Growth-linked anti-cyclical debt: A solution for Europe’s public debt overhangs

Alberto Gallo, Lee Tyrrell-Hendry, Mateja Popovic, Tao Pan and Ashleigh Grant

Journal of Risk Management in Financial Institutions, 2015, vol. 8, issue 3, 277-288

Abstract: European governments are overburdened with debt, yet Europe’s debt-centred financial markets lack a mechanism to efficiently reduce overhangs. In the private sector, household and corporate losses have left €1tn of non-performing loans on the balance sheets of banks, which have grown to 3.1 × GDP. In the public sector, despite the recent introduction of collective action clauses on sovereign bonds, the Greek example highlights still-limited flexibility to restructure sovereign debt. In this paper we analyse the impact of flexible debt that adjusts interest payments in line with growth performance: growth-linked anti-cyclical debt (GLAD). We model the economic impact of replacing nominal debt with growth-linked bonds for an economy subject to random external shocks as well as political cycles (eg pre-election excess spending). Our analysis shows GLAD bonds reduce the probability of austerity-debt spirals, by easing the burden of interest payments on economies hit by negative shocks, and smoothing cycles. GLAD bonds are naturally a more volatile instrument than normal fixed rate bonds, but they can be calibrated to give the same average payoff as a normal bond, ie compensating for the transfer of risk from creditors to debtors. In a currency union, where monetary policy is set based on the whole and therefore based mostly on large countries, GLAD bonds can provide an additional channel of flexibility for small countries.

Keywords: Greece; growth-linked bonds; European crisis; debt overhangs; debt sustainability (search for similar items in EconPapers)
JEL-codes: E5 G2 (search for similar items in EconPapers)
Date: 2015
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Persistent link: https://EconPapers.repec.org/RePEc:aza:rmfi00:y:2015:v:8:i:3:p:277-288

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