SÉRGIO PEREIRA LEITE
As many countries, including several that formerly relied on central planning, have begun to implement financial sector reforms, one of the challenges facing them is how to coordinate monetary and public debt management so that they are mutually supportive. Indeed, the development of financial markets is an interactive and evolutionary process—financial reforms have implications for public debt management and, conversely, debt management can contribute to, or impede, the reform process and monetary policy implementation. Moreover, without active financial markets—particularly government security markets—there are few options for monetary management.
Financial sector reforms aim at improving resource allocation through increased emphasis on market signals. Interest rate liberalization, central bank independence, and a more competitive financial system are key components of a liberalized financial system. These changes in the way the financial sector operates, however, bring with them the seeds of contradiction between public debt and monetary policy objectives. For while most of the objectives of public debt and monetary management are common or complementary (see box), monetary policy goals are broader than those of public debt management; there are also short-term differences of strategy that may place monetary and public debt management policies at loggerheads.
In economies with liberalized financial systems and independent central banks, for example, it is not uncommon to find finance ministers complaining bitterly about high interest rates, or central bank governors harshly stating the need to reduce the fiscal deficit. There are also less publicized discussions on the access of the government to overdraft facilities at the central bank, on the maturity and profile of the public debt, and on intervention (and regulation) policies of the central bank in government security markets.
In a fully liberalized system, these divergences are part of the system of checks and balances and contribute to sound compromises and economic policies. During the process of financial reform, however, lack of coordination between monetary and public debt management can paralyze the reform process and result in costly slipups in policy implementation. The importance of adequate coordination never disappears, but it increases from the preparatory phase of the reform process to the middle (transitional) phase of the reform—where primary placement of government securities must have both public debt and monetary policy goals—before declining as direct central bank financing of the budget becomes marginal. This article analyzes the links between monetary and fiscal policy, suggesting how the central bank and the treasury can work together toward common objectives.
The pre-reform phase
The main objective of the initial phase of the financial reform is to set up the preconditions for successful financial liberalization. This phase generally includes measures to initiate the macroeconomic adjustment of the economy, to strengthen the banking system, and to modernize the central bank. The size of the budget deficits must be reduced to levels that are consistent with sound public debt and monetary policies.
Coordinating committee. The experience of many countries suggests that during the early process of developing and coordinating public debt and monetary management policies, it is useful to establish a committee comprising officials of the finance ministry and the central bank responsible for carrying out financial reforms. This coordinating committee is normally charged with:
conducting a regular debt planning exercise aimed at setting quarterly and yearly targets for the sale of securities over the succeeding 12-month period; these targets should reflect government cash flow requirements, the demand for government securities, and monetary policy considerations;
assessing the demand for government securities, both short-term issues, which are held mostly to meet liquidity management needs of financial institutions, and long-term bonds, which are preferred by investors such as pension funds and insurance companies;
consulting with financial institutions to gauge their preferences regarding debt instruments to be sold at auction: In particular, decisions must be made on the term of the instrument; whether there will be a coupon; minimum denomination of bonds; auction procedures; frequency of the offerings; bearer or registered securities; physical issuance of bonds and bills; dealer duties and privileges; and information provided to market participants; and
requesting studies and making recommendations regarding the development of the securities market, such as the regulatory/supervisory framework for trading in securities and settlement arrangements for government securities.
Other reform measures. Among other initiatives, reforms of the banking and payment systems are especially important because they require close coordination between the treasury and the central bank.
Banking reforms. Banks are traditionally major holders of treasury bills, thus allowing the central bank to conduct its monetary policy through purchases and sales of these securities in the market (open-market policies). However, these policies are effective only if banks are competitive and interest sensitive, conditions that are often absent at the onset of the financial reforms. In particular, the rehabilitation of poorly capitalized financial institutions with nonperforming loans often requires financial contributions from the government. This has traditionally taken the form of a swap of government securities for doubtful and substandard loans. Thus, to improve monetary policy implementation, government securities may need to be issued, which will increase interest costs and require close discussions between the central bank and the treasury to find a solution that is acceptable to both parties.
