To be a successful issuer of government securities, the government must earn the confidence of financial market participants. In addition to pursuing sound and sustainable fiscal and monetary policies and establishing an appropriate legal and regulatory infrastructure, the government needs a credible government bond issuing strategy, based on a strong commitment to market financing and a well-structured management framework. The strategy must provide a clear mapping of the portfolio structure and the instruments to obtain that structure. It must also devise procedures for marketing government securities issues and managing the government’s cash position in ways that establish efficient distribution channels and encourage the development of secondary markets.
3.1 Introduction
Increased reliance by governments on market sources for finance and the greater exposure to financial risks resulting from financial liberalization and larger international capital flows have created new opportunities and challenges for government debt management. This new financing environment can provide governments with a large and more diversified investor base, which can reduce its refinancing risk and lead to lower debt-service cost over time. In order to attract new investors and manage the risks associated with new market-based financial instruments, many governments have improved the quality of their macroeconomics and regulatory policies, as well as their debt management policies and operations.
This chapter discusses some of the key measures that the government as an issuer, and in particular as a debt manager, can consider in order to support the development of the government bond market. The focus is on the more strategic considerations, such as the market orientation of the funding strategy and the need for a sound debt management framework, rather than on more technical issues, such as developing a primary market and building the yield curve. These technical issues are addressed in subsequent chapters. This chapter draws heavily on the Guidelines for Public Debt Management, which was produced by the IMF and the World Bank, working in cooperation with national debt management experts.42
3.2 Market-Oriented Funding Strategy
A market-oriented government funding strategy is an essential pillar for developing a domestic securities market. Such a strategy includes the government’s adherence to basic market principles in its funding operations, the need to design a sustainable issuance strategy, and the government’s proactive approach in developing the necessary regulatory framework to support market development.
3.2.1 Adherence to Basic Market Principles
To embrace market financing, the government needs to adopt market discipline, ensure broad market access and fairness, and take steps to make government debt issuance and operations transparent and credible to the investor. This requires a change of outlook and the political commitment to sustain the reformation in the face of adverse market conditions. The specific steps needed are outlined below.
3.2.1.1 Commitment to Market Discipline
A commitment by the government to finance its borrowing needs through the market requires it to introduce market-based financial instruments and to follow market discipline. An early step is for the government to accept the principle that debt instruments should be priced at market rates. Irrespective of whether the buyer is the central bank, a commercial bank, or another entity, or whether the sale is conducted though auctions or underwriting, the price of government securities should reflect market conditions. For countries with a large or rapidly growing government debt, moving to full market pricing of debt instruments can lead to a major increase in the government’s debt-servicing costs.43
Converting to market financing of government borrowing means that the government should phase out or immediately cease borrowing from the central bank and also remove requirements that force commercial banks and other captive institutions to lend to the government at below-market interest rates. Governments should also give careful consideration to the liquidity of the market, the volume of securities issued in nonmarketable form, and the rate of interest that the government pays on such debt. The debt manager may need to accelerate the conversion of this debt or part of it to support market development.
Committing to be a price taker and maintaining the commitment to market pricing over time is essential. The likely increase in the government’s debt-servicing costs associated with market-based funding constitutes the major challenge to adopt a commitment to market pricing of government bond issues. This may lead to political pressure to continue relying on subsidized funding through compulsory investment regulation or borrowing from the central bank at below-market rates. Although the long-term benefits of market-based government funding have been confirmed in academic literature and the experience of countries practicing market-based pricing for government securities, political pressure to continue what seem to be low-cost and assured sources of financing is often considerable.
If the government’s funding needs are very large relative to domestic savings, the government may try to preserve some captive sources of funding or phase them out gradually. There is, however, a danger in doing so, as the government debt market may not fully develop because investors perceive a lack of government commitment to market financing. Continued reliance on captive sources for government funding and the resulting limited development of the market may set a vicious circle in motion, perpetuating the manager’s reliance on captive funding sources.
3.2.1.2 Broad Market Access and Fairness
Measures that establish broad access to the government securities market, and treat investors fairly and equitably, can be important in earning investor confidence and helping to lower the government’s borrowing costs. Providing broad access requires that the government understand the sources of demand for its instruments and review the nature of the barriers that inhibit participation by different types of investors.
Fairness considerations in issuing government securities mean that the government should provide a level playing field for all market participants and not seek to profit by taking advantage of privileged information, such as budgetary information that is not in the public domain.
