Prof Stephany Griffith-Jones, Institute of Development Studies
Prof Avinash Persaud, Chair, Intelligence Capital
Lauren Phillips, Research Fellow, ODI
Simon Maxwell, Director, ODI
Prof Stephany Griffith-Jones divided her presentation into two parts:
She began by outlining that since the 1970s capital account fluctuations induced countries to adopt pro-cyclical policies. In good times, when there was no restriction on finances, governments in developing countries would adopt expansionary fiscal policies, further enhancing the speed of the cycle. On the contrary in bad times, countries would have to tighten their expenditures as finance was not widely available, thus worsening the cycle.
This is particular relevant when financial flows, instead of gradually diminishing, dry up suddenly as it happens during a financial crisis. Studies show that an estimated 25% loss of GDP for developing countries has occurred following financial crises. Thus Prof. Griffith-Jones highlighted the importance of anti-cyclical instruments to help avoid these crises.
Despite the fact that the world is generally experiencing "good financial times", there are still important threats posed by the current financial system, where global imbalances are sizeable and on the increase. One way to deal with these threats, maximising the long-run benefits of financial flows is to develop new instruments, which favour long-term development perspectives of countries. One such instrument is the GDP-indexed bond.
These bonds limit pro-cyclicality of government spending by linking the interest rate on them to the GDP of the country. The challenge would be to help countries issue these instruments in good times, when it is easier to do so. These instruments could benefit various actors:
a) borrowers, as they would help governments stabilise their spending, limiting the pro-cyclicality in good and bad times and reduce the probability of default and debt crises. Governments in both developed and developing countries may take advantage of these instruments;
b) creditors, who may have a valuable diversification opportunity and who would benefit from less frequent and costly defaults
c) the global financial system in terms of positive externalities for all the agents operating in it.
These externalities call for public action to help develop these instruments in the first place. In particular International Financial Institutions, such as the World Bank should have a crucial role in starting their development.
The concerns which surround these instruments, including the potential problems related to the pricing mechanism, and GDP measurement issues do not seem to be important enough to constrain their development. In fact the times seem now appropriate for these instruments, as the investors' appetite for emerging markets' risk has grown and Argentina has successfully adopted similar instruments as part of the post-crisis restructuring of the debt.
Prof Avinash Persaud started his intervention by trying to put debt issues for developing countries in context. He argued that the development community tends to overemphasise debt in developing countries. The proof is that the cost of defaulting on its own debt has been limited for most developing countries, which usually recover quite quickly from a debt default. Financial markets have short memory and are ready to invest again in a country after a default if it is undertaking structural reforms which will help long-run growth prospects.
Prof Persaud went on to highlight the role of lenders as the main drivers in choosing the type of financial instruments to develop. This raises the important question when thinking about the development of new instruments of why lenders never thought of issuing GDP-indexed bonds.
Finally Prof Persaud presented the commodity-linked bond as a type of bond which may be more palatable for financial markets than GDP-indexed bonds and may provide a natural hedge against the risks of the volatility in commodity prices. Such bonds would offer the chance to hedge against risks in commodity markets in the long-run (today it is not possible to do so for period longer than two years) through the natural hedge provided by commodity exporters. However, again the main challenge is to convince these exporting countries to issue such bonds in good times when they have no incentive to do so (as they receive large inflows of capital from abroad).
Dr Lauren Phillips started her intervention by outlining that notwithstanding the current global optimism about high liquidity, a number of challenges are still characterising the financial markets. For instance although the debt/GDP ratio is decreasing on average, some large developing countries, such as Brazil, Turkey, the Philippines, are actually experiencing an increase in the ratio.
Discussion about reform of the sovereign debt regime seems to focus on whether the architecture of financial markets should be reformed or new financial instruments should be developed; however, developing countries' (which should be the major beneficiaries of the reform) perspective is hardly taken into account in such discussion. It is not clear why the IMF should be the actor to decide on those issues. Many developing countries did not support the last restructuring mechanism (SDRM) led by the IMF.
Finally she pointed out that we know little of what markets may want in terms of financial architecture - i.e. whether the situation of the Argentine default was acceptable to them.
Questions that emerged after the discussion included:
- What is the need for instruments such as GDP-indexed bonds if countries like China are doing something similar through FDI buy-back? China is a different case as it has little borrowing needs and its reserves are constituted also through other sources, such as trace surplus.
- What is the potential importance of local-currency denominated bonds as an alternative to GDP-indexed bonds? These may be relevant although most developing countries are still not able to issue bonds in local currency.
- Is there a "selling the jewels of the family" type of political issue when considering issuing instruments such as commodity-indexed bonds? This may well be an issue which needs to be dealt with at the national level.
This meeting focused on the private bond and bank debt regime, looking at innovations such as GDP indexed bonds, access to finance in local currency and other trends aimed at making debt burdens more sustainable and less prone to volatility and crisis.