Accompanying Document to the Guidelines for Public Debt Management
Accompanying Document to the Guidelines for Public Debt Management
1. Recognizing the important role that public debt management can play in helping countries cope with economic and financial shocks, the International Monetary and Financial Committee (IMFC) requested that staff from the IMF and World Bank work together in cooperation with national debt management experts to develop a set of guidelines for public debt management to assist countries in their efforts to reduce financial vulnerability. When the Executive Boards of the IMF and the World Bank endorsed the Guidelines in the Spring of 2001, they requested that the staffs of the two institutions also prepare an accompanying document to the Guidelines containing sample case studies to illustrate how a range of countries from around the world and at different stages of economic and financial development are developing their debt management capacity in a manner consistent with the Guidelines. The experiences of these countries should offer some useful practical suggestions of the kinds of steps that other countries could take as they strive to build their capacity in public debt management.
2. The eighteen case studies presented in this report clearly illustrate the rapid evolution that is taking place in the field of public debt management. In contrast to 15 or 20 years ago, countries are much more focused on managing the financial and operational risks inherent in the debt portfolio than was the case in the past. And the way in which the stock of debt is managed is becoming increasingly sophisticated, especially in those countries that have had histories of excessive debt levels or have experienced shocks associated with the reversal of capital flows. These points are embodied in several over-arching themes that emerge from the country case studies. These themes are highlighted below.
3. The first key theme is that the objectives for managing debt and the institutional framework for meeting these objectives are becoming more formalized. All of the countries surveyed have explicit objectives for managing their debt, which focus on managing the need to borrow at the lowest possible cost over a medium- to long-term time frame. While most countries’ statements of objectives also make explicit reference to the need to manage risks prudently, this is not universal. Even so, the reference to managing costs over the medium- to long-term can be seen as an awareness of the need to avoid taking on dangerous debt structures that might have lower costs in the short-run but could trigger much higher debt service costs in the future. They clearly do not strive to minimize costs in the short-run without regard to risk. Avoiding dangerous debt structures is, of course, easier said than done. In some countries, the costs of borrowing domestically by issuing long-term fixed-rate instruments may simply be too prohibitive in the short run due to weak macroeconomic conditions or because this segment of the market is not functioning well. As a result, many countries are dedicating significant effort and resources towards developing the domestic market for government debt so that down the road they can reduce rollover risk and other market risks in the debt stock, even though the benefits of doing so may only emerge over time, and entail higher debt service costs in the short run.
4. Another aspect of the more formal institutional framework can be seen in the organizational structure underpinning debt management. There is a clear trend towards providing a proper legal framework to support debt management, and centralizing debt management activities as much as possible in one entity, even though the preferred entity varies depending on country circumstances. As circumstances permitted, the countries surveyed took steps to separate the conduct of monetary policy from debt management, while ensuring that there continues to be adequate coordination at the operational level, so that there is appropriate sharing of information on the government’s liquidity flows between debt managers, fiscal, and monetary policy authorities, and so the two activities do not operate at cross-purposes in financial markets. They have also taken a number of steps to clearly specify the roles and responsibilities of those involved in debt management, and subject the conduct of debt management activities to appropriate financial and management controls. This has helped to ensure that appropriate safeguards are in place to manage the operational risks associated with debt management.
5. The more formal institutional framework has also been accompanied by transparency in debt management activities and appropriate accountability mechanisms. Debt managers in all of the case study countries emphasized the need to ensure that the public is fully informed on the government’s financial condition, the objectives governing debt management, and the strategies and modalities employed by debt managers to pursue these objectives. They also make use of a variety of communication vehicles, such as regular formal reports and media announcements, to report on their performance in meeting the objectives laid out for them, and to outline in general terms their plans and priorities for the year ahead. In some countries, their performance in both a financial and broader stewardship sense is also subject to regular external review. This reflects a general consensus among the countries that markets work best, and debt service costs are minimized, when uncertainty regarding the objectives and conduct of debt management and the state of government finances is kept to a minimum.
6. A second key theme relates to the high level of awareness of the importance of risk management of public debt and of a growing consensus for the appropriate techniques for managing risk. Many of the countries surveyed use cash flow modeling for analyzing the costs and risks of different debt strategies, where cost is measured as the expected, or most likely, cost of debt service over the medium- to long-term, while risk is the potential increase or volatility in cost over the same period. One rationale for this is that the cost of debt is best considered in terms of its impact on the government’s budget, and that cash flow measures are a natural way of quantifying this impact. A few countries are beginning to experiment with modeling debt service and macro-variables jointly in order to more directly measure cost and risk of debt relative to the government’s revenues and other expenditures—that is to model the government’s assets and liabilities jointly. In a number of other cases, this asset-liability management or ALM approach has been used in a more limited way by analyzing the risk characteristics of government financial assets (such as foreign exchange reserves) and debt jointly in order to determine the appropriate structure of debt and assets.
7. The management of operational risk is also receiving increased attention. In large part this is addressed by having institutional structures that permit clear assignment of authority and responsibility, operations manuals detailing all important procedures, conflict of interest rules, clear reporting lines, and formal audits. But many debt offices now also have separate middle offices with responsibility for analyzing risk and designing and implementing risk control procedures (some of these same offices also have responsibility for analyzing strategies for managing the costs and risks of debt, although in others, the responsibility for strategic analysis is separate from the risk control unit).
8. Those debt offices, which trade their debt or take tactical risk positions, have particularly strong middle office control structures. The focus on formal risk analysis and control structures is not universal, however, as it depends largely on country circumstances. In the past, the industrial countries seen as leaders in this field also had large and risky debt structures, including a substantial share of foreign currency debt. Consequently, the benefits of taking a more systematic approach to the financial and risk management of the government’s debt were substantial. While others, which have deep and liquid domestic debt markets and consequently little or no foreign currency debt, have a much less risky debt structure and less of a need for a formal strategy for managing debt based on cost/risk tradeoffs. On the other hand, emerging market and developing countries, many of which also have had risky debt structures, had a later start in building the capacity for managing this risk. While some of these countries are now using models and systems which are similar to the industrialized countries, others are still in the process of building this capacity, and while good progress has been made, the experience of the leading practitioners demonstrate that this process can take several years. That said, some countries may not need to build models and systems as sophisticated as those found in the industrial countries because their debt issuance options are narrower and their markets less amenable to statistical analysis. Instead, they should strive to set achievable goals for their models that are limited to the genuinely useful aspects.
9. It also is clear that a lot of financial resources and management time is being devoted to developing the technology and systems needed to perform these tasks. This speaks to the need to ensure that the systems acquired are appropriate to the government’s needs given a country’s stage of development. The systems acquired do not necessarily have to include all of the latest and most sophisticated features—many of the cash flow simulation models used for cost/risk analysis are spreadsheet based. Countries also have pursued the acquisition of technology in different ways, depending on country-specific circumstances. Some have opted to acquire these systems by purchasing commercially available systems that were designed for private sector financial institutions and customizing them to suit their own needs, while others have opted instead to develop their own systems in-house. Some systems are very basic, focusing on the primary needs of debt recording, reporting and analysis, while others are integrated with other cash management, accounting, and budget systems. This highlights the fact that the appropriate technology varies considerably depending on country-specific circumstances, and that many countries are still experimenting to find out which systems work best.
10. A third key theme that emerged from the case studies is the striking convergence in approaches taken by countries to issue debt and promote a well-functioning domestic financial market. Auctions of standardized market instruments are commonly used to issue debt in domestic markets, and debt managers are cognizant of the need to avoid excessive fragmentation of the debt stock if they are to encourage deep and liquid markets for government securities. Where differences exist, they tend to be at the level of execution, such as in terms of the features of instruments issued and the extent to which debt managers are prepared to rely on primary dealers to market their debt to end-investors. Nonetheless, it is important to note that all of the countries surveyed made reference to the advantages of working with market participants in a collaborative fashion to develop their domestic government securities markets and minimize the amount of uncertainty in the market regarding government financing activities. Over time, this appears to be paying off in the form of more efficient domestic financial markets, and ultimately lower borrowing costs for the government, in that the presence of a thriving domestic market makes it easier for debt managers to achieve a debt stock structure that embodies the government’s preferred risk-cost tradeoff.
11. Fourth, it is important to highlight what sound debt management in and of itself cannot deliver. It is no substitute for sound macroeconomic and fiscal policies, and on its own will not be enough to ensure that a country is well insulated from economic and financial shocks. Developing public debt management in a manner consistent with the Guidelines clearly has an important role to play in fostering prudent debt management practices and contributing to the development of a well-functioning market for government securities. However, many countries also stressed the need for a sound macroeconomic policy framework, characterized by an appropriate exchange rate regime, a monetary policy framework that is credibly focused on the pursuit of price stability, sustainable levels of public debt, a sound external position, and a well-supervised financial system. Such a framework is an important underpinning to instilling confidence among financial market participants that they can invest in government securities with a minimum of uncertainty. It is thus an important precondition if debt managers are to succeed in achieving a debt structure that reflects the government’s preferred risk-cost trade-off, and helping the country at large to minimize its vulnerability to economic and financial shocks. Indeed, through their links to financial markets and their risk management activities, government debt managers are well-positioned to gauge the effects of government financing requirements and debt levels on borrowing costs, and to communicate this information to fiscal policy advisors.
12. Finally, while the examples of debt management practices presented in the case studies and the lessons drawn here offer some practical guidance for policymakers in all countries that are striving to strengthen the quality of their public debt management and reduce their country’s vulnerability to economic and financial shocks, they are especially relevant for the HIPCs and less developed transition economies. These are at an earlier stage of developing their capacity in public debt management. For them, in addition to continuing to strengthen their budget and cash management functions, an important priority will be to draw from the experiences outlined in the case studies to build a proper foundation for conducting debt management. In this regard, some important first steps for many of these countries are the need to introduce appropriate governance and institutional structures so that the operational and financial risks associated with debt management are properly managed, to develop information systems that fully capture the financial characteristics of all of the government’s financial obligations and contingent liabilities, and the need to develop a debt strategy that encompasses both domestic and external debt. The latter is especially important, and the experiences of the countries covered by the case studies suggests that the development of a domestic debt market can play an important role over time in helping to broaden the range of borrowing opportunities for a country, and making it easier for it to achieve its desired cost-risk trade-off.
Part I - Implementing the Guidelines in Practice
13. A government’s debt portfolio is usually the largest financial portfolio in the country. It often contains complex financial structures and can create substantial balance sheet risk for the government. Large and poorly structured debt portfolios also make governments more vulnerable to economic and financial shocks and have often been a major factor in economic crises. Recognizing the important role that public debt management can play in helping countries cope with economic and financial shocks, the International Monetary and Financial Committee (IMFC)1 requested that staff from the IMF and World Bank work together in cooperation with national debt management experts to develop a set of guidelines on public debt management to assist countries in their efforts to reduce financial vulnerability. The IMFC’s request, which was endorsed by the Financial Stability Forum, was made as part of a search for broad principles that could help governments improve the quality of their policy frameworks for managing the effects of volatility in the international monetary and financial system.
14. By involving national debt management authorities in the preparation of the Guidelines, the process was one that sought to strengthen countries’ sense of ownership of them and helped to ensure that they are in line with sound practice. Government debt managers from around 30 countries provided input into an initial draft that was discussed by the Executive Boards of the IMF and World Bank in July 2000. Following these discussions, more than 300 representatives from 122 countries attended five outreach conferences on the Guidelines in Abu Dhabi, United Arab Emirates; Hong Kong Special Administrative Region; Johannesburg, South Africa; London, United Kingdom; and Santiago, Chile.2 The feedback provided was taken into account in the final version that was approved by the Executive Boards of the two institutions in March 2001, and endorsed by the IMFC and the Development Committee3 at their Spring meetings in April 2001. Since then, the Guidelines have been available on the IMF and World Bank web sites in five languages (English, French, Spanish, Russian, and Arabic), and a hard copy version was published by the two institutions in September 2001.4 The Guidelines are summarized in Appendix I.
15. In the course of the Board discussions, Executive Directors of the IMF and the World Bank asked the staffs to prepare an accompanying document to the Guidelines that would contain sample case studies of countries that are developing strong systems of public debt management. At the same time, the Boards requested that this report should not expand or add to the Guidelines, but instead delineate the experiences of various countries in the form of case studies. In response, staff from the IMF and World Bank have prepared this document, which contains 18 country case studies to illustrate how a range of countries from around the world and at different stages of economic and financial development are developing their capacity in debt management in a manner consistent with the Guidelines. The diverse nature of the countries represented in the case studies is illustrated by the economic and financial indicators presented in Table 1. The experience of these countries should offer some useful practical suggestions of the kinds of steps that other countries could take as they strive to build their capacity in government debt management.
Selected Macroeconomic and Financial Indicators for Case Study Countries in 2001
Source: IMF World Economic Outlook, Bankscope databases, and IMF staff estimates.
Gross debt as a percent of GDP.
M2 data are not available at the national level for members of the European Monetary Union.
End of fiscal year 2001/2002.
Selected Macroeconomic and Financial Indicators for Case Study Countries in 2001
Source: IMF World Economic Outlook, Bankscope databases, and IMF staff estimates.
Gross debt as a percent of GDP.
M2 data are not available at the national level for members of the European Monetary Union.
End of fiscal year 2001/2002.
16. In line with the process adopted for the Guidelines, the preparation of the Accompanying Document has been one that has sought to foster countries’ sense of ownership of the product, and ensure that the descriptions of individual country practice and the lessons learned are well grounded. The 18 country case studies were prepared by government debt managers coordinated by IMF and World Bank staffs. They cover both their domestic debt management and foreign financing activities. After collecting the information and preparing initial drafts of the case studies, the officials involved in preparing the case studies were invited to an Outreach conference in Washington in September 2002 to discuss the conclusions drawn from the cases by IMF and World Bank staff, and the document as a whole.
A. What Is Public Debt Management and Why Is It Important?
17. Public debt management is the process of establishing and executing a strategy for managing the government’s debt in order to raise the required amount of funding, pursue its cost and risk objectives, and to meet any other public debt management goals the government may have set, such as developing and maintaining an efficient and liquid market for government securities.
18. In a broader macroeconomic context for public policy, governments should seek to ensure that both the level and rate of growth in their public debt is fundamentally sustainable over time, and can be serviced under a wide range of circumstances while meeting cost and risk objectives. Government debt managers share fiscal and monetary policy advisors’ concerns that public sector indebtedness remains on a sustainable path and that a credible strategy is in place to reduce excessive levels of debt. Debt managers should ensure that the fiscal authorities are aware of the impact of government financing requirements and debt levels on borrowing costs.5 Examples of indicators that address the issue of debt sustainability include the public sector debt service ratio, and ratios of public debt to GDP and to tax revenue.6
19. Every government faces policy choices concerning debt management objectives, its preferred risk tolerance, which part of the government balance sheet those managing debt should be responsible for, how to manage contingent liabilities, and how to establish sound governance for public debt management. On many of these issues, there is increasing convergence in the global debt management community on what are considered prudent sovereign debt management practices that can also reduce vulnerability to contagion and financial shocks. These include: (i) recognition of the benefits of clear objectives for debt management; (ii) weighing risks against cost considerations; (iii) the separation and coordination of debt and monetary management objectives and accountabilities; (iv) a limit on debt expansion; (v) the need to carefully manage refinancing and market risks and the interest costs of debt burdens; (vi) the necessity of developing a sound institutional structure and policies for reducing operational risk, including clear delegation of responsibilities and associated accountabilities among government agencies involved in debt management; and (vii) the need to carefully identify and manage the risks associated with contingent liabilities.
20. Public debt management problems often find their origins in the lack of attention paid by policymakers to the benefits of having a prudent debt management strategy and the costs of weak macroeconomic management and excessive debt levels. In the first case, authorities should pay greater attention to the benefits of having a prudent debt management strategy, framework, and policies that are coordinated with a sound macro policy framework. In the second, inappropriate fiscal, monetary, or exchange rate policies generate uncertainty in financial markets regarding the future returns available on local currency-denominated investments, thereby inducing investors to demand higher risk premiums. Particularly in developing and emerging markets, borrowers and lenders alike may refrain from entering into longer-term commitments, which can stifle the development of domestic financial markets, and severely hinder debt managers’ efforts to protect the government from excessive rollover and foreign exchange risk. A good track record of implementing sound macropolicies can help to alleviate this uncertainty. This should be supplemented with appropriate technical infrastructure—such as a central registry and payments and settlement systems—to facilitate the development of domestic financial markets.
21. In addition, poorly structured debt in terms of maturity, currency, or interest rate composition and large and unfunded contingent liabilities have been important factors in inducing or propagating economic crises in many countries throughout history. For example, irrespective of the exchange rate regime, or whether domestic or foreign currency debt is involved, crises have often arisen because of an excessive focus by governments on possible cost savings associated with large volumes of short-term or floating rate debt. This has left government budgets seriously exposed to changing financial market conditions, including changes in the country’s creditworthiness, when this debt has to be rolled over. Foreign currency debt also poses particular risks, and excessive reliance on foreign currency debt can lead to exchange rate and/or monetary pressures if investors become reluctant to refinance the government’s foreign-currency debt. By reducing the risk that the government’s own portfolio management will become a source of instability for the private sector, prudent government debt management, along with sound policies for managing contingent liabilities, can make countries less susceptible to contagion and financial risk.
22. The size and complexity of a government’s debt portfolio often can generate substantial risk to the government’s balance sheet and to the country’s financial stability. As noted by the Financial Stability Forum’s Working Group on Capital Flows, “recent experience has highlighted the need for governments to limit the build-up of liquidity exposures and other risks that make their economies especially vulnerable to external shocks.”7 Therefore, sound risk management by the public sector is also essential for risk management by other sectors of the economy “because individual entities within the private sector typically are faced with enormous problems when inadequate sovereign risk management generates vulnerability to a liquidity crisis.” Sound debt structures help governments reduce their exposure to interest rate, currency and other risks. Sometimes these risks can be readily addressed by relatively straightforward measures, such as lengthening the maturities of borrowings and paying the associated higher debt servicing costs (assuming an upward sloping yield curve), adjusting the amount, maturity, and composition of foreign exchange reserves, and reviewing criteria and governance arrangements for contingent liabilities.
23. There are, however, limits to what sound debt management policies can deliver in and of themselves. Sound debt management policies are no panacea or substitute for sound fiscal and monetary management. If macroeconomic policy settings are poor, sound sovereign debt management may not by itself prevent any crisis. Even so, sound debt management policies can reduce susceptibility to contagion and financial risk by playing a catalytic role for broader financial market development and financial deepening.
B. Purpose of the Guidelines
24. The Guidelines are designed to assist policymakers in considering reforms to strengthen the quality of their public debt management and reduce their country’s vulnerability to domestic and international financial shocks. Vulnerability is often greater for smaller and emerging market countries because their economies may be less diversified, have smaller bases of domestic financial savings (relative to GDP), and less developed financial systems. They could also be more susceptible to financial contagion, if foreign investor exposures are significant, through the relative magnitudes of capital flows. As a result, the Guidelines should be considered within a broader context of the factors and forces affecting a government’s liquidity more generally, and the management of its balance sheet. Governments often manage large foreign exchange reserves portfolios, their fiscal positions are frequently subject to real and monetary shocks, and they can have large exposures to contingent liabilities and to the consequences of poor balance sheet management in the private sector. However, irrespective of whether financial shocks originate within the domestic banking sector or from global financial contagion, prudent government debt management policies, along with sound macroeconomic and regulatory policies, are essential for containing the human and output costs associated with such shocks.
25. The Guidelines cover both domestic and external public debt and encompass a broad range of financial claims on the government. They seek to identify areas in which there is broad agreement on what generally constitutes sound practices in public debt management. The Guidelines endeavor to focus on principles applicable to a broad range of countries at different stages of development and with various institutional structures of national debt management. They should not be viewed as a set of binding practices or mandatory standards or codes. Nor should they suggest that a unique set of sound practices or prescriptions exists, which would apply to all countries in all situations. The Guidelines are mainly intended to assist policymakers by disseminating sound practices adopted by member countries in debt management strategy and operations. Their implementation will vary from country to country, depending on each country’s circumstances, such as its state of financial development. Heavily Indebted Poor Countries (HIPCs) face special challenges in this regard.8 The terms and conditions surrounding debt relief provided to them typically include provisions that focus on the need to improve debt management practices in ways that are consistent with the Guidelines (Box 1).
Applying the Guidelines to HIPCs
The Heavily Indebted Poor Countries (HIPC) Initiative was launched by the World Bank and IMF in 1996 (and later enhanced in 1999) as a comprehensive effort to eliminate unsustainable debt in the world’s poorest, most heavily indebted countries. Through the provision of debt relief to eligible HIPCs that show a strong track record of economic adjustment and reform, the Initiative was designed to help these countries achieve a sustainable debt position over the medium term. Insufficient attention paid to public debt management is widely thought to have been one of the most important factors that contributed to the accumulation of unsustainable levels of debt in these countries. Together with sound overall macroeconomic policy settings, prudent debt management in the HIPCs remains central to ensuring a durable exit from the unsustainable debt burden.
A recent survey by staffs of the World Bank and the IMF revealed that several very important weaknesses continue to exist in key aspects of debt management in the HIPCs, notably in the design of their legal and institutional frameworks, coordination of debt management with macroeconomic policies, new borrowing policy, and in the human and technical requirements for performing basic debt management functions.1/ In the area of the legal framework, while most HIPCs have an explicit legal instrument governing the debt office and its functions, the legal framework is not always clearly defined and adequately implemented. In addition, transparency and accountability in debt management, including public access to debt information, requires strengthening. Institutional responsibilities for debt management in many HIPCs are also not clearly defined and coordinated. Moreover, their debt management activities are undermined by a number of institutional weaknesses and low implementation capacity due to insufficient human, technical, and financial resources. To overcome these difficulties, a first step could be to implement clear and transparent legal and institutional frameworks. The Guidelines and the governance lessons drawn from the case studies can help HIPCs strengthen their legal and institutional frameworks for debt management. For example, they highlight some ways in which borrowing authority can be delegated from the Parliament and the Council of Ministers to debt managers with appropriate accountability mechanisms, the merits of centralizing debt management activities in a single unit, and some ways in which appropriate controls can be introduced to manage the operational risks associated with debt management activities. And, they illustrate how some countries have taken steps to obtain more control over contingent liabilities issued in the name of the government.
Regarding policy coordination, the survey showed that less than half of HIPCs have in place a comprehensive forward-looking strategy focused on medium-term debt sustainability. Many do not conduct a debt sustainability analysis on a regular basis, and very little coordination of information between debt offices and other agencies involved in macroeconomic management takes place. Clearly, coordination of debt management with macroeconomic policies, as well as regular conduct of debt sustainability analysis are critical, not only as part of the requirements for the HIPC process, but also if these countries are not to relapse into an unsustainable debt position. In particular, close coordination between the budget, cash management, planning functions, and the debt management office is essential. Again, the Guidelines and the lessons drawn from the case studies provide some insights into how they can develop debt management strategies that pay attention to the medium-to-long term implications of economic policies, and the resulting implications for debt sustainability. For example, they show how various countries have built linkages between debt managers, cash managers, and monetary and fiscal policymakers to ensure that relevant information is shared on a regular basis, and that their respective policies and operational activities are appropriately coordinated.
Unsustainable debt burdens in HIPCs have, in the past, also resulted from unsound policies regarding new borrowing even after benefiting from concessions, including rescheduling. To date, up to two-thirds of these countries still do not have in place a sound policy framework for new borrowing, a direct consequence of the fact that they have yet to develop a comprehensive debt strategy, and many lack complete information on the total debt they have incurred or guaranteed. Moreover, even though domestic debt is becoming an important aspect of fiscal sustainability in some low-income countries, including HIPCs, underdeveloped domestic financial markets seriously limit the role of domestic debt in most HIPCs. If they are to ensure long-term sustainability beyond the HIPC completion point, however, they need to develop borrowing strategies that are clear, transparent and enforceable and begin to develop a domestic debt market so that they can broaden the range of borrowing options available to them. The Guidelines and the case studies offer some lessons on how they could implement a framework that could not only be used by them to develop an overall debt management strategy—including sound new borrowing policies—and develop their domestic debt markets, but would also allow debt managers in these countries to identify and manage the trade-offs between the expected costs and risks in the government debt portfolio. For example, they highlight the benefits of using an asset-liability management (ALM) approach to assessing the debt service costs of different borrowing strategies in tandem with the financial characteristics of government revenues, expenditures, and financial assets. They encourage debt managers to stress test the results obtained so that debt strategy decision-makers have an understanding of how the chosen strategy will perform in a variety of economic and financial settings. And, they note how increased transparency in debt management activities and the choice of borrowing instruments can be used to promote the development of a liquid market for domestic government securities.
To be able to develop strong systems for debt management in a manner consistent with the Guidelines, HIPCs will continue to need technical assistance to build their debt management capacity. Long-term debt sustainability should be viewed not only in relation to the debt burden but also in terms of the structures, processes and management information services required to manage the debt burden effectively. The HIPC process itself recognizes this by focusing on, among other things, the technical assistance requirements of HIPCs reaching the decision point. At the same time, the countries themselves must supplement the assistance efforts by ensuring that there are adequate numbers of motivated staff in debt offices that could benefit from technical assistance. In addition, full political support is critical to the success of any efforts to strengthen debt management capacity.
In general, while the Guidelines and the lessons drawn from the case studies should be useful for all countries striving to develop their policy frameworks and capacity for debt management, they are particularly relevant for HIPCs. For them, the Guidelines and lessons drawn can not only facilitate achievement of the decision and completion points of the HIPC process, more importantly they can help ensure that debt sustainability is maintained for many years to come.
1/ See External Debt Management in Heavily Indebted Poor Countries, Board Discussion Paper, IDA/ SecM2002-0148, Washington D.C., 2002.
26. Building capacity in sovereign debt management can take several years and country situations and needs vary widely. Their needs are shaped by: the capital market constraints they face; the exchange rate regime; the quality of their macroeconomic, fiscal, and regulatory policies; the effectiveness of the budget management system; the institutional capacity to design and implement reforms; and the country’s credit standing. Capacity building and technical assistance therefore must be carefully tailored to meet stated policy goals, while recognizing the policy settings, institutional framework, technology, and human and financial resources that are available. The Guidelines should assist policy advisors and decision makers involved in designing debt management reforms as they raise public policy issues that are relevant for all countries. This is the case whether the public debt comprises marketable debt or debt from bilateral or multilateral official sources, although the specific measures to be taken will differ, to take into account a country’s circumstances.
II. Lessons from the Country Case Studies
27. This chapter pulls together the main lessons from the 18 country case studies contained in Part II of the document plus the results of a survey of debt management practices, summarized in Table 2, to show how many countries at different stages of economic and financial developments are developing their public debt management practices in a manner consistent with the Guidelines. The aim is to highlight the different ways in which countries can improve their debt management activities by illustrating the variety of ways that the key principles contained in the Guidelines have been implemented in practice. References to specific practices contained in the case studies demonstrate how the Guidelines are applied; further details on individual country practices can be found in the country cases in Part II of the document. Implications of these practices for countries seeking to improve their own debt management capabilities are also discussed. The conclusions are grouped in accordance with the six sections of the Guidelines: objectives for debt management and coordination with fiscal and monetary policies; transparency and accountability for debt management activities; institutional framework governing debt management activities; debt management strategy; the framework used for managing risks; and developing and maintaining an efficient market for government securities.
Survey of Debt Management Practices
Note: Percentages are computed on the basis of the number of responses to each question, since some countries did not answer all of the questions.
Survey of Debt Management Practices
Annual borrowing authority
Debt ceiling limit
Domestic and foreign currency debt programs managed together
Separate debt agency
Separate front and back offices
Separate Risk Management Unit (middle office)
Formal guidelines for managing market and credit risk
Annual debt management reports
Regular external peer reviews of debt management activities
Annual audits of debt management transactions
Code-of-Conduct and conflict of interest guidelines for debt management staff
Business recovery procedures in place
Stress test of market risk exposures
Trading conducted to profit from expected movements in interest or exchange rates
Government cash balances managed separately from debt
Foreign currency borrowing integrated with foreign exchange reserves management
Specialized management information technology in place for risk management
Primary Market Structure for Government Debt
Auctions used to issue domestic debt
UP = Uniform price
MP = Multiple price
Fixed-price syndicates used to issue domestic debt
Benchmark issues for domestic market
Pre-announced auction schedule
Central bank participates in the primary market
- only on a non-competitive basis
Primary dealer system
Universal access to auctions
Limits on foreign participation
Collective Action Clause, domestic issues
Collective Action Clause, external issues
Secondary Market for Government Debt
Over-the-counter (OTC) market
Exchange-traded market mechanism
Clearing and settlement systems reflect sound practices
Note: Percentages are computed on the basis of the number of responses to each question, since some countries did not answer all of the questions.
A. Debt Management Objectives and Coordination
28. The guidelines in this section address the main objectives for public debt management, the scope of debt management, and the need for coordination between debt management and monetary and fiscal policies. They encourage authorities to consider the risks associated with dangerous debt strategies and structures when they set the objectives for debt managers, and suggest that debt management should encompass the main financial obligations over which the central government exercises control. Given the importance of ensuring appropriate coordination between debt management, fiscal, and monetary policies, they recommend that authorities share an understanding of the public policy objectives in these domains. They also promote the sharing of information on the government’s current and future liquidity needs, but argue that where the level of financial development allows, there should be a separation of debt management and monetary policy objectives and accountabilities.
29. The objectives governing debt management in all 18 countries emphasize the need to ensure that the government’s financing needs and its payment obligations are met at the lowest possible cost over the medium to long run. However, while most countries’ statement of objectives makes explicit references to the need to manage risks in a prudent fashion, this is not universal. For example, the goals governing debt management in the U.S. emphasize the need to “meet the financing needs of the government at the lowest cost over time.” Similarly, Jamaica’s objectives are defined as “to raise adequate levels of financing on behalf of the Government of Jamaica at minimum costs, while pursuing strategies to ensure that the national public debt progresses to and is maintained at sustainable levels over the medium term.” Even though no explicit reference is made to the need to manage risks in a prudent fashion, these countries do not simply strive to minimize costs in the short-run without regard to risk.
30. Many countries also promote the development and maintenance of an efficient primary and secondary market for domestic government securities as an important complementary objective for debt management. In the short-run, governments may have to accept higher borrowing costs as they seek to develop a domestic market for their securities. However, most governments are willing to incur these costs because they expect that over time they will be rewarded with lower borrowing costs as the domestic market matures and becomes more liquid across the yield curve. In turn, this also should help them achieve a less-risky debt stock, since a well-functioning domestic market would enable them to issue a larger share of their debt in longer-term, fixed-rate domestic currency-denominated securities, and thus, reduce interest rate, exchange rate, and rollover risks in the debt stock.9 For example, countries such as Brazil, Jamaica, Morocco, and South Africa have focused on the need to develop the domestic debt market as a means of lessening dependence on external sources of financing. And even when this objective is not explicitly included in the list of objectives governing debt management, in practice debt managers play an active role in developing the domestic government securities market. An example in this regard is the active role played by debt managers in many countries in working with market participants to introduce electronic trading in their domestic government debt markets.
31. Developing the market for government securities can also help to stimulate the development of domestic markets for private securities. For example, in Japan the development of the secondary market for government securities is considered to be an important objective for debt management because this market, by virtue of being low credit risk, serves as the foundation for domestic financial markets, and is by far the most actively traded segment of the domestic bond and debenture market.
32. Debt management activities in most countries surveyed encompass the main financial obligations over which the central government exercises control. Where differences arise, they tend to be over the extent to which debt managers play a role in managing: retail debt issued directly to households (e.g., non-marketable savings instruments); contingent liabilities; debt issued by sub-national governments; and also on the extent to which foreign currency debt management is integrated with domestic debt management. For example, in the U.K., the wholesale and retail debt programs are managed by separate agencies, while in the U.S., both debt programs are managed by a single group. In Ireland, the management of explicit contingent liabilities is handled by the Ministry of Finance (Exchequer), while wholesale debt funding is managed by the debt management agency, whereas in Colombia and Sweden, debt managers play an active role in the management of explicit contingent liabilities. The Colombian approach reflects, in part, a response to past experience where these obligations had grown rapidly due to weak oversight and inappropriate pricing. In the latter two countries, involving debt managers in the valuation of explicit contingent liabilities enabled governments to tap the expertise needed to price them in a more rigorous fashion.