If the government wants to build trust and credibility in its commitment to market forces, investors will need to be confident that the government’s debt managers are not opportunistically transacting on the basis of privileged or inside information. To reduce investors’ uncertainty, many governments ensure that the timing of auctions and other issuance activities are predictable by publishing auction timetables for a 12-month period, deviating from these timetables in exceptional circumstances only if, for instance, the budget situation changes significantly. Governments also need to ensure that regulatory measures do not result in captive investors for their securities, which would distort pricing. Establishing a level playing field requires the government to provide clear, transparent, and equitable rules and regulations that apply to all market participants. This is essential in order to build trust among investors and intermediaries and attract the greatest number of market participants.
3.2.1.3 Transparency of Government Securities Issuance and Debt Management Operations
A government can strengthen its credibility by providing timely and relevant information on the government’s finances; its debt portfolio, including its redemption profile; its borrowing strategy; and data on primary and secondary market activity.44 Producing and disseminating relevant debt and budgetary information that is generated by different government agencies and departments requires considerable coordination. It also needs modern information systems that link various data producers with the debt office and the debt office with the market.
Several emerging market governments have recently started to disclose more comprehensive information about their debt exposure. Others, with less-developed markets, still do not regularly disclose the maturity profile or the structure of their debt. Regular disclosure of the nature of the government’s indebtedness is essential in order to reduce uncertainty for investors. One of the factors that catalyzed the Mexico financial crisis of the mid-1990s was a drastic loss of market confidence, abetted by the government’s failure to disclose adequate information about the issuance of U.S. dollar–linked government securities (tesobonos).
An important feature of a market-oriented strategy is the two-way nature of the information process between the issuer and the market. Debt managers need to listen to investors’ and market makers’ views on ways of improving the efficiency and openness of financial markets and, in turn, provide information on a range of topics such as the government’s debt management objectives, debt strategy, current and projected borrowing needs, and arrangements surrounding the sale of government securities.
The information provided needs to be of high quality if investors are to maintain confidence in the government’s debt management. Providing this information requires management information systems and processes that control inconsistencies and hold the source agencies accountable for their data. The quality of information depends on a set of generally accepted accounting rules that meet, as much as possible, international standards. For many emerging markets, this will require training staff in the debt office to disclose information in a systematic way. For governments with some experience in international markets, this will be a matter of transferring that discipline to a domestic market context.
Governments need to exercise judgment in deciding what information to release. For example, governments may not want to release in advance information on their intentions to buy back or exchange large amounts of foreign currency debt. In many instances, however, the need to be concerned about releasing market-sensitive information is driven more by the timing of when the information should be released rather than a determination to permanently withhold the information from the public.
3.2.2 A Sustainable Issuance Strategy
A transparent, flexible, and effective medium-term issuance strategy is the backbone for any sustainable public debt management program. This strategy should be consistent with the macroeconomic framework and published as a measurable goalpost in order to establish clear accountability. The strategy should build on a comprehensive assessment of current debt management practices and should address the main shortcomings, if possible, with a proposed sequencing of key measures with targeted implementation dates. The strategy needs to be discussed with market participants and reflect the specific needs of market development. A consensus should be reached that helps reduce political pressure for a short-term-focused financing stance.
Three principles should be considered absolutely essential: First, the macroeconomic policy framework should be consistent with denomination of new issues. For example, if a country is moving toward dollarization, it makes little sense to pay a premium for new issuance in domestic currency. Conversely, if a country is aiming to reverse a dollarization trend and to reduce an existing currency mismatch, it becomes necessary to develop short-term benchmarks in domestic currency. Moreover, in case foreign portfolio investors are part of the targeted investor base, capital account issues (such as convertibility) as well as taxation issues (such as double-taxation treaties) should be clarified prior to new issuance.
Second, the principle of sharing risks at market rates should be established, which allows the issuance of government bonds with progressively higher risks. For example, if a country is issuing fully indexed short-term bonds that are securitized by foreign collateral, the market is assuming minimum risk at the expense of the government. In this case, the issuance strategy should aim to move away from collateral-backed issuance, to progressively extend maturities, and to phase out indexation by establishing a fixed-rate benchmark. Although the move away from indexation (that is, floating rate bonds) normally requires several years, in some cases in which a derivate market exists, it may be facilitated by a transitional step where an instrument is stripped into the equivalent of an underlying fixed-rate instrument (new benchmark) plus an additional derivative instrument (interest-rate future), where the latter component is phased out over time.
