Countercyclical Financial Instruments: Prospects for Transition Economies

High levels of public debt and its risk profile–particularly the prevalence of short-term and foreign currency-denominated debt–are widely viewed as primary indicators of vulnerability to international financial crises. These factors helped trigger Russia’s financial crisis in 1998, as well as a series of high-profile debt defaults across ‘emerging market’ economies, including Argentina and Turkey in 2001, and Uruguay in 2002. The high social costs of these crises underscore the importance of improving sovereign debt structures and introducing countercyclical market-based financial instruments which, along with sound macroeconomic policies, could help reduce the vulnerability of emerging economies to external shocks. GDP-indexed bonds (GIBs) and other contingency-linked debt instruments could help make public debt structures more sustainable, reduce the risks of currency crises, and yield substantial benefits in economic performance.

Why countercyclical financial instruments?
Debt instruments that are indexed to real economic variables such as GDP and exports, or their determinants (e.g. natural disasters, commodity prices, or changes in total imports purchased by key trading countries) can provide considerable insurance benefits. These instruments can be seen as comprising bond and insurance contract elements, with payments contingent on the performance of these real variables. The issuance of bonds whose nominal values or coupon payments are linked to commodity prices seems sensible for countries with a poorly diversified export structure where a few products dominate.

Commodity-linked bonds could benefit transition economies like Azerbaijan, Kazakhstan, and Russia, whose development prospects in general–and fiscal and external positions in particular–can be quite sensitive to terms-of-trade movements. Similarly, hedging against shocks to prices of key imports, notably gas and oil, could be very important for such small open economies as Belarus and Moldova. Disaster insurance contracts would be beneficial to small countries that are vulnerable to natural catastrophes like Georgia or Tajikistan, for whom the cumulative damage from various natural disasters reached 70 and 58 percent of GDP respectively in 1975-2002 (Borensztein et al. 2004). Larger and more diversified economies could benefit from greater use of hedging against macroeconomic fluctuations by linking the nominal values of their debt to GDP growth trends.  

To the extent that they allow investors to share the returns and risks of economic upturns and downturns, GIBs resemble equity-like instruments. When bond returns are linked to GDP growth in the issuing country, its debt burden is reduced in the event of adverse shocks and weak economic performance, and vice versa. For example, a country with an anticipated GDP growth rate of 4 percent that is paying interest on its standard (‘plain vanilla’) government bonds of 8 percent can consider issuing GIBs that would pay one percentage point extra for each 1 percent above the baseline growth rate, and 1 percent less for every percentage point by which real GDP growth falls short of 4 percent. In years of economic slowdown with growth, say, equal to 2 percent, the issuing country would pay 6 percent (instead of 8 percent on the non-indexed bond).¹

Such indexation mechanisms work as automatic stabilizers, reducing the country’s debt-servicing costs–and the possibility of default–during economic downturns (Borensztein and Mauro 2004). By increasing the ‘space’ for countercyclical fiscal policy, GIBs can help keep debt/GDP ratios relatively stable, thereby reducing the likelihood of debt and currency crises. They can also help restrain new spending during periods of high growth. Broader use of GIBs would reduce the need to pursue contractionary macroeconomic policies during periods of slow growth, in order to maintain access to international financial markets or to IMF and World Bank funding. This may improve the investment and business climates, enhancing prospects for economic growth and poverty reduction.

Obstacles to the expansion of countercyclical debt instruments
Despite these benefits, GIBs have been used only sparingly in the region. So far, only Bosnia and Herzegovina and Bulgaria have issued bonds containing an element of GIBs as part of their Brady restructurings that included clauses providing higher coupon payments when GDP growth reaches a certain threshold.²

A number of obstacles limit the spread of GIBs in the region. These include:

• GDP measurement and moral hazard: The accuracy of GDP data, which is essential in determining the value of GIB coupon payments, is not always above reproach in transition economies. Moreover, the authorities may be tempted to misreport or revise the official figures, in order to reduce coupon payments during economic upturns.   

• Data revisions and lags in publication: Large revisions of GDP data for transition economies are not uncommon; significant over- or under-payment of coupon payments can result. Lags in data publication and revisions could reverse the GIBs’ countercyclical effects.

• Complex pricing: Some investors may be reluctant to purchase GIBs because of difficulties in understanding their pricing. A well-established pricing model for GIBs should be developed–possibly by the international development community.

• Illiquidity: Markets for new debt instruments are usually illiquid, and the cost of their issuance is higher than for standard bonds, whose large turnover can minimize transactions costs. The ensuing liquidity risk could reduce GIBs’ attractiveness for investors.

• Callability: Many bonds are ‘callable’: they contain clauses allowing the issuer to repurchase them when they reach a certain price. Making GIBs callable could allow governments to repurchase them during periods of high economic growth, preventing investors from obtaining the anticipated higher coupon payments. In general terms, then, GIBs would have to be non-callable if they were to be used extensively.

Many of these obstacles reflect the start-up costs associated with any market innovation, financial or otherwise. International development agencies like the World Bank, IMF, and the UN system–whose mandates include promoting economic growth and reducing poverty via better management of the global governance architecture–could accelerate the expansion of GIBs by underwriting some of the costs of their development.

Conclusions
Their past vulnerability to currency and debt crises suggests that transition economies could benefit from the issuance of GIBs. However, GIBs are a rather specialized financial product; many transition economies are focusing instead on deepening the market for their ‘plain vanilla’ bonds. Indeed, a number of the poorest CIS countries do not have sovereign credit ratings, effectively making their ‘plain vanilla’ bonds–for which domestic markets are quite under-developed–too risky for most international investors. Thus, many transition economies which might find GIBs potentially beneficial are unable to issue them on the international markets at a reasonable cost. 

However, in transition economies with relatively well-developed financial systems, there is scope for GIBs to develop further. This is particularly important in light of the need for deeper domestic markets for long-term, local-currency instruments that could help make public debt structures less prone to crises. GIBs issued in local currency on domestic capital markets may appeal to institutional investors, such as emerging hedge funds, insurance companies, and pension funds. The latter in particular are likely to have an interest in debt instruments that carry a relatively low default risk, and are either inflation-indexed or denominated in local currency. The mandatory-funded pension schemes that have emerged recently in many transition economies as the second pillar of pension systems could in particular increase the demand for GIBs. Prospects for the more rapid expansion of trading in these instruments would improve if international development agencies could help bear the risks of deepening these markets by underwriting some of their costs.

Julia Korosteleva is Lecturer in Business Economics at University College, London.