A. Rollover/Refinancing Risk

The maturity structure (profile) of government debt is an important source of identifying rollover/refinancing risk. Rollover risk refers to the uncertainty that debt may have to be rolled over at an unusually high interest cost or cannot be rolled over at all. The rollover risk is higher when the maturity profile is concentrated on or around a particular maturity and when the maturity profile is short with large individual redemptions.¹⁰ Refinancing risk is typically a major concern for countries with volatile and/or rapidly deteriorating economic indicators, lower credit rating, perceived poor governance, and high political risk, as well as for highly indebted countries and countries under financial distress.¹¹

The average time to maturity (ATM) is often used to indicate the speed at which the debt portfolio matures, where debt service is captured in nominal terms.¹² The time to maturity of a bond measures the time between the date that the exposure is calculated and the date that the principal is due. As an example, the time to maturity for a bullet bond is the time remaining until the repayment date. For an amortizing bond, the time to maturity is a weighted average of all times remaining until each partial amortization is made, with the weights given by the proportion of the total loan paid in each installment, i.e., it is the average time until a unit (e.g., dollar) of principal is repaid.¹³

The ATM is often expressed as follows:¹⁴

where P_τ = the principal payment at time τ and is counted from the current period, or the period when exposure is assessed, until the principal payment occurs.

Although the ATM is widely used, it is a crude indicator of refinancing risk. Its advantage is simplicity, its easiness to understand, follow, and control ex-post. Its drawback is, because it is an average, concentrations of redemptions may be hidden in the figure making the ATM as a stand-alone measure of refinancing risk an incomplete measure (unless a flat redemption profile is assumed). Acknowledging this drawback, debt managers often consider it as a broad guideline, together with additional guides that describe the maturity structure of the debt portfolio (i.e., redemption profile). Also, ATM figures need to be assessed in the context of the respective country’s overall sovereign debt portfolio risk structure, while policy decisions regarding changes in debt compositions should be based on such assessments and on the authorities’ views about future funding conditions.¹⁵

Rollover/refinancing risk depends on liquidity risk, with this relationship being often incorporated into the risk quantification. For example, if a sovereign faces ample market liquidity and market appetite, then it is likely that most maturity points on the yield curve will be refinanced with little difficulty (including the short-end).¹⁶ However, regardless of liquidity, if investors are risk-averse to the country’s debt, it is likely to prefer trading at the short-end of the market and to demand high risk premia. Under these circumstances, any news perceived as negative for the country could cause market participants not to extend financing at any cost.

For debt managers, it is also common to set targets aimed at smoothing the maturity profile. Formulation of such a target requires special attention, for example, for a maximum amount allowed to mature each year, may lead the debt manager to miss windows of opportunity for issuance and redemption in the debt market, and it may expose the debt portfolio to sudden changes in borrowing requirements.

However, it is advisable that debt managers consider the possibility of putting a ceiling on how much debt should be allowed to mature in the subsequent 12 months.¹⁷ This could be expressed as share of the outstanding debt or a monetary-value limit based on liquidity circumstances. Further, it might be prudent to also limit the amount of debt maturing in each quarter, so as all maturities do not concentrate at a single point in the year. In doing so, the near-term refinancing risk is contained. Nonetheless, such a guideline requires careful analysis, good planning, and constant follow-up.

B. Interest Rate Risk

The interest rate risk is associated with the cost of servicing the government’s new or existing floating debt, stemming from potential changes in domestic and foreign interest rates. The concept of average time to re-fixing (ATR) has been adapted by many debt managers to provide a detailed sense of exposure to interest rate risk.¹⁸ In practice, however, many debt managers rely on a number of metrics, such as the share of the debt, in nominal or net present value (NPV) terms to GDP, maturing in any given period or periods (IMF, 2009), even if these indicators are more related to the refinancing risk. To capture better the variable-rate debt portfolio, other debt managers rely on the share of debt with floating rate and/or interest rate to be refixed in a given period (see also previous section). For both domestic and foreign currency debt, changes in interest rates affect debt servicing costs on new issues when fixed-rate debt is refinanced, and on floating rate debt at the rate-reset dates. Hence, short-term or floating rate debt is usually considered to be more interest rate risk sensitive than long-term and fixed rate debt because of the periodic reset of interest rates. The ATR shows on average the time it takes for principal payments to be subject to a new interest rate. As an average measure, this indicator gives information over time of the change in the debt portfolio’s average time to re-fixing. A shortening of this indicator suggests that the debt portfolio is, on average, facing a new interest rate more frequently and therefore is more exposed to re-fixing shocks.¹⁹ The ATR can be expressed as:

where ATR_t = the average interest rate re-fixing period of the debt portfolio $D_t^{\upsilon }$ = principal cash flow of variable-rate debt at time t,

• $D_t^f$ = principal cash flow of fixed-rate debt at time t

• D_t = the total principal debt

• s = time to the next interest rate reset for the variable-rate debt

• t = time until the fixed-rate principal is due

• ω^ν, ω^f, are respective shares of the variable-rate debt outstanding and fixed-rate principal falling due.

While the focus is often on the volatility of interest rates (fixed/floating), the ATR is also an important interest-rate risk indicator as it reflects the volatility in the redemption of the refixing profile, i.e., the volatility of the weights. Further, this highlights the importance of setting targets for smoothing the maturity profile (see above).

For market analysis, traditional measures of interest rate risk for a bond or a bonded portfolio are typically its duration and convexity. In the fixed-income markets, where about three-fourths of the volatility of bond prices is explained by a common interest rate factor (Jorion and Khoury, 1966), a first-order, linear approximation (first derivative) of the exposure of an asset to movements in interest rates is called duration, and the second-order form of price adjustment (second derivative) is called convexity:

where P = the market value of a bond

R = interest rates

and

where YTM = yield to maturity

while

Bond convexity is a measure of the non-linear relationship of bond prices to changes in interest rates, while duration is a linear measure of the sensitivity of bond prices to interest rate changes. Thus, depending on the curvature of the interest rate function, a bond price is not likely to change linearly with an interest rate change and, in turn, the more inaccurate duration is as a measure of interest rate sensitivity. The more curved the price function of the bond is, the more appropriate convexity is as a measure of bond price changes in response to interest rate changes, with more convexity implying more bond price volatility or risk. As such, duration and convexity can help (debt managers and investors) in predicting bond prices and (investors) in managing the market risk exposure of a bond portfolio, e.g., reducing the interest rate sensitivity of bonds in a portfolio through interest rate swaps.

For a fixed-income asset (liability) or a portfolio of assets (liabilities), duration and convexity, along with yield, are essential metrics/variables to an investor (debt manager) for measuring the price sensitivity of a bond to changes in the yield-to-maturity. The use of a consistent yield-calculation method is particularly important when computing the average yield of a portfolio containing a variety of bond-debt instruments. Also, accurate computations of duration and convexity are essential for evaluating the interest rate riskiness of a bond-debt portfolio. A widely-used measure of duration is the Macaulay duration:

where Dm = Macaulay duration, in a number of periods

t = the time period (annual, semiannual, or other) that each fixed coupon or principal payment occurs

T = the number of periods to final maturity

Ct = the interest or principal payment in period t

PV (Ct) = the present value of Ct

It should be noted that D (duration) (or, “modified” duration), as a linear approximation of the price/yield relationship, is an elasticity/sensitivity measure. However, Dm (Macaulay duration), as a weighted average of the present values of principal and interest payments expressed as a number of periods (years), has a time dimension. The relationship between D (or “modified” duration) and Dm is

which implies that D is (slightly) less than Dm.

Sovereign debt managers have sometimes expressed doubts on the relevance of duration and convexity for debt management. These metrics are considered appropriate interest-rate risk measures to analyze the price/yield relationship of a security or a portfolio of securities from an investor perspective. However, as pointed out in section II.B, duration has signification shortcomings, which caution against overreliance on this indicator. In particular, duration tends to be very sensitive to market yield movements, irrespective of debt management objectives and actions by the debt manager. In fact, prudent debt management, supported by cost-at-risk (CaR) analysis, may require that the interest rate mix is skewed toward fixed rates, which will generate volatility in the present value of the interest and principal payments and, hence, in Dm. This, however, does not have a particular meaning for a set strategic objective of a debt portfolio. These skeptical perspectives on duration have led to the development and use of CaR measures.

As interest cost is a crucial factor for budget purposes, many debt managers estimate the impact of changes in market rates on the budget, i.e., their exposure to interest rate risk, with CaR measures. CaR is closely related to VaR, which expresses the maximum decline in a portfolio’s market value with a given probability over a given period, typically relatively short. VaR notably has limitations in describing what happens on occasional days (for example, twice or three times a year) rather than rare outlier days (for example, once every 10 years) (Marrison, 2002).²⁰ While VaR determines the maximum portfolio value that can be expected to be lost under non-extreme circumstances, CAR is defined as the x percent-quantile of the cost distribution. CaR calculations depend on the model applied and the assumptions made, but are nonetheless useful as a supplemental measure used in the management of the interest-rate risk government debt. This is because they quantify the debt portfolio risk and provide input to the weighing of interest-rate risk against costs.

The calculation of CaR is based on the expected future costs of the existing debt. On the basis of scenarios for future interest rates and borrowing strategies, possible future cost profiles related to the domestic and foreign-currency debt are calculated.²¹ On the basis of a number of scenarios for future costs, a probability distribution of the costs is found. For example, an absolute CaR for a given year indicates the maximum debt service costs within the specified probability (for example, 95 percent), whereas a relative CaR is the difference between absolute CaR and the average debt service costs. Relative CaR thereby indicates the maximum increase in debt service, e.g., interest, costs for a given year, with a specified probability (“Danish Government Borrowing and Debt,” 2010).²²

Debt managers usually control interest rate risk by establishing strategic targets for risk indicators, such as duration, ATR, and CaR.²³ These targets define the authorities’ preferences about the trade-off between expected cost and risk, enabling them to simplify the communication and monitoring of the risk management strategy. It is important for debt managers to ensure that, even if rates increase significantly, the interest costs remain within the interest rate risk tolerance of the fiscal authorities. Typical analyses in this area, often involving the use of simulations and probability distributions, focus on the following year, but also look into the likelihood of having unacceptable cost increases in any given year. It should be emphasized that analyses cover a broader horizon to ensure that the debt portfolio remains within certain risk parameters for extended periods.

Derivatives, when used appropriately, can help reduce sovereign debt portfolio risks by, e.g., assisting in re-profiling the underlying debt cash flows. However, their use to hedge, e.g., market risks, such as interest rate and foreign exchange (FX) risk, may raise a number of additional needs, as they can influence liquidity risk.^{24, 25} Debt managers set limits around risk exposures by applying portfolio-type techniques to asset-liability management and monitoring mismatches periodically. When using options, commonly used measures of exposure are: (1) delta, sensitivity to the price of the underlying instrument, (2) gamma, sensitivity to delta, (3) vega, sensitivity to changes in the volatility of the underlying instrument, (4) rho, sensitivity to interest rate movements, and (5) position size. However, hedging through options is not common in public debt management.

Changes in the value of the exposure are identified using periodic mark-to-market measurement, allowing implicit exposure measurement and evaluation of hedge effectiveness.²⁶ Portfolio managers are required to determine the extent to which an exposure can be revalued on a daily basis by referencing an active, liquid, two-way market. For debt portfolio risks, VaR measures allow assessment across instruments and correlations among them.

C. Exchange Rate Risk

From the perspective of public debt management, foreign currency risk is associated with the volatility in exchange rates and its impact on interest and exchange rate cost for the foreign currency debt.²⁷ For many countries, it is one of the principal risks in a government debt portfolio that need to be appropriately managed.²⁸ In particular, the FX risk relates to the vulnerability of the government’s debt portfolio and the implied debt cost, stemming from a depreciation/devaluation in the external value of the domestic currency, that need to be estimated for budget purposes.

A risk factor is the volatility of the exchange rate, and the extent of the exchange rate exposure of the debt portfolio depends on the magnitude of the changes in exchange rates. The debt manager can affect the exposure by varying the composition of his debt portfolio, but he cannot affect the risk factor: the exchange rate. From this relationship, it is easy to observe that the more the risk factor is transferred into the foreign currency risk, the greater the exposure to foreign currency risk. The following indicator provides a measure to the exposure to this risk:

where ${\text{d}}_{\text{t}}^{\text{fx}}$ = share of foreign currency debt in the debt portfolio

$D_t^{FX}$ = foreign currency debt

D_t = total debt

$D_t^{DX}$ = domestic currency debt

t, j, m and n = time intervals

e_t,j = exchange rates

An analysis of the mismatch in terms of level and currency composition of foreign currency liabilities in relation to foreign currency reserves can also be used to assess the extent of the government’s debt portfolio exposure to foreign currency risk:

where $d_t^{fxr}=\frac{D_t^{fx}}{R_t}$ = the ratio of foreign currency debt to foreign currency reserves R_t = foreign currency reserves. Note that the composition of the foreign currency reserves may differ from that of the foreign currency debt when e_t,j ≠ e_t,h for any h and j.

