Greece wants to index bond payments to economic growth. Not a bad idea
THE tie-less leaders of the new Greek government are short of neckwear but not of off-beat policy ideas. Their talk of reversing some hard-fought budget cuts, most notably by rehiring hordes of sacked bureaucrats, put markets in a panic. But the “smart debt engineering” mooted by Yanis Varoufakis, Greece’s new finance minister, shows more promise. At the heart of his proposal is a plan to swap lots of existing Greek debt for “GDP-linked bonds”–an old idea whose time may at last have come.
Since the 1980s globalization has sent periodic surges of capital from the rich world to sovereign borrowers in the developing world. Many were ill-equipped to cope. Borrowing binges often ended in crises, prompting economists to think about ways to make swimming in the torrent of global capital less dangerous.
Indebted economies are more likely to get into trouble when the economic outlook changes. During booms borrowing often seems attractive to leaders, who reckon that rising incomes will make servicing the debt a doddle. Commodity exporters make similar calculations when the prices of oil, metals and the like go up. But good times inevitably end, dashing the borrowers’ assumptions and making their debts more difficult to bear.
The solution, as many economists have suggested over the years, is to link the interest on government debt to an economic variable such as net exports or GDP growth. A country with an average growth rate of 3% might sell bonds which pay 9% interest when GDP grows by 5% per year, for instance, and 1% interest when GDP grows by 1% per year. This approach would leave governments with smaller payments to creditors during rough economic periods and bigger bills in times of plenty. That, in turn, could help prevent government from resorting to “pro-cyclical” fiscal policy, whereby they exacerbate both busts, by slashing spending, and booms, by bingeing.
Linking bond payments to GDP should also make a country’s debt-to-GDP ratio less prone to sudden jumps, and thus lower the odds of a debt crisis. The total amount paid out over the life of a GDP-linked bond would vary according to the growth rates enjoyed during that period. A long boom would mean bigger payments to creditors. That would leave the government in question with less revenue to redeem debt, and thus a higher debt-to-GDP ratio than it would otherwise have had. But in a slump, a government that had issued lots of GDP-linked bonds would pay far less interest, and would not have to issue so much new debt to cover its costs. That might save it from a vicious cycle in which interest payments and total borrowing chase one another ever higher.
In a working paper published last year, the Bank of England argued that such automatic moderation would be especially valuable not only to poorer countries, but also to members of currency unions.* In such places, the authors reckon, debt of more than 90% of GDP leads to a loss of confidence in a government’s ability to repay, and thus higher borrowing costs and a downward debt spiral. GDP-linked bonds, in contrast, give governments much more fiscal space: markets might not panic until debt ratios approach 150-200% of GDP, the authors suspect.
Despite these potential advantages, GDP-linked bonds are rare. Mexico has issued debt with payments linked to oil prices, but such instruments have mainly been used in restructurings. In 2002 Argentina issued GDP-linked warrants to investors who had held Argentine debt before its default the previous year. There was no principal associated with the warrants; instead, the government made dividend-like payments which varied with the performance of Argentina’s economy. Greece itself issued GDP warrants in 2012, as part of the package offered to participants in its first debt restructuring.
Why aren’t GDP-linked bonds more common? One reason may be the additional risk creditors are asked to assume. With conventional bonds, it is the issuer who pays the price if an economy fails to grow as expected. GDP-linked bonds transfer that risk to the lender, who would naturally demand higher interest in return. The average interest rate over the life of a GDP-linked bond should therefore be higher than on a conventional bond.
However, some research suggests that the premium investors would demand might not be so big. Different countries grow at different rates and on different cycles, so the risk of disappointing growth should be easy to minimize through diversification.
Another potential headache–that the issuing governments might diddle their growth numbers to minimize their payments–is harder to get round. There is much skepticism about Argentina’s economic data, for example. Fears of statistical funny business would presumably also add to the premium investors would demand.
The trouble then becomes persuading governments to accept higher borrowing costs during good times, when conventional debt is often available on good terms. Any regime willing to accept the short-term pain this would entail for uncertain long-term gains is prudent almost by definition, and therefore less likely to need the insurance GDP-linked bonds provide.
Yet even if they do not take the world by storm, GDP-linked bonds could find a home within the euro area. A transnational agency, Eurostat, oversees European economic statistics (although that did not prevent Greece from fudging its budget numbers before the euro crisis). Given the constraints of a shared monetary policy and restrictions on budget deficits, euro-area governments have less wriggle-room than their counterparts elsewhere. Flexible debt instruments could help.
“Linked in; Free exchange.” The Economist 7 Feb. 2015: 72(US). Business Insights: Essentials. Web. 30 Aug. 2021.
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