GUIDELINES FOR PUBLIC DEBT MANAGEMENT ...

GUIDELINES FOR PUBLIC DEBT MANAGEMENT:

ACCOMPANYING DOCUMENT AND SELECTED CASE STUDIES

Prepared by the Staffs of the International Monetary Fund and the World Bank

International Monetary Fund and The World BankWashington, DC

© 2003 International Monetary Fund

Production: IMF Multimedia Services DivisionCover design: Lai Oy Louie

Typesetting: Grammarians, Inc.

Cataloging-in-Publication DataMACKENZIE, G.A. (GEORGE A.), 1950–Guidelines for public debt management : accompanying document and selected casestudies / prepared by the staffs of the International Monetary Fund and the WorldBank – Washington, D.C. : International Monetary Fund : World Bank Group, c2003.

p. cm.

Includes bibliographical references.ISBN 1-58906-194-2

1. Debts, Public. I. International Monetary Fund. II. World Bank.

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Foreword v

Acknowledgments vii

Glossary and List of Abbreviations ix

Executive Summary xiii

PART I IMPLEMENTING THE GUIDELINES IN PRACTICE 1

1 Introduction 3

What Is Public Debt Management and Why Is It Important? 5Purpose of the Guidelines 6

2 Lessons from the Country Case Studies 10

Debt Management Objectives and Coordination 10Transparency and Accountability 15Institutional Framework 17Debt Management Strategy 21Risk Management Framework 24Developing and Maintaining an Efficient Market for Government Securities 26

PART II COUNTRY CASE STUDIES 33

1 Brazil 352 Colombia 493 Denmark 554 India 665 Ireland 816 Italy 967 Jamaica 1098 Japan 1179 Mexico 12710 Morocco 14311 New Zealand 15312 Poland 16713 Portugal 17914 Slovenia 19015 South Africa 203

iii

Contents

16 Sweden 21517 United Kingdom 23418 United States of America 250

Appendix: Summary of the Debt Management Guidelines 259

Tables

I.1. Selected Macroeconomic and Financial Indicators for Case Study Countries in 2001 4I.2. Survey of Debt Management Practices 11II.1.1. Number of Series Outstanding 46II.1.2. Internet Sales 46II.15.1. Management of Risk 211II.17.1. Details of the Debt Portfolio at December 31, 2001 241II.17.2. Distribution of Gilt Holdings as of end-December 2001 241II.17.3. Changing Levels of Debt 246II.17.4. April 2002 Public Borrowing Requirement Forecasts for

the Central Government Net Cash Requirement 247Figures

II.1.1. Assets and Liabilities Imbalances, December 2001 39II.1.2. Average Maturity—Auction Issued Debt 40II.1.3. Percentage of Central Government Internal Debt Maturing in 12 Months 41II.1.4. Maximum Maturity at Issuance—Fixed-Rate Securities (LTN), in Months 42II.1.5. Maximum Maturity at Issuance—Floating-Rate Securities (LFT), in Months 42II.1.6. Debt Composition per Index 43II.1.7. Foreign Bond Issuance in the International Capital Market 44II.1.8. External Bonded Debt—Federal Government 45II.1.9. Yield Curve—NTN-C 47II.1.10. Yield Curve—LTN 47II.9.1. Public Debt Evolution, 1971–2001 131II.9.2. Internal Debt Composition by Type of Instrument 132II.9.3. Amortization Profile of Domestic Debt (year end) 133II.9.4. Ratio of Net Public External Debt to Total Export 134II.9.5. Federal Government External Debt Amortization Profile, as of September 30, 2001 135II.9.6. Agencies External Debt Amortization Profile, as of September 30, 2001 136II.9.7. Percentage of Public External Debt 137II.9.8. Average Life 138II.9.9. Evolution of the Interest Rate Curve 139II.9.10. Secondary Market Trading of Bonos 140II.9.11. UMS Market External Debt Issuance, 1996–2002 141II.9.12. UMS Dollar Yield Curve 142II.16.1. Central Government Debt, 1990–2001 221II.16.2. Bond Issuance and Swap Volumes, 1996–2001 224II.16.3. Maturity Profile for Nominal Bonds, December 2001 228II.16.4. Maturity Profile for Treasury Bills, December 2001 229II.17.1 Composition of Debt Stock 241

Box

I.1. Applying the Guidelines to the HIPCs 7

iv GUIDELINES FOR PUBLIC DEBT MANAGEMENT

A government’s debt stock is usually the largest finan-cial portfolio in the country. It often contains complexfinancial structures and can create substantial balancesheet risk for the government. Several debt marketcrises have highlighted the importance of sound debtmanagement practices and the need for efficient andsound capital markets. Improved debt managementwill reduce a country’s vulnerability to economic andfinancial shocks and support the environment forgrowth.

The Accompanying Document and Selected Case Studiescomplements the IMF and World Bank’s Guidelines forPublic Debt Management, which were endorsed by theInternational Monetary and Financial Committee andthe Development Committee at their spring 2001meetings. It illustrates the variety of approaches takenby 18 countries from different parts of the world, andat different stages of economic and financial develop-ment, to develop their public debt management prac-tices in a manner consistent with the Guidelines. The

experience of these countries should offer some usefulpractical suggestions of the kinds of steps that othercountries could take as they strive to build their capac-ity in public debt management.

In line with the process adopted for the Guidelines,the preparation of the Accompanying Document andSelected Case Studies has sought to ensure that thedescription of individual country practice and thelessons learned are well grounded. To this end, thecase studies were prepared by government debt man-agers with the coordination of staff from the IMF andthe World Bank. IMF and World Bank staffs also pre-pared Part I of the document, which summarizes keylessons from the case studies. Two formal rounds ofconsultations were held with the country officials whoprepared the case studies, and an outreach conferenceorganized by IMF and World Bank staffs was held inWashington in September 2002 so that the countryofficials could meet to discuss the lessons drawn fromthe case studies and the book as a whole.

v

Foreword

Anne Krueger Jeffrey GoldsteinFirst Deputy Managing Director Managing DirectorInternational Monetary Fund The World Bank

Guidelines for Public Debt Management: AccompanyingDocument and Selected Case Studies was prepared by MatsFilipsson and Mark Zelmer of the InternationalMonetary Fund, Tomas Magnusson of the World Bank,and the officials from the 18 countries that prepared thecase studies. The project was supervised by Piero Ugoliniof the International Monetary Fund and Fred Jensen ofthe World Bank. Valuable feedback and suggestions forimproving this book of case studies were obtained fromthe country officials who prepared the case studies andstaff within the International Monetary Fund and theWorld Bank. In particular, Stefan Ingves and V.

Sundararajan of the Fund and Graeme Wheeler and KenLay of the World Bank provided very useful comments.

Special thanks are due to Natalie Baumer, whohelped to edit this book; Sandra Marcelino for herhelp in compiling data and preparing charts andtables; and Stephen Swaray for his help in preparingthe box “Applying the Guidelines to the HIPCs.”Thanks are also due to William Murray and SeanCulhane of the External Relations Department of theIMF and to Craig Carter of the Public DebtManagement Group of the World Bank who managedthe production of this document.

vii

Acknowledgments

ix

Glossary and List of Abbreviations

ADB Asian Development BankALM Asset and Liability ManagementALM Branch Asset and Liability Management Branch (of the National Treasury, South Africa)BAM Bank Al-Maghrib (Morocco)BaR Budget-at-RiskBdR Banco de la República (Colombia)BESA Bond Exchange of South AfricaBIS Bank of International SettlementBOI Bank of ItalyBOJ Bank of JamaicaBoJ Bank of JapanBOJ-NET Bank of Japan Financial Network SystemBOM Bank of MexicoBOS Bank of SloveniaBOTs Buoni Ordinari del TesoroBPD Bureau of the Public DebtBTEs Buoni del Tesoro (Italy)BTPs Buoni del Tesoro Poliennali (Italy)CaR Cost-at-RiskCBB Central Bank of Brazil CBI Central Bank of IrelandCBISSO Central Bank of Ireland Securities Settlements OfficeCCIL Clearing Corporation of India Ltd.CCTs Certificati di Credto del Tesoro (Italy)CDP Cassa Depositi e Prestini (Italy)Cetes Certificados de la Tesorería (Mexico)COI Obligacje czteroletnie indeksowane oszczędnościowe (Poland)CP Commercial Paper CPSS Committee on Payment and Settlement Systems (of the central banks of the Group of Ten

countries)CRR Cash Reserve RatioCSE Copenhagen Stock Exchange

CTEs Certificati del Tesoro (Italy)CTOs Certificati del Tesoro con Opzione (Italy)CTZs Certificati del Tesoro Zero-Coupon (Italy)Dáil Lower House of Irish ParliamentDCV Depósito Central de Valores (Colombia)Diet The Japanese ParliamentDMFAS Debt Management and Financial Analisis System (Colombia)DMO The U.K. Debt Management OfficeDMU Debt Management Unit (of the Ministry of Finance and Planning, Jamaica)DNB Danmarks NationalbankDOS Obligacje dwuletnie oszczędnościowe o stałej stopie procentowej (Poland)DRMR Debt and Reserves Management Report (U.K.)DS Obligacje dziesięcioletnie o oprocentowaniu stałym (Poland)DsaR Debt-Service-at-RiskDvP Delivery-versus-PaymentDZ Obligacje dziesięcioletnie o oprocentowaniu zmiennym (Poland)ECB European Central BankECB External Commercial Borrowing (India)ECP Euro Commercial PaperECU European Currency UnitEEC European Economic CommunityEFFAS European Federation of Financial Analysts SocietiesEMS European Monetary SystemEMTN Euro Medium-Term NotesEMU European Monetary UnionEONIA Euro Overnight Index AverageERM II European Exchange Rate Mechanism IIESCB European System of Central BanksEU European UnionEuribor Euro Interbank Offered RateEurostat Statistical Office of the European CommunitiesFAA Financial Administration and AuditFed Federal Reserve SystemFILP Fiscal Investment and Loan Program (Japan)FMC Financial Markets CommitteeFMS Financial Management ServiceFRL Fiscal Responsibility Law (Brazil)FSC Financial Services CommissionGDCF Government Debt Consolidation Fund (Japan)GEMM Gilt-Edged Market Makers (U.K.)HIPC Heavily Indebted Poor CountriesIDB Interdealer BrokerIG GEMM Index-Linked Gilt-edged Market Makers (U.K.)IGCP Instituto de Gestão do Credito Publico (Portuguese Government Debt Agency) IGR Impôt Général sur le Revenu (Morocco)IMF International Monetary FundIMFC International Monetary and Financial Committee

x GUIDELINES FOR PUBLIC DEBT MANAGEMENT

IOSCO International Organization of Securities CommissionsIPAB Instituto de Protección al Ahorro Bancario (Mexico)IRS Interest Rate SwapIS Impôt sur les Sociétés (Morocco)ISDA International Swap Dealers AssociationISMA International Securities Market AssociationIT Information TechnologyIVT Intermédiaires en Valeurs du Trésor (Morocco)JCSD Jamaica Central Securities DepositoryJGB Japanese Government BondLFT Letras Financeiras do Tesouro (Brazil)LOA Lei Orçamentária AnualLRS Local Registered Stocks (Jamaica)LSE London Stock ExchangeLTN Letras do Tesouro NacionalM2 Broad Money 2MEDIP The Portuguese acronym for “Special Market for Public Debt”MEF Ministry of the Economy and Finance (Italy)MoF Ministry of FinanceMP Multiple-PriceMTN Medium-Term NotesMTS Electronic trading system for fixed-income securitiesNBP National Bank of PolandNDS National Depository for SecuritiesNDS Negotiated Dealing SystemNPV Net Present ValueNTMA The National Treasury Management Agency (Ireland)NTN-C Notas do Tesouro Nacional - Série CNZDMO New Zealand Debt Management OfficeOECD Organization for Economic Cooperation and DevelopmentOK Obligacje dwuletnie zerokuponowe (Poland)OPCVMs Organismes de placement Collectif en valeurs Mobilières (Morocco)OT Obrigações do Tesouro (standard fixed-rate treasury bonds, Portugal)OTC Over the CounterPDD Public Debt Department (of the Ministry of Finance, Poland)PDD Public Debt Direction (of the Italian Treasury Department) PS Obligacje pięcioletnie o oprocentowaniu stałym (Poland)R&I Rating and Investment Information, Inc.RAPM Risk-Adjusted Performance MeasurementRBI Reserve Bank of IndiaRTGS Real-Time Gross SettlementSARB South African Reserve BankSDDS Special Data Dissemination StandardSEBRA Sistema Electrónico de Banco de la República (Colombia)Secad Secretaria Adjunta do Tesouro Nacional (Brazil)SEN Sistema Electrónico de Negociación de Deuda Pública (Colombia)SFC Secretaria Federal de Controle (Brazil)

Glossary and List of Abbreviations xi

SLR Statutory Liquidity RatioSNDO Swedish National Debt OfficeSOEs State-Owned EnterprisesSP Obligacje pięcioletnie o stałej stopie procentowej (Poland)SPF Social Pension FundSTRIPS Separate Trading of Registered Interest and Principal of SecuritiesSWIFT Society for Worldwide Interbank Financial TelecommunicationTARGET Trans European Real-time Gross Settlement Express TransferTCU Tribunal de Contas da União (external auditing agency, Brazil)TES Treasury Security (Colombia)TPR Transfer-Pricing RegimeTZ Obligacje trzyletnie o oprocentowaniu zmiennym (Poland)UMS United Mexican StatesUNCTAD United Nations Conference on Trade and DevelopmentUP Uniform-PriceUSD CP U.S. Dollar Commercial PaperVaR Value-at-RiskWMAs Ways and Means AdvancesWS Obligacje dwudziestoletnie o oprocentowaniu stałem (Poland)

xii GUIDELINES FOR PUBLIC DEBT MANAGEMENT

Recognizing the important role that public debt man-agement can play in helping countries cope with eco-nomic and financial shocks, the InternationalMonetary and Financial Committee (IMFC) requestedthat staff from the International Monetary Fund andWorld Bank work together in cooperation withnational debt management experts to develop a set ofguidelines for public debt management to assist coun-tries in their efforts to reduce financial vulnerability.When the Executive Boards of the IMF and the WorldBank endorsed the guidelines in the spring of 2001,they requested that the staff of the two institutions alsoprepare an accompanying document to the guidelinescontaining sample case studies to illustrate how arange of countries from around the world and at dif-ferent stages of economic and financial developmentare developing their debt management capacity in amanner consistent with the guidelines. The experi-ences of these countries should offer some useful prac-tical suggestions of the kinds of steps that othercountries could take as they strive to build their capac-ity in public debt management.

The 18 case studies presented in this report clearlyillustrate the rapid evolution that is taking place in thefield of public debt management. In contrast to 15 or20 years ago, countries are much more focused onmanaging the financial and operational risks inherentin the debt portfolio. Also, the way in which the stockof debt is managed is becoming increasingly sophisti-cated, especially in those countries that have had his-tories of excessive debt levels or have experiencedshocks associated with the reversal of capital flows.

These points are embodied in several overarchingthemes that emerge from the country case studies.

The first key theme is that the objectives for man-aging debt and the institutional framework for meetingthese objectives are becoming more formalized. All ofthe countries surveyed have explicit objectives for man-aging their debt, which focus on managing the need toborrow at the lowest possible cost over a medium- tolong-term time frame. Most countries’ statements ofobjectives also make explicit reference to the need tomanage risks prudently, but this is not universal. Evenso, the reference to managing costs over the medium tolong term can be seen as an awareness of the need toavoid taking on dangerous debt structures that mighthave lower costs in the short run but could trigger muchhigher debt-service costs in the future. They clearly donot strive to minimize costs in the short run withoutregard to risk. Avoiding dangerous debt structures is, ofcourse, easier said than done. In some countries, thecosts of borrowing domestically by issuing long-termfixed-rate instruments may simply be too prohibitive inthe short run because of weak macroeconomic condi-tions or because this segment of the market is not func-tioning well. As a result, many countries are dedicatingsignificant effort and resources toward developing thedomestic market for government debt so that down theroad they can reduce rollover risk and other marketrisks in the debt stock, even though the benefits ofdoing so may only emerge over time and entail higherdebt service costs in the short run.

Another aspect of the more formal institutionalframework can be seen in the organizational structure

xiii

EXECUTIVE SUMMARY

underpinning debt management. There is a cleartrend toward providing a proper legal framework tosupport debt management, and centralizing debtmanagement activities as much as possible in oneentity, even though the preferred entity variesdepending on country circumstances. As circum-stances permitted, the countries surveyed took stepsto separate the conduct of monetary policy from debtmanagement, while ensuring continued adequatecoordination at the operational level, so that there isappropriate sharing of information on the govern-ment’s liquidity flows between debt managers and fis-cal and monetary policy authorities, and so that thetwo activities do not operate at cross-purposes infinancial markets. They have also taken a number ofsteps to clearly specify the roles and responsibilities ofthose involved in debt management and subject theconduct of debt management activities to appropri-ate financial and management controls. This hashelped to ensure that appropriate safeguards are inplace to manage the operational risks associated withdebt management.

The more formal institutional framework hasalso been accompanied by transparency in debt man-agement activities and appropriate accountabilitymechanisms. Debt managers in all of the case studycountries emphasized the need to ensure that thepublic is fully informed about the government’sfinancial condition, the objectives governing debtmanagement, and the strategies and modalities usedby debt managers to pursue these objectives. Theyalso use a variety of communication vehicles, such asregular formal reports and media announcements, toreport on their performance in meeting the objec-tives laid out for them and outline in general termstheir plans and priorities for the year ahead. In somecountries, their performance in both a financial anda broader stewardship sense is also subject to regularexternal review. This reflects a general consensusamong the countries that markets work best, anddebt service costs are minimized, when uncertaintyregarding the objectives and conduct of debt man-agement and the state of government finances is keptto a minimum.

A second key theme relates to the high level ofawareness of the importance of risk management ofpublic debt and of a growing consensus on the appro-

priate techniques for managing risk. Many of thecountries surveyed use cash-flow modeling for analyz-ing the costs and risks of different debt strategies,where cost is measured as the expected, or mostlikely, cost of debt service over the medium to longterm and risk is the potential increase or volatility incost over the same period. One rationale for this isthat the cost of debt is best considered in terms of itsimpact on the government’s budget, and that cash-flow measures are a natural way of quantifying thisimpact. A few countries are beginning to experimentwith modeling debt service and macrovariablesjointly to more directly measure cost and risk of debtrelative to the government’s revenues and otherexpenditures—that is, to model the government’sassets and liabilities jointly. In a number of othercases, this asset and liability management (ALM)approach has been used in a more limited way byjointly analyzing the risk characteristics of govern-ment financial assets (such as foreign exchangereserves) and debt to determine the appropriatestructure of debt and assets.

The management of operational risk is alsoreceiving increased attention. In large part, this isaddressed by having institutional structures that per-mit clear assignment of authority and responsibility,operations manuals detailing all important proce-dures, conflict of interest rules, clear reporting lines,and formal audits. But many debt offices now alsohave separate middle offices with responsibility foranalyzing risk and designing and implementing risk-control procedures. (Some of these same offices alsohave responsibility for analyzing strategies for man-aging the costs and risks of debt, although in others,the responsibility for strategic analysis is separatefrom the risk-control unit.)

Those debt offices, which trade their debt or taketactical risk positions, have particularly strong mid-dle-office control structures. The focus on formal riskanalysis and control structures is not universal, how-ever, because it depends largely on country circum-stances. In the past, the industrial countries seen asleaders in this field also had large and risky debtstructures, including a substantial share of foreigncurrency debt. Consequently, the benefits of taking amore systematic approach to the financial and riskmanagement of the government’s debt were substan-

xiv GUIDELINES FOR PUBLIC DEBT MANAGEMENT

tial. Others, which have deep and liquid domesticdebt markets and consequently little or no foreigncurrency debt, have a much less risky debt structureand less of a need for a formal strategy for managingdebt based on cost/risk trade-offs. However, emerg-ing market and developing countries, many of whichalso have had risky debt structures, had a later start inbuilding the capacity for managing this risk.Although some of these countries are now usingmodels and systems that are similar to those in indus-trialized countries, others are still in the process ofbuilding this capacity. Good progress has been made,but the experience of the leading practitionersdemonstrates that this process can take several years.That said, some countries may not need to buildmodels and systems as sophisticated as those found inthe industrial countries because their debt issuanceoptions are narrower and their markets lessamenable to statistical analysis. Instead, they shouldstrive to set achievable goals for their models that arelimited to the genuinely useful aspects.

It also is clear that a lot of financial resources andmanagement time is being devoted to developing thetechnology and systems needed to perform thesetasks. This speaks to the need to ensure that the sys-tems acquired are appropriate to the government’sneeds, given a country’s stage of development. Thesystems acquired do not necessarily have to includeall of the latest and most sophisticated features—many of the cash-flow simulation models used forcost/risk analysis are spreadsheet based. Countriesalso have pursued the acquisition of technology indifferent ways, depending on country-specific cir-cumstances. Some have opted to acquire these sys-tems by purchasing commercially available systemsthat were designed for private sector financial institu-tions and customizing them to suit their own needs,and others have opted instead to develop their ownsystems in-house. Some systems are very basic, focus-ing on the primary needs of debt recording, report-ing, and analysis, and others are integrated withother cash management, accounting, and budget sys-tems. This highlights the fact that the appropriatetechnology varies considerably depending on coun-try-specific circumstances, and that many countriesare still experimenting to find out which systemswork best.

A third key theme that emerged from the casestudies is the striking convergence in approachestaken by countries to issue debt and promote a well-functioning domestic financial market. Auctions ofstandardized market instruments are commonly usedto issue debt in domestic markets, and debt managersare cognizant of the need to avoid excessive frag-mentation of the debt stock if they are to encouragedeep and liquid markets for government securities.Where differences exist, they tend to be at the level ofexecution, such as in terms of the features of instru-ments issued and the extent to which debt managersare prepared to rely on primary dealers to markettheir debt to end-investors. Nonetheless, it is impor-tant to note that all of the countries surveyed referredto the advantages of working collaboratively with mar-ket participants to develop their domestic govern-ment securities markets and minimize the amount ofuncertainty in the market regarding governmentfinancing activities. Over time, this appears to be pay-ing off in the form of more efficient domestic finan-cial markets, and ultimately lower borrowing costs forthe government, in that the presence of a thrivingdomestic market makes it easier for debt managers toachieve a debt-stock structure that embodies the gov-ernment’s preferred cost/risk trade-off.

Fourth, it is important to highlight what sounddebt management in and of itself cannot deliver. It isno substitute for sound macroeconomic and fiscalpolicies, and on its own will not be enough to ensurethat a country is well insulated from economic andfinancial shocks. Developing public debt manage-ment in a manner consistent with the guidelinesclearly has an important role to play in fostering pru-dent debt management practices and contributing tothe development of a well-functioning market for gov-ernment securities. However, many countries alsostressed the need for a sound macroeconomic policyframework, characterized by an appropriate exchangerate regime, a monetary policy framework that is cred-ibly focused on the pursuit of price stability, sustain-able levels of public debt, a sound external position,and a well-supervised financial system. Such a frame-work is an important underpinning to instilling confi-dence among financial market participants that theycan invest in government securities with a minimumof uncertainty. It is thus an important precondition if

Executive Summary xv

debt managers are to succeed in achieving a debtstructure that reflects the government’s preferredcost/risk trade-off and helping the country at large tominimize its vulnerability to economic and financialshocks. Indeed, through their links to financial mar-kets and their risk management activities, governmentdebt managers are well positioned to gauge the effectsof government financing requirements and debt lev-els on borrowing costs, and to communicate this infor-mation to fiscal policy advisers.

Finally, although the examples of debt manage-ment practices presented in the case studies and thelessons drawn here offer some practical guidance forpolicymakers in all countries that are striving tostrengthen the quality of their public debt manage-ment and reduce their country’s vulnerability to eco-nomic and financial shocks, they are especiallyrelevant for the heavily indebted poor countries(HIPCs) and developing transition economies. Theseare at an earlier stage of developing their capacity inpublic debt management. For them, in addition to

continuing to strengthen their budget and cash man-agement functions, an important priority will be todraw from the experiences outlined in the case stud-ies to build a proper foundation for conducting debtmanagement. In this regard, some important firststeps for many of these countries are the need tointroduce appropriate governance and institutionalstructures so that the operational and financial risksassociated with debt management are properly man-aged, the need to develop information systems thatfully capture the financial characteristics of all of thegovernment’s financial obligations and contingentliabilities, and the need to develop a debt strategythat encompasses both domestic and external debt.The last is especially important, and the experiencesof the countries covered by the case studies suggestthat the development of a domestic debt market canplay an important role over time in helping tobroaden the range of borrowing opportunities for acountry, making it easier for it to achieve its desiredcost/risk trade-off.

xvi GUIDELINES FOR PUBLIC DEBT MANAGEMENT

IIMPLEMENTING THE GUIDELINES IN PRACTICE

A government’s debt portfolio is usually the largestfinancial portfolio in the country. It often containscomplex financial structures and can create substantialbalance-sheet risk for the government. Large andpoorly structured debt portfolios also make govern-ments more vulnerable to economic and financialshocks and have often been a major factor in eco-nomic crises. Recognizing the important role that pub-lic debt management can play in helping countriescope with economic and financial shocks, theInternational Monetary and Financial Committee(IMFC)1 requested that staff from the InternationalMonetary Fund and World Bank work together incooperation with national debt management expertsto develop a set of guidelines on public debt manage-ment to assist countries in their efforts to reduce finan-cial vulnerability. The IMFC’s request, which wasendorsed by the Financial Stability Forum, was made aspart of a search for broad principles that could helpgovernments improve the quality of their policy frame-works for managing the effects of volatility in the inter-national monetary and financial system.

By involving national debt management authori-ties in the preparation of the guidelines, the process

sought to strengthen countries’ sense of ownership ofthem and helped to ensure that they are in line withsound practice. Government debt managers fromabout 30 countries provided input to an initial draftthat was discussed by the Executive Boards of the IMFand World Bank in July 2000. Following these discus-sions, more than 300 representatives from 122 coun-tries attended five outreach conferences on theguidelines in Abu Dhabi, United Arab Emirates; HongKong Special Administrative Region; Johannesburg,South Africa; London, United Kingdom; and Santiago,Chile.2 The feedback provided was taken into accountin the final version that was approved by the ExecutiveBoards of the two institutions in March 2001, andendorsed by the IMFC and the DevelopmentCommittee3 at their meetings in April 2001. Sincethen, the guidelines have been available on the IMFand World Bank web sites in five languages (English,French, Spanish, Russian, and Arabic), and a hardcopy version was published by the two institutions inSeptember 2001.4 The guidelines are summarized inAppendix I.

In the course of the Board discussions, theExecutive Directors of the IMF and the World Bank

3

1Introduction

asked their staff to prepare an accompanying docu-ment to the guidelines that would contain samplecase studies of countries that are developing strongsystems of public debt management. At the sametime, the Boards requested that this report shouldnot expand or add to the guidelines, but insteaddelineate the experiences of various countries inthe form of case studies. In response, staff from theIMF and the World Bank have prepared this docu-ment, which contains 18 country case studies toillustrate how a range of countries from around theworld and at different stages of economic andfinancial development are developing their capac-ity in debt management in a manner consistentwith the guidelines. The diverse nature of the coun-tries represented in the case studies is illustrated bythe economic and financial indicators presented inTable I.1. The experience of these countries shouldoffer some useful practical suggestions of the kinds

of steps that other countries could take as theystrive to build their capacity in government debtmanagement.

In line with the process adopted for the guide-lines, the preparation of the accompanying docu-ment has sought to foster countries’ sense ofownership of the product and ensure that thedescriptions of individual country practice and thelessons learned are well grounded. The 18 countrycase studies were prepared by government debt man-agers coordinated by IMF and World Bank staff. Theycover both their domestic debt management and for-eign financing activities. After collecting the informa-tion and preparing initial drafts of the case studies,the officials involved in preparing the case studieswere invited to an outreach conference inWashington in September 2002 to discuss the conclu-sions drawn from the cases by IMF and World Bankstaff, as well as the document as a whole.

4 GUIDELINES FOR PUBLIC DEBT MANAGEMENT

Table I.1. Selected Macroeconomic and Financial Indicators for Case Study Countries in 2001

Standard and Poor’sGeneral Broad Stock market long-term Moody’s

Nominal GDP government money capitalization debt ratings long-term per capita net debt (M2) (1999 data) Foreign Local debt

(US$) (%GDP) (%GDP) (%GDP) currency currency ratings

Brazil 2,986 56 25 30 BB– BB+ B1Colombia 2,021 47a 31 13 BB BBB Ba2Denmark 30,160 39 39 60 AAA AAA AaaIndia 466 90 65 41 BB BBB– Ba2Ireland 26,596 25 n.a.b 45 AAA AAA AaaItaly 18,904 104 n.a.b 62 AA AA AaaJamaica 3,758 130c 44 38 B+ BB– Ba3Japan 32,637 66 131 105 AA AA Aa1Mexico 6,031 42 29 32 BBB– A– Baa2Morocco 1,147 76 75 39 BB BBB Ba1New Zealand 12,687 18 89 52 AA+ AAA Aa2Poland 4,562 36 46 19 BBB+ A+ Baa1Portugal 10,587 59a n.a.b 58 AA AA Aa2Slovenia 10,605 1 52 11 A AA A2South Africa 2,490 43a 60 200 BBB– A– Baa2Sweden 23,547 –3 46 156 AA+ AAA Aa1United Kingdom 23,765 31 95 203 AAA AAA AaaUnited States 36,716 42 53 182 AAA AAA Aaa

a. Gross debt as a percent of GDP.b. M2 data are not available at the national level for members of the European Monetary Union.c. End of fiscal year 2001–02.Source: IMF World Economic Outlook, Bankscope databases, and IMF staff estimates.

What Is Public Debt Management andWhy Is It Important?

Public debt management is the process of establish-ing and executing a strategy for managing the gov-ernment’s debt to raise the required amount offunding, pursue its cost/risk objectives, and meet anyother public debt management goals the governmentmay have set, such as developing and maintaining anefficient and liquid market for government securities.

In a broader macroeconomic context for publicpolicy, governments should seek to ensure that boththe level and the rate of growth in their public debtare fundamentally sustainable over time and can beserviced under a wide range of circumstances whilemeeting cost/risk objectives. Government debt man-agers share fiscal and monetary policy advisers’ con-cerns that public sector indebtedness remains on asustainable path and that a credible strategy is inplace to reduce excessive levels of debt. Debt man-agers should ensure that the fiscal authorities areaware of the impact of government financing require-ments and debt levels on borrowing costs.5 Examplesof indicators that address the issue of debt sustain-ability include the public sector debt-service ratio andratios of public debt to GDP and to tax revenue.6

Every government faces policy choices concern-ing debt management objectives, its preferred risktolerance, which part of the government balancesheet those managing debt should be responsible for,how to manage contingent liabilities, and how toestablish sound governance for public debt manage-ment. On many of these issues, there is increasingconvergence in the global debt management com-munity on what are considered prudent sovereigndebt management practices that can also reduce vul-nerability to contagion and financial shocks. Theseinclude (a) recognition of the benefits of clear objec-tives for debt management; (b) weighing risks againstcost considerations; (c) the separation and coordina-tion of debt and monetary management objectivesand accountabilities; (d) a limit on debt expansion;(e) the need to carefully manage refinancing andmarket risks and the interest costs of debt burdens;(f) the necessity of developing a sound institutionalstructure and policies for reducing operational risk,including clear delegation of responsibilities and

associated accountabilities among government agen-cies involved in debt management; and (g) the needto carefully identify and manage the risks associatedwith contingent liabilities.

Public debt management problems often origi-nate in the lack of attention paid by policymakers tothe benefits of having a prudent debt managementstrategy and the costs of weak macroeconomic man-agement and excessive debt levels. In the first case,authorities should pay greater attention to the bene-fits of having a prudent debt management strategy,framework, and policies that are coordinated with asound macropolicy framework. In the second, inap-propriate fiscal, monetary, or exchange rate policiesgenerate uncertainty in financial markets regardingthe future returns available on local currency–denom-inated investments, thereby inducing investors todemand higher risk premiums. Particularly in devel-oping and emerging markets, borrowers and lendersalike may refrain from entering into longer-term com-mitments, which can stifle the development of domes-tic financial markets and severely hinder debtmanagers’ efforts to protect the government fromexcessive rollover and foreign exchange risk. A goodtrack record of implementing sound macropoliciescan help to alleviate this uncertainty. This should besupplemented with appropriate technical infrastruc-ture—such as a central registry and payments and set-tlement systems—to facilitate the development ofdomestic financial markets.

In addition, poorly structured debt in terms ofmaturity, currency, or interest rate composition andlarge and unfunded contingent liabilities has beenimportant factors in inducing or propagating eco-nomic crises in many countries throughout history. Forexample, irrespective of the exchange rate regime, orwhether domestic or foreign currency debt is involved,crises have often arisen because of an excessive focusby governments on possible cost savings associatedwith large volumes of short-term or floating-rate debt.This has left government budgets seriously exposed tochanging financial market conditions, includingchanges in the country’s creditworthiness, when thisdebt has to be rolled over. Foreign currency debt alsoposes particular risks, and excessive reliance on for-eign currency debt can lead to exchange rate or mon-etary pressures or both if investors become reluctant to

Introduction 5

refinance the government’s foreign currency debt. Byreducing the risk that the government’s own portfoliomanagement will become a source of instability for theprivate sector, prudent government debt manage-ment, along with sound policies for managing contin-gent liabilities, can make countries less susceptible tocontagion and financial risk.

The size and complexity of a government’s debtportfolio often can generate substantial risk to thegovernment’s balance sheet and to the country’sfinancial stability. As noted by the Financial StabilityForum’s Working Group on Capital Flows, “recentexperience has highlighted the need for govern-ments to limit the build-up of liquidity exposures andother risks that make their economies especially vul-nerable to external shocks.”7 Therefore, sound riskmanagement by the public sector is also essential forrisk management by other sectors of the economy“because individual entities within the private sectortypically are faced with enormous problems wheninadequate sovereign risk management generates vul-nerability to a liquidity crisis.” Sound debt structureshelp governments reduce their exposure to interestrate, currency, and other risks. Sometimes these riskscan be readily addressed by relatively straightforwardmeasures, such as lengthening the maturities of bor-rowings and paying the associated higher debt-servic-ing costs (assuming an upward-sloping yield curve),adjusting the amount, maturity, and composition offoreign exchange reserves, and reviewing criteria andgovernance arrangements for contingent liabilities.

There are, however, limits to what sound debtmanagement policies can deliver in and of themselves.Sound debt management policies are no panacea orsubstitute for sound fiscal and monetary management.If macroeconomic policy settings are poor, soundsovereign debt management may not by itself preventany crisis. Even so, sound debt management policiescan reduce susceptibility to contagion and financialrisk by playing a catalytic role for broader financialmarket development and financial deepening.

Purpose of the Guidelines

The guidelines are designed to assist policymakers inconsidering reforms to strengthen the quality of their

public debt management and reduce their country’svulnerability to domestic and international financialshocks. Vulnerability is often greater for smaller andemerging market countries because their economiesmay be less diversified, have smaller bases of domes-tic financial savings (relative to GDP), and less devel-oped financial systems. They could also be moresusceptible to financial contagion, if foreign investorexposures are significant, through the relative mag-nitudes of capital flows. As a result, the guidelinesshould be considered within a broader context of thefactors and forces more generally affecting a govern-ment’s liquidity and the management of its balancesheet. Governments often manage large foreignexchange reserves portfolios, their fiscal positions arefrequently subject to real and monetary shocks, andthey can have large exposures to contingent liabilitiesand to the consequences of poor balance-sheet man-agement in the private sector. However, irrespectiveof whether financial shocks originate within thedomestic banking sector or from global financial con-tagion, prudent government debt management poli-cies, along with sound macroeconomic andregulatory policies, are essential for containing thehuman and output costs associated with such shocks.

The guidelines cover both domestic and externalpublic debt and encompass a broad range of financialclaims on the government. They seek to identify areasin which there is broad agreement on what generallyconstitutes sound practices in public debt manage-ment. The guidelines focus on principles applicableto a broad range of countries at different stages ofdevelopment and with various institutional structuresof national debt management. They should not beviewed as a set of binding practices or mandatory stan-dards or codes, nor should they suggest that a uniqueset of sound practices or prescriptions exists thatwould apply to all countries in all situations. Theguidelines are mainly intended to assist policymakersby disseminating sound practices adopted by membercountries in debt management strategy and opera-tions. Their implementation will vary from country tocountry, depending on each country’s circumstances,such as its state of financial development. Heavilyindebted poor countries (HIPCs) face special chal-lenges in this regard.8 The terms and conditions sur-rounding debt relief provided to them typically


include provisions that focus on the need to improvedebt management practices in ways that are consistentwith the guidelines (see Box I.1).

Building capacity in sovereign debt manage-ment can take several years, and country situationsand needs vary widely. Their needs are shaped bythe capital market constraints they face; theexchange rate regime; the quality of their macroe-conomic, fiscal, and regulatory policies; the effec-

tiveness of the budget management system; the insti-tutional capacity to design and implement reforms;and the country’s credit standing. Capacity buildingand technical assistance therefore must be carefullytailored to meet stated policy goals, while recogniz-ing the policy settings, institutional framework,technology, and human and financial resources thatare available. The guidelines should assist policyadvisers and decision makers involved in designing

Introduction 7

Box I.1. Applying the Guidelines to the HIPCs

The HIPC Initiative was launched by the World Bank and the IMF in 1996 (and later enhanced in 1999) as a compre-hensive effort to eliminate unsustainable debt in the world’s poorest, most heavily indebted countries. Through the pro-vision of debt relief to eligible HIPCs that show a strong track record of economic adjustment and reform, the initiativewas designed to help these countries achieve a sustainable debt position over the medium term. Insufficient attention paidto public debt management is widely thought to have been one of the most important factors that contributed to the accu-mulation 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 staff of the World Bank and the IMF revealed that several very important weaknesses continue to existin key aspects of debt management in the HIPCs, notably in the design of their legal and institutional frameworks, coor-dination of debt management with macroeconomic policies, new borrowing policy, and the human and technical require-ments for performing basic debt management functions.a In the area of the legal framework, although most HIPCs havean explicit legal instrument governing the debt office and its functions, the legal framework is not always clearly definedand adequately implemented. In addition, transparency and accountability in debt management, including public accessto debt information, require strengthening. Institutional responsibilities for debt management in many HIPCs are also notclearly defined and coordinated. Moreover, their debt management activities are undermined by a number of institutionalweaknesses and low implementation capacity due to insufficient human, technical, and financial resources. To overcomethese difficulties, a first step could be to implement clear and transparent legal and institutional frameworks. The guide-lines and the governance lessons drawn from the case studies can help HIPCs strengthen their legal and institutionalframeworks for debt management. For example, they highlight some ways in which borrowing authority can be delegatedfrom the parliament and the council of ministers to debt managers with appropriate accountability mechanisms, the mer-its of centralizing debt management activities in a single unit, and some ways in which appropriate controls can be intro-duced to manage the operational risks associated with debt management activities. They also illustrate how some countrieshave taken steps to obtain more control over contingent liabilities issued in the name of the government.

Regarding policy coordination, the survey showed that fewer than half of the HIPCs have in place a comprehensive,forward-looking strategy focused on medium-term debt sustainability. Many do not regularly conduct a debt sustain-ability analysis, and very little coordination of information between debt offices and other agencies involved inmacroeconomic 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 HIPCInitiative process, but also if these countries are not to relapse into an unsustainable debt position. In particular, closecoordination among the budget, cash management, and planning functions and the debt management office is essen-tial. Again, the guidelines and the lessons drawn from the case studies provide some insights into how they candevelop debt management strategies that pay attention to the medium- to long-term implications of economic poli-cies and the resulting implications for debt sustainability. For example, they show how various countries have builtlinkages among debt managers, cash managers, and monetary and fiscal policymakers to ensure that relevant infor-mation is regularly shared and their respective policies and operational activities are appropriately coordinated.

(Box continues on the following page.)

debt management reforms as they raise public pol-icy issues that are relevant for all countries. This isthe case whether the public debt comprises mar-ketable debt or debt from bilateral or multilateralofficial sources, although the specific measures tobe taken will differ, to take into account a country’scircumstances.

Notes

1. The IMFC is an advisory body that reports to the IMF’sBoard of Governors on issues regarding the management of theinternational monetary and financial system.

2. In addition, staff from the IMF and the World Bank par-ticipated in a seminar on debt and fiscal management in Whistler,Canada, attended by representatives from Western Hemispherecountries, which included a discussion of the draft guidelines.


Unsustainable debt burdens in the HIPCs have also resulted from unsound policies regarding new borrowing evenafter benefiting from concessions, including rescheduling. To date, up to two-thirds of these countries still do not havein place a sound policy framework for new borrowing, a direct consequence of the fact that they have yet to developa comprehensive debt strategy, and many lack complete information on the total debt they have incurred or guaran-teed. Moreover, even though domestic debt is becoming an important aspect of fiscal sustainability in some low-income countries, including the HIPCs, underdeveloped domestic financial markets seriously limit the role ofdomestic debt in most HIPCs. If they are to ensure long-term sustainability beyond the HIPC Initiative completionpoint, however, they need to develop borrowing strategies that are clear, transparent, and enforceable and begin todevelop a domestic debt market so that they can broaden the range of borrowing options available to them. Theguidelines and the case studies offer some lessons on how they could implement a framework that they could not onlyuse to develop an overall debt management strategy—including sound new borrowing policies—and develop theirdomestic debt markets, but also allow debt managers in these countries to identify and manage the trade-offs betweenthe expected costs and risks in the government debt portfolio. For example, they highlight the benefits of using anasset and liability management (ALM) approach to assessing the debt service costs of different borrowing strategiesin tandem with the financial characteristics of government revenues, expenditures, and financial assets. They encour-age debt managers to stress test the results obtained so that debt strategy decision makers have an understanding ofhow the chosen strategy will perform in a variety of economic and financial settings. They also note how increasedtransparency in debt management activities and the choice of borrowing instruments can be used to promote thedevelopment 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, the HIPCswill continue to need technical assistance to build their debt management capacity. Long-term debt sustainabilityshould be viewed not only in relation to the debt burden but also in terms of the structures, processes, and manage-ment information services required to manage the debt burden effectively. The HIPC Initiative process itself recog-nizes this by focusing on, among other things, the technical assistance requirements of HIPCs reaching the decisionpoint. At the same time, the countries themselves must supplement the assistance efforts by ensuring that there areadequate numbers of motivated staff in debt offices that could benefit from technical assistance. In addition, full polit-ical support is critical to the success of any efforts to strengthen debt management capacity.

In general, the guidelines and the lessons drawn from the case studies should be useful for all countries striving todevelop their policy frameworks and capacity for debt management, but they are particularly relevant for the HIPCs.For them, the guidelines and lessons drawn can not only facilitate achievement of the decision and completion pointsof the HIPC Initiative process, but, more important, they can help ensure that debt sustainability is maintained formany years to come.

a. See International Development Association, “External Debt Management in Heavily Indebted Poor Countries,”Board Discussion Paper IDA/ SecM2002-0148, (Washington), 2002.

Box I.1. (continued)

3. The Development Committee of the Boards of Governorsof the IMF and the World Bank advises the two Boards on criticaldevelopment issues and on the financial resources required topromote economic development in developing countries.

4. International Monetary Fund and the World Bank, 2001,Guidelines for Public Debt Management Washington.

5. Excessive levels of debt that result in higher interest ratescan have adverse effects on real output. See, for example, A.Alesina, M. de Broeck, A. Prati, and G. Tabellini, “Default Risk onGovernment Debt in OECD Countries,” Economic Policy: AEuropean Forum (October 1992), pp. 428–63.

6. Guidelines for Public Debt Management, p. 1. For a discussionof indicators of external vulnerability for a country, seeInternational Monetary Fund, Debt- and Reserve-Related Indicators ofExternal Vulnerability, SM/00/65 (Washington), 2000.

7. Financial Stability Forum, Report of the Working Group onCapital Flows, (Basel), April 5, 2000, p. 2.

8. Forty-one countries are considered to be HIPCs. A list ofthe HIPCs and an overview of the HIPC Initiative can be found inInternational Monetary Fund and the World Bank, Debt Relief forPoverty Reduction: The Role of the Enhanced HIPC Initiative(Washington), 2001.

Introduction 9

10

This chapter pulls together the main lessons from the18 country case studies contained in Part II of the doc-ument plus the results of a survey of debt managementpractices, summarized in Table I.2, to show how manycountries at different stages of economic and financialdevelopments are developing their public debt man-agement practices in a manner consistent with theguidelines. The aim is to highlight the different ways inwhich countries can improve their debt managementactivities by illustrating the variety of ways that the keyprinciples contained in the guidelines have beenimplemented in practice. References to specific prac-tices contained in the case studies demonstrate howthe guidelines are applied; further details on individ-ual country practices can be found in the country casestudies in Part II of the document. Implications ofthese practices for countries seeking to improve theirown debt management capabilities are also discussed.The conclusions are grouped in accordance with thesix sections of the guidelines: objectives for debt man-agement and coordination with fiscal and monetarypolicies, transparency and accountability for debt man-agement activities, institutional framework governingdebt management activities, debt management strat-

egy, the framework used for managing risks, and devel-oping and maintaining an efficient market for govern-ment securities.

Debt Management Objectives andCoordination

The guidelines in this section address the main objec-tives for public debt management, the scope of debtmanagement, and the need for coordination amongdebt management and monetary and fiscal policies.They encourage authorities to consider the risks asso-ciated with dangerous debt strategies and structureswhen they set the objectives for debt managers andsuggest that debt management should encompass themain financial obligations over which the central gov-ernment exercises control. Given the importance ofensuring appropriate coordination among debt man-agement and fiscal and monetary policies, they recom-mend that authorities share an understanding of thepublic policy objectives in these domains. They alsopromote the sharing of information on the govern-ment’s current and future liquidity needs, but argue

2Lessons from the Country Case Studies

Lessons from the Country Case Studies 11

Table I.2. Survey of Debt Management Practices

Yes No

Institutional frameworkAnnual borrowing authority 14 78% 4 22%Debt ceiling limit 10 56% 8 44%Domestic and foreign currency debt programs managed together 13 76% 4 24%Separate debt agency 4 22% 14 78%Separate front and back offices 15 83% 3 17%Separate risk management unit (middle office) 12 67% 6 33%Formal guidelines for managing market and credit risk 10 56% 8 44%Annual debt management reports 15 83% 3 17%Regular external peer reviews of debt management activities 10 63% 6 38%Annual audits of debt management transactions 16 89% 2 11%Code-of-conduct and conflict of interest guidelines for debt management staff 12 67% 6 33%Business recovery procedures in place 11 69% 4 25%

Portfolio managementStress test of market risk exposures 10 59% 7 41%Trading conducted to profit from expected movements in interest or exchange rates 5 29% 12 71%Government cash balances managed separately from debt 11 65% 6 35%Foreign currency borrowing integrated with foreign exchange reserves management 5 31% 11 69%Specialized management information technology in place for risk management 9 56% 7 44%

Primary market structure for government debtAuctions used to issue domestic debt 18 100% 0 0%

UP = uniform price 10 56% 8 44%MP = multiple price 15 83% 3 17%

Fixed-price syndicates used to issue domestic debt 5 28% 13 72%Benchmark issues for domestic market 16 89% 2 11%Preannounced auction schedule 17 94% 1 6%Central bank participates in the primary market 6 33% 12 67%

only on a competitive basis 6 43% 8 57%Primary dealer system 13 72% 5 28%Universal access to auctions 10 56% 8 44%Limits on foreign participation 1 6% 17 94%Collective action clause, domestic issues 0 0% 18 100%Collective action clause, external issues 6 33% 12 67%

Secondary market for government debtOver-the-counter (OTC) market 15 88% 2 12%Exchange-traded market mechanism 14 82% 3 18%Clearing and settlement systems reflect sound practices 17 94% 1 6%Limits on foreign participation 1 6% 17 94%

Portfolio management statistics: strategic benchmarksDuration 11 65% 6 35%Term-to-maturity 12 71% 5 29%Fixed-floating Ratio 12 71% 5 29%Currency composition 14 88% 2 13%Are benchmarks publicly disclosed? 8 50% 8 50%Use of derivatives 9 56% 7 44%

Note: Percentages are computed on the basis of the number of responses to each question because some countries did not answer all of the questions.

that where the level of financial development allows,there should be a separation of debt managementand monetary policy objectives and accountabilities.

Application

Objectives

The objectives governing debt management in all 18countries emphasize the need to ensure that the gov-ernment’s financing needs and its payment obliga-tions are met at the lowest possible cost over themedium to long run. However, although most coun-tries’ statement of objectives makes explicit refer-ences to the need to manage risks prudently, this isnot universal. For example, the goals governing debtmanagement in the United States emphasize theneed to “meet the financing needs of the governmentat the lowest cost over time.” Similarly, Jamaica’sobjectives are defined as “to raise adequate levels offinancing on behalf of the Government of Jamaica atminimum costs, while pursuing strategies to ensurethat the national public debt progresses to and ismaintained at sustainable levels over the mediumterm.” Even though no explicit reference is made tothe need to manage risks in a prudent fashion, thesecountries do not simply strive to minimize costs in theshort run without regard to risk.

Many countries also promote the developmentand maintenance of efficient primary and secondarymarkets for domestic government securities as animportant complementary objective for debt man-agement. In the short run, governments may have toaccept higher borrowing costs as they seek to developa domestic market for their securities. However, mostgovernments are willing to incur these costs becausethey expect that over time they will be rewarded withlower borrowing costs as the domestic marketmatures and becomes more liquid across the yieldcurve. In turn, this also should help them achieve aless risky debt stock, because a well-functioningdomestic market would enable them to issue a largershare of their debt in longer-term, fixed-rate, domes-tic currency–denominated securities and thus reduceinterest rate, exchange rate, and rollover risks in thedebt stock.1 For example, countries such as Brazil,

Jamaica, Morocco, and South Africa have focused onthe need to develop the domestic debt market as ameans of lessening dependence on external sourcesof financing. And even when this objective is notexplicitly included in the list of objectives governingdebt management, in practice debt managers play anactive role in developing the domestic governmentsecurities market. An example in this regard is theactive role played by debt managers in many coun-tries in working with market participants to introduceelectronic trading in their domestic government debtmarkets.

Developing the market for government securitiescan also help to stimulate the development of domes-tic markets for private securities. For example, inJapan the development of the secondary market forgovernment securities is considered to be an impor-tant objective for debt management because this mar-ket, by virtue of being a low credit risk, serves as thefoundation for domestic financial markets and is byfar the most actively traded segment of the domesticbond and debenture market.

Scope

Debt management activities in most countries sur-veyed encompass the main financial obligations overwhich the central government exercises control.Where differences arise, they tend to be over theextent to which debt managers play a role in manag-ing retail debt issued directly to households (e.g.,nonmarketable savings instruments), contingent lia-bilities, and debt issued by subnational governments,and also on the extent to which foreign currency debtmanagement is integrated with domestic debt man-agement. For example, in the United Kingdom, thewholesale and retail debt programs are managed byseparate agencies, but in the United States, both debtprograms are managed by a single group. In Ireland,the management of explicit contingent liabilities ishandled by the Ministry of Finance (Exchequer), andwholesale debt funding is managed by the debt man-agement agency, whereas in Colombia and Sweden,debt managers play an active role in the managementof explicit contingent liabilities. The Colombianapproach reflects, in part, a response to past experi-


ence where these obligations had grown rapidly as aresult of weak oversight and inappropriate pricing. Inthe latter two countries, involving debt managers inthe valuation of explicit contingent liabilities enabledgovernments to tap the expertise needed to pricethem in a more rigorous fashion.

Most national debt managers do not play a rolein the management of debt issued by other levels ofgovernment, because the national governments typi-cally are not liable for debts incurred by those gov-ernments. The United States is a good example inthis regard. However, in Colombia and India, debtmanagers are actively involved in the management ofdebt at both national and subnational levels of gov-ernment. In Colombia, difficulties encountered bysome other Latin American countries due to exces-sive borrowing by subnational governments led fed-eral debt managers to set limits on subnationalgovernment borrowing to ensure that the financialcondition of these governments does not underminethe health of federal finances. In India, the involve-ment of the central bank in the management of thedebts of the states is a voluntary contractual arrange-ment that enables the states to access the debt man-agement expertise and resources that exist within thecentral bank.

Even if national debt managers are not directlyinvolved in the management of debt issued by otherlevels of government, recent financial crises haveshown that these debts can contribute to financialinstability. Thus, the national government in somecountries, such as Italy, requires other levels of gov-ernment to provide it with information on their bor-rowing activities. In addition, situations can arisewhere the national government may need to play arole in managing these debts even if it does notdirectly involve the national debt managers. Forexample, when the Brazilian central governmentrefinanced debts issued by Brazilian states in 1997and municipalities in 1999, as a condition of theserefinancing programs, the Brazilian Treasury estab-lished contracts with these subnational borrowers.These contracts have strict rules on subnationalspending and new borrowings. Adherence to theserules and those governments’ fiscal situations are reg-ularly monitored by the treasury.

Coordination with monetary and fiscal policies

The industrial countries have advanced the furthestin separating the objectives and accountabilities ofdebt management from those of monetary policy andintroducing appropriate mechanisms for sharinginformation between debt managers and the centralbank on government cash flows. This is most evidentfor those countries surveyed that are members of theEuropean Economic and Monetary Union (EMU),because monetary policy is conducted by theEuropean System of Central Banks (ESCB), and debtmanagement is conducted by the national authori-ties, thereby minimizing the risk of possible conflictsof interest between debt management and monetarypolicy. Provisions in the Maastricht Treaty, which pre-vent governments from borrowing from theirnational central banks, and debt limits, which fosterdebt sustainability, reinforce the separation of debtmanagement from monetary policy in the EMU. Also,there are appropriate information-sharing mecha-nisms in place to ensure that the national centralbanks have the information they need on their gov-ernments’ liquidity flows so that they and theEuropean Central Bank can work together to managethe amount of liquidity circulating in the eurosystem.For example, in Italy, debt managers from the ItalianTreasury continuously monitor and formulate projec-tions of expected government cash flows, taking intoaccount the usual annual cyclical and extraordinarypatterns of revenues and expenditures. In addition,debt managers and the Bank of Italy regularlyexchange information on the movements of cash inand out of the cash account that the treasury holdswith the bank, through which most government cashflows are channeled. To ensure proper financial con-trol over the government’s finances, only the treasuryis authorized to transact through this account.

The industrialized countries surveyed have alsotaken steps to ensure that debt managers and centralbanks coordinate their activities in financial marketsso that they are not operating at cross-purposes. Inthe United Kingdom, for example, the DebtManagement Office (DMO) avoids holding auctionsat times when the Bank of England is conductingmoney market operations, and it does not hold


reverse repo tenders at the 14-day maturity range. Italso does not conduct ad hoc tenders on days whenthe bank’s Monetary Policy Committee is announcingits interest rate settings. However, these restrictionsdo not apply to bilateral operations conducted by theDMO because of their relatively low market profilecompared with auctions. An example of what canhappen when there is insufficient coordination at anoperating level was cited by one country at the out-reach conference. It admitted that a past failure tocoordinate activities between the central bank anddebt managers in financial markets led to an awkwardsituation where the ministry of finance was repayingforeign currency debt at the same time as the centralbank was in need of foreign exchange reserves.

Industrial countries have also found ways to dealwith the potential conflicts that can arise betweencentral banks and debt managers when central banksseek to use government securities in their open mar-ket operations. This issue is especially acute whengovernment borrowing requirements are modest ornonexistent, but the central bank needs a large vol-ume of low-risk assets for use in implementing mon-etary policy. In the EMU, for example, the ESCB hasdeveloped a broad list of public and private securi-ties that it is willing to use in its open market opera-tions so as to avoid the need to rely strictly ongovernment securities. Similar steps have also beentaken by central banks in the other industrial coun-tries surveyed.2

The coordination challenges are more acute foremerging market and developing countries that donot have well-developed financial markets. The lackof central bank independence and the absence ofwell-developed domestic markets make it difficult forthem to wean governments from central bank credit.This also makes it difficult to separate debt manage-ment and monetary policy objectives, because bothactivities often need to rely on the same marketinstruments and are forced to operate at the shortend of the yield curve.

Many countries, such as Poland, have also expe-rienced difficulties in projecting government rev-enues and expenditures3 and establishingappropriate coordination mechanisms and informa-tion-sharing arrangements between the ministry offinance and the central bank.4 Nonetheless, some

have taken important steps toward ensuring propercoordination between debt management and mone-tary policy activities. For example, in Brazil andColombia, debt managers and central bankers regu-larly meet to share information and construct projec-tions of the government’s current and future liquidityneeds.5 In Mexico, debt management, fiscal policy,and monetary policy are formulated using a commonset of economic and fiscal assumptions. Moreover,the Mexican central bank acts as the financial agentof the government in many transactions. This helpsto cement a continuous working relationship inMexico among fiscal, debt management, and mone-tary policy authorities and foster the appropriatesharing of information. In Slovenia, the central bankis given an opportunity to comment ahead of time onthe annual financing program contained within thefiscal documents, and the government is legally pro-hibited from borrowing directly from the centralbank. In addition, under a formal agreement, theSlovenian Ministry of Finance supplies the centralbank with regularly updated forecasts of projectedday-to-day cash flows of all government revenues andexpenditures over one- and three-month horizons.Officials from both institutions also meet regularly toshare information on the technical details regardingthe implementation of their respective policies.

Among other emerging market countries—inJamaica, for example—the transfer of debt manage-ment activities from the central bank to the Ministryof Finance and Planning has resulted in greater coor-dination of fiscal policy and debt management activi-ties, and, as in many countries, it has also allowed fora more clearly defined set of debt management objec-tives that are determined independently of monetarypolicy considerations. At the policy level, there areregular meetings between senior officials of the plan-ning authorities—the Ministry of Finance andPlanning, the Bank of Jamaica, the Planning Instituteof Jamaica, and the Statistical Institute of Jamaica—toensure consistency in the government’s economicand financial program. At the technical level, thereare regular weekly meetings where information isshared on the government’s liquidity requirementsand borrowing programs, as well as on current mon-etary conditions and developments in financial mar-kets. In India, the requisite coordination among debt


management, fiscal, and monetary policies isachieved through various regular meetings within thecentral bank, as well as through regular discussionsbetween central bank and Ministry of Finance staffon the government’s fiscal situation and the implica-tions for borrowing requirements. In addition, debtmanagement officials attend the monthly monetarypolicy strategy meeting, and there is an annual pre-budget exercise that seeks to ensure consistencybetween the monetary and fiscal programs (at boththe central and state government levels). However,the Indian authorities believe that a formal separa-tion of debt management from monetary policy inthe future would depend on the development ofdomestic financial markets, the achievement of rea-sonable control over the fiscal deficit, and legislativechanges. In Morocco, the Treasury and ExternalFinance Department, which is responsible for debtmanagement, participates actively in defining the ori-entations of the budget law, particularly the level ofthe budget deficit and the resources to cover it.

Implementation considerations

The introduction of appropriate, well-articulatedobjectives for debt management is an important stepthat can be introduced by any country regardless ofits state of economic and financial development.Indeed, in recent years, many countries have intro-duced objectives that explicitly mention the need tomanage risks as well as achieve low funding costs forthe government, or at least make clear that the focuson costs is over a medium- to long-run horizon so thatdebt managers are not tempted to pursue short-termdebt-service cost savings at the expense of taking ondangerous debt structures that expose them to ahigher risk of sovereign default. Highlighting thecost/risk trade-off in the objectives can be a usefulway of anchoring ensuing discussions on debt man-agement strategy and the execution of borrowingdecisions.

Country circumstances, such as the state ofdomestic financial markets and the degree of centralbank independence, play an important role in deter-mining the range of activities that are handled bydebt management, as well as the extent to which debtmanagement and monetary policy objectives and

instruments can be separated. Coordination betweenthe budget management and debt management func-tions is crucial. This is particularly the case in transi-tion and developing economies, where the lack ofcapacity to accurately forecast government revenuesand expenditure flows means that coordination ongovernment liquidity requirements and day-to-daycash flows needs to be frequent and well structured.Nonetheless, as shown above, there are many stepsthat countries can take to build appropriate coordi-nation mechanisms over time, regardless of theirstate of economic and financial development.

Particularly for developing and emerging marketcountries, it is important to have good coordinationbetween the fiscal policy advisers and the debt man-agement function. The debt managers’ role here is toconvey their views not only on the costs and risks asso-ciated with government financing requirements, butalso the financial market’s views on the sustainabilityof the government’s debt levels.

Transparency and Accountability

The guidelines in this section argue in favor of dis-closing the allocation of responsibilities among thoseresponsible for executing different elements of debtmanagement, the objectives for debt management,and the measures of cost/risk that are used. They alsoencourage countries to disclose materially importantaspects of debt management operations and infor-mation on the government’s financial condition andits financial assets and liabilities, and highlight theneed to ensure that debt management activities areaudited to foster proper accountability.

Application

Clarity of roles, responsibilities, and objectives offinancial agencies responsible for debt management

In many industrial countries, the objectives for debtmanagement and the roles and responsibilities of theinstitutions involved are explicitly stated in the lawsgoverning debt management activities. This informa-tion also is often published in annual reports pre-pared by debt management authorities and on


official web sites. Indeed, as indicated in Table I.2, 15countries reported that they produce annual debtmanagement reports. Among emerging market anddeveloping countries, there are less formal ways todisclose these items. In Morocco, for example, theMinister of Economy and Finance announces theobjectives for debt management each year at anannual press conference, whereas Sloveniaannounces the goals and instruments for debt man-agement in the annual Financing Program and otherpolicy documents, which are available on govern-ment web sites.

Not all countries in the survey set specific targetsfor risk (such as targets for duration and currencycomposition)—the results in Table I.2 suggest thatabout one-third, including Japan and the UnitedStates, do not—but most of those that do set targets,disclose them. For example, Brazil’s benchmark tar-gets are publicly disclosed in the government’s annualborrowing program, which also provides a compre-hensive overview of debt management activities andthe government’s financial situation. Denmark pub-lishes its targets in a special announcement to thestock exchange and as part of its annual report, andSweden’s targets are published in the annual debtmanagement guidelines given to the SwedishNational Debt Office (SNDO) by the government(cabinet) before the start of the fiscal year. In Italy,public disclosure of strategic cost/risk analysis is at anearly stage of development; however, current versionsare available on the Italian Treasury’s web site.

Public availability of information on debtmanagement policies

All countries disclose materially important aspects oftheir debt management operations and informationon the government’s financial condition and itsfinancial assets and liabilities. The Italian Treasury,for example, maintains an extensive web site thatincludes information on the government’s annualauction calendar, the quarterly issuing program, ten-der announcements, auction results, and informa-tion on government securities and the primarydealers in Italian government securities markets.

Among emerging market countries, the Jamaicangovernment’s debt strategy is presented to

Parliament at the start of the fiscal year in the form ofa Ministry Paper that has widespread public distribu-tion and is available on the ministry’s web site.Comprehensive information on Jamaica’s debt is alsoavailable on the ministry’s web site. In addition, therules for participating in primary debt auctions arewidely disclosed, and notices for future domestic debtissues and auction results are reported through printand electronic media and on the ministry’s web site.In India, an auction calendar was introduced in April2002, which has improved the transparency of theborrowing program. In addition, the Reserve Bank ofIndia regularly issues statistical information on theprimary and secondary markets for government secu-rities, and it began issuing data on trades in govern-ment securities on a real-time basis through its website in October 2002. In Morocco, the Minister ofEconomy and Finance’s annual press conference alsoincludes a presentation on the key results and statis-tics on government debt for the previous year plus anoverview of the measures and actions to be imple-mented in the coming year. Moroccan authoritiesalso issue monthly announcements on the resultsfrom the previous month’s auctions and details ofupcoming auctions, and they hold regular meetingswith market participants to enhance their under-standing of debt management activities.

Accountability and assurances of integrity byagencies responsible for debt management

Almost all countries’ debt management activities areaudited annually by a separate government-auditingagency that reports its findings to parliament. Thedata in Table I.2 indicated that 16 countries haveannual debt management audits, and 10 have regularexternal peer reviews. For example, in Ireland, theannual accounts are audited by the state auditor(Comptroller and Auditor General), even though theIrish debt management agency engages a major inter-national accounting firm to undertake an internalaudit of all data, systems, and controls. In Denmark,the state auditor (Auditor General) audits govern-ment debt management with the help of the centralbank’s internal audit department. In India, however,separate financial accounts for the debt managementoperations at the central bank are not prepared and


thus cannot be subjected to a formal audit. Althoughaccounting for government debt is done by the gov-ernment’s Controller General of Accounts, theaccounts are subject to audit by the Comptroller andAuditor General of Accounts, a constitutional body.The relevant central bank departments are also sub-jected to an internal management audit and concur-rent audit.


All countries surveyed issue a wide range of informa-tion on their debt management objectives, issuanceprocedures, and financial requirements to marketparticipants and the general public, and the level ofdisclosure does not appear to be overly dependent ona country’s state of economic and financial develop-ment. This process has been helped immeasurably bythe introduction of the Internet, which provides avehicle for issuing this information in a cost-effectivemanner to a worldwide audience. However, as notedin Box I.1 for HIPCs, for many developing countries,an important step toward improving transparency intheir debt management activities is obtaining com-plete and reliable data on their debt obligations.Such a step is a necessary precondition to operatingin a manner consistent with the disclosure require-ments of the guidelines.

Institutional Framework

The guidelines in this section address the importanceof sound governance and good management of oper-ational risk. They recommend that the authority toborrow and undertake other transactions related todebt management as well as the organizational frame-work be clear and well specified. To reduce opera-tional risk, they highlight the need for well-articulatedresponsibilities for staff and a system of clear moni-toring and control policies and reporting arrange-ments. They also stress the importance of separatingthe execution of market transactions (front office)from the entering of transactions into the accountingsystems (back office). The development of an accu-rate and comprehensive management informationsystem, a code of conduct, conflict-of-interest guide-

lines, and sound business recovery procedures is alsoencouraged.

Application

Governance

In all of the countries surveyed, the legal authority toborrow in the name of the central government restswith the parliament or congressional legislative body.However, practices differ with respect to the delega-tion of borrowing power from the parliament to debtmanagers. In most of the countries, legislation hasbeen enacted authorizing the ministry (or minister)of finance (or its equivalent) to borrow on behalf ofthe government. In some others, that power has beendelegated 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 the minister of finance seems to bemore of a formality that recognizes country conven-tions regarding the decision making within the gov-ernment than a practical matter.

