Chile: Selected Issues

The report gives details of the economic analysis for the implementation of Chile's inflation targeting framework. It reviews the current state of liquidity in the Chilean fixed-income markets and developments and impediments to the supply of corporate bonds to the market. The paper considers a number of microstructure issues, transparency in the Over-the-Counter (OTC) market, addresses the role of public debt in facilitating development of the financial markets, and discusses a potential debt management framework that would support the development of a liquid public debt market.

Abstract

The report gives details of the economic analysis for the implementation of Chile's inflation targeting framework. It reviews the current state of liquidity in the Chilean fixed-income markets and developments and impediments to the supply of corporate bonds to the market. The paper considers a number of microstructure issues, transparency in the Over-the-Counter (OTC) market, addresses the role of public debt in facilitating development of the financial markets, and discusses a potential debt management framework that would support the development of a liquid public debt market.

III. Public Sector Debt and Market Development 1

Executive Summary

  • This paper addresses the role of public debt in facilitating the broader development of the financial markets and discusses a potential debt management framework that would support the development of a liquid public debt market.

  • The government’s decision to invest the bulk of its projected fiscal surpluses in financial assets will broadly preserve the stock of public debt at current levels. This will create a need for the government to refinance existing debt as it falls due. A risk management approach would suggest that the central government should refinance this debt in the domestic market by issuing long-dated debt.

  • In order to maximize liquidity in the domestic public debt market, coordination of issuance plans across the central bank and the government will be crucial. Regular dialog with market participants to discuss issuance plans, review market developments, and discuss technical factors will enhance the liquidity of the market.

A. Public Debt in Chile

1. Public debt plays an important role in supporting the development of a well functioning financial system. In general, Treasury securities play three key roles as a benchmark, providing: (i) an indicator of the risk-free rate, which is required for the valuation of other securities; (ii) the benchmark rate for portfolio allocation decisions; and (iii) the tools for risk management, trade facilitation, and relative value comparison, facilitating the provision of intermediation services to the private sector by allowing dealers’ hedge positions.2, 3

2. Total public sector debt in Chile is relatively low by international standards. At end–2005, it was equivalent to 31.7 percent of GDP, with marketable debt amounting to 24 percent of GDP. The public sector had issued US$22.4 billion of marketable securities in the domestic market and US$5.7 billion in the international market. Public debt securities are issued by three main institutions:

  • Central bank. It is the main issuer of public debt. Its instruments account for 90 percent of total domestic marketable public debt outstanding; it has not issued debt in the external markets. Its marketable debt outstanding at end-2005 amounted to US$19.8 billion, equivalent to 17 percent of GDP.

  • Central government.It has issued bonds in the international capital market and long-dated inflation-indexed bonds (BTUs) in the domestic market. As of end-2005, it had US$5.5 billion of marketable debt outstanding (US$3.5 billion abroad and US$2.1 billion in the domestic market). Total marketable central government debt was equivalent to 4.7 percent of GDP. The central government also had US$3.2 billion of non-marketable promissory notes outstanding, held on the central bank’s balance sheet.

  • CODELCO.The state-owned copper company CODELCO, a high quality credit, helps provide benchmarks in the external market.4 It is a natural issuer abroad, given the source of its revenues, and provides a credible benchmark for other Chilean corporate issuers. At end-2005, it had 5 bullet bonds outstanding in the external markets, with residual maturities ranging from 3 years (2009) to 30 years (2035) and total value outstanding of US$2.2 billion. In the domestic market, it had 2 inflation-indexed bullet bonds outstanding, equivalent to US$0.5 billion. The presence of CODELCO in the international market reduces the need for the government to provide a benchmark in these markets, giving it flexibility to focus its issuance in the domestic market.

B. The Current Conjuncture

3. The central government is projected to continue enjoying fiscal surpluses in the years ahead, raising the question of how best they should be used. A number of options are available, some with consequences for the stock of public debt. In recent years, the government has used part of its surpluses to prepay debt, however its room to prepay more debt is now limited. Other options include recapitalizing the central bank or investing the funds to meet future government liabilities. Prepaying debt or recapitalizing the central bank could lead to a significant reduction in the stock of marketable public debt.