Third, a strong link between bond market development and growth of institutional investors should be recognized, which suggests that needs of institutional investors should be taken into account when the government designs new instruments. Otherwise, markets become fragmented and segments become captive, which often leads to lower domestic savings and/or capital outflows. For example, pension funds and insurance companies take long-term liabilities on their balance sheet, which need to be balanced by long-term assets, ideally linked to long-term prices. In this case, by offering long-term inflation-linked bonds, the government could meet market needs while simultaneously achieving lower yields in addition to higher confidence in its policies that target price stability. At the same time, debt dynamics require that long-term real interest rates remain below long-term real growth rates in order to remain on a sustainable path.
While following these principles, the government should maintain some flexibility to respond to adverse market conditions. For example, the debt manager may confront situations in which it is considered very important to extend the average maturity in order to reduce the refinancing risk, at the price of reducing duration or increasing exchange rate exposure. Moreover, it may become too costly to keep extending the yield curve during adverse market conditions, when the debt manager may have to consolidate the shorter segment of the yield curve by issuing shorter maturity debt. It is important that the debt manager develop a proper analytical framework that allows for the quantification of costs and risks as well as the evaluation of these trade-offs over time.
Strategic portfolio benchmarks can be effective tools to help governments choose their issuance strategies and carry out debt management. They represent the portfolio structure that the government would prefer to have, given its cost/risk preferences, debt management horizon, borrowing needs, constraints imposed by market conditions, choice of instruments and market development considerations. The benchmark portfolio may be adjusted periodically, to incorporate changing market conditions and government policies. It sets the direction for debt management and provides a framework within which alternate issuance strategies are evaluated, guiding the debt manager to move closer to the strategic benchmark portfolio.45
3.2.3 A Proactive Government Approach
The final component of a market-oriented funding strategy is for the government to be proactive in accelerating the development of the government bond market. As highlighted in a recent APEC publication, “the government can play a catalytic role” in developing a government bond market, and “it should develop a comprehensive strategy in consultation with the central bank, the relevant regulatory agencies, and market participants.”46
Such an approach can be particularly important when there is a need to develop the secondary market in order to intermediate transactions among investors, such as institutional investors, who require considerable market liquidity in order to transact efficiently. This was the case in many OECD countries during the 1970s and 1980s, when financial market deregulation and the development of efficient public debt markets was also stimulated by strong government interest in attracting foreign institutional investors.
A proactive approach could include elements such as supporting the active engagement of market makers and interdealer brokers (IDBs) that could facilitate large transactions among intermediaries and between intermediaries and institutional investors; promoting an efficient and safe infrastructute with prompt and reliable delivery versus payment; seeking a primary market organization that provides the proper concentration of paper (regularity and fungibility) and an efficient distribution of securities (by primary dealers, for example); actively supporting a competitive environment among intermediaries; and facilitating the proper flow of information and transaction links among different market segments. In each of these areas, the debt manager can promote and support the development of efficient market practices. These types of government involvement are described in detail in subsequent chapters of the handbook.
However, given the involvement of different government agencies and private sector institutions, the challenge is how best to articulate and coordinate a proactive approach among the different participants. One way of doing so is to create a high-level committee led by the Ministry of Finance with representation from the central bank, the different supervisory agencies involved in the markets (banking, insurance, pensions, and securities), and principal market participants.47 The committee’s main function would be to establish and manage the agenda for developing the government bond market, maintain consensus within and outside the government regarding this process, and ensure a coordinated effort by the government agencies involved. Such a committee would also ensure that the bond market development agenda is consistent with debt management mandates and the objectives of fiscal and monetary policy.
3.3 Sound Debt Management Framework and Operations
Sound debt management will improve the credibility of the issuer and enable the debt manager to develop an issuing and debt management strategy that is sustainable over time. It may also contribute to improving the country’s credit rating and facilitate access to domestic and foreign markets in a cost-effective way. Moreover, it should help to make the debt manager more accountable and less subject to political pressure while assuring the markets of the government’s policy framework.
The principal components of sound debt management in many countries are based on the importance of having clear debt management objectives, proper coordination between debt management and monetary and fiscal policy, a prudent risk management framework, an effective institutional framework, and a strong operational capacity enabling efficient funding and sound risk management practices. This capacity is essential to implement the market-oriented funding strategy described above.
