1. Rationale for coordination

The basic rationale for coordination and the associated institutional and operational arrangements derive from the following interrelated objectives:

• a. to set internally consistent targets and objectives of monetary and debt management, with a view to achieve stabilization goals;

• b. to contribute to the development and liberalization of financial markets; and

• c. to facilitate efficient implementation of the objectives of monetary and public debt management through mutually supportive information sharing and structural policies.

Table 1 below highlights the government’s consolidated (treasury and the central bank) budget constraint which will be used to demonstrate the need for and kinds of coordination arrangements.

Table 1:

Government Budget Constraint and Policy Coordination

Table 1:

Government Budget Constraint and Policy Coordination

Fiscal Policy		Debt Management			Monetary Policy
(1)	Dt	=	[Bt - Bt-1]	+	[Mt - Mt-1]

View Table

Table 1:

Government Budget Constraint and Policy Coordination

Fiscal Policy		Debt Management			Monetary Policy
(1)	Dt	=	[Bt - Bt-1]	+	[Mt - Mt-1]

The budget constraint highlights the fact that the main elements of fiscal policy (the size of the budget deficit), debt management (the issuance of public debt), and monetary policy (the rate of expansion of monetary base) are linked. Expression (1) shows that the government’s deficit in the current period (D_t) must be financed either through net bond sales (B_t - B_t-1) to the public (banks, corporations, or persons), or through central bank credit to government, resulting in a rise in monetary base (M_t - M_t-1), held by the public in the form of currency or bankreserves. ^{1/ 2/} Since all three policies cannot be independently determined, a need arises to coordinate. There are three possible cases, highlighted below, with different implications for the scope of coordinating arrangements.

Case (a): The monetary authorities are in a position to determine the supply of base money M_t, t=1, 2, 3, …, consistent with an inflation target. The deficit path is then determined in relation with monetary objectives and financing possibilities. Clearly, this arrangement requires a central bank with operational autonomy to set a path for monetary base (at least the domestic component of the monetary base if the exchange rate is fixed), and sufficient policy coordination and fiscal discipline to align the fiscal balance.

Case (b): The fiscal authorities determine the deficit path D_t, t=1, 2, 3, …., and the monetary authorities then supply whatever volume of base money is required to finance government deficits. Consequently, the central bank’s mandate for delivering the desired level of price stability may be jeopardized, particularly, when the fiscal deficit is large in relation to stabilization goals and the scope for debt issuance outside the central bank is limited. This case is typical of many economies in transition in the undeveloped stage.

Case (c): The fiscal authorities and monetary authorities take independent decisions about the size of the fiscal deficit and the path for the monetary base, respectively. Debt management operations in well-developed government securities markets finance the deficit in a non-inflationary manner through bond sales B_t, t=1, 2, 3, … outside of the central bank to banks and the nonbank public. In this arrangement, interest rates--and also exchange rates, depending upon the exchange system--adjust in well-developed financial markets and bring about the alignments needed to satisfy the government budget constraint.

In economies in transition, the coordinating arrangements under Case (c) are not realistic--with undeveloped financial markets, it is impossible to independently set the deficit and the supply of money, as the budget constraint demonstrates. Hence, if the plans of the fiscal and monetary authorities prove incompatible with the budget constraint and stabilization goals, then either the government or the central bank has to modify their targets. Otherwise, stabilization would be unlikely to be achieved.

The above discussion also suggests that for economies in transition, which are typically characterized by Case (b), coordination of monetary and fiscal policies should encompass not only the reconciliation of targets for fiscal balances and monetary growth, but also the development of financial markets, particularly government securities markets. Market development would enable a greater scope for independent fiscal and monetary policies in due course, with market prices providing the signals for policy adjustments, rather than explicit operational coordination arrangements, which could be limited to essentials such as information sharing. ^1/

2. Coordination of debt and monetary management objectives, and the development of financial markets

The pace of financial market deepening will depend greatly on the strategies for the development of primary securities markets--the choice of debt and monetary instruments and the management of the instruments (discussed in Chapter III)--, and of secondary markets--the role played by the central bank in market development (discussed in Chapter IV). Moreover, in the absence of secondary markets, the primary market for government securities may be used for both debt and monetary management purposes.

In these circumstances, the objectives and operations of monetary and debt management cannot be strictly separated, and will have to be more closely coordinated to achieve the goals of financial market development, on the one hand, and liquidity management, on the other hand. In this context, it is vital to articulate a debt management objective so that the design of the debt management program may be consistent with the harmonization of debt and monetary management and the attainment of financial market development goals. This is discussed below.

The objectives of debt management and hence the details of coordination arrangements are likely to vary with the economy’s stage of development. In modern market economies, a widely accepted debt management objective is to minimize the expected cost of debt service. This presupposes that debt management policies are part of a system (Case (c)) that includes macroeconomic policies (fiscal and monetary) geared toward economic stabilization, well-developed financial markets, a regulatory framework which supports voluntary holdings of government debt, constraints which limit central bank financing of the government (and the requirement of maintaining positive cash balances), and a central bank which determines the overall monetary stance (i.e., the debt managers treat interest rates as a variable exogenous to the debt management strategy).

