDP than consumer prices. To overcome these problems, the importance of macroeconomic indicators could be reemphasized in the current drive toward increased transparency and improved data quality, which involves efforts such as the Reports on the Observance of Standards and Codes (ROSCs).15 Governments could likewise strive to guarantee the independence of statistical agencies. Alternatively, GDP-linked contracts could be based on indicators produced by independent sources not affiliated with the government, or the quality of the data could be assessed by independent reviewers.16

  • Drafting a sample indexation clause. As in the case of collective action clauses, a sample indexation clause could be designed for possible inclusion in bond contracts. To avoid uncertainty and scope for opportunistic tampering with the data, such a clause could provide a clear definition of the variables determining payments due. The definition could include the agency responsible for producing the data, the time of data release and coupon payment, and a statement that methodological changes would not be taken into consideration for the purposes of determining payments due. Alternatively, an outside party could vet that any methodological change stemmed from purely technical motives. A clear method for dealing with revisions could also be established. One possibility would be to state that data revisions would be ignored, and to establish that coupon payments for each given date would be based on GDP as estimated on a predetermined date.

  • Drawing on commitment to sound policies. Countries whose commitment to sound policies is underpinned by rules or formal agreements (e.g., the Stability and Growth Pact) might be especially good candidates for real indexation. In fact, not only would such countries be more likely to derive benefits from less procyclical fiscal policies but they would also find it easier to persuade markets that real indexation would not result in inappropriate policies.

  • Building on existing systems of peer monitoring of data. Countries that have already shown they can agree on common statistical standards to define and monitor GDP data for an important purpose (such as European countries involved in the Maastricht convergence process and the Stability and Growth Pact) might find it relatively easy to persuade markets of the reliability of their macroeconomic data.

  • Meeting demand by institutional investors. Opportunities to place nonstandard bonds are sometimes created by the investment objectives of institutional investors. For example, inflation-indexed bonds are often considered to be attractive to private pension funds. Some advanced economies’ public pension systems de facto tend to index pension benefits to GDP. Private pension plans, which may seek returns close to that benchmark, might therefore be interested in investing in GDP-indexed bonds issued by the government.

Real Indexation: Which Variables for Which Countries?

Which variables are more likely to make real indexation attractive to both borrowing countries and international investors? Individual country characteristics are most relevant in determining borrowers’ interest. Tailor-made contracts could be provided over the counter, especially to small countries, by global private financial institutions. However, some degree of standardization of contracts across countries would be key for the emergence of a dedicated class of traders and investors, and would be especially important for the creation of an active and liquid secondary market on an organized exchange.

In considering which variables or set of variables they could index to, individual countries would seek to identify the variables that would best help preserve debt sustainability while attracting interest on the part of international investors. In choosing among variables that are largely outside the control of the authorities, the main criterion is likely to be which contingency best adjusts the value of debt to the country’s repayment capacity. Insurance against natural disasters or changes in commodity prices may be desirable for a number of countries, including several small developing countries and those emerging market countries whose production structures rely on one or a few commodities. For larger and more diversified economies at a higher stage of economic development, indexing to trading-partner output growth is more likely to be relevant.

When considering variables that are partly within the control of the authorities, considerations related to the credibility of policies and measurement are likely to weigh more heavily. While the exercises above have considered the case of GDP indexation, the volume of exports is also a relevant measure of economic performance and external repayment capacity, and the debt-to-exports ratio is a closely watched indicator. Indeed, for many developing countries, data on exports might well be more reliable than data on GDP. At the same time, government policies may affect trade openness more directly than they affect GDP, and indexation to a country’s overall exports might reduce incentives to undertake policies promoting trade openness. Other alternatives include industrial production or electricity consumption, which in some countries are highly correlated with GDP and yet possibly harder to tamper with than GDP data. However, the extent to which these variables represent good proxies for overall economic activity varies widely across countries. All in all, GDP—the most comprehensive and generally accepted measure of a country’s income—would seem the most natural candidate if the bonds of many different countries were to be indexed to the same economic variable.