Because sovereigns with a substantial share of their debt portfolios denominated in foreign currencies assume commensurate exchange risk exposures, they often consider hedging part or all of such positions.²⁹ However, comprehensively measuring the exchange rate exposure is often not an easy task, given the co-movements between exchange rates and interest rates and the prevailing high correlations among bond markets. In addition to the above indicator, exchange rate risk is typically measured by combining the sensitivity of the debt portfolio to exchange rate changes and the probability of realization of a given exchange rate change.³⁰

Accordingly, in managing exchange rate risk, more sophisticated measures to assess foreign currency risk can also be used (see also section II.A.). The Swedish National Debt Office has in the past applied the mean variance optimization framework to determine the optimal foreign-currency debt structure, where the objective of the debt manager is to identify the weights of different currencies in the debt portfolio that minimize the standard deviation of associated costs. The VaR methodology is then used for the active management of the foreign-exchange exposure, which is a small part of the portfolio and, in contrast to the total portfolio, is based on mark-to-market valuation (Swedish National Debt Office, 2003).

The investor base for government debt is also of interest to a country’s vulnerability to funding shocks. If a country’s debt is held mainly by foreign private investors, the country could become more vulnerable to an external funding shock (a “sudden stop”), even if the debt is denominated in local currency (Arslanalp and Tsuda, 2014). On the one hand, if the foreign-currency debt is held mainly by official investors or investors with home bias, the liquidity risk and foreign exchange risk for the government is diminished.³¹ On the other hand, international investors, given the counter-cyclical nature of exchange rates (depreciating in bad times), may lead to a currency depreciation through an external funding shock (Guscina, Pedras, and Presciuttini, 2014). For the case of a potential sudden stop and consequent refinancing difficulties, some governments institute rules that allow them to maintain a reserve cushion for covering maturities due of up to 18 months.

D. Funding Liquidity and Market Liquidity Risks

From a public debt management perspective, funding liquidity risk arises from insufficient liquidity in a specific security’s market or in a segment of it. In general, funding liquidity relates to the ability of a sovereign issuer to fund its borrowing needs. Typically, the associated risk refers to the volume of available liquid assets being insufficient to meet cash flow obligations and/or a possible difficulty in raising funds through borrowing in the short term (temporarily).³² It is difficult to always isolate liquidity risk, as it tends to be compounded with other risks, including contagion risk.

From an investor’s perspective, there is a financial entity’s liquidity risk, with a corresponding measurement. The most basic measure of a financial entity’s liquidity risk is the liquidity gap. This static measure is simply the short-term liabilities net of sovereign liquid assets, but this requires extensive information on mismatches between the timing of payments and the availability of cash (Lienert, 2009). This simple test for liquidity risk looks at future net cash flows on a day-by-day basis, and singles out any day that has a sizeable negative net cash flow.³³ Another measure of an entity’s sovereign liquidity risk is the liquidity risk elasticity.³⁴ This measures an entity’s sensitivity to a change in the liquidity premium (which represents the amount of compensation required by a lender for lending at the long end of the market, or, irrespective of the tenor, the additional spread on bonds that are not benchmark size, i.e., large enough volume for secondary-market trading to occur). The liquidity risk elasticity of a portfolio of exposures is calculated according to the following formula (Culp, 2001, pp. 424–429):

where NV_t = the current value of net assets, and

V_t and L_t = the current values of assets and liabilities, respectively; w is the proportion of liabilities funded with assets.

Ξ = the liquidity premium on the sovereign’s funding cost, often defined as the difference between long-term and short-term nominal interest rates on the same credit-rating yield curve for a given date. (Alternatively, liquidity premium is defined as the amount that forward interest rates exceed expected future spot short-term interest rates.³⁵) (Papaioannou, 2006).

Further, market liquidity of sovereign instruments, i.e., the ability of trading a sovereign’s securities in the markets, is widely recognized as a multidimensional concept that is difficult to capture with a single indicator. It is described by a variety of metrics, including traded volumes, turnover ratios, bid-ask spreads, bid-ask spread over duration, volatility of volumes and costs, distortions in the interpolated yield curve, specialness in the repo market, and yield spreads between government bonds and government-guaranteed agency bonds where available. In certain jurisdictions where highly-liquid bond repo and futures markets exist, bonds in some maturity segments benefit from liquidity premia owing to their eligibility to be delivered for repo and futures contract.

In practice, the liquidity effects in government bond markets are often assessed on the basis of comparisons of yield curves that are estimated for different potential liquidity measures, including issue size and bid–ask spreads.^{36, 37} However, some cross-country studies indicate that relative liquidity cannot explain the size of the yield spreads among different issuers (Bangia, Diebold, Schuermann, and Stroughair, 1999; and Neofotistos, 2002). This implies that factors other than liquidity effects, like credit risk, are important drivers of cross-country yield spreads. Other empirical studies of liquidity have focused on time spans of a year or less. Traditionally, daily spreads, and transaction activity on individual bonds (or averaged over several bonds) traded in a specific exchange, have been studied for a specified historical period.

An additional indicator is the Investor Base Risk Index (IRI), which reflects the likelihood of sudden outflows by different types of investors in the sovereign investor base. The IRI is constructed in three steps: (1) historical correlations between changes in investor holdings and bond yields, (2) risk scores for each investor based on the previous correlations, and (3) investor risk index by assigning an aggregate score to the investor base (Arslanalp and Tsuda, 2012). Although the IRI provides important insights into the management of refinancing risk, i.e., relative tolerance for debt maturing in concentrated periods, a high reading of this index is also associated with emerging market liquidity difficulties.

E. Sovereign and Counterparty Credit Risks

From an investor perspective, sovereign credit risk often relates to the ability and/or willingness of a central government to service its debt, which directly affects the value of an investment portfolio. In particular, for bonded debt, it arises from the potential of a bond default when a sovereign fails to make a scheduled payment. Typically, as governments accumulate more debt, the perceived ability to repay debt holders is reduced. Some researchers argue that for emerging-market countries, the threshold level of total net outstanding government debt to annual Gross National Product (GNP) is below 40 percent, while that for developed economies may exceed annual GNP (Reinhart, Rogoff, and Savastano, 2003). The associated credit risk, reflected in a sovereign’s credit rating, credit premia, and CDS spreads, is difficult to be managed by debt managers. However, this risk becomes relevant to debt managers as it will determine respective bond yields and borrowing costs. These impacts tend to be more pronounced for non-reserve currency sovereigns. In addition to sovereign credit ratings, sovereign credit default swap (CDS) spreads, and the spread to core-sovereign, the contingent claims approach (CCA) is widely used to measure sovereign credit risk (Gapen, et al, 2008 and Papaioannou, 2006).³⁸

Another type of credit risk that is relevant to debt managers is the counterparty credit risk, most notably relating to a derivative contract, which depends on the probability of the counterparty defaulting, the size of the future potential exposure, and the recovery value in the event of default.³⁹ The size of the exposure is typically only a small proportion of the notional amount of the underlying contract, but can change substantially over the life of the contract as the underlying asset prices and the perceived probability of a counterparty defaulting change. Further, even if the price of the underlying asset (liability) does not change, the counterparty credit risk varies with certainty in the case of a change in the price of the derivative. For example, a plain vanilla interest rate swap, through which an issuer hedges a floating-rate note by swapping its floating-rate liability into a fixed-rate one over a specified period, generates a changing credit exposure when interest rates vary even if the price of the underlying liability does not change (because credit spreads have not changed—in fact, the price of a floater is not affected by interest rate movements but by credit/liquidity spreads movements). Further, the counterparty risk depends on the extent to which any collateral (which affects recovery) is correlated with the likelihood of the issuer defaulting.

When a sovereign utilizes derivatives, margin calls largely mitigate associated counterparty credit risks. A typical prerequisite for entering into non-centrally cleared derivative transactions is the signing of ISDA and collateral agreements.⁴⁰ In this framework, as derivatives transactions require collateralization, the impact of these risk exposures on collateral posting (signed through an ISDA Credit Support Annex with bank counterparties) and the implicit cost of increased levels of collateral should be closely monitored. It should be noted that exposures can change fairly dramatically and in a very short time. For example, when a country is downgraded and experiences problems, daily derivative exposure may swing considerably, especially as it may also be adversely impacted by broader market conditions and ISDA-related Additional Termination Events (ATE) and Independent Amount triggers.

Debt managers also face counterparty risk if they are managing liquid assets or lending to other entities. In general, depending on the type of counterparty (e.g., sovereign government, corporation, individual) and the type of obligation (e.g., government bonds, corporate bonds, derivatives transactions, lines of credit, loans), credit risk takes different forms and, therefore, is assessed and managed differently (Bank for International Settlements 2000).⁴¹ Quantitative models enable the calculation of capital (or collateral) necessary to absorb unexpected credit losses at a targeted confidence level. Pricing of credit risk is similar to pricing traditional insurance frequency and severity risk (see CreditMetrics, CreditRisk+). Traditional models usually evaluate the expected loss on an asset or a portfolio of assets by taking into account (in a functional form) the relevant exposure (credit exposure) and uncertainty (default probability and recovery rate in the event of a default) (Culp, 2001). In a risk management framework, the reduced form formula is used to estimate credit risk related losses: Expected Loss = Default Probability × Credit Exposure × Expected Loss Given Default.

F. Contingent and Fiscal Risks

Guarantees and other contingent liabilities represent potential financial claims against the government that have not yet materialized, but that could trigger a financial obligation or liability under certain circumstances.⁴² A new financial obligation or liability has a direct impact on the debt portfolio and can impact the borrowing plan. Debt managers might need to ensure that the impact of risks associated with contingent liabilities on the government’s financial position, including its overall liquidity condition, is taken into consideration when designing debt management strategies. For example, this could be done by factoring a portion of the contingent liabilities into the projections for future borrowing requirements that are made for the medium-term debt management strategy. Similarly, it is advisable that debt managers be aware of the explicit contingent liabilities that the government has entered into and understand the potential magnitude and conditions that could trigger implicit contingent liabilities.⁴³

Contingent liabilities (CLs) may crystallize into actual liabilities to the government following events in the parties whose obligations are guaranteed, such as debt default, insolvency, or insufficient revenues. CLs can be grouped broadly into two categories:

• Explicit. CLs may reflect payment commitments stipulated in a contract or by law. The most important are often guarantees for borrowing and obligations of the state-owned enterprises (SOEs).⁴⁴ Although SOEs pose typically the greatest risk, other forms of public guarantees, e.g., contract performance of certain infrastructure projects, entail similar CL risks.

• Implicit. CLs arise from possible default on non-guaranteed obligations, as well as from systemic shocks. In such cases, contractual or statutory obligations are lacking, but the government faces a high cost of not providing financial support, whether it is done for financial, “moral,” or “political” reasons. These include disaster relief, defaults on non-guaranteed debt of SOEs, local government units, and financial or corporate sector bailouts.

CLs have many of the characteristics of government debt, and if triggered, they will directly add to public debt. In the case of loan guarantees, the obligation of the guarantor is to honor the payment obligations in the event the borrower defaults and thus it constitutes a credit risk. In such a case, the creditor owns a put option on the guarantor since the creditor has, in effect, a put option to sell the guaranteed debt to the guarantor at an agreed price, that is, the face value of the debt. If the put option is then exercised, the guarantor normally has recourse to the beneficiary and can demand the amount in question. This translates into a risk representing a financial loss to the debt manager, whose loss may be mitigated by collecting premiums from guarantee beneficiaries through the establishment of a contingency reserve fund that is financed by the fees received by the guarantee recipients and/or the budget.⁴⁵ Equally important are guidelines and safeguards to limit such risks ex ante by having a sound policy to ensure adherence to sound legal and fiscal principles (Box 1).

Arguably, explicit CLs, especially loan guarantees, may be the most frequent type of indirect liability, but implicit CLs are often the most costly and include bailouts of SOEs, banks, and local governments, as well as natural disasters. CLs can significantly add to a government’s balance sheet risk inasmuch as they imply additional leveraging and tend to be triggered in times of financial stress, with realized costs having a major impact on a country’s fiscal position and debt sustainability.

Fiscal risks arise from macroeconomic shocks and the realization of CLs.⁴⁶ Risks associated with sovereign debt are one example of fiscal risks to which governments are exposed. Debt servicing costs can deviate significantly from expectations as a result of shocks to interest rates and exchange rates. However, there are many other sources of fiscal risks (Table 1).

Table 1.

Sources of Fiscal Risks

Source: Polackova, 1998.

Table 1.

Sources of Fiscal Risks

Source of Obligation	Direct Liabilities (certain)	Contingent Liabilities (contingent on future events)
Explicit liabilities (legal obligation)	Foreign sovereign borrowing Domestic sovereign borrowing Other direct borrowing (e.g., from the social security fund) Current committed budget expenditures (may include direct subsidies/transfers to SOEs) Legally mandatory future expenditures (e.g., social and health insurance schemes)	Guarantees for subnational governments and SOE obligations Guarantees for SOE fiscal performance (e.g., electricity uptake) Guarantees for policy banks’ borrowing (Development Bank) Guarantees for trade and exchange rate risks Guarantees for private investments (PPPs) State insurance schemes (e.g., on bank deposits, private pension funds, crop failure, flood, war)
Implicit liabilities (public/political choice)	SOE arrears to the government Future public pensions, social security schemes, health care financing (if not required by law) Future recurrent cost of public investments	Default of subnational governments and SOEs on non-guaranteed debt and other obligations Default of banks (support beyond state insurance) Failure of non-guaranteed pension funds or other social security funds Natural disaster relief, environmental recovery disaster relief, military financing

Source: Polackova, 1998.

