Abstract

As argued in Section II, several obstacles to financial innovation involve the need to coordinate the actions of many economic agents. This suggests that financial innovation may be expected to take place in discrete steps, rather than gradually, which at times are hard to predict. Indeed, financial innovation in practice turns out to look like a rather haphazard process. New financial instruments do not seem to be adopted as the end-product of a systematic search, or a gradual evolution leading to superior forms of finance. Instead, innovation seems to result from historical accident, a constellation of special circumstances, or strong intervention on the part of policymakers.1

As argued in Section II, several obstacles to financial innovation involve the need to coordinate the actions of many economic agents. This suggests that financial innovation may be expected to take place in discrete steps, rather than gradually, which at times are hard to predict. Indeed, financial innovation in practice turns out to look like a rather haphazard process. New financial instruments do not seem to be adopted as the end-product of a systematic search, or a gradual evolution leading to superior forms of finance. Instead, innovation seems to result from historical accident, a constellation of special circumstances, or strong intervention on the part of policymakers.1

Financial Innovation in Sovereign Borrowing: A Haphazard Process

While the bulk of sovereign borrowing has historically taken the form of plain vanilla debt, sovereign borrowers have displayed considerable creativity over the years. In 1782, the State of Virginia issued bonds linked to the price of land and slaves. In 1863, the Confederate States of America issued “cotton” bonds payable in pounds sterling or French francs but convertible into cotton at a predetermined price. This was an excellent hedge: if cotton prices went up, higher value would be transferred from the borrower to the lender—as investors requested payment in the form of cotton—just as revenues rose for the Confederate States, a major cotton producer (Barone and Masera, 1997). In the pre–World War I era of bond finance, it was common for the emerging market countries of the day to issue bonds simultaneously in more than one major exchange, with coupons payable in any one of a few currencies, at the discretion of the investor. For example, in 1913 China issued a bond with coupons payable in sterling, rubles, marks, francs, or yen (Flandreau and Sussman, 2002). “Gold clauses,” effectively indexing payments to the price of gold, were widespread in the United States in the nineteenth century through 1933 (Kroszner, 1999).

Despite such creativity, innovations in sovereign borrowing have been limited, and regularities in their timing and form are hard to discern on the basis of macroeconomic fundamentals. Leadership and intervention on the part of the official sector often underlie the timing and nature of financial innovation. This point may be illustrated by referring to three historical experiences: first, the history of the introduction of inflation-indexed bonds in a variety of countries; second, the episode of syndicated bank loans in the 1970s; and third, the recent introduction of collective action clauses.

  • Inflation-indexed bonds. The case for inflation-indexed bonds has been made at various stages during the past couple of centuries by many of the leading economists of their day (Barone and Masera, 1997). Yet, countries’ experiences differ widely on the timing and circumstances under which they introduced inflation-indexed bonds (Table 8). A few sovereigns began issuing inflation-indexed bonds several decades ago; others have done so more recently; the vast majority have never issued indexed bonds at all. There does not appear to be much association between country characteristics and the introduction of inflation-indexed bonds. Countries that have issued indexed debt are at various stages of development, including both advanced economies and emerging market countries. (Developing countries with relatively limited statistical capacity have not issued such bonds.) While some countries, such as Brazil, Israel, and the United Kingdom, began issuing inflation-indexed bonds during periods of high inflation, others have experienced high inflation without resorting to these bonds, and several, such as Canada, Sweden, and the United States, began issuing indexed bonds during periods of low inflation. Moreover, for inflation-prone countries, indexed bonds are not necessarily issued in the proximity of inflation peaks. Similarly, while some countries introduced inflation-indexed bonds around the time they promoted the use of private pension plans, there is no simple relationship with pension system or reform.

  • Syndicated bank loans. One reading of history is that the largest innovation in how emerging markets countries have financed themselves during the past two centuries—namely, the temporary switch to syndicated bank loans in the 1970s—largely owed to official encouragement and implicit guarantees. Indeed, bond issues, now the predominant form of financing for emerging markets, have historically been the norm: financial flows to emerging markets took this form almost exclusively during the first golden era of global financial integration, until World War I brought such flows to an end (Bordo, Eichengreen, and Kim, 1998; Mauro, Sussman, and Yafeh, 2002). When international capital started flowing again toward emerging markets, in the aftermath of the first oil price shock, it did so in the form of syndicated bank loans. Why did savings by residents of oil-rich countries ultimately make their way to oil-importing emerging markets through banks in advanced economies rather than directly through bonds? Official encouragement and implicit guarantees of bank lending by the advanced economies led oil-rich country residents to place their savings primarily in a handful of the largest and most prestigious banks in the advanced economies. In turn, these banks found it profitable to on-lend such funds to emerging markets—at least until the debt crisis struck in the early 1980s. The return to bonds in the 1990s through the Brady deals of course also involved considerable intervention and subsidies on the part of the official sector.

  • Collective action clauses. Finally, collective action clauses (CACs) had failed to emerge in New York law contracts until recently, even though the case for their introduction had been made for a number of years as part of the debate on reforming the international financial architecture. Once the international community mustered sufficient consensus about the desirability of CACs, they were adopted in sovereign bonds issued by several countries within a few months.2 This is one example of how innovation may take place in the context of international coordination.

Table 8.

Introduction of Inflation-Indexed Securities by Sovereigns

article image
Sources: Campbell and Shiller (1996); Kopcke and Kimball (1999); Price (1997); Deacon and Derry (1998); official websites of country authorities; and IMF staff estimates.

January 2003.

February 2003.

Only one issue of inflation-indexed bonds.

One issue in September 2003, indexed to euro area inflation measured by Eurostat.

One issue in March 2004.

From March 2004.

From April 2000.

Index-linked national savings certificates.

Road Maps for Future Innovation

Financial innovation in sovereign markets seems to be a somewhat haphazard process, and many beneficial financial innovations require intervention to be successful. Some of the instruments described in this paper seem to have desirable properties, and with some improvement in statistical resources and credibility of data and policies, they might attract investors’ interest.

While the process of financial innovation always faces significant hurdles, externalities would seem especially strong in the case of real indexation to variables that are partly within the control of the authorities. It would thus be difficult to develop a market for indexed bonds of this type through a gradual approach. A small initial issue would not be very attractive because it would do little to reduce the likelihood of a debt crisis. The holders of contingent debt would be implicitly subsidizing the holders of noncontingent debt. Two factors would substantially increase the chances of success: large scale would help both to reduce the probability of default significantly and to ensure sufficient liquidity on secondary markets; international coordination would help both to create a dedicated class of investors and to provide opportunities for risk diversification.

Two scenarios seem plausible for new types of bonds to be issued successfully:

  • A large-scale launch by one country swapping a substantial proportion of the existing debt, possibly in the context of a debt restructuring. Indeed, historically, restructurings have provided opportunities for innovation: for example, value recovery rights (VRRs) were incorporated into Brady bond deals as investors looked for an upside opportunity to recoup previous losses. Other countries might follow, perhaps with large one-off swaps, not necessarily in the context of debt servicing difficulties.

  • A launch of new bonds of the same type by several countries with some degree of—possibly informal—coordination. The recent introduction of collective action clauses by several issuers seems to constitute a precedent in this respect.

Note: The author of this section and the next is Paolo Mauro.

1

Borensztein and Mauro (2004) provide greater detail and further evidence on the issues addressed in this section.

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