The mandate to borrow is usually restricted,either by a borrowing limit expressed in net or grossterms or by a clause regarding the purpose of the bor-rowing. Most countries surveyed rely on borrowinglimits (Table I.2) defined in terms of a debt ceiling oran annual borrowing limit. The most common struc-ture is that the parliament sets an annual limit in con-nection with the approval of the fiscal budget, whichthen functions as a means for it to control the bud-get. With the “purpose” clause, the mandate isrestricted to certain borrowing purposes, the mainones being to finance the budget deficit and refi-nance existing obligations. In practice, the parlia-ment has significant control over the debt, even whenthe borrowing is restricted to certain purposes. Themain purpose is always to cover any budget deficit,which the parliament influences when it approves theexpenditures and tax measures contained in the bud-get. If the deficit deviates significantly from the pathprojected in the budget, it is possible for the parlia-ment to intervene, either during the fiscal year or bymodifying the budget for subsequent fiscal years.

Another example of a legislative debt ceiling isthe one used by Poland, a prospective EMU member.


Poland has inserted into its Constitution a require-ment that total government debt, augmented by theamount of anticipated disbursements on guarantees,is not allowed to exceed 60 percent of GDP, the debtlimit stipulated by the Maastricht Treaty. Denmarkand the United States are examples of other coun-tries that also have legislative limits on the stock ofdebt outstanding.

The country with the most open mandate is theUnited Kingdom, where the National Loans Act of1968 permits the Treasury to raise any money that itconsiders expedient for the purpose of promotingsound monetary conditions and in such manner andon such terms and conditions as the Treasury sees fit.However, the U.K. Parliament has an indirect influ-ence on the size of the deficit, and hence the debtlevel, in that it approves tax rates and the govern-ment’s spending plans. Moreover, in the current fis-cal policy framework, the government has the statedobjective to limit net debt to a maximum of 40 per-cent of GDP.

Delegation of debt management authority fromthe council of ministers or the ministry of finance tothe unit responsible for the debt management is usu-ally stipulated in the form of either a governmentalordinance or a power of attorney. However, mostcountries surveyed ensure that the government orthe ministry retains the power to decide on the debtmanagement strategy, normally after considering aproposal from the debt managers. Most countries,especially those with a separate debt agency, haveadopted formal guidelines for that purpose. At theoutreach conference, it was noted that it is importantto ensure that decision makers are fully informedabout the consequences of their chosen debt man-agement strategy. In one country, the failure to do soleft its debt managers exposed to criticism when thedebt strategy did not achieve the expected results. Inaddition, some other countries admitted that in thepast, the lack of clear objectives and weak governancearrangements led to political pressure on them tofocus on achieving short-term debt-service cost sav-ings at the expense of leaving the debt portfolioexposed to the risk of higher debt-service costs in thefuture. In one country, this also led to an awkward sit-uation where political interference in the timing ofdebt issues forced the debt managers to raise a sig-

nificant amount of the annual borrowing require-ment toward the end of the fiscal year, after it becameapparent that interest rates were not going to evolveas expected.

The details contained in these guidelines differacross countries. In Sweden, for example, the guide-lines are set each year by the Council of Ministers,and they specify targets for the amount of foreigncurrency debt, inflation-linked debt, and nominaldomestic currency debt. They also indicate the gov-ernment’s preferred average duration for total nomi-nal debt, the maturity profile of the total debt, andrules for the evaluation of the debt management. InPortugal, which also has a separate debt agency, theguidelines are determined by three different deci-sions. First, the Minister of Finance sets long-termbenchmarks for the composition of the debt portfo-lio. These reflect selected targets concerning theduration, currency risk, and refinancing risk, andthey are used to evaluate the cost and performance ofthe debt portfolio. Second, the government (Councilof Ministers) specifies annually which debt instru-ments are to be used and their respective gross bor-rowing limits. Finally, the Minister of Financeannually approves guidelines for specific operations,such as buybacks; repos; the issuing strategy in termsof instruments, maturities, timing, and placementprocedures; measures regarding the marketing of thedebt; and the relationship with the primary dealersand other financial intermediaries.

The case studies reveal a clear trend toward cen-tralizing public debt management functions. Mostcountries have placed them in the ministry of finance.For example, as mentioned previously, Jamaica cen-tralized the core debt management functions in theDebt Management Unit of the Ministry of Financeand Planning in 1998. Before then, they had beendivided between the ministry and the central bank. Inthe same year, Poland also centralized its domesticand foreign debt management in the Public DebtDepartment of the Ministry of Finance. Brazil plans tocentralize all aspects of debt management within theTreasury in September 2003; the central bank cur-rently handles the front office activities associatedwith international capital market borrowings, anddomestic debt management is handled by theTreasury. Four countries (Ireland, Portugal, Sweden,


and the United Kingdom) have located their debtagencies outside the Ministry of Finance in that theseagencies are from an organizational point of view notdirectly part of the ministry (Table I.2). These agen-cies also have some independence regarding staffingpolicies, and they are physically located in offices out-side the ministry. However, they report to and theiractivities are evaluated by the Council of Ministers orthe Ministry of Finance. For example, Portugal con-solidated its debt management functions into a sepa-rate debt agency in 1997. Before then, this activity hadbeen split between the Treasury Department (exter-nal debt and treasury bills) and the Public CreditDepartment (domestic debt, excluding the treasurybills). In two countries (Denmark and India), the debtmanagement unit is located in the central bank. InDenmark’s case, this reflects a consolidation of activi-ties that had previously been split between the min-istry and the central bank. In India, the central bankmanages domestic debt, and the Ministry of Financehas responsibility for external debt.

All countries with a debt management unit in theministry of finance, except Slovenia, use the centralbank to conduct auctions in the domestic debt mar-ket. This stands in contrast to those with separatedebt agencies, where all market contacts, includingthe conduct of auctions, are handled by the agency.In Sweden, even the acquisition of foreign currenciesin the market needed to service the external debt hasbeen shifted to the debt agency from the centralbank, starting in July 2002.

The rationale behind the different organiza-tional structures differs across countries. For exam-ple, although the United Kingdom and Denmarkboth delegate the management of foreign currencydebt and foreign exchange reserves to the centralbank, they have taken different approaches in themanagement of domestic debt. The UnitedKingdom, which shifted domestic debt managementfrom the central bank to a debt agency in 1998,believes it is important to have separate objectives formonetary policy and domestic debt management tomitigate any perception that the debt managementmight benefit from inside knowledge over the futurepath of interest rates. Denmark, which moved debtmanagement functions from the Ministry of Financeto the central bank in 1991, has in place strict fund-

ing rules between debt management and monetarypolicy, and found that the move to the central bankhas helped to centralize the retention of knowledgeof most aspects of financial markets within a singleauthority. Moreover, because Danish interest rates arelargely determined by interest rate developments inthe euro area, the involvement of the Danish centralbank in domestic debt management is unlikely togenerate a perception that domestic debt manage-ment benefits from inside information on the futurepath of interest rates.

Ireland and Portugal, which both created sepa-rate debt agencies (in 1990 and 1996, respectively),highlighted the need to attract and retain staff withthe relevant skills and centralize all debt manage-ment functions in one unit. Sweden, whose separatedebt agency was founded in 1789, notes the historicalreason and that the system provides a clear distribu-tion of responsibilities between the parties con-cerned. However, it also reflects a long-standingtradition in Sweden of working with small ministriesresponsible for policy decisions and delegating oper-ational functions to agencies that have separate man-agement teams and are at arm’s length from theministries.

Poland placed debt management activities in thepublic debt department of the Ministry of Finance onthe grounds that at the very early stage of develop-ment of its domestic financial market, when the tran-sition to the free market economy had just begun,that department had more instruments to supportdevelopment of the market, cooperate with otherregulatory institutions, and prepare an efficient legaland infrastructure environment. New Zealand, whichalso chose to set up a unit within the Ministry ofFinance (the New Zealand Debt Management Office[NZDMO]) instead of a separate debt agency, sug-gested that important linkages would otherwise belost. In addition to debt-servicing forecasts for thebudget and other fiscal releases, the NZDMO pro-vides a range of capital markets advice to other sec-tions of Treasury.

The role of the parliament or congress in themanagement of the debt, apart from delegating itsborrowing power, differs among the countries. InSweden, for example, the Parliament has stated theobjective of the central government debt manage-


ment in an act, and the Council of Ministers isobliged to send an annual report to the Parliamentevaluating the management of the debt. In Mexico,the Congress approves the annual limit for net exter-nal and domestic borrowing as well as the debt strat-egy; the latter is scrutinized closely, because debtmanagement issues have been a contributing factorto past financial crises in Mexico. At the end of theyear, the Mexican Congress also (through its auditingorganization) reviews the accounts and other specifictopics that are of interest to its members. In Irelandand the United Kingdom, the chief executive of thedebt agency reports directly to the Parliament in thepresentation of the accounts.

Management of internal operations

Fifteen countries have separate front and back officesfor the management of the debt (Table I.2). Twelvecountries, including all of the countries that activelytrade to profit from expected movements in interestrates or exchange rates, have a separate middleoffice, too (Table I.2). From an operational risk pointof view, it is useful to have a separate middle office ina debt unit where many transactions are being con-ducted regularly. Its main functions are to ensure thatall transactions done by the front office are withinpredetermined risk limits, assess the performance(where relevant) of the front office’s trading againsta strategic benchmark portfolio, set proper opera-tional procedures and ensure that they are followed,and, in some countries, play a leading role in thedevelopment of the debt management strategy.

Most of the surveyed countries have code-of-con-duct and conflict-of-interest guidelines for the debtmanagement staff and business recovery proceduresin place (Table I.2). Brazil has also created an Ethicsand Professional Conduct Committee.

Some countries, such as Ireland, New Zealand,Portugal, Sweden, and the United Kingdom, haveboards that provide external input on specific areasof expertise. In Ireland, the board assists and advisesthe National Treasury Management Agency (NTMA)(the Irish debt agency) on matters referred to it bythe NTMA. In New Zealand, the board has a qualityassurance role. It oversees the NZDMO’s activities,the risk management framework, and the business

plan, and reports directly to the Secretary of theTreasury. In Portugal, it plays an advisory role onstrategic matters. Sweden has a decision-makingboard, chaired by the Director General of the SNDO.Of the external members, four are members ofParliament and the other three have professionalexperience as economists. In the United Kingdom,the board advises the DMO’s senior management onstrategic, operational, and management issues, butonly in an advisory capacity because it has no formaldecision-making role.

Many debt managers noted that they are con-fronted with significant challenges in attracting andretaining staff because of intense competition forsuch staff from the private sector. As described above,in some cases, this has been one of the driving forcesbehind the transfer of the debt management func-tion from the ministry of finance to either the centralbank or to a separate debt agency. To alleviate thisproblem, many countries have sought to offer theirstaff challenging and interesting tasks, good training,and further education. Brazil, for instance, offers agraduate course in debt management. Slovenia alsosupports postgraduate education through time-offallowances and payment of tuition fees.

In all of the cases where management informa-tion systems were discussed (Colombia, Denmark,Ireland, Morocco, New Zealand, and Portugal),countries have experimented with differentapproaches. Some have developed their own systems,and others purchased off-the-shelf systems and cus-tomized them to meet their particular needs. Forexample, New Zealand relied on its own internallydeveloped system until the mid-1990s, when itacquired a commercial system. However, significantcustomization was required, and work on it has con-tinued over the years to meet the NZDMO’s evolvingrequirements.

Portugal provides an example of a strategy toreduce operational risk. When the Portuguese debtagency was created, an analysis of operational risk ledto the adoption of an organizational structure basedon the financial industry standard of front, middle,and back office areas with clearly segregated func-tions and responsibilities. It has since been a focus ofattention by means of three main initiatives, namely asignificant investment in information technology


(IT) (including the purchase of a management infor-mation system), followed by the development of amanual of internal operating procedures, and finallyattracting and retaining specialized expertise. In thefuture, these measures will be supplemented with aninternal auditing function to complement the exter-nal auditing that is already done by the Audit Court.


The case studies show that only four countries(Ireland, Portugal, Sweden, and the UnitedKingdom), all highly developed and with well-func-tioning domestic capital markets, have created sepa-rate debt agencies for the management of the centralgovernment debt. However, in other countries, thereare ongoing discussions about the merits of such anagency. One argument, which is often mentioned infavor of a separate agency, is that it provides for morefocused debt management policy, in part becausethere is a top management whose main responsibilityis debt management, not fiscal or monetary policy,and thus has the time to focus on debt managementissues. When debt management is part of the ministryof finance or central bank, there is a risk that debtmanagement policy could be a secondary considera-tion. This focus fosters professionalism and gives debtmanagement staff attention from top management,which together with competitive salaries, makes it eas-ier to hire and retain skilled staff. However, as notedby some countries at the outreach conference, if onegoes down this path, the introduction of a separatedebt agency should be accompanied by strong inter-nal governance, accountability, and transparencymechanisms to ensure that the agency performs asexpected and is held accountable for decisions withinits remit.

This is not to say that every country should havea separate debt agency. A common argument forplacing the debt office in the ministry of finance isthe importance of maintaining key linkages to otherparts of the government, such as budget and fiscalpolicy. Especially in countries with less developedfinancial markets, coordination of debt managementpolicy with that of fiscal and monetary policy is ofsuch importance that centralization of responsibili-ties either in the ministry of finance or the central

bank often makes sense. Moreover, even when sepa-rate, the debt agency always reports to the council ofministers (cabinet) or ministry of finance, whichdecides on the debt management strategy and evalu-ates the work of the debt agency. To fulfill theseduties, the ministry of Finance may also find it advan-tageous to have some staff skilled in debt manage-ment.

The role of the parliament or congress differsamong the countries, partly because of historical rea-sons. However, if the legislature is the political bodythat approves tax and spending measures, which isnormally the case, one could argue that it should alsoapprove overall borrowing by the government as wellas broad debt management policy issues, such as debtlimits and the objectives for managing debt, giventhat the management of debt ultimately has signifi-cant repercussions for future tax and spending levels.Within these limits and policy objectives, the councilof ministers and debt managers should have suffi-cient authority to implement the approved policies asthey deem appropriate, subject to being heldaccountable for their actions by the legislature.

Debt Management Strategy

The guidelines in this section stress the importanceof monitoring and assessing the risks in the debtstructure, and they recommend that the financialand other risk characteristics of the government’scash flows be considered when setting the desireddebt structure. In particular, the debt managershould carefully assess and manage the risks associ-ated with foreign currency and short-term or floating-rate debt, and ensure there is sufficient access to cashto avoid the risk of not being able to honor financialobligations when they fall due.

Application

Debt managers’ risk awareness is high, and most haveformal guidelines for managing market and creditrisk (see Table I.2). However, the risks that countriesfocus on vary depending on country-specific circum-stances. For example, Colombia aims to limit theexposure of its foreign currency debt portfolio to


market shocks and international crises, whereas Italyconcentrates its efforts on reducing both interest raterisk and rollover risk after having experienced gov-ernment indebtedness levels that reached 124 per-cent of GDP in 1994. Recent financial crises in LatinAmerica and Russia have shown that the manage-ment of rollover risk is an especially important taskfor many developing and emerging market countries.An inability to roll over debt when markets are tur-bulent can severely compound the effects of eco-nomic and financial shocks.

The cases also show a trend toward using an ALMframework, at least conceptually, to assess the risksand cost of the debt portfolio by evaluating the extentto which debt-service costs are correlated with gov-ernment revenues and noninterest expenditures.6

One issue that arises is how to measure cost/risk. InPortugal, for example, one of the objectives, stated inthe Portuguese Public Debt Law, is to ensure a bal-anced distribution of debt costs over several years.Against that background and with the focus on bud-get volatility, the Portuguese debt agency has found ituseful to measure market risk on a cash-flow basis.However, it is still working on the development andimplementation of an integrated budget-at-risk(BaR) indicator for the debt portfolio. In Sweden,the SNDO is using a cost-to-GDP ratio in its analysis ofthe costs for different debt portfolios. This is a step inthe direction of ALM because the assumption here isthat the budget balance covaries with GDP via bothtax and expenditure channels. A debt portfolio witha relatively stable cost-to-GDP ratio will thus con-tribute to deficit (tax) smoothing.

Some countries also explicitly incorporate spe-cific government assets and liabilities (such as foreignexchange reserves and contingent liabilities) into anoverall risk management framework. Countries usingthis approach, or which have started to look at it, areBrazil, Denmark, New Zealand, and the UnitedKingdom. They have found, for example, that usageof such a framework highlights the benefits of coor-dinating the maturity and currency composition offoreign currency debt issued by the government withthat of the foreign exchange reserves held by eitherthe government or the central bank so as to hedgethe government’s exposure to interest rate andexchange rate risk. Indeed, in the United Kingdom,

foreign exchange reserves and foreign currency bor-rowings are managed together by the Bank ofEngland using an ALM framework.

The debt management section of the Danish cen-tral bank also manages the assets of the SocialPension Fund. In managing interest rate risk, it inte-grates assets and liabilities and monitors the durationof the net debt. As a result, a reduction in the dura-tion of net debt can be achieved by raising the dura-tion of the asset portfolio. New Zealand, which hasbeen using the ALM approach for more than adecade, created an Asset and Liability ManagementBranch in the Treasury in 1997, of which the NZDMOconstitutes one part. The ALM strategy is implicitlyincorporated into the NZDMO’s strategic objective tomaximize the long-term economic return on the gov-ernment’s financial assets and debt in the context ofthe government’s fiscal strategy, particularly its aver-sion to risk. The objective has regard to both the bal-ance sheet and fiscal implications of the debt strategy.Going forward, debt strategy in New Zealand is likelyto be influenced by an analysis that is under way inthe Treasury and aimed at understanding the finan-cial risks that exist throughout the government’soperations, and how its balance sheet is likely tochange through time.

Debt management strategies, such as the selec-tion of debt maturities and the choice between rais-ing funds in domestic or foreign currencies, dependto a large degree on the special circumstances in thecountries, such as the characteristics of the debt port-folio, the vulnerability of the economy to economicand financial shocks, and the stage of development ofthe domestic debt market. Brazil, for example, whichbefore the Asian financial crisis sought to lengthenthe average term-to-maturity of its debt by issuinglonger fixed-rate securities, switched in October 1997to floating-rate and inflation-indexed securities toachieve a quicker reduction in rollover risk. At thattime, investors were more willing to invest for thelonger term if the securities in question carried float-ing-rate or inflation-indexed coupons than if theywere fixed for the tenor of the instrument. However,the reduction in rollover risk came at the expense ofmaking Brazil’s debt dynamics more sensitive tochanges in interest rates. Before the onset of finan-cial market turbulence in 2002, it also sought to


reduce its vulnerability to interest rate fluctuations byextending the domestic yield curve and building upcash reserves.

Mexico’s experience underlines the need forsound macroeconomic policies, fiscal discipline, anda prudent and consistent debt management policy. Inthe wake of the 1994–95 financial crisis, when its pub-lic finances were undermined by excessive relianceon short-term, foreign currency–linked debt, the gov-ernment has been actively promoting the develop-ment of the domestic debt markets by introducingnew instruments and making the necessary regula-tory adjustments to reduce its dependence on short-term domestic debt and foreign currency (andforeign currency–linked) debt. Today, Mexico’s debtmanagement strategy aims to reduce rollover, interestrate, and exchange rate risks by issuing a combina-tion of domestic currency, medium-term, floating-rate notes and medium- to long-term fixed-rateinstruments. The issuance of the floating-rate debthelps to reduce rollover risk. Over time, the issuanceof domestic currency fixed-rate instruments atincreasingly longer tenors should reduce rollover riskfurther and, at the same time, lower interest rate andexchange rate risk.

In Morocco, debt managers have sought toreduce debt-service costs of the external debt by exer-cising debt-equity swap options, triggering cancella-tion and prepayment rights to retire onerous debt,and by refinancing or revising interest rates as per-mitted by the loan agreements. They also have a pol-icy of promoting the development of the domesticdebt market so that more financing needs can be metin domestic currency.

Turning now to the most developed countries,the United States, for example, has sought to mini-mize debt-service costs over time by championing adeep and liquid market for U.S. Treasury securities.This has involved taking steps to ensure that treasurysecurities maintain their consistency and predictabil-ity in the financing program, issuing across the yieldcurve to appeal to the broadest range of investors,and aggregating all the financing needs of the centralgovernment into one debt program. Portugal, a par-ticipant in the euro area, has a strategy of building agovernment yield curve of liquid bonds (at least 5billion outstanding for each series) along different

maturity points. Since 1999, every year the priorityhas been to launch a new 10-year issue and, second,to launch a new 5-year issue. As part of this strategy,priority has been given to the development of effi-cient primary and secondary treasury debt markets.At the highest level, New Zealand’s strategy regardingdomestic debt management is to be transparent andpredictable. The NZDMO maintains a mix of fixed-and floating-rate debt and a relatively even maturityprofile for debt across the yield curve. It has takensteps to develop the market for domestic governmentsecurities, including a derivatives market, which thecommitment to transparency, predictability, andevenhandedness supports.

Participation in European Exchange RateMechanism II (ERM II) for Denmark and prospectiveEMU membership for Slovenia are important factorsin managing the exchange rate risk of debt issued bythese countries. Since 2001, all of Denmark’s foreigncurrency exposure is in euros. In Slovenia, more than90 percent of its foreign currency exposure is in euro.Slovenia also issues euro-denominated bonds in itsdomestic market to support the pricing of long-terminstruments issued by other Slovenian borrowers.

Although all countries pay close attention to thecost/risk trade-off, some countries with stablemacroeconomic conditions, strong fiscal positions,and well-developed domestic debt markets are in abetter position than others to pursue cost savings atthe expense of some increase in the riskiness of thedebt. Sweden, for instance, has decided to have a 2.7-year duration target for its nominal debt, andDenmark has shortened the duration of its debt from4.4 years at the end of 1998 to 3.4 years at the end of2001. In both countries, these actions reflect, first, asignificant decline in their debt loads in recent years;second, a view that debt-service cost savings can berealized over time in an upward-sloping yield curveenvironment; and third, a view that these countriesare generally well insulated from economic andfinancial shocks because of their strong macroeco-nomic policy frameworks.

The benefit of having well-functioning domesticcurrency markets is also shown in cash management.Most of the countries hold cash balances so that theycan honor their financial obligations on time, evenwhen their ability to raise funds in the market is tem-


porarily curtailed or very costly. However, Sweden issufficiently secure in its ability to access markets atany time that it has opted not to hold cash balances,but instead rely completely on its ability to raise fundsin the market. To do that, it is also important to havecomplete control over the government cash flows, sothat the timing of these flows can be managedaccordingly.

As will be discussed in more detail below, almostall the surveyed countries are building up, or plan tobuild up, liquid benchmark securities in their domes-tic currency markets (Table I.2). The most commonmethods used to reduce the rollover risk associatedwith large benchmark securities are buyback or bond-switching operations near the maturity dates.

Countries typically adjust the financial character-istics of their debt portfolios by adjusting the mix ofsecurities issued in their borrowing programs or byrepurchasing securities before they mature andreplacing them with new ones that better reflect itscost/risk preferences. In addition, as indicated inTable I.2, half of the countries use financial deriva-tives, mainly interest rate swaps and cross-currencyswaps, to separate funding decisions from portfoliomanagement decisions and adjust the risk character-istics of their debt portfolios. However, this is not anoption available to all countries. Those with under-developed domestic markets may not have access todomestic derivatives markets, and those with weakcredit ratings may not be able to access global deriva-tives markets at a reasonable cost. Moreover, there isa need for careful management of the counter-partyrisks associated with derivatives transactions.Denmark, New Zealand, and Sweden, for example,noted that they use credit exposure limits and collat-eral agreements to reduce the credit (counter-party)risks associated with these transactions.


The debt management strategies pursued by coun-tries generally reflect their particular circumstancesand their own analysis of the risks associated withtheir debt portfolios. Thus, it is not surprising thatthe strategies pursued differ considerably acrosscountries. However, one element that seems to becommon across all countries, regardless of their stage

of development, is the focus on developing or main-taining the efficiency of the domestic debt market asa means of reducing excessive reliance on short-termand foreign currency-linked debt. Another aspectworthy of note is the move toward using an ALMframework to assess the risks and costs of debt anddetermine an appropriate debt structure.

Particularly for developing and emerging marketcountries, the level of the debt and the soundness ofthe macroeconomic policies are important con-straints on the amount of discretion that countrieshave in setting and pursuing their debt managementstrategies. Regarding the debt level, decisive factorsare the central government’s capacity to generate taxrevenues and savings, as well as its sensitivity to exter-nal shocks.

Risk Management Framework

The guidelines in this section recommend that aframework should be developed to enable debt man-agers to identify and manage the trade-offs betweenexpected costs and risks in the government debt port-folio. They also argue in favor of stress tests of thedebt portfolio as part of the risk assessment, and thatthe debt manager should consider the impact of con-tingent liabilities. In addition, they discuss the impor-tance of managing the risks of taking marketpositions.

Application

The framework used to trade off expected costs andrisks in the debt portfolio differs across countries.Most seem to use rather simple models, based ondeterministic scenarios, and judgment. However, newrisk models are under development in many coun-tries. Only a few (Brazil, Denmark, Colombia, NewZealand, and Sweden) use stochastic simulations. Forexample, New Zealand developed a stochastic simu-lation model to improve its understanding of thetrade-off between the cost/risk associated with differ-ent domestic debt portfolio structures. Most coun-tries also use stress testing as a means to assess themarket risks in the debt portfolio and the robustnessof different issuance strategies. Stress testing is par-


ticularly important for the assessment of debt sus-tainability.

Consistent with the ALM framework discussedabove, most countries measure cost on a cash-flowbasis over the medium to long term. This facilitatesan analysis of debt in terms of its budget impact. Riskis typically measured in terms of the potentialincrease in costs resulting from financial and othershocks. Some countries, such as Brazil, Portugal, andSweden, are experimenting with measures such ascost-to-GDP or concepts such as BaR to reflect theexplicit incorporation of a joint analysis of debt andGDP or budget flows to shocks.

Four countries (Brazil, Colombia, Denmark, andNew Zealand) use “at-risk” models to quantify themarket risks. For example, Colombia uses a debt-ser-vice-at-risk (DsaR) model to quantify the maximumdebt-service cost of the debt portfolio with 95 percentlikelihood. The methodology takes into considera-tion the exposure to different market variables, suchas interest rates, exchange rates, and commodityprices (24.5 percent of the debt is price indexed). Formanaging the cost/risk dimensions of the debt port-folio, the middle office presents a monthly report offunding alternatives based on DsaR analysis. Thisreport compares the cost of the expected scenariowith the 95 percent risk scenario for each of the dif-ferent funding alternatives. Denmark uses a cost-at-risk (CaR) model to quantify the interest rate risk bysimulation of multiple interest scenarios. The modelanalyzes different strategies, such as the issuing strat-egy, the amount of buybacks, and the duration target.

Scope for active management

Among the countries in this survey, only Ireland, NewZealand, Portugal, and Sweden actively manage theirdebt portfolios to profit from expected movements ininterest rates and exchange rates. New Zealand andSweden limit the positions taken to the foreign cur-rency portfolios, but Ireland and Portugal, being rel-atively small players in the euro area, are prepared totrade the euro segment of their debt. The argumentsfor position taking vary, and it is worth noting thatthese countries have centralized their debt manage-ment activities outside the central bank. It might bedifficult for debt managers in the central bank to take

active positions in the market because of concernsthat such actions may be seen to convey signals withrespect to other policies that affect financial markets.New Zealand argues that temporary pricing imper-fections sometimes occur, making it possible to gen-erate profit from tactical trading. In addition, itbelieves that tactical trading helps to build debt man-agers’ understanding of how various markets operateunder a variety of circumstances, which improves theNZDMO’s management of the overall portfolio. Forexample, it suggested that tactical trading enables itto develop and maintain skills in analysis, decisionmaking under uncertainty, deal negotiations, anddeal closure. The immediate benefit is a reduced riskof mistakes when transacting and the projection of amore professional image to counter-parties. However,it is important to make sure that tactical trading activ-ities are properly controlled. At the outreach confer-ence, it was noted that one country had used swaps tospeculate on an expected convergence in Europeaninterest rates in the early 1990s. This strategy led tolosses when the European Exchange RateMechanism broke down in the autumn of 1992.

To mitigate the market risk associated with thetactical trading, New Zealand uses both value-at-risk(VaR) and stop-loss limits, the determination ofwhich is aided by stress tests of the portfolio. The VaRis measured at a 95 percent confidence level relativeto notional benchmark portfolios or subportfolios,which embody the approved strategy. Trading perfor-mance is measured on a risk-adjusted basis, using anotional risk capital for market, credit, and opera-tional risk use. The risk-adjusted performance returnis defined as the net value added divided by thenotional risk capital.

Even if only a few countries are actively takingpositions in the market, most of them do try to takeadvantage of pricing anomalies in the market. Themost common approach is to buy back illiquid bondissues, financed through new issues in liquid bench-mark securities. Another similar method, noted byMorocco, is to refinance onerous bank loans by exer-cising prepayment rights in the loan agreements andrefinancing the prepayments through new loans withmore favorable terms. Other examples include usingthe swap market to achieve lower borrowing costs.Ireland, for example, obtains cheaper short-term


domestic currency funding by issuing commercialpaper denominated in U.S. dollars and swapping theproceeds into euros, instead of raising euro-denomi-nated funds.

Contingent liabilities

Most of the case studies did not comment on themanagement of contingent liabilities.7 Among thecountries that did, only Colombia, Morocco, NewZealand, and Sweden seem to have an organizationalstructure within the debt management unit or min-istry of finance that facilitates the coordination of themanagement of explicit financial guarantees with themanagement of the debt. Such coordination is essen-tial, because government guarantees have been sig-nificant contributors to the public debt burden inmany developing and transition economies. At theoutreach conference, some countries noted that thelevel of these guarantees is typically determined else-where in the government, and their contingentnature makes them very difficult to quantify.However, others argued that although their valuationis difficult, they should not be ignored. Consequently,they recommended that these guarantees be borne inmind when setting debt strategy, especially when con-ducting stress tests of prospective strategies.

None of the countries surveyed appear to involvedebt managers in the management of implicit contin-gent liabilities. The latter finding is not too surprising,because these claims often arise in response to weak-nesses in prudential supervision and regulation—areas that are usually outside the scope of debtmanagement. Nonetheless, these claims can posemajor risks for governments, as evidenced by the costsimposed on several countries in Asia and LatinAmerica in the 1990s, when governments were forcedto recapitalize failed banking systems. Thus, they needto be judged in conjunction with other macroeco-nomic risk factors. Similarly, national governments inArgentina and Brazil found themselves unexpectedlytaking on significant liabilities when they had toassume the liabilities of subnational governments thathad borrowed excessively. In Brazil’s case, controlshave since been placed on subnational governmentborrowings, and these governments are repaying the

amounts refinanced by the national government. Asnoted previously, the latter issue has led countriessuch as Brazil and Colombia to set limits on subna-tional government borrowing, and others regularlymonitor these borrowings and ensure that the subna-tional governments in question have independentsources of revenue to service their obligations.


Most of the countries in the case studies rely onfairly simple models to assess the trade-offs betweenexpected costs and risks in the debt portfolios. Somecountries may lack enough data needed to run morecomplicated models. It is also important to bear inmind that the usefulness of all models depends to alarge degree on the quality of the data used asinputs and the assumptions that underpin themodel. The latter may behave differently in extremesituations, can change over time, and can be influ-enced by policy responses. Thus, the parametersand assumptions underpinning these models shouldbe regularly reviewed, and it is important to beaware of the limitations and underlying assumptionsof the model. These should be carefully describedand understood when results are applied in thedecision-making process.

Developing and Maintaining an EfficientMarket for Government Securities

Most of the guidelines in this section focus on thebenefits of governments raising funds using market-based mechanisms in a transparent and predictablefashion, and the merits of a broad investor base fortheir obligations. Others discuss the benefits of gov-ernments and central banks working with marketparticipants to promote the development ofresilient secondary markets and the need for soundclearing and settlement systems to handle transac-tions involving government securities. Further infor-mation on the steps that countries can take todevelop a domestic government debt market can befound in a handbook published by the World Bankand the IMF in 2001.8


Application

Primary market

Most of the countries surveyed use similar techniquesfor issuing government securities in the domesticmarket in that all of them except Denmark use pre-announced auctions to issue debt. Most also use mul-tiple-price auction formats for conventional securitiesand, in some cases, uniform-price formats to issueinflation-indexed instruments, although the U.S.Treasury now issues all of its securities using uniform-price auctions. It shifted away from multiple-priceauctions after evidence showed that the range of suc-cessful bidders tended to be broader in uniform-priceauctions, and that bidders tend to bid more aggres-sively as a result of a reduction in the so-called win-ner’s curse (the risk that a successful bidder will paymore than the common market value of the securityin the postauction secondary market).

The advent of the euro has led to significantchanges in the debt management practices of somesmaller EMU members. For example, Portugal nowuses syndications to launch the first tranche of eachnew bond, because this tranche corresponds toaround 40 percent of the targeted final amount to beissued. It believes that as a small player in the eurogovernment bond market, syndications help it toachieve more control over the issue price and help tofoster a broader diversification of the investor base.Auctions are then used for future issues of the samesecurity.

When borrowing in foreign markets, most coun-tries rely on underwriting syndicates to help themprice and place securities with foreign investors,because these borrowings are usually not undertakenin sufficient volume or on a regular enough basis towarrant the use of an auction technique. However,some countries, such as Sweden and the UnitedKingdom, have found it more cost-effective to sepa-rate funding decisions from portfolio decisions byusing financial derivatives and raise foreign currencyfunds by issuing more domestic currency debt andswapping it into foreign currency obligations—atechnique that has the added benefit of helping tomaintain large issuance volumes in domestic markets

when domestic borrowing requirements are modest.The largest industrial countries—the United Statesand Japan—have a long-standing policy of issuingonly domestic currency–denominated securities intheir domestic markets and avoid raising funds off-shore. Potential EMU members, such as Poland andSlovenia, and the ERM II participant, Denmark, pre-fer to issue euro-denominated securities when raisingexternal financing, because these would ultimatelybecome domestic currency instruments if they jointhe EMU.

Most countries have taken steps to increase thetransparency of the auction process in the domesticmarket to reduce the amount of uncertainty in theprimary market and achieve lower borrowing costs.Almost all countries preannounce their borrowingplans and auction schedules (Table I.2) so thatprospective investors can adjust their portfoliosahead of time to make room for new issues of gov-ernment securities, and the rules and regulations gov-erning the auctions and the roles and responsibilitiesof primary dealers are publicly disclosed so that mar-ket participants fully understand the rules of thegame. For example, in Brazil and Poland, the basicrules for treasury bills and bond issuance are coveredby ordinances issued by the minister of finance, andthe details of specific issues are described in Lettersof Issue published on the ministry’s web site. Dates ofauctions are announced at the beginning of eachyear in Poland and monthly in Brazil, and a calendaris maintained on the ministry’s web site. Two daysbefore the tender in Poland, detailed information onthe forthcoming auction is made available on the website and through Reuters.

Auction processes are also becoming more effi-cient as countries automate their auction processesand explore the possibility of using the Internet toissue securities. For example, Ireland and Portugalconduct their auctions using the electronicBloomberg auction system, which has reduced thelag between the close of bidding to the release of auc-tion results to less than 15 minutes. Among emergingmarket and developing countries, India and Jamaicahave moved to introduce electronic bidding in theirdebt auctions, and Brazil, besides using electronicbidding in its debt auctions since September 1996,


began issuing securities to small investors over theInternet in January 2002.

Countries are also taking steps to remove regula-tions that have created captive investor classes anddistorted auction outcomes, and only one countryreported limits on foreign participation in auctions(Table I.2). Such regulations have been a particularproblem in many emerging market and developingcountries, especially where prudential regulationsrequired some institutions to hold a prescribed por-tion of their assets in government securities. As aresult, Morocco and South Africa, for example, tooksteps to gradually remove these requirements andbroaden the base of investors that hold governmentsecurities. Although the removal of these require-ments may result in interest rates moving up in theshort run to market-clearing levels, the ensuingbroadening of the investor base should bring about adeeper and more liquid domestic market for govern-ment securities. This should result in debt-servicecost savings over time as the government is betterpositioned to implement its preferred debt structure.

One issue of debate is over the merits of using pri-mary dealers to support the issuance of securities inthe domestic market.9 According to Table I.2, 13countries surveyed have introduced primary dealersystems on the grounds that these institutions help toensure that auctions are well bid, that there is a regu-lar source of liquidity for the secondary market, andthey have found that primary dealers can be a usefulsource of information for debt managers on marketdevelopments and debt management policy issues.Moreover, at the outreach conference, some countriessuggested that a primary dealer system offering spe-cial privileges can help to encourage market partici-pants to play a role in the development of the marketas a whole, especially when the market is at an earlystage of development. However, there are severalindustrial countries—Denmark, Japan, and NewZealand—that have not found it necessary to intro-duce a primary dealer system. Indeed, at the outreachconference, one country noted that its borrowingcosts declined significantly after it abolished its pri-mary dealer system. Similarly, some developing andemerging market countries have questioned the ben-efits of introducing primary dealer systems becausetheir markets are too small, and the number of mar-

ket participants too few, to warrant such a system.Thus, they have been prepared to let the secondarymarket participants themselves determine which ofthem can profit from playing the role of marketmaker in the secondary market. Moreover, somecountries that have primary dealer systems, such asthe United States, do not restrict access to the auc-tions to primary dealers, but also allow other marketparticipants to bid, provided they have a paymentmechanism in place to facilitate settlement of theirauction obligations. Consequently, each countryneeds to evaluate its own situation in decidingwhether the potential benefits of a primary dealer sys-tem outweigh the costs. The trade-off will likelydepend on the state of financial market development,and some countries may not need to offer special priv-ileges to encourage market participants to take thelead in developing the market.

To foster deep and liquid markets for their secu-rities, most governments have taken steps to mini-mize the fragmentation of their debt stock. Sixteencountries reported that they strive to build a limitednumber of benchmark securities at key points alongthe yield curve (Table I.2). They generally use a mix-ture of conventional treasury bills and coupon-bear-ing bonds that are devoid of embedded optionfeatures. These benchmark securities are typicallyconstructed by issuing the same security over thecourse of several auctions (“reopenings”) and, insome cases, by repurchasing older issues before matu-rity that are no longer actively traded in the market.Extending the yield curve for fixed-rate instrumentsbeyond a limited number of short-term tenors hasposed a major challenge for countries that have hada history of weak macroeconomic policy settings.Consequently, Brazil, Colombia, Jamaica, andMexico, for example, have sought to extend thematurity of their debt by initially offering securitiesthat are indexed to inflation or an exchange rateuntil such time as they can develop investor interestin longer-term fixed-rate securities.

Despite the desire to minimize the fragmentationof the debt stock, some industrial countries plusSouth Africa have been working hard to develop amarket for government securities that are indexed toinflation. In contrast to emerging market and devel-oping countries, where such instruments are thought


to be a useful device for extending the yield curve,the attraction of these instruments for industrialcountries and South Africa is that they have enabledsome of them to reduce borrowing costs by avoidingthe need to compensate investors for the inflationuncertainty premium that is thought to exist in nom-inal bond yields. This was especially true when theseprograms were first launched, because, in manycases, the spread between nominal and inflation-indexed yields at that time (an indicator of the mar-ket’s expectations for future inflation) tended to beabove the central bank’s stated inflation objective,even though the inflation-indexed securities were lessliquid than their nominal counterparts. They alsohelp to reduce the total risk embedded in the debtstock, because the debt-service costs of inflation-indexed securities are not highly correlated withthose for conventional securities.10 That said, mostcountries have found it difficult to develop a liquidsecondary market for inflation-indexed securities,implying that the yields paid by governments mayinclude a premium to compensate investors for theirlack of liquidity.

In situations where domestic borrowing require-ments are modest or declining over time in responseto fiscal surpluses, debt managers in Brazil, Denmark,Ireland, New Zealand, South Africa, Sweden, theUnited Kingdom, and, to a lesser extent, the UnitedStates have repurchased securities that are no longerbeing actively traded in the market to maximize thesize of new debt issues, and they will often offer toexchange older securities for newly issued bench-mark securities of similar terms-to-maturity. Thishelps to minimize debt-stock fragmentation and con-centrate market liquidity in a small number of secu-rities, thereby helping to ensure that they can still beactively traded even though the total debt outstand-ing may be on the decline. The United Kingdom hasalso sought to maintain new issuance volumes in thebond market in a period of fiscal surpluses by allow-ing its holdings of financial assets to rise temporarilywhen it received an unexpectedly large injection ofcash from the sale of mobile phone licenses. In addi-tion, Denmark, Sweden, and the United Kingdomoffer market participants a facility to borrow tem-porarily or obtain by repo specific securities that arein short supply in the market, albeit at penalty inter-

est rates, to ensure that the government securitiesmarket is not unduly affected by pricing distortions inthe market.

The countries surveyed also maintain an activeinvestor relations program, whereby they meet regu-larly with major market participants to discuss gov-ernment funding requirements and marketdevelopments and examine ways in which the pri-mary market can be improved. Such a program, withappropriate staff and a public presence, has provento be very helpful in assisting countries manage theirdebt in times of stress and in conveying messages onthe government’s economic and financial policies todomestic and foreign creditors. For example, SouthAfrican authorities operate an investor relations pro-gram in which debt management officials conductroad shows to meet investors, primary dealers, andother financial institutions and explain developmentsin the South African market and governmentfinances. Similarly, Japan and Denmark’s investorrelations programs enable debt managers to main-tain regular and close contact with the financial com-munity. This is considered to be an importantchannel in both countries for building investorunderstanding of the government’s financial situa-tion and debt management operations, and the pro-grams are given high priority in these countries’ debtmanagement activities. Market participants in bothcountries are given an opportunity through regularmeetings with debt management officials to discussthe management of the government debt, includingthe potential need for changes to or the introduc-tions of new financial instruments.

In the wake of Argentina’s debt default in 2001,one issue that has emerged is whether governmentdebt instruments should also have renegotiation orcollective action clauses covering the coupon andrepayment terms, such as majority voting rules,attached to them. Indeed, as indicated in itsSeptember 28, 2002, communiqué, the IMFC encour-aged the official community, the private sector, andsovereign debt issuers to continue work on develop-ing collective action clauses and promote their use ininternational sovereign bond issues. According to thedata presented in Table I.2, six countries (Brazil,Denmark, Slovenia, Sweden, Poland, and the UnitedKingdom) have introduced them for some securities


issued in international markets, but none haveattached them to their domestic debt. The ability of acountry to attach collective action clauses to its inter-national debt issues depends on the practice and lawsin the market where the security is issued. For exam-ple, Slovenia and Sweden have attached these clausesto debt issued in the eurobond market, which is gov-erned by British law. However, these clauses are notattached to securities issued in some other markets,such as Germany and the state of New York.

Secondary market

Debt managers in many countries actively work withmarket participants and other stakeholders toimprove the functioning of the secondary market forgovernment securities. For example, authorities inItaly, Poland, Portugal, Sweden, and the UnitedKingdom have introduced primary dealer systemsand have worked closely with market participants topromote electronic trading of government securities.In addition, debt managers in India and Italy haveworked with other interested parties to alleviate dis-tortions caused by the tax treatment of returns ongovernment securities. And those in Japan, NewZealand, South Africa, and the United Kingdom haveworked with market participants to develop ancillarymarkets, such as futures, repo, and strips markets thathelp to deepen the government securities market.

Given the importance of sound clearing and set-tlement systems to the functioning of the governmentsecurities market, it is not surprising to find thatmany debt managers have been working with the rel-evant stakeholders to improve the systems in theircountries. For example, in Brazil, Japan, and Poland,debt managers helped champion the introduction ofreal-time gross settlement for government securitiestransactions. In India, the central bank helped estab-lish a central counter-party for the settlement of out-right and repo transactions in government securities,which is expected to lead to substantial growth intrading activity in these markets. Also, to increase theefficiency of secondary market trading, the Jamaicanauthorities are working with market participants todematerialize government securities within the cen-tral depository.


Although the preceding discussion suggests thatthere are a number of steps that governments cantake to develop the primary and secondary marketsfor their securities, the sequencing of reforms andspeed of deregulation will depend on country-spe-cific circumstances. Nonetheless, the experience ofdeveloping these markets in many countries demon-strates the importance of having a sound macroeco-nomic and fiscal policy framework in place so thatinvestors are willing to hold government securitieswithout fear that their investment returns will beunexpectedly eroded by inflation or debt sustainabil-ity concerns.

Countries seeking to develop their domesticmarkets should also take heed that attempts todevelop a market for government securities acrossthe yield curve may entail some short-term costs forgovernments as debt managers strive to develop aninvestor base for their securities. For example, theyield curve could be very steep as a result of weakmacroeconomic conditions, and, in some situations,the effect on debt sustainability of incurring extradebt-service costs could be very severe, or investorsmay simply be unwilling to purchase this debt. Thus,debt managers need to decide on a case-by-case basiswhether the benefits outweigh the costs. In addition,to ensure a well-functioning market, debt should beissued in a predictable fashion, using standardizedinstruments and practices, so that the issuer’s behav-ior does not disrupt market activity and investors canbecome accustomed to the instruments that aretraded. Of course, situations may arise where it iscostly for the government to honor a commitment orwhere it might be tempting to seek out short-termcost savings by manipulating the outcome of an auc-tion. However, a demonstrated commitment to thedevelopment of the market should, over time, con-tribute to increased market liquidity and lower bor-rowing costs.


Notes

1. Developing a well-functioning domestic financial marketalso helps to improve the conduct of monetary policy. See A.Carare, A. Schaechter, M. Stone, and M. Zelmer, “EstablishingInitial Conditions in Support of Inflation Targeting,” IMFWorking Paper 02/102 (Washington: International MonetaryFund), 2002.

2. Issues surrounding the securities used by industrial coun-tries’ central banks in their open market operations and held ontheir balance sheets are discussed in M. Zelmer, “MonetaryOperations and Central Bank Balance Sheets in a World ofLimited Government Securities.” IMFPolicy Discussion Paper01/7 (Washington: International Monetary Fund), 2001.

3. At the outreach conference, one country noted that a pastfailure to take account of the uncertainty in fiscal projections ledit to issue too much short-term debt. This debt ultimately had tobe rolled over into longer-term debt in the middle of a financialcrisis when interest rates were high.

4. Information on the Polish experience can be found in P.Ugolini, 1996. National Bank of Poland: The Road to IndirectInstruments, IMFOccasional Paper No. 144 (Washington:International Monetary Fund), 1996.

5. In Brazil, the central bank also has an opportunity tocomment ahead of time on the annual financing program, andthe government is legally prevented from borrowing directly fromthe central bank.

6. Further information on ALM in the context of publicdebt management can be found in: G. Wheeler, and F. Jensen

Sound Practice in Sovereign Debt Management. (Washington: WorldBank), forthcoming.

7. Further information on the management of contingentliabilities in a sovereign context can be found in H.P. Brixi and A.Schick, eds., Government at Risk: Contingent Liabilities and FiscalRisk(Washington: World Bank), 2002.

8. World Bank and International Monetary Fund, DevelopingGovernment Bond Markets: A Handbook (Washington), 2001.

9. Primary dealers are a group of dealers in governmentsecurities designated by the authorities to play a role as specialistintermediaries between the authorities and investors. They areusually granted special bidding privileges in primary auctions ofgovernment securities (and, in some cases, access to central bankcredit) in exchange for agreeing to ensure that the auctions arefully subscribed and perform market-making functions in the sec-ondary market.

10. A useful side benefit of issuing inflation-indexed securi-ties is that central banks in countries that have such securitieshave found that the spread between yields on nominal and infla-tion-indexed debt can be a useful indicator of expected inflationfor the conduct of monetary policy. However, the reliability ofthis indicator requires that the market for inflation-indexed secu-rities be sufficiently liquid so that prices are not distorted by tech-nical factors associated with individual transactions, or at leastthat the distortions be fairly stable over time. Further informationon the benefits and design of inflation-indexed securities can befound in R.T. Price, 1997. “The Rationale and Design of Inflation-Indexed Bonds,” IMF Working Paper 97/12 (Washington:International Monetary Fund), 1997.


33

IICOUNTRY CASE STUDIES

This part of the document contains the 18 country case studies prepared by government debt managers. Eachcase study focuses on the steps taken by the country to improve public debt management practices in recent yearsand their connection with the Guidelines for Public Debt Management.

The Brazilian government has been implementing sev-eral measures to improve the conduct of public debtmanagement. This document provides an overview ofthe main guidelines currently followed by Brazilianpublic debt officials, drawing comparisons to thoseproposed by the IMF and the World Bank in their jointreport, Guidelines for Public Debt Management.

The first section, “Developing a Sound Governanceand Institutional Framework,” covers a broad array ofissues. It starts with a brief discussion of the objectives andscope of public debt management in Brazil and its coor-dination with monetary and fiscal policies. Following is adescription of the main measures to enhance trans-parency and accountability by means of well-defined rolesand attributions for debt management, comprehensiveinformation disclosure, and frequent examination of debtmanagement activities by external auditors. Concludingthe section, the most relevant events regarding gover-nance and the management of internal operations,including recent institutional reforms, are presented.

The second section, “Establishing a Capacity toAssess and Manage Cost and Risk,” focuses on theguidelines that have been considered in determiningoptimal strategies for keeping the cost and risk of the

public debt at sustainable levels. Along with an illustra-tion of the recent behavior of several debt managementindicators, this section describes the implementation ofan ALM framework and strategies envisaging reduc-tions in refinancing and market risks. The main fea-tures of the risk management models currently in placeand under development are also described.

The third and concluding section covers theactions that have been taken for developing the mar-kets for government securities. Emphasis is given tothe description of some noteworthy measures releasedby the Brazilian Treasury and central bank inNovember 1999 and to the continuous effort to stimu-late the demand for long-term securities.

Developing a Sound Governance andInstitutional Framework

Debt management objectives and coordination

Objectives

In line with the guidelines suggested by the IMF andthe World Bank, the basic directive pursued by the

35

1Brazil1

Brazilian government for public debt management iscost minimization over the long term, taking intoconsideration the maintenance of judicious levels ofrisks. As a secondary and complementary objective,the Brazilian Debt Management Unit has been takingactions toward the development of its domestic pub-lic securities market.

Although debt management officers strive toimplement strategies aiming at cost minimization ofthe Brazilian government debt, special attention isgiven to the risks embodied in each strategy.Government efforts in the establishment of a solidreputation with creditors, respecting contracts, andavoiding an opportunistic approach in its relation-ship with the market are also of importance.

Emphasis has been given to the monitoring ofrefinancing and market risks, most specifically theformer. In this respect, the Brazilian Treasury, asreported in greater detail below, has successfullyextended the average maturity of the debt andachieved a smoother redemption profile. Close atten-tion is paid to the amount of debt maturing in theshort term (12 months), reducing the treasury’sexposure to undesirable events that may occur.

The gradual replacement of floating-rate securi-ties for fixed-rate securities represents another majorguideline pursued by the Brazilian debt managementoffice. Nevertheless, although it is an important mea-sure to reduce market risk, changing the compositionof debt toward greater concentration of fixed-rateinstruments has often diverged from the objective ofmaintaining refinancing risk at comfortable levels.This dilemma occurs as a result of the still limiteddemand for long-term fixed-rate bonds. As thedemand for these securities becomes more pro-nounced and macroeconomic policies are keptsound and stable, a more aggressive strategy in favorof those securities will follow.

Finally, the Brazilian Treasury seeks the develop-ment of the secondary market as a main venue toachieve these objectives. Some measures are alreadyin effect (see the third section, “Developing theMarkets for Government Securities”), such as

• improvement of the term structure of interestrates,

• standardization of financial instruments, and

• fungibility for floating-rate securities.

Scope

The scope of Brazilian public debt management isalso in line with the IMF and World Bank guidelines.It encompasses the main financial obligations overwhich the central government exercises control,which include both marketable and nonmarketabledebts, domestic and foreign currency debts, and con-tingent liabilities.2 Given that the Brazilian Treasuryhas adopted an integrated ALM framework, assetcharacteristics are also taken into account in the con-duct of public debt management.


Relative to the coordination with fiscal policy, borrow-ing programs are based on fiscal projections estab-lished by the federal budget and approved byparliament. The treasury also elaborates and publishesa detailed Annual Borrowing Plan that is submitted tothe revision and approval of the minister of finance.

In the coordination with monetary policy, thereis close interaction between treasury and centralbank officials. Regular meetings with members ofboth institutions are held, and information on thegovernment’s current and future liquidity needs isshared. Moreover, although the final decisionsregarding public debt financing strategies are underthe responsibility of the national treasury, officialsfrom the Central Bank of Brazil (CBB) are alwaysconsulted in advance to measure the potential impactof such strategies on the conduct of monetary andexchange rate policies.

An important step taken in Brazil is that as of May2002, the CBB is no longer allowed by the FiscalResponsibility Law (FRL) to issue its own securities.3

Monetary policy is now conducted through sec-ondary market operations with treasury securities,enhancing the transparency between fiscal and mon-etary policy.

Transparency and accountability

Brazilian debt management authorities seek trans-parency and accountability by publicly disclosing the


roles and responsibilities for debt management andproviding the public with information regarding debtmanagement policies and statistics. In addition,external auditors frequently examine and evaluatethe activities of public debt management.

Roles and responsibilities for debt management

The roles and responsibilities for debt managementare clearly and formally defined by legal instruments.A summary of legislation is available at the treasury’sweb site.4 Foreign and domestic public debt manage-ment is handled by the ministry of finance and, inturn, within the ministry of finance by the NationalTreasury Secretariat (that is, the Public Debt Office).Similarly, all regulations related to debt managementare disclosed, including those on the activities of pri-mary and secondary markets, and on clearing andsettlement arrangements for trade in governmentsecurities.

Public availability of information

Information on debt management policies and oper-ations is publicly disclosed by means of a regular cal-endar of auctions and regular report publications, allavailable on the treasury’s web site. Besides publish-ing its Annual Borrowing Plan, which includes themain guidelines and strategies to be pursued over theyear, the National Treasury Secretariat providesdetailed public debt statistics through two monthlyreports: the Federal Government Domestic Debt Report (incooperation with the CBB) and the National TreasuryFiscal Results.

External auditing

Debt management activities are audited annually byexternal auditors. Two entities are commonly incharge of such attribution: the Secretaria Federal deControle ([SFC] internal auditing agency—executivebranch) and the Tribunal de Contas da União([TCU] external auditing agency). These agenciesare, respectively, affiliated with the executive and leg-islative branches of the federal government.Although the SFC plays an important role by con-ducting a preliminary audit of public debt manage-

ment activities, the TCU is responsible for ultimatelyapproving them.

In addition, some reports required by parliamentare related to debt management activities, amongwhich are Report on Fiscal Management—follow-up ofdebt limits,5 and Account Balance of the FederalGovernment—a description of all federal expensesthroughout the year, forwarded annually to parlia-ment and the TCU.

Institutional framework

Governance

The National Treasury Secretariat has implemented anew debt management organizational frameworksince November 1999, based on the internationalexperience of the DMO. The Public Debt Office com-prises three main branches:

• The back office, which is in charge of the registry,control, payment, and accounting of bothdomestic and foreign debts.

• The middle office, which is responsible for thedevelopment of medium- and long-term strate-gies aiming at reductions of debt cost and risk,macroeconomic follow-up, and investor relations.

• The front office, which is responsible for thedesign and implementation of short-term strate-gies related to bond issuances in domestic mar-kets. Front office activities associated withinternational capital market borrowings are cur-rently handled by the CBB, but will be trans-ferred to the treasury in September 2003.

The new institutional arrangement resulted in asubstantial improvement in debt management allow-ing for the standardization of operational controls,monitoring of risks, and separation of functions con-cerning long-term (strategic) and short-term (tacti-cal) planning. Currently, approximately 90 financialanalysts compose the Public Debt Office.


To strengthen internal operations and in response toan increasing number of nonintegrated data sys-tems—making the process of gathering information

Country Case Studies: Brazil 37

cumbersome, time-consuming, and highly exposedto operational risk—the treasury has engaged in acooperative program with the World Bank. The pro-gram contemplates three modules:

• IT system development; • control, internal auditing and security standards,

governance and organizational structure; and • risk management.

Although these modules are interrelated, focushas been given to the development of the IT system.The project is, therefore, mainly directed to theestablishment of an integrated platform that willenhance the efficiency and reliability of public debtaccounting and reporting, improving the treasury’scapacity and transparency in the conduct of publicdebt management.

The new institutional framework, mentionedpreviously, also represents an important step towardthe reduction of operational risks. Front and backoffice functions have been clearly separated, and themiddle office has been established to respond to thesetting and monitoring of risk analysis independentlyfrom the area responsible for executing market trans-actions. Registry and auction services are presentlyprovided by the CBB, for which a formal agreementhas been recently formulated.

The process of hiring personnel was subject tosome improvements enacted in the face of competi-tion among different careers within the executivebranch. Although there is still some degree of com-petition with other institutions from both the privateand public sectors, the treasury has managed to hireand keep qualified staff by restructuring the career oftreasury financial analysts and implementing a strictselection process mostly directed to professionalswith strong backgrounds in economics and finance.Considerable resources have also been spent in spe-cialized training for the debt management staff, suchas a graduate course in debt management.

Another step taken toward the improvement ofdebt management was the establishment of a Code ofConduct for Public Debt Managers in February 2001,which contemplates some directives related to theirconduct—for example, the prohibition on buyingpublic bonds—and the creation of an Ethics and

Professional Conduct Committee of Public DebtManagers.

Legal framework relating to borrowing

The main legislation regarding borrowing can bebasically specified in four instruments: (1) theBrazilian Constitution—limits on public debt, (2) theFRL regulatory framework for fiscal policy, (3) theBudget Guidelines Law, and (4) the Annual BudgetLaw (the amount borrowed throughout the year can-not exceed the total established in the specific bud-getary sources included in the LOA). Furthermore, aceiling on new external debt borrowings is deter-mined by a senate resolution.

Among the legal instruments mentioned above,the FRL constitutes a milestone in public finance atall levels of government. By means of a set of rules, itimposes limits on the government’s payroll spendingand the amount of outstanding debt,6 requiringhigher transparency of public accounts, stricter rulesfor elected officials of the executive branch at theend of their mandates, and administrative andpenalty sanctions on administrators who fail to com-ply with fiscal legislation.

The FRL reinforced the “golden rule” estab-lished in Article 167-III of the Brazilian FederalConstitution, which states that it is forbidden to carryout credit transactions that exceed the amount ofcapital expenses. It also imposes restrictions on creditoperations among government entities, including thenational treasury and the CBB, and established thatthe CBB, as of May 2002, would no longer be allowedto issue its own securities in the primary market.

Establishing a Capacity to Assess andManage Cost and Risk

Debt management strategy

Brazilian debt management strategy follows guide-lines that are initially prepared by the Public DebtOffice and submitted for the approval of the secre-tary of the national treasury and the minister offinance.

The treasury has been gradually moving towardan ALM framework. In this context, the risks inher-


ent in the current debt structure are evaluated, tak-ing into account the characteristics of assets, tax rev-enues, and other cash flows available to servicing thedebt. Net exposures in the balance sheet of the cen-tral government are identified by selecting financialassets and liabilities, including guarantees, counter-guarantees, and contingent liabilities.

Results of such analysis under an ALM frame-work suggest that in Brazil (as is usual in most coun-tries), debt managers should seek a debt compositionwith heavier reliance on fixed-rate and inflation-indexed instruments. The main mismatches betweenassets and liabilities of the Brazilian central govern-ment, as of December 2001, are presented in FigureII.1.1.

Note that the main mismatches concern thoserelated to interest rate and exchange rate exposures.Although there are several difficulties in achieving adebt portfolio that matches the characteristics ofassets in the short and medium term, debt manage-ment officials find this type of ALM analysis

extremely valuable in setting long-term strategies forreaching optimal debt composition.

Along with the objective of gradual minimizationof the interest rate and exchange rate exposures, theBrazilian government, in line with IMF and WorldBank guidelines, has established among its prioritiesthe reduction of refinancing risk. These objectives,however, are often conflicting, given the still limiteddemand for long-term fixed-rate and inflation-indexed securities. Meanwhile, the national treasuryand the CBB have concentrated efforts in developingsecondary markets and stimulating operations withlong-term fixed-rate and inflation-indexed instru-ments. These measures have proven to be helpful inpaving the way to a more appropriate composition ofthe public debt in the future.

Cash management represents another importantaspect of the debt management strategy currentlyadopted by the Brazilian government. The treasury hasbeen keeping enough cash reserves to allow greaterflexibility in the pursuit of its financing strategies and,


Figure II.1.1. Assets and Liabilities Imbalances, December 2001(In billions of reais)

Exchange rate

Floating rate

Fixed rate

Others

Equities

Price index

–400 –300 –200 –100 0 100 200

Net liability Net asset

most important, reduce the risk of rolling over thedebt under temporarily unfavorable conditions.

The debt management guidelines, which empha-size the reduction in refinancing risk and follow anALM framework, have already reached good results.With the intent of illustrating the main achievements ofsuch a strategy, and keeping in mind the still long way toattaining a more appropriate debt structure, the recentbehavior of several debt management indicators andsome of the lessons learned by Brazilian debt manage-ment officials over the past years are presented below.

Lengthening of debt average maturity to reducerefinancing risk

The average term of the outstanding domestic secu-rities debt reached 35 months in December 2001, up

from 27 months in December 1999. Behind such anachievement are the efforts to extend the maturity ofsecurities issued through auctions, which representapproximately 70 percent of the domestic debt.7

Figure II.1.2 reports the outstanding increase in theaverage maturity of these securities, growing from 4.6months in July 1994 to approximately 29 months inDecember 2001. This rise is linked to the objective ofreducing refinancing risk and can be mainlyexplained by long-term issues of floating-rate (LFT)and inflation-indexed bonds (NTN-C).

Improving the redemption profile

The percentage of public securities maturing in 12months, which was reduced from 53 percent inDecember 1999 to 26 percent in December 2001, is a


Figure II.1.2. Average Maturity—Auction Issued DebtNational Treasury (In months)

0

10

20

30

40

Jul-9

4

Oct

-94

Jan-

95

Ap

r-95

Jul-9

5

Oct

-95

Jan-

96

Ap

r-96

Jul-9

6

Oct

-96

Jan-

97

Ap

r-97

Jul-9

7

Oct

-97

Jan-

98

Ap

r-98

Jul-9

8

Oct

-98

Jan-

99

Ap

r-99

Jul-9

9

Oct

-99

Jan-

00

Ap

r-00

Jul-0

0

Oct

-00

Jan-

01

Ap

r-01

Jul-0

1

Oct

-01

remarkable advance in the Treasury’s financing pol-icy, as shown in Figure II.1.3.

Gradual replacement of floating-rate securities forfixed-rate securities

In mid-1995, the national treasury started a processaimed at redefining its debt composition. One of themain measures contemplated was the public debtdeindexation by means of a gradual increase in theshare of fixed-rate debt. The graphs in figures II.1.4and II.1.5 illustrate the strategy of gradual replace-ment of floating-rate (LFT) for fixed-rate (LTN secu-rities. Note that fixed-rate securities were issued withincreasing maturities up to the wave of crises that hitemerging markets starting in October 1997. Untilthen, the treasury had been able to suspend newissues of LFT.

Figures II.1.4 and II.1.5 also show the change infocus of debt management strategy in Brazil towardthe reduction of refinancing risk and the adoption ofa sustainable strategy of issuance of fixed-rate instru-ments. To reach these goals, starting in 1999, the trea-sury has implemented benchmark issues of long-termfixed-rate securities issued periodically and hasdecided to extend the maturity of the debt by issuingfloating-rate securities of much longer terms thanthose observed historically

Debt composition

The composition of the domestic debt has changeddramatically over the past seven years (see FigureII.1.6). The substantial increase in the fixed-rateinstruments pursued in the first few years of eco-nomic stabilization, which followed the launch of the


Figure II.1.3. Percentage of Central Government Internal Debt Maturing in 12 Months

24

29

34

39

44

49

54

59

Dec

-99

Jan-

00

Feb-

00

Mar

-00

Ap

r-00

May

-00

Jun-

00

Jul-0

0

Aug

-00

Sep

-00

Oct

-00

Nov

-00

Dec

-00

Jan-

01

Feb-

01

Mar

-01

Ap

r-01

May

-01

Jun-

01

Jul-0

1

Aug

-01

Sep

-01

Oct

-01

Nov

-01

Dec

-01


Figure II.1.4. Maximum Maturity at Issuance—Fixed-Rate Securities (LTN), in Months

0

6

12

18

24

30

Sep-

94

Apr

-

Oct

-95

Apr

-

Oct

-96

Apr

-

Oct

-97

Apr

-

Oct

-98

Apr

-

Oct

-99

Apr

-

Oct

-00

Apr

-

Figure II.1.5. Maximum Maturity at Issuance—Floating-Rate Securities (LFT), in Months

0

12

24

36

48

60

72

Dec

-94

Jun-

95

Dec

-95

Jun-

96

Dec

-96

Jun-

97

Dec

-97

Jun-

98

Dec

-98

Jun-

99

Dec

-99

Jun-

00

Dec

-00

Jun-

02

Real Plan in July 1994, proved to be unsustainable asemerging market economies faced a period of strongturbulence after October 1997. In the new economicenvironment, the Brazilian government had toaccept an increase in the floating-rate share, and aconsequent reduction in the fixed-rate portion, toavoid an increase in rollover risk.

Implicit in the discussion presented so far is avery important lesson drawn from the Brazilian debtmanagement experience. Allied to the need forsound and stable macroeconomic policies, as a pre-condition for developing high-quality debt manage-ment, the development of (long-term) debt marketsis also of fundamental importance. In this respect,the measures recently taken to enhance liquidity inthe secondary markets and the already mentionedimplementation of benchmark issues of long-termfixed-rate and inflation-indexed securities representimportant steps toward a sustainable improvement inthe debt composition.

External debt

In 1995, after 15 years out of the market, the Braziliangovernment restored its presence in the internationalcapital market, issuing sovereign bonds with greatsuccess. Since then, the main measures underlyingthe Brazilian government strategies regarding theinternational capital markets have been

• consolidation of Brazilian yield curves in strate-gic markets (U.S. dollar, euro, yen) with liquidbenchmarks,

• paving the way for other borrowers to accesslong-term financing, and

• broadening of the investor base in Brazilian pub-lic debt.

