Front Matter Page

IMF DEPARTMENTAL PAPER

Front Matter Page

Cataloging-in-Publication Data

Joint Bank-Fund Library

Names: Kim, Jun (Jun Il) | Ostry, Jonathan David, 1962- | International Monetary Fund.

Title: Boosting fiscal space : The roles of GDP-linked debt and longer maturities / Jun I. Kim and Jonathan D. Ostry.

Other titles: The roles of GDP-linked debt and longer maturities. | IMF departmental paper.

Description: [Washington, DC] : International Monetary Fund, 2017. | Includes bibliographical references.

Identifiers: ISBN 9781484330937 (paper)

Subjects: LCSH: Fiscal policy. | Debts, Public. | Debt Maturity.

Classification: LCC HJ192.5.K548 2017

Contents

• Executive Summary

• 1. Introduction

• 2. Some Relevant Literature

• 3. Expanding Fiscal Space with GDP-Linked Debt

  • Theory

  • Simulations

• 4. Expanding Fiscal Space with Long-maturity Debt

  • Theory

  • Simulations

• 5. Sensitivity to Underlying Assumptions

  • Investor Risk Neutrality

  • Interactions among Multiple Shocks

  • Debt Composition and Marginal Gains in Fiscal Space

• 6. Conclusion

• Appendix

• References

• Boxes

  • 1. Calibrating Growth Uncertainty

• Figures

  • 1. Debt Limit under Uncertainty: Nominal and GDP-linked Bonds

  • B1. Probability Distribution of the Growth Rate: 1980–2020

  • 2. Debt Limit under Uncertainty: One-period and Long-duration Bonds

• Tables

  • 1. Debt Limits: Nominal and GDP-linked Bonds

  • 2. Debt Limits: Long-duration Nominal Bonds and GDP-linked Bond

  • 3. Maximum Risk Premiums and Sharpe Ratios: GDP-linked Bond

  • 4. Effects of Cyclical Fiscal Policy on Fiscal Space

  • 5. Marginal Gains in Fiscal Space and the Share of GLBs

Executive Summary

Fears about secular stagnation have given greater prominence to the use of fiscal tools to support economic growth, especially given the diminishing returns from monetary easing. But the aftermath of the global financial crisis has left many advanced economies with very high sovereign debt ratios, and, likewise, some emerging markets with worrisomely high debt. This has led to caution in using the fiscal instrument even to address well-recognized infrastructural bottlenecks, despite the opportunity afforded by record low interest rates. Against this backdrop, this paper asks whether there are ways to expand fiscal space that do not involve either paying down the debt today or promising to do so in the future (which markets might take cum grano salis). Put differently, are there ways to make fiscal consolidation, if needed, more growth friendly?

We argue that debt management policies may provide an answer, that is a way to expand fiscal space for a given path of primary fiscal balances. Such policies would operate by reducing the risk that a sovereign may default in bad states and, as such, would generate a payoff in terms of reduced real borrowing costs (a tangible benefit for all segments of the IMF’s membership—advanced, emerging, and developing). We explore two debt management policies: issuance of GDP-linked debt and issuance of longer-maturity bonds, as opposed to short-term debt. Such policies, it turns out, can have a powerful effect on fiscal space (defined in this paper as the distance between the current public debt ratio and the debt limit where the sovereign is shut out of the debt market).

The mechanism in play arises because sovereign debt/GDP ratios are buffeted by random shocks to GDP. An assessment of sovereign creditworthiness takes a hit in bad states (recessions) because the probability that the government will be unable to service its debt rises in such states. GDP-linked debt contracts can reduce the variability in debt ratios by aligning debt service to the sovereign’s ability to pay and reducing the risk of default, allowing debt contracts to be struck at a lower average interest rate, and boosting fiscal space.

Longer maturities also exert a favorable effect on fiscal space. The reason is that the pricing of longer-maturity debt confers a risk-sharing benefit to the issuer, much as equity does, reducing the default premium. Along with other features of longer duration, a lengthening of maturities will act to reduce default risk, lower average borrowing costs, and enhance fiscal space.

Our simulation results suggest that, by managing debt along these two dimensions, gains in fiscal space on the order of 5–40 percent of GDP are plausible taking account of a reasonable allowance for investor risk aversion (and 10–60 percent under the assumption of investor risk neutrality), depending on the extent of growth uncertainty and the cyclicality of fiscal policy. Results also suggest that the scope for gain to the issuer is larger when GDP-linked bonds account for only a negligible share of debt as at present, and that mutual gains for issuers and investors alike should be feasible unless the latter are exceptionally risk-averse or constrained in risk diversification opportunities.