Managing Sovereign Debt and Debt Markets through a Crisis - Practical Insights and Policy Lessons

The crisis highlighted the importance of debt management in containing debt-related risks and the associated impact on debt markets. The impact of the crisis on debt levels, and the consequent implications for fiscal consolidation, has been the subject of much discussion and analysis. However, there has been relatively less focus on the issue of how that debt should be managed, including how its composition should be structured so as to mitigate key risk exposures, and its implications for debt market functioning. That task proved significantly complex and challenging through the crisis, particularly in advanced economies, with additional dimensions of risk revealed.

Abstract

The crisis highlighted the importance of debt management in containing debt-related risks and the associated impact on debt markets. The impact of the crisis on debt levels, and the consequent implications for fiscal consolidation, has been the subject of much discussion and analysis. However, there has been relatively less focus on the issue of how that debt should be managed, including how its composition should be structured so as to mitigate key risk exposures, and its implications for debt market functioning. That task proved significantly complex and challenging through the crisis, particularly in advanced economies, with additional dimensions of risk revealed.

I. Overview and Summary1

1. The crisis highlighted the importance of debt management in containing debt-related risks and the associated impact on debt markets. The impact of the crisis on debt levels, and the consequent implications for fiscal consolidation, has been the subject of much discussion and analysis. However, there has been relatively less focus on the issue of how that debt should be managed, including how its composition should be structured so as to mitigate key risk exposures, and its implications for debt market functioning. That task proved significantly complex and challenging through the crisis, particularly in advanced economies, with additional dimensions of risk revealed.

2. At the heart of the operational challenge was how to meet increased borrowing needs against a backdrop of intensely challenging market conditions. This required sovereign debt managers be more creative in their operational approaches—modifying the issuance mix and financing modalities, and stepping up market management activities, complemented in some cases with coordinated support from central banks.

3. The crisis also tested the efficacy of risk management frameworks for managing the sovereign debt portfolio and its resilience. The experience highlights the need for risk management frameworks to identify target debt structures that reflect more closely the level of debt, degree of macro policy flexibility, market depth, and concentration of the investor base. The risk of significant negative feedback effects between the financial and fiscal sectors—one that was exacerbated by large and damaging cross-border spillover effects in this crisis—now also needs to be factored in. The availability of liquidity buffers has also assumed greater importance, especially for countries where monetary policy is constrained, and those with concentrated or fragile investor bases.

4. So long as financing needs remain elevated and market conditions volatile, achieving the desired debt structure will prove challenging. In some cases, the crisis has led to a re-categorization of sovereign debt from low credit risk to high credit risk, which will complicate the debt management task further, even for the systemically important sovereign issuers. This increased perception of the credit risk associated with sovereign debt could also exacerbate the interconnections between the debt capital markets, the financial sector and the sovereign. This carries far-reaching implications for how debt will be managed going forward and the financial sector reforms currently under consideration.

5. A recalibration of sovereigns’ debt management policies and practices is desirable at this point. This is due to the combination of deepening fiscal imbalances and long-term fiscal risks, currently high levels of public debt, weaknesses in sovereign balance sheets, and the fuller information on the nature of debt portfolio and contingent liability risks revealed by the crisis. An effective response requires sovereign debt managers to take action along the lines below. These steps will complement the implementation of credible and sustainable fiscal policies and effective macro-prudential and financial sector policies, which are also necessary to reduce sovereign risk:

  • Augmenting risk management frameworks to capture a wider set of risk considerations. Explicitly incorporate: (i) the potential materialization of contingent liabilities; (ii) the interaction of sovereign risk with financial sector risk; and (iii) the degree of macroeconomic policy flexibility, especially exchange rate and monetary policy constraints, and its effect on financing costs under stress. Potential cross-border spillovers also need to be recognized, an issue that is as relevant for advanced economies as for emerging markets.

  • Improving the resilience of debt structures to financing and macroeconomic shocks. Initiate steps, including liability management operations, to lengthen maturity and reduce rollover and liquidity risk. In this context, there may be scope for emerging markets to take advantage of capital inflows to further lengthen the maturity of their domestic currency debt. Appropriate liquidity buffers can complement these strategies.

  • Ensuring sufficient operational flexibility. Maintain adequate operational flexibility, including the scope to adapt primary issuance techniques, and use liability management operations to alleviate secondary market impairments and support liquidity. This can reduce execution risk, improve price discovery, and address market dislocations. Systemically important sovereign issuers, which provide a reference for the wider debt capital markets, need to be particularly cognizant of the risk of broader market disruption that could follow any unsuccessful market operation.

  • Strengthening communication with stakeholders and investors. Better understand the nature of the investor base and its investment philosophy, the impact of regulatory reforms on investors, and other factors affecting global asset allocation decisions. Apart from improving investors’ understanding of the macro-economic fundamentals, structural developments and debt management philosophy, issuers should focus on identifying potential debt capital market vulnerabilities. This will help inform instrument design, shape market perceptions and mitigate the risk of a sudden loss of market access.

6. Enhanced collaboration among debt managers and other policy makers will also be essential for identifying, monitoring and mitigating risk on the sovereign balance sheet.

This collaboration should focus on an ex-ante determination of the extent of exposure, such as to the financial sector or demographic pressures, so as to inform any necessary debt management related interventions, including the need for any liability management operations, and the appropriate size of liquidity buffers. Collaboration will also ensure the consistency of debt management policies with financial sector and macroeconomic policies, and facilitate cross-institutional efforts to enhance debt market liquidity. Where appropriate, institutional arrangements for macro-prudential monitoring could be leveraged to achieve this goal.

7. The paper thus reviews the sovereign debt management response during this period, and discusses the main lessons for country authorities in managing sovereign debt going forward. It builds on discussions held at the 10th Annual IMF consultations on —Policy and Operational Challenges Facing Public Debt Management’ (July 1-2, 2010), from which the “Stockholm Principles” for managing sovereign risk and high levels of public debt emerged, and at the High-Level Roundtable on Sovereign Risk and Financial Stability (March 18, 2011), providing more detailed analysis of the key issues and specific suggestions on how key vulnerabilities should be addressed going forward. While the paper focuses on the challenges faced by advanced economies, the broader lessons are equally relevant for emerging markets and those developing countries where debt structures remain relatively weak and markets shallow. They also have relevance for those LICs who anticipate increased reliance on non-concessional sources of financing and are seeking to establish durable market access. The structure of the paper is as follows. Section II describes how debt managers coped with the challenges of meeting large financing needs given challenging market conditions. Section III discusses the lessons of the crisis for debt management strategy formulation and risk management. Section IV examines the debt management challenges to be faced in the period ahead. Section V looks at the importance of collaboration between debt mangers and other policy makers. Finally, Section VI sets out the issues for discussion.