Since 1996, the Brazilian government has also pur-sued a strategy of buying back restructured debt (theBrady bonds) and replacing them with new bonds.


Figure II.1.6. Debt Composition per Index

Floating Rate

Fixed Rate

Exchange Rate

Price Index

0%

10%

20%

30%

40%

50%

60%

70%

80%

Nov

-96

Jan-

97

Mar

-97

May

-97

Jul-9

7

Sep

-97

Nov

-97

Jan-

98

Mar

-98

May

-98

Jul-9

8

Sep

-98

Nov

-98

Jan-

99

Mar

-99

May

-99

Jul-9

9

Sep

-99

Nov

-99

Jan-

00

Mar

-00

May

-00

Jul-0

0

Sep

-00

Nov

-00

Jan-

01

Mar

-01

May

-01

Jul-0

1

Sep

-01

Nov

-01

Figures II.1.7 and II.1.8 illustrate the new moneyand exchange operations held since 1995, totalingUS$25.5 billion of sovereign debt issued in diversifiedmarkets. Note that the Brazilian government imple-mented seven exchange operations from May 1997 toMarch 2001 that helped to reduce the participation ofBrady bonds in external bonded debt from 95.1 percentin December 1996 to 36.5 percent in December 2001.

Risk management framework

Within the ALM framework, risk analysis is con-ducted in a model that allows debt managers to pro-ject expected and potential costs of the debt underseveral different refinancing strategies in themedium and long term. Key debt management indi-cators, such as average maturity, duration, and debtcomposition, are generated for each strategy, allow-ing senior management to decide which is the moreappropriate strategy to pursue. The main risks moni-tored are refinancing risk, market risk, and credit risk

(most federal government assets are composed ofcredits from states and municipalities).

A new risk management system customizedaccording to the needs of the risk management groupwas implemented in the first semester of 2002. Besidesallowing the same type of analysis that was conducted,this new system allows for a more integrated examina-tion of assets and liabilities characteristics and theadoption of several types of at-risk models, such asCaR, cash-flow-at-risk, and BaR. At the present time,the risk management group conducts risk analysisbased on deterministic and stochastic scenarios. Stressscenarios analysis is also used as a complement.

Besides improving its risk management systems,the Brazilian debt management office has been con-centrating efforts in developing the skills of its per-sonnel by means of training, external contacts, andhiring advisers. With this purpose, the aforemen-tioned cooperation with the World Bank contem-plates a risk management module that will provide anextensive background on international experience


Figure II.1.7. Foreign Bond Issuance in the International Capital Market(In Millions of US$)

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

1995 1996 1997 1998 1999 2000 2001

New money Exchange

related to best practices of leading sovereign debtoffices. The primary objective is to build capacity inassessing and managing the financial risks for asovereign debt portfolio, and it will initially focus onan ALM framework. The participants will be trainedin the various techniques used by the debt offices,and they will learn about future path modeling formarket variables. To the extent that several of thesetechniques are already being developed in parallel bythe Brazilian staff, a deeper examination of the riskmanagement tools adopted in other countries willallow useful and valuable comparisons.

Developing the Markets for GovernmentSecurities

Improvement measures for the governmentsecurities market

During the second semester of 1999, the BrazilianTreasury and the CBB designated a working groupwith the objective of preparing a diagnosis of the prob-lems related to the markets of public debt securities.

Since then, some procedures have been reorganized,and new instruments and norms were introduced, aim-ing at the recovery of securities market dynamism. Theworking group also discussed strategies that couldenhance the demand for long-term government secu-rities and released several measures, products, andprojects directed to the public debt in primary and sec-ondary markets. Some of these actions include:

• reduction in the number of outstanding series ofdomestic securities debt,

• use of the reoffer and buyback mechanisms,• implementation of firm bid (price discovery) auc-

tions for issuing long-term fixed-rate securities,• release of a monthly schedule of auctions of trea-

sury securities,• regular and comprehensive information disclo-

sure of public debt policies and statistics, and• regular meetings with dealers, institutional

investors, risk-rating agencies, and others.

The firm bid auctions comprise two stages. In thefirst stage, only primary dealers are allowed to submitbids, committing themselves to buying the securities


Figure II.1.8. External Bonded Debt—Federal Government(In Billions of US$)

0

10

20

30

40

50

60

Dec

-96

Apr

-97

Aug

-

Dec

-97

Apr

-98

Aug

-

Dec

-98

Apr

-99

Aug

-

Dec

-99

Apr

-00

Aug

-

Dec

-00

Apr

-01

Aug

-

Restructured debt New bond

auctioned at the prices and quantities specified intheir bids. This does not guarantee, however, thatthese institutions have won the auction. The treasurydetermines the amount of securities to be auctionedat the final phase and releases such informationalong with the corresponding cutoff price observedin the first stage, acting as a price reference for thesecond stage. A discriminatory price auction with theparticipation of all financial institutions is then con-ducted. This auction procedure plays an importantrole in reducing the uncertainty regarding the pric-ing of fixed-rate long-term bonds issued by the trea-sury, given that references in the Brazilian market forthese bonds are still incipient.

Measures undertaken for the development of thegovernment securities market have been favorable.The noticeable improvements in the term structureof interest rates and the establishment of fungibilityfor floating-rate and inflation-indexed securities havecontributed to stimulating negotiations in the sec-ondary market. As a consequence of this latter mea-sure, a reduction was observed in the number ofoutstanding series of floating-rate (LFT) and fixed-rate (LTN) securities, illustrated in Table II.1.1.

Improvement of term structure

The interest rate and inflation-indexed term struc-tures have improved as a consequence of the trea-sury’s strategy of building benchmark issues oflong-term instruments. At the present time, there areparameters for price index curves up to 30 years,whereas price references for fixed-rate instrumentsreach 18 months.

Sales through the Internet

As part of the recent actions toward the development ofthe market for government securities, in January 2002,the Treasury began conducting sales of public debtinstruments through the Internet. With low minimumand maximum buying limits (approximately US$80 pertransaction and US$80,000 per month, respectively),this measure is mainly directed to small investors andtries to stimulate long-term domestic savings.

As shown in Table II.1.2, the amount issuedthrough the Internet as of July 2002 was aroundUS$11 million, of which 77 percent were fixed-ratesecurities. The number of investors totaled morethan 4,000, from 24 of 27 Brazilian states.


Table II.1.1. Number of Series Outstanding

Floating-rate securities Fixed-rate securities Inflation-linked securities(LFT )a (LTN) (NTN-C) Total

Oct. 1999 47 21 2b 70Dec. 2000 49 12 3 64Dec. 2001 40 14 6 60

a. Only for LFTs issued through auctions.b. As of December 1999.

Table II.1.2. Internet Sales (As of July 31, 2002)

R$ US$

Total amount sold 32,502,739 10,834,246Floating-rate (%) 8Fixed-rate (%) 77Price index (%) 15

Total number of investors 4,481

Average amount per investor 7,254 2,418

Note: US$1.00 = R$3.00.Source: Brazilian authorities.


Figure II.1.9. Yield Curve—NTN-C (Duration in Months)

10.2%

10.4%

10.6%

10.8%

11.0%

11.2%

3 24 45 66 87 108 129 150 171

Figure II.1.10. Yield Curve—LTN (Duration in Months)]

19.0%

19.5%

20.0%

20.5%

21.0%

21.5%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

As of December 31, 2001.

Notes

1. The case study was prepared by the Debt ManagementUnit/Secad III of the Brazilian National Treasury.

2. For debt management purposes, the national treasuryconsiders the contingent liabilities that have not yet materializedand for which there is a legal or contractual obligation or both,such as government guarantees on foreign exchange borrowingsand government programs, among others.

3. In anticipation of this measure, the CBB stopped issuingits own securities in October 2001.

4. www.tesouro.fazenda.gov.br.5. Debt limits were established by the FRL and are currently

being discussed by parliament and the executive branch. The trea-sury secretary will regularly report to parliament on these limits.

6. These limits are based on the relation between the debtoutstanding and net current revenue.

7. Besides issuing securities through auctions, the BrazilianTreasury is sometimes required by law to issue debt directly tospecific creditors, mainly as a result of debt securitization.



Objective

The main objective of debt management is to ensurethat financing needs are met with a low funding cost ina long-term perspective, within a sustainable path, andwith a prudent level of risk. The risks considered arerefinancing, market, credit, operational, and legal.

Scope of debt management activities

Debt management covers both internal and externaldebt. In addition to funding, debt management alsoincludes management of outstanding debt and contin-gent liabilities, the latter especially related to infras-tructure and public credit operations.


The 1991 Constitution states that Banco de laRepública (BdR), the central bank, will be the inde-pendent agent responsible for monetary and foreignexchange policy, and the ministry of finance will be

responsible for fiscal policy. The DMO, DirecciónGeneral de Crédito Público (Directorate General ofPublic Credit), is situated within the ministry.

Issues that require coordination with the BdRregarding monetary policy, debt management, and themacroeconomic agenda are discussed in the regularbiweekly meetings of the board of the central bank, ofwhich the minister of finance is member. The BdR isalso in charge of the settlement and clearing of thedomestic debt market, which involves coordinationbetween fiscal and monetary authorities in the man-agement of the domestic public debt.

Two officials from the BdR are also members ofthe Debt Advisory Committee, which determined theguidelines for debt management and the debt issuingprogram.

Legal framework

The legal framework for debt management is includedin Decree 2681 of 1993, which covers

• Public credit transactions that involve new fundingand, therefore, increasing the debt stock.

49

2Colombia1

• Debt management transactions that reduce port-folio risk and do not increase debt stock. Thesetransactions include hedging operations such ascross-currency swaps, interest rate swaps, debtexchanges, refinancing, debt conversions, andthe like.

Institutional structure

As mentioned, the ministry of finance is responsiblefor debt management, and the DMO (DirecciónGeneral de Crédito Público) is a division of the min-istry. The ministry of Finance has six divisions:

• Superior (minister, deputy ministers, general sec-retary),

• Macroeconomic Policy Division,• National Treasury (Tesoro Nacional),• Budget Division,• Subnational Governments Division, and• Dirección General de Crédito Público.

The DMO is in charge of debt management, andthe National Treasury is in charge of cash and assetmanagement. Coordination and communicationwith the treasury is essential. Although the DMOworks closely with the treasury to create synergiesbetween the two areas, communication could bevastly improved by merging these two divisions. Nodoubt, this merger would also improve ALM.However, at present, there are no plans for a merger.


The DMO adopted a new internal structure in May2001, following recommendations from the WorldBank. The new structure, including responsibilities, isthe following:

• front office—local and external funding,• middle office—analysis of portfolio risks and

strategy, and• back office—operational issues.

Besides these three sections, the DMO alsoincludes the legal affairs office and the IT office.

The new structure improves communication andcoordination among front, middle, and back offices,thereby reducing operational risk. Completion of adocument describing the DMO procedures has alsoreduced operational risk.

Debt management decisions and actions must bebased on accurate and updated information aboutthe debt portfolio. To improve databases and analysistools, DMFAS software from the United NationsConference on Trade and Development (UNCTAD)2

is currently in the process of being implemented.This software is especially designed to strengthen thetechnical capacity to record, manage, and analyzeexternal and internal debt. It also provides facilitiesfor the recording and monitoring of bond issues, on-lending, and private nonguaranteed debt. After thesoftware is adjusted for the Colombian requirements,it is expected to

• reduce operational risks,• simplify procedures,• produce debt profiles and financial risk quantifi-

cation in real time,• improve capacity to evaluate statistical models,• be compatible with other information systems,• increase accuracy of exercises,• allow Internet operability, and• provide a proactive alarm system, which will

alert management if the portfolio reaches anydebt management policy limits, such as thestated currency or interest rate composition ofthe debt.

Retain qualified staff with financial market skills

Staff members receive continual training, allowingthem to acquire important market skills, while help-ing the DMO attract and retain qualified staff. This isparticularly true in the middle office, where staffreceive ongoing training in portfolio analysis andstrategy. Individuals are often attracted to this benefitof acquiring knowledge in these areas, thus makingthe DMO a good working environment. This is espe-cially important because salaries in the public sectoroften are not competitive with those in the privatesector.


Incentives and guidelines to ensure implementationof strategies

A benchmark for external debt has been establishedsince 1997. Although there is no legal obligation oreconomic incentive that will ensure that debt man-agement is implemented prudently, historically thebenchmarks have been met. Internal debt bench-marks have not been formally adopted; however,according to present plans, the authorities approveda benchmark for the internal debt in June 2002.

Transparency

Transparency of the debt figures is achieved throughthe yearly report of the ministry of finance. This reportincludes a summary of the previous year’s agenda aswell 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.

Debt Management Strategy and RiskManagement Framework

Reducing the country’s vulnerability

During the mid- and late 1990s, the main concernwas minimizing the exposure of the external debtportfolio to market shocks and international crisis. Asa consequence of this concern, the Public DebtAdvisory Committee (Comité Asesor de DeudaPública) was created on April 21, 1997, integrated byofficials from the ministry of finance and the BdR.The main objectives of the committee are to analyzeand discuss guidelines for the internal and externalindebtedness and propose risk management guide-lines.

In 1997, the ratio of internal debt to externaldebt was approximately the same as it is today. In con-trast to the external debt, the internal debt was con-sidered as carrying less risk, because it was made upmainly of liabilities with the public sector. Therefore,the main concern was minimizing the exposure ofthe external debt portfolio to market shocks andinternational crisis. As a consequence, benchmarksfor the external public debt were established as ref-

erence points for the central government and for theeight public entities with the highest outstandingexternal debt. The benchmarks cover refinance risk,interest rate risk, currency risk, and duration andhave been an important tool in controlling and min-imizing the exposure to external shocks. The amorti-zation profile has never exceeded the 15 percentlimit a year, considerably reducing refinancing risk,and the portfolio has met the currency and interestrate composition in the benchmarks, thereby mini-mizing market risk.

Because the characteristics of the domestic capi-tal market are different from those of the interna-tional capital market, it is not possible to use theexternal debt benchmark for the internal debt port-folio. For management of the internal debt portfolio,risk management guidelines have been taken intoconsideration but no explicit benchmark has beenadopted. However, the Public Debt AdvisoryCommittee approved a benchmark for the internaldebt in June 2002.

Main risks in the government’s domestic andforeign debt portfolio

To reduce vulnerability, the DMO focuses on refi-nancing and market risks. The benchmark for theshare of internal debt is 67 percent and 33 percentfor external debt.

Since 1997, the Public Debt Advisory Committeehas established benchmarks for external debt. Thesebenchmarks have been updated yearly and werereviewed in May 2002. The benchmarks for the exter-nal debt are

• Refinancing: No more than 15 percent of thetotal external debt can mature in any given year.The ideal is 10 percent. (The rationale behindthese figures is that market conditions mayrequire executing a funding strategy that exceedsthe 10 percent limit, but never the 15 percentlimit.)

• Currency composition: U.S. dollar, 83 percent;euro, 13 percent; and yen, 4 percent.

• Interest rate composition: fixed and semifixedrate ≥ 70 percent, floating rate <_ 30 percent.

Country Case Studies: Colombia 51

• Modified duration: 3.5 years.

For the internal debt, the following benchmarkswere approved at the meeting of the Public DebtAdvisory Committee in June 2002. The new bench-marks will guarantee that future funding programswill be in line with debt guidelines. The benchmarksfor the domestic debt are

• Refinancing: No more than 20 percent of thetotal internal debt can mature in any given year.The ideal is 15 percent.

• Fixed and price-indexed: Colombian peso, fixed,92–96 percent; price-indexed, 4–8 percent.

• Interest rate composition: Because local debtinstruments are either fixed, price-indexed, orU.S. dollar–indexed, there is no interest ratebenchmark for the internal debt.

How different risks are quantified and balanced

Two methods are used to quantify the portfolio risk.The first method compares the actual portfolio withthe benchmarks. The second method, called debt-service-at-risk (DsaR), is currently used. DsaR allowsthe DMO to quantify the maximum debt-service costof the debt portfolio with 95 percent likelihood. Themethodology takes into consideration the exposureto different market variables, such as interest rates,exchange rates, and commodity prices. For managingthe cost and risk dimensions of the debt portfolio,the middle office presents a monthly report of fund-ing alternatives based on DsaR analysis. This reportcompares the cost of the expected scenario with therisk scenario of the different funding alternatives.

The funding strategy takes the benchmarks intoconsideration. The front office analyzes the marketsituation and different funding alternatives. If thefunding strategy requires exceeding one or more lim-its established in the benchmarks, the possibility of ahedging transaction is analyzed.

Reducing the risk of losing access to domestic andinternational financial markets

To have access to financial markets, control over bothrefinancing and market risk is essential. As previously

mentioned, since 1997, the amortization profile ofexternal debt has never exceeded the 15 percent limit,considerably reducing refinancing risk. Recent crisesin Russia, Brazil, Turkey, and Argentina have empha-sized the importance of monitoring these two risks.

Refinancing in advance, when the conditions ofthe external capital markets are favorable, has been asuccessful strategy. It allows the ministry of finance toguarantee the funding needs at a low cost, whileanticipating future market shocks. The view of themarket is a combination of judgments of parameterssuch as political conditions, falling spreads, tighteryields, and investors’ demand for bonds, in additionto various bank surveys.

For domestic debt, it is important to rememberthat the local market for public debt is only five yearsold. Moreover, investors are only progressivelydemanding longer-term instruments. The first issueswere securities with one-, two-, and three-year maturi-ties. Therefore, the amortization profile historicallyshowed concentrations in the first and second years.Now, when the daily volume traded has increasedconsiderably and inflation has reached one-digit lev-els, fixed-rate securities with longer maturities (5, 7,and 10 years) have been successfully introduced.Securities with longer-term maturities (10 and 15years) are price indexed.

Several voluntary debt swaps have also been exe-cuted recently:

• In June 2001, an internal voluntary debt swap wasconducted. Short-term (2001–05) amortizationswere reduced by US$2.4 billion, and the refi-nancing risk was reduced considerably.

• In January and March 2002, two internal voluntarydebt swaps took place. US$512 million of short-and mid-term amortizations of U.S. dollar–denom-inated TES were exchanged for 10-year tenor,fixed-rate peso-denominated TES, considerablyreducing exchange rate and refinancing risk.

• In May 2002, another voluntary swap took place,exchanging US$589 million of external bonds(euro- and U.S. dollar–denominated) maturingbetween 2002 and 2005 for 10-year TES maturingin 2012.

• In June 2002, an external voluntary debt swapwas executed. External bond short-term


(2002–05) amortizations were reduced byUS$255 million, considerably reducing refinanc-ing risk.

• Other small internal debt exchanges are heldregularly.

Management of risks associated with embeddedoptions

So far, the Colombia has issued eight bonds withoptions, two of which have already been exercised (a“knock-out” yen option and a put option).Management of the risks associated with these optionshas been conservative. For budgetary purposes, allbonds with put options are always registered as if allthe investors exercised the option. This allows therepublic to have funds on hand to cover the option.

Strategies to generate returns

The DMO does not engage in active debt manage-ment strategies. Transactions such as interest rate andcurrency swaps have only a hedging purpose.However, by following interest and currency rates,transactions that could reduce debt service are con-sidered if favorable market opportunities occur.

Management of contingent liabilities

The DMO middle office is responsible for explicitcontingent liabilities. The responsibilities of theDMO are to verify the methodologies used by thepublic entities that generate these liabilities. Withthese models, the DMO structures a contributed pay-ment plan to create a fund, which will be managed bya fiduciary. This fund allows having liquidity to paythe liabilities when the contingency occurs.

In addition, the DMO operates by

• implementing and developing methodologies forquantifying contingent liabilities on guaranteesoffered by the government to private agents inconcession projects of state-owned infrastructure(highways, electricity generation, water, and com-munications),

• developing methodologies for quantifying con-tingent liabilities in public credit transactions

(guarantees of the central government on exter-nal or internal debt of municipal governmentsand public entities), and

• creating methodologies for credit risk analysis ofmunicipal public entities.

The procedure of contingent liabilities manage-ment includes appointments with investment banksand public entities, developing simulation models forrisk assessment, and developing a schedule for thecontingent liabilities payouts (including the proba-bility of payouts).

Management information systems used to assessand monitor risk

The IT office created a database that has been in usesince 1997. This software allows inquiries about the cur-rent debt portfolio; however, it does not have a risk-monitoring module. For risk quantification, the middleoffice uses its own models based on Excel spreadsheets.

As previously described, more sophisticatedDMFAS software will be implemented in 2003. A teamis currently working on the transition process. Besidesallowing for the possibility for consultation of debtinformation, the new software will provide analysis ofthe exposure of the debt portfolio to volatility in inter-est rates and exchange rates and have the capacity tomake simulations of new funding strategies.

Development in markets for private sector debt

The DMO has been one of the most important agentsinvolved in the development of the local capital mar-kets. The treasury bond market has become a modelfor private debt issuers. This means that the privatesector takes into account all developments in thepublic debt market.


Development of the primary market

The DMO is the only agency that issues central govern-ment debt. The central bank no longer issues bonds formonetary policy purposes. The DMO is also responsi-

Country Case Studies: Colombia 53

ble for updating the database of the public debt, whichincludes debt of the central government plus otherpublic institutions and subnational governments.

The profile of the internal debt portfolio haschanged since 1997. Today, 76 percent of the internalportfolio consists of treasury bonds and notes (exposedto market risks), compared with more than 90 percentfive years ago. In 1997, 34 percent of outstanding trea-sury bonds and notes were liabilities with privateinvestors; today, the ratio has increased to 40 percent.

The DMO issues 1- to 10-year fixed-rate instru-ments, and 5-, 7-, and 10-year instruments are issuedas price-indexed securities. U.S. dollar–indexed secu-rities in 2-, 3-, 5-, and 8-year maturities are issued onlywhen the exchange rate of the Colombian peso to theU.S. dollar undergoes periods of considerable volatil-ity or those that are not part of the normal fundingprogram. To diversify the debt stock across the yieldcurve, the DMO considers the amortization profile,market conditions, funding cost, and bond liquiditywhen deciding on the issuing plan.

Treasury securities in the domestic market areissued by two mechanisms. In 2002, weekly primaryDutch auctions counted for 40 percent of internalfunding. The remaining 60 percent of internal fundingin 2002 was covered by direct placement to public enti-ties. Direct placements (mandatory and agreed-upon)are made with public entities that have cash surpluses.These public entities are price takers in the market.

In the international market, bonds are issued inthe U.S. dollar, euro, and yen markets. Borrowing isalso executed by loans from multilateral credit agen-cies and syndicates, as well as other commercial loans.

The ministry of finance issues official pressreleases with information on bond (local and exter-nal) placements as well as agreed loans. Thesereleases are available on the web site, www.min-hacienda.gov.co.

Development of the secondary market

Since 1997, one of the objectives of the DMO hasbeen the development of the local public debt mar-ket. For this purpose it has established the Programade Creadores de Deuda Pública (Public Debt MarketMaker Program). In this program, 24 of the mostimportant financial institutions, of which 22 are pri-

vate and 2 are public, participate in weekly primaryauctions of treasury bills, notes, and bonds.

Contacts with the financial community

Communication between the DMO and the financialinstitutions is regarded as very important. Meetingsbetween representatives of the financial institutionsand officials from the DMO take place at least everyquarter. In the local market, there is constant commu-nication with financial institutions, members of themarket maker program, and important investors suchas pension funds, fiduciary funds, and insurance com-panies. For the external market, it is important to keepclose contact with various financial institutions thatprovide market feedback, promote trading of instru-ments, and have direct contact with key investors.

Clearing and settlement

The following systems are used to settle and clearlocal debt market transactions:

• DCV (Depósito Central de Valores), the elec-tronic central depository that handles all of thepublic local debt;

• SEN (Sistema Electrónico de Negociación deDeuda Pública), the system that handles the elec-tronic local public debt market; and

• SEBRA (Sistema Electrónico de Banco de laRepública), the electronic settlement systemused for primary auctions for public local debt.

Tax treatment of government securities

Government securities are tax free only for the prof-its on the principal of stripped securities.Nonstripped government securities have the same taxtreatment as corporate securities.

Notes

1. The case study was prepared by Gustavo Navia, JorgeCardona, and Carlos Eduardo León, from the Directorate Generalof Public Credit of the Ministry of Finance and Public Credit.

2. UNCTAD is the principal organ of the United NationsGeneral Assembly to deal with trade, investment, and develop-ment issues.



Objectives

The overall objective of Denmark’s government debtpolicy is to achieve the lowest possible long-term bor-rowing costs, consistently with a prudent degree ofrisk. The authorities pursue this objective while takingvarious factors into account, including the objective ofa well-functioning domestic financial market. Recently,more emphasis has been placed on the discipline ofrisk management.

Scope of debt management

The debt of the central government is compiled as thenominal value of domestic and foreign debt minus thecentral government’s account with the central bank,Danmarks Nationalbank (DNB), and the assets of theSocial Pension Fund (SPF). All administrative func-tions related to government debt management areundertaken by the DNB.

Two conditions establish a dividing line between fis-cal and monetary policy in Denmark. First, governmentborrowing is subject to a set of funding rules based onan agreement between the government and the DNB.Second, the prohibition on monetary financing in theMaastricht Treaty regulates the central bank’s role as afiscal agent and bank to the government.

Since the early 1980s, central government borrow-ing has been subject to funding rules for both domes-tic and foreign borrowing. The present funding ruleswere stipulated in a 1993 agreement between the gov-ernment and the central bank, which replaced theinformal agreement from the early 1980s, when theDanish fixed exchange rate regime was implemented.

In overall terms, the domestic rule ensures thatdomestic borrowing in Danish kroner matches thecentral government’s gross domestic financingrequirement for the year. Thus, the domestic rule ster-ilizes the liquidity impact from government paymentsfor the year as a whole. The rule for foreign borrowingstates that new foreign loans are normally raised torefinance the redemptions on the foreign debt. If thelevel of foreign exchange reserves is considered inap-

55

3Denmark1

propriate, a decision can be made to reduce orincrease the level of foreign debt. Foreign exchangereserves are owned by the DNB, and the central gov-ernment’s DNB account provides the link betweengovernment foreign debt and foreign exchangereserves.

In accordance with the Maastricht Treaty’s prohi-bition of monetary financing, the central govern-ment’s account with the DNB may not show a deficit.The government’s borrowing is therefore planned toensure an appropriate balance on its account.

The central government receives interest on itsaccount with the DNB. This interest rate is equal tothe discount rate set by the central bank. The dis-count rate is equivalent to the current-account rate(folio rate), which is the interest rate for the banks’and mortgage-credit institutions’ current-accountdeposits with the DNB. This arrangement implies,together with the fact that the surplus of the centralbank after reserve allocations is transferred to thegovernment, that the government receives an interestrate on the account that is comparable to what wouldbe obtained if the account were placed in a commer-cial bank.

Legislative basis for central government borrowing

The legal authority for the central government toborrow is stipulated in legislation enacted in 1993. Itallows the minister of finance to borrow in the nameof the government. It also empowers the minister offinance to raise loans on behalf of the central gov-ernment, up to a maximum of DKr 950 billion, whichis the limit for the total domestic and foreign govern-ment debt. Moreover, it empowers the minister offinance to transact swaps and other kinds of financialinstruments.

Before the beginning of a new fiscal year, afinance bill is adopted by parliament. It authorizesthe minister of finance to raise loans to finance thecentral government’s projected gross financingrequirement, which is the sum of the current centralgovernment deficit plus redemptions on domesticand foreign debt. The borrowing is obtained accord-ing to the domestic and foreign norm. During a fiscalyear, changes may occur in the gross financingrequirement. This happens primarily because of

changes in the central government deficit or becauseof buybacks that increase the amount of redemp-tions. Changes in the gross financing requirementare similarly financed by government loans. Theseloans are authorized by an act of supplementaryappropriation of the finance bill at the end of theyear or by the Financial Committee of the Parliamentduring the year.

Besides the government debt, the central govern-ment guarantees the borrowing and financial transac-tions related to the borrowing of a number of publicentities. The entities are mainly related to infrastruc-ture projects, for example, the Great Belt Bridge andsubway construction in Copenhagen. The board ofdirectors and the management of the individual entityare responsible for the financial transactions of theentity, but the central government establishes borrow-ing limits and guidelines for the borrowing activities.The guidelines are determined in a set of agreementsbetween the DNB and the ministry of finance or theministry of transport and between the relevant min-istry and the individual entity. The agreementbetween the central bank and the relevant ministrysets out the main tasks and responsibilities of the par-ties involved. The set of agreements also includes a listof acceptable types of loans. The list describes whichkind of financial transactions and currency exposurethe entity is allowed to incur.

The entities publish their own annual report andare covered by the general legislation applied to pri-vate firms.

The Danish debt office is placed within the centralbank

The responsibility to parliament for central govern-ment borrowing rests with the ministry of finance.Since 1991, the central bank has undertaken alladministrative functions related to government debtmanagement. The division of responsibility is setforth in an agreement between the ministry offinance and the DNB. By power of attorney, DNB offi-cials are authorized to sign loan documents on behalfof the minister of finance.

Before 1991, the debt office was part of the min-istry of finance. In 1991, the debt office was moved tothe central bank—the structural change occurring


partly as a consequence of a report prepared by thepublic auditors. The report indicated that most of theassignments related to the central government debtwere already carried out by the DNB, but duplicationof assignments occurred between the central bankand the ministry of finance. Furthermore, the reportsuggested that a stronger coordination between themanagement of the foreign exchange reserve in theDNB and the central government’s foreign debtwould be beneficial. Finally, it suggested that attract-ing and maintaining staff with the relevant skills forthe debt office would be easier if the debt office wereplaced in the central bank. The move to the centralbank has helped to centralize the retention of knowl-edge of most aspects of financial markets within a sin-gle authority.

The relation between the debt office and theministry of finance

At quarterly meetings, the ministry of finance and theDNB determine the overall strategy for governmentborrowing on the basis of written proposals from theDNB. The adopted strategy is authorized and signedby the ministry of finance. In December each year,the overall strategy for the next year is determined, aswell as the detailed strategy for the first quarter of thenext year. At the following quarterly meetings,amendments to and specifications of the main strat-egy for the subsequent quarter are decided.

The strategy specifies the expected domestic andforeign borrowing requirements and includes a set ofdecisions for the next year. Among the decisions are

• bands for duration of the central governmentdebt,

• a list of on-the-run issues for the domestic debt, • the borrowing strategy for foreign debt,• a list of government securities eligible for buy-

backs or switch operations,• a list of government securities in the securities

lending facility, and• maximum amounts of buybacks and use of inter-

est rate swaps.

The first four items are published after the meet-ing in December. If changes in these decisions occur

during the year, these are published as well.Maximum amounts of buybacks and use of interestrate swaps are not made public.

On the basis of these conclusions, the centralbank handles the necessary borrowing transactionsand the ongoing management of the debt. Besidesthe formal meetings, the DNB is in regular contactwith the ministry of finance, and ad hoc adjustmentsin the strategy may occur during the year.

Structure of the debt office within the central bank

Within the DNB, four departments are involved in themanagement of the central government debt—theGovernment Debt Management unit of the FinancialMarkets Department, the Market OperationsDepartment, the Accounting Department, and theInternal Audit Department. The division of the man-agement of government debt into a front, middle, andback office structure was implemented in 1996 todiminish operational risk.

The Government Debt Management unit isresponsible for middle office functions and constitutesthe Danish debt office. It formulates the principalaspects of the debt management strategy and carriesout analysis and risk management. The unit also for-mulates guidelines for the Market OperationsDepartment on sale of domestic bonds, buybacks, swaptransactions, and the amount of foreign borrowing.

The Market Operations Department is responsi-ble for front office functions, such as sale of securitiesand issuance of foreign loans. Responsibility for backoffice functions, such as settlement and bookkeep-ing, is handled in the Accounting Department andGovernment Debt Accounting.

The Internal Audit Department in the centralbank assists the Auditor General (the national auditoffice) in the auditing of government debt manage-ment. In handling the government debt, the depart-ments involved in the process also draw on resourcesfrom other departments in the central bank, forexample, the legal experts.

Information policy

The Danish government debt strategy is aiming at ahigh degree of transparency toward the general pub-

Country Case Studies: Denmark 57

lic and the financial markets. Therefore, the DNBcompiles and publishes a wide and frequent range ofinformation on central government borrowing anddebt.

The information policy is based on severalannouncements to the public. Some of them follow afixed annual schedule. The most importantannouncements and publications are the following:

• Before the beginning of each half year, normallyin June and December, the central bank sends anannouncement to the Copenhagen StockExchange (CSE) and market participants withdetails of central government benchmark issuesconcerning July and January, respectively. Theannouncement also presents more general infor-mation on the plans for the central government’sdomestic borrowing.

• Before the opening of new government securitiesseries, an announcement is sent to the CSE withdetails of the coupon, maturity, and opening dayof the new loan.

• On the first banking day of each month, the DNBsends an announcement to the CSE and otherinterested parties on the sale and buyback ofdomestic government securities during the pre-ceding month. On the second banking day ofeach month, the DNB issues a press release withdetails of the government’s actual borrowingrequirements and other important financialdetails of the preceding month.

• Details of the sale and buyback of domestic gov-ernment securities are issued daily via the DNB’sweb site2 and an electronic information system(DN News). Most of this information is repro-duced directly by Reuters, for example. Furtherinformation on prices and circulating amounts ofgovernment bonds is available from the CSE.

• Terms and conditions for treasury bill auctionsand results are announced via the CSE and theelectronic auction system.

• The ministry of finance regularly publishes infor-mation on the development in the governmentbudget.

• Other information on Danish government bor-rowing and debt appears in the DNB’s annualreport.

The DMO in the central bank publishes anannual report (Danish Government Borrowing andDebt), usually in February. The annual report is thecornerstone of the implementation of the informa-tion policy. The report informs the public, marketparticipants, parliament, and ministry of financeabout all activities related to Danish debt manage-ment in the preceding year. Since 1998, the reporthas also been published in English. The reportdescribes considerations and factors concerning bor-rowing and debt management. It also includes sec-tions on special topics of relevance to governmentdebt management. Finally, it includes a comprehen-sive appendix of tables with detailed central govern-ment borrowing and debt statistics, including a list ofall government loans.

Enhancing quality and reducing operational risk

Procedures manualA procedures manual ensures proper governmentdebt administration for the relevant units in thedepartments working with government debt. Themanual describes authorities and obligations of theunit. The central bank’s Audit Department is respon-sible for any changes to the written procedures,which are then passed on to the ministry of finance.Developing and maintaining the procedures manualis a key element in enhancing quality and reducingoperational risk, and it is thus an area of high prior-ity in debt management.

Work descriptions are used in daily work as a sup-plement to the procedures manual. A work descrip-tion is a detailed description of a particular task thatis regularly carried out. For example, there are workdescriptions for such factors as the opening of a newgovernment bond, a buyback auction, calculations ofduration and CaR, and monthly releases of publicinformation on the government debt. The use ofwork descriptions contributes to consistency andaccuracy in the administration of the governmentdebt.

Guidelines for acceptable loan categories are setout for the central government’s foreign borrowing.The guidelines stipulate requirements of the overallloan structure, including both the underlying loanand any related derivatives. The purpose of these


guidelines is to minimize the political, legal, andoperational risks.

Codes of conductThe DNB staff must adhere to internal codes of con-duct based on the guidelines on speculation set bythe Danish Financial Supervisory Authority and thelegislation against insider trading. In short, thismeans that the staff is allowed to invest only personalcapital and only in nonspeculative investments.

Recruiting and maintaining highly skilled staffThe placement of the DMO within the central bankhas helped the office in recruiting highly skilled staff.Contributing to this is the fact that the DMO is a partof a larger environment, where finance, financialmarkets, and policy are major areas. Therefore, it isable to recruit both internally from other depart-ments and externally, offering new employees anopportunity to be part of a large and highly skilledorganization that is well known to the public.

The staff in the Government Debt Managementunit (middle office) consists of a mix of senior staff,who have worked with debt management for a num-ber of years, have worked in other areas of the bank,or both, and young economists recently employed inthe DNB.

Including employees working in the front andback offices, around 20 staff are working mainly withtasks related to the central government debt.

Management information system and use of ITStrong and reliable IT systems are crucial to limitingoperational risk. In the Danish DMO, the current ITstrategy is primarily built upon a specially developedback office system (System Statsgæld) combined withthe use of other software. All borrowing and swaptransactions for the central government debt enterSystem Statsgæld. Transactions are controlled by theback office.

The back office system generates information onpayments to be made or received; input to the centralbookkeeping system, which covers all governmententities; and data for analytical purposes.

During 2002, the plan was to implement a newmiddle office system. The purpose of this system is toautomate important calculations used on a regular

basis, for example, duration calculations, marketvalue, and various risk factors on the debt. The newsystem will draw data directly from the back office sys-tem. The implementation of the new middle officesystem will further reduce operational risks.

Debt Management Strategy and theRisk Management Framework

Limiting country vulnerability

The objective and strategy for government debt man-agement focuses on reducing the risk of negativespillover effects from the government debt to the sur-rounding economy. In that respect, interest rate riskand exchange rate risk are considered the mostimportant risk factors.

To reduce country vulnerability, it is important tolimit interest and exchange rate risk. In Denmark,this is done primarily through steering the durationand redemption profile on the debt and by borrow-ing only in euros or Danish kroner.

Borrowing strategy

Domestic debt

The strategy for domestic borrowing involves build-ing up large government security series in the inter-nationally important 2-, 5-, and 10-year maturitysegments. The liquidity premium resulting from thisstrategy contributes to low borrowing costs for thecentral government. A range of government debtinstruments is applied to ensure large liquid bench-mark issues. This includes domestic interest rateswaps, buybacks, and swaps from Danish kroner toeuros. The domestic borrowing strategy also includesa treasury bills program with monthly issues of billswith maturity up to 12 months.

Given that the central government is a dominantissuer on the domestic bond market, the measurementof performance does not encompass comparison ofthe cost relative to that of a specific benchmark port-folio constructed on the basis of domestic bond issues.

The Danish domestic government bonds arepriced on a competitive financial market, which con-


sists of both domestic and international investors.Furthermore, the bonds are comparable to otherdomestic and foreign bonds and are issued in theinternationally most important maturity segments. Inthat respect, the pricing is based on market conditions.

In the case of buybacks, the government deter-mines whether buybacks are advantageous as seenfrom a broad government debt perspective. Buybacksare used to concentrate government debt in liquidbonds, in cash management, and to control theredemption profile. Buybacks take place at marketprices. Comparing prices with theoretical prices cal-culated on the basis of zero-coupon yield curvesdrawn from the market ensures that buybacks will bepurchased at the market price.

Over the years, there has been a gradual changein the domestic borrowing strategy toward a concen-tration of borrowing on a reduced number of bench-mark bonds and an increase in the use of interest andcurrency swaps. The changes have been carried outto ensure the outstanding amount and the liquidityin the bonds in a time with reduced borrowing needsas a result of budget surpluses since 1997.

The issuance of bonds takes place only in the 2-,5-, and 10-year maturity segments. The 5- and 10-yearbonds are on average open for issuance for 2 years,and the 2-year bonds are open for about 1 year. Theissuance in the 30-year segment was effectivelystopped by the end of 1997. By the end of 2001, 99percent of the total outstanding amount in domesticbonds and treasury bills were distributed on 11 bondsand 4 treasury bills. The bonds are among the lead-ing bonds on the CSE. Three of these bonds are con-sidered benchmarks; the benchmark in the 10-yearsegment is the most important.

Foreign debt

All foreign borrowing takes place directly in euros orvia loans swapped to euros. All central governmentforeign currency exposure, including swap transac-tions, is in euros. In 2002 and the coming years, theborrowing strategy is now based on raising primarilybigger loans, preferably directly in euros. The strat-egy is supplemented by the opportunity to issuedomestic bonds combined with currency swaps toeuros.

The strategy for foreign borrowing has changedgradually over the years, from small loans and, insome cases, structured loans to a mixture of smallerand bigger loans with end exposure in euros. Thepresent strategy, focusing on bigger bullet loansdirectly in euros, is in line with this developmenttoward a more standardized foreign borrowing.

When foreign exchange reserve considerationsentail an immediate need for foreign currency bor-rowing, the central government may issue short-termcommercial paper (CP). The central government canuse short-term CP programs in periods when the bal-ance of the central government’s account with theDNB is expected to be low.

The euro interbank offered rate (Euribor) servesas a reference in the assessment of borrowing costsfor the foreign government debt. In addition, thecost of different instruments is compared, for exam-ple, direct borrowing in euros is compared with bor-rowing in other currencies swapped to euros. Theborrowing costs for the foreign debt are also com-pared with the levels achieved by peer countries.

Main types of risk

The main risks for the government debt portfolio areinterest rate, exchange rate, credit, and operationalrisks:

• Interest rate risk is the risk that the developmentin interest rates will lead to higher borrowingcosts. The concept of interest rate risk also coversrefinancing risk, which is the risk that existingdebt will have to be refinanced at a time withunfavorable market conditions or particularlyunfavorable borrowing terms for the central gov-ernment. Interest rate risk is relevant for thedomestic debt and the foreign debt.

• Exchange rate risk is the risk that the value of thedebt will increase as a consequence of develop-ment in exchange rates.

• The central government undertakes a credit riskwhen it enters into swap transactions. A swap isan agreement between two parties to exchangepayments during a predetermined period. Thus,there is a risk that the counter-party will defaulton its obligations. Credit exposure is included in


the management of the credit risk as soon as theswap is transacted.

• The central government is also exposed to otherrisks, such as the risk of error in the administra-tion of the debt by itself or by counter-parties.

Managing the risks

As described above, the government debt comprisesfour subportfolios: the domestic debt, the foreigndebt, SPF assets, and the central government accountwith the DNB.

The four subportfolios that make up the govern-ment net debt are all subject to management by thecentral bank as an agent of the central government.

Interest rate risk

Management of interest rate risk is based on the netdebt as a whole. This is a direct consequence of thesubportfolios being more and more integrated. Anexample of more integration among the portfolios isthe use of currency swaps from Danish kroner to eurosto raise foreign loans, which at the same time affect theinterest rate risk on domestic and foreign debt.

Interest rate risk is primarily managed by a dura-tion target and a duration band for the total centralgovernment debt (net). Historically, each subportfo-lio had a separate duration target, but this practicewas abolished by the end of 1999.

One important consequence of targeting onlythe duration on the net debt is that a reduction induration may be achieved by, for example, usingeither domestic or foreign interest rate swaps. Areduction in duration on the net debt can also beachieved by an increase in the duration of the centralgovernment asset portfolio. Therefore, targeting onlythe duration of the net debt brings higher flexibilityto the management of the duration.

Smoothing the redemption profile is also a partof the interest rate risk management, and this isapplied separately to domestic and foreign debt.Ensuring a smooth redemption profile, whereby amore or less constant proportion of the debt isredeemed each year, reduces the risk of beingobliged to refinance the debt at a time when marketconditions in general are unfavorable or when the

borrowing terms for the central government are par-ticularly unfavorable.

The SPF portfolio, which is a subasset portfolio ofthe net government debt, contains mortgage bonds.These mortgage bonds can be redeemed at par valueat any time, that is, they include an option. For thesebonds, an option-adjusted duration is used in the cal-culation of the duration on the government net debt.

Exchange rate risk

The Danish exchange rate policy is based on maintain-ing a stable rate for the Danish krone against the eurowithin the ERM II framework. As a result of this policy,the exchange rate risk on the foreign government debtis handled by taking only foreign loans with an end riskin euros (that is, borrowing takes place directly in eurosor via loans that are swapped to euros).

From 1991 to 2000, the exchange rate risk on theforeign government debt was handled together withthe exchange rate risk on the foreign exchangereserve in the central bank in a formalized set-up. Inthis way, the exchange rate risk for the governmentdebt and the central bank was measured on a net basis.The formalized set-up was abolished by end of 2000 asa result of the decision that all foreign governmentdebt should be in euros. Also, the central bank hasonly a very small amount of exchange reserves in cur-rencies other than the euro, thus there was no needfor a formalized arrangement by the end of 2000.

Credit risk

Credit risks exist on the swap portfolio of the centralgovernment. Therefore, risk principles for credit riskmanagement of the portfolio have been laid down.Significant elements of credit risk management are highratings for the counter-parties and credit exposureswithin relatively tight credit lines. New transactions takeplace only with counter-parties that have signed a collat-eral agreement. By the end of 2001, 80 percent of theswap portfolio consisted of collateralized agreements.

Cash management risk

As mentioned above, the government has an accountwith the DNB. According to the Maastricht Treaty,


the government is not allowed to overdraw thisaccount. To ensure that this requirement is fulfilled,there is a minimum deposit requirement for the gov-ernment’s account of DKr 10 billion ( 1.3 billion),and, at certain times, the requirement is higher.Every year, a detailed forecast of the government’spayments in the next year is made. On the basis ofthis forecast, an estimate is made concerning thedaily deposits to the government’s account in theDNB. Because redemptions on the government debtare usually placed toward the end of the year, liquid-ity on the government’s account is front loaded dur-ing the first part of the year to meet the redemptionrequirements. The amount of front-loading isreduced by buybacks of bonds redeemed in the cur-rent year.

Operational and legal risks

The separation of the various debt managementfunctions (front, middle, and back offices) is a mea-sure against administrative errors and operationalrisks. As described above, procedure manuals andinternal procedures ensure a clear division of author-ity and responsibility allocated to the three functions.The use of simple, well-known, debt managementinstruments also contributes to minimizing the oper-ational risks. Finally, the central government debtmanagement area is subject to audit by the AuditorGeneral. Legal risk is minimized by using standard-ized contracts.

Risks in relation to state guaranties

The government guarantees the borrowing and thefinancial transactions of a number of public entities.This implies a risk for the government. This risk islimited by setting up guidelines for the borrowingactivities of the entities (see the first section of thiscase study for a discussion of the legislative basis forcentral government borrowing).

In 2001, the government-guaranteed entitiesobtained greater access to relending of governmentloans through the central government. Relendingassures the government-guaranteed entities of acheaper way of funding compared with a situationwhere they raise all funding individually. The loans

offered to the entities are identical to existing gov-ernment loans, including bonds, which are notbenchmark issues. Relending increases the centralgovernment’s gross financing requirement and isfinanced by on-the-run issues. This improves consoli-dation of the borrowing of the public sector.

Determining the level of risks

At the meetings of the ministry of Finance and theGovernment Debt Management unit, the overallobjective for the interest rate risk of the governmentdebt is determined by weighing borrowing costsagainst the risk.

In this process, a CaR model is used as a supportin selecting the preferred issuing strategy and dura-tion target. In the CaR model, different approachesto issuing strategy, amount of buybacks, and durationtarget are analyzed. The results are presented to anddiscussed with the ministry of finance.

The CaR model is developed in-house by theGovernment Debt Management unit. The model isused to quantify the interest rate risk by simulation ofmultiple interest rate scenarios, but it is also used as ascenario model in which specific scenarios are ana-lyzed and discussed more thoroughly. The horizon ofthe analysis is up to 10 years.

Analyzing specific scenarios has played a majorrole in determining the overall strategy for the gov-ernment debt during the last years. By using a sce-nario model, future developments in the outstandingamount of different bonds, redemption profiles, andthe time path for the duration can be analyzed verythoroughly. This can determine whether a certainstrategy is feasible, given some exogenous assump-tions. Among the most important assumptions in thiskind of analysis is the development in the govern-ment budget.

The duration target for central government debthas been reduced in the last few years. This reductionis primarily the result of falling debt and reducedinterest costs, which have increased the willingness totake on risk. The nominal net debt has fallen fromDKr 601 billion in 1997 to DKr 514 billion by the endof 2001, a drop from 54 percent to 38 percent of GDP.

From end-1998 to end-2001, the duration of thecentral government debt has been reduced from 4.4


to 3.4 years. The exact development in the durationduring the previous year is made public in the annualreport, which is published in February.

In the process of determining risks and borrow-ing strategy, normally neither domestic nor foreignborrowing is based on a particular interest rate out-look. Therefore, the managers do not in generalactively try to generate excess returns—for example,by having views on the future interest development,which is different from market expectations.


Background

The Danish bond market is among the largest inEurope. The market value of the volume of bonds incirculation at the CSE was DKr 2.198 trillion at nomi-nal value by the end of 2001. Besides governmentbonds, the Danish market has a large volume of mort-gage-credit bonds. The large proportion of thesebonds is explained by the long-standing tradition offinancing construction and private housing by issuingmortgage-credit bonds. All domestic governmentsecurities are listed on the CSE. Government bondsmake up one-third of the volume, and mortgage-credit bonds make up the remaining two-thirds.

The government bond yield curve

The Danish bond market is relatively large andmature, and, as mentioned above, government bondsmake up only one-third of the outstanding value.Issuing bonds along the curve in many different matu-rity segments is therefore not a necessity underDanish policy to maintain a well-functioning capitalmarket. Instead, in past years, the main focus has beenon ensuring liquidity in government bonds by using astrategy of issuing fewer bonds with longer maturities,mainly because of a surplus on the government bud-get. Furthermore, buybacks have for some time beenan important instrument in the Danish policy. Partlyas a way of increasing the borrowing needs during theyear, and partly as a way of reducing the outstandingamounts in old, non-market-conforming securities

(for example, old bonds with a high coupon), the buy-backs are made in a time with surpluses.

In the domestic market, treasury bills are issued in3-, 6-, 9-, and 12-month maturities and bonds in 2-, 5-, and 10-year maturities. All bonds are bullet loanswith a fixed coupon. By the end of 1998, the govern-ment had ceased issuing 30-year bonds as a result oflow borrowing needs and a reduction in the durationtarget for the government debt. Government bondsare used as benchmarks on the Danish bond market.Index bonds are not an instrument in the Danish gov-ernment debt strategy because of their relatively lowliquidity: The Danish strategy focuses on liquidity.

If government debt continues to fall, it isexpected that mortgage bonds can play a benchmarkrole again, as was the situation until the beginning ofthe 1990s.

Issuing mechanisms

Issuing domestic debt

Government bonds and treasury notes are issued ontap by the central bank on behalf of the central gov-ernment via the electronic trading system, Saxess, ofthe CSE. All licensed traders on the CSE may pur-chase government bonds directly from the DNB viathe Saxess system.

Tap sales signify that government securities areissued when a borrowing requirement exists.Normally, the DNB does not underbid itself within thesame day or within a few days. The sale of governmentsecurities on the preceding day is published daily.

The use of tap sales has a long tradition in theDanish mortgage bond market; therefore, it was nat-ural to choose this issuing method when the govern-ment bond market was established. The use of tapsales gives the government a flexible system with theopportunity to issue bonds daily. It is the generalassessment that tap sales are an appropriate way ofissuing domestic government bonds in the Danishbond market.

The planning of tap sales for the year is based onselling nearly the same amount in each remainingmonth. This means that by the beginning of the year,the assumed expectation with respect to monthly salesis an evenly distributed sale during the year. This strat-


egy is implemented by authorizing the front office totarget a specified amount of issuance each month.The target is supplemented by a minimum and a max-imum for each individual sale. The front office han-dles the tap sale within these boundaries. After eachmonth, the expected monthly sale for the rest of theyear is updated. Within the month, the dealers at thefront office handle the tap sale. It is aimed to “tap” themarket when market demands are high. Views on thefuture development in the interest rates are generallynot a part of the planning of the tap sale.

The licensed traders on the CSE are obliged toreport transactions that take place outside the Saxessplatform. Transactions should be reported within fiveminutes. Of the total turnover, 10 percent arereported to the CSE and take place over the Saxesssystem. The remaining 90 percent are transacted bytelephone sale between the market participants.Telephone sales are based on price indications froman electronic system at the CSE.

Treasury bills are sold at monthly auctions via anelectronic system at the central bank. All licensedtraders on the CSE and the DNB’s monetary policycounter-parties may bid at the auctions. Bids aremade for interest rates. All bids at or below the fixedcutoff interest rate are met at the cutoff interest rate(uniform pricing). Bids at the cutoff interest rate maybe subject to proportional allocation.

Issuing foreign currency debt

Foreign loans have normally been established on thebasis of concrete approaches from foreign investmentbanks, which are in contact with investors with specialplacement requirements. The currency swaps fromDanish kroner to euros are established on the basis ofcompetitive bidding from different investment banks.

As described above, the foreign strategy for 2002and beyond focuses primarily on obtaining larger syn-dicated loans directly in euros, using one or morelead managers.

Primary dealers, market makers, and lendingschemes

Primary dealers are not used in issuing domestic gov-ernment securities in Denmark. All licensed traders

on the CSE may buy government bonds and treasurynotes directly from the DNB via Saxess on the CSE.Licensed stock exchange traders and the DNB’s mon-etary policy counter-parties may participate in thetreasury bill auctions.

There are two voluntary market maker schemesfor government securities under the auspices of theCSE and the Danish Securities Dealers Association,respectively. Participants in these schemes areobliged to quote two-way prices for a certain amountof appropriate bonds at any time. Under the CSE,scheme prices are set only in the 10-year benchmark,whereas the scheme of the Danish Securities DealersAssociation comprises other liquid government secu-rities as well. The central bank does not take part inthe market maker plans.

To support liquidity, securities lending schemeshave been set up. Two lending schemes exist, oneheld by the central government and one held by theSPF. A lending scheme supports the liquidity in thegovernment bond market because situations involv-ing any shortage of bonds are prevented. The lend-ing scheme held by the government was introducedin 1998, and the SPF lending scheme was introducedin 2001. In both plans, Danish government bonds areaccepted as collateral.

The lending scheme held by the governmentcomprises mainly benchmark issues not held by theSPF. The SPF lending scheme consists of governmentbonds in the portfolio of the government bullet-loantype. The two lending schemes do not overlap withrespect to bonds. Together, they consist of lending inmost government bonds, including treasury bills.

Financial market contact

A regular and close contact with the financial marketcommunity is important for the government debtpolicy and is therefore given high priority. In regularmeetings, different aspects of the management of thecentral government debt are discussed with marketparticipants. At these meetings, market participantsget the opportunity to discuss the management of thegovernment debt with representatives of theGovernment Debt Management unit, including dis-cussion of the potential need for changes or intro-duction of new financial instruments.


Clearing and settlement system

Government bonds, treasury notes, and treasury billshave been registered electronically in the DanishSecurities Center (VP-system) since 1983. Danishgovernment securities may also be registered inEuroclear and Clearstream. A direct link betweenEuroclear and VP-system aids easy transfer of securi-ties between them without loss of trading days.Government securities trades are normally settled inVP-system, but may also be settled in Euroclear andClearstream. Foreign loans are registered inEuroclear or Clearstream. All three systems adhere tothe principles set forth in the Committee on Paymentand Settlement Systems (CPSS)–InternationalOrganization of Securities Commissions (IOSCO)standards of November 2001 on securities settlementsystems. The DNB as overseer conducted a formalassessment of VP-system against these standards dur-ing the first half of 2002.

Tax issues and effects on trading off governmentsecurities

Danish government bonds are treated equally toother bonds on the Danish bond market. No dis-criminatory tax rules exist. This means that the gen-eral legislation for taxation of bonds applies togovernment bonds. Foreigners investing in Danishbonds do not pay withholding tax.

For noncorporate investors who pay taxes to theDanish government, a minimum coupon rule existsfor domestic bonds. This rule implies that capitalgains on bonds with a coupon higher than the mini-mum coupon are free of taxation. The minimumcoupon is normally revised semiannually accordingto the development in the general interest rate level.

Notes

1. The case study was prepared by the Government DebtManagement Office of Danmarks Nationalbank.

2. www.nationalbanken.dk.


India operates under a fiscal regime, with theConstitution of India specifying the fiscal responsibili-ties for the central and the state governments throughthe three lists: the Union List, the State List, and theConcurrent List. According to current budgetary prac-tice, there are three sets of liabilities of the govern-ment that constitute public debt: internal debt,external debt, and “other liabilities.”

Total outstanding liabilities of the central govern-ment as a proportion of GDP reached the peak level of65.4 percent at the end of March 1992, after which itrecorded a significant consolidation over the first halfof the 1990s and declined to 56.4 percent by the endof March 1997 (see Table A.1 in the Appendix). In thenext period, however, it showed an increasing trend,reaching 65.3 percent of GDP by the end of March2002 and is projected to be around 67 percent by theend of March 2003.

As in the case of the central government, the debt-GDP ratio of state governments first recorded animprovement, falling from 19.4 percent at the end ofMarch 1991 to 17.8 percent by the end of March 1997;later, the ratio increased significantly, reaching 24.1percent by the end of March 2001 (see Table A.2 in the

Appendix) in the revised estimates. According to thebudget estimates of the state governments, the debt-GDP ratio was estimated to be 23.9 percent at the endof March 2002. Concomitantly, the interest pay-ments–GDP ratio of the states increased from 1.5 per-cent in 1990–91 to a budgeted level of 2.6 percent in2001–02.

The combined central and state governments lia-bilities had similar trends and stood at 72.9 percent ofGDP at the end of March 2001 (see Table A.2 in theAppendix) and were estimated to be about 76 percentat the end of March 2002, significantly higher than63.5 percent at the end of March 1997. The sharpincrease in the debt-GDP ratio in 2001–02 is mainlyattributable to the increase in the total liabilities of thecentral government. The continuing high level of pub-lic debt leads to increasing interest payments, which inturn necessitate higher market borrowings and putpressure on the fiscal deficit.

Until the early 1990s, India used a developmentstrategy based on its predominant role in the publicsector. Large statutory preempts and borrowing fromthe Reserve Bank of India (RBI), the central bank ofthe country, provided the government the ability to

66

4India1

finance the large fiscal deficits. Lower administeredyields on government securities coupled with highcash and liquidity reserve requirements resulted in arepressed financial system with very little scope foractive debt management.

Reorientation of the debt management strategybegan under the overall process of financial sectorreforms that were started in the early 1990s. Theauthorities preferred a gradual approach for this pur-pose, wherein sequencing the policy initiatives wasgiven the utmost importance.

The first initiative in the reforms process was toallow market-determined rates in the primaryissuance market for government securities throughauctions (1992). To compensate to some extent forthe escalation in the cost of borrowing, and in view ofthe market preference under the new regime as wellas the expectation that interest rates would experi-ence downward trends over the years, the maturityprofile of the debt issuance was shortened. The tenorof new loans issued during the next few years aftermoving toward price discovery mechanism wasrestricted to 10 years. The move was also prompted bythe recommendations of the Committee to Reviewthe Working of the Monetary System. This was fol-lowed by a stoppage of automatic monetization of thefiscal deficit and gradual withdrawal of the centralbank’s support to finance the government budget atsubsidized rates.

The role of net market borrowing in financinggross fiscal deficit gradually increased from 21 per-cent in 1991–92 to 66.2 percent at present. This hashappened even while statutory preempts were beingreduced. Reserve requirements were brought down.The statutory liquidity ratio (SLR), which requiresbanks to invest a certain percentage of their liabilitiesin government securities, was brought down from apeak of 38.5 percent in 1990 to 25 percent in 1997.(At present, the SLR continues to be at 25 percent,which is the statutory minimum.) The cash reserveratio (CRR), which requires banks to keep a certainproportion of their liabilities in the form of cash withthe RBI, was also brought down from a high of 25percent in 1992 (including the CRR on incrementalliabilities) to 5 percent in June 2002.

Debt management strategy began to focus, onthe one hand, on the interest rate and refinancing

risks inherent in managing public debt and, on theother hand, on monetary policy objectives so that thedebt management policy would be consistent withthe objectives of the monetary policy. This strategy, inturn, required the authorities to develop the institu-tional, infrastructure, legal, and regulatory frame-work for the government securities market.


Objective

The objective of the debt management policy haschanged over the years. It first focused on minimizingthe cost of borrowing, but now the objective is mini-mizing the cost of borrowing over the long run, tak-ing into account the risk involved, and ensuring thatdebt management policy is consistent with monetarypolicy.

Scope

Under the current Indian budgetary classifications,three sets of liabilities constitute central governmentdebt: internal debt, external debt, and “other liabilities.”

Internal debt and external debt constitute thepublic debt of India and are secured under theConsolidated Fund of India, as reported under“Consolidated Fund of India—Capital Account” inthe Annual Financial Statement of the Union Budget.Article 292 of the Indian Constitution provides forplacing a limit on public debt secured under theConsolidated Fund of India but precludes “other lia-bilities” under the Public Account There is also a sim-ilar provision in Article 293 with respect to borrowingsby the states, wherein the state legislature has thepower to set limits on state borrowings upon the secu-rity of the Consolidated Fund of the state. However, astate’s power to borrow is limited to internal debt, anda state is required to obtain prior consent of the gov-ernment of India as long as the state has outstandingloans made by the government of India.

Internal debt includes market loans; special secu-rities issued to the RBI; compensation and otherbonds; treasury bills issued to the RBI, state govern-

Country Case Studies: India 67

ments, commercial banks, and other parties; as wellas nonnegotiable and non-interest-bearing rupeesecurities issued to internal financial institutions. Theinternal debt is classified into market loans, otherlong- and medium-term borrowing, and short-termborrowing and is shown in the receipt budget of theunion government. External debt represents loansreceived from foreign governments and bodies. Theliabilities other than internal and external debtsinclude other interest-bearing obligations of the gov-ernment, such as post office savings deposits, depositsunder small savings schemes, loans raised throughpost office cash certificates, provident funds, interest-bearing reserve funds of departments such as railwaysand telecommunications, and certain other deposits.

The “other liabilities” of the government arise inthe government’s accounts more in its capacity as abanker than as a borrower. Hence, such borrowings,not secured under the Consolidated Fund of India,are shown as part of the Public Account.Furthermore, some of the items of other liabilities,such as small savings, are more in the nature ofautonomous flows, which to a large extent are deter-mined by public preference and the relative attrac-tiveness of these instruments. Nevertheless, it shouldbe emphasized that all liabilities are obligations ofthe government.

Provisional Actual Budget data for the year2001–02 show that the gross fiscal deficit of the cen-tral government at 6 percent of GDP was financed bydomestic market borrowings to the extent of 69.4percent and through other liabilities to the extent of26.1 percent. External financing accounted for only1.6 percent of the gross fiscal deficit. According tobudget estimates for 2002–03, the gross fiscal deficitof the central government is targeted at 5.3 percentof GDP and is to be financed by domestic market bor-rowings to the extent of 70.7 percent and by other lia-bilities to the extent of 28.7 percent; externalfinancing would contribute only 0.6 percent.


The RBI acts as the government’s debt manager formarketable internal debt. Because the RBI is alsoresponsible for monetary management, there is aneed for coordination between the monetary and

debt management policies, especially in view of thelarge market borrowing program to be completed atmarket-related rates. At the time the budget is pre-pared, there are consultations between the govern-ment of India and the RBI on the overall magnitudeof the market borrowing program of the central gov-ernment and the aggregate market borrowings of allthe states.

The coordination among debt management andfiscal and monetary policies is achieved through

• the Financial Markets Committee (FMC) withinthe RBI (the heads of departments responsiblefor debt management, monetary policy, and for-eign exchange reserves management), whichmeets daily to assess the markets, liquidity, andother financial considerations that might arise;

• involvement of the debt management func-tionaries in the monetary policy strategy meeting,which is held at least once a month;

• the Standing Committee on Cash and DebtManagement (with representatives from the RBIresponsible for debt management and opera-tions as banker to the government and the min-istry of finance (MoF), which meets once amonth; and

• the annual pre-budget exercise of dovetailing themonetary budget with government finances,including the finances of subnational govern-ments.

During the first stages of market development,especially for countries such as India with large netmarket borrowing (3 to 4 percent of GDP in therecent period), having the central bank responsiblefor both debt management and monetary manage-ment has the advantage of appropriate policy coordi-nation. During this early period, however, as themarkets develop, the economy opens up for capitalflows and the private sector starts contributing moreto the economic activity, and there is a need for inde-pendent monetary management and separation ofthe debt management function from the centralbank. Under the Fiscal Responsibility and BudgetManagement Bill (currently before parliament) andas a first step toward separation of debt managementfrom monetary management, it is proposed that


within three years, RBI participation in the primarymarket for government securities will be eliminated.

The approach of separation of the debt manage-ment function from the central bank has in principlebeen accepted. However, separation of the two func-tions would be dependent on the fulfillment of threepreconditions: reasonable control over the fiscaldeficit, development of financial markets, and neces-sary legislative changes. The actual separation of debtmanagement functions would depend on the extentand speed with which the fiscal deficit can be broughtdown. The large borrowing requirements of the gov-ernment and the need to minimize the impact ofsuch borrowing requirements on interest rates hasnecessitated private placements of securities with theRBI from time to time or participation in the primaryissuance market as a noncompetitive bidder with thelater sale of such securities to the market as condi-tions improve. Elimination of RBI participation inthe primary market is perceived as the first step inseparating the function of debt management frommonetary management. A lower fiscal deficit is thusenvisaged as a required precondition for ensuringthat the government borrowings are not disruptingthe financial markets and enabling a smooth transi-tion to the separation of the debt management func-tion. In the development and integration of thefinancial markets, significant progress has been madewith the introduction of new instruments and partic-ipants, strengthening of the institutional infrastruc-ture, and greater clarity in the regulatory structure.On the legislative front, two important changes are(a) the proposed amendment in the RBI Act of 1934to take away the mandatory nature of public debtmanagement by the RBI, vesting the discretion withthe central government to undertake the manage-ment either by itself or to assign it to some otherindependent body; and (b) the proposed FiscalResponsibility and Budget Management Bill, which isexpected to rein in the fiscal deficit.

Legal framework

The Constitution of India gives the executive branchthe power to borrow upon the security of theConsolidated Fund of India, or that of the respectivestate, within such limits, if any, as may from time to

time be fixed by law by parliament or the respectivestate legislature.

Although parliament or the state legislature givesthe authority to borrow by approving the budget, theRBI as an agent of the government (both union andthe states) implements the borrowing program.

The RBI draws the necessary statutory powers fordebt management from the RBI Act of 1934. Themanagement of the union government’s public debtis an obligation of the RBI, but the RBI undertakesthe management of the public debts of the variousstate governments by agreement.

The procedural aspects in debt managementoperations are governed by the Public Debt Act of1944 and the Public Debt Rules framed hereunder.Considering the technological changes and otherdevelopments taking place in the government securi-ties market, the authorities are interested in replacingthe 1944 act with an updated proposed GovernmentSecurities Act.