Payments system. Large transactions in government securities are not uncommon if the central bank uses open-market operations to regulate liquidity in the economy. In order for these operations to take place smoothly and safely, parties to the transactions should be able to transfer ownership of securities in a manner that is timely and closely coordinated with the transfer of associated payments. This requires the central bank, together with the finance ministry, to set up an adequate system of securities registration that is tightly linked with the payments system. Coordination is often achieved by asking the central bank—which is normally in charge of the payments system—to maintain the registration of government securities as part of its task as fiscal agent for the government.
|Public debt management||Monetary management|
|1. Minimizes the interest cost of deficit financing, while relying on voluntary, market-based means to finance the government.||Aims at achieving domestic and external stability of the national currency.|
|2. Contributes to limiting the inflationary impact of deficit financing.||Contributes to limiting the inflationary impact of deficit financing.|
|3. Helps the development of money and capital markets, and thus the future capacity of the government to finance its operations.||Helps the development of money and capital markets, and thus the future capacity of the central bank to conduct open-market operations.|
|4. Avoids short-term disruptions in financial markets resulting from public debt rollovers and large changes in outstanding debt.||Avoids short-term disruptions in financial markets resulting from public debt rollovers and large changes in outstanding debt.|
|5. Provides the central bank with the tools to carry out open-market policies.||Develops and uses market-based tools for monetary management.|
|6. Ensures that public sector borrowing is carried out at rates that fully reflect the opportunity cost of resources.||Prevents systemic financial sector crisis resulting from isolated real or financial sector events.|
The transitional phase
The transitional phase of financial reform generally involves making interest rates more responsive to market developments. During the transition phase, government securities are used for the first time for monetary policy purposes. They are sold at auction to (1) allow interest rates for government securities to reflect market trends; (2) provide a reference rate that can be used to set other interest rates; and (3) contribute to the control of reserve money.
Interest rates. An important question during this phase is to what extent the government (and the central bank) should try to influence interest rates, even if this is done through market, and not administrative, means. In a free market, interest rates are determined by supply and demand. The supply of government securities is basically determined by the size of the deficit and of debt rollovers, while the demand depends not only on economic conditions but also on the characteristics of the instrument itself, such as its liquidity. The interest rate on government securities, however, has an impact on the deficit, and influences other interest rates in the economy. Thus, the choice of an interest rate adjustment path, either through a flexible targeting of interest rates or through the targeting of monetary and credit aggregates, will be a source of discussion, and possibly disagreement, among officials in charge of public debt and monetary management.
Usually, this debate is carried out in terms of what to do if government financing needs exceed the amounts that the central bank feels should be placed with the market. The traditional wisdom is that, if this is a one-shot event, the central bank may wish to absorb the difference, preferably by purchasing the remaining securities at the average interest rate of the auction. If, however, there is a chronic divergence between the financing needs of the government and the capacity of the market to absorb public debt placements, the government must reduce its deficit to a manageable size. Here no other compromise is possible, as sustained absorption of government securities by the central bank would increase the money supply and lead to inflation and balance of payments problems. Up to a point, however, there is room for legitimate differences of opinion regarding the growth rate of public debt and the interest rate levels in an economy.
The amount of securities offered at each auction must be decided carefully by the coordination committee to ensure that monetary policy objectives are met. At this point in the development of the money market, the amount of securities placed at each auction must vary according to the monetary conditions at the time of the auction, as there is not yet a secondary market that would allow the central bank to smooth out seasonal liquidity movements. While it would be useful from the market development viewpoint to be able to standardize the size of the issues, this may have to wait for the final phase of the reforms.
Information requirements. A key factor in the quest to use government securities as an instrument of monetary policy is information on the amount of government securities maturing at each point in time, the characteristics of each type of government security outstanding, and the cash flow requirements of the government. Combined with data on the liquidity situation of the banking system and other major investors, this information allows debt and monetary policy managers, working together, to maximize their chances of finding an optimal strategy to minimize the cost of the debt without complicating monetary management.
The central bank and the treasury must cooperate closely in compiling this information. The treasury is the only institution that can put together meaningful forecasts of the cash flow requirements of the government. The central bank, on the other hand, is in daily contact with market participants and, thus, is in a privileged position to evaluate the market demand for securities. Details on the outstanding public debt are sometimes kept by the central bank and sometimes by the treasury. The combination of this information in a manner that is useful for monetary and public debt management is called liquidity forecasting; it is a key area of central bank activity when indirect monetary policy instruments are used. This activity cannot, however, be successfully accomplished without collaboration from the treasury.