33. Most national debt managers do not play a role in the management of debt issued by other levels of government, since the national governments typically are not liable for debts incurred by those governments. The U.S. is a good example in this regard. However, in Colombia and India, debt managers are actively involved in the management of debt at both national and sub-national levels of government. In the case of Colombia, difficulties encountered by some other Latin American countries due to excessive borrowing by sub-national governments led federal debt managers to set limits on sub-national government borrowing in order to ensure that the financial condition of these governments do not undermine the health of federal finances. In India, the involvement of the central bank in the management of the debts of the states is a voluntary contractual arrangement that enables the states to access the debt management expertise and resources that exist within the central bank.
34. Even if national debt managers are not directly involved in the management of debt issued by other levels of government, recent financial crises have shown that these debts can contribute to financial instability. Thus, the national government in some countries, such as Italy, require other levels of government to provide it with information on their borrowing activities. And, situations can arise where the national government may need to play a role in managing these debts even if it does not directly involve the national debt managers. For example, when the Brazilian central government refinanced debts issued by Brazilian states in 1997 and municipalities in 1999, as a condition of these refinancing programs, the Brazilian Treasury established contracts with these sub-national borrowers. These contracts have strict rules on sub-national spending and new borrowings. Adherence to these rules and those governments’ fiscal situations are regularly monitored by the Treasury.
Coordination with monetary and fiscal policies
35. The industrial countries have advanced the furthest in separating the objectives and accountabilities of debt management from those of monetary policy and introducing appropriate mechanisms for sharing information between debt managers and the central bank on government cash flows. This is most evident for those countries surveyed that are members of the European Monetary Union (EMU), since monetary policy is conducted by the European System of Central Banks (ESCB), while debt management is conducted by the national authorities, thereby minimizing the risk of possible conflicts of interest between debt management and monetary policy. Reinforcing the separation of debt management from monetary policy in the EMU are provisions in the Maastricht Treaty, which prevent governments from borrowing from their national central banks, and debt limits, which foster debt sustainability. And, there are appropriate information-sharing mechanisms in place to ensure that the national central banks have the information they need on their governments’ liquidity flows so that they and the European Central Bank can work together to manage the amount of liquidity circulating in the eurosystem. For example, in Italy debt managers from the Italian Treasury continuously monitor and formulate projections of expected government cash flows, taking into account the usual annual cyclical and extraordinary patterns of revenues and expenditures. In addition, debt managers and the Bank of Italy regularly exchange information on the movements of cash in and out of the cash account that the Treasury holds with the Bank, through which most government cash flows are channeled. Only the Treasury is authorized to transact through this account in order to ensure proper financial control over the government’s finances.
36. The industrialized countries surveyed have also taken steps to ensure that debt managers and central banks coordinate their activities in financial markets so that they are not operating at cross-purposes. In the U.K., for example, the Debt Management Office avoids holding auctions at times when the Bank of England is conducting money market operations, and does not hold reverse repo tenders at the 14-day maturity range. It also does not conduct ad hoc tenders on days when the Bank’s Monetary Policy Committee is announcing its interest rate settings. However, these restrictions do not apply to bilateral operations conducted by the DMO owing to their relatively low market profile compared to auctions. An example of what can happen when there is insufficient coordination at an operating level was cited by one country at the Outreach conference. It admitted that a past failure to coordinate activities between the central bank and debt managers in financial markets led to an awkward situation where the Ministry of Finance was repaying foreign currency debt at the same time as the central bank was in need of foreign exchange reserves.
37. Industrial countries have also found ways to deal with the potential conflicts that can arise between central banks and debt managers when central banks seek to use government securities in their open market operations. This issue is especially acute when government borrowing requirements are modest or non-existent, but the central bank needs a large volume of low-risk assets for use in implementing monetary policy. In the EMU, for example, the ESCB has developed a broad list of public and private securities that it is willing to use in its open market operations so as to avoid the need to rely strictly on government securities. Similar steps have also been taken by central banks in the other industrial countries surveyed.10
38. The coordination challenges are more acute for emerging market and developing countries that do not have well-developed financial markets. The lack of central bank independence and the absence of well-developed domestic markets makes it difficult for them to wean governments off of central bank credit. It also makes it difficult to separate debt management and monetary policy objectives because both activities often need to rely on the same market instruments and are forced to operate at the short end of the yield curve.
39. Many countries, such as Poland, have also experienced difficulties in projecting government revenues and expenditures,11 and in establishing appropriate coordination mechanisms and information sharing arrangements between the Ministry of Finance and the central bank.12 Nonetheless, some have taken important steps towards ensuring proper coordination between debt management and monetary policy activities. For example, in Brazil and Colombia, debt managers and central bankers regularly meet to share information and construct projections of the government’s current and future liquidity needs.13 In Mexico, debt management, fiscal policy, and monetary policy are formulated using a common set of economic and fiscal assumptions. Moreover, the Mexican central bank acts as the financial agent of the government in many transactions. This helps to cement a continuous working relationship in Mexico between fiscal, debt management, and monetary policy authorities, and to foster the appropriate sharing of information. In Slovenia, the central bank is given an opportunity to comment ahead of time on the annual financing program contained within the fiscal documents, and the government is legally prohibited from borrowing directly from the central bank. In addition, under a formal agreement the Slovenian Ministry of Finance supplies the central bank with regularly updated forecasts of projected day-to-day cash flows of all government revenues and expenditures over a one and three month horizon. Officials from both institutions also meet regularly to share information on the technical details regarding the implementation of their respective policies.
40. Among other emerging market countries, in Jamaica, for example, the transfer of debt management activities from the central bank to the Ministry of Finance and Planning has resulted in greater coordination of fiscal policy and debt management activities, and, as in many countries, has also allowed for a more clearly defined set of debt management objectives that are determined independently of monetary policy considerations. At the policy level, there are regular meetings between senior officials of the planning authorities—the Ministry of Finance and Planning, the Bank of Jamaica, the Planning Institute of Jamaica, and the Statistical Institute of Jamaica—to ensure consistency in government’s economic and financial program. At the technical level there are regular weekly meetings where information is shared on the government’s liquidity requirements and borrowing programs, as well as on current monetary conditions and developments in financial markets. In India, the requisite coordination among debt management, fiscal, and monetary policies is achieved through various regular meetings within the central bank, as well as through regular discussions between central bank and Ministry of Finance staff on the government’s fiscal situation and the implications for borrowing requirements. In addition, debt management officials attend the monthly monetary policy strategy meeting, and there is an annual pre-budget exercise that seeks to ensure consistency between the monetary and fiscal programs (at both the central and state government levels). However, the Indian authorities believe that a formal separation of debt management from monetary policy in the future would depend on: (i) the development of domestic financial markets; (ii) the achievement of reasonable control over the fiscal deficit; and (iii) legislative changes. In Morocco, the Treasury and External Finance Department, which is responsible for debt management, participates actively in defining the orientations of the budget law, particularly the level of the budget deficit and the resources to cover it.
41. The introduction of appropriate well-articulated objectives for debt management is an important step that can be introduced by any country regardless of its state of economic and financial development. Indeed, in recent years many countries have introduced objectives that explicitly mention the need to manage risks as well as achieve low funding costs for the government, or at least make clear that the focus on costs is over a medium to long-run horizon so that debt managers are not tempted to pursue short-term debt service cost savings at the expense of taking on dangerous debt structures that expose them to a higher risk of sovereign default. Highlighting the cost-risk trade-off in the objectives can be a useful way of anchoring ensuing discussions on debt management strategy and the execution of borrowing decisions.
42. Country circumstances, such as the state of domestic financial markets and the degree of central bank independence, play an important role in determining the range of activities that are handled by debt management, and the extent to which debt management and monetary policy objectives and instruments can be separated. Coordination between the budget management and debt management functions is crucial. This is particularly the case in transition and developing economies, where the lack of capacity in accurately forecasting government revenues and expenditure flows means that coordination on government liquidity requirements and day-to-day cash flows needs to be frequent and well-structured. Nonetheless, as shown above, there are many steps that countries can take to build appropriate coordination mechanisms over time regardless of their state of economic and financial development.
43. Particularly for developing and emerging market countries, it is important to have good coordination between the fiscal policy advisors and the debt management function. The debt managers’ role here is to convey their views not only on the costs and risks associated with government financing requirements, but also the financial market’s views on the sustainability of the government’s debt levels.
B. Transparency and Accountability
44. The guidelines in this section argue in favor of disclosing the allocation of responsibilities among those responsible for executing different elements of debt management, the objectives for debt management, and the measures of cost and risk that are used. They also encourage countries to disclose materially important aspects of debt management operations and information on the government’s financial condition and its financial assets and liabilities, and highlight the need to ensure that debt management activities are audited in order to foster proper accountability.
Clarity of roles, responsibilities, and objectives offinancial agencies responsible for debt management
45. In many industrial countries the objectives for debt management and the roles and responsibilities of the institutions involved are explicitly stated in the laws governing debt management activities. This information often also is published in annual reports prepared by debt management authorities and on official web sites. Indeed, as indicated in Table 2, fifteen countries reported that they produce annual debt management reports. Among emerging market and developing countries one finds less formal ways to disclose these items. In Morocco, for example, the Minister of Economy and Finance announces the objectives for debt management each year at an annual press conference, while Slovenia announces the goals and instruments for debt management in the annual Financing Program and other policy documents, which are available on government web sites.
46. Not all countries in the survey set specific targets for risk (such as targets for duration and currency composition)—the results in Table 2 suggest that about one-third, including Japan and the U.S. do not—but most of those that do disclose them. For example, Brazil’s benchmark targets are publicly disclosed in the government’s annual borrowing program, which also provides a comprehensive overview of debt management activities and the government’s financial situation. Denmark publishes its targets in a special announcement to the stock exchange and as part of its annual report, while Sweden’s targets are published in the annual debt management guidelines given to the Swedish National Debt Office (SNDO) by the Government (Cabinet) before the start of the fiscal year. In the case of Italy, public disclosure of strategic cost/risk analysis is at an early stage of development; however, current versions are available on the Italian Treasury’s web site.
Public availability of information on debt management policies
47. All countries disclose materially important aspects of their debt management operations and information on the government’s financial condition and its financial assets and liabilities. The Italian Treasury, for example, maintains an extensive web site that includes information on the government’s annual auction calendar; the quarterly issuing program; tender announcements; auction results; and information on government securities and the primary dealers in Italian government securities markets.
48. Among emerging market countries, the Jamaican government’s debt strategy is presented to Parliament at the start of the fiscal year in the form of a Ministry Paper that has widespread public distribution and is available on the Ministry’s web site. Comprehensive information on Jamaica’s debt is also available on the web site. In addition, the rules for participating in primary debt auctions are widely disclosed, and notices for future domestic debt issues and auction results are reported through print and electronic media and on the Ministry’s web site. In India, an auction calendar was introduced in April 2002, which has improved the transparency of the borrowing program. In addition, the Reserve Bank of India regularly disseminates statistical information on the primary and secondary markets for government securities, and began disseminating data on trades in government securities on a real-time basis through its web site in October 2002. In Morocco, the Minister of Economy and Finance’s annual press conference mentioned previously also includes a presentation on the key results and statistics on government debt for the previous year plus an overview of the measures and actions to be implemented in the coming year. Moroccan authorities also issue monthly announcements on the results from the previous month’s auctions and details of upcoming auctions, and hold regular meetings with market participants to enhance their understanding of debt management activities.
Accountability and assurances of integrity by agencies responsible for debt management
49. Almost all countries’ debt management activities are audited annually by a separate government-auditing agency that reports its findings to parliament. The data in Table 2 indicated that sixteen countries have annual debt management audits, and ten have regular external peer reviews. For example, in Ireland, the annual accounts are audited by the state auditor (Comptroller and Auditor General) even though the Irish debt management agency engages a major international accounting firm to undertake an internal audit of all data, systems, and controls. In Denmark, the state auditor (Auditor General) audits government debt management with the help of the central bank’s internal audit department. On the other hand, in India separate financial accounts for the debt management operations at the central bank are not prepared, and thus cannot be subjected to a formal audit. While accounting for government debt is done by the government’s Controller General of Accounts, the accounts are subject to the audit by the Comptroller and Auditor General of Accounts, a consitutional body. The relevant central bank departments are also subjected to an internal management audit and concurrent audit.
50. All countries surveyed disseminate a wide range of information on their debt management objectives, issuance procedures, and financial requirements to market participants and the general public, and the level of disclosure does not appear to be overly dependent on a country’s state of economic and financial development. This process has been helped immeasurably by the introduction of the Internet, which provides a vehicle for disseminating this information in a cost-effective manner to a worldwide audience. However, as noted in Box 1 for HIPCs, for many developing countries, an important step towards improving transparency in their debt management activities is obtaining complete and reliable data on their debt obligations. Such a step is a necessary precondition to operating in a manner consistent with the disclosure requirements of the Guidelines.
C. Institutional Framework
51. The guidelines in this section address the importance of sound governance and good management of operational risk. They recommend that the authority to borrow and undertake other transactions related to debt management as well as the organizational framework be clear and well specified. In order to reduce operational risk, they highlight the need for well-articulated responsibilities for staff, and a system of clear monitoring and control policies and reporting arrangements. They also stress the importance of separating the execution of market transactions (front office) from the entering of transactions into the accounting systems (back office). The development of an accurate and comprehensive management information system, a code-of-conduct, conflict-of-interest guidelines, and sound business recovery procedures are also encouraged.
52. In all of the countries surveyed, the legal authority to borrow in the name of the central government rests with the parliament or congressional legislative body. However, practices differ with respect to the delegation of borrowing power from the parliament to debt managers. In most of the countries, legislation has been enacted authorizing the Ministry (or Minister) of Finance (or its equivalent) to borrow on behalf of the government. In some others, that power has been delegated to the Council of Ministers (the Cabinet), and in one case (India) directly to the central bank. Whether the delegation is to the Council of Ministers, the Ministry, or Minister of Finance seems to be more of a formality that recognizes country conventions regarding the decision making within the Government than a practical matter.
53. The mandate to borrow is usually restricted, either by a borrowing limit expressed in net or gross terms, or by a clause regarding the purpose of the borrowing. Most countries surveyed rely on borrowing limits (Table 2), defined in terms of a debt ceiling or an annual borrowing limit. The most common structure is that the parliament sets an annual limit in connection with the approval of the fiscal budget, which then functions as a means for it to control the budget. With the “purpose” clause, the mandate is restricted to certain borrowing purposes, the main ones being to finance the budget deficit and refinance existing obligations. In practice, the parliament has significant control over the debt even when the borrowing is restricted to certain purposes. The main purpose is always to cover any budget deficit, which the parliament influences when it approves the expenditures and tax measures contained in the budget. If the deficit deviates significantly from the path projected in the budget, it is possible for the parliament to intervene, either during the fiscal year or by modifying the budget for subsequent fiscal years.
54. Another example of a legislative debt ceiling is the one used by Poland, a prospective EMU-member. Poland has inserted into its Constitution a requirement that total government debt, augmented by the amount of anticipated disbursements on guarantees, is not allowed to exceed 60 percent of GDP, the debt limit stipulated by the Maastricht treaty. Denmark and the U.S. are examples of other countries that also have legislative limits on the stock of debt outstanding.
55. The country with the most open mandate is the U.K., where the National Loans Act of 1968 permits the Treasury to raise any money that it considers expedient for the purpose of promoting sound monetary conditions, and in such manner and on such terms and conditions as the Treasury sees fit. However, the U.K. Parliament has an indirect influence on the size of the deficit, and hence the debt level, in that it approves tax rates and the Government’s spending plans. Moreover, in the current fiscal policy framework the Government has the stated objective to limit net debt to a maximum of 40 percent of GDP.
56. Delegation of debt management authority from the Council of Ministers or the Ministry of Finance to the unit responsible for the debt management is usually stipulated in the form of either a governmental ordinance or a power of attorney. However, most countries surveyed ensure that the Government or the Ministry retains the power to decide on the debt management strategy, normally after considering a proposal from the debt managers. Most countries, especially those with a separate debt agency, have adopted formal guidelines for that purpose. At the Outreach conference, it was noted that it is important to ensure that decision-makers are fully informed about the consequences of their chosen debt management strategy. In one country the failure to do so left its debt managers exposed to criticism when the debt strategy did not achieve the expected results. In addition, some other countries admitted that in the past, the lack of clear objectives and weak governance arrangements led to political pressure on them to focus on achieving short-term debt service cost savings, at the expense of leaving the debt portfolio exposed to the risk of higher debt service costs in the future. In one country this also led to an awkward situation where political interference in the timing of debt issues forced the debt managers to have to raise a significant amount of the annual borrowing requirement towards the end of the fiscal year after it became apparent that interest rates were not going to evolve as expected.
57. The details contained in these guidelines differ across countries. In Sweden, for example, the guidelines are set each year by the Council of Ministers, and specify targets for the amount of foreign currency debt, inflation-linked debt, and nominal domestic currency debt. They also indicate the government’s preferred average duration for total nominal debt, the maturity profile of the total debt, and rules for the evaluation of the debt management. On the other hand, in Portugal, which also has a separate debt agency, the guidelines are determined by three different decisions. First, the Minister of Finance sets long-term benchmarks for the composition of the debt portfolio. These reflect selected targets concerning the duration, currency risk and refinancing risk, and are used to evaluate the cost and performance of the debt portfolio. Secondly, the Government (Council of Ministers) specifies annually which debt instruments are to be used and their respective gross borrowing limits. Finally, the Minister of Finance annually approves guidelines for specific operations, such as: buybacks; repos; the issuing strategy in terms of instruments, maturities, timing and placement procedures; measures regarding the marketing of the debt; and the relationship with the primary dealers and other financial intermediaries.
58. The case studies reveal a clear trend towards centralizing public debt management functions. Most countries have placed them in the Ministry of Finance. For example, as mentioned previously, Jamaica centralized the core debt management functions in the Debt Management Unit of the Ministry of Finance and Planning in 1998. Prior to then, they had been divided between the Ministry and the central bank. In the same year, Poland also centralized its domestic and foreign debt management in the Public Debt Department of the Ministry of Finance. Brazil plans to centralize all aspects of debt management within the Treasury in September 2003; the central bank currently handles the front office activities associated with international capital market borrowings, while domestic debt management is handled by the Treasury. Four countries (Ireland, Portugal, Sweden and the U.K.) have located their debt agencies outside the Ministry of Finance in that these agencies are from an organizational point of view not directly part of the Ministry (Table 2). These agencies also have some independence regarding staffing policies, and are physically located in offices outside the Ministry. However, they report to and their activities are evaluated by the Council of Ministers or the Ministry of Finance. For example, Portugal consolidated its debt management functions into a separate debt agency in 1997. Prior to then, this activity had been split between the Treasury Department (external debt and treasury bills) and the Public Credit Department (the domestic debt, excluding the treasury bills). In two countries (Denmark and India) the debt management unit is located in the central bank. In Denmark’s case this reflects a consolidation of activities that had previously been split between the Ministry and the central bank. In India, the central bank manages domestic debt while the Ministry of Finance has responsibility for external debt.
59. All countries with a debt management unit in the Ministry of Finance, except Slovenia, use the central bank to conduct auctions in the domestic debt market. This stands in contrast to those with separate debt agencies, where all market contacts, including the conduct of auctions, are handled by the agency. In Sweden, even the acquisition of foreign currencies in the market needed to service the external debt has been shifted to the debt agency from the central bank, starting from July 2002.
60. The rationale behind the different organizational structures differs across countries. For example, while the U.K. and Denmark delegate the management of foreign currency debt and foreign exchange reserves to the central bank, they have taken different approaches in the management of domestic debt. The U.K., which shifted domestic debt management from the central bank to a debt agency in 1998, believes it is important to have separate objectives for monetary policy and domestic debt management to mitigate any perception that the debt management might benefit from inside knowledge over the future path of interest rates. Denmark, which moved debt management functions from the Ministry of Finance to the central bank in 1991, has in place strict funding rules between debt management and monetary policy, and found that the move to the central bank has helped to centralize the retention of knowledge of most aspects of financial markets within a single authority. Moreover, since Danish interest rates are largely determined by interest rate developments in the euro area, the involvement of the Danish central bank in domestic debt management is unlikely to generate a perception that domestic debt management benefits from inside information on the future path of interest rates.
61. Ireland and Portugal, which both created separate debt agencies (in 1990 and 1996, respectively), highlighted the need to attract and retain staff with the relevant skills, and to centralize all debt management functions in one unit. Sweden, whose separate debt agency was founded in 1789, notes the historical reason and that the system provides a clear distribution of responsibilities between the parties concerned. However, it also reflects a long-standing tradition in Sweden of working with small ministries, responsible for policy decisions, and delegating operational functions to agencies that have separate management teams and are at arm’s length from the ministries.
62. Poland placed debt management activities in the public debt department of the Ministry of Finance on the grounds that at the very early stage of development of its domestic financial market, when the transition to the free market economy had just begun, that department had more instruments to support development of the market, to cooperate with other regulatory institutions, and to prepare an efficient legal and infrastructure environment. New Zealand, which also chose to set up a unit within the Ministry of Finance (the New Zealand Debt Management Office or NZDMO) instead of a separate debt agency, suggested that important linkages would otherwise be lost. In addition to debt-servicing forecasts for the budget and other fiscal releases, the NZDMO provides a range of capital markets advice to other sections of Treasury.
63. The role of the parliament or congress in the management of the debt, apart from delegating its borrowing power, differs between the countries. In Sweden, for example, the parliament has stated the objective of the central government debt management in an Act, and the Council of Ministers is obliged to send an annual report to the parliament evaluating the management of the debt. In Mexico, the Congress approves the annual limit for net external and domestic borrowing as well as the debt strategy; the latter is scrutinized closely, since debt management issues have been a contributing factor to past financial crises in Mexico. At the end of the year, the Mexican Congress also (through its auditing organization) reviews the accounts and other specific topics that are of interest to its members. In Ireland and U.K., the Chief Executive of the debt agency reports directly to the parliament in the presentation of the accounts.
Management of internal operations
64. Fifteen countries have separate front and back offices for the management of the debt (Table 2). Twelve countries, including all of the countries which actively trade to profit from expected movements in interest rates or exchange rates, have a separate middle office too (Table 2). From an operational risk point of view it is useful to have a separate middle office in a debt unit where many transactions are being conducted on a regular basis. Its main functions are to: ensure that all transactions done by the front office are within predetermined risk limits; assess the performance (where relevant) of the front office’s trading against a strategic benchmark portfolio; set proper operational procedures and ensure that they are followed; and, in some countries, play a leading role in the development of the debt management strategy.
65. Most of the surveyed countries have code-of-conduct and conflict of interest guidelines for the debt management staff, and business recovery procedures in place (Table 2). Brazil has also created an Ethics and Professional Conduct Committee.
66. Some countries, such as Ireland, New Zealand, Portugal, Sweden, and the U.K., have boards, which provide external input on specific areas of expertise. In Ireland’s case, the board assists and advises the National Treasury Management Agency (NTMA) (the Irish debt agency) on matters referred to it by NTMA. In New Zealand, the board has a quality assurance role. It oversees the NZDMO’s activities, the risk management framework, and the business plan, and reports directly to the Secretary to the Treasury. In Portugal, it plays an advisory role on strategic matters. Sweden has a decision-making board, chaired by the Director General of the SNDO. Of the external members, four are members of parliament and the other three have professional experience as economists. In the U.K., the board advises the DMO’s senior management on strategic, operational, and management issues, but only in an advisory capacity as it has no formal decision-making role.
67. Many debt managers noted that they are confronted with significant challenges in attracting and retaining staff due to intense competition for such staff from the private sector. As described above, in some cases this has been one of the driving forces behind the transfer of the debt management function from the Ministry of Finance to either the central bank or to a separate debt agency. In order to alleviate this problem, many countries have sought to offer their staff challenging and interesting tasks, good training, and further education. Brazil, for instance, offers a graduate course in debt management. Slovenia and it also support post-graduate education through time-off allowances and payment of tuition fees.
68. In all of the cases where management information systems were discussed (Colombia, Denmark, Ireland, Morocco, New Zealand and Portugal), countries have experimented with different approaches. Some have developed their own systems, while others purchased off-the-shelf systems and customized them to meet their particular needs. For example, New Zealand relied on its own internally developed system until the mid-1990s, when it acquired a commercial system. However, significant customization was required, and work on it has continued over the years to meet the NZDMO’s evolving requirements.
69. Portugal provides an example of a strategy to reduce operational risk. When the Portuguese debt agency was created, an analysis of operational risk led to the adoption of an organizational structure based on the financial industry standard of front, middle and back office areas with clearly segregated functions and responsibilities. It has since been a focus of attention by means of three main initiatives, namely: a significant investment in IT (including the purchase of a management information system), followed by the development of a manual of internal operating procedures, and finally attracting and retaining specialized expertise. In the future these measures will be complemented with an internal auditing function, to complement the external auditing that is already done by the Audit Court.
70. The case studies show that only four countries (Ireland, Portugal, Sweden, and the U.K.), all highly developed and with well functioning domestic capital markets, have created separate debt agencies for the management of the central government debt. However, in other countries there are ongoing discussions about the merits of such an agency. One argument, which is often mentioned in favor of a separate agency is that it provides for more focused debt management policy, in part because there is a top management whose main responsibility is debt management, not fiscal or monetary policy, and thus have the time to focus on debt management issues. When debt management is part of the Ministry of Finance or central bank, there is a risk that debt management policy could be a secondary consideration. This focus fosters professionalism and gives debt management staff attention from top management, which together with competitive salaries, makes it easier to hire and retain skilled staff. However, as noted by some countries at the Outreach conference, if one goes down this path, the introduction of a separate debt agency should be accompanied by strong internal governance, accountability, and transparency mechanisms to ensure that the agency performs as expected, and is held accountable for decisions within its remit.
71. This is not to say that every country should have a separate debt agency. A common argument for placing the debt office in the Ministry of Finance is the importance of maintaining key linkages to other parts of the government, such as budget and fiscal policy. Especially in countries with less developed financial markets, coordination of debt management policy with that of fiscal and monetary policy is of such importance that centralization of responsibilities either in the Ministry of Finance or the central bank often makes sense. Moreover, even when separate, the debt agency always reports to the Council of Ministers (Cabinet) or Ministry of Finance, which decides on the debt management strategy and evaluates the work of the debt agency. In order to fulfill these duties, the Ministry of Finance may also find it advantageous to have some staff skilled in debt management.
72. The role of the parliament differs among the countries, partly because of historical reasons. However, if the parliament is the political body that approves tax and spending measures, which is normally the case, one could argue that it should also approve overall borrowing by the government as well as broad debt management policy issues, such as debt limits and the objectives for managing debt, given that the management of debt ultimately has significant repercussions for future tax and spending levels. Within these limits and policy objectives, the Council of Ministers and debt managers should have sufficient authority to implement the approved policies as they deem appropriate, subject to being held accountable for their actions by the parliament.
D. Debt Management Strategy
73. The guidelines in this section stress the importance of monitoring and assessing the risks in the debt structure, and recommend that the financial and other risk characteristics of the government’s cash flows be considered when setting the desired debt structure. In particular, the debt manager should carefully assess and manage the risks associated with foreign currency and short-term or floating-rate debt, and ensure there is sufficient access to cash to avoid the risk of not being able to honor financial obligations when they fall due.
74. Debt managers’ risk awareness is high, and most have formal guidelines for managing market and credit risk (Table 2). However, the risks that countries focus on vary depending on country-specific circumstances. For example, Colombia aims to limit the exposure of its foreign currency debt portfolio to market shocks and international crises, while Italy concentrates its efforts on reducing both interest rate risk and rollover risk after having experienced government indebtedness levels that reached 124 percent of GDP in 1994. Recent financial crises in Latin America and Russia have shown that the management of rollover risk is an especially important task for many developing and emerging market countries. An inability to rollover debt when markets are turbulent can severely compound the effects of economic and financial shocks.
75. The cases also show a trend towards using an asset-liability management (ALM) framework, at least conceptually, to assess the risks and cost of the debt portfolio by evaluating the extent to which debt service costs are correlated with government revenues and non-interest expenditures.14 One issue that arises is how to measure cost and risk. In Portugal, for example, one of the objectives, stated in the Portuguese Public Debt Law, is to ensure a balanced distribution of debt costs over several years. Against that background and with the focus on budget volatility, the Portuguese debt agency has found it useful to measure market risk on a cash-flow basis. However, it is still working on the development and implementation of an integrated budget-at-risk indicator for the debt portfolio. In Sweden, the SNDO is using a cost-to-GDP ratio in its analysis of the costs for different debt portfolios. This is a step in the direction of ALM as the assumption here is that the budget balance co-varies with GDP via both tax and expenditure channels. A debt portfolio with a relatively stable cost-to-GDP ratio will thus contribute to deficit (tax) smoothing.
76. Some countries also explicitly incorporate specific government assets and liabilities (such as foreign exchange reserves and contingent liabilities) into an overall risk management framework. Countries using this approach, or which have started to look at it, are: Brazil; Denmark; New Zealand; and the U.K. They have found, for example, that usage of such a framework highlights the benefits of coordinating the maturity and currency composition of foreign currency debt issued by the government with that of the foreign exchange reserves held by either the government or the central bank so as to hedge the government’s exposure to interest rate and exchange rate risk. Indeed, in the U.K., foreign exchange reserves and foreign currency borrowings are managed together by the Bank of England using an ALM framework.
77. The debt management section of the Danish central bank also manages the assets of the Social Pension Fund. In managing interest rate risk, it integrates assets and liabilities, and monitors the duration of the net debt. As a result, a reduction in the duration of net debt can be achieved by raising the duration of the asset portfolio. New Zealand, which has been using the ALM approach for more than a decade, created an Asset and Liability Management Branch in the Treasury in 1997, of which the NZDMO constitutes one part. The ALM strategy is implicitly incorporated into the NZDMO’s strategic objective to maximize the long-term economic return on the government’s financial assets and debt in the context of the government’s fiscal strategy, particularly its aversion to risk. The objective has regard to both the balance sheet and fiscal implications of the debt strategy. Going forward, debt strategy in New Zealand is likely to be influenced by an analysis underway in Treasury aimed at understanding the financial risks that exist throughout the government’s operations, and how its “balance sheet” is likely to change through time.
78. Debt management strategies, such as the selection of debt maturities and the choice between raising funds in domestic or foreign currencies, depend to a large degree on the special circumstances in the countries, such as the characteristics of the debt portfolio, the vulnerability of the economy to economic and financial shocks, and the stage of development of the domestic debt market. Brazil, for example, which prior to the Asian financial crisis sought to lengthen the average term-to-maturity of its debt by issuing longer fixed-rate securities, switched in October 1997 to floating rate and inflation-indexed securities in order to achieve a quicker reduction in rollover risk. At that time, investors were more willing to invest longer-term if the securities in question carried floating-rate or inflation-indexed coupons than if they were fixed for the tenor of the instrument. However, the reduction in rollover risk came at the expense of making its debt dynamics more sensitive to changes in interest rates. Prior to the onset of financial market turbulence in 2002, it also sought to reduce its vulnerability to interest rate fluctuations by extending the domestic yield curve and by building up cash reserves.
79. Mexico’s experience underlines the need for sound macroeconomic policies, fiscal discipline and a prudent and consistent debt management policy. In the wake of the 1994-95 financial crisis where its public finances were undermined by excessive reliance on short-term foreign currency-linked debt, the government has been actively promoting the development of the domestic debt markets by introducing new instruments and making the necessary regulatory adjustments in order to reduce its dependence on short-term domestic debt and foreign currency (and foreign currency-linked) debt. Today, Mexico’s debt management strategy aims to reduce rollover, interest rate, and exchange rate risks by issuing a combination of domestic currency medium-term floating rate notes and medium- to long-term fixed-rate instruments. The issuance of the floating-rate debt helps to reduce rollover risk. Over time, the issuance of domestic currency fixed-rate instruments at increasingly longer tenors should reduce rollover risk further, and at the same time, lower interest rate and exchange rate risk.
80. In Morocco, debt managers have sought to reduce debt service costs of the external debt by exercising debt/equity swap options, triggering cancellation and prepayment rights to retire onerous debt, and by refinancing or revising interest rates as permitted by the loan agreements. They also have a policy of promoting the development of the domestic debt market so that more financing needs can be met in domestic currency.
81. Turning now to the most developed countries, the U.S., for example, has sought to minimize debt service costs over time by championing a deep and liquid market for U.S. Treasury securities. This has involved taking steps to ensure that Treasury securities maintain their consistency and predictability in the financing program, issuing across the yield curve in order to appeal to the broadest range of investors, and aggregating all the financing needs of the central government into one debt program. Portugal, a participant in the euro-area, has a strategy of building a government yield curve of liquid bonds (at least euro five billion outstanding for each series) along different maturity points. Since 1999, the priority has been every year to launch a new ten-year issue, and secondly to launch a new five-year issue. As part of this strategy, priority has been given to the development of efficient primary and secondary treasury debt markets. At the highest level, New Zealand’s strategy regarding domestic debt management is to be transparent and predictable. The NZDMO maintains a mix of fixed and floating rate debt, and a relatively even maturity profile for debt across the yield curve. It has taken steps to develop the market for domestic government securities, including a derivatives market, which the commitment to transparency, predictability, and even-handedness supports.