View Table

Table 1.

Sources of Fiscal Risks

Source of Obligation	Direct Liabilities (certain)	Contingent Liabilities (contingent on future events)
Explicit liabilities (legal obligation)	Foreign sovereign borrowing Domestic sovereign borrowing Other direct borrowing (e.g., from the social security fund) Current committed budget expenditures (may include direct subsidies/transfers to SOEs) Legally mandatory future expenditures (e.g., social and health insurance schemes)	Guarantees for subnational governments and SOE obligations Guarantees for SOE fiscal performance (e.g., electricity uptake) Guarantees for policy banks’ borrowing (Development Bank) Guarantees for trade and exchange rate risks Guarantees for private investments (PPPs) State insurance schemes (e.g., on bank deposits, private pension funds, crop failure, flood, war)
Implicit liabilities (public/political choice)	SOE arrears to the government Future public pensions, social security schemes, health care financing (if not required by law) Future recurrent cost of public investments	Default of subnational governments and SOEs on non-guaranteed debt and other obligations Default of banks (support beyond state insurance) Failure of non-guaranteed pension funds or other social security funds Natural disaster relief, environmental recovery disaster relief, military financing

Source: Polackova, 1998.

Actions to better identify fiscal risks from CLs,⁴⁷ including the call for increased information on the financial health of SOEs, are critical and is often seen within a broad set of key policy processes that the government might consider to better manage CLs:⁴⁸

• Creating a general policy for government exposure to CLs: this includes identifying the types of risk to cover, the circumstances in which a guarantee, rather than a loan or subsidy, is justified, and what entity within the government is best placed to bear such risk. Guidelines are expected to be based on a clear framework for roles and responsibilities, especially with regards to who has the authority to decide on issuing guarantees, what types of risk would be accepted by the government, minimum requirements for project support, risk-sharing, and fees policies.

• Ensuring budgetary transparency and discipline: explicit CLs should be identified, registered, and disclosed. The expected cost and maximum probable loss should also be quantified.⁴⁹ Good practice is to include a provision within the annual budget to meet estimated sums falling due for payment in the fiscal year. Some of the costs and risk of CLs will be correlated: problems for one SOE will generate problems for another, and this interaction (i.e., structural dependencies) can be analyzed within a portfolio approach.

• Applying financial risk management: the main risks affecting CLs are similar to those affecting other assets and direct liabilities (for example, macroeconomic volatility).⁵⁰ Consequently, the techniques for quantifying CL risk can be similar to those used for estimating risk of other balance sheet items. Through the same processes, methodologies can be designed for pricing guarantees and charging risk premiums.⁵¹

Debt managers often monitor the risk exposures arising from explicit contingent liabilities, and ensure that they are well informed of the associated risks of such liabilities.⁵² They tend to be also conscious of the conditions that could trigger implicit contingent liabilities, such as lax supervision and other policy distortions that could lead to poor asset and liability management (ALM) practices in the banking sector and public enterprises with liquidity or even solvency implications. Moreover, debt managers typically ensure that the impact of risks associated with contingent liabilities on the government’s financial position, including its overall liquidity condition, is considered when designing public debt management strategies (IMF, 2014).

G. Legal Risk

Debt managers face various legal risks, ranging from uncertainty related to legal actions to the applicability or interpretation of contracts, laws, and regulations.⁶⁰ Legal risks may also arise from weaknesses in the legal framework for debt management, as well as from lapses in compliance with relevant substantive and procedural legal requirements for debt management, e.g., compliance with the terms of issuance or with applicable legislation regarding the procedures used for such issuance. Further, debt managers could face legal risks in the context of broader legal claims resulting in judgments or arbitration awards against the government and implications for the sovereign balance sheet. In this context, bond contractual provisions should be able to provide sufficient protection and flexibility to a country. Although sovereign bonds, particularly international sovereign bonds, often contain a number of provisions that, depending on their drafting, offer protection to the sovereign vis-a-vis its creditors, e.g., CACs, particularly aggregated CACs, there are also provisions that could present legal risks depending on their scope, e.g., waiver of immunity, events of default and cross-default, and interpretation, e.g., of pari passu. Other aspects, such as interest rate conventions, e.g., the use of indexation to inflation, currencies or commodities, authority to enter into contractual agreements, or compatibility of terms with legislation are crucial principles that must be carefully monitored (Box 2).

H. Operational Risk

“Operational risk” refers to a wide variety of risks faced by debt managers that can disrupt debt service. Unlike market or credit risk, operational risk is mainly endogenous to the debt management office (DMO) (Storkey, 2011). It includes transaction errors in the various stages of executing and recording transactions; inadequacies or failures in internal controls, or in systems and services; insufficient expertise of staff; reputational risk; security breaches; terrorism; and natural disasters that affect a debt manager’s ability to operate its ongoing business processes.⁶¹

As the operational risk is linked to the scope of a government’s debt activities and has multiple sources, it cannot often be easily identified, measured, monitored, and reported. Even in a less-advanced debt management environment, operational risks may be substantial due, for example, to mishandling of transaction data, databases and spreadsheet-computations, or mismanagement of key personnel and disruption of routine processes. However, once a debt portfolio becomes increasingly complicated, for example, with the use of derivatives, it requires a transition to more comprehensive risk management and integrated debt management systems that can process such transactions and maintain control of the debt portfolio structure. In general, the more complex the debt portfolio becomes, the higher the operational risk if clear operational instructions are not in place and, thus, the greater the need to develop an appropriate operational risk management system.

An Operational Risk Management Framework (ORM) will take time and effort to identify the risks and adopt the mitigation techniques in a constantly-changing environment. It requires a culture of risk awareness and understanding of senior management since operational risk needs to be made clear to all staff and embedded into day-to-day operations of treasury (Storkey, 2011).

A. Decisions on Overall Debt Portfolio Structure

In deciding on the overall debt portfolio structure, the debt manager needs to evaluate a number of borrowing strategies over the horizon of the analysis. This analysis requires detailed information on the current debt portfolio and its risk, information about the expected path of the primary balance, including anticipated government revenues and expenditures and economic growth. When preparing the analysis, the debt manager would typically assess the debt management strategies under the constraints and future scenarios for the primary balance and market rates previously determined. S/he would also want to be aware of any vulnerabilities among primary dealers (see Appendix 2) and of liquidity squeezes, in particular relating to the repo market. The strategies’ cost and risk performance would then be evaluated under relevant risk/stress scenarios (IMF-World Bank, 2009). The debt management strategy selected would provide the short- vs. long-term mix and diversification of investor base, along with the debt portfolio risk indicators, or strategic benchmarks, that define the desired debt structure and provide guidelines for the strategy’s implementation.⁶²

The use of efficient frontier analysis can provide valuable information for debt managers when determining the cost and risk tradeoffs, although debt portfolio optimization for sovereign debt managers has not been widely applied. A strategic benchmark for debt managers reflects the portfolio structure that the government would like to have for its debt portfolio. As opposed to an asset manager, a debt manager will not base the portfolio structure on views about relative prices, but will reflect the government’s preference on the tradeoff between expected cost and risk (Wheeler, 2004).⁶³ A common problem encountered in debt management is ex ante performance measurement, because measurement against market indices is not possible, i.e., defining an ex ante reference point.

To determine the strategy for the overall debt portfolio structure, debt managers can apply various techniques, but need to take into account several practical considerations. The broad debt management philosophy and goals, such as tolerance for debt service volatility, and exchange rate and debt sustainability considerations, should be reflected, as well as the formation of a yield curve with appropriate liquid benchmark maturity points. The strategy would also be subject to constraints faced by the debt manager in terms of market access, domestic debt market development, and availability of hedging instruments.⁶⁴ Finally, the strategy should be robust under a wide range of economic scenarios and time horizons because a strategy that is dependent on a few key assumptions may need to be frequently revised or the debt manager could be forced into frequent changes in direction (Wheeler, 2004).

Stochastic analysis can be helpful to simulate yield curves and to estimate pricing within the period that is being considered. This is particularly important for cost and risk simulations where the portfolio is stress-tested under various conditions, such as by applying a CaR analysis to quantify the interest rate risk on the government debt (Bolder, 2003; Papaioannou, 2009). In such an application, deterministic scenarios of the future development in interest rates are simulated combined with a stochastic simulation of interest rates (United Kingdom DMO, 2006).⁶⁵ On this basis, the expected future interest costs on the debt and the related interest rate risk can be calculated. The risk is calculated as the highest costs or the largest increase in costs that can be expected with a set probability level. The calculations are made subject to various strategic assumptions concerning the government debt policy. For example, the cost and risk profile for various duration objectives is calculated. The choice of a particular duration objective thus reflects a weighing of costs against risk that is deemed appropriate (Danish Government Debt, 2002, p.73).⁶⁶

B. The Application of Market-Based Indicators in Debt Management

Market variables for measuring interest cost and exchange rate risk of debt stocks have not yet been fully adapted by debt managers. Although it is widely accepted that market-based indicators provide very useful information to investors,⁶⁷ some debt managers have chosen, for example, not to rely on duration or “modified” duration for setting debt portfolio targets.⁶⁸ A fundamental shortcoming of the duration measures cited by debt managers is their dependence on the level of discount rates used—other things being equal, duration falls (rises) when the discount rate rises (falls). This poses a problem because the same borrowing strategy can be assessed differently depending on the selection of the discount rate applied.⁶⁹ Debt managers using market interest rates as discount rates could experience a varying duration, even when the portfolio structure remains unchanged. More important, debt managers following a duration target would be forced to extend the debt portfolios duration and lock in long-term rates when rates are high, although it might be argued that the debt manager could actually do the opposite. Various approaches have been used by debt managers to mitigate this effect, including the use of a fixed discount rate or simpler risk measures, such as the share of debt portfolio that is subject to repricing over a set period.⁷⁰

Full adoption of market-based indicators by debt managers might require an alternative way to present sovereign liabilities that would apply an economic value on the outstanding debt portfolio and account for changes in valuation.⁷¹ However, sovereigns applying cash budgeting do not account for the economic value of their debt.⁷² Accrual accounting principles, such as those recommended by the International Public Sector Accounting Standards (IPSAS) and International Organization of Supreme Audit Institutions (INTOSAI), do not capture market valuations but include accrued interest rates in the case of accrual accounting standards. Further, accounting for derivatives on sovereign balance sheets has become more advanced with the application of market valuation on those positions. This has had spillover effects for bond debt because back-to-back swaps may trigger market valuation of the underlying debt position as well. Thus, the universe of accounting varies and includes cash or accrual accounting, as well as national accounting standards and harmonized standards such as the ESA 2010, but none of the standards fully reflects market valuation of liabilities.

Comprehensive guidance for debt managers on how to choose the optimal interest rate and currency structure for their external debt is not yet established.⁷³ Theoretical approaches point to the relationship between exchange rate volatilities and covariances and domestic fundamentals, where practical implementations are not straightforward (Melecky, 2007). Of principal concern is, however, the correlation between debt charges and the domestic primary balance. This probably practically boils down to the relationship between domestic output and the exchange rate, in other words, the potential for the spillover of the volatility of debt service cost into budgetary volatility that is of concern to a government. Operational rules employed by governments that borrow in foreign currency appear to be generally consistent with this logic. A country may do better, for example, by merely attempting to minimize volatility of debt service costs without explicit consideration of its primary balance. Or, alternatively, it may make sense to match the foreign currency composition to the currency profile of the country’s export revenues or reserves.

The optimum currency composition of debt is often determined by a quantitative optimization exercise.⁷⁴ This takes into account both the minimization of projected debt servicing costs and maximization of the risk-adjusted return of the country’s assets (in particular, international reserves⁷⁵ and projected primary balances) subject to constraints regarding specified risks and the country’s asset-liability structures. This approach, in essence, espouses the view that the currency composition of the debt (liabilities) should closely match that of the assets in a sovereign’s balance sheet (Das, et al., 2012).⁷⁶ Another approach links the optimum currency composition with the relationship between traded and non-traded goods in GDP. This rule, followed by Uruguay, provides good protection against exchange rate volatility.

C. Adoption of a Sovereign Asset and Liability Management Approach

The term “asset liability management (ALM)” is well understood in the context of financial institutions, but not as much in a sovereign setting. ALM is conceptually different for governments as (1) most governments do not compile a full statement of financial positions (balance sheet), thus being difficult to directly observe all assets and liabilities; (2) many government assets are tangible in nature (for example, land, building, plant), consequently not lending themselves to analysis of financial risk; (3) a government’s main asset is its ability to tax, which is not directly related to its balance-sheet financial items; (4) the government is a large player in the domestic economy and domestic financial markets; and (5) the government has public policy objectives beyond portfolio risk-return optimization.