3.3.1 Clear Objectives of Debt Management
Several countries express their government debt management objectives in terms of expected cost and risk. A typical objective might be “to ensure that the government’s financing needs and its payment obligations are met at the lowest possible cost over the medium to long run, consistent with a prudent degree of risk.” Development of the domestic debt market is also often included as a prominent government objective. This objective is particularly relevant for countries where short-term debt, floating rate debt, and foreign currency debt are, at least in the short run, the only viable alternatives to extensive borrowing from the central bank.
Clear and transparent objectives make the debt manager more accountable and less subject to external political pressures that could result in poor debt management decisions, including undesirable trade-offs between cost and risk. With prudent macroeconomic policies and a sound regulatory framework with respect to the capital market, clarity of debt management goals and adoption of policies and practices that ensure they are being met are important for reducing uncertainty among investors and attracting their support. In many emerging market economies, the objectives for debt management have often not been clearly defined, and the governance framework and the legal authority are vague. This can lead to substantial uncertainty among government debt managers, investors, and intermediaries.
3.3.2 Coordination with Monetary and Fiscal Policies
An important component of a sound debt management operation is proper coordination of debt management with monetary and fiscal policy decisions. The Guidelines for Public Debt Management suggest the following:
Debt managers, fiscal policy advisors, and central bankers should share an understanding of the objectives of debt management, fiscal, and monetary policies given the interdependencies between their different policy instruments. Debt managers should convey to fiscal authorities their views on the costs and risks associated with government financing requirements and debt levels. Policymakers should understand the ways in which the different policy instruments operate, their potential to reinforce one another, and how policy tensions can arise. Prudent debt management, fiscal and monetary policies can reinforce one another in helping to lower the risk premia in the structure of long-term interest rates. In this context, the monetary authorities should inform the fiscal authorities of the effects of government debt levels on the achievement of their monetary objectives. Borrowing limits and sound risk management practices can help to protect the government’s balance sheet from debt servicing shocks. In some cases, conflicts between debt management and monetary policies can arise owing to the different purposes—debt management focuses on the cost/risk trade-off, while monetary policy is normally directed towards achieving price stability. For example, some central banks may prefer that the government issue inflation-indexed debt or borrow in foreign currency to bolster the credibility of monetary policy. Debt managers may believe that the market for such inflation-indexed debt has not been fully developed and that foreign currency debt introduces greater risk onto the government’s balance sheet. Conflicts can also arise between debt managers and fiscal authorities, for example, on the cash flows inherent in a given debt structure (e.g., issuing zero-coupon debt to transfer the debt burden to future generations). For this reason, it is important that coordination take place in the context of a clear macroeconomic framework.
Where the level of financial development allows, there should be a separation of debt management and monetary policy objectives and accountabilities. Clarity in the roles and objectives for debt management and monetary policy minimizes potential conflicts. In countries with well-developed financial markets, borrowing programs are based on the economic and fiscal projections contained in the government budget, and monetary policy is carried out independently from debt management. This helps ensure that debt management decisions are not perceived to be influenced by inside information on interest rate decisions, and avoids perceptions of conflicts of interest in market operations. A goal of cost minimization over time for the government’s debt, subject to a prudent level of risk, should not be viewed as a mandate to reduce interest rates, or to influence domestic monetary conditions. Neither should the cost/risk objective be seen as a justification for the extension of low-cost central bank credit to the government, nor should monetary policy decisions be driven by debt management considerations.
Debt management, fiscal, and monetary authorities should share information on the government’s current and future liquidity needs. Since monetary operations are often conducted using government debt instruments and markets, the choice of monetary instruments and operating procedures can have an impact on the functioning of government debt markets, and potentially on the financial condition of dealers in these markets. By the same token, the efficient conduct of monetary policy requires a solid understanding of the government’s short- and longer-term financial flows. As a result, debt management and fiscal and monetary officials often meet to discuss a wide range of policy issues. At the operational level, debt management, fiscal, and monetary authorities generally share information on the government’s current and future liquidity needs. They often coordinate their market operations so as to ensure that they are not both operating in the same market segment at the same time. Nevertheless, achieving separation between debt management and monetary policy might be more difficult in countries with less-developed financial markets, since debt management operations may have correspondingly larger effects on the level of interest rates and the functioning of the local capital market. Consideration needs to be given to the sequencing of reforms to achieve this separation.