II. The Crisis and its Impact on Debt Management and Debt Market Operations

8. The crisis raised significant challenges for debt managers, especially in advanced economies (Table 1). Debt managers in these economies had never faced such significant and widespread financing challenges and market disruption. The scale of the shock represented an intense test of operational and strategic frameworks, requiring the adoption of more flexible approaches that could cope more readily with changing market conditions. Overall, there was a sharp increase in the number of financing operations, which elevated execution risk2 and put the debt management function under significant operational strain.3

Table 1.

Gross Central Government Financing Need: Selected Countries

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Sources: WEO; and BIS.Note: Gross borrowing is calculated as the sum of the overall fiscal balance (based on WEO data) and maturing debt (based on BIS data on short-term debt).

9. Most emerging markets, on the other hand, experienced a relatively less severe impact on their financing operations. This partly reflected the fact that they were more insulated from the causes of the crisis. Nevertheless, especially in the early phase of the crisis, many emerging markets also faced some financing stress as a consequence of a sharp outflow of capital, changes in investor demand and the effective closure of international capital markets in the latter half of 2008 (Figure 1). The impact of that stress would have been much more severe if emerging markets had not made sustained efforts to enhance the resilience of their debt profiles and strengthen their debt management frameworks over the past decade (Box 1).4

Figure 1.
Figure 1.

Cumulative Net Weekly Flows to Emerging Market Funds

(In billions of U.S. dollars)

Citation: Policy Papers 2011, 031; 10.5089/9781498338943.007.A001

Source: EPFR Global.

Debt Management Challenges in Emerging Markets: Then and Now

The relative resilience of emerging markets to date has been a notable feature of this crisis. This is in sharp contrast to the past. While this partly reflects that the causes of the crisis were not centered in emerging markets, it also reflects sustained improvements to macroeconomic and financial sector fundamentals over the past decade, supported by the strengthening of debt management policies and practices:

  • Debt managers have been actively addressing the key vulnerabilities in debt structures that were highlighted in past crises. Thus, the maturity profile of debt has been extended, while reliance on floating rate and foreign currency denominated (or linked) debt has been reduced (IMF, 2007). These changes were facilitated by policies tackling fiscal dominance and inflation, which gave rise to the “original sin” dilemma—see Appendix IV.

  • In parallel, emphasis was placed on improving institutional arrangements for debt management, enhancing transparency, establishing active investor relations programs, and working with other agencies on developing local capital markets. In some instances—e.g., Brazil and Uruguay—these institutional improvements were also contributing factors to credit rating upgrades.

As a result, vulnerabilities to sharp changes in the exchange rate, interest rates, or market access have been significantly reduced relative to previous emerging market debt crises (de Bolle, et al, 2006), contributing to an improvement in credit ratings (Figure 2).

Figure 2.
Figure 2.

Improved Resilience in Emerging Markets

Citation: Policy Papers 2011, 031; 10.5089/9781498338943.007.A001

Sources: BIS; Fitch; Moody’s; OECD; S&P; and Fund staff estimates. Based on WEO country groupings.Note: Net rating changes are calculated as the difference between the number of upgrades and number of downgrades across all three credit rating agencies.

Nevertheless, debt structures in emerging markets are, in general, still weaker than in most advanced economies, and remain vulnerable to a variety of macroeconomic shocks (e.g., inflation, commodity price, exchange rate). Notwithstanding the other associated policy challenges, emerging markets should take advantage of all conjunctural and structural opportunities to further lengthen the maturity of their debt structures and strengthen their resilience to risk.1/

1/The Fund staff discusses these issues with emerging market debt managers on an annual basis within the context of the IMF “Consultations on the Policy and Operational Challenges facing Public Debt Management”. Over the last three years, the coverage of these consultations has expanded to also include advanced economy debt managers.

10. The debt management challenge facing low-income countries (LICs) remains (largely) different. LICs were relatively insulated from the crisis, given their low integration in international financial markets; consequently, there was a much smaller impact on financing needs. For most LICs, the challenges reflected potential shortfalls in donor disbursements and more constrained access to concessional loans rather than concerns about more volatile market conditions (see IMF, 2010b). However, the broad lessons will become pertinent for LICs as they seek to diversify financing sources and increase their reliance on market-based financing to meet their infrastructure and other long-term investment needs going forward.

Responding to increased financing needs

11. To address these challenges, debt managers used three broad approaches (Table 2).5

Table 2.

Summary of Debt Management Responses: A Cross-Country Sample

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Note: See Appendix I for more detail of the changes.

To accommodate the large and sudden increase in financing needs, without overwhelming the markets, debt managers adjusted the issuance mix to include more short-term debt (Figure 3).6 This was particularly true in Belgium, the Netherlands, U.K. and the U.S. where the financing of financial support schemes represented a significant proportion of GDP. However, even where the increase in borrowing was not so significant, the fragile state of the markets also warranted more short-term debt (e.g., Germany, France). This was also true in a number of emerging markets in the initial phase of the crisis (e.g., Hungary, Poland, Mexico), where debt managers had to respond to an abrupt departure or the absence of foreign investors.

Figure 3.
Figure 3.

Key Portfolio Risk Indicators

Citation: Policy Papers 2011, 031; 10.5089/9781498338943.007.A001

Sources: BIS, OECD, WEO, and Fund staff estimates.

