Market risk in a broader context

The central role of risk in government debt management is reflected in the main objective of government debt management. Although phrased in many different ways, the main objective of government debt management to ensure that the government’s financing requirements and its payment

obligations are met at the lowest possible cost over the medium to long run, consistent with a prudent degree of risk,³ is widely shared among government debt managers. This main objective implies that government debt managers needs to assess the trade-offs between cost and risk when determining how to finance the government’s borrowing requirements; that is, assessing these trade-offs are at the core of the government debt strategy.

The central-government debt entails interest-rate risk because future debt financing and debt costs are subject to future unknown interest rates;

e.g.due to redemptions and refinancing of fixed-rate debt and re-setting of floating-rate debt. Short-duration debt (short-term or floating) means that within a short period new interest rates must be fixed for a large proportion of the debt portfolio and is usually considered more risky than long duration (long-term, fixed-rate) debt. On the other hand, the interest rate tends to increase with longer time-to-maturity and duration. Therefore, there is a cost-risk trade-off in the choice between short-and long duration debt.

A related risk is refinancing risk, i.e.,the risk that the debt need to be refinanced at very high rates or, in the extreme case, cannot be rolled over at all. This risk is related to country specific circumstances and not only to the general development in market rates. In particular refinancing risk is important for countries with a high debt level and unstable macroeconomic and financial market conditions. The distinction between interest-rate risk and refinancing risk may be less pronounced in countries with stable macroeconomic conditions and well-developed markets.

The assessment of risk implies capturing the uncertainty about future debt costs. In order to assess and quantify the interest-rate risk, it is necessary to form a view of, and model, the future development in the debt, financing requirements, and interest rates at which the future debt financing takes place.

The government’s financing requirement is derived from the refinancing requirements of the existing debt and the government’s budget balance.

Fiscal policy is responsible for the primary budget balance (the budget balance excluding debt costs). Thus, the effect on the debt and financing requirements coming from the primary budget balance is exogenous to the debt management problem. The same holds true for market rates.

However, the development in future primary budget balances and interest rates should still be taken into account in the analysis of risk in order to conduct a proper assessment of the interest-rate risks entailed in the government debt and strategy. This is a common practice among OECD government debt managers. The inclusion of the budget balance in the government debt risk analysis is linked to Asset and Liability Management (ALM) procedures.

Debt sustainability

Government debt is sustainable if the government will be able to continue servicing it, without the need to make an unrealistically large future correction to the balance of income and expenditure.⁴ Clearly, the assessment of debt sustainability is a broader exercise than the analysis of costs and risk by the debt manager. It involves also fiscal policy, so as to ensure prudent debt levels via government expenditures and taxes.

However, the risk analysis of debt management has many conceptual similarities with the analysis of debt sustainability, and the tools applied by government debt managers provide information about many of the same key variables as in a debt sustainability assessment as described in “Assessing Sustainability” (2002) by the IMF:

“Assessing sustainability in the first instance means forming a view of how outstanding stocks of liabilities are likely to evolve over time. This requires projecting the flows of revenues and expenditures – including those for servicing debt – as well as exchange rate changes (given the currency denomination of the debt). Projections of the debt dynamics thus depend, in turn, on macroeconomic and financial market developments, which are intrinsically uncertain and highly variable. Here, a key factor is the markets willingness to provide financing, which determines the costs of rolling over debt.”

In other words, the analysis of the cost and risk of the debt portfolio contains useful information for debt sustainability analysis and vice versa.⁵ Asset and liability management

Asset and liability management (ALM) captures the idea that, as far as possible, the entire balance sheet (i.e.,both assets and liabilities), should be included in the risk analysis so as to assess the overall risk exposure. This makes it possible in principle to limit the risk by matching the risk characteristics of respectively assets and liabilities. In this way, one side of the balance sheet hedges the other.

A fundamental issue is which assets and liabilities to include in the government’s balance sheet and how to take them into account in the risk analysis of the government debt. This issue is related to the fact that the government’s balance sheet is characterised by items outside the category of conventional financial assets and liabilities.

ALM comes in different flavours. A first approach consists of matching the risk characteristics of the various financial assets and liabilities on the government’s balance sheet. This approach implies risk management of the government’s net financial positions.

A second approach is an extension of the financial ALM approach with real physical assets included in the government’s balance sheet (for example, public infrastructure). This approach is rarely used by debt managers.⁶

A third ALM approach is to relate the future debt-service costs to the government’s ability to serve them, i.e., to the government’s budget balance.