Amendments to the RBI Act have been proposedto remove the mandatory nature of public debt man-agement by the RBI and allow the government toentrust the public debt management function to anyagent. This would remove a legal hurdle for separa-tion of debt management functions from the RBI.

Organizational structure

All debt management functions for marketable inter-nal debt are currently undertaken in the RBI, albeitin different departments. The middle office func-tions relating to decisions on the maturity profile andtiming of issuance are undertaken in consultationwith the MoF.

As regards management of the external debt, sev-eral territorial divisions in the Department ofEconomic Affairs of the MoF, such as the IMF-WorldBank Division, the European Central Bank (ECB)Division, ADB Division, EEC Division, and JapanDivision, in addition to the RBI, act as the frontoffices. The External Debt Management Unit of theMoF acts as the middle office, and the Office of theController of Aid Accounts and Audit of the MoF actsas the back office.

The RBI is vested with the powers of managinggovernment debt, of both the union and the state


governments, under the provisions of the RBI Act of1934. Management of debt of the union statutorilydevolves upon the RBI, but management of the debtof the states has been undertaken by the RBI throughmutual agreements between the central bank and therespective states. Thus, the RBI is responsible formanaging the market borrowing program of theunion and state governments.

Within the RBI, the Internal Debt ManagementUnit performs the debt management function. Themain functions comprise formulation of a core cal-endar for primary issuance, deciding the desiredmaturity profile of the debt, designing the instru-ments and methods of raising resources, deciding thesize and timing of issuance, and other critical deci-sions, taking into account the government’s needs,market conditions, and preferences of various seg-ments while ensuring that the entire strategy is con-sistent with the overall monetary policy objectives.The Unit also conducts auctions.

The actual receipt of bids and settlement func-tions are undertaken at various offices of the RBI.Various public debt offices also manage the registryand depository functions and keep securitiesaccounts, including the book entry form of owner-ship. The central accounts are maintained by theDepartment of Government and Bank Accounts.

Decisions on the implementation of the borrow-ing program, based on proposals made by the Unitand market preference, are periodically made by theStanding Committee on Cash and DebtManagement, made up of MoF and RBI officials. Thisrepresents a formal working relationship between theMoF and the RBI, and it is complemented by regulardiscussions between the ministry’s Budget andExpenditure Divisions and the RBI.

Another standing committee is the TechnicalAdvisory Committee on Money and GovernmentSecurities Market, which advises the RBI on develop-ment and regulation of the government securitiesmarket. This committee is made up of eminent peo-ple from the financial sector, representatives of mar-ket associations such as the Primary DealersAssociation of India, the Fixed Income MoneyMarkets and Derivatives Association of India, mutualfunds, academia, and the government.

The operations of the debt management func-tions are subject to the statutory audit that takes placeat the RBI, which covers all the functions of the RBI.The concerned departments within the RBI are alsosubjected to internal audit, including managementaudit and concurrent audit. Separate financialaccounts of the debt management operations at theRBI are not prepared, hence there is no scope forsubjecting these operations to a formal audit.However, although accounting for the debt manage-ment operations is done by the government’sController General of Accounts, the accounts aresubject to the audit by the Comptroller and AuditorGeneral of Accounts, a constitutional body.

The internal debt management functions arereported in the Annual Report of the RBI, which is astatutory report and is placed before parliament, andthe external debt management functions arereported in the Annual Status Report on External Debtpresented to parliament by the minister of finance.

Risk Management Framework and DebtManagement Strategy


In view of the large fiscal deficits of the central gov-ernment—in the range of 5-7 percent of GDP in the1990s—there is a need to ensure a long-term stableenvironment for facilitating economic growth withprice stability. As regards management of externaldebt, the Indian government has adopted a cautiousand step-by-step approach toward capital accountconvertibility. It has initially liberalized non-debt-cre-ating financial flows followed by liberalization oflong-term debt flows. There is partial liberalization ofexternal commercial borrowing, but only for themedium-term and long-term maturities. There istight control on short-term external debt and a closewatch on the size of the current account deficit. Infact, the government of India does not borrow fromexternal commercial sources, and there is no short-term external debt on the government account.There is a high share of concessional debt, amount-ing to nearly 80 percent of sovereign external debt at


the end of March 2002. The maturity of governmentdebt is also concentrated toward the long end for thedebt portfolio.

These policies have paid dividends. Capitalaccount restrictions for residents and modest short-term liabilities helped India to protect itself duringthe East Asian economic crisis from 1997 to 2000.There has been significant improvement of externaldebt indicators over the years. The World Bank’sGlobal Development Finance now classifies India as a low-indebted country. The incidence of external debtburden, as measured by debt-to-GDP ratio, wasreduced to 20 percent at the end of December 2001,from the peak level of 38.7 percent at the end ofMarch 1992. Similarly, the burden of debt service as aproportion of gross current receipts on externalaccount declined from a peak of 35.3 percent in1990–91 to 16.3 percent in 2000–01. With the steadycontraction in the stock of short-term debt, the ratioof short-term to total external debt declined from apeak of 10.2 percent at the end of March 1991 to 3.4percent at the end of March 2001. At the same time,with a substantial increase in foreign exchangereserves, short-term debt as a proportion of foreignexchange assets declined from a high of 382 percentto 8.8 percent.

As regards internal debt, there is a natural incen-tive to focus on long-term sustainability of interestrates, keeping in view the fiscal scenario and othermacroeconomic developments, while planning thematurity pattern of debt and the component of fixed-and floating-rate and external debt. There has been aconscious attempt to avoid issuance of floating-rateand short-term debt and foreign currency–denomi-nated debt.

During the early years of the move to market-determined rates, keeping in sight the investors’ pref-erence, the average maturity of new debt (issuedduring a year) was between 5.5 and 7.7 years duringthe period 1992–93 to 1998–99. As inflationary con-ditions receded and markets developed, keeping inview the redemption pattern of existing debt stock,the need to smooth the maturity pattern of the debtstock, and the need to minimize the refinancing risk,debt management policy has consciously attemptedto 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 theyear ending December 2001, the average maturity ofloans issued during the year stood at about 14 years.The average maturity of the total debt stock, whichwas about 6 years in March 1998, stood at about 8.20years at the end of December 2001.

The trade-off between market timing (whichinvolves carrying cost) and the just-in-time pattern(which involves the risk of uncertain markets) istaken into account while tapping the market. Withinthe year, to ensure that the markets do not becomevolatile as a result of the large volume of borrowingsmade by the government or uncertainties in the for-eign exchange markets, the RBI at times subscribes tothe primary issuances through private placements ofdebt with itself. These are later sold in the secondarymarket when liquidity conditions ease and uncer-tainty diminishes. To minimize the risk arising fromoccasional RBI participation in primary auctions,which results in an increase in reserve money, the RBIundertakes active open market operations adjustedto the needs of liquidity in the system using domesticand external operations.

However, the major risk in debt management isthe size of the debt itself and the pressures of servic-ing the debt. Hence, as part of its advisory role and asdebt manager, the RBI has been urging the govern-ment of India to enforce a ceiling on overall debt. Ithas also provided the technical inputs in formulatingthe Fiscal Responsibility and Budget ManagementBill to ensure that the country’s vulnerability is mini-mized. Currently before parliament, the FiscalResponsibility and Budget Management Bill envis-ages targeted reduction in the fiscal deficit, especiallyrevenue deficit and total debt as a share of GDP, aswell as elimination of RBI participation in the pri-mary issuance of debt.

Strategy

Given the size of the market borrowing program ofthe union and the states, the approach to risk man-agement has been one of minimizing the cost of rais-ing debt subject to refinancing risk. Thus, thedecisions on composition and maturity of debt reflect


a risk-averse preference in the context of the prevail-ing fiscal deficit and likely fiscal deficits in the future.It comprises three tenets:

• minimizing refinancing risk,• minimizing external debt, and• minimizing floating-rate debt.

Simultaneously, the focus has been on ensuringthat the interest rates are sustainable over time.

As regards external debt, the focus has been onrelatively concessional loans and highest maturity.Recently, the government of India also adopted thepolicy of prepaying a part of the debt taken from mul-tilateral institutions and other countries. In somecases, maturity and interest rates of these expensiveloans have been restructured by the lending institu-tions or countries.

Avoiding external sovereign debt and floating-rate debt has considerably reduced the country’s vul-nerability. According to the revised estimates for2001–02, internal debt constituted about 61 percentof the total liabilities, and other internal liabilitiesconstituted 24 percent of total outstanding liabilitiesof the central government (see Table A.2 in theAppendix). External debt (at current exchangerates), which consists mostly of debt to multilateralinstitutions and other countries, constituted about 15percent of the total liabilities. The nonmarketabledebt, including mainly the small savings mobiliza-tions, is managed by the government. The refinanc-ing risk is very well recognized. The debtmanagement policy focuses on managing the matu-rity profile of the debt and deciding on the share of364-day treasury bills in the total borrowing programas well as the share of floating-rate debt.

The process of debt consolidation—involving thereopening and reissuance of existing stock—hashelped in more or less containing the number ofbonds to the prevailing level at the end of 1999 (fis-cal year). The results of the process of consolidationmay be gauged from the fact that of the 110 out-standing loans,2 43 loans (39 percent) account for 77percent of the marketable debt stock. However, inview of the large and growing net borrowings by thegovernment, there has been a need to extend thematurity profile of government debt to minimize the

refinancing risk. The loans maturing within the next5 years account for 31 percent of the total debt stock,3

another 37 percent of the loans mature between thesixth and tenth year. Thus, about 32 percent of theloans mature after 10 years. The weighted averagematurity of the debt stock was about 8.20 years as ofthe end of 2001, compared with about 6 years as ofMarch 31, 1998.

Reopenings through price-based auctions (asopposed to earlier yield-based auctions) began in1999 and have greatly improved market liquidity andhelped the emergence of benchmark securities in themarket. In addition, such reopenings also havehelped the price discovery process, acting as a proxyfor the when-issued market.

Callbacks of numerous existing loans inexchange for a few benchmark stocks have not beenconsidered worthwhile because of administrative,cost, and legal considerations. In the absence of bud-get surpluses and a call provision for existing stocks,this form of active consolidation would be difficult toachieve.

However, during 2001–02, the government hadprepaid a part of expensive external debt from mul-tilateral institutions and restructured some costlyexternal debt from other countries. The governmenthas also allowed selected public sector enterprises toprepay a part of their expensive external debt, whichwas guaranteed by the government. These policieshave helped to reduce sovereign external debt, aswell as contingent liabilities of the government, tosome extent.

Cash management

In a landmark development in 1994, the governmentof India entered into an agreement with the RBI tophase out the system of automatic monetization ofbudget deficits within three years. Accordingly, thesystem of financing the government through creationof ad hoc treasury bills was abolished effective April 1,1997. Under a new arrangement, a scheme of waysand means advances (WMAs) was introduced to helpthe government of India to address the temporarymismatches in its cash flows. According to thisscheme, a limit was fixed for WMAs, so that when thegovernment reached 75 percent of the limit, the RBI


could enter the market on behalf of the governmentto raise funds. This arrangement meant that the gov-ernment has to fund its budget requirements at mar-ket-related rates. Keeping in view the trends in thegovernment’s cash flows, the limit for WMAs for thesecond half of the year is kept lower than that for thefirst half of the year. The introduction of the WMAsscheme demanded greater skills in active debt man-agement on the part of the RBI. It also brought upthe government’s need for efficient cash manage-ment. Accordingly, surplus funds, if any, in the gov-ernment’s account are invested in its own securitiesavailable in RBI’s portfolio, thus reducing the netborrowing from the RBI as well as the cost.

The RBI also provides WMAs to the states. Thelimits are fixed through a formula linked to their rev-enue receipts and capital expenditure. Once the lim-its are reached, the accounts go into overdraft, andthey are not only limited in size to the WMA boundbut also not allowed to continue beyond 12 workingdays. Beyond this point, payments are stopped onbehalf of the respective state government.

Surplus funds of states are invested in specialintermediate treasury bills of the central government.Because these instruments can be instantly redis-counted whenever required, the interest rate is fixedat the bank rate minus 1 percent. At the request ofthe state governments, the RBI also invests their sur-plus funds in dated securities offered by the govern-ment of India from its investment portfolio at pricesprevailing in the secondary markets.


Contingent liabilities of the central government arisebecause of the government’s role in promoting pri-vate savings and investment by issuing guarantees.Contingent liabilities of the central governmentcould be both domestic and external contingent lia-bilities and could also be explicit or implicit innature. Domestic contingent liabilities of the centralgovernment are made up of direct guarantees ondomestic debt, recapitalization costs for public sectorenterprises, or unfunded pension liabilities. Externalcontingent liabilities are made up of direct guaran-tees on external debt, exchange rate guarantees onexternal debt such as Resurgent India Bonds and

Indian Millennium Deposits, and counter-guaranteesprovided to foreign investors participating in infras-tructure projects, particularly for electric power.Although from the accounting point of view, contin-gent liabilities do not form part of the governmentdebt, they could pose severe constraints on the fiscalposition of the government in the event of default.

The total outstanding direct credit guaranteesissued by the central government on both domesticand external debt remained stable around Rs 1 tril-lion from the end of March 1994 to the end of March1999. Domestic guarantees increased modestly dur-ing the corresponding period, but there was an abso-lute decline in the guarantees on external debt. As aproportion of GDP, however, both domestic guaran-tees and external guarantees registered a decline of 3percent from 1993 to 1999. Thus, the total guaran-teed debt of the central government declinedsteadily, from 11.8 percent of GDP in 1993–94 to 5.9percent 1998–99.

In addition, the exchange rate guarantee onexternal debt has implications for the finances of thecentral government. For example, for ResurgentIndia Bonds, according to the agreement, exchangerate loss in excess of 1 percent on the total foreigncurrency, or the equivalent of US$4.2 billion, wouldhave to be borne by the government of India. Theextent of such a loss, since August 1998, whenResurgent India Bonds were first issued, woulddepend on the exchange rate prevailing at the timeof redemption in 2003. A similar exchange rate guar-antee was provided on the amount of US$5.5 billionraised through India Millennium Deposits fromOctober to November 2000. Counter-guarantees pro-vided to foreign investors participating in infrastruc-ture projects bring about similar risk for thegovernment exchequer. There is also a growing vol-ume of implicit domestic contingent liabilities in pen-sion funds.

Legal ceilings on government debt andcontingent liabilities

Given the legacy of huge public debt and interestburden due to a long history of high fiscal deficits,which has increasingly constrained maneuverabilityin fiscal management, the central government intro-


duced the Fiscal Responsibility and BudgetManagement Bill (2000) in parliament. The bill aimsat ensuring intergenerational equity in fiscal man-agement and long-term macroeconomic stability.This would be accomplished by achieving sufficientrevenue surplus; eliminating fiscal deficit; removingfiscal impediments in the effective conduct of mone-tary policy and prudential debt management consis-tent with fiscal sustainability through limits on centralgovernment borrowings, debt, and deficits; and estab-lishing greater transparency in fiscal operations. Thespecific target for debt management in this regard isto ensure that the total liabilities of the central gov-ernment (including external debt at the currentexchange rate) is reduced during the next 10 yearsand does not exceed 50 percent of GDP.Simultaneously, the central government will not bor-row from the RBI in the form of subscription to theprimary issues by the RBI.

The bill also attempts to check the contingentliability by restricting guarantees to 0.5 percent ofGDP during any financial year. In particular, trans-parency in budget statements would involve disclo-sure of contingent liabilities created by way ofguarantees, including guarantees to financeexchange risk on any transactions, and all claims andcommitments made by the central government thathave potential budgetary implications.


Need and approach

The development of deep and liquid markets for gov-ernment securities is of critical importance to the RBIin facilitating price discovery and reducing the cost ofgovernment debt. Such markets also enable the effec-tive transmission of monetary policy, facilitate intro-duction and pricing of hedging products, and serveas a benchmark for other debt instruments. Hence,as the monetary authority, the RBI has a stake in thedevelopment of debt markets. Liquid markets implymore transparent and correct valuation of financialassets; they also facilitate better risk management andare therefore extremely useful to the RBI as a regula-

tor of the financial system. As the system integrateswith the global markets, it is necessary to ensure low-cost financial intermediation in domestic markets orthe intermediation will move offshore. This rein-forces the argument for development of domesticdebt markets.

Therefore, since the early 1990s, the RBI hasbeen focusing on development of the governmentsecurities markets through carefully and cautiouslysequenced measures within a clear agenda for pri-mary and secondary market design, development ofinstitutions, enlargement of participants and prod-ucts, sound trading and settlement practices, dissem-ination of market information, and prudentialguidelines on valuation, accounting, and disclosure.

Primary dealers

In 1996, the structure of primary dealers was adoptedfor developing both the primary and the secondarymarkets for government securities in India. Theobjective of promoting an institutional mechanismfor primary dealers is to ensure development ofunderwriting and market-making capabilities for gov-ernment securities outside the RBI, so that the latterwill gradually shed these functions; the purpose isalso to strengthen the infrastructure in the govern-ment securities market to make it vibrant, liquid, andbroad-based. The intermediate goals include improv-ing the secondary market trading system, whichwould contribute to price discovery, enhance liquid-ity and turnover, encourage voluntary holding of gov-ernment securities among a wider investor base, andmake primary dealers an effective conduit for con-ducting open market operations.

Among their obligations are giving annual bid-ding commitments to the RBI, to underwrite the pri-mary issuance and offer two-way quotes in selectgovernment securities. The annual bidding commit-ments are determined through negotiations betweenthe RBI and the primary dealers. Serious bidding isensured through a stipulation of a success ratio (40percent) linked to the bidding commitments. Inreturn, the dealers are extended a liquidity supportby the RBI. This support, which was entirely a stand-ing facility in the initial years (linked to their biddingcommitments and secondary market activity with a


cap, a certain ratio of their net worth), is being grad-ually withdrawn. The primary dealers, along withbanks, are allowed to participate in the LiquidityAdjustment Facility of the RBI, whereby the RBI oper-ates in the market through repos and reverse repos.

Primary dealers are essentially well-capitalized,nonbanking finance companies, set up as subsidiariesof banks and financial institutions or as corporateentities, and they are predominant players in the gov-ernment securities market. Currently, 18 primarydealers are authorized by the RBI.

The RBI also envisaged the institutional mecha-nism of satellite dealers to further the efforts of theprimary dealers with a main objective of developing aretail market for government debt. As their namesuggests, they were to establish a link with a primarydealer, and thus the RBI did not extend them thesame benefits as those extended to primary dealers.This lack of access to the call money market and theimpediments in transacting in the repo market(including prohibition of sale of securities purchasedunder repos and prohibition of short sale) haverestricted the operations of the satellite dealers.Thus, the system has never succeeded. Althoughsome of the satellite dealers later became primarydealers, others have been active only as brokers.

Brokers

Although banks are encouraged to deal directly with-out involving brokers, they can undertake trades ingovernment securities through the member brokersof the National Stock Exchange, the Bombay StockExchange, and the Over-the-Counter Exchange ofIndia. About 35 percent of trades are OTC trades.The remaining trades are negotiated through bro-kers who are members of the exchanges and arereported on the exchanges. After irregularities in thesecurities market that involved fraudulent linksbetween the brokers and banks, banks were advisedby the RBI not to trade more than 5 percent of theirtransactions through a single broker.

Instruments

In the early 1990s, there was experimentation withissuing a variety of instruments, such as zero coupon

bonds, stocks for which investors could pay in install-ments, floating-rate bonds, and capital-indexedbonds, in addition to fixed-rate bonds.

The requirements of the various segments of themarket, the need to smooth the redemption patternacross different years, and the need to focus on issu-ing new securities in key benchmark maturities are allfactors that have resulted in issuing relatively longerdated securities in the last few years. To the greatestpossible extent, the RBI endeavors to issue securitiesacross the yield curve. Although the extended matu-rity profile has benefited long-term investors such asinsurance companies and pension or provident funds,it has resulted in asset liability mismatches for thebanking sector, which continues to be the major finalinvestor in, and holder of, government securities.Recognizing this, the RBI is attempting to develop theseparate trading of registered interest and principal ofsecurities (STRIPS) market in government securities.The consultative paper on STRIPS has been placed onthe RBI web site for wider consultation.4

Further, to facilitate interest rate risk manage-ment, the RBI has reintroduced floating-rate bondsin a modest way (the first issuance of floating-ratebonds was made in 1995). The outstanding floating-rate bonds account for less than 1.5 percent at pre-sent. Bonds with callable options have not beenexperimented with, taking into account the size ofthe overall debt, new issuance programs, and refi-nancing risk.

Issuance procedures

Government stock is normally sold through auction.Sometimes it is sold through a tap system with a fixedcoupon. The salient features of the issuance proce-dures have been codified and are placed in the pub-lic domain through a government notification called“general notification.” The public is notified of thedetails of each issuance, generally three to seven daysbefore the flotation or auction.

Issuance of a calendar has to address the trade-offbetween certainty for the market and flexibility for theissuer in terms of market timing. The uncertain trends inthe cash-flow pattern of the government also greatly con-strain the publication of the issuance calendar. An indica-tive calendar for issuance of marketable dated securities


by the government of India was introduced in April 2002for the first half of the fiscal year. It was followed by anannouncement of an indicative borrowing calendar forthe second half of the year in September 2002. This prac-tice of announcing the calendar twice a year is expectedto continue, to enable institutional and retail investors tobetter plan their investments and provide further trans-parency and stability in the government securities mar-ket. There is already a preannounced issuance calendarfor treasury bills auctions.

For the states, the RBI normally prefers a prean-nounced coupon method, and the yields are fixed about25 basis points above the rate prevailing in the marketfor a union government stock of similar maturity.

The auctions of government securities are openfor individuals, institutions, pension funds, providentfunds, nonresident Indians, overseas corporate bod-ies, and foreign institutional investors. Individualsand small investors such as provident and pensionfunds and corporations can also participate in auc-tions on a noncompetitive basis in certain specificissues of dated government securities and in treasurybill auctions. Noncompetitive bidding has beenallowed since January 2002, and up to 5 percent isallocated to noncompetitive bidders at weighted aver-age cutoff rates. Bids are received through banks andprimary dealers. A multiple-price auction format hasbeen the predominant method used for the auctions.However, the RBI of late has started using the uni-form-price auction method on an experimental basis.

Whenever there is an urgent need for the govern-ment to raise resources from the market, and sufficienttime is not available to prepare the market for a publicissuance, the RBI takes a private placement (at market-related rates based on the secondary market rates) andsuch acquisitions are off loaded in the secondary mar-ket during appropriate market conditions. The tapmethod is also used when the demand is uncertain andthe RBI and the government do not want to take on theuncertainty of auctioning the security. This approach iswidely used in the case of state government loans.

Technological development and settlementmechanism

The RBI developed a negotiated dealing system(NDS), which became operational in February 2002.

The NDS facilitates electronic bidding in auctions andoffers a straight-through settlement, because it con-nects with the public debt offices and banks’ accountswith the RBI. Banks, primary dealers, and other finan-cial institutions, including mutual funds, can negotiatedeals in government securities through this electronicmode on a real-time basis and report all trades to thesystem for settlement. The details of all trades aretransparently available to the market on the NDS. InOctober 2002, the RBI also began disseminating dataon trades in government securities reported on theNDS on a real-time basis through its web site.

The delivery-versus-payment system (DvP), intro-duced in 1995 for the settlement of transactions ingovernment securities, has greatly mitigated the set-tlement risk and facilitated growth in the volume oftransactions in the secondary market for governmentsecurities. Completion of the ongoing projects andlaunching of the associated functions and productsrelating to the Clearing Corporation of India Ltd.(CCIL), the NDS, electronic funds transfer, and theReal-time gross settlement (RTGS) system, as well asthe proposed Government Securities Act (in lieu ofthe existing Public Debt Act of 1944), would furtheraugment the efficiency and safety of the governmentsecurities market.

A clearing corporation, the CCIL, was intro-duced simultaneously with the NDS in February 2002.The CCIL acts as a central counter-party in the settle-ment of outright and repo transactions in govern-ment securities. The settlements through the CCILare guaranteed by the corporation through a settle-ment guarantee fund within the corporation, which isfunded by the members. The establishment of theCCIL is seen as a major step in the development ofthe government securities market, and the repo mar-ket is expected to witness significant growth.

Work on the RTGS system has already begun, andit is expected to bring about further improvement inthe payment and settlement system.

Retail market

The RBI has been encouraging wider retail participa-tion in government securities. As part of these efforts,the RBI has been promoting the gilt mutual funds todevelop a retail market for government securities.


Gilt funds are mutual funds with 100 percent of theirinvestments in government securities; the fund inturn sells its units to investors. The RBI offers a lim-ited liquidity support to the mutual funds in the formof repos to promote an indirect retail market for gov-ernment securities.

The RBI allows retail participation at the auc-tions on a noncompetitive basis up to a maximum of5 percent of the notified amount. Banks and primarydealers operate the scheme.

To bring about efficient and easy retail transac-tions in government securities, an order-driven,screen-based system is proposed to be implementedthrough the stock exchanges with adequate safe-guards for settlement.

Coordination between public debt managementand private sector debt

Together with active debt management of mar-ketable government debt, the RBI has been focusingon the need to rationalize the continuing adminis-tered interest rates and tax regime on small savingsand contractual savings, such as provident and pen-sion funds, not only to minimize the effective cost ofoverall debt but also to align the interest rates onthese liabilities with market-determined rates. Publicfinancial institutions, or long-term developmentbanking institutions, are the largest issuers of debt inthe nongovernmental sector, and guidelines havebeen issued to them for ensuring that the interestrates on debt they issue do not go beyond certainspreads over government securities of similar tenor.Corporate debt is not governed by the RBI and whilecommunicating to the government of India (MoF)the acceptable level of total market borrowing, theRBI takes into account the needs of the corporatesector that have to be met from both credit marketand capital (debt) markets.

Laws and regulations

The existing Public Debt Act of 1944 is expected tobe replaced by a new government securities bill. Theproposed legislation seeks to streamline and sim-plify procedures in the handling of public debt ofthe central and state governments and will reflect

the changes in the operating and technologicalenvironment.

Under the amendments in March 2000 to theSecurities (Contracts) Regulation Act, powers havebeen clearly delegated to the RBI for regulating thedealings in the government securities market.5

Short selling of securities is not permitted underthe current regulatory framework.

Tax treatment

Government securities are not subject to withholdingtax. Gains are treated as both income and capitalgains, depending on the nature of the transaction, andinvestors are allowed to pay tax on both a cash and anaccrual basis. Such a treatment, however, could causedistortions in the market when the STRIPS market ongovernment securities comes into existence. TheCentral Board of Direct Taxes has amended the guide-lines on tax treatment of zero-coupon bonds or deepdiscount bonds by requiring that for tax purposes, themark-to-market gains in the relevant year will be reck-oned. The tax incentive on nonmarketable debt, suchas small savings, has tended to distort the market forgovernment securities and a committee under theDeputy Governor of RBI recently recommended ratio-nalization of tax treatment on such instruments.

Adherence to CPSS-IOSCO standards

A detailed examination of CPSS-IOSCO standards isbeing undertaken separately. Nevertheless, the broadadherence to the standards can be described:

• Presettlement risk: Currently, all trades betweendirect market participants are confirmed directlybetween the participants on the same day and aresettled either on the same day or on the next day,thereby minimizing presettlement risk. Fortrades undertaken through members of theexchanges, confirmation is done on T+0, but set-tlement can be done up to T+5.

• Settlement risk: All trades undertaken by banks,financial institutions, primary dealers, and mutualfunds having “scripless” accounts with the RBI inits Public Debt Office are settled under a grosstrade-by-trade DvP system with queuing up to the


end of the day, when funds settlement is eventu-ally known. At this time, if there is shortage ofsecurities or funds, trades are considered “failed.”Such failure constituted only around 0.01 percentof the total number of trades in 2001 and about0.3 percent of the total value of trades in 2001.Both the presettlement and settlement risks wereminimized with the setting up of the CCIL and itsability to provide guaranteed settlement by vari-ous risk management systems, including the con-stitution of the settlement guarantee fund.

• Legal risk: Several of the legal safeguards recom-mended for securing safe settlement systems—including rights of central counter-parties to thesettlement guarantee fund in the event of, forexample, insolvency of members—are yet to be

put in place. However, pending detailed legisla-tive changes, the legality of various aspects of thesettlement process has been achieved throughthe framing of mutual agreements under con-tract law and through the use of concepts such asnovation for ensuring legality of netting.

Notes

1. The case study was prepared by Usha Thorat and CharanSingh from the Reserve Bank of India and Tarun Das from theMinistry of Finance.

2. These results are as of the end of 2001.3. These figures also occurred as of the end of 2001.4. www.rbi.org.in.5. The Securities and Exchanges Board of India is the capi-

tal market regulator. A High-Level Committee on Capital Marketcoordinates both the regulators.


Appendix

Table A.1. Outstanding Liabilities of the Central Government(In Rs 10 million)

Total Total outstanding

Internal Other outstanding External liabilities liabilities Internal internal External liabilities debt adjustedb

Year (3+4) debt liabilities debta (2+5) adjustedb (2+7)

1 2 3 4 5 6 7 8

1990–91 283,033 154,004 129,029 31,525 314,558 66,314 349,3471991–92 317,714 172,750 144,964 36,948 354,662 109,685 427,3991992–93 359,654 199,100 160,554 42,269 401,923 120,987 480,6411993–94 430,623 245,712 184,911 47,345 477,968 127,808 558,4311994–95 487,682 266,467 221,215 50,929 538,611 142,514 630,1961995–96 554,984 307,869 247,115 51,249 606,233 148,398 703,3821996–97 621,438 344,476 276,962 54,238 675,676 149,564 771,0021997–98 722,962 388,998 333,964 55,332 778,294 161,418 884,3801998–99 834,551 459,696 374,855 57,255 891,806 177,934 1,012,4851999–2000 962,592 714,254 248,338 58,437 1,021,029 186,791 1,149,3832000–01 1,111,081 803,698 307,383 65,945 1,177,026 189,990 1,301,0712001–02 (RE) 1,274,369 909,052 365,317 67,899 1,342,268 222,780 1,497,1492002–03 (BE) 1,444,248 1,021,739 422,509 68,520 1,512,768 n.a. n.a.

(As percent of GDP)

1990–91 49.8 27.1 22.7 5.5 55.3 11.7 61.4 1991–92 48.6 26.5 22.2 5.7 54.3 16.8 65.4 1992–93 48.1 26.6 21.5 5.6 53.7 16.2 64.2 1993–94 50.1 28.6 21.5 5.5 55.6 14.9 65.0 1994–95 48.2 26.3 21.8 5.0 53.2 14.1 62.2 1995–96 46.7 25.9 20.8 4.3 51.0 12.5 59.2 1996–97 45.4 25.2 20.2 4.0 49.4 10.9 56.4 1997–98 47.5 25.5 21.9 3.6 51.1 10.6 58.1 1998–99 47.9 26.4 21.5 3.3 51.2 10.2 58.2 1999–2000 49.9 37.0 12.9 3.0 52.9 9.7 59.6 2000–01 53.2 38.5 14.7 3.2 56.4 9.1 62.3 2001–02 (RE) 55.6 39.7 15.9 3.0 58.6 9.7 65.3 2002–03 (BE) 56.9 40.3 16.6 2.7 59.6 n.a. n.a.

a. At historical exchange rate.b. Converted at year-end exchange rates. Source: Indian authorities.


Table A.2. Combined Outstanding Liabilities of the Central and State Governments(In Rs 10 million)

State govt.Central government debt Combined central and state governments

Year Domestic Externalb Total Domestic Domestic Externalb Total

1 2 3 (2+3) 5 6 7 (6+7)

1990–91 283,033 66,314 349,347 110,289 319,432 66,314 385,7461991–92 317,714 109,685 427,399 126,338 360,787 109,685 470,4721992–93 359,654 120,987 480,641 142,178 410,579 120,987 531,5661993–94 430,623 127,808 558,431 160,077 489,546 127,808 617,3541994–95 487,682 142,514 630,196 184,527 557,294 142,514 699,8081995–96 554,984 148,398 703,382 212,225 638,296 148,398 786,6941996–97 621,438 149,564 771,002 243,525 719,390 149,564 868,9541997–98 722,962 161,418 884,380 281,207 836,207 161,418 997,6251998–99 834,551 177,934 1,012,485 341,978 978,018 177,934 1,155,9521999–2000 962,592 186,791 1,149,383 420,132 1,145,905 186,791 1,332,6962000–01 1,111,081 189,990 1,301,071 504,248 1,333,156 189,990 1,523,1462001–02 (RE) 1,274,369 222,780 1,497,149 n.a. n.a. 222,780 n.a.2002–03 (BE) 1,444,248 n.a. n.a. n.a. n.a. n.a. n.a.

(As percent of GDP)

1990–91 49.8 11.7 61.4 19.4 56.2 11.7 67.8 1991–92 48.6 16.8 65.4 19.3 55.2 16.8 72.0 1992–93 48.1 16.2 64.2 19.0 54.9 16.2 71.0 1993–94 50.1 14.9 65.0 18.6 57.0 14.9 71.9 1994–95 48.2 14.1 62.2 18.2 55.0 14.1 69.1 1995–96 46.7 12.5 59.2 17.9 53.7 12.5 66.2 1996–97 45.4 10.9 56.4 17.8 52.6 10.9 63.5 1997–98 47.5 10.6 58.1 18.5 54.9 10.6 65.5 1998–99 47.9 10.2 58.2 19.6 56.2 10.2 66.4 1999–2000 49.9 9.7 59.6 21.8 59.4 9.7 69.1 2000–01 53.2 9.1 62.3 24.1 63.8 9.1 72.9 2001–02 (RE) 55.6 9.7 65.3 n.a. n.a. 9.7 n.a.2002–03 (BE) 56.9 n.a. n.a. n.a. n.a. n.a. n.a.

a. At historical exchange rate.b. Converted at year-end exchange rates.


The management of the national debt in Ireland wasdelegated to the National Treasury ManagementAgency (NTMA) by legislation enacted in 1990. Thisdelegated authority includes issuance, secondary mar-ket activity, and all necessary ancillary activity, such as,for example, arranging for clearing and settlement.

Debt Management Objectives andCoordination

Objectives of debt management

The key objectives of the NTMA in managing thenational debt are, first, to protect liquidity to ensurethat the exchequer’s funding needs can be financedprudently and cost effectively and, second, to ensurethat annual debt-service costs are kept to a minimum,subject to containing risk within acceptable limits. Itmust also have regard to the absolute size of the debtinsofar as its actions can affect it (deep discounts andcurrency mix).

Although the broad objectives of debt manage-ment have remained more or less unchanged, the

emphasis on how best to achieve these objectives haschanged, particularly in response to Ireland’s adoptionof the euro.

Scope

Debt management activity covers both the issue and thesubsequent management of the central government’sshort-term and long-term debt as well as the manage-ment of its cash balances. The management of the debtis concerned with both the annual cost of debt service,in the traditionally understood sense of measuring andcontrolling the total value of interest and debt issuancecosts each year, as well as with the economic impact,over the life of the debt, of all debt management activ-ity. This latter aspect of debt management is capturedby measuring the net present value (NPV) of the debtand comparing it with a benchmark.

Coordination with monetary and fiscal policy

The annual debt service cost, in terms of cash flows, isa major part of the overall expenditure in the budget ofthe ministry of finance (MoF) and is framed to be con-

81

5Ireland1

sistent with the general level of borrowing or surplusenvisaged by that budget. Monetary policy is the pre-rogative of the European Central Bank (ECB), andbefore the introduction of the euro, it was under thecontrol of the Central Bank of Ireland (CBI). Debtmanagement policy is not coordinated with the ECB’smonetary policy. Before 1999, neither was there anyformal coordination of debt management policy withthe monetary policy of the central bank, even thoughthere was a nonstatutory exchange of information andviews with the CBI on the main thrust of debt man-agement policy. In managing the debt, the NTMA wasconscious of the need to avoid any conflict with thecentral bank’s monetary and exchange rate policies.The advent of the euro in 1999 ended the scope ofand need for such policy sensitivity.

Treasury service and advice to other arms ofgovernment

The debt management activity of the NTMA relatesonly to the debt of the central government. The debt ofother arms of the government, such as local govern-ment authorities, regional health boards, and state bod-ies, remains the responsibility of those bodies, subjectto approvals and guidelines issued by the departmentof finance. The NTMA has been empowered, however,to offer a central treasury service, in the form of depositand loan facilities, as well as treasury advice to a rangeof designated local authorities, health boards, and localeducation committees. It has also been authorized toadvise ministers on the management of funds undertheir control and, where the requisite authority is dele-gated, to manage such funds on behalf of those minis-ters. The NTMA currently manages the assets of theSocial Insurance Fund under such delegated authority.It has also been mandated to manage the NationalPensions Reserve Fund under the direction of theNational Pensions Reserve Fund Commissioners, whoare appointed by the minister of finance.


Relationship with the minister of finance

The minister of finance approves the budget forannual debt-service costs, and the NTMA is obliged

under legislation to achieve that budget as near as maybe. Its performance relative to this budget is reportedto the MoF, as is the performance in NPV terms againsta benchmark portfolio. However, all debt-service pay-ments, including redemptions, are a first charge onthe revenues of the government and, under the provi-sions of the legislation that authorizes the raising ofdebt, are not subject to annual approval by the minis-ter or by parliament. The NTMA also reports to theMoF on the very broad outlines of its borrowing plansfor each year, indicating how much it intends borrow-ing in the currency of the state and how much in othercurrencies. The minister gives directions to the NTMAeach year in the form of widely drawn and prudentiallyintended guidelines covering the major policy areas,such as the mix of floating- and fixed-rate debt, thematurity profile, foreign currency exposure, and otherfinancial data. The public auditor, the comptroller andauditor general, carries out an audit each year on theagency’s compliance with these guidelines.

Role of debt managers and the central bank

The debt managers and the CBI have distinct andnonoverlapping roles from both a legal and an insti-tutional perspective in that the central bank has norole in debt management policy. The introduction ofthe euro in 1999 did not essentially alter the relation-ship, except to the extent that it removed the necessityfor the degree of informal exchange of informationand views that had existed before that date in theinterest of the smooth operation of both monetarypolicy and debt management policy. At present, theNTMA cooperates with the central bank’s actions inimplementing the liquidity management policy of theECB by maintaining an agreed level of funds in theexchequer account in the central bank each day. TheCBI also maintains the register of holders of Irish gov-ernment bonds. In December 2000, the clearing andsettlement function for Irish government bonds wastransferred from the central bank to Euroclear.

Open process for formulating and reporting of debtmanagement policies

The NTMA’s annual report and accounts include afull statement of its accounting policies. In addition,


it publishes at the beginning of each year a calendarof its bond auctions for that year, together with astatement of the total amount of issuance planned forthe year. The NTMA’s bond auctions are multiple-price auctions and are carried out by means of com-petitive bids from the recognized primary dealers. Atpresent, there are seven such dealers who are obligedto quote electronically indicative, two-way prices indesignated benchmark bonds within maximumbid/offer spreads for specified minimum amountsfrom 8:00 a.m. to 4:00 p.m. each day. In addition,primary dealers are required to be market makers inIrish government bonds on the international elec-tronic trading system, Euro MTS, and on the domes-tic version of it, MTS Ireland.

Public availability of information on debtmanagement policies

The government’s budgetary forecasts for the com-ing year and the two following years are publishedannually in December. These forecasts include fig-ures for the overall budget surplus or deficit of thegovernment for each year. The preliminary out-turnfor the current year is also shown. In addition, thefinance accounts published each year by the govern-ment contain detailed information on the composi-tion of the debt, including the type of instrument,the maturity structure, and the currency composi-tion. During the course of the year, the MoF pub-lishes detailed information on the evolution of thebudgetary aggregates at the end of each quarter,together with an assessment of the outlook for theremainder of the year. The NTMA publishes anannual report that contains its audited accounts aswell as a description of its main activities. It also pub-lishes information during the year on the details ofall the markets on which it operates and the amountoutstanding on the various debt instruments used inthese markets. Also, information on the amount out-standing on each of the bonds it has issued isreleased each week to the public.

Accountability and assurances of integrity

The NTMA has a control and a compliance officerwho reports to the chief executive. It also engages a

major international accounting firm to undertake aninternal audit of all data, systems, and controls. Inaddition, the annual accounts are audited by the stateauditor, the comptroller and auditor general, beforetheir presentation to parliament within a statutorydeadline of six months after the end of the account-ing year. The comptroller and auditor generalreports the findings to parliament.


Governance

The National Treasury Management Agency Act of1990 provided for the establishment of the NTMA “toborrow moneys for the Exchequer and to manage theNational Debt on behalf of and subject to the controland general superintendence of the Minister forFinance and to perform certain related functions andto provide for connected matters.”

The 1990 Act enabled the government to dele-gate the finance minister’s borrowing and debt man-agement functions to the NTMA, such functions tobe performed subject to such directions or guidelinesas he or she might give. Obligations or liabilitiesundertaken by the NTMA in the performance of itsfunctions have the same force and effect as if under-taken by the minister.

The chief executive, who is appointed by theMoF, is directly responsible to the minister and is theaccounting officer for the purposes of the Dáil’s(lower house of parliament) Public AccountsCommittee. The NTMA has an advisory committee,comprising members from the domestic and interna-tional financial sectors and the MoF, to assist andadvise on such matters as are referred to it by theNTMA.

The main reasons behind the decision to estab-lish the NTMA were outlined as follows by the minis-ter of finance when he introduced the legislation tothe parliament in 1990:

… debt management has become an increas-ingly complex and sophisticated activity,requiring flexible management structuresand suitably qualified personnel to exploitfully the potential for savings.

Country Case Studies: Ireland 83

… it has become increasingly clear that theexecutive and commercial operations of bor-rowing and debt management require anincreasing level of specialization and are nolonger appropriate to a GovernmentDepartment. Also, with the growth of thefinancial services sector in Dublin, theDepartment [of Finance] has been losingstaff that are qualified and experienced inthe financial area and it has not been possi-ble to recruit suitable staff from elsewhere.

… [in the agency] there will be flexibility asto pay and conditions so that key staff can berecruited and retained; in return, they will beassigned clear levels of responsibility andmust perform to these levels: the agency’sstaff will not be civil servants.

It was considered that locating all debt manage-ment functions within one organization, which had amandate to operate on commercial lines and had thefreedom to hire staff with the requisite experience,would lead to a more professional management ofthe debt than would be possible within the con-straints of the civil service system.

To ensure the complete independence of theNTMA from the civil service, the legislation establish-ing it expressly precludes its staff from being civil ser-vants. However, political accountability is maintainedby having the NTMA’s chief executive report directlyto the minister of finance and by making the chiefexecutive the accounting officer responsible for theNTMA’s activity before the Public AccountsCommittee of parliament.

The overall borrowing and debt managementpowers of the minister have been delegated to theNTMA and further annual parliamentary or legisla-tive authority to borrow or engage in other debt man-agement activities is not required. However, theNTMA is required to present to the MoF each year astatement setting out how much it intends to borrowin the currency of the state and in other currenciesduring the course of the year. Broadly speaking, it isempowered to use transactions of a normal bankingnature for the better management of the debt. Thisbroad power includes the use of derivatives as well as

power to buy back debt or, where the borrowinginstrument permits, to redeem it early.

Structure within the debt office

The NTMA’s structure reflects the fact that it has anumber of other functions in addition to debt man-agement, namely the management of the NationalPensions Reserve Fund, under the direction of theNational Pensions Reserve Fund Commissioners, andthe processing of personal injury and property dam-age claims against the state, in which role the NTMAis known as the state claims agency.

Directors report to the chief executive on fund-ing and debt management and IT, risk and financialmanagement, legal and corporate affairs (includingretail debt), the National Pensions Reserve Fund, andthe state claims agency. The NTMA also has an advi-sory committee, appointed by the MoF, to advise onthe chief executive’s remuneration and such mattersas are referred to it by the NTMA.

The separation of the front office function (fund-ing and debt management) from the middle officefunction (risk management) and the back officefunction (financial management) is in accordancewith best practice and ensures an appropriate separa-tion of powers and responsibilities.

The NTMA retains key staff through its employ-ment contracts and remuneration packages, whichare flexible and designed to attract qualified perma-nent or temporary personnel as required. This free-dom to recruit and pay staff in line with marketlevels was a key element in the government’s deci-sion to establish the NTMA. Because the NTMA is arelatively small organization, the training of staff isgenerally outsourced as the most efficient option.Its IT department has built the back office IT sup-port systems to provide straight-through processingof trades from front office to back office and also togenerate the required management reports.Temporary IT expertise was contracted as necessaryto achieve this objective. The NTMA is a member ofthe Society for Worldwide Interbank FinancialTelecommunication (SWIFT) and theTransEuropean Real-Time Gross Settlement ExpressTransfer (TARGET), which enables real-time pro-cessing of payment transactions.



Internal operational risk is controlled by rigorouspolicies and procedures governing payments and theseparation of duties, in line with best practice in thefinancial sector generally, including:

• Segregation of duties between front office andback office functions: This practice is enforced bylogical and physical controls over access to com-puter systems and by the application of officeinstructions and product descriptions.

• Office instructions describe detailed proceduresfor key functions and assign levels of authorityand responsibility.;

• Product descriptions set out a description of theparticular product and detailed processinginstructions and highlight inherent risks.

• Bank mandates are established with institutionswith whom dealing is permitted.

• Third-party confirmations are sought for alltransactions.

• Reconciliations and daily reporting.• Monitoring of credit exposures arising from

deposits and derivative transactions, which aremanaged within approved limits.

• Voice recording of certain telephones.• Head of control function/internal audit/exter-

nal audit.• Code-of-conduct and conflict-of-interest guide-

lines

Disaster recovery plans are also in place that wouldenable the NTMA to resume its essential functionsfrom a back-up site within one to four hours. This planis tested regularly and is made possible by the arrange-ments for complete back-up of all computer data andtheir storage off-site three times each day.


The overall debt management strategy is to protectliquidity so as to ensure that the exchequer’s fundingneeds can be financed prudently and cost effectivelyand at the same time ensure that the annual costs of

servicing the debt are kept to a minimum, subject toan acceptable level of risk.

Risk management

The main risks associated with managing the debtportfolio, apart from operational risk, which has beendiscussed, are credit risk, market risk, and fundingliquidity risk.

Credit risk

Credit limits for each counter-party are proposed bythe risk management unit and approved by the chiefexecutive. The credit exposures are measured eachday, and any breach is immediately brought to theattention of the chief executive.

In setting credit limits for individual counter-par-ties, there is a single limit on the consolidated busi-ness with the counter-party—that is, all businesses arebrought together under one limit. Each limit isdivided into short-term (up to one year to maturity)and long-term (more than one year to maturity). Indetermining the maximum size of an exposure to acounter-party that the NTMA is willing to undertake,account is taken of the size of the counter-party’s bal-ance sheet and the return on capital, as well as thecredit rating and outlook assigned by Moody’s,Standard and Poor’s, and Fitch, the major credit-rat-ing agencies. The market value of derivatives is usedin measuring the credit risk exposures. The creditrisks are also assessed by reference to potentialchanges in the exposures as a result of market move-ments and the position is kept under continuousreview.

Market risk

The NTMA manages the cost and risk dimensions ofthe debt portfolio from a number of perspectives,including (a) managing the performance of theactual portfolio relative to the benchmark portfolioon an NPV basis and (b) managing the debt-servicebudget. Both interest rate risk and currency risk arecontrolled, measured, and reported on.

The benchmark reflects the medium-term strate-gic debt management objectives of the exchequer


and encapsulates the NTMA’s appetite for marketrisk. When the benchmark has been agreed uponwith its external advisers, it is then approved by theminister of finance. The minister decides whether itis consistent with his or her overall guidelines on themanagement of the debt. Revisions to the benchmarkare made from time to time (subject to approvals bythe NTMA’s external advisers and the Department ofFinance) to take account of significant changes instructural economic relationships but not in responseto short-term market movements.

The benchmark portfolio is a computer-basednotional portfolio representing an appropriate targetinterest rate, currency mix, maturity profile, andduration for the portfolio. The benchmark is basedon a medium-term cost/risk trade-off derived fromsimulation analysis. Cost is defined in terms of themark-to-market value of the debt, and risk is definedin terms of the likelihood that debt-service costs willexceed the budget provision of the minister offinance. The simulations lead to the choice of abenchmark portfolio, which is robust under a rangeof possible out-turns rather than highly dependenton one set of assumptions regarding the future evo-lution of interest rates and exchange rates.

One of the major risks that must be controlled isthe possibility that the annual debt-service cost willfluctuate wildly from year to year and exceed the targetlevel set out by the minister of finance. In tandem withthis, the benchmark seeks to minimize the overall costof the debt in terms of its mark-to-market value. In con-structing the benchmark, the simulation exercises seekto find a portfolio that minimizes the mark-to-marketvalue (the cost) while ensuring that the annual debt-service cost is at the minimum level consistent with notfluctuating wildly from year to year. The stability of thedebt-service budget over time is more important thanminimizing the cost in any one year. Overall, thebenchmark seeks to strike a balance between thepotentially conflicting objectives of minimizing theNPV of the debt while maintaining the lowest possiblestable debt-service costs over the medium term.

Reports

The fiscal budget for annual debt-service costs is sen-sitive to exchange rate and interest rate risks. Each

month, two estimates are produced and reported toquantify the level of this risk:

• Sensitivity of the fiscal budget to a 1 percentmovement in interest rates: The interest compo-sition of the outstanding debt and the expectedfunding requirements are taken into considera-tion while assessing the possible gains or lossesthat could be incurred were interest rates tomove by 1 percent.

• Sensitivity of the fiscal budget to a 5 percentmovement in exchange rates: This takes into con-sideration the currency composition of the debt.It looks at the possible gains or losses to the debt-service budget in the event of exchange ratemovements.

A set of internal monthly fiscal risk limits is put inplace early each year. These limits reflect the prudentrisk limit for the fiscal budget. The sensitivity reportsare compared to these limits to check for compli-ance.

The main reports for the ongoing managementof the debt-service budget are:

• Monthly update of the debt-service forecast forthe current year: The forecast is broken down bythe various debt instruments and includes amonthly profile of the full year’s debt-servicebudget.

• An analysis of the variances between the debt-ser-vice out-turn and the debt-service forecast.

• Monthly report on the debt-service budget, ana-lyzing the effect of possible exchange rate andinterest rate movements: This report is done forboth current year’s fiscal budget sensitivities andfuture years’ fiscal budget sensitivities.

Benchmarking of the domestic portfolio

When the Irish government debt management opera-tions were carried out in the context of an Irish pound(punt) market, before the introduction of the euro, thebenchmarking of performance on the domestic debtportfolio was much more difficult than benchmarkingthe foreign portfolio. Nevertheless, it was consideredbeneficial to benchmark domestic performance to pro-


vide appropriate incentives for the debt portfolio man-agers. The benchmarking system was devised to givecredit for any structural improvements in the domesticbond market brought about by the portfolio managers(e.g., the introduction of the primary trading systemand the concentration of liquidity into a smaller num-ber of benchmark issues). The benchmark was alsoused to assess the effectiveness of the domestic debtmanagers in achieving their funding target within pre-viously agreed duration limits. The managers were freeto vary the timing of their funding actions comparedwith the benchmark, depending on their interest rateview. Thus, at all times, the debt managers wererequired to have a view on interest rates when decidingon their issuance policy.

With the development of a relatively uniformeuro-area government bond market, Ireland becamea very small part of a large liquid market and thus thebenchmarking of the domestic debt managementoperations became more straightforward.

Funding liquidity risk

The NTMA prepares and manages a detailed multi-year funding plan that shows the amount and timingof funding needs, including the effect of the projectedsurpluses or deficits on the government’s budget. Inlight of this plan, it determines the size and timing ofits long-term debt issuance and manages its short-termliquidity positions through the issuance of short-termpaper or the use of short-term cash balances.

The main reports for the ongoing maintenanceof the exchequer’s funding and liquidity require-ments are

• the weekly updating of the NTMA’s overall fund-ing plan, which includes a review of its underly-ing assumptions and a review of immediateliquidity requirements; and

• regular reports on the main features of the devel-opments in the government’s overall budgetaryposition to date, and a review of the current out-look.

With the introduction of the euro, the NTMA tooka number of steps to enhance the marketability of itsbonds and thus reduce funding risk. Broadly speaking,

the technical characteristics of Irish governmentbonds (e.g., day-count convention) have beenchanged to bring them into line with the bonds of thelarge, core euro-area issuers. In addition, a number ofbond exchange and bond buyback programs havebeen executed with the objective of concentrating liq-uidity into a smaller number of large, liquid bench-mark issues. At present, virtually all the marketable,long-term, euro-denominated debt with more thanone year to maturity is concentrated into five bonds.The NTMA also promotes the openness, predictability,and transparency of the market in Irish governmentbonds through announcing in advance its schedule ofbond auctions, by having a primary dealing system tosupport the market in the bonds, and by arranging forthe listing of the bonds on one of the main electronictrading platforms used for trading euro-area sovereigndebt. The deep liquidity thus generated for the marketin Irish government bonds reduces the funding risk bymaking the bonds more attractive to a wider pool ofinvestors. Given that Ireland represents a very smallproportion of the total euro-area government debtmarket (about 1 percent), the NTMA has little diffi-culty in raising short-term funds to smooth the fundingrequirement around the time of the redemption ofbonds, whose size is quite large by historical standards.

Medium-term focus of debt management

A number of approaches are adopted to ensure thatthe NTMA’s debt management activities are notfocused on short-term advantage at the cost of poten-tial longer-term cost. First, each year, the minister offinance issues a set of guidelines covering policyissues such as the mix of floating- and fixed-rate debt,the maturity profile, the foreign currency exposure,the permissible extent of discounted issues, and thecredit rating of counter-parties. These guidelines aredrawn relatively broadly and are designed as pruden-tial limits, which the NTMA must observe. Second,the NTMA’s performance in managing the debt ismeasured by reference to an independent and exter-nally approved and audited benchmark portfolio.This benchmark performance measurement systemtakes account not just of current cash flows but also ofthe NPV of all liabilities; in effect, it calculates theimpact of the NTMA’s debt management activities


not only in the year under review but also their pro-jected impact over the full life of the debt. Under theNPV approach, all future cash flows (both interestand principal) of the notional benchmark debt port-folio and of the actual portfolio are marked to mar-ket at the end of each year and discounted (based onthe zero-coupon yield curve) back to their respectiveNPVs. If the NPV of the liabilities in the actual port-folio is lower than the NPV of the notional bench-mark portfolio’s liabilities, then the NTMA is deemedto have added value in economic terms. This perfor-mance against the benchmark is reported to the MoFand published in the NTMA’s annual report.

Limitations on activities to generate a return

The managers of the debt portfolio are free to man-age the debt within certain risk limits relative to theagreed benchmark. The limits are expressed in termsof the possible change in the market value of theportfolio. Value-at-risk (VaR) and interest and cur-rency sensitivity analysis are used to measure theshort-term deviations from the benchmark on aweekly basis (or more frequently, if required). Anyposition that exceeds the agreed limit relative to thebenchmark portfolio is immediately brought to theattention of the chief executive.

In managing the debt relative to a benchmark itis necessary to take views on movements in interestrates, unless one wishes to passively track the bench-mark. However active daily trading simply to generatea profit does not take place. The trades entered intoby the NTMA are for the purpose of managing thedebt, and in the course of this certain arbitrageopportunities may arise. For example, one area ofarbitrage that is exploited by the debt managers is theissuance of commercial paper, mainly in U.S. dollarsbut also in other foreign currencies, and the swap-ping of these currencies into euros for an overalllower cost of funds than could be achieved by directborrowings in the euro-denominated commercialpaper markets.

Strict limits are placed on the activities of thedebt managers in availing of arbitrage opportunitiesbetween different markets. Although it is generallyfeasible for the debt managers to raise funds in theshort-term paper markets at lower interest rates than

could be obtained in placing those funds on depositin the market, the general policy of the NTMA is thatborrowing activity will be related to the fundingneeds of the exchequer. It is, however, desirable tomaintain a continuous and predictable presence inthe government debt markets, and, in addition, cashsurpluses will emerge from time to time on the exche-quer account because of mismatches between thetiming of government receipts and payments. Thesurpluses that arise in this way can be placed ondeposit in the markets, subject to the constraints ofthe limits on counter-party credit risk.

The main reports for performance measurementagainst the benchmark portfolio are

• daily performance results and positions, whichare electronically circulated to the dealers’ desks;

• monthly VaR analysis to ensure that all risk limitsare complied with; and

• quarterly detailed reports on the attribution ofperformance.

Models to assess and monitor risk

To assess and monitor risk, the NTMA uses modelsdeveloped in-house and models purchased exter-nally; the latter are used particularly for mark-to-mar-ket valuations as part of the risk assessment process.These systems are used mainly to measure and reporton market risk and counter-party credit risk expo-sures on a daily basis.


The NTMA is not responsible for the government’scontingent liabilities. These contingent liabilities thatarise from government guarantees of the borrowingsof state companies or other state bodies are moni-tored and managed by the Department of Finance.


Filling out the yield curve

The NTMA issues the following debt instruments:


• Commercial paper is issued directly to investorsor via intermediate banks. The commercialpaper is available in all currencies, with tenorsnot normally exceeding a year.

• Exchequer notes are treasury bills with a maturityrange from one day to one year. Each day, theNTMA issues the notes directly through an “openwindow” facility to a broad range of institutionalinvestors, including corporate investors andbanks. The NTMA is prepared to buy back exche-quer notes before maturity. At present, there isjust a small secondary market. The NTMA isexamining the possibility of improving the sec-ondary market by having the notes traded on anelectronic trading platform.

• Section 69 notes: In Section 69 of the FinanceAct of 1985, the MoF provided for the issue ofinterest-bearing notes to foreign-owned compa-nies in Ireland. The interest on these noteswould not be subject to tax in Ireland. Thisincentive was introduced to encourage thesecompanies to keep their surplus cash in Irelandrather than repatriate funds to their overseas par-ent companies. Section 69 notes can be issued inany currency (minimum 100,000) for any tenor.

• Fixed-rate, euro-denominated bonds with matu-rities up to 14 years are issued by auctions. Thebonds are listed on the Irish Stock Exchange andsupported in the market by seven market makers(primary dealers).

Foreign and domestic currency debt

Although issuing debt in foreign currencies is nowregarded as appropriate for Ireland, because of theadvent of the euro with its deep liquid capital market,it is important to remember that conditions for asmall open economy such as Ireland were very differ-ent in the 1980s.

The problem essentially arose as a result of theoil crisis of 1979 and the subsequent worldwide reces-sion that, along with the prevailing high internationalinterest rates, had severe adverse consequences forIreland 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.

These factors, coupled with the underdevel-oped nature of the domestic Irish bond market, ledto large-scale foreign borrowing, with a rapidgrowth in overall indebtedness. In 1991, the posi-tion was that foreign currency debt accounted for35 percent of the national debt and nonresidentsheld a further 15 percent denominated in Irish cur-rency. Thus, nonresidents held 50 percent of thetotal national debt.

The NTMA faced a much-changed domestic andinternational borrowing environment with the grad-ual abolition of currency controls and the relaxationof the primary and secondary liquidity ratios onbanks. During the 1980s, these controls (althoughhindering the development of the domestic capitalmarket) had ensured something of a “captive mar-ket” for Irish government bonds and paper. TheNTMA now faced a more competitive environmentfor attracting investors. Internationally, sovereignnames were moving away from the traditional syndi-cated loans toward capital market instruments.

Priorities for the early years of the NTMA

In the early 1990s, the NTMA identified the followingpriorities for its borrowing program:

• expanding, broadening, and diversifying theinvestor base through such ideas as marketingIreland’s name abroad and keeping it visiblethrough road shows and presentations to influ-ential investors (Japanese yen Samurai, CHF pri-vate placement, and U.S. dollar Yankee marketswere very important for Ireland in the early daysof the NTMA);

• tapping new markets;• keeping access to retail and institutional

investors;• lengthening the duration of the debt and creat-

ing a more balanced maturity profile;• targeting upgrades in Ireland’s credit ratings

(campaigns to get upgrades ahead of time or thatwere forward looking);


• marketing campaigns to improve the interna-tional image of Ireland (emphasizing the rarityvalue of Ireland’s name); and

• opportunistic approach to foreign borrowing.

The payoff from this approach was that Irelandwas very successful in terms of pricing new issues andregularly achieved tighter or keener pricing than sim-ilar or more highly rated sovereign borrowers.

In response to the need to diversify the sources offunding, because all markets are not open at thesame time, and to broaden and deepen the rangeand quality of instruments available for debt manage-ment, Ireland put in place standardized medium-term notes (MTNs), euro medium-term notes(EMTNs), euro commercial paper (ECP), and U.S.dollar commercial paper (USD CP) programs. Bymid-1992, the NTMA had put in place facilities in arange of currencies totaling about US$3 billion,which allowed Ireland immediate and cost-effectiveaccess to short- and medium-term funds with maxi-mum flexibility.

These facilities showed their worth in theautumn of 1992, when, because of the shock of thehuge extra borrowing needs of sovereign namescaused by the turmoil in the exchange rate mecha-nism of the European Monetary System, large syndi-cated loans and capital market issues becameparticularly expensive as spreads widened.

Although in the early years of the NTMA’s exis-tence, there was more focus on achieving cash savingson the debt-service cost because of government bud-getary pressures, the liquidity risk due to the unevenmaturity profile also required urgent attention.

Moves to smooth the maturity profile occurred in1991. In 1995, the NTMA arranged a 7-year US$500million, backstop, multicurrency revolving creditfacility to support the issuance of commercial paper.Moreover, it arranged the syndication itself to cutdown on fees and achieved the tightest pricing everby a sovereign.

The NTMA also took steps to ensure that deriva-tive instruments (such as interest rate swaps, cross-currency swaps, caps, floors, futures, and foreigncurrency forward contracts) as well as spot transac-tions in foreign currencies were available to be usedin the management of the debt. The great advantage

of recent financial innovations is not that they canhelp to lower the cost of funds, but rather that theseinstruments can help to protect the portfolio againstdifferent kinds of risks by, for example, shortening orlengthening the average effective duration of the out-standing debt.

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 marketrisk more efficiently and dynamically.

The NTMA took the view that the most sophisti-cated debt managers are not those who achieve thelowest possible cost of borrowing. The goal needs toinclude minimizing exposure to risk as well as mini-mizing costs. It is worth paying more to create debtstructures that cushion, rather than amplify, theimpact of negative shocks. These developmentsproved positive for credit ratings, investors, and thespreads on Irish sovereign debt as they reduced therelative risk premium.

In 1998, the NTMA decided that, with the immi-nent introduction of the euro and the relatively posi-tive outlook for government finances, the largeeuro-area bond and money markets would more thanadequately meet Ireland’s funding needs for theforeseeable future; therefore, it was no longer neces-sary to retain exposure to non–European Economicand Monetary Union (EMU) currencies in the port-folio. Consequently, all noneuro debt, with the excep-tion of a residual 6 percent that was left in poundssterling, was swapped back into euros during late1998 and early 1999. This remains the policy today.

The pound sterling exposure was maintained noton the basis of a cost/risk trade-off for debt manage-ment purposes, but rather as a macroeconomichedge for public finances in the event of a suddenand significant weakening of the pound sterlingexchange rate. This decision was taken on the basis ofa study of the economic links with the U.K. economyof a considerable number of firms whose output isbased on relatively low-skilled labor and whose profitmargins tend to be low. These firms compete with


U.K. firms on the domestic market, the U.K. market,and third markets. Any substantial weakening ofpound sterling would lead to a loss of competitivenessand consequential redundancies in this sector, result-ing in higher social welfare support payments by theexchequer. This would have been offset to somedegree by the lower cost, in Irish pound and euroterms, of servicing the sterling-denominated debt.However, the NTMA is currently reviewing this policy,and it has reduced the pound sterling exposure toabout 4 percent of the national debt.

Reduction of fragmented debt stock andissuance of consolidated debt

Securities exchange program

With the objective of reducing borrowing costs forthe government, a number of initiatives have beentaken by the NTMA over the years to improve liquid-ity in the Irish bond market. After the launch of theeuro, the NTMA decided that a major initiative wasrequired to ensure that Irish bonds traded effectivelyin the new, euro-denominated, pan-European mar-ket. The initiative taken was the securities exchangeprogram. The rationale underlying the program wasthe NTMA’s belief that to be competitive in the neweuro environment, Irish government bonds that are“on the run” must have a relatively large issue sizeand technical characteristics analogous to those inother euro-area markets.

In May 1999, the NTMA addressed the aboveissues, within the constraints of the overall limitedsize of the Irish government bond market, by launch-ing a securities exchange program that consolidatedabout 80 percent of the market into four bonds, eachwith outstanding amounts of 3–5 billion, withcoupons around current market yields and technicalcharacteristics similar to bonds in other Europeanmarkets. In the absence of such an initiative, therewas a risk that the bonds would trade at yields inap-propriate to Ireland’s credit rating.

Execution of the program

The exchange program was launched in May 1999,with the majority of the transactions taking place in

three phases—that is, on May 11, 17, and 25. On com-pletion of the third phase, more than 91 percent ofthe outstanding amount of old bonds covered by theprogram had been exchanged for new bonds.

As a result of the exchange program, the ratio ofgeneral government debt (based on nominal value)to GDP was increased by some 5 percentage points.However, because of the effect of the very rapidgrowth in GDP, the ratio, which was 55.1 percent atthe end of 1998, had fallen to 49.6 percent at the endof 1999, including the effects of the exchange pro-gram. The program did not affect the economic valueof the outstanding debt. Cash-flow savings repre-sented by the lower annual coupons on the new bondsoffset the addition to the capital stock of the debt. Thebonds bought back under the program were tradingabove par, because they had been issued at a timewhen interest rates were very much higher than in1999. However, the bonds issued under the programwere priced very close to par. Hence, the nominalvalue of the debt increased as a result of the program.

Bond switching program, 2002

In January 2002, the NTMA conducted its first majorbond switch since the 1999 securities exchange pro-gram. Two of Ireland’s existing benchmark bonds(the 3.5 percent 2005 and the 4 percent 2010) werenow “off the run” in terms of their euro-area peergroup.

The NTMA wished to launch two new bench-mark bonds that would have a good shelf life andwould be of sufficient critical mass (a5 billion) to jointhe Euro MTS electronic trading system by mid-2002.The intention was that the two new bonds would bereopened by way of auctions in 2002. The best way toachieve these strategic aims was to offer the marketswitching terms out of the former 2005 and 2010bonds into to new benchmark issues (a 2007 and a2013 bond).