12. Debt managers expanded their use of non-core markets and borrowing instruments.

For example, before the crisis, both Belgium and the Netherlands had introduced a medium-term note (MTN) program to promote investor diversification and to secure some cost advantages.7 Several other debt managers also expanded the scale of activities in international capital markets to improve investor diversification and help ease the financing burden on domestic markets (see Figure 3).8 This highlighted the benefits of maintaining a presence in these markets in better times, which could be exploited to complement their core issuance programs. In some instances, increased borrowing needs were met by re-introducing some debt instruments. For example, both Canada and the U.S. re-introduced a three-year maturity, while Australia re-introduced inflation-linked bonds. Similarly, in some emerging markets, there was a temporary resurgence in the use of floating rate notes (e.g., Poland).

13. Supplementary issuance programs that complemented the core issuance program helped raise additional financing at the margin. For instance, in both Hungary and the U.K. a post-auction non-competitive facility was introduced for primary dealers. In many other countries, smaller issues of “off-the-run” bonds became a more frequent and significant part of the financing program (e.g., the Netherlands, Belgium, Italy, Germany, U.K.).9 These supplementary programs helped.

Limiting the effects of market disruptions and other dislocations

14. Debt managers had to also address the challenge of deteriorating market functioning and confidence. Market perceptions of sovereign risk10 intensified as sovereign balance sheets deteriorated reflecting worsening economic conditions and the general health of the financial sector. This, in particular, brought into sharp focus the interconnectedness between sovereign risk and the financial sector, which was most vividly illustrated in the cases of Iceland and Ireland (Appendix II). More generally, the market became increasingly more sensitive to differences in credit quality (Figure 4). AAA-rated issuers benefited from “safe haven” flows, while less creditworthy issuers experienced greater market volatility, in particular where countries’ ratings approached or breached thresholds set in investment mandates.11

Figure 4.
Figure 4.

Differential Cost Conditions: Euro Area Issuers

Citation: Policy Papers 2011, 031; 10.5089/9781498338943.007.A001

Source: Bloomberg.

15. Cross-border spillovers also exacerbated the general deterioration in market conditions. In several instances in Europe, market concerns about sovereign credit risk in one country spread to others perceived to be afflicted by similar fiscal, financial, and growth vulnerabilities. While cross-border contagion was a feature of the emerging market debt crisis of the 1990s, this was a relatively new risk factor for advanced economy debt managers that further aggravated market volatility and increased financing strains.

16. The fragility of markets affected both primary and secondary segments forcing adaptations of operational frameworks. Issuance mechanisms were modified to support the primary market. Given the vulnerabilities on primary dealer balance sheets, more efforts were made to use mechanisms that would facilitate a larger participation of investors in primary issues.12 In some cases, this led to an increased use of syndication (e.g., in the U.K. where it accounted for over 13 percent of issuance in 2009-10, and 16 percent in 2010-11). In other cases, the format of auctions was changed to make it more attractive for investors to participate.

17. Although transparency and predictability remained at the core, debt managers recognized the benefits of increased flexibility. Greater flexibility was introduced in the size and choice of debt instruments to be issued through auctions, and by adapting auction programs to changing market conditions. For example, Italy widened the band between the minimum and maximum size of an auction, while Hungary cut the time between announcement of the precise bond to be issued and the issue date (although the calendar remains pre-announced on an annual basis).

18. Primary dealer frameworks were also adapted to these more challenging market circumstances. Vulnerability in the banking sector impaired dealers’ ability to take large positions, leading to a significant decline in secondary market liquidity. Responding to this, market making obligations were relaxed or adapted during the crisis by many countries. In some instances, these changes have become permanent (e.g., Belgium).13

19. Debt managers engaged in a number of operations to enhance market liquidity.

These included liability management operations, such as debt exchanges and purchases or sales of “off-the-runs” (depending on market circumstances). Often these operations were initiated at the request of dealers (e.g., Italy). Other market-support mechanisms, such as repo facilities offered by debt management offices, were also expanded (e.g., Belgium). Despite these efforts, liquidity in secondary markets, particularly of the non-benchmark issuers, remains relatively poor.

20. Investor relations activities were refocused on restoring market confidence. Debt managers have put increasing emphasis on ensuring that investors (and other stakeholders) are kept informed.14 Investor relations activities have been stepped up with an increase in non-deal road-shows and other activities that allow investors direct access to debt managers and other policy officials. These activities have also contributed to efforts to attract new investors, particularly from Asia and the Middle East.

21. The actions of other policy makers, particularly central banks, also helped improve market conditions (Figure 5). Coordinated and sustained monetary easing has helped keep interest rates low in the benchmark currencies. In some cases, quantitative easing (QE) programs, while driven by monetary policy considerations, contributed to improving market liquidity.15 These programs have required enhanced coordination across debt managers and central banks (e.g., U.K., U.S.).16 In contrast, the European Central Bank’s (ECB) Securities Market Program (SMP) has been designed to directly target and mitigate extreme conditions in the secondary debt markets in the euro area, while being neutral from a monetary policy perspective.

Figure 5.
Figure 5.

Central Bank Purchases of Government Securities

Citation: Policy Papers 2011, 031; 10.5089/9781498338943.007.A001

Source: Fiscal Monitor (April 2011).

22. Nevertheless, market conditions remain fragile. Volatility, especially in higher spread countries in the euro area, remains elevated and continues to constrain investor appetite for certain issuers’ bonds (see Figure 4). In particular, foreign investors have reduced their exposure to higher spread euro area government issuers, with domestic banks offsetting the consequent reduction in many cases (see IMF, 2011a). Improving market conditions remains a priority for debt managers.

Taking on other crisis-related functions

23. In parallel with meeting these challenges, debt managers had to cope with other

operational demands. The range of activities assigned to debt managers increased in a number of instances, taking them into other policy areas and requiring new institutional mechanisms to be established. These included taking an active role in managing the government’s financial sector acquisitions (e.g., Sweden, U.S.) and bank-related guarantee schemes (e.g., Belgium, U.K.). In a few instances, debt managers were tasked to support market liquidity in other sectors (e.g., Sweden).

