Asset management
9 February 2015
Economist Insights
GDP: Growth dependent payments
Greece proposed last week that it would drop its call for
an outright debt haircut, if the Eurozone agreed to swap
some of the Greek bonds it holds for GDP-linked bonds.
GDP-linked bonds would not be such a big leap for the
Eurozone, given that last time Greece ran into growth
problems, the Eurozone lent more money, lowered the
interest rate and extended the maturity (an implicit GDP link).
However, GDP-linked bonds may not necessarily guarantee
long-term sustainability of the Greek debt.
Joshua McCallum
Head of Fixed Income Economics
UBS Global Asset Management
[email protected]
Gianluca Moretti
Fixed Income Economist
UBS Global Asset Management
[email protected]
The exercise in game theory that is the Greek bailout
negotiations intensified last week. After announcing that the
government would reject a bailout, the Greek finance minister
Yanis Varoufakis said that Greece would be willing to maintain
a primary surplus, forget the call for an outright debt haircut
and hold off on some of Syriza’s campaign promises. That is,
if the Eurozone agreed to swap some of the Greek bonds they
hold for a different type. Mr Varoufakis proposed swapping
the bonds the ECB holds for perpetual bonds, but as this is as
close to outright monetary financing as to be indistinguishable,
it is a non-starter. The other proposal is to swap the Greek
debt held by the Eurozone for GDP-linked bonds.
For a small country which does not control its own
monetary policy this link is unlikely to occur. In fact, for all
intents and purposes, ECB monetary policy is completely
independent of what happens in Greece because Greece
is so small relative to the overall Eurozone. So the principle
of using GDP-linked debt makes a lot of sense for Greece
(and quite a few other economies in the Eurozone). The pain
was obvious in recent years, but it applies to the other side
as well. In the early 2000s Greece needed higher interest
rates, but slow growth in Germany kept ECB rates low. This
encouraged the Greek government to borrow too much
‘cheap’ money.
The idea of a GDP-linked bond is not new; credit for the idea is
usually given to Nobel Laureate Robert Shiller in 1993. Since then
a whole body of literature has built up on the idea, with various
models for how the bonds should be linked to nominal GDP. But
all share one idea in common: when the economy is stronger then
payments are higher, and when the economy is weak payments
are lower or non-existent. The aim is that by reducing payments
when the country is least able to pay, the risk of default falls and
everybody wins. And there is the added benefit of discouraging
governments from borrowing too much when times are good.
In an interview with Spanish newspaper El Pais, Mr
Varoufakis proposed that the GDP-linked bonds would
be repaid normally at nominal growth rates above 7%, at
one third between 5 and 7% and not at all when growth
is below 5%. Ignoring the fact that the IMF’s forecast for
longer-term Greek nominal GDP growth is just 5.5%, this
would mean that there is a high risk that the debt is never
repaid, which makes the proposal another non-starter.
Try asking your bank if you only need to make mortgage
payments if your income is growing at 7% per annum and
see how far you get.
What people may not realise is that for most governments
their debt is already indirectly GDP linked, at least in part.
When nominal GDP is strong this means real GDP or inflation
is high, either of which is likely to encourage the central bank
to raise interest rates. The central bank may cut rates when
nominal GDP is weak. Since the interest rate on government
bonds moves up and down with the central bank rate, it will be
cheaper for the government to borrow when the economy is
weak and tax revenues are low. The GDP link is limited because
the current rate only applies to new debt, but the idea is there.
In our view, a more feasible approach would be to link the
interest rate to growth, effectively turning the debt into
a floating rate note (FRN). This would restore that crucial
cyclical link that countries like the US or UK have, but
could be even more effective because it would apply to the
existing stock of debt as well, not just newly issued debt.
To see just how effective this could be, consider what the
Greek debt situation might have looked like if Greece had
only had GDP-linked bonds in the run up to the crisis.
For simplicity, assume that the interest rate paid on the bonds
is equal to nominal GDP growth the year before, with a floor
of 0% (so lenders never had to pay Greece). Now this may
not be the effective interest rate because investors would
be unlikely to pay face value (in other words, to raise the
same amount of money today Greece would have had to
issue more bonds). For the sake of argument, assume that
the premium is 1%. Instead, the bonds could be made more
favourable by not requiring principal repayment when growth
the prior year was negative. This does not mean investors
would not be repaid (as Mr Varoufakis blithely suggested
in his interview) but the maturity of the bonds would be
automatically extended for a year.
How would Greece have fared if all its debt was GDPlinked as it came into the financial crisis? If we assume that
all spending plans and GDP growth remained unchanged
and all the debt numbers were correctly reported before
the crisis, Greece would have come into the financial crisis
with a higher debt level (see chart) but once growth turned
negative, interest costs would have fallen to zero and debt
would be lower. However, according to the IMF forecasts
nominal growth will eventually rise enough to offset that
benefit and by 2022 debt would be the same (whether there
was a haircut in 2012 or not).
If investors actually demanded a lower premium than 1%
to compensate for the uncertainty and pro-cyclicality of the
returns, then debt would be lower throughout. However, if
Greece had to refinance or increase borrowing while GDP
growth was negative it would be likely that the premium
would in fact be higher.
Although linking Greek debt to GDP seems like a big shift,
it would not actually be such a big leap for the Eurozone.
After all, last time that Greece ran into growth problems,
the Eurozone lent more money, lowered the interest rate
and extended the maturity of the loans. That sounds a
lot like an implicit GDP link. The technical issues about
calculating GDP are not insurmountable: it is done for
inflation-linked bonds, and at least there is the external
EuroStat to certify the numbers.
So in the end, GDP-linked bonds may not help Greece
all that much unless there is no premium. If Greece can
convince its official creditors (the rest of the Eurozone) to
link interest payments to GDP but not to charge a premium
then it may work. Unfortunately, it may turn out to be
against the “no-bailout” clause of the Lisbon Treaty for
another member state to lend money at less than it cost
them to raise it. Such an eventuality could easily occur if
Greece’s growth turns negative.
Growth linking
Impact of GDP-linked bonds on Greek debt as % of GDP, assuming
same primary balance and nominal GDP growth as the bailout program,
and assuming a constant 1.5% primary balance from 2015
180
170
160
150
140
130
The Greek re-negotiation plan is really all about the size of
the primary budget surplus (before interest), which Syriza
wants to limit to the current 1.5% instead of the more
demanding 4.5% Troika target for 2016. Even with GDPlinked bonds, within seven years debt in both cases would
have stabilised at 140% of GDP – a level which the Troika
would consider far too high. That would be equivalent
to the rest of the Eurozone giving Greece an extra EUR 5
billion a year. Trying to sell that to the German public would
probably be harder than convincing your bank to link your
mortgage payments to your income growth.
120
110
100
2006 2008
Baseline
GDP-linked
2010 2012 2014 2016
Baseline (1.5% balance)
GDP-linked (1.5% balance)
2018
2020
2022
Source: IMF, European Commission, UBS Global Asset Management
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