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One of the unicorns of macroeconomics is GDP-linked bonds. And it’s not just fantasist sovereign debt academics either.
Over the years the International Monetary Fund, the Federal Reserve, the Reserve Bank of Australia, the Banque de France the Bank of England and the Bank of Canada and the United Nations have all come out in favour of some variant of the idea. Even some investors are keen on it.
After all, as the BoE and BoC said in a joint paper over a decade ago:
GDP-linked bonds help reduce the likelihood of solvency crises. This is because GDP-linked bonds provide a form of ‘recession insurance’ that reduces principal and interest payments when a country is hit by a negative growth shock. This helps to both stabilise the debt-to-GDP ratio and increase a sovereign’s capacity to borrow at sustainable interest rates.
What’s not to love? Well, a lot, apparently.
Because despite GDP-linked bonds being a staple of many economist debates since at least 1980s — Robert Shiller advocated for them in 1994 by describing global GDP as “the mother of all markets” — they remain an obscure curio of the sovereign debt world.
As far as FT Alphaville knows, the only GDP-linked instruments ever issued have been warrants occasionally attached as sweeteners to debt restructurings, and have generally not been considered successful.
It’s not just a general aversion against novelty. There has been a lot of financial innovation over the past four decades after all. The US only launched inflation linkers in 1997, and floating-rate notes debuted as recently as 2013. The reality is that the vast majority of investors don’t like the idea of GDP linked bonds, and countries don’t want to pony up a massive premium for the sake of experimenting. Inertia rules.
Which is why we were so intrigued by the abstract of a new paper by Michael Bradley and Irving De Lira Salvatierra of Duke University and occasional Alphaville contributor Mitu Gulati of the University of Virginia.
In the world of sovereign debt instruments, the Holy Grail of financial instruments is the GDP indexed bond. That is, a borrowing instrument that operates counter cyclically. The sovereign would make smaller payments to lenders when times were tough and higher ones during good times. If such products were to be widespread, the risk of sovereign financial crises would be ameliorated. However, years of research have so far yielded little success. The Israeli diaspora bonds program — while not fitting the conventional conception of a GDP indexed bond — might well have found the magic elixir. Spreads between Israeli diaspora bonds and conventional bonds suggest a countercyclical payment pattern. The Israeli program may be sui generis. But it also possible that its design contains clues as to how to design a successful countercyclical sovereign financing program.
Upon digging in, it is depressing to see that — despite the titillating hints of the abstract — Israel’s diaspora bonds actually offers hardly anything on how one might actually construct a successful GDP-linked bond programme.
The paper itself IS interesting. Many countries have over the years attempted to market bonds directly to its diaspora as an explicit way to raise cheap financing from “patriots”. But Israel’s is the biggest.
The first was possibly the Irish independence movement, which sold bonds to Irish-Americans in the early 1900s where payments were contingent on independence from the UK. More recently, Ukraine has sold war bonds also marketed to overseas Ukrainians.
Less successfully, Lebanon was able to rack up an astonishing government debt burden because of its vast diaspora sending money back home to be deposited in local banks (because of the pegged currency and juicier rates), which got recycled into Lebanon’s bonds. That did not end well.
Israel’s diaspora bond programme is by far the oldest, best-established and most efficient. And as Bradley, Salvatierra and Gulati show, the diaspora bonds have generally yielded a premium over Israel’s conventional debt but tends to be cheaper when there is a crisis that causes a wave of support from overseas supporters (for example, after last year’s Hamas attack).
However, despite cruelly tantalising Alphaville in the abstract, the professors conclude that read-throughs to the wider GDP-linked bonds debate are actually limited.
The inevitable question is whether this program is replicable. And many of those who we spoke to in the course of the research for this project answered that question in the negative. They explain that the Jewish diaspora is unique and the structure of Israel’s diaspora bond program might not be replicable. Our results suggest that a diaspora bond program can be set up that is economically beneficial to both sides. This is not to suggest that setting up a successful diaspora bonds program is as simple as paying higher rates in good times. As those who have studied the program in detail have described, there is a great deal more that goes into the success of Israel’s diaspora bonds program than bond yields.
Ah well. 😐
