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Research Summaries: Sovereign Bonds and Public Debt Management

Author(s):
International Monetary Fund. Research Dept.
Published Date:
September 2003
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By Torbjörn Becker

Managing the public debt to minimize its costs and risks to society is key to debt sustainability, efficiency, and intergenerational welfare trade-offs. Appropriate debt management can also help promote a country’s securities markets. This article reviews recent IMF research on sovereign bond features and public debt management practices aimed at reducing the likelihood of crises, improving risk sharing, and fostering financial development.

In many countries, the debt managers’ primary objective of securing funds to finance the government deficit is complemented by objectives of minimizing the costs and risks of the debt portfolio, and promoting financial development and efficient markets. The main focus of the public debt management (PDM) literature is on how debt managers should select instruments and maturities to minimize costs and risks, though it also discusses several of the other objectives. This summary opens with a brief overview of theoretical models of optimal debt portfolios and the empirical support for such models. Later, it discusses issues related to promoting well-functioning securities markets and some practical considerations for debt managers, before concluding with a short discussion of legal features of bond contracts.

Theoretical models on the optimal choice of instruments and their maturities usually focus on hedging motives and time inconsistencies or signaling considerations. The models typically assume that government (noninterest) expenditure and the tax base follow exogenous (stochastic) processes and that the distortions from taxation grow quadratically with the tax rate. These assumptions lead to the standard tax smoothing objective of PDM. The instruments in the portfolio are chosen such that the real value of interest payments on the debt portfolio is negatively correlated with the primary deficit to avoid changes in the tax rate. Optimal portfolio shares are therefore a function of the variance-covartance structure of the shocks in the model—typically shocks to inflation, the exchange rate, and the tax base.

The problem can be turned around to ask, What is the optimal instrument? Barro (1995) shows that perfect tax smoothing can be achieved by issuing perpetual debt contingent on the primary deficit. Since the government finances all current and expected future deficits today, all shocks to the budget and interest rates are perfectly hedged. This type of instrument also prevents unsustainable debt dynamics in the future. Severe moral hazard problems would prevent the use of debt contingent on the primary deficit. Thus, the debt manager has to rely on indirect hedges to reduce the variability in tax rates: Barro (1995) suggests that debt indexed to the tax base or GDP would be a partial move toward the optimal instrument. Borensztein and Mauro (2002) develop the case for adding GDP-indexed bonds to the debt managers’ toolbox to foster international risk sharing and reduce the likelihood of debt crises. The authors argue that the premiums on such bonds compared with plain vanilla instruments could be small, because cross-country growth rate risks are largely diversifiable.

The government’s ability to issue nominal debt as a hedge can be limited by uncertainties about the government’s preferences for inflation and the lack of commitment devices that prevent inflation surprises. Price-indexed debt or foreign-currency-denominated debt may thus be issued despite their tendency to make the deficit more volatile and default more likely (Drudi and Prati, 1997; Goldfajn, 1998).

Becker (1999) and Jeanne (2003) modify and extend the standard model. Becker adds the potential costs of bailing out the private sector and shows that both the level and composition of private sector debt influence the optimal public debt portfolio. Jeanne presents a model where the currency composition of debt is chosen to minimize the probability of default. He shows that the less credible monetary policy is, the more foreign-currency-denominated debt will be issued—a theoretical prediction that he finds to be supported by cross-country data.

IMF’s New Economic Counsellor

Raghuram Rajan will be the IMF’s next Economic Counsellor and Director of the Research Department, succeeding Kenneth Rogoff, who is returning to academia in the fall of 2003. Rajan’s most recent appointment was as Professor of Finance at the University of Chicago Graduate School of Business. Rajan, 40, and an Indian national, has been the Program Director for Corporate Finance at the National Bureau of Economic Research, a Director of the American Finance Association, an Associate Editor of the American Economic Review, and a consultant at the U.S. Federal Reserve Board, the World Bank, the IMF, and several financial institutions. In January 2003, he received the American Finance Association’s inaugural Fisher Black Prize—an award given to a person under 40 who has contributed the most to the theory and practice of finance.

