Eurozone bailout policies in crisis: A novel win-win approach is needed

Economic growth-linked bonds convertible to natural gas for Cyprus  Robert Shiller suggested we can solve the debt crisis by issuing bonds linked to GDP and that “the opportunity to participate in the uncertain economic growth of the issuer might well excite, rather than scare off, investors—just as it does in the stock market.” (HBR, 2012) EU politicians have been locked in recent years in myopic and often self-defeating policies regarding bailout of troubled eurozone countries. They have insisted, in principle correctly, that troubled countries bring their finances to a sustainable path. But the chosen austerity measures oftentimes choke the sovereign economies killing their growth prospects and damaging their very ability to repay the lenders. And the less able the borrowers become, the tougher the repayment terms, leading to a vicious cycle of further deterioration and sequels of ineffective rescue packages. The European Central Bank recently stated that eurozone countries in rescue programs must regain full access to sovereign bond markets before being able to apply for ECB help to lower borrowing costs under the new OMT program. So the high borrowing costs facing troubled economies with poor credit rating will remain a key challenge. New approaches are desperately needed. One alternative is to make the coupon interest paid on rescue loans variable and linked to the rate of growth of the country’s economy. In the downward phase when the economy is in recession, the interest burden will be lower, helping the country to boost growth; when in the future economic growth picks up, GDP-linked payments will be higher precisely when the country can afford it. Moreover, the higher interest payments in the upward phase of the economy will constrain politicians from generous increases in public spending, a likely cause of trouble in the first place. In essence, during recession EU lenders will be providing insurance and interest subsidy to troubled Eurozone members, helping  them to pull themselves up, in exchange for higher growth potential during good times. Markets price such instruments daily (e.g., via interest-rate swaps), setting a variable rate (e.g., LIBOR + spread) that is a fair exchange for a fixed rate. The spread is analogous to an insurance premium. If the instrument provides a hedge benefit or significant upside potential, the premium might even be negative. Suppose the fixed interest rate on a rescue loan by Troika is 3%, and Cyprus’ steady-state GDP growth rate is 4%. In the case of GDP-linked bonds for Cyprus, for example, the interest rate might be GDP growth -1%. If GDP growth next year is 0%, the interest will be a subsidy of 1% helping  economic recovery. If after 10 years GDP growth will be 7%, the interest will be higher, at 6%. It is possible to set a floor below which interest payments will not fall, e.g., 0%, which also can be fairly priced in. In exchange for this downside protection option given to lenders, the spread might narrow. Alternatively, there can be an offsetting cap protecting the issuing government against excessively high payments beyond a specified threshold. Economic growth-linked bonds have obvious benefits for affected countries: they reduce cyclical vulnerability for troubled or developing economies, while preventing misuse of excess funds by politicians in expansion times. By lowering the interest due in hard times they help stabilize government spending and avoid the need for excessive social spending cuts that hurt the poorest levels of society; they also help them pull out of recessions and reduce the likelihood of sovereign default and debt crises. GDP-linked bonds may be attractive to investors, interested in an equity-like position on specific countries’ growth prospects. For example, Cyprus currently has a struggling banking sector and stock market, but promising long-term growth prospects due to its natural gas discoveries. The correlation among these investing possibilities is not that high. The international investor may not be willing to bet on Cyprus’ stock market or banking sector, but may well be willing (perhaps even excited) to take an option on its natural gas prospects or long-term GDP growth.  Evidence from the financial markets confirms that investors are willing to accept lower average returns in the short-term in exchange for a chance at high future growth potential. In fact, many important businesses, such as venture capital, pharmaceuticals or the movie industry, owe their success to actively managing such portfolios of (low probability) high growth prospects. GDP-linked bonds would provide broader benefits to the global financial system. By helping reduce the risk of sovereign defaults and contagion effects, they would strengthen EU stability and the global financial system. The European Commission, the ECB, IMF, even the World Bank and the United Nations, should all encourage a global market for GDP-linked bonds. This will provide a unique global investment opportunity to achieve valuable risk diversification benefits, while preserving the advantages of positively skewed distribution of returns. If growth prospects across emerging markets are less correlated, global investors should actually improve their return/risk performance. This is also a way for rich but low-growth countries to obtain a stake in high-prospect countries currently in trouble, as a fair exchange for their current support to recovery and realization of growth potential. This is a common-sense proposition that is in their best interest and provides a win-win solution out of the prolonged crisis. There is little doubt that many institutional investors would be attracted. Sovereign funds, hedge funds and others interested to have stakes on growth would be natural customers. International risk diversification with upside growth potential would appeal to insurance and pension funds. Domestic pension funds in troubled economies might invest to obtain an inflation hedge and a growth stake. Investors are well familiar already with inflation-linked bonds, protecting bond returns from price increases. However, inflation-linked bonds offer little upside exposure to economic expansion.  