- International Monetary Fund
- Published Date:
- August 2003
Developing a Sound Governance and Institutional Framework
Public debt management aims 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.
The importance of the government’s debt management strategy lies in helping generate macroeconomic stability and stronger public finances. The debt policy for 2002 had the objective of adequately managing the government’s debt and helping to generate a stable macroeconomic environment as well as stronger public finances. This was even more important during a year in which most economies were encountering difficulties, characterized by low growth rates and uncertainty in the international capital market. In this regard, the government adopted the following debt management policy for 2002:
As in past years, the fiscal deficit was financed in the domestic market. The uncertainty in the international market also underlined the need for this strategy during 2002.
The strategy in the domestic debt was focused on three areas:
– improving the maturity profile,
– extending the average life of domestic debt, and
– developing the long-term yield curve. It is important to note that issuance of the 10-year nominal fixed rate bond dates only to July 2001.
The external debt strategy is expected to continue to extend the maturity profile and at the same time lower costs by implementing active debt management strategies aiming at reducing market imperfections in the sovereign yield curve. The strategy also intends to avoid refinancing risk due to large concentrations of maturities in any given year.
The legal framework for the debt management is covered by the following articles:
Article 73, Section VIII of the Political Constitution of the United Mexican States (UMS) empowers the congress to establish the basis upon which the executive may borrow upon the credit of the nation, approve such borrowings, and order the repayment of the national debt.
Article 89, Section I of the Political Constitution of the UMS empowers and establishes the duty of the president to promulgate and execute the laws enacted by the congress to provide for exact observance of the laws by the government.
Article 31, Sections V and VI of the Organic Law of the Federal Public Administration provides that the ministry of finance and public credit shall manage the public debt of the federation and perform and authorize all transactions involving the public credit.
Article 1 of the General Law of Public Debt provides that the following entities are authorized to borrow: (a) The federal executive and its branches, acting through the ministry of finance and public credit; (b) decentralized public agencies as well as public corporations (i.e., corporations with majority government ownership); (c) government credit institutions and auxiliary credit organizations, government insurance and surety companies; and (d) trusts for which the grantor is the federal government or any of the agencies mentioned above.
Article 4, Section V of the General Law of Public Debt establishes that the federal executive, acting through the ministry of finance and public credit, shall be vested with the power to contract for, and manage, the federal government public debt and provide the guarantee of the federal government in credit transactions.
Coordination with monetary and fiscal policies
Debt management policy is determined by fiscal policy. If fiscal policy is coordinated with monetary policy, debt management policy will be indirectly related to monetary policy. In this regard, borrowing programs are based on the economic and fiscal projections contained in the government budget. The financial projections used in the government budget, such as the inflation rates and interest rates, are consistent with the monetary program of the Bank of Mexico (BOM), the central bank. In addition, as will be described, the BOM acts as financial agent of the federal government for many transactions. This requires a continuous working relationship between the fiscal and monetary authorities regarding debt management policy.
Guidelines for debt management
When the budget is authorized at the end of each year, the congress approves the annual limit for net external and internal borrowing submitted by the government through the ministry of finance and public credit. This limit reflects the debt policy for the coming year, which is also submitted to the congress, which analyzes this information carefully. This institutional framework supports implementation of a prudent government debt management strategy.
In addition, every new administration sets forth a general program for borrowing and debt management, directly related to the fiscal objectives established for the period.
Institutional structure of debt management
The principal agency of debt management is the ministry of finance and public credit, acting through the unit general direction of public credit unit. The main powers delegated to the unit are to negotiate and execute all documents related to
the public credit;
the authorization and registration of borrowings by public entities, including the development banks; and
financial transactions and derivatives to which the government is a party.
The President of the UMS appoints the general director of public credit. The senate must ratify the appointment.
The general director of public credit reports to the undersecretary of finance and public credit. Every quarter, the issuance program for domestic debt is discussed with the undersecretary before its publication. The reporting covers the negotiations related to the authorization of borrowings by public entities and the financial transactions to which the government is a party. This covers, for example, every new operation of the government in the international capital market. The frequency of the reporting depends on when these negotiations take place.
As mentioned, the central bank acts as financial agent of the government in the issuance and service of domestic bonds as well as other liability management operations. The BOM is also in charge of paying the government debt derived from most of the external debt with the funds of the federal government and under the instruction of the general public credit direction. This entails a constant working relationship between the two entities.