3.3.2.1 Role of Central Bank in Debt Management Operations
In many countries, the central bank provides services for the government debt managers, including operating Treasury bill and bond tenders, undertaking cash management operations, and providing registry services. In many emerging markets, the central bank also undertakes the foreign currency borrowing and, in some countries, the domestic borrowing. This is usually because the central bank has a larger number of staff with capital market expertise, and some of this information is needed to monitor levels of market liquidity as part of assessing monetary conditions.
In providing these services, it is desirable that clear quality standards be agreed upon between the debt manager and the central bank and there be discussions on how these functions can be undertaken without conflicting with the central bank’s monetary policy functions. Wherever possible, there should be a clear separation between the central bank’s debt management objectives and its accountability for monetary policy.
Over the last two decades, a consensus has emerged on the need to ensure that responsibility for debt management policy is managed within the Ministry of Finance and that, where the central bank has an operational role for debt management, the nature of these outputs and their timing and quality be specified. In most cases, the operational responsibility for debt management is assumed by the Ministry of Finance or an autonomous debt management organization (DMO) established outside the ministry. In emerging-market countries, where there is often a shortage of staff with financial skills in the Ministry of Finance, the central bank may need to transfer or second employees to the ministry in order to provide the needed capability. This has been the practice in some OECD countries, which have recently established an independent DMO, such as Hungary, Portugal, and the United Kingdom.
Even in cases in which this shift of responsibility has occurred, the central bank has often continued to run auctions on behalf of the government. If such activities are properly supported by clear procedures, there should not be any conflict with the central bank’s monetary policy responsibilities.
3.3.3 Prudent Risk Management Framework
When developing debt management strategies and deciding between different funding strategies, debt managers in emerging-market countries are often required to manage different types of risks (see Box 3.1), given the constraints they face in the local and international markets. Some of these decisions require assessing different trade-offs of cost against risk with respect to alternative debt management and funding strategies. In order to help evaluate and manage these risks, many government debt managers have developed analytical frameworks grounded in risk analysis.
The Guidelines for Public Debt Management suggests the following:
Risks Encountered in Sovereign Debt Management Risk Description
| Risk | Description |
|---|---|
| Market Risk | Refers to the risks associated with changes in market prices, such as interest rates, exchange rates, and commodity prices, on the cost of the government’s debt servicing. For both domestic and foreign currency debt, changes in interest rates affect debt servicing costs on new issues when fixed-rate debt is refinanced and on floating rate debt at the rate reset dates. Hence short-duration debt (short-term or floating rate) is usually considered to be more risky than long-term, fixed-rate debt. (Excessive concentration in very long-term, fixed-rate debt can also be risky, since future financing requirements are uncertain.) Debt denominated in or indexed to foreign currencies also adds volatility to debt servicing costs as measured in domestic currency owing to exchange rate movements. Bonds with embedded put options can exacerbate market and rollover risks. |
| Rollover Risk | The risk that debt will have to be rolled over at an unusually high cost or, in extreme cases, cannot be rolled over at all. To the extent that rollover risk is limited to the risk that debt might have to be rolled over at higher interest rates, including changes in credit spreads, it may be considered a type of market risk. However, because the inability to roll over debt and/or exceptionally large increases in government funding costs can lead to, or exacerbate, a debt crisis, thereby causing real economic losses in addition to the purely financial effects of higher interest rates, it is often treated separately. Managing this risk is particularly important for emerging-market countries. |
| Liquidity Risk | There are two types of liquidity risk. One refers to the cost or penalty investors face in trying to exit a position when the number of transactors has markedly decreased or because of the lack of depth of a particular market. This risk is particularly relevant in cases in which debt management includes the management of liquid assets or the use of derivatives contracts. The other form of liquidity risk, for a borrower, refers to a situation in which the volume of liquid assets can diminish quickly in the face of unanticipated cash flow obligations or a possible difficulty in raising cash through borrowing in a short period of time. |
| Credit Risk | The risk of nonperformance by borrowers on loans or other financial assets or by a counterparty on financial contracts. This risk is particularly relevant in cases where debt management includes the management of liquid assets. It may also be relevant in the acceptance of bids in auctions of securities issued by the government as well as in relation to contingent liabilities and derivative contracts entered into by the debt manager. |
