The debt burden on developing countries is significant and debt servicing in this post-COVID-19 and war-torn era is difficult. Therefore, policymakers, as well as multilateral institutions are already quite concerned about the current debt vulnerabilities worldwide. Debt was already excessively high before the first COVID-19 lockdown and then the Ukrainian war is currently adding more risks to high public borrowing, particularly as the government budgets did not recover yet from the pandemic.
Hence, policymakers are required to cooperate to ease the debt burdens of vulnerable countries, promote better debt sustainability and simultaneously consider the interests of both debtors and creditors. During the pandemic, both deficits and debt augmented as borrowing rose to 256% of GDP in 2020, according to the IMF’s Global Debt Database. Developing countries’ debt and servicing costs have also risen steadily in recent years: Around 60% of low-income countries are facing the risk of distress.
Concerns due to increased inflation
Although inflation may lessen debt-to-GDP ratios in the short run, the steady and volatile aspects of inflation do augment the cost of borrowing in the long run, particularly for countries that do have short debt maturities. Therefore, the situation in developing countries is particularly alarming, as they face continuous GDP and revenue losses.
Hence, government spending will continue to increase and the SDGs far to be met, in addition to the high augmentation in energy and food prices and the erosion of living standards.
Furthermore, main global central banks already augmented interest rates to slow down inflation, while sovereign spreads in developing countries are still high. Debt restructurings are expected to become more recurrent and may require improvements such as using financial instruments that may satisfy and help address the concerns of both creditors and debtors.
The financial signs
Part of the challenge for better debt servicing is the importance of the choice of a convenient debt instrument. Before suggesting or designing the financial products that may be used, we need to first study and analyse the requirements that these financial products need to fulfil.
A suitable debt instrument needs to consider several challenges, such as to help solve the issue of mismatching, described as the “original sin” by Eichengreen and Hausmann (1999). Particularly the mismatching in debt maturity and earnings is one of the main reasons that led to financial crises and caused the vulnerability of the financial industry, especially during the global financial crisis of 2008 (Baily et al., 2008).
An appropriate financial product also needs to successfully tackle the floating interest dilemma, as the rate can float up and augment the periodic payments so that the borrower cannot make them, which is one crucial factor that led to the world debt crisis in the 1980s and the US subprime crisis that turned into a global financial recession.
Therefore, we do believe that variable-return products, particularly GDP-linked shares can help address both issues and constitute a better alternative to the conventional bonds:
Variable-return products emerge once again as the right financial instruments to address the concerns (Al-Suwailem 2006). The set of these products involves “commodity-linked bonds”, which are debt securities, where the coupon payments are directly linked to the price of the underlying commodity and the “GDP shares”, proposed by the Nobel prize laureate Robert Shiller (2012).
The GDP-linked bonds or “GDP shares” or “Trills” were suggested by several prominent economists and were supported by many central banks and multilateral institutions such as the bank of England and the IMF (Griffith-Jones 2018).
The coupon and the principal of the GDP-linked bonds are proportional to the issuing country’s GDP, so governments may issue GDP-linked bonds to collect funds and promise to pay in proportion to their GDP, just as companies issue shares.
Indexing of debt servicing to GDP emerged in the 1980s and received support from many prominent economists, such as Robert Shiller and Joseph Stiglitz, after the recurrent debt crises. Among the attractive advantages of GDP-linked bonds is that it may allow the issuing government to benefit from debt ease if the economic growth is low and the tax income decreases, from one side.
On the other side, the investors will be released from being tied to low-interest rates by being exposed to the real economy in case the latter takes off (Benford et al. 2018). The repayments of this portfolio may be indexed to the growth rate of several issuing countries at the same time (Griffith-Jones 2018).
The connection that GDP-linked bonds may have with the economy may also be appealing to investors, who are interested in development impact bonds as well. Hence, GDP-linked bonds may permit global financial risk to be better shared, by reducing the necessity for international sovereign bailouts. It is worth mentioning that the world nowadays is financially extremely connected, a default of one country will have an impact on the other countries, particularly the ones, which are highly connected to it economically and financially. If GDP-linked bonds reflect the economic growth then the economic performance of a country and the ability to perform its debt servicing would contribute to reducing the likelihood of default and lessen the risk of contagion of some countries by the default of a specific country.
