Growth-indexed Bonds Advantages Help avoid defaults and collateral damage Help avoid defaults and collateral damage Avoid pro-cyclical fiscal policy Avoid pro-cyclical fiscal policy Promote international risk sharing Promote international risk sharing Eduardo Borensztein IMF, 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 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. Suppose that in 1990, for Mexico and Argentina: r* = 7 percent r* = 7 percent g* = average growth rate of previous 20 years g* = average growth rate of previous 20 years 50 percent of government debt is growth-indexed 50 percent of government debt is growth-indexed

Mexico

Argentina

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

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

Two Specifications of Growth- Indexed Bonds

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

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

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