The debt management office is organized as follows:
The deputy general direction of external credit manages the issuance of securities in the international capital markets and carries out liability and risk management concerning the debt portfolio.
The deputy general direction of internal credit formulates the policies and manages the programs concerning the financing in the domestic market.
The deputy general direction of international financial organisms negotiates the conditions of the loans with the World Bank, the Inter-American Development Bank, and other financial organisms.
The deputy general direction of project financing negotiates and implements the policy regarding the financial operations, special schemes, and infrastructure projects.
The deputy general direction of legal procedures is in charge of solving issues related to the legal framework applicable to public debt management and provides legal advice to the general direction of public credit and to the other deputy general directions.
The deputy general direction of public debt negotiates, authorizes, and registers the public debt. This department also gathers and records the statistical information related to the public debt.
Retain qualified staff
Newly hired directors, deputy directors, and heads of departments must have a strong knowledge of at least one of the following subjects: public finances, economics, accounting, public debt management, law, statistics, and any other subject relating to public debt management.
For the staff, there are internal training programs in public finances, law, and accounting. In addition, scholarship programs are offered to the staff according to the specific area where they work.
Excluding the deputy general directors, directors, and deputy directors, the staff turnover within the general direction of public credit is low. The economic benefits are the same for all government employees, thus there are no additional economic incentives for public credit staff. However, because there are opportunities to learn different aspects of debt management—such as policies concerning financing in the international capital markets and the domestic market, knowledge of the legal framework related to public debt management, and risk management of the debt portfolio—the public credit direction is regarded as an attractive place to work.
Transparency and accountability
During the course of each year, a unit of the ministry of the comptroller and administrative development monitors the accounts, financial statements, activities, and operations of the general direction of public credit. Also during each year, the congress, through its auditing organization, reviews the accounts, financial statements, and other specific topics that are of interest to its members. The audit follows generally accepted auditing standards as well as generally accepted accounting principles applicable to government finances and debt management.
In addition, it is important to mention that Mexico belongs to the Data Dissemination Group of the International Monetary Fund. In this regard, historical data on Mexico’s public debt from the ministry of finance and public credit is available on its web page (www.shcp.gob.mx).
Debt Management Strategy and Risk Management Framework
The government has been able to reduce the country’s vulnerability to contagion of international financial crises mainly through sound macroeconomic policies and fiscal discipline. The fiscal deficit has been decreasing for the past several years, and the government will continue with its medium-term goal of achieving a balanced budget. On the monetary policy front, discipline has contributed to the achievement of the BOM’s inflation target for the past two years and, consequently, to more stable domestic financial markets.
A prudent and consistent debt management policy has also been an important tool in the ambition to reduce the country’s vulnerability. Since the late 1980s, issues regarding public debt have acquired greater importance in the strategy carried out by Mexican authorities. The focus has been on a strategic debt management that permits control over the debt and, at the same time, improves the debt’s terms and conditions.
Since 1995, the public debt as a proportion of GDP has diminished substantially, reaching levels not seen since the mid-1970’s (see Figure II.9.1). This has resulted in an important reduction in the debt-service allocation, reducing the vulnerability of the economy to external shocks and also decreasing the pressure on public finance. Furthermore, as a result of the effective transmission of fiscal and monetary policies, a reduction in the interest rates has also been observed.
Figure II.9.1.Public Debt Evolution, 1971–2001
Note: The IPAB (Instituto de Protección al Ahorro Bancario) is an institution created by the government to back up credit defaults, thus avoiding banking system failure.
Naturally, debt policy has to coincide with economic policy. A greater local indebtedness could put pressure on interest rates and increase the financing cost for the private sector, causing a “crowding-out” effect in the domestic market. Furthermore, a greater external indebtedness increases the refinancing risk and could lead the local currency to appreciate, affecting the competitiveness of the private sector and motivating imports of products and services. Therefore, the yearly debt policy approved by the congress establishes what will be the sources of the financing the government requires—whether it will fund itself abroad, in the domestic market, or a combination of both—in accordance with the economic policy. The issuance of debt by both the government and the agencies has to be considered in debt policy to avoid concentration of repayments in the same year. Consolidated reports on this issuance of debt are also presented to the congress.