This debt management objective can be illustrated by expanding expression (1) to form equations (2) and (3), as explained below. Given an exogenously determined financing requirement (government spending on goods and services (G_t), less revenues (R_t), plus debt service (S_t)), what mix of debt instruments--short-term bonds (B^s_t) and long-term bonds (B¹_t) minimizes the expected debt-service costs (S_t+1). This cost minimization problem depends on the shape of the yield curve--short-term interest rates (I^s1/2) versus long-term interest rates (I¹)--and the expected future course of interest rates (I^S2/2). ^1/

In economies lacking well-developed financial markets and with high deficit financing requirements, a debt management framework of cost minimization, as highlighted above, is unsuitable. Given a scarcity of market sources of financing (there will not likely exist a long-term bond market, let alone a short-term market), such an objective could encourage the government to borrow from the central bank (at the expense of fostering inflation). Or, as illustrated by equation (4) below, private sector borrowing--loans from banks (B^cb_t) and nonbank financial institutions(B^p_t)--would likely be at nonmarket interest rates [(I^cb) and (I^P)], enforced by statutory regulations such as high liquid asset requirements on these captive sectors.

where: I^cb and I^P are typically unequal and fixed at below the rate of inflation

Such a segmented market approach to debt management would undermine the development of financial markets and exacerbate the costs of stabilization through distortions in the interest structure. Thus, the challenge for economies in transition is to articulate and adopt a debt management objective which is compatible with the broader goals of monetary stabilization and the development of financial markets. One broad objective might be as follows:

To enhance economic stabilization and promote financial system development, to be accomplished by: (i) government borrowing from non-inflationary (noncentral bank) sources; (ii) inducing voluntary holdings of government debt through establishing market-related rates of return; and (iii) minimizing the cost of debt service by enhancing the liquidity of government debt instruments through the development of a government securities market, while taking actions to increase investor confidence.

The above objective may also involve tradeoffs between multiple policy objectives (and constraints). For example, recapitalization and restructuring of banks may be needed to support effective competition and interest rate flexibility, but this would require additional fiscal adjustment and additional debt issues to cover the costs of restructuring. In this case, additional debt issuance could be made part of the government securities market development strategy; in this strategy, refinement of monetary operations plays a crucial role in fostering liquid markets in government debt instruments.

In summary, in economies in transition, stabilization and the development of financial markets are common objectives binding monetary and fiscal authorities, while monetary and public debt management policies cannot be strictly separated. Therefore, coordination of policy has to be achieved through the sharing of common objectives and the pursuit of joint actions--involving stabilization and institution-building measures--to achieve those objectives.

3. Institutional and operating arrangements

The coordination of fiscal, debt, and monetary policies has to be supported by concrete institutional and operating arrangements. Types of arrangements, their rationale, and their likely evolution in the course of transition are discussed briefly below, and more fully in Chapter V.

First, institutional arrangements that limit central bank credit to the government can reduce conflicts between the central bank and the MoF in decisions regarding the sources of deficit financing, and enhance the operational autonomy of the central bank.

Second, institutional arrangements, such as a debt and monetary management committee, can play an important role in coordinating the volume of debt issuance in the primary market with monetary policy goals and help resolve conflicts concerning the stance of interest rate policy.

Third, operational arrangements to share information and to forecast variations in government balances with the central bank or expected changes in the government’s overdrafts, can help to facilitate appropriate adjustment of instruments and the attainment of both the reserve money and debt issuance objectives.

Fourth, arrangements and rules for the treatment of central bank profits and losses will be important for maintaining central bank operational autonomy through the preservation of the central bank’s capital, while removing incentives for inflationary spending that may result from transference of profits.

Fifth, the central bank and the MoF have a joint interest in developing secondary markets in government securities. Well-functioning secondary markets are important for the MoF as they stimulate demand and render the absorption of relatively large issues less problematic. Thus, the central bank may need to consider institutional arrangements to enhance secondary markets, such as establishing a secondary market window or developing market makers, while arrangements in the primary market will need to be designed to enhance market deepening by improving the auction system.

Such institutional arrangements will generally evolve along with the stages of transition. In the initial stage (the undeveloped stage, noted in Figure 1), regulatory changes may be required: for example, central bank legislation may need to be altered to permit the central bank to issue its own securities, or purchase and sell government securities in the open market; changes may also be needed to permit it to act as fiscal agent for the MoF. In addition, a ministerial decree or a public debt act may be needed to permit the government to issue securities and to allow investors to trade in securities.

In the preparatory stage, the coordination of debt and monetary instruments will probably require the formal establishment of a high level policy coordination committee, comprising MoF and central bank officials. The placement of limits on central bank credit to the government, and the introduction of debt instruments and selling techniques to serve both monetary and fiscal objectives would be important aspects of coordination.