| Settlement Risk | Refers to the potential loss that the government could suffer as a result of failure to settle, for whatever reason other than default, by the counterparty. |
| Operational Risk | This includes a range of different types of risks, including transaction errors in the various stages of executing and recording transactions; inadequacies or failures in internal controls, or in systems and services; reputation risk; legal risk; security breaches; or natural disasters that affect business activity. |
| Risk | Description |
|---|---|
| Market Risk | Refers to the risks associated with changes in market prices, such as interest rates, exchange rates, and commodity prices, on the cost of the government’s debt servicing. For both domestic and foreign currency debt, changes in interest rates affect debt servicing costs on new issues when fixed-rate debt is refinanced and on floating rate debt at the rate reset dates. Hence short-duration debt (short-term or floating rate) is usually considered to be more risky than long-term, fixed-rate debt. (Excessive concentration in very long-term, fixed-rate debt can also be risky, since future financing requirements are uncertain.) Debt denominated in or indexed to foreign currencies also adds volatility to debt servicing costs as measured in domestic currency owing to exchange rate movements. Bonds with embedded put options can exacerbate market and rollover risks. |
| Rollover Risk | The risk that debt will have to be rolled over at an unusually high cost or, in extreme cases, cannot be rolled over at all. To the extent that rollover risk is limited to the risk that debt might have to be rolled over at higher interest rates, including changes in credit spreads, it may be considered a type of market risk. However, because the inability to roll over debt and/or exceptionally large increases in government funding costs can lead to, or exacerbate, a debt crisis, thereby causing real economic losses in addition to the purely financial effects of higher interest rates, it is often treated separately. Managing this risk is particularly important for emerging-market countries. |
| Liquidity Risk | There are two types of liquidity risk. One refers to the cost or penalty investors face in trying to exit a position when the number of transactors has markedly decreased or because of the lack of depth of a particular market. This risk is particularly relevant in cases in which debt management includes the management of liquid assets or the use of derivatives contracts. The other form of liquidity risk, for a borrower, refers to a situation in which the volume of liquid assets can diminish quickly in the face of unanticipated cash flow obligations or a possible difficulty in raising cash through borrowing in a short period of time. |
| Credit Risk | The risk of nonperformance by borrowers on loans or other financial assets or by a counterparty on financial contracts. This risk is particularly relevant in cases where debt management includes the management of liquid assets. It may also be relevant in the acceptance of bids in auctions of securities issued by the government as well as in relation to contingent liabilities and derivative contracts entered into by the debt manager. |
| Settlement Risk | Refers to the potential loss that the government could suffer as a result of failure to settle, for whatever reason other than default, by the counterparty. |
| Operational Risk | This includes a range of different types of risks, including transaction errors in the various stages of executing and recording transactions; inadequacies or failures in internal controls, or in systems and services; reputation risk; legal risk; security breaches; or natural disasters that affect business activity. |
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…. 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 tradeoff 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.
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.48 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.49
The extent to which governments need to develop this capacity for risk analysis and evaluation depends on the overall risk of the government debt portfolio and the nature of those risks. For a country like the United States, with a strong sovereign credit rating and where all the central government debt is fixed-rate domestic currency debt distributed along a 30-year government yield curve, the portfolio risks are relatively small. Where governments have substantial amounts of foreign currency debt, foreign-currency-linked debt, or floating rate debt in their debt portfolio, or have considerable rollover risk, the government should develop techniques for assessing and managing those risks.
3.3.4 Building a Strong Institutional Framework
A sound institutional framework for government debt management embodying good governance practices, prudent procedures, and strong capacity for managing operational risks, is essential given the size of government debt portfolios and the close linkages between debt management policies and government macroeconomic and regulatory policies.
3.3.4.1 Governance
As outlined in the Guidelines for Public Debt Management, a clear legal framework, well-specified organizational arrangements, and public disclosure and auditing procedures are key elements of an effective governance structure for public debt management:50
The legal framework should clarify the authority to borrow and to issue new debt, invest, and undertake transactions on the government’s behalf. The authority to borrow should be clearly defined in legislation.51 Sound governance practices are an important component of sovereign debt management, given the size of government debt portfolios.
