RISK MANAGEMENT FRAMEWORK ON PUBLIC DEBT
Cost and risk
A framework should be developed to enable debt managers to identify and manage the trade-offs between expected cost and risk in the government debt portfolio. The cost of government debt includes two components: (1) the financial cost, which typically is considered to be the cost of servicing the debt over the medium- to long-run (and may be measured in terms of its impact on the government's fiscal position), and (2) the potential cost of real economic losses that may result from a financial crisis if a government has a particular strategy for managing the portfolio, debt servicing costs can be projected forward over the medium- to long-term, based on assumptions of future interest and exchange rates and future borrowing needs. To minimize bias in choosing among different strategies, some governments use "market neutral" assumptions of future interest and exchange rates; e.g., based on market measures of forward rates, or on simple assumptions that rates will remain unchanged, etc. The expected cost can be evaluated both in terms of the projected financial impact on the government's budget or other measure of its fiscal position, as well as for possible real costs if the projected debt service is potentially unsustainable in terms of its impact on future tax rates or government programs, or if there is a potential for default.
Market risk is then measured in terms of potential increases in debt servicing costs from changes in interest or exchange rates relative to the expected costs. The potential real economic losses that may result from such increases in costs or if the government cannot roll over its debt should also be considered. An important role of the debt manager is to identify these risks, assess to the extent possible their magnitude, and develop a preferred strategy for managing the trade-off between expected cost and risk. Following government approval, the debt manager also is normally responsible for the implementation of the portfolio management and risk management policies. To carry out these responsibilities, debt managers should have access to a range of financial and macroeconomic projections. Where available, debt managers should also have access to an accounting of official assets and liabilities, on a cash or accrual basis. They also require complete information on the schedule of future coupon and principal payments and other characteristics of the government's debt obligations, together with budget projections of future borrowing requirements.
Risk assessment
To assess risk, debt managers should regularly conduct stress tests of the debt portfolio on the basis of the economic and financial shocks to which the government --- and the country more generally --- are potentially exposed. This assessment is often conducted using financial models ranging from simple scenario-based models, to more complex models involving highly sophisticated statistical and simulation techniques. When constructing such assessments, debt managers need to factor in the risk that the government will not be able to roll over its debt and be forced to default, which has costs that are broader than just to the government's budget. Moreover, debt managers should consider the interactions between the government's financial situation and those of the financial and non- financial sectors in times of stress in order to ensure that the government's debt management activities do not exacerbate risks in the private sector. In general, models used should enable government debt managers to undertake the following types of risk analysis:
*Project expected future debt servicing costs over a medium- to long-term horizon based on assumptions regarding factors affecting debt-servicing capability, such as: new financing requirements; the maturity profile of the debt stock; interest rate and currency characteristics of new debt; assumptions for future interest rates and exchange rates and the behavior of relevant non-financial variables (e.g., commodity prices for some countries);
*Generate a "debt profile", consisting of key risk indicators of the existing and projected debt portfolio over the projected horizon;
*Calculate the risk of future debt servicing costs in both financial and real terms by summarizing the results of stress tests that are formulated on the basis of the economic and financial shocks to which the government and the country more generally are potentially exposed. Risks are typically measured as the potential increase in debt servicing costs under the risk scenarios relative to the expected cost; and
*Summarize the costs and risks of alternative strategies for managing the government's debt portfolio as a basis for making informed decisions on future financing alternatives.
The appropriate strategy depends on the government's tolerance for risk. The degree of risk a government is willing to take may evolve over time depending on the size of the government debt portfolio, and the government's vulnerability to economic and financial shocks. In general, the larger the debt portfolio and the vulnerability of the country to economic shocks, the larger the potential risk of loss from financial crisis or government default, and the greater the emphasis should be on reducing risks rather than costs. Such strategies include selecting maturities, currencies and interest rate terms to lower risk, as well as fiscal authorities placing more stringent limits on debt issuance. The latter approach may be the only option available to countries with limited access to market-based debt instruments, such as those that rely primarily on concessional financing from bilateral or multilateral creditors.
Risk management
Debt managers in well-developed financial markets typically follow one of two courses: periodically determine a desired debt structure to guide new debt issuance for the subsequent period, or set strategic benchmarks to guide the day-to-day management of the government's debt portfolio. Such portfolio benchmarks typically are expressed as numerical targets for key portfolio risk indicators, such as the share of short-term to long-term debt, and the desired currency composition and interest rate duration of the debt. The key distinction between these two approaches is the extent to which debt managers operate in financial markets on a regular basis to adhere to the "benchmark". However, the use of a strategic benchmark may be less applicable for countries with less-developed markets for their debt, since a lack of market liquidity may limit their opportunities to issue debt with the desired characteristics on a regular basis. Even so, many emerging market countries have found it useful to establish somewhat less stringent "guidelines" for new debt in terms of the desired maturities, interest rate structure, and currency composition. These guidelines often incorporate the government's strategy for developing the domestic debt market.
