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On the benefits of GDP-indexed government debt: lessons from a model of sovereign defaults

Listed author(s):
  • Juan Carlos Hatchondo
  • Leonardo Martinez

Whether governments should issue GDP-indexed sovereign debt continues to be the subject of policy debates. This article contributes to this debate by studying the effects of issuing GDP-indexed sovereign debt contracts using the equilibrium default model studied by Aguiar and Gopinath (2006) and Arellano (2008). We consider an extension with perfect indexation, i.e., the government issues Arrow-Debreu securities with payoffs that depend on the next-period aggregate income realization. The ex-ante welfare gain from the introduction of income-indexed bonds is equivalent to a permanent increase in consumption of 0.5 percent. Introducing income-indexed bonds results in welfare gains because it 1) eliminates defaults, 2) increases the average level of debt, and 3) reduces the volatility of consumption.

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Article provided by Federal Reserve Bank of Richmond in its journal Economic Quarterly.

Volume (Year): (2012)
Issue (Month): 2Q ()
Pages: 139-157

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Handle: RePEc:fip:fedreq:y:2012:i:2q:p:139-157:n:v.98no.2
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  1. Michael Tomz & Mark L. J. Wright, 2007. "Do Countries Default in "Bad Times" ?," Journal of the European Economic Association, MIT Press, vol. 5(2-3), pages 352-360, 04-05.
  2. Juan Carlos Hatchondo & Leonardo Martinez & Francisco Roch, 2012. "Fiscal rules and the sovereign default premium," Working Paper 12-01, Federal Reserve Bank of Richmond.
  3. Graciela L. Kaminsky & Carmen M. Reinhart & Carlos A. Végh, 2005. "When It Rains, It Pours: Procyclical Capital Flows and Macroeconomic Policies," NBER Chapters, in: NBER Macroeconomics Annual 2004, Volume 19, pages 11-82 National Bureau of Economic Research, Inc.
  4. Tauchen, George, 1986. "Finite state markov-chain approximations to univariate and vector autoregressions," Economics Letters, Elsevier, vol. 20(2), pages 177-181.
  5. Talvi, Ernesto & Vegh, Carlos A., 2005. "Tax base variability and procyclical fiscal policy in developing countries," Journal of Development Economics, Elsevier, vol. 78(1), pages 156-190, October.
  6. Paolo Mauro & Marcos d Chamon, 2005. "Pricing Growth-Indexed Bonds," IMF Working Papers 05/216, International Monetary Fund.
  7. Satyajit Chatterjee & Burcu Eyigungor, 2012. "Maturity, Indebtedness, and Default Risk," American Economic Review, American Economic Association, vol. 102(6), pages 2674-2699, October.
  8. Juan Carlos Hatchondo & Leonardo Martinez & César Sosa-Padilla, 2016. "Debt Dilution and Sovereign Default Risk," Journal of Political Economy, University of Chicago Press, vol. 124(5), pages 1383-1422.
  9. Krugman, Paul, 1988. "Financing vs. forgiving a debt overhang," Journal of Development Economics, Elsevier, vol. 29(3), pages 253-268, November.
  10. Cristina Arellano, 2008. "Default Risk and Income Fluctuations in Emerging Economies," American Economic Review, American Economic Association, vol. 98(3), pages 690-712, June.
  11. Horacio Sapriza & Filippo Taddei & Guido Sandleris, 2008. "Indexed Sovereign Debt: An Applied Framework," 2008 Meeting Papers 1064, Society for Economic Dynamics.
  12. Chamon, Marcos & Mauro, Paolo, 2006. "Pricing growth-indexed bonds," Journal of Banking & Finance, Elsevier, vol. 30(12), pages 3349-3366, December.
  13. Jonathan Eaton & Mark Gersovitz, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Oxford University Press, vol. 48(2), pages 289-309.
  14. Aguiar, Mark & Gopinath, Gita, 2006. "Defaultable debt, interest rates and the current account," Journal of International Economics, Elsevier, vol. 69(1), pages 64-83, June.
  15. Juan Carlos Hatchondo & Francisco Roch & Leonardo Martinez, 2012. "Fiscal Rules and the Sovereign Default Premium," IMF Working Papers 12/30, International Monetary Fund.
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