4. In effect, the government has chosen a mix of alternatives. The government plans to gradually recapitalize the central bank, at a rate of ½ percent of GDP a year, will invest 0.2–0.5 percent of GDP to meet future public pension liabilities, and invest any residual surpluses in the Fund for Economic and Social Stabilization (FESS). This choice will tend to preserve the stock of public debt at current levels, giving rise to an ongoing need for the government to refinance existing debt.

5. This approach is similar to that adopted in other countries facing fiscal surpluses. These countries have chosen to maintain a stock of public debt, on the basis that there is a need for the government to provide a risk-free benchmark to support the broader financial markets. Consequently, any fiscal surpluses have generally been invested, with the existing stock of debt rolled over:

  • In Australia, the government has determined that the general level of interest rates in the economy would be higher in the absence of government debt. This position is consistent with findings on the U.S. Treasuries market in Shinasi, et al (2001) that a reduced stock would increase transactions costs and lead to a higher cost of funding for the private sector. Wolfnilower (2000) also found that a reduction in the availability of U.S. Treasuries would lead to a reduction in the supply of private capital to the fixed-income markets and an increase in the cost of financing. Consequently, Australia is committed to maintaining sufficient benchmark bonds to support the market, concentrating its issuance in bonds eligible for delivery into interest rate futures contracts.

  • Norway has continued to issue debt, despite the existence of a fund where the surpluses invested by the government exceed 100 percent of GDP. Fiscal surpluses in Norway are transferred to the Government Pension Fund (GPF) and fiscal deficits are financed by transfers from the GPF. The Norwegian authorities believe that there is a need to preserve issuance of government securities to: (i) help maintain a liquidity reserve; (ii) support the Norges Bank’s liquidity management operations; and (iii) maintain and develop smoothly functioning and efficient financial markets.

6. More generally, maintaining a presence in the domestic markets will facilitate a country’s access to the market in case of a need for re-entry. If a country needs to re-enter the market because its fiscal situation suddenly deteriorates, it could face significant re-entry costs. The decision to maintain such a presence was, for example, significant in the U.K. government’s decision to maintain a new supply of government bonds during the period 1998–2001 and to explicitly commit to a minimum amount of gross issuance in 2000, in the face of a windfall from the sale of third generation mobile phone licenses (Box 1).

Bond Exchanges and Buybacks: The U.K. Experience, 1998–2001

In response to a decline in financing requirements in 1998–2001, the U.K. Debt Management Office (DMO) introduced innovative operations to build liquidity in new benchmarks in the absence of outright net issuance. These operations helped establish new liquid benchmarks at the 5-, 10-, and 30-year tenors of the nominal curve. Over the period, the DMO issued a total of £46.3 billion of new bonds, relative to an overall decline in the size of the portfolio of £28.9 billion. Three types of operation were used: conversions (four in total); switch auctions (five); and reverse auctions (six).

  • Conversions were fixed price offers where the DMO would set a fixed price ratio, based on its fitted yield curve, at which it was prepared to exchange the source bond for the new benchmark. The intention was to buy back as much of possible of the source bonds, which were generally older, higher coupon, bonds. Smaller-sized bonds were targeted and, to facilitate retail participation, the offer was held open for a period of three weeks.

  • Switch auctions were targeted at larger-sized source bonds. The intention was to switch a small amount of the old bond for the new bond, leaving the old bond with sufficient liquidity. Similar to the exchange offer held by the central bank of Chile in 2002, these operations were structured as an auction. The DMO determined the reference price of the source bond and market participants then submitted bids for the destination bond against that price. Source bonds were determined on the basis of minimizing the duration mismatch with the new benchmark. The auctions were structured as competitive bid price auctions

  • Reverse auctions were held for a basket of bonds, with short residual maturity (below 5 years), that the DMO was prepared to purchase. Offers of eligible bonds were ranked on the basis of whether they were “cheap” to the DMO’s fitted yield curve. The auctions were conducted on a competitive offer price basis and financed through the regular bond issuance program, splitting the connection between the purchase and sale of new bonds.