The government has been very active in promoting the development of the local debt markets by providing new regulations and instruments. This policy has allowed Mexico to fund its budgetary needs with local debt, which in turn also has helped the development of local debt markets and allowed a reduction of the external debt. In this sense, external debt as a percentage of total debt has demonstrated a clear downward trend thanks to declining limits on net external indebtedness.
The Mexican government today faces two different types of risk with respect to domestic debt.
Interest rate risk: Given that a large amount of floating-rate debt is still outstanding, there is an inherent risk that an increase in interest rates will result in higher financial costs. However, as can be seen in Figure II.9.2, the relative importance of floating-rate debt has decreased over recent years.
Figure II.9.2.Internal Debt Composition by Type of Instrument
Note: Cetes (certificados de la tesorería) are short-term zero-coupon instruments with maturities of 1, 3, 6, and 12 months.
Refinancing risk: This risk arises from the possibility of an adverse environment in the global capital market, where the government could face difficulties in rolling over its maturing debt in favorable conditions. Given the improvement of the amortization profile during the past few years (see Figure II.9.3), the refinancing risk is manageable.
Figure II.9.3.Amortization Profile of Domestic Debt (year end)
To manage the interest rate risk and the refinancing risk, the government has undertaken an issuance strategy based on the following assumptions:
issuance of long-term floating-rate debt with 3- to 5-year maturities to reduce the refinancing risk started in 1997, and
gradual issuance of fixed-rate long-term instruments in 3-, 5-, and 10-year maturities to further reduce refinancing risk, at the same time lowering interest rate risks.
Because the market for instruments with long duration is not deep, the Mexican government has continued to issue floating-rate debt. When the market permits, a gradual shift to fixed-rate debt issuance will occur.
This issuing strategy is part of the overall debt management strategy that the government has in place. To guarantee that the current strategy in the local market is sustainable, the government has put special emphasis on macroeconomic policies, both fiscal and monetary, aimed at promoting stability.
The solid fiscal position registered throughout the most recent years, along with the structural reforms aimed at opening the economy to the external sector, has strengthened the liquidity position of the public sector with its external creditors. This development has led to a reduction in Mexico’s vulnerability. Today, the entire stock of public external debt could be covered with a half year’s worth of exports, a level not seen since the 1950s. The government regards it as highly important to maintain this situation through prudent management of public finance and external debt. The issuance of external debt by the government and the agencies is constrained by a ceiling imposed in the budget by the congress at the beginning of the year.
The risk management framework for external debt management is oriented toward covering the government’s refinancing needs, servicing existing debt, and improving the maturity profile, as well as lowering the financing cost of debt. The main risks that the government faces with respect to its external debt portfolio are refinancing risk, currency risk, and interest rate risk.
Figure II.9.4.Ratio of Net Public External Debt to Total Export Figure II.9.5.Federal Government External Debt Amortization Profile, as of September 30, 2001 Figure II.9.6.Agencies External Debt Amortization Profile, as of September 30, 2001
The U.S. dollar is the natural source of external funding because of the large inflows of U.S. dollars that enter Mexico through foreign direct investment, portfolio investment, and transfers of dollars from Mexicans living in the United States. Consequently, the non-dollar-denominated debt represents greater risk for the government.
The government has been prudent in selecting the portfolio’s composition of floating- and fixed-rate debt, thus it is composed mainly of fixed-rate instruments. To hedge against any risk incurred from any floating-rate debt, the government may use the derivative market. In hedging securities with derivatives, the government mainly uses cross-currency swaps, embedded options, and interest rate forwards.
The government’s external debt portfolio consists of both marketable and nonmarketable debt. Collateral deposits guarantee some of the external debt of the government, which are mostly Brady bonds. This guaranteed debt is usually bought back or called whenever there are net present value savings, to monetize the collateral and generate additional resources for the government. The government is currently trying to retire this debt by adding more market debt to its debt stock (see Figure II.9.7), making its portfolio more liquid and qualifying it for more benchmark credit indices as a large and liquid issuer, adding value to the government’s bonds.
Figure II.9.7.Percentage of Public External Debt
The government takes advantage of market opportunities as they occur. In the last few years, as a result of favorable market conditions, it has completed its funding early in the year. Because funding requirements have been relatively low, refinancing risk, as such, has not concentrated in any particular month within the year. Once the external funding needs are fulfilled, either in capital markets or from bilateral or multilateral institutions, the government focuses on management of the debt according to the ceiling imposed by the congress. Liability management is mostly used to retire collateralized debt (i.e., Brady bonds) and debt with embedded options, allowing the federal government to benefit from net present value savings.
