My Say: Financing Covid-19 stimulus packages with GDP-linked sukuk

This article first appeared in Forum, The Edge Malaysia Weekly, on June 22, 2020 - June 28, 2020.
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We live in unprecedented times. As the world braced itself for an impending recession in 2020, it was caught unawares by a global pandemic. The Covid-19 pandemic immediately shut down all travel and non-essential sectors of the economy and quarantined people in their homes. Responding to the pandemic has elicited from governments and world health officials some of the most drastic strategies that we have seen in recent history.

The consequential lockdowns of entire provinces and even countries have slowed down economic activities substantially. The possibility that the virus is airborne and can live for days or weeks on any surface means economic shutdowns have to be considered until a medically-proven vaccine is found. Research also shows that the virus is most infectious before the patient displays any symptoms, which complicates matters when dealing with the virus.

Our lack of knowledge about the virus is our greatest weakness in combating it. Not knowing who has been infected, or who is a carrier without symptoms, contributes to higher infection rates. Not knowing enough about the virus delays our ability to treat those infected or release those from quarantine with absolute confidence. It hinders our judgement on restarting the economy and leaves us little choice but to take a measured approach in getting people back to work and to allow businesses to return to operations.

Containment measures to “flatten the curve” are still being enforced and loosened in phases in order to prevent a second wave, which historically has been more deadly than the first (the Spanish flu pandemic of 1918 is an example). Adjustments to work-from-home (WFH) orders and social distancing have transformed business-as-usual to such an extent that shifts in the economy will be inevitable. It is likely that within the next few months, there will be companies, both big and small, that will file for bankruptcy and there will be sovereign defaults as countries face drying liquidity.

The fiscal cost of fighting the economic fallout of the pandemic has been great for each nation. Many governments have already pledged billions in grants to support fiscal stimulus packages for health care, liquidity to the private sector (in the form of credit lines to small and medium enterprises or SMEs), short-time work schemes and assistance to households whose incomes were affected by the lockdowns. Through moratoriums and debt relief programmes, capital that would have otherwise been used to pare down debts will instead be utilised by vulnerable groups and SMEs to support their expenditures in times of reduced income. These expenditures will in turn contribute towards GDP growth and, directly and indirectly, save jobs and limit unemployment.

But in order to do so, governments have to dig deep into their reserves. Others have had to resort to debt. The need for stable capital flows to help moderate economic recovery requires support for the real economy. If capital runs out before the economy recovers adequately, we could potentially be dealing with a possible default on sovereign debt. It is therefore important to develop and utilise market instruments that can boost the recovery curve.

To prevent such unwanted situations, governments typically issue public-debt instruments such as sovereign bonds or sukuk. However, doing so creates more fiscal indebtedness. This indebtedness also reduces fiscal space for governments to manoeuvre when managing their debt levels. We propose that governments fund their multiple fiscal stimulus packages through a GDP-linked instrument issued by the country.

GDP-linked sukuk is one way to convert those debts into equity repayments based on the GDP performance of the country. Such a growth-linked financial instrument is akin to a “stock on a country”, in the sense that it has “equity-like” features. Similarly, it pays more “dividends” to its investors when the performance is better, and less when it is worse than expected.

The advantage of issuing such an instrument is that, firstly, by converting debt to equity, the government can now increase its debt limits. The debt limit is defined as “the maximum level of debt that a sovereign is likely to be able to sustain before it risks facing a crisis”. That space between debt ratio and debt limit is deemed as the fiscal space. Having more fiscal space allows governments more room to manage their debt levels. Although creating more fiscal space may allow for more debt to be issued in the future, we would rather recommend it as an instrument to reduce total debt, so as not to undermine sustainability. Too much debt has severe implications on the stability of nations and their economies.

Secondly, the repayment on this sukuk will be in proportion to the country’s GDP whereby the repayment automatically declines when growth is weak and increases when GDP is strong. In doing so, an anticipated deep recession caused by the global pandemic slowdown will make it less likely to trigger a sovereign debt crisis. Such a strategy would provide the issuing government with an economic reprieve when growth weakens and tax receipts decline.

Also, during lower-than-expected growth, the creditworthiness assessment of sovereign bonds falls due to a higher-than-expected debt ratio, which raises default risk if more fiscal space is not created. Such flexibility in exchange for an increased rate of return during good times would allow the debt contract to be written with a lower average profit or return rate, in the absence of an interest rate.

Lastly, the idea of issuing GDP-linked sukuk is similar to having a kind of insurance against unprecedented economic shocks in very uncertain times. Debt crises that involved countries such as Portugal, Ireland, Greece and Spain over a decade ago would have been less severe if their debt had been coupled to their GDP. Investment in GDP-linked instruments allows for risks to be more acceptable, given the potential upside to investing in entire economies.

In addition, global investors can achieve the benefits of diversification by holding GDP-linked sukuk. Investors can view this shared-risk instrument as an alternative asset class through exposure to the real economy, given the low interest rate environment. Both sides are incentivised by the debt-stabilising effects of issuance that would make sovereign defaults less likely and balance risk-taking.

The system-wide benefits afforded by growth-linked instruments far exceed those that can be achieved by individual investors or countries. GDP-indexed securities can be viewed as desirable vehicles for international risk sharing and for avoiding the disruptions arising from formal default. The dead-weight costs of long debt restructuring in times of crises would be avoided, as debt is automatically modified.

GDP-linked instruments have the characteristics of a public good as they generate systemic benefits above those accruing to individual investors and countries. If the GDP-linked sukuk lower default risks, they would make remaining conventional bonds safer in the same country. By reducing the likelihood of defaults, they would also benefit a broader range of investors than just those directly affected, along with economies not issuing them, but which would reduce their chance of contagion from other countries, as well as economic and multilateral institutions.

The reality is that, despite its demonstrated benefits, GDP-indexed instruments have not been widely issued, beyond countries having difficulties in servicing their debts. The inertia caused by financial innovation coupled with the complexity of implementing new financial inventions may be the impediments. But like most things worth accomplishing, it takes time and effort to pursue an innovation until its successful implementation. Perhaps, the current economic dire straits caused by the pandemic may provide the impetus and motivation to do so.

With sovereign debt levels rising and reserves diminishing, GDP-linked instruments are attractive because they can ensure that debt stays in step with the growth of the economy in the long run and can create fiscal space for countercyclical policies during recessions. Thus, GDP-linked instruments would give governments more room to manoeuvre in their fiscal policy space, which would be especially valuable at a time like the present when fiscal space is scarce and immediate solutions are urgently needed.

While innovative sukuk development is still not widespread, the sukuk capital markets have come a long way and have been the compelling force behind the growth of Islamic finance. With their ability to protect the vulnerable groups and SMEs at this crucial time when most countries are restarting their stalled economies, such instruments help international investors manage country risks and raise the sovereign’s desirability.

The proposed GDP-linked sukuk would also allow risk to be shared across borders more efficiently and safely, and make sovereign defaults less likely while balancing investor risk-taking.


Hazik Mohamed is the managing director of Stellar Consulting Group and lectures part-time at Putra Business School. He has a PhD in Islamic Finance. His wide research interests include financial inclusion, poverty alleviation, sustainable practices and the use of digital technologies to advance them.

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