III. Implications of the Crisis for Debt Management Strategies

24. The crisis brought into sharp focus key interconnections between debt management and macroeconomic policy constraints. The sovereign’s vulnerability to financial sector contingent liabilities, particularly for those countries with outsized financial sectors, has also been clearly highlighted (Figure 6 and Appendix II). The rollover needs of countries with high debt levels and a fragile investor base have had a critical bearing on the market’s assessment of sovereign risk, leading to a sharp re-pricing of some countries’ sovereign debt. In particular, it highlights the importance of actively managing liquidity risk, especially within a monetary union. More generally, the relative importance of these factors point to a number of imperatives for debt management policies and strategies going forward, including the need to (i) have in place a strong risk management framework; (ii) actively use the structure of the debt to mitigate shocks; (iii) maintain access to a liquidity buffer; (iv) adopt an integrated asset-liability (ALM) management framework to monitor and mitigate risk on the sovereign balance sheet; and (v) address vulnerabilities in the investor base.

Figure 6.
Figure 6.

Relative Importance of the Banking Sector, End-2010

(In percent of GDP)

Citation: Policy Papers 2011, 031; 10.5089/9781498338943.007.A001

Sources: Economist Intelligence Unit; Dealogic; World Economic Outlook; and Fund staff calculations.Notes: All figures are as of end December 2010. Values are shown in logarithmic 10-based units.

25. The extent to which constraints on liquidity support within a monetary union can aggravate sovereign financing difficulties has received relatively little focus.17 As solvency risk and credit spreads on debt increase, vulnerable countries face rising issuance costs. This can, in turn, aggravate rollover concerns and liquidity risk, raise spreads further and exacerbate the risk of a debt crisis (Box 2).18 However, this dynamic is aggravated in the case of a monetary union given that countries are more policy constrained in their response relative to those outside the union.19 In such cases, the timely provision of a robust liquidity support mechanism for individual countries becomes important, allowing them room to undertake necessary macroeconomic, structural and financial sector reforms.

Sovereign Debt Developments in the Euro Area

Despite the monetary and financial integration of euro area countries over the past decade, the degree of financing stress faced over the crisis diverged sharply across countries (see Figure 3). A number of key factors are likely to have influenced that outcome— the level of debt, the scale of the financing need and structure of the investor base. Each factor is potentially benign in isolation—countries can tolerate higher levels of short-term debt where debt levels are lower or where markets are more robust— but can be disruptive in combination.

In particular, models of debt crises emphasize the role of short maturity debt structures and vulnerable investor bases which can lead to an intensification of liquidity risk and sharp increases in financing costs. This increase in financing cost can then aggravate solvency risk, possibly to the extent of rendering a sovereign insolvent. While these factors have undoubtedly raised investor concerns and contributed to the widening of spreads seen in some countries in the euro area, nevertheless, the varied experiences illustrates that these are not necessary or sufficient conditions for a debt crisis.

A more significant factor is likely to have been the combination of these debt management factors with a broader assessment of the extent of fiscal, structural and financial sector vulnerabilities of these countries. That overall risk assessment would typically be captured in sovereign credit ratings, which heavily influence investors’ behavior, including that of domestic institutional investors (IMF, 2011a). A number of countries in the euro area have experienced a series of sharp rating downgrades that aggravated the liquidity risk and financing stress already facing debt managers as a consequence of the overall high financing needs, and which in the case of both Greece and Ireland led eventually to the need for external support.

In response to these developments and recognizing the need to safeguard financial stability in the euro area, on March 25, 2011, the European Council established a permanent crisis mechanism—the European Stability Mechanism (ESM), that will be available for euro area Member States from June 2013 (see European Council, 2011); this replaces the temporary European Financial Stability Facility. Financial assistance under the ESM will be provided on the basis of an agreed adjustment program. This will provide countries a greater degree of liquidity support, which will create sufficient financing space within which to deliver the required macroeconomic, structural and financial sector reforms necessary to strengthen economies and put debt on a sustainable path.

Enhancing the risk management framework

26. The crisis highlighted the need for debt managers to revisit their approach to risk management.20 Traditional cost-at-risk analysis is typically used to inform the preferred maturity structure of the debt, but it may not be particularly effective at capturing the full range of risk factors.21 This means that important interactions between macroeconomic vulnerabilities and debt structures can be missed. Moreover, models calibrated on historical outcomes would not have captured an event as extreme as the current crisis.

27. In particular, efforts are needed to ensure nontraditional risk exposures are also adequately captured. For example, financing shocks that materialize as a result of implicit financial sector contingent liabilities—a key feature of this crisis—, as well as from large quasi-sovereign and sub-national debt, are generally not accounted for in many cost-at-risk models. Nor are shocks that arise from a sudden withdrawal of investors effectively captured—an issue brought into sharp focus by the euro area debt crisis (Box 2). For example, nonresidents may be more sensitive to events that undermine the quality of the sovereign balance sheet and led to a downgrade in credit quality. If there is excessive reliance on these investors, their exit from the market will aggravate financing risk even further.

28. overall, the importance of augmenting traditional cost-risk analysis with appropriately designed stress tests has been brought into sharp relief. The importance of conducting regular stress tests of the debt portfolio was recognized in the Guidelines for Public Debt Management (IMF-World Bank, 2001). Stress testing provides a flexible and tractable approach for debt managers to consider the impact of a wide variety of risks, including the materialization of contingent liabilities from large banking sectors and quasi-sovereign and sub-national debt (Box 3). The outcomes can then be discussed with other policy makers (e.g., financial sector regulators) to help inform, where relevant, the appropriate set of risk mitigation options. However, as a generally accepted approach to determine and assess the impact of extreme events is lacking, there is considerable variation in country practices.22

Developing a Stress-Testing Framework for Public Debt Portfolios

The importance of stress-testing the public debt portfolio was first highlighted in the Fund-Bank Guidelines for Public Debt Management (2001). Debt managers re-iterated this in the “Stockholm Principles” (Appendix III). The key purpose of stress-testing is to assess the impact of a shock or extreme event on key cost and risk debt indicators—for example, indicators of liquidity risk, such as the timing and scale of debt servicing cash flows.1

The general approach adopted by debt managers has focused on stress testing the debt portfolio for some standardized shocks to key variables, often with limited feedback to other variables. A typical cost-at-risk model will capture the impact of these standardized shocks, which could be generated either stochastically or deterministically. For example, a stress test could be as simple as considering the impact of a two standard deviation parallel shift in the yield curve on interest costs, while holding all other variables constant. However, a more complete form of that stress test would also factor in the feedback from higher interest rates on GDP and the budget position, or consider the impact on the nature of investor demand (depending on the assumed source of the shock to interest rates). In practice, that would require a more complete model of the economy potentially requiring input from other officials (e.g., the economic research department of the central bank).

