In an article in the Financial Times this week, Patrick Honohan, Governor of the Central Bank of Ireland, proposes that Irish debt repayments be linked to the country’s growth:
“One dimension which, in my personal view, has not yet received the attention it deserves is the potential for mutually beneficial risk-sharing mechanisms. A variety of financial engineering options could be considered going beyond the plain vanilla bonds currently employed.
A simple version, which could indeed be useful beyond the specific case of Ireland, would, over time, shape the arrangements with European partners in such a way that Ireland pays more if its GNP growth is strong; less and slower if growth remains weak. The aim of such GNP-linked bonds or similar risk-sharing innovations must be to restore, through growth, a favourable dynamic to the sovereign debt ratio, putting its sustainability too, like that of the banks, beyond doubt.”
After a sharp decline in GNP per capita that put Ireland back a decade, Patrick Honohan is worried that the downward cycle of debt overhang and austerity measures will further erode growth and make debt even more burdensome.
Tying the coupon payments to GNP performance alleviates the debt service in economic downturns in exchange for higher payments during periods of high growth. The idea has been around since the sovereign debt crisis of Highly Indebted Poor Countries (HIPC) in the eighties. There is a vast literature in support of it—see this IMF research paper from 1985 as an example of that earlier vintage. The objective is to link the size of the debt obligation to the ability to pay, alleviating the impact of negative growth shocks and reducing the incidence of defaults. However, only a few such securities have been issued with mixed results. In a timely comment to Honohan’s proposal, Joseph Cotterill, of the Alphaville blog, points to some of the drawbacks of these securities: the quality of statistics on growth, absence of derivatives to hedge country specific shocks, illiquidity and pricing issues.
The proper design of such contracts is indeed crucial, and GNP-linked warrants (GLWs), bonds with detachable warrants, appear to be a possibility.
But GLWs only make sense if they help to create the right incentives and separate the wheat from the chaff. Risks created by bad government policy should not be passed along to bondholder. Risks that are not attributable to bad government policy can be passed along to bondholders. The problem is that GLWs do little to avoid the policy mistakes made by the PIGS -Portugal, Ireland, Greece and Spain. GLWs are linked to growth regardless of its source and composition, be that growth that is sustainable or growth that is fueled by levered consumption, reckless banking, mediocre regulation, fiscal irresponsibility and investment bubbles. Which it is – sustainable or unsustainable growth – is, in part, a result of government policy. Governments often delay needed structural reform until the situation becomes desparate. Since GLWs cushion the impact on bondholders of eventual hard landings, they might even reduce the market’s monitoring and delay much needed economic reforms.
True that the problems in the EU periphery were also the result of the one size fits all monetary policy, that led to negative real rates in the PIGS countries. A step to mimic some sort of country specific monetary policy would be for countries to issue a combination of GLWs and inflation linked warrants (ILWs), using as a reference the EU potential GNP (for the GLWs portion) and the EU target rate of inflation (for the ILWs portion). This way, a country would adopt an automatic version of the Taylor rule, albeit imperfectly, and create some sort of monetary discipline to cope with deviations within the currency area.