The switch was successfully conducted via theNTMA’s primary dealers. The 2005 and 2010 bondsceased to be designated as benchmarks, because, underNTMA rules, once 60 percent or more of the amountin issue has been bought back, a bond loses its bench-mark status. This stipulation acts as in incentive forinvestors via the primary dealers to take part in the


switch, because most investors do not wish to be in non-benchmark stocks with the resultant price illiquidity.

Bond issuance procedures

Regular auction scheduleBetween February and November 2002, subject tonormal market conditions prevailing, the NTMA hasheld a bond auction on the third Thursday of eachmonth. Each auction is normally in the a500 mil-lion–700 million range and involves the new 2007and 2013 benchmark bonds (and the 2016 bond,which was first issued in 1997). The primary dealershave exclusive access to the auctions, which add fur-ther depth and liquidity in these issues. Five businessdays before each auction, the NTMA announces tothe market the bond to be auctioned and the amountthrough Bloomberg and Reuters. The Bloombergauction system is used to conduct the auction. Thisreduces the time between the close of the biddingand the release of the auction result to about threeminutes, thus reducing the risk for bidders.

Auction resultsThe auction results are published on Bloomberg(page NTMA, menu item 2) and Reuters (pageNTMB) simultaneously within about three minutes ofthe cutoff time for bids.

Noncompetitive auctionsUp to 48 hours after the announcement of the auctionresults, the NTMA will accept bids in a noncompetitiveauction from primary dealers at the weighted averageprice in the competitive auction. The amount on offerin the noncompetitive auction will not exceed theequivalent of 20 percent of the amount sold to the pri-mary dealers in the current competitive auction.

Structure of the Irish Government BondMarket

Primary dealer system

The Irish government bond market is based on a pri-mary dealer system to which the NTMA is committed.Seven primary dealers recognized by the NTMA make

continuous two-way prices in designated bonds in min-imum specified amounts and within maximum speci-fied spreads. There are also a number of stockbrokerswho match client orders. However, the primary dealersaccount for about 95 percent of turnover. This system,which was introduced at the end of 1995, has broughtimproved depth and liquidity to the market while thebond repo market has grown in tandem, adding to theliquidity in the bond market. Primary dealers aremembers of the Irish Stock Exchange, and govern-ment bonds are listed on the exchange.

With the switch to electronic trading and the listingof the new 2007 and 2013 benchmark bonds on theEuro MTS in the middle of 2002, the current system hasbeen augmented by six new institutions, which arepurely price makers in the new 2007 and 2013 bonds.These new institutions are not to be primary dealers anddo not have access to supply at the monthly auctions.

The liquidity of the Irish government bond marketis underpinned by the primary dealer system. However,to further enhance the liquidity of the market, theNTMA provides these facilities to primary dealers:

• a continuous bid to the market in Irish govern-ment benchmark bonds,

• switching facilities between the benchmarkbonds, and

• repo and reverse repo facilities in benchmarkbonds.

Buybacks

To enhance the liquidity of the market, the NTMA isprepared to buy back amounts of illiquid, nonbench-mark, euro-denominated Irish government bondsthat have relatively insignificant amounts outstand-ing. It is also prepared to buy back amounts of for-eign currency–denominated Irish government bondsas opportunities arise in the market. This improvesthe debt profile, eliminates certain off-the-run andilliquid bonds, and facilitates greater issuance in theliquid benchmark bonds.

Secondary trader

The NTMA maintains a secondary trading functionto trade in its bonds with other market participants.


The role of the secondary trader is to provide liquid-ity to the market and act as a source of market intel-ligence for the NTMA. The secondary trader ismandated to deal as a retail customer with marketmakers and brokers in Irish government bonds. Thesecondary trading is separated from the primarybond desk activity by means of “Chinese walls.”

Move to electronic trading of Irish bonds

The NTMA listed the new benchmark 4.5 percent2007 and 5 percent 2013 Irish government bonds onthe Euro MTS electronic trading system at the end ofJune 2002. A domestic version of MTS was establishedat the same time, on which the existing 2016 bench-mark bond is listed; this bond does not yet meet the5 billion issue size requirement for listing on the

main Euro MTS system. The listing of the bonds onthese systems has greatly enhanced turnover, pricetransparency, and liquidity, and it ensures that Irishbonds are maintained in the mainstream of the euro-area government bond market.

Standard market conventions

All Irish benchmark bonds have a day-count conven-tion based on actual number of days (actual/actual).The bonds trade on a clean price basis, with pricesquoted in decimals. The business days for trading areTARGET operating days, and bond dealings settle infull on a T+3 basis, but deferred settlement can bearranged upon request. These are standard featuresof euro-area bond markets. Irish government bondsare eligible for use as collateral in ECB money marketoperations.

Settlement

In December 2000, the settlement of Irish govern-ment bonds was transferred from the domestic settle-ment system, the Central Bank of Ireland SecuritiesSettlements Office (CBISSO), to Euroclear, Brussels.Ireland was the first European country to transfer thesettlement of government bonds from its centralbank to an international securities depository. TheCBI remains the registrar.

The objectives of the transfer to Euroclear were

• increased liquidity of Irish government bonds inthe international capital markets as a result ofimproved access to a broader range of investors;

• a simplified and cost-effective settlement infras-tructure, in which safekeeping and settlement ofdomestic and cross-border transactions are cen-tralized within the same entity;

• optimized settlement efficiency, due to the inte-gration of the settlement activity into an interna-tional real-time settlement environment; and

• access to a wide range of markets for the formerCBISSO members through the Euroclear system.

Inclusion in indices

The following indices have an Irish Governmentbond component:

• Bloomberg/EFFAS,• 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.

Credit rating

Ireland has the top long-term credit rating of AAAfrom Standard and Poor’s, Moody’s, Fitch, and theJapanese credit rating agency, Rating and InvestmentInformation, Inc. (R&I). Ireland also has the topshort-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

There is no withholding tax on Irish governmentbonds. Nonresident holdings are exempt from allIrish taxation. However, the provisions of theEuropean Union (EU) Savings Directive may affectthis position in relation to nonresident personalinvestors. The objective of the EU directive is toensure a minimum of effective taxation of savingsincome in the form of interest payments within theEU. The directive applies to individuals (not corpo-


rations) who are resident in an EU member state andreceive interest income from their investments inanother member state. Each member state would beobliged to provide information on such interest pay-ments to the member state in which the beneficialowner of the interest resided.

Indexed debt

To date, Ireland has not issued any index-linked debt.

Establishing and maintaining contacts with thefinancial community

Despite all the technical and market innovations ofthe last two decades, financial markets are still a peo-ple-driven business, and by maintaining and develop-ing strong contacts, Ireland has traditionally beenable to obtain more favorable borrowing costs thanone might have expected, given its credit rating. Thisactive engagement with the market has also helpedthe staff of the NTMA enhance and deepen theirknowledge and understanding of market develop-ments and keep abreast of the latest financial marketinnovations. Provision of accurate and timely infor-mation is also part of Ireland’s strategy to keep itsname visible in capital markets. To this end, theNTMA makes active use of the following:

• the NTMA web site (www.ntma.ie), which isupdated regularly with the latest available infor-mation;

• an Ireland Information Memorandum publishedand distributed annually in March and availableon the NTMA web site;

• The NTMA annual report, which is publishedannually in June;

• regular press conferences and relevant pressreleases to update the market on importantdevelopments;

• the NTMA Reuters pages (ntma/b/c);• an annual reception in December for all NTMA’s

banking contacts;• credit lines for financial institutions;• regular road shows and marketing campaigns to

keep Ireland’s name visible, particularly inadvance of any major issuance program;

• regular contact with the credit-rating agencies(Ireland has the top, AAA rating from Moody’s,Standard and Poor’s, R&I, and Fitch.);

• active use of the Bloomberg messaging system toseek quotes in non-price-sensitive instrumentssuch as deposits and foreign exchange forwardpoints (This ensures both optimum pricing andthat every bank the NTMA has a line with has achance to quote.); and

• listing Irish government bonds on the major elec-tronic trading platform, Euro MTS.

CPSS and IOSCO standards

The IMF Financial Sector Assessment Program mis-sion reported, “Ireland observes the CPSS core prin-ciples for systemically important payment systems.The only systemically important payment system isIRIS, the Irish real-time gross settlement system. Thisis facilitated by ECB actions to ensure that nationalpayment systems participating in the Trans-EuropeanReal-time Gross Settlement Express Transfer (TAR-GET) embody all the features necessary for thesmooth functioning of cross-border transactions.”The NTMA operates a securities settlement system asissuer, registrar, and settler of its exchequer note pro-gram in accordance with the core principles of theIOSCO standards. The CBI is the registrar for Irishgovernment bonds, which are settled at Euroclear.Both the CBI and Euroclear operate in accordancewith the core principles of the IOSCO standards.

The challenge of the euro

The EMU and the advent of the euro have led to agreater degree of intra-euro-area portfolio diversifi-cation as the disappearance of foreign exchange risksand transaction costs and deregulation of the variousdomestic euro-area member domestic markets haveresulted in an ever-greater redistribution of assetswithin euro-area portfolios. Hence, in the case ofIreland, nonresident holdings of Irish governmentbonds have risen from about 21 percent to 60 per-cent in June 2002 as domestic investors who wereheavily invested in the Irish bond market diversifiedand were replaced by new, predominantly felloweuro-area investors.


With no exchange risk, unidirectional yields, andlower spreads stemming from convergence (due tomore equalization in the sovereign credit ratings ofmember countries of the euro area), investors’ moti-vations may be reduced to questions of price liquid-ity, transparency, and market efficiency.

Note

1. The case study was prepared by Oliver Whelan, Fundingand Debt Management, National Treasury Management Agency.


The public debt management policy in Italy, as con-ducted in the last decade, has followed the prescrip-tions of the Maastricht Treaty, which created amonetary union and the single currency, the euro,among those European countries respecting the crite-ria of economic stability and fiscal discipline.

Since 1992, the Italian Treasury has undergone aprocess of profound change in the structure of its lia-bilities. The main goals to be reached at the end of thisprocess were, in brief:

• the reversion in the growth path of general gov-ernment consolidated gross debt, as definedaccording to the specification of the excessivedeficit procedure related to the EuropeanMonetary Union (EMU);

• the overall reduction of the pressure on capitalmarkets due to excessive supply of bonds;

• the reduction of the exposure to interest rate fluc-tuations; and

• the creation of a deep and liquid market for gov-ernment securities.

The strong commitment to the attainment ofthese goals has been expressed in the legislation

passed from 1992 on and in the organizational andstructural reforms in the field of public debt man-agement.


Debt management objective and scope

Objectives

The strategic guidelines for 2002 and 2003 define theobjective of public debt management as “…to ensurethat the financing needs of the State and its repay-ments obligations are met, minimizing the cost ofdebt, the level of risk being equal.”

Scope

Referring to the legal framework of responsibilities,the Public Debt Direction (PDD) of the ItalianTreasury Department is directly responsible for theissuance and management of public debt domesticsecurities.

96

6Italy1

The PDD is also responsible for issuance andmanagement of all other securities. This includesborrowing and other activities in the internationalcapital market, such as issuing syndicated loans andcommercial paper and activity on the swap market.The PDD also manages the public debt sinking fundand the cash account (conto disponibilità) at the Bankof Italy (BOI) (both dating back to 1993).

The PDD also exercises surveillance over accessto financial market funding of public entities, localauthorities, and companies controlled by the statethat have or do not have a state guarantee


Coordination between fiscal and monetary policiesand debt management activities is a priority forItalian authorities. The division of responsibility andspecialization of tasks among the different institu-tions is clearly stated. The PDD has the responsibilityof the issuance and management of public debt. TheItalian Treasury Department is responsible for themanagement of the state treasury and monitoring thefinancing needs of the central government. TheBOI—as a member of the European Central Bank(ECB)—is in charge of monetary policy and surveil-lance over the Italian financial system.

The set of rules and constraints and the differenttasks assigned to each of the acting departments(PDD, treasury department, BOI, and also generalgovernment entities) require a deep and constantcoordination in activities to prevent the breaking oflegal rules and ensure the orderly functioning of stateactivities (collection of revenues and distribution ofpayments).

As it is for all members of the EMU, the issue ofcoordination of debt management with monetarypolicy in Italy must be seen in the framework of theMaastricht Treaty. The treaty establishes a prohibitionagainst monetary authorities financing the statedeficit by buying government securities on the pri-mary market. This provision of the treaty wasreflected in national legislation in 1993, which pro-hibited the BOI from participating in governmentbond auctions. Regarding the conduct of monetarypolicy, the PDD has never had any privileged infor-mation, because the setting of official interest rates

was an exclusive privilege of the BOI until 1998 andof the ECB thereafter.

The legal framework ensures a complete separa-tion of objectives and accountability for monetarypolicy and debt management. The BOI is fully inde-pendent from the government and acts as an inde-pendent authority, or an institution performing itsactivities with no interference and deriving its powersfrom specific legislation, without any possibility ofintervention or influence by the government ongingto specified categories. However, according to theBOI statute, the majority of shares must be in thehands of public entities or companies owned by pub-lic entities. As of December 31, 2000, there were 86shareholders (80 with voting rights).

In addition, Italian law, in accordance withArticle 101 of the treaty establishing the EuropeanCommunity as modified by the Maastricht Treaty, for-bids all overdraft facilities of the state with the BOI orthe ECB, in any form and amount. Since 1993, thedirect purchase of public debt instruments from theBOI is forbidden by law. The system also includes thecash account of the treasury at the BOI, implying theremoval of any overdraft facility for the treasury.According to the law, this account has to show anaverage positive balance of a15.49 billion.

However, even though Italy has implemented aclear separation of roles between the treasury and theBOI, these two institutions have always maintained aclose dialogue on public debt management issues.First, they exchange views in regular meetings inwhich issuance policy matters such as amount andinstrument mix to be offered are discussed. Second,the BOI is usually involved in workgroups that areoccasionally established to work on specific innova-tions or questions that are relevant for debt manage-ment, such as the creation of the strip market, thedefinition of new facilities, and the like. Third, a closeexchange of information is maintained on theissuance activity in foreign currency, given its impli-cations on reserves management and the fact that theBOI is the fiscal agent of the republic.

The smooth functioning of the borrowing activityof the PDD requires constant monitoring of thefinancing needs of the state in coordination with thedirection of the treasury department. This constantmonitoring is also done by means of estimates and

Country Case Studies: Italy 97

forecasts of the possible future trends in those needs,taking into account the usual annual cyclical andextraordinary patterns of cash expenses and revenues(typically, revenues from direct and indirect taxation,expenses for salaries, and the like). Finally, thefinancing requirements need to take into account thematurity and reimbursement profile of outstandingdebt.

A close exchange of information is also main-tained on the balance of the cash account that thetreasury holds at the BOI, through which most pay-ments of the republic are channeled. Although thisaccount is established at the BOI, only the treasury isentitled to order any payment or receipt. However,the two institutions keep close contact on the balanceon account because of its implications for liquidity inthe system and therefore on monetary policy.


Governance

The budget law (legge finanziaria), passed annually byparliament, sets the binding limit for the net borrow-ing of the state and for the market borrowing activityduring the financial year. The latter represents, inbrief, the total amount of gross issuance of publicdebt.

The legal framework for public debt managementactivity is defined first by the state law, which hasrecently created the new ministry of the economy andfinance (MEF). The MEF is assigned—among oth-ers—the competencies related to the “… funding ofGovernment’s financing needs and of Public Debt. …”

A secondary regulation defines the concreteorganization and division of competencies assignedto the treasury department within the MEF, and inparticular to the PDD.

The PDD is responsible for the issuance andmanagement of domestic and external public debt,the management of public debt sinking fund, andsurveillance of market financing activities of otherlocal and public entities. This surveillance over pub-lic and especially local entities is a sensitive issue forthe PDD. The obligations of the state related to theexcessive deficit procedure are to be met at the gen-eral government level—for example, taking into

account the funding activity of the local entities andof all entities included in the general governmentsector.

The particular legislative framework, togetherwith the hierarchy of legislative sources, entails asound assurance that Italian government standsbehind any transactions the PDD managers enterinto. The officials of the PDD are civil servants; themanagers of the various offices that form the PDD aresubject to accountability principle, implying civil,administrative, accounting, and criminal law respon-sibility.

The PDD produces four main documents illus-trating its activities and strategic plans for the future:

• The annual strategic guidelines are drafted inter-nally after extensive discussions among the vari-ous offices of the department. The directorgeneral of the PDD coordinates the preparationof the document and is responsible for present-ing it to the director general of the treasury, whoapproves the draft. There is no formal presenta-tion to parliament or direct control by the minis-ter of the economy.

• The semiannual report to the Supreme AuditCourt (Corte dei Conti).

• The quarterly bulletin of public debt.• The public debt section within the quarterly pub-

lic sector cash balance and borrowing require-ment report.

The last two documents are also provided underthe Special Data Dissemination Standard (SDDS)program of the IMF.

The nature of public debt management activity isrecognized as essentially governmental. Options foralternative institutional arrangements have been con-sidered in the past, such as an independent office oragency operating in a civil law environment.Although a precise analysis of costs and benefits andan evaluation of the project have never been con-ducted in an exhaustive manner, the current deputyminister of economy and finance has been put incharge of exploring the possibility of establishing anindependent agency for public debt management.For the moment, this remains an issue for academicdiscussion and research.



The management of operational risk is conducted bymeans of sound practices developed during severalyears of activity and, in particular, starting from 1991,when the present organizational structure of thePDD was outlined. This process was completed in1997, when all activities related to public debt man-agement were brought under the authority andresponsibility of the PDD.

The legislative division of labor in public debtmanagement makes a clear distinction between thetreasury department and the BOI, thus avoiding anyconflict of interest between the two entities. There isa tradition of cooperation between the two institu-tions and the smooth functioning of the auction andsettlement procedures, and all operations connectedto the secondary market activity, is the result of thesuccessful public debt management reforms in Italy.In particular, an auction procedure manager (at theBOI), of secondary market autonomous trading plat-forms,2 and an independent depository institution(Monte Titoli SpA) ensure that the responsibilitiesare clearly separated and provide full accountability.

Staff

A great effort has been made in in human resourcesmanagement to ameliorate and renew the humancapital endowment of the PDD. The main effort isaddressed toward strengthening information tech-nology (IT) and foreign language skills in Italianpublic administration. The advancements made areconsiderable and connected with a broader effort ofItalian public administration as a whole.

Compared with private institutions, the turnoverrate of staff is low. Most of the mobility involves peo-ple moving from one department of the MEF toanother, from one office of the PDD to another, orretiring. Nevertheless, recently more staff have beenmoving to international or private institutions(mostly financial institutions). The Italian legislativeframework does not provide flexibility in salaries andincentives, except for a few top managers (generallydepartment heads or general directors). The recentlegislative reforms, however, try to sketch a moreflexible and dynamic framework, especially for man-

agers (the level immediately below general direc-tors), allowing for temporary contracts and some“weak form” of performance-related bonuses.Nonetheless, the PDD, among the other administra-tions, can offer to its staff training and the develop-ment of skills comparable to those offered by theprivate sector.

A specific code of conduct does not exist, butPDD officials are subject to normal provisions forpublic officials. The Italian administrative and crimi-nal laws meet all of the criteria of impartiality andhelp to avoid any conflict of interest.

Audit procedures

The public debt management activity is subject to thecontrol of the accounting department of the MEFand of the Italian Supreme Audit Court.

The formal control by the MEF accountingdepartment is continuous and conducted only on adocumentary basis for the whole administration andfor a limited number of activities specified by law.This means that the auditing procedures examineand certify the ex ante conformity to the law andaccounting regularity of the documentary evidence.

The Supreme Audit Court performs formal con-trols based in specific laws. Some documents andactivities (e.g., purchase agreements above a speci-fied amount) require ex ante legal and accountingapproval by the Supreme Audit Court. The SupremeAudit Court’s ex post nonformal control of the yearlyactivity is conducted by sampling the entire Italianadministration and, therefore, does not regularlycover the PDD’s activity.

In addition, the PDD submits a biannual publicdebt management activity report to the SupremeAudit Court, detailing the evolution in the composi-tion of public debt and describing the operationsundertaken during the semester. This document isnot made public. Its main aim is to deepen theknowledge and comprehension of public debt man-agement activity. The examination of numericalresults—routinely made by the Supreme AuditCourt—is enlarged to include evaluation and expla-nation of strategies and actions in connection, forinstance, with trends in the international capitalmarkets.


Transparency

Transparency is a strategic priority for the ItalianTreasury and the PDD, and the commitment to it isvery strong. The PDD’s web site (www.tesoro.it/pub-licdebt) is updated daily and fully available inEnglish. The web site is the result of the great impor-tance attached to communication with the vast audi-ence of international and domestic investors.

A document describing the strategic guidelinesfor public debt management is published yearly onthe web site. The strategic guidelines disclose theobjectives of the PDD in terms of risk management,portfolio composition, liquidity of the securities onthe secondary market, and forecasts of possible grossissuances and of the number of new bonds and trea-sury bills to be placed on the market. The public dis-closure of strategic cost/risk analysis and objectives isat an early stage, but has been provided in the lateststrategic guidelines document.

Also available on the web site are

• the annual auction calendar,• the quarterly issuing program,• the quarterly bulletin of the PDD,• the offering announcements for treasury bills

and bonds,• the results of the latest auctions of all bonds and

treasury bills, and• specific sections devoted to

– specialists on Italian government bonds,– public debt statistics,– the Italian public debt sinking fund,– a listing and description of Italian Treasury

securities, and– other information and news (e.g., new legis-

lation on fiscal treatment of bonds and trea-sury bills).

The administrative and organizational frameworkfor debt management is designed primarily throughthe Italian law and the regulations of the MEF.

The regulations and the procedures for the pri-mary distribution of public debt securities are madeclear to the participants through

• the legislative framework,

• the annualdiffusion of the rankings of specialists(on the web site), and

• the public availability of the criteria for evalua-tion by specialists (on the web site).

As regards the auction framework for Italian pub-lic debt securities, the law provides a set of rules, andthe electronic procedure for public auctions ensuresa clear carrying out of all operations (sending of bids,opening, ranking, and assignment of quantities).Manual or semielectronic recovery procedures areprovided in case of IT failure. Since 1988, the sec-ondary market for public debt has been conductedthrough an electronic platform (MTS.

The reform process of the secondary marketended in 1998, when a law and two decrees werepassed to regulate the framework of the secondarymarket and the role of the MTS electronic platformin the wholesale market for Italian and foreign gov-ernment bonds.

Information about the flow and stock of govern-ment debt is sent to the market with the availability offinal data. The PDD releases a quarterly bulletin ofthe public debt market, showing

• the results of the latest auctions of Italian publicdebt securities,

• the outstanding amount of benchmark securities,• the quarterly issuance program of new securities,• the breakdown by instrument of outstanding gov-

ernment debt,• historical data on average life of government

debt,• redemptions of outstanding bonds,• redemptions of the next 12 months, and• the trading volumes and average bid/offer

spreads observed in the secondary market (MTS).

In addition, the Italian Treasury Department pro-vides, when needed, information about changes infiscal treatment of public debt securities. This hashappened with the recent innovations in the taxationregime (withholding tax) for nonresidents: Theexplanatory notes on the reform and an applicationform have been published on the PDD web site.

As regards the financing needs of the public sec-tor , a partial disclosure of summary data referring to


those aggregates is provided monthly by the ItalianTreasury Department. No official forecasts are pro-vided to the public because of the fluctuations anduncertainty of these data.


Italy has one of the largest debt stocks amongadvanced economies, both in nominal terms and as apercentage of GDP. The debt-to-GDP ratio, whichstood at 97.2 percent in 1990, reached a peak of 124.3percent in 1994, when it started to decline as a resultof a major fiscal consolidation. Such an enormousdebt burden undermined the financial stability of thecountry and conditioned the government’s action inthe political economy domain. Throughout the 1980sand the first half of the 1990s, Italy was facing increas-ingly large expenditure outlays due to the debt ser-vice to the point that, in 1993, interest payments onthe public debt absorbed 22.6 percent of total expen-diture. To service its debt, the republic needed tokeep taxes at a high level, and there was very littleroom for maneuvering to use fiscal policy as a coun-tercyclical tool. Doing so would result in a relaxed fis-cal policy that would soon exacerbate the balance ofthe country’s fiscal accounts. Even the independentconduct of monetary policy, which was fighting infla-tion through a restrictive stance on official rates,could have a negative impact on public financethrough an increase in the cost of debt. However,because Italy was not overly exposed to foreign cur-rency–denominated debt (only 3.5 percent of totaldebt was denominated in foreign currency in 1993),there were not large implications of the large stock ofdebt on reserves management. As recently as1994–95, the spread between Italian and German 10-year bonds was still oscillating between 250 and 600basis points, and it became clear that such a widespread was unsustainable over the long term.

In this context, although up to the early 1980sthe PDD’s main concern was to raise the necessarycash to fund the government’s operations, the PDDdecided to better define its mission and put togethera more precise strategy to guide its action. Therefore,even though a set of constraints remained, which

made it difficult to shift away from the risky treasurybill market, the treasury department began to put for-ward some basic concepts to be followed in debt man-agement policy.

A general objective of debt management policywas then considered of minimizing the cost of fund-ing. However, to avoid excessive risks in the presenceof specific market conditions, it was decided that thisobjective should be achieved in a context of carefulcontrol of the interest rate risk and refinancing risk.The rationale was that the objective of minimizationof the funding cost was not sufficient in itself to pre-vent the budget from possible shocks. For example,in a situation of declining interest rates, this objectivecould have led to an excessive issuance of short-datedsecurities. Although this strategy could indeed savemoney in the short term, it could also lead the gov-ernment to assume an unnecessary exposure to therisk that interest rates would rise in the future anddetermine a sharp increase in the cost of debt.

The work undertaken to better evaluate the mainrisks faced by the PDD was instrumental in definingthe mission of debt management activity.Throughout the 1990s, because of the size and com-position of its debt, Italy was largely exposed to twomain risks:

• Interest rate (market) risk: Because of the veryshort duration of the public debt, the cost of debtwas very sensitive to changes in interest rates.

• Refinancing (rollover) risk: The average life ofpublic debt was only 2.6 years in 1990. Thisimplied that every year, the Italian authoritieshad to roll over massive amounts of securities,overloading the market with frequent and largeauctions.

The approach to interest rate (market) risk

The need to contain the interest rate risk requiredthe PDD to engage in an active debt managementpolicy with the aim of modifying the composition andincreasing the duration of the stock of debt.

The beginning of the fiscal consolidation and thereduction in the inflation rate created a better envi-ronment for investors to buy long-term securities.The increased demand made it possible to issue certi-


ficati di credito del tesoro ([CCTs] 7-year floating-ratebills) and buoni del tesoro poliennali ([BTPs] 3-, 5-, 10-,and 30-year bonds) in higher amounts. In 1990,short-term and floating-rate notes accounted for 73percent of the total debt, declining to 49 percent in1995 and reaching 30 percent by 2000. At the sametime, the duration of the debt portfolio increasedfrom 1.7 years in 1993 to 3.7 years in 2000.

As a result, the exposure to fluctuations in inter-est rates declined significantly. Given the currentcomposition of the debt, the impact of a 1 percentshift in the yield curve would determine an increasein interest expenditure of about one-third lower withrespect to 1996.

The approach to refinancing (rollover) risk

An even bigger challenge for Italy was that of reduc-ing rollover risk. The structure of the public debt was,until recently, such that the short average life causeda constant need to roll over maturing debt. For exam-ple, in 1995, the public debt to be reimbursedamounted to 50 percent of the total debt outstand-ing. There was also a high concentration of maturi-ties on specific dates, and consequently the recourseto the market had to be particularly large to meetthose redemptions.

The strategy to address this risk was based on twopillars. First, the objective was to increase the averagelife of the public debt. During the 1990s, the averagelife more than doubled from 2.6 years in 1990 to 5.7years in 2000. Second, the aim was for a smoother dis-tribution of maturities during the year. Although theborrowing requirement maintained a pronouncedseasonality, the PDD strived to spread out maturitiesmore evenly across the various months.

The operative framework to address market androllover risk

The quest to reduce these two risks went on for mostof the 1980s and 1990s, when Italy adopted an activedebt management policy and explored all possibleavenues to educate investors to buy securities otherthan short-term treasury bills, which were the back-bone 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 dependexcessively on a specific segment of the market. ThePDD launched innovations on both the primary andthe secondary markets. In the primary market, theaction concentrated mainly on two lines, the diversi-fication of instruments and the introduction of newissuance procedures.

In terms of diversification of instruments, therewas a policy aimed at increasing the types of securitiesto be offered so that the treasury could target a widerrange of investors, increase the average maturity ofthe debt, and obtain a smoother redemption profile.Several new types of securities were introduced:

• The CCT: In a constant struggle to reduce therecourse to short-term treasury bills, in 1978Italy introduced the CCTs with the aim of length-ening the average life of its debt. However,because of the then prevailing reluctance toinvest in long-dated, fixed-rate Italian securities,the PDD decided to index the coupon paymentsto the current treasury bill rate. This new instru-ment (whose maturity initially varied but stabi-lized at seven years in the early 1990s) wasextremely successful, especially with households,and accounted for more than 40 percent of thetotal debt in 1990. In this way, the PDD was ableto substantially reduce refinancing risk, butremained exposed to variations in the interestrate level.

• The certificati del tesoro(CTEs) denominated inEuropean currency units (ECU): With the CTE,launched in 1982, Italy was among the firstissuers to offer securities denominated in theEuropean unit of account, the basket of curren-cies that was to generate the euro. In doing so,the PDD was able to attract new investors tolonger maturities, preventing the fears of devalu-ation of the Italian lira from discouraging them.

• The buoni del tesoro (BTEs) denominated in ECU:Similar to CTEs, but with shorter maturities,these were introduced in 1987.

• The certificati del tesoro con opzione (CTOs): Thesesecurities, introduced in 1988, were six-yearfixed-rate bonds embedding the option for theholder to request advance reimbursement afterthree years.


• The first 30-year BTP was launched in 1993 withthe objective of increasing the duration of thepublic debt.

• The funding program in foreign currency:Starting in 1984, the Italian governmentlaunched bonds denominated in foreign curren-cies to attract those investors that were not willingto invest in a currency characterized by highinflation. Eventually, Italy became one of themain issuers in the Eurobond market and subse-quently complemented this activity with theinclusion of sources of financing other thanbenchmark bonds, such as the euro medium-term notes (EMTNs) program launched in 1999.

For issuance procedures, several changes havebeen adopted over the years to improve placementtechniques, especially for medium- and long-termbonds. Until the 1980s, medium- and long-termbonds were placed through a syndicate of majordomestic banks. To avoid excessive market fluctua-tions, the PDD would indicate the amount and priceof securities to be sold . In 1985, in light of the grow-ing number of intermediaries that could access theItalian market, and with a view to standardizing itsplacement procedures, the PDD started to test theuniform-price auction and began to make this a stan-dard practice in 1988. By 1990, all treasury securitiesexcept foreign currency bonds and treasury bills wereplaced via uniform-price auction, and in 1992, therequirement of a base price was removed.

As for buoni ordinari del tesoro (BOTs), treasurybills of varying maturities, the decision to remove theindication of a base price for the auction (whichcame in 1988 for 3-month bills and in 1989 for 6-month and 12-month bills) was a very importantmove, which favored a more precise separation ofroles between the treasury and the BOI. The indica-tion of a base price for treasury bills was regarded asextremely important by market participants, whotried to extract from it a signal of the direction of offi-cial interest rates. This approach favored a confusionof roles between the treasury and the BOI and wouldsometimes generate uncertainty in monetary policyexpectations.

Another important step in issuance proceduresconcerned the introduction of reopening auctions

for medium- and long-term bonds in 1990. This deci-sion responded to the need to boost the liquidity ofthe newly established on-screen secondary market(MTS). Transactions on this market could not pickup momentum as expected because of the large num-ber of bonds outstanding, none of which was liquidenough to absorb large transactions. Benchmarkbonds would change very frequently, and the marketremained fragmented. Therefore, the PDD started toconduct several auctions over time on the samebonds, reducing the number of bonds issued on thesame maturity, initially for a period of two to threemonths, and then for progressively longer periods.Today, a 10-year bond can remain open for morethan 6 months and a 30-year bond for more than 1year. This allows the bonds to reach an optimal out-standing amount, and there is evidence that theintroduction of reopening auctions contributed toreducing the cost of debt because investors weremore willing to buy liquid securities. This reform wasalso key to the development of an efficient secondarymarket.

More recently, the PDD also announced a final-ized program to exchange securities nearing maturitywith securities in the process of being issued(exchange offers). The objective is to make the pro-file of maturities more uniform. By means ofexchange offers, the PDD will retire old bonds with ashort remaining maturity and exchange them fornewly issued securities with a longer maturity. Thebenefit will be twofold:

• On refinancing: By retiring old bonds with ashort remaining maturity, the PDD can smoothout the redemption profile for the near term(usually the securities to be repurchased have amaturity up to one year). The securities are usu-ally replaced by new medium- and long-termbonds, which help in spreading out maturitiesover a longer time horizon.

• On market liquidity: In general, bonds nearingmaturities are no longer liquid, therefore theytend to not being actively traded on the sec-ondary market, resulting in an increased burdenfor primary dealers if they are obliged to quotethem. Through the exchange offer facility, theprimary dealers are given a window to swap illiq-


uid bonds with highly liquid ones, such as thoseused by the PDD to execute the exchange offers.

The exchange offers, which were executed forthe first time in early 2002, can be carried out accord-ing to two procedures:

• through auction, by following the same proce-dure used for buyback operations made with theproceeds of privatization. (These transactionswill preferably be made in the middle of themonth, concurrent with three- and five-year BTPauctions.); and

• at a later stage, by operating directly on the reg-ulated secondary market through bilateral trans-actions.

In both cases, these transactions are reserved forspecialists in government bonds, because they are themost active operators on the secondary market andthose on whom the treasury relies to maintain highliquidity and efficiency in the secondary market.

Information systems

Given the sophistication that characterizes today’smarkets, the development of adequate informationsystems is key to a smooth functioning of debt man-agement. Over the past 10 years, the PDD has workedto improve its systems by focusing on three areas:pricing systems, forecasting systems, and risk man-agement systems.

Pricing systems are instrumental for the frontoffice, because they enable the PDD to have a betterunderstanding and evaluation of the trades that areentered into. The need to develop such systems firstarose for liability management purposes, when thePDD started to directly negotiate derivatives contractswith its counterparts; later, such systems were used forissuance activity and other operations on the domes-tic debt as well. Rather than develop in-house models,the PDD chose to draw upon the experience ofinvestment banks in this field. Therefore, it benefitedfrom their advice in setting up and customizing thepricing tools needed in debt management opera-tions. These models are used for a wide range of pur-poses, from simple calculation operations such as

discount rates, to pricing of complex structures ordetermination of the fair value of bonds to be repur-chased on the secondary market.

Forecasting systems are being developed for thePDD to have its own views on the evolution of keyvariables for debt management, such as interestexpenditure, stock of debt outstanding at futuredates, and so on.

The other area under development is that of riskmodels, which are gaining importance for reportingand accountability purposes. Here, work is under wayto refine the models that allow the PDD to accuratelymeasure its exposure at any given time. Most existingmodels are based on customizing the value-at-risk(VaR) models, which are the most widely used byinvestment banks. However, because of the peculiarnature of the fund-raising activity and the accountingmethodology for recording debt, the PDD is alsoworking to develop more tailored indicators, such asmodels calculating the sensitivity of the interestexpenditure to variations of interest rates or tochanges in the composition of the debt outstanding.The interest expenditure, given its impact on Italianpublic finances, is a variable that needs to be closelymonitored, and it is one for which the PDD can takevery little risk. For this reason, many of the simula-tions that are regularly run at the PDD concern thetesting of various compositions of the debt portfolioto see how the interest rate expenditure would reactunder different market circumstances. The results ofsuch simulations are also the basis for strategic plan-ning of the issuance activity.


Italy has invested extensive resources to develop anefficient securities market. Given the heavy financingneeds managed by the PDD, the need to create adependable mechanism for raising funds was one ofthe top priorities during the 1980s. Work was carriedout to develop both the primary and the secondarymarkets.

Since then, the Italian financial system hasundergone constant and rapid development—mostlyin the field of IT trading, settlement, and depository


systems. Separate institutions were created during the1990s to operate the secondary market for publicdebt securities. A wholesale market to trade Italiangovernment securities, MTS SpA, by means of ascreen-based system was introduced in 1988. In 1994,MOT, a retail market for securities was created as abranch of Borsa Italia SpA. The latest innovation,started in August 2001, is BondVision (a division ofMTS SpA), an Internet-based, multidealer-to-client,wholesale, fixed-income market.

In parallel, since 1991, a number of laws havebeen passed, ensuring the modernization of thefinancial markets and institutional investors–relatedlegislation.

Domestic government securities

In the domestic market, the PDD today issues the fol-lowing instruments:

• BOTs (3-, 6-, and 12-month treasury bills);• BTPs (3-, 5-, 10-, 15-, and 30-year bonds);• certificati del tesoro zero-coupon ([CTZs] 24-month

zero-coupon bills); and• certificati di credito del tesoro ([CCTs] 7-year floating-

rate bills).

Primary market

To place its debt, the Italian government uses verystandardized and reliable mechanisms. Traditionally,domestic debt has been issued via auctions and for-eign debt via syndication of banks. Today, theseremain the most important mechanisms, eventhough, as new products are developed, some otherchannels may gain ground. The methods can be sum-marized as follows:

• Treasury bills: competitive auction without anyindication of the base price. Investors can submitup to three bids, each of which is assigned theprice requested. There is a cutoff price to avoidspeculative bids.

• Medium- and long-term bonds: marginal auc-tion, whereby each request is assigned at themarginal price, which is determined by acceptinghigher bids until the total amount of bids

accepted equals the amount offered. There is acutoff price to avoid speculative bids.

• Bonds denominated in foreign currency: syndi-cation.

• Commercial paper: direct quote on various net-works and over the telephone.

Besides issuing marketable debt, the Italian gov-ernment also guarantees the debt of the CassaDepositi e Prestiti (CDP), which is placed through thepost offices. The CDP is a public institution in chargeof funding local authorities or specific projects forpublic infrastructure. However, to ensure that theborrowing of the CDP is done on similar terms to thefunding managed by the PDD, the minister of theeconomy and finance, who is responsible for debtmanagement, is given the authority to set the finan-cial conditions under which the CDP can issue debt.

Auctions

Issuance procedures have been continuouslyenhanced in transparency and effectiveness. At theend of 1994, to improve transparency and pre-dictability of issuance policy, the PDD started to dis-close an advance calendar of the auction dates for thefollowing year, along with a quarterly issuance pro-gram that gives more detail about the bonds and theamounts to be issued in the coming quarter. In thisway, all market participants are given detailed infor-mation, which is key to accurate planning of theiractivity for the next year or quarter.

Since 1995, the auctions have been carried outvia a completely automated procedure at the BOI. Asa result of constant improvement, the lag betweenthe collection of the bids and the announcement ofthe results has been reduced to a few minutes. Thenumber of institutions allowed to participate in theauctions has been increased over time, and today anaverage of 40 institutions submit bids at each auction,including foreign institutions, who can submit bidseven if they are not resident in Italian territory.

Supplementary auctions

Supplementary auctions take place at the end of everyregular auction of medium- and long-term bonds.


Only specialists are allowed to participate in this partof the auction. Each specialist who has been assignedbonds during the regular auction is entitled to submitvoluntary bids for an extra allotment of bonds. Theextra allotment equals 25 percent of that offered atthe regular auction if it concerns a newly opened lineof bond (i.e., the first tranche); otherwise, it is 10 per-cent. The price for the supplementary auction is thesame as the regular auction price (the weighted aver-age for treasury bill auctions or the marginal price foruniform-price auctions). This privilege, which trans-fers the market risk to the treasury (if only for a fewhours), is valued highly by the selected institutions.

Bids for the supplementary auction can be submit-ted until noon of the business day following that of theregular auction, and they follow the same procedure asthe regular auction. Each specialist is entitled to beallotted a share of the supplementary auction equal tothe ratio between the total amount assigned to the spe-cialist in the last three auctions and the total amountassigned to all specialists in the same three auctions.

By means of supplementary auctions, the PDDhas found a way to increase the amounts issued ateach auction without committing in advance to largeramounts, which might have proved difficult to place.Instead, the possibility to increase the amount beingissued is left in part to the market conditions. If themarket yields are decreasing, specialists will find itconvenient to participate in the supplementary auc-tions and the issued amount will rise. Conversely,nothing will happen if market conditions deterioratein the hours following the regular auction.

Specialists in government bonds

A very important innovation concerned the establish-ment of the specialists in government bonds. This cat-egory of operators, introduced in 1994, was selectedfrom among the primary dealers operating in theItalian-regulated on-screen market (MTS) with a viewto enhancing the demand at auctions of Italian gov-ernment bonds, increasing liquidity of the secondarymarket, and assisting the treasury with advice on debtmanagement policy issues.

The specialists in government bonds are grantedthe exclusive right to participate in supplementaryauctions and have also been exclusively entitled to

participate in the buyback operations launched bythe treasury to reduce the public debt outstanding.

Strategic guidelines

In 2000, a strategic guidelines document was intro-duced, outlining the principles to be followed in debtmanagement policy for the coming year and released atthe end of each year. This document is published to dis-close as much information as possible on the reasoningbehind the decisions that guide the PDD’s action indebt management. In this way, market participants areoffered useful tools to help them form their expecta-tions on issuance activity for the year to come.

Secondary market

On the secondary market the key reform was theestablishment in 1988 of MTS, the on-screen marketfor government bonds. The MTS model was based ona very simple concept, that is, to provide easy, low-costaccess for market makers to the Italian governmentbond market and facilitate transactions as much aspossible. These conditions helped enormously tobuild up liquidity and favored the stability of the mar-ket, because investors could always count on an effi-cient tool to divest their positions, and suchcircumstances attracted new investors to the Italianmarket. Today, the Italian secondary market is one ofthe most liquid in the world, with very high tradingvolumes and tight bid/ask spreads. Moreover, the on-screen market is very reliable in times of severe crises.Because of their discretionary nature, transactionsbased on over-the-counter systems tend to diminish involume in times of uncertainty or disruption in thefinancial markets. However, it is standard practice thatmarket makers undertake specific commitments toshow two-way quotes on the on-screen market. Thiscommitment is very valuable to the issuer, who canbenefit from the information (however little it may bewhen liquidity tends to dry up) that on-screen systemscontinue to provide, even during periods of distress.

Tax treatment

Another sector that was key to developing the Italianmarket was the fiscal treatment of government secu-


rities. In the mid-1980s, it was decided to put an endto the long-standing policy of tax exemption onItalian government bonds and enforce a 12.5 percentwithholding tax on new bonds. This measure deter-mined a fragmentation of the market, because itintroduced the practice of quoting the yield on a net-versus-gross basis, depending on the tax treatment ofthe holder. Moreover, it hampered the appeal ofItalian bonds for foreign investors, because theItalian authorities decided to establish a quite com-plex procedure to avoid double taxation. Such a pro-cedure would require foreign investors to pay thewithholding tax as if they were subject to tax and thenapply for a refund. Given the long period that wasusually required to process the applications, for sometime, there was extensive arbitrage activity on Italianbonds based on this mechanism. Therefore, the PDDstarted a process that was initially aimed at streamlin-ing the procedure for reimbursement of the with-holding tax and eventually (in 2001) implemented amajor reform that granted fiscal exemption to virtu-ally all nonresident investors, provided they are notresident in fiscal havens. This reform responds to theassumption that in debt management—and in partic-ular, in fiscal issues associated with debt manage-ment—the simpler, the better.

Investor relations

The reform of the taxation for nonresidents was oneof the by-products of a closer and more frequent dia-logue established by the PDD with investors, and inparticular international investors, who may not havebeen aware of the opportunities offered by the Italianmarket. For example, because of the technicalitiesrelated to the management of the withholding tax,those involved in debt management could gain a goodunderstanding of the problems outstanding becauseof direct contacts with the interested investors. Basedon this experience, the PDD has expanded this type ofactivity. Today, regular meetings are held with marketmakers to gain better input on market trends, thetreasury conducts road shows to bring new productsor market innovations to the attention of investors,and videoconferences are organized as requested tofavor exchange of views, preferences, and informationbetween the PDD and investors.

Dealing with exceptional events and financialcrises

The system of auction, settlement, and trading forItalian government securities has shown a goodresilience to financial crises or disruption at the con-tinental or world level. For instance, in 1992, whenthe Italian lira was devalued and forced out of thefixed-rate regime of the European Monetary System(EMS), causing continuing pressure on the Italianfinancial market and the widening of the interest ratespread with major sovereign issuers, the marketproved to be efficient and continued to price Italiangovernment securities, despite some problems withthe auction procedures.

Another important and decisive test came in1995, when, after the Mexican crisis of 1994, theframework of primary dealers and specialists and newcriteria for quoting securities on MTS proved to be awelcome resilience during major international crises.On that occasion, the benefits were transferred fromthe secondary to the primary market, where no dis-ruptions were observed in the auction mechanism.The treasury department could continue to place itsbonds without any adverse effect.

More recently, on the occasion of the terroristattacks of September 11, 2001, the treasury depart-ment and the PDD continued their activity on the pri-mary market and fulfilled all their plans of auction.In that case, the smooth functioning of the secondarymarket was ensured by the combination of continen-tal-scale intervention (especially from the ECB) and awell-tested market infrastructure.

Lessons

Based on these experiences, there are a few lessonsthat can be drawn. First, developing the market mayrequire the issuer to pay a price initially. For example,when the PDD decided to increase the maturity ofthe public debt, it did so mainly by issuing floating-rate bills (CCTs) in the beginning. This instrument,because of its peculiarity in the indexation of thecoupon, was considered by some analysts to be toocostly for the treasury. However, the commitmentdemonstrated by the PDD to develop the market for


CCTs determined a comfortable pickup in liquidityand allowed the treasury to initiate a process oflengthening the maturity of the public debt.

Second, it is advisable that debt managers do notengage in the proposal of too complex or sophisti-cated securities ahead of time. For example, in 1988,when the treasury department started to issue long-term bonds with an embedded option (CTOs), themarket was not yet able to correctly price the value ofthe option. Because investors were not accustomed tosuch securities, pricing models were not aswidespread as they are today, research on volatilitywas not developed and available, and investors weretreating these bonds as if they were bullet bonds,ignoring the value of the option. This implied thatthe issuer, while incurring the risk of advance reim-bursement associated with the option, could notmonetize the premium associated with it.

Third, there may be a trade-off between therequirements for the establishment of an efficient mar-ket and short-term gains. To ensure smooth function-ing, an efficient market must be organized with simple

and standardized practices, so that the issuer’s behav-ior is predictable and does not come as a disruption tonormal activity. Italy has followed these prescriptionsby adopting, for example, a yearly calendar of govern-ment bond auctions, disseminating formal guidelinesthat anticipate for each year the innovations in debtmanagement policy, and publishing quarterly calen-dars that detail the characteristics of any new bonds tobe sold. A consequence of such a level of disclosure isthat the PDD may face situations in which it is costly tohonor a commitment. However, credibility is a highlyimportant attribute of the issuer: in the long run, thereis a payoff from the commitments that are undertaken,even if a mere short-term perspective may indicate thatsome costs are being incurred.

Notes

1. The case study was prepared by Domenico Nardelli andGianluca Colarusso from the Public Debt ManagementDepartment of the Italian Treasury.

2. MTS, MOT, and BondVision, described in the section“Developing the Government Securities Market.”


Jamaica faces serious challenges to long-termgrowth and development imposed by a substantial debtoverhang. Like many other Latin America andCaribbean countries, Jamaica emerged from the 1980swith a heavy external debt burden. The focus then hadbeen the effective management of the external debtportfolio. The combination of external factors—suchas low export earnings, reduced access to long-termloans on concessionary terms, and the internal devel-opments of weak output performance and low revenueintake—saw the government relying on domesticfinancing. Consequently, by the 1990s, the high levelsof external debt and attendant issues combined withthe cost of rehabilitating the financial sector after thecrisis in the financial sector in the mid-1990s resultedin high and rising levels of domestic debt, high inter-est rates, and fiscal deficits.

Jamaica has taken steps to ensure that sound eco-nomic fundamentals are in place to address these issues.A major thrust of the government’s economic programhas been the reduction of the overall debt. Given thatthe high levels of public debt and debt service severelylimit the government’s ability to invest in physical andsocial infrastructure necessary to promote investment

and growth, since the second half of the 1990s, themajor challenge to the government of Jamaica has beenthe management of debt dynamics. Emphasis has beenplaced on management of the domestic debt, the largerand more expensive share of the public debt.

Macroeconomic Policy Framework

Jamaica accelerated its structural reform program inthe early 1990s with, among other developments, theliberalization of the foreign exchange market, theremoval of price controls, reduction in trade barriers,and the reform of the tax system. The containment ofinflation and the maintenance of relative stability inthe foreign exchange market became the focus of themacroeconomic stabilization program introduced in1991. This was to be achieved through a combinationof tight monetary and fiscal policies.

The government succeeded in reducing inflationto single-digit levels and maintaining relative stability inthe foreign exchange market. However, one of the costsof the stabilization was the marked increase in the levelof the domestic debt, beginning in fiscal year 1994/95.

109

7Jamaica1

In addition to deficit financing, the increase in thestock of domestic debt was incurred largely to provideassistance to the central bank, the Bank of Jamaica(BOJ), in its liquidity management objectives andcover the BOJ’s losses. Increases were also due to theassumption of debt obligations of parastatal entities.The debt problem was exacerbated by the financialsector crisis, which emerged in 1996, and the cost tothe government of rehabilitating and restructuringthe sector. All outstanding contingent liabilities thatresulted from the rehabilitation and restructuring ofthe sector (approximately 35 percent of GDP) wereassumed by the government as of April 1, 2001.

Jamaica’s public debt–GDP ratio amounted to130 percent at the end of fiscal year 2001/02 com-pared with 110 percent at the end of fiscal year1994/95. Domestic debt as a percentage of GDPincreased from 32.6 percent at the end of fiscal year1994/95 to 63.9 percent at the end of fiscal year2000/01. With the government’s assumption of theremaining liabilities associated with the rehabilitationand restructuring of the financial sector, the domes-tic debt increased to 87.5 percent on April 1, 2001. Bythe end of fiscal year 2001/02, domestic debt stood at77.5 percent of GDP. Debt servicing accounted for66.1 percent of budgetary expenditure for fiscal year2001/02, with domestic debt-servicing costs account-ing for 54.8 percent of budgeted expenditure.

Over the last 10 years, considerable progress hasbeen made in reducing the level of external indebt-edness and the attendant debt-service burden.Jamaica’s external debt has been reduced from 109.3percent of GDP at the end of fiscal year 1991/92 to52.4 percent of GDP at the end of fiscal year 2001/02.Jamaica’s external debt-service ratio (total debt ser-vice as a percentage of exports of goods and services)has fallen from 29.2 percent in fiscal year 1990/91 to12.3 percent in fiscal year 2001/02.

The steady decline in the external debt and theimprovement in Jamaica’s external debt indicatorsled to the World Bank’s 1999 reclassification ofJamaica from a severely indebted to a moderatelyindebted country. This achievement crowns a seriesof advances that includes

• Jamaica’s exit from commercial bank restructur-ing in 1990,

• its “graduation” from Paris Club bilateralrescheduling in the mid-1990s, and

• its reentry into the international capital marketsin 1997, which was subsequently buoyed by creditratings from Moody’s Investors Service (Ba3) andStandard and Poor’s (B) in 1998 and 1999,respectively. Standard and Poor’s upgradedJamaica’s credit rating to B+ in May 2001.

Despite these positive developments, Jamaicacontinues to face a heavy debt burden, the result ofthe acceleration in the rate of domestic debt accu-mulation. Thus, although the composition of thedebt has changed markedly over the decade, with theshare of domestic debt increasing from 26 percent atthe end of fiscal year 1990/91 to 60.7 percent at theend of fiscal year 2001/02, the overall debt burdenremains onerous.

Cognizant of the importance of reducing thedebt to sustainable levels, the authorities took thenecessary steps to strengthen Jamaica’s debt manage-ment capability and embarked on a path toward theimplementation of debt reduction strategies and pru-dent debt management practices. In addition, stepswere taken to facilitate the development of thedomestic capital market.

Centralization of debt management functions

The need for institutional building and improve-ments in the government’s debt management capa-bility was critical to the formulation andimplementation of credible debt management strat-egy and policies. Since April 1998, there has been acentralization of the debt management functions inthe debt management unit (DMU) of the ministry offinance and planning. Before that, the debt manage-ment functions were shared by the ministry and thecentral bank.

Responsibility for the core debt managementfunctions—debt policy and strategy formulation andanalyses, debt-raising activities, and the registrar andpayment function for government securities and debtrecording and monitoring—now fully resides withinthe DMU. The BOJ, in its agency capacity, is respon-sible for effecting external debt payments, conduct-ing primary market issues, and issuing and


redeeming treasury bills. The accountant generaldepartment, a department of the ministry of financeand planning, has responsibility for treasury opera-tions, including the servicing of the debt.

At the operational level, the centralization of thecore debt management functions within a single unitin the ministry of finance and planning has led toconsiderable strengthening of debt strategy imple-mentation. Several factors explain this, foremost ofwhich are increased capacity in debt managementexpertise, greater clarity of debt management objec-tives, and improved consolidation of debt manage-ment information.

Debt management objectives and coordination

Clear debt management objectives have been devel-oped. The principal debt management objective is toraise adequate levels of financing on behalf of theGovernment of Jamaica at minimum costs, while pur-suing strategies to ensure that the national publicdebt progresses to and is maintained at sustainablelevels over the medium term.

The influences of debt management on and bymonetary and fiscal policies in a situation of deficitfinancing and rehabilitation and restructuring of thefinancial sector have been far reaching, thereby rein-forcing the need for strong policy coordination. InJamaica, the coordination of debt management, fiscal,and monetary policies is undertaken within the contextof a clear and consistent macroeconomic frameworkdesigned to lower inflation and achieve economic sta-bility and sustainable growth and development.

The transfer of the shared debt managementfunction from the BOJ to the ministry of finance andplanning has also resulted in greater coordination offiscal policy and debt management objectives. It alsoallows for a more clearly defined set of debt manage-ment objectives determined independently frommonetary policy considerations. Despite these sepa-rate objectives, there is a high degree of coordinationbetween the fiscal and monetary authorities.

At the policy level, there are regular meetingsbetween senior officials of the planning authorities—the ministry of finance and planning, the BOJ, thePlanning Institute of Jamaica, and the StatisticalInstitute of Jamaica—to ensure consistency in the

government’s economic and financial program. Atthe technical level, there are regular meetings whereinformation is shared on the government’s cash-flowrequirements and financing program, as well as oncurrent monetary conditions and developmentswithin the money and foreign exchange markets.There are weekly meetings within the ministry of theDMU, fiscal policy management unit, cash manage-ment unit, and the accountant general department,as well as between the ministry and the BOJ.

Legal framework

A well-developed legal and institutional frameworkexists for the execution of debt management. UnderJamaica’s Constitution, all loans charged on the con-solidated fund, including all external and domesticdebt payments, represent a statutory charge on therevenue and assets of Jamaica. This provision allowsfor debt payments to be made without any require-ment of parliamentary approval, and before fundsare available for other policies and programs. In addi-tion, the constitution and the FinancialAdministration and Audit (FAA) Act give the ministryof finance and planning overall responsibility for themanagement of Jamaica’s public debt.

The government’s borrowing requirements foreach financial year are determined by the ministry offinance and planning and set out in the budget pre-sented to parliament at the beginning of the finan-cial year.

The authority to borrow is established by statutes.The Loan Act, 1964, and subsequent amendmentsprovide the government with the authority to borrowfrom the domestic and external markets. The LoanAct establishes overall quantitative limits on theamount the government can borrow. Increases in theceiling have to be obtained by parliamentaryapproval.

For domestic borrowings, there are specific actsthat govern the issuance of the various debt instru-ments. These are the Treasury Bill, Local RegisteredStock, Debenture, Land Bond, and Saving Bonds Acts.

The borrowing powers of public sector entities areset out in the FAA Act and the legislation governing thecorporations and are complemented by the new PublicBodies Management and Accountability Act. The

Country Case Studies: Jamaica 111

board of directors of the public entity determines theextent of borrowing, and the ministry responsible forthe entity must approve the borrowing plan. However,the approval of the ministry of finance and planninghas to be obtained by all public sector entities needingto finance their operations through debt financing.

Transparency

Considerable efforts have been made to increasetransparency and accountability in debt managementoperations in recent years.

The government’s debt management strategy ispresented to parliament at the start of the financialyear. Since fiscal year 1999/2000, this strategy hasbeen published in the form of a ministry paper thathas widespread public distribution. The document isavailable through the Internet on the web site of theministry of finance and planning, www.mof.gov.jm.

Comprehensive information on Jamaica’s debt ispublished on the ministry’s web site and routinelyupdated. In addition to information on past debtactivity, including debt outstanding, debt-service pay-ments, and debt structure and composition, the website is also used as a vehicle to announce future debtoperations especially as they relate to debt issuance inthe domestic market.

The rules for participating in primary debt issues,specifically the auction of medium-term governmentsecurities, have also been widely disclosed. Noticesfor future domestic debt issues are also published inthe print media. Similarly, the results of governmentdebt issues are widely reported through the print andelectronic media and on the ministry’s web site.

There is also regular dissemination of informa-tion to players in the international capital markets,credit-rating agencies, and international and regionalfinancial institutions.

Establishing a Capacity to Assess andManage Cost and Risk


The primary aim of Jamaica’s debt management strat-egy is to ensure that overall borrowing is kept within

prudent levels and secured on the best terms avail-able. Over the medium term, it is envisaged that debtmanagement strategies will be supported by a contin-ual fall in interest rates, a relatively stable exchangerate environment, a reduction of the fiscal deficit,and a return to fiscal surplus.

Jamaica’s public debt management strategy isdefined within the context of a macroeconomicframework of fiscal balance, price stability, andgrowth. Consistent with this, the strategic objective isto bring total debt to sustainable levels over themedium term. Achieving sustainable levels of debthas necessitated the design and implementation of acomprehensive debt management strategy.

The government’s debt management strategy isintended to achieve five broad objectives over themedium term:

• satisfying the government’s annual borrowingrequirements,

• minimizing borrowing and debt service costs,• achieving a balanced maturity structure,• building and promoting a liquid and efficient

market for government securities, and• ensuring continued or wider access to markets,

both domestic and external.


Increased attention has been given to managing thegovernment’s exposures to unexpected interest rateand currency movements in relation to both thedomestic and external debt portfolios. At the end fis-cal year 2001/02, more than 57 percent of Jamaica’sdomestic debt portfolio was composed of floating-rate instruments. This has left the government vul-nerable to increases in interest rates with theattendant increases in debt-servicing costs. To reduceinterest rate risk, the current debt strategy has beento increase the proportion of fixed-rate debt in thedomestic debt portfolio. Progress has been made inthis direction, because all local registered stocksissued through auction have been issued on a fixed-rate basis. Fixed-rate debt will continue to be issuedover the medium term, thereby redistributing the bal-ance between fixed- and floating-rate debt to moreprudent levels. Over the medium term, the govern-


ment will seek to maintain the fixed-rate target of 60percent of the domestic debt portfolio, in keepingwith international best practice.

The management of the Jamaican debt portfo-lio’s currency exposure will include limiting the shareof U.S. dollar exposure in the domestic debt portfo-lio. Jamaica’s issuance of U.S. dollar-denominatedand U.S. dollar–indexed securities in the domesticmarket has led to an increasing share of the domesticdebt portfolio exposed to U.S.-dollar currency risk. Atthe end of fiscal year 2001/02, these categoriestogether made up 15.5 percent of the domestic debt,compared with 8.1 percent at the end of fiscal year2000/01. Although the government is committed toproviding an array of instruments to the domesticmarkets, maintaining a prudent domestic debt struc-ture requires that the U.S. dollar exposure of theportfolio remain low. Consistent with this, the strate-gic objective will be to reduce the exposure over themedium term.

External debt

The currency composition of Jamaica’s external debtis changing after years of holding steady. The adventof the euro and the replacement of multipleEuropean currencies by a single currency have signif-icantly altered the composition of Jamaica’s externaldebt portfolio. In addition, success in diversifying theportfolio by raising funds in the international capitalmarkets has influenced the currency composition ofthe debt. Although more than 75 percent of the exter-nal debt portfolio is denominated in U.S. dollars, agrowing portion of the debt is denominated in euros.The euro is now the second largest currency compo-nent of Jamaica’s external debt, accounting for 14percent of the external debt at the end of March 2002.

The seeming complexity of hedging instruments(swaps and options), with its specialized knowledgerequired to use such instruments effectively, and thecosts of using such tools have tended to makeJamaica, like many other developing countries, shyaway from actively employing these mechanisms. Thenotable shift in the currency composition of the pub-lic external debt makes it prudent for the govern-ment to adopt strategies to manage the currency riskassociated with this exposure, because unhedged

exposures can lead to significant increases in debt-service costs. As a result, steps will be taken to mini-mize the portfolio’s vulnerability to adversemovements in the euro by using hedging mecha-nisms, where appropriate, to minimize the portfolio’sforeign currency exposure.


The need to record and assess the impact of the gov-ernment’s contingent liabilities has become increas-ingly important in recent years. The government isconcerned not only with limiting the total face valueof contingent liabilities, but also minimizing both thelikelihood of contingent liabilities being called andthe size of public outlays in the event that a call ismade. In assessing the appropriateness of contingentliabilities, consideration is given to how theseresources will be used to ensure that they will be usedfor developmental purposes and are in keeping withgovernment’s economic strategy.

A number of measures to minimize the govern-ment’s risk exposure associated with contingent lia-bilities are being implemented. Foremost amongthese is the strengthening of the monitoring andanalysis of contingent liabilities so that the potentialfuture impact for debt servicing can be fully evalu-ated. Legislation designed to enhance accountabilityand transparency in public sector bodies has beenenacted. Work is also under way to ensure the com-prehensive data capture of contingent liabilities andthe development of a proper risk managementframework. Another means of limiting government’srisk exposure is to require some level of risk sharingin the issue of government guarantees.

Development and Maintenance of anEfficient Market for GovernmentSecurities

Primary market

A core debt management objective is to ensure thatfunds are raised as cost-effectively as possible. Onestep in this direction, within the domestic market, hasbeen to adopt a market-based mechanism for selling


local registered stocks (LRS),2 the medium- to long-term instrument. A multiple-price auction system wasintroduced in October 1999. Previously, the govern-ment set rates on these instruments. This often cre-ated price distortions in the domestic market, whichat times manifested itself in the government’s financ-ing needs not being fully met from the market issues,necessitating private placements.

A more competitive pricing of medium- and long-term securities has been achieved through the use ofthe auction system. This mechanism has resulted in asignificant narrowing of interest differentials betweenlong-term and short-term domestic securities. Sincethe introduction of the auction system, LRS issueshave been significantly oversubscribed. Over time, theprice range for bids has narrowed. This policy shifthas resulted in the government meeting its financingneeds at competitive rates. When circumstances makeit necessary for the government to raise funds throughprivate placements, it is done through a competitivebidding process.

Another significant development has been theincreased ability of the government to extend thematurity structure of its debt since the introductionof the auction system. As of March 2002, 35.1 percentof total domestic debt was scheduled to mature afterfive years. This compares favorably with the positionone year earlier, when 23.3 percent of the totaldomestic debt was scheduled to mature after fiveyears. At the same time, 17.5 percent of the domesticdebt was scheduled to mature after 10 years, com-pared with 6.6 percent at the end of March 2001.

The appetite for longer-term securities hasresulted in a positive shift in the maturity profile ofthe domestic debt. A milestone was reached inAugust 2000, when the first 10-year LRS instrumentwas successfully auctioned. Of the new debt issued infiscal year 2001/02, some 86.4 percent of LRS issuedthrough the auction system had maturities of fiveyears or more, compared with 53.5 percent of newissues through the same process in the previous fiscalyear. In fiscal year 2001/02, 15.5 percent of newdomestic debt issued has maturities of 10 years ormore. With continued improvement in macroeco-nomic conditions and renewed investor confidence,the government has been able to successfully auctionLRS with maturities as long as 30 years.

The market’s appetite for longer-term securities isalso reflected in the successful issuance of government-guaranteed, 30-year, inflation-indexed infrastructurebonds for the financing of Jamaica’s first toll road.

The conversion of the contingent liabilities asso-ciated with the rehabilitation and restructuring of thefinancial sector into tradable government securitiesprovided an opportunity for further lengthening thematurity profile of the domestic debt. These obliga-tions were converted into securities with maturities ofup to 25 years.

Announcements

To facilitate the development of an orderly and well-functioning domestic securities market, the approachhas been to not only regularly access the market, butalso to inform the market of upcoming issues.Considerable progress has been made in informingthe market and increasing the predictability of thegovernment’s debt operations. In addition to thepublication of a calendar of treasury bill tenders andissue dates at the start of each fiscal year, announce-ments have been extended to include the publicationof an issuance calendar for LRS auctions. This dis-semination of information and the regular consulta-tions with primary dealers have allowed for greatertransparency and predictability in the domestic capi-tal market.

Portfolio diversification

The domestic debt portfolio comprises short-termtreasury bills, fixed- and floating-rate medium- to long-term LRS, medium-term debentures, fixed-rate for-eign currency domestic bonds, indexed bonds, savingsand developmental bonds, and commercial loans.

Although a significant proportion of the domes-tic debt portfolio is made up of floating-rate instru-ments, the use of the auction mechanism to price thegovernment’s primary debt-raising instruments, theLRS, has meant that over the medium term, anincreasing share of the debt will be on a fixed-ratebasis. This will insulate the portfolio from interestrate shocks and rollover risks.

The principal holders of government securitiesare the central bank, commercial banks, insurance


companies, pension funds, and the money marketfund managers. In recent years, the government’s debtissuance program has tried to meet the needs of themarket players. A priority has been to introduce newinstruments that are more closely tailored to meet theneeds of different market segments. In addition tooverall capital market development, the benefit to thegovernment is a larger pool of resources from whichfinancing can be tapped on improved terms.