Multilateral Development Banks (MDBs) may play a crucial role in promoting GDP-linked bonds by developing an appealing portfolio of loans for a proper set of investors that are interested in this kind of product. It is crucial to identify the pool of investors, who are interested in such products. Since GDP-linked bonds have similarities with equities, potential investors may be mainly equity investors and those who are interested in hybrid products.
GDP Sukuks: A resort for our MCs
The Sharia-compliant alternative to GDP bonds is GDP Sukuk, which may be of strategic importance for IsDB: It is a structure that benefits both from the advantages of the design of GDP bonds and Sukuk at the same time.
In 2018, the Bank of England proposed to issue a fixed income GDP-linked Sukuk, with the coupon at issuance indexed to expected inflation and growth rate of real GDP of the issuing economy. Later both the coupon and the principal may be fixed as per the terms of the Sukuk contract (Arshadur Rahman, 2018)
The design of GDP-linked Sukuk shall not be quite different from the design of GDP-linked bonds, it must only be Sharia compliant from a financial product point of view. The risk-sharing GDP-linked Sukuk is essentially a Sukuk based on a standard contract like Ijarah, but with coupon/dividends linked to GDP growth.
A basic form is that dividends are a linear function of GDP growth, while the principal part is paid into a sinking fund, ideally also repaid based on GDP growth. Another alternative is the perpetual only GDP-linked dividends that would look like pure equity. Generally, the more equity-like the structure is, the more variable, the cashflows are and therefore the higher the needed profit is.
|First stage: |
The sovereign employs the funds raised through the SPV to produce some fixed assets (such as schools, hospitals, and infrastructure).
|Second stage: |
The sovereign would lease the asset back from the sukuk holders for a determined period. The asset would be then completely bought at maturity for a predetermined amount. The periodic lease payments to the investors are made on a variable return based on GDP.
Fig. A possible GDP-linked Ijarah Sukuk structure.
The range of investors interested in GDP-linked Sukuk is larger than those interested in GDP-linked bonds as it would involve the investors interested in the latter, in addition to, the Islamic investors.
Crypto GDP-linked Sukuk
Crypto Sukuk is a variant of crypto assets that are a digital “tokenized” form of both Sukuk certificates and their underlying terms of contracts. They may be issued and exchanged, using blockchain technology through dedicated platforms.
Crypto GDP Sukuk may be valuable to both private and public Islamic financial institutions, as well as multilateral development institutions such as IsDB as the Sukuk issuance, distribution, and potentially trading processes would be trustworthy, more limpid, and easier to be verified. Furthermore, tokenized Sukuk allows Sukuk issuance to be less costly.
GDP-linked Sukuk can be issued using Distributed Ledger Technology, such as Blockchain Technology, given that it is better from a governance and efficiency viewpoint. The use of Blockchain technology can achieve several advantages, inter alia the transaction ease and speed as the Blockchain technology may enhance the payment and money transfer services while reducing the cost of these services.
The blockchain network may also provide the origin of a transaction, as well as transaction traceability and transparency. Blockchain may be perceived as a technological evolution that can support and enhance the transparency feature, which is the core underlying principle of all transactions in the Islamic finance industry (Lacasse et al., 2018).
Moreover, the Blockchain includes public-key encryption and adopts a decentralized network instead of a single server to record and verify transactions. In terms of concept and content, blockchain consists of mathematical applications that eliminate prohibited elements, such as “Gharar”. Hence, the verification process is robust and transparent for all network participants (Murray et al., 2019).
Hence, the blockchain system can assist the Islamic financial industry in reaching out to a wider range of clients. The time is ripe to make a change by using instruments that can help in better management of debt for economic development, such as our suggested Crypto GDP Sukuk.
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