Professor Michael Mainelli
Published by Journal of Risk Finance, Volume 10, Number 5, Emerald Group Publishing Limited (November 2009), pages 537-39.
Government innovation, despite its rarity, isn’t an oxymoron. Governments, when forced, can be as innovative as other large organisations. However, what force might be strong enough to force governments to innovate? James Carville, an advisor to President Clinton, quipped – the bond markets - “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a 0.400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody” [Wall Street Journal, 25 February 1993]. And there are big changes afoot in government bond markets.
Government debt is about to rise sharply due to a perfect storm of financial crises, recession, fiscal stimulus costs, falling tax receipts due to recession and falling tax receipts due to stimuli, under a looming overhang of demographic change leading to rising healthcare and pension costs. Throw in the facts that private finance initiatives may be coming back to haunt government balance sheets and vastly larger off-balance sheet pension obligations are moving into current expenditure.
The Economist summarised a recent IMF report(“Fiscal Implications of the Global Economic and Financial Crisis”, 9 June 2009); “by next year  the gross public debt of the ten richest countries attending the summits of the G20 club of big economies will reach 106% of GDP, up from 78% in 2007. That translates into more than $9 trillion of extra debt in three years … The IMF economists’ baseline is that the government debt of the rich ten will hit 114% of GDP by 2014. Under a darker scenario in which economies languish for longer while fears about governments’ solvency push interest rates up, the debt ratio could be 150%” [“Government Debt: The Big Sweat”, 11 June 2009]. Against global GDP of some $55 trillion, that’s a lot of new debt. The UK government estimates that it will be issuing £260 billion of gilts (UK government bonds) in 2010 alone on UK GDP of £1.2 trillion.
Whew, governments’ finances are a right mess. So what’s new? Well, the scale and simultaneity are new. On the IMF’s optimistic estimates, government debt will grow by 36% in three years; on its pessimistic estimates, by 50%. The skies will darken with so much debt. So much debt is likely to create serious market trouble as it crowds out private sector debt. The ratio of global public sector debt to private sector debt is about 2 to 1, so there’s going to be a lot of crowding. So much debt will increase governments’ temptations to escape through inflation and default. Yet, the silver lining is that so much debt will encourage innovation. In any market where supply is about to grow massively, producers (governments) need to lower their costs (increase the yield) and tailor their products to customers (investors). Governments are going to compete heavily to issue this debt and thus need to find ways to distinguish themselves. And this leads to innovation.
It’s questionable how much true innovation exists in finance. Everyone talks about innovation and it’s certainly appeared over the decades in retail technology such as credit cards or cash machines. A lot of so-called innovation is tediously obvious, e.g. online banking; it stares you in the face that if you can buy everything online why not bank online. A lot of capital markets innovation has ancient roots (futures and options simply updated), and who wouldn’t use computers for calculations. Still, bond markets have been innovative themselves over the decades at a technical level, e.g. clawback provisions (options to redeem a specified fraction of the bond issue within a specified period at a predetermined price with funds that come from a subsequent equity offer) and at a structural level, e.g. inflation-linked bonds. Inflation-linked bonds emerged during similar periods when governments were in tough spots issuing debt, the UK in 1981, followed by Australia in 1985, then Canada in 1992, Sweden in 1994. The premise behind this article is that we can expect an explosion of new ways of structuring and selling government debt because governments are competing heavily; all at once.
What might these new products look like? One idea, Index-Linked Carbon Bonds, was highlighted in a London Accord team paper and presented to the World Bank Government Borrowers’ Forum at Ljubljana in May 2009. At their simplest, index-linked carbon bonds would set interest rates on government debt by linking to governments’ carbon emission targets, tariff feed-in prices, in-country fossil fuel prices or carbon prices. Governments would pay more interest when they missed targets or when relevant green prices were lower than governments had promised. This kind of index-linked bond could easily be issued by any government (national, state, province) or multi-lateral agency without any need for a global initiative. Governments claim they are serious about meeting carbon emission targets and moving to a low carbon economy. Given that failure to perform would cost, governments would have real incentives to meet their own emission targets.
These bonds would change the risk management of large energy projects. Clean tech projects, for example, face virtually the same risks as traditional energy projects, except for one thing – their competitiveness depends on government policy being enacted. Investors cannot hedge emission target failure or low feed-in tariffs, nor hedge low fossil fuel prices or low carbon price risks over a significant part of the project life. But that is where index-linked carbon bonds would come in – by issuing debt whose interest rate is linked to these risks over the life of the project. This government debt provides investors with a risk profile that mirrors their clean tech investment risk, allowing them to hedge against governments failing to deliver. An investor would invest in a low-carbon project (either equity or debt), and simultaneously buy a proportion of index-linked government carbon bonds. With close to no faith in government, the hedging might be one to one, i.e. each $1 of government debt issued would result in $1 invested in clean tech. If even a small proportion of the $9 trillion of forthcoming government debt, say a little over 10% or $1 trillion, was in index-linked carbon bonds at one-for-one confidence levels, governments would come close to meeting the clean tech investment targets of reviews such as the Stern Report. As confidence rose in governments, the multiplier effect would increase. Further, the debt price would provide a constant speedometer about confidence in governments meeting green targets.
Index-linked carbon bonds are but one idea. Imagine governments issuing debt linked to other areas they control, branching out from inflation and carbon targets to education, healthcare or crime. We’ll borrow the money, but guarantee we meet our targets. If these markets grew, they would transform corporate risk management and give a new twist to public-private partnership. We’ll locate our corporate facilities in deprived areas (poor education rates, high murder or crime rates) and hedge the risks with government debt (education quality bonds, crime-linked bonds). Of course, risk managers can stimulate innovation by looking at how corporate risks are intertwined with government policies and targets, and then making suggestions.
There are certainly complexities, such as auditing and authentication of government figures, liquidity, leverage opportunities, stripping, etc. As with any new government-private products there will grafters and fraudsters. But faced with bringing far too much product to market at once, governments will have to innovate. As they innovate, governments will join everyone else in needing to prove that “my word is my bond”, and index-linked bonds are likely to proliferate. Naturally, the ultimate innovation will be the government bond whose interest rate goes down as government debt goes down. Fat chance.