Note: The authors of this section are Eduardo Borensztein and Paolo Mauro.

1

Slow growth underlies many debt crises, including the Latin American debt crisis of the 1980s and the debt crisis of the highly indebted poor countries (HIPCs) in the 1980s and 1990s. The growth slowdown that began in Argentina in 1998 contributed to its recent debt crisis—though vulnerabilities had built up previously (IMF, 2003f). Several studies find that slow economic growth or high debt help predict debt crises (Detragiache and Spilimbergo, 2001; Easterly, 2001; Kraay and Nehru, 2003; and Manasse, Roubini, and Schimmelpfennig, 2003).

2

Gavin and Perotti (1997) find that during deep recessions the fiscal surplus typically increases in Latin American countries, whereas it falls in OECD countries. They also find that public spending is far more procyclical in Latin American countries than it is in OECD countries—a result confirmed by Talvi and Végh (2000) and the World Economic Outlook (September 2003, Chapter 3) for emerging markets and developing countries more generally.

3

Using a broad panel of countries, Easterly and others (1993) find that a favorable terms-of-trade shock of 1 percentage point per annum was associated with an increase in the annual growth rate of real GDP per capita by 0.42 percentage points in the 1970s and 0.85 percentage points in the 1980s. Studies based upon vector autoregressions find that, for the typical emerging market country, only a small share of output fluctuations can be attributed to terms-of-trade shocks (Hoffmaister and Roldós, 1997).

4

The data refer to 1999 and are drawn from UNCTAD (2001). Products are defined at the Standard Investment Trade Classification (SITC-3) level.

5

Panel regressions estimated by IMF staff, though not reported in this paper for the sake of brevity, yield smaller and less significant coefficients for both commodity-producing and other countries.

6

Shocks to commodity prices tend to be highly persistent, implying that schemes to stabilize commodity export earnings would be exceedingly costly (Cashin and others, 2000). Davis and others (2001) suggest that the record of stabilization funds for renewable resources is mixed.

7

What would the president of an oil company say—after a rise in oil prices—to the treasurer who had hedged against the price change in the futures market? See Hull (2002, p. 74).

8

Data are only available for the direct loss of capital in a sampled area affected by the disaster, and such estimates could be biased, particularly if they are made very soon after a disaster strikes. The overall effect on the economy is harder to gauge. The impact on income is likely greater in the immediate aftermath of the disaster, as demand by economic agents affected by the disaster declines and economic activity is disrupted more generally. Later on, however, growth may accelerate somewhat, as the economy rebuilds its capital stock and catches up toward its previous levels of activity.

9

Emergency loans are subject to the basic rate of charge and must be repaid within 3/4–5 years (without expectation of early repayment).

10

Trading-partner output growth is constructed as a weighted average of output growth for all trading partners for which data are available. For year t, the weights are computed as the share of exports to each country and are 11-year moving averages centered on year t.

11

Similarly, the relationship is statistically significant in 18 out of 23 advanced economies, but there are only 9 out of 28 emerging market countries and 9 out of 49 developing countries for which data are available for at least 20 years.

12

This is in line with studies that show large, unrealized gains from international risk sharing resulting from the relatively low correlation of income growth rates across countries, at a variety of horizons (Athanasoulis, Shiller, and van Wincoop, 1999).

13

The sample period is 1970–2001. The broad findings are unchanged, focusing on subperiods that might be viewed as characterized by greater financial and trade globalization or more frequent emerging market crises.

14

It is not clear whether episodes of cheating on the data would necessarily kill a market: stock markets, for example, have survived many scandals of this type. Misreporting is always a possibility that investors are aware of, and it is presumably reflected in asset prices.

15

On best practices with respect to data revisions, see Carson, Khawaja, and Morrison (2004).

16

Payments arising from inflation-indexed securities issued by Brazil’s federal government are based upon an inflation measure produced by the Getúlio Vargas Foundation.

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    Interest Savings over the Economic Cycle

    (Interest bill savings as percent of GDP, left scale; Coupon and GDP growth rates in percent, right scale)

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