The soundness and credibility of the financial system can be supported by assurances that the government debt portfolio is being managed prudently and efficiently. Moreover, counterparties need assurances that the sovereign debt managers have the legal authority to represent the government, and that the government stands behind any transactions its sovereign debt managers enter into. An important feature of the legal framework is the authority to issue new debt, which is normally stipulated in the form of either borrowing authority legislation with a preset limit or a debt ceiling.
The organizational framework for debt management should be well specified, and ensure that mandates and roles are well articulated.52 Legal arrangements should be supported by delegation of appropriate authority to debt managers. Experience suggests that there is a range of institutional alternatives for locating the sovereign debt management functions across one or more agencies, including in one or more of the following: the ministry of finance, central bank, autonomous debt management agency, and central depository.53 Regardless of which approach is chosen, the key requirement is to ensure that the organizational framework surrounding debt management is clearly specified, there is coordination and sharing of information, and that the mandates of the respective players are clear.54
Many debt managers file an annual debt management report, which reviews the previous year’s activities, and provides a broad overview of borrowing plans for the current year based on the annual budget projections. These reports increase the accountability of the government debt managers. They also assist financial markets by disclosing the criteria used to guide the debt program, the assumptions and trade-off underlying these criteria, and the managers’ performance in meeting them.
In order to support the governance structure and provide quality assurance in respect to the operations of the debt managers, many governments have introduced an advisory board (or a similar structure) between the minister of finance and the head of the DMO. The advisory board’s mandate could be to provide advice on a range of management issues or extend into more technical issues relating to debt management strategy. Interdepartmental or interagency committees are also frequently established to discuss and exchange information that is important for liquidity management. These committees often include representatives from the Ministry of Finance and the central bank.
Debt management activities should be audited annually by external auditors.55 The accountability framework for debt management can be strengthened by public disclosure of audit reviews of debt management operations. Audits of government financial statements should be conducted regularly and publicly disclosed on a preannounced schedule, including information on the operating expenses and revenues.56 A national audit body, like the agency responsible for auditing government operations, should provide timely reports on the financial integrity of the central government accounts. In addition, there should be regular audits of debt managers’ performance and of systems and control procedures.
3.3.4.2 Operational Capacity
For many governments that have only recently moved to market-based financing, debt management has traditionally involved very basic operations. In these countries, debt management has usually been focused on back-office practices (debt registry, disbursements, and debt-service payments), with limited strategic and financial analysis carried out by the debt management team. Important financing and strategic decisions have often been taken by the minister of finance or in the central bank (sometimes in the context of a fiscal or balance of payments crisis), with the debt office playing a limited role.57
The most attractive issuers in the different regions have been active in the international markets for several years. They have strengthened the analytical capacity within the debt office and, in many instances, established portfolio management teams with responsibility for negotiating and executing borrowing and hedging transactions in the market.58
In many emerging market countries, however, inadequate levels of skilled debt management staff and a lack of management information systems (or expertise on their most effective adaptation) has been a major constraint in building debt management capacity. Building this capacity should be an important priority, especially when the portfolio is large and contains risky debt structures.
The Guidelines for Public Debt Management offer the following measures for managing operational risks:
Risks of government losses from inadequate operational controls should be managed according to sound business practices, including well-articulated responsibilities for staff, and clear monitoring and control policies and reporting arrangements…. Sound risk monitoring and control practices are essential to reduce operational risk.
Operational responsibility for debt management is generally separated into front and back offices with distinct functions and accountabilities, and separate reporting lines. The front office is typically responsible for executing transactions in financial markets, including the management of auctions and other forms of borrowing, and all other funding operations. It is important to ensure that the individual executing a market transaction and the one responsible for entering the transaction into the accounting system are different people. The back office handles the settlement of transactions and the maintenance of the financial records. In a number of cases, a separate middle or risk management office has also been established to undertake risk analysis and monitor and report on portfolio-related risks, and to assess the performance of debt managers against any strategic benchmarks. This separation helps to promote the independence of those setting and monitoring the risk management framework and assessing performance from those responsible for executing market transactions. Where debt management services are provided by the central bank (e.g., registry and auction services) on behalf of the government’s debt managers, the responsibilities and accountabilities of each party and agreement on service standards can be formalized through an agency agreement between the central bank and the government debt managers.