Sovereigns are susceptible to various risks and uncertainties relating to their financial assets and liabilities, depending on the country’s level of economic and financial development. These risks, if realized, could cause a significant fiscal and financial drain and a consequent fall in the country’s domestic absorption and potential output, besides affecting the balance of payments. To help identify and manage effectively the key financial exposures, a sovereign asset and liability management (SALM) framework, based on the balance-sheet approach, can be employed.

The SALM approach aims to help detect sovereign risk exposures from a consolidated public-sector portfolio perspective. It allows one to analyze the financial characteristics of the balance sheet, identifying sources of costs and risks, and quantifying the correlations among these sources. The SALM approach entails monitoring and quantifying the impact of movements in economic and financial variables, including exchange rates, interest rates, inflation, and commodity prices, on sovereign assets and liabilities, and containing other debt-related vulnerabilities in a coordinated way.

In managing sovereign risk exposures, ALM techniques applied to government operations can uncover interest-rate and currency mismatches between assets and liabilities and make clear the “cost-of-carry” of debt-financed financial assets. More broadly, ALM can help policymakers identify net risk positions requiring management, as well as highlight cash flows available to service net debt, and thereby provide input for the development of debt management strategies.

In cases where the match of financial characteristics of the assets and liabilities is only partial, risk management could focus on the unmatched portions, i.e., net financial positions. In a short- to medium-term perspective, a financial risk management strategy could then be developed to reduce such exposures.

The SALM approach can also be utilized to facilitate a country’s long-term macroeconomic and developmental objectives such as economic diversification, broadening of the export market, or reducing the dependence on key import products. Further, the SALM approach can even help identify long-term fiscal challenges, such as unfunded social security liabilities, implying a future claim on resources. In this context, the SALM framework forms an integral part of an overall macroeconomic management strategy. Especially for commodity-exporting countries, the SALM approach can clarify the potential asset management challenges that stem from a medium-term fiscal strategy.

Arguably, the SALM framework may be complex to implement due to a number of policy and institutional factors:

• Monetary policy objectives have an impact on SALM strategies, by affecting either market—interest rate and exchange rate—risk management or directly the size. On the liability side, debt management strategy typically aims at minimizing debt service cost subject to a prudent level of risk.⁷⁷ On the asset side, strategic asset management aims primarily at accumulating an adequate level of net foreign assets, including foreign exchange reserves, to be used for conducting effective monetary and foreign exchange policies, and as a buffer against external shocks. Also, it may involve the management of “excess” foreign currency assets (e.g., reserves above an adequate level), including through the design and management of investment portfolios through sovereign wealth funds (SWFs) so that returns on international assets can be enhanced and passed on to future generations, or help offset the impact of domestic and external shocks on the fiscal position.

• Fiscal policy objectives that aim at limiting annual debt service costs may put constraints on the duration and currency composition of public debt, since a high share of short-term debt may be perceived to lead to greater volatility in debt service costs.

• The structure of international and domestic capital markets also shapes SALM implementation. Some developing countries cannot issue domestic debt because of illiquid and/or shallow domestic debt capital markets and a lack of a reliable local investor base. Their attempts to issue domestic-currency external debt have also not been well-received in international markets owing, in part, to their vulnerability to shocks, restrictions on foreign investors to buy local-currency debt (e.g., on type of instruments, minimum holding period), poor transparency, and/or a lack of interest rate and exchange rate hedging instruments.

The interaction between the public debt management (PDM) strategy and the SALM strategy should be clear. Maintaining robust formal institutional arrangements in developing the PDM strategy provides investors and the public with a greater degree of assurance about the management of the sizable risks in the government’s balance sheet. A well-articulated PDM strategy, which has as much specificity as possible and clearly explains the analysis and rationale for the chosen approach, is essential for such purpose. Logical and detailed explanations of policy decisions, ex ante, may also reduce the likelihood that outside commentators criticize the policy actions ex post. A forum for an open dialogue can help secure support for the strategy, as part of the government’s overall approach to macroeconomic management and financial stewardship.

The potential role of the debt manager as the “residual risk manager” for the public sector need to be factored into the development of the debt management strategy. This implies that (1) the needs of public sector entities will have to be regarded as a constraint that should be considered and (2) an analysis of the composition of public debt on a net basis is required, which will indicate net liability exposures in light of the characteristics of sovereign assets and government revenues.

The effects of implementing an ALM strategy should be carefully analyzed. In any effort to develop a comprehensive and meaningful sovereign ALM framework, the potential implications on macroeconomic objectives and policies should be assessed in parallel with the potential benefits from a consolidated sovereign portfolio management. Especially, the impacts of adopting an ALM strategy on policies to support the reduction of inflation, maintain financial stability and enhance the resilience of the economy to external shocks should be taken into account. In this regard, the role of an ALM framework in developing appropriate local-currency debt instruments to mitigate sovereign balance sheet risks and macroeconomic vulnerabilities should be explored.

Many countries apply SALM concepts, at least partially, by adopting strategies to reduce vulnerabilities of the sovereign assets and liabilities without necessarily having explicit SALM identified objectives (Table 2).

Table 2.

Selected SALM Country Cases

Source: Lu, Yinqiu, Michael Papaioannou, and Iva Petrova, 2012, “Sovereign Risk and Asset and Liability Management—Conceptual Issues”, WP 12/241 and country websites.

Table 2.

Selected SALM Country Cases

Country	Management of Sovereign Assets and Liabilities
Canada between the entities involved in SALM	Decision-making authority for both assets and liabilities is assigned to the Ministry of Finance, which delegates the day-to-day management is delegated to the Central Bank. The coordination mechanism is instituting regular meetings
New Zealand	Manages local currency and foreign currency assets and provides derivative transactions for government entities
Australia	Allocation of assets between alternative portfolios and funds may take account of the government’s broader priorities and objectives, but not specifically of balance sheet risks, coordination is by the responsible ministry
Hungary, Uruguay	The coordination mechanism is instituting regular meetings between the entities involved in SALM
Mexico	Reduced its external debt in 2006 through issuing domestic securities and using the proceeds to acquire FX from the central bank, which in turn redeemed its securities to reduce negative carry-costs improving the composition of the sovereign balance sheet
Denmark	Manages the consolidated position of the government debt by considering assets of government funds (e.g., pension funds, holding primarily government bonds and on-lending), guidelines for government guaranteed entities on exchange rate risks and loan types
Turkey	Manages the currency composition of the international reserves based on the maturity structure and currency composition of the government foreign exchange liabilities
Finland, Turkey	Management of central government debt and cash reserves is on a net basis

Source: Lu, Yinqiu, Michael Papaioannou, and Iva Petrova, 2012, “Sovereign Risk and Asset and Liability Management—Conceptual Issues”, WP 12/241 and country websites.

View Table

Table 2.

Selected SALM Country Cases

Country	Management of Sovereign Assets and Liabilities
Canada between the entities involved in SALM	Decision-making authority for both assets and liabilities is assigned to the Ministry of Finance, which delegates the day-to-day management is delegated to the Central Bank. The coordination mechanism is instituting regular meetings
New Zealand	Manages local currency and foreign currency assets and provides derivative transactions for government entities
Australia	Allocation of assets between alternative portfolios and funds may take account of the government’s broader priorities and objectives, but not specifically of balance sheet risks, coordination is by the responsible ministry
Hungary, Uruguay	The coordination mechanism is instituting regular meetings between the entities involved in SALM
Mexico	Reduced its external debt in 2006 through issuing domestic securities and using the proceeds to acquire FX from the central bank, which in turn redeemed its securities to reduce negative carry-costs improving the composition of the sovereign balance sheet
Denmark	Manages the consolidated position of the government debt by considering assets of government funds (e.g., pension funds, holding primarily government bonds and on-lending), guidelines for government guaranteed entities on exchange rate risks and loan types
Turkey	Manages the currency composition of the international reserves based on the maturity structure and currency composition of the government foreign exchange liabilities
Finland, Turkey	Management of central government debt and cash reserves is on a net basis

Source: Lu, Yinqiu, Michael Papaioannou, and Iva Petrova, 2012, “Sovereign Risk and Asset and Liability Management—Conceptual Issues”, WP 12/241 and country websites.

D. Guidelines for Debt Portfolio Management⁷⁸

The debt management strategy is typically based on a sound institutional structure and governance arrangements supported by a legislative framework that clearly establishes the authority and responsibility of the DMO. In turn, this requires a governance structure for the DMO that is guided by the principles of clear allocation and separation of responsibilities and accountabilities, as well as hierarchical levels with clear rules for delegation of authority. This structure can be complemented by a committee for efficient decision-making and oversight. A modern DMO often encompasses front-, middle- and back-office functions for clear separation of roles and responsibilities and increased efficiency.

An appropriate legislative framework for public debt management should be in place to ensure its well-functioning (“Revised Public Debt Management Guidelines,” IMF 2014). While economic and political factors tend to influence debt policies and the quality of debt management practices, a good legal framework helps also promote operational discipline, transparency, and accountability, which are critical to achieving sustainable debt. The design of the legal framework involves a set of interactions among distinct but related legal competencies, where striking a careful balance between flexibility in the exercise of authority, and adequate controls and safeguards is important (Addo Awadzi, 2015).⁷⁹

Among the middle-office responsibilities is the development of a risk management framework, which typically includes all relevant risks.⁸⁰ All risk exposures and associated risk tolerance tend to be monitored continuously to determine whether they have been extended beyond risk tolerance and appropriate actions identified. To assess the risk and vulnerability of the debt portfolio, the debt manager usually conducts stress tests to ascertain the potential effects of macroeconomic and financial variables or shocks, including extreme events. A significant change in the risk profile might prompt a review of the debt management strategy,⁸¹ whereby the correlation between the risks of the additional loans or issuances and those deriving from the debt portfolio should be accounted for. This exercise may also benefit from an ALM approach that considers all relevant consolidated public balance sheet risks, including contingent liabilities and natural hedges (Developing a Medium-Term Debt Management Strategy Guidance Note for Country Authorities, IMF–World Bank, 2009, p.11).

A centerpiece of the risk management framework is the medium-term debt management strategy (MTDS). The MTDS transforms the debt management objective into operational guidelines that the debt manager can use to formulate targets, such as a stipulated average time to maturity. An example of a debt management strategy document is provided in Box 3.

Formulating targets enhances transparency for debt management, guides operational work, anchors decisions, and provides a clear overview of the direction of the debt management. The latter could better facilitate communication with investors, making the debt management objective tractable. Last, they form a base for control, reporting, and evaluation of debt management activities and thus contribute to a robust control environment.

The guidelines can be expressed in qualitative and/or quantitative terms. Many governments express the guidelines as quantitative targets, such as for interest rate risk. Often the targets are set with intervals in order to avoid frequent or short-term adjustments, which could result in high transaction or other costs and potentially increase operational risk. Generally, guidelines remain reasonably stable over time to help ensure predictability in debt management, thereby contributing to cost minimization. It is also common to express the guidelines as directions, without expressing a firm quantitative target.⁸² In practice, many governments use a combination of qualitative and quantitative targets. This could, for example, be expressed as reaching a specific target over the medium term, thus taking timing of actions into account.

Hard quantitative targets generally require developed bond and derivatives markets. A debt manager needs the ability and appropriate instruments to manage the debt according to the targets. This requires flexibility in the primary market to select the amount and maturities, as well as the use of liability management operations and derivatives. If these instruments are not in place, it could be costly or impossible to achieve the targets. Overall, quantitative targets give a more precise direction for facilitating, for example, market communication and the evaluation of the debt management strategy. However, hard targets and wrongly formulated guidelines can also force debt managers into costly transactions that adjust the debt portfolio accordingly, with less possibility to take market conditions into account (this also presents the possibility of the market’s exploiting the situation).

Qualitative or semi-quantitative targets provide the direction of the range of allowed debt management flexibility, however, at the price of less accuracy. While they ensure that the DMO works in line with set objectives and that the market understands the direction of the debt management, they give debt managers the flexibility to take market circumstances into account in the timing of operations. This could be useful depending on the stage of market development and/or if the market environment is uncertain. Consequently, they do not give the precise information to the market that could impose a higher cost due to the uncertainty premium (which is difficult to quantify).⁸³

Strategic decisions on debt management can be embodied in a benchmark portfolio that represents the desired or optimal portfolio given the debt management objectives and risk constraints. In order to guide debt management operations, the desired benchmark portfolio needs to be well defined in terms of the notional size, instruments, debt composition, and rebalancing rules. Considerations in the selection of the currency mix within the benchmark portfolio include liquidity and currency risks.⁸⁴ The DMO could, for example, hold cash buffers in the main intervention currency, or in specific currencies to facilitate debt servicing.⁸⁵ It should also consider whether other major liquid currencies may be held for purposes of natural hedging.⁸⁶ A method applied by sovereigns, particularly in the late 1990s, was to set up a passive, rule-based benchmark portfolio against which the debt manager was able to fund at different dates to take advantage of favorable market conditions. In some cases, a discretionary margin can be applied where the debt manager could deviate from currency composition or duration targets (IMF, 1997).

The stage of development of the government securities market may cause several bottlenecks in terms of instrument choice and market absorptions. Governments looking to transition rapidly on their market reforms may need to make strategic choices where they not only prioritize among different initiatives that will advance the market to a next stage, but also realistically consider the time horizon of different initiatives (see also section V and Appendix 1).