In the transitional stage, the promotion of a secondary market should make it possible for the central bank to further develop open market-type operations; this would require the establishment of an open market committee and direct-dealing relationships with market participants, and more intensive day-to-day coordination of primary issues with other instruments of monetary management (e.g., credit auctions). At the same time, greater emphasis would need to be given to short-term liquidity forecasting for the conduct of open market operations, which would, in turn, require more frequent information about the central bank’s balance sheet. In addition, increased information sharing between the central bank and the MoF would be needed to monitor and project government cash balances. Arrangements for primary auctions might also become increasingly market-based to further market development: for example, the authorities might switch from a minimum price tender (setting the cutoff rate) to a market-clearing auction (setting a fixed supply).

Given deepening financial markets in the developed stage, institutional arrangements may delineate separate objectives for debt management and monetary management policies, supported by greater reliance on market operations and market signals to ensure coordination, and further development of institutional arrangements to reduce policy conflicts. Such arrangements could include stricter limitations on direct central bank financing of the government, permitting only indirect purchases of government securities in the secondary market. In some countries, a separate statutory institution--a debt management office--has been established to pursue the objective of cost minimization in a market environment.

1. Primary markets in government securities: designing an appropriate strategy

The design of an appropriate program of debt sales, instruments, and the choice of selling mechanism will depend upon the overall strategy for stabilization, debt and monetary management policies, and the strategy for the development of government securities markets. The main elements in building a market-based strategy for debt and monetary management are highlighted below.

First, the debt sales program should form part of the overall process of stabilization by seeking non-inflationary sources of financing. If debt sales are seen as an opportunity to increase expenditures and run larger fiscal deficits, this will raise inflationary expectations, and at a minimum, raise borrowing costs to the government.

Second, in the context of developing efficient financial markets to support stabilization, as well as broader structural reform objectives, debt management policies should avoid creating distortions in capital and credit markets, which as country experiences have shown, will tend to slow the development of secondary markets. Thus, the primary issuance of government debt should be based on selling arrangements that are market-based with flexible and competitive interest rate determination, inducing voluntary holdings of securities by investors, rather than based on involuntary holdings by captive market segments using statutory reserve and liquid asset requirements and interest rate restrictions.

Third, an overall strategy for the development of the government securities markets should be developed and agreed upon. Typically, most countries embarking on financial reform have placed the initial emphasis on treasury bill markets, as part of money market development, and gradually extended the maturity spectrum of government securities to encourage capital market development. ^1/ The parallel development of market-based monetary management has helped to stimulate money and interbank market activity by inducing banks, in particular, to actively manage their liquidity, using short-term liquid instruments such as treasury bills.

Fourth, as part of the strategy for economic stabilization and overall market development, the central bank and the MoF will need to decide whether to use the primary market for treasury bills strictly as a means of financing the fiscal deficit (and smoothing short-term fluctuations in treasury cash flows), or, to also use it as a significant monetary management tool.

2. Coordination of primary market issuance of government debt

In the absence of secondary markets in treasury bills or other market-based instruments to manage bank reserves, many countries have used treasury bill auctions as a substitute for “open market operations.” Since indirect monetary management consists of targeting the level of bank reserves in order to control the lending capacity of banks and short-term interest rates, and thereby the overall monetary expansion and the general interest rate level, primary issues of government debt can, in principle, be used not only to meet debt management objectives but also to implement indirect monetary management.

The use of treasury bills to regulate the level of bank reserves requires that the volumes sold be varied from time to time in response to variations in autonomous factors affecting bank reserves, while ensuring that sufficient amounts of treasury bills always remain outstanding in the market to permit liquidity management by holders and foster market development. ^1/ In general, using treasury bills as a monetary management tool requires that an auction technique be adopted to sell the bills regularly, frequently, and at market-clearing interest rates; that the volume of sales be used as a means to regulate the level of bank reserves; and that the interest rate resulting from the auctions be used to signal the authorities’ intentions and thereby guide other interest rates in the financial system.

The coordination of policies insofar as they relate to the primary issuance of securities is typically done in a joint committee (or working group) of central bank and MoF officials. If deficit financing is the primary objective, then central banks will essentially play an advisory role, while the MoF will normally have the final authority concerning the terms of primary issues including, in particular, the volume of issue, but also the interest rates and maturities. In the case where issuance is for monetary management purposes, the central bank will normally be granted much greater discretion in choosing the volume of securities to issue. In addition, arrangements may be required, and agreement sought, to sterilize the proceeds from the sale of securities on the balance sheet of the central bank to eliminate the attendant risk that an increase in government cash balances could induce an expansion in government expenditures. Finally, the central bank and the MoF should also agree on various technical aspects of treasury bill sales, or to leave technical aspects for the central bank to decide. These include frequency of offerings, settlement times, the range of bidders, type of auctions, items to be preannounced, etc.

If fiscal deficits are sizable, debt financing solely through sales of treasury bills may not be sufficient. In this case, either the fiscal deficits will have to be reduced or efforts will need to be made to sell a wider range of government debt instruments to tap different markets (or a combination of both). It is therefore important that, in parallel with introducing treasury bill auctions, the fiscal and monetary authorities agree on a comprehensive program of government debt management, including the use of a range of debt instruments, and selling techniques, and a phasing-in strategy for the various debt instruments.

