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Growth-indexed Bonds

Growth-indexed Bonds. Advantages Help avoid defaults and collateral damage Avoid pro-cyclical fiscal policy Promote international risk sharing Eduardo Borensztein IMF, January 2004. Precedents (Ideas).

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Growth-indexed Bonds

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  1. Growth-indexed Bonds Advantages • Help avoid defaults and collateral damage • Avoid pro-cyclical fiscal policy • Promote international risk sharing Eduardo Borensztein IMF, January 2004

  2. Precedents (Ideas) • 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.

  3. Growth-indexed Bond—An Example Consider a floating-rate bond with a coupon rate equal to: with a minimum of zero. Suppose that in 1990, for Mexico and Argentina: • r*= 7 percent • g*= average growth rate of previous 20 years • 50 percent of government debt is growth-indexed

  4. Mexico

  5. Argentina

  6. Issues/Nonissues • Too risky? • Already exposed to GDP. Less default risk • Too complicated? • Growth is well-understood and followed • Misreporting of GDP data • Incentives not strong. Could be audited and penalties set for delays or revisions

  7. Issues/Nonissues (cont.) • Fixed income investors do not want an equity-like instrument • Specification could include a minimum assured coupon • Moral hazard • Political resistance to pay insurance in good times

  8. Two Specifications of Growth-Indexed Bonds

  9. Precedents • Brady Bonds Value Recovery Rights (VRRs) • GDP VRRs (Costa Rica, Bulgaria, Bosnia) • Ciudad de Buenos Aires • Options on US economic statistics (Longitude-DB-GS) • Inflation-indexed bonds

  10. Which Instrument? • Different risks, different contingencies. Is there room for several different liquid markets for the same country? • Commodity-linked • Good proxy for growth and tax revenues? • Not under control of the sovereign • Already some market base exists, but only at short maturities • Domestic Currency Debt • Correlated with growth—also provides same type of insurance. Could correlation change if debt is denominated in domestic currency? • Growth-indexed domestic-currency debt • Risks of capital controls, exchange rate manipulation

  11. How Will It Happen? • Financial innovation is somewhat random, eg, Banks vs Bonds in sovereign finance, inflation-indexed bonds • Externalities and coordination problems. Official intervention • Debt Restructuring: time for innovation? • First mover problem? Groucho Marx problem?

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