The introduction of new instruments began in1999, when, on a small-scale, Jamaica offered U.S.dollar–indexed bonds to the domestic market. Theseinstruments have proven to be attractive to thoseinstitutional and retail investors uncertain about thefuture movements in the exchange rate and who aredesirous of maintaining the value of their assets. It isintended to reintroduce savings bonds, whichbecause of their structure and method of distributionare attractive to a wider cross section of investors,including household savers. In January 2002, Jamaicaintroduced 30-year, inflation-linked bonds in thedomestic market for financing of the first toll road.These were purchased mainly by pension funds.

Portfolio diversification has also occurred withthe external debt. Renewed access to funding fromthe international capital markets since 1997 hashelped to broaden Jamaica’s investor base in terms ofthe geographic distribution and the type of investorsparticipating in Jamaica’s international bond issues.In addition to the 1.375 billion in Eurobonds issuedmainly to U.S. investors, Jamaica gained successfulentry into the European capital markets in February2000 and February 2001, issuing euro-denominatedbonds totaling a375 million. This market has pro-vided an excellent alternative and a relatively cheapersource of financing for the government of Jamaicaand created greater flexibility and choice in meetingits financing needs. The U.S. dollar–denominatedbonds were purchased mainly by institutions andfund managers, but the euro-denominated transac-tions involved widespread participation by retailinvestors. The registration of future Eurobond offer-ings with the U.S. Securities and ExchangeCommission in February 2002 will also enableJamaica to further broaden its investor base, becausethe registration allows for greater access to U.S.investors.

Secondary market

Primary dealers have played a critical role in buildingthe securities market in Jamaica. In 1994, the BOJcreated a new financial market arrangement involv-ing primary dealers. The dealers were to be themedium through which the central bank conducts itsopen market operations. They were also expected toprovide continuous underwriting support for newissues of government securities, thereby providingsecondary market liquidity. Though not mandatory,dealers—currently numbering 14—are required totake up a total of 45 percent of all primary issues.

Secondary market development in Jamaica isconstrained by the absence of exchange trading insecurities. The Jamaica Central Securities DepositoryLtd. (JCSD), a subsidiary of the Jamaica StockExchange, began operation in 1998. However, thedepository currently trades equities only. The processto reduce the issuance of paper certificates for gov-ernment securities has been initiated. This demateri-alization of securities, which the central securitiesdepositories provides, will increase the efficiency ofsecondary market trading and reduce the risk associ-ated with the holding, trading, and settlement ofsecurities. As part of the fiscal year 2002/03 debtstrategy, steps will be initiated to reduce the issuanceof paper certificates for government securities. Thiswill involve, initially, consulting with market partici-pants and the relevant institutions integral to the pro-cess involved in the holding of securities in electronicform. The immobilization of government securitieswill allow for the further development of the domes-tic capital market by increasing efficiency and reduc-ing the risk associated with the holding, trading, andsettlement of securities.

Taxation

Although taxes on interest have been levied at a rateof 33.3 percent for corporations and 25 percent forindividuals, before 1999, taxes were withheld only onsavings deposits. In 1999, the government increasedthe number of financial institutions that wererequired to withhold taxes on interest as well as therange of financial instruments covered. Withholdingtax on interest was increased from 15 percent in 1999


to 25 percent in 2000 on all financial instruments.Corporations are liable for the remaining 8.3 percentwhen tax returns are filed. In addition to the increasein revenue from this source, there has been a reduc-tion in distortions in the domestic market. In an effortto encourage long-term savings by individuals, thegovernment granted tax-free status to approved long-term savings accounts. These are deposits where theprincipal amounts are held for at least five years. If thedeposits are redeemed before the minimum five-yearperiod, then tax is payable at the 25 percent rate.

Technological developments

The introduction of new and improved technologiesis also contributing to the development of the domes-tic capital market. One such development is theintroduction of a new system that allows primary deal-ers and other financial institutions to electronicallybid for securities. An immediate benefit is the greaterefficiency in conducting auctions of governmentsecurities. Similarly, upgrades to debt management,monitoring, and payment systems are contributing tomore comprehensive information being recorded, agreater selection of tools available for debt analysis,and speedier processing of debt payments.

Summary

Jamaica has recognized the need to adopt sound debtmanagement practices. Although advances are still tobe made, there has been considerable progress inrecent years in strengthening the government’s debtmanagement capacity. Clear debt management objec-tives have led to the articulation of a comprehensivedebt strategy, and the increased reliance on marketmechanisms to sell government securities has led to

the issue of longer-term securities at lower interestcosts. The availability of information, greater pre-dictability of issues, and more frequent dialogue withthe market have increased market confidence.

The imperative for the future is to build on theseachievements, so that over time the culmination ofsound debt management policies and practices is sus-tained economic growth and development for Jamaica.There are a number of factors that will facilitate the fur-ther development of the market. These include

• The renewed health of the financial sector:Rehabilitation and restructuring efforts haveresulted in a consolidation of the sector intofewer institutions with greater critical mass.

• Further improvements in the legislative frame-work governing the financial sector: A new regu-latory authority—the Financial ServicesCommission (FSC)—was established in April2001. The FSC is responsible for the efficient reg-ulation and supervision of entities dealing insecurities, collective investment funds (e.g.,mutual funds and unit trusts), investment advis-ers, the insurance industry, and pension funds.

• Planned reform of the pension system: This willcreate a larger pool of funds for long-term invest-ment.

• Plans to reopen government debt issues to createbenchmark securities across the yield curve: Thiswill increase the liquidity of the instruments, fur-ther extend the maturity profile of the debt, andlower borrowing costs.

Notes

1. The case study was prepared by the Debt ManagementUnit of the Ministry of Finance and Planning.

2. LRS may be both fixed- and floating-rate securities.


Governance Framework

Debt management objectives

Debt management policies in Japan have two primaryobjectives: first, to ensure smooth and stable fundingfor fiscal management; second, to curb costs onmedium-to long-term financing, thus alleviating theburden on taxpayers.

Smooth funding aims to ensure that Japanese gov-ernment bond (JGB) issuance will not have a turbulentimpact on the market. This can be accomplished bymaintaining high levels of transparency, predictability,and considerations to financial market trends. Stablefunding means to issue bonds according to theplanned amount of government bond issuance.

Improving the secondary market is also an essen-tial element that needs to be taken into account in for-mulating debt management policies. The governmentbond market is the market where credit risk–free inter-est rates are formed. Thus, it serves as the foundationfor the broader financial marketplace. JGBs alsoaccount for the majority of securities in the domesticbond and debenture market, both in issue amount and

trading volume. Consequently, efforts to improve liq-uidity and increase efficiency in the secondary market,instead of improving the primary market alone, areessential to foster the financial market as a whole. Inthe end, this will help to increase the Japanese mar-ket’s international competitiveness. Another point isthat an improved secondary market will also facilitate asmoother, more stable, and low-cost issuance of gov-ernment bonds.


The primary objectives of debt management policiesare to ensure smooth and stable funding while curbingfinancing costs to alleviate the fiscal burden.Accordingly, debt management policies must facilitatefiscal management.

Both debt management policies and monetarypolicies can affect the economy via interest rates. So,unless consistency is secured between these two areas,appropriate economic policies cannot be imple-mented. Therefore, it is essential for the governmentand the central bank to maintain adequate levels ofconsistency and transparency in their own policies

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8Japan1

while fully taking into account policy interactionsduring the process of policymaking.

In the relations with monetary policy, it is essentialto prohibit the central bank from underwriting gov-ernment bonds in the primary market and adhere tothe principle of issuing government bonds in the mar-ket. This is mandatory in the context of maintainingfiscal restraints and the independence of the centralbank, and it is legally set forth in Japan’s Finance Law(Article 5). One exception exists. With the approval ofthe parliament (the Diet), refunding bonds can beissued directly to the Bank of Japan (BoJ) when gov-ernment bonds held by the BoJ mature. This excep-tion is permitted because such issuance of refundingbonds will not lead to increased money supply.

The government should not be allowed torequest the central bank to ease its monetary policy,alleviate the fiscal burden, or purchase governmentbonds to help absorb JGBs. Requests such as thesewould be detrimental to debt management policies,because they would undermine investor confidencein government bonds and also could fuel inflationaryexpectations. Therefore, such requests are nevermade. Moreover, developing monetary policy is theprerogative of the policy board at the BoJ, and thefinal decision making concerning the purchase ofgovernment bonds lies with the BoJ.

Legal framework of government debtmanagement

Article 85 of the constitution stipulates that nomoney shall be expended, nor shall the state obligateitself, except as authorized by the Diet. Accordingly,JGBs are, without exception, issued on legal grounds.

Laws that serve as a basis for issuance varyaccording to the use of funds

In principle, the issue amount of government bondsis determined for each fiscal year, which begins onApril 1 and ends on March 31 the following year. Atpresent, four main laws provide the grounds for theissuance of government bonds:

• Construction bonds under the Public FinanceLaw: Although the Public Finance Law stipulates

that, in principle, government expenditure mustbe financed by tax revenue (Body, Paragraph 1 ofArticle 4), it allows for government bondissuance or borrowing only as a means to financepublic works (Proviso, Paragraph 1 of Article 4).The maximum issue amount for each fiscal yearis specified in the general provisions of the bud-get and must be approved by the Diet.

• Special deficit-financing bonds under the speciallaws: As mentioned, the Public Finance Law per-mits the issuance of government bonds only tofinance public works. However, when there is abudgetary deficit, a special law enacted for eachfiscal year based on Article 4 of the PublicFinance Law authorizes the government to issuespecial deficit-financing bonds. Also, with specialdeficit-financing bonds, the maximum issueamount for each fiscal year is specified in thegeneral provisions of the budget and must beapproved by the Diet.

• Refunding bonds under the Special Account Lawof the Government Debt Consolidation Fund:The government can issue refunding bonds(except for fiscal loan fund special accountbonds) up to the amount required for consolida-tion or redemption of government bonds duringa given fiscal year (Article 5 and 5-2 of the SpecialAccount Law of the Government DebtConsolidation Fund). Because refunding bondissues will not affect the outstanding governmentdebt, their maximum issue amount is not subjectto approval from the Diet. The actual issueamount is determined according to the so-called60-year redemption rule (discussed in anothersection).

• Fiscal loan fund special account bonds under theFiscal Loan Fund Special Account Act: The gov-ernment can now issue bonds or borrow tofinance fiscal loan programs (Article 11 of theFiscal Loan Fund Special Account Act) as a resultof the reform of the Fiscal Investment and LoanProgram (FILP) system that took effect in April2001. (Under the old system, all postal savingsand pension reserves were deposited with thetrust fund bureau to finance the FILP. Such ascheme with a compulsory deposit no longerexists. Instead, under the new system, each FILP


agency must in principle raise funds from themarket by issuing FILP agency bonds. Should cir-cumstances necessitate, however, the funds canbe raised in part by issuing government bonds.)

The laws define how the proceeds will be used.However, from the investor’s perspective, there is nodifferentiation between construction bonds, specialdeficit-financing bonds, refunding bonds, and fiscalloan fund special account bonds.

Law- and ordinance-based handling of governmentbonds

The minister of finance is granted the authority bythe Law Concerning Government Bonds to deter-mine government bond issuance, registration, andother basic procedural matters related to govern-ment bonds. Specific procedures are stipulated in theministry ordinances established by the LawConcerning Government Bonds. The law also speci-fies the BoJ’s role in handling government bonds.

The government debt consolidation fundDebt reduction in Japan is built around the govern-ment debt consolidation fund (GDCF). Fiscalresources for all interest payments and redemptionof government bonds are funneled into the GDCF,accumulated, and disbursed from the GDCF.

Funds are transferred from the general accountto the special account for the GDCF. Revenue fromissuing refunding bonds is also stored at the GDCF, tobe used to redeem bonds at maturity. Independentmanagement of the cash flow regarding interest pay-ments and redemption, as such, aims to contribute toinvestor confidence in the security of interest pay-ments and redemption.

Sixty-year redemption ruleThe so-called 60-year redemption rule—meaningeach issue of debt should be redeemed over a span of60 years—plays a central role in the debt reductionsystem. The concept is based on the average eco-nomic depreciation period of the assets purchased byconstruction bonds and special deficit-financingbonds being about 60 years, so redemption should becompleted during that period.

The rule allows calculation of the net amount tobe redeemed out of the gross redemption amount formaturing bonds. In other words, the rule is used todetermine the amount of fiscal resources to befinanced by issuing refunding bonds (for the purposeof net redemption). The 60-year redemption rule isnot applied to fiscal loan fund special account bonds,because the fund collected from the FILP investmentwill be used for their redemption.

The following is an example to show how the ruleactually works. A new ¥60 billion, 10-year fundingbond is issued. When the bonds become due, ¥10 bil-lion yen—or one-sixth of the original issue amount—will be put toward cash redemption (in the GDCF)and refunding bonds for the remaining ¥50 billionwill be issued. Assume these refunding bonds are infive-year bonds. When the refunding bonds becomedue in five years, ¥5 billion—or five-sixtieths of theoriginal issue amount—of the redeem and refundingbonds for the remaining ¥45 billion will be issued.Repeating this, the entire issue would be redeemed60 years after the initial issuance.

Organizational structure

The issue amount in JGBs is determined during thebudgetary process for each fiscal year. Within the min-istry of finance, the following departments areinvolved in the work related to government borrowing:

• Budget bureau: The budget bureau compiles theamount of new issuance of funding bonds thatconstitute the revenue of the general account.

• Financial bureau, fiscal investment and loan pro-gram division: As the division in charge of theFILP, this section compiles the issue amount offiscal loan fund special account bonds that con-stitute the revenue of fiscal loan fund specialaccount.

• Financial bureau, government debt division: Asthe name suggests, this division plays the centralrole in debt management policies, which rangefrom compiling a government bond issuanceplan and setting terms for each issue, to design-ing new schemes and programs, such as the sep-arate trading of registered interest and principalof securities ([STRIPS] that were launched in fis-

Country Case Studies: Japan 119

cal year 2002). The government debt divisionalso calculates the issue amount of refundingbonds based on the 60-year redemption rule.

• Financial bureau, treasury division: This divisionis responsible for the day-to-day cash-flow man-agement of the general account, based on the cir-cumstances of debt issuance. It also issuesfinancing bills to cover fund shortages in theshort term.

• Tax bureau: Government bond–related tax sys-tems fall under the jurisdiction of the tax bureau.

The BOJ handles all the governmentbond–related procedural work, from issuance toredemption. Serving as the central securities deposi-tory for government bonds, the BOJ also provides thefinancial network system, BOJ-NET, which is an onlinesystem in which a number of financial institutions par-ticipate to settle both government bonds and funds.

Being responsible for supervision of financialmarkets, the financial services agency takes the initia-tive in establishing rules and systems for trading aswell as supervising the secondary market.



As mentioned, the objectives of debt managementcan be summarized in three points:

• first, to ensure smooth and stable funding for fis-cal management;

• second, to curb costs on medium- to long-termfinancing, thus alleviating the burden on taxpay-ers; and

• third, to develop a debt market that has high lev-els of efficiency and liquidity.

To accomplish these objectives as a whole, it isessential that debt management policy be based ontwo different, yet closely related, perspectives—to bemarket friendly and to promote market development.

This section outlines the debt management strat-egy with a focus on the implementation of policies

that are market friendly. Market development is thefocus of the next section.

Strengthened communications with the market

To ensure smooth and stable funding, it is essential tofully take into account the trends and needs in themarket so as not to cause turbulence. Therefore, toimplement policies that are market friendly, anappropriate understanding of market trends andneeds is indispensable. It is equally essential to workon market expectations through two-way communi-cations for any major change in policy.

The government debt division within the min-istry of finance, in charge of the issuance and main-tenance of government bonds, has severalmonitoring officials who maintain daily contact withbond market participants. Vital information collectedthrough this channel is reported to higher reaches ofgovernment. At the time of issue, a number of marketparticipants are interviewed just before the bidding,so that issue terms can be fine tuned to meet marketneeds.

Although such day-to-day market monitoring bythe officials in charge is instrumental to market-baseddebt management, it was realized that an advisorygroup, made up of a wide range of participants,would be helpful for a multilateral exchange of views.Thus, in September 2000, the ministry of financeestablished the Meeting on the Japanese GovernmentBond Market, a forum of key market participants,scholars, and experts. Although this meeting is notgranted policymaking powers, it promotes an activeparticipation of its members by appropriately reflect-ing the content of discussion on debt managementpolicies. Moreover, through discussion at the meet-ing, the debt management authority can indicate itspolicy stance, either explicitly or implicitly. Thus, thesubjects discussed at the meeting are diverse, rangingfrom short-term agenda, such as maturity structure,to longer-term issues, such as institutional improve-ment of the government bond market.

Meetings of this group take place more or lessmonthly. Market participants who take part areelected once every six months, based on their bid-ding performance. However, it is important that par-ticipation in a meeting with the debt management


authority does not lead to giving special attention tothose who participate. Thus, in the case of theMeeting on the Japanese Government Bond Market,the chair holds a press conference immediately aftereach meeting to announce the content of the discus-sion. Furthermore, detailed minutes are publishedbefore the market opens the following morning, thuseliminating any information gap between membersand nonmembers.

Issuance at par value

Japanese investors tend to prefer issues to take placeat or near par value. Accordingly, when determiningissue terms, the coupon and maturity must be basedon the actual market situation so that the issue pricecomes close to par value. Consequently, an outstand-ing issue can be reopened only when the market rateimmediately before an auction is close to the couponrate of the outstanding bond. As a result, whether ornot the reopening rule will be applied will not beknown until the announcement of the issue terms onthe bidding day. One consequence is that it is ratherdifficult to predict the final outstanding amount foreach issue. This is a problem that remains to beaddressed, for example, by introducing a regularreopening rule, such as those used in some othercountries. A change could make the issue price eithersubstantially over par or under par. Thus, it is crucialto see if the par-driven propensity of Japaneseinvestors will change when current value accountingbecomes more prevalent.

Bond issuance via auction

To ensure that government bond issuance is marketfriendly, it is desirable that the primary and sec-ondary markets be linked. Accordingly, an effectiveapproach to market-based issuance of governmentbonds is to hold auctions among a number of marketparticipants.

In Japan, 10-year bonds—the main tenor sincethe beginning of the JGB history—are issued excep-tionally through syndicate underwriting. At present,however, 60 percent of the issue is distributed to syn-dicate members via a competitive-price auction, toreflect the market mechanism as much as possible.

The remaining 40 percent are allocated to syndicatemembers at a fixed price and share. As to the amountoffered at a competitive-price auction, when theoffered bids amount to less than the scheduledamount, the syndicate members are supposed toundertake the remaining balance according to theirfixed shares at a price equivalent to the average con-tract price in the competitive-price auction.2

All other bonds are issued by use of auctions. Asa result, 90 percent of the government bonds issuedin the financial market during fiscal year 2001 wereoffered at auctions.

What method of auction to choose—price oryield auction, or whether to issue bonds at a uniformprice or each at a bidding price—is another point tobe considered. In Japan, a price auction method hasbeen adopted for all government bonds, except for30-year bonds and 15-year floating-rate bonds,3 andissues each of them at a contract price.

With 30-year bonds, the current market yield—the basis for determining the coupon rate—is notreadily available, because the secondary market for30-year bonds is not yet fully functioning. Thesebonds are therefore offered by a yield auction, andthe coupon rate is determined afterward based onauction results, a method that ensures the bonds areissued at or near par. All winning bidders can pur-chase the bonds at the maximum contract yield (i.e.,single-price method). This method is regarded aseffective for issuing bonds with a long maturity.

Risk management

The largest risks the debt issuing authority can faceare interest rate fluctuation risks and refinancingrisk. For example, concentrating issues on a specificmaturity when determining maturity structure couldincrease the risk of raising yields, or concentratingredemption on a specific timing could increaserefunding risks in the future. Therefore, a priority isto maintain an appropriate balance among differentmaturity zones in the debt portfolio. This is achievedby assessing the market latitude for each zone, suchas short-term, medium-term, long-term, and super-long-term.

In recent years, JGBs with maturity other than 10years have quickly established themselves as new


benchmark bonds with increasing liquidity, which hasfacilitated risk management. However, as a result, theappropriate balance among different maturity zoneshas also been in a state of flux. Thus, at present, nofixed standard exists for either maturity-wise ratios oraverage maturity.

It is also essential to smooth the redemptionstructure in the debt portfolio as much as possible. Infiscal year 2002, a buyback program with the aim ofadjusting the maturity structure in the debt portfoliois expected to be implemented.

When the distribution of debt issuance amongmaturity zones is subject to change, it could lead toincreasing interest rate fluctuation risks. Similarly, achange in debt-related systems (i.e., systems govern-ing debt market activities such as legal systems or set-tlement systems) could increase interest ratefluctuation risks if it is not expected by the market.Therefore, when making a policy change, it is desir-able to create a soft landing by sending signals to themarket via various channels to ensure that thechange will be a factor already considered in the mar-ket expectations. For example, in a government bondissuance plan for each fiscal year, the market is par-ticularly interested in knowing the issue amount foreach maturity zone. This is where the Meeting on theJapanese Government Bond Market can prove itsworth. An opportunity to have discussions with mar-ket participants, which will help us better understandthe market needs, together with prompt disclosure ofthe content of discussions, should help increase thepredictability of the yet-to-be-announced maturitystructure.

Developing the Government SecuritiesMarket

Diversification of government bond maturityand product appeal

To develop an efficient market for governmentbonds, it is essential to achieve a smooth yield curveby developing a benchmark bond for each maturityzone, thus increasing liquidity across the entire yieldcurve. In the past, the maturity structure focused on10-year bonds, making it virtually the only bench-

mark bond in Japan. In recent years, however, intro-ducing new types of government bonds with maturi-ties of other than 10 years has diversified maturityzones.4 Also, in compiling the issuance plan for eachfiscal year, issues have increased in 2-year, 5-year,5 10-year, and 20-year bonds to develop them into bench-marks while taking into account the balance amongthem. When determining the terms of issue based onthe market situation, whether or not the reopeningrule can be applied depends on the circumstances atthe time of issue, as described. But when the reopen-ing rule is applied, it is aimed and expected toincrease liquidity of that particular issue.

However, an excessive diversification of maturityzones will be incompatible with the effort to developbenchmarks. At present, it would be inappropriate toadd yet other benchmarks by establishing new matu-rity bonds in addition to 2-year, 5-year, 10-year, and20-year bonds.

To provide investors with varied investment oppor-tunities focused just on maturities, it is also necessary toconsider diversification from the standpoint of imple-mentation of suitable, needs-oriented instruments andfrom the angle of product appeal. For example, today,15-year floating-rate bonds, with the semiannualcoupon pegged to the interest rate of 10-year bonds,are offered in public auctions, a response to the grow-ing investor needs for products that can allow them tohedge against interest rate fluctuation risks.

In addition, the STRIPS system is expected to beintroduced shortly. This introduction should not onlyincrease the number of options available to investors,but also it will help achieve a more precise zero-coupon yield curve, thus increasing the efficiency ofthe debt market.

Information regarding bond issuance

Issuance plan for each fiscal year

To make debt issuance transparent and predictable,the ministry of finance formulates and announces agovernment bond issuance plan for the coming fiscalyear at the same time as the announcement of thebudget. The issuance plan consists of two parts: clas-sification by funding purpose and classification byissuance methods and maturity.


The latter classification is divided into two: thetotal amount to be distributed in the private sectorand the total amount to those in the public sector.The amount to be distributed in the private sector isfurther broken down by maturity, and the amount tobe distributed in the public sector is further classifiedby public entity.

Because the ministry of finance makes it a rule tolevel each issue amount for a given maturity, marketparticipants should be able to predict the approxi-mate amount per issue based on the total issueamount by maturity.

Auction calendar

In March 1999, in an effort to make debt issuancemore transparent and predictable, the ministry offinance began to publish the auction calendar andoffering amount prior to auctions. Previously, theauction calendar for the coming three months wasannounced quarterly. The shortcoming of thismethod, however, was that investors had to wait untilthe last minute to be informed of the first auction inthe coming quarter. Thus, in October 2001, theannouncing method was changed to a monthlyannouncement of the auction calendar scheduled forthe three months ahead. This has added to the pre-dictability of debt issuance.

Issue terms

The total offering amount for each issue is publishedapproximately one week before each auction. Thecoupon rate and the date of redemption, however,are announced on each auction date, because thesetwo are determined by referring to the market situa-tion up to the last minute before the auction starts.

Publication of this information is made to marketparticipants at predetermined times via the Internetand news agencies.

Auction results

To minimize the risks on the part of market partici-pants, it is desirable to announce the auction resultsas promptly as possible. Since May 2001, auctionresults have been produced within one and one-half

hours. However, results used to take as long as twoand one-half hours to appear, but by April 2000, thetime had been shortened to two hours.

Government bond–related taxation

A 20 percent withholding tax is levied on the intereston coupon-bearing bonds. Those held by designatedfinancial institutions (e.g., banks and securitiesfirms), however, are exempted from withholding tax.

Furthermore, in September 1999, a withholdingtax exemption system for interest on governmentbonds held by nonresident investors was introduced.In April 2001, the tax benefit was expanded even fur-ther. Under the expanded scheme, withholding taxexemption is also granted to interest on governmentbonds deposited by nonresident investors in the BOJbook-entry systems through foreign financial institu-tions (including so-called global custodians).

Profits on redemption of discount bonds are sub-ject to an 18 percent withholding tax automatically atthe time of purchase. However, profits on treasurybills and financing bills are exempted from withhold-ing tax, because they are now held via the transfer set-tlement system.

Diversified market participants

To develop a debt market with high levels of liquidity,it is essential to diversify market participants as muchas possible, thus increasing the depth of the market.

One of the characteristics of the Japanese debtmarket is that the government sector (including thepublic financial sector, such as postal savings),together with the private banking and insurance sec-tor, hold a large share of the outstanding JGBs,whereas the share of JGBs held by individual investorsand nonresident investors remains at a low level com-pared with other countries.6 Perhaps one underlyingfactor is Japan’s indirect finance–oriented structure.Even today, a large amount of household financialassets (totaling ¥1,400 trillion) is invested indirectlyin government bonds via bank deposits and postalsavings. One of the reasons that have added to thistrend has been the deteriorating demand for fundsin the private sector because of stagnation in theeconomy in recent years.


As such, the structure of debt holders in any givencountry is so deeply rooted in the financial system as awhole that it is impossible to categorically argue howit should take shape. However, when a limited numberof institutional investors hold the majority of out-standing JGBs, the debt market is more likely to movemore dramatically if there is a shock. Thus, to increasethe stability of the debt market, it is far better to diver-sify debt holders as much as possible.

Also, the introduction of the payoff system inApril 2002 (meaning a deposit insurance system thatguaranteed term deposits up to ¥10 million, com-pared with an unlimited amount in the past) isexpected to heighten the public awareness of creditrisks. As a result, macroeconomic flows of capital maybecome more risk conscious. If that happens, thereshould be greater needs for government bonds,because they are credit risk–free financial assets.

In diversifying market participants, the currentpolicy priorities are to promote further participationby individual investors, nonresident investors, andnonfinancial corporations.

Regarding individual investors, various publicrelations activities have started to communicate thebenefits of investing in government bonds. Towardthe end of 2001, for example, a public relations mediacampaign was designed to reach individual investors,using television, radio, newspapers, magazines, andposters. In addition, plans have been set in fiscal year2002 to introduce nonmarketable government bondsspecifically designed for individual investors.

As for nonresident investors, the tax exemptionmeasures have already facilitated their entry into theJGB market, and there are plans to further promotetheir understanding of Japan’s tax system and otherrelated regulatory frameworks. For the overseas audi-ence, the Internet, in particular, is regarded as aneffective vehicle to deliver information.

Improved settlement system

The BoJ serves as the central securities depository forgovernment bonds and provides settlement servicesfor JGBs. The platform for settlement of book-entrysecurities is the BOJ-NET system. Bidding-relatedprocedures in the issuance of these securities are alsoprocessed online via the BOJ-NET system.7

Book-entry securities are settled on-line on theBOJ-NET Japanese Government Securities TransferSystem, a part of the BOJ-NET system. Another partof the BOJ-NET system is the BOJ-NET FundsTransfer System, an on-line system for the electronictransfer of funds across the current accounts at theBoJ. These separate services were linked in April 1999to allow for the delivery-versus-payment (DVP)method of settlement. To maintain security of the set-tlement system, the DVP method of settlement isessential, thus avoiding the risks arising from the dif-ferent timing of settling funds and securities.

Furthermore, in January 2001, a shift in themethod of settling government bonds and the cur-rent accounts at the BoJ took place––from desig-nated-time net settlement to real-time grosssettlement (RTGS). Such a system involves a settle-ment mode that limits the direct effect of a financialinstitution’s inability to pay (e.g., in the event theinstitution is unable to transfer funds or governmentbonds for any reason) to the counter-parties in atransaction. In other words, the changeover to theRTGS system was aimed at reducing the systemic riskinherent in designated-time net settlement.8

Introduction of the RTGS system has also solvedanother problem of the former designated-time netsettlement. Under the old settlement system, eachpayment was interrelated with other payments settledat the same settlement time through the netting pro-cess, whereas with RTGS, each payment is settledindividually.

In addition, under the RTGS method, settlementof most transactions at the BoJ is now completedearly in the day. The earlier timing of settlement hasalso contributed to the reduction of systemic risk bysubstantially reducing the amount outstanding oftransactions remaining unsettled on the settlementday. However, RTGS is not totally free from delays insettlement and an increase in loop transactions (a sit-uation where, for example, three counter-partiesshort-sell a security among each other, which will starta loop because no one has the security to transfer)deriving from an increase in settlement work or achain of transactions. Therefore, the occurrence offails,9 up to a certain degree, needs to be permitted.

Previously, designated-time net settlement wasthe norm for the Japanese bond market. Thus, to


avoid the systemic risk inherent in this settlementmethod, failed transactions were generally not per-mitted. Accordingly, the so-called good-fail rule (uni-fied business practice for treatment of fails) was notin demand then. However, introduction of the RTGSsystem has changed the circumstances, promptingthe Japan Securities Dealers Association to study andintroduce a good-fail rule similar to the ones estab-lished in key overseas markets (for explanation, seethe Appendix).

Development of related markets

Increased convenience of the futures market and therepo market should facilitate hedged or arbitratedtransactions among three markets, including the cashmarket (i.e., underlying assets market), thus adding tothe liquidity of the government bond market as a whole.

Japan’s futures market for government bondsopened in 1985 at the Tokyo Stock Exchange.Trading of long-term (10-year) JGB futures, whichaccount for the majority of JGB futures transactions,in the contract month traded most actively hasextremely high levels of liquidity.10 This is due, inpart, to the fact that many market participants takepart for a variety of purposes, such as arbitragebetween contract months or spot versus futures,hedging, and speculations.

The repo market in Japan used to have two typesof transactions––old-type repurchase agreement andrepo transactions of JGBs using cash as collateral(known as the “JGB repo”). Both types had someproblems to be addressed. Previously, repo transac-tions of JGBs using cash as collateral were employed

for coupon-bearing government bonds, and the for-mer repurchase agreement was the norm for short-term government bonds. In other words, Japan’srepo market used to be divided by these two differenttypes of transactions.

In July 1998, market participants began studyingnew guidelines for repurchase agreements. Thisresulted eventually in the Master RepurchaseAgreement11 compiled by the Japan SecuritiesDealers Association, paving the way to the April 2001introduction of a global standard–oriented method(i.e., new-type repurchase agreement), which is saferand more convenient than the previous method oftransactions. The main characteristics of the new-typerepurchase agreement are

• a nonresident-friendly method based on interna-tional standards and legally positioned as a “buy-and-sell” transaction,

• higher levels of safety due to strengthened meth-ods for risk management (including haircut andmargin call, also existing in the JGB repo) andincorporated measures for handling the defaultof a counter-party, and

• a newly incorporated substitution right (the rightto substitute a security with another security dur-ing the course of the repo transaction) to facili-tate term loan and deposit.

From now on, it is expected that all transactionswill be consolidated into the new-type repurchaseagreement. The new consolidated method of trans-actions should also help the efficient formulation ofshort-term benchmark interest rates that are risk free.


Appendix

The Good-Fail Rule

Under the good-fail rule, a party who fails to honor atransaction on a timely basis is subject to neither pun-ishment nor delinquency charges. This is because therule is based on the understanding that a fail accom-panies the economic effect that as such serves as adeterrent to the occurrence of a fail and, should itoccur, as an incentive to address it.

The rule can be illustrated by this example.Suppose X (deliverer) failed to deliver the JGBs to Y(receiver) on the contract date. Then, certainly Xcannot receive the money for those JGBs. Thus, Xmay have to bear the extra cost of raising fundsneeded to keep holding the securities, or X has toabandon the opportunity to invest the money thatwas supposed to be paid by Y on the contract date.Besides, X will only be entitled to receive the interestpayment for the period that ends on the contractdate, no matter how long X is going to hold thoseJGBs. So, simply put, for X, a fail is nothing but badnews. However, Y will be entitled to receive the inter-est payment for the period from the contract date tothe date of actual delivery, even though the JGBs arenot yet in Y’s possession. Also, Y can keep investingthe money Y was supposed to pay on the contract dateuntil the actual receipt of the securities. Thus, Y willgain from a fail on the part of X.

However, under the current situation of pro-longed low interest rates, the mentioned economicrationality is less effective in serving as deterrent.Thus, to put an extra drag on fails, a temporary mea-sure has been introduced that allows Y, for the timebeing, to demand that X pay for the cost Y wouldneed to obtain the equivalent amount of securities byborrowing JGBs against cash collateral.

Notes

1. The case study was prepared by Kunimasa Antoku fromthe Government Debt Division, the Financial Bureau of theMinistry of Finance.

2. To implement public offering auctions, it is essential thatthe secondary market be relatively mature and sizable. Thus,when the market is at a relatively early stage of development,introducing a mechanism that ensures stable funding, such as thesyndicate underwriting system in Japan, could be a valid policyoption.

3. With 15-year floating-rate bonds, auctions are held on thespread from the reference rate (i.e., the yield on 10-year bonds atthe most recent bidding).

4. Public offering auctions have begun in recent years forthe following government bonds: 1-year treasury bills (in April1999), 30-year coupon-bearing bonds (in September 1999), 5-yearcoupon-bearing bonds (in February 2000), 15-year floating-ratebonds (in June 2000), and 3-year discount bonds (in November2000).

5. Although bonds with maturities of four and six years usedto be issued, these bonds were discontinued in fiscal year2001/02, and five-year bonds were positioned as the benchmarkfor the medium-term zone. This occurred in response to theincreased liquidity of the five-year coupon-bearing bonds intro-duced in February 2000.

6. At March 31, 2000, individuals held 2.5 percent and non-resident investors 5.2 percent of outstanding JGBs.

7. The BoJ was the first to introduce such an on-line biddingsystem for government bonds. The system dramatically reducedthe time needed for bidding procedural work, enabling the same-day publication of auction results.

8. This risk involves the systemic disruptions posed to finan-cial institutions, and ultimately to the entire financial system,through a chain of settlement failures or delays in settlement.

9. A fail is a situation in which a recipient of governmentbonds in a transaction does not receive the bonds from the deliv-ering party on the scheduled settlement date.

10. Super-long-term (20-year) JGB futures and medium-term(5-year) JGB futures are also traded, but the actual trading vol-ume is negligible at present.

11. The Master Repurchase Agreement is based on theGlobal Master Repurchase Agreement, a standard agreement forrepurchase agreement used in Europe and the United States thatwas compiled by the Bond Market Association and theInternational Securities Market Association.



Objectives

Public debt management aims to ensure that the gov-ernment’s financing needs and its payment obligationsare met at the lowest possible cost over the medium tolong run, consistent with a prudent degree of risk.

The importance of the government’s debt man-agement strategy lies in helping generate macroeco-nomic stability and stronger public finances. The debtpolicy for 2002 had the objective of adequately manag-ing the government’s debt and helping to generate astable macroeconomic environment as well as strongerpublic finances. This was even more important duringa year in which most economies were encountering dif-ficulties, characterized by low growth rates and uncer-tainty in the international capital market. In thisregard, the government adopted the following debtmanagement policy for 2002:

• As in past years, the fiscal deficit was financed inthe domestic market. The uncertainty in the inter-

national market also underlined the need for thisstrategy during 2002.

• The strategy in the domestic debt was focused onthree areas:– improving the maturity profile,– extending the average life of domestic debt,

and – developing the long-term yield curve. It is

important to note that issuance of the 10-yearnominal fixed rate bond dates only to July2001.

• The external debt strategy is expected to continueto extend the maturity profile and at the sametime lower costs by implementing active debtmanagement strategies aiming at reducing marketimperfections in the sovereign yield curve. Thestrategy also intends to avoid refinancing risk dueto large concentrations of maturities in any givenyear.

Legal framework

The legal framework for the debt management iscovered by the following articles:

127

9Mexico1

• Article 73, Section VIII of the PoliticalConstitution of the United Mexican States (UMS)empowers the congress to establish the basis uponwhich the executive may borrow upon the creditof the nation, approve such borrowings, andorder the repayment of the national debt.

• Article 89, Section I of the Political Constitutionof the UMS empowers and establishes the duty ofthe president to promulgate and execute the lawsenacted by the congress to provide for exactobservance of the laws by the government.

• Article 31, Sections V and VI of the Organic Lawof the Federal Public Administration providesthat the ministry of finance and public creditshall manage the public debt of the federationand perform and authorize all transactionsinvolving the public credit.

• Article 1 of the General Law of Public Debt pro-vides that the following entities are authorized toborrow: (a) The federal executive and itsbranches, acting through the ministry of financeand public credit; (b) decentralized public agen-cies as well as public corporations (i.e., corpora-tions with majority government ownership); (c)government credit institutions and auxiliarycredit organizations, government insurance andsurety companies; and (d) trusts for which thegrantor is the federal government or any of theagencies mentioned above.

• Article 4, Section V of the General Law of PublicDebt establishes that the federal executive, actingthrough the ministry of finance and publiccredit, shall be vested with the power to contractfor, and manage, the federal government publicdebt and provide the guarantee of the federalgovernment in credit transactions.


Debt management policy is determined by fiscal pol-icy. If fiscal policy is coordinated with monetary pol-icy, debt management policy will be indirectly relatedto monetary policy. In this regard, borrowing pro-grams are based on the economic and fiscal projec-tions contained in the government budget. Thefinancial projections used in the government budget,such as the inflation rates and interest rates, are con-

sistent with the monetary program of the Bank ofMexico (BOM), the central bank. In addition, as willbe described, the BOM acts as financial agent of thefederal government for many transactions. Thisrequires a continuous working relationship betweenthe fiscal and monetary authorities regarding debtmanagement policy.

Guidelines for debt management

When the budget is authorized at the end of eachyear, the congress approves the annual limit for netexternal and internal borrowing submitted by thegovernment through the ministry of finance and pub-lic credit. This limit reflects the debt policy for thecoming year, which is also submitted to the congress,which analyzes this information carefully. This insti-tutional framework supports implementation of aprudent government debt management strategy.

In addition, every new administration sets forth ageneral program for borrowing and debt manage-ment, directly related to the fiscal objectives estab-lished for the period.

Institutional structure of debt management

Institutional structure of debt management withinthe government

The principal agency of debt management is the min-istry of finance and public credit, acting through theunit general direction of public credit unit. The mainpowers delegated to the unit are to negotiate andexecute all documents related to

• the public credit;• the authorization and registration of borrowings

by public entities, including the developmentbanks; and

• financial transactions and derivatives to whichthe government is a party.

The President of the UMS appoints the generaldirector of public credit. The senate must ratify theappointment.

The general director of public credit reports tothe undersecretary of finance and public credit.


Every quarter, the issuance program for domesticdebt is discussed with the undersecretary before itspublication. The reporting covers the negotiationsrelated to the authorization of borrowings by publicentities and the financial transactions to which thegovernment is a party. This covers, for example, everynew operation of the government in the interna-tional capital market. The frequency of the reportingdepends on when these negotiations take place.

As mentioned, the central bank acts as financialagent of the government in the issuance and serviceof domestic bonds as well as other liability manage-ment operations. The BOM is also in charge of pay-ing the government debt derived from most of theexternal debt with the funds of the federal govern-ment and under the instruction of the general publiccredit direction. This entails a constant working rela-tionship between the two entities.

Organizational structure within the debtmanagement office

The debt management office is organized as follows:

• The deputy general direction of external creditmanages the issuance of securities in the interna-tional capital markets and carries out liability andrisk management concerning the debt portfolio.

• The deputy general direction of internal creditformulates the policies and manages the pro-grams concerning the financing in the domesticmarket.

• The deputy general direction of internationalfinancial organisms negotiates the conditions ofthe loans with the World Bank, the Inter-American Development Bank, and other finan-cial organisms.

• The deputy general direction of project financ-ing negotiates and implements the policy regard-ing the financial operations, special schemes,and infrastructure projects.

• The deputy general direction of legal proceduresis in charge of solving issues related to the legalframework applicable to public debt manage-ment and provides legal advice to the generaldirection of public credit and to the other deputygeneral directions.

• The deputy general direction of public debt nego-tiates, authorizes, and registers the public debt.This department also gathers and records the sta-tistical information related to the public debt.

Retain qualified staff

Newly hired directors, deputy directors, and heads ofdepartments must have a strong knowledge of at leastone of the following subjects: public finances, eco-nomics, accounting, public debt management, law,statistics, and any other subject relating to public debtmanagement.

For the staff, there are internal training pro-grams in public finances, law, and accounting. Inaddition, scholarship programs are offered to thestaff according to the specific area where they work.

Excluding the deputy general directors, direc-tors, and deputy directors, the staff turnover withinthe general direction of public credit is low. The eco-nomic benefits are the same for all governmentemployees, thus there are no additional economicincentives for public credit staff. However, becausethere are opportunities to learn different aspects ofdebt management—such as policies concerningfinancing in the international capital markets and thedomestic market, knowledge of the legal framework

Country Case Studies: Mexico 129

General Direction of Public Credit

Deputy General

Direction of External Credit

Deputy General Direction of Internal

Credit

Deputy General Direction of International

Financial Organisms

Deputy General Direction of

Project Financing

Deputy General Direction of Legal

Procedures

Deputy General Direction of Public Debt

related to public debt management, and risk man-agement of the debt portfolio—the public creditdirection is regarded as an attractive place to work.


During the course of each year, a unit of the ministryof the comptroller and administrative developmentmonitors the accounts, financial statements, activi-ties, and operations of the general direction of publiccredit. Also during each year, the congress, throughits auditing organization, reviews the accounts, finan-cial statements, and other specific topics that are ofinterest to its members. The audit follows generallyaccepted auditing standards as well as generallyaccepted accounting principles applicable to govern-ment finances and debt management.

In addition, it is important to mention thatMexico belongs to the Data Dissemination Group ofthe International Monetary Fund. In this regard, his-torical data on Mexico’s public debt from the min-istry of finance and public credit is available on itsweb page (www.shcp.gob.mx).


The government has been able to reduce the coun-try’s vulnerability to contagion of international finan-cial crises mainly through sound macroeconomicpolicies and fiscal discipline. The fiscal deficit hasbeen decreasing for the past several years, and thegovernment will continue with its medium-term goalof achieving a balanced budget. On the monetarypolicy front, discipline has contributed to theachievement of the BOM’s inflation target for thepast two years and, consequently, to more stabledomestic financial markets.

A prudent and consistent debt management policyhas also been an important tool in the ambition toreduce the country’s vulnerability. Since the late 1980s,issues regarding public debt have acquired greaterimportance in the strategy carried out by Mexicanauthorities. The focus has been on a strategic debt man-agement that permits control over the debt and, at thesame time, improves the debt’s terms and conditions.

Since 1995, the public debt as a proportion ofGDP has diminished substantially, reaching levels notseen since the mid-1970’s (see Figure II.9.1). This hasresulted in an important reduction in the debt-ser-vice allocation, reducing the vulnerability of theeconomy to external shocks and also decreasing thepressure on public finance. Furthermore, as a resultof the effective transmission of fiscal and monetarypolicies, a reduction in the interest rates has alsobeen observed.

Naturally, debt policy has to coincide with eco-nomic policy. A greater local indebtedness could putpressure on interest rates and increase the financingcost for the private sector, causing a “crowding-out”effect in the domestic market. Furthermore, a greaterexternal indebtedness increases the refinancing riskand could lead the local currency to appreciate,affecting the competitiveness of the private sectorand motivating imports of products and services.Therefore, the yearly debt policy approved by thecongress establishes what will be the sources of thefinancing the government requires—whether it willfund itself abroad, in the domestic market, or a com-bination of both—in accordance with the economicpolicy. The issuance of debt by both the governmentand the agencies has to be considered in debt policyto avoid concentration of repayments in the sameyear. Consolidated reports on this issuance of debtare also presented to the congress.

The government has been very active in promot-ing the development of the local debt markets by pro-viding new regulations and instruments. This policyhas allowed Mexico to fund its budgetary needs withlocal debt, which in turn also has helped the devel-opment of local debt markets and allowed a reduc-tion of the external debt. In this sense, external debtas a percentage of total debt has demonstrated a cleardownward trend thanks to declining limits on netexternal indebtedness.

Internal debt

The Mexican government today faces two differenttypes of risk with respect to domestic debt.

• Interest rate risk: Given that a large amount offloating-rate debt is still outstanding, there is an


inherent risk that an increase in interest rates willresult in higher financial costs. However, as can beseen in Figure II.9.2, the relative importance offloating-rate debt has decreased over recent years.

• Refinancing risk: This risk arises from the possi-bility of an adverse environment in the globalcapital market, where the government could facedifficulties in rolling over its maturing debt infavorable conditions. Given the improvement ofthe amortization profile during the past few years(see Figure II.9.3), the refinancing risk is man-ageable.

To manage the interest rate risk and the refi-nancing risk, the government has undertaken anissuance strategy based on the following assumptions:

• issuance of long-term floating-rate debt with 3- to5-year maturities to reduce the refinancing riskstarted in 1997, and

• gradual issuance of fixed-rate long-term instru-ments in 3-, 5-, and 10-year maturities to furtherreduce refinancing risk, at the same time lower-ing interest rate risks.

Because the market for instruments with longduration is not deep, the Mexican government hascontinued to issue floating-rate debt. When the mar-ket permits, a gradual shift to fixed-rate debt issuancewill occur.

This issuing strategy is part of the overall debtmanagement strategy that the government has inplace. To guarantee that the current strategy in the


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External debt Domestic debt IPAB

Figure II.9.1. Public Debt Evolution, 1971–2001(In percent of GDP)

Note: The IPAB (Instituto de Protección al Ahorro Bancario) is an institution created by the government to back up credit defaults, thus avoiding bank-ing system failure.

local market is sustainable, the government has putspecial emphasis on macroeconomic policies, bothfiscal and monetary, aimed at promoting stability.

External debt

The solid fiscal position registered throughout themost recent years, along with the structural reformsaimed at opening the economy to the external sector,has strengthened the liquidity position of the publicsector with its external creditors. This developmenthas led to a reduction in Mexico’s vulnerability.Today, the entire stock of public external debt couldbe covered with a half year’s worth of exports, a levelnot seen since the 1950s. The government regards itas highly important to maintain this situationthrough prudent management of public finance andexternal debt. The issuance of external debt by the

government and the agencies is constrained by a ceil-ing imposed in the budget by the congress at thebeginning of the year.

The risk management framework for externaldebt management is oriented toward covering thegovernment’s refinancing needs, servicing existingdebt, and improving the maturity profile, as well aslowering the financing cost of debt. The main risksthat the government faces with respect to its externaldebt portfolio are refinancing risk, currency risk, andinterest rate risk.

• The refinancing risk is managed by maintaininga prudent maturity profile (see Figures II.9.5 andII.9.6) and not allowing large amounts to maturein a single year.

• The U.S. dollar is the natural source of externalfunding because of the large inflows of U.S. dol-


Figure II.9.2. Internal Debt Composition by Type of Instrument

53%

39%

30% 32% 28%

31%

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1997 1998 1999 2000 2001

Cetes Floating-rate Fixed-rate Inflation-indexed bonds

Note: Cetes (certificados de la tesorería) are short-term zero-coupon instruments with maturities of 1, 3, 6, and 12 months.

lars that enter Mexico through foreign directinvestment, portfolio investment, and transfers ofdollars from Mexicans living in the United States.Consequently, the non-dollar-denominated debtrepresents greater risk for the government.

• The government has been prudent in selectingthe portfolio’s composition of floating- and fixed-rate debt, thus it is composed mainly of fixed-rateinstruments. To hedge against any risk incurredfrom any floating-rate debt, the government mayuse the derivative market. In hedging securitieswith derivatives, the government mainly usescross-currency swaps, embedded options, andinterest rate forwards.

The government’s external debt portfolio consistsof both marketable and nonmarketable debt.Collateral deposits guarantee some of the externaldebt of the government, which are mostly Brady

bonds. This guaranteed debt is usually bought back orcalled whenever there are net present value savings, tomonetize the collateral and generate additionalresources for the government. The government is cur-rently trying to retire this debt by adding more marketdebt to its debt stock (see Figure II.9.7), making itsportfolio more liquid and qualifying it for morebenchmark credit indices as a large and liquid issuer,adding value to the government’s bonds.

The government takes advantage of marketopportunities as they occur. In the last few years, as aresult of favorable market conditions, it has com-pleted its funding early in the year. Because fundingrequirements have been relatively low, refinancingrisk, as such, has not concentrated in any particularmonth within the year. Once the external fundingneeds are fulfilled, either in capital markets or frombilateral or multilateral institutions, the governmentfocuses on management of the debt according to the


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Figure II.9.3. Amortization Profile of Domestic Debt (year end)(In percent of total debt)

ceiling imposed by the congress. Liability manage-ment is mostly used to retire collateralized debt (i.e.,Brady bonds) and debt with embedded options,allowing the federal government to benefit from netpresent value savings.

To assess risk and find an opportunity to lowercosts, the government constantly monitors the finan-cial markets, especially markets for securities issuedby similarly rated sovereign and corporate borrowers.Nevertheless, the main factors that help the govern-ment to reduce the cost and risk of its debt portfolioare without doubt sound fiscal and macroeconomicpolicies.


The government also guarantees debt issued by theagencies. Every three months, it presents a report tothe congress containing all the relevant informationabout public debt, which includes the public sector’s

debt stock, amortizations, new funding, and similarinformation.

Management information systems

The government’s debt managers have the necessaryinformational tools to analyze the risk profile of thedebt portfolio. This is achieved mainly from day-to-day observation of the different financial and eco-nomic indicators, taking this information andperforming various stress tests using current interestand foreign currency rates, then examining the out-come of each scenario and assessing the probabilityof an adverse outcome. This is supplemented withperiodic reports and databases.

Naturally, any analysis depends on the continuityand reliability of quality information, adding greatimportance to the various information systems usedby the government. It currently uses, through its debtmanagement office, such services as Bloomberg,


Figure II.9.4. Ratio of Net Public External Debt to Total Export(In percent)

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1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001/p

Reuters, and Infosel, as well as having accessdatabases, valuation programs, and on-line quotesfrom both the local and the external markets.


Internal debt

In addition to the strategy followed by the govern-ment to develop the domestic debt market, the cen-tral authorities have undertaken measures to fosterthe development of an efficient secondary market.

Extend the yield curve

As can be seen in Figure II.9.8, the average maturityof the debt portfolio has increased substantially dur-

ing recent years. To continue the development of thelong-term government securities market, the lengthof the yield curve has been extended throughissuance of longer-term bonds. Instruments of 3-, 5-,and 10-year fixed-rate maturity were introduced inJanuary and May 2000 and July 2001 (see FigureII.9.9). This strategy will be continued to consolidatethe yield curve and possibly extend it further. Withthe development of the yield curve, the governmenthas also paved the way for private sector issuers andhas facilitated the development of a liquid derivativesmarket.

Introduction of market makers (primary dealers)

In October 2000, market makers were introduced tothe market to increase liquidity, reduce transactioncosts, and facilitate end-buyers’ purchases of govern-ment securities. Based on their activity in the primary


Figure II.9.5. Federal Government External Debt Amortization Profile, as of September 30, 2001(In billions of US$)

0.0

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and secondary markets, brokerage firms and finan-cial institutions can be selected as market markers.There is also a continuous evaluation of the marketdevelopment vis-à-vis the activity of the market mak-ers, to guarantee that they continue to play an impor-tant role in the development of the domestic market.

Market makers have the following main obliga-tions:

• place bids in the primary auction for each type offixed-rate instrument for a minimum amount of20 percent of the auctioned amount;

• continuously place bid-offer quotes for fixed-rateinstruments with authorized brokers for a mini-mum amount of Mex$20 million and a maxi-mum bid-offer spread of 125 basis points (interms of yield); and

• provide authorities with all the requested infor-mation to quantify their activity.

In exchange for the obligations, market makershave the following privileges:

• The right to buy securities after the primary auc-tion. This call option (“green shoe”) has thesecharacteristics:– only good for fixed-rate instruments offered

in the primary auction,– can be exercised only by market makers who

offered a competitive rate in the primary auction,– additional securities will be assigned at the

weighted average rate registered in the pri-mary auction, and

– the maximum amount that can be exercisedthrough the call option is 20 percent of theauctioned amount.

• The market makers may borrow from the centralbank the minimum of the following fixed-ratesecurities of treasury certificates and bonds:


0.0

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Figure II.9.6. Agencies External Debt Amortization Profile, as of September 30, 2001(In billions of US$)

– 2 percent of the total outstanding amount ofeach issue of treasury certificates and bonds, and

– 4 percent of the total amount of outstandingtreasury certificates and bonds.

With the introduction of market makers, animportant increase in secondary market liquidity (seeFigure II.9.10) has occurred. As a result, bid-offerspreads for all fixed-rate securities also have tight-ened substantially. On average, the spreads havedecreased from 36 basis points in January 2000 to 27basis points in November 2001. This has facilitatedthe distribution of government securities all the waydown to end-buyers and smaller clients.

Reopening of outstanding issues to increase sizeand liquidity

To increase liquidity in the government securities sec-ondary market, the government has been reopening

outstanding issues. This has helped to build up issueswith a larger outstanding amount and at the sametime reduce the number of issues in the market,thereby concentrating liquidity. Currently, the aver-age outstanding amount of long-term securities isMex$17,000 million per issue, compared with lessthan Mex$4 billion per issue at 1999.

Securities linked to an inflation index

The government is now regularly issuing 10-yearinflation-indexed securities. As a result of the cur-rent price stability, the relative importance for thistype of instruments has declined (see FigureII.9.2). Nevertheless, because there is a naturaldemand for inflation-indexed instruments comingfrom pension funds and insurance companies, it ishighly possible that the government will continueto incorporate these instruments into the issuingprogram.


Figure II.9.7. Percentage of Public External Debt

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95Q1 95Q3 96Q1 96Q3 97Q1 97Q3 98Q1 98Q3 99Q1 99Q3 00Q1 00Q3 01Q1 01Q3

Market debt Restructured debt

Other measures

In line with the objective of strengthening govern-ment securities markets, the government has alsobeen doing the following:

• The government securities auction calendar isannounced quarterly.

• Continuous contact with the financial commu-nity: There are monthly meetings with marketmakers to discuss recent developments in thelocal markets and the overall macroeconomicenvironment. Moreover, periodic meetings orconference calls are held with other institutionalinvestors to discuss relevant issues and get feed-back on the current issuing program of govern-ment securities.

• Improvement in the repo market and securitieslending regulation: Substantial changes arebeing discussed on the way the repo market cur-

rently operates with the financial community.Some of these changes include the standard doc-umentation by which this market regulates itself(International Swap Dealers Association[ISDA]–type), which is not used currently forrepo transactions.

External debt

Mexico is always sensitive to market demands when-ever investors are interested in investing in a newissue. Efforts are made wherever possible to satisfyinvestors who take the risk of providing funding, andin the end motivate good performance in the sec-ondary market. This allows Mexico to better define itsyield curve and lower its financing costs. Another stepthe government has taken to facilitate healthy andwell-performing portfolios is to issue new bonds in anamount that is lower compared with the total orders


Figure II.9.8. Average Life(In days)

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1997 1998 1999 2000 2001

made by investors for the new bonds. In this way, thegovernment is able to avoid oversupplying the marketwith the new issue, which in some ways could affectsecondary market performance. The supply-demandinformation, provided by investment banks, is crucialto better understand the timing and size of a newissue. The government also devotes itself to trying toimprove the composition of the debt portfolio byretiring or replacing bonds that cause distortions onthe curve. This generates cost savings for the govern-ment and satisfies investors.

When selecting the best borrowing alternative inthe international market, the government has to con-sider private sector needs. It does this by trying tochoose a tenor that will fill a gap in the sovereignyield curve in the international market and, when-ever possible, establish points of reference—in the

form of benchmark issues—for market participantsfrom the private sector. Once the government hasestablished a well-defined yield curve, it will be easierto price a new bond issue for Mexican corporations.Because the sovereign risk component is establishedand measured with the sovereign yield curve, corpo-rations only have to price their own risk, mainlycredit risk. This will achieve a more accurate price ofcorporate bonds.

To finance itself abroad, the government mainlyuses three different markets, which provide differentadvantages. These are markets for the dollar, theeuro, and the yen (see Figure II.9.11).

Because of the large flows of dollars from tradeinto and out of Mexico, and because some fiscal rev-enues are also dollar related, the most important for-eign market for the government to finance itself


Figure II.9.9. Evolution of the Interest Rate Curve

0%

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12%

14%

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18%

20%

0 1 2 3 4 5 6 7 8 9 10

Maturity (years)

Nov 1999 Jan 2000 May 2000 Aug 2001 Jan 2002

abroad is the dollar market. The yield curve of thedebt portfolio in this market is the most complex thegovernment has built in external markets, with secu-rities ranging up to 30 years in maturity and very liq-uid benchmarks (see Figure II.9.12).

Having a well-defined yield curve in the dollarmarket allows the government to distribute its debtplacements through times when refinancing debt orwhen new financing is needed. This also helps theprivate sector to finance itself abroad, by establishingreference points they can compare to, making it eas-ier to value their credit risk. The government hasbeen able to build a yield curve that has provided themarket with information and has allowed the govern-ment to correctly price its market debt in any givenmaturity. Although the government has had animportant success in the achievement of this goal in

the dollar market, it plans to continue doing so whileproviding other markets, such as the euro market,with this information.

Even if the euro and yen markets are smaller inproportion compared with the dollar market, theysometimes present arbitrage opportunities in terms ofspread over the U.S. Treasury once euros and yen areswapped into dollars, making financing possible at alower cost compared with that of the dollar market.

Information

Mexico attaches high importance to providing accu-rate and transparent information to the financialcommunity, whether it is foreign or domestic. Towardthis end, senior government officers carry out regularroad shows in financial capitals, where they present


Figure II.9.10. Secondary Market Trading of Bonos(In millions of pesos)

0

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15,000

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25-J

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-Dec

-00

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1

AnnouncementBeginning

October 2, 2000Change of rulesJanuary 8, 2001

Change of rulesMay 7, 2001

the most recent economic developments in the econ-omy and projections for the near future. Duringthese presentations, the government also announcesany new policies that have been made.

Whenever the government accesses the interna-tional market with a new debt issue, it distributes apress bulletin to the media containing the most rele-vant characteristics of the bond issue with commentson how the issue complies with the debt and eco-nomic policy.

The government also makes available relevantinvestor information on its web site (www.shcp.gob.mx).This information consists of quarterly reports contain-ing debt statistics, tables, and the like. Since 2001, thegovernment has been also publishing monthly debtreports. Even though monthly reports have less detailed

information, they are often useful in monitoring publicfinance and debt.

Tax treatment of government securities

The fiscal treatment for holders of bonds issued bythe government also can be attractive for investors, inthat any payments of principal or interest are exemptfrom any withholding tax if they are held by a non-resident of Mexico or through a temporary establish-ment in Mexico.

Note

1. The case study was prepared by the Mexican Public DebtDepartment of the Ministry of Finance.


Figure II.9.11. UMS Market External Debt Issuance, 1996–2002(as of January 14, 2002)

Dollar72%

Other2%Euro

17%

Yen9%


Figure II.9.12. UMS Dollar Yield Curve(as of February 13, 2002)

UMS 10

UMS 05

UMS 06

UMS 07

UMS 08

UMS 09

UMS 11UMS 12

UMS 16

UMS 19

UMS 26

UMS 31

5%

6%

7%

8%

9%

10%

2 3 4 5 6 7 8 9 10 11 12Duration (years)

As an introduction to the description of public debtmanagement in Morocco, it is useful to present someaggregates, illustrating trends in Morocco’s publicdebt burden and associated charges.

At the end of 2000, external public debt (directand guaranteed debt) amounted to US$16 billion—equivalent to 48 percent of GDP or 121 percent of bal-ance of payments current revenues. External publicdebt is distributed between the treasury’s direct debtand guaranteed debt in the proportions of approxi-mately 70 and 30 percent, respectively. Charges on theexternal public debt paid during 2000 amounted tomore than US$2.5 billion, in other words, 19 percentof balance of payments current revenues.

The treasury’s direct debt (domestic and external)at end-2000 amounted to the equivalent of US$25.2 bil-lion, representing 76 percent of GDP, includingUS$14.1 billion, or 42 percent of GDP, in domestic debt.

The treasury’s direct debt service amounted toUS$3.7 billion, including US$2 billion in domesticdebt and US$1.7 billion in external debt. Interestcharges, which amounted to the equivalent of US$1.7billion, absorbed 22 percent of current budget rev-enues.

During the period 1983–92, the Moroccan author-ities concluded six rescheduling arrangements with theParis Club and three with the London Club, entailingthe rescheduling of US$12.7 billion (US$6.9 billionwith the Paris Club and US$5.8 billion with the LondonClub). Morocco ended the rescheduling cycle in 1993.

Framework for Public Debt Management

Public debt management objectives

The objectives pursued in the area of public debt man-agement have been established in the light of thetrends in Morocco’s economic and financial situationand the constraints that the country has had toaddress. Accordingly, until the early 1980s, emphasiswas placed primarily on raising the funds required tofinance the central government’s ambitious invest-ment program. In this context and to offset insuffi-cient domestic saving, the authorities reliedsubstantially on the international financial market,where abundant liquidity was available with favorableinterest rates.

143

10Morocco1

With the outbreak of the debt crisis in the early1980s, debt management objectives shifted substan-tially to reducing pressure on the balance of pay-ments and the budget by rescheduling of debtcharges, mobilizing concessional financing; and rely-ing on domestic resources to cover the treasury’srequirements.

Beginning in 1993, as Morocco’s macroeconomicviability was restored, the authorities adopted a moredynamic approach to debt management, with theobjectives of

• financing the treasury’s requirements with opti-mized costs and risks through arbitrage betweendomestic and external resources, and

• reducing the burden and cost of existing publicdebt to sustainable levels.

Legal framework for debt management

Public debt operations, in terms of borrowing(domestic borrowing issues and external loanarrangements) as well as debt expenditure (paymentof principal, interest, and commissions), are, like gov-ernment revenue and expenditure, subject to theprinciple of prior authorization incorporated eachyear into the budget law.

The annual budget law voted by parliamenttherefore includes specific provisions authorizing thegovernment to borrow externally within the ceiling ofthe programmed overall amount and borrow domes-tically to cover the treasury’s deficit and cash require-ments. Parliament also approves the budgetappropriations required to honor payments of prin-cipal in connection with medium- and long-term debtand interest on all debt.

On the revenue side, the authorization to borrowis covered by two decrees accompanying the budgetlaw, under which the prime minister delegates powerfor that purpose to the minister of economy andfinance or his or her authorized representative toarrange external borrowing and provide governmentguarantees under the first decree and issue domesticdebt under the second decree.

On the expenditure side, the minister of finance,who is the authorizing officer for settlement ofdomestic and external debt service, delegates powers

to make scheduled debt payments to the managingunits’ officers.

Institutional framework for debt management

Public debt management is the responsibility of thetreasury and external finance department of the min-istry of economy and finance. This department isresponsible for

• meeting the treasury’s financing requirementsthrough mobilization of the required domesticand external resources,

• borrowing and payment of debt service,• dynamic management of existing debt, and• proposing legislative and regulatory texts and

reforms relating to the treasury financing andthe financial market in general.

At the external level, the treasury and externalfinance department establishes the external financestrategy and coordinates the tasks of negotiating andmobilizing the resources involved. The department istherefore responsible for negotiating financial proto-cols, mobilizing borrowing in connection with thebalance of payments and structural adjustment loans,addressing issues related to on-lending, and provid-ing guarantees for external borrowing. It also cen-tralizes external debt data relating to the public andprivate sectors.

At the domestic level, this department’s tasksconsist of

• initiating domestic borrowing issues by supervis-ing operations to issue treasury instruments andestablishing the needed amounts to be borrowed,issue conditions, and redemption modalities;

• monitoring debt stock and repaying debt charges; • processing records related to domestic central

government guarantees; and • supervising the program to modernize and

reform the financial sector and initiate the rele-vant legislative and regulatory texts.

The role of Bank Al-Maghrib (BAM), the centralbank, acting as financial agent of the government,consists of


• collecting drawings in foreign currencies in con-nection with external borrowing and supervisingtreasury instruments auctions (domestic issues),by crediting the treasury’s current account forthe dirham equivalents of external drawings andthe amounts subscribed through the auctionmarket; and

• making settlements on the basis of paymentorders received from the treasury and externalfinance department for debt service in foreigncurrencies to foreign creditors, and in dirhams tolocal subscribers, by debiting the treasury’s cur-rent account.

Last, a central depository, known as Maroclear,was established after the dematerialization of certifi-cates of indebtedness (including treasury instru-ments). Maroclear is responsible for custody oftreasury instruments and supervising settlement anddelivery operations in connection with buying andselling of treasury notes on the secondary market.

Organizational framework for debtmanagement

Debt management is the responsibility of the treasuryand external finance department, primarily throughthree divisions:

• Treasury operations division, whose tasks are to(a) prepare budget projections, monitor govern-ment finance equilibria, and determine the trea-sury’s financing requirements; (b) mobilizedomestic resources needed to cover financingrequirements by conducting treasury instru-ments auctions; (c) propose reforms and mea-sures to stimulate the market; and (d) processand monitor on-lending of external loans.

• External debt management division is responsi-ble for (a) covering public external borrowingand settling central government debt service; (b)preparing debt statistics and analyses on debt, ona sectoral basis and in aggregate form (by coun-try, sector, currency, and so forth); (c) analyzingdebt and financial conditions for loans and for-mulating proposals to reduce debt service, debtstock, or both; and (d) implementing debt relief

activities, such as refinancing onerous debt andrenegotiating interest rate.

