The risk of sub-optimal allocation of government spending when implementing GDP-linked bonds

Abstract: This paper examines the risk of suboptimal allocation of public resources in countries issuing GDP-linked bonds and how such risk can be mitigated. Throughout the analysis, a linear interest rate function for GDP-linked bonds is used. The paper shows that converting some share of the national debt to GDP-linked bonds makes growth above the expected growth trend relatively more costly compared to countries having solely plain vanilla bonds. Using this insight we develop a model of allocation of public resources where governments are faced with a trade-off between productive and unproductive spending. Applying the model, we find that introducing GDP-linked bonds should lead to a reallocation of public resources, in favour of more unproductive spending. As investors are unable to fully observe, verify and control governmental behavior in the post-contract period and as incentives are not necessarily inlined, there is a risk of moral hazard related to GDP-linked bonds. The paper further discusses ways to mitigate the moral hazard risk and propose increased transparency and monitoring to be viable ways forward.