Wednesday, 4 February 2015

The Social Impact of GDP linked bonds.

After a rocky first week, the proposal of Greece’s new Finance Minister, Yanis Varoufakis, of swapping current debt for new GDP linked bonds seems to open a constructive dialogue between Greece and its creditors. 

This proposal reminded me of Social Impact Bonds (SIBs) a highly interesting financial device. A quick overview of SIBs and their use can explain the potential of GDP linked bonds to provide a solution that meets the requirements of debtors and indebted countries. 

A Social Impact Bond is a financial instrument where a government or a commissioner pays investors a return based upon the achievement of a determined outcome (figure 1). 

Figure 1: Social Impact Bond Model 

The key point of a SIB is that investors only get paid if the social outcome previously agreed is achieved, if it is they get the bond and a return, if not they lose their investment. Thus, the great promise of SIBs is the hope of allowing innovative approaches to tackle social issues and reduce government expenditure, transferring risk from taxpayers to social enterprises and its backers. It remains a controversial and young instrument, as exemplified by the first Social Impact bond introduced in the UK, to finance a programme aimed to reduce re-offending among inmates at Peterborough prison that has been finished early by the Cabinet Office.  However it would be too early to call for the demise of SIBS. Social Finance UK, the designer of the Peterborough SIB, is expanding its range of Social Impact Bonds and reforming it from the lessons learned at Peterborough. In the United States, Goldman Sachs is investing in a similar scheme in Rikers Island[1]

The potential of the widespread use of SIBs is huge. Nowadays, organisations that believe they had an innovative approach that could help to solve any given social issue need to lobby to shift government policy or at least get a pilot trial. SIBs would allow them to raise money and to recuperate their investment with a return if successful. 

The use of GDP linked bonds predates the use of SIBS. In the 1980s, GDP linked bonds were key in the Brady plan designed to restructure the debt of the Less developed countries (LDCs)[2]. Of course, GDP linked bonds are not SIBs but they are similar in a key component: the return on the investment based on achieving a certain outcome, which is in this case a certain threshold of GDP.  The difference is that in the case of the GDP linked bonds, the successful outcome by its very nature entails the generation of incremental cash flows which can then be used to repay the bond. 

To highlight the similarities we need to take into account the conditionality of the bail-out programs. Therefore we have a series of practitioners, in this case the Troika,  offering Greece a recipe to slim down the state, with the aim of making the country better able to repay its debts. However, up until now Greece has had minimal scope to reject or even contest the troika recipes. This situation has lasted years during which time we have seen a clash between the democratic interests of the debtor countries and the indebted countries – as summed up in Hans-Peter Friedrich, a senior member of Chancellor Merkel's conservative bloc, words:The Greeks have the right to elect whoever they want; we have the right to no longer finance Greek debt”.  In practice, this dilemma has been solved by strong-arming – usually by unelected ECB officials – southern politicians into accepting programmes highly unpopular amongst their citizens. In the medium term, this situation seems to have brought a considerable political shock across these countries, as now seen in Greece and may yet be seen in Spain.  However, the GDP linked bond may prove the solution to this conundrum. 

GDP linked bonds might be viewed as a large-scale Social Impact bond programme that has the ECB and EU as an investor, the GDP threshold as a social outcome, and the Greek Government and the EU as a social enterprise and commissioner. By agreeing on the outcome, the ECB, EU, and Greece can avoid the aforementioned democratic clash and associated risks. The principal challenge is that Greece would need to outline policies that realistically could improve the Greek economy and public sector in the eyes of their EU partners – a daunting task, even more taking into account the troublesome history between the Greek state with its track record of fiddling statistics and precipitating the Euro crisis. 

Certainly this alone would not solve the imbalances created by the Monetary Union, and in this article we had not analysed the possible effects of GDP linked bonds on macro-economic and monetary policies. Nonetheless, it can be pointed that GDP linked bonds seems to offer the hope of aligning more closely the interests of debtor nations and indebted nations, something that no other proposal on the table has yet offered.

[1] Goldman Sachs has participated in the United States first SIB, investing $9.6 million in a programme aimed to reduce recidivism amongst inmates at Rikers Island Prison.  A detailed analysis of the Rikers Island SIB can be found at the Federal Reserve Bank of San Francisco

[2] More detailed information of GDP Linked bonds can be found on Barr, D., Bush, O and A. Pienkowski (2014) “GDP-linked bonds and sovereign default”. Bank of England Working Paper No.484; and Borensztein, E and P. Mauro (2002) “Reviving the Case for GDP-Indexed Bonds” IMF Policy Discussion Paper 02/10.  A more extensive analysis of Varoufakis proposal can be found at Lars Christensen’s Market Monetarist Blog ; which also includes a complete series of links about GDP linked bonds.

1 comment:

  1. nice one.loved reading might like this research proposal on inflation , I guess. Let me know if you like it. :) . Thanks for sharing such a great post.