Determining the appropriate calibration of an extreme event can be challenging. The intention of testing a more extreme scenario, such as an international financial crisis, is to complement these statistically generated indicators by considering specific scenarios that have a low probability of occurrence but have a large impact.2 Historical analysis can help, particularly if the country has experienced such an extreme scenario and the impact on key variables can be observed. Still, the current crisis showed that extreme events can take place that are larger in scale than any past experience.

Fund staff is currently working on developing a set of principles that addresses some key issues in the calibration of stress tests and their use. This will be discussed at the forthcoming 11th Annual IMF Consultations on Public Debt Management Policy and Operational Issues to be held in collaboration with the Government of Korea, in Seoul in June 2011. This work will also complement ongoing work by Fund staff to enhance the stress-testing framework applied under the Fund-Bank Debt Sustainability Framework (IMF, 2002).

1 Note that terminology is not common across users. For example, the Swedish National Debt Office refers to this as “consequence analysis” (see Swedish National Debt Office, 2004); others might refer to this simply as “scenario analysis.”2 This would allow the assessment of specific scenarios that are of particular interest, such as an increase in interest rates associated with a tightening of global liquidity conditions, or increased market uncertainty as a consequence of weaknesses in the financial sector.

29. Ideally, the stress test performed by key stakeholders should, at a minimum, converge to a joint stress test of the sovereign balance sheet and financial sector. Currently, stress tests are carried out as standalone exercises by different stakeholders (e.g., debt managers, bank supervisors, sovereign wealth funds, etc.). However, subjecting these different elements to a common shock (even if in a stylized form) would allow a more holistic assessment of vulnerabilities.

structuring the debt portfolio to mitigate shocks

30. The experience of the crisis also highlights some imperatives for debt portfolio structures. These reflect the currently high debt levels and continuing high financing needs, which intensify the scale and importance of any risk exposure, coupled with the fuller information on the nature of risk revealed by the crisis. There is a broad understanding of the effectiveness of portfolio structures in providing insurance against a range of shocks (Box 4 and Appendix VI). This is an area where many emerging markets have put considerable emphasis since the debt crises of the 1990s, in particular placing a significant premium on mitigating rollover risk and external vulnerabilities. This has contributed to their resilience in this crisis.

Mitigating Risk: Building Resilience through the Debt Structure

Countries are exposed to a wide range of shocks—demand, supply, terms of trade, balance of payments, etc. The structure of the debt portfolio can help mitigate or aggravate the effects of these shocks on the fiscal position, and consequently the financing need. For example, variable-rate debt protects against negative demand shocks (such as a banking or global demand crisis) where monetary policy makers respond with lower interest rates. Fixed-rate debt protects against negative supply shocks that push up interest rates. Inflation-linked bonds provide for debt service that is well correlated with government revenue, and can reduce rollover risk if used to lengthen maturities (see Appendix VI).

Recent events highlight how the structure of debt can also offer protection against increasing sovereign credit/default risk. In cases where increases in interest rates reflect market perceptions of elevated sovereign risk, long-term fixed-rate debt would offer the best protection by minimizing the extent to which the increase in the interest rate is captured in debt service costs. In contrast, depending on the nature of the underlying reference rate, variable rate debt, as well as short-term fixed rate debt, can aggravate this risk as any deterioration in credit quality could translate almost immediately into higher interest rates.

Finally, the debt structure can also shield the budget against liquidity risk, i.e., the risk that a government will be unable to discharge its obligations due to a lack of liquid resources, despite being fundamentally solvent. Again, a relatively longer and smoother maturity profile, which limits the amount of principal payments falling due during any specific period, will mitigate this risk and create financing space to absorb other fiscal needs.

31. The crisis clearly illustrated the benefits of a relatively low rollover profile. Some countries that were hit by the materialization of contingent liabilities from the financial sector were able to absorb that shock, in part due to their relatively manageable rollover needs. For example, in fiscal year 2008, reflecting its unusually long average term to maturity (ATM),23 the U.K. only needed to refinance GBP 17 billion of bonds (about 1.3 percent of GDP). Maintaining a low rollover profile has further benefits: it (i) reduces the risk that an investor strike will drive up yields; (ii) provides resilience where the exchange rate regime constrains policy choices; (iii) reduces the cost of servicing the debt as a consequence of any deterioration in creditworthiness; and (iv) makes it easier to absorb the financing impact of reduced tax receipts and an accommodative fiscal policy.

Recalibrating liquidity buffers

32. The appropriate scale of liquidity buffers could also usefully be recalibrated.

Liquidity buffers, by providing access to resources to meet redemptions, can play a similar role in reducing rollover risk. For example, some countries were able to rely on previously established macro-stabilization (or other sovereign wealth) funds to offset increased financing needs (e.g., Chile, Ireland, Norway, Russia). Indeed, many debt managers actively pre-fund (or equivalently buyback shorter-dated maturities) as part of their ongoing operations (e.g., Belgium, Netherlands, Portugal). However, some are more constrained by their fiscal frameworks in the extent to which cash buffers can be established (e.g., Finland).24 If these buffers are very large, they can also have consequences for both government cash management and central bank liquidity management. Consequently, the decision on whether and how large a buffer should be established will need to be coordinated across a range of stakeholders.

33. Nevertheless, building resilience through these mechanisms will entail costs. The key

policy decision for debt management is to determine the appropriate trade-off between cost and risk in light of an assessment of the scale of the risk exposure.25 Key factors that should influence this trade-off are the level of debt, degree of fiscal space, and potential flexibility of monetary and exchange rate policy, coupled with an assessment of the scale, and likelihood of materialization, of contingent liabilities, and the durability of market access. The new information regarding the nature of risks that has been revealed through the crisis will allow debt managers and policy makers re-calibrate their assessment of these factors.