82. Participation in ERM II for Denmark and prospective EMU membership for Slovenia are important factors in managing the exchange rate risk of debt issued by these countries. Since 2001, all of Denmark’s foreign currency exposure is in euro. In Slovenia, over 90 percent of its foreign currency exposure is in euro. Slovenia also issues bonds denominated in euro in its own domestic market to support the pricing of long-term instruments issued by other Slovenian borrowers.
83. Although all countries pay close attention to the cost-risk trade-off, some countries with stable macroeconomic conditions, strong fiscal positions, and well-developed domestic debt markets are in a better position than others to pursue cost savings at the expense of some increase in the riskiness of the debt. Sweden, for instance, has decided to have a 2.7-year duration target for its nominal debt, while Denmark has shortened the duration of its debt from 4.4 years at the end of 1998 to 3.4 years at the end of 2001. In both countries, these actions reflect: first, a significant decline in their debt loads in recent years; second, a view that debt service cost savings can be realized over time in an upward-sloping yield curve environment; and third, a view that these countries are generally well-insulated from economic and financial shocks due to their strong macroeconomic policy frameworks.
84. The benefit of having well functioning domestic currency markets is also shown in cash management. Most of the countries hold cash balances so that they can honor their financial obligations on time even when their ability to raise funds in the market is temporarily curtailed or very costly. On the other hand, Sweden is sufficiently secure in its ability to access markets at any time that it has opted not to hold cash balances, but instead rely completely on its ability to raise funds in the market. However, in order to do that it is also important to have complete control over the government cash flows, so that the timing of these flows can be managed accordingly.
85. As will be discussed in more detail below, almost all the surveyed countries are, or have plans to, building up liquid benchmark securities in their domestic currency markets (Table 2). The most common methods used to reduce the rollover risk associated with large benchmark securities are buyback or bond-switching operations near the maturity dates.
86. Countries typically adjust the financial characteristics of the debt portfolios by adjusting the mix of securities issued in their borrowing programs or by repurchasing securities before they mature and replacing them with new ones that better reflect its cost-risk preferences. In addition, as indicated in Table 2, half of the countries use financial derivatives, mainly interest rate swaps and cross-currency swaps, to separate funding decisions from portfolio management decisions, and adjust the risk characteristics of their debt portfolios. However, this is not an option available to all countries. Those with underdeveloped domestic markets may not have access to domestic derivatives markets, and those with weak credit ratings may not be able to access global derivatives markets at a reasonable cost. Moreover, there is a need for careful management of the counterparty risks associated with derivatives transactions. Denmark, New Zealand and Sweden, for example, noted that they use credit exposure limits and collateral agreements to reduce the credit (counterparty) risks associated with these transactions.
87. The debt management strategies pursued by countries generally reflect their particular circumstances and their own analysis of the risks associated with their debt portfolios. Thus, it is not surprising that the strategies pursued differ significantly across countries. However, one element that seems to be common across all countries, regardless of their stage of development, is the focus on developing/maintaining the efficiency of the domestic debt market as a means of reducing excessive reliance on short-term and foreign currency-linked debt. Another aspect worthy of note is the move towards using an ALM framework to assess the risks and costs of debt and determine an appropriate debt structure.
88. Particularly for developing and emerging market countries, the level of the debt and the soundness of the macroeconomic policies are important constraints on the amount of discretion that countries have in setting and pursuing their debt management strategies. Regarding the debt level, decisive factors are the central government’s capacity to generate tax revenues and savings, and its sensitivity to external shocks.
E. Risk Management Framework
89. The guidelines in this section recommend that a framework should be developed to enable debt managers to identify and manage the trade-offs between expected costs and risks in the government debt portfolio. They also argue in favor of stress tests of the debt portfolio as part of the risk assessment, and that the debt manager should consider the impact of contingent liabilities. They also discuss the importance of managing the risks of taking market positions.
90. The framework used to trade-off expected costs and risks in the debt portfolio differs across countries. Most seem to use rather simple models, based on deterministic scenarios, and judgment. However, new risk models are under development in many countries. Only a few (Brazil, Denmark, Colombia, New Zealand and Sweden) use stochastic simulations. For example, New Zealand developed a stochastic simulation model to improve its understanding of the trade-off between the cost and risk associated with different domestic debt portfolio structures. Most countries also employ stress testing as a means to assess the market risks in the debt portfolio, and the robustness of different issuance strategies. Stress testing is particularly important for the assessment of debt sustainability.
91. Consistent with the ALM framework discussed above, most countries measure cost on a cash flow basis over the medium- to long-term. This facilitates an analysis of debt in terms of its budget impact. Risk is typically measured in terms of the potential increase in costs resulting from financial and other shocks. Some countries, such as Brazil, Portugal and Sweden, are experimenting with measures such as cost-to-GDP or concepts such as “budget-at-risk” to reflect the explicit incorporation of a joint analysis of debt and GDP or budget flows to shocks.
92. Four countries (Brazil, Colombia, Denmark and New Zealand) use “at-risk” models to quantify the market risks. For example, Colombia uses a debt-service-at-risk (DsaR) model to quantify the maximum debt service cost of the debt portfolio with 95 percent likelihood. The methodology takes into consideration the exposure to different market variables, such as interest rates, exchange rates and commodity prices (24.5 percent of the debt is price indexed). For managing the cost and risk dimensions of the debt portfolio, the middle office presents a monthly report of funding alternatives based on DsaR analysis. This report compares the cost of the expected scenario versus the 95 percent risk scenario for each of the different funding alternatives. Denmark uses a cost-at-risk (CaR) model to quantify the interest rate risk by simulation of multiple interest scenarios. In the model, different strategies, such as the issuing strategy, the amount of buybacks, and the duration target, are analyzed.
Scope for active management
93. Among the countries in this survey, only Ireland, New Zealand, Portugal, and Sweden actively manage their debt portfolios to profit from expected movements in interest rates and exchange rates. New Zealand and Sweden limit the positions taken to the foreign currency portfolios, while Ireland and Portugal, being relatively small players in the euro zone, are prepared to trade the euro segment of their debt. The arguments for position taking vary, and it is worth noting that these countries have centralized their debt management activities outside of the central bank. It might be difficult for debt managers located in the central bank to take active positions in the market due to concerns that such actions may be seen to convey signals with respect to other policies that affect financial markets. New Zealand argues that temporary pricing imperfections sometimes occur, making it possible to generate profit from tactical trading. In addition, it believes that tactical trading helps to build understanding for debt managers of how various markets operate under a variety of circumstances, which improves the NZDMO’s management of the overall portfolio. For example, it suggested that tactical trading enables it to develop and maintain skills in analysis, decision making under uncertainty, deal negotiations, and deal closure. The immediate benefit is a reduced risk of mistakes when transacting, and the projection of a more professional image to counterparties. However, it is important to make sure that tactical trading activities are properly controlled. At the Outreach conference, it was noted that one country experienced had used swaps to speculate on an expected convergence in European interest rates in the early 1990s. This strategy led to losses when the European Exchange Rate Mechanism broke down in the Autumn of 1992.
94. To mitigate the market risk associated with the tactical trading, New Zealand uses both value-at-risk (VaR) and stop-loss limits, the determination of which are aided by stress tests of the portfolio. The VaR is measured at a 95 percent confidence level relative to notional benchmark portfolios or sub portfolios, which embody the approved strategy. Trading performance is measured on a risk-adjusted basis, using a notional risk capital for market, credit and operational risk utilization. The risk-adjusted performance return is defined as the net value added divided by the notional risk capital.
95. Even if only a few countries are actively taking positions in the market, most of them do try to take advantage of pricing anomalies in the market. The most common approach is to buyback illiquid bond issues, financed through new issues in liquid benchmark securities. Another similar method, noted by Morocco, is to refinance onerous bank loans by exercising prepayment rights in the loan agreements and refinancing the prepayments through new loans with more favorable terms. Other examples include using the swap market to achieve lower borrowing costs. Ireland, for example, obtains cheaper short-term domestic currency funding by issuing commercial paper denominated in U.S. dollars and swapping the proceeds into euro, compared to raising euro-denominated funds.
96. Most of the case studies did not comment on the management of contingent liabilities.15 Among the countries which did, only Colombia, Morocco, New Zealand, and Sweden seem to have an organizational structure within the debt management unit/Ministry of Finance that facilitates the coordination of the management of explicit financial guarantees with the management of the debt. Such coordination is essential, since government guarantees have been significant contributors to the public debt burden in many developing and transition economies. At the Outreach conference, some countries noted that the level of these guarantees are typically determined elsewhere in the government, and their contingent nature makes them very difficult to quantify. However, others argued that while their valuation is difficult, they should not be ignored. Consequently, they recommended that these guarantees be borne in mind when setting debt strategy, especially when conducting stress tests of prospective strategies.
97. None of the countries surveyed appear to involve debt managers in the management of implicit contingent liabilities. The latter finding is not too surprising, since these claims often arise in response to weaknesses in prudential supervision and regulation—areas that are usually outside the scope of debt management. Nonetheless, these claims can pose major risks for governments, as evidenced by the costs imposed on several countries in Asia and Latin America in the 1990s when governments were forced to recapitalize failed banking systems. Thus, they need to be judged in conjunction with other macroeconomic risk factors. Similarly, national governments in Argentina and Brazil found themselves unexpectedly taking on significant liabilities when they had to assume the liabilities of sub-national governments that had borrowed excessively. In Brazil’s case controls have since been placed on sub-national government borrowings, and these governments are repaying the amounts refinanced by the national government. As noted previously, the latter issue has led countries like Brazil and Colombia to set limits on sub-national government borrowing, while others regularly monitor these borrowings and ensure that the sub-national governments in question have independent sources of revenue to service their obligations.
98. Most of the countries in the case studies rely on fairly simple models to assess the trade-offs between expected costs and risks in the debt portfolios. Some countries may lack enough data needed to run more complicated models. It is also important to bear in mind that the usefulness of all models depends to a large degree on the quality of the data used as inputs and the assumptions that underpin the model. The latter may behave differently in extreme situations, can change over time, and can be influenced by policy responses. Thus, the parameters and assumptions underpinning these models should be regularly reviewed, and it is important to be aware of the limitations and underlying assumptions of the model. These should be carefully described and understood when results are applied in the decision-making process.
F. Developing and Maintaining an Efficient Market for Government Securities
99. Most of the guidelines in this section focus on the benefits of governments raising funds using market-based mechanisms in a transparent and predictable fashion, and the merits of a broad investor base for their obligations. Others discuss the benefits of governments and central banks working with market participants to promote the development of resilient secondary markets and the need for sound clearing and settlement systems to handle transactions involving government securities. Further information on the steps that countries can take to develop a domestic government debt market can be found in a handbook published by the World Bank and the IMF in 2001.16
100. Most of the countries surveyed use similar techniques for issuing government securities in the domestic market in that all of them except Denmark use pre-announced auctions to issue debt. Most also use multiple-price auction formats for conventional securities and in some cases uniform-price formats to issue inflation-indexed instruments, although the U.S. Treasury now issues all of its securities using uniform price auctions. It shifted away from multiple price auctions after evidence showed that the range of successful bidders tended to be broader in uniform price auctions, and that bidders tend to bid more aggressively due to a reduction in the so-called “winner’s curse,” (the risk that a successful bidder will pay more than the common market value of the security in the post-auction secondary market).
101. The advent of the euro has led to significant changes in the debt management practices of some smaller EMU members. For example, Portugal now uses syndications to launch the first tranche of each new bond, since this tranche corresponds to around 40 percent of the targeted final amount to be issued. It believes that being a small player in the euro government bond market, syndications help it to achieve more control over the issue price and help to foster a broader diversification of the investor base. Auctions are then used for future issues of the same security.
102. When borrowing in foreign markets, most countries rely on underwriting syndicates to help them price and place securities with foreign investors, since these borrowings are usually not undertaken in sufficient volume or on a regular enough basis to warrant the use of an auction technique. However, some countries like Sweden and the U.K. have found it more cost-effective to separate funding decisions from portfolio decisions by using financial derivatives, and raise foreign currency funds by issuing more domestic currency debt and swapping it into foreign currency obligations—a technique that has the added benefit of helping to maintain large issuance volumes in domestic markets when domestic borrowing requirements are modest. The largest industrial countries—the U.S. and Japan—have a long standing policy of only issuing domestic currency-denominated securities in their domestic markets, and avoid raising funds offshore. Potential EMU members like Poland and Slovenia, and the ERM II participant, Denmark, prefer to issue euro-denominated securities when raising external financing, since these would ultimately become domestic currency instruments if they join EMU.
103. Most countries have taken steps to increase the transparency of the auction process in the domestic market in order to reduce the amount of uncertainty in the primary market and achieve lower borrowing costs. Almost all countries pre-announce their borrowing plans and auction schedules (Table 2) so that prospective investors can adjust their portfolios ahead of time to make room for new issues of government securities, and the rules and regulations governing the auctions and the roles and responsibilities of primary dealers are publicly disclosed so that market participants fully understand the rules of the game. For example, in Brazil and Poland the basic rules for Treasury bills and bond issuance are covered by ordinances issued by the Minister of Finance, and the details of specific issues are described in Letters of Issue published on the Ministry’s web site. Dates of auctions are announced at the beginning of each year in Poland and monthly in Brazil, and a calendar is maintained on the Ministry’s web site. Two days prior to the tender in Poland, detailed information on the forthcoming auction is made available on the web site and on Reuters.
104. Auction processes are also becoming more efficient as countries automate their auction processes and explore the possibility of using the Internet to issue securities. For example, Ireland and Portugal conduct their auctions using the electronic Bloomberg auction system, which has reduced the lag between the close of bidding to the release of auction results to less than 15 minutes. Among emerging market and developing countries, India and Jamaica have moved to introduce electronic bidding in its debt auctions, and Brazil, besides using electronic bidding in its debt auctions since September 1996, began issuing securities to small investors over the Internet in January 2002.
105. Countries are also taking steps to remove regulations that have created captive investor classes and distorted auction outcomes and only one country reported limits on foreign participation in auctions (Table 2). Such regulations have been a particular problem in many emerging market and developing countries, especially where prudential regulations required some institutions to hold a prescribed portion of their assets in government securities. As a result, Morocco and South Africa, for example, took steps to gradually remove these requirements and broaden the base of investors that hold government securities. While the removal of these requirements may result in interest rates moving up in the short run to market-clearing levels, the ensuing broadening of the investor base should bring about a deeper and more liquid domestic market for government securities. This should result in debt service cost savings over time as the government is better positioned to implement its preferred debt structure.
106. One issue of debate is over the merits of using primary dealers to support the issuance of securities in the domestic market.17 According to Table 2, thirteen countries surveyed have introduced primary dealer systems on the grounds that these institutions help to ensure that auctions are well-bid, that there is a regular source of liquidity for the secondary market, and have found that primary dealers can be a useful source of information for debt managers on market developments and debt management policy issues. Moreover, at the Outreach conference, some countries suggested that a primary dealer system offering special privileges can help to encourage market participants to play a role in the development of the market as a whole, especially when the market is at an early stage of development. However, there are several industrial countries—Denmark, Japan, and New Zealand—that have not found it necessary to introduce a primary dealer system. Indeed, at the Outreach conference, one country noted that its borrowing costs declined significantly after it abolished its primary dealer system. Similarly, some developing and emerging market countries have questioned the benefits of introducing primary dealer systems as their markets are too small, and the number of market participants too few, to warrant such a system. Thus, they have been prepared to let the secondary market participants themselves determine which of them can profit from playing the role of market maker in the secondary market. Moreover, some countries that have primary dealer systems, such as the U.S., do not restrict access to the auctions to primary dealers, but also allow other market participants to bid provided they have a payment mechanism in place to facilitate settlement of their auction obligations. Consequently, each country needs to evaluate in their own situation whether the potential benefits of a primary dealer system outweighs the costs. The tradeoff will likely depend on the state of financial market development, and some countries may not need to offer special privileges to encourage market participants to take the lead in developing the market.
107. In order to foster deep and liquid markets for their securities, most governments have taken steps to minimize the fragmentation of their debt stock. Sixteen countries reported that they strive to build a limited number of benchmark securities at key points along the yield curve (Table 2). They generally use a mixture of conventional treasury bills and coupon-bearing bonds that are devoid of embedded option features. These benchmark securities are typically constructed by issuing the same security over the course of several auctions (“reopenings”) and, in some cases, by repurchasing older issues prior to maturity that are no longer actively traded in the market. Extending the yield curve for fixed-rate instruments beyond a limited number of short-term tenors has posed a major challenge for countries that have had a history of weak macroeconomic policy settings. Consequently, Brazil, Colombia, Jamaica, and Mexico, for example, have sought to extend the maturity of their debt by initially offering securities that are indexed to inflation or an exchange rate until such time as they can develop investor interest in longer-term fixed-rate securities.
108. Despite the desire to minimize the fragmentation of the debt stock, some industrial countries plus South Africa have been working hard to develop a market for government securities that are indexed to inflation. In contrast to emerging market and developing countries where such instruments are thought to be a useful device for extending the yield curve, the attraction of these instruments for industrial countries and South Africa is that they have enabled some of them to reduce borrowing costs by avoiding the need to compensate investors for the inflation uncertainty premium that is thought to exist in nominal bond yields. This was especially true when these programs were first launched, since in many cases the spread between nominal and inflation-indexed yields at that time (an indicator of the market’s expectations for future inflation) tended to be above the central bank’s stated inflation objective even though the inflation-indexed securities were less liquid than their nominal counterparts. They also help to reduce the total risk embedded in the debt stock because the debt service costs of inflation-indexed securities are not highly correlated with those for conventional securities.18 That said, most countries have found it difficult to develop a liquid secondary market for inflation-indexed securities, implying that the yields paid by governments may include a premium to compensate investors for their liquidity.
109. In situations where domestic borrowing requirements are modest or declining over time in response to fiscal surpluses, debt managers in Brazil, Denmark, Ireland, New Zealand, South Africa, Sweden, the U.K., and to a lesser extent the U.S. have repurchased securities that are no longer being actively traded in the market in order to maximize the size of new debt issues, and will often offer to exchange older securities for newly-issued benchmark securities of similar terms-to-maturity. This helps to minimize debt stock fragmentation and concentrate market liquidity in a small number of securities, thereby helping to ensure that they can still be actively traded even though the total debt outstanding may be on the decline. The U.K. has also sought to maintain new issuance volumes in the bond market in a period of fiscal surpluses by allowing its holdings of financial assets to rise temporarily when it received an unexpectedly large injection of cash from the sale of mobile phone licenses. In addition, Denmark, Sweden, and the U.K., offer market participants a facility to borrow temporarily or obtain by repo specific securities that are in short supply in the market, albeit at penalty interest rates, in order to ensure that the government securities market is not unduly affected by pricing distortions in the market.
110. The countries surveyed also maintain an active investor relations program, whereby they meet regularly with major market participants to discuss government funding requirements and market developments, and examine ways in which the primary market can be improved. Such a program, with appropriate staff and a public presence, has proven to be very helpful in assisting countries manage their debt in times of stress, and in conveying messages on the government’s economic and financial policies to domestic and foreign creditors. For example, South African authorities operate an investor relations program, whereby debt management officials conduct road shows to meet investors, primary dealers, and other financial institutions and explain developments in the South African market and government finances. Similarly, Japan and Denmark’s investor relations programs enable debt managers to maintain regular and close contact with the financial community. This is considered to be an important channel in both countries for building investor understanding of the government’s financial situation and debt management operations, and the programs are given high priority in these countries’ debt management activities. Market participants in both countries are given an opportunity through regular meetings with debt management officials to discuss the management of the government debt, including the potential need for changes to or the introductions of new financial instruments.
111. In the wake of the debt default by Argentina in 2001, one issue that has emerged is whether government debt instruments should also have renegotiation or collective action clauses covering the coupon and repayment terms, such as majority voting rules, attached to them. Indeed, as indicated in its September 28, 2002 Communique, the IMFC encouraged the official community, the private sector, and sovereign debt issuers to continue work on developing collective action clauses, and to promote their use in international sovereign bond issues. According to the data presented in Table 2, six countries (Brazil, Denmark, Slovenia, Sweden, Poland, and the U.K.) have introduced them for some securities issued in international markets, while none have attached them to their domestic debt. The ability of a country to attach collective action clauses to its international debt issues depends on the practice and laws in the market where the security is issued. For example, Slovenia and Sweden have attached these clauses to debt issued in the eurobond market, which is governed by English law. On the other hand, these clauses are not attached to securities issued in some other markets, such as Germany and the State of New York.
112. Debt managers in many countries actively work with market participants and other stakeholders to improve the functioning of the secondary market for government securities. For example, authorities in Italy, Poland, Portugal, Sweden, and the U.K. have introduced primary dealer systems, and have worked closely with market participants to promote electronic trading of government securities. In addition, debt managers in India and Italy have worked with other interested parties to alleviate distortions caused by the tax treatment of returns on government securities. And those in Japan, New Zealand, South Africa, and the U.K. have worked with market participants to develop ancillary markets, such as futures, repo, and strips markets that help to deepen the government securities market.
113. Given the importance of sound clearing and settlement systems to the functioning of the government securities market, it is not surprising to find that many debt managers have been working with the relevant stakeholders to improve the systems in their countries. For example, in Brazil, Japan and Poland, debt managers helped champion the introduction of real-time gross settlement for government securities transactions. In India, the central bank helped establish a central counterparty for the settlement of outright and repo transactions in government securities, which is expected to lead to significant growth in trading activity in these markets. The Jamaican authorities are working with market participants to dematerialize government securities within the central depository in order to increase the efficiency of secondary market trading.
114. Although the preceding discussion suggests that there are a number of steps that governments can take to develop the primary and secondary markets for their securities, the sequencing of reforms and speed of deregulation will depend on country-specific circumstances. Nonetheless, the experience of developing these markets in many countries demonstrates the importance of having a sound macroeconomic and fiscal policy framework in place so that investors are willing to hold government securities without fear that their investment returns will be unexpectedly eroded by inflation or debt sustainability concerns.
115. Countries seeking to develop their domestic markets should also take heed that attempts to develop a market for government securities across the yield curve may entail some short-term costs for governments as debt managers strive to develop an investor base for their securities. For example, the yield curve could be very steep due to weak macroeconomic conditions, and in some situations the effect on debt sustainability of incurring extra debt service costs could be very severe or investors may simply be unwilling to purchase this debt. Thus, debt managers need to decide on a case-by-case basis whether the benefits outweigh the costs. In addition, in order to ensure a well-functioning market, debt should be issued in a predictable fashion using standardized instruments and practices so that the issuer’s behavior does not disrupt market activity and investors can become accustomed to the instruments that are traded. Of course, situations may arise where it is costly for the government to honor a commitment or where it might be tempting to seek out short-term cost savings by manipulating the outcome of an auction. However, a demonstrated commitment to the development of the market should, over time, contribute to increased market liquidity and lower borrowing costs.
Part II - Country Case Studies
116. This part of the document contains the 18 country case studies prepared by government debt managers. Each case study focuses on the steps taken by the country to improve public debt management practices in recent years, and their connection with the Guidelines for Public Debt Management.
117. The Brazilian government has been implementing several measures to improve the conduct of public debt management. This document provides an overview of the main guidelines currently followed by Brazilian public debt officials, drawing comparisons to those proposed by the IMF and the World Bank in their joint report: “Guidelines for Public Debt Management.”
118. Section A covers a broad array of issues. It starts with a brief discussion on the objectives and scope of public debt management in Brazil and its coordination with monetary and fiscal policies. Following is a description of the main measures to enhance transparency and accountability, by means of well-defined roles and attributions for debt management, comprehensive information disclosure and frequent examination of debt management activities by external auditors. Concluding the section, the most relevant events regarding governance and the management of internal operations, including recent institutional reforms, are presented.
119. Section B focuses on the guidelines that have been considered in determining optimal strategies for keeping the cost and risk of the public debt under sustainable levels. Along with an illustration of the recent behavior of several debt management indicators, this section describes the implementation of an Asset and Liability Management (ALM) framework and of strategies envisaging reductions in refinancing and market risks. The main features of the risk management models currently in place and under development are also described.
120. The third and concluding section covers the actions that have been taken for developing the markets for government securities. Emphasis is given to the description of some noteworthy measures released by the Brazilian Treasury and Central Bank, in November 1999, and to the continuous effort in stimulating the demand for long-term securities.
A. Developing a Sound Governance and Institutional Framework Debt management objectives and coordination
121. In line with the guidelines suggested by the IMF and the World Bank, the basic directive pursued by the Brazilian government for public debt management is the cost minimization over the long term, taking into consideration the maintenance of judicious levels of risks. As a secondary and complementary objective, the Brazilian public debt office has been taking actions toward the development of its domestic public securities market.
122. Although debt management officers strive to implement strategies aiming at cost minimization of the Brazilian government debt, special attention is given to the risks embodied in each strategy. Also of significant importance are the government efforts in the establishment of a solid reputation with creditors, respecting contracts and avoiding an opportunistic approach in its relationship with the market.
123. As to the risks involved, emphasis has been given to the monitoring of refinancing and market risks, most specifically the former. In this respect, the Brazilian Treasury, as reported in greater detail below, has successfully extended the average maturity of the debt and achieved a smoother redemption profile. Close attention is paid to the amount of debt maturing in the short-term (12 months), reducing the Treasury’s exposure to undesirable events that may occur.
124. The gradual replacement of floating-rate securities for fixed-rate securities represents another major guideline pursued by the Brazilian debt management office. Nevertheless, while an important measure to reduce market risk, changing the composition of debt toward greater concentration of fixed-rate instruments has often diverged with the objective of maintaining refinancing risk under comfortable levels. This dilemma occurs due to the still limited demand for long-term, fixed-rate bonds. As the demand for these securities becomes more pronounced and macroeconomic policies are kept sound and stable, a more aggressive strategy in favor of those securities will follow.
125. Finally, it is worth mentioning that the Brazilian Treasury seeks the development of the secondary market as a main venue to achieve the previous objectives. Some measures are already in effect (see Section C), such as:
improvement of the term structure of interest rates;
standardization of financial instruments; and
fungibility for floating-rate securities.
126. The scope of Brazilian public debt management is also in line with the IMF and World Bank guidelines. It encompasses the main financial obligations over which the central government exercises control, which include both marketable and non-marketable debts, domestic and foreign currency debts, and contingent liabilities.20 Given that the Brazilian
Treasury has adopted an integrated Assets and Liabilities Management framework, asset characteristics are also taken into account in the conduct of public debt management.
Coordination with monetary and fiscal policies
127. Relative to the coordination with fiscal policy, borrowing programs are based on fiscal projections established by the federal budget and approved by Parliament. The Treasury also elaborates and publishes a detailed Annual Borrowing Plan that is submitted to the revision and approval of the Minister of Finance.
128. In reference to the monetary policy, there is close interaction between Treasury and central bank officials. Regular meetings with members of both institutions are held and information on the government’s current and future liquidity needs is shared. Moreover, although the final decisions regarding public debt financing strategies are under the responsibility of the National Treasury, officials from the Central Bank of Brazil (CBB) are always consulted in advance in order to measure the potential impact of such strategies on the conduct of monetary and exchange rate policies.
129. An important step taken in Brazil is that as of May 2002, the central bank is no longer allowed by the Fiscal Responsibility Law to issue its own securities.21 Monetary policy is now conducted through secondary market operations with Treasury securities, enhancing the transparency between fiscal and monetary policy.
Transparency and accountability
130. Brazilian debt management authorities seek transparency and accountability by publicly disclosing the roles and responsibilities for debt management and by providing the public with information regarding debt management policies and statistics. In addition, external auditors frequently examine and evaluate the activities related to public debt management.
Roles and responsibilities for debt management
131. The roles and responsibilities for debt management are clearly and formally defined by legal instruments. A summary of legislation is available at the Treasury’s web site.22 Foreign and domestic public debt management is handled by the Ministry of Finance and in turn, within the Ministry of Finance by the National Treasury Secretariat, (i.e.—t he Public Debt Office). Similarly, all regulations related to debt management are disclosed, including those on the activities of primary and secondary markets, and on clearing and settlement arrangements for trade in government securities.
Public availability of information
132. Information on debt management policies and operations are publicly disclosed by means of regular calendar of auctions, and regular report publications, all available on the Treasury’s web site. Besides publishing its Annual Borrowing Plan, which includes the main guidelines and strategies to be pursued over the year, the National Treasury Secretariat provides detailed public debt statistics through two monthly reports: the Federal Government Domestic Debt Report (in cooperation with the CBB); and the National Treasury Fiscal Results.
133. Debt management activities are audited annually by external auditors. Two entities are commonly in charge of such attribution: the Secretaria Federal de Controle - SFC (internal auditing agency - executive branch); and the Tribunal de Contas da Uniâo - TCU (external auditing agency). These agencies are, respectively, affiliated with the Executive and Legislative branches of the federal government. Although SFC plays an important role by conducting a preliminary audit of public debt management activities, TCU is held responsible for ultimately approving them.
134. In addition, there are some reports required by the Parliament related to debt management activities, among which the following are worth mentioning:
Report on Fiscal Management—follow up of debt limits;23 and
Account Balance of the Federal Government—a description of all federal expenses throughout the year, forwarded annually to the Parliament and TCU.
135. The National Treasury Secretariat has implemented a new debt management organizational framework since November 1999, based on the international experience of Debt Management Office (DMO). The Public Debt Office comprises three main branches:
The back office, which is in charge of the registry, control, payment and accounting of both domestic and foreign debts.
The middle office, which is responsible for the development of medium- and long-term strategies aiming at reductions on debt cost and risk, macroeconomic follow-up and investor relations.
The front office, that is responsible for the design and implementation of short-term strategies, related to bond issuances in domestic markets. Front office activities associated with international capital market borrowings are currently handled by the central bank, but will be transferred to the Treasury in September 2003.
136. The new institutional arrangement resulted in a substantial improvement in debt management allowing for the standardization of operational controls, the monitoring of risks and the separation of functions concerning long-term (strategic) and short-term (tactical) planning. Currently, approximately 90 financial analysts compose the Public Debt Office.
Management of internal operations
137. To strengthen internal operations and in response to an increasing number of non-integrated data systems—making the process of gathering information cumbersome, time consuming and highly exposed to operational risk—the Treasury has engaged in a cooperative program with the World Bank. The program contemplates three modules:
IT System Development;
Control, Internal Auditing and Security Standards, Governance and Organizational Structure; and
138. Although the modules mentioned above are interrelated, focus has been given to the development of the IT System. The project is, therefore, mainly directed to the establishment of an integrated platform that will enhance the efficiency and reliability of public debt accounting and reporting, improving the Treasury’s capacity and transparency in the conduct of public debt management.
139. The new institutional framework, mentioned previously, also represents an important step toward the reduction of operational risks. Front and back office functions have been clearly separated, and the middle office has been established to respond to the setting and monitoring of risk analysis, independently from the area responsible for executing market transactions. It is worth mentioning that registry and auction services are presently provided by the central bank, for which a formal agreement has been recently formulated.
140. The process of hiring personnel was subject to some improvements enacted in the face of competition among different careers within the Executive branch. Although there is still some degree of competition with other institutions, both from the private and public sectors, the Treasury has managed to hire and keep qualified staff by restructuring the career of Treasury financial analysts, and implementing a strict selection process mostly directed to professionals with strong backgrounds in economics and finance. Considerable resources have also been spent in specialized training for the debt management staff, such as a graduate course in debt management.
141. Another step taken towards the improvement of debt management operation was the establishment of a Code of Conduct for Public Debt Managers in February 2001, which contemplates some directives related to their conduct—for example, the prohibition to buy public bonds—and the creation of an Ethics and Professional Conduct Committee of Public Debt Managers.
Legal framework relating to borrowing
142. The main legislation regarding to borrowing can be specified, basically, in four instruments: (i) Brazilian Constitution - limits for public debt; (ii) Fiscal Responsibility Law (FRL) regulatory framework for fiscal policy; (iii) Budget Guidelines Law; and, (iv) Annual Budget Law - LOA (the amount borrowed throughout the year cannot exceed the total established in the specific budgetary sources included in the LOA). Furthermore, a ceiling to new external debt borrowings is determined by a Senate resolution.
143. Among the legal instruments mentioned above, it is worth mentioning the Fiscal Responsibility Law, which constitutes a milestone in public finance at all levels of government. By means of a set of rules, it imposes limits to the government’s payroll spending and to the amount of outstanding debt,24 requiring higher transparency of public accounts, stricter rules for elected officials of the executive branch at the end of their mandates, and administrative and penalty sanctions to the administrators who fail to comply with fiscal legislation.