Coordination of monetary policy instruments. A major concern during this phase is to ensure that all instruments of monetary policy are moving in the same direction. For example, in the early stages of financial sector development, the central bank is often a major source of funds to the financial sector. But the elimination of financial repression often expands opportunities for banks and other financial institutions to raise deposits from the public. Thus, it is reasonable at this juncture for the central bank to change its rediscount policy to limit it to providing liquidity to the market on a lender-of-last-resort basis only. Moreover, the central bank may want to limit its rediscounts to government securities. The central bank rate should be such as to provide a profit opportunity for financial intermediaries willing to engage in secondary market transactions. An adequate discount policy is also important to encourage banks to use government securities as collateral for their own interbank transactions. Other instruments that sometimes need to be adjusted to the new policy framework are reserve and liquidity requirements. For example, poorly designed reserve requirements may create temporary liquidity imbalances on those days when banks are checked for compliance with the requirements. The result may be large interest rate swings that disrupt both monetary policy and public debt management.
“It is important to emphasize important to emphasize that the development of markets for government securities helps not only monetary policy but also fiscal policy and the development of financial markets in general.”
Financial market development. It is important to emphasize that the development of markets for government securities helps not only monetary policy but also fiscal policy and the development of financial markets in general. The government is typically the largest and most creditworthy borrower, so that government securities are relatively marketable and liquid. Once the market for government securities develops, then the market for somewhat less creditworthy instruments can follow.
During the transitional phase, the government may also want to consider converting all or at least part of its debt to the central bank into marketable securities bearing market-related interest rates. This will build up the stock of marketable instruments in the hands of the central bank, thus allowing it more flexibility in the conduct of monetary policy.
The consolidation phase
The final phase—the consolidation phase—aims at achieving an active and sufficiently deep secondary market in monetary instruments to permit the use of open-market policies as the main instrument of monetary policy. Other desirable targets are a broadening of the instruments available in financial markets by gradually introducing instruments bearing different characteristics and maturities, and further increasing competition by facilitating the entry of new institutions into financial markets.
Placement of treasury bills. Treasury bills will be placed by auctions. Once a secondary market has developed, the central bank will intervene in the securities market mostly through purchases and sales in that market, and not by varying the size of the primary issues. A long-term goal should be to regularize and standardize issue schedules to make it easier for market participants to establish a consistent bid strategy based on their analysis of market developments. The central bank should also consider the use of repurchase and reverse repurchase agreements whenever it needs to make short-term, reversible adjustments in financial sector liquidity.
During this phase, the financial markets should already provide reasonable liquidity for treasury bills without much help from the central bank. The liquidity of the treasury bills should be provided mostly by dealers that stand ready to discount these bills at a market-related discount rate. Access to central bank rediscount will, for the most part, be limited to dealers.
Government bonds. In the consolidation phase, the government may want to increase its efforts to place longer-term securities, which will again require close coordination between the central bank and the treasury. Several arguments justify such a strategy. The need to engage in frequent debt rollovers may be administratively inconvenient and may contribute to magnifying interest rate fluctuations or to generating a confidence crisis; it seems reasonable to finance projects that will take some time to mature by using long-term debt; and there is a considerable demand for risk-free, long-term savings instruments that could be tapped by the government.
It is important to note that the central bank normally has less interest in government bonds than in treasury bills. The reason is simple: it is easier to use short-term than long-term securities in the conduct of monetary policy. Moreover, there is general agreement that monetary policy is only able to influence short-term interest rates, so it is natural that central bank attention will be more focused on treasury bills. However, it is also possible to use repurchase and reverse repurchase agreements of government bonds to carry out monetary policy. Again, some degree of coordination between the actions of the treasury and the central bank seems advisable.
In most countries, the central bank acts as financial adviser and agent for the government. For that reason, the central bank is often in charge of all operational matters regarding public debt management—including maintaining the book-entry system and a database on outstanding securities—as well as all matters related to auction procedures. Market intervention and regulatory issues are primarily central bank functions directly related to its responsibilities for monetary management and supervisory issues. The finance ministry, however, normally retains final responsibility for decisions on the amounts, types, and maturity of government securities that will be placed in the primary markets. Hence, without close coordination between the central bank and the finance ministry on public debt and monetary management issues, the road to financial liberalization is strewn with obstacles. In the early stages of the financial reform process, a coordination committee is critical to ensure a forum for discussions between the two institutions on matters of public debt and monetary management.
Further, both the finance ministry and the central bank should have units in charge of public debt management. In the finance ministry, the unit should be part of the treasury; it should monitor cash flow requirements and the performance of the central bank as debt manager. The centralbank will also need to have a unit in charge of operational matters related to the placement of securities. Finally, it is not only the budget deficit that places a burden on monetary management. The reverse is also true. Poorly conceived monetary instruments, such as reserve requirements and rediscount policies, can make it extremely difficult to develop a sufficiently deep and active government securities market.