GDP-linked bonds : design, effects, pricing and way forward

GDP-linked bonds could play an important role in helping countries to avoid solvency crises, defaults and sovereign debt restructurings. Indexing a country’s debt payments to its economic performance could give governments some type of insurance against periods of declining growth rates. In this context, this thesis illustrates the potential advantages of the issuance of such an instrument, namely by quantifying the above mentioned insurance effect. As such, the interest savings for a group of countries most affected by the European sovereign debt crisis should they have issued GDP-linked bonds in the beginning of the decade are calculated. It is concluded that theses savings would have been considerable. Furthermore, in order to understand the additional room for countercyclical fiscal measures created by this product, the correlation between primary balance and GDP growth is simulated for both scenarios: debt with indexation to GDP growth and without it. It is then concluded that correlation between those two variables would be significantly higher with indexation. In the same vein, it is also simulated the issuance of this instrument in currency unions, in particular in the euro area, applying the corresponding fiscal constraint to the total deficit of 3% of GDP. Thus, the correlation between primary balance and GDP growth shows that indexing debt to GDP growth has the potential to offset the curbing effect of the mentioned constraint. Moreover, through simple regressions and using the Capital Asset Pricing Model, it is concluded that the portion of undiversified risk associated to the indexation to GDP growth would be low