The case for GDP bonds

August 3, 2009

Around the world, governments are struggling to drum up buyers for the mountain of bonds they need to sell. And that’s especially true for big deficit, low savings countries like Britain and the United States.

The returns they are offering on conventional government bonds are low and there’s the risk of inflation eating away at their value. Perhaps it is time for a different approach.

Rather than hiring investment banks to bamboozle the public into subscribing for unwanted conventional bonds, or cramming them down the throats of the banks as part of expanded reserve requirements, governments should consider issuing bonds linked to gross domestic product.

GDP bonds are not a new idea but few governments have issued them. Those that have don’t make for a distinguished roll call, including as they do Bosnia Herzegovina, Bulgaria and Argentina, which swapped conventional bondholders into GDP bonds after its currency collapse in 2001.

Instead of paying a fixed return, or one purely adjusted for inflation, the interest payments on these bonds are linked to a country’s nominal GDP. Imagine a country that normally grew its GDP at 5 percent a year. To the extent it grew at 6 percent, the coupon would be reset upwards by one percentage point. If it undershot by one percentage point, the interest rate would be similarly reduced.

Most investors have three objectives: long-term growth; inflation protection and low price volatility. Conventional bonds offer a fixed return but no inflation protection. Equities offer growth and the possibility of a higher return but at the cost of volatility. Index-linked bonds offer inflation protection but no growth. GDP bonds meet all three requirements.

Moreover, they are an ideal investment for those saving for retirement. The objective of a pension fund (whether or not the benefits it offers are defined) is to meet liabilities that grow in line with predicted growth in earnings. Since GDP is by definition equivalent to gross domestic income, GDP is a good proxy for this liability.

For the issuer, GDP bonds also have appeal. As Willem Buiter has recently observed, they would give government debt some of the characteristics of an equity security. Their servicing costs would rise and fall in line with the state’s own ability to pay. This, Buiter observes, “would reduce the expansion of the public debt through the intrinsic debt dynamics that comes out of the product of the interest rate and the outstanding stock of debt.”

Of course there are problems. The biggest is that GDP figures can be gerrymandered and are subject to retrospective revision. There are no easy answers. There would need to be agreement on the methodology for, and timing of, any revisions. Put and call mechanisms could be inserted to protect against substantial changes.

GDP bonds might check stock market bubbles. Their existence, former fund manager turned economist Paul Woolley has argued, should act as a reality check for equity investors and offer a substitute asset,¬†should equity valuations get wildly out of whack. Another argument in their favour is that they are almost ideal buy and hold investments and as such should require very little active management — keeping management costs to a minimum.

This may be why few investment bankers, however many governments employ to sell their debt, would advocate issuing GDP bonds. That must be an argument in their favour.


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