The government has the ability to pay down the principal of government debt if, and only if, it runs future budget surpluses. The inclusion of the government’s future budget balance (the future revenues and expenditures) in the analysis of the interest-rate risk conceptually captures the idea of ALM.

The government’s financial liabilities (the government debt) are in principle analysed jointly with its assets in the form of the future government budget balances, although in practice the focus is on cost and budget flows rather than assets and liabilities.

“IMF/WB Guidelines for Public Debt Management”⁷ point to the usefulness of a wider scope for risk management of government debt than considering the interest cost and risk of the debt. “In order to help guide borrowing decisions and reduce the government’s risk, debt managers should consider the financial and other risk characteristics of the government’s cash flows. Rather than simply examining the debt structure in isolation, several governments have found it valuable to consider debt management within a broader framework of the government’s balance sheet and the nature of its revenues and cash flows.” Within the asset and liability framework it can be examined whether the structure of the government’s debt is consistent with the revenues and cash flows available to the government to service the debt (in most countries, these mainly comprise tax revenue).

Taking into account the effect on the budget balance

In the economic literature, smoothing of tax rates is often mentioned as the relevant objective for government debt management. The reason is that fluctuations in tax rates magnify the welfare losses related to the adverse economic incentive effects of taxation. The overall implication for debt management is that the debt strategy should aim at a debt structure that minimises the risk that tax rates will have to be changed in response to economic developments.⁸

However, since tax smoothing is more difficult to implement in a direct way, government debt managers focus in practice on the impact of the variability in debt-service costs on the variability in the overall budget balance.⁹ Budget-smoothing is related to tax Budget-smoothing. For this reason, the likelihood of future changes in tax rates in response to economic disturbances is reduced when the debt strategy reduces the variability of the government’s budget balance. A budget-smoothing objective for government debt managers may in particular be

pursued in an environment where governments operate with a legal or political constraint on the size of budget deficits, as is the case for EMU countries.¹⁰

Debt-service costs contribute to the variability of the budget balance via the debt-service costs’ own variability and the covariance of the debt-service costs and the primary budget balance. A reduction in the volatility of debt-service costs would – all other things being equal – dampen or reduce budget variability. Likewise, a positive covariance (e.g.a situation where a deterioration of the primary budget balance is associated with falling debt-service costs), would – all other things being equal – dampen or reduce budget balance volatility.¹¹

Most debt managers focus on the modelling of the variability of the debt-service costs themselves, while some government debt managers also explicitly take into account the covariance between the primary budget balance and the debt-service costs in their models (see Section III).

Debt structure and risk

The debt structure concerns the distribution of the debt over the various instruments in terms of indexation, maturity, currency composition, etc. A debt structure that entails a positive correlation between debt-service costs and economic activity may be less risky in the sense that it provides better insulation of the government’s budget balance (while it also contributes to tax smoothing) as the debt-service costs typically are low when the government’s finances are weak.¹²

There is typically a positive correlation between the debt-service costs of floating-rate or indexed¹³ debt and economic output in an economy where demand shocks are prevalent or where short-term interest rates are pro-cyclical (e.g.due to monetary policy reactions to economic cycles). On the other hand, fixed-rate nominal debt may provide a better hedge of the government’s budget balance against supply shocks to the economy or where monetary policy rates are raised in response to inflationary pressure while economic growth remain subdued.

The cost of foreign currency debt may be negatively correlated with government income, as the domestic currency is more likely to depreciate in periods of weak (domestic) economic development. There is thus a risk that foreign-exchange debt will have high costs in periods when government income is lower.¹⁴

A number of considerations must be taken into account when structuring the debt and assessing the risk of different debt structures. Firstly, there may be restrictions on the debt structure. Instruments like GDP-contingent bonds, that from at theoretical point of view would insulate the government budget by implying low debt-service costs during recessions, may be highly illiquid or

not available/marketable at all.¹⁵ In less developed markets it may be necessary to issue short-term debt indexed to foreign currency to attract investors and borrow at reasonable rates.

Secondly, it is not a straightforward exercise to assess the future correlation between the budget balance and debt-service cost of different financial instruments. The correlation structure based on historical observations may be unstable, and it is uncertain whether it will prevail in the future. In addition, domestic interest rates may to some extent be detached from the domestic business cycle – and thus the government-budget balance – in an increasingly integrated world.