DEBT MANAGEMENT STRATEGY

The risks inherent in the government's debt structure should be carefully monitored and evaluated. These risks should be mitigated to the extent feasible by modifying the debt structure, taking into account the cost of doing so. A range of policies and instruments can be engaged to help manage these risks.

Identifying and managing market risk involves examining the financial characteristics of the revenues and other cash flows available to the government to service its borrowings, and choosing a portfolio of liabilities which matches these characteristics as much as possible. When they are available, hedging instruments can be used to move the cost and risk profile of the debt portfolio closer to the preferred portfolio composition.

Some emerging market governments would be well served to accept higher liquidity premia to keep rollover risks under control, since concentrating the debt in benchmark issues at key points along the yield curve may increase rollover risk. On the other hand, reopening previously issued securities to build benchmark issues can enhance market liquidity, thereby reducing the liquidity risk premia in the yields on government securities and lowering government debt service costs. Governments seeking to build benchmark issues often hold liquid financial assets, spread the maturity profile of the debt portfolio across the yield curve, and use domestic debt buybacks, conversions or swaps of older issues with new issues to manage the associated rollover risks.

Some debt managers also have treasury management responsibilities. In countries where debt managers are also responsible for managing liquid assets, debt managers have adopted a multi-pronged approach to the management of credit risk inherent in their investments in liquid financial assets, and financial derivatives transactions. In countries where credit ratings are widely available, debt managers should limit investments to those that have credit ratings from independent credit rating agencies that meet a preset minimum requirement. All governments, however, should set exposure limits for individual counterparties that take account of the government's actual and contingent consolidated financial exposures to that counterparty arising from debt and foreign exchange reserves management operations. Credit risk can also be managed by holding a diversified portfolio across a number of acceptable financial counterparties and also through collateral agreements. Settlement risk is controlled by having clearly documented settlement procedures and responsibilities, and often placing limits on the size of payments flowing through any one settlement bank.

In order to help guide borrowing decisions and reduce the government's risk, debt managers should consider the financial and other risk characteristics of the government's cash flows. Rather than simply examining the debt structure in isolation, several governments have found it valuable to consider debt management within a broader framework of the government's balance sheet and the nature of its revenues and cash flows. Irrespective of whether governments publish a balance sheet, conceptually all governments have such a balance sheet, and consideration of the financial and other risks of the government's assets can provide the debt manager with important insights for managing the risks of the government's debt portfolio. For example, a conceptual analysis of the government's balance sheet may provide debt managers with useful insights about the extent to which the currency structure of the debt is consistent with the revenues and cash flows available to the government to service that debt. In most countries, these mainly comprise tax revenues, which are usually denominated in local currency. In this case, the government's balance sheet risk would be reduced by issuing debt primarily in long-term, fixed rate, domestic currency securities. For countries without well-developed domestic debt markets, this may not be feasible, and governments are often faced with the choice between issuing short-term or indexed domestic debt and foreign currency debt. Issues such as crowding out of private sector borrowers and the difficulties of issuing domestic currency debt in highly dollarized economies should also be considered. But the financial analysis of the government's revenues and cash flows provides a sound basis for measuring the costs and risks of the feasible strategies for managing the government's debt portfolio.

Some countries have extended this approach to include other government assets and liabilities. For example, in some countries where the foreign exchange reserves are funded by foreign currency borrowings, debt managers have reduced the government's balance sheet risk by ensuring that the currency composition of the debt that backs the reserves, after taking account of derivatives and other hedging transactions, reflects the currency composition of the reserves. However, other countries have not adopted this practice because of considerations relating to exchange rate objectives and the institutional framework, including intervention and issues related to the role and independence of the central bank.

Debt managers should carefully assess and manage the risks associated with foreign-currency and short-term or floating rate debt. Debt management strategies that include an over reliance on foreign currency or foreign currency-indexed debt and short-term or floating rate debt are very risky. For example, while foreign currency debt may appear, ex ante, to be less expensive than domestic currency debt of the same maturity (given that the latter may include higher currency risk and liquidity premia), it could prove to be costly in volatile capital markets or if the exchange rate depreciates. Debt managers should also be aware of the fact that the choice of exchange rate regime can affect the links between debt management and monetary policy. For example, foreign currency debt may appear to be cheaper in a fixed exchange rate regime because the regime caps exchange rate volatility. However, such debt can prove to be very risky if the exchange rate regime becomes untenable.