3. The development of additional monetary instruments

In practice, the use of treasury bill auctions for monetary management will not be sufficiently flexible and the development of additional monetary instruments will often be necessary to facilitate monetary management, especially in cases where liquidity fluctuations are volatile and large, or permanent. For example, if liquidity shortages suddenly develop, say due to short-term capital outflows, the authorities may wish to contain the resulting increases in short-term interest rates. However, an injection of liquidity would be difficult to achieve solely through the maturing of treasury bills at discrete intervals. At the same time, sharp reductions in the amounts offered may disrupt market development and investment planning by buyers. Therefore, in many countries, refinance/rediscount instruments and/or repurchase agreements are used to inject or withdraw liquidity for short periods. This raises technical issues regarding the coordination of treasury bill auctions with other instruments which are discussed later in this section.

In cases where the initial situation is one of high excess liquidity in the banking system (or if such a situation develops), it may not be feasible or desirable to absorb this excess by treasury bill issues alone. Reserve requirements could be raised, but this is inefficient if the required reserves are not adequately remunerated. In such a case, it may be preferable to sterilize the excess liquidity, if feasible, through the issuance of medium-term government debt. Another possibility is the issuance of central bank securities. This might be more appropriate if the issuance of government securities would lead to an excessive buildup of government deposits. ^1/ Yet another possibility is that the authorities could restrain the volume of central bank credit to banks, which, in combination with an increase in the volume of treasury bills sold, could also be used to offset the excess liquidity. Such control in the volume of central bank credit at the initiative of the central bank would require additional instruments, such as credit auctions. The appropriate choice (or combination) of instruments highlighted above, naturally, would depend upon the circumstances.

In practice, therefore, the authorities would typically need an arsenal of instruments, which could be used in some combination to regulate the level of bank reserves as well as the level of interest rates in the treasury bill and interbank markets. The use of primary issuance of treasury bill auctions alone would not normally be enough and would have to be supplemented by other instruments, such as credit auctions, short-term repurchase agreements, special issues of securities (central bank or government) for monetary purposes, government deposits, reductions in central bank credit to priority sectors, and variations in reserve requirements (see Appendix I). A few of these instruments are discussed below.

4. Design of primary auctions

In the early stages of financial sector reform, a common issue in the management of primary issues of treasury bills (and other government securities) is whether the central bank should participate in the auction and, if so, how. In general, arrangements whereby a minimum price is set beforehand (which may or may not be preannounced) and the central bank is required to take up the amounts that remain unsold is an undesirable practice. At the least, it complicates monetary management, at the worst it creates pressures to finance the government, undermining the stabilization efforts as well as the progress toward market-based mechanisms. It is preferable, therefore, not to have the central bank participate in the auctions and to acquire treasury bills through the secondary market. If for reasons of limited absorptive capacity of the market the central bank is required to participate, it should not do so as a competitive bidder, since this will reduce the confidence in and transparency of the auctions. Instead, the central bank should participate on a noncompetitive basis at the weighted average auction price; preferably, the central bank should preannounce the amount to be purchased or, at the least, the market should be informed upon announcing the auction results of the amount purchased by the market and the central bank. Such arrangements will help to convince market participants that awards at the auction are truly based on market-clearing prices, which will build up confidence and encourage more active participation in markets.

The use of both credit auctions and treasury bill auctions for monetary management requires coordination of technical aspects. Experience suggests that the maturity of credit auctions should generally be less than the minimum initial maturity of treasury bills. This improves control over bank reserves and short-term interest rates, and thereby permits smoother management of treasury bill auctions. The synchronization of settlement for treasury bills and credit auctions and the timing of auctions in relation to banks’ reserve maintenance period are both important for efficient management of money markets. The management of the interest rate structure--the relationship between the credit auction rate, the interest rates on direct central bank credit, the treasury bill auction rate, and the central bank’s bid/offer rate for treasury bills in the secondary market--also requires careful coordination. For example, under normal market conditions, credit auction rates should be higher than treasury bill yields of similar maturity; if not, central bank financing may be used for market arbitrage. In addition, the rediscount rate or the bid rate quoted by the central bank in the nascent secondary market for treasury bills might be less than the credit auction rate, in order to foster liquidity in the secondary market, particularly in the initial stages; it might also encourage the establishment of yield spreads reflecting differences in credit risk--credit to commercial banks versus credit to government.

1. Actions to develop the market

In light of the considerations enumerated above, the authorities’ actions to stimulate the secondary market, discussed below, can be viewed as either affecting the market value and the process of price discovery, i.e., how the price and interest rates are determined by coordinated monetary and fiscal policies and primary market arrangements (items a-d above), or as affecting the secondary market structure and its operational efficiency, i.e., how the buyers and sellers interact through the microstructure of secondary markets (items e-g above). There are a number of measures that can be taken.

