Public Debt Management At The Cross-Roads - Brief Article - Statistical Data Included

OECD Economic Outlook, Dec, 1999

Introduction

Debt management issues came to the fore with rising public debt...

Rising debt-to-GDP ratios until the 1990s made governments more aware of cost in managing their public debt. At the same time, the shift away from bank financing of budget deficits towards non-bank sources increased the focus on the risk of rolling over the debt at higher interest rates, not least in the context of financial markets that have become increasingly open internationally. The result has been the development of more market-oriented and more sophisticated debt management procedures and techniques (discussed in the Appendix to this chapter). Partly to this end, the promotion of domestic financial markets became a supplementary role of debt management in a number of countries.

More recently, with the advent of low inflation and progress in reducing public deficits (the exception being Japan), debt management concerns have abated somewhat. By the late 1990s, longer-term, fixed rate instruments accounted for a large part of government debt (Tables VI. 1 and VI. 2), reducing rollover and interest rate risk. Moreover, with the deepening of secondary markets, the impact on market interest rates from government issuance activity in primary markets appears to have been considerably reduced and with it the potential conflict between debt management and the operation of monetary policy. In fact, the link between monetary policy considerations and debt management issues is largely through the signalling effects of debt levels and maturity structures on policy makers' credibility.

... and are about to change with the shift in budgetary prospects

Looking forward, however, debt managers will face different challenges as the evolution of debt-to-GDP ratios is seen to diverge quite significantly across countries (Table VI.3).

- For the United States (and to a lesser extent the United Kingdom, Canada and Sweden), [1] in view of the projections of a rapidly diminishing gross debt, policy makers will have to confront the implications of lower liquidity in traditional government issues that play an important role for the functioning of the bond market.

- For the euro area, despite recent improvements in primary balances, debt levels are unlikely to decrease rapidly. The introduction of the euro raises the question of the need for co-ordination among the eleven autonomous debt managers with a view to supporting the creation of a larger and more efficient euro-area financial market.

- In the case of Japan, estimates suggest a rapidly rising level of debt as a per cent of GDP. Thus, an emphasis on improving the efficiency of debt management techniques has the potential to produce budgetary savings.

The subsequent three sections of this chapter deal with each of these issues in turn. [2]

Debt management as debt is dramatically lowered: the case of the United States

For the United States, the relevant issue is the extent to which financial market liquidity would be affected...

Budget surpluses are currently projected by the US government to be sustained into the future and, on optimistic scenarios, the gross debt of the United States would even be eliminated by as early as 2015. [3] If outstanding government debt falls to low levels, policy makers will face a new set of challenges. The issues discussed here relate mainly to the level of gross government debt which is sufficient for the well functioning of debt markets in general. In this respect, market participants are reportedly already noting the impact on US bond prices of the reduced flow of new supply.

The role and uses of government debt in financial markets

...since government bonds currently play an important hedging and pricing role

Government securities have contributed to the development and functioning of financial markets, in part because of their liquidity (Box VI.l). In highly developed markets, in particular those of the United States, examples of their importance include:

-- Governments, reflecting their taxation power, provide securities with no (or a negligible) credit risk. Markets use (central) government debt to calculate prices of other debt and derivative instruments. Such benchmarking is considered to be important for the development of a corporate bond market.

- Estimates of the yield curve and interest rate futures are mostly based on medium- to long-term government bonds. As well, options are often written on government bond futures, because their valuation requires a large, active and well-arbitraged market in the underlying security. In the swap market, [4]

government securities serve, not only as the basis for pricing such transactions, but also as one side of a credit risk swap.

Government debt is often a critical component of strategies aimed at reducing overall portfolio risk. For example, short positions in government bonds can be used to hedge interest-rate risk from holding other fixed-income securities.

More generally, government debt is part of bank regulatory capital. In many countries, guidelines and/or direct quantitative regulations of private pension funds specify minimum compulsory investment shares in government securities.