Many countries are beginning to ease the lockdowns and re-open their economies. But, even if this process succeeds globally, most countries are facing a sharp increase in their current fiscal deficits and public debt. The IMF estimates advanced country fiscal deficits will average 11% of GDP in 2020, while debt to GDP ratios will rise from an average of 105% in 2019 to 122% in 2020.
In the aftermath of the 2008 global financial crisis, many governments focused on what maximum debt to GDP ratio would be ‘safe’ to protect them from loss of confidence in financial markets – although different considerations applied in the US as the dollar is the global reserve currency.
This time there is more focus on the cost of debt as, with extremely low long-term interest rates, a debt to GDP ratio well above 100% could still be consistent with a manageable burden on the taxpayer and stability in financial markets. But now it is becoming clearer that high levels of debt are likely to be sustained for a long period, governments should also review the form of their debt issuance and consider stepping up their issuance of index-linked debt.
Fixed rate of return
Index-linked debt as a solution provides protection against inflation risk to both investors and the issuer. The principal invested and the interest payments received over the life of a bond are indexed to the consumer price level, so the real rate of return is fixed at the time of issue.
And a wide range of advanced countries already issue index-linked debt, including all members of the G7. In fact, the UK is one of the most prolific issuers with more than 20% of its total debt issuance in index-linked form.
Government debt managers are typically cautious about making radical shifts in issuance strategy so as to avoid disrupting markets. But despite that, there are several reasons why they should now consider a substantial increase in the proportion of long-term index-linked debt they issue.
First, given the real interest rate on index-linked debt is extremely low and sometimes even negative - currently -0.5% on ten-year US Treasury debt - the real burden on the government of this form of debt is guaranteed to remain low, and may even fall over its lifetime. The same cannot be said of nominal local currency debt or foreign currency debt, even when the nominal interest rate is extremely low.
Second, issuing index-linked debt hedges the government against the high degree of uncertainty over the future course of inflation. One current view is that sustained high unemployment and depressed demand could lead to a period of falling prices. But another is that the combination of supply constraints - due to the continuing effects of the pandemic on supply chains and the vast injection of liquidity by central banks through QE - will lead to a high level of inflation. However, if a government issues index-linked debt, its real cost will be the same regardless of what happens to inflation.
Third, issuing large amounts of index-linked debt could help reinforce the message that governments and central banks intend to grow their way out of high debt levels over the long-term, rather than resorting to an inequitable and distortionary inflation shock to devalue nominal government debt.
This potentially gives central banks and governments more credibility with financial markets, which in turn gives them more scope to deploy short-term measures such as QE and direct lending to governments without triggering a negative market response.
Such credibility also helps ensure that long-term rates on both public and private nominal debt remain low and stable. And it would underpin a widening in the short-term inflation target bands maintained by many central banks. This may add useful flexibility in making short-term monetary decisions.
This signalling effect might also make index-linked debt appropriate to finance the 500bn euro fund proposed by Emmanuel Macron and Angela Merkel, reinforcing the message that the new vehicle - and the shift in the EU’s role it represents - is designed to be fully consistent with the ECB’s low inflation mandate.
Finally, increasing index-linked debt issuance now would be of benefit to pension funds, which need to lock in the eventual payments to those nearing pension age, and also low-income investors who cannot take the risk of investing in equities.
Low income investors would otherwise be forced to save through near-zero nominal interest rate accounts which risk delivering substantial negative real returns. There is actually a strong case for governments to offer positive real return index-linked savings accounts targeted on this group, even if it means effectively giving a subsidy relative to the cost of wholesale debt issuance.
There are currently two possible concerns with stepping up reliance on index-linked debt. First, the short-term problems that lockdown restrictions on consumer activity have created for measuring inflation. And the possibility that a sharp increase in index-linked issuance could outpace structural demand and lead to a rise in real yields which does not reflect the underlying economic fundamentals.
However, the lagged indexing process on index-linked debt typically gives time for any difficulties in inflation measurement to be sorted out, while debt managers will be able to monitor the impact of stepped up index-linked issuance on real yields and modify the strategy if needed.
Overall, index-linked debt offers a win-win solution for both governments and investors at a time of peak uncertainty about the future course of inflation. And it is an effective way for authorities to signal to both investors and the general public that - while they need to deploy monetary policy in an innovative and flexible way in the short-term - they do not intend to use inflation to default partially on the vast amounts of new debt they have to issue.
In short, those countries which have already been nurturing this instrument over several decades should take advantage of it.