Government debt management requires staff with a combination of financial market skills (such as portfolio management and risk analysis) and public policy skills. Regardless of the institutional structure, the ability to attract and retain skilled debt management staff is crucial for mitigating operational risk. This can be a major challenge for many countries, especially where there is a high demand for such staff in the private sector, or an overall shortage of such skills generally. Investment in training can help alleviate these problems, but where large salary differentials persist between the public and private sector for such staff, government debt managers often find it difficult to retain these skills.
Debt management activities should be supported by an accurate and comprehensive management information system with proper safeguards. Countries who are beginning the process of building capacity in government debt management need to give a high priority to developing accurate debt recording and reporting systems. This is required not only for producing debt data and ensuring timely payment of debt service, but also for improving the quality of budgetary reporting and the transparency of government financial accounts. The management information system should capture all relevant cash flows, and should be fully integrated into the government’s accounting system. While such systems are essential for debt management and risk analysis, their introduction often poses major challenges for debt managers in terms of expense and management time. However, the costs and complexities of the system should be appropriate to the organization’s needs.
Staff involved in debt management should be subject to a code-of-conduct and conflict-of-interest guidelines regarding the management of their personal financial affairs. This will help to allay concerns that staff’s personal financial interests may undermine sound debt management practices.
3.4 Conclusion
Building the government’s credibility as an issuer of government securities and developing a broad investor base for such issues requires commitment by the government to an overall market orientation supported by a suitable funding strategy and a strong institutional framework for debt management.
The government must fully endorse the principles of broad market access, fairness, and transparency in its interaction with market participants. To implement these principles, a durable funding strategy must be developed, whose important elements must include issuing marketable instruments at market prices, dismantling captive sources of borrowing, and supporting the development of efficient market infrastructure and sound regulatory practices. Coordination between the government debt managers, the fiscal authorities, and the central bank is also critical and will result in smoother liquidity management by the government. This will lead to an issuance strategy that will build liquidity in a range of benchmark securities and will also help to improve investor confidence and strengthen the development of the local government bond market.
Governments can support the development of the government bond market and enhance their credibility as an issuer of debt by building a strong institutional framework for debt management. Such a framework must ensure that debt management objectives are clear and are able to guide debt management decisions. Investor uncertainty is reduced by prudent fiscal management and by a legal framework that controls the volume of government debt and the number of issuers in addition to assuring investors that the government stands behind the transactions entered into on its behalf by the government debt managers.
Experience in many countries suggests that building credibility as an issuer of government debt and developing an efficient government bond market can be a difficult and lengthy process and require coordination across many policy fronts. Changing political sentiment and financial market crises can occasionally check or reverse these processes. However, the benefits from pursuing these reforms and developing an efficient market in government securities as well as a strong reputation as an issuer of government securities usually substantially outweigh the adjustment costs.
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When governments borrow at below-market rates, they are introducing distortions in terms of reducing the income of financial intermediaries, causing them to change their portfolio allocation decisions in other areas and, in many cases, forcing them to increase interest rate spreads for commercial banks. Borrowing from the central bank at below-market rates may appear less costly to the government, but such borrowing can result in inflation.
This discussion of transparency is consistent with IMF and World Bank work on transparency practices in the conduct of public policy (see IMF 1998, 1999, 2000; IMF and World Bank 2000) as they relate to debt management operations.
APEC (1999) recommends a high-level coordination committee.
Complex simulation models should be used with caution. Data constraints may significantly impair the usefulness of these models, and the results obtained may be strongly model dependent and sensitive to the parameters used. For example, some parameters may behave differently in extreme situations or be influenced by policy responses.
Of course, governments should also take corrective measures, such as eliminating policy biases that may encourage excessive risk taking by the private sector.
See Section 11.2 in IMF 1998.
See also Section 2.1 of the Guidelines and Section 1.3 in IMF 1999.
A few countries have privatized elements of debt management within clearly defined limits, including, for example, back-office functions and the management of the foreign currency desk stock.
See Section 3.3.2.1. above.
See Section 3.3.2.1. above.
The audit process may differ depending on the institutional structure of debt management operations.
During the 1980s and early 1990s, Latin America, among other regions, became involved in major debt restructuring (Paris Club, Brady bonds) that demanded high-quality debt management skills. In most cases, the process was carried out by consultants reporting directly to the minister of finance or by senior officials of the central bank.
In Latin America, for example, it was only in the early 1990s that Argentina, Colombia, and Mexico started to upgrade the front office for external debt, while countries such as Brazil decided to build this capacity within the central bank.