A. Rollover/Refinancing Risk Management

Debt managers can manage the refinancing risk through a proper borrowing plan that avoids concentrations of maturities, amortizing bonds,⁹² debt exchanges of bonds with short ATM to longer ones, pre-financing of maturing bonds, buying back bonds before they mature, issuance of short-term debt,⁹³ reimbursements on maturity date made out of the Treasury Single Account, sinking funds earmarked to the repurchase of government debt, contingent credit lines, ⁹⁴ a combination of these operations.⁹⁵ A widely-used approach is to partly or fully pre-finance a redemption by issuing new bonds ahead of the redemption. This can be achieved, for example, by issuing a new bond (destination bond) at several occasions (i.e., through reopenings) ahead of the redemption of the old bond (source bond) and using the proceeds to pay back the old. However, pre-financing entails a cost of carry and addition of credit risk when proceeds need to be invested before they are used. Both of these concerns are typically taken into account when deciding on the extent of pre-financing.

A common approach among debt managers is to buy back securities before redemption, that is, to purchase bonds prior to their maturity.⁹⁶ In order to manage rollover risk caused by the concentration of maturing debt where large benchmark issues may apply, the proceeds of new issues can be used to buy back outstanding bonds. While the aim is to reduce refinancing risk through buyback operations, cost considerations associated with a buyback premium and the benefit of lower funding costs through enhanced liquidity are generally analyzed and factored in the overall cost-risk tradeoff framework. There are three main variants of buyback operations: (1) reverse auction, (2) bond conversion, and (3) outright purchase.

B. Interest and Exchange Rate Risk Management¹¹³

The application of an asset-liability management approach involves a number of practical decisions. For example, in matching foreign-currency debt and foreign-exchange reserves, the interest cost to be hedged would require that income from foreign-currency assets be accessed by (or transferred to) the Ministry of Finance (MoF) to cover debt-service charges on foreign-currency debt. Provided that this is possible, there are practical difficulties, as the currency and maturity structure of the foreign exchange reserves may not match the preferences of the debt manager, thus either resulting in a failure to construct a robust hedge or constraining the policy choices of either the debt manager or the reserve manager.¹¹⁴ Regardless of practical difficulties, Canada, Denmark, and New Zealand have adopted an approach by which the composition of external debt (both currency and interest rate exposure) reflects the composition of foreign exchange reserves.¹¹⁵

Debt managers’ use of interest rate and exchange rate derivatives is largely strategic and involves setting clear objectives (Box 4). Debt managers could use derivatives when it is in line with achieving their risk and cost objectives within a well-specified debt strategy.¹¹⁶ Derivatives are commonly accepted not to be used to “earn money” by taking position against the debt portfolio targets based on future expectations in order to decrease debt service costs.¹¹⁷ Within this framework, the implementation of the debt strategy may include the use of derivatives to separate funding decisions from the optimal portfolio composition decision, reduce the cost of borrowing, manage risks in the portfolio (in particular, interest rate risk and refinancing risk)¹¹⁸, and adjust the currency composition of liabilities. Debt managers typically determine the purpose of transactions in order to select the appropriate instrument(s) and structure(s) and determine the most effective way to achieve the desired risk profile, which may well be through direct borrowing. Also, they commonly assess the liquidity risk implications due to the need to post collateral in case of a two-way “Credit Support Annex,” where both parties have to post collateral as and when they are out-of-the-money. Further, if debt managers observe an apparent mispricing in the market, they could use derivatives to temporarily deviate from a strategic benchmark, instead of changing the borrowing plans or the strategic benchmark.

C. Funding Liquidity and Market Liquidity Risk Management

Liquidity risk is referred to both the funding liquidity of an issuer, i.e., the sovereign’s ability to service its obligations, and the market liquidity of an instrument. Although these concepts are linked, they should be looked at separately. For example, large benchmark-size bonds tend to be more liquid in secondary market trading. However, a large benchmark bond increases the liquidity risk of the issuer, as well as the refinancing risk at the time of redemption. Thus, building up benchmark bonds to provide liquidity to the market (and thereby reduce costs to the sovereign) is an important element of public debt management, which is separate and distinct from the sovereign managing its own funding liquidity risk (see also IV. D.).

Debt managers regard secondary market liquidity of debt securities as a highly desirable attribute of their sovereign debt portfolio. This is due to the liquidity premium, as liquid debt instruments trade at a premium compared to less liquid instruments, thus leading to lower borrowing costs.¹¹⁹ In addition, liquid sovereign bonds may be bought and sold at fair market value and low costs (bid-ask spreads), while investors with short investment horizons may be comfortable holding longer-dated bonds, as markets allow these bonds to be easily sold should a liquidity need arise.

Creation of large and liquid benchmark bonds can increase funding liquidity risk and increase refinancing risk. For a debt manager, bunching of sovereign debt redemptions, along with the corresponding rollover/refinancing risk, are major concerns and the subject of constant assessment. In response, many debt managers take a proactive approach in managing their benchmarks by promoting issuances with amortizing structures and, prior to maturity, by establishing buybacks and/or exchanges as a regular feature of their borrowing programs.¹²⁰

From an issuer’s perspective, a first line of defense against liquidity risk is to ensure regular funding operations and a balanced maturity profile of new issuances. Maintaining consistency and predictability in a country’s financing program should be a debt management priority. This entails issuance of securities on a regular schedule with set well-defined issuance procedures, as this helps reduce market uncertainty and reduces risk premia. The auction cycles, frequencies of issuances, and auction sizes may need to be adjusted depending on the size of the borrowing requirement and should ensure market liquidity, which, in turn, promotes efficiency in capital markets, lowering debt service costs over time.¹²¹

Additional tools are potentially available to debt managers to manage the sovereign’s funding liquidity risk, such as the use of extendible bonds that give the issuer the right to extend their term beyond a specified date.¹²² Depending on the design of the extendible bond, the issuer can have one or more opportunities to defer the repayment of the bond’s principal, during which time interest payments continue to be paid. In addition, the bond issuer may have the option to exchange the bond for one with a longer maturity, at an equal or higher rate of interest (see also Box 5).¹²³ Another potential tool is committed credit lines, although covenants could be overly restrictive and capital requirements and fees would be driving up costs.¹²⁴

D. Management of Sovereign and Counterparty Credit Risk

Sovereign credit risk arises from a potential bond default, when a sovereign fails to make a scheduled payment on its bond debt.¹²⁸ As governments accumulate more debt relative to GDP, the perceived ability to repay long-term debt holders becomes increasingly questionable.¹²⁹ The associated sovereign credit risk is reflected in higher bond yields and credit default swaps (CDS) and in lower credit ratings for some governments. This may signal a need for the debt manager to inform fiscal authorities about appropriate actions that need to be taken to address market concerns so that sovereign bond yields and credit default spreads are reduced and ratings are improved.¹³⁰

LMOs, on-lending, and/or acquired assets in the sovereign balance sheet may involve derivatives, requiring the debt manager to manage their credit risk exposure.¹³¹ For debt managers, although credit risk evaluation of a counterparty may be complicated, a certain creditworthiness/credit risk, often assessed on the basis of a credit rating, is typically assigned to the counterparty (or the specific obligation), to be used in credit decisions (Saunders and Allen, 2002). The ratings thus inform the uncertainty (default probability and recovery rate in the event of a default)¹³² that is used to evaluate the expected loss and is translated into the relevant exposure (credit exposure) (Culp, 2001).¹³³ Collateral posting is often used to manage counterparty credit risk. However, credit risk management of cash management operations is usually conducted through rating requirements, limits, follow up and use of collateralized instruments such as reverse repos and tri-party repos.

Debt managers using swaps need to carefully monitor market values, as a swap with a positive market value is an asset and reflects a credit risk exposure. In practice, debt managers monitor the market value of the swap portfolio and receive collateral that is also determined by a rating-dependent threshold value. This requires the counterparties to pledge additional collateral when the market value exceeds the threshold value (Box 6).¹³⁴ In addition, counterparty agreements may contain a trigger by which a swap may be terminated if the credit rating falls below a certain level (Danish Government Debt, 2013, p. 33).^{135, 136} Further, debt managers should take into account the implications of changes in derivatives regulations on the existing and planned derivatives portfolio.

Several DMOs, including the Danish, German, Dutch, and Swedish Debt Management Offices use derivatives in general and swaps in particular to reach the desired debt portfolio exposure in the most cost-effective manner—separating funding from exposure. Sophisticated debt managers may use swaps to achieve comparative advantage, such as by issuing long maturities, and diversify the portfolio across instruments and markets using derivatives to achieve its target risk profile.¹³⁷ This approach requires a comprehensive framework to manage credit risk exposures using an integrated risk management system. In all cases of derivative transactions, an ISDA Master Agreement, along with other legal documents that govern margin collateral, serve as the main instruments to manage credit risk (see also section III.F).

E. Management of Guarantees and Other Contingent Liabilities

The process for managing government guarantees, once a preliminary decision to issue a guarantee has been taken, is fairly extensive. This would include: (1) risk assessment of new guarantees and determination of fees, (2) monitoring and risk assessment of existing guarantees, (3) coordination with borrowing operations, and (4) restructuring and recovery of called guarantees.¹³⁹

The process for granting new lending and on-lending to government entities will be almost identical to that for granting new guarantees. Where the policy requirements are met for providing financing through a loan from the government, the policy assessment, the credit risk assessment, and the fee calculation (or yield spread over the government cost of borrowing) will be the same as for guarantees. The government will finance the loan through the budget in the normal manner, either as a direct loan from its revenue resources or from its own borrowing.

Governments also often take steps to manage the risks associated with contingent liabilities (including public–private partnerships, PPPs). If structured without appropriate incentives or controls, contingent liabilities are often associated with moral hazard for the government. To encourage positive incentives, steps can be taken to set up a clear legal framework for commitments creating explicit contingent liabilities that can be made by the government.

Loan guarantees and borrowing can be closely interlinked. These links are particularly prominent in the case of credit guarantees for foreign loans and sovereign borrowing in foreign markets where it is important to undertake sufficient consultation between the debt manager and the guarantee recipient. Proactive communication will help to project positivity to investors, as this may lead to more favorable terms for all parties involved.

Debt managers normally monitor contingent liabilities to the extent that they can impact the debt management strategy and its implementation. The governance framework for guarantees and on-lending can limit the level of credit risk in the guarantee portfolio, and coupled with a robust credit risk assessment framework can reduce moral hazard when guarantees are granted. It is furthermore important for debt managers to monitor the financial terms and loan documents to ensure that these do not unnecessarily impose a burden on them by negatively impacting interest rates. Finally, debt managers need to monitor the development of credit risk over the term of the guarantee to maintain a proactive approach to guarantees that could be called and could impact the debt portfolio. In this regard, it is also a good practice to make budgetary provisions for guarantees that are assessed to be potentially called. (For managing contingent liabilities and fiscal risks, see also IMF, 2016a).

F. Management of Legal Risk¹⁴⁰

As debt managers typically have the legal authority to borrow, conduct LMOs, and enter into derivative transactions on behalf of the sovereign, they should have the capacity to understand and evaluate legal agreements.¹⁴¹ In particular, debt managers need to use standard legal agreements for managing their credit and counterparty risk, for example, ISDA agreements including credit support annexes (CSAs) for full collateralization of exposures.¹⁴² Further, debt managers and their legal advisors typically ensure that bond contracts incorporate sound legal features, such as legal jurisdiction, defining events of defaults, negative pledge clauses, collective action provisions, pari passu clauses, and the scope of the waiver of sovereign immunity (“Revised Public Debt Management Guidelines,” IMF 2014).

G. Management of Operational Risk¹⁴³

The operational risk management framework is an integral part of the risk management framework and requires both resources and a good understanding of risks. For the framework to be successful, it is extremely important to develop a culture of risk awareness and, with endorsement from senior management, to assign responsibility to line managers and more broadly to DMO staff. The process should include the following principles: (1) understand and document business activities; (2) identify, assess, and measure risks; (3) develop risk management strategies and business continuity plans; (4) implement capabilities; (5) monitor performance; and (6) continuous improvement (Magnusson et al., 2010, pp. 6–10).¹⁴⁴

H. Selected Liability Management Operations Used by Debt Managers

Table 2 summarizes typical LMOs used by debt managers for the various types of sovereign debt portfolio risks:

A. Fiscal Policy

Fiscal policy authorities and debt managers should share an understanding of the objectives of debt management, and coordinate on the inclusion of comprehensive debt servicing forecasts in the budget (“Revised Public Debt Management Guidelines,” IMF 2014). Debt managers require fiscal forecasts to adequately plan financing activities.¹⁴⁸ Conflicts may arise if fiscal policy makers attempt to reduce debt servicing costs in the short run, without due regard for the risks and longer-term costs (for example, through the use of zero coupon instruments or excessive short-term debt). In this regard, regular consultations and a feedback loop from debt managers to policy makers should remain active.

Fiscal rules, e.g., debt rules or ceilings, could affect debt management. Addo Awadzi (2015) mentions that the authority to borrow is often subject to controls designed to promote discipline and accountability, consistent with overall fiscal policy and public financial management objectives. The types of controls reflected in the legal framework are often shaped by policy and political economy realities and may include specification of the sources from which government may borrow, borrowing purposes, debt ceilings, and others.