To assess risk and find an opportunity to lower costs, the government constantly monitors the financial markets, especially markets for securities issued by similarly rated sovereign and corporate borrowers. Nevertheless, the main factors that help the government to reduce the cost and risk of its debt portfolio are without doubt sound fiscal and macroeconomic policies.
The government also guarantees debt issued by the agencies. Every three months, it presents a report to the congress containing all the relevant information about public debt, which includes the public sector’s debt stock, amortizations, new funding, and similar information.
Management information systems
The government’s debt managers have the necessary informational tools to analyze the risk profile of the debt portfolio. This is achieved mainly from day-today observation of the different financial and economic indicators, taking this information and performing various stress tests using current interest and foreign currency rates, then examining the outcome of each scenario and assessing the probability of an adverse outcome. This is supplemented with periodic reports and databases.
Naturally, any analysis depends on the continuity and reliability of quality information, adding great importance to the various information systems used by the government. It currently uses, through its debt management office, such services as Bloomberg, Reuters, and Infosel, as well as having access databases, valuation programs, and on-line quotes from both the local and the external markets.
Developing the Markets for Government Securities
In addition to the strategy followed by the government to develop the domestic debt market, the central authorities have undertaken measures to foster the development of an efficient secondary market.
As can be seen in Figure II.9.8, the average maturity of the debt portfolio has increased substantially during recent years. To continue the development of the long-term government securities market, the length of the yield curve has been extended through issuance of longer-term bonds. Instruments of 3-, 5-, and 10-year fixed-rate maturity were introduced in January and May 2000 and July 2001 (see Figure II.9.9). This strategy will be continued to consolidate the yield curve and possibly extend it further. With the development of the yield curve, the government has also paved the way for private sector issuers and has facilitated the development of a liquid derivatives market.
Figure II.9.8.Average Life Figure II.9.9.Evolution of the Interest Rate Curve
In October 2000, market makers were introduced to the market to increase liquidity, reduce transaction costs, and facilitate end-buyers’ purchases of government securities. Based on their activity in the primary and secondary markets, brokerage firms and financial institutions can be selected as market markers. There is also a continuous evaluation of the market development vis-à-vis the activity of the market makers, to guarantee that they continue to play an important role in the development of the domestic market.
Market makers have the following main obligations:
place bids in the primary auction for each type of fixed-rate instrument for a minimum amount of 20 percent of the auctioned amount;
continuously place bid-offer quotes for fixed-rate instruments with authorized brokers for a minimum amount of Mex$20 million and a maximum bid-offer spread of 125 basis points (in terms of yield); and
provide authorities with all the requested information to quantify their activity.
In exchange for the obligations, market makers have the following privileges:
The right to buy securities after the primary auction. This call option (“green shoe”) has these characteristics:
– only good for fixed-rate instruments offered in the primary auction,
– can be exercised only by market makers who offered a competitive rate in the primary auction,
– additional securities will be assigned at the weighted average rate registered in the primary auction, and
– the maximum amount that can be exercised through the call option is 20 percent of the auctioned amount.
The market makers may borrow from the central bank the minimum of the following fixed-rate securities of treasury certificates and bonds:
– 2 percent of the total outstanding amount of each issue of treasury certificates and bonds, and
– 4 percent of the total amount of outstanding treasury certificates and bonds.
With the introduction of market makers, an important increase in secondary market liquidity (see Figure II.9.10) has occurred. As a result, bid-offer spreads for all fixed-rate securities also have tightened substantially. On average, the spreads have decreased from 36 basis points in January 2000 to 27 basis points in November 2001. This has facilitated the distribution of government securities all the way down to end-buyers and smaller clients.
Figure II.9.10.Secondary Market Trading of Bonos
To increase liquidity in the government securities secondary market, the government has been reopening outstanding issues. This has helped to build up issues with a larger outstanding amount and at the same time reduce the number of issues in the market, thereby concentrating liquidity. Currently, the average outstanding amount of long-term securities is Mex$17,000 million per issue, compared with less than Mex$4 billion per issue at 1999.
The government is now regularly issuing 10-year inflation-indexed securities. As a result of the current price stability, the relative importance for this type of instruments has declined (see Figure II.9.2). Nevertheless, because there is a natural demand for inflation-indexed instruments coming from pension funds and insurance companies, it is highly possible that the government will continue to incorporate these instruments into the issuing program.