144. The FRL reinforced the “golden rule” established in Article 167-III of the Brazilian Federal Constitution, which states that it is forbidden to carry out credit transactions that exceed the amount of capital expenses. It also imposes restrictions to credit operations among government entities, including the National Treasury and the CBB and establishes that the CBB, as of May 2002, would no longer be allowed to issue its own securities in the primary market.
B. Establishing a Capacity to Assess and Manage Cost and Risk Debt management strategy
145. Brazilian debt management strategy follows guidelines that are initially prepared by the Public Debt Office, and submitted for the approval of the Secretary of the National Treasury and the Minister of Finance.
146. The Treasury has been gradually moving towards an Asset and Liability Management (ALM) framework. In this context, the risks inherent in the current debt structure are evaluated taking into account the characteristics of assets, tax revenues and other cash flows available to servicing the debt. Net exposures in the balance sheet of the central government are identified by selecting financial assets and liabilities, including guarantees, counter-guarantees and contingent liabilities.
147. Results of such analysis under an ALM framework suggest that in the Brazilian case (as usual in most countries) debt managers should seek a debt composition with heavier reliance on fixed-rate and inflation-indexed instruments. The main mismatches between assets and liabilities of the Brazilian central government, as of December 2001, are presented in Figure 1.
148. Note that the main mismatches concern those related to interest and exchange rate exposures. Although there are several difficulties to achieve in the short and medium term a debt portfolio that matches the characteristics of assets, debt management officials find this type of ALM analysis extremely valuable in setting long-term strategies for reaching optimal debt composition.
149. Along with the objective of gradual minimization of the interest and exchange rate exposures, the Brazilian government, in line with IMF and World Bank guidelines, has established among its priorities the reduction of refinancing risk. These objectives, however, are often conflicting, given the still limited demand for long-term fixed-rate, and inflation-indexed securities. Meanwhile, the National Treasury and the central bank have concentrated efforts in developing secondary markets and in stimulating operations with long-term fixed-rate, and inflation-indexed instruments. These measures have proved to be helpful in paving the way to a more appropriate composition of the public debt in the future.
150. Cash management represents another important aspect of the debt management strategy currently adopted by the Brazilian government. The Treasury has been keeping enough cash reserves to allow greater flexibility in the pursuit of its financing strategies and, most important, to reduce the risk of rolling over the debt under temporarily unfavorable conditions.
151. The debt management guidelines, which emphasize the reduction in refinancing risk and follow an ALM framework, have already reached good results. With the intent of illustrating the main achievements of such strategy, and keeping in mind the still long way to attaining a more appropriate debt structure, the recent behavior of several debt management indicators and some of the lessons learned by Brazilian debt management officials over the past years are presented below.
Lengthening of debt average maturity in order to reduce refinancing risk
152. The average term of the outstanding domestic securities debt reached 35 months in December 2001, from 27 months in December 1999. Behind such achievement are the efforts to extend the maturity of securities issued through auctions, which represent approximately 70 percent of the domestic debt.25Figure 2 reports the outstanding increase in the average maturity of these securities, growing from 4.6 months in July 1994 to approximately 29 months in December 2001. This rise is linked to the objective of reducing refinancing risk and can be mainly explained by long-term issues of floating-rate (LFT) and inflation-indexed bonds (NTN-C).
Improving the redemption profile
153. A remarkable advance regarding Treasury’s financing policy refers to the percentage of public securities maturing in 12 months, which was reduced from 53 percent in December 1999 to 26 percent in December 2001, as reported in Figure 3.
Gradual replacement offloating-rate securities for fixed-rate securities
154. As from mid-1995, the National Treasury started a process aiming at redefining its debt composition. One of the main measures contemplated was the public debt de-indexation by means of a gradual increase in the share of fixed-rate debt. The two graphs shown below illustrate the strategy of gradual replacement of floating-rate (LFT) for fixed-rate (LTN) securities. Note that fixed-rate securities were issued with increasing maturities up to the wave of crises that hit emerging markets starting in October 1997. Until then the Treasury had been able to suspend new issues of LFT.
155. The following figures (Figures 4 and 5) also report the change in focus of debt management strategy in Brazil toward the reduction of refinancing risk and the adoption of a sustainable strategy of issuance of fixed-rate instruments. To reach these goals, starting in 1999 the Treasury has implemented benchmark issues of long-term fixed-rate securities issued periodically and has decided to extend the maturity of the debt by issuing floating-rate securities of much longer terms than those observed historically.
156. The composition of the domestic debt has changed dramatically over the past seven years (see Figure 6). The significant increase in the fixed-rate instruments pursued in the first few years of economic stabilization that followed the launch of the Real Plan in July of 1994, proved to be unsustainable as emerging market economies faced a period of strong turbulence after October 1997. Under the new economic environment, the Brazilian government had to accept an increase in the floating-rate share, and a consequent reduction in the fixed-rate portion, to avoid an increase in rollover risk.
157. Implicit in the discussion presented so far is a very important lesson drawn from the Brazilian debt management experience. Allied to the need for sound and stable macroeconomic policies, as a precondition for developing high quality debt management, the development of (long-term) debt markets is also of fundamental importance. In this respect the measures recently taken to enhance liquidity in the secondary markets and the already mentioned implementation of benchmark issues of long-term fixed-rate, and inflation-indexed securities represent important steps toward a sustainable improvement in the debt composition.
158. In 1995, after 15 years out of the market, the Brazilian Government restored its presence in the international capital market, issuing sovereign bonds with great success. Since then, the main measures underlying the Brazilian government strategies regarding the international capital markets have been:
consolidation of Brazilian yield curves in strategic markets (U.S. dollar, euro, Japanese yen) with liquid benchmarks;
paving the way for other borrowers to access long-term financing; and
broadening of the investor base in Brazilian public debt.
159. As from 1996, the Brazilian government has also pursued a strategy of buying back restructured debt (the so-called Brady Bonds), and replacing them for new bonds.
160. The following figures illustrate new money and exchange operations held since 1995, totaling US$25.5 billion of sovereign debt issued in diversified markets. Note that the Brazilian government has implemented seven exchange operations from May 1997 to March 2001 that helped to reduce the participation of Brady Bonds in External Bonded Debt from 95.1 percent in December 1996 to 36.5 percent in December 2001.
Risk management framework
161. Within the ALM framework, risk analysis is conducted in a model that allows debt managers to project expected and potential costs of the debt under several different refinancing strategies in the medium and long-term. Key debt management indicators, such as average maturity, duration, and debt composition are generated for each strategy allowing senior management to decide the more adequate strategy to be pursued. The main risks monitored are refinancing risk, market risk, and credit risk (most federal government assets are composed by credits from states and municipalities).
162. A new risk management system customized according to the needs of the risk management group was implemented in the first semester of 2002. Besides allowing the same type of analysis that has been currently conducted, this new system allows for a more integrated examination of assets and liabilities characteristics and the adoption of several types of “at risk” models, such as: Cost at Risk; Cash Flow at Risk; and Budget at Risk. At the present time, the risk management group conducts risk analysis based on deterministic and stochastic scenarios. Stress scenarios analysis is also used as a complement.
163. Besides improving its risk management systems, the Brazilian debt management office has been concentrating efforts in developing the skills of its personnel, by means of training, external contacts, and hiring of advisors. With this purpose, the aforementioned cooperation with the World Bank contemplates a risk management module that will provide an extensive background on international experience related to best practices of leading sovereign debt offices. The primary objective is to build capacity in assessing and managing the financial risks for a sovereign debt portfolio, and will be initially focused on an asset and liability management (ALM) framework. The participants will be trained in the various techniques used by the debt offices, and will get acquainted with future path modeling for market variables. To the extent that several of these techniques are already being developed in parallel by the Brazilian staff, a deeper examination of the risk management tools adopted in other countries will allow useful and valuable comparisons.
C. Developing the Markets for Government Securities Improvement measures for the government securities market
164. During the second semester of 1999, the Brazilian Treasury and the CBB designated a working group with the objective of preparing a diagnosis covering the problems related to the markets of public debt securities. Since then, some procedures have been reorganized and new instruments and norms were introduced aiming at the recovery of securities market dynamism. The working group also discussed strategies that could enhance the demand for long-term government securities and released several measures, products, and projects directed to the public debt in primary and secondary markets. Among the actions selected, the following are worth mentioning:
reduction in the number of outstanding series of domestic securities debt;
use of the re-offer and buyback mechanisms;
implementation of firm bid (price-discovery) auctions for issuing long-term fixed-rate securities;
release of a monthly schedule of auctions of Treasury securities;
regular and comprehensive information disclosure of public debt policies and statistics;
regular meetings with dealers, institutional investors, risk rating agencies, and others.
165. The firm bid auctions comprise two stages. In the first stage, only primary dealers are allowed to submit bids, committing themselves to buying the securities auctioned at the prices and quantities specified in their bids. This does not guarantee, however, that these institutions have won the auction. The Treasury determines the amount of securities to be auctioned at the final phase and releases such information along with the corresponding cutoff price observed in the first stage, acting as a price reference for the second stage. A discriminatory price auction with the participation of all financial institutions is then conducted. This auction procedure plays an important role in reducing the uncertainty regarding the pricing of fixed-rate long-term bonds issued by the Treasury, given that references in the Brazilian market for these bonds are still incipient.
166. Measures undertaken for the development of the government securities market have been favorable. The noticeable improvements in the term structure of interest rates and the establishment of fungibility for floating-rate and inflation-indexed securities have contributed to stimulating negotiations in the secondary market. As a consequence of this latter measure, it was observed a reduction in the number of outstanding series of floating-rate (LFT) and fixed-rate (LTN) securities, illustrated as follows.
167. The interest rate and inflation-indexed term structures have improved as a consequence of the Treasury’s strategy of building benchmark issues of long-term instruments. At the present time, there are parameters for price-index curves up to 30 years, whereas price references for fixed-rate instruments reach 18 months.
Sales through the Internet
168. As part of the recent actions toward the development of the market of government securities, starting in January 2002, the Treasury began conducting sales of public debt instruments through the Internet. By setting low minimum and maximum buying limits (approximately US$80 per transaction and US$80,000 per month, respectively) this measure is mainly directed to small investors and endeavors to stimulate long-term domestic savings.
169. As indicated in Table 2, the amount issued through the Internet as of July 2002 was around US$11 million, of which 77 percent were fixed-rate securities. The number of investors totaled more than four thousand from 24 of 27 Brazilian states.
A. Developing a Sound Governance and Institutional Framework
170. The main objective of debt management is to assure that financing needs are met with a low funding cost in a long-term perspective, within a sustainable path and with a prudent level of risk. The risks considered are refinancing, market, credit, operational, and legal.
Scope of debt management activities
171. Debt management covers both internal and external debt. In addition to funding, debt management also includes management of outstanding debt and contingent liabilities, the latter especially related with infrastructure and public credit operations.
Coordination with monetary and fiscal policies
172. The 1991 Constitution states that Banco de la República (BdR), the central bank, will be the independent agent responsible for monetary and foreign exchange policy, while the Ministry of Finance will be responsible for fiscal policy. The Debt Management Office (DMO), Dirección General de Crédito Público, is situated within the Ministry.
173. Issues that require coordination with the BdR regarding monetary policy, debt management and the macroeconomic agenda are discussed in the regular bi-weekly meetings of the Board of the Central Bank, where the Minister of Finance is member. Banco de la República is also in charge of the settlement and clearing of the domestic debt market, which implies for strong coordination between fiscal and monetary authorities in the management of the domestic public debt.
174. Two officials from the BdR are also members of the Debt Advisory Committee, which determined the guidelines for debt management and debt issuing program.
175. The legal framework for debt management is included in the Decree 2681 of 1993, which covers:
Public Credit transactions that involve new funding, and therefore increasing the debt stock.
Debt management transactions that reduce portfolio risk and not increase debt stock. These transactions include hedging operations such as cross currency swaps, interest rate swaps, debt exchanges, refinancing, debt conversions, and the like.
176. As mentioned, the Ministry of Finance is responsible for debt management, and the Debt Management Office (Dirección General de Crédito Público) is a division of the Ministry. Altogether, the Ministry of Finance has six divisions:
Superior (Minister, Deputy Ministers, General Secretary);
Macroeconomic Policy Division;
Treasury Division (Tesoro Nacional);
Sub-national Governments Division and;
Debt Management Office (Dirección General de Crédito Público).
177. The Debt Management Office is in charge of debt management, while the Treasury Division is in charge of cash and asset management. Coordination and communication with the Treasury is essential. Although the Debt Management Office works closely with the Treasury to create synergies between the two areas, communication could be vastly improved by merging these two divisions. No doubt this merger would also improve asset-liability management. However, at present there are no plans for a merger.
Management of internal operations
178. The Debt Management Office adopted a new internal structure in May 2001, following recommendations from the World Bank. The new structure, including responsibilities, is the following:
Front Office - local and external funding;
Middle Office - analyzing portfolio risks and strategy and;
Back Office - operational issues.
179. Besides these three sections, the DMO also includes the legal affairs office and the IT (information technology) office.
180. The new structure improves communication and coordination between front-, middle-and back offices, thereby reducing the operational risk. Completing a document describing the procedures of the debt office has also reduced operational risk.
181. Debt management decisions and actions must be based on accurate and updated information on the debt portfolio. In order to improve databases and analysis tools, DMFAS software from UNCTAD 27 is currently in the process of being implemented. This software is especially designed to strengthen the technical capacity to record, manage, and analyze external and internal debt. It also provides facilities for the recording and monitoring of bond issues, on-lending, as well as private non-guaranteed debt. After the software is adjusted for the Colombian requirements, it is expected to:
Reduce operational risks;
Produce debt profiles and financial risk quantification in real time;
Improve capacity of evaluate statistical models;
Be compatible with other information systems;
Increase accuracy of exercises;
Allow internet operability and;
Provide proactive Alarm System, which will alert management if the portfolio reaches any debt management policy limits, such as the stated currency or interest rate composition of the debt.
Retain qualified staff with financial market skills
182. Staff members receive continual training, allowing them to acquire important market skills. This is particularly true in the middle office where staff receive ongoing training in portfolio analysis and strategy. Individuals are often attracted to this benefit of acquiring knowledge in these areas, thus making the DMO a good working environment. It is especially so because salaries in the public sector are often not competitive with those in the private sector.
Incentives and guidelines to ensure implementation of strategies
183. A benchmark for external debt has been established since 1997. Although there is no legal obligation or economic incentive that will ensure that debt management is implemented prudently, historically the benchmarks have been met. Internal debt benchmarks have not been formally adopted; however, according to present plans, the authorities will approve a benchmark for the internal debt in June 2002.
184. Transparency of the debt figures is achieved through the yearly report of the Ministry of Finance. This report includes a summary of last year’s agenda as well as the state of the economy and debt portfolio. Two web sites are also available for debt figures, www.minhacienda.gov.co and www.coinvertir.org.co.
B. Debt Management Strategy and Risk Management Framework Reducing the country’s vulnerability
185. During the mid- and late 1990s, the main concern was minimizing the exposure of the external debt portfolio to market shocks and international crisis. As a consequence of this concern, the Public Debt Advisory Committee (Comité Asesor de Deuda Pública) was created on April 21, 1997, integrated by officials from the Ministry of Finance and the BdR. The main objectives of the committee are to analyze and discuss guidelines of the internal and external indebtedness and to propose risk management guidelines.
186. In 1997 the ratio of internal debt to external debt was approximately the same as today. In contrast to the external debt, the internal debt was considered as carrying less risk, since it mainly was made up by liabilities with the public sector. Therefore, the main concern was minimizing the exposure of the external debt portfolio to market shocks and international crisis. As a consequence, benchmarks for the external public debt were established as reference points for the central government and for the eight public entities with the highest outstanding external debt. The benchmark covers refinance risk, interest rate risk, currency risk and duration and have been an important tool to control and minimize the exposure to external shocks. The amortization profile has never exceeded the 15 percent limit per annum, reducing refinancing risk considerably, and the portfolio has met the currency and interest rate composition in the benchmark, thereby minimizing market risk.
187. Since the characteristics of the domestic capital market are different from those of international capital, it is not possible to use the external debt benchmark for the internal debt portfolio. For management of the internal debt portfolio, risk management guidelines have been taken into consideration but no explicit benchmark has been adopted. However, the Debt Committee will approve a benchmark for the internal debt in June 2002.
Main risks in the government’s domestic and foreign debt portfolio
188. In order to reduce vulnerability, the DMO focuses on two main risks, namely the refinancing and market risks. The benchmark for the share of internal debt is 67 percent and 33 percent for external debt.
189. As mentioned previously, since 1997 the Debt Committee has established benchmarks for external debt. These benchmarks have been updated yearly and were reviewed in May 2002. The benchmarks for the external debt are the following:
Refinancing: No more than 15 percent of the total external debt can mature on any given year. The ideal is 10 percent. (The rational behind these figures is that market conditions may require executing a funding strategy that exceeds the 10 percent limit, but never the 15 percent limit.);
Currency composition: U.S. dollar 83 percent, euro 13 percent and Japanese yen 4 percent;
190. For the internal debt, the following benchmarks are going to be approved at the meeting of the Debt Committee in June 2002. The new benchmark will guarantee that future funding programs will be in line with debt guidelines. The benchmarks for the domestic debt is suggested as following:
Refinancing: No more than 20 percent of the total internal debt can mature on any given year. The ideal is 15 percent;
Interest rate composition: Since local debt instruments are either fixed, price-indexed or U.S. dollar-indexed, there is no interest rate for benchmark the internal debt.
How different risks are quantified and balanced
191. Two methods are used to quantify the portfolio risk. The first method compares the actual portfolio versus the benchmarks. The second method, called Debt Service at Risk (DsaR), has currently been implemented. DsaR allows the Debt Management Office to quantify the maximum debt service cost of the debt portfolio with 95 percent likelihood. The methodology takes into consideration the exposure to different market variables, such as interest rates, exchange rates, and commodity prices. For managing the cost and risk dimensions of the debt portfolio, the middle office presents a monthly report of funding alternatives based on DsaR analysis. This report compares the cost of the expected scenario versus the risk scenario of the different funding alternatives.
192. The funding strategy takes into consideration the benchmarks. The front office analyzes the market situation and different funding alternatives. If the funding strategy requires exceeding one or more limits established in the benchmarks, the possibility of a hedging transaction is analyzed.
Reducing the risk of losing access to domestic and international financial markets
193. In order to have access to financial markets, control over both refinancing and market risk are essential. As previously mentioned, since 1997 the amortization profile of external debt has never exceeded the 15 percent limit, reducing refinancing risk considerably. Recent crisis in Russia, Brazil, Turkey and Argentina have emphasized the importance of monitoring these two risks.
194. Refinancing in advance, when the conditions of the external capital markets are favorable, has been a successful strategy. It allows the Ministry of Finance to guarantee the funding needs at a low cost, while anticipating future market shocks. The view of the market is a combination of judgment of parameters such as political conditions, falling spreads, tighter yields, and investors’ demand for bonds, in addition to various bank surveys.
195. For domestic debt, it is important to remember that the local market for public debt is only five years old. Moreover, investors are only progressively demanding longer-term instruments. The first issues were securities with 1-, 2- and 3-year maturities. Therefore, the amortization profile historically showed concentrations in the first and second years. Now, when the daily volume traded has increased considerably and inflation has reached one-digit levels, fixed-rate securities with longer maturities (5, 7, and 10 years) have been successfully introduced. Securities with longer-term maturities (10 and 15 years) are price-indexed.
196. Several voluntary debt swaps have also been executed recently:
On June 2001 an internal voluntary debt swap was conducted. Short-term (20012005) amortizations were reduced by US$ 2.4 billion, and the refinancing risk was reduced considerably;
On January and March 2002 two internal voluntary debt swaps took place. US$ 512 million of short and mid term amortizations of US$ denominated TES were exchanged for 10 year tenor fixed rate peso denominated TES, reducing exchange rate and refinancing risk considerably;
On May 2002 another voluntary swap took place, exchanging US$ 589 million of external bonds (euro and US$ denominated) maturing between 2002-2005 for 10 years TES maturing in 2012;
On June 2002 an external voluntary debt swap was executed. External Bond short-term (2002-2005) amortizations were reduced by US$ 255 million, reducing refinancing risk considerably;
Other small internal debt exchanges are held on a regular basis. Management for risks associated with embedded options
197. So far, the Republic of Colombia has issued eight bonds with options, two of which have already been exercised (a “knock-out” yen option and a put option). Managing the risks associated with these options has been conservative. For budgetary purposes, all bonds with put options are always registered as if all the investors exercised the option. This allows the Republic to have funds on hand to cover the option.
Strategies to generate returns
198. The DMO does not engage in active debt management strategies. Transactions such as interest rate and currency swaps have a hedging purpose only. However, by following interest and currency rates, transactions that could reduce debt service are considered if favorable market opportunities occur.
Management of contingent liabilities
199. The Middle Office of the DMO is responsible for explicit contingent liabilities. The responsibilities of the Debt Office are to verify the methodologies used by the public entities that generate these liabilities. With these models, the DMO structures a contributed payment plan in order to create a fund, which will be managed by a fiduciary. This fund allows having liquidity to pay the liabilities when the contingency occurs.
200. In addition, the Debt Management operates in the following areas by:
Implementing and developing methodologies for quantifying contingent liabilities on guarantees offered by the government to private agents in concession projects of state owned infrastructure (highways, electrical energy generation, water and communications);
Developing methodologies for quantifying contingent liabilities in public credit transactions (guarantees of the central government on external or internal debt of municipal governments and public entities);
Creating methodologies for credit risk analysis of municipal public entities.
201. The procedure of contingent liabilities management includes appointments with investment banks and public entities, developing simulation models for risk assessment and developing a schedule for the contingent liabilities payouts (including the probability for payouts).
Management information systems used to assess and monitor risk
202. The IT office created a database system that has been in use since 1997. This software allows inquiries to the current debt portfolio; however it does not have a risk-monitoring module. For risk quantification, the middle-office uses its own models based on Excel spreadsheets.
203. As previously described, more sophisticated software called DMFAS will be implemented in 2003. Currently a team is working on the transition process. Besides allowing for the possibility of consulting debt information, the new software will provide analysis of the exposure of the debt portfolio to volatility in interest rates and exchange rates, while also having the capacity to make simulations of new funding strategies.
Development in markets for private sector debt
204. The Debt Management Office has been one of the most important agents involved in the development of the local capital markets. The treasury bond market has become a model for private debt issuers. This means that the private sector takes into account all developments in the public debt market.
C. Developing the Markets for Government Securities Development of the primary market
205. The Debt Management Office is the only agency that issues central government debt. The central bank no longer issues bonds for monetary policy purpose. The DMO is also responsible for updating the database of the public debt, which includes debt of the central government plus other public institutions and sub-national governments.
206. The profile of the internal debt portfolio has changed since 1997. Today 76 percent internal portfolio consists of treasury bonds and notes (exposed to market risks) compared to more than 90 percent five years ago. In 1997, 34 percent of outstanding treasury bonds and notes were liabilities with private investors; today the ratio has increased to 40 percent.
207. The Debt Management Office issues 1-10-years fixed-rate instruments, and 5-, 7- and 10-years are issued as price-indexed securities. U.S. dollar-indexed securities in 2-, 3-, 5- and 8-year maturities are only issued when Colombian peso to the U.S. dollar exchange rate undergoes periods of considerable volatility, or those that are not part of the normal funding program. In order to diversify the debt stock across the yield curve, the Debt Management Office considers the amortization profile, market conditions, funding cost, and bond liquidity when deciding on the issuing plan.
208. Treasury securities in the domestic market are issued by two mechanisms. In 2002, weekly primary Dutch auctions counted for 40 percent of internal funding. The remaining 60 percent of internal funding in 2002 was covered by direct placement to public entities. Direct placements (mandatory and agreed-upon) are with public entities that have cash surpluses. These public entities are price takers in the market.
209. In the international market, bonds are issued in the U.S. dollar, euro, and Japanese yen markets. Borrowing is also executed by loans from multilateral credit agencies, syndicates, and other commercial loans.
210. The Ministry of Finance issues official press releases with information on bond (local and external) placements as well as agreed loans. These releases are available on the web site www.minhacienda.gov.co.
Development of the secondary market
211. Since 1997, one of the objectives of the Debt Management Office has been the development of the local public debt market. For this purpose it has established the Programa de Creadores de Deuda Pública (Public Debt Market Maker Program). In this program, 24 of the most important financial institutions, of which 22 are private and 2 are public, participate in weekly primary auctions of treasury bills, notes and bonds.
Contacts with the financial community
212. Communication between the Debt Management Office and the financial institutions is regarded as very important. Meetings between representatives of the financial institutions and officials from the DMO take place at least every quarter. In the local market, there is constant communication with financial institutions members of the market maker program and important investors such as pension funds, fiduciary funds and insurance companies. For the external market, it is important to keep close contact with various financial institutions that provide market feedback, promote trading of instruments, and have direct contact with key investors.
Clearing and settlement
213. The following systems are used to settle and clear local debt market transactions:
DCV (Depósito Central de Valores), the electronic central depository that handles all of the public local debt;
SEN (Sistema Electrónico de Negociación de Deuda Pública), the system which handles the electronic local public debt market;
SEBRA (Sistema Electrónico de Banco de la República), the electronic settlement system used for primary auctions for public local debt.
Tax treatment of government securities
214. Government securities are tax free only for the profits on the principal of stripped securities. Non-stripped government securities have the same tax treatment as corporate securities.
A. Developing a Sound Governance and Institutional Framework
215. The overall objective of Denmark’s government debt policy is to achieve the lowest possible long-term borrowing costs, consistenty with a prudent degree of risk. The authorities pursue this objective while taking various factors into account, including the objective of a well-functioning domestic financial market. Recently, more emphasis has been placed on the discipline of risk management.
Scope of debt management
216. The debt of the central government is compiled as the nominal value of domestic and foreign debt minus the central government’s account within the central bank, Danmarks Nationalbank (DNB), and the assets of the Social Pension Fund (SPF). All administrative functions related to the government debt management are undertaken by the DNB.
217. Two conditions establish a dividing line between fiscal and monetary policy in Denmark. First, government borrowing is subject to a set of funding rules nased on an agreement between the government and DNB Second, the prohibition on monetary financing in the EU Treaty regulates the central bank’s role as a fiscal agent and bank to the government.
218. Since the early 1980s the central government borrowing has been subject to funding rules for both domestic and foreign borrowing. The present funding rules have been stipulated in an agreement from 1993 between the government and the central bank, thus replacing the informal agreement from the early 1980s, when the Danish fixed exchange rate regime was implemented.
219. In overall terms, the domestic rule ensures that domestic borrowing in Danish kroner matches the central government’s gross domestic financing requirement for the year. Thus, the domestic rule sterilizes the liquidity impact from government payments for the year as a whole. The rule for foreign borrowing states that new foreign loans are normally raised to refinance the redemptions on the foreign debt. If the level of foreign exchange reserves is considered inappropriate, a decision can be taken to reduce or increase the level of foreign debt. Foreign exchange reserves are owned by DNB and the central government’s account in DNB provides the link between government foreign debt and foreign exchange reserves.
220. In accordance with the EU Treaty’s prohibition of monetary financing, the central government’s account with the DNB may not show a deficit. The government’s borrowing is therefore planned to ensure an appropriate balance on its account.
221. The central government receives interest on its account with the DNB. This interest rate is equal to the discount rate set by the central bank. The discount rate is equivalent to the current-account rate (folio rate), which is the interest rate for the banks’ and mortgage-credit institute’s current-account deposits with the DNB. This arrangement implies, together with the fact that the surplus of the central bank after reserve allocations is transferred to the government, that the government receives an interest rate on the account, which is comparable to what would be obtained if the account were placed in a commercial bank.
Legislative basis for central-government borrowing
222. The legal authority for the central government to borrow is stipulated in legislation enacted in 1993. It allows the Minister of Finance to borrow in the name of the government. It also empowers the Minister of Finance to raise loans on behalf of the central government up to a maximum of DKr 950 billion, which is the limit for the total domestic and foreign government debt. Moreover, it empowers the Minister of Finance to transact swaps and other kinds of financial instruments.
223. Before the beginning of a new fiscal year, a Finance Bill is adopted by Parliament. It authorizes the Minister of Finance to raise loans to finance the projected central government gross financing requirement, which is the sum of the current central government deficit plus redemptions on domestic and foreign debt. The borrowing is obtained according to the domestic and foreign norm. During a fiscal year, changes may occur in the gross financing requirement. This happens primarily because of changes in the central government deficit or because of buybacks that increase the amount of redemptions. Changes in the gross financing requirement are similarly financed by government loans. These loans are authorized by an act of supplementary appropriation of the Finance Bill at the end of the year or by the Financial Committee of the Parliament during the year.
224. Besides the government debt the central government guarantees the borrowing and the financial transactions related to the borrowing of a number of public entities. The entities are mainly related to infrastructure projects, for example the Great Belt Bridge and subway construction in Copenhagen. The board of directors and the management of the individual entity are responsible for the financial transactions of the entity, but the central government establishes borrowing limits and guidelines for the borrowing activities. The guidelines are determined in a set of agreements between the DNB and the Ministry of Finance or the Ministry of Transport and between the relevant ministry and the individual entity. The agreement between the central bank and the relevant ministry sets out the main tasks and responsibilities of the parties involved. The set of agreements also includes a list of acceptable types of loans. The list describes which kind of financial transactions and currency exposure the entity is allowed to incur.
225. The entities publish their own annual report and are embraced by the general legislation applied to private firms.
The Danish debt office is placed within the central bank
226. The responsibility to Parliament for central-government borrowing rests with the Ministry of Finance. Since 1991 the central bank has undertaken all administrative functions related to government debt management. The division of responsibility is set forth in an agreement between the Ministry of Finance and the DNB. By power of attorney, officials from Danmarks Nationalbank are authorized to sign loan documents on behalf of the Minister of Finance.
227. Before 1991 the debt office was an integrated part of the Ministry of Finance. In 1991, the debt office was moved to the central bank—the structural change occurring partly as a consequence of a report prepared by the public auditors. The report indicated that most of the assignments related to the central government debt were already carried out by the DNB, but it happened that duplication of assignments occurred between the central bank and the Ministry of Finance. Furthermore, the report suggested that a stronger coordination between the management of the foreign exchange reserve in the DNB and the central-government foreign debt would be beneficial. Finally it was suggested, that attracting and maintaining staff with the relevant skills to the debt office would be easier if the debt office was placed in the central bank. It is believed that the move to the central bank has helped to centralize the retention of knowledge of most aspects of financial markets within a single authority.
The relation between the debt office and the Ministry of Finance
228. The Ministry of Finance and the DNB determine the overall strategy for government borrowing at quarterly meetings on the basis of written proposals from the DNB. The adopted strategy is authorized and signed by the Ministry of Finance by a set of written conclusions at the meeting signed. In December each year, the overall strategy for the following year is determined, as well as the detailed strategy for the first quarter of the following year. At the following quarterly meetings, amendments to and specifications of the main strategy for the subsequent quarter are decided.
229. The strategy specifies the expected domestic and foreign borrowing requirement and includes a set of decisions for the following year. Among the decisions are:
Bands for duration of the central-government debt;
List of on-the-run issues for the domestic debt;
Borrowing strategy for foreign debt;
List of government securities eligible for buybacks/switch operations;
List of government securities in the securities lending facility; and
Maximum amounts of buybacks and use of interest rate swaps.
230. The first four bullet points are published after the meeting in December. If changes in these decisions occur during the year, these are published as well. Maximum amounts of buybacks and use of interest rate swaps are not made public.
231. On the basis of these conclusions, the central bank handles the necessary borrowing transactions and the ongoing management of the debt. Besides the formal meetings, the DNB is in contact with the Ministry of Finance on a regular basis, and ad hoc adjustments in the strategy may occur during the year.
Structure of the debt office within the central bank
232. Within the DNB, basically four departments are involved in the management of the central-government debt—The Government Debt Management unit of the Financial Markets Department, the Market Operations Department, the Accounting Department, and the Internal Audit Department. The division of the management of government debt in a front-, middle-and back-office structure was implemented in 1996 in order to diminish operational risk.
233. The Government Debt Management section is responsible for middle-office functions and constitutes the Danish debt office. It formulates the principal aspects of the debt management strategy and carries out analysis and risk management. The section also formulates guidelines to Market Operations regarding sale of domestic bonds, buybacks, swap transactions, and the amount of foreign borrowing.