The level of debt is mainly determined by fiscal policy, although ex-post the debt composition can play an important role. A debt management strategy would be formulated within a medium-term fiscal framework (MTFF). Debt sustainability analysis (DSA) will assess whether the fiscal policy implied by the MTFF, and the associated debt level, is sustainable over the long term. A DSA will show the development of debt ratios if (a) the primary balance does not change (improve) and (b) projections of GDP growth are closer to the historic outcome than the assumed outlook, and through bound tests to examine the impact on debt of shocks to key macro variables. The debt management strategy will add to this analysis by providing a more detailed analysis of the cost and risk characteristics of different debt management strategies. Moreover, the debt manager may identify strategies that generate a profile of interest costs consistent with debt sustainability and strengthen fiscal planning by contributing an analysis of the likely, and possible, budget implications for debt service costs (IMF-World Bank, 2009). Box 7 illustrates a simplified debt sustainability framework.¹⁴⁹

B. Monetary Policy

The monetary policy regime, the instruments used for monetary policy operations, and the institutional setting, as well as the credibility of monetary policy, all have important implications for debt managers.¹⁵⁰ The core objective of the monetary authority is price stability. Targets for inflation, interest rates, monetary aggregates, or the exchange rate are managed through open market operations or through non-market controls, such as setting reserve requirements. A credible monetary policy will be successful in taming inflationary expectations and reduce future uncertainty, which will in turn reduce the risk premium on domestic currency debt.

A clear and transparent framework for monetary policy and debt management contributes to the effectiveness of each policy. In general, where the level of financial development allows, there is a separation of debt management and monetary policy objectives and accountabilities. This principle helps to ensure that conflict between these two important public policy objectives is minimized.¹⁵¹ For example, a government’s objective for financing cost minimization, subject to a prudent level of risk, should not be viewed as a mandate to reduce interest rates, or to influence domestic monetary conditions.¹⁵² Neither should the cost/risk objective be seen as a justification for the extension of low-cost central bank credit to the government.¹⁵³

Monetary operations are often conducted using government debt instruments and markets. The choice of monetary instruments and operating procedures needs to be coordinated with debt management policies for effective overall policy implementation and well-functioning of the government debt markets. In countries with developed financial markets, central bank interventions usually take place in secondary markets, reducing the need for coordination between fiscal and monetary authorities at the operational level (IMF, 1994). In countries with less developed financial systems, central banks start issuing their own securities or use government securities as their intervention instrument for open market operations that are often implemented in the primary market, raising the need for effective coordination on issues such as the tender volume,¹⁵⁴ so as to allow the central bank to issue more securities than is strictly necessary for debt management purposes and decide on mechanisms to bear the cost of overfunding the government’s budget (Gray and Pongsaparn, 2015).

C. Financial Stability

Debt management plays an important role in securing the economic benefits of a sound policy framework in several ways. First, the debt management strategy is an essential complement to sound macroeconomic policies, an appropriate socio-political environment, and the judicious choice of a policy regime in achieving financial stability (Das et al., 2010). Second, improvements in the debt structure can be an essential complement to fiscal consolidation in ensuring a robust recovery in a post crisis environment. Third, such improvements, when implemented opportunistically (that is, during a cyclical upswing), can strengthen the effectiveness of managing public debt of countercyclical macroeconomic policy going forward, at a relatively low cost.

Financial institutions in most countries typically hold a significant share of public debt.¹⁵⁵ Debt managers must recognize that their actions can have a major impact on the balance sheets of these institutions. Regulations affecting debt management actions are important in this respect.¹⁵⁶ Moreover, given the usually high level of interdependence of financial institutions, the effects can have potential systemic implications. This impact is relevant not only when discussing possible sovereign liability management and debt restructuring operations, but also when thinking about the targeted composition of the debt.¹⁵⁷

The public debt should have a structure that sustains low levels of refinancing risk for the sovereign throughout the business cycle. Inappropriate debt structures and poor debt management can inhibit a sovereign’s ability to ensure financial stability by affecting investors’ country risk perception and exacerbating pressures, initially on financial institutions’ balance sheets, incomes, and capital reserves and ultimately on the sovereign balance sheet, thereby raising sovereign risks. Measures include the substitution of debt denominated in domestic currency for foreign currency or foreign currency-linked debt; an extension of the maturity profile of the debt portfolio at a reasonable cost; the assignment of maturity brackets that avoid a bunching of refinancing need; financial market reform that promotes diversification of the domestic financial sector (i.e., commercial banks, insurance companies, asset managers, etc.); and a widening of the investor base through, for example, attracting foreign investors into the domestic debt market.^{158, 159}

Debt managers can play a key role in mitigating financial stability risks by:

• Playing a preemptive role in developing the investor base further, by issuing instruments targeted at a specific group of investors and by working on increasing a specific group’s participation in the debt or in particular instruments.

• Facilitating bond liquidity. Doing so would not only reduce costs for the issuer through a liquidity premium and term transfers, but it would also enhance the efficiency of capital markets and in turn of LMOs, (Crocket, 2008). For these reasons, it has become accepted best practice to issue benchmark securities in large individual series, which are critical to creating the basis for a liquid bond market (and eventually of the futures and repo markets)¹⁶⁰ (IMF Diagnostic, 2014).

• Participating in debates on the regulatory scheme and trying to affect the rules in ways that improve the effectiveness of debt management policy and ultimately strengthen financial stability.

• Communicating with investors¹⁶¹ and other key stakeholders and avoid abrupt changes in direction that could result in constant shifts in the investors’ portfolios.¹⁶² Under such conditions, investors cannot hold positions based on a medium-term view; instead, they have to keep changing instruments based on reports and perceptions, which increases their risk and the cost to the government.

Table 3 shows the main debt management channels to financial stability.

Table 3.

Liability Management Operations Used by Debt Managers

Table 3.

Liability Management Operations Used by Debt Managers

Risk	Liability Management Operation
Refinancing risk/rollover risk	Smooth maturity profile by well-planned primary market issuance Regular use of buybacks and exchanges to reduce size of large individual maturities Use of amortizing bonds/debt
Funding liquidity risk and market liquidity risk	Funding liquidity risks: Use of cash buffers and contingency credit lines Market liquidity risk: Issuance in key maturity segments; concentrate on small number of instrument types; transparency to reduce uncertainty Use of market makers and securities lending facilities Use of buybacks and bond exchanges to contribute to trading in on-the-run issues
Interest rate risk	Targets for issuance of fixed/floating rate instruments in primary market issuance Interest rate derivatives to change interest rate structure and duration Changes in portfolio composition to manage interest rate sensitivity
Exchange rate risk	Limits for overall foreign exchange risk and benchmark portfolio composition Well-structured primary market issuance Use of bond exchanges to achieve a targeted mix of local and foreign currency in the debt portfolio Use of cross-currency swaps or optionality in loan agreements (where they exist) Use of foreign exchange derivatives to hedge other foreign exchange risk deriving from other instruments such as foreign-currency bonds or CP, as well as assets
Credit risk	Alerting fiscal authorities of the need to take appropriate action and address market concerns so sovereign bond yields and credit default spreads are reduced
Counterparty risk for derivative transactions and assets on the balance sheet	Counterparty credit risk limits Monitoring of counterparty creditworthiness and adequate posting of collateral
Legal risk	Use of standard legal agreements Sound internal processes and a legal strategy for the use of collective action and pari passu clauses; consistent application of cross default and negative pledge clauses
Operational risk	Internal structure that delineates responsibilities Well-documented internal processes and systems Four-eye principle and well-trained staff A risk management culture that rewards reporting of failed processes or close calls Use of standardized platforms such as DMFAS program
Contingent risk	Management of guarantees Risk assessment of new guarantees, on-lending and CLs

View Table

Table 3.

Liability Management Operations Used by Debt Managers

Risk	Liability Management Operation
Refinancing risk/rollover risk	Smooth maturity profile by well-planned primary market issuance Regular use of buybacks and exchanges to reduce size of large individual maturities Use of amortizing bonds/debt
Funding liquidity risk and market liquidity risk	Funding liquidity risks: Use of cash buffers and contingency credit lines Market liquidity risk: Issuance in key maturity segments; concentrate on small number of instrument types; transparency to reduce uncertainty Use of market makers and securities lending facilities Use of buybacks and bond exchanges to contribute to trading in on-the-run issues
Interest rate risk	Targets for issuance of fixed/floating rate instruments in primary market issuance Interest rate derivatives to change interest rate structure and duration Changes in portfolio composition to manage interest rate sensitivity
Exchange rate risk	Limits for overall foreign exchange risk and benchmark portfolio composition Well-structured primary market issuance Use of bond exchanges to achieve a targeted mix of local and foreign currency in the debt portfolio Use of cross-currency swaps or optionality in loan agreements (where they exist) Use of foreign exchange derivatives to hedge other foreign exchange risk deriving from other instruments such as foreign-currency bonds or CP, as well as assets
Credit risk	Alerting fiscal authorities of the need to take appropriate action and address market concerns so sovereign bond yields and credit default spreads are reduced
Counterparty risk for derivative transactions and assets on the balance sheet	Counterparty credit risk limits Monitoring of counterparty creditworthiness and adequate posting of collateral
Legal risk	Use of standard legal agreements Sound internal processes and a legal strategy for the use of collective action and pari passu clauses; consistent application of cross default and negative pledge clauses
Operational risk	Internal structure that delineates responsibilities Well-documented internal processes and systems Four-eye principle and well-trained staff A risk management culture that rewards reporting of failed processes or close calls Use of standardized platforms such as DMFAS program
Contingent risk	Management of guarantees Risk assessment of new guarantees, on-lending and CLs

Table 4.

Debt Management Channels to Financial Stability

Source: Das et al., 2010.

Table 4.

Debt Management Channels to Financial Stability

Channels	Preemptive Policy	Risk Mitigation Policy
Stock of Debt	Issue low-cost, low-risk instruments.	Debt buybacks, debt exchanges
Profile of Debt	Issue low-cost, low-risk instruments.	Exchange auctions, derivatives
Investor Base	Diversify investor base; monitor investor base risk indicators and adapt appropriate strategy.	Debt buybacks, exchange auctions, investor relations programs
Debt Market Structure	Issue benchmark securities; establish appropriate primary dealers and market makers structure; coordinate with regulatory bodies; put in place appropriate legal framework; draft debt market development strategy.	Changes in legal framework and debt strategy
Institutional Aspects	Coordinate with monetary policy and cash-management policy; maintain good communications channels; adopt a well thought out program, taking into account international practices and domestic idiosyncrasies and constraints.	Changes in legal framework governance and debt strategy

Source: Das et al., 2010.

View Table

Table 4.

Debt Management Channels to Financial Stability

Channels	Preemptive Policy	Risk Mitigation Policy
Stock of Debt	Issue low-cost, low-risk instruments.	Debt buybacks, debt exchanges
Profile of Debt	Issue low-cost, low-risk instruments.	Exchange auctions, derivatives
Investor Base	Diversify investor base; monitor investor base risk indicators and adapt appropriate strategy.	Debt buybacks, exchange auctions, investor relations programs
Debt Market Structure	Issue benchmark securities; establish appropriate primary dealers and market makers structure; coordinate with regulatory bodies; put in place appropriate legal framework; draft debt market development strategy.	Changes in legal framework and debt strategy
Institutional Aspects	Coordinate with monetary policy and cash-management policy; maintain good communications channels; adopt a well thought out program, taking into account international practices and domestic idiosyncrasies and constraints.	Changes in legal framework governance and debt strategy

Source: Das et al., 2010.

Debt managers generally maintain an understanding of the risk transfer to different investor categories and monitor their balance sheet structure. It is important for debt managers to understand that the majority of investors will be sensitive to market risk, given their requirement to value their government securities at market prices. To achieve this, debt managers need to monitor the investments of key players and the structure of their holdings, and assess their gross exposures. Doing so can give debt managers important information to gauge investors’ appetite for new government securities and/or reversals in their preferences.

Debt managers should exercise caution when they are dealing with debt defaults or debt devaluations, and must consider the impact of their decisions on financial system stability. In cases where the government will need funding to go forward, the outcome of such a deal is crucial: badly conducted debt management could impair the government’s ability to keep raising money efficiently in the markets. In cases of debt restructuring, it is imperative for debt managers to provide assessments on a broad range of topics, such as instruments to be issued and exchanged, haircut levels, and timing of operations (Kumhof and Tanner, 2005).

An often-overlooked contribution of a sound debt management strategy is the efficacy of tactical LMOs, in which debt managers credibly intervene in domestic debt markets in emergency situations to quickly rebuild investor confidence. In periods of distress but not loss of market access, appropriate adjustments in the size and maturity structure of issues, as well as undertaking targeted domestic debt buybacks, could quell investor concerns and help restore market confidence.¹⁶³ Also, the low level of market development in most developing countries, the still vulnerable structures of debt in many emerging markets, and the rise in debt levels in a number of developed economies make sound sovereign debt management even more challenging for global financial stability in the future, particularly given the higher global funding pressures. Understanding the risks and the channels of their transmission to financial stability is an essential element of formulating appropriate policies for strengthening domestic and international financial stability (Das et al., 2010).