In line with the objective of strengthening government securities markets, the government has also been doing the following:
The government securities auction calendar is announced quarterly.
Continuous contact with the financial community: There are monthly meetings with market makers to discuss recent developments in the local markets and the overall macroeconomic environment. Moreover, periodic meetings or conference calls are held with other institutional investors to discuss relevant issues and get feedback on the current issuing program of government securities.
Improvement in the repo market and securities lending regulation: Substantial changes are being discussed on the way the repo market currently operates with the financial community. Some of these changes include the standard documentation by which this market regulates itself (International Swap Dealers Association [ISDA]–type), which is not used currently for repo transactions.
Mexico is always sensitive to market demands whenever investors are interested in investing in a new issue. Efforts are made wherever possible to satisfy investors who take the risk of providing funding, and in the end motivate good performance in the secondary market. This allows Mexico to better define its yield curve and lower its financing costs. Another step the government has taken to facilitate healthy and well-performing portfolios is to issue new bonds in an amount that is lower compared with the total orders made by investors for the new bonds. In this way, the government is able to avoid oversupplying the market with the new issue, which in some ways could affect secondary market performance. The supply-demand information, provided by investment banks, is crucial to better understand the timing and size of a new issue. The government also devotes itself to trying to improve the composition of the debt portfolio by retiring or replacing bonds that cause distortions on the curve. This generates cost savings for the government and satisfies investors.
When selecting the best borrowing alternative in the international market, the government has to consider private sector needs. It does this by trying to choose a tenor that will fill a gap in the sovereign yield curve in the international market and, whenever possible, establish points of reference—in the form of benchmark issues—for market participants from the private sector. Once the government has established a well-defined yield curve, it will be easier to price a new bond issue for Mexican corporations. Because the sovereign risk component is established and measured with the sovereign yield curve, corporations only have to price their own risk, mainly credit risk. This will achieve a more accurate price of corporate bonds.
To finance itself abroad, the government mainly uses three different markets, which provide different advantages. These are markets for the dollar, the euro, and the yen (see Figure II.9.11).
Figure II.9.11.UMS Market External Debt Issuance, 1996–2002
Because of the large flows of dollars from trade into and out of Mexico, and because some fiscal revenues are also dollar related, the most important foreign market for the government to finance itself abroad is the dollar market. The yield curve of the debt portfolio in this market is the most complex the government has built in external markets, with securities ranging up to 30 years in maturity and very liquid benchmarks (see Figure II.9.12).
Figure II.9.12.UMS Dollar Yield Curve
Having a well-defined yield curve in the dollar market allows the government to distribute its debt placements through times when refinancing debt or when new financing is needed. This also helps the private sector to finance itself abroad, by establishing reference points they can compare to, making it easier to value their credit risk. The government has been able to build a yield curve that has provided the market with information and has allowed the government to correctly price its market debt in any given maturity. Although the government has had an important success in the achievement of this goal in the dollar market, it plans to continue doing so while providing other markets, such as the euro market, with this information.
Even if the euro and yen markets are smaller in proportion compared with the dollar market, they sometimes present arbitrage opportunities in terms of spread over the U.S. Treasury once euros and yen are swapped into dollars, making financing possible at a lower cost compared with that of the dollar market.
Mexico attaches high importance to providing accurate and transparent information to the financial community, whether it is foreign or domestic. Toward this end, senior government officers carry out regular road shows in financial capitals, where they present the most recent economic developments in the economy and projections for the near future. During these presentations, the government also announces any new policies that have been made.
Whenever the government accesses the international market with a new debt issue, it distributes a press bulletin to the media containing the most relevant characteristics of the bond issue with comments on how the issue complies with the debt and economic policy.
The government also makes available relevant investor information on its web site (www.shcp.gob.mx). This information consists of quarterly reports containing debt statistics, tables, and the like. Since 2001, the government has been also publishing monthly debt reports. Even though monthly reports have less detailed information, they are often useful in monitoring public finance and debt.
Tax treatment of government securities
The fiscal treatment for holders of bonds issued by the government also can be attractive for investors, in that any payments of principal or interest are exempt from any withholding tax if they are held by a non-resident of Mexico or through a temporary establishment in Mexico.
The case study was prepared by the Mexican Public Debt Department of the Ministry of Finance.