234. Market Operations is responsible for front-office functions such as sale of securities and rise of foreign loans. Responsibility for back-office functions, such as settlement and bookkeeping, is handled in Accounting and Government Debt Accounting.
235. The Internal Audit department in the central bank assists the Auditor General (the National Audit Office) in the auditing of government debt management. In handling the government debt, the departments involved in the process also draw on resources from other departments in the central bank, for example, the legal experts.
236. The Danish government debt strategy is aiming at a high degree of transparency towards the general public and the financial markets. Therefore, the DNB compiles and publishes a wide and frequent range of information on central government borrowing and debt.
237. The information policy is based on several announcements to the public. Some of them follow a fixed annual schedule. The most important announcements and publications are the following:
Prior to the beginning of each half-year normally in June and December—the central bank sends an announcement to the Copenhagen Stock Exchange (CSE) and market participants with details of central-government benchmark issues concerning July and January respectively. The announcement also presents more general information on the plans for the central government’s domestic borrowing.
Prior to the opening of new government securities series an announcement is sent to the CSE with details of the coupon, maturity and opening day of the new loan.
On the first banking day of each month, the DNB sends an announcement to the CSE and other interested parties on the sale and buyback of domestic government securities during the preceding month. On the second banking day of each month, DNB issues a press release with details on the government’s actual borrowing requirement and other important financial details of the preceding month.
On a daily basis details of the sale and buyback of domestic government securities are issued via the DNB’s web site29 and an electronic information system (DN News). Most of this information is reproduced directly by Reuters, for example. Further information on prices and circulating amounts of government bonds is available through the Copenhagen Stock Exchange.
Terms and conditions for treasury bill auctions and results are announced via the Copenhagen Stock Exchange and the electronic auction system.
The Ministry of Finance publishes information on the development in the government budget on a regular basis.
Other information on “Danish Government Borrowing and Debt” appears in the Annual Report.
238. The debt management office in the central bank publishes an annual report (“Danish Government Borrowing and Debt”) usually in February. The annual report is a cornerstone of the implementation of the information policy. The public, market participants, the Parliament, and the Ministry of Finance are informed via the report about all activities related to Danish debt management in the preceding year. From 1998, the report has been published also in English. The report describes considerations and factors concerning borrowing and debt management. Furthermore it includes sections on special topics of relevance to government debt management. Finally, it includes a comprehensive appendix of tables with detailed central government borrowing and debt statistics, including a list of all government loans.
Enhancing quality and reducing operational risk
239. For the relevant units in the departments working with government debt a written procedures manual ensures proper government debt administration. The written procedures manual describes authorities and obligations of the unit. The central bank’s Audit Department is responsible for any changes to the written procedures, which are subsequently passed on to the Ministry of Finance. Developing and maintaining the procedures manual is considered a key element in enhancing quality and reducing operational risk, and is thus an area of high priority in debt management.
240. As a supplement to the procedures manual, work descriptions are used in daily work. A work description is a detailed description of a particular task, which is carried out on a regular basis. As an example, there are work descriptions for such factors as the opening of a new government bond, a buyback auction, calculations of duration and cost-at-risk, and monthly releases on public information on the government debt. The use of work descriptions is contributing to consistency and accuracy in the administration of the government debt.
241. Guidelines for acceptable loan categories are set out for the central government’s foreign borrowing. The guidelines stipulate requirements of the overall loan structure, including both the underlying loan and any related derivatives. The purpose of these guidelines is to minimize the political, legal, and operational risks.
Codes of conduct
242. The DNB staff must adhere to internal codes of conduct based on the guidelines toward speculation set by the Danish Financial Supervisory Authority and the legislation against insider trading. In short, this means that the staff is only allowed to invest personal capital and only in non-speculative investments.
Recruiting and maintaining highly skilled staff
243. The placement of the debt office within the central bank has helped the office in recruiting highly skilled staff. Contributing to this is the fact that the debt office is a part of a larger environment, where finance, financial markets and policy are major areas. Therefore the debt office is able to recruit internally from other departments and externally offering new employees to be part of a large and highly skilled organization, which is well known to the public.
244. The staff in the Government Debt Management section (middle-office) consists of a mix of senior staff, who have worked with debt management for a number of years and/or have worked in other areas of the bank, and young economists recently employed in the DNB.
245. Inclusive people working in front- and back-office, around 20 persons, are working mainly with tasks related to the central government debt.
Management information system and use of IT
246. Strong and reliable IT-systems are crucial to limiting operational risk. In the Danish debt office the current IT-strategy is primarily built upon a specially developed back-office system (“System Statsgœld”) combined with the use of other software. All borrowing and swap transactions for the central-government debt enter “System Statsgœld.” Transactions are controlled by the back-office.
247. The back-office system generates information on payments to be made or received, input to the central bookkeeping system, which covers all government entities and finally data for analytical purposes.
248. During 2002 it is the plan to implement a new middle-office system. The purpose of this system is to automate important calculations used on a regular basis, for example duration calculations, market value and various risk factors on the debt. The new system will draw data directly from the back-office system. The implementation of the new middle-office system is considered to further reduce operational risks.
B. Debt Management Strategy and the Risk Management Framework Limiting country vulnerability
249. The objective and strategy for government debt management focuses on reducing the risk of negative spillover effects from the government debt to the surrounding economy. In that respect interest rate risk and exchange rate risk are considered the most important risk factors.
250. To reduce country vulnerability it is therefore important to limit interest and exchange rate risk. In the Danish case this is done primarily through steering the duration and redemption profile on the debt and by borrowing only in euro or Danish kroner cf. the Danish fixed rate policy vis-à-vis the euro.
251. The strategy for the domestic borrowing involves building up large government security series in the internationally important 2-, 5- and 10-year maturity segments. The liquidity premium resulting from this strategy contributes to low borrowing costs for the central government. A range of government debt instruments is applied in order to ensure large liquid benchmark issues. This includes domestic interest rate swaps, buybacks and swaps from Danish kroner to euro. The domestic borrowing strategy also includes a treasury bills program with monthly issues of bills with maturity up to 12 months.
252. Given that the central government is a dominant issuer on the domestic bond market, the measurement of performance does not encompass comparison of the cost relative to that of a specific benchmark portfolio constructed on the basis of domestic bond issues.
253. The Danish domestic government bonds are priced on a competitive financial market, which consists of both domestic and international investors. Furthermore, the bonds are comparable to other domestic and foreign bonds and are issued in the internationally most important maturity segments. In that respect the pricing is based on market conditions.
254. In the case of buybacks, the government determines whether buybacks are advantageous as seen from a broad government debt perspective. Buybacks are used to concentrate government debt in liquid bonds, in cash-management and to control the redemption profile. Buybacks take place at market prices. Comparing prices with theoretical prices calculated on the basis of zero-coupon yield curves drawn from the market ensures that buybacks will be purchased at the market price.
255. Over the years there has been a gradual change in the domestic borrowing strategy toward a concentration of borrowing on a reduced number of benchmark bonds and an increase in the use of interest- and currency swaps. The changes have been carried out in order to ensure the outstanding amount and the liquidity in the bonds in a time with reduced borrowing needs as a result of budget surpluses since 1997.
256. The issuance of bonds takes place only in the 2-, 5- and 10-year maturity segments. The 5- and 10-year bonds are on average open for issuance for 2 years, while the 2-year bonds are open for about 1 year. The issuance in the 30-year segment was effectively stopped by end of 1997. By end 2001, 99 percent of the total outstanding amount in domestic bonds and treasury bills were distributed on 11 bonds and 4 treasury bills. The bonds are among the leading bonds on the Copenhagen Stock Exchange. Three of these bonds are considered as benchmarks; the benchmark in the 10-year segment is the most important one.
257. All foreign borrowing takes place directly in euro or via loans swapped to euro. All central-government foreign currency exposure, including swap transactions, is in euro. In 2002 and the coming years, the borrowing strategy will be based on raising primarily bigger loan preferably directly in euro. The strategy is supplemented with the opportunity to issue domestic bonds combined with currency swaps to euro.
258. The strategy for foreign borrowing has changed gradually over the years from small loans, and in some cases structured loans to a mixture of smaller and bigger loans with end exposure in euro. The present strategy described above, focusing on bigger bullet loans directly in euro, is in line with this development toward a more standardized foreign borrowing.
259. In cases where foreign exchange reserve considerations entail an immediate need for foreign currency borrowing, the central government may issue short-term commercial paper (CP). Finally the central government can use short-term CP programs in periods, when the balance of the central government’s account with the Nationalbank is expected to be low.
260. The Euribor rate serves as a reference in the assessment of borrowing costs for the foreign government debt. In addition the cost of different instruments is compared, e.g., direct borrowing in euro is compared with borrowing in other currencies swapped to euro. The borrowing costs for the foreign debt are also compared to the levels achieved by peer-group countries.
Main types of risk
261. The main risks for the government debt portfolio are interest risks, exchange rate risk, credit risk and operational risks. These risks are defined in the following.
Interest risk comprises the risk that the development in interest rates will lead to higher borrowing costs. The concept of interest rate risk also covers refinancing risk, which is the risk that existing debt has to be refinanced at a time with unfavorable market conditions or particularly unfavorable borrowing terms for the central government. Interest risk is relevant for the domestic debt and the foreign debt.
Exchange-rate risk is the risk that the value of the debt will increase as a consequence of the development in exchange rates.
The central government undertakes a credit risk when it enters into swap transactions. A swap is an agreement between two parties to exchange payments during a predetermined period. Thus there is a risk that the counterparty will default on its obligations. Credit exposure is included in the management of the credit risk as soon as the swap is transacted.
The central government is also exposed to other risks, such as the risk of error in the administration of the debt by itself or by counterparties.
Managing the risks
262. The government debt is as described earlier comprised of four sub-portfolios: the domestic debt, the foreign debt, assets of the Social Pension Fund and the central government account with the DNB.
263. The four sub-portfolios comprising the government net debt are all subject to management by the central bank as an agent to the central government.
264. Management of interest-rate risk is based on the net debt as a whole. This is a direct consequence of the fact that the sub-portfolios are more and more integrated. An example of more integration between the portfolios are the use of currency-swaps from Danish kroner to euro to raise foreign loans, which at the same time affect the interest rate risk on domestic and foreign debt.
265. Interest-rate risk is primarily managed by a duration target and a duration band for the total central government debt (net). Historically each individual sub-portfolio had a separate duration target, but this practice was abolished by the end of 1999.
266. One important consequence of only targeting the duration on the net-debt is that a reduction in duration may be achieved by for example using either domestic or foreign interest rate swaps. A reduction in duration on the net-debt can also be achieved by a raise in the duration of the central government asset portfolio. Therefore only targeting the duration of the net debt brings therefore higher flexibility to the management of the duration.
267. Smoothening the redemption profile is also a part of the interest rate risk management, and this is applied separately to domestic and foreign debt. Ensuring a smooth redemption profile, whereby a more or less constant proportion of the debt is redeemed each year, reduces the risk of being obliged to refinance the debt, at a time when market conditions in general are unfavorable, or when the borrowing terms for the central government are particularly unfavorable.
268. The portfolio of the Social Pension Fund, which is a sub asset portfolio of the net government debt, contains mortgage bonds. These mortgage bonds can be redeemed at par value at any time, i.e., they include an option. For these bonds an option adjusted duration is used in the calculation of the duration on the government net debt.
Exchange rate risk
269. The Danish exchange-rate policy is based on maintaining a stable rate of the Danish kroner against the euro within the ERM2-framework. As a result of this policy the exchange-rate risk on the foreign government debt is handled by only taking foreign loans with an end risk in euro (i.e., borrowing takes place directly in euro, or via loans which are swapped to euro).
270. In the period 1991-2000 the exchange risk on the foreign government debt was handled together with the exchange rate risk on the foreign exchange reserve in the central bank in a formalized set-up. In this way the exchange risk for the government debt and the central bank was measured on a net basis. The formalized setup was abolished by end of 2000, due to the decision that all foreign government debt should be in euro. Together with the fact that the central bank only has a very small amount exchange reserve placed in other currencies than euro, there was no need for a formalized arrangement by end-2000.
271. Credit-risks exist on the swap portfolio of the central government. Therefore risk principles for credit-risk management of the portfolio have been laid down. Significant elements of the credit-risk management are high rating for the counterparties and credit exposures within relatively tight credit lines. Finally, new transactions only take place with counterparties, which have signed a collateral agreement. By the end-2001 80 percent of the swap portfolio consisted of collateralized agreements.
272. As mentioned above, the government has an account with the DNB. According to the Maastricht Treaty the government is not allowed to overdraw this account. To ensure this requirement is fulfilled it has been decided to have a minimum deposit requirement for the government’s account of DKr 10 billion (i.e., EUR 1.3 billion) and at specific times higher. Every year a detailed forecast for the government’s payments the following year is made. On the basis of this forecast, an estimate is made concerning the daily deposits on the government’s account in the DNB. Due to the fact that redemptions on the government debt are usually placed toward the end of the year there is a front-loading of liquidity on the government’s ac-count during the first part of the year in order to meet the redemption requirements. The amount of frontloading is reduced by buybacks of bonds redeeming in the current year.
Operational and legal risks
273. The separation of the various debt management functions (front-, middle- and backoffice) is a measure against administrative errors and operational risks. As described earlier procedure manuals and internal procedures en-sure a clear division of authority and responsibility allocated to the three functions. The use of simple, well-known, debt management instruments also contributes to minimizing the operational risks. Finally, the central-government debt management area is subject to audit by the Auditor General (the National Audit Office). Legal risk is minimized by using standardized contracts.
Risks in relation to state guaranties
274. The government guarantees the borrowing and the financial transactions of a number of public entities as described earlier. This implies a risk for the government. This risk is limited by setting up guidelines for the borrowing activities of the entities (see section A on the legislative basis for central government borrowing).
275. In 2001, the government-guaranteed entities obtained greater access to re-lending of government loans through the central government. Re-lending ensures the government-guaranteed entities a cheaper way of funding as compared to a situation, where they raise all funding on an individual basis. The loans, which are offered to the entities are identical to existing government loans, including bonds, which are not benchmark issues. Re-lending increases the central government gross financing requirement and is financed by on-the-run issues. This improves consolidating the borrowing of the public sector.
Determining the level of risks
276. At the meetings of the Ministry of Finance and the Debt Management section the overall objective for the interest-rate risk of the government debt is determined on the basis of weighing borrowing costs against the risk.
277. In this process a Cost-at-Risk (CaR) model is used as a support in the decision making to select the preferred issuing strategy and duration target. In the CaR model different strategies with respect to issuing strategy, amount of buybacks and duration target are analyzed. The results are presented to and discussed with the Ministry of Finance.
278. The CaR model is developed in-house by the Debt Management section. The model is used to quantify the interest rate risk by simulation of multiple interest rate scenarios, but it is also used as a scenario model where specific scenarios are analyzed and discussed more thoroughly. The horizon of the analysis is up to 10 years.
279. Analyzing specific scenarios has played a major role in determining the overall strategy for the government debt during the last years. By using a scenario-model, future developments in the outstanding amount of different bonds, redemption profiles and the time path for the duration can be analyzed very thoroughly. This can determine whether a certain strategy is in fact feasible given some exogenous assumptions. Among the most important assumptions in this kind of analysis is the development in the government budget.
280. The duration target for central-government debt has been reduced in the last few years. This reduction is primarily the result of falling debt and thereby reduced interest costs, which has increased the willingness to take on risk. The nominal net debt has fallen from DKr 601 billion in 1997 to DKr 514 billion by end-2001, measured relative to GDP, a drop from 54 percent to 38 percent of GDP.
281. From end-1998 to end-2001, the duration of the central-government debt has been reduced from 4.4 to 3.4 years. As described earlier, the duration band for the year is public. The exact development in the duration during the previous year is made public in the annual report, which is published in February.
282. In the process of determining risks and borrowing strategy, normally neither domestic nor foreign borrowing is based on a particular interest rate outlook. Therefore the managers do not in general actively try to generate excess returns for example by having views on the future interest development, which is different from market expectations.
C. Developing the Markets for Government Securities
283. The Danish bond market is among the largest in Europe. The market value of the volume of bonds in circulation at the Copenhagen Stock Exchange was DKr 2,198 billion at nominal value by the end-2001. Besides government bonds, the Danish market has a large volume of mortgage-credit bonds. The large proportion of these bonds is explained by the longstanding tradition of financing construction and private housing by issuing mortgage credit bonds. All domestic government securities are listed on the Copenhagen Stock Exchange. Government bonds comprise one-third of the volume, whereas mortgage-credit bonds make up the remaining two-thirds.
The government bond yield curve
284. The Danish bond market is relatively large and mature, and as mentioned above government bonds comprise only one-third of the outstanding value. Issuing bonds along the curve in many different maturity segments is therefore not a necessity under Danish policy to maintain a well-functioning capital market. Instead, in past years the main focus has been on ensuring liquidity in government bonds by using a strategy of issuing fewer bonds with longer maturities, mainly because of a surplus on the government budget. Furthermore, buybacks have for some time been an important instrument in the Danish policy. Partly as a way of increasing the borrowing needs during the year, the buybacks are made in a time with surpluses, partly as a way of reducing the outstanding amounts in old non-market conforming securities. The latter includes, for example, old bonds with a high coupon.
285. In the domestic market, treasury bills are issued in the 3-, 6-, 9-, and 12-month maturities and bonds in the 2-, 5- and 10-year maturities. All bonds are bullet loans with a fixed coupon. By end-1998, the government had ceased issuing the 30-year bonds as a result of low borrowing needs and a reduction in the duration target for the government debt. Government bonds are used as benchmarks on the Danish bond market. Index-bonds are not an instrument in the Danish government debt strategy because of their relatively low liquidity—the Danish strategy having a focus on liquidity.
286. If government debt continues to fall, it is expected that mortgage bonds again can play the benchmark role, as was the situation up until the beginning of the 1990s.
Issuing domestic debt
287. Government bonds and treasury notes are issued on tap by the central bank on behalf of the central government via the electronic trading system, Saxess, of the Copenhagen Stock Exchange (CSE). All licensed traders on the CSE may purchase government bonds directly from the DNB via the Saxess electronic system.
288. Tap sales signify that government securities are issued when a borrowing requirement exists. Normally, Danmarks Nationalbank does not underbid itself within the same day or within a few days. The sale of government securities on the preceding day is published on a day-to-day basis.
289. The use of tap sales has a long tradition in the Danish mortgage-bond market, and therefore it was also natural to choose this issuing method when the government bond market was established. The use of tap sales gives the government a flexible system with the opportunity to issue bonds on a day-to-day basis. It is the general assessment that tap sales are an appropriate way of issuing domestic government bonds in the Danish bond market.
290. The planning of tap sales for the year is based on selling nearly the same amount in each remaining month. This means that by the beginning of the year the ex-ante expectation with respect to monthly sales is an evenly distributed sale during the year. This strategy is implemented by authorizing the front office to target a specified amount of issuance each month. The target is supplemented by a minimum and a maximum for each individual sale. The front office handles the tap sale within these boundaries. After each month the expected monthly sale for the rest of the year is updated. Within the month, the dealers at the front office handle the tap sale. It is aimed to “tap” the market when market demands are high. Views on the future development in the interest rates are generally not a part of the planning of the tap sale.
291. The licensed traders on the CSE are obliged to report transactions, which take place outside the electronic platform Saxess. Transactions should be reported within five minutes. Of the total turnover, 10 percent is reported to the CSE and takes place over the Saxess electronic system. The remaining 90 percent is transacted by telephone sale between the market participants. Telephone sales are based on price indications from an electronic system at the CSE.
292. Treasury bills are sold at monthly auctions via an electronic system at the central bank. All licensed traders on the Copenhagen Stock Exchange and the DNB’s monetary policy counterparties may bid at the auctions. Bids are made for interest rates. All bids at or below the fixed cutoff interest rate are met at the cutoff interest rate (uniform pricing). Bids at the cutoff interest rate may be subject to proportional allocation.
Issuing foreign-currency debt
293. Foreign loans have normally been established on the basis of concrete approaches from foreign investment banks, which are in contact with investors with special placement requirements. The currency swaps from Danish kroner to euro are established on the basis of competitive bidding from different investment banks.
294. As described earlier, the foreign strategy from 2002 and beyond will focus primarily on obtaining larger syndicated loans directly in euro, using one or more lead managers.
Primary dealers, market makers and lending schemes
295. Primary dealers are not used in relation to the issuing of domestic government securities in Denmark. All licensed traders on the Copenhagen Stock Exchange may buy government bonds and treasury notes directly from the National Bank via Saxess on the Copenhagen Stock Exchange. Licensed Stock Exchange traders and the National Bank’s monetary policy counterparties may participate in the treasury bill auctions.
296. There are two voluntary market maker schemes for government securities under the auspices of the Copenhagen Stock Exchange (CSE) and the Danish Securities Dealers Association respectively. Participants in these schemes are obliged to quote two-way prices for a certain amount of appropriate bonds at any time. Under the CSE, scheme prices are set only in the 10-year benchmark, while the scheme of the Danish Securities Dealers Association comprises other liquid government securities as well. The central bank does not take part in the market-maker plans.
297. To support liquidity, securities lending schemes have been set up. Two lending schemes exist, one held by the central government and one held by the Social Pension Fund. A lending scheme supports the liquidity in the government bond market since situations involving any shortage of bonds are prevented. The lending scheme held by the government was introduced in 1998, while the Social Pension Fund lending scheme was introduced in 2001. In both plans, Danish government bonds are accepted as collateral.
298. The lending scheme held by the government comprises mainly benchmark issues not held by the Social Pension Fund. The Social Pension Fund lending scheme consists of government bonds in the portfolio of the government bullet-loan type. The two lending schemes do not overlap with respect to bonds. Together the two lending schemes consist of lending in most government bonds including treasury bills.
Financial market contact
299. A regular and close contact to the financial market community is considered to be important for the government debt policy and is therefore given high priority. In regular meetings, different aspects of the management of the central government debt are discussed with market participants. On these meetings market participants get the opportunity to discuss the management of the government debt with representatives of the Debt Management units, including potential need for changes or introductions of new financial instruments.
Clearing and settlement system
300. Government bonds, Treasury notes and treasury bills have been registered electronically in the Danish Securities Centre (“VP-system”) since 1983. Danish government securities may also be registered in Euroclear and Clearstream. To facilitate easy transfer of securities between Vpsystem and Euroclear without loss of trading days, there is a direct link between Euroclear and the VP-system. Government securities trades are normally settled in the VP-system, but may also be settled in Euroclear and Clearstream. Foreign loans are registered in Euroclear or Clearstream. All three systems adhere to the principles set forth in the CPSS/IOSCO standards of November 2001 on securities settlement systems. The National Bank as overseer will conduct a formal assessment of the VP-system against these standards during first half of 2002.
Tax-issues and effects on trading off government securities
301. Danish government bonds are treated equally to other bonds on the Danish government bond market. No discriminatory tax rules exist. This mean that the general legislation for taxation of bonds applies to government bonds. Foreigners investing in Danish bonds do not pay withholding tax.
302. For non-corporate investors, who pay taxes to the Danish government, a minimum coupon rule exists for domestic bonds. This rule implies that capital gains on bonds with a coupon higher than the minimum coupon is free of taxation. The minimum coupon is normally revised semi-annually according to the development in the general interest rate level.
303. India operates under a fiscal regime, with the Constitution of India specifying the fiscal responsibilities for the Central and the State Governments through the three lists: the Union List, the State List and the Concurrent List. As per the current budgetary practice there are three sets of liabilities of the government, which constitute public debt—namely, internal debt, external debt, and “other liabilities.”
304. Total outstanding liabilities of the central government as a proportion of GDP reached the peak level of 65.4 percent at end March 1992, after which it recorded a significant consolidation over the first half of the 1990s and declined by 9 percentage points to 56.4 percent by end-March 1997 (see Table 1 in Appendix). In the subsequent period, however, it showed an increasing trend, reaching 65.3 percent of GDP by end-March 2002 and is projected to be around 67 percent by end-March 2003.
305. As in the case of the Central Government, the debt-GDP ratio of State Governments initially recorded an improvement, almost modest, falling from 19.4 percent at end March 1991 to 17.8 percent by end-March 1997; subsequently the ratio increased significantly, reaching 24.1 percent by end-March 2001 (see Table 2 in appendix) in the revised estimates. According to the budget estimates of State Governments, the debt-GDP ratio is estimated to be 23.9 percent at end-March 2002. Concomitantly, the interest payments to GDP ratio of States increased from 1.5 percent in 1990-91 to a budgeted level of 2.6 percent in 2001-02.
306. The combined Central and State Government liabilities had similar trends and stood at 72.9 percent of GDP at end-March 2001 (see Table 2 in Appendix) and is estimated to be about 76 percent at end-March 2002, significantly higher than 63.5 percent at end-March 1997. The sharp increase in the debt-GDP ratio in 2001-02 is mainly attributable to the increase in the total liabilities of the central government. The continuing high level of public debt leads to increasing interest payments, which in turn, necessitates higher market borrowings and puts pressure on the fiscal deficit.
307. Until the early 1990s India had adopted a development strategy based on its predominant role in the public sector. Large statutory preempts and borrowing from the Reserve Bank of India (RBI), the central bank of the country, provided the Government the ability to finance the large fiscal deficits. Lower administered yields on Government securities coupled with high cash and liquidity reserve requirements resulted in a repressed financial system with very little scope for active debt management.
308. Reorientation of the debt management strategy commenced under the overall process of financial sector reforms initiated in the early 1990s. The authorities preferred a gradual approach for this purpose wherein sequencing the policy initiatives was given the utmost importance.
309. The first initiative in the reforms process was to allow market-determined rates in the primary issuance market for government securities through auctions (1992). In order to compensate to some extent for the escalation in cost of borrowing, and in view of the market preference under the new regime as well as the expectation that interest rates would experience downward trends over the years, the maturity profile of the debt issuance was shortened. The tenor of new loans issued during the next few years after moving toward price discovery mechanism was restricted to 10 years. Such a move was also prompted by the recommendations of the Committee to Review the Working of the Monetary System (Reserve Bank of India, 1985). This was followed by a stoppage of automatic monetization of the fiscal deficit and gradual withdrawal of the central bank’s support to finance the Government budget at subsidized rates.
310. The role of net market borrowing in financing gross fiscal deficit gradually increased from 21 percent in 1991-92 to 66.2 percent at present. This has happened even while reducing statutory pre-empts. Reserve requirements were brought down. The statutory liquidity ratio (SLR) (requiring banks to invest a certain percentage of their liabilities in government securities) was brought down from a peak of 38.5 percent in 1990 to 25 percent in 1997 (and at present continues to be at 25 percent which is the statutory minimum). The cash reserve ratio (CRR) (the banks are required to keep a certain proportion of their liabilities in the form of cash with the RBI) was also brought down from a high of 25 percent in 1992 (including CRR on incremental liabilities) to 5 percent in June 2002.
311. Debt management strategy began to focus, on the one hand, on the interest rate and refinancing risks inherent in managing public debt and on the other hand, on monetary policy objectives so that the debt management policy would not be inconsistent with the objectives of monetary policy. Such a strategy, in turn, required the authorities to develop the institutional, infrastructure, legal and regulatory framework for the Government securities market.
A. Developing a Sound Governance and Institutional Framework
312. The objective of the debt management policy has changed over the years. Initially, it focused on minimizing the cost of borrowing, but at present, the objective is minimizing the cost of borrowing over the long run taking into account the risk involved, while ensuring that debt management policy is consistent with monetary policy.
313. Under the current Indian budgetary classifications, there are three sets of liabilities, which constitute Central Government debt—namely, internal debt, external debt, and “other liabilities.”
314. Internal debt and external debt constitute public debt of India and are secured under the Consolidated Fund of India, as reported under the “ConsolidatedFund of India - Capital Account” in the Annual Financial Statement of the Union Budget. The Indian Constitution under Article 292 provides for placing a limit on public debt secured under the Consolidated Fund of India but precludes “other liabilities” under the Public Account. There is also a similar provision under Article 293 of the Indian Constitution with respect to borrowings by the States, wherein the State legislature has powers to fix limits on State borrowings upon the security of the Consolidated Fund of the State. However, a State’s power to borrow is limited to internal debt and a State is required to obtain prior consent of the Government of India, as long as the State has outstanding loans made by the Government of India.
315. Internal debt includes market loans, special securities issued to the Reserve Bank of India (RBI), compensation and other bonds, treasury bills issued to the RBI, State governments, commercial banks and other parties, as well as non-negotiable and non-interest bearing rupee securities issued to internal financial institutions. The internal debt is classified into market loans, other long and medium-term borrowing and short-term borrowing and shown in the receipt budget of union government. External debt represents loans received from foreign governments and bodies. The liabilities other than internal and external debts include other interest-bearing obligations of the government, such as post office savings deposits, deposits under small savings schemes, loans raised through post office cash certificates, provident funds, interest-bearing reserve funds of departments like railways and telecommunications and certain other deposits.
316. The “other liabilities” of government arise in government’s accounts more in its capacity as a banker rather than as a borrower. Hence, such borrowings, not secured under the Consolidated Fund of India, are shown as part of public account. Furthermore, some of the items of “other liabilities’ like small savings are more in the nature of autonomous flows, which to a large extent are determined by public preference, and relative attractiveness of these instruments. Nevertheless, it should be emphasized that all liabilities are obligations of the government.
317. As per the Provisional Actual Budget data for the year 2001-02 the gross fiscal deficit of the Central Government at 6 percent of GDP was financed by domestic market borrowings to the extent of 69.4 percent and through other liabilities to the extent of 26.1 percent. The external financing accounted for only 1.6 percent of gross fiscal deficit. As per the Budget estimates for the year 2002-03, the gross fiscal deficit of the Central Government is targeted at 5.3 percent of GDP and is to be financed by domestic market borrowings to the extent of 70.7 percent, by other liabilities to the extent of 28.7 percent and external finance would contribute only 0.6 percent.
Coordination with monetary and fiscal policies
318. The Reserve Bank of India acts as the debt manager to the Government for marketable internal debt. Since the RBI is also responsible for monetary management, there is a need for coordination between the monetary and debt management policies, especially in view of the large market-borrowing program to be completed at market related rates. At the time the Budget is prepared, there are consultations between the Government of India and the RBI on the overall magnitude of the Market Borrowing Program of the Centre and the aggregate Market Borrowings of all States put together.
319. The requisite coordination among debt management, fiscal and monetary policies is achieved through:
the Financial Markets Committee (FMC) within the RBI (represented by the Heads of departments responsible for debt management, monetary policy and foreign exchange reserves management) which meets daily to assess the markets, liquidity, and other financial considerations that might arise;
involvement of the debt management functionaries in the Monetary Policy Strategy Meeting held at least once a month;
the constitution of Standing Committee on Cash and Debt Management (with representatives from the RBI responsible for debt management and operations as banker to government and the Ministry of Finance, Government of India responsible for budget preparation, fiscal policy and government accounts) which meets once a month; and,
the annual pre-budget exercise of dovetailing monetary budget with government finances including the finances of sub-national government.
320. During the initial stages of market development, especially for countries like India with large net market borrowing (3 to 4 percent of GDP in the recent period) having the central bank responsible for both debt management and monetary management has the advantage of appropriate policy coordination. During this early period, however, as the markets develop, the economy opens up for capital flows and the private sector starts contributing more to the economic activity, and there is a need for independent monetary management and separation of debt management function from the central bank. Under the proposed Fiscal Responsibility and Budget Management Bill (currently before Parliament) and as a first step toward separation of debt management from monetary management it is proposed that in a three-year period, RBI participation in the primary market for government securities will be eliminated.
321. The approach of separation of debt management function from the central bank has in principle been accepted. However, separation of the two functions would be dependent on the fulfillment of three preconditions, viz., reasonable control over the fiscal deficit, development of financial markets, and necessary legislative changes. The actual separation of debt management functions would depend upon the extent and speed with which fiscal deficit can be brought down. The large borrowing requirements of the government and need to minimize the impact of such borrowing requirements on the interest rates has necessitated private placements of securities with the RBI from time to time or through participation in the primary issuance market as a non-competitive bidder with the subsequent sale of such securities to the market as conditions improve. Elimination of RBI participation in the primary market is perceived as the first step in separation of functions of debt management from monetary management. A lower fiscal deficit is thus envisaged as a required precondition for ensuring that the government borrowings are not disrupting the financial markets and enabling a smooth transition to the separation of the debt management function. In the development and integration of the financial markets, significant progress has been made with the introduction of new instruments and participants, strengthening of the institutional infrastructure, and greater clarity in the regulatory structure. On the legislative front, two important changes are: (i) the proposed amendment in the RBI Act to take away the mandatory nature of public debt management by the RBI, and vesting the discretion with the Central Government to undertake the management either by itself or to assign it to some other independent body; and (ii) the proposed Fiscal Responsibility and Budget Management Bill, which is expected to rein in the fiscal deficit.