Nominal GDP-linked debt combines the advantages of inflation protection and real growth prospects of growth stocks in one. If the country has natural resources or commodities (e.g., oil for Mexico or gas for Cyprus), these instruments can capture the advantages of an option as well. As with any idea to be put in practice, there are legitimate concerns, which can be mitigated through careful design. The difficulty of pricing such instruments can be mitigated by keeping the structure as simple as possible. For example, these bonds should not be callable by the issuer when growth exceeds a threshold (as was done in Bulgaria) as that would remove the growth incentive. A critical mass and standardization of terms across issues would help to achieve market liquidity and facilitate pricing. This would also allow securitization in the international market. Market swaps of fixed-rate and GDP linked bonds may facilitate price discovery. Some might argue that the yield on a GDP-linked bond is more variable and should require a premium over a similar fixed-rate bond. However, given that the correlation between a typical troubled or an emerging country and the developed countries or the global equity markets is rather low (sometimes negative), such risk premium should be low. In fact, if the country offers significant future growth prospects (as in Cyprus due to its gas), the risk premium may actually be negative due to the growth option and positive skewness of returns. That is in line with recent market evidence on growth stocks. In sum, in countries with significant growth prospects, the variable rate on the GDP-bonds might even be lower than the fixed rate on an equivalent normal loan. There is also a concern about delays or possible manipulation of reported GDP growth which may cause uncertainty in the interest payments. The involvement of Eurostat (for eurozone members) would ensure reliability of statistics to alleviate these concerns. A variant that does not suffer from this problem is commodity-linked bonds, such as a bond linked to natural gas prices that might be quite suitable for the case of Cyprus. Many emerging countries that have natural resources can benefit from such instruments. Commodity prices are reported with no delays and have an established market record, in spot, futures and other derivative transactions. Cyprus has significant growth potential due to its gas reserves which could  provide additional insurance through an extra option: a GDP linked-bond convertible into gas.  Part B An alternative  to current (failed) Eurozone bailout policies is  to consider GDP-linked bonds, which in the case of Cyprus might also be convertible into natural gas. This might work as  follows.  International investors would be invited to buy these convertible bonds at various denominations, say from 25 M, 100 M, 500 M, up to one billion Euro, corresponding to specific quantities of future natural gas delivery (potentially in Cyprus’s economic zone), to raise a total of 17 billion Euro (the estimate for bailing out Cyprus). Each bond would have a maturity of, say, 15 or 20 years. In the first 10 years the bond simply pays a variable-coupon interest linked to Cyprus’s GDP growth +/- spread. The spread can be set by standard financial practices, taking account of the growth options given to investors. After 10 years (a conversion-protection period), the bond can be converted into specific amounts of natural gas (depending on the denomination chosen) to be purchased, for example at a 10% discount to the current price. Conversion times after year 10 could be graduated or alternative bond denominations may allow conversion in different subperiods to preclude all investors exercising at the same time and producing a (predictable) future shock in the spot market for Cypriot gas.  The above conversion  option has a market price determinable today that can offset part of the loan repayment or can be converted into an equivalent reduction in the spread and interest payments on the loan. In the early years when Cyprus’ GDP growth is low and the economy struggling, the country will benefit from the subsidized lower interest payments to be able to recover. Within a decade, as gas growth prospects materialize and GDP growth rises, investors can choose to keep it as a bond receiving higher GDP-linked payments or convert it into specified amounts of natural gas at the set discount price. The latter option will provide investors more assurance about the hybrid loan’s upside potential. Gas prices are less subject to potential manipulation or mismanagement by the government than GDP growth statistics, gas revenues, government budgets or the future state of the domestic economy. In effect, the gas linked option collaterizes the loan with gas, reducing its riskiness thereby lowering the interest rate. In case future economic growth slackens instead of picking up investors will convert to gas. The above may also have implications for the cost of funding of the gas venture itself.  Neither the GDP-linked bond nor a bond convertible into a commodity (such as gas or cotton) are really new ideas (though their suggested combination here might be). Exactly 150 years ago (on March 19, 1863), in the midst of a losing Civil War, The Confederate States of America (the eleven Southern states that seceded from the Union to preserve slavery and their cotton plantations), issued a 7% Coupon bond, convertible into cotton (the “Cotton” Loan). At the time, cotton was the analogue of what oil and gas is today for the global economy (the textile-driven industrial economies of England and France were heavily dependent on cotton). The bond was issued in five European cities and raised $8.5 Million at the time. It offered a clause permitting conversion into cotton (deliverable in Southern Confederate ports) at a specified price per pound. They were offered in 4 denominations (e.g., 1,000 £ or 25,000 Fr for 40,000 lbs of cotton). Whereas the price of a Southern straight-bond issued in Amsterdam at the same time plummeted each time the South lost a battle and the probability of default rose, the price of cotton rose and the convertible bond gained value in the midst of an ugly civil war. The cotton convertible bonds effectively provided a hedge against the risk of war and was a common sense solution to Southern funding. The cotton convertible bond was a huge success. Ships were rented from Europe to take delivery in Southern ports, bypassing the Union’s blockade. It was a win-win business deal for the European lenders and the issuing government alike that took center stage and marginalized politics. Although the economic and military prospects for the South were deteriorating daily, and the probability of default rising, Europeans focused primarily on the prospects in the price of cotton in valuing the cotton-linked loans and funded the South generously. Shouldn’t we all (the EU Commission, the Troika, the Cyprus government) take lessons from (financial) history? After repeated failed attempts of half-baked policies that have curtailed growth prospects, shouldn’t we take another look at other common sense win-win alternatives? 150 years ago the Southerners and Europeans relied on common business sense. Why can’t we do the same today? The case of Cyprus currently confronting the Eurozone provides a unique opportunity, due to gas growth prospects, for the EU and global financial institutions to try out a novel common-sense approach. European policy makers should stay clear of suggestions for “haircuts” in uninsured bank deposits. No self-respecting economist or lender would countenance proposals that would kill the chance of recovery and damage financial credibility. A loss of confidence in the safety of Eurozone bank deposits tested in Cyprus will not only destroy the banking system and professional services’ sector of the island nation, but will produce contagion effects that will reverberate through the European and global financial systems.  Lenos Trigeorgis holds a PhD (DBA) from Harvard University and is the Bank of Cyprus Chair Professor of Finance at the University of Cyprus and President of the Real Options Group. He has been a Visiting Professor of Finance at the London Business School. He is the author of Real Options (MIT Press, 1996), Strategic Investment (Princeton University Press, 2004) and Competitive Strategy (MIT Press, 2011).