A number of papers have looked at the empirical support for the theoretical results. Goldfajn (1998) finds that changes in the use of inflation-indexed bonds in Brazil are consistent with theoretical predictions, whereas the increase in foreign currency debt is not. De Fontenay, Milesi-Ferretti, and Pill (1997) discuss the role of foreign currency debt in public debt management in a number of OECD countries and document a positive association between the share of debt in foreign currency and the yield spread between domestic and foreign currency borrowing. Drudi and Prati (1997) present empirical evidence that foreign-currency-denominated debt reduces inflation differentials but increases default premiums. Detragiache and Spilimbergo (2003) suggest that the observed correlation between short-term debt and crises may simply reflect countries’ difficulties in issuing long-term debt when crises look likely. They thus introduce a note of caution to earlier proposals that had suggested that policymakers should discourage short-term borrowing.

Additional objectives for public debt management include promoting well-functioning securities markets and providing instruments for monetary policy. Price (1997) presents arguments for inflation-indexed bonds that go beyond cost and risk minimization of public debt. De Broeck, Guillaume, and Van der Stichele (1998) conclude that moving away from relationship financing and introducing options and futures on government bonds contribute to more efficient bond markets. Arnone and Iden (2003) suggest that primary dealers help improve debt markets. Rossi (1998) argues that the cost of debt can be reduced by avoiding debt auctions at times when news about important macroeconomic variables is to be released.

Practical guidelines for debt managers have been produced by the IMF and the World Bank (2001). Drawing on an extensive set of country studies, the Guidelines for Public Debt Management note that a host of country-specific factors, such as fiscal policies, monetary policies, and the degree of financial sector development, are important in determining appropriate PDM arrangements. Cassard and Folkerts-Landau (1997) stress the importance of transparency and accountability and make a case for independent debt management offices with clear benchmarks for performance evaluation.

Several papers deal with the special challenges that face debt managers in low income countries, emerging markets, and Islamic countries. Bangura, Kitabire, and Powell (2000) provide practical advice for debt managers in low income countries, including on how to create an appropriate institutional framework and improve data collection. Gray and Woo (2000) argue that the costs and risks of external borrowing for emerging markets are often understated. De Mello and Hussein (2001) provide evidence that the currency composition of public debt in a number of emerging market countries is not optimal. Sundararajan, Marston, and Shabsigh (1998) discuss the use of instruments with returns contingent on the performance of projects—similar to equity—that are especially interesting for Islamic countries.

Books from the IMF

Sweden’s Welfare State: Can the Bumblebee Keep Flying?

Subhash Thakur, Michael Keen, Balázs Horváth, and Valerie Cerra

The Prime Minister of Sweden, Göran Persson, once compared the Swedish welfare state to a bumblebee. Given its “overly heavy body and little wings,” aerodynamicists marvel at how the bumblebee, which should not be able to fly, does. Similarly, he implied, economists (the butt of the joke, as usual) marvel at the success of the Swedish welfare state.

It turns out in fact that aerodynamicists have a pretty good idea of how the bumblebee flies. In the same spirit, Sweden’s Welfare State: Can the Bumblebee Keep Flying? tries to understand how the Swedish economic system has delivered such a high quality of life for its people. The book asks whether the Swedish state can continue to do so while facing demographic pressures in an increasingly globalized world, and what lessons the Swedish experience holds for other countries.

Reflecting the broad range of ways in which the government affects the Swedish economy, Sweden’s Welfare State covers a breadth of topics, including the macroeconomic framework adopted in the 1990s; the impact of the welfare state on growth; labor market interventions; the effect of tax and spending policies on incentives to work, save, and invest; and the consequences for fairness and the relief of poverty. The picture that emerges is of a complex interplay among institutions, incentives, and social consensus. Sweden faces challenges that are real but—with measures of the kind proposed in the book—can be weathered to “keep the bumblebee flying.”

Finally, in the context of the debate on the relative merits of a sovereign debt restructuring mechanism and contractual approaches, many studies have asked whether the legal features of sovereign bond contracts have important implications for crisis resolution. (The case for a sovereign debt restructuring mechanism has been made by Krueger, 2002. For an extensive survey of the literature, see Rogoff and Zettelmeyer, 2002.) In particular, research has focused on collective action clauses (CACs) in bond contracts, where the benefit from less costly restructuring has to be weighed against the risk of more frequent defaults. Eichengreen and Mody (2000) and Eichengreen, Kletzer, and Mody (2003) have argued that, for low-rated borrowers, the moral hazard concern would dominate, but for high-rated borrowers, the opposite is true, and they provide empirical support for this hypothesis. Becker, Richards, and Thaicharoen (2001), however, find no evidence of CACs increasing borrowing costs for either high- or low-rated borrowers.

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