• Measure a. Provide a transparent and equitable system for regulation and supervision of secondary markets

A transparent and equitable regulatory framework is essential. In recent years, most countries have tended to favor establishing a single centralized authority--such as a securities commission (by various names)--which is responsible for promulgating securities laws and is the primary and final authority on securities market regulation and supervision. Some of its powers are formally delegated by specific acts to either the treasury or the central bank, or to self-regulatory organizations, which may have a comparative advantage in terms of expertise, information, resources, and independence. ^1/ Specific institutional arrangements are established regarding the participation and interaction of the central bank or the MoF, or both, with other bodies involved in securities market regulations and supervision.

The key objectives of financial sector regulation and supervision are to monitor and enforce sound operations, ensure that there is adequate capital in relation to risk, create efficient trading systems, and at the same time, encourage competition and innovation. These objectives require that the regulatory constraints on specific activities be applied uniformly across various institutions and in a flexible manner so as not to stifle innovation.

Typically, countries have endeavored to modernize their government securities markets by adapting the basic regulatory framework to the needs of investors and market professionals with respect to liquidity, transparency, and the adequacy and efficiency of trading facilities. These adaptations have often resulted in the creation of a new securities commission or in a broadening of the supervisory powers of the existing commissions and a clearer delineation of responsibilities between various official bodies. ^2/ Appendix III summarizes the regulation of securities markets in a selection of countries.

While the overall regulatory and supervisory framework for securities markets and the delegation of powers to central banks and the ministries of finance in specific areas vary from country to country, central banks are typically involved in the prudential supervision of securities activities and the asset-liability management of commercial banks, as well as those of nonbank financial institutions with whom central banks directly interact in implementing monetary policy.

• Measure b. Develop an efficient and secure clearing and settlement system for transactions in government securities

As lender-of-last-resort to the banks and given the responsibility for ensuring the soundness of the payments system, central banks have a clear interest in ensuring that clearing and settlement systems for securities are well-designed to control credit, liquidity, and operational risks, and to ensure that systemic risks are minimized. As fiscal agent to the government, central banks have to help ensure the marketability and distribution of securities; and, as a market participant, the central bank, just as any player in the market, is concerned that securities trades are completed properly, with delivery of securities matched by receipt of payments.

There are four key elements for a clearing and settlement system for securities: (i) trade comparison and clearing arrangements; (ii) a depository, which handles securities and maintains a book-entry securities transfer system; (iii) a money transfer system; and (iv) a custodial/safekeeping arrangement where members of the depository can safely keep securities on behalf of clients.

The central bank may participate in the clearing and settlement system by providing all or some of the above services. However, regardless of whether the central bank is a provider of any of these services, it should ensure that the architecture of the system is sound. In particular, the movement of securities by the depository and the opposite movement of funds through the money transfer system should be simultaneously combined so that the clearing and settlement system ensures “delivery versus payment” (DVP). This eliminates “principal risk” which can arise when either securities are transferred before funds are received or vice versa. Appendix IV outlines the systems of a number of countries.

Since, typically, central banks organize and operate large value transfer systems (LVTS) for interbank funds, the development of clearing and settlement of government securities in book-entry form could be integrated with the large value transfer system to ensure delivery versus payments and support security market development.

• Measure c. Foster an appropriate microstructure of money and securities markets, and support the role of “market-makers” in government securities

The central bank and the MoF should play an active role in fostering an appropriate market microstructure and price discovery process.

Most secondary markets for government securities have in recent years tended to be modeled on that of the United States, where authorized primary dealers are charged with making continuous markets in government securities through continuous bid and offer quotations and are given certain privileges to match their market-making obligations. Primary dealers are also required to keep the government debt manager and the central bank (in its function as fiscal agent) up-to-date on market developments, assisting the authorities in the design of market-based debt and monetary operations and the smooth functioning of the market, thereby increasing the depth and breadth of the government securities market. The role of such dealers is highlighted in Appendix V.

Dealers provide “immediacy” of execution by purchasing and selling securities as principals, at quoted prices. Thus, successful dealer markets tend to be characterized, and sometimes dominated, by institutional investors who transact in large block sizes and attach a premium on immediacy of execution. At the same time, the promotion of dealers that are prepared to transact at quoted prices facilitates the central bank’s liquidity management using open market operations, which also requires immediacy of execution. The licensing of market-makers, the definition of their privileges and obligations, and their subsequent supervision is, in many countries, the responsibility of the central bank in view of the importance of such market-makers in the implementation of monetary policy.

Government securities may also be traded on exchanges (e.g., Ireland) which provide a secondary “auction” market. These markets direct buy-and-sell “orders” (limit orders or market orders) into a single location (on an exchange floor or electronic order matching system), where they are executed at the market clearing or “best price.” Auction markets rely on the flow of buy-and-sell orders to assure that markets are continuous and that sufficient market depth exists. When order flow is insufficient, a large block order can destabilize auction markets resulting in “execution risk” for the buyer or seller.

In nascent markets, sufficient order flow is likely to be lacking. In such a case, the encouragement of a group of dealers to support, maintain, and promote secondary markets will benefit market development and enhance secondary market liquidity. Alternatively, auction markets can be organized along the lines of a “call auction” where securities are traded at a particular time of the day or week. The concentration of orders in a batch (periodic) market helps stabilize prices and ensures liquidity to the investor through the accumulation of orders over time. In addition, the costs of execution and settlement are lower, while the existence of a single price per day, or trading period, reduces the risk of settlement errors.

In the initial stages of market development, when the size of the market is not sufficient to support several market-makers, central banks have often established a secondary market window by standing ready to buy and sell government securities. The buy-and-sell prices in these cases could either be set by the central bank itself, or the central bank could respond at its discretion and on a dynamic basis, depending on market developments and in response to quotes provided by the market. The latter method is generally preferable, since it permits the central bank more flexibility and encourages the development of market-making by participants. Importantly, the development and experience gained in setting up and operating a secondary market window prepares the central bank for full-fledged open market operations as the market develops.

In some countries, the authorities have established a discount house, which could be jointly or wholly owned by the central bank, to act as market-maker. A line of credit would be extended to the discount house to help provide financing for inventory. This approach is an extension of the secondary window method and has the advantage of clearly separating monetary policy functions from dealer functions. However, as a monopoly “market-maker,” the discount house could discourage the emergence of competing market-makers in the nongovernment sector. In general, therefore, the above transitional secondary market arrangements should be replaced as soon as possible by a more competitive structure of secondary markets, with central banks indirectly supporting the market through monetary operations.

Where transparency of price in formation or communication systems are problematic, some central banks (for example, Italy and Poland) have supported secondary markets by providing a trading system, often as part of facilities to clear and settle government securities transactions. This approach can offer improved transparency as compared to telephone over-the-counter markets and operational efficiency by linking the trading system with the clearing and settlement system.

• Measure d. Manage liquidity actively with market-based instruments using government securities

Central banks should manage bank reserves actively to minimize excessive volatility in banking system liquidity, while maintaining sufficient flexibility in interest rates. Excessive volatility in banking system liquidity, and consequently in short-term interest rates, will discourage market participants from taking positions in longer-term treasury bills given the increased liquidity risk--the risk of being unable to borrow overnight (or short-term) in order to fund longer-term securities positions.

In the initial stages, central banks use simple market-based instruments--as discussed in Chapter III--to manage the level of bank reserves in line with monetary policy objectives, and in the process build up active interbank markets, laying the foundation for secondary markets in government securities. ^1/ While the specific mix of indirect monetary policy instruments will vary according to the evolution of bank reserves, the state of development of money markets, and the details of the clearing and settlement system, the authorities can use their monetary operations to stimulate markets in treasury bills. For example, treasury bills (or other government securities) may be required as collateral for credit auctions, or equivalently, the central bank may auction repurchase agreements (repo) against treasury bills. This would stimulate the treasury bill market. The central bank would also maintain a sufficient stock of treasury bills in its own portfolio, if necessary by converting part of its outstanding claims on government into treasury bills, which could then be sold on a repurchase basis for a short period; this would be a supplementary means of sterilizing bank reserves, in addition to outright sales of treasury bills and adjustments in the volume of credit auctioned. Thus, progressively greater use of government securities in monetary operations--as indicated above--would foster further development of government securities markets.

The use of repurchase operations in treasury bills to manage money market liquidity is an important way in which central banks can support the development of interbank and treasury bill markets. As markets develop, central banks mostly use repurchase agreements in government securities--and occasionally outright sales and purchases--to influence overall liquidity conditions in the money markets, and to provide financing support to dealers in government securities, and thereby influence the level and volatility of interest rates. The central banks’ monetary operations have an immediate impact on interest rates in interbank markets and money markets, which will, in due course, influence long-term rates, since dealers in long-term government securities typically finance their securities holdings for distribution and market-making activities in the money markets and investors adjust their portfolio of assets in response to changes in relative yields. During the initial stages of market development, some central banks may intervene in securities markets directly through a secondary window or a discount house.

Some countries have agencies that intervene in the secondary market, on behalf of the government, for price stabilization purposes. In these cases, intervention is carried out either by the central bank or through a joint body involving both the central bank and the MoF. In several countries, the MoF (or a national debt office charged with the role of debt manager) also intervenes in the secondary markets occasionally, to buy up illiquid securities and replace them with more liquid securities with desirable technical features.

1. Coordination of debt and monetary policies and its execution

b. Intervention instruments for monetary management

Coordination of operating arrangements help to achieve debt and monetary policy goals. In particular, in countries with rudimentary financial markets, a higher degree of coordination is required, since both the monetary authorities and the fiscal authorities operate in the primary market and, in many cases, government securities may serve a dual purpose--monetary and debt management.

Three general types of operating arrangements for the conduct of debt and monetary management can be described: Arrangement I (same market/different instrument) uses the primary market for both monetary and debt management but different securities--for example, central bank securities, special-issue treasury securities, or credit auctions for monetary management, while government securities are used for debt management purposes only. Arrangement II (different market/same instrument) uses the primary market for new-issue government securities for debt management purposes, while the central bank operates in the secondary market through open market operations in outstanding government securities--this is the dominant arrangement in developed countries. Arrangement III (same market/same instrument) uses the primary market for government securities for both debt and monetary management purposes, in the absence of developed secondary markets. Table 2 shows the operating arrangements for the conduct of debt and monetary management in a sample of countries.

Table 2.

Operating Arrangements for Debt and Monetary Management in Selected Countries

Table 2.

Operating Arrangements for Debt and Monetary Management in Selected Countries

Arrangement I	Arrangement II	Arrangement III
Different Instruments Same Market	Same Instrument Different Market	Same Instrument Same Market
Many economies in transition Russia Romania New Zealand Poland (initially)	Most developed economies U.S. France Spain Poland (presently)	Many developing countries

View Table

Table 2.

Operating Arrangements for Debt and Monetary Management in Selected Countries

Arrangement I	Arrangement II	Arrangement III
Different Instruments Same Market	Same Instrument Different Market	Same Instrument Same Market
Many economies in transition Russia Romania New Zealand Poland (initially)	Most developed economies U.S. France Spain Poland (presently)	Many developing countries

These arrangements differ according to the extent of day-to-day coordination required of volumes, prices, and forecasts by monetary and fiscal authorities. Arrangement II, typical of OECD countries, requires a lower degree of coordination, because deficit financing takes place in primary markets and monetary management in secondary markets.

It can be argued that the need for coordination is also minimal in Arrangement I, when the central bank intervenes by using specifically designed instruments, such as nongovernment paper (i.e., central bank bills, such as in New Zealand); or distinct government securities (i.e., treasury bills of a specific maturity that are exclusively used for monetary management purposes, such as in the United Kingdom). Although specifically tailored instruments may seem to require a lower degree of day-to-day coordination, clear arrangements that specify the joint and individual responsibilities are essential for transparency and effectiveness. The need for both policy and day-to-day operational coordination is clearly the strongest in Arrangement III, common in many developing countries in the process of liberalization. An important principle, essential for the effectiveness of all three arrangements, is that the Treasury regards the interest rate (price) as endogenous--influenced jointly by monetary management of the central bank and by market conditions.

In many economies in transition, two key factors need to be considered when deciding on the most suitable arrangement for monetary operations: (i) the undeveloped primary and secondary markets for government securities; and (ii) commercial banks’ heavy dependence on central bank credit. This suggests that it may be best to use Arrangement I, under which the MoF initially develops the primary treasury bill market to finance the deficit while the central bank uses credit auctions to implement monetary policy.

However, sales of government securities--regardless of their purpose--may still have a monetary effect which needs to be taken into account, for instance when proceeds or subscriptions for sales of government securities are temporarily deposited with the central bank. Also, on occasion, debt can be issued to serve a monetary objective, for example, the sterilization of excess reserves. Thus, government securities would supplement monetary management, coordinated with the MoF, as in Arrangement III. Moreover, where appropriate, Arrangement III is preferred in order to avoid market segmentation created by introducing two similar-but-different instruments.

c. Institutional arrangements for public debt management and the relationship between the central bank and the Treasury

The legal framework for public debt management generally authorizes the Treasury or the MoF to borrow on behalf of the government. In addition, the Treasury or MoF are empowered to delegate debt management functions to the central bank. In this way, the Treasury can focus on its primary responsibilities--financial planning of government operations, control of budget execution, and cash management--while delegating other aspects of debt management to the central bank or, alternatively, to a separate statutory agency--the Debt Management Office.

The rationale for dividing various debt management functions between the MoF and the central bank is discussed below, followed by a brief discussion concerning the establishment of a Debt Management Office.

(1) The allocation of debt management functions

Public debt management comprises a number of separate but related functions; these are highlighted in Table 3. Different institutional arrangements for the division of labor of debt management functions is possible. ^1/ This is likely to be influenced by historical and sociopolitical factors that can, in part, explain the division of labor of debt management functions between the Treasury, or MoF, the central bank and, where applicable, the Debt Management Office.

Table 3.

Debt Management Functions

Table 3.

Debt Management Functions

Debt Management Functions	Description of Function
Policy	• formulation of debt management objectives • setting of instruments to meet those objectives • coordination with monetary management • approval of debt program
Planning	• projection of fiscal requirements • formulation of debt program regarding frequency, volume, and issuance by instrument
Primary issuance	• short-term management of primary market including management of issuance volumes and borrowing calendar
Fiscal	• management of cash balances • short-term projection of cash balance requirements
Selling	• management of selling arrangements (auctions, subscriptions, etc.)
Secondary market	• management of outstanding stock in secondary market for active debt management policy • development of secondary market depth and liquidity
Advisory	• debt management agent(s) may provide advice to the Treasury (or MoF) on the above debt management functions
Issuance/ redemption	• administration of delivery and redemption of security versus receipt/payment
Accounting	• management of records of debt instruments and stock of debt

View Table

Table 3.

