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Contribution Details

Type Master's Thesis
Scope Discipline-based scholarship
Title The introduction of GDP-linked bonds and the potential effects on some selected European countries
Organization Unit
  • Xavier Schuwey
  • Thorsten Hens
  • English
Institution University of Zurich
Faculty Faculty of Business, Economics and Informatics
Number of Pages 93
Date July 2017
Zusammenfassung Executive Summary After the financial crisis of 2008, sovereigns in general have seen their public debt ratio increase. This has lead to a sovereign debt crisis, which was particularly strong in Europe, and some countries are still suffering, like Greece. Debt ratios do have negative externalities domestically and internationally. Improvement of the debt to GDP ratio to sustainable levels is needed. The objective of this paper is to come up with a tool in order to help governments to better control their debt ratios. The solution is GDP-linked bonds (indexed bonds), whose returns are cyclical, i.e. higher payments will be made in times of high economic growth and inversely. They will not only decrease the burden of interest payments in bad economic times, but may also have a positive effect on the primary fiscal balance, which could act as an insurance. The underlying theory is the fiscal insurance theory (Faraglia, Marcet and Scott, 2008). Since indexed bonds will align interest payments to the countries’ ability to pay, therefore, a narrowing in the debt dynamics as well as a decrease in the debt level are to be expected. The anti-cyclical primary balance budget will leave room for fiscal stimulus when needed and act as a break when the economy enters a booming period. In sum, this paper assumes that with indexed bonds, sovereign debts would become more sustainable, and could have positive spillovers. The approach pursued in this paper is similar to Blanchard, Mauro and Acalin (2016), which is predicting the future paths of debt ratios over time, but extends it by introducing VAR model to forecast future values. The variables that are predicted by the VAR model are the real interest rates, the GDP growth rates and the primary fiscal balances. The VAR model has been built on the historical data as well as the forecasts provided by the IMF WEO (2015). Another extension of the Blanchard, Mauro and Acalin (2016) model is that the return of the indexed bonds could be expressed with several formulas. More importantly, this paper introduces returns in line with the prescription of the fiscal insurance theory of bonds (Faraglia, Marcet and Scott, 2008). Returns will positively depend on the GDP growth differentials. The paper further shows the variation in the debt dynamics under various assumptions. Simulated results are compared with the results from nominal bonds. The results are country-specific. More importantly they differ with respect to the return formulas. Countries have been categorized into three groups, low, medium, and highly indebted countries to cover the entire debt ratio spectrum. One general conclusion is that the higher the initial debt ratio, the larger the impact of indexed bonds. However, if the debt ratio is too high, the positive effect of such bonds may decline. Another general observation is that the higher the GDP baseline in indexed bonds’ returns, the larger the incentives to issue indexed bonds. Another important characteristic to look at is the correlation coefficient between the real interest rates and the GDP growth rates. In general, countries which have a negative correlation between those two variables are more likely to benefit from the introduction of indexed bonds. However, a crucial point for indexed bonds is the growth premium. A precise idea of it will help sovereigns to accurately gauge the benefits of such bonds.
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