* Proposal to avert sovereign default flawed in practice
* Costs of recession insurance too high
* Reliance on credible data reporting poses problems
By John Geddie
LONDON, Feb 21 (IFR) - Investors say a proposed form of
government debt that would let countries pay interest depending
on their rate of economic growth, intended to avert potential
default, will never work.
Some of the world's leading economists have united behind
the concept of bonds linked to GDP, which they say could prevent
painful debt restructurings like those in Argentina and Greece.
The Bank of England last month published a paper on
GDP-linked bonds, joining Yale University and the International
Monetary Fund, which have also pushed the idea in recent years.
"Return on these bonds varies in proportion to the country's
GDP," the bank wrote.
"When growth is weak, the debt servicing cost and repayment
amount automatically declines; and when growth is strong, the
return on the bond increases."
But investors say the idea will never fly.
"This is an interesting academic exercise, but I believe it
is unlikely that we will ever see widespread issuance of
GDP-linked bonds," said Mark Dowding, a senior portfolio manager
at Bluebay, one of Europe's largest bond funds.
In theory, GDP bonds would allow countries to manage
debt-servicing costs depending on their economic cycles, in
essence providing a form of recession insurance.
At the same time investors could take comfort knowing that
they would not be subject to a Greek bond-style haircut on their
Yet purchasers of the debt would likely demand a return high
enough to nullify a sovereign's other benefits in issuing such
"I know investors who would buy these kind of products,"
said Gabriel Sterne, an economist at distressed debt brokerage
"But I don't know any who would accept them unless they were
compensated significantly for the uncertainty of income
ONLY A SWEETENER
Ironically, instruments related to GDP already exist - and
they emerged from the ashes of the same kinds of debt
restructurings that their supporters say they could prevent.
Both Argentina and Greece offered GDP-linked warrants as a
sweetener to encourage bondholders to take drastic writedowns on
their sovereign holdings.
"It's the equivalent of receiving equity in a corporate
restructuring," said a debt specialist at an investment manager
with over US$100bn under management.
"If things really turn around, you get exposure to the
In the case of Greece, investors attributed little value to
the warrants at first. But as the country's economic outlook has
improved, trading in these securities has ratcheted up.
The warrants, which slumped to a low of 25 cents in the
first months after Greece's restructuring, are now worth more
than five times that amount.
Even so, the warrants account for only a tiny portion of
Greece's outstanding debts.
The total market value of the warrants is around EUR820m,
which is nothing compared to the EUR62bn of Greek government
"For GDP-linked bonds to have a meaningful impact on debt
servicing/debt sustainability, then a large portion (or a
majority) of bond issuance would need to be in this format,"
said Bluebay's Dowding.
"That seems very unlikely at any point in the foreseeable
Experts say countries that could benefit most from
GDP-linked debt are those, such as the eurozone, where monetary
policy is constrained as part of a currency union.
But the euro bloc includes some of the most heavily indebted
countries in the world. According to the CIA's World Factbook,
nine of the 30 most indebted nations are in the eurozone.
Replacing a significant amount of all that debt with
GDP-linked bonds would be a nearly impossible task.
Furthermore, governments would be less willing to build a
significant buffer of GDP-linked bonds in a good economic
climate, as it would then be more expensive to service them.
And once the GDP-linked warrants became a significant part
of Argentina's debt-servicing costs, for example, investors
feared the country would be unable to pay them.
Greece learnt from Argentina's experience and capped the
coupon payments on its warrants at 1% of the notional amount
annually, with a call option from 2020.
Perhaps the biggest obstacle is that the proposed bonds are
linked ultimately not to GDP but to whatever a government claims
that GDP is - which opens the door to potential shenanigans.
Until changes this month, for instance, investors have
seethed for years at what they believe was unfair returns on
Argentina's inflation-linked bonds.
After then-president Nestor Kirchner overhauled the National
Statistics Institute in 2007, the country's reported inflation
rates differed wildly from private estimates.
The government said consumer prices rose 10.9% in 2013, less
than half the 28% increase estimated by other economists.
Only this month, after the government unveiled a new
inflation-linked index - and reported a staggering 3.7% rise in
January alone - have investors had reason to cheer.
"It introduces a political element," said a portfolio
manager at an emerging markets specialist debt fund who asked
not to be named.
"There is always the potential temptation to fudge the
numbers so that these type of securities don't pay a lot."
(Reporting by John Geddie, additional reporting by Christopher
Whittall; Editing by Alex Chambers and Marc Carnegie)