Growth-indexed BondsGrowth-indexed Bonds

AdvantagesAdvantages

• Help avoid defaults and collateral damageHelp avoid defaults and collateral damage

• Avoid pro-cyclical fiscal policyAvoid pro-cyclical fiscal policy

• Promote international risk sharingPromote international risk sharing

Eduardo BorenszteinEduardo BorenszteinIMF, January 2004IMF, January 2004

• Debt crisis of 1980s: Krugman (1988), Froot, Scharfstein and Stein (1989). Index to exogenous indicator (export prices) to maximize investment

• Shiller (1992) securities. Perpetual GDP-indexed claims for international risk diversification

• More recently: Caballero (2001,2003): debt indexed to indicators correlated to business cycle (“copper bonds” for Chilean public and private debt). Hausmann’s original sin.

Precedents (Ideas)

Growth-indexed Bond—An ExampleGrowth-indexed Bond—An Example

Consider a floating-rate bond with a coupon rate equal to:Consider a floating-rate bond with a coupon rate equal to:

with a minimum of zero. with a minimum of zero.

Suppose that in 1990, for Mexico and Argentina:Suppose that in 1990, for Mexico and Argentina:• r*r* = 7 percent= 7 percent• g*g* = average growth rate of previous 20 years= average growth rate of previous 20 years• 50 percent of government debt is growth-indexed50 percent of government debt is growth-indexed

* *t tCoupon r g g

MexicoMexico

0

2

4

6

8

10

1991 1993 1995 1997 1999 2001

Coupon Rates Average: 5.9%

-1

-0.5

0

0.5

1

1.5

2

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

FIscal Savings as % of GDPAverage: 0.2

ArgentinaArgentina

0

5

10

15

20

1991 1993 1995 1997 1999 2001

Coupon RatesAverage: 8.8%

-2

-1

0

1

2

3

4

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Fiscal Savings as % of GDPAverage: 0.4

Issues/NonissuesIssues/Nonissues

• Too risky? Too risky? • Already exposed to GDP. Less default riskAlready exposed to GDP. Less default risk

• Too complicated?Too complicated?• Growth is well-understood and followedGrowth is well-understood and followed

• Misreporting of GDP dataMisreporting of GDP data• Incentives not strong. Could be audited and Incentives not strong. Could be audited and

penalties set for delays or revisionspenalties set for delays or revisions

Argentina. Growth and EMBI Spread, 1993-2002

-15.0 -10.0 -5.0 0.0 5.0 10.0

GDP Growth

Inv

ers

e o

f S

pre

ad

2002

2001

1995

1999

2000

19971993

1994

1996

1998

Issues/Nonissues (cont.)Issues/Nonissues (cont.)

• Fixed income investors do not want an Fixed income investors do not want an equity-like instrumentequity-like instrument• Specification could include a minimum Specification could include a minimum

assured couponassured coupon

• Moral hazardMoral hazard• Political resistance to pay insurance in Political resistance to pay insurance in

good timesgood times

Two Specifications of Growth-Indexed Bonds

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

-7.0 -6.0 -5.0 -4.0 -3.0 -2.0 -1.0 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0 11.0 12.0 13.0

Growth Rate

Cou

pon

"Symmetric" bond(c*=7%, g*=3%)

"Growth upside" bond(c*=5%, g*=2%)

PrecedentsPrecedents

• Brady Bonds Value Recovery Rights Brady Bonds Value Recovery Rights (VRRs)(VRRs)

• GDP VRRs (Costa Rica, Bulgaria, Bosnia)GDP VRRs (Costa Rica, Bulgaria, Bosnia)• Ciudad de Buenos AiresCiudad de Buenos Aires• Options on US economic statistics Options on US economic statistics

(Longitude-DB-GS)(Longitude-DB-GS)• Inflation-indexed bondsInflation-indexed bonds

Which Instrument?Which Instrument?

• Different risks, different contingencies. Is there room for Different risks, different contingencies. Is there room for several different liquid markets for the same country?several different liquid markets for the same country?

• Commodity-linkedCommodity-linked• Good proxy for growth and tax revenues?Good proxy for growth and tax revenues?• Not under control of the sovereignNot under control of the sovereign• Already some market base exists, but only at short maturitiesAlready some market base exists, but only at short maturities

• Domestic Currency DebtDomestic Currency Debt• Correlated with growth—also provides same type of insurance. Correlated with growth—also provides same type of insurance.

Could correlation change if debt is denominated in domestic Could correlation change if debt is denominated in domestic currency?currency?

• Growth-indexed domestic-currency debtGrowth-indexed domestic-currency debt• Risks of capital controls, exchange rate manipulationRisks of capital controls, exchange rate manipulation

How Will It Happen?How Will It Happen?

• Financial innovation is somewhat random, Financial innovation is somewhat random, eg, Banks vs Bonds in sovereign finance, eg, Banks vs Bonds in sovereign finance, inflation-indexed bondsinflation-indexed bonds

• Externalities and coordination problems. Externalities and coordination problems. Official interventionOfficial intervention

• Debt Restructuring: time for innovation?Debt Restructuring: time for innovation?• First mover problem? Groucho Marx First mover problem? Groucho Marx

problem?problem?

Period of Issue in million US$in Percent of Total Govt

Debt

1985-1988 8.4 --- ---1993- 3.8 27,860 29.5

Canada 1991- 4.6 6,636 1.5Finland 1945- n.a. 0.7 0.0France 1998- 1.7 3,994 0.6Greece 1997- 7.6 197 0.2

Iceland 1955- 4.3 494 2/ 11.5 2/

Ireland 1983- 18.6 260 1.1

Italy 1983 3/ 18.5 0 0.0

1977-1984 14.2 n.a. n.a.1994- 1.4 361 2.3

Norway 1982- 9.8 30 0.1

1975- 5/ 10.7 --- ---

1981- 13.2 55,288 12.0USA 1997- 2.8 57,014 0.8

1/ January 2003.2/ February 2003.3/ Only one issue of inflation-indexed bonds.4/ From April 20005/ Index-linked national savings certificates.

New Zealand

Sources: Campbell and Shiller (1996), Kopcke and Kimball (1999), Price (1997); Deacon, M. and A. Derry (1998), official web sites of country authorities, and IMF desks.

UK

Introduction of Inflation Indexed Securities by Sovereigns

Average CPI Inflation Rate in Three Years Prior to Introduction

(in percent)

Indexed Public Debt Outstanding in 1999

Australia

Period of Issue in million US$in Percent of Total Govt

Debt

Argentina 1972-1989 18.6 0 0.0Brazil 1964- n.a. 45,291 19.6Chile 1956- 39.6 14,960 62.0

Colombia 1967- 13.7 4,949 1/ 13.2 1/

Czech Republic 1997- 9.3 150 1.7Hungary 1995- 23.2 394 3.0India n.a. n.a. 166 0.2Israel 1955- 32.7 79,037 80.2Mexico 1989- 110.7 2,528 8.4

Poland 1992-2000 292.2 0 4/ 0.0 4/

Turkey 1994- 80.8 8,561 24.3

1/ January 2003.2/ February 2003.3/ Only one issue of inflation-indexed bonds.4/ From April 20005/ Index-linked national savings certificates.

Sources: Campbell and Shiller (1996), Kopcke and Kimball (1999), Price (1997); Deacon, M. and A. Derry (1998), official web sites of country authorities, and IMF desks.

Introduction of Inflation Indexed Securities by Sovereigns

Average CPI Inflation Rate in Three Years Prior to Introduction

(in percent)

Indexed Public Debt Outstanding in 1999