Adopting an integrated ALM framework

34. More generally, adopting a more comprehensive and integrated sovereign asset and liability management (ALM) framework could be useful. A joint analysis of the characteristics of the financial assets and liabilities on the sovereign balance sheet would allow decision makers take into account more fully the interrelationships and correlations among sources of risks in formulating appropriate strategies and policies. This would provide a natural environment for a more comprehensive stress testing exercise. This could allow countries to achieve their desired level of balance sheet risk exposure more efficiently and cost effectively.26

Addressing vulnerabilities in the investor base

35. There may be scope to strengthen the resilience of the investor base through changes in the debt structure. In particular, some instruments may make a greater contribution to the goal of investor diversification. For example, certain classes of investor may be attracted by issuances in specific foreign currencies or with specific transaction size limits.27 Traditionally, greater issuance of inflation-linked debt or longer-dated debt will appeal to institutional investors, such as pension and insurance companies, but may not meet banks’ needs as investors. Reducing the concentration of investor type would not only reduce exposure to rollover risk but could also enhance market liquidity and, consequently, contribute to the broader policy goal of enhancing financial stability.28 Increasing the participation of the domestic investor base might provide greater resilience to a sudden stop in market access, although this could increase the risk associated with a greater degree of interconnection between the domestic financial sector and the sovereign. However, targeting a specific investor base composition is generally difficult for debt managers, with care needed to avoid inadvertently creating a captive investor base to the broader detriment of market functioning and financial stability. In particular, targeting the domestic investor base is difficult in a monetary union.29

IV. Challenges for Debt Management Practices and the Functioning of Debt Markets

36. Going forward, the challenges facing debt managers remain significant. There are several inter-related priorities: (i) achieving over time more robust debt structures, while meeting immediate financing needs; (ii) restoring market liquidity; (iii) managing the impact of new regulations; and (iv) contributing to the more effective management of sovereign risk. While these issues may be more acute for advanced economies, they remain relevant for emerging market economies, where there remains further scope for debt managers to improve portfolio structures and enhance the robustness of market access (both domestic and external). In addition, there are also important lessons for LICs, where the nature and extent of debt management challenges will change rapidly as the scale of non-concessional and market-based borrowing increases to meet infrastructure, and other, investment needs.

Ensuring sufficient operational flexibility

37. Given continuing financing needs, coupled with elevated sovereign balance sheet and market risks, it will be vital that market-related debt management operations remain flexible. In particular, debt managers should ensure they have scope to tailor the size of financing operations to market conditions. Where possible, all opportunities to secure a more robust portfolio structure should be exploited. Nevertheless, such flexibility should not imply a reduction in transparency or predictability. This can be achieved, for example, through the use of issuance ranges to preserve the predictability of an operation while allowing scope to adjust the size to revealed market demand. More generally, as set out in the “Stockholm Principles”, debt managers should adopt proactive and timely market communication strategies that ensure any changes to the operational framework are quickly and clearly communicated.

Lengthening maturities

38. Achieving the desired lengthening of maturities could prove challenging. Given that overall financing needs will remain elevated into the medium term,30 and, particularly, until confidence has been restored, market conditions are likely to remain volatile. Debt managers will need to consider the ongoing merits of meeting specific investor needs to maximize the probability of smooth absorption of new issues, relative to the nature of risks that are to be contained. However, debt managers need to be cognizant of the potential impact on investor portfolios and consider whether such a strategy aggravates other dimensions of risk by, for example, increasing financial sector fragility. Moreover, sovereigns are likely to face increased competition from banks, whose demand for long-term financing is set to rise as a result of regulatory efforts to increase capital buffers.

39. The cost of lengthening maturities may be further aggravated by rising interest rates as monetary conditions eventually tighten. For most countries, rising nominal interest rates will further constrain the pace at which they can lengthen the maturity of the debt portfolio. Moreover, if inflation expectations become entrenched, there is a risk of significant increases in nominal fixed-rate yields, which will raise the relative costs of extending maturities through nominal debt and make the relative merits of inflation-indexed debt more evident. Under these conditions, countries that have an established and relatively deep market for inflation-linked debt should consider expanding their issuance of these instruments.

40. For emerging markets, the recent trend of capital inflows represents an opportunity to further lengthen the maturity of domestic currency debt (Box 1). In the years preceding the crisis, some emerging market debt managers (e.g., Brazil, Mexico) took advantage of the relatively higher risk appetite of international investors to increase issuance of longer-term fixed rate and inflation-linked instruments. This improved the debt profile and enhanced market efficiency. Going forward, notwithstanding the other related policy challenges, debt managers should, to the extent possible, resume this policy and consolidate further their portfolio of longer-term debt securities.31

Potential benefits of LMOs

41. There may be some scope for debt managers to achieve a more desirable portfolio structure through liability management operations (LMOs) (Box 5). As part of the portfolio transition, debt managers can also contemplate a series of LMOs spread over time to help accelerate the process of moving the debt structure in the desired direction. For example, a systematic program of reverse auctions or debt exchanges for near-maturity bonds could be instituted as a longer-term solution to reduce rollover needs.32 However, to have a more significant impact on the structure of the portfolio, larger operations are likely to be necessary. Depending on country circumstances, these could prove more challenging to implement, particularly where investor sentiment remains fragile.

Liability Management Operations as a Risk Management Tool

Liability management operations (LMOs)—buying back or exchanging outstanding debt —have been regularly used by sovereign debt managers over the last two decades as a normal financing technique, as well as an important risk management tool.

For sovereign debt managers that have focused on building large benchmark issues, particularly if they use a limited set of coupon dates to stimulate either the futures market or the strips market, LMOs are an integral part of the toolkit necessary to manage rollover risk. These debt managers will provide a standing mechanism to repurchase near-maturity bonds on a bilateral basis (e.g., Belgium does this as part of its ongoing cash management operations). Alternatively, debt managers can focus on more significant reverse auction events (e.g., Portugal.).

Debt exchanges can be one of the more useful tools for both achieving a more favorable debt servicing profile or for facilitating a change in investor preferences (e.g., U.K in 2000s.). Some debt managers use debt exchanges as part of their regular ongoing business (e.g., Brazil and Turkey), or to respond to particular market needs. Others use them on a more ad hoc basis to achieve particular portfolio objectives. For example, the Philippines exchanged nearly $3bn of outstanding debt for longer dated issues in September 2010, in what was the largest ever LMO in Asia.

Sources: Euroweek (2010); and EU Working Group on Bonds and Bills Markets (2001).

