Developing Countries – Growth Bonds for Escaping the Debt Trap?

High hopes rest on a new tool that could possibly prevent developing countries from falling into the debt trap: so-called growth bonds. In the course of its current debt restructuring negotiations, Argentina mentioned growth bonds as a means to regain access to international capital markets.

What makes this type of bond special is that the amount of the interest payment depends on the economic growth rate in the emitting country. As a result, interest rates are relatively low or even non-existent in times of crisis, whereas an economic boom causes considerable interest rate increases. The investor thus participates directly in the country's economic development. By now, international organisations such as the International Monetary Fund have also shown interest in this new type of bond as it may generally improve development financing. The Mannheim Centre for European Economic Research (ZEW) has examined, whether growth bonds actually deliver what they promise.

There are different ways to bind the cash flows of government bonds to economic growth. The easiest one consists in having annual interest payments which depend directly on the rate of year-on-year GDP change. An example: In the event of stagnation (zero growth), the paid interest rates are rather low, four per cent, for instance. When there is positive growth, interest rates increase with each percentage point of GDP growth. A three per cent growth would thus generate an interest rate of seven per cent. In the event of a recession (minus four per cent), there would be no interest payment at all. Negative interests, subsequent contributions paid by the creditor, which may incur in the course of a severe recession, are ruled out.

When determining bond prices on the capital market, the latest GDP expectations are taken into account. Therefore, investors can only benefit from higher GDP figures if the actual growth is higher than expected. Should growth fall short of expectations, the emitting country has an advantage, paying relatively low interests.

These price responses show that shifting the GDP risk from the government to the investor is an important feature of growth bonds investors should hence be rewarded for underwriting these risks, for example by being granted comparably high average interests (risk premium). This would incite creditors to invest in bonds. In times of "normal" economic activity, this would be an additional budgetary burden for the emitting state, but at the same time guarantee more security with regard to future GDP trends.

Factors like novelty of the product, the fact that no experiences have yet been made concerning the assessment or price developments, and the difficulty of forecasting the future GDP rates are likely to entail further yield mark-ups. Furthermore, investors cannot hedge against GDP risks at the very beginning due to the lack of corresponding markets. Besides, market liquidity would probably be very low reducing the likeliness of short-term tradability.

The ZEW study shows that investors benefit from growth bonds as long as the national GDP's correlation with global GDP is low or negative. The correlation is negative if the GDP of a country runs counter to the global economy. In this case, the creditor's investment in growth bonds can actually lower the GDP risk of their bond portfolio. Correspondingly, risk mark-ups required by the market should be negative.

Such a win-win situation, which benefits both the government and the investor, is, indeed, realistic, for example for countries like Egypt, India, Pakistan, Vietnam, and Zimbabwe. Another potential candidate is Argentina due to its rather low correlation between the GDP and the world economy. Issuing growth bonds, however, cannot be regarded as a blueprint solution for rescuing Argentina's national budget. It is also conceivable that the emission of conventional bonds can lead to a more cost-efficient result. This would be the case in particular if the yield mark-up for the new growth bonds required by the market turns out to be disproportionately high.

Contact

Prof. Dr Michael Schröder, Phone: +49(0)621/1235-140, E-mail: schroeder@zew.de