Sovereign Debt Structure for Crisis Prevention (IMF OP 237)

1. Sovereign Debt Structure for Crisis Prevention (IMF OP 237) E. Borensztein, M. Chamon, O. Jeanne, P. Mauro, J. Zettelmeyer (IMF Research Department) • Existing debt structures are crisis-prone. Much crisis prevention can be done with existing instruments. • The case for growth-indexed bonds • Pricing growth-indexed bonds

2. Motivation: • Existing debt structures are crisis-prone, especially in emerging markets (short term, foreign currency). • Debt servicing more costly in recessions. Procyclical fiscal policies. • Crisis Prevention with Existing Debt Instruments: • A few countries have improved their debt structures within a few years • How? Credible inflation stabilization, institutional reforms committing to stable policies, lengthening debt structure first with inflation-indexed.

3. The Case for Growth-Indexed Bonds • An old idea • Advantages • Obstacles (theory, practice, survey) • Precedents (how past innovations emerged) • Resolve one obstacle: pricing

4. Benefits of Growth-Indexed Bonds For issuing countries: • Fewer defaults and collateral damage • Less pro-cyclical fiscal policy • Greater international risk sharing For investors: • New assets whose return has low correlation with GDP of investors’ country • Fewer defaults

5. Growth-Indexed Bonds—an example Consider a floating-rate bond with a coupon rate equal to: Coupon = r*+(g-g*) with a minimum of zero. Suppose that in 1990: • r*= 7 percent • g*= average real GDP growth rate over previous 20 years • 50 percent of government debt is growth-indexed Define Fiscal saving = reduction in annual interest payments resulting from indexation

6. Interest Savings over the Economic Cycle: Argentina

7. Table 2. Correlation between the Primary Balance and Real GDP Growth ________________________________________________________________ Emerging Markets Advanced Countries Without With Without With Indexation Indexation Indexation Indexation _________________________________________________________________ Mean 0.30 0.77 0.40 0.64 Median 0.37 0.80 0.45 0.74 __________________________________________________________________ Sources: OECD Analytical Database; and International Financial Statistics, Government Finance Statistics, and Country Reports, International Monetary Fund. Note: This analysis includes 25 emerging market countries and 20 advanced countries.

8. But is it going to be too expensive? How much of an insurance premium should countries pay over and above what they pay on standard bonds? Not much: cross-country GDP risk is largely diversifiable

9. Table 4 : Comovement of Individual Country Real GDP Growth with World Market Portfolio Real GDP Growth Real Stock Returns World United States World United States 2 2 2 2 R R R R coeff std. error coeff std. error coeff std. error coeff std. error Advanced Countries Median 0.266 1.011 0.307 0.076 0.289 0.183 0.159 0.138 0.060 0.042 0.086 0.062 Average 0.277 0.988 0.430 0.135 0.345 0.245 0.159 0.125 0.083 0.077 0.095 0.088 Average of Abs (1-coeff) 0.431 0.696 0.875 0.905 Emerging Markets Median 0.056 0.715 0.587 0.016 0.236 0.291 0.019 0.023 0.119 0.013 -0.048 0.108 Average 0.105 0.810 0.668 0.028 0.203 0.310 0.038 0.032 0.151 0.033 -0.055 0.137 Average of Abs (1-coeff) 0.783 0.797 0.968 1.055 Developing Economies Median 0.127 1.370 0.869 0.022 0.322 0.372 0.037 0.087 0.184 0.012 -0.020 0.120 Average 0.125 1.117 0.995 0.054 0.447 0.500 0.068 0.070 0.190 0.041 0.002 0.161 Average of Abs (1-coeff) 0.963 0.841 0.930 1.019 Notes : Regressions of individual country real GDP growth rates on world (or U.S.) real GDP growth or world (or U.S.) real stock returns (one-year lead). The data refer to 27 advanced countries, 39 emerging markets (S&P/IFC definition), and 26 relatively large developing countries. Sources : International Monetary Fund and Morgan Stanley Capital International.

10. Obstacles to Financial Innovation • Financial Innovation is always difficult: externalities and coordination problems; product uncertainty; need for critical mass; standards; community of professionals. • Innovation by corporates vs. sovereigns: scale; control over policies and statistics.

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

12. Challenges • Too risky? Already exposed to GDP. Less default risk. Diversifiable across countries. • Too complicated? Difficult to price? Growth is well-understood and followed. Inflation-indexed. Pricing model at the end. • Misreporting of GDP data? Political incentives. Could be audited • Moral Hazard? • Political resistance to pay insurance?

13. How Will It Happen? • Financial innovation in history evolves randomly, e.g. inflation-indexed bonds • Externalities and coordination problems, official intervention

14. Table 5. Introduction of Inflation Indexed Securities by Sovereigns Indexed Public Debt Outstanding in 1999 in Percent of Total Govt Average CPI Inflation Rate in 3 Years Prior to Introduction (in percent) Debt Period of Issue in million US$ 1972-1989 18.6 0 0.0 Argentina 1985-1988 8.4 --- --- Australia 1993- 3.8 27,860 29.5 1964- n.a. 45,291 19.6 Brazil 1991- 4.6 6,636 1.5 Canada 1956- 39.6 14,960 62.0 Chile 1967- 13.7 Colombia 4,949 13.2 1997- 9.3 150 1.7 Czech Republic 1945- n.a. 0.7 0.0 Finland 1998- 1.7 3,994 0.6 France 1997- 7.6 197 0.2 Greece 1995- 23.2 394 3.0 Hungary 1955- 4.3 Iceland 494 11.5 n.a. n.a. 166 0.2 India 1983- 18.6 260 1.1 Ireland 1955- 32.7 79,037 80.2 Israel 18.5 0 0.0 Italy 1983 1989- 110.7 2,528 8.4 Mexico 14.2 n.a. n.a. 1977-1984 New Zealand 1.4 361 2.3 1994- 1982- 9.8 30 0.1 Norway 1992-2000 292.2 Poland 0 0.0 8.2 --- --- Sweden 1952 1994- 5.4 15,475 12.5 Turkey 1994- 80.8 8,561 24.3 10.7 --- --- 1975- UK 1981- 13.2 55,288 12.0 UK 1997- 2.8 57,014 0.8 USA