The DMO also continues to buy back bonds directly in the secondary market at a price of its own determination when they near maturity.

C. A Potential Framework

7. A continuing challenge for the Chilean authorities is how to maximize liquidity in the fixed-income markets, given a broadly stable stock of public debt. In general, several factors contribute to enhancing liquidity in the market, including issuer transparency, regularity of issuance, use of standardized instruments and building of benchmarks. Jeanneau and Verdia (2005) discuss how the successful increase in liquidity in the Mexican government bond market can be attributed to the decision by the Secretaria de Hacienda y Crédito Público to develop and follow a clear and comprehensive public debt management strategy (Box 2).

Improving Liquidity in the Government Bond Market: The Mexican Experience

Liquidity in the Mexican government bond market has improved significantly since the late 1990s, reflecting in large part actions undertaken by the Secretaria de Hacienda y Crédito Público to develop a comprehensive public debt management strategy. The Mexican government debt is now one of the most actively traded local debt markets, bid-offer spreads on benchmarks have narrowed, and bid dispersion in auctions has declined. This strategy included five key elements:

  • A shift to the financing of fiscal deficits in the domestic market;

  • Lengthening the maturity structure of government debt;

  • A commitment to the development of a liquid domestic yield curve;

  • Greater predictability and transparency in operations; and

  • Structural initiatives to strengthen the market, including reducing the time taken to announce the results of auctions; introducing market makers; creating a securities lending facility for market makers at the Bank of Mexico; and promoting authorized price vendors to disseminate prices and strengthen valuation.

8. While the Chilean central bank has set out an explicit objective for its debt management, there is still a need for the central government to do so. The stated objective of the central bank is to manage its debt in order to minimize financing costs, with limited financial risks, and to the extent possible, contribute to the development of the financial market. By contrast, the finance ministry has not announced a specific objective with respect to its debt management, which hinders its ability to communicate effectively with the market. In 2003, for example, the ministry began issuing 20-year inflation-indexed bonds (BTUs) but there is uncertainty in the market about the prospects for supply in 2006 and beyond. Similarly, in 2005 the finance ministry issued a 10-year BTU but without any clear commitment to future issuance, thus forcing the central bank to resume issuance to ensure a continued supply of bonds at this key maturity point.

9. To reduce fragmentation, the finance ministry and the central bank should design and publish a coordinated calendar of issuance. The current calendar of the central bank suggests that it would take 6–24 months to fully establish new benchmarks (6-12 months for the 2- and 5-year segments and 12–24 months for the 10-year segment). Committing to a minimal issuance plan, which would involve introducing new 2- and 5-year benchmarks every year and longer-term benchmarks at least every other year, appears feasible going forward (in Australia, new benchmarks are introduced every other year).

10. Issuance should be concentrated at the current benchmark points of both the peso and inflation-indexed yield curves. To maximize the positive impact on the fixed-income market, issuance should be focused on the standard bullet bonds recently introduced by the central bank. These provide the basis for the swaps market and facilitate the measurement of the yield curve. Benchmarks exist at the 2-, 5-, and 10-year tenors of the peso curve. When market conditions permit, a 20-year peso bond could be considered. Over time, this will increase the stock of peso-denominated bullet bonds in the market, enhancing liquidity in the peso swap market and facilitating greater peso issuance by the corporate sector. With respect to indexed bonds, the authorities should concentrate on the 5-, 10- and 20-year tenors, which are key maturities for the life insurance industry and the pension funds.