322. The Constitution of India gives the Executive Branch the powers to borrow upon the security of the Consolidated Fund of India or that of the respective State within such limits, if any, as may from time to time be fixed by Parliament or by the respective State Legislature by law.
323. While the Parliament/State legislature gives the authority to borrow by approving the Budget, the RBI as an agent of the Government (both Union and the States) implements the borrowing program.
324. The RBI draws the necessary statutory powers for debt management from the Reserve Bank of India Act, 1934. While the management of Union Government’s public debt is an obligation for the RBI, the RBI undertakes the management of the public debts of the various State Governments by agreement.
325. The procedural aspects in debt management operations are governed by the Public Debt Act, 1944 and the Public Debt Rules framed thereunder. Considering the technological changes and other developments taking place in the government securities market, the authorities are interested in replacing the Public Debt Act, 1944 by a more current proposed Government Securities Act.
326. Amendments have been proposed in the Reserve Bank of India Act to remove the mandatory nature of public debt management by the RBI and to allow the government to entrust the public debt management function to any agent. This would remove a legal hurdle for separation of debt management functions from the RBI.
327. All debt management functions for marketable internal debt are undertaken in the Reserve Bank currently, albeit in different departments. The middle office functions relating to decisions on the maturity profile and timing of issuance are undertaken in consultation with the Ministry of Finance.
328. As regards management of the External Debt, several territorial Divisions in the Department of Economic Affairs in the Ministry of Finance (MoF), such as the Fund-Bank Division, ECB Division, ADB Division, EEC Division, and Japan Division, in addition to the Reserve Bank of India act as the front offices. The External Debt Management Unit, located in the Ministry of Finance, acts as the Middle Office, and the Office of the Controller of Aid Accounts and Audit in the Ministry of Finance acts as the back Office.
329. The RBI is vested with the powers of managing the government debt, both that of the Union and the State (Provincial) Governments under the provisions of the Reserve Bank of India Act, 1934. While the management of debt of the Union statutorily devolves upon the RBI, management of the debt of the states has been undertaken by the RBI through mutual agreements between the central bank and the respective states. Thus the RBI is responsible for managing the market-borrowing program (MBP) of the Union and State Governments.
330. Within the RBI, the Internal Debt Management Cell performs the debt management function. The main functions comprise formulation of a core calendar for primary issuance, deciding the desired maturity profile of the debt, designing the instruments and methods of raising resources, deciding the size and timing of issuance, and other critical decisions, taking into account government’s needs, market conditions, and preferences of various segments while ensuring that the entire strategy is consistent with the overall monetary policy objectives. The Cell also undertakes the conduct of auctions.
331. The actual receipt of bids and settlement functions are undertaken at various offices of the RBI. Various Public Debt Offices also manage the registry and depository functions, keeping securities accounts including the book entry form of ownership. The central accounts are maintained by the Department of Government and Bank Accounts.
332. Decisions on the implementation of the borrowing program, based on proposals made by the Cell and market preference, are periodically taken by the Cash and Debt Management Committee. This is a standing committee of officials from the MoF and the RBI. While this represents a formal working relationship between the MoF and the RBI, it is further complemented by regular discussions between the Ministry’s Budget and Expenditure Divisions and the RBI.
333. Another standing committee is the Technical Advisory Committee on Money and Government Securities Market, which renders advisory services to the RBI on development and regulation of the Government securities market. This committee is represented by eminent people from the financial sector, representatives of market associations such as the Primary Dealers Association of India, the Fixed Income Money Markets and Derivatives Association of India, mutual funds, academia, and the Government.
334. The operations of the debt management functions are subject to the statutory audit that takes place at the RBI covering all the functions of the RBI. The concerned departments within the RBI are also subjected to internal audit including management audit and concurrent audit. Separate financial accounts of the debt management operations at the RBI are not prepared and hence there is no scope for subjecting these operations to a formal audit. However, while accounting for the debt management operations is done by the government’s Controller General of Accounts, the accounts are subject to the audit by the Comptroller and Auditor General of Accounts, a constitutional body.
335. While the internal debt management functions are further reported in the Annual Report of the RBI, which is a statutory report and is placed before the Parliament, the external debt management functions are reported in the Annual Status Report on External Debt presented to the Parliament by the Finance minister.
B. Risk Management Framework and Debt Management Strategy Risk management framework
336. In view of the large fiscal deficits of the Central Government—in the range of 5-7 percent of GDP in the 1990s—there is a need for ensuring a long-term stable environment for facilitating economic growth with price stability. As regards management of external debt, the Indian government has adopted a cautious and step-by-step approach toward capital account convertibility. It has initially liberalized non-debt creating financial flows followed by liberalization of long-term debt flows. There is partial liberalization of external commercial borrowing, only for the medium-term and long-term maturity. There is tight control on short-term external debt and a close watch on the size of the current account deficit. In fact, the Government of India does not borrow from external commercial sources, and there is no short-term external debt on government account. There is a high share of concessional debt, amounting to nearly 80 percent at the end of March 2002 of sovereign external debt. The maturity of government debt is also concentrated towards long-end for the debt portfolio.
337. These policies paid dividends. Capital account restrictions for residents and modest short-term liabilities helped India to protect itself from the East Asian economic crisis from 1997-2000. There has been significant improvement of external debt indicators over the years. India is now classified as a “low indebted’ country as per the World Bank classification in its Global Development Finance publication. The incidence of external debt burden, as measured by debt to GDP ratio, has been reduced by nearly half to 20 percent at the end of December 2001 from the peak level of 38.7 percent at the end March 1992. Similarly, the burden of debt service as a proportion of gross current receipts on external account declined by more than half from a peak of 35.3 percent in 1990-91 to 16.3 percent in 2000-01. While the steady contraction in the stock of short-term debt, the ratio of short-term to total external debt declined from a peak of 10.2 percent at end March 1991 to 3.4 percent at end-March 2001. At the same time, with a significant increase in foreign exchange reserves, short-term debt as a proportion of foreign exchange assets declined from a high of 382 percent to 8.8 percent during the corresponding period.
338. As regards internal debt, there is also a natural incentive to focus on long-term sustainability of interest rates, keeping in view the fiscal scenario and other macro economic developments, while planning the maturity pattern of debt and the component of fixed- and floating rate and external debt. There has been a conscious attempt to avoid issuance of floating rate and short-term debt and foreign currency-denominated debt.
339. During the early years of the move to market determined rates’, keeping in sight the investors’ preference, the average maturity of new debt (issued during a year) was between 5.5 and 7.7 years during the period 1992/93 to 1998/99. As inflationary conditions receded and markets developed, keeping in view the redemption pattern of existing debt stock, the need to smooth the maturity pattern of the debt stock and to minimize the refinancing risk, debt management policy has consciously attempted to extend the maturity pattern of the debt. Thus the average maturity of new debt issued after 1998/99 (issued during a year) was above 10 years and for the current year till December 2001, the average maturity of loans issued during the year stood at about 14 years. The average maturity of the total debt stock, which was about 6 years in March 1998, stands at about 8.20 years as of the end of December 2001.
340. The trade-off between market timing (which involves carrying cost) and the just-in-time pattern (which involves the risk of uncertain markets) are taken into account while tapping the market. Intra year, in order to ensure that the markets do not become volatile due to unpredictable and the large volume of borrowings made by the government or because of uncertainties in the foreign exchange markets, the RBI at times, subscribes to the primary issuances through private placements of debt with itself. These are subsequently sold in the secondary market when liquidity conditions ease and uncertainty diminishes. With a view to minimizing the risk arising on account of occasional RBI participation in primary auctions, which results in an increase in reserve money, the RBI undertakes active open market operations adjusted to the needs of liquidity in the system on account of domestic and external operations.
341. The major risk, however, faced in debt management is in regard to the size of debt itself and the pressures on account of servicing the debt. Hence, as part of its advisory role and as debt manager, the RBI has been urging the Government of India to enforce a ceiling on overall debt. It has also provided the technical inputs in formulating a Fiscal Responsibility and Budget Management Bill (FRBMB) to ensure that the country’s vulnerability is minimized. Currently before the Parliament, the FRBMB envisages targeted reduction in the fiscal deficit, especially revenue deficit and total debt as a share of GDP, as well as elimination of RBI participation in the primary issuance of debt.
342. Given the size of the market-borrowing program of the Union and the States, the approach to risk management has been one of minimizing the cost of raising debt subject to refinancing risk. Thus, the decisions on composition and maturity of debt reflect a risk averse preference in the context of prevailing fiscal deficit and likely fiscal deficits in future. It comprises three tenets:
Minimizing refinancing risk;
Minimizing external debt; and
Minimizing floating rate debt.
Simultaneously, the focus has been on ensuring that the rates of interest are sustainable over time.
343. As regards external debt, the focus has been on relatively concessional loans and highest maturity. Recently, the Government of India has also adopted the policy of prepaying a part of the debt taken from multilateral institutions and bilateral countries. In some cases, maturity and interest rates of the expensive loans have been restructured by the lending countries.
344. Avoiding external sovereign debt and floating rate debt have considerably reduced country vulnerability. As per the revised estimates for 2001/02, internal debt constitutes about 61 percent of the total liabilities, and other internal liabilities constitute 24 percent of total outstanding liabilities of the Central Government (see Table 2 in Appendix). External debt (at current exchange rates), which consists of mostly debt to multilateral institutions and bilateral countries, constitutes around 15 percent of the total liabilities. The non-marketable debt including mainly the small savings mobilizations, are managed by the Government. The refinancing risk is very well recognized. The debt management policy focuses mainly on managing the maturity profile of the debt and deciding on the share of 364-day treasury bills in the total borrowing program as well as the share of floating rate debt.
345. The process of debt consolidation—involving the reopening and reissuance of existing stock—has helped in more or less containing the number of bonds to a level that was prevailing at the end of 1998-99. The results of the process of consolidation may be gauged from the fact that of the 110 outstanding loans,31 43 loans (39 percent) account for 77 percent of the marketable debt stock. On the other hand in view of the large and growing net borrowings by the government, the need to extend the maturity profile of government debt has been felt so as to minimize the refinancing risk. The loans maturing within the next 5 years account for 31 percent of the total debt stock,32 another 37 percent of the loans mature between the sixth and tenth year. Thus, around 32 percent of the loans mature after 10 years. The weighted average maturity of the debt stock was about 8.20 years as and-2001 as compared to about 6 years as of March 31, 1998.
346. Reopenings through price-based auctions (as opposed to earlier yield based auctions) commenced in 1999, and have greatly improved market liquidity and helped the emergence of benchmark securities in the market. In additions, such reopenings also have helped the price discovery process, acting as a proxy to when issued market.
347. Callbacks of existing numerous loans in exchange for a few benchmark stocks have not been considered worthwhile in view of administrative, cost and legal considerations. In the absence of budget surpluses and a call provision for existing stocks, this form of active consolidation would be difficult to achieve.
348. However, as explained earlier, during 2001/2002, the government had prepaid a part of expensive external debt from multilateral institutions and restructured some costly external debt from bilateral countries. The government has also allowed selected public sector enterprises to pre-pay a part of their expensive external debt, which was guaranteed by the government. These policies have helped to reduce sovereign external debt as well as contingent liabilities of the government to some extent.
349. In a landmark development in 1994, the Government of India entered into an agreement with the RBI to phase out the system of automatic monetization of budget deficits within a period of three years. Accordingly, the system of financing the government through creation of ad hoc treasury bills was abolished effective April 1, 1997. Under a new arrangement, a scheme of Ways and Means Advances (WMA) was introduced to facilitate the Government of India to address the temporary mismatches in its cash flows. According to this scheme a limit was fixed for WMA, so that when the government reached 75 percent of the limit, the RBI could enter the market on behalf of the government to raise funds. This arrangement meant of course that the government has to fund its budget requirements at market-related rates. Keeping in view the trends in the government’s cash flows, the limit for WMA for the second half of the year is kept lower than that for the first half of the year. The introduction of the WMA Scheme demanded greater skills on the part of the RBI for active debt management. It also brought up the need for efficient cash management for the government. Accordingly, surplus funds if any in the government’s account are invested in its own securities available in RBI’s portfolio, thus reducing the net borrowing from RBI as also the cost.
350. For the States also, the RBI provides Ways and Means Advances. The limits are fixed through a formula linked to their revenue receipts and capital expenditure. Once the limits are reached, the accounts go into overdraft, which are not only limited in size to the WMA limit but are also not allowed to continue beyond 12 working days. Beyond this point payments are stopped on behalf of the respective State Government.
351. Surplus funds of States are invested in special intermediate treasury bills of the central government. Since these instruments can be rediscounted instantly whenever required, the interest rate interest is fixed at the Bank Rate minus 1 percent. At the request of the State governments, RBI also invests surplus funds of States in dated securities of the Government of India offered from its investment portfolio at prices prevailing in the secondary markets.
352. Contingent liabilities of the Central Government arise because of the government’s role to promote private savings and investment by issuing guarantees. Contingent liabilities of the Central Government could be both domestic and external contingent liabilities and could also be explicit or implicit in nature. Domestic contingent liabilities of the Central Government constitute direct guarantees on domestic debt, recapitalization costs for public sector enterprises, or unfunded pension liabilities. External contingent liabilities constitute direct guarantees on external debt, exchange rate guarantees on external debt like Resurgent India Bonds and Indian Millennium Deposits, and counter-guarantees provided to foreign investors participating in infrastructure projects, particularly for electric power. Although from the accounting point of view, contingent liabilities do not form part of the government debt, they could pose severe constraints on the fiscal position of the government in the event of default.
353. The total outstanding direct credit guarantees issued by the Central Government on both domestic and external debt remained stable around Re 1000 billion during end-March 1994 to end-March 1999. While domestic guarantees increased modestly during the corresponding period, there was an absolute decline in the guarantees on external debt. As a proportion of GDP, however, both domestic guarantees and external guarantees registered a decline of 3 percentage points during 1993-1999. Thus, the total guaranteed debt of the central government declined steadily from 11.8 percent of GDP in 1993-94 to 5.9 percent 1998-99.
354. In addition, exchange rate guarantee on external debt also has implications for the finances of the Central Government. For example, for Resurgent India Bonds, as per the agreement, exchange rate loss in excess of 1 percent on the total foreign currency, or the equivalent of US$4.2 billion, which would have to be borne by the Government of India. The extent of such a loss, since August 1998, the time when Resurgent Indian Bonds were first issued, would depend upon the exchange rate prevailing at the time of redemption in 2003. Very recently, a similar exchange rate guarantee was provided on the amount of US$ 5.5 billion raised through India Millennium Deposits, from October to November 2000. For counter guarantees provided to foreign investors participating in infrastructure projects, similar risk arises for the Government exchequer. At the same time, there is a growing volume of implicit domestic contingent liabilities in the nature of pension funds.
Legal ceilings on government debt and contingent liabilities
355. Given the legacy of huge public debt and interest burden due to a long history of high fiscal deficits, which has increasingly constrained the maneuverability in fiscal management, the Central Government has recently introduced a Fiscal Responsibility and Budget Management Bill, 2000 to the Parliament. The proposed bill aims at ensuring inter-generational equity in fiscal management and long-term macro-economic stability. This would be achieved by achieving sufficient revenue surplus, eliminating fiscal deficit, removing fiscal impediments in the effective conduct of monetary policy and prudential debt management consistent with fiscal sustainability through limits on central government borrowings, debt and deficits, and greater transparency in fiscal operations. The specific targets for debt management in this regard is to ensure that the total liabilities of the central government (including external debt at current exchange rate) is reduced during the next ten years and does not exceed 50 percent of GDP. Simultaneously, the Central Government shall not borrow from the RBI in the form of subscription to the primary issues by the RBI.
356. The bill also attempts to check the contingent liability by restricting guarantees to 0.5 percent of GDP during any financial year. In particular, transparency in budget statements would involve disclosure of contingent liabilities created by way of guarantees including guarantees to finance exchange risk on any transactions, all claims and commitments made by the Central Government having potential budgetary implications.
C. Developing the Markets for Government Securities Need and approach
357. As debt manager to the Government, the development of deep and liquid markets for government securities is of critical importance to the RBI in facilitating price discovery and reducing the cost of government debt. Such markets also enable the effective transmission mechanism of monetary policy, facilitates introduction and pricing of hedging products and serve as a benchmark for other debt instruments. Hence as monetary authority, the RBI has a stake in the development of debt markets. Liquid markets imply more transparent and correct valuation of financial assets; they also facilitate better risk management and are therefore extremely useful to the RBI as a regulator of the financial system. As the system integrates with the global markets it is necessary to ensure low cost financial intermediation in domestic markets or else the intermediation will move offshore. This reinforces the argument for development of domestic debt markets.
358. The RBI, therefore, since the early 1990s has been consciously focusing on the development of the government securities markets, through carefully and cautiously sequenced measures within a clear cut agenda for primary and secondary market design, development of institutions, enlargement of participants and products, sound trading and settlement practices, dissemination of market information, prudential guidelines on valuation, accounting and disclosure.
359. The structure of primary dealers has been adopted for developing both the primary and secondary markets for government securities in India. This structure has been operating since 1996. The objective of promoting an institutional mechanism for primary dealers is to ensure development of underwriting and market-making capabilities for government securities outside the RBI, so that the latter will gradually shed these functions; the purpose is also to strengthen the infrastructure in the government securities market in order to make it vibrant, liquid, and broad based. The intermediate goals include improving the secondary market trading system which would contribute to price discovery, enhance liquidity, and turnover and encourage voluntary holding of government securities amongst a wider investor base and to make primary dealers an effective conduit for conducting open market operations.
360. Among their obligations are giving annual bidding commitments to the RBI, to underwrite the primary issuance and to offer two-way quotes in select Government securities. The annual bidding commitments are determined through negotiations between the RBI and the primary dealers. Serious bidding is ensured through a stipulation of a success ratio (40 percent) linked to the bidding commitments. In return, the dealers are extended a liquidity support by the RBI. This support, which was entirely a standing facility in the initial years (linked to their bidding commitments and secondary market activity with a cap; a certain ratio of their net worth), is being gradually withdrawn. The primary dealers along with banks are allowed to participate in the Liquidity Adjustment Facility (LAF) of the RBI whereby the RBI operates in the market through repos and reverse repos.
361. Primary dealers are essentially well-capitalized nonbanking finance companies, set up as subsidiaries of banks and financial institutions or as corporate entities, and are predominant players in the government securities market. Currently 18 primary dealers are authorized by the RBI.
362. The RBI also envisaged the institutional mechanism of satellite dealers subsequently to further the efforts of the primary dealers with a primary objective of developing a retail market for government debt. As their name suggests, they were to establish a link with a primary dealer and thus the RBI did not extend them the same benefits as those extended to primary dealers. This subsequent lack of access to the call money market and the impediments in transacting in the repo market (including prohibition on sale of securities purchased under repos and prohibition on short sale) have restricted the operations of the satellite dealers. Thus the system has never succeeded. While some of the satellite dealers later became primary dealers, the others have only been active as brokers.
363. While banks are encouraged to deal directly without, to the possible extent, involving brokers, they can undertake trades in government securities through the member-brokers of the National Stock Exchange, the Bombay Stock Exchange and the Over-The-Counter Exchange of India (OTCEI). About 35 percent of trades are OTC trades. The remaining are negotiated through brokers who are members of the exchanges and reported on the exchanges. Following the irregularities in the securities market that involved fraudulent links between the brokers and banks, banks were advised by the RBI not to trade more than 5 percent of their transactions through a single broker.
364. In the early years of 1990s there was experimentation with issuing a variety of instruments such as zero coupon bonds, stocks for which payment by investors could be in installments, floating rate bonds, capital-indexed bonds, in addition to fixed rate bonds.
365. Keeping in mind the requirements of the various segments of the market, the need to smoothen the redemption pattern across different years, and the need to focus on issuing new securities in key benchmark maturities are all factors that have resulted in issuing relatively longer dated securities in the last few years. The RBI, to the possible extent endeavors to issue securities across the yield curve. While the extended maturity profile has benefited long-term investors like insurance companies and pension/provident funds, it has resulted in asset liability mismatches for the banking sector, which continues to be the major final investor in, and holder of government securities. Recognizing this, the RBI is attempting to develop the STRIPS market in Government securities. The consultative paper on STRIPS has been placed on the RBI web site for wider consultation.33
366. Further, to facilitate interest rate risk management, the RBI has reintroduced the Floating Rate Bonds (FRB) in a modest way (maiden issuance of Floating Rate Bonds was made in 1995). The outstanding FRBs account for less than 1.5 percent at present. Bonds with callable options have also not been experimented with, taking into account the size of the overall debt, new issuance program and the refinancing risk.
367. Government stock is normally sold through auction. Sometimes they are sold through a tap system with a fixed coupon. The salient features of the issuance procedures have been codified and are placed in the public domain through a Government notification called general notification. The public is notified of the details of each issuance, generally three to seven days prior to the floatation/auction.
368. Issuance of a calendar has to tackle the tradeoff between certainty to the market and flexibility to the issuer in terms of market timing. The uncertain trends in cash flow pattern of the Government also greatly constrain the publication of the issuance calendar. An indicative calendar for issuance of marketable Government of India dated securities was introduced for the first time in April 2002 for the first half of the fiscal year. It was followed by an announcement of an indicative borrowing calendar for the second half of the year in September 2002. This practice of announcing the calendar twice a year is expected to continue to enable institutional and retail investors to plan their investments in a better manner, and also to provide further transparency and stability in the Government securities market. There is already a preannounced issuance calendar for treasury bills auctions.
369. For the States, the RBI normally prefers a pre-announced coupon method and the yields are fixed around 25 basis points above the rate prevailing in the market for a stock of similar maturity of the Union Government.
370. The auctions of government securities are open for individuals, institutions, pension funds, provident funds, nonresident Indians (NRIs), Overseas Corporate Bodies (OCBs) and foreign institutional investors. Individuals and small investors such as provident and pension funds and corporations can also participate in auctions on a non-competitive basis in certain specific issues of dated government securities and in treasury bill auctions. Non-competitive bidding has been allowed since January 2002 and a small percentage of up to 5 percent is allocated for allotment to non-competitive bidders at weighted average cutoff rates. Bids are received through banks and primary dealers. A multiple-price auction format has been the predominant method used for the auctions. However, the RBI of late started using the uniform price auction method on an experimental basis.
371. Whenever there is an urgent need for the government to raise resources from the market, and sufficient time is not available to prepare the market for a public issuance, the RBI takes a private placement (at market related rates based on the secondary market rates) and such acquisitions are off-loaded in the secondary market during appropriate market conditions. The tap method is also used when the demand is uncertain and the RBI and government do not want to take the uncertainty of auctioning the security. This approach is widely used in the case of State Government loans.
Technological development and settlement mechanism
372. The RBI is currently developing a Negotiated Dealing System (NDS), which became operational in February 2002. The NDS facilitates electronic bidding in auctions, and offers a straight through settlement, since it has connectivity with the Public Debt Offices and the accounts of the banks with the RBI. Banks, primary dealers and other financial institutions including mutual funds can negotiate deals in government securities through this electronic mode on a real-time basis and report all trades to the system for settlement. The details of all trades will be transparently available to the market on the NDS. The RBI also began disseminating data on trades in government securities reported on the NDS on a real-time basis through its web site in October 2002.
373. The Delivery-versus-Payment system (DvP) (Method I) introduced in 1995 for the settlement of transactions in government securities has greatly mitigated the settlement risk and has facilitated growth in volume of transactions in the secondary market for government securities. Completion of the ongoing projects and launching of the associated functionalities and products relating to the Clearing Corporation of India Ltd., (CCIL), the Negotiated Dealing System (NDS), Electronic Funds Transfer (EFT), and the Real-Time Gross Settlement (RTGS), as well as the proposed legislation on the Government Securities Act (in lieu of the existing Public Debt Act, 1944) would further augment the efficiency and safety of the government securities market.
374. A clearing corporation, that is the Clearing Corporation of India Ltd. (CCIL) was introduced simultaneously with the NDS in February 2002. The CCIL acts as a central counterparty in the settlement of outright and repo transactions in government securities. The settlements through the CCIL are guaranteed by the Corporation through a settlement guarantee fund, within the Corporation, to be funded by the members. The establishment of CCIL is seen as a major step in the development of Government securities market and the repo market is expected to witness significant growth.
375. Work on the Real-Time Gross Settlement System has already commenced and is expected to bring about further improvement in the payments and settlement system.
376. The Reserve Bank of India has been encouraging wider retail participation in government securities. As part of these efforts, the RBI has been promoting the Gilt mutual funds to develop a retail market for government securities. Gilt funds are mutual funds with 100 percent of their investments in Government securities; the fund in turn sells its units to the investors. RBI offers a limited liquidity support to the mutual funds in the form of repos to promote an indirect retail market for government securities.
377. The RBI allows retail participation at the auctions on a non-competitive basis up to a maximum of 5 percent of the notified amount. Banks and the primary dealers operate the scheme.
378. In order to facilitate efficient and easy retail transactions in government securities, an order-driven screen based system is proposed to be implemented through the stock exchanges with adequate safeguards for settlement.
Coordination between public debt management and private sector debt
379. Together with active debt management of marketable government debt, RBI has also been focusing on the need for rationalizing the continuing administered interest rates and tax regime on small savings and contractual savings such as provident and pension funds, not only to minimize the effective cost of overall debt but also to align the interest rates on these liabilities to market-determined rates. Public financial institutions, or long-term developmental banking institutions are the largest issuers of debt in the non-government sector and hence guidelines have been issued to them for ensuring that the interest rates on debt issued by them do not go beyond certain spreads over government securities of similar tenor. Corporate debt is not governed by the RBI and while communicating to the Government of India (Ministry of Finance) the acceptable level of the total market borrowing, RBI takes into account the needs of the corporate sector which have to be met from both credit market and capital (debt) markets.
Laws and regulation
380. The existing Public Debt Act 1944 is expected to be replaced by a new Government Securities Bill. The proposed legislation seeks to streamline and simplify procedures in the handling of public debt of the Central and State Governments and will reflect the changes in the operating and technological environment.
381. Under the amendments in March 2000 to the Securities (Contracts) Regulation Act (SCRA), powers have been clearly delegated to the RBI for regulating the dealings in the government securities market, thus defining the regulatory jurisdiction of the RBI so far as the dealings in the government securities market34 are concerned.
382. Short selling of securities is not permitted under the current regulatory framework.
383. On the taxation front, the government securities are not subject to withholding tax. Gains are treated both as income and capital gains depending on the nature of transaction and investors are allowed to pay tax both on a cash and accrual basis. Such a treatment, however, could cause distortions in the market when the STRIPS market on government securities comes into existence. The Central Board of Direct Taxes (CBDT) has amended the guidelines on tax treatment of zero coupon bonds/deep discount bonds by requiring that for tax purposes the mark-to-market gains in the relevant year will be reckoned. The tax incentive on non-marketable debt such as small savings has tended to distort the market for government securities and a Committee under the Deputy Governor of RBI recently recommended rationalization of tax treatment on such instruments.
Adherence to CPSS/IOSCO standards
384. A detailed examination of CPSS / IOSCO standards is being undertaken separately. Nevertheless, the broad adherence to the standards is described below.
Pre-settlement risk: Currently all trades between direct market participants are confirmed directly between the participants on the same day and are settled either on the same day or on the next day thereby minimizing pre-settlement risk. For trades undertaken through members of the exchanges, confirmation is done on T+0, but settlement can be done up to T+5.
Settlement risk: All trades undertaken by banks, financial institutions, primary dealers and mutual funds having “scripless” accounts with the RBI in its Public Debt Office are settled under a gross trade by trade DvP system with queuing up to the end of the day when funds settlement is eventually known. At this time, if there is shortage of securities or funds, trades are considered “failed”. Such failure constituted only around 0.01 percent of the total number of trades in 2001 and around 0.3 percent total value of trades in 2001. Both the pre-settlement and settlement risks were minimized with the setting up of the CCIL and its ability to provide guaranteed settlement by various risk management systems, including the constitution of the settlement guarantee fund.
Legal risk: Several of the legal safeguards recommended for securing safe settlement system, including rights of central counterparties to the Settlement Guarantee Fund, in the event of insolvency of members etc., are yet to be put in place. However, pending detailed legislative changes, the legality for various aspects of the settlement process has been achieved through the framing of mutual agreements under contract law, and through the use of concepts such as novation for ensuring legality of netting.
385. The management of the national debt in Ireland was delegated to the National Treasury Management Agency (NTMA) by legislation enacted in 1990. This delegated authority includes issuance, secondary market activity and all necessary ancillary activity such as, for example, arranging for clearing and settlement.
A. Debt Management Objectives and Coordination Objectives of debt management
386. The key objectives of the NTMA in managing the national debt are, first, to protect liquidity to ensure that the Exchequer’s funding needs can be financed prudently and cost effectively and, secondly, to ensure that annual debt service costs are kept to a minimum subject to containing risk within acceptable limits. It must also have regard to the absolute size of the debt insofar as its actions can affect it (deep discounts and currency mix).
387. While the broad objectives of debt management have remained more or less unchanged, the emphasis on how best to achieve these objectives have changed, particularly in response to Ireland’s adoption of the euro.
388. Debt management activity covers both the issue and subsequent management of the central government’s short-term and long-term debt as well as the management of its cash balances. The management of the debt is concerned with both the annual cost of debt service, in the traditionally understood sense of measuring and controlling the total value of interest and debt issuance costs each year, as well as with the economic impact over the life of the debt of all debt management activity. This latter aspect of debt management is captured by measuring the net present value of the debt and comparing it with a benchmark.
Coordination with monetary and fiscal policy
389. The annual debt service cost, in terms of cash flows, is a major part of the overall expenditure in the budget of the Minister of Finance (MoF) and is framed so as to be consistent with the overall level of borrowing or surplus envisaged by that budget. Monetary policy is the prerogative of the European Central Bank (ECB), and prior to the introduction of the euro, it was under the control of the Central Bank of Ireland (CBI). Debt management policy is not coordinated with the ECB’s monetary policy. Prior to 1999 neither was there any formal coordination of debt management policy with the monetary policy of the central bank, even though there was a non-statutory exchange of information and views with the CBI on the main thrust of debt management policy. In managing the debt, the NTMA was conscious of the need to avoid any conflict with the central bank’s monetary and exchange rate policies. The advent of the euro in 1999 ended the scope and need for such policy sensitivity.
Treasury service and advice to other arms of government
390. The debt management activity of the NTMA relates only to the debt of the central government. The debt of other arms of the government, such as local government authorities, regional health boards and state bodies, remains the responsibility of those bodies, subject to approvals and guidelines issued by the Department of Finance. The NTMA has been empowered, however, to offer a central treasury service, in the form of deposit and loan facilities, as well as treasury advice to a range of designated local authorities, health boards and local education committees. It has also been authorized to advise ministers on the management of funds under their control and, where the requisite authority is delegated, to manage such funds on behalf of that minister. The NTMA currently manages the assets of the Social Insurance Fund under such delegated authority. It has also been mandated to manage the National Pensions Reserve Fund under the direction of the National Pensions Reserve Fund Commissioners who are appointed by the Minister for Finance.
Transparency and accountability Relationship with the Minister of Finance
391. The Minister of Finance approves the budget for annual debt service costs, and the NTMA is obliged under legislation to achieve that budget as near as may be. Its performance relative to this budget is reported to the MoF, as is the performance in net present value terms against a benchmark portfolio. However, all debt service payments, including redemptions, are a first charge on the revenues of the government, and under the provisions of the legislation that authorizes the raising of debt, are not subject to annual approval by the Minister or by Parliament. The NTMA also reports to the MoF on the very broad outlines of its borrowing plans for each year, indicating how much it intends borrowing in the currency of the State and how much in other currencies. The Minister gives directions to the NTMA each year in the form of widely drawn and prudentially intended guidelines covering the major policy areas, such as the mix of floating and fixed rate debt, the maturity profile, foreign currency exposure, and other financial data. The public auditor, the Comptroller and Auditor General, carries out an audit each year on the Agency’s compliance with these guidelines.
Role of debt managers and the central bank
392. The debt managers and the CBI have distinct and non-overlapping roles both from a legal and institutional perspective in that the central bank has no role in debt management policy. The introduction of the euro in 1999 did not essentially alter the relationship except to the extent that it removed the necessity for the degree of informal exchange of information and views which had existed prior to that date in the interest of the smooth operation of both monetary policy and debt management policy. At present, the NTMA cooperates with the central bank’s actions in implementing the liquidity management policy of the ECB by maintaining an agreed level of funds in the Exchequer Account in the central bank each day. The CBI also maintains the register of holders of Irish Government bonds. In December 2000, the clearing and settlement function for Irish Government bonds was transferred from the central bank to Euroclear Bank.