15. How to Price Growth-Indexed Bonds • How do people price standard bonds? p(no default)*return on sovereign bond+ p(default)*recovery value = return on U.S. treasuries • Extract from there reasonable combinations of p(default) and recovery values • Estimate standard deviations and correlations of growth, primary balance, and real exchange rate, based on past data • Extract debt/GDP default trigger that yields the probability of default implicit in the spreads • Simulate 100,000 paths (MonteCarlo) and compute expected payoffs

16. Distribution of NPDV pay-offs (baseline where all debt is plain-vanilla)

18. Pricing: Key Messages • Growth-indexed bonds are not much more difficult to price than are plain vanilla bonds. • Externality from growth-indexed bonds to standard bonds: large issuance of growth-indexed bonds reduces the probability of default, thereby reducing the required coupon on standard bonds as well.

19. Additional Slides Survey of Investor Attitudes

20. Background and Assumptions Assume an emerging market sovereign borrower that has successfully tapped international financial markets for a number of years, currently not experiencing major problems, but whose bonds trade at substantial spreads above US Treasuries. This country will be called EmergingLand (“EL”). EL has experienced real gross domestic product (GDP) growth of 3 percent on average over the past 15 years, with a maximum of 7 percent, and a minimum of negative 8 percent. Most analysts expect average growth and volatility of GDP to be similar in the next decade. We will ask you to price a new financial instrument--and variations on it--to be issued by this country. Assume that ten-year eurobonds (U.S. dollar-denominated) issued by EL with a coupon of 7 percent currently trade at a spread of 400 basis points above U.S. Treasuries. We’ll call these bonds the “Plain Vanilla Bonds” (“PV Bonds”). EL is contemplating issuance of a growth-indexed bond (“Growth Bond”) with a ten-year maturity and with a coupon of 7 percent plus the difference between real GDP growth during that year and 3 percent. However, coupon payments can never be negative: Coupon = 7 percent + (real GDP growth – 3 percent), with a minimum of zero

21. At what spreads would you be willing to purchase the Growth Bonds? • A) Spreads more than 50 basis points lower than PV Bonds • B) Spreads 10-50 basis points lower than PV Bonds • C) Same spreads as PV Bonds • D) Spreads 10-50 basis points higher than PV Bonds • E) Spreads 50-100 basis points higher than PV Bonds • F) Spreads 100-200 basis points higher than PV Bonds • G) Spreads 200-300 basis points higher than PV Bonds • H) Spreads more than 300 basis points higher than PV Bonds • I) Unwilling to purchase regardless of the spreads

22. 2. Consider this variation. The yearly coupon now has a minimum of 3.5 percent, and an extra payoff in years of positive growth. The formula is the following: Coupon = 3.5 percent + real GDP growth, with a minimum of 3.5 percent Assume that, given expectations of the growth rate of GDP in EL, the average expected payoff of this bond is the same as for the bonds described in question 1.

23. At what spreads would you be willing to purchase this alternative Growth Bond? • A) Spreads more than 50 basis points lower than PV Bonds • B) Spreads 10-50 basis points lower than PV Bonds • C) Same spreads as PV Bonds • D) Spreads 10-50 basis points higher than PV Bonds • E) Spreads 50-100 basis points higher than PV Bonds • F) Spreads 100-200 basis points higher than PV Bonds • G) Spreads 200-300 basis points higher than PV Bonds • H) Spreads more than 300 basis points higher than PV Bonds • I) Unwilling to purchase regardless of the spreads

25. 4. Please tell us which of the following factors make you reluctant to hold Growth Bonds regardless of their specific design. (1 is very important, 4 is not important). What other factors make you reluctant to hold growth bonds

26. Commodity-Indexed Bonds 5.Assume that EL’s economy is heavily dependent on exports of a single commodity, and it decides to issue commodity-indexed bonds, that is, bonds whose return is indexed to the price of the commodity. Please indicate which factors would make you reluctant to invest in commodity-indexed bonds (1 is very important, 4 is not important). What other factors are important to you?

27. Domestic Currency Bonds. 6.EL is now considering issuing a domestic-currency denominated bond. Please indicate which factors would make you reluctant to invest in bonds denominated in EL’s currency (1 is very important, 4 is not important).

28. Additional Slides miscellaneous

29. Interest Savings over the Economic Cycle: Mexico

30. 6.00 4.00 Real GDP Growth 2.00 Rate 0.00 -2.00 3 percent limit -4.00 -6.00 Total Balance/GDP -8.00 1979 1984 1989 1994 1999 2002 2.50 1.50 Primary Balance/GDP under SGP 0.50 -0.50 -1.50 Primary Balance/GDP under SGP with Indexed Debt -2.50 Primary Balance/GDP -3.50 2002 1979 1984 1989 1994 1999 Figure 2. France: Primary Balance with and without Indexed Debt, 1979-2002