11. The authorities should aim at building a smooth redemption profile, to ensure that there is sufficient debt amortizing in any one year to support their issuance pattern. This will require the authorities to continue with active management of the debt portfolio, including exchanging off-the-runs for new on-the-runs when opportunities present themselves. Similar exchange operations have been effective in many countries, particularly in Europe, in helping build new benchmarks rapidly.5 In addition, this mechanism could support the redistribution of amortizations, helping smooth the overall redemption profile. At the central bank, refinancing longer-dated PRCs through exchanges may provide additional scope to issue more of the newer benchmarks.6 A buyback program could also be considered.

12. Any program of exchanges or buybacks should aim for cost neutrality, preferably under an auction format. In late 2002, the central bank effectively piloted such a program of debt exchange. Banks active in the swaps market expressed a strong interest in such operations. At present, these banks need to use a portfolio of assets of similar duration to hedge their exposures. Increasing the supply of standard bullet bonds at key maturities would enhance their hedging effectiveness in the swaps market. To ensure cost-effectiveness, the authorities could consider using a competitive price auction format, rather than the standard uniform price format used for outright issuance. This would provide a price incentive for market participants, while allowing the authorities to control the overall cost. Initially, the authorities may also want to keep the size of such operations relatively small or allow for some upward flexibility in the size, depending on the quality of bids received. The quality of the bids received in an exchange (or offers in a buyback) should be assessed against the authorities’ internal yield curve.

13. To mitigate costs, the authorities could consider providing a fixed bid in a “shop window” for ad hoc buybacks. Under these arrangements, the Finance Ministry or the central bank could indicate the price at which they would be prepared to buy a specific bond. The price would be determined on the basis of the authorities’ yield curve and could take account of say, the implied price ratio of the bond being purchased relative to the new bond that would be issued, forward to the next planned auction of that new bond. The price would vary from day to day. This could be effected very simply by submitting a limit order to the Bolsa de Comercio de Santiago. Details of stock bought back through this process should be regularly communicated to the market (monthly basis), and the authorities should be transparent about their plans for canceling (and refinancing) such debt.

14. Establishing a framework for structured dialog with market participants would help the authorities explain their plans and decisions. Such a dialog would help provide an appropriate forum to discuss the modalities of any debt exchange operations. Involving the market in the design of the program should enhance the success of the operations. The authorities could also seek market feedback on the desired size and frequency of auctions of the various instruments.

D. Split of Issuance Across Institutions

15. Delivering the minimal issuance plan described above would require a minimum gross issuance of around US$1.5 billion a year. The current amortization profile of existing public debt, both domestic and external, suggests that this could be readily achieved over the next five years (Figure 1). However, given that amortizations are not evenly spread over the years, the authorities might want to use money market instruments or debt exchanges to help distribute issuance more evenly.7

Figure 1.
Figure 1.

Amortization Profile of Total Marketable Public Debt

(As at 31 December 2005, US$ billions)

Citation: IMF Staff Country Reports 2006, 336; 10.5089/9781451807653.002.A003

16. The current stock of central government debt in the market will need to be refinanced. An asset-liability management (ALM) approach to the balance sheet of the government suggests that it should focus its issuance in the domestic market at the long-end of the curves. Given the nature of tax revenues, the main income flow of the government, longer-dated inflation-indexed debt is an attractive instrument from a risk-management perspective, providing beneficial “fiscal smoothing” properties.8 Nominal fixed-rate bonds also perform well from a risk management perspective, providing useful insurance against negative supply-side shocks. Therefore, issuing some longer-dated peso bonds would also be appropriate. Biasing future government issuance at these tenors would complement the continued issuance of central bank liabilities along current lines, providing a long-dated benchmark for the market.

17. The central bank currently issues bullet bonds with a maximum maturity of 10-years. The central bank’s liabilities finance its asset position, principally international reserves, which accounted for 64 percent of its total assets as at end-2005 (74 percent of which were held in short-term or floating rate instruments).9 Within these investment parameters, the central bank aims at minimizing the duration gap with its liabilities. This is facilitated by the current structure of its debt portfolio, with new liabilities biased towards short- and medium-term maturities and with a maximum maturity of 10-years.

