Are Indexed Bonds a Remedy for Sudden Stops?

C. Bora Durdu

No 11, Computing in Economics and Finance 2006 from Society for Computational Economics

Abstract: Recent policy proposals call for setting up a benchmark indexed bond market to prevent "Sudden Stops". This paper analyzes the macroeconomic implications of these bonds using a general equilibrium model of a small open economy with financial frictions. In the absence of indexed bonds, negative shocks to productivity or to the terms of trade trigger Sudden Stops through a debt-deflation mechanism. This paper establishes that whether indexed bonds can help to prevent Sudden Stops depends on the "degree of indexation", or the percentage of the shock reflected in the return. Quantitative analysis calibrated to a typical emerging economy suggests that indexation can improve macroeconomic conditions only if the level of indexation is less than a critical value due to the imperfect nature of the hedge provided by these bonds. When indexation is higher than this critical value (as with full-indexation), "natural debt limits" become tighter, leading to higher precautionary savings. The increase in the volatility of the trade balance that accompanies the introduction of indexed bonds outweighs the improvement in the covariance of the trade balance with income, increasing consumption volatility. Additionally, we find that at high levels of indexation, the borrowing constraint can become suddenly binding following a positive shock, triggering a debt-deflation.

Keywords: Indexed Bonds; Degree of Indexation (search for similar items in EconPapers)
JEL-codes: E44 F32 F41 (search for similar items in EconPapers)
Date: 2006-07-04
New Economics Papers: this item is included in nep-cfn, nep-fmk and nep-mac
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