Short-term or floating rate debt (whether domestic or foreign currency-denominated), which may appear, ex ante, to be less expensive over the long run in a positively-sloped yield curve environment, can create substantial rollover risk for the government. It may also constrain the central bank from raising interest rates to address inflation or support the exchange rate because of concerns about the short-term impact on the government's financial position. However, such actions might be appropriate from the viewpoint of macroeconomic management and, by lowering risk premiums, may help to achieve lower interest rates in the longer run. Macro-vulnerabilities could be exacerbated if there is a sudden shift in market sentiment as to the government's ability to repay, or when contagion effects from other countries lead to markedly higher interest rates. Many emerging market governments have too much short-term and floating-rate debt. However, over reliance on longer-term fixed rate financing also carries risks if, in some circumstances, it tempts governments to deflate the value of such debt in real terms by initiating surprise inflation. Any such concerns would be reflected in current and future borrowing costs. Also, unexpected disinflation would increase the ex-post debt-servicing burden in real terms. This could create strains in countries, which because of an already heavy debt burden; have to pay a higher risk premium.

If a country lacks a well-developed market for domestic currency debt, a government may be unable to issue long-term, fixed-rate domestic currency debt at a reasonable cost, and consequently must choose between risky short-term or floating rate domestic currency debt and longer-term, but also risky, foreign currency debt. Even so, given the potential for sizeable economic losses if a government cannot roll over its debt, rollover risk should be given particular emphasis, and this risk can be reduced by lengthening the maturity of new debt issues. Options to lengthen maturities include issuing floating-rate debt, foreign currency or foreign currency-indexed debt and inflation indexed debt. Over the medium- term, a strategy for developing the domestic currency debt market can relieve this constraint and permit the issuance of a less risky debt structure, and this should be reflected in the overall debt management strategy. In this context, gradual increases in the maturity of new fixed rate domestic currency debt issues may raise cost in the short run, but they reduce rollover risk and often constitute important steps in developing domestic debt markets. However, debt structures which entail extremely "lumpy" cash flows should, to the extent possible, be avoided.

There should be cost-effective cash management policies in place to enable the authorities to meet with a high degree of certainty their financial obligations as they fall due. The need for cost-effective cash management recognizes that the window of opportunity to issue new securities does not necessarily match the timing of planned expenditures. In particular, for governments lacking secure access to capital markets, liquid financial assets and contingent credit lines can provide flexibility in debt and cash management operations in the event of temporary financial market disturbances. They enable governments to honor their obligations, and provide flexibility to absorb shocks where access to borrowing in capital markets is temporarily curtailed or very costly. However, liquid assets are a more secure source of funds than unconditional, contingent credit lines, since financial institutions called upon to provide funds under these lines may attempt to prevent their exposures from expanding by withdrawing other lines from the government. On the other hand, some governments that do have secure access to capital markets prefer to minimize their holdings of liquid financial assets and instead rely on short-term borrowings and overdraft facilities to manage day-to-day fluctuations in their revenues and cash flows. Sound cash management needs to be supported by efficient infrastructure for payments and settlements, which are often based on dematerialized securities and a centralized, book-entry register.

Sound cash management by its nature combines elements of debt management and monetary operations. Particularly in some developing countries where it is not given a high priority, poor or inadequate cash management practices have tended to hamper efficient debt management operations and the conduct of monetary policy. Notwithstanding the desirability for a clear separation of debt management and monetary policy objectives and accountabilities, the search for liquidity creates a challenge for cash managers that might be more easily dealt with if debt and cash management functions are integrated in the same institution or work in close collaboration. Where cash and debt management functions are separately managed, for example by the Central Bank and Treasury or Ministry of Finance, respectively, close coordination and information flows, in both directions, are of paramount importance to avoid short-run inconsistencies between debt and monetary operations. A clear delineation of institutional responsibilities, supported by a formal service agreement between the central bank, Treasury and debt management officials, as appropriate, can further promote sound cash management practices.

Appropriate policies related to official foreign exchange reserves can also play a valuable role in increasing a government's room for maneuver in meeting its financial obligations in the face of economic and financial shocks. More broadly, the level of foreign exchange reserves should be set in accordance with the government's access to capital markets, the exchange rate regime, the country's economic fundamentals and its vulnerability to economic and financial shocks, the cost of carrying reserves, and the amount of short-term foreign currency debt outstanding. Governments lacking secure access to international capital markets could consider holding reserves that bear an appropriate relationship to their country's short-term external debt, regardless of whether that debt is held by residents or nonresidents. In addition, there are some indicators specific to the government's debt situation that governments and debt managers need to consider. Ratios of debt to GDP and to tax revenue, for example, would seem to be very relevant for public debt management, as would indicators such as the debt service ratio, the average interest rate, various maturity indicators, and indicators of the composition of the debt.

(by IMF & World Bank)