Growth-Indexed Bonds and Debt Distribution: Theoretical Benefits and Practical Limits

Abstract

Sovereign state-contingent bonds, in particular growth-indexed bonds (GIBs), have rarely been issued in practice despite their theoretical benefits. This paper provides support for this apparent sovereign noncontingency puzzle by deriving the impact of GIBs on the upper tail of the distribution of the public debt-to-GDP ratio. Although this impact varies importantly across countries and indexation formulas, empirical estimates show there is almost no reduction in the upper tail of the distribution under the realistic assumption that GIBs only represent 20 percent of the stock of debt. Moreover, a sustained premium of 100 basis points would actually increase the upper tail of the distribution for most countries.

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“…However, as noted by Blanchard, Mauro, and Acalin (2016), this benefit must be balanced against the cost with GIB's from increase in premia due to liquidity and novelty (at least initially) and growth risk. Simulations (Acalin, 2018) suggest that the reduction in the upper tail would be modest for representative parameter values and simple indexing formulas, thus explaining why GBI's have not been introduced widely. Moreover, GIB's would tempt governments to manipulate the indexes (e.g., GDP, unemployment) to lower debt costs.…”