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GDP-linked bonds: design, effects, and way forward
GDP-linked bonds have been proposed as a tool to help avoid sovereign defaults and debt restructurings. This article discusses potential advantages underlying the issuance of such an instrument, namely by quantifying the potential benefits that might arise when a country goes through periods of low growth rates and may face difficulties in meeting its financial commitments. The estimates suggest that there are potential benefits in terms of interest expenses. We simulate the correlation between primary balances and GDP growth in two scenarios: one with debt indexation to GDP growth and another one without such mechanism. As expected, the correlation between these two variables is significantly higher with indexation, suggesting that GDP-linked bonds could leave more room for automatic stabilizers to work during recessions. We run a similar exercise, but now considering a scenario where a country has to comply with a fiscal rule, and the main results are consistent. After establishing these facts, we examine recent issuances of GDP-linked bonds and discuss their limitations and weaknesses. This is crucial to understand what needs to be improved in the design of GDP-linked bonds to make them a universally used instrument.