• Debt restructuring and international financialmarket division is responsible for (a) implement-ing debt relief and restructuring operations, suchas conversion of debt into public and privateinvestment; (b) preparing for Morocco’s return tothe international financial market and initiatingissuance operations in that market; and (c) exe-cuting swap operations involving existing debt.

The treasury and external finance departmentalso has a subdepartment responsible for mobilizingand coordinating traditional external financing, adivision responsible for bank regulation and mone-tary research, and a balance of payments divisionresponsible for, among other things, regulating exter-nal financial and commercial operations.

In terms of human resources, the debt manage-ment units have a team of 30 professionals highlytrained in the areas of economics, finance, law, com-puter science, and statistics, among others. These pro-fessionals have developed sound expertise in debtmanagement through their acquired experience in thisarea and through targeted continuing education—internally (study days, workshops, and training semi-nars) and externally (in-service training and coursesorganized by international banks and institutions).

Budget and monetary policy coordination

Coordination of debt management policy with cen-tral government budget policy and the monetary pol-icy implemented by the central bank poses noparticular problems.

In this connection, the treasury and externalfinance department, which is responsible for debtmanagement, participates actively in defining the ori-entations of the budget law, particularly at the level ofthe budget deficit and the resources to cover it, bud-get execution, and rectification of any overruns thatmay occur. It also prepares government cash projec-tions generated during the budget execution andidentifies and implements financing mechanisms.

At the monetary level, coordination with the cen-tral bank is the task of an oversight joint committeethat is responsible for, among other things, defining

Country Case Studies: Morocco 145

monetary and inflation objectives, monitoring theirexecution, and proposing reforms and measures to beenacted. Guidelines and measures to be applied arepresented to participants at meetings of the nationalcommittee on money and saving, which is held at thecentral bank and is chaired jointly by the minister ofeconomy and finance and the governor of BAM.

Further, as the main borrower on the domesticmarket, the treasury enhances the stability of themoney market, primarily through its constant pres-ence on the auction market and the announcementof its financing requirements to provide maximumvisibility on that market. This is increasingly impor-tant as the interest rate curve on government bondshas become a reference for Morocco’s financial mar-ket in general, particularly for remuneration of sav-ing and financial instruments.

Transparency and communication

During the annual press conference on financingpolicy held after adoption of the budget law, the min-ister of economy and finance assesses indebtednessby presenting the key results and statistics on debt forthe year ended and announces the objectives estab-lished to cover the treasury’s financing requirementsfor the current fiscal year and the measures andactions to be implemented in the area of financing.

Some statistical data on treasury debt such asdrawings, amortization, and outstanding balances arepublished on the Internet (www.mfie.gov.ma/dtfe/tbstat.htm) in a note de conjoncture (economic brief)produced monthly by the treasury and externalfinance department.

The Moroccan authorities also report externalpublic debt data annually to the World Bank (ReportForms I and II) for publication in the form of sum-mary statements and intend to subscribe to the IMFSpecial Data Dissemination Standard.

In addition, the treasury and external financedepartment organizes meetings from time to timeamong various participants in the domestic marketand, in particular, the central bank and transactors(treasury securities dealers, mutual funds, stock bro-kerage firms, and so forth) to enhance communica-tion and transparency in indebtedness policy. Topicsdiscussed are mainly related to macroeconomic fun-

damentals, financial market developments (such asthe liquidity in the market and the interest ratecurve), and reform proposals.

In addition, while working toward achieving theadopted objectives, the treasury and external financedepartment issues monthly announcements of theamounts to be raised on the auction market and theresults of subscriptions in terms of volume, interestrates, and maturities.

Collection of debt data

The treasury and external finance department isresponsible for collection and centralization of pub-lic debt data. The data available to the departmentare supplemented and cross-checked regularly withinformation provided by

• various departments of the ministry of economyand finance and, in particular, the budget depart-ment, central guarantee fund and foreignexchange office;

• the central bank for credit and debit noticesrelating to drawings and reimbursements of trea-sury debt;

• public enterprises benefiting from a governmentguarantee, for data on their external borrowing; and

• creditors.

Where government debt is concerned, data col-lection does not pose any particular problem as thechannels for systematic data reporting are well estab-lished and the indebtedness processes—external(commitment, disbursement, and repayment) anddomestic (subscription and repayment)—are central-ized within the ministry of economy and finance.

For external debt guaranteed by the central gov-ernment, data collection problems were solved byrecording information upstream upon the issue ofguarantees and by disseminating a circular from theminister of economy and finance instituting therequirement for public enterprises to register theirexternal financing agreements with the external debtmanagement division and file monthly or quarterlyreports with the division, containing the data on theirexternal debt, using standard reporting forms pro-vided for that purpose.


For domestic guaranteed debt, data collectionposes no problems because guarantees are grantedby a decree of the prime minister and decision of theminister of economy and finance establishing themaximum amount of each issue. In addition, guaran-tee operations have so far involved only a few publicinstitutions, and securities issues have been sub-scribed by government agencies and insurance com-panies.

Private debt statistics are collected by the foreignexchange office based on information collected atthe level of the banking system, in which a form mustbe completed for each customer’s external borrow-ing operations and the relevant movements.Similarly, an awareness campaign was conducted withthe banking system, and major enterprises wereinformed that they should report this informationdirectly to the foreign exchange office.

Computerization of debt management

A debt management computer system designed by aMoroccan research firm for public external debt(both central government and public enterprises)became operational in mid-1993 and was laterextended to domestic debt and on-lending activities.This system, developed on the basis of a relationaldatabase management system known as Informix,operates in a Unix multitask, multiuser environment.A program generator is used to facilitate mainte-nance and development of the management system,which are the responsibility of the computer unit ofthe treasury and external finance department.

The system was audited in 1997 by an expertfrom the United Nations Conference on Trade andDevelopment (UNCTAD), who deemed it satisfac-tory from the standpoints of design, functioning,and functionalities. In fact, it meets the require-ments for current management, including establish-ment of a comprehensive debt database, calculationand generation of repayment schedules, issue ofpayment orders, and coverage of payments. It alsocan be used to produce a full complement of statis-tical statements required for management, analysis,and preparation of reports to be used as decision-making aids.

This system was recently updated to

• incorporate active debt management operationsimplemented, such as conversion of debt intoinvestment, prepayment, and cancellations;

• reflect the introduction of the euro while main-taining all prior transactions in the original cur-rency; and

• register swap transactions, particularly currencyand interest rate swaps to be initiated in connec-tion with risk management.

In the area of statistical processing, the systemproduces standard statistical reports on debt—theo-retical (based on initial schedules and conditions),actual, or projected—and on outstanding balances,debt service (principal, interest, and commissions),and drawings, broken down by lender, borrower, cur-rency, interest rate, and so on. The system can also beused to produce World Bank Report Forms I and IIand generate treasury debt charges to be incorpo-rated into the budget law.

Debt Management Strategy

After a decade of structural adjustment and externaldebt rescheduling, the Moroccan authorities havemanaged to reduce the country’s vulnerabilitythrough significantly enhanced economic and finan-cial equilibria and by ending Morocco’s reschedulingcycle in 1993.

The external debt burden, however, hasremained high, and the balance of transactionsinduced by the public external debt (amortizationplus interest less drawings) during the period1993–97 led to significant net outward transfers,which exceeded US$1.5 billion per annum. Thesetransfers were expected to increase sharply withthe beginning of principal repayments of resched-uled debt from 1999 for the London Club arrange-ment and the Paris Club’s fifth arrangement, aswell as from 2001 for the Paris Club’s sixtharrangement.

As a result of this debt trend and considering themacroeconomic framework improvement, Moroccohas undertaken an active management strategy forits debt with three main thrusts, described in the fol-lowing.


Treatment of the treasury’s external debt

Since 1996, treatment of the treasury’s externaldebt involved a stock of more than US$2 billion (20percent of the treasury’s external debt). In this con-nection, the following two mechanisms were used.

Conversion of debts into investment

This mechanism is applied as provided in the ParisClub proceedings. The last two reschedulingarrangements (the fifth and sixth) concluded withthe Paris Club provided that the lenders may sell orexchange—in the framework of debt-for-nature,debt-for-aid, or debt-for-equity swaps or other localcurrency debt swaps—the amounts of outstandingloans rescheduled and eligible for rescheduling witha ceiling of 100 percent for governmental debt and10 percent or US$10 million for commercial debt.The latter ceiling was increased to 20 percent in1997 and subsequently to 30 percent or US$40 mil-lion in 1999.

Implementation of these provisions has requiredidentification of (a) potential rescheduled debts suit-able for conversion operations classified by lendercountry and (b) actions to be undertaken to convincethese countries of the advantage of the debt conver-sion mechanism to both the lender and the debtor.

Two types of conversions were implemented inthis connection:

• Conversion of debts into public investment: Thecreditor cancels an agreed amount of therescheduled debt, and Morocco uses the counter-value of the canceled amount to carry out publicinvestment projects.

• Conversion of debt into private investment: Afterdebt conversion agreement, the foreign investorpresents an investment project to Moroccanauthorities for approval. This approval sets aredemption price of a given amount of the debt.After that, the investor purchases the saidamount of debt from the creditor country at alower price. Then, the investor transfers this debtto Morocco and receives the agreed price aftercommitting to carry out the investment project.

Treatment of onerous debt

This treatment is carried out through prepayment ofonerous debts using domestic or external resourcesassociated with more favorable terms or by renegoti-ating interest rates on onerous loans to align themwith the rates prevailing on the financial market.

Implementation of this mechanism requires pre-liminary work in these areas:

• use of the debt database and use of actuarialtechniques to determine onerous debt potentialand to identify onerous loans;

• analysis of legal clauses in loan agreements todetermine the conditionality of prepayment, refi-nancing, or interest rate revision;

• identification and selection of refinancingresources that can be mobilized with relevantfinancial conditions; and

• assessment of the present value of the gain—debtservice to be saved—and potential for annualreduction of the interest charges generated bythe operation.

For operations involving treatment of guaranteeddebt of government institutions, the initiative maycome from the treasury and external finance depart-ment or from the debtor institution. In both cases, thedepartment, in consultation with other departments ofthe ministry of economy and finance, issues an opin-ion on the prepayment operation envisaged based onan assessment of the institution’s financial situationand the budget implications that may be involved.

Policy to mobilize financing

Since rescheduling ended, domestic financing hasbeen relied upon substantially to cover the budgetdeficit and negative net transfers associated withexternal borrowing. Despite low levels of the budgetdeficit, this situation has led to an increase in thestock of domestic debt, which amounted to US$14.1billion (representing 42 percent of GDP) at end-2000, compared with the equivalent of US$12.5 bil-lion (35 percent of GDP) at end-1996 and US$8.8billion (31 percent of GDP) at end-1993.


This policy, which is explained by the prudentstance of the authorities in the area of externalfinancing, was fostered by availability of resources onthe domestic market at favorable rates and theauthorities’ concern to develop an efficient, moderndomestic market to meet the requirements of alltransactors in connection with the overall reform ofthe domestic financial market undertaken in 1993.

For external financing, a highly selectiveapproach was established, characterized by

• selection of new commitments according to thedegree of concessionality,

• enhanced selection of investment projects tobenefit from financing from bilateral sources ormultilateral financial institutions, and

• improved performance in executing financedprojects.

In addition, a process to enable Morocco to reac-cess the international financial markets was under-taken with the establishment of an internationalrating by Standard and Poor’s and Moody’s to allowinvestors to assess Morocco’s risk, and through afamiliarization with risk management instruments bydeveloping technical skills for ongoing monitoring ofthe exposure of Morocco’s debt to market risks, aswell as the use of appropriate swap operations, asrequired.

Framework for risk management

The process of implementing a risk managementframework, undertaken in 1996, primarily involvesthree factors, described in the following.


A study of the legal environment has revealed thatMorocco’s legal system does not contain any provi-sion opposing dynamic debt management and thatthe government is authorized under the current leg-islation to use hedging instruments only for the pur-pose of stabilizing or lowering debt-service costs.

Accordingly, a decree of the prime minister hassince 1998 been appended to the texts accompanying

the budget law, delegating authority to the minister ofeconomy and finance, or his/her authorized represen-tative, to contract external borrowing to repay onerousdebt and enter into foreign exchange and interest rateswap arrangements to stabilize debt service.

Further, with a permanent budget law provision,a special treasury account was established to reflectforeign exchange and interest rate swaps separatelyand on a multiyear basis, as well as to cover thecharges generated by these operations.

Management of risks related to external debt

Analysis of the treasury’s external debt structureshows that this debt is substantially sensitive toexchange rate and interest rate fluctuations and thatthe liquidity risk is limited because the debt is amor-tizable and arranged exclusively in the medium andlong terms.

Where the exchange risk is concerned, debtexposure exists because the foreign exchange struc-ture of the debt is still inadequate to accommodateMorocco’s foreign trade structure. As for interestrates, the risk is attributable to the substantial shareof debt associated with floating interest rates, whichrepresents more than 36 percent of the debt.

Accordingly, a benchmark portfolio was identi-fied for external debt, with which the treasury’s cur-rent debt structure must converge, and to guideexternal debt financing and management policies.The foreign exchange structure of this benchmark is60 percent euros, 35 percent U.S. dollars, and 5 per-cent yen, and the interest rate component entails 20percent floating-rate debt.

In this connection, the conversion into euros ofWorld Bank currency pool loans denominated in U.S.dollars and yen was undertaken in the amount ofUS$1.3 billion to increase the euro-denominateddebt’s share.

Management of risks associated with domestic debt

After the establishment of an auction market with thekey features of a modern financial market, analysis ofthe debt portfolio has brought to light certain risksrelated to maturities and interest rates, and a risk man-


agement program was implemented to manage risksrelated to repayment, financing, and interest rates.

• To address the repayment risk, debt managers tryto smooth the debt schedule as much as possibleto avoid excessive concentrations of maturities.

• To offset potential financing risk and enable thetreasury to raise the required funds in a timelymanner, in addition to smoothing of the debtschedule, the treasury ensures, in connectionwith government cash management, that the rateof revenue collection is commensurate with therate of expenditure execution.

• Concerning the interest rate risk, first, it shouldbe borne in mind that treasury instruments areissued at fixed rates. The risk therefore appearswhen rates decline and remain below the rate ofthe issue. To address this risk, then, the treasuryand external finance department has estab-lished the objective of adopting a level of 25 per-cent, which is deemed sustainable, forshort-term debt. The treasury is also now focus-ing on indexing medium- and long-term matu-rities to shorter ones. The treasury, accordingly,has already proceeded with two 10-year borrow-ing operations indexed on 52-week treasury billsand is now studying the possibility of issuing 5-year indexed bonds.

Information system

Debt managers are provided direct access to the debtdatabase by use of client Windows stations withGraphical Query Language, making it possible to usecustomized queries to perform data analysis and gen-erate various reports and graphics. In addition, thesedata can be exported to other applications or soft-ware (Excel spreadsheets, for example) for othertypes of processing, as required.

This flexibility also makes it possible to preparemedium- and long-term projections based on differ-ent assumptions of trends in interest rates, exchangerates, or both. Similarly, different indebtedness orrefinancing strategy scenarios are prepared with arbi-trage between use of domestic or external resourcesand the choice of currency and interest rates.

In addition, managers of the treasury and exter-nal finance department were introduced, with sup-port from international financial institutions andwith a management system used by banks, to tech-niques for managing different types of risks inherentin external debt, mainly interest rate risk andexchange rate risk, and a model for managingdomestic debt is being prepared.

Development of an Efficient DomesticMarket

Concurrently with the vast program to modernize thefinancial sector and institutional reforms of theMoroccan financial system in the area of mobilizationand allocation of resources, it was necessary to reviewthe policy in place for domestic financing, which ischaracterized by

• mandatory holdings in the form of floors on gov-ernment instruments that the banking system wasrequired to subscribe at low interest rates, whichhad amounted to 35 percent of deposits;

• issue of government borrowing at widely attrac-tive interest rates and long-term bonds sub-scribed by institutional investors;

• total exemption of interest accrued on instru-ments subscribed by individuals; and

• recourse to the BAM for additional financings.

To end this situation, the treasury’s financingmethod was thoroughly reformed so that the requireddomestic resources could be mobilized at market termsby instituting the treasury instruments auction market asa sole source of financing, and measures were imple-mented to eliminate distortion and stimulate the market.

Elimination of the treasury’s privileges

The privileges from which the treasury benefited,compared with other borrowers, were eliminated by

• a gradual reduction of mandatory holdings in theform of a floor on government instruments untiltheir total elimination in 1997;


• subjecting interest generated by treasury instru-ments subscribed by individuals to the corporatetax or the general income tax; and

• abandonment of different types of issues, such asbond issues at attractive rates, national borrowingoperations, and so on, that promote segmenta-tion of the market and limit the liquidity of thoseinstruments.

Institution of the treasury instruments auctionmarket

The treasury instruments auction market, which hasbecome the main financing source for the treasury, isgoverned by a decree of the minister of economy andfinance and a set of joint circulars issued by the trea-sury and external finance department and BAM.

The treasury and external finance departmentinforms investors of the monthly schedule of auctionsto be held with the following periodicity, by maturity:

• every Tuesday for 13-, 26-, and 52-week bills;• the second and last Tuesday of the month for 2-,

5-, 10-, and 15-year bonds; and• the last Tuesday of the quarter for 20-year bonds.

The department reserves the right, however, to can-cel scheduled sessions or to hold additional auctions.These changes are announced one week in advance.

The auctions, held according to the Dutch auctionmethod, proceed as follows: Institutions authorized tosubmit bids transmit them by fax to the BAM no laterthan 10:30 a.m. on Tuesday. The BAM then submits thebids to the treasury and external finance department inordered, anonymous form. The department selects theinterest rate or limit price for the auction, which itreports to the BAM. The latter in turn individuallyinforms the bidding institutions of the status of theirbids. The results are also disseminated through Reuters.For the successful bids, the equivalent amounts are paidon the Monday following the auction.

Finally, only issues of six-month bills have beenmaintained to assist in mobilizing small savers. Thesebills, reserved for nonfinancial institutions and indi-viduals, are issued below par, with a coupon. They areissued on a continuous basis, with small face values,

redeemable after three months by surrendering thecoupon. These securities are dematerialized.

Stimulating the auction market

Action has been taken to stimulate the auction mar-ket and enhance the liquidity of securities throughthe following.

Designation of treasury securities dealers

To stimulate the auction market and contribute to itswell-functioning, certain institutions have been desig-nated as treasury securities dealers. To that end, thesedealers agree to report periodically to the treasuryand external finance department on their assessmentof overall market demand on the domestic treasurysecurities and subscribe to at least securities.

In return, treasury securities dealers may submitnoncompetitive bids within the limit of an approvedmaximum based on an award coefficient calculatedto reflect their participation in the past three weeksin competitive auctions involving securities in thesame category.

To encourage treasury securities dealers to con-tribute effectively to stimulating the secondary mar-ket, these operators committed, in connection withan agreement between themselves and the treasuryand external finance department, to quote a certainnumber of lines covering all maturities.

Introduction of issues by assimilation

The treasury and external finance department intro-duced the technique of issues by assimilation todevelop the secondary market for treasury securitiesand enhance their liquidity. This technique consistsof announcing the coupon in advance, associatingnew issues with existing lines to establish substantialresources, and reducing the number of lines issued.

Introduction of enhanced communication withpartners

The treasury and external finance department optedto establish permanent contact with the financial


community to keep it abreast of its interventions inthe market.

To this end, periodic meetings are held betweenthe various participants—the treasury department,the BAM, Treasury securities dealers, and secondarymarket transactors (mutual funds, brokerage firms,and so on)—for more effective communications.

Further, in connection with the agreementbetween the treasury department and treasury securi-ties dealers, meetings are organized regularly withthese dealers to discuss the market situation and any

problems that the different institutions mayencounter. The treasury department also coordinateswith treasury securities dealers in connection with theimplementation of new measures aimed to developthe auction market.

Note

1. The case study was prepared by Lahbib El Idrissi Lalamiand Ahmed Zoubaine from the Treasury and External FinancesDepartment of the Ministry of Economy, Finance, Privatization,and Tourism.


The New Zealand Debt Management Office (NZDMO)was established in 1988 with the aim of improving the man-agement of risk associated with the government’s debtportfolio. It is responsible for managing the government’sdebt, overall net cash flows, and some of its interest-bearingassets within an appropriate risk management framework.

This chapter outlines the evolution of public debtmanagement in New Zealand, the portfolio and riskmanagement framework in which the NZDMO oper-ates, and the development of the market for govern-ment securities.


Objective of the NZDMO

The objective of the NZDMO is to maximize the long-term economic return on the government’s financialassets and debt in the context of the government’s fis-cal strategy, particularly its aversion to risk. That objec-tive requires the NZDMO to balance the likely risksincurred in minimizing cost.

In terms of managing the government’s debt port-folio, the NZDMO adopts a risk-averse approach for anumber of reasons. For instance:

• Evidence suggests that individuals tend to be riskaverse in their decision making and expect thegovernment to reflect that preference in manag-ing its interests.

• Losses incurred in the government’s portfolioimpose costs that taxpayers are unable to avoid.

• The government does not have a competitiveadvantage over other market participants inattempting to derive excess returns from its port-folio management, except for its privilege as aninstitution exempt from taxation and regulation,which the NZDMO does not consider ethical toexploit.

The debt management objective has changedthrough time, with earlier versions placing an empha-sis on risk reduction. That position reflected the sig-nificantly higher net debt levels in the late 1980s andearly 1990s and the fact that nearly half of the debt wasdenominated in foreign currencies. Since then, net

153

11New Zealand1

debt has been reduced by 65 percent, and foreign-currency exposure has been eliminated.

Responsibilities of the NZDMO

The NZDMO’s major responsibilities involve

• developing and maintaining a portfolio manage-ment framework that promotes the government’sdebt management objectives;

• financing the government’s gross borrowingrequirement, managing foreign currency assetsrequired to meet net foreign currency interestand principal payments, and settling andaccounting for all debt transactions;

• managing the six principal types of risk—market,credit, liquidity, funding, operational, and con-centration—in a manner consistent with the gov-ernment’s fiscal strategy and the NZDMO’sinternal policies;

• determining a portfolio structure in terms of cur-rency, maturity, and credit exposures consistentwith the government’s risk aversion and havingregard for costs;

• implementing a sound framework for measuringperformance on a risk-adjusted basis;

• maximizing the value added to the portfolio, ona risk-adjusted basis, subject to limits set inrespect of market, credit, and liquidity exposure;

• disbursing cash to government departments andfacilitating departmental cash management;

• undertaking lending to government organiza-tions and state-owned enterprises and facilitatingand executing derivatives transactions in accor-dance with government policy;

• providing capital markets advice for other areasof the New Zealand Treasury, other govern-ment departments, and government organiza-tions;

• providing debt-servicing estimates and account-ing reports for fiscal forecasting and reportingpurposes; and

• maintaining and enhancing, where appropriate,relationships with investors who hold, or arepotential holders of, New Zealand governmentsecurities, financial intermediaries, and the inter-national credit-rating agencies.

Establishment of the NZDMO

The NZDMO was established because a large volumeof government debt created considerable risks for thetaxpayer, and those risks needed to be managed in acomprehensive manner.

Beginning in the 1970s, large fiscal deficitsbecame the norm in New Zealand, and ineffectivemonetary policy led to one of the highest rates ofinflation in the Organization for EconomicCooperation and Development (OECD). By the early1980s, a price and wage freeze had been introduced,and monetary policy was exercised primarily throughdirect controls and regulation. At the same time, tolimit the rate of monetary growth, financial institu-tions were subject to lending-growth guidelines, whichin practice were largely ineffective. Increasinglyrestrictive measures were introduced by tighteningreserve-ratio requirements for banks and raising thegovernment-securities ratios for finance companiesand building societies. An attempt was made in 1983to absorb excess liquidity through auctions of govern-ment securities. The effectiveness of the auction pro-gram to neutralize the fiscal injection through highervoluntary holdings of government securities wasseverely constrained by a requirement that upwardpressure was not be exerted on interest rates. In thatenvironment, most of the government’s borrowingwas in foreign currencies, which also served to financethe country’s persistent balance of payments deficits.

Following the election of a new government in1984, dramatic changes occurred in economic man-agement through a series of macroeconomic andmicroeconomic reforms that enabled the price sys-tem to emerge as the dominant signal for investment,production, and consumption decisions. Majorchanges included

• the removal of controls on prices, interest rates,and wages;

• a free float of the New Zealand dollar and theremoval of capital controls;

• a reduction in marginal tax rates and a broaden-ing of the tax base;

• the elimination of subsidies and price supports;• the removal of reserve-asset requirements for

financial institutions;


• extensive deregulation; and• substantial reforms of the public sector.

Transparency around fiscal policy improved, anddeficits were reduced. As was typical of most OECDcountries at the time, New Zealand had no separateobjective regarding debt management. There was agrowing view, however, that a more professionalapproach to portfolio and risk management wasrequired to manage the stock of public sector debt,particularly the large foreign currency component.Against that backdrop, the NZDMO was formed in1988 to manage the public debt denominated in bothforeign currency and New Zealand dollars under theauthority of the minister of finance.

The NZDMO was established as a self-containedunit within the New Zealand Treasury, rather than asa separate entity, because at the time it was thoughtthat important linkages would otherwise be lost. Inaddition to debt-servicing forecasts for the budgetand other fiscal releases, the NZDMO provides arange of capital markets advice to other sections ofthe treasury. Location within the treasury also allowsclose monitoring of the NZDMO’s development andits effectiveness in managing the government’s assetand liability portfolios.

Later restructuring of the treasury, prompted by aheightened emphasis on the government’s aggregatebalance sheet, led to the NZDMO being folded moreclosely into the treasury’s branch structure. Since 1997,the NZDMO has formed part of the asset and liabilitymanagement branch. Activities of the branch that arenot the responsibility of the NZDMO include managingthe government’s contingent liabilities and advising onthe financial management of departments, state-ownedenterprises, and other institutions in which the govern-ment has an ownership or balance-sheet interest.

Structure of the NZDMO

The secretary of the treasury is directly responsible tothe minister of finance for the actions of theNZDMO. The head of the NZDMO is the treasurer,who reports to the asset and liability managementbranch manager, who is a deputy secretary.

In addition to normal accountability arrange-ments, the NZDMO’s operations are also overseen by

an advisory board, which provides the secretary of thetreasury with quality assurance on the NZDMO’s activ-ities, risk management framework, and business plan.Members of the advisory board are selected on thebasis of their experience in supervising portfolio man-agement, payments, and banking activities; financeand risk management theory; and operational riskand reporting requirements. The advisory board cur-rently includes a senior partner with a major account-ing firm, the director of a corporate treasury and riskmanagement advisory firm, and a finance academic.

By design, the structure of the NZDMO resem-bles that of a private sector financial-markets institu-tion, with separate front, middle, and back offices.That structure leads to clearly defined responsibilitiesand accountabilities, procedural controls, and thesegregation of duties, which is consistent with bestpractice. The portfolio management group is respon-sible for portfolio analysis, developing and negotiat-ing transactions, managing the government’sliquidity and cash disbursement system, and relation-ship management with international investors andrating agencies. The risk policy and technologygroup is responsible for measuring the NZDMO’sperformance in adding value, measuring risk, moni-toring compliance with the approved policies formanaging the government’s net debt portfolio, main-taining the NZDMO’s portfolio and risk managementframework consistently with international best prac-tice, and maintaining the NZDMO’s informationtechnology (IT) systems. The accounting and trans-actional services group is responsible for theNZDMO’s accounting and forecasting functions andensuring that transactions are settled in a timely, effi-cient, and secure manner.

When the government had a significant propor-tion of its debt in foreign currencies, the NZDMOmaintained an office in London. It was responsiblefor a range of foreign currency transactions, includ-ing commercial paper issuance, and for relationshipmanagement with financial institutions in theEuropean and North American capital markets. Thisenabled the NZDMO to maintain a 24-hour transact-ing capacity, mitigating the effects of the time-zonedifferences between New Zealand and major finan-cial markets. The London office was closed in 1997,after the elimination of net foreign currency debt.

Country Case Studies: New Zealand 155

The NZDMO’s staff currently numbers 24, withlegal and some administrative services provided byother personnel within the treasury.

Legal framework for borrowing

The legal framework in which the NZDMO carries outits functions includes the Public Finance Act, 1989,and the State Sector Act, 1988. In general, the powersin those acts are vested in the minister of finance, butmany of them have been delegated to the secretary tothe treasury and then subdelegated to specified per-sonnel within the NZDMO. One power that cannot bedelegated is the power to borrow in the name of thegovernment, and the NZDMO recommends andobtains approval for its borrowing activities.

The NZDMO must operate within the strategicparameters approved by the minister of finance, butmuch of the discretion over day-to-day operations hasbeen delegated to the treasurer of the NZDMO.

Coordination with fiscal policy

The NZDMO coordinates with other parts of the trea-sury that advise the minister of finance on the content

of the government’s annual budget and prepare budgetdocuments and the government’s financial statements.

The Fiscal Responsibility Act, 1994, requires thegovernment to act in accordance with the principlesof responsible fiscal management. The act establishesfive principles:

• reducing debt to a prudent level,• maintaining debt at a prudent level,• achieving and maintaining the government’s net

worth at a level that provides a buffer againstadverse future events,

• prudent management of fiscal risk, and• reasonably predictable tax rates.

The act does not define a prudent level of debt.Rather, each government determines and publiclydiscloses what it regards as prudent. However, thecurrent official gross debt target is 30 percent of GDPon average over the economic cycle.

Coordination with monetary policy

During the mid-1980s, debt management was sec-ondary to monetary policy. The priority at the time


Portfolio Management Group

Risk Policy and Technology Group

Accounting and Transactional Services Group

Treasurer, NZDMO

Branch Manager, Asset and Liability Management Branch

Secretary to the Treasury

Minister of Finance

Advisory Board

was to stabilize the economy. By the end of thedecade, the NZDMO was established and the ReserveBank, the central bank, was made independent in theimplementation of monetary policy. Under theReserve Bank Act, 1989, the objective of maintainingprice stability was identified as the central bank’s pri-mary role.

The NZDMO is responsible for managing thegovernment’s debt and ensuring that the govern-ment’s cash management is conducted efficiently.The Reserve Bank is responsible for the formulationand implementation of monetary policy. The twoorganizations have a close working relationship,which is formalized in agency agreements.

The NZDMO manages the government’s liabili-ties. Financial assets, in the form of bank deposits andhigh-grade marketable securities, are held to enablethe NZDMO to meet that function. The ReserveBank manages the government’s foreign currencyreserves of about $NZ 4.9 billion as of July 2002,which are maintained to mitigate serious liquidityproblems in the New Zealand foreign exchange mar-ket, should they ever occur. Although these reservesare available to the Reserve Bank for interventionwhen needed, the Reserve Bank has not intervenedin the foreign exchange market since the NewZealand dollar was floated in March 1985. The for-eign currency reserves are funded by loans to theReserve Bank from the NZDMO. An agency agree-ment clarifies the responsibilities of both organiza-tions, including in the event of foreign exchangeintervention.

Another agency agreement between theNZDMO and the Reserve Bank clarifies the centralbank’s roles where it provides services for theNZDMO. The Reserve Bank acts as the NZDMO’sissuing agent, registrar, and paying agent in thedomestic market. It conducts auctions of treasurybills and government bonds on the NZDMO’sbehalf, but the NZDMO retains responsibility for allpricing decisions on these instruments. In addition,the Reserve Bank publishes information on domesticgovernment securities that supports the market inthose securities.

The Reserve Bank offers advice to the NZDMO onthe structure of the government’s domestic borrowingprogram. The NZDMO, however, has sole responsibil-

ity for advising the minister of finance on the size andstructure of the domestic borrowing program.

An important provision in the agency agreementon cash and wholesale debt management is that allfunctions carried out by the Reserve Bank as agentfor the NZDMO are conducted without reference tomonetary policy considerations.


The Fiscal Responsibility Act requires the govern-ment to be explicit about its objectives and explainany changes to them and ensures the provision ofcomprehensive financial information for informedand focused debate about fiscal policy. Two docu-ments called for in the act are the Budget PolicyStatement and the Fiscal Strategy Report. The gov-ernment is required to table them in parliament toshow that its actions are fiscally responsible. They out-line the government’s short-term fiscal intentionsand long-term fiscal objectives, including thoseregarding gross and net debt, and explain the consis-tency of those intentions and objectives with the four-year forecasts in the Economic and Fiscal Updates,which are published with the budget and at midyear.

The government’s monthly financial statementsare prepared according to generally accepted account-ing practice and are made public. They show how pub-lic resources have been used and report thegovernment’s assets and liabilities, revenues andexpenses, cash flows, borrowings, contingent liabilities,and commitments. The annual financial statements, inparticular, provide detailed information on the stockof outstanding New Zealand dollar and foreign cur-rency debt, the maturity profile and interest rate struc-ture of that debt, and cash flows during the yearassociated with issuance, redemption, and servicing ofdebt. The notes disclose information on the NZDMO’srisk management practices and the extent of off-bal-ance-sheet positions. The Public Finance Act requiresthe audit office, an office of parliament, to audit theannual financial statements presented by the govern-ment and express an independent opinion on them.

The NZDMO’s responsibilities are not codified inlegislation. For the past decade, it has operated atarm’s length from the minister of finance, but that isa matter of custom and practice as opposed to statu-


tory independence. Nothing in the Public FinanceAct or the Fiscal Responsibility Act explicitly con-strains the minister of finance in his or her relationswith, or power to direct, the NZDMO.


The basis of operation, strategic objective, risk man-agement framework, and performance measurementframework for the NZDMO are specified in its portfo-lio management policy, and the NZDMO’s activitiesare audited for compliance with it. Internal operationsare managed through a body of policies, reporting andperformance management requirements, proceduralmanuals, established processes, limits, formal delega-tions, and segregated duties. Managers within theNZDMO warrant compliance with those controls.

The NZDMO has in place procedures andresources to mitigate risk to its operations caused bynatural disasters, infrastructure failures, or other dis-ruptions. Live tests of the business continuity plan areroutinely conducted.

The State Sector Act establishes the standards andgeneral obligations of the public service, and the trea-sury’s corporate policies and code of conduct establishthe guidelines for behavior expected of treasury per-sonnel. Additional guidelines for ethical behavior applyto NZDMO personnel to ensure that they are free fromreal, potential, or apparent conflicts of interest and thatthe NZDMO conforms to the practices and conductexpected of a participant in the financial markets.

The NZDMO recruits successfully from the pri-vate sector and places a strong emphasis on stafftraining and professional development within theorganization. Among other reforms of the public sec-tor in the late 1980s was the decentralization of remu-neration to departmental chief executives. As aresult, the NZDMO is able to offer terms and condi-tions of employment that are competitive with privatesector financial institutions, in the context of theunique opportunities that can be offered.

Information management systems

An information management system that integratesthe front, middle, and back offices underpins theNZDMO’s operations.

The information management systems used bythe NZDMO have evolved through the years. Until1987, prior to the establishment of the NZDMO, theofficial recording of outstanding debt and interestpayments was contained in manual ledgers and infor-mal spreadsheet tools that lacked adequate controland verification. Innovations in the financial marketsduring the 1980s also gave urgency to the develop-ment of an effective information management sys-tem. At the time, no commercially available productcould satisfy the most pressing needs for valuation,performance measurement, and sensitivity analysis,owing in large part to the diversity of instruments inthe government’s debt portfolio. Consequently, a cus-tom-built information management system was devel-oped that, with near continuous development, servedthe NZDMO through 1997.

By the mid-1990s, however, it was apparent thatthe closed design of that system would be inadequatein the long run. By that time, as well, commercial sys-tems had advanced to the point where they couldaccommodate most of the NZDMO’s requirements.In 1995, contracts for the purchase and maintenanceof a commercial system were signed. Implementationwas completed on time and within budget in 1998.Although the new system adequately met front officeneeds, significant customization, accomplished in-house, was necessary to satisfy requirements of theback and middle offices. That said, the new systemprovided tangible benefits in terms of

• enhanced pricing, reference benchmarking, andrisk management functionality;

• greater system integrity; and• reductions in in-house development costs, system

maintenance overhead, and key person depen-dency.

Over the years, the system has been continuallydeveloped to meet the NZDMO’s ongoing require-ments. That development has taken place outside thecommercial system. Although it generally meets theNZDMO’s current requirements, the commercial sys-tem lacks the flexibility for the agency’s increasinglysophisticated requirements. The NZDMO is currentlyconsidering its IT strategy for the next three to fiveyears. The preferred approach is likely to be a series


of incremental solutions rather than an entirely newsystem, with the high cost and risk that would entail.


Strategy for debt management

Over the past decade, the NZDMO has undertaken aconsiderable amount of work to analyze the structureof the government’s liabilities within an asset-liabilityframework. There are several points of departure forsuch a framework.

One approach is to argue that the governmentshould concern itself with constructing a debt portfo-lio with the aim of hedging the economy as a wholeagainst shocks to national income or net worth.Under such an analysis, domestic debt is regarded asan internal transfer, and the objective is to determinea configuration of net external liabilities that wouldfall in value if a shock negatively affected the collec-tive economic balance sheet of residents.

A second, narrower approach is to consider theassets and liabilities that relate to only the govern-ment as an entity. Even if public accounting conven-tions do not extend to the publication of a balancesheet, it can be constructed in a notional manner.

A third way to define the relevant assets and lia-bilities is to adopt definitions that accord with gener-ally accepted accounting practice. In such a manner,the asset side comprises physical infrastructure, lend-ing by government, securities, receivables, and so on.In addition to debt, liabilities include payables, provi-sions, and unfunded pension liabilities.

To help identify the characteristics of a low-riskportfolio of liabilities, the NZDMO researched pri-vate sector best practice and the academic literature.It was concluded that decisions on the government’sasset and liability management should be taken withreference to the government’s balance sheet. In par-ticular, the risk characteristics of the government’sliabilities should match as closely as possible the riskcharacteristics of the government’s assets.

With that principle in mind, the NZDMO com-missioned specialists in duration theory to quantifythe risk characteristics of the assets in the govern-

ment’s balance sheet. Although there were sizablestandard errors around the estimates of the interestrate sensitivity of the assets, three important recom-mendations emerged, which were implemented overthe course of the 1990s:

• The duration of the assets tends to be quite long,implying that the debt portfolio should also havea long duration.

• The assets are sensitive to changes in real interestrates, implying that there is a case for issuingsome inflation-indexed debt.

• The asset values are not sensitive to exchangerate movements, implying that there is little rea-son to hold foreign currency debt in the govern-ment’s debt portfolio.

Tax-smoothing considerations support those con-clusions as well. The objective there is to structuretotal public debt to hedge against fluctuations in thetax base, with a view to stabilizing tax rates over timeand reducing deadweight costs. The government’srevenue flows exhibit little sensitivity to the exchangerate, implying that the level of foreign currency debtshould be reduced. Similarly, the susceptibility ofNew Zealand to negative supply shocks, which havethe effect of increasing inflation and reducing realincome, leading to a deteriorating fiscal position,favors a debt portfolio of predominantly nominallong-term debt.

Recently, the NZDMO developed a stochasticsimulation model to improve understanding of thetrade-off between financial cost and risk associatedwith the composition of the portfolio of domesticborrowing. The NZDMO is using the model to iden-tify opportunities to reduce the cost or risk of theportfolio, stress-test alternative strategies, and informdecision making when establishing the borrowingprogram for the coming years.

Going forward, debt strategy is likely to be influ-enced by analysis that is under way in the treasuryaimed at understanding financial risks across the gov-ernment from a whole-of-government perspectiveand how the government’s balance sheet is likely tochange through time. Financial assets will increas-ingly dominate other assets, allowing more flexibilityin terms of implementing a desired composition to


meet net worth–related and other objectives, whilenecessitating new approaches to government-widefinancial risk management.

Management of domestic currency debt

Within the asset-liability framework, the domesticdebt portfolio is shaped by a set of subobjectives, orprinciples, that support the NZDMO’s debt manage-ment objective, rather than one strategic benchmark.They are used to manage the risks and costs of thedomestic debt portfolio and help the NZDMO issuedebt cost-effectively.

At the highest level, the issue of debt composi-tion has been tackled by thinking about the govern-ment’s balance sheet. The conclusions from thatwork have helped identify the rationale for holdingnominal and inflation-indexed debt. Underlying thatwork, however, are differences in theoretical opinionand considerable empirical challenges. To date, it hasnot been possible to identify with any precision theproportions of each type of debt that should be held.

An additional reason for using a set of subobjec-tives to manage the domestic debt portfolio isbecause existing risk-pricing models do not addressthe trade-offs between different types of risk. In addi-tion, they do not help the NZDMO understand therisk preferences of a sovereign, a sovereign’s appro-priate level of indebtedness and creditworthiness, theimplications for the New Zealand economy as awhole, or intergenerational equity issues.

The principles for managing the New Zealand–dollar debt portfolio include the following:

• To manage risk with respect to refinancing, theNZDMO maintains a relatively even maturity pro-file for term debt across the yield curve to reducepressure on the domestic bond market when sup-ply increases unexpectedly and provide the gov-ernment with greater flexibility in anenvironment of fiscal surpluses.

• The funding program is calculated on the basisof the cash required within one financial year.

• The NZDMO builds benchmark bonds of around$NZ 3 billion to improve liquidity in the marketand, consequently, reduce the government’s costof borrowing.

• When deciding which benchmarks to build up inthe current financial year, the NZDMO trades offthe size and number of benchmarks to beoffered.

• To diversify interest rate risk and lower the cost ofthe portfolio, the NZDMO maintains a mix offixed-rate and floating-rate debt and uses interestrate swaps. Inflation-indexed debt makes up acomponent of the portfolio and is issued when itis cost effective to do so.

• When issuing debt, the NZDMO samples interestrates throughout the year by conducting about10 tenders of government bonds.

• The NZDMO is committed to transparency, pre-dictability, and evenhandedness.

The NZDMO seeks to lower the government’scost of funds by reducing price uncertainty andencouraging competitive bidding through an effi-cient auction program. The NZDMO issues alldomestic debt securities through auctions. Reservepricing is used only in very exceptional circum-stances, on only two occasions since 1993, to encour-age investors to cover the government’s borrowingrequirements.

Nominal bonds and treasury bills are auctionedthrough a multiple-price system. Inflation-indexedbonds have not been issued since 1999, because it hasnot been cost effective to do so. They had been auc-tioned through a uniform-price system to reduce thepotential “winner’s curse” problem, which is viewedto be greater for a less liquid instrument that is moredifficult to price.

Transparency surrounding the government’sdomestic borrowing intentions is enhanced by thepublication of the details of the borrowing programwhen the annual budget and midyear fiscal updatesare released. For instance, the NZDMO issues a pressrelease that states the financing arithmetic for domes-tic currency borrowing and sets out the schedule forbond auctions. It states the parameters of the treasurybill program and notes whether the NZDMO intendsto undertake New Zealand–dollar interest rate swaptransactions. Similarly, the NZDMO consults the mar-ket before introducing new policies and practices,which reduces uncertainty around the process of pol-icy change. That predictability enables market partic-


ipants to plan with confidence, helping the marketabsorb sizable amounts of government securities.

Although these principles limit the NZDMO’sability to borrow opportunistically or engage in sec-ondary market intervention, the possible opportunis-tic gains are outweighed by the benefits of beingtransparent.

This debt management framework also assistsother public policy objectives. It seeks to enhance thedevelopment of the domestic capital market, includinga derivatives market for managing risk, and reduce thecost of capital for private sector borrowers by improv-ing New Zealand’s sovereign creditworthiness.

Management of foreign currency debt

Since the float of the New Zealand dollar in 1985, thegovernment has borrowed externally only to financeforeign exchange reserves. All other borrowing hasbeen in the domestic market. At the same time, morethan $NZ 18 billion of foreign currency debt hasbeen retired, largely through the proceeds from assetsales and, since 1994, sizable fiscal surpluses. Net for-eign currency debt was eliminated in 1996.

Unless otherwise directed by the minister offinance, net foreign currency debt is kept close tozero. The NZDMO aims to

• maintain a foreign-currency liquidity buffer;• hedge the remaining foreign currency debt in a

low-risk and efficient manner, having regard forthe government’s overall balance sheet;

• fund the Reserve Bank in a low-risk and efficientmanner, having regard for the government’soverall balance sheet; and

• manage funding risk through the maintenanceof adequate reserves and diversified and long-term funding.

The decision to reduce net foreign currency debtto zero was an outcome of the analysis of the govern-ment’s debt in an asset-liability framework, which indi-cated that the value of the government’s assets aresensitive to movements in domestic interest rates butnot movements in the exchange rate. Other consider-ations were the volatility of New Zealand’s terms oftrade and susceptibility to exchange rate shocks, which

could not be effectively hedged, given the magnitudeof the overall external debt portfolio and the capacityof the New Zealand foreign exchange market.

Prior to the elimination of net foreign currencydebt, the strategy for the foreign-currency debt port-folio drew insights from mean-variance modeling thatconsistently showed that the U.S. dollar representedthe dominant currency when attempting to reducerisk. The mix between yen and European currencieswas unstable, and rebalancing costs were prohibitive.Consequently, the NZDMO adopted a benchmark forthe net liability of 50 percent in U.S. dollars, 25 per-cent in yen, and 25 percent in European currencies.Those allocations corresponded approximately to rel-ative GDP weights of the currency blocs, and so werealso consistent with a “sell the market” strategy. Forthe target duration for each currency subportfolio,the NZDMO adopted the duration of the govern-ment bond market in each currency.

Strategic and tactical portfolio management

The portfolio is managed at both a strategic and a tacti-cal level. Strategic management refers to the manage-ment of the overall parameters of the portfolio, in termsof currency mix and interest rate sensitivity, within theconstraints established from time to time in respect ofthe mix of New Zealand dollar and foreign currencydebt. The strategic parameters are disclosed in the gov-ernment’s annual financial statements. The minister offinance approves the strategic parameters of the portfo-lio and the annual New Zealand dollar borrowing pro-gram on the recommendation of the NZDMO.

Tactical management refers to the discretionarymanagement of the net debt portfolio within estab-lished limits around the strategic portfolio. Withinthose limits, portfolio managers have discretion as tothe use of instruments and timing of transactions toeffect movements in the portfolio. Arguments infavor of providing the NZDMO with the flexibility tomanage tactical positions within established limits, asopposed to adhering to the strategic parameters,include the following:

• Temporary pricing imperfections do sometimesoccur, making it possible to generate profit fromtactical decision making.


• Tactical trading brings with it knowledge of howvarious markets operate under a variety of cir-cumstances, which improves the NZDMO’sunderstanding in managing the overall portfolio.It is important, for instance, to maintain high-quality information flows about markets or sec-tors where intermediation transactions occur butare infrequent. Intermediation transactionsoccur when a substantial proportion of the valueof tactical management is realized.

• Tactical trading enables the NZDMO to developand maintain skills in analysis, decision makingunder uncertainty, negotiations, and deal clo-sure. The immediate benefit is a reduced risk ofmistakes when transacting and the projection ofa more professional image to counter-parties.

Consistent with its commitment to transparency,predictability, and evenhandedness, the NZDMOdoes not engage in tactical trading with respect to thedomestic debt portfolio.

Risk management

With ministerial approval, the NZDMO maintains aportfolio and risk management framework withinwhich it operates. That includes the NZDMO’s strate-gic objective, objectives for New Zealanddollar–denominated and foreign currency debt, theinstruments in which the NZDMO may transact, lim-its regarding market and credit risk use, and compo-sition requirements for the liquidity asset portfolio.

The NZDMO manages six principal types of risk:market, credit, liquidity, funding, operational, andconcentration.

The NZDMO manages market risk associated withtactical trading through the use of value-at-risk (VaR)limits and stop-loss limits. It maintains a VaR limit for theoverall tactical portfolio and also VaR limits for individ-ual currency subportfolios. The limits are expressed overdaily, monthly, and annual time horizons at a 95 percentconfidence level and reflect the risk tolerance of the gov-ernment in respect of tactical activity undertaken by theNZDMO. The limits are set so that the NZDMO

• can efficiently operate its daily business activitieswithin the limits,

• has sufficient capacity to intermediate transac-tions on behalf of departments and other gov-ernment organizations and manage the fundingrequirements for the Reserve Bank, and

• can absorb increases in market risk as a result ofchanges in global volatilities and correlationswithin the risk tolerance of the NZDMO.

The limits have evolved with the reduction of theforeign currency portfolio to a net zero position andin step with the evolution of international best prac-tice. When the tactical trading limits were firstapproved by the minister of finance in the early 1990s,interest rate exposure and exchange rate exposurewere managed separately, whereas the current VaR-based limits recognize diversification benefits.

Stop-loss limits are in place to protect theNZDMO from further losses once actual losses reacha certain point. They reflect the tolerance of the gov-ernment in respect of maximum acceptable lossesover monthly, quarterly, and annual time horizons.

The NZDMO uses back-testing to evaluate theperformance of its VaR model. Actual profit and lossare compared with the market risk estimates calcu-lated using the VaR model to determine its integrityand performance. Consistent with industry best prac-tice, the NZDMO supplements VaR with stress-testingto understand how extreme or unusual events wouldaffect the portfolio.

The NZDMO manages credit risk associated withtransaction counter-parties and security issuersthrough the use of credit exposure limits. Becausethe NZDMO maintains credit exposures only withhighly rated institutions, for which the probability ofdefault is low, it is primarily concerned with lossesarising from downgrade. Credit risk is further con-trolled by incorporating credit support annexes intothe NZDMO’s master swap agreements with swap andforeign exchange counter-parties.

The nature of the NZDMO’s business is such thatlarge amounts may be settled on one day. For thatreason, monetary limits are not placed on theNZDMO’s exposure to transaction banks, custodians,fiscal agents, and clearing brokers. The NZDMOmanages risk with respect to those institutionsthrough its procedures for selecting and monitoringits transaction settlement agents.


The NZDMO measures credit risk using an in-house credit model, because no suitable externalproduct was available when it was developed in 1996.The model has been reviewed, and inputs to it havebeen updated, periodically since then. The modelcan be characterized as a mark-to-market model,which allows for credit losses as a result of changes incredit quality; a multiyear time horizon model, whichspans the entire life of each transaction; and a bot-tom-up model, which calculates the credit risk foreach individual transaction and then aggregatesthose individual credit risks at a portfolio level.

The objective for managing the NZDMO’s for-eign-currency liquidity portfolio is to have sufficientliquid assets available to meet all the government’sobligations as they fall due. Liquidity risk is managedthrough policies that require the NZDMO to holdassets of appropriate quantity and quality.

To manage funding risk associated with NewZealand dollar borrowing, NZDMO establishes a rel-atively even maturity profile for term debt across theyield curve to manage the funding requirement, andthe uncertainty around it arising from fiscal shocks,flexibly and without putting undue pressure on inter-est rates. With respect to foreign currency borrowing,the NZDMO establishes a maturity profile for termdebt that reduces the likelihood of the governmentbeing unable to access markets in a timely manner orraise funds at an acceptable cost.

Operational risks in the NZDMO are managed ina number of ways. Operational risk policies span, forinstance, transaction processing, legal and regulatoryissues, ethical standards, physical and systems secu-rity, and business continuity. They are supported byclose communications and regular managementmeetings that, in turn, reinforce a strong team ethic.Independent experts, such as external auditors, andspecific initiatives provide additional support in man-aging operational risk. The combination of soft andhard practices provides the basis by which opera-tional risks are managed and serves to heightenawareness of relevant risk events.

The NZDMO manages concentration risk as asecond-order risk that forms part of the other risksthat are managed. The NZDMO’s approach is toensure that risk concentrations are managed pru-dently within the context of the other individual risks.

The NZDMO’s risk management framework hasbeen in place since the NZDMO was established.However, the specifics of implementation have been,and are, subject to continuous improvement asresources allow and as IT capability and analyticaltechniques have improved. Careful prioritization hasbeen required to ensure that scarce resources areallocated to managing the most significant risks firstand fundamental risks are covered. In addition, theNZDMO periodically commissions reviews of its riskmanagement framework and practices, including thestrategic parameters of the portfolio, by externalexperts.

Performance measurement

The NZDMO measures performance on a risk-adjusted basis. The performance measurementregime provides these benefits:

• NZDMO management has information regard-ing the magnitude of risk associated with discre-tionary decisions, which assists thinking onalternative financing or investment strategies.

• Portfolio managers have information to assistthem in managing the controllable risks forwhich they are responsible and feedback on thequality of their decisions.

• Information necessary to generate incentivestructures that ensure staff incentives are alignedwith those of the NZDMO.

The NZDMO undertakes performance measure-ment as a tool for internal management purposes,including the allocation of resources and the assess-ment of performance of individuals. It is not arequirement under generally accepted accountingpractice, which establishes the framework for theNZDMO’s public reporting. For that reason, the per-formance out-turn is not publicly disclosed.

As noted previously, the overall portfolio man-aged by the NZDMO is divided into strategic and tac-tical portfolios. Performance measurement applies toonly the tactical portfolios, which are considered“performance” portfolios, whereas strategic portfo-lios are considered “nonperformance.” All activitywith respect to domestic currency borrowing is strate-


gic. The daily profit or loss for each tactical portfoliois calculated as the difference in the present value ofthe portfolio from one day to the next.

In 1999, the NZDMO implemented a transfer-pricing regime (TPR) to allocate the change in theend-of-day valuation from one period to the next.The TPR enables transactions and risk positions to betransferred under agreed-upon rules from one sub-portfolio to another and better track the attributionof value added by activity. Prior to the implementa-tion of that program, performance was measured rel-ative to a shadow, or benchmark, portfolio. It was alsomeasured on a cost basis alone with respect to liquid-ity management, investment, and foreign exchangetransactions. The introduction of the TPR made itpossible to measure performance on a risk-adjustedbasis.

Value added—that is, profit or loss—is measuredfor each day, month, quarter, and financial year bythe tactical portfolio and also by currency. Risk posi-tions are measured against the net zero foreign-cur-rency debt strategic benchmark. Risk use is calculatedfor the total tactical portfolio and also by currency.

Risk-adjusted performance measurement(RAPM) refers to the return of tactical managementrelative to the risk undertaken to achieve that return.RAPM provides information, in addition to simpleprofit and loss or risk use, that NZDMO managementcan use to assess the performance of tactical portfoliomanagement activity. The practical effect of RAPM isto encourage portfolio managers to take on risk onlywhen the potential upside is high compared with thesize of the risk.

The risk-adjusted performance return is definedas net value added divided by notional risk capital.Net value added accounts for profit or loss and rec-ognizes the expenses incurred in tactical manage-ment. It is defined as gross value added, less expensesattributable to tactical management. Notional riskcapital accounts for market, credit, and operationalrisk use. Market risk is measured relative to the strate-gic net zero foreign-currency debt position and isbased on the average total monthly VaR. Credit risk ismeasured relative to a credit risk–free position, whichthe NZDMO defines as a portfolio with exposure toonly AAA-rated entities, and is based on the averagemonthly deviation from that AAA benchmark. It is

estimated using the NZDMO credit risk model.Operational risk is assumed to be either zero or themaximum of market or credit risk, because theNZDMO does not have a model to quantify that risk.

Risk-adjusted performance is calculated monthly.The NZDMO compares current risk-adjusted perfor-mance against historical performance, instead of astatic benchmark. Annual risk-adjusted performanceis measured as a moving average of the monthlyreturns in the previous 12 months.


In 1989, net foreign currency debt was $NZ 13 bil-lion, equivalent to 19 percent of GDP and 43 percentof total net debt. Given the government’s borrowingrequirements at the time, the scope for reduction inthe foreign currency exposure of the public debt tomeet the NZDMO’s balance sheet objectives was lim-ited by the capacity of the New Zealand market toabsorb additional borrowing. That encouraged theNZDMO to give a high priority to the development ofthe domestic debt market.

The preconditions with respect to securities mar-ket regulation and market infrastructure were alreadyin place. There was a long-standing, sound legalframework, as well as appropriate accounting andauditing practices. Banking, clearing, and settlementsystems were efficient. An independent central bankwas able to implement monetary policy and managemarket liquidity.

To develop the primary market for governmentsecurities, the NZDMO established a commitment tothe principles of transparency, predictability, andevenhandedness in its activities, as described before.

In 1988, the minister of finance agreed to con-centrate the issuance of bonds in benchmarks oflarge-volume, standardized securities. The aim of thatapproach is to reduce debt-servicing costs by achiev-ing greater liquidity in the market, thereby attractinginvestors for whom liquidity is a major requirement.The domestic debt market until that time consistedof many tranches of relatively small volumes. By 1993,it had been transformed into eight benchmark matu-rities, each with up to $NZ 2.5 billion in outstanding


volume. That pattern has continued through today,although the maximum outstanding volume is nowaround $NZ 3 billion.

A major consideration when first establishingbenchmark bonds was that the maturity of a bondwith a large outstanding volume involves a major out-flow from the government to the private sector, whichrequires careful handling through the Reserve Bank’sliquidity management operations. In New Zealand,benchmark bonds are large relative to the size of theeconomy, at about 3 percent of GDP, so their redemp-tion represents a major flow through the financialsystem. That has been mitigated by buying backbonds in the final six months of life. The ReserveBank also undertakes reverse repos in open marketoperations with maturity dates that coincide with thematurity date of a benchmark bond. A number ofbenchmark bonds have matured since 1993, andthose processes have worked well, without distortionto the cash market.

To accelerate the building of benchmark bonds,the NZDMO introduced bond switches in 1989. Theyinvolved the issuance of new benchmark bonds inexchange for existing illiquid bonds. The processthat was used included both reverse auctions, typi-cally when a switch window was first opened, andnegotiations with individual investors. The pricingfor those negotiations was framed as a spread to thebenchmark bond curve, on a duration-adjusted basis.At times, the savings to the government were sub-stantial, of up to 30 basis points per year.

A further development was the lengthening ofthe maturity of government securities to reduce fund-ing risk. The original benchmark was for 5 years. A 7-year benchmark was introduced in 1990 and a 10-yearbenchmark in 1991. The timing of each successiveextension was a judgment about the level of demandin the market and, in New Zealand, it was closely asso-ciated with disinflation. The 10-year maturity hasbecome an important pricing point in the market forinternational investors, because it is a common pointof comparison across markets.

The NZDMO has not found it necessary to intro-duce primary dealers or officially appointed marketmakers to assist with the distribution of securities.Instead, the NZDMO considers that a better outcomeis market making in government securities on the

basis of commercial decisions by market participantsthemselves. New Zealand’s banking system is efficientand open to new entrants, and this was also the casewhen a liquid government bond market was devel-oped in the late 1980s and early 1990s. The bankingsystem has been characterized by a high degree offoreign ownership for more than a century, andfinancial market reforms beginning in the mid-1980sincluded the removal of any limit to the number ofregistered banks. It has been comparatively easy forNew Zealand banks to develop the necessary skillsand systems required for a domestic bond market.

All market participants, including end-investors,may bid in auctions, subject to criteria related tocreditworthiness. The arrangement has worked well,with a core group of about six to eight market makersat any one time, who agree among themselves on sec-ondary market standards for liquidity, such as ticketsize and spread. A similar approach applies in theNew Zealand–dollar foreign exchange market.

A further development that was important forthe expansion of the market was the effective removalof nonresident withholding tax. The NZDMO hadbeen aware for some time that this was an issue withinternational investors, but earlier action had notbeen possible because of a number of considerationsrelating to tax policy. Although investors were able toavoid the tax by not holding securities on couponpayment dates, that procedure imposed costs andinconvenience, and many international investorswere not prepared to take those measures for ethicalreasons.

Holdings by nonresidents of New Zealand gov-ernment securities increased markedly from 1993.According to surveys by the Reserve Bank, nonresi-dent holdings peaked at 62 percent in 1997, slippingback to 33 percent in 2000. The reduction has beenorderly and has occurred for a number of reasons,including a fall in differential interest rates betweenNew Zealand and major markets and a depreciationin the New Zealand dollar as an adjustment processto a weak external position.

One potential concern about high levels of non-resident participation is the threat that thoseinvestors could attempt to exit the market all at once.Over the years, there have been periods of divest-ment, but they have tended to be orderly. Part of the


reason is that the number of foreign investors partic-ipating in the market has increased over time, so theexit and entry of individual investors is based on theirindividual views, which tend to vary over time.Another reason is that successive governments haveadhered to transparent and prudent fiscal and mon-etary policies, which provide an anchor of stability forthe market.

Another feature of the maturity of the market hasbeen its ability to weather a number of crises in inter-national markets. Events such as the 1994 interna-tional bond market sell-off saw yields adjust upward,but the market continued to function continuouslyand prices generally adjusted smoothly.

One development in recent years that hasimproved the efficiency of the secondary market hasbeen the increased use of repos. The NZDMO, alongwith the Reserve Bank, encouraged the developmentand use of standardized repo documentation, whichassisted in that process. The increased use of swaptransactions, by both residents and nonresidents, hasalso had spin-offs for the liquidity of the bond market.

Conclusion

Over the last 13 years, the NZDMO has undertakencontinuous improvement in all aspects of its manage-ment of the government’s debt. The latter half of thatperiod has seen a considerable improvement in thegovernment’s finances and a reduction in debt levels.That has created its own technical challenges in rela-tion to debt defeasance and management of uncer-tainty surrounding asset-sale proceeds and the size ofsurpluses. Changes in government policy and otherinitiatives have seen the NZDMO’s role expand in theareas of intermediation and risk management. Thatis likely to continue in the future and, combined withfinance industry–driven improvements to risk man-agement techniques, will lead to further evolution ofgovernment debt management in New Zealand.

Note

1. The case study was prepared by Greg Horman from theNew Zealand Debt Management Office.



Objectives

In 2001, the evaluation of the existing objectives andchanges in macroeconomic conditions led to revision ofthe existing objectives.2 The new objectives were incorpo-rated in the strategy of debt management for the years2002–04. The major change in comparison with the pre-vious strategy was a shift in emphasis regarding the goalof cost minimization, from reducing the cost burden inthe three-year time horizon to long-term cost minimiza-tion. The objectives are divided into two groups withthree main objectives and four complementary (condi-tional) objectives. The fulfillment of the conditional goalswill depend on the situation in the financial markets.

The main objectives are:

• Minimization of debt service costs: This is to beachieved through an optimal selection of debtmanagement instruments, their structure, andissue dates. The time horizon is determined by the

maturities of debt management instruments withthe longest maturity.

• Limitation of the exchange rate risk and the risk ofrefinancing in foreign currencies: This objective isto be met mainly through reducing the share offoreign debt.

• Optimization of state budget liquidity manage-ment.

The complementary (conditional) objectives are:

• Limitation of the refinancing risk in the domesticcurrency is to be mainly achieved through the risein the average maturity of domestic debt.

• Limitation of the interest rate risk is to be metthrough increasing the share of long-term fixed-rate instruments in total debt.

• Increasing flexibility of debt structure is to beachieved mainly through conversion of nonmar-ketable debt into marketable instruments.

• Decrease in debt monetization is to be metthrough increased share of the nonbanking sectorin total debt.

167

12Poland1

Scope

The debt management policy pursued by the centralgovernment encompasses all activities involving themanagement of state budget debt. This includes theissuance, management, and service of treasury secu-rities as well as the management and monitoring ofother liabilities of the state budget. The influence onthe central government debt, other than state budgetdebt, as well as on the local government debt, is indi-rect only (unless special procedures of recoveringsound financial policies are executed) and includesimposing legal and formal regulations.


To coordinate the debt management policy with mon-etary and fiscal policies, the committee of public debtmanagement was founded in 1994. The committeecomprises members from the ministry of finance(MoF), the National Bank of Poland (NBP), and theministry of state treasury. The meetings of the com-mittee are held monthly and have an advisory charac-ter. However, the participation of directors of crucialdepartments of the MoF and the NBP, responsible forimplementing and executing the policies, ensures astrong informal authority of the conclusions drawn bythe committee. The main fields discussed by the com-mittee include monthly plans for financing the statebudget borrowing needs, the budgetary situation, andthe situation of the money market.

The management of liquidity is coordinated onan interdepartmental level within the MoF. Underthe constraint of a predetermined safe level of thebalance of the account (excluding the risk of losingliquidity), the coordination ensures the minimizationof alternative costs of holding cash on the central gov-ernment account. The main instruments of the liq-uidity management are short-term deposits of surpluscash and issuance of short-term treasury bills.

Legal framework

The Constitution of the Republic of Poland, Article216 forbids the acceptance of loans and grant guar-antees and sureties, as a result of which the relationbetween public debt augmented by the amount of

the anticipated disbursements on sureties and guar-antees to the annual gross domestic product wouldexceed 60 percent. With the purpose of not exceed-ing the limit referred to in the principal rule, a pro-vision of similar content was included in Article 37 ofthe Public Finance Act and reinforced in Article 45by the definition of the so-called prudence and recov-ery procedures that come into play if the 50 and 55percent thresholds are exceeded. The minister offinance must control the public finance sector in gen-eral and, to ensure the principal rule, the state trea-sury debt.

The basic legislation governing the conditions ofthe government debt managers is the Public FinanceAct. Under this act, only the minister of finance isauthorized to draw financial commitment on behalfof the state treasury, repay the drawn commitment,and carry out other financial transactions connectedwith debt management, including transactionsrelated to derivative financial instruments.

The Public Finance Act requires the minister offinance to develop a three-year strategy of publicfinance sector debt management. At the same time,the minister of finance also presents a strategy forinfluencing public sector debt. These two topics arepresented in one document. The need for these reg-ulations was a consequence of the provisions of theConstitution of the Republic of Poland.

To govern the general conditions of issuingbonds, in 1999, the minister of finance issued fiveordinances under the delegation laid down in thePublic Finance Act.

Institutional structure

Institutional structure within the government

The debt management unit in Poland is situatedwithin the MoF. As one of the units of the ministry,the public debt department (PDD) manages day-to-day debt policy, prepares the strategy of debt man-agement, and cooperates with the Polish andinternational financial markets in the fields of bor-rowing and development of the treasury securitiesmarket.

The position of the PDD as a part of the MoF hasadvantages and disadvantages. At the very early stage


of development of the domestic financial market,when the transition to the free market economy hadjust begun, the PDD (the unit with administrativepower) had more instruments to support develop-ment of the market, cooperate with other regulatoryinstitutions, and prepare efficient legal and infras-tructure environments.