Debt Management Functions

Debt Management Functions	Description of Function
Policy	• formulation of debt management objectives • setting of instruments to meet those objectives • coordination with monetary management • approval of debt program
Planning	• projection of fiscal requirements • formulation of debt program regarding frequency, volume, and issuance by instrument
Primary issuance	• short-term management of primary market including management of issuance volumes and borrowing calendar
Fiscal	• management of cash balances • short-term projection of cash balance requirements
Selling	• management of selling arrangements (auctions, subscriptions, etc.)
Secondary market	• management of outstanding stock in secondary market for active debt management policy • development of secondary market depth and liquidity
Advisory	• debt management agent(s) may provide advice to the Treasury (or MoF) on the above debt management functions
Issuance/ redemption	• administration of delivery and redemption of security versus receipt/payment
Accounting	• management of records of debt instruments and stock of debt

Economic factors, however, can be equally important. For example, the allocation of debt management functions between institutions may depend on economies of scale in performing a particular function, thereby minimizing the operational cost (in terms of hiring personnel or purchasing resources) of performing the functions. For example: the post offices in a number of countries are used to distribute debt instruments to the public; and the central bank’s agency network used for servicing currency distribution may also be used for issuing and redeeming debt. In addition, comparative advantage is an important economic factor. For example, in light of its monetary policy role, the central bank may be made responsible for the secondary market function, given its greater access to information about money, bond, and credit markets, and its developed expertise in interpreting and analyzing market developments.

The primary debt management objective may also determine the location of debt management functions. For example, in the case where development of the secondary markets is the primary debt management objective, or where debt issuance is tailored to institutional maturity preferences or subject to “timing of market developments,” the central bank (as in the U.K.) may have considerable scope in determining debt management, decisions concerning issuance type, size, and timing. On the other hand, where debt service or interest cost minimization is the primary objective, or where debt issuance is according to a regular and invariant program, the MoF or Treasury generally manages most aspects of the debt policy (as in the U.S. and France).

Finally, the operating arrangements for monetary management, discussed in the previous section, will play a key role in the allocation of debt management functions.

The minimum responsibilities a central bank normally performs in debt management are highlighted below.

As advisor, the central bank informs the MoF on the liquidity situation in the banking system, interest rate movements, and evolution of money and credit aggregates. The advice of the central bank on the volume, structure, and timing of government securities is important both for the financing of the budget deficit and achieving monetary policy targets. Coordination between the central bank and the MoF to maintain orderly market conditions--by neutralizing unanticipated changes in the supply of reserve money--is important to the government debt manager to ensure the continued flow of funds from investors to the government securities market, notably the new issue market.

As issuing agency and redemption agent, the central bank sets procedures for issuing government securities (e.g., auctions), delivery of securities, and collection of payments for the MoF, as well as for redemption of securities on maturity.

As fiscal agent, the central bank makes payments (including the servicing of principal and interest payment to investors) and receives payments. The government cashier role of the central bank is an additional reason for government deposits to be held at the central bank. The second reason is based on monetary policy considerations, as explained further below.

In summary, a diverse combination of institutional arrangements and allocation of debt management functions exist and are influenced by sociopolitical as well as economic factors, such as economies of scale and comparative advantage, the debt management objective, and the intervention instrument for monetary policy.

(2) Establishment of a Debt Management Office

In economies with well-developed markets, there is increased scope for more “micro” objectives of debt management, such as cost minimization. In general, pursuit of such an objective is supported by a separation of debt and monetary instruments, and/or by institutional arrangements which enable the monetary and fiscal authorities to operate in different segments of well-developed financial markets (for example, Arrangements I and II discussed earlier). In addition, a separate Debt Management Office may be established to achieve a more formal institutional separation of objectives, instruments, and functions.

New Zealand, Sweden, and Ireland have established a Debt Management Office, and offer an example of an institutional separation of debt and monetary management objectives and responsibilities. However, this does not lessen the need for coordination arrangements in these countries. For example, the Reserve Bank of New Zealand makes recommendations regarding the volume, terms, and timing of primary market operations. In addition, it acts as fiscal agent and cashier of the government. In Sweden, senior officials of the Central Bank and the Debt Office are members of two advisory groups--one for domestic currency operations and one for forex borrowing operations--that discuss the financing of government borrowing requirements. In Ireland, the Debt Office keeps the Central Bank fully informed of its day-to-day transactions in order to ensure that its operations do not conflict with central bank monetary operations. In times of currency crisis, the Debt Office and the Central Bank, together with the MoF, will coordinate their intervention and other market activities.

2. Collecting the required information

For monetary and debt management operations, reliable projections of the major components of the central bank balance sheet, as well as of government cash balances and net credit to the government, are essential.

3. Other operational and legal arrangements

Legal and operational arrangements relating to management of government cash balances, central bank credit to the government, and the treatment of central bank profits and losses have special significance for central bank government relations; they can also have an impact on the effectiveness of monetary and debt management.