Indebtedness, Interests, and Incentives: State-contingent Sovereign Debt Revisited

40 Pages Posted: 3 Oct 2015 Last revised: 30 Oct 2017

See all articles by Andrin Bögli

Andrin Bögli

University of Zurich - Department of Banking and Finance; Ecole Polytechnique Fédérale de Lausanne

Felix Fattinger

University of Melbourne - Department of Finance

Date Written: October 30, 2017

Abstract

This paper studies state-contingent debt as an alternative refinancing instrument for advanced economies. In times of high sovereign indebtedness, increasing yields impose eminent debt roll-over risks. We analyze the welfare implications of two state-contingent debt instruments: puttable and GDP-to-debt-indexed bonds, both temporary in nature and intended to improve deleveraging feasibility. In return for an insurance premium, puttable bonds offer protection against sovereign default, thereby internalizing the implicit risk-sharing mechanism inherited by the ECB's "Outright Monetary Transactions" program. Similar to GDP-linked debt, bonds indexed to a country's GDP-to-debt ratio, henceforth "GDR bonds," allow for consumption smoothing via state-contingent interest payments. In contrast to GDP-linked debt, GDR bonds permit competitive risk-return profiles even in the face of pessimistic growth outlooks. We find that, in the presence of default costs, state-contingent bonds allow for substantial welfare improvements relative to standard sovereign debt. For risk-averse consumers, the counter-cyclical fiscal leeway created by GDR bonds dominates the interest savings provided by puttable bonds. We verify this preference order by calibrating our model to the five Eurozone countries most heavily affected by the debt crisis: Portugal, Ireland, Italy, Greece, and Spain. We discuss implied deleveraging incentives, limited commitment, and practical implementation issues for GDR bonds.

Keywords: state-contingent sovereign debt, puttable bonds, GDP-linked bonds, sovereign debt crisis, outright monetary transactions

JEL Classification: H63, G13, G28, F45

Suggested Citation

Bögli, Andrin and Fattinger, Felix, Indebtedness, Interests, and Incentives: State-contingent Sovereign Debt Revisited (October 30, 2017). Available at SSRN: https://ssrn.com/abstract=2668176 or http://dx.doi.org/10.2139/ssrn.2668176

Andrin Bögli (Contact Author)

University of Zurich - Department of Banking and Finance ( email )

Schönberggasse 1
Zürich, 8001
Switzerland
+41446342781 (Phone)

Ecole Polytechnique Fédérale de Lausanne ( email )

c/o University of Geneve
40, Bd du Pont-d'Arve
1211 Geneva, CH-6900
Switzerland
+41446342781 (Phone)

Felix Fattinger

University of Melbourne - Department of Finance ( email )

Faculty of Economics and Commerce
Parkville, Victoria 3010
Australia

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