E. Conclusion

18. The decision by the government to invest the bulk of its projected fiscal surpluses in financial assets will broadly preserve the stock of public debt at current levels. Within this context, enhancing the liquidity of the market will require an active and creative approach to debt management by the authorities. There will be a need to actively manage the overall redemption profile to ensure that there are sufficient amortizations in any one year to allow a minimal issuance plan. Exchanges and buybacks could also help the authorities establish new benchmarks quickly, with positive externalities for market intermediaries’ risk management capabilities.

19. In an environment of limited issuance, coordination of issuance plans between the central bank and the government will be crucial. This will reduce any uncertainty in the market about the source of future supply and reduce the scope for potential fragmentation of the market. Given the structure of the balance sheet of the respective institutions, such coordination should be possible. Clear communication of these intentions to the market will be imperative in maximizing the impact on liquidity. Ideally, the authorities would establish a regular dialog with market participants to review developments in the public debt markets and to discuss technical factors relating to specific operations.

References

  • Banco Central de Chile, 2005, “Monetary Policy Report: September 2005.”

  • Comley, Blair and David Turvey, 2005, “Debt Management in a Low Debt Environment: The Australian Government’s Debt Management Framework,” Treasury Working Paper.

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  • Economic and Financial Committee on EU Government Bills and Bonds Markets, 2001, “Report on Bond Exchanges and Debt Buybacks: A Survey of Practice by EU Debt Managers.”

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  • Giavazzi, Francesco and Alessandro Missale, 2004, “Public Debt Management in Brazil,” NBER Working Paper No. W10394.

  • Jeanneau, Serge and Carlos Verdia, 2005, “Reducing Financial Vulnerability: The Development of the Domestic Government Bond Market in Mexico,” BIS Quarterly Review.

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  • OECD, 2005, “Advances in Risk Management of Government Debt,” OECD.

  • Schinasi, Garry., Kramer, Charles and Todd Smith, 2001, “Financial Implications of the Shrinking Supply of U.S. Treasury Securities,” IMF Working Paper WP 01/61.

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  • Singh, Manmohan., 2003, “Establishing Debt Benchmarks in Chile: The Role of the Public Sector,” IMF Chile Selected Issues.

  • Wheeler, Graeme., 2004, “Sound Practice in Government Debt Management,” World Bank.

  • Wojnilower, Albert., 2000, “Life Without Treasury Securities,” Business Economics.

  • Zamsky, Steven., 2000, “Diminishing Treasury Supply: Implications and Benchmark Alternatives,” Business Economics.

Appendix I. Management of Government Financial Assets and Liabilities: Selected Cross Country Experience

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See www.aofm.au for full details.

See www.norgesbank.no and www.odin.dep.no/fin for more details.

1

Prepared by Allison Holland, based on the findings of an MFD Technical Assistance mission.

2

Zamsky (2000). This assumes that valuation is made on the basis of discounted cash flows. Maintaining liquidity at key points of the curves will enhance the quality of these prices and implied discount factors, and, thus, the effectiveness of investors’ valuations and resource allocation decisions.

3

The inclusion of the risk-free instrument shifts the location of investors’ efficient frontier, allowing them to achieve a better risk-return outcome.

4

It is currently rated A+ by Standard and Poor’s compared to A for the Government of Chile.

5

See Economic and Finance Committee Working Group on EU Government Bills and Bonds Markets (2001).

6

As at 31 December 2005, PRCs represented approximately 25 percent of the debt portfolio of the Central bank.

7

For example, New Zealand considers the projected budget balance over the following 3-years and then determines the average financing need, taking account of any redemptions. This average financing need provides the basis for their program of issuance. The NZDMO then uses money market instruments to balance the requirements across the years.

8

See OECD (2005) or Wheeler (2004) for a fuller discussion of risk management approaches for public debt managers or Giavazzi and Missale (2005) for an application to the case of Brazil.

9

See BCCh (2005) for a discussion of the central bank’s policies with respect to its international reserves.

Chile: Selected Issues
Author: International Monetary Fund