A set of indicators can be used to analyze the size, liquidity, and contribution of government securities markets to domestic and global financial stability such as (IMF 2014 and Appendix 1):

• Macroeconomic variables: (1) GDP growth and inflation, (2) fiscal balance and public debt to GDP ratio, (3) current account and level and volatility of capital flows, and (4) share of household savings to GDP.

• Market structure: (1) debt securities statistics, (2) yield curve and structure of benchmark instruments, (3) composition and diversity of the investor base, (4) foreign holdings of local bonds, (5) types of fixed-income instruments, and (6) derivatives market and types of hedging instruments.

• Market liquidity: (1) volume of outstanding benchmark instruments, (2) size of transactions and turnover ratios, (3) bid–ask spreads, (4) bid to coverage ratios, and (5) accepted ranges of bids in the primary market.¹⁶⁴

D. Cash Management

Cash management has implications for debt management and a wide range of policy issues.¹⁶⁵ The first policy consideration is directly relevant for fiscal management, where budget execution interacts with cash inflows and outflows. Cash management should provide flexibility to accommodate temporary fiscal shocks,¹⁶⁶ thereby minimizing their impact on the orderly execution of the budget. The second policy consideration relates to the extent that the level of cash balances is a policy target. Minimizing idle cash balances reduces the economic cost of borrowing, where effective targeting requires cash flow forecasts, and efficient budget execution facilitates their preparation.¹⁶⁷ Depending on how closely the cash balance target is met, there are likely to be benefits to monetary policy, which is the third policy consideration. In other words, cash management should contribute to the smooth implementation of monetary policy by the central bank. The fourth policy consideration is particularly relevant for debt management because it involves market transactions to meet the target in a way that enables the sound financing of any deficit or the management of excess resources. Finally, the fifth policy consideration is how those actions support or impede domestic market development (Williams, 2010).¹⁶⁸

Cash management is distinct from budget execution. Budget execution is concerned with ensuring that the budget is managed consistently within agreed financial limits. This covers aspects from control over cash releases linked to resource availability, to ensuring that releases are in line with spending commitments, through to delegation of budget management to line ministries. In contrast, cash management is concerned with ensuring that the government has the liquidity available to fund its expenditure in a timely manner and to meet its obligations as they become due. This requires planning ahead and making cost-effective use of the government’s available cash. Cutting planned expenditure because of a lack of cash is cash rationing. It would not be considered cash management; rather, effective cash management removes the need for cash rationing (Lienert, 2009).¹⁶⁹

Government banking arrangements are an important factor in managing and controlling government cash resources. Such arrangements are critical for ensuring that (1) all tax and non-tax revenues are collected and payments are made correctly in a timely manner and (2) government cash balances are optimally managed to reduce borrowing costs (or to maximize returns on surplus cash). This is achieved by establishing a unified structure of government bank accounts via a treasury single account (TSA) system.¹⁷⁰

A TSA is a prerequisite for modern cash management and is an effective tool to establish oversight and centralized control over government cash resources. It provides a number of other benefits and thereby enhances the overall effectiveness of a public financial management (PFM) system (Pattanayak and Fainboim, 2011).

This centralization of government cash balances is particularly important. In most advanced countries, nearly all revenues are consolidated daily in a TSA, which is under the control of the Treasury of the MoF or the DMO.¹⁷¹ Through the TSA, the MoF has full access to all cash resources held in the central government ministries and agencies at any given time. The main bank account of the TSA system of accounts is held at the central bank and is used for receiving all government revenues and making government payments. When establishing a TSA, the government payment function can be centralized—with all disbursements made directly from the main operational account of the TSA at the central bank (with few exceptions). Alternatively, payments can be decentralized, and made by spending ministries from accounts held in commercial banks. Each day, the balances in ministries’ bank accounts are swept into the TSA, and the government’s cash manager ensures that only a minimum end-of-day balance remains in the TSA’s main account at the central bank. Temporary cash surpluses are usually remunerated by the central bank or placed in financial market instruments.¹⁷²

The coverage of the upcoming TSA needs to be comprehensive to be effective. The coverage should extend to all government-funded entities and special accounts. Public corporations that are not discharging a government function should remain outside the TSA to preserve their autonomy to operate on a commercial basis. If a public company is discharging a government function, however, it should be designated as a government unit in line with the definition in the Government Finance Statistics Manual 2014, and its activities and resources should be integrated with the budget and the TSA. The separation between the permission to spend and making actual cash payments means that flows through the TSA must be the focus of the forecast. Ideally, forecasts of daily cash flows across the TSA should be available for at least three months ahead. This must be coupled with an ability to monitor actual changes in the aggregate balance of the TSA top account, close to real time.

Forecasts of future cash flows are essential for more active cash and debt management and planning debt issuance. Debt managers need to know what to borrow and when. This is a precondition for planning future borrowing, and making decisions on the range of instruments to issue. These decisions involve assessing tradeoffs of bills and bonds, taking into account demand, supply, and price information. In relation to demand, intermediaries and/or end-investors may need a steady flow of T-bonds to meet their obligations or shorter-term instruments for liquidity management. Their needs will vary throughout the year with their own cash flows and market developments. An additional important task facing debt managers is linking issuance dates with redemption dates to maximize the opportunities for investors to roll over into a new issue. Maturity dates should be selected to avoid weeks, and especially days, of heavy cash outflow (for example, salary payments¹⁷³), and indeed should target days of cash inflow (the due date for tax payments). Debt managers can mitigate the cash management problems that potentially arise when large bonds come to maturity (Appendix section III.A.) (Williams, 2010).

Cash management has an important role in the management of refinancing risk. Building a cash buffer to meet upcoming maturities has an opportunity cost, as the sovereign’s funding cost is higher than the return on the buffer because the yield curve is typically upward sloping.^{174, 175} Therefore, there is a trade-off to assess between cost on one hand, and the benefits and possible risk reduction provided by the buffer on the other. Commonly, cash buffers consist of a (1) transactions buffer for an unanticipated fall in cash balances stemming, inter alia, from the combination of volatility and forecasting errors in the cash forecasting, and (2) a safety buffer for an unanticipated fall in cash balances stemming, for example, from sudden disruptions in capital markets for a period when no bond/bill issuances would be possible.¹⁷⁶

The size of the cash buffer should, inter alia, be based on the debt manager’s needs in its debt and liability management operations. Some countries determine their cash buffers as the maximum amount of financing needed if capital markets were disrupted for several months, and no issuance could take place during those months. Another rationale for the buffer, closely related to the first, is to provide comfort to investors that will be able to honor its debt obligations. A flexible cash buffer would be needed to leave room for inflows from possible pre-financing. Finally, a cash buffer may be used for contingent liabilities and/or for buybacks of outstanding maturities, which will also influence its size. The last three factors are directly related to LMOs.¹⁷⁷

E. Institutional Factors

Transparency and accountability are key factors in debt management operations. This follows from the debt management objectives, which should be clearly defined and publicly disclosed, and the measures of cost and risk that are adopted should be explained. The legal authority to borrow should state who has the authority to undertake transactions on the government’s behalf. The organizational framework for debt management needs to be clearly specified, and the mandates and roles well-articulated. Experience suggests that there is a range of institutional alternatives for locating the public debt management functions, including in one or more of the following: the MoF, the central bank, or an autonomous debt management agency. Regardless of which approach is chosen, consolidation of debt management functions in the same authority could enhance efficiency in debt management operations. The key requirement is to ensure that the organizational framework surrounding debt management is clearly specified and that the mandates of the respective players are clear. This gives debt managers the operational independence to execute their strategies and objectives.¹⁷⁸

Experience shows that unless there are compelling reasons related to effectiveness, it is not advisable for different agencies to be responsible for the same set of functions (Wheeler, 2006). Government debt management generally operates more efficiently if responsibility for decision making and implementation is not spread across several government departments (such as the ministries of finance, planning, and commerce) or across several different departments within the MoF. In most OECD countries, responsibility for government debt management is centralized either within the MoF or in a DMO outside that ministry. When a DMO is established outside the MoF, the ministry should retain the key responsibility for advising the minister of finance on debt management strategy (often in conjunction with the debt office) and for approving important risk management policies or advising the finance minister on them.

Governments’ centralizing debt management functions have generally opted for two types of DMOs.¹⁷⁹ One type is an office established outside of the MoF but reporting to the minister of finance. Legislative options include either a specific and detailed legislation or a broader government legislation involving regulations, decrees, or policy decisions.¹⁸⁰ The other type is an office located within the MoF or treasury.

An office located outside of the MoF warrants sound governance arrangements and involves an additional monitoring function by its principal. Experience shows that the farther removed the DMO is from the MoF, the more formally monitoring must be carried out to manage agency risk. Governance arrangements can consist of boards of directors or advisory boards, where financial accountability requires internal and external audit arrangements. Furthermore, a government instruction is required to specify the activities of the debt management agent. It is unavoidable that the government needs to retain sufficient competence to both monitor the agent and the enactment of the instruction. Officials from OECD countries have acknowledged that oversight given to them by MoF officials has been weak because of the small number of staff dedicated to oversight and insufficient training in debt management (Currie, Dethier, and Togo, 2003).

For developing and emerging market countries that are only beginning to develop the role of government debt management, the arguments for building this competency within the MoF are compelling and setting up an autonomous DMO when adequate capacity to manage the government debt has been developed.¹⁸¹ A key issue for emerging market economies is the limited degree to which debt management policy can reasonably be implemented independent of other policy-making bodies, notably the monetary authorities, and the challenges facing the government in developing the government securities market (see Appendix 1). This has important implications for the governance and location of the DMO. In the context of achieving the stated objectives and strategic target, if the debt manager is unable to influence the composition of the debt portfolio—or if its actions are significantly compromised by the actions of other policy-making bodies—then the need of having an MTDS and the degree to which the debt manager can be held accountable for its own actions become questionable (Currie, Dethier, and Togo, 2003).

Many DMOs have adopted an organizational structure similar to that found in leading corporate and banking treasuries and in the reserve asset management departments of many central banks. Functional responsibilities for managing transactions are divided among offices within the debt management organization, and procedures are established to ensure internal control and accountability (Wheeler, 2004). Usually, this involves the creation of front, middle, and back offices and of separate reporting lines to the head of the debt office (Box 8).¹⁸²

A. Role of Domestic Markets in LMOs

Development of the domestic and foreign government yield curves is imperative for attracting a relatively diverse investor base and accurate pricing of government instruments in issuances and LMOS. When debt management operations are able to lower the government yield curve, there will be some beneficial spillover effects on other domestic debt issuers. In addition to developing a benchmark domestic curve with a range of maturities for various investor groups, it is also crucial to maintain a diversified product range that includes GMTN/EMTN programs for private placement in domestic and foreign currency, inflation-linked bonds, floating-rate bonds, and, for some countries, retrial debt products, e.g., Ireland. Further, other indexed instruments, e.g., GDP-linked and financially-indexed bonds, may be considered depending on the specific country’s circumstances and investor demand. For example, financially-indexed bonds, such as long-term bonds whose return is indexed to a short-term rate, allow the issuer to lengthen the maturity of the debt (though not the duration) when the term premium (i.e., the yield on a bond of x years that exceeds the average of expected future short rates over the life of the bond) is particularly steep and thus issuing fixed-rate bonds would be too costly.

Domestic markets can play an integral role in sovereign debt portfolio management, and vice versa. Market development can be considered in terms of three stages of development with different priorities (see also Appendix 1): (1) initial stage: negligible liquidity in the primary market, focus on establishing a functioning primary market and creating the preconditions for secondary market development; (2) deepening stage: basic elements of the primary market and secondary market are established and functioning, focus on improving liquidity on the secondary market; and (3) maturing stage: well-functioning primary market, liquid secondary market in normal times, focus on the development of sophisticated instruments and segments such as derivatives, and making the market internationally competitive (Árvai and Heenan, 2008).

Reforms that target the investor base are usually regarded as fundamental at early stages of government securities market development. An early start of the process of pension and insurance reform might be prudent because of the time it takes to feel the positive impact of such reforms on the capital market. Taking concurrent initiatives with short- and long-term effects, therefore, needs to be considered. The resources available in both the public and private sectors set limits for this kind of sequenced market development. A needs assessment early in the process will be essential to devise an optimal allocation of the scarce resources among different initiative possibilities (Appendix 1).

B. Role of International Capital Market Issuance in LMOs

International bond issuance increases the funding options for a sovereign issuer, but also entails several debt portfolio risks. The key challenge for all sovereign bond issuers, including first-time issuers, is to maintain sound macroeconomic policies, especially fiscal sustainability. This is needed to ensure sovereign creditworthiness, as international investors’ confidence in many emerging market countries and low-income countries is often fragile and quickly reversible. Other risks include the sovereign’s foreign currency risk exposure from an international bond issue, possible refinancing needs—especially in periods of tight international financial liquidity conditions—and adverse terms-of-trade shocks (Papaioannou, 2008).

