The case for GDP-indexed bonds

Abstract

GDS-indexed bonds This paper seeks to revive the case for countries to insure against economic growth slowdowns by issuing bonds indexed to the rate of growth of GDP. We show that GDP‐indexed bonds could provide substantial benefits in reducing the likelihood of default crises and allowing countries to avoid pro‐cyclical fiscal policies. We simulate the effects of GDP‐indexed bonds under different assumptions about fiscal policy reaction functions and their output effects and find that they could substantially reduce the likelihood of debt/GDP paths becoming explosive. The insurance premium would likely be small, because cross‐country comovement of GDP growth rates is low and cross‐country GDP growth risk is thus largely diversifiable for an investor holding a portfolio of GDP‐indexed bonds. Potential obstacles to the emergence of a market for these bonds include the verifiability of GDP data, the trade‐off between insurance and moral hazard, and the need for liquidity. Theory and past experience suggest that financial innovation often requires official intervention and its timing and form are difficult to predict. We discuss institutional fixes and suggest an approach for attempting to start up a market. — Eduardo Borensztein and Paolo Mauro