Open process for formulating and reporting of debt management policies
393. The NTMA’s Annual Report and Accounts include a full statement of its accounting policies. In addition, it publishes at the beginning of each year a calendar of its bond auctions for that year together with a statement of the total amount of issuance planned for the year. The NTMA’s bond auctions are multiple price auctions and are carried out by means of competitive bids from the recognized primary dealers. At present, there are seven such dealers who are obliged to quote electronically indicative two-way prices in designated benchmark bonds within maximum bid/offer spreads for specified minimum amounts from 8:00 a.m. to 4:00 p.m. each day. In addition, primary dealers are required to be market makers in Irish government bonds on the international electronic trading system, EuroMTS, and on the domestic version of it, MTS Ireland.
Public availability of information on debt management policies
394. The government’s budgetary forecasts for the coming year and the two following years are published in December of each year. These forecasts include figures for the overall budget surplus or deficit of the government for each year. The preliminary outturn for the current year is also shown. In addition, the finance accounts published each year by the government contain detailed information on the composition of the debt, including the type of instrument, the maturity structure and the currency composition. During the course of the year, the Ministry of Finance publishes detailed information on the evolution of the budgetary aggregates at the end of each quarter together with an assessment of the outlook for the remainder of the year. The NTMA publishes an Annual Report that contains its audited accounts as well as a description of its main activities. It also publishes information during the year on the details of all the markets on which it operates and the amount outstanding on the various debt instruments utilized in these markets. And each week, information on the amount outstanding on each of the bonds it has issued is released to the public.
Accountability and assurances of integrity
395. The NTMA has a Control and a Compliance officer who reports to the Chief Executive. It also engages a major international accounting firm to undertake an internal audit of all data, systems and controls. In addition, the annual accounts are audited by the state auditor, the Comptroller and Auditor General, prior to their presentation to parliament within a statutory deadline of six months after the end of the accounting year. The Comptroller and Auditor General reports the findings to parliament.
396. The National Treasury Management Agency Act, 1990 provided for the establishment of the NTMA “to borrow moneys for the Exchequer and to manage the National Debt on behalf of and subject to the control and general superintendence of the Minister for Finance and to perform certain related functions and to provide for connected matters.”
397. The 1990 Act enabled the government to delegate the borrowing and debt management functions of the MoF to the NTMA, such functions to be performed subject to such directions or guidelines as he might give. Obligations or liabilities undertaken by the NTMA in the performance of its functions have the same force and effect as if undertaken by the Minister.
398. The Chief Executive, who is appointed by the MoF, is directly responsible to the Minister and is the Accounting Officer for the purposes of the Dáil’s (lower house of parliament) Public Accounts Committee. The NTMA has an Advisory Committee, comprising members from the domestic and international financial sectors and the Ministry of Finance, to assist and advise on such matters as are referred to it by the NTMA.
399. The main reasons behind the decision to establish the NTMA were outlined as follows by the MoF when he introduced the legislation to the parliament in 1990:
“…debt management has become an increasingly complex and sophisticated activity, requiring flexible management structures and suitably qualified personnel to exploit fully the potential for savings.
…it has become increasingly clear that the executive and commercial operations of borrowing and debt management require an increasing level of specialization and are no longer appropriate to a Government Department. Also, with the growth of the financial services sector in Dublin, the Department [of Finance] has been losing staff that are qualified and experienced in the financial area and it has not been possible to recruit suitable staff from elsewhere.
…[in the agency] there will be flexibility as to pay and conditions so that key staff can be recruited and retained; in return, they will be assigned clear levels of responsibility and must perform to these levels: the agency’s staff will not be civil servants.”
400. It was considered that locating of all debt management functions within one organization, which had a mandate to operate on commercial lines and had the freedom to hire staff with the requisite experience, would lead to a more professional management of the debt than would be possible within the constraints of the civil service system.
401. So as to ensure the complete independence of the NTMA from the civil service, the legislation establishing it expressly precludes its staff from being civil servants. However, political accountability is maintained by having the NTMA’s Chief Executive report directly to the MoF and by making the Chief Executive the accounting officer responsible for the NTMA’s activity before the Public Accounts Committee of parliament.
402. The overall borrowing and debt management powers of the Minister have been delegated to the NTMA and further annual parliamentary or legislative authority to borrow or engage in other debt management activities is not required. However, the NTMA is required to present to the MoF each year a statement setting out how much it intends to borrow in the currency of the State and in other currencies during the course of the year. Broadly speaking, it is empowered to use “transactions of a normal banking nature” for the better management of the debt. This broad power includes the use of derivatives as well as power to buy back debt or, where the borrowing instrument permits, to redeem it early.
Structure within the Debt Office
403. The NTMA’s structure reflects the fact that it has a number of other functions in addition to debt management, namely the management of the National Pensions Reserve Fund under the direction of the National Pensions Reserve Fund Commissioners, and the processing of personal injury and property damage claims against the State, in which role the NTMA is known as the State Claims Agency.
404. The Chief Executive has directors reporting to him in the following areas, Funding and Debt Management and IT; Risk and Financial Management; Legal and Corporate Affairs (including retail debt); the National Pensions Reserve Fund; and the State Claims Agency. The NTMA also has an Advisory Committee, appointed by the MoF, to advise on the Chief Executive’s remuneration and such matters as are referred to it by the NTMA.
405. The separation of the front office funding and debt management function from the middle office risk management function and the back office financial management function is in accordance with best practice and ensures an appropriate separation of powers and responsibilities.
406. The NTMA retains key staff through its employment contracts and remuneration packages, which are flexible and designed to attract qualified personnel on either a permanent or temporary basis as required. This freedom to recruit and pay staff in line with market levels was a key element in the government’s decision to establish the NTMA. Because the NTMA is a relatively small organization, the training of staff is generally outsourced as the most efficient option. Its IT Department has built the back office support IT systems to provide straight-through processing of trades from front office to back office and also to generate the required management reports. IT expertise was contracted on a temporary basis as necessary to achieve this objective. The NTMA is a member of SWIFT and TARGET, which enables real time processing of payment transactions.
Management of internal operations
407. Internal operational risk is controlled by rigorous policies and procedures governing payments and the separation of duties, in line with best practice in the financial sector generally, including:
Segregation of duties between front office and back office functions. This practice is enforced by logical and physical controls over access to computer systems and by the application of Office Instructions and Product Descriptions described below;
Office Instructions, which describe detailed procedures for key functions and assign levels of authority and responsibility;
Product Descriptions, which set out a description of the particular product, detailed processing instructions and highlight inherent risks;
Bank Mandates, which are established with institutions with whom dealing is permitted;
Third party confirmations, which are sought for all transactions.
Reconciliations and Daily reporting;
Monitoring of Credit Exposures arising from deposits and derivative transactions, which are managed within approved limits;
Voice recording of certain telephones;
Head of Control function/Internal Audit/External Audit; and
Code of conduct and conflict of interest guidelines.
408. Disaster recovery plans are also in place that would enable the NTMA to resume its essential functions from a back up site within one to four hours. This plan is tested regularly and is possible because of the arrangements for the complete backup of all computer data and its storage off-site three times each day.
B. Debt Management Strategy and Risk Management Framework
409. The overall debt management strategy is to protect liquidity so as to ensure that the Exchequer’s funding needs can be financed prudently and cost effectively and at the same time ensure that the annual costs of servicing the debt are kept to a minimum, subject to an acceptable level of risk.
410. The main risks associated with managing the debt portfolio, apart from operational risk, which is discussed earlier, are credit risk, market risk, and funding liquidity risk.
411. Credit limits for each counterparty are proposed by the Risk Management Unit and approved by the Chief Executive. The credit exposures are measured each day, and any breach is immediately brought to the attention of the Chief Executive.
412. In setting credit limits for individual counterparties, there is a single limit on the consolidated business with the counterparty, that is all businesses are brought together under one limit. Each limit is divided into short term (up to one year) and long term (more than one year to maturity). In determining the maximum size of a exposure to a counterparty, which the NTMA is willing to undertake, account is taken of the size of the counterparty’s balance sheet and the return on capital as well as the credit rating and outlook assigned by the major credit rating agencies, Moody’s, Standard and Poor’s and Fitch. The market value of derivatives are used in measuring the credit risk exposures. The credit risks are also assessed by reference to potential changes in the exposures as a result of market movements and the position is kept under continuous review.
413. The NTMA manages the cost and risk dimensions of the debt portfolio from a number of perspectives, including (a) managing the performance of the actual portfolio relative to the benchmark portfolio on a net present value basis, and (b) managing the Debt Service Budget. Both interest rate risk and currency risk are controlled, measured and reported on.
414. The benchmark reflects the medium term strategic debt management objectives of the Exchequer and encapsulates the NTMA’s appetite for market risk. When the benchmark has been agreed with its external advisors, it is then approved by the MoF who decides whether, in his view, it is consistent with his overall guidelines on the management of the debt. Revisions to the benchmark are made from time to time (subject to approvals by the NTMA’s external advisors and the Department of Finance) to take account of significant changes in structural economic relationships but not in response to short term market movements.
415. The benchmark portfolio is a computer-based notional portfolio representing an appropriate target interest rate, currency mix, maturity profile and duration for the portfolio. The benchmark is based on a medium-term cost/risk tradeoff derived from simulation analysis. Cost is defined in terms of the mark-to-market value of the debt, while risk is defined in terms of the likelihood that debt service costs will exceed the budget provision of the Minister for Finance. The simulations lead to the choice of a benchmark portfolio, which is robust under a range of possible outturns rather than highly dependent on one set of assumptions regarding the future evolution of interest rates and exchange rates.
416. One of the major risks that must be controlled is the possibility that the annual debt service cost will fluctuate wildly from year to year and exceed the target level set out by the MoF. In tandem with this, the benchmark seeks to minimize the overall cost of the debt in terms of its mark to market value. In constructing the benchmark the simulation exercises seek to find a portfolio, which minimizes the mark-to-market value (the cost) while at the same time ensuring that the annual debt service cost is at the minimum level consistent with not fluctuating wildly from year to year. The stability of the debt service budget over time is of more importance than minimizing the cost in any one year. Overall the benchmark seeks to strike a balance between the potentially conflicting objectives of minimizing the net present value (NPV) of the debt while maintaining the lowest possible stable debt service costs over the medium term.
417. The fiscal budget for annual debt service costs is sensitive to exchange rate and interest rate risks. Each month two estimates are produced and reported to quantify the level of this risk:
Sensitivity of the fiscal budget to a 1 percent movement in interest rates. (The interest composition of the outstanding debt and the expected funding requirements are taken into consideration while assessing the possible gains or losses which could be incurred were interest rates to move by 1 percent.)
Sensitivity of the fiscal budget to a 5 percent movement in exchange rates. (This takes into consideration the currency composition of the debt. It looks at the possible gains or losses to the debt service budget in the event of exchange rates movements.)
418. A set of internal monthly fiscal risk limits is put in place early each year. These limits reflect the prudent risk limit for the fiscal budget. The above sensitivity reports are compared to these limits to check for compliance.
419. The main reports for the ongoing management of the Debt Service Budget are:
Monthly update of the debt service forecast for the current year—the forecast is broken down by the various debt instruments and includes a monthly profile of the full year debt service budget.
Analysis of the variances between the debt service outturn and the debt service forecast.
Monthly report on the debt service budget, analyzing the effect of possible exchange rate and interest rate movements. This report is done for both current year fiscal budget sensitivities and future years fiscal budget sensitivities.
Benchmarking of domestic portfolio
420. When the Irish Government debt management operations were carried out in the context of an Irish Pound market, prior to the introduction of the euro, the benchmarking of performance on the domestic debt portfolio was much more difficult than in the case of the foreign portfolio. Nevertheless, it was considered beneficial to benchmark domestic performance so as to provide appropriate incentives for the debt portfolio managers. The benchmarking system was devised so as to give credit for any structural improvements in the domestic bond market brought about by the portfolio managers (e.g., the introduction of the primary trading system and the concentration of liquidity into a smaller number of benchmark issues). The benchmark was also used to assess the effectiveness of the domestic debt managers in achieving their funding target within previously agreed duration limits. The managers were free to vary the timing of their funding actions, as compared with the benchmark, depending on their interest rate view. Thus, at all times, the debt managers were required to have a view on interest rates when deciding on their issuance policy.
421. With the development of a relatively uniform euro area government bond market, Ireland became a very small part of a large liquid market and thus the benchmarking of the domestic debt management operations became more straightforward.
Funding liquidity risk
422. The NTMA prepares and manages a detailed multi-year funding plan that shows the amount and timing of funding needs, including the effect of the projected surpluses or deficits on the government’s budget. In the light of this plan, it determines the size and timing of its long-term debt issuance, and manages its short-term liquidity positions through the issuance of short-term paper or the use of short-term cash balances.
423. The main reports for the ongoing maintenance of the Exchequer’s funding and liquidity requirements are:
The weekly updating of the NTMA’s overall funding plan, which includes a review of its underlying assumptions and a review of immediate liquidity requirements.
Regular reports on the main features of the developments in the government’s overall budgetary position to date, and a review of the current outlook.
424. With the introduction of the euro, the NTMA took a number of steps to enhance the marketability of its bonds and thus reduce funding risk. Broadly speaking, the technical characteristics of Irish Government bonds (e.g., day-count convention) have been changed so as to bring them into line with the bonds of the large core euro-area issuers. In addition, a number of bond exchange and bond buyback programmes have been executed with the objective of concentrating liquidity into a smaller number of large liquid benchmark issues. At present, virtually all the marketable long-term euro-denominated debt with more than one year to maturity is concentrated into five bonds. The NTMA also promotes the openness, predictability and transparency of the market in Irish Government bonds through announcing in advance its schedule of bond auctions, by having a primary dealing system to support the market in the bonds and by arranging for the listing of the bonds on one of the main electronic trading platforms used for trading euro area sovereign debt. The deep liquidity thus generated for the market in Irish Government bonds reduces the funding risk by making the bonds more attractive to a wider pool of investors. Given that Ireland represents a very small proportion of the total euro-area government debt market (about one percent), the NTMA has little difficulty in raising short-term funds to smooth the funding requirement around the time of the redemption of bonds whose size is quite large by historical standards.
Medium-term focus of debt management
425. A number of approaches are adopted to ensure that the NTMA’s debt management activities are not focused on short-term advantage at the cost of potential longer-term cost. First, the Minister for Finances issues each year a set of guidelines covering policy issues such as the mix of floating and fixed rate debt, the maturity profile, the foreign currency exposure, the permissible extent of discounted issues and the credit rating of counterparties. These guidelines are drawn relatively broadly and are designed as prudential limits, which the NTMA must observe. Second, the NTMA’s performance in managing the debt is measured by reference to an independent and externally approved and audited benchmark portfolio. This benchmark performance measurement system takes account not just of current cash flows but also of the net present value (NPV) of all liabilities; in effect it calculates the impact of the NTMA’s debt management activities not only in the year under review but also their projected impact over the full life of the debt. Under the NPV approach, all future cash flows (both interest and principal) of the notional benchmark debt portfolio and of the actual portfolio are marked to market at the end of each year and discounted (based on the zero coupon yield curve) back to their respective net present values. If the net present value of the liabilities in the actual portfolio is lower than the net present value of the notional benchmark portfolio’s liabilities, then the NTMA is deemed to have added value in economic terms. This performance against the benchmark is reported to the MoF and published in the NTMA’s Annual Report.
Limitations on activities to generate a return
426. The managers of the debt portfolio are free to manage the debt within certain risk limits relative to the agreed benchmark. The limits are expressed in terms of the possible change in the market value of the portfolio. Value-at-Risk and interest and currency sensitivity analysis are used to measure the short-term deviations from the benchmark on a weekly basis (or more frequently if required). Any position that exceeds the agreed limit relative to the benchmark portfolio is immediately brought to the attention of the Chief Executive.
427. In managing the debt relative to a benchmark it is necessary to take views on movements in interest rates, unless one wishes to passively track the benchmark. However active trading on a day-to-day basis simply to generate a profit does not take place. The trades entered into by the NTMA are for the purpose of managing the debt and in the course of this certain arbitrage opportunities may arise. For example, one area of arbitrage which is exploited by the debt managers is the issuance of commercial paper, mainly in U.S. dollars but also in other foreign currencies, and the swapping of these currencies into euro for an overall lower cost of funds than could be achieved by direct borrowings in the euro-denominated commercial paper markets.
428. Strict limits are placed on the activities of the debt managers in availing of arbitrage opportunities between different markets. While it is generally feasible for the debt managers to raise funds in the short-term paper markets at lower interest rates than could be obtained in placing those funds on deposit in the market, the general policy of the NTMA is that borrowing activity will be related to the funding needs of the Exchequer. It is, however, desirable to maintain a continuous and predictable presence in the government debt markets and, in addition, cash surpluses will emerge from time to time on the Exchequer Account because of mismatches between the timing of government receipts and payments. The surpluses which arise in this way can be placed on deposit in the markets, subject to the constraints of the limits on counter-party credit risk.
429. The main reports for performance measurement against the benchmark portfolio are:
Daily performance results and positions, which are electronically circulated to the dealers’ desks.
Monthly Value at Risk analysis to ensure that all risk limits are complied with.
Quarterly detailed reports on the attribution of performance.
Models to assess and monitor risk
430. To assess and monitor risk, the NTMA uses models developed in-house and models purchased externally, the latter are used particularly for mark-to-market valuations as part of the risk assessment process. These systems are used mainly to measure and report on market risk and counterparty credit risk exposures on a daily basis.
431. The NTMA is not responsible for the government’s contingent liabilities. These contingent liabilities that arise from government guarantees of the borrowings of state companies or other state bodies are monitored and managed by the Department of Finance.
C. Developing the Markets for Government Securities Filling out the yield curve
432. The NTMA issues the following debt instruments:
Commercial Paper is issued directly to investors or via intermediate banks. The commercial paper is available in all currencies, with tenors not normally exceeding a year.
Exchequer notes are treasury bills with a maturity range from one day to one year. The notes are issued through an “open window” facility each day directly by the NTMA to a broad range of institutional investors, including corporate investors and banks. The NTMA is prepared to buy back Exchequer Notes before maturity. At present, there is just a small secondary market. The NTMA is examining the possibility of improving the secondary market by having the Notes traded on an electronic trading platform.
Section 69 Notes. In Section 69 of the Finance Act, 1985, the Minister of Finance made provision for the issue to foreign-owned companies located in Ireland of interest bearing notes. The interest in these notes would not be subject to tax in Ireland. This incentive was introduced to encourage these companies to keep their surplus cash in Ireland rather than repatriate funds to their overseas parent company. S.69 Notes can be issued in any currency (minimum EUR 100,000) for any tenor.
Fixed rate euro-denominated bonds with maturities up to 14 years are issued by auctions. The bonds are listed on the Irish Stock Exchange and supported in the market by seven market makers (Primary Dealers).
Foreign and domestic currency debt
433. While issuing debt in foreign currencies is now regarded as appropriate for Ireland, because of the advent of the euro with its deep liquid capital market, it is important to remember that conditions for a small open economy like Ireland were very different in the 1980s.
434. The problem essentially arose as a result of the oil crisis of 1979 and the subsequent world-wide recession which, along with the prevailing high international interest rates, had severe adverse consequences for Ireland in terms of:
Low growth, and higher unemployment levels;
High fiscal deficits;
High domestic interest rates; and
Fear of “crowding out” on the domestic capital market.
435. These factors, coupled with the underdeveloped nature of the domestic Irish bond market, led to large-scale foreign borrowing, with a rapid growth in overall indebtedness. In 1991, the position was that foreign currency debt accounted for 35 percent of the national debt and nonresidents held a further 15 percent denominated in Irish currency. Thus, nonresidents held 50 percent of the total national debt.
436. The NTMA faced a much-changed borrowing environment domestically and internationally with the gradual abolition of currency controls and the relaxation of the primary and secondary liquidity ratios on banks. During the 1980s, these controls (while hindering the development of the domestic capital market) had ensured something of a “captive market” for Irish government bonds and paper. The NTMA now faced a more competitive environment for attracting investors. Internationally sovereign names were moving away from the traditional syndicated loans towards capital market instruments.
Priorities for the early years of the National Treasury Management Agency
437. In the early 1990s, the NTMA identified the following priorities for its borrowing programme:
Expanding, broadening and diversifying the investor base, through such ideas as marketing Ireland’s name abroad and keeping it visible through road shows and presentations to influential investors (JPY Samurai, CHF private placement and USD Yankee markets were very important for Ireland in the early days of the NTMA).
Tapping new markets.
Keeping access to retail and institutional investors.
Lengthening the duration of the debt and creating a more balanced maturity profile.
Targeting upgrades in Ireland’s credit ratings (campaigns to get upgrades “ahead of time” or that were forward looking).
Marketing campaigns to improve the international image of Ireland (emphasizing the rarity value of Ireland’s name).
Opportunistic approach to foreign borrowing.
438. The payoff from this approach was that Ireland was very successful in terms of pricing new issues and regularly achieved tighter/keener pricing than similar or more highly rated sovereign borrowers.
439. In response to the need to diversify the sources of funding, as all markets are not “open” at the same time, and to broaden and deepen the range and quality of instruments available for debt management, Ireland put in place standardized Medium-Term Notes (MTN), Euro Medium-Term Notes (EMTN) Programmes, and Euro Commercial Paper (ECP), and USD Commercial Paper (USD CP) Programmes. By mid-1992, the NTMA had put in place facilities in a range of currencies totaling about US$3billion which allowed Ireland immediate and cost effective access to short- and medium-term funds with maximum flexibility.
440. These facilities showed their worth in the Autumn of 1992 when, due to the shock of the huge extra borrowing needs of sovereign names caused by the turmoil in the Exchange Rate Mechanism of the European Monetary System, large syndicated loans and capital market issues became particularly expensive as spreads widened.
441. While in the early years of the NTMA’s existence, there was more focus on achieving cash savings on the debt service cost because of government budgetary pressures, the liquidity risk due to the uneven maturity profile also required urgent attention.
442. 1991 saw moves to smooth the maturity profile. In 1995, the NTMA arranged a 7-year US$500 million backstop multi-currency revolving credit facility to support the issuance of commercial paper. Moreover, it arranged the syndication itself to cut down on fees and achieved the tightest pricing ever by a sovereign.
443. The NTMA also took steps to ensure that derivative instruments—such as interest rate swaps, cross currency swaps, caps, floors, futures and foreign currency forward contracts—as well as spot transactions in foreign currencies were available to be utilized in the management of the debt. The great advantage of recent modern financial innovations is not that they can help to lower the cost of funds, but rather, that these instruments can help to protect the portfolio against different kinds of risks by, for example, shortening or lengthening the average effective duration of the outstanding debt.
444. The various strategies produced a positive mix of:
Cost savings through cheaper funding,
Greater flexibility in funding and hedging,
More fiscal certainty on debt service, and
Reduced liquidity and rollover risk and greater availability of instruments to deal with market risk more efficiently and dynamically.
445. The NTMA took the view that the most sophisticated debt managers are not those who achieve the lowest possible cost of borrowing. The goal needs to include minimizing exposure to risk as well as that of minimizing costs. It is worth paying more to create debt structures that cushion, rather than amplify, the impact of negative shocks. These developments proved positive for credit ratings and positive for investors and for the spreads on Irish sovereign debt as it reduced the relative risk premium.
446. In 1998, the NTMA decided that, with the imminent introduction of the euro and the relatively positive outlook for the government finances, the large euro area bond and money markets would more than adequately meet Ireland’s funding needs for the foreseeable future and that, therefore, it was no longer necessary to retain exposure to non-EMU currencies in the portfolio. Consequently, all non-euro debt with the exception of a residual 6 percent which was left in sterling was swapped back into euro during late 1998 early 1999. This remains the policy today.
447. The sterling exposure was maintained, not on the basis of a cost/risk trade-off for debt management purposes but rather as a macro-economic hedge for the public finances in the event of a sudden and significant weakening of the sterling exchange rate. This decision was taken on the basis of a study of the economic links with the U.K. economy in the case of a significant number of firms whose output is based on relatively low-skilled labor and whose profit margins tend to be low. These firms compete with U.K. firms on the domestic Irish market, the U.K. market and on third markets. Any significant weakening of s sterling would lead to a loss of competitiveness and consequential redundancies in this sector and higher social welfare support payments by the Exchequer which would have been offset to some degree by the lower cost, in Irish Pound and euro terms, of servicing the sterling-denominated debt. However, the NTMA is currently reviewing this policy, and has reduced the sterling exposure to about four percent of the national debt.
Reduction of fragmented debt stock and issuance of consolidated debt
Securities Exchange Programme
448. A number of initiatives had been taken by the NTMA over the years to improve liquidity in the Irish bond market with the objective of reducing borrowing costs for the government. Following the launch of the euro, the NTMA decided that a major initiative was required to ensure that Irish bonds traded effectively in the new euro-denominated pan-European market. The initiative taken was the Securities Exchange Programme. The rationale underlying the programme was the NTMA’s belief that, in order to be competitive in the new euro environment, Irish Government bonds that are “on the run” must have a relatively large issue size, and have technical characteristics analogous to those in other euro-zone markets.
449. In May 1999, the NTMA addressed the above issues, within the constraints of the overall limited size of the Irish Government Bond market by launching a securities exchange programme which consolidated about 80 percent of the market into four bonds, each with outstanding amounts of EUR 3-5 billion, with coupons around current market yields and technical characteristics similar to bonds in other European markets. In the absence of such an initiative, there was a risk that the bonds would trade at yields inappropriate to Ireland’s credit rating.
Execution of the Programme
450. The Exchange Programme was launched in May 1999 with the majority of the transactions taking place in three phases, that is, on the 11th, 17th and 25th of May. On completion of the third phase, over 91 percent of the outstanding in the old bonds covered by the Programme had been exchanged for new bonds.
451. As a result of the Exchange Programme, the ratio of General Government Debt (based on nominal value) to GDP was increased by some 5 percentage points. However, because of the effect of the very rapid growth in GDP, the ratio, which was 55.1 percent at end-1998, had fallen to 49.6 percent at end-1999, including the effects of the Exchange Programme. The Programme did not affect the economic value of the outstanding debt. Cash flow savings represented by the lower annual coupons on the new bonds offset the addition to the capital stock of the debt. The bonds bought back under the program were trading above par, as they had been issued at a time when interest rates were very much higher than in 1999. On the other hand, the bonds issued under the programme were priced very close to par. Hence, the nominal value of the debt increased as a result of the programme.
Bond Switching Programme 2002
452. In January 2002, the NTMA conducted its first major bond switch since the 1999 Securities Exchange Programme. Two of Ireland’s existing benchmark bonds (the 3.5 percent 2005 and the 4 percent 2010) were now “off the run” in terms of their euro-zone peer group.
453. The NTMA wished to launch two new benchmark bonds that would have a good shelf life and that would be of sufficient critical mass (EUR 5 billion) to join the Euro MTS electronic trading system by mid-2002. The intention was that the two new bonds would be reopened by way of auctions in 2002. The best way to achieve these strategic aims was to offer the market switching terms out of the former 2005 and 2010 bonds into to new benchmark issues (a 2007 and a 2013 bond).
454. The switch was successfully conducted via the NTMA’s Primary Dealers. The 2010 and 2005 bonds ceased to be designated as benchmarks as, under NTMA rules, once
60 percent or more of the amount in issue has been bought back, a bond loses its benchmark status. This stipulation acts as in incentive for investors via the primary dealers to take part in the switch, as most investors do not wish to be in non-benchmark stocks with the resultant price illiquidity.
Bond issuance procedures
Regular auction schedule
455. Between February and November 2002, subject to normal market conditions prevailing, the NTMA has held a bond auction on the third Thursday of each month. Each auction is normally in the EUR 500 million-EUR 700 million range and involves the new 2007 and 2013 Benchmark bonds (and the 2016 bond, which was first issued in 1997). The auctions add further depth and liquidity in these issues. The primary dealers have exclusive access to the auctions. Five business days before each auction, the NTMA announces to the market through Bloomberg and Reuters the bond to be auctioned and the amount. The Bloomberg Auction System is used to conduct the auction. This reduces the time between the close of the bidding and the release of the auction result to about three minutes, and thus reduces the risk for bidders.
456. The auction results are published on Bloomberg (page NTMA, menu item 2) and Reuters (page NTMB) simultaneously within about 3 minutes of the cutoff time for bids.
457. After the announcement of the auction results, the NTMA will accept for a period of up 48 hours bids in a non-competitive auction from primary dealers at the weighted average price in the competitive auction. The amount on offer in the non-competitive auction will not exceed the equivalent of 20 percent of the amount sold to the primary dealers in the current competitive auction.
D. Structure of the Irish Government Bond Market Primary dealing system
458. The Irish Government bond market is based on a Primary Dealer system to which the NTMA is committed. There are seven primary dealers recognized by the NTMA, who make continuous two-way prices in designated bonds in minimum specified amounts and within maximum specified spreads. There are also a number of stockbrokers who match client orders. However, the primary dealers account for about 95 percent of turnover. This system, which was introduced at the end of 1995, has brought improved depth and liquidity to the market while the bond repo market has grown in tandem, adding to the liquidity in the bond market. Primary dealers are members of the Irish Stock Exchange, and government bonds are listed on the Exchange.
459. With the switch to electronic trading and the listing of the new 2007 and 2013 benchmark bonds on the Euro MTS in the middle of 2002, the current system has been augmented by six new institutions, which are purely price makers in the new 2007, and 2013 bonds. These new institutions are not be primary dealers and do not have access to supply at the monthly auctions.
460. The liquidity of the Irish Government bond market is underpinned by the Primary Dealing system. However, to further enhance the liquidity of the market, the NTMA provides the following facilities to Primary Dealers:
a continuous bid to the market in Irish government benchmark bonds,
switching facilities between the benchmark bonds, and
repo and reverse repo facilities in benchmark bonds.
461. To enhance the liquidity of the market the NTMA is prepared to buy back amounts of illiquid non-benchmark Irish Government euro-denominated bonds, which have relatively insignificant amounts outstanding. It is also prepared to buy back amounts of Irish Government foreign currency bonds according as opportunities arise in the market. This improves the debt profile, eliminates certain off-the-run and illiquid bonds and facilitates greater issuance in the liquid benchmark bonds.
462. The NTMA maintains a secondary trading function to trade in its bonds with other market participants. The role of the secondary trader is to provide liquidity to the market and to act as a source of market intelligence for the NTMA. The Secondary trader is mandated to deal, as a retail customer, with market makers and brokers in Irish Government Bonds. The secondary trading is separated from the primary bond desk activity by means of “Chinese
Move to electronic trading of Irish bonds
463. The NTMA listed the new benchmark 4.5 percent 2007 and 5 percent 2013 Irish government bonds on Euro MTS electronic trading system at end-June, 2002. A domestic version of MTS was established at the same time, on which the existing 2016 benchmark bond is listed; this one does not yet meet the Euro 5 billion issue size requirement for listing on the main EuroMTS system. The listing of the bonds on the above systems has greatly enhance turnover, price transparency and liquidity and ensures that Irish bonds are maintained in the mainstream of the euro area government bond market.
Standard market conventions
464. All Irish benchmark bonds have a day count convention based on actual number of days (Actual / Actual). The bonds trade on a clean price basis with prices quoted in decimals. The business days for trading are TARGET operating days and bond dealings settle in full on a T+3 basis, but deferred settlement can be arranged upon request. These are standard features of euro area bond markets. Irish government bonds are eligible for use as collateral in ECB money market operations.
465. In December 2000, the settlement of Irish government bonds was transferred from the domestic settlement system, the Central Bank of Ireland Securities Settlements Office (CBISSO), to Euroclear Bank, Brussels. Ireland was the first European country to transfer the settlement of government bonds from its central bank to an international securities depository. The Central Bank of Ireland remains the registrar.
466. The objectives of the transfer to Euroclear were:
Increased liquidity of Irish government bonds in the international capital markets, as a result of improved access to a broader range of investors;
A simplified and cost-effective settlement infrastructure, in which safekeeping and settlement of domestic and cross-border transactions are centralized within the same entity;
Optimized settlement efficiency, due to the integration of the settlement activity into an international real-time settlement environment; and
Access to a wide range of markets for the former CBISSO members, through the Euroclear System.
Inclusion in indices
467. The following indices have an Irish Government bond component:
J.P. Morgan Irish Government Bond Index;
Lehman Brothers Global Bond Index;
Merrill Lynch Global Government Bond Index 11; and
Salomon Smith Barney World Government Bond Index.
