- Experience shows that investors are wary of GDP-linked bonds
- And data difficulties don’t help
How bad is the UK’s debt problem?
The UK’s debt-to-GDP ratio has breached 100 per cent, and the Office for Budget Responsibility (OBR) warns that it could rise even higher: according to its baseline forecasts, debt will reach 300 per cent of gross domestic product (GDP) by the 2070s.
Economic shocks have contributed to this thorny public finance position. The OBR calculates that the pandemic and energy crisis have already added around 15 per cent of GDP to debt in three years. And if the watchdog adjusts its forecasts to allow for future economic surprises, things look even bleaker: a large shock each decade could see debt reach 435 per cent of GDP in 50 years' time (see chart).
A disappointing outlook for growth is making things even harder. After all, the debt-to-GDP ratio is determined not only by debt, but by gross domestic product, too. This raises an interesting question – could GDP-linked bonds offer a solution?
What are GDP-linked bonds?
GDP-linked bonds tie debt repayments to an economy’s wellbeing. Just as the coupon on an index-linked gilt moves with inflation (in the UK, at least), the coupon on such a bond can be adjusted depending on a country’s GDP.
It is easy to be sceptical. After all, index-linked gilts are hardly helping the UK’s public finance position at the moment. The latest figures show that almost £4bn of the £7.7bn interest payable in July was thanks to increases in retail price index (RPI) inflation – which is currently running at 9 per cent.
But GDP-linked bonds have some persuasive advantages. Firstly, they can reduce the likelihood of a sovereign default. If the economy is tanking, negative growth erodes the value of the coupon that the government ultimately has to pay.
And by sparing debt repayments, GDP-linked gilts give governments a useful set of options. According to economist Stephen Cecchetti, in a deep recession, policymakers can buy back bonds (thus stopping the debt-to-GDP ratio from rising further) or use the money that would have otherwise serviced debt for expansionary fiscal policies.
In theory, the bonds should be attractive for investors, too. Evidently, they let investors buy a share of their country’s (or multiple countries’) GDP, offering many a low-cost way to diversify internationally.
Are they too good to be true?
The execution of the idea is far more complicated. In 2015, Angel Ubide, then a senior fellow at the Peterson Institute for International Economics, pointed out that “growth risk is exotic, difficult to price and hedge properly (no financial instrument has a high correlation to real growth) and therefore costly for investors”. He added that as a result, the “investor universe” for GDP-linked bonds is “narrow and highly speculative”, which tends to add to the cost of the debt.
Argentina issued GDP-linked gilts in 2005, as did Greece in 2012 and Ukraine in 2012. In all cases, economists estimate that investors demanded a premium (a humongous 1,200 basis points in the case of Argentina) for holding the debt, even once default and liquidity risk was taken into account. There are probably several reasons for this investor scepticism.
Just as index-linked gilts can encourage policymakers to pursue low inflation, GDP-linked bonds could encourage governments to pursue low growth. Although it might sound far-fetched, it is hard to escape the fact that the benefits of the bonds really kick in as the economy fares badly. Cecchetti even warns that “a government could pressure national statistical agencies to understate nominal GDP” as a result.
Then there are data difficulties to contend with. Revisions recently revealed that the UK economy had recovered far better from the pandemic than first thought, and changes of this magnitude are not uncommon – even in the UK, where national statistics are rigorous. The ONS found that between 1970 and 2016 there have been 45 quarters where the first estimate of GDP recorded a fall in output – but the final estimate recorded a contraction in only 31 of those.
Cecchetti points out that “from the government’s perspective, the key benefit of GDP-linked bonds comes from times when GDP falls significantly… however, it is at precisely such times that early-vintage readings of GDP are most likely to be revised”. So while the bonds sound like a neat idea in theory, the reality is a whole lot messier.
