Stabilising economic growth through risk sharing macro instruments

• Published date: 01 March 2018
• Author: Syed Aun R. Rizvi,Shaista Arshad
• Date: 01 March 2018
• DOI: http://doi.org/10.1111/twec.12513

SPECIAL ISSUE ARTICLE

Stabilising economic growth through risk sharing

macro instruments

Syed Aun R. Rizvi

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Shaista Arshad

2

1

Lahore University of Management Sciences (LUMS), Lahore, Pakistan

2

Nottingham University Business School, University of Nottingham Malaysia Campus, Malaysia

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INTRODUCTION

A slowdown in the economic system or a sudden stop can create havoc to an indebted economy.

Countries affected by economic recession are more likely to experience debt servicing difficulties.

In these circumstances, an indebted country has three options, all of which lead to disastrous econ-

omic results. First, it can choose to default on its obligations, resulting in traumatic long-term

effect for the economy. Second, it can renegotiate and seek restructuring, which in principle would

have the same consequences as in the case of default. Third, it can undertake deep-reaching auster-

ity programmes, and tightening fiscal policies, all of which impose substantial economic and social

cost.

However, there is an alternative to the above detrimental options. Heavily indebted countries

can opt to index their sovereign debt payments to real economic variables as a mechanism to

reduce financial distress. The underlying principle of this mechanism is based on improving risk

sharing among debtor countries and international creditors. On this, Bailey (1983) suggested the

transfer of sovereign debt into claims on exports of a sovereign country. Krugman (1988) and

Froot, Keen, and Stein (1989) further elaborated on this study and delved into analysing relative

merits of indexing sovereign debts to variables completely and partially under the control of the

country. Meanwhile, Shiller (1993) proposed a concept of GDP-linked securities, which essentially

were perpetual claims on a fraction of a country’s GDP.

In this paper, the benefits of using a GDP-linked sovereign paper as an instrument in providing

economic stability to the developing economies are analysed, in particular for Islamic countries.

Despite the estimated global Muslim population of 1.4 billion (Pew Research Centre, 2013), and

Muslim countries rich in oil reserves, the estimated asset size of Islamic finance is only 1% of the

global financial system. One of the reasons for underachievement of the potential is the heavy

indebtedness of Muslim nations and reliance on multilateral agencies for meeting the borrowi ng

needs of the government. Hence, the savings of the Muslim economies fund the growth of Western

economies. This raises the question of first whether the modern-day Islamic financial system has

the instruments needed and second whether there is the capacity to address the recurring borrowing

and financial deficit needs of Muslim governments.

DOI: 10.1111/twec.12513

World Econ. 2018;41:781–800. wileyonlinelibrary.com/journal/twec ©2017 John Wiley & Sons Ltd

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Hence, the objective of this paper was to bring forth strong empirical evidence on the benefits

of using a GDP-linked sovereign paper in particularly for Islamic countries. Using instruments

from Islamic finance, this study simulates results of the potential benefits could be reaping had the

proposed instrument of a GDP-linked sovereign paper been used.

This study is novel in this area as it is a humble attempt to initiate empirical resear ch-based

argument to provide policymakers and economists an alternative Sharia compliant instrument as a

replacement of the conventional sovereign debt. Only one such study is available; Diaw, Bacha,

and Lahsasna (2012) have discussed the potential benefits of a GDP-linked Sukuk (Sharia compli-

ant fixed income instrument) and the structuring of the instrument basing the structure on forward

Ijarah (Sharia compliant leasing). We further the study by proposing a pure risk sharing (mushara-

kah) paper, owing to its more risk sharing nature.

A multistep process is used to achieve the above objective. First, the sample countries are

divided into five groups based on their real GDP per capita over the last 5 years, ranging from less

than US$600 to up to US$10,000. Second, a fully modified OLS is done to estimate the coeffi-

cient of the five groups, and this will tell us whether debt servicing has a n impact on real GDP

per capita. Third, using the estimates, we calculate the cumulative impact the proposed instrument

would have on real GDP per capita. Fourth, we simulate the real GDP per capita for all the sample

countries by calculating the mean and volatility. Fifth, the viewpoint of investor concern is exam-

ined by analysing the returns in a risk-adjusted framework using the Sharpe ratio. To affirm the

validity of our results, the sample countries are taken as a cluster of countries rather than a country

analysis, and the results hold.

The outcomes of this research provide significant contribution to existing literature. First, the

result that debt servicing tends to have a positive impact on the real GDP per capita for lower

income countries is in line with literature (see Cohen, 1993; Chawdhury, 2001; Schclarek, 2004).

Second, our findings exhibit lowest income group countries to be the biggest beneficiary of this

instrument, as their average real GDP per capita over 20-year period of 1992–2012 will be signifi-

cantly higher than their actual real GDP per capita recorded. These results are in line with Obstfeld

and Peri (1998), Caballero (2002), Kamstra and Shiller (2008, 2009). Third, analysis on investor

risk showed that there was a positive Sharpe ratio for almost all the countries in the sample.

The present paper is structured as follows: Succeeding the introduction is an insight into the

need of our proposed risk sharing instrument in Section 2. Section 3 discusses the methodology in

brief followed by the empirical-based argument in Section 4. Subsequently, the authors provide

concluding remarks in Section 5.

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GDP-LINKED SUKUK

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Need for GDP-linked sovereign paper

GDP-linked sovereign paper aims to provide a breathing room to economies when they go into

recession and on the other side provide an automatic slowing-in mechanism when the economy

goes into high growth zones and into overheat. Analysing the advantages of this instrument, we

can find two sets of clear advantages from an economic point of view for Muslim countries.

First, since the payment of profit is linked to the actual growth of the economy, it can reduce

the likelihood of crises. In comparison with the normal borrowing mechanism that Muslim econ-

omies are subjected to via plain vanilla sovereign bonds or multilateral agency debts, the payments

are fixed, and any slowdown in economy results in a ballooning of debt.

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