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There has been increasing interest in creating bonds linked to the growth of a countries’ gross domestic product. At the spring meetings of the International Monetary Fund and the World Bank, both potential issuers and investors expressed a clear appetite for such bonds. The servicing of these GDP-linked bonds would be higher in times of rapid growth and lower when growth was slow or negative.

GDP-linked bonds would have important advantages when compared with conventional debt for borrowers and investors, as well as significant externalities for the international financial system. For borrowers, issuing such bonds would help stabilise public spending throughout the cycle as governments would service more debt when they could better afford to, and less in more difficult times. It would also significantly reduce the likelihood of costly and disruptive defaults and debt crises. Defaulting on debt is a last-resort that governments find highly undesirable and costly to the country’s international reputation. A temporary reduction of a country’s debt service when the economy deteriorates would facilitate more rapid recovery.

For investors, defaults are costly as they result in expensive renegotiation and sometimes in very large losses. As GDP-linked bonds would help reduce the probability of default, effective total payments will tend to be higher than with conventional bonds. Furthermore, GDP-linked bonds would give investors the opportunity of taking a position on a range of countries’ growth rates, offering a valuable diversification opportunity. If GDP-linked bonds became widespread across countries, investors could take a position on growth worldwide – the ultimate risk diversification.

For international institutions, there would be benefits from the decreased likelihood of debt crises. Reduced risk of crisis contagion would also benefit other countries. These externalities and the fact that financial innovations are difficult to introduce may justify some initial public action (for example, from the World Bank) to help develop this market instrument. The World Bank could, for instance, make loans whose servicing would be linked to GDP. The loans could then be grouped, securitised and sold to the financial markets.

GDP-linked bonds should be a core element of government financing both for developed and creditworthy developing countries. Both of these could start today. Developed countries are the best equipped to issue GDP-linked bonds immediately, because of the relatively high trust that is placed in their capital markets and in their GDP accounting. Their doing so would have a valuable demonstration effect around the world.

Developing countries stand to gain more from issuing these bonds and they could start issuing GDP-linked bonds now. The issuance of even small quantities of these bonds by creditworthy emerging economies would help set in motion an important process of financial development.

The history of financial innovation is essentially one of learning by doing. Inflation-indexed bonds met initial scepticism, relating to problems such as precise measurement of inflation. In fact, once these bonds started to be issued, inflation statistics improved further. Inflation-indexed bonds are now widely accepted across the world; in the UK, they represent around a quarter of government debt. A similar evolution can be envisaged for GDP-linked bonds.

Introducing GDP-linked bonds would create a market for the economies themselves. The widespread impression that the stock market of a country is a market for the entire economy is mistaken. Stock markets are claims on net corporate profits that can constitute as little as 10 per cent of GDP.

GDP-linked bonds could take a couple of forms. Simplest is a perpetual bond that pays a share, say a trillionth, of GDP, at regular intervals to the bond holders. Creating such a form would be analogous to listing a country on a market as if it were a stock and would yield the most transparent price discovery. Another form that may be easier to introduce is a conventional bond that pays a coupon tied by a formula to growth rates of GDP, but guarantees a minimum level of debt servicing, even if the economy stops growing.

Whichever way they are created, GDP-indexed bonds would have important advantages for different actors. The moment is particularly favourable. Investor appetite for emerging countries’ risk continues to be strong. Investors’ experience with Argentine GDP-warrants, issued as part of their debt restructuring, has been very positive: their price has been rising significantly. The time seems ideal for one or more creditworthy countries to start issuing GDP-linked bonds and for investors to buy them. Any country whose growth slows significantly would be thankful afterwards that they bought the insurance such bonds represent. Recent instability is showing yet again the value of insurance against economic fluctuations.

Stephany Griffith-Jones is professorial fellow at the Institute of Development Studies and adviser to the United Nations Department of Economic and Social Affairs; Robert Shiller is professor of economics at Yale University and chief economist at MacroMarkets LLC

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