42. Derivatives will also continue to play a role in helping debt managers achieve a more favorable risk profile. For example, the use of standard interest rate swaps can provide some protection against potentially higher interest rates, complementing efforts to reduce interest rate exposure through maturity extension. The overall effectiveness of these tools will depend on country specific circumstances.33 Ongoing changes in collateral provisions related to the use of these instruments—driven to a large extent by the regulatory reform agenda—may significantly change the market environment for some debt managers and change the cost-benefit trade-off.

Managing execution risk

43. Investor appetite, including for new instruments, will prove critical to achieving the desired financing targets. It may be possible to try to increase investor diversification through instrument design. Tailoring products to meet a specific investor’s needs (as with an MTN) may help secure some financing at the margin. However, focusing the core financing program on standard benchmark instruments, which maximizes liquidity, will likely remain the most effective way to generate investor appetite. Nevertheless, within that, there is scope to consider whether it is possible to exploit any “preferred habitats” to secure a more robust investor structure. For example, institutional investors—particularly pension and insurance companies— tend to have a preference for inflation-indexed debt; consequently, there may be scope to increase their participation in the investor base by increasing issuance of this instrument.

44. Overall, given the scale of the challenge, debt mangers will need to tailor the speed of portfolio adjustment to market conditions. Although the medium-term portfolio objective may be clear, in the short-term, debt managers may need to place greater emphasis on minimizing execution risk. In particular, debt managers from the “benchmark issuers”—which could be considered systemically important sovereign issuers—should take account of how the effectiveness and success of their operations will have repercussions for the wider debt capital markets through their role as a market reference.34 In that context, positive steps to enhance investor relations programs and improve transparency, including through enhanced data provision, will be critical.35 These efforts will play a key role in minimizing investor uncertainty and containing costs as investors would be provided the required information to form reasonable expectations and manage their investment decisions. An effective investor communications strategy will also play a vital role in restoring confidence and improving market liquidity.

Restoring market liquidity

45. Debt managers will need to consider further steps to help mitigate market volatility and restore liquidity. In this context, there may be an effective role for LMOs. For example, debt exchanges that allow investors to lock in a desired relative price can provide an effective mechanism to help liquidity move from an “off-the-run” bond to a new benchmark bond.36 Both Brazil and Turkey use this mechanism to good effect by providing an exchange option to primary dealers as part of their regular auction framework. Alternatively, buybacks and debt exchanges can be used specifically to address market dislocations, as they were during the crisis in several emerging markets (e.g., Brazil, Korea) to alleviate pockets of illiquidity. Targeted bond sales (i.e., “taps”), which were also used by many during the crisis (e.g., Belgium, Netherlands), can also relieve market liquidity at specific points of the curve.

46. Debt managers, along with central banks and other financial stability authorities, should work together to identify other effective mechanisms to restore market liquidity. For

example, debt managers and central banks could usefully review the effectiveness of the various buyback programs, QE programs, and the SMP in smoothing market volatility and consider whether there is merit in establishing a more permanent liquidity backstop in markets (effectively a “market maker of last resort”). For example, some debt managers, notably Germany, are active participants in the secondary market, using their balance sheets to effectively provide a market making service to dealers in the market. Some others, notably Brazil, conduct regular buyback auctions to provide a window of opportunity for investors to liquidate their investments. Providing this reassurance of liquidity to investors complements the process of improving the debt portfolio composition by encouraging their market participation. These types of facilities were generally more prevalent in the 1990s and early 2000s (e.g., Poland, U.K.); however, they fell into disuse as markets developed and as debt managers imposed tighter market making obligations on primary dealers. Nevertheless, given market making obligations are typically relaxed in extreme market conditions, there may be some merit to the wider use of such programs.

47. The challenge will be complicated by any unwinding of QE programs. This will release bonds back into the market, again raising the prospect of market indigestion, with added volatility potentially spilling over into other asset markets. Consequently, ongoing dialogue between debt managers and central banks will be critical in this phase.

Strengthening sovereign balance sheets

48. Improving market liquidity will require restoring market confidence and strengthening sovereign balance sheets. Strengthening sovereign balance sheets will require credible fiscal policies over a sustained period of time and strengthened fiscal institutions to support these policies (Fiscal Monitor, November, 2010). The insurance buffers in the debt structure need to be enlarged, especially for those countries with structural risk factors such as large financial sectors or those that have limited means to deal with rollover risk. The authorities also need to focus on making financial institutions safer in order to mitigate and manage the sovereign’s exposure to contingent liabilities on its balance sheet.

49. Debt managers will experience first-hand whether policies are perceived to be credible. This will be an important factor in the feedback loop and in identifying the virtuous circle, where enhanced credibility of policies contributes to a reduction in the perception of sovereign risk, reflected in lower financing costs, which reinforces the benefits of credible policies.

Monitoring the impact of changes in the regulatory framework

50. Regulatory changes will also impact the market environment. The current initiatives to enhance the regulatory frameworks for the banking sector, including strengthened capital and liquidity buffers, and improvements in the quality of capital and transparency of markets should be highly welcome as a means to reduce the sovereign contingent exposure to the banking sector.37 However, specific proposals—in particular the liquidity coverage and the leverage ratios—may create problems for some countries (those with low debt in relation to the size of the domestic banking sector) or for some operations (notably repo operations) (Box 6). While demand for government bonds may rise for some countries, these new regulations may have detrimental effects on secondary market liquidity. In particular, an increase in the propensity of banks to buy and hold sovereign debt securities is likely to change the demand and supply dynamics in the secondary market and could reduce market liquidity.38 These effects are likely to be more aggravated in countries where the supply of debt securities is small relative to the size of the banking sector. Debt managers, along with central banks and other financial stability authorities, should closely monitor the impact of these new regulations on secondary market liquidity and primary market participation.

New Regulatory Initiatives and Sovereign Debt Markets

New financial regulations that aim to improve the resilience of the financial sector could have important implications for liquidity, price formation and the use of collateral in sovereign debt markets. These need careful analysis.