468. Ireland has the top long-term credit rating of AAA from Standard and Poor’s, Moody’s, Fitch and the Japanese credit rating agency, Rating and Investment Information, Inc. (R&I). Ireland also has the top short-term credit ratings of A-1+, P-1, F1 and a-1+ from Standard and Poor’s, Moody’s, Fitch and R&I respectively.
Tax treatment of Irish Government Bonds
469. There is no withholding tax on Irish Government Bonds. Nonresident holdings are exempt from all Irish taxation. However the provisions of the EU Savings Directive [Com (1998) 295 final], may affect this position in relation to non-resident personal investors. The objective of the EU Directive is to ensure a minimum of effective taxation of savings income in the form of interest payments within the EU. The Directive applies to individuals (not corporations) who are resident in an EU member state and receive interest income from their investments in another member state. Each member state would be obliged to provide information on such interest payments to the member state in which the beneficial owner of the interest resided.
470. To date, Ireland has not issued any index-linked debt.
Establishing and maintaining contacts with the financial community
471. Despite all the technical and market innovations of the last two decades, financial markets are still a people-driven business and, by maintaining and developing strong contacts, Ireland has traditionally been able to obtain more favorable borrowing costs than one might have expected given its credit rating. This active engagement with the market has also helped the staff of the NTMA enhance and deepen its knowledge and understanding of market developments and to keep abreast of the latest financial market innovations. Provision of accurate and timely information is also part of Ireland’s strategy to keep its name visible in capital markets. To this end, the NTMA makes active use of the following:
The NTMA Web site (www.ntma.ie), which is updated regularly with the latest available information;
An Ireland Information Memorandum published and distributed annually in March and available on the NTMA web site;
The NTMA Annual Report which is published annually in June;
The NTMA regular press conferences and relevant press releases to update the market on important developments;
The NTMA Reuters pages (ntma/b/c);
The NTMA’s annual reception in December for all it’s banking contacts;
The NTMA’s credit lines for financial institutions;
The NTMA’s regular road shows and marketing campaigns to keep Ireland’s name visible, particularly in advance of any major issuance programme;
The NTMA’s regular contact with the credit rating agencies (Ireland has the top, triple A rating from Moody’s, Standard and Poor’s, and Fitch);
The NTMA’s active use of the Bloomberg messaging system to seek quotes in non-price sensitive instruments such as deposits and foreign exchange forward points. This ensures both optimum pricing and that every bank the NTMA has a line with has a chance to quote; and
Listing of Irish government bonds on the major electronic trading platform, EuroMTS. CPSS and IOSCO standards
472. The IMF Financial Sector Assessment Project mission reported, “Ireland observes the CPSS core principles for systemically important payment systems. The only systemically important payment system is IRIS, the Irish real-time gross settlement system. This is facilitated by ECB actions to ensure that national payment systems participating in the Trans-European Real-time Gross Settlement Express Transfer (TARGET) embody all the features necessary for the smooth functioning of cross-border transactions.” The NTMA operates a Securities Settlement System as issuer, registrar and settler of its Exchequer Note programme in accordance with the core principles of the IOSCO standards. The Central Bank of Ireland is the registrar for Irish Government Bonds, which are settled at Euroclear. Both Central Bank of Ireland and Euroclear operate in accordance with the core principles of the IOSCO standards.
The challenge of the euro
473. EMU and the advent of the euro have led to a greater degree of intra-euro area portfolio diversification, as the disappearance of foreign exchange risks and transaction costs and deregulation of the various domestic euro-area member domestic markets has resulted in an ever greater redistribution of assets within euro-area portfolios. Hence, in the case of Ireland, nonresident holdings of Irish government bonds has risen from about 21 percent to 60 percent at June 2002 as domestic investors who were heavily invested in the Irish bond market diversified and were replaced by new, predominantly fellow euro-area investors.
474. With no exchange risk, unidirectional yields and lower spreads stemming from convergence (due to more equalization in the sovereign credit ratings of member countries of the euro-area), investors’ motivations may be reduced to questions of price liquidity, transparency and market efficiency.
475. The public debt management policy in Italy, as conducted in the last decade, has followed the prescriptions of the Maastricht Treaty, creating a monetary union and the single currency, the euro, among those European countries that were respecting the criteria of economic stability and fiscal discipline.
476. The Italian Treasury has since 1992 undergone a process of profound change in the structure of its liabilities. The main goals to be reached at the end of this process were, in brief:
The reversion in the growth path of general government consolidated gross debt (as defined according to the specification of the Excessive Deficit Procedure related to the European Monetary Union);
The overall reduction of the pressure on capital markets due to excessive supply of bonds;
The reduction of the exposure to interest rates fluctuations;
The creation of a deep and liquid market for government securities.
477. The strong commitment to the attainment of these goals has been expressed in the legislation passed from 1992 on and in the organizational and structural reforms in the field of public debt management.
A. Developing a Sound Governance and Institutional Framework
Debt management objective and scope
478. The strategic guidelines for 2002 and 2003 define the objective of public debt management as “.. .to ensure that the financing needs of the State and its repayments obligations are met, minimizing the cost of debt, the level of risk being equal.”
479. Referring to the legal framework of responsibilities, the Public Debt Direction (PDD) of the Italian Treasury Department is directly responsible for the issuance and management of public debt domestic securities.
480. The PDD is also responsible for issuance and management of all other securities. This includes borrowing and other activities in the international capital market, such as issuing of syndicated loans and commercial papers and activity on the swap market. The PDD also manages the “Public Debt Sinking Fund” and the “Cash Account” (“Conto Disponibilité”) at the Bank of Italy (both dating back to 1993).
481. The PDD also exercises surveillance over the access to financial market funding of public entities, local authorities, companies controlled by the State, having or not having a State guarantee.
Coordination with monetary and fiscal policies
482. Coordination between fiscal and monetary policies and debt management activities is a priority for Italian authorities. The division of responsibility and specialization of tasks among the different institutions is clearly stated. The PDD has the responsibility of the issuance and management of public debt. The Italian Treasury Department is responsible for the management of the State Treasury and for monitoring the financing needs of the central government (“Fabbisogno del Settore Statale”). The Bank of Italy (BOI)—as a member of the ECB, the European Central Bank—is in charge of monetary policy and surveillance over the Italian financial system.
483. The set of rules and constraints and the different tasks assigned to each of the acting departments (PDD, Treasury Department, BOI and also general Government entities) require a deep and constant coordination in the action, both to prevent the breaking of legal rules and to assure the orderly functioning of the State activities (collection of revenues and distribution of payments).
484. As for all members of the Economic and Monetary Union, the issue of coordination of debt management with monetary policy in Italy must be seen in the framework of the Maastricht Treaty. The Treaty establishes a prohibition for monetary authorities to finance the state deficit by buying government securities on the primary market. This provision of the Treaty was reflected in the national legislation in 1993, which prohibited the BOI from participating to government bond auctions. Regarding the conduct of monetary policy, the PDD has never had any privileged information, as the setting of official interest rates was an exclusive privilege of the BOI until 1998 and of the ECB thereafter.
485. The legal framework assures a complete separation of objectives and accountability for monetary policy and debt management. The BOI is fully independent from the government and acts as an independent authority, or an institution performing its activities with no interference, and deriving its powers from a specific legislation, without any possibility of intervention or influence by the State or Government. Its property is divided into shares, owned by private institutions and public entities belonging to specified categories. However, the majority of shares, according to the BOI statute (which could be modified only by law) must be in the hands of public entities or companies owned by public entities. The shareholders, as of December 31, 2000, were 86 (80 with voting rights).
486. In addition, the Italian law, in accordance with article 101 of the Treaty establishing the European Community, as modified by the Maastricht Treaty, forbids all overdraft facilities of the State with the BOI or the ECB, in any form and amount. Since 1993, the direct purchase of public debt instruments from the BOI is forbidden by law. The system also includes the cash account of the Treasury at the BOI, implying the removal of any overdraft facility for the Treasury. This account has—according to the law—to show an average positive balance of EUR 15.49 billion.
487. However, even though Italy has implemented a clear separation of roles between the Treasury and the BOI, these two institutions have always maintained a close dialogue on public debt management issues. First, they exchange views in regular meetings in which issuance policy matters are discussed, such as amount and instrument mix to be offered. Second, the BOI is usually involved in workgroups that are occasionally established in order to work on specific innovations or questions that are relevant for debt management, such as the creation of the strip market, the definition of new facilities, and the like. Third, a close exchange of information is maintained on the issuance activity in foreign currency, given its implications on reserves management and the fact that the BOI is the fiscal agent of the Republic.
488. The smooth functioning of the borrowing activity of the PDD requires constant monitoring of the financing needs of the State (“Fabbisogno del Settore Statale” in cash terms) in coordination with the Direction of the Treasury department. This constant monitoring is also done by means of estimates and forecasts of the possible future trends in those needs, taking into account the usual annual cyclical and extraordinary patterns of cash expenses and revenues (typically, revenues from direct and indirect taxation, expenses for salaries, and the like). Finally, the financing requirements need to take into account the maturity and reimbursement profile of outstanding debt.
489. A close exchange of information is also maintained on the balance of the cash account that the Treasury holds at the BOI, through which most payments of the Republic are channeled. Although this account is established at the BOI, only the Treasury is entitled to order any payment or receipt. However, the two institutions keep close contact on the balances on account because of its implications on liquidity in the system and therefore on monetary policy.
490. The budget law (“Legge Finanziaria”), passed annually by the Parliament, sets the binding limit for the net borrowing of the State and for the market borrowing activity during the financial year. The latter represents, in brief, the total amount of gross issuance of public debt.
491. The legal framework for Public Debt Management activity is defined firstly by the state law, which has recently created the new Ministry of the Economy and Finance (MEF). MEF is assigned—among others—the competencies related to the “. funding of Government’s financing needs and of Public Debt ...”
492. A regulation of secondary level defines the concrete organization and division of competencies to be assigned to the Treasury Department within the MEF, and in particular to the Public Debt Direction.
493. The PDD is responsible for the issuance and management of domestic and external public debt, for the management of public debt sinking fund and surveillance of market financing activities of other local and public entities. This activity of surveillance over public and especially local entities is a sensitive issue for the PDD. The obligations of the State related to the Excessive Deficit Procedure, are to be met at the “General Government” level, for example, taking into account the funding activity of the local entities and of all entities included in the General Government Sector.
494. The particular legislative framework, together with the hierarchy of legislative sources, entails a sound assurance that the Republic of Italy stands behind any transactions the PDD managers enter into. The officials of the PDD are civil servants; the managers of the different offices that form the PDD are subject to accountability principle, implying civil, administrative, accounting and criminal law responsibility.
495. The PDD produces four main documents illustrating the previous activities and the strategic plans for the future:
The annual strategic guidelines. The document containing the strategic guidelines for a specific year is drafted internally in the PDD, following extensive discussions among the various offices of the Department. The Director General of the PDD coordinates the preparation of the document and is responsible for presenting it to the Director General of the Treasury, who approves the draft. There is no formal presentation to Parliament or direct control by the Minister of the Economy.
The semi-annual report to the Supreme Audit Office.
The quarterly bulletin of Public Debt.
The Public Debt section within the quarterly Public Sector Cash Balance and Borrowing Requirement Report.
The last two documents are also provided under the SDDS program of the IMF.
496. The nature of public debt management activity is recognized as essentially public. Options for alternative institutional arrangements have been considered in the past years, such as the constitution of an independent office or agency, operating in a civil law environment. Although a precise analysis of costs and benefits and an evaluation of the project have never been conducted in an exhaustive manner, the current Deputy Minister for Economy and Finance has been put in charge of exploring the possibility of establishing an independent agency for public debt management. For the moment, this remains an issue for academic discussion and research.
Management of internal operations
497. The management of operational risk is conducted by means of sound practices developed during several years of activity and, in particular, starting from 1991, when the present organizational structure of the PDD was outlined. This process was completed in 1997, when all activities related to public debt management were brought under the authority and responsibility of the PDD.
498. The legislative division of labor in public debt management, as pointed out, makes a clear distinction between the Treasury Department and the BOI, thus avoiding any conflict of interests between the two entities. There is a tradition of cooperation between the two institutions and the smooth functioning of the auction and settlement procedures, and all operations connected to the secondary market activity, is the result of the successful story of public debt management reforms in Italy. In particular, the presence of an auction procedure manager (BOI), of secondary market autonomous trading-platforms37 and of an independent depository institution (Monte Titoli SpA) ensures that the responsibilities are clearly separated and provides a full accountability.
499. In the field of Human Resource management, a great effort has been made in order to ameliorate and renew the human capital endowment of the PDD. In particular, the main effort is addressed to reduce the traditional gap of Italian Public Administration as regards the information technology and the foreign language. The advancements made are significant, especially because they are connected with a broader effort of the Italian Public Administration as a whole.
500. The turnover rate of staff, compared with private institutions, is low. The highest level of mobility regards people moving from one department of the MEF to another, from one office of the PDD to another or retiring. Nevertheless, recently the occurrence of people moving toward international institutions or private institutions (mostly financial institutions) is more frequent. The Italian legislative framework does not give any flexibility in the field of salaries and incentives, with the exception of a few top managers (generally Heads of Department or General Directors). The recent legislative reforms, however, try to sketch a more flexible and dynamic framework, especially for managers (the level immediately below General Directors), allowing for temporary contracts, and some “weak form” of performance salary. Nonetheless, the PDD, among the other administrations, can offer to its staff training and a bulk of skills comparable to the private sector.
501. A specific code of conduct does not exist, but PDD officials are subject to normal provisions for public officials. The Italian administrative and criminal law meet all of the criteria of impartiality and help to avoid any conflict of interests.
502. The public debt management activity is subject to the control of the Accounting Department of the Ministry of the Economy (MEF) and Finance and of the Italian Supreme Audit Office (It. ‘Corte dei Conti’).
503. The formal control of the Accounting Department at the MEF is continuous and conducted only on a documentary basis for the whole Administration and for a limited number of acts, whose list is specified by law. This means that the auditing procedures examine and certify the ex-ante conformity to the law and accounting regularity of the documental evidence.
504. The specific formal controls of the Supreme Audit Court are also conducted on a legal basis. Some documents and acts (e.g., purchase agreements above a specified amount) need to be sent to the Supreme Court for Legal and Accounting ex ante approval. The ex post nonformal control of the Supreme Office over the yearly activity is conducted on a sampling basis, for the entire Italian Administration and, therefore, does not cover the PDD’s activity on a regular basis.
505. In addition, the PDD submits a six-monthly “Public Debt Management Activity Report,” to the Supreme Audit Office, detailing the evolution in the composition of public debt and describing the operations undertaken during the semester. This document is not made public. Indeed, its main aim is to deepen the knowledge and comprehension of Public Debt Management Activity. The mere examination of numerical results—routinely made by the Supreme Audit Office—is enlarged to include the evaluation end the explanation of strategies and actions, also in connection, for instance, with trends in the International Capital Markets.
506. For the Italian Treasury and the PDD, transparency is a strategic priority and the commitment to it is very strong. The web site of the PDD 38 is updated daily and is fully available in English. The web site is the result of the great importance attached to the communication with the vast audience of international and domestic investors.
507. A document illustrating the strategic guidelines of public debt management is published yearly on the web site. The strategic guidelines disclose the objectives of the PDD in terms of risk management, portfolio composition, liquidity of the securities on the secondary market, forecasts of possible gross issuances and of number of new bonds and treasury bills to be placed on the market. The public disclosure of strategic cost/risk analysis and objectives is also at an early stage and has been provided in the last strategic document.
508. Also available on the web site are:
The annual auction calendar;
The quarterly issuing program;
The quarterly bulletin of the PDD;
The bills and bonds offering announcements;
The results of latest auctions of all bonds and treasury bills; and
Specific sections devoted to:
- Specialists on Italian Government Bonds;
- Public Debt Statistics;
- Italian Public Debt Sinking Fund;
- Listing and Description of Italian Treasury Securities;
- Other information and news (e.g., related to new legislation on fiscal treatment of bonds and bills).
509. The administrative and organizational framework for debt management is designed primarily through the Italian law and, subsequently, through the regulation of the Ministry of Economy and Finance.
510. The regulation and the procedures for the primary distribution of public debt securities are made clear to the participants through:
the legislative framework;
the periodical (annual) diffusion of the ranking of Specialists (web site); and
the public availability of the criteria for evaluation of Specialists (web site).
511. As regards the auction framework for Italian public debt securities, the law provides a set of rules while the electronic procedure for public auctions assures a clear and unambiguous carrying out of all operations (sending of bids, opening, ranking, and assignment of quantities). Manual or semi-electronic recovery procedures are provided in the case of an information technology failure. The secondary market for public debt has been, since 1988, conducted through an electronic platform (MTS).
512. The reform process of the secondary market ended in 1998, when a law and two decrees were passed, regulating the framework of the secondary market and the role of the MTS electronic platform in the wholesale market for Italian and foreign government bonds.
513. The information about the flow and stock of government debt is sent to the market, coherently with the availability of final data. The PDD releases a “Quarterly Bulletin” of the public debt market, showing:
The results of the last auctions of Italian public debt securities;
The outstanding amount of benchmark securities;
The quarterly Issuance program (of new securities);
The breakdown by instrument of outstanding Government debt;
The historical data of average life of government debt;
The redemptions of outstanding bonds;
The redemptions of the next 12 months;
The trading volumes and average bid/offer spreads observed in the secondary market (MTS).
514. In addition, the Italian Treasury Department provides, when needed, information about changes in fiscal treatment of public debt securities. This has happened in the case of the recent innovations regarding the taxation regime (withholding tax) for nonresidents: the explanatory notes of the reform and an application form have been published on the PDD web site.
515. As regards the financing needs of the Public Sector (“Fabbisogno del Settore Statale”), a partial disclosure of summary data referring to those aggregates is provided monthly by the Italian Treasury Department. No official forecasts are handled to the public, due to the fluctuations and uncertainty of these data.
B. Debt Management Strategy And the Risk Management Framework
516. Italy has one of the largest debt stocks among advanced economies, both in nominal terms and as a percentage of GDP. The debt to GDP ratio, which stood at 97.2 percent in 1990, reached a peak of 124.3 percent in 1994, when it started to decline thanks to a major fiscal consolidation. Such an enormous debt burden undermined the financial stability of the country and conditioned the government’s action in the political economy domain. Throughout the 1980s and the first half of the 1990s, Italy was facing increasingly large expenditure outlays due to the debt service to the point that, in 1993, interest payments on the public debt absorbed 22.6 percent of total expenditure. In order to service its debt the Republic needed to keep taxes at a high level, and there was very little room for maneuvering to use fiscal policy as a counter cyclical tool. Doing so would result in a relaxed fiscal policy that would soon exacerbate the balance of the country’s fiscal accounts. Even the independent conduct of monetary policy, which was fighting inflation through a restrictive stance on official rates, could have a negative impact on public finance through an increase of the cost of debt. However, as Italy was not overly exposed to foreign currency-denominated debt (only 3.5 percent of total debt was denominated in foreign currency in 1993) there were not large implications of the large stock of debt on reserves management. As recently as 19941995, the spread between Italian and German 10-year bonds was still oscillating between 250 and 600 basis points, and it became clear that such a wide spread was unsustainable over the long term.
517. In this context, while up to the early 1980s the main concern of the PDD was to raise the necessary cash to fund the government’s operations, the PDD decided to better define its mission and to put together a more precise strategy that should guide its action. Therefore, even though there remained a set of constraints, which made it difficult to shift away from the risky treasury bill market, the Treasury Department began to put forward some basic concepts to be followed in debt management policy.
518. A general objective of debt management policy was then considered of minimizing the cost of funding. However, in order not to take excessive risks in the presence of specific market conditions, it was decided that this objective should be achieved in a context of careful control of the interest rate risk and refinancing risk. The rationale was that the objective of minimization of the funding cost was not sufficient in itself to prevent the budget from possible shocks. For example, in a situation of declining interest rates, this objective could have led to an excessive issuance of short-dated securities. While this strategy could indeed save money in the short term, it could lead the government to assume an unnecessary exposure to the risk that interest rates would rise in the future and determine a sharp increase in the cost of debt.
519. The work undertaken to better evaluate the main risks faced by the PDD was instrumental to define the mission of debt management activity. Throughout the 1990s, because of the size and composition of its debt, Italy was largely exposed to two main risks:
interest rate (market) risk. Because of the very short duration of the public debt, the cost of debt was very sensitive to changes in interest rates;
refinancing (rollover) risk. The average life of public debt was only 2.6 years in 1990. This implied that the Italian authorities had to roll over every year massive amounts of securities, overloading the market with frequent and large auctions.
The approach to interest rate (market) risk
520. The need to contain the interest rate risk required the PDD to engage in an active debt management policy with the aim to modify the composition and increase the duration of the stock of debt.
521. The beginning of the fiscal consolidation and the reduction in the inflation rate created a better environment for investors to buy long-term securities. The increased demand made it possible to issue CCTs (7-year floating rate bills) and BTPs (3-, 5-, 10- and 30-year bonds) in higher amounts. In 1990, short-term and floating rate notes accounted for
73 percent of the total debt, declining to 49 percent in 1995 and reaching 30 percent by the year 2000. At the same time, the duration of the debt portfolio increased from 1.7 years in 1993 to 3.7 years in 2000.
522. As a result, the exposure to fluctuations in interest rates declined significantly. Given the current composition of the debt, the impact of a 1-percentage-point shift in the yield curve would determine an increase in interest expenditure of about one third lower respect to 1996.
The approach to refinancing (rollover) risk
523. An even bigger challenge for Italy was that of reducing rollover risk. The structure of the public debt was, until recently, such that the short average life caused a constant need to rollover maturing debt. For example, in 1995 the public debt to be reimbursed amounted to 50 percent of the total debt outstanding. There was also a high concentration of maturities on specific dates and consequently the recourse to the market had to be particularly large to meet those redemptions.
524. The strategy to address this risk was based on two pillars. First, the objective was to increase the average life of the public debt. During the 1990s, the average life more than doubled from 2.6 years in 1990 to 5.7 years in 2000. Second, the aim was for a smoother distribution of maturities during the year. Although the borrowing requirement maintained a pronounced seasonality, the PDD strived to spread out maturities more evenly across the various months.
The operative framework to address market and rollover risk
525. The quest to reduce these two risks went on for most of the 1980s and 1990s, when Italy adopted an active debt management policy and explored all possible avenues to educate investors to buy securities other than short-term treasury bills, which were the backbone of the portfolio of any Italian investor. Moreover, there was a need to diversify the range of instruments used to raise funds, so as not to depend excessively on a specific segment of the market. The PDD launched innovations both on the primary and the secondary market. As regards the primary market, the action concentrated mainly on two lines, the diversification of instruments and the introduction of new issuance procedures.
526. In terms of diversification of instruments, there was a policy aimed at increasing the types of securities to be offered so that the Treasury could target a wider range of investors, increase the average maturity of the debt, and obtain a smoother redemption profile. Several new types of securities were introduced, namely:
the Certificati di Credito del Tesoro (CCT). In a constant struggle to reduce the recourse to short-term treasury bills, in 1978 Italy had introduced the CCTs with the aim of lengthening the average life of its debt. However, due to the then prevailing reluctance to invest in long dated fixed-rate Italian securities, the PDD decided to index the coupon payments to the current treasury bill rate. This new instrument (whose maturity initially varied but stabilized at seven years in the early 1990s) was extremely successful, especially with households, and accounted for over 40 percent of the total debt in 1990. By doing so, the PDD was able to significantly reduce refinancing risk, but remained exposed to variations in the interest rate level;
the Certificati del Tesoro(CTE) denominated in ECU. With the CTE, launched in 1982, Italy was among the first issuers to offer securities denominated in the European unit of account, the basket of currencies that was to generate the euro. In doing so, the PDD was able to attract new investors to longer maturities, preventing the fears of devaluation of the Italian lira from discouraging them;
the Buoni del Tesoro (BTE) denominated in ECU. Similar to CTEs, but with shorter maturities, introduced in 1987;
the Certificati del Tesoro con Opzione (CTO). These securities, introduced in 1988, were 6-years fixed-rate bonds embedding the option for the holder to request advance reimbursement after three years.
the first 30-year BTP was launched in 1993 with the objective to increase the duration of the public debt;
the funding program in foreign currency. Starting in 1984, the Republic of Italy launched bonds denominated in foreign currencies to attract those investors that were not willing to invest in a currency characterized by high inflation. Eventually, Italy became one of the main issuers in the Eurobond market and subsequently complemented this activity with the inclusion of sources of financing other than benchmark bonds, such as the EMTN program (launched in 1999).
527. In terms of issuance procedures, several changes have been adopted over the years in order to improve placement techniques, especially for medium- and long-term bonds. Until the 1980s, medium- and long-term bonds were placed through a syndicate of major domestic banks. The PDD would indicate the amount and price of securities to be sold, so as to avoid excessive market fluctuations. In 1985, in light of the growing number of intermediaries that could access the Italian market, and with a view to standardizing its placement procedures, the PDD started to test the uniform price auction and began to make this a standard practice in 1988. By 1990, all treasury securities except foreign currency bonds and treasury bills were placed via uniform price auction, and in 1992 the requirement of a base price was removed.
528. As for Buoni Ordinari del Tesoro (BOTs), treasury bills of varying maturities, the decision to remove the indication of a base price for the auction (which came in 1988 for 3-month bills and in 1989 for 6-month and 12-month bills) was a very important move, which favored a more precise separation of roles between the Treasury and the BOI. The indication of a base price for treasury bills was regarded as extremely important by market participants, who tried to extract from it a signal on the direction of official interest rates. This approach favored a confusion of roles between the Treasury and the BOI and would sometime generate uncertainty in the expectations on monetary policy.
529. Another important step in issuance procedures concerned the introduction of reopening auctions for medium- and long- term bonds in 1990. This decision responded to the need to boost the liquidity of the newly established on-screen secondary market (MTS, see below). Transactions on this market could not pick up momentum as expected because of the large number of bonds outstanding, none of which was liquid enough to absorb large transactions. Benchmark bonds would change very frequently and the market remained fragmented. Therefore the PDD started to conduct several auctions over time on the same bonds, reducing the number of bonds issued on the same maturity, initially for a period of two to three months, and then for progressively longer periods. Today, a 10-year bond can remain open for over 6 months and a 30-year bond for over one year. This allows the bonds to reach an optimal outstanding amount and there is evidence that the introduction of reopening auctions contributed to reducing the cost of debt because investors were more willing to buy liquid securities. This reform was also key for the development of an efficient secondary market.
530. More recently, the PDD also announced a finalized program to exchange securities nearing maturity with securities in the process of being issued (exchange offers). The objective is to make the profile of maturities more uniform. By means of exchange offers, the PDD will retire old bonds with a short remaining maturity and exchange them with newly issued securities with a longer maturity. The benefit will be twofold:
on refinancing. By retiring old bonds with a short remaining maturity, the PDD can smooth out the redemption profile for the near term (usually the securities to be repurchased have a maturity up to one year). The securities are usually replaced by new medium and long-term bonds, which help in spreading out maturities over a longer time horizon;
on market liquidity. In general, bonds nearing maturities are no longer liquid, and therefore they tend to not being actively traded on the secondary market, resulting in an increased burden for primary dealers if they are obliged to quote them. Through the exchange offer facility, the primary dealers are given a window to swap illiquid bonds with highly liquid ones such as those used by the PDD to execute the exchange offers.
531. The exchange offers, which were executed for the first time in early 2002, can be carried out according to two procedures:
through auction, by following the same procedure used for buyback operations made with the proceeds of privatization. These transactions will preferably be made in the middle of the month, concurrent with three- and five-year BTP auctions;
at a later stage, by operating directly on the regulated secondary market through bilateral transactions.
532. In both cases these transactions are reserved only for specialists in government bonds, since they represent the most active operators on the secondary market and those on whom the Treasury relies to maintain high liquidity and efficiency in the secondary market.
533. Given the sophistication that characterizes today’s markets the development of adequate information systems is key to a smooth functioning of debt management. Over the past 10 years, the PDD has worked to improve its systems by focusing on three areas:
forecasting systems; and
risk management systems.
534. Pricing systems are instrumental for the front office, since they enable the PDD to have a better understanding and evaluation of the trades that are entered into. The need to develop such systems first arose for liability management purposes, when the PDD started to directly negotiate derivatives contracts with its counterparts; subsequently such systems were used for issuance activity and other operations on the domestic debt as well. Rather than develop in-house models, the PDD chose to draw upon the experience of investment banks in this field. Therefore, it benefited from their advice in setting up and customizing the pricing tools needed in debt management operations. These models are used for a wide range of purposes, from simple calculation operations such as discount rates, to pricing of complex structures or determination of the fair value of bonds to be repurchased on the secondary market.
535. Forecasting systems are being developed in order for the PDD to have its own views on the evolution of key variables for debt management, such as interest expenditure, stock of debt outstanding at future dates, and so on.
536. The other area that is under development is that of risk models, which is gaining growing importance for reporting and accountability purposes. Here, work is under way to refine the models that allow the PDD to accurately measure its exposure at any given point in time. Most existing models are based on customizing the Value-at-Risk (VaR) models, which are the most widely used by investment banks. However, because of the peculiar nature of the fund raising activity and the accounting methodology for recording debt, the PDD is also working to develop more tailored indicators, such as models calculating the sensitivity of the interest expenditure to variations of interest rates or to changes in the composition of the debt outstanding. The interest expenditure, given its impact on Italian public finances, is a variable that needs to be closely monitored, and one for which the PDD can take very little risk. For this reason, many of the simulations that are regularly run at the PDD concern the testing of various compositions of the debt portfolio to see how the interest rate expenditure would react under different market circumstances. The results of such simulations are also the basis for strategic planning of the issuance activity.
C. Developing the Markets for Government Securities
537. Italy has invested extensive resources in order to develop an efficient securities market. Given the heavy financing needs managed by the PDD, the need to create a dependable mechanism for raising funds was one of the top priorities during the 1980s. Work was carried out to develop both the primary and the secondary markets.
538. Since then, the Italian financial system has undergone constant and rapid development—mostly in the field of information technology trading, settlement and depository systems. Separate institutions have been created during the 1990s to operate the secondary market for public debt securities. A wholesale market to trade Italian government securities, MTS SpA, by means of a screen-based system was introduced in 1988. In 1994, MOT, a retail market for securities was created as a branch of Borsa Italia SpA. The latest innovation, started in August 2001, was “BondVision” (a division of MTS SpA), an Internet-based multi dealer-to-client wholesale fixed income market.
539. In parallel, since 1991 a number of laws have been passed, ensuring the modernization of the financial markets and of institutional investors related legislation.
Domestic government securities
540. In the domestic market, the PDD today issues the following instruments:
Buoni Ordinari del Tesoro (BOT), 3-, 6-, and 12-month treasury bills;
Buoni del Tesoro Poliennali (BTP), 3-, 5-, 10-, 15-, and 30-year bonds;
Certificati del Tesoro Zero-Coupon (CTZ), 24-month zero coupon bills, and;
Certificati di Credito del Tesoro (CCT), 7-year floating rate bills.
541. In order to place its debt, the Republic of Italy uses very standardized and reliable mechanisms. Traditionally, domestic debt has been issued via auctions and foreign debt via syndication of banks. Today, these remain the most important mechanisms, even though, as new products are developed, some other channels may gain ground. The methods can be summarized as follows:
Treasury bills: competitive auction without any indication of the base price. Investors can submit up to three bids, and each of which is assigned the price requested. There is a cutoff price in order to avoid speculative bids;
Medium- and long-term bonds: marginal auction, whereby each request is assigned at the marginal price, which is determined by accepting higher bids until the total amount of bids accepted equals the amount that is offered. There is a cutoff price in order to avoid speculative bids;
Bonds denominated in foreign currency: syndication;
Commercial paper: direct quote on various networks and through telephone.
542. Besides issuing marketable debt, the Republic of Italy also guarantees the debt of the “Cassa Depositi e Prestiti (CDP)” which is placed through the Post Offices. The CDP is a public institution in charge of funding local authorities or specific projects for public infrastructures. However, to ensure that the borrowing of the CDP is done on similar terms to the funding managed by the PDD, the Minister of the Economy and Finance, who is responsible for debt management, is given the authority to set the financial conditions under which the CDP can issue debt.
543. Issuance procedures have been continuously enhanced, in terms of transparency and effectiveness. At the end of 1994, in order to improve transparency and predictability of issuance policy, the PDD started to disclose an advance calendar of the auction dates for the following year, along with a quarterly issuance program that gives more detail about the bonds and the amounts to be issued in the coming quarter. By doing so, all market participants are given detailed information, which is key to accurate planning of their activity for the following year or quarter.
544. Since 1995, the auctions are carried out via a completely automated procedure at the Bank of Italy. As a consequence of a constant improvement, the lag between the collection of the bids and the announcement of the results has been reduced t