Inflation-Linked Bonds Issuance: A potential tool in Debt Management Strategy for MEFMI Countries

By Cappitus J.O. Chironga
April 2015
Debt management strategy remains one of the key policy instruments Governments all over the world use to ensure that public and publicly guaranteed debt remain sustainable in the medium term. Among the objectives, both primary and secondary, embedded in a typical DMS are; Cost – Risks management goals, Cash Management, Policy implementation and domestic financial development. Various tools used in attainment of these objectives have proven effective to a large extend in many countries. However, the use Inflation Linked Bonds (ILBs) as a direct public dent management strategy tool remain less exploited more so in Africa and the MEFMI region in particular. The instrument has grown in usage in developed and emerging markets economies across the globe. Sadly, Africa continues to lag behind in tapping this tool in its debt management frameworks. To the best of the knowledge of the author, only South Africa has actively used this instrument (annex I and II) among the African countries as part of its debt management strategy. This paper has tried to show the many benefits that accrue to use of ILBs from three perspectives derived from public DMS objectives; Public Debt Management Operations, Monetary Policy implementation, and Financial Markets Development. From the empirical literature, global experiences and econometric analysis results, we deduce that ILBs contribute immensely to cost savings to the extent of inflation expectations and inflation risk premium. In addition, the fact that the Cash flows (interest and principal pay-outs) of ILBs are indexed on realized inflation and so are the Government tax collections since both are nominal variables, ILBs therefore minimizes the mismatch between the two cash flows that be caused by sudden inflation dynamics, thus contributing to the stability of Government debt cost structure. The OLS estimation using Kenya’s quarterly data shows significant impact of inflation on tax collections, and intuitively on debt service costs. From monetary policy perspective, if ILBs portfolio accounts for a critical proportion of overall Government Debt Portfolio, then monetary authorities will experience enhance policy credibility towards price stability. The breakeven inflation (yield spread between ILB and nominal bond of similar maturity) provide information signalling mechanism to the monetary policy authorities about average inflation expectations build-up. In terms of financial markets development, ILBs provide alternative asset for inflation hedging, and therefore become a preferred instrument by long term investors like pension and insurance firms. In effect, inflation protection element of ILBs dissuades potential investors from divesting from fixed income into commodities, real estate and even imports, thereby contributing to a more developed and vibrant long term capital markets. Care should however be taken so that ILBs do not lead to over-indexation of other sectors of the economy, including wages, loans, and other contracts.