Along with the development of the market inPoland, the situation has changed. The number ofsophisticated market participants has increased, thebase of securities is well developed, and hedginginstruments are available. Together with challenges inthe risk management of the debt, a more flexible andactive approach to debt management is required. Thebureaucratic structure in the MoF, subjected to longprocedures, hampers the flexibility of debt manage-ment. The tendency in Organisation for EconomicCo-operation and Development (OECD) countries toseparate debt management offices from the MoF isbased on experience of being a unit of the MoF, whichmakes it hard to avoid the conflict between short-termobjectives of the fiscal policy and the longer-term onesfor debt management. Lessons learned from theyearly meetings of the OECD working group indicatethat acting outside the MoF as a separate debt officemakes it possible to avoid direct intervention in theborrowing policy, the structure of offered instru-ments, and the policy of minimization of debt-servic-ing costs on the medium- and long-term horizon.

Organizational structure in the debt managementoffice

In 1998, domestic and foreign debt managementwere concentrated in the PDD and divided into fourfunctional units: front office, middle office, backoffice, and the foreign debt unit. The decision todevelop a separate unit for foreign debt was the resultof the sizable percentage of foreign debt within totaldebt. However, external financial institutions per-form a large part of the traditional front and backoffices operations, and the work of the PDD retains arather analytical character. Currently, 49 people workat the PDD.

The framework and the point of reference fordaily debt management will be described in the nextsection, where objectives and tasks of debt manage-

ment are clearly defined. The formal procedures ofdaily management are still a work in progress.

The main operating risk of debt management isthe lack of an integrated information system for debtmanagement, because the databases are fragmentedand not fully compatible with each other. The inte-grated debt management system was implemented bythe end of 2002.

Auditing

The financial accounts of the public debt, as well asother parts of the state budget, are subject to annualaudit by the supreme audit office, reporting to par-liament. Regardless of that reporting structure, thesupreme audit office has the authority to carry outadditional control in any area of public finances.Thee minister of finance submits the report on exe-cution of debt-servicing costs quarterly to parlia-ment’s commission of the public finance.


Policies are implemented to ensure that the publicdebt management is carried out in a prudent andpredictable way, with the aim of minimizing any pos-sible threats to public finances and the country’seconomy.

Public debt management is one of the crucialareas where the accountability of applied policies andmacroeconomic prospects of the economy are subjectto scrutiny. To prevent excessive levels of debt by legalmeasures, the limits of the public debt to GDP ratiowere imposed, including special procedures if the debtexceeds 50 percent and 55 percent. As mentioned,these rules and regulations were set forth in the PublicFinance Act, and an upper limit of 60 percent was setby the Constitution of the Republic of Poland.

To increase the credibility of public debt man-agement, each year the council of ministers submitsto parliament the debt management strategy for thecoming three years, which includes a set of clear goalsof debt management, the assessment of executing theobjectives of previous strategies, and analysis of possi-ble scenarios regarding public debt.

Country Case Studies: Poland 169

The main risks that the government faces withrespect to its foreign currency debt portfolio are therefinancing risk and the exchange rate risk. For thedomestic currency debt portfolio, the main risks arethe refinancing risk and the interest rate risk.

The policy of reducing the foreign debt out-standing and financing mainly in the domestic mar-ket results in the development of a large and stabledomestic debt market, which reduces the country’sexposure to foreign currency crises and adverseexternal shocks.

Strategy for managing the costs and risks

Foreign currency debt portfolio

Despite considerably higher service costs of thedomestic debt, limitation of the exchange rate riskand the refinancing risk in foreign currencies isamong the primary goals in the public finance sectordebt management strategy for 2002–04. The basicmeasure of these two types of risk is the share of for-eign debt in total debt. Hence, the main means ofreducing the exposure to both these risks is decreas-ing this foreign debt share.

Consequently, the overall strategy states that theborrowing needs of the government should be satis-fied to the greatest possible extent in the domesticmarket. Funds raised in the foreign market shouldnot be higher than the amount of principal of theforeign debt due in the given fiscal year. However,additional borrowing can be executed in the foreignmarket to facilitate early repayment of the foreigncurrency debt. The maturity of the newly issued debtshould avoid the years with the highest foreign debtrepayments, namely 2004–09. Furthermore, proceedsfrom privatization obtained in foreign currencies areused for foreign debt service and repayment.

The percentage of foreign debt (according to theplace of issue) as part of total debt decreased from 49percent in 1999 to 35 percent at the end ofNovember 2001. During the same period, the debtexpressed in terms of U.S. dollars fell from US$31.3billion to US$24.7 billion in November 2001. Thesesignificant declines were mainly the result of the earlyredemption of Brady bonds. In addition, Polandsigned an agreement with Brazil in October 2001,

under which, by exception and approval of the ParisClub, debt with nominal value of $US3.32 billion wasrepaid early for the amount of $US2.46 billion.

Currently, an important issue is the preparationof the foreign debt refinancing for the period of peakpayments to the Paris Club in the years 2004–09.Owing to the very strong dependence of the debtrepayment manner on Poland’s political and eco-nomic situation, the actions undertaken should begeared to the current situation. Poland’s entry intothe European Union (EU) will strengthen the coun-try’s credibility and broaden its access to interna-tional markets, and subsequently joining theEuropean Economic and Monetary Union will meana substantial decrease in the share of foreign debt.

The strategy of establishing and maintainingaccess to the most important segments of the inter-national capital market is continuing because of thepossible necessity of having to refinance most or all ofthe maturing foreign debt in the period under con-sideration. This will be conducted through the place-ment of issues of treasury securities in the key marketsegments. Moreover, to upgrade its credit rating, thestate treasury conducts operations, within its currentcapabilities, of early repayment of some debt aimedat reducing foreign debt, minimizing service costs,and reducing principal repayments in the years2004–09.

In the future, when zlotys will be replaced witheuros, the situation will change. Because 43 percentof the external debt consists of euros, the exchangerate risk connected with foreign debt will be reducedsubstantially. The possibilities of raising funds infinancial markets will also change greatly. Poland’sentry into the EU will have a considerable influenceon the country’s credit rating, which will enablefinancing costs to be reduced. The inflow of the EUfunds could also help lower foreign refinancing byallocating the EU funds for repayment of the foreigndebt and enlarging domestic debt to raise money tofinance goals for which the EU funds were originallyintended.

To avoid distorting the exchange rate resultingfrom large inflows of foreign currency to the market,the privatization proceeds in foreign currencies areput into the special account used for foreign debt ser-vicing.


Domestic currency debt portfolio

The refinancing risk is most often measured by theaverage term to maturity. Hence, limiting refinancingrisk in domestic currency can be achieved by increas-ing the average maturity of domestic debt. The aver-age term to maturity of domestic market debt inFebruary 2002 was 2.52 years; at the same time, theduration of the market debt denominated in zlotysamounted to 1.90 years. These maturities do notguarantee the appropriate level of safety in themedium term. Extension of the average maturity ofdomestic debt should be done gradually, along withthe development of financial market in Poland,increase in demand for long-term instruments, andfall in long-term interest rates.

The refinancing risk can also be assessed by thetime structure of the future redemptions. The policyof reduction of debt in treasury bills in favor ofincreased debt in medium- to long-term bondsresults in the smoothing of a redemption profile ora reduction of redemptions in the next few years(increasing simultaneously the redemptions in theyears afterward). This same policy of increased debtin fixed-rate bonds and a decline of debt in treasurybills caused a reduction in interest rate risk. Theshare of fixed-rate marketable bonds in the domes-tic debt of the state treasury grew from 39 percent in1999 to 53 percent at the end of February 2002. Theincrease was mainly a result of increased sales andthe effects of conversion of the nonmarketable secu-rities into fixed-rate marketable securities. Theshare of treasury bills in domestic debt amounted to20 percent in February 2002 and has not changedsince 1999.

These measures have led to a decreased sensitiv-ity of debt-service costs to the fluctuations of interestrates on the financial market, as well as an increase inthe rate of predictability of these costs, in both thecurrent years and future years.

Risk analysis undertaken

When the debt management strategy and the budgetact were formulated, different scenarios were consid-ered. Several included the possible macroeconomicand market risks of adverse events, as well as the bud-

get environment. Possible threats to the realization ofthe strategy were also taken into account.

The main concern in applying the debt manage-ment strategy involved a trade-off between minimiz-ing costs and reducing risks. The risks are especiallyinterest rate risk, refinancing risk and exchange raterisk, as well as liquidity management. This requires adynamic approach, taking current market and bud-get conditions into consideration. The process ofdecision making is heuristic, rather than involvingthe use of formal procedures, although some quanti-tative measures and formalized models are used as asupport (a system of formal procedures is still a workin progress).

The risk measures are computed historically, andforecasts are made. The desired characteristics con-cerning foreign/domestic and fixed/floating ratios,as well as duration, are modified according to themarket situation and financing needs. Currently,these measures of risk are used:

• the debt-to-GDP ratio and the ratio of debt-ser-vice costs to GDP—the most general measures,summarizing the overall ability to service publicdebt;

• the share of foreign debt in total debt—mainly asa measure of exchange rate risk;

• the average maturity of the domestic debt—as ameasure of refinancing risk;

• duration of the domestic market debt—as a mea-sure of refinancing and interest rate risk; and

• other measures, mainly descriptive statistics, suchas the share of floating- and fixed-rate debt,maturity profile by months and years, and similardata.

Econometric and other quantitative3 models,developed within the PDD, are also used. Formalizedoptimization problems solved periodically are alsoused to support various decisions made. However, theresults derived from these models depend heavily onthe assumptions regarding future interest rates andother forecasted variables, which can be subjective attimes.

The quantification of risks is subject to furthermethodological research. A breakthrough in thisarea is expected after the implementation of the inte-


grated debt management system. Currently, informa-tion systems used to assess and monitor risk arehighly fragmented and are not automated. The inputdata are manually collected from different databases.The tools of risk monitoring also are not integrated.

The quality of risk assessment and monitoring, aswell as other aspects of data management, areexpected to improve significantly when the inte-grated debt management system, financed by PHARE2000 program funds, is introduced, as well as a loanfrom the World Bank. The objective of the project isto prepare (in cooperation with the Finnish Ministryof Finance) for a more effective and efficient debtmanagement through an integrated informationtechnology (IT) system in conformity with standardsin place in the EU member countries. The system willsupport the public debt management and the budgetprocess, including defining financing needs anddebt-service costs. It will also reduce debt-service costsby using sophisticated analytical tools provided by thesystem. Furthermore, it will improve the knowledgeof the development in the capital markets andstrengthen the market approach to debt manage-ment. The system will also enhance risk managementand control.

Currently, no benchmark portfolio is in use. Thecomparison of the actual portfolio and forecasts isoften informative because of high market volatilityand frequent changes of long-term assumptions con-cerning budget deficits and market conditions.

Active debt management

Public debt management does not encompass activityin the domestic secondary market. The primary con-cern is cost minimization over the long term, and thecurrent policy is subordinated to it. Active debt man-agement includes actions undertaken besides the reg-ular calendar of debt issuance and servicing, aimed atexecuting the goals of the debt management strategy.These include occasional buybacks of the domesticand foreign debt before its maturity, regular switchauctions of treasury bonds, swap transactions, and useof other derivative instruments. The last two optionsare planned.

Active debt management is not used to generatereturns in foreign currency debt. The only exception

involves buybacks of collateralized Brady bonds,which generate proceeds from sold collateral.

Management-contingent liabilities

A separate department within the MoF coordinatesthe management of contingent liabilities, especiallygranting sureties and guaranties by the state treasury.The disbursements effected under this departmentconstitute a service cost of public debt as a whole.The anticipated amount is important for the debtmanagement process.

The management of risks associated withembedded options

A put option (the possibility for an investor to receivean early redemption) is used only in savings bonds,namely the two-year fixed-rate bonds and the four-year inflation-indexed savings bonds. The relativelysmall share of these instruments in total debt, as wellas historical data on the share of bonds where theoption was executed, shows that the risk involved wasinsignificant. Early redemption accounts for about 4percent of the total value of bonds with this option.One of reasons for this low percentage is the rela-tively low sensitivity of retail investors to changes inmarket conditions. However, the potential threatsconnected with the options are taken into account,and suitable precautions are made to reduce the liq-uidity risk.

Early redemption is financed by the interestaccrued from not taking back funds by bondholders,which is then placed in a bank account maintained bythe issue agent. In addition, the issuer has a one weekto submit cash to the bondholder executing theoptions.


Borrowing instruments

According to the public finance sector debt manage-ment strategy for the years 2002–04, government bor-rowing should be realized mainly in the domestic


market. Borrowing in the foreign market is limited torefinancing maturing debt. In the future, the fundsraised in the foreign market will gradually increasealong with the increasing repayments of the debt tothe creditors associated within the Paris Club.

The increasing significance of minimizing costs,over a time determined by the maturities of debtmanagement instruments with the longest maturity,affected the structure of sales of treasury securities,especially in 2001. Decisions concerning the choicebetween the issuance of short- and long-term instru-ments was determined by market conditions and thepredicted future shape of the yield curve. Theincrease in the average term to maturity is acknowl-edged to be the main means of reducing the refi-nancing risk of domestic debt.

Marketable and savings treasury securities issuedon the domestic market in 2001 included theseinstruments:

• treasury bills with maturities ranging from 1 to 52weeks;

• Treasury bonds offered at auction (“wholesalebonds”): – 2-year zero-coupon bonds,– 5-year fixed-rate bonds,– 10-year fixed-rate bonds, and– 10-year floating-rate bonds;4

• treasury bonds offered in the retail network(“retail bonds”):– 2-year fixed-rate savings bonds– 3-year floating-rate bonds– 4-year savings bonds indexed to inflation, and– 5-year fixed-rate bonds.

In 2002, a 20-year fixed-rate bond was intro-duced. The first auction took place on April 17, 2002.

Retail instruments are used to back up the salesof wholesale instruments, widen the investor base,and promote the propensity for saving. The taskswithin this area will include the diversification ofinstruments offered and the increase in their accessi-bility to potential investors through the implementa-tion of the new IT. The sale of retail indexed bondsaccounted for about 1.0 percent of the total value ofall bonds sold by the MoF and approximately 5.8 per-cent of retail bonds.

The maturity of bonds issued on internationalcapital markets is constrained by the existing foreigndebt redemption profile. Until 2001, because of verylow funding needs, the MoF executed only onebenchmark transaction a year in the internationalmarket, not exceeding the amount of principal pay-ments. The main reasons for issuing bonds in theinternational market are to maintain access to themost important segments of the international capitalmarket because of the possible necessity of refinanc-ing most or all of the foreign debt in the years2004–09 and to create a benchmark for issues ofPolish corporate bonds.

Consolidation of public debt

Data on Polish public debt (debt of units included inthe sector of public finance)5 have been availablesince 1999 (since 2001 in a consolidated form). Sincethen, based on the Public Finance Act, two ordi-nances regulating the recording of debt have beenissued. The first ordinance regulates the recording ofdebt of units included in budgetary entities. The sec-ond regulates the recording of debt of the rest of theunits of the public finance sector. These regulationsmake it possible for the MoF (which has the obliga-tion of publishing data on public debt twice a year) tocalculate the entire amount of debt of the public sec-tor after consolidation. The regulations also aim toobtain the data needed to meet the requirements ofinternational reporting (e.g., reports prepared forthe EUROSTAT, IMF, and OECD).

Mechanisms used to issue debt

Treasury bills and treasury bonds

Treasury bills and treasury bonds are offered for salein the primary market at auctions organized and heldby the NBP. Bids are submitted to the NBP by 11:00a.m. on the auction day. Upon receipt of a bid sum-mary, the MoF makes a decision on the minimumprice with a given maturity. Bids with prices that arehigher than the minimum price are accepted in theirentirety, and bids with the minimum price can bereduced or accepted in whole. Each bidder buysbonds at the proposed price.


Dates of auctions are announced at the begin-ning of each year in a calendar of issuance, publishedon the MoF’s web site.6 The detailed information onforthcoming auction is published on the MoF’s website and on Reuter’s two days before the date of thetender. The announcement contains the type andmaturity of the instrument offered, value of the offer,a brief description of terms of issue, and the time andplace for submitting bids.

Treasury bills are sold at a discount at auctions,which are held on the first business day of each week(i.e., usually on Mondays). However, extra auctionscan be held on other days. Participants allowed tosubmit bids in the auctions are entities that purchasedat least 0.2 percent of all bills sold in the primary mar-ket in the previous quarter. They are verified everyquarter according to this criterion. Other investorscan participate through their intermediation.Payment for bills purchased and redemption ofmaturing bills are usually effected on the second dayafter the auction through banks’ current accountsmaintained by the NBP payment system department.

Treasury bonds auctions are usually held onWednesday.7 Additional auctions can be held onother days. Entities allowed to submit bids in the auc-tions are direct participants of the national deposi-tory for securities (NDS); other interested parties canparticipate through their intermediation. Auctions oftreasury bonds are settled in cash and in securitiesthrough the NDS; cash settlements of bonds auctionsare handled directly by the NDS through its accountwith the NBP.

Retail bonds

The sale and management of retail bonds intendedfor small investors is handled by the central broker-age house of Bank Pekao S.A. (CDM Pekao S.A.)under agreements signed with the minister offinance. CDM Pekao S.A. is the issuing agent and alsothe organizer of a consortium of the largest bankingand nonbanking brokerage houses, a total of 21.Bonds are offered through a network of customer ser-vice outlets—at the beginning of 2000, about 550units throughout the country—and via the Internet.

The marketable bonds (three-year floating-rateand five-year fixed-rate bonds) are sold at the issue

price published before the commencement of sale.The sales price contains, in addition to the issueprice, interest accrued from the sale commencementdate to the purchase date. There are four seriesissued every year, with distribution taking place in thefollowing three months. The sales price for five-yearbonds is settled monthly. The savings bonds (the two-year fixed-rate and the four-year indexed) are sold atZl 100 polish on every business day. During eachmonth, the issuer introduces a new series for eachtype of savings bond.

Disbursement of interest and repurchase ofbonds take place at the point of purchase or via thebank account indicated. It is also possible to depositthe three-year floating rate and five-year fixed-ratebonds in an investment account at any stock broker-age house, wherethe servicing and redemption of thebonds takes place via the same account. Both types ofbonds are admitted to official listing on the regulatedmarket (the Warsaw Stock Exchange).

Foreign debt

The standard mechanism of foreign bond issuance isused, including a syndicate of international investmentbanks. Each transaction in the international market iscarefully prepared, using the public debt management’sand investment banks’ expertise to select the best tim-ing and segment of the market. The pricing of bonds isbased on market conditions and takes into account thesecondary market performance of the bonds.

Development of the secondary market

The main actions taken to increase the liquidity,effectiveness, and transparency of the treasury securi-ties in the secondary market are

• elimination or reduction of restrictions in the set-tlement infrastructure—for example, the imple-mentation of the real-time gross settlement(RTGS) system and securities borrowing, thereduction of transaction fees and commissions,and the development of the repo market;8

• support of trading on the electronic platform fordebt instruments and their smooth incorpora-tion into the registration and settlement system;


• continuation of the policy to increase the depthof the treasury securities market through sizableissues of different series, which means fewermaturity dates for different types of treasurysecurities and an increase in their value in theindividual series;

• support of the activity toward elimination of reg-ulations aimed to subject repo transactions to thesystem of mandatory reserves; and

• introduction of switch operations.

The introduction of a primary dealer system is awork in progress. In 2001, the rules of governing,selecting, and properly assessing primary dealers,and an evaluation of the scope of their rights andduties, were prepared, and then verified duringmeetings with the banks. The cooperation with pri-mary dealers will also lead to the identification ofrisks for public debt management and the develop-ment of the treasury securities market. The processof monitoring and evaluating the candidates beganon April 26, 2002.

Contacts with the financial community

A proper relationship between debt managers andinvestors is crucial to the effective management ofpublic debt. To achieve this, regular meetings withgroups of domestic investors such as banks, broker-age houses, pension funds, investment funds, andinsurance companies are held. Individual meetingswith important domestic and foreign participant inthe treasury securities market are also held.

Relation to the private sector market

The debt market in Poland is dominated by govern-ment securities (treasury bonds and treasury billsaccount for about 90 percent of the total debt out-standing). The issues of nontreasury bonds aremainly private placements. The modest significanceof private sector debt makes public debt manage-ment independent of considerations regarding thecurrent situation in the private debt market. On thecontrary, the development of the public debt marketconstitutes a key condition of the development of pri-vate debt markets.

Rules of taxation

Taxation of residents

Legal entitiesInterest and discount income as well as income fromthe sale of treasury securities were subject to incometax under general principles, that is, at the rate ofincome tax applicable to income realized by legalentities in the year in which the income was obtained(in 2001, the rate amounted to 28 percent).

Private personsInterest or discount on securities issued by the statetreasury and acquired by private persons beforeDecember 1, 2001, was exempt from tax. Interest ordiscount on securities issued by the state treasury andacquired by taxpayers after November 31, 2001, aresubject to withholding tax of 20 percent.

Income from the sale of domestic treasury bonds(issued after January 1, 1989, and acquired beforeJanuary 1, 2003) received by December 31, 2003, isnot subject to income tax unless the sale is the objectof business activity. Income from the sale of securitiesother than bonds issued by the state treasury is sub-ject to personal income tax.

Taxation of Nonresidents

Persons realizing income from treasury securitiespurchased on the domestic market were subject tothe provisions of treaties on the avoidance of doubletaxation between Poland and the country of resi-dence or domicile of the nonresident earningincome in Poland. Where no such treaty existed, thefollowing principles applied.

Legal entitiesInterest and discount were subject to withholding taxof 20 percent. Income from the sale of treasury bondsor bills was subject to income tax under general prin-ciples, that is, at the rate of income tax applicable toincome realized by legal entities in the year in whichthe income was obtained (in 2001, the rate amountedto 28 percent).

Income realized by legal entities based abroadfrom the sale, conversion, or other legal transaction


transferring rights in bonds issued by the StateTreasury of the Republic of Poland on foreign mar-kets since the year 1995 has been exempt from tax.

Private personsForeign private persons with a domicile other thanPoland or those with no right of permanent or tem-porary residence in the territory of Poland (tempo-rary residence being a sojourn with a duration of notmore than 183 days in a tax year) were liable to taxonly on income from work performed in the territoryof Poland under a service-based relationship oremployment relationship, irrespective of where theremuneration is paid, and on other income realizedin Poland.

Interest and discounts on securities issued by thestate treasury in the domestic market acquired by tax-payers before December 1, 2001, were exempt fromtax. Interest or discounts on securities issued by thestate treasury and acquired by taxpayers afterNovember 31, 2001, are subject to withholding tax of20 percent.

Income from the sale of domestic treasury bonds(issued after January 1, 1989, and acquired before

January 1, 2003) received by December 31, 2003, isnot liable to income tax unless such sale was theobject of business activity. Income from the sale ofother domestic securities issued by the state treasurywas liable to personal income tax.

Income realized by foreign private persons hav-ing their domicile abroad from the sale, conversion,or other legal transaction transferring rights in bondsissued by the State Treasury of the Republic of Polandon foreign markets in the years 1995–01 was exemptfrom tax.

Effect of tax on trading of government securities

Currently, the sale of government securities is notaffected by taxation because of the relief from the taxon civil actions, which has been in force since 1998.

Therefore, it is difficult to give an estimate of theeffect of taxation on private persons’ trading becauseof the short period of tax law that is binding. At thesame time, income from all kinds of bank depositswas taxed; therefore both of these forms of invest-ment are treated equally. This pattern is also appliedin the EU.


Appendix

Development and Changes in DebtManagement Objectives Before 2001

The debt management strategy was first prepared in1999, as a document submitted to parliament withjustification of the draft State Budget Act. Long- andshort-term objectives were formulated. The long-termhorizon of the strategy corresponded to the maturityprofile of most of Poland’s external debt (to the ParisClub), and it coincided with the horizon adopted forthe Public Finance and Economic Development Strategy:Poland 2000–2010. The primary objectives of the debtmanagement strategy for the period were:

• reduce the share of external debt in total debt byrefinancing part of the debt due with internaldebt and early redemption of certain external lia-bilities;

• achieve the desirable value of the indicatorsdescribing the debt maturity structure—averagematurity, duration, and the ratio of debt due in agiven year to total debt;

• ensure even distribution of debt repayments anddebt-servicing costs over time—in particular, toeliminate peaks of payments;

• reduce the risk related to variability of debt-ser-vicing costs (increase their predictability) byincreasing the share of fixed-income instrumentsin total debt; and

• make the external debt structure more flexible.

The following objectives were set forth in thestrategy for the three-year horizon:

• Minimize the debt servicing costs under con-straints on– the borrowing needs of the state budget (net

cash requirements);– the level of risk involved in debt financing,

including exchange risk, refinancing risk,and interest rate risk;

– the ability of the domestic market to absorbmedium- and long-term instruments, giventhat the national budget does not displacecredit for the economy);

– the conditions prevailing on the interna-tional financial market related to a countrycredit rating; and

– compliance with the monetary policy of thecentral bank.

• Develop an optimum schedule of external debtpayments for the years 2004–09 (i.e., during theperiod of high intensity of the payments).

• Reduce the degree of debt monetization byincreasing the nonbanking sector’s share in totaldebt.

The goals presented in the first strategy weremodified in 2000 as a result of conditions that arosein relation to the need to lay greater emphasis on theminimization of the burden of debt-service costs forpublic finance in the period of the next two to threeyears.

Goals formulated in the strategy were as follows:

• Minimization of the debt service costs over theadopted horizon—understood as– minimization of the burden of debt-service

costs for public finance in 2001–03, mainlythrough the rising share of the fixed-ratebonds in total debt and the limitation of theshare of treasury bills and floating-rate bonds;

– costs minimization over a time limit deter-mined by the maturities of debt managementinstruments with the longest maturity andwith the preset parameters (including thosearising from the need to minimize the costsin the period between 2001 and 2003)—through an optimal selection of debt man-agement instruments and their structure andissue dates;

– minimization of the service costs to eliminatethe reasons causing fixing of debt interestrates at a level higher than the minimal one,which can be attained on the marketthrough increased liquidity and depth of thesecondary market for treasury securities,increase in the transparency and safety oftrade in debt instruments, and actions aimedat elimination of the technical hindrances inthe trade in treasury securities (fees, settle-ment system, and so forth).


• Limitation of the exchange rate risk and the riskof refinancing in foreign currencies as a result ofthe lowering of the foreign debt share.

• Limitation of the refinancing risk, mainlythrough the rise in the average maturity ofdomestic debt.

• Limitation of the interest rate risk through anincrease in the share of medium- and long-termfixed-rate instruments in total debt.

• Increasing flexibility of debt structure as a resultof the conversion of nonmarketable debt intomarketable instruments.

• Decrease in the debt monetization through anincreased share of the nonbanking sector in totaldebt.

• Optimization of the foreign debt amortizationschedule for years 2004–09.

• Optimization of state budget liquidity manage-ment.

Notes

1. The case study was prepared by the Public DebtDepartment of the Ministry of Finance.

2. See Appendix for a detailed description of the previousobjectives.

3. The models use applications of mathematical program-ming, game theory, and neural networks, among others.

4. The sales of DZ were suspended in 2002.5. The NBP is not included in the sector of public finance.6. www.mofnet.gov.pl.7. Specifically, the auctions are held on the first Wednesday

of every month for 2- and 5-year fixed-rate and zero-couponbonds, the second Wednesday of the even months for 10-yearfloating-rate bonds, and the third Wednesday of the odd monthsfor 10-year fixed-rate bonds.

8. The RTGS system was launched on April 26, 2002.


As a result of Portugal’s entry into the EuropeanEconomic and Monetary Union (EMU), the environ-ment underlying the management of the Portuguesegovernment debt has gone through very importantchanges in the last few years. By adopting the euro asits currency, the country now benefits from both thecredibility of a monetary policy that is defined at thelevel of the European Union (EU) and the fiscal disci-pline that EU members have to comply with.Furthermore, the constraints on government debtmanagement resulting from the execution of the mon-etary policy have been greatly diminished with EUmembership, because Portugal has gained access to amuch larger “domestic” financial market—the eurodebt market. The challenge the country faces with thisnew position is the loss of being the reference issuer ofthe Portuguese escudo and becoming a small borrowerin a large market, where one has to compete withother sovereign issuers for the same base of investors.

In the second half of the 1990s, and in anticipationof these changes, a series of important reforms tookplace that aimed to develop conditions for a more effi-cient management of public debt in this new environ-ment. These reforms included, at the institutional

level, the creation of an autonomous debt agency, theInstituto de Gestão do Credito Publico ([IGCP]Portuguese Government Debt Agency), in 1996; thepublication of a new Public Debt Law approved by par-liament in 1998, and government approval of formalguidelines for debt management in 1999.


Debt management objectives

The strategic objectives to be pursued in governmentdebt management and state financing were madeexplicit by the new Public Debt Law, which states thatthese activities should aim to guarantee the financialresources required for the execution of the state bud-get and be conducted in such a way as to

• minimize the direct and indirect cost of publicdebt in a long-term perspective,

• guarantee a balanced distribution of debt coststhrough the several annual budgets,

179

13Portugal1

• prevent an excessive temporal concentration ofredemptions,

• avoid excessive risks, and• promote an efficient and balanced functioning

of financial markets.

Minimizing the cost of debt was already animplicit objective of debt management before theapproval of the new Public Debt Law. Nevertheless, itsenactment has been an important step in that it hasformalized these objectives, clarifying the issue of theminimization of cost so that it would be pursued in along-term perspective and introducing an explicit ref-erence to risk limitation, that is, how to reduce refi-nancing risk and the volatility of debt cost over time.

The objective of promoting an efficient and bal-anced functioning of the domestic financial marketwas particularly important before the creation of theEMU, in a context where most of the debt was denom-inated in escudos and placed on the domestic market.The relevance of creating and maintaining a bench-mark yield curve to support the escudo capital marketvanished as the escudo was integrated into the euro.

The guidelines for debt management, approvedby the minister of finance in late 1998 and in forcesince 1999, adopted a model for risk managementand translated the strategic objective of minimizingdebt costs into the definition of a benchmark that,since then, has been the reference point for debtmanagement. The risk management approach hasfour basic components:

• adoption of a consistent model for the develop-ment of primary and secondary markets forPortuguese public debt;

• development and implementation of clear debtmanagement guidelines and risk/performanceevaluation (benchmark);

• investment in information technology (IT) sys-tems to support well-informed management deci-sions, reduce operational risk, and increasetransparency by improving availability and qual-ity of all transaction data; and

• development and implementation of a compre-hensive manual of operational procedures toreduce operational risk and support external andinternal auditing.

The scope of debt management activity

Debt management includes the issuing of debt instru-ments, the execution of repo transactions, and thecompletion of other financial transactions with the pur-pose of adjusting the structure of the debt portfolio.

There is no limitation in the Public Debt Law as tothe nature of the financing instruments that can beused for funding. However, concerns about the liquid-ity of the government debt led to a progressive con-centration of the financing activity into the issuance ofa restricted number of standard fixed-rate treasurybonds (obrigações do tesouro [OTs]) and euro commer-cial paper (ECP). The issuance of savings certificates, aretail instrument sold to individuals on a continuousbasis, remains an important funding source.

As a facility of last resort, repo transactions aremade available to market makers. The objective is tosupport the market-making obligations of the pri-mary dealers in the secondary market of the OTs.Repos are provided in a range of amounts for eachsecurity. Taking into account market conditions, theprice is fixed at a rate below the average posted euroovernight interest rate (euro overnight index average[EONIA]).

To adjust the redemption profile of the govern-ment debt, the Public Debt Law includes the earlyredemption and buyback of existing debt and thedirect exchange of securities within the scope ofoperations allowed to debt managers. Since 2001, thispractice has also been used more intensively for thepurpose of promoting liquidity in the treasury bondmarket through the concentration of existing debtinto larger and more liquid issues.

The Public Debt Law also includes within thescope of debt management the trading of derivatives,namely interest rate and currency swaps, forwards,futures, and options. Those transactions must belinked to the underlying instrument in the debt port-folio. Swaps and foreign currency forwards have beenthe instruments most used for this purpose.

Although contingent liabilities are not now takeninto account in debt management decisions, it isplanned to analyze them in the future with a view toincluding them in the risk management framework.The debt agency, IGCP, is responsible only for themanagement of the direct public debt of the central


government, even though it is required to appraisethe financial terms of guaranteed debt and debtissued by (public sector) services and funds withadministrative and financial autonomy.2 Within theministry of finance, the treasury department follows,quantifies, and reports explicit contingent liabilitiesin a systematic way.

For the time being, the scope of the IGCP’s activ-ity does not include the investment of surpluses thatmay exist in the state central cash accounts, which arealso under the responsibility of the treasury depart-ment.3 The permanent exchange of information onpolicies and forecasted treasury flows between thetwo entities is carried out to coordinate funding andsurplus investment effectively.

Legal framework

The main legal framework that regulates the issuanceof central government debt and the management ofpublic debt includes

• the Public Debt Law, which states that statefinancing has to be authorized by parliament;

• the annual Budget Law, which establishes limitsfor the amounts that the government is autho-rized to borrow during the year in terms of netborrowing (The annual Budget Law may alsodefine maximum terms for the debt to be issuedand limits to the currency exposure and to thefloating rate debt.); and

• the decree-law that regulates the activity of theIGCP.

According to the legal framework, the IGCP’sresponsibility is to negotiate and execute all financialtransactions related to the issuing of central govern-ment debt and the management of the debt. Theminister of finance is empowered to define specificguidelines to be followed by the IGCP in the execu-tion of the financing policy.

Permanent guidelines from the minister offinance were formalized through the adoption of along-term benchmark structure for the compositionof the debt portfolio. The benchmark reflectsselected targets concerning the duration, interestrate risk, currency risk, and refinancing risk and sets

the reference for the evaluation of the cost and per-formance of the actual debt portfolio.

The government approves annually, through acouncil of ministers resolution, the debt instrumentsthat should to be used in state financing for the yearand their respective gross borrowing limits. The min-ister of finance annually approves specific guidelinesfor the IGCP. The guidelines include broad lines forthe management of the debt portfolio (e.g., buybackof debt and repo transactions) and the issuing strat-egy in terms of instruments, maturities, timing, andplacement procedures. The guidelines also covermeasures to be implemented regarding the market-ing of the debt and the relationship with the primarydealers and other financial intermediaries. Theseguidelines are made public.

Organization

Previously, two departments inside the ministry offinance were in charge of central government debtmanagement. The treasury department was responsi-ble for the external debt and the issuance of treasurybills, and the public credit department was responsi-ble for domestic debt (excluding treasury bills). Since1997, operational activities associated with centralgovernment debt management, including the servic-ing of the debt, have been centralized in the IGCP.The IGCP is empowered to negotiate and carry outall financial transactions related to the issuing of cen-tral government debt and the active management ofthe debt portfolio, in compliance with the guidelinesapproved by the minister of finance.

The IGCP is organized to allow the flexible use ofits resources, namely with recourse to project teams.The organizational structure comprises the board ofdirectors, two departments, and five technical andfour operational units, with a total staff of 65 people.

The agency is governed by a board of three direc-tors, appointed by the council of ministers for a termof three years. The board reports to the minister offinance. An advisory board, composed of the chair-man of the board of directors, a member of the cen-tral bank’s board of directors, and four experts ineconomic and financial matters, appointed by thecouncil of ministers, provides recommendations onstrategic matters.

Country Case Studies: Portugal 181

The debt management department is responsiblefor all the aspects related to the definition of issuingand portfolio management policies, follow-up of thesecondary market, relationships with the primarydealers and other financial intermediaries, negotia-tion and placement of nonretail debt, and activemanagement of trading. The department comprisestwo units, the trading room and a markets unit.

The operations department is responsible formatters related to the confirmation and settlement ofthe wholesale transactions executed by the tradingroom, debt accounting, and procedures related towithholding tax on the debt interest. The departmentis also responsible for the issuance and amortizationof savings certificates and the debt service of otherretail instruments. The operations department is incharge of the post office, which acts as an agent forthe selling and redemption of savings certificates. Itincludes three operational units, a documentationand settlements unit, a debt accounting and budget-ing unit, and a retail debt unit.

Four other units report directly to the board ofdirectors:

• the financial control unit, which is responsiblefor all aspects related to risk and performanceevaluation, internal control, procedures defini-tion, and internal auditing;

• the research and statistics unit, which produceseconomic analysis, definition of scenarios, andexternal reporting;

• the IT systems unit; and • the administration unit, which is in charge of all

internal matters, including personnel, acquisi-tions, and on-site premises.

A markets committee meets weekly to analyzemarket developments, treasury forecasts, and theposition of the debt portfolio against the benchmarkand define guidelines for the activity during theweek. The committee includes the directors andheads of the debt department, operations depart-ment, financial control unit, research and statisticsunit, trading room, and markets unit.

There has been a strong concern with trans-parency since the IGCP began to operate in 1997. Keyfunctions are now covered by written internal proce-

dures, which include delegation of powers and therole of each unit inside the organizational structure.

A detailed quarterly report is submitted to theminister of finance, which describes all the transac-tions executed during the period and presents thefigures for cost and risk of the debt portfolio relativeto the benchmark. A report describing the activitiescarried out throughout the year and presenting thefinancial accounts of the debt is published annually.

To allow the IGCP to hire and retain qualifiedstaff, some aspects were legally provided for, includinga high degree of administrative and financial auton-omy within an annual budget approved by the minis-ter of finance and the possibility of hiring personnelunder the general labor law, that is, not as civil ser-vants. The guidelines for personnel compensation—approved by the minister of finance—are based onthe need to maintain competence in competition withthe private banking sector. Budgeting was also ade-quate in providing the financial resources necessary toacquire and update the information systems.

Auditing

An audit committee is responsible for following upand controlling the financial management of theIGCP as well as supervising its accounting procedures.The audit committee is composed of a chairman nom-inated by the inspectorate-general of finances and twopermanent members (one being an official charteredaccountant) appointed by the minister of finance.

The audit court (public sector audit body) isresponsible for overseeing the activity of the IGCP, cov-ering the financial accounts of the debt and the com-pliance with the guidelines and limits established byparliament and the government. This audit has beenrecently extended to the internal procedures and to thequarterly report presented to the minister of finance.


Main risk variables

Since the inception of the IGCP, a significant effort wasmade to formulate and, whenever possible, quantifythe types of risk relevant to public debt management.4


The main priority for the IGCP is to guaranteethe fulfillment of Portugal’s yearly borrowing require-ments. To minimize the risk of not being able to meetthis requirement, the focus has been on two keyareas—first, the development of an efficient marketfor the public debt and, second, smoothing theredemption profile of the debt portfolio.

Consequently, a high priority was given to theminimization of refinancing risk5 in spite of the com-fort derived from the depth and liquidity of the eurocapital market. The constraints imposed at this levelare increasingly important, given the market’s con-stant demand for liquid bonds, basically meaninglarge outstanding volumes. The reconciliationbetween these two conflicting requirements has beenpartially achieved by investing both on the efficiencyof the primary and secondary markets (basically try-ing to compensate lack of size with extra efficiency)and on the set-up of other methods of managing theredemption profile (besides issuance), namely buy-back programs. Subject to that, the debt manager hasthe overall objective to minimize the long-term costof debt without incurring any excessive risks. In thiscontext, the IGCP assessed the major risk for a publicdebt manager as being the extent to which the volatil-ity of financial variables affects the budgets’ volatility(through changes in debt-servicing costs), thusreducing the range of maneuvering of the fiscal poli-cymaker. Therefore, in management of the debt, riskis more accurately measured on a cash-flow basis, incontrast to a value-at-risk basis commonly used byasset managers. As a result and like several other pub-lic debt managers, the IGCP is working on the devel-opment and implementation of an integratedbudget-at-risk (BaR) indicator for the debt portfolio.

Until the process to implement the BaR model isfinished and tested, cash-flow risk is measuredthrough a combination of indicators, namely dura-tion, refixing profile,6 and currency exposure.Duration works as a proxy for the degree of cash-flowcost immunization to interest rate movements andhas the advantage of being a standard market mea-sure. To give a more comprehensive picture of totalinterest rate risk, the duration indicator is comple-mented with the refixing profile. Since 1999 and theintroduction of the euro, the foreign exchange risk,measured as the percentage of the portfolio denomi-

nated in foreign currency, has been significantlyreduced, so that now it is almost negligible.

In a pure liability management framework,7 onlythe use of derivatives causes credit risk. Derivatives areused when the desired portfolio structure is impossi-ble to obtain, for whatever reason, through fundingtransactions. The IGCP measures this type of risk withan adapted version of the Bank of Internal Settlement(BIS) model,8 and controls it through tight proce-dures for counter-party approval, including creditscoring, limits attribution, and International SwapDealers Association (ISDA) agreement negotiation.The use of collateral as a means of partially coveringcredit risk has been approved by the minister offinance and was implemented during 2002.

Finally, the IGCP incurs operational risk in itsdebt management activities. This last type of risk isnot measured explicitly, but underlies several policymeasures. It was first addressed when the IGCP wascreated, leading to the choice of an organizationalstructure based on the financial industry standard offront, middle, and back offices with clearly segre-gated functions and responsibilities. The operationalrisk has since been a focus of attention by means ofthree main initiatives: a significant investment in IT(e.g., the purchase of a management information sys-tem), followed by the development of a manual ofinternal operating procedures, and finally investmentin qualified and experienced human resources. Inthe future, these measures will be complementedwith internal auditing, besides the external auditingthat is already done by the audit court.

Management guidelines and benchmarkportfolio

The debt portfolio management mandate given bythe minister of finance to the IGCP was further for-malized in 1998 with the approval of managementguidelines and a reference portfolio in the form of abenchmark.

The management guidelines aim to describe themain types of risks associated with the debt portfolio,specify whether they are measured on an absolute(e.g., refinancing and credit risk) or a relative9 basis(cash-flow risk), and, where appropriate, impose lim-its on the risk variables. The maximum divergence


that the debt portfolio can show relative to the bench-mark for the relevant risk variables (i.e., the maxi-mum level of additional risk the debt manager cantake) is also established in the guidelines.

The main purpose behind the adoption of abenchmark by the IGCP was to have a measurable ref-erence of the long-term target portfolio structure,based on the conviction that this type of guidancewould improve consistency between day-to-day debtmanagement decisions and long-term goals.Furthermore, the fact that the IGCP was created as anindependent entity raised the need for a tool thatallowed an objective evaluation of managementresults (accountability). This influenced the decisionto adopt the benchmark as well for performancemeasurement purposes.

No standard exists for how to establish and followa benchmark for public debt management. TheIGCP’s approach is to create a management instru-ment, which incorporates the governments’ prefer-ence concerning the trade-off between short- andlong-term risks and costs. The benchmark is thereforedeemed to incorporate the long-term objectives of theportfolio owner—that is, the minister of finance, act-ing on behalf of the tax payers in terms of risk profileand expected level of cost—embodied in a financingstrategy and the resulting portfolio structure.

The determination of this benchmark portfoliowas based on a mixed simulation-optimization model,in which the key decision variables were cash-flowcost and risk, with a restriction to address explicitlyrefinancing risk (other risk components were ana-lyzed for every possible solution, but no limits wereimposed on them in the model). A short list was thenmade of the model’s solutions, not only in terms ofefficiency, but also in terms of robustness to themodel’s main assumptions (macroeconomic andinterest rate scenarios).10 The final choice of a solu-tion among the subset of efficient and robust possi-bilities was determined by the conjunction of threefactors:

• The trade-off between cash-flow risk and costs:The shape of the efficient frontier given by themodel showed a clear reduction in cash-flow riskfor portfolio durations of up to 2–2.5 years, justi-fying the increase in expected cost. For durations

longer than 3.5–4 years, the marginal decrease incash-flow risk was low, compared with theexpected increase in cost. This analysis led to thechoice of a first subgroup of possible solutions.

• Comparison of the resulting risk figures (espe-cially interest rate risk) with the equivalent valuesfor other euro-area sovereigns: Consideration ofthe relevant framework in which fiscal policyoperates in Portugal, namely the existence of thestability pact and of a single monetary policy, ledto the conviction that the Portuguese debt port-folio should not take on excessive relative interestrate risks when compared to the other sovereignsin the euro area. A survey done at that time onthe durations of the public debt portfolios inother countries showed durations varyingbetween three and five years. Based on this, it wasthen decided that the benchmark portfolioshould have an expected duration close to thethree-to-four years range.

• Finally, the financing strategy associated witheach possible solution was analyzed, because thefunding strategy associated with the benchmarkportfolio had to be a feasible strategy for a euro-area sovereign issuer.

These factors ended up determining the choiceof the portfolio that should be taken as a benchmarkfor the debt management at the IGCP and associatedfinancing strategy.

Formally, the management guidelines approvedby the minister of finance are divided into five sec-tions, containing

• a list of relevant definitions (of scope andrisk/cost variables),

• the set of authorized instruments and transactions,• limits for the key risk variables (namely refinanc-

ing profile, modified duration, refixing profile,and currency exposure) and reporting require-ments (timing and content),

• composition and dynamics of the benchmarkportfolio, and

• credit risk.

Of these, the first three were published. The the-oretical model behind the definition of the bench-


mark was also published in the IGCP’s Annual Report1999, even though the approved benchmark portfo-lio is not publicly disclosed (neither are the creditrisk guidelines).

To use the benchmark as a fair basis for perfor-mance measurement, conditions that allow a separa-tion of funding and market development decisionsfrom portfolio management decisions must be inplace. For Portugal, this possibility came about in 1999,with the first stage of the EMU. Since then, the eurocapital market became the relevant “domestic” market,in which Portugal is a sufficiently small player for itsderivatives transactions to have no major impact andsubject to no other interpretation from market partic-ipants than pure portfolio management decisions.

In this type of framework, debt managementdecisions performed through the combination offinancing and derivative transactions aim at a certainrelative positioning versus this benchmark, in termsof both interest rate and foreign exchange risk,expected by the debt managers to outperform thebenchmark. However, when the benchmark modelwas first developed and analyzed, it was done with astrong emphasis on the strategic objectives, meaningthat the main purpose of that reference portfolio wasto improve the consistency between the day-to-daymanagement decisions and the long-term portfoliogoals. For reasons of accountability, the IGCPdecided to also propose its use for evaluation pur-poses, and this led naturally to the expectation of out-performance. However, there is no formal orinformal policy statement (from either the ministerof finance or the IGCP) transforming that expecta-tion into a debt management objective, as such.

The benchmarking process in the IGCP had anexperimental year in 1999 and has since been inplace formally. Even though the overall assessment ofits usefulness is positive, it has to be said that it is, ina liability management context, a less straightforwardprocess than asset management, for several reasons.First, not only is it very difficult to quantify all therestrictions and objectives of a sovereign debt man-ager, but also these change in time, which leads toeither the nonduplicability of the benchmark (i.e.the possibility to replicate the benchmark, making itunfair as a performance measurement tool) or to theneed to make frequent changes in the benchmark

itself, a situation that goes against the desired natureof such a tool.

Another specific problem is that, even in a smallplayer–big market situation like Portugal’s in theeuro market, the funding policy adopted by the IGCPhas an influence on the credit spreads of Portuguesegovernment bonds, which, however, is very difficult toquantify. This circumstance makes it even harder toestimate the cost levels associated with different fund-ing policies (e.g., the cost of the benchmark-simu-lated financing strategy), turning the operationalmaintenance of that reference portfolio into a rela-tively complex exercise.

The IGCP is continuously improving the modelfor determining the benchmark portfolio and themethodology for its implementation. However, theproject is still in an early phase, and the benchmarkhas therefore not been made public. In addition, thedisclosure of the benchmark may be negative for thedebt manager, because it may allow the market toanticipate its position. This problem could occurwhen the debt manager is asking for quotes onderivatives, such as interest rate swaps. This is a riskthat should be analyzed carefully, even in the contextof the large euro market. This question will bereassessed during the next revision of the guidelines(including the benchmark), which is scheduled forthe end of 2002.

Finally, a performance benchmark in sovereignliability management should always be taken with ahigh degree of pragmatism and discernment by boththe portfolio manager and the portfolio owner (inthis case, the government).

Management information systems

At the end of 1999, the IGCP bought a standard trea-sury system11 to support its debt management trans-actions. The choice of a user-friendly front, middle,and back office–integrated system12 was made notonly to mitigate operational risk, but also because ofthe conviction that, by increasing the use and shareof information across the IGCP, it would lead to bet-ter data quality. Having one robust database of alldebt transactions was one of the selection process’smain priorities. The system was initially developedand designed for corporations, thus it had a strong


cash-flow focus with a good fit to the risk manage-ment policy at the IGCP.

Moreover, a system was developed to handleretail debt transactions, which are then registeredmonthly in the new treasury system only in aggregateform for position-keeping, accounting, and reportingpurposes.

Operational procedures manual

The implementation of these two systems had a con-siderable impact on the internal processes at the IGCP,increasing the need for the development of a writtenmanual of operating procedures, including the newtools for operational control. This is an ambitious pro-ject, which started in 2001 with aims not only to opti-mize the internal processing circuits at the IGCP, butalso and in that process, to develop a new cultureregarding operational risk matters and associated con-trol procedures (including internal auditing).

Debt Management Strategy andGovernment Securities Markets


Portuguese debt management follows a market-ori-ented funding strategy. It acknowledges the impor-tance of issuing marketable instruments at marketprices and building up a government yield curve withliquid bonds along different maturities. The neweuro environment did not change this target.However, this goal now exists in a different environ-ment. The former role of developing a benchmarkyield curve to support the development of the domes-tic capital market disappeared. Instead, the new com-petitive environment in the euro area has beendriving the funding strategy. A much larger domesticmarket, where the 12 euro countries compete,replaced the protected Portuguese escudo market. Asa consequence, the market participants requirehigher liquidity and more efficient markets.

Liquidity became, in fact, one of the most impor-tant factors behind the spreads displayed by sovereigndebt in the euro area. An outstanding amount of noless than 5 billion is commonly accepted as a first cri-

terion of liquidity. Therefore, the target size forPortuguese treasury bonds was increased to this newthreshold.13 Because of the relatively low level of thePortuguese gross annual borrowing needs, a gradualapproach to achieving this goal has been followed.Since 1999, every year, priority is given, first, to theintroduction of a new 10-year issue and, second, to anew 5-year issue. These two maturities, backed by anefficient derivatives market, reflect the market’s pref-erence. In support of this strategy, most of the fundingthrough marketable instruments has been channeledto the euro-denominated treasury bond market. Toaccelerate this strategy, since 2001, the IGCP has alsobeen relying on an active buyback program aimed atrefinancing old issues (with small outstanding sizesand coupons not in line with current market yields)with on-the-run issues.

Feeding liquidity into the OTs market14 reducedthe variety of instruments used to standard and“plain-vanilla” fixed-rate bonds. The issuance of float-ing-rate bonds has been suspended, and index-linkedsecurities have been ruled out so far. Moreover, in themeantime, the access to the Eurobond market, whichwas regular before 1999, has been excluded. A globalmedium-term notes program, in place since 1994,now plays the role of a safety-net funding alternative,with no new issue placed after September 1999.

Although not always cost-efficient in a short-termperspective, the priority given to the issuance ofmedium- and long-term bonds, putting aside “oppor-tunistic” funding alternatives, is conceived as amedium-term strategy to reduce country vulnerability.Simultaneously, priority has been given to the devel-opment of efficient primary and secondary treasurydebt markets, making use of advanced technical infras-tructures. Foreign and domestic financial intermedi-aries and final investors were all granted equal accessto these markets. This strategy is being rewarded by theincreasingly widespread geographic distribution of theOT in the euro area and by its dispersion between buy-and-hold investors and active traders.

Government securities issuance and primarymarket structure

Credibility is a decisive feature whenever a market-driven funding strategy is followed. Transparency and


predictability are, therefore, important pillars ofPortuguese debt management.

The strategic guidelines are regularly explainedto market participants, financial intermediaries, and,in particular, institutional investors.

At the beginning of the year, the components ofthe annual funding program are publicly announced,with particular emphasis on the issuance of medium-and long-term tradable debt securities. The market isinformed of the estimate of the annual gross borrowingrequirements and the amount to be funded throughthe issuance of Portuguese treasury bonds (OTs). Theamounts to be placed, the maturity and final size of thenew lines, the mechanisms for placing the OT (syndi-cation and auction), and the financial intermediariesto be involved are also announced. A more precise cal-endar is published quarterly. The auctions have beenkept fixed at the second Wednesday of each month,whenever there is room for such a placement.

About 75–80 percent of the gross borrowingrequirements are funded through the placement ofOTs.15 Short-term market instruments and nontrad-able debt (savings certificates), issued on demandfrom private investors, account for the remaining 20percent. The issuance of ECP is a backup alternativesupporting the implementation of the treasury bondprogram.

For liquidity reasons, the initial size of a new trea-sury bond line corresponds to about 40 percent ofthe targeted final amount. Therefore, the IGCP isusing syndication when launching a new OT line.This option aims to achieve better control of the issueprice and, at the same time, further diversify theinvestors’ base. The preference given to the place-ment of the initial tranche through syndication is dueto the belief that it is the most effective way to simul-taneously achieve significant size (more than 10 timesthe indicative amount of auctions held in 1998) andefficient and controlled pricing. Moreover, it helps toachieve a wide and diversified investors’ distribution,particularly within the euro area, and increases thevisibility of the issuer’s name and its debt instruments.

Furthermore, a syndicated structure makes it pos-sible to target specific groups of investors and coun-tries. The IGCP has been closely monitoring thebook-building process in all syndicated issues,demanding the investors’ identity disclosure from the

underwriters. New syndicated structures have beendeveloped, giving increasing importance to the book-building process. More recently, the pot system wasstudied and has been used. In the pot system, allorders are centralized and collected to a single orderbook shared by the joint lead banks in the syndicate,in contrast to traditional syndication, in which thejoint lead banks are managing separate order books.This gives the IGCP possibility of allocating the distri-bution after certain desired targets for the investorbase are reached. The fees to the banks are set inadvance and are not affected by the final distribution.

Only the primary dealers (13 banks) can beinvited to be underwriters of the syndicated issues.This is a privilege that not only rewards their com-mitment to the OT market, but also recognizes thatthey are the financial intermediaries who know bestthe OT base of investors.

After the initial OT tranche is issued throughsyndication, the amount is increased through auc-tions.16 Multiple-price electronic auctions are nor-mally conducted once a month (but not everymonth). In 2000, the technical support for the auc-tions was radically changed. The fax system previouslyused for bidding was replaced by an electronic sys-tem, the Bloomberg Auction System . This systemallows the auction participants to introduce andupdate bids until the cutoff time (strictly controlled)and have faster access to auction results, thus incur-ring fewer risks. The possibility of monitoring thereception of bids in real time enables the issuer toreduce the time needed for a decision on the allot-ment of each auction. Currently, the average timefrom the bid cutoff time to the release of the auctionresults to the participants is less than five minutes.17

The settlement of primary market transactions iscarried out through efficient and internationally rec-ognized central securities depository (Euroclear andClearstream), making the fulfillment of standard set-tlement cycles possible for both domestic and foreigninvestors.

Secondary market for government securities

The development of an efficient primary market fortreasury bonds has to be supported by an efficientsecondary market. In 1999, a special market for pub-


lic debt was created, the MEDIP (the Portugueseacronym for “special market for public debt”), whichwas designed to be a regulated market under theinvestment services directive. To ensure an efficientand competitive environment, an electronic tradingplatform (MTS-Portugal) was chosen, based on theMTS platform.18 After the creation of MEDIP, threesegments coexist in the secondary market:

• the exchange market, whose trading structure ismainly directed at the retail segment and thetrading of small lots (this segment is traded in theEuronext Lisbon), and participants are thosewho have access to this market;

• the over-the-counter market, which should offermaximum flexibility in terms of trading and reg-istration of transactions; and

• MEDIP, which aims to centralize wholesale trad-ing by offering the most efficient conditions forthis type of transaction where the most importantplayers are the primary dealers.

The creation of MEDIP and the adoption of elec-tronic trading were decisions that fostered financialintegration while preserving the national “location”of the wholesale treasury debt market. The setting-upof MEDIP–MTS-Portugal therefore marked animportant and decisive step in the modernization ofthe Portuguese government debt market, a step pro-moting its efficient integration into the euro financialmarket and the vast global market. This step, taken bythe issuer and the primary dealers together, was theculminating point of a strategy that took almost threeyears to unfold. This ongoing dialogue, acknowledg-ing the critical role of the primary dealers in devel-oping the secondary market, was an outstandingfeature of this process, which led to the selection ofthe best electronic trading platform to be used.

As a regulated market, MEDIP’s access and listingconditions, its governing rules, and its code of con-duct are nondiscriminatory and subject to theapproval of the Portuguese Securities MarketCommission. This market aims at wholesale propri-etary trading among specialists. It uses a blind tradingplatform based on the electronic platform MTS-Telemático, managed by MTS-Portugal (which is ajoint-stock company incorporated under Portuguese

law and supervised by the Portuguese SecuritiesMarket Commission).19

The MEDIP market is driven by market-makingobligations, and it settles with Euroclear/Clearstreamand has access to repo trading facilities inEuroMTS/MTS-Italy. Real-time prices are disclosedto nonparticipants on the Reuters wire, and a dailymarket bulletin is published via the Internet. Themarket makers have the obligation to quote firm bidand ask prices for a set of liquid securities accordingto maximum spreads—ranging between 5 and 10basis points, depending of type of security and matu-rity—and minimum lot sizes. The market dealers canonly take prices from market makers. The primarydealers must participate as market makers, and otherparticipants can act either as market makers or mar-ket dealers. Prices formed on MEDIP are used as areference for mark-to-market purposes.

The primary dealers’ strategic role

Portuguese debt management relies on the criticalrole of the primary dealers. The primary dealer sys-tem was introduced in Portugal in 1993, but only in1998 did the role of the primary dealers gain a newstrategic dimension. By then, new selection rules hadbeen defined to limit the participation of each majordomestic banking group to only one institution, thusinducing the development of critical mass on domes-tic operators. Also in 1998, this status was first grantedto nonresident banks. After 1999, the primary dealerswere defined as the principal channel for distributingPortuguese debt, and a network for the regular dis-tribution of debt within the euro area was created.

Primary dealer status is granted for periods coin-ciding with calendar years and may be renewed annu-ally, depending on the fulfillment of several duties.To be granted primary dealer status, a bank has to ful-fill a certain group of obligations vis-à-vis the marketand the issuer,20 namely minimum quotas in the pri-mary and secondary markets have to be attained.Besides being invited to be underwriters of syndi-cated issues, primary dealers are also granted exclu-sive access to noncompetitive auctions.21 Theincreasingly important direct contact between theissuer and final investors is also conducted in cooper-ation with the primary dealers.


Counting on a credible and relatively stable groupof primary dealers, with a recognized distributioncapability (both within the euro area and worldwide)and committed in the long run to the development ofthe Portuguese debt market, the IGCP established anongoing partnership for the continuous distributionof the Portuguese debt and for creating a liquid andefficient wholesale secondary market.

Notes

1. The case study was prepared by Rita Granger, LuciaLeitao, and Vasco Pereira from the Instituto de Gestão do CreditoPublico ([IGCP], Portuguese Government Debt Agency).

2. Above a certain threshold, set yearly.3. The decree-law that created the IGCP recognized the

importance of further integration of treasury management anddebt management. Formal integration is under consideration.

4. For that purpose, all the learning processes associatedwith the modeling of a benchmark portfolio made a critical con-tribution, making that project, as such, a worthwhile investment.

5. For instance, such risk involves not being able to roll overthe maturing debt close to previous market prices or, in theextreme, at any price.

6. The refixing profile indicates, in nominal terms, the per-centage of the portfolio that will either be refixed or have to berefinanced in the future, aggregated in yearly time buckets. Itaims to indicate the sensitivity of cash-flow cost to future changesin interest rates.

7. Not considering the cash management function or the“credit” component of settlement risk.

8. In this model, the credit risk is assessed by calculating thecurrent market value of the contract and then adding a factor toreflect the potential future exposure over the remaining life ofthe contract.

9. Measured as a deviation from the benchmark portfolioequivalent figures.

10. Given the context in which Portuguese debt manage-ment is performed, this reference portfolio was built so as not tohave any net foreign exchange risk.

11. Finance Kit by Trema12. This was done at the loss of a more specialized risk man-

agement software.13. The a5 billion standard corresponds to almost twice the

average size of the treasury bond lines issued before 1999.14. Since 1999, the final size of each new OT line has on

average been twice that of those issued up to that date.15. The features of the OTs have been kept stable, and the

conventions used are in line with the standards of the euro debtmarket.

16. The 1999 auctions were already three times larger thanthe previous ones; in 2000, the average size increased fivefold,

and when compared with 1998 and between 1998 and 2001, theincrease was sixfold.

17. Portuguese OT auctions include a competitive phase (inwhich participation is open to all primary dealers and other auc-tion participants) as well as a noncompetitive phase. Beforeevery quarter, the IGCP releases a calendar of the auctions,although the indicative amount of the auctions is confirmed onlyslightly before it takes place. A predefined day of the monthtends to be used. Each institution can make up to five bids,whose total value may never exceed the amount announced forthe competitive phase of the auction. Participating institutionsare informed of the bids that were accepted and of the overallresults immediately after the close of the auction (on average,two to three minutes after the cutoff time). The overall results ofthe auction are also immediately announced to all market partic-ipants via the IGCP pages in Reuters (IGCP04) and Bloomberg(IGCP). The subscription for the noncompetitive phase of theauction is made at the highest yield accepted in the competitivephase. The maximum amount each primary dealer can subscribein the noncompetitive phase corresponds to the percentage ofits participation in the competitive phase of the previous threebond auctions, considering only the amount placed through pri-mary dealers.

18. The platform became active in July 2000.19. Shareholders in MTS-Portugal are the IGCP, 15 percent;

MTS S.p.A., 15 percent; and primary dealers, 70 percent.20. Duties of primary dealers:• participate actively in bond auctions by bidding and

subscribing a share no less than 2 percent of theamount placed at the competitive phase of the auc-tions;

• participate actively on the secondary market forPortuguese government debt securities, ensuring theliquidity of these instruments;

• participate in the wholesale electronic market(MEDIP–MTS-Portugal) as market maker, maintaininga share not lower than 2 percent of this market’sturnover in the previous two years;

• participate as shareholder in the managing company ofMEDIP–MTS-Portugal; and

• operate as privileged consultant to the issuer in themonitoring of financial markets.

Rights of the primary dealers:• participation in the competitive phase of the bond auc-

tions and exclusive access to the noncompetitive phase;• preference in the formation of syndicates;• access to the facilities created by the IGCP to support

the market, namely the “last resort” repo window facil-ity;

• preferential counterpart in the active management ofthe public debt; and

• privileged hearing in matters of common interest.21. Another group of banks can also have access to the auc-

tions—the other market participants—but they are not allowed toparticipate in the noncompetitive auctions.


After attaining independence in 1991 andthroughout the first half of the 1990s, efforts weredevoted to the reestablishment of Slovenia’s access tointernational financial markets, which involvedSlovenia’s assumption of a share in the external debtof the former Yugoslavia. It also involved a smoothexecution of the process of rehabilitating the bankingsystem and restructuring various enterprises. Giventhe fact that the budget remained in surplus until1997, debt management operations focused on estab-lishing access for borrowing in different financial mar-kets. Borrowing operations started in the domesticmarket through short-term borrowing to manage liq-uidity, continued in 1996 with the first Eurobond issuein the euro market, and, in 1997, with issuance ofinflation-indexed bonds and loans in the domesticmarket.

When relatively small budget deficits emerged, themain objective was to develop a domestic market fordebt, primarily for bonds, to finance the budget andany debt obligations incurred before 1996 in the suc-cession process to the former Socialist FederalRepublic of Yugoslavia and cover programs of real andbanking sector rehabilitation.

Developing the domestic market for debt hasbecome a priority to ensure timely financing in domes-tic currency and reduce macroeconomic risk associ-ated with financing the deficit with external debt. Thistask has been eased recently by the lifting of capitalcontrols and increase of foreign direct investment. Agrowing market capacity for government borrowinghas just recently allowed undertaking of active debtmanagement operations to reduce the overall cost ofthe portfolio. Efforts have also been devoted toenhancing the transparency and tradability of instru-ments, with the aim of deepening and enhancing liq-uidity of the secondary market. Similarly, building up ayield curve to price other instruments in the markethas also been a priority.


Objective

The basic principle underlying debt managementactivities is harmonization of the goals of (a) minimiz-

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14Slovenia1

ing borrowing costs over the long term with a matu-rity structure that ensures a sustainable level of risk inrefinancing the debt and (b) a currency and interestrate structure that minimizes the exposure toexchange rate, interest rate, and other risks.

In 1998, for the first time, an annual program offinancing the central government budget (financingprogram) was adopted, stating the main objectives—both strategic and operational—and targets for debtmanagement. These main guidelines were supportedby the Public Finance Act, which was enacted inOctober 1999.

Strategic objectives include, next to provision ofsufficient and timely financing of the budget, costminimization; maximum reliance on financing in thedomestic market, pending the crowding out or dis-torted effects on the market; broadening both thedomestic and the foreign investors’ base; minimizinginterest rate risk; minimizing foreign currency riskthrough continued increase of euros in the currencystructure of foreign debt; and minimizing the risk ofinflation in the debt in domestic currency by pursu-ing interest rate nominalism.

Operational objectives include determination ofthe short-term versus long-term financing mix consis-tent with a view on the term structure of the portfo-lio; determination of the external/foreign currencyborrowing mix in total borrowing consistent with thestrategy of prioritizing the domestic market; determi-nation of the structure of the instruments, includingthe shares of fixed-rate, variable-rate, and foreign cur-rency–indexed debt consistent with the strategytoward nominalism and cost and risk considerations.

Scope

Debt management encompasses all direct financialobligations of the central government. The annualfinancing program includes the amount to finance,which is determined by the annual budget and is thesum of the deficit and debt repayment obligations inthe given fiscal year. It sets the amounts for bothdomestic and foreign currency borrowings, which arecoordinated within the program. The choice of mar-ket is given in the form of minimal domestic andmaximum foreign borrowing amounts and as maxi-mum short-term and minimal long-term financing.

The public debt management department(PDMD) within the ministry of finance (MoF) alsoexercises central administrative and control functionsover debt of public sector entities, whose debt repre-sents contingent liabilities of the central governmentand issuance of government guarantees.


There is a clear legal, regulatory, and actual separa-tion of debt management and monetary policy objec-tives and accountabilities. The Bank of Slovenia(BOS), the central bank, is an independent institu-tion and not a part of the executive government. Thegovernment is legally banned from borrowing fromthe BOS, which, however, manages the foreign cur-rency reