Time for GDP-linked bonds to shine?
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Time for GDP-linked bonds to shine?

A Bank of England paper has mooted the idea of GDP-linked bonds as a means of reining in governments’ ballooning debt to GDP ratios.

With global economic growth anaemic, and with debt to GDP ratios at their highest level since the Second World War, a means of keeping burgeoning debt in check does seem attractive.

The counter-cyclical nature of the bonds is supposed to deter governments from overspending during periods of growth and from making excessively savage cuts when times get tougher.

However, this logic only works if the borrowing cost is higher than conventional bonds, because if the cost is lower (which some argue it should be given that it should reduce the risk of default), the product will do nothing to curb borrowing. It also relies on governments that wish to spend heavily being at all concerned about the long-run cost of their debt

And, if the borrowing cost is higher than for conventional bonds, surely sovereigns will simply not make use of them, unless of course, they feel a recession is on the way, in which case, investors will demand a premium, which will erode the usefulness of the product.

The potential knock-on effect of such a metric on consumer confidence is left to the reader’s imagination.

Of course, for more beleaguered sovereigns with existing debt problems, GDP-linked bonds do have a place. 

Greece mulled making use of GDP-linked warrants to delay coupon payments until its economy was growing and, perhaps if it had used them in the years before 2008, it might have been better able to manage its debt burden.

Still, there are hundreds of thorny issues lying in wait for whichever debt management office feels brave enough to introduce such a product. For instance, the reliability of the metrics used is, regrettably, far from guaranteed. In 2007, Argentina’s GDP-linked products enraged investors with low returns justified by fudged government statistics.

As the Bank of England’s paper concedes, while GDP-linked bonds could provide a route for governments to lower their debt burdens, “governments could, conceivably, simply increase borrowing.”

The paper refers to debt reaching an “unsustainable trajectory”. However, while the debt to GDP ratio is one metric for what constitutes unsustainable debt, it does not take into account the fact that, thanks to remarkably loose monetary policy and unending central bank support, borrowing costs have never been lower. 

The debt mountain under which governments are labouring is remarkably cheap to service.

However, if your concern really is to force governments to reduce their debt, there might be a simpler means of doing so than the introduction of the untested and unpredictable GDP-linked bond: that age-old, all but forgotten policy tool, the interest rate rise.

Cheap credit has a role to play in kickstarting the economy but the consequences of keeping rates low indefinitely may be just as severe as the alternative. We should not leap at new financial products just to preserve the low rate environment. If the government debt burden does seem unsustainable, before turning to a wild card like GDP-linked bonds, we should ensure we have exhausted more conventional routes.

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