To reduce the risk of unfavorable developments related to a debut issue, sovereigns need to make appropriate preparations before accessing the markets. Judging by past successful cases of sovereigns that accessed capital markets, most governments’ preparations had primarily focused on issuing and utilizing the proceeds of a debut bond without compromising the sovereign’s creditworthiness. Before a debut bond was issued, appropriate analysis was undertaken to examine its balance sheet implications within a medium-term macroeconomic framework. This was to ensure that additional fiscal and debt-related vulnerabilities, as well as adverse effects on international reserve dynamics, did not arise. In this process, the sovereign also had to define the specific strategic characteristics of a debut issue, including its size, maturity, choice of fixed versus flexible interest rate, and currency of denomination.¹⁹⁶ Further, tactical issues, including the choice of legal and financial advisors, lead managers/underwriters, and jurisdiction of issuance, were paramount in making decisions about a sovereign debut debt issue.¹⁹⁷

An international issue includes an increase in transparency and closer market scrutiny. The prospectus or the offering memorandum of a bond issue requires disclosure of a substantial amount of data, allowing investors a close look at the current economic situation of the issuing country, and a better assessment of the country’s prospects for successfully meeting its debt service payments. The successful issue of an international bond signals approval of current and planned economic policies, and may help maintain a steady momentum in maintaining prudent macroeconomic policies and carrying out critical structural reforms, especially because markets subject issuers to close scrutiny and monitor economic developments on a regular basis.¹⁹⁸

When planning for an initial international bond issue, the government needs to make a number of decisions at various points in the process. Some are broader and more strategic in nature, and can be best addressed in the context of an asset liability management framework and a medium-term debt management strategy. Others are primarily tactical and related to the execution of the issue, although no less important. Regardless of the nature of these considerations, laying this groundwork early improves the chances of meeting the objectives of the issue, lowering its costs, and helping achieve a more stable investor base.

Another important decision that a new issuer faces is to choose between issuing a bullet bond and issuing an amortizing bond. Bullet bonds tend to increase the rollover risk for the issuer, as they create a “hump” in the debt repayment profile. Similarly, reopening such a bond at a later date only increases the size of the payment due on the maturity date, while debt management operations to smooth debt service humps (for example, pre-funding or debt buybacks and debt exchanges) are often costly and not always easy to conduct.¹⁹⁹

Small countries and issuers that anticipate going to the markets relatively infrequently should weigh very carefully the advantages of an amortizing structure rather than the more common bullet bond, and ensure an adequate level of preparedness. In general, amortizing bonds are considered to smooth the repayment profile, make reopening easier (the issuer can reopen the bond while avoiding a substantial increase in the bullet payment), and decrease information asymmetry between the issuer and investors. Regular payments help investors monitor the issuer, and reassure them that the issuer is able to honor the payments. This can lead to a more rapid reduction in risk spreads. Also, amortizing bonds have typically a shorter duration than bullet bonds, thus making them less risky and, in turn, contributing to a lower cost of the issue.²⁰⁰ Moreover, there is no evidence that small or occasional issuers pay a yield or liquidity premium for issuing amortizing bonds.²⁰¹ However, callable bonds, an alternative, are generally less preferred because of the difficulty in their pricing and the relative aversion of investors toward these bonds (Box 9).

A. Sovereign Debt Restructuring

While the analysis so far focuses on the management of sovereign debt portfolio risks under so-called normal times, this section deals with debt management policies during debt distress periods. A distinction needs to be made from the outset between market stress, with various degrees of market-access challenges, and debt distress problems, which may lead to a sovereign debt restructuring. In addition to the causes, processes, and outcomes of sovereign debt restructurings, this section also examines the role of market access in restructurings, along with determinants and strategies to maintain/regain market access.

Under debt distress situations, a sovereign debt restructuring usually implies some form of debt reduction in present value terms. Standard & Poor’s (2006) defines sovereign debt restructurings as debt exchanges at terms less favorable than the original bond or loan terms.²⁰⁸ Clearly, distressed debt exchanges should be distinguished from restructurings that are part of routine LMOs, such as debt swaps, where there is no net-present-value decrease of debt (Das, Papaioannou, and Trebesch, 2012). LMOs are purely voluntary market exchanges, and usually occur in normal times (Medeiros, Polan, and Ramloga, 2007; and Papaioannou, 2009). In normal LMOs, the issuer may offer a premium to encourage investors to participate in an exchange, e.g., to extend maturity, so that there may be an increase in the net present value of their debt holdings.

Sovereign debt restructurings can have drastic adverse consequences for economic growth, trade, capital flows, banks, and other financial institutions. A debt restructuring should therefore only be initiated if, on the basis of a debt sustainability analysis, it is concluded that a macroeconomic adjustment program cannot realistically restore sustainability, and the scope of debt relief should always be proportional to the country’s debt sustainability problem (Das, Papaioannou, and Trebesch, 2010).

Allowing an unsustainable debt situation to fester is costly to the debtors, creditors, and the international monetary system. For debtors, a situation of debt overhang depresses investment and growth and creates a sense of financial uncertainty that can raise the eventual magnitude of the debt problem. Moreover, it may exacerbate burden sharing and moral hazard concerns to the extent that continued financing by the official sector results in the exit of private creditors. Delays that magnify the scale of economic dislocations also tend to reduce the economic value of creditors’ claims. In addition, residual private creditors who have not yet been bailed out when the restructuring eventually takes place will have to absorb a greater loss because the entire burden will fall on a smaller group of creditors (IMF, 2013).

Debt restructurings that are based on good faith negotiations often involve private creditors in an adequate way. These negotiations should be transparent and fair and include an open dialogue with creditors and timely information sharing. While collective action clauses (CACs) can play an important role in facilitating debt restructurings, their presence is not a guarantee for a quick debt exchange with high participation. Other legal vehicles and exchange characteristics can play an important role as well, in particular exit consents, and minimum participation thresholds.

In general, private creditors wish to avoid a debt restructuring, therefore pressing for a bailout by the official sector if possible. But when a debt restructuring is the only option to deal with a liquidity shock or to restore solvency, for example, in situations where available financing and policy adjustment have been exhausted, delays end up amplifying the ultimate costs. Also, if authorities delay action while funding is running out, it may not be feasible to execute a preemptive debt restructuring.

In a sovereign debt restructuring process, there is a risk that a minority of holdout creditors could slow or disrupt an agreement that a qualified majority would be prepared to support. Collective action problems can impede the debt restructuring process as creditors may apply a holdout strategy that delays debt restructuring. If a government is forced to restructure its public debt in a time of distress, CACs in bond contracts could help achieve a more orderly and efficient resolution. The design and incorporation of such clauses in the documentation of bonds issued under foreign law have received increasing attention in recent years. These clauses allow a qualified majority of bondholders to bind all bondholders to the financial terms of a restructuring, and limit the ability of a minority of bondholders to disrupt the restructuring process by enforcing their claims after a default.^{209, 210}

By mitigating this risk, CACs can contribute to more orderly and rapid public debt resolutions. Given these potential benefits, debt managers should, when issuing international sovereign bonds (that is, bonds issued or guaranteed by a government or a central bank, and either governed by a law other than the law of the issuer or subject to jurisdiction of a foreign court), consider including enhanced CACs in new borrowings, in consultation with their financial and legal advisors (IMF, 2014).²¹¹

Debt managers play a key role in preparing the debt restructuring process. Lim, Medeiros, and Xiao (2005) suggest verifying the following key characteristics:

• the face and market value of bonds or loans

• the amortization schedule (bullet versus amortization and/or the existence of a sinking fund)

• interest rate and coupons (fixed versus flexible and/or the existence of step-up or linked features)

• currency of denomination of the instruments (local versus foreign currency)

• enhancements, including embedded options or collateral

• legal clauses, including CACs and non-default clauses, and the ability to include exit consents.

The verification of claims allows governments to ascertain their debt stock, debt-service profile, and the value of debt instruments. This lays the foundation for the detailed debt sustainability analysis, which provides an indication of the financing gap, the macroeconomic adjustment effort, and the degree of required debt relief. On this basis, governments typically develop a set of restructuring scenarios and prepare a final restructuring proposal, often with the support of legal and financial advisors (Figure 1) (Das, Papaioannou, and Trebesch, 2012).

Stylized Timeline of a Sovereign Debt Restructuring

Citation: IMF Working Papers 2018, 074; 10.5089/9781484350546.001.A001

Source: Das et al, 2012.

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Stylized Timeline of a Sovereign Debt Restructuring

Citation: IMF Working Papers 2018, 074; 10.5089/9781484350546.001.A001

Source: Das et al, 2012.

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Stylized Timeline of a Sovereign Debt Restructuring

Citation: IMF Working Papers 2018, 074; 10.5089/9781484350546.001.A001

Source: Das et al, 2012.

• Download Figure
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After the restructuring offer is presented to creditors, they have to decide whether to accept or reject the offer. In most cases, a successful exchange requires a certain minimum threshold of acceptance by creditors. Creditor coordination problems and holdout risks are thus likely to be most acute during this period.²¹² In most crisis cases, restructurings mark the end of a debt crisis episode, because the exchange of old into new debt puts the country back on the path of debt sustainability. However, if this is not the case, a second or even a third restructuring may follow within a relatively short period, e.g., Belize 2006–07, 2012–13, and 2016–present.

B. Role and Determinants of Market Access

IMF lending requires a determination of whether loss of market access (LMA) has occurred. An LMA represents an important signal that, from the perspective of investors, the ability to meet debt obligations has become uncertain. An assessment of whether a sovereign continues to have market access requires the exercise of judgment, and would be based on an assessment of whether the sovereign can tap international capital on a sustained basis through the contracting of loans or issuance of securities across a range of maturities (in both local and foreign currencies) at interest rates compatible with reasonable medium-term growth rates and an achievable primary fiscal position.

A range of indicators can be used to assess whether the country has lost market access or whether such loss is imminent. Such indicators would be assessed covering a period of at least 24 months and combined with judgment²¹³ (IMF, 2014):

• Sovereign spreads: conduct a debt sustainability analysis (DSA) scenario to assess whether debt would become unbounded if spreads were maintained at recent levels, and compare changes in the country’s spreads to other sovereign spreads within the same asset class.

• Patterns of recent primary market bond issuances: examine whether there have been significant departures in recent primary bond issuance practices (volume, frequency, maturity, and financing terms) from what the sovereign would normally do when it has market access.

• Volume: compare with (1) total financing needs and (2) preannounced bond auction schedule.

• Frequency: compare with (1) average frequency of issuances and (2) bond auction schedule (for example, in case auctions are cancelled or delayed).²¹⁴

• Maturity: compare with average original maturity of instruments.

• Financing terms: compare recent financing terms with past placements (for example, if there is a shift from fixed interest rates to variable rates).

• Nonresident holding of public debt: examine whether there has been a significant and sustained fall in nonresident holdings of public debt.

• Government bond rollover rates: examine whether government bond rollover rates have fallen on a sustained basis. As a corollary, assess the extent to which there is greater reliance on non-tradable instruments (for example, retail instruments and directly placed instruments such as commercial papers and medium-term notes) to meet financing needs.

• Government cash balances: examine whether there has been an abnormal decline in government cash balances.

• Sovereign credit ratings: observe changes in ratings and assess whether the country has lost creditworthiness (for example, if the sovereign rating was downgraded to low sub-investment grade in the past 12 months).²¹⁵

• Bond trading activity: assess the volume of recent bond trading in secondary markets and bid–ask spreads (for example, if trading volumes are thinner and limited and bid–ask spreads wider).

C. Strategies for Regaining Market Access

Sovereign borrowers that experience serious debt distress are faced with a set of new challenges because of a new class of investors that buy their credit. During downgrades and exclusion from debt indices, investment guidelines require investors to exit their investment, although some will remain in the credit if they do not share these constraints. Dealing with a new type of investor, distressed investors and hedge funds, marks a shift in investor relations for debt managers, as this class of investors tend to be more short-term focused and often want to engage directly with senior policymakers and impact policy. In this context, it is important that debt managers monitor the investor base and explain to policymakers the direction, who is buying the credit, and why.

Debt managers can typically re-access the market when yields fall to sustainable levels, as well as when the yield curve starts normalizing and becomes positively sloping. At this time, it can also be demonstrated that the required policy efforts, typically fiscal, have been successful.²¹⁶ Private sector debt issuance and normalization of market access is a consequent step, as it reinforces the fiscal adjustment by demonstrating that fiscal adjustment is working. Following steps requires a focus on market maintenance, essentially with a focus on building liquid bond issues to ensure continuous market access.

Experience shows that countries stress the following elements as critical on the path to re-accessing markets: (1) decisive action by policymakers and focus on debt sustainability, (2) no complacency in implementation of reforms and focus on the structure of debt; (3) internal coordination and focus on investor needs and expectations, and (4) communication throughout all phases with investors (regular, realistic, and in person) (Moody’s, 2013).

Some guiding principles and concrete actions for debt managers are as follows: (1) ensure sound policies and good policy coordination within the government; (2) restart the domestic bond market to demonstrate return to normality; (3) undertake measured exchange operations and issuances, starting perhaps with private placements;²¹⁷ (4) continuously improve the structure of maturity profile, such as by extending maturities; (5) bolster credibility by gathering cash buffers; (6) diversify the investor base; (7) ensure frequent and consistent communications with credit rating agencies and investors.