Several new regulations are expected to increase the demand for sovereign debt. Basel III establishes two liquidity standards—a liquidity coverage ratio (LCR) and a net stable financing ratio (NSFR) to be introduced after an observation period. As of end-2009, the Basel Committee on Banking Supervision (BCBS) estimates that the additional financing needed to meet the LCR ratio is about EUR1.7 trillion across large and internationally active banks.1 For the most part, this financing gap is expected to be closed through increased purchases of sovereign debt by banks. In addition, new regulations on capital and risk weighted assets could also incentivize banks to shift demand towards safer assets that carry a lower risk weight, increasing demand for sovereign debt further.

In parallel, regulations being introduced for the nonbank financial sector may also increase demand—e.g., new regulations on money market funds in the U.S. or on insurance companies in Europe. Initiatives that reduce the reliance on credit rating agencies may also shift demand towards sovereign debt which is easier to evaluate relative to other securities. Regulatory reforms designed to encourage greater use of central counterparties for both repurchase agreements and derivative transactions are anticipated also to increase the demand for government debt for collateral purposes.

This regulation-induced demand for sovereign debt, in particular the LCR, may reduce liquidity in debt markets by requiring banks to hold relatively more government debt securities on their own balance sheets, and consequently reduce the proportion available for sale. This might then reduce trading in the secondary markets, which would also impede price discovery and distort market signals.2,3 These factors will be aggravated in jurisdictions, such as Australia and Denmark, where the stock of debt is not sufficient to cover the increased demand from banks to meet the LCR. Other countries with a low stock of sovereign debt may face similar challenges if the new standards become part of the Basel core principles and are adopted more widely. Although the Basel process allows for exceptions to the standards and allows for country specific solutions to this problem, the formal rules for exceptions have not yet been formulated.

Other regulations on trading and leverage that disincentivize repo activity may further reduce liquidity in debt markets. Collateralized lending in the form of repos is successful as they are a very safe form of lending, with virtually no credit risk beyond the exposure to the sovereign. The proposal of an outright leverage ratio that includes the repos as part of leverage, despite their safety, could make this lending practice costly in terms of the capital needed. Accordingly, some debt management offices are concerned that, in the absence of a well-functioning repo market, government bond markets will become broker markets where market makers neither trade on their own books nor provide continuous pricing.

1 Bank for International Settlements (2010).2 Lundgren, B., and Hörngren, L. (2010).1 Olofsson, T., (2010).

V. Debt Management and Enhanced Collaboration

51. To be in a position to meet these overall debt management challenges effectively, debt managers will require closer interaction with other policy areas. In particular, given the extent to which the health of the financial sector is interconnected with the sovereign (Appendix II), debt managers should play a more central role in monitoring, and possibly measuring, the sovereign’s exposure to banking sector contingent liabilities and assessing the likelihood of their materialization. Countries with large contingent liabilities, especially outsized banking sectors, will need to monitor such risk closely. Enhanced sovereign risk monitoring will require collaboration and information sharing across key institutions, and may necessitate new cross-institutional arrangements. For instance, in some country circumstances, it might be efficient and worthwhile to consider including debt managers on newly established macro-prudential committees.39, 40

52. These efforts could be facilitated by adopting a wider ALM approach to the management of sovereign risk. That will require a consolidated view of the sovereign balance sheet and its risk exposure, drawing information from a broad range of policy areas, and a coordinated decision on the most appropriate portfolio strategies to be adopted to manage that risk effectively. Nevertheless, the design of an effective framework that can be operationalized is an issue that requires further work, and would likely entail significant institutional challenges.

53. Establishing an effective dialogue between debt managers and financial sector regulators will also mitigate the risk that regulatory changes have unintended consequences. Debt managers could usefully contribute to a discussion on proposed regulatory changes at an early stage and help identify any potentially negative impacts on debt markets (e.g., the proposed ban on short-selling of sovereign debt). That would allow a fuller assessment of the likely costs and benefits of such regulatory changes and alternative solutions to be explored where appropriate.

54. Fund staff will continue to support debt managers’ efforts in these areas. On the one

hand, staff can help illuminate more fully the nature and extent of key risks that should be taken into account when designing debt management strategies. Staff can also contribute to the technical work on developing stress-testing methodologies and risk monitoring frameworks.41 In addition, the Fund can facilitate the development of a consensus on these issues through its regular multilateral interactions with debt managers, contributing to the discussion on the basis of its ongoing bilateral and multilateral surveillance.

VI. Going Forward: The Key Issues

55. This paper has highlighted a number of key issues with respect to vulnerabilities in debt management. Staff believe that country authorities need to take action along the following lines, and would welcome Directors’ views:

strengthening risk management

  • Risk management frameworks should be enhanced, and greater attention paid to stress testing. A more comprehensive approach is needed that takes greater account of (i) the degree of macroeconomic policy flexibility available; (ii) the degree of exposure of the sovereign balance sheet to, and interaction with, the financial sector; (iii) the extent of other contingent liabilities, including those arising from quasi-sovereign and sub-national debt; (iv) investor base fragility; and (v) the risk of cross-border spillovers.

  • Debt structures need to be strengthened and appropriate risk buffers established, notably to limit rollover risk. LMOs can be used to modify debt structures more actively. A pragmatic approach will be needed to determine the extent of portfolio adjustment that is feasible. Emerging market economies should use the opportunity of increased capital inflows and renewed risk appetite of investors to further lengthen the maturity of their debt structures.

Greater collaboration

Collaboration should be strengthened across debt managers, fiscal authorities and financial sector regulators. This will enhance risk monitoring and risk management, including the monitoring of contingent risks in the financial sector, and will better inform fiscal and financial stability assessments.

Capital market considerations

  • The operational toolkit for debt management should continue to be flexible and comprehensive to deal with a variety of market circumstances. This involves techniques to mitigate identified market and liquidity risks, coupled with operations to improve secondary market liquidity. In that context, “benchmark issuers” (or systemically important sovereign issuers) need to be particularly mindful of how the effectiveness and success of their operations carry ramifications for the functioning of debt capital markets on a wider scale.

  • Debt managers need to focus on enhancing investor relation programs along the lines suggested by the “Stockholm Principles.”42 This will help overcome any limitations in the primary dealer networks and will reduce market volatility. Debt issuance choices should contribute to diversifying the investor base where feasible—both in terms of residency and type.

Managing Sovereign Debt and Debt Markets through a Crisis - Practical Insights and Policy Lessons
Author: International Monetary Fund