For those governments that frequently adjust their debt stock, strategic portfolio benchmarks can be powerful management tools because they represent the portfolio structure that the government would prefer to have, based on its preferences with respect to expected cost and risk. As such, they can help guide sovereign debt managers in their portfolio and risk management decisions, for example, by requiring that debt management decisions move the actual portfolio closer to the strategic benchmark portfolio. Governments should strive to ensure that the design of their strategic portfolio benchmarks is supported by a risk management framework that ensures the risks are well specified and managed, and that the overall risk of their debt portfolios is within acceptable tolerances. Where markets are well developed, debt managers should try to ensure that their desired debt structures or strategic benchmarks are clear and consistent with the objectives for debt management, and publicly disclosed and explained.
Scope for active
management
Debt managers who seek to manage actively the debt portfolio to profit from expectations of movements in interest rates and exchange rates, which differ from those implicit in current market prices, should be aware of the risks involved and accountable for their actions. These risks include possible financial losses, as well as conflicts of interest, and adverse signaling with respect to monetary and fiscal policies. In order to be able to lower borrowing costs without increasing risk by taking market views, debt managers require information or judgment that is superior to that of other market participants (and must also be able to transact in an efficient manner).
Debt managers may have better information on financial flows in the domestic market and the financial condition of market participants due to the government's privileged role as supervisor or regulator of the financial system. However, most governments consider it unwise and unethical to try and capitalize on such inside information, especially in the domestic market. In particular, debt managers and policymakers should not engage in tactical trading on the basis of inside information with respect to future fiscal or monetary policy actions. This is because the government is usually the dominant issuer of debt in the domestic market, and it risks being perceived as manipulating the market, if it buys and sells its own securities or uses derivatives for the purpose of trying to generate additional income. Moreover, if the debt managers adopt interest rate or currency positions, their actions could also be interpreted as signaling a government view on the desired future direction of interest rates or the exchange rate, thereby making the central bank's task more difficult.
In foreign capital markets, debt managers generally have little or no information on the nature of financial flows beyond that available in the market generally. Even so, some governments actively manage their foreign currency debt in the hope of generating risk-adjusted returns, or to enable their portfolio managers to accumulate greater market knowledge, in an attempt to generate cost savings on major borrowings. Many governments do not consider it appropriate to undertake such tactical trading. In cases where such trading is permitted, it should be conducted under clearly defined portfolio guidelines with respect to position and loss limits, compliance procedures, and performance reporting. In countries where government debt managers undertake tactical trading, it normally comprises only a small fraction of a government's portfolio management activities.
Debt managers should consider the impact that contingent liabilities have on the government's financial position, including its overall liquidity, when making borrowing decisions. Contingent liabilities represent potential financial claims against the government which have not yet materialized, but which could trigger a firm financial obligation or liability under certain circumstances. They may be explicit (such as government guarantees on foreign exchange borrowings by certain domestic borrowers, government insurance schemes with respect to crop failures or natural disasters, and instruments such as put options on government securities) or implicit, where the government does not have a contractual obligation to provide assistance, but (ex post) decides to do so because it believes the cost of not intervening is unacceptable. (Examples could include possible bailouts of the financial sector, state-owned enterprises, or sub-central governments). Unlike most government financial obligations, however, contingent liabilities have a degree of uncertainty---they may be exercised only if certain events occur, and the size of the fiscal payout depends on the structure of the undertaking. Experience indicates that these contingent liabilities can be very large, particularly when they involve recapitalization of the banking system by the government or government obligations that arise from poorly designed programs for privatization of government assets. If structured without appropriate incentives or controls, contingent liabilities are often associated with moral hazard for the government, since making allowances ahead of time can increase the probability of these liabilities being realized. As a result, governments need to balance the benefits of disclosure with the moral hazard consequences that may arise with respect to contingent liabilities.
Governments should monitor the risk exposures they are entering into through their explicit contingent liabilities, and ensure that they are well informed of the associated risks of such liabilities. They should also be conscious of the conditions that could trigger implicit contingent liabilities, such as policy distortions which can lead to poor asset and liability management practices in the banking sector. Some governments have found it useful to centralize this monitoring function. In all cases, the debt managers should be aware of the explicit contingent liabilities that the government has entered into.
The fiscal authorities should also consider making budget allowances for expected losses from explicit contingent liabilities. In cases where it is not possible to derive reliable cost estimates, the available information on the cost and risk of contingent liabilities or a liquidity drain can be summarized in the notes to the budget tables or the government's financial accounts, since contingent liabilities may represent a significant balance sheet risk for a government.
Governments can also do a great deal to reduce the risks associated with contingent liabilities by strengthening prudential supervision and regulation, introducing appropriate deposit insurance schemes, undertaking sound governance reforms of public sector enterprises, and improving the quality of their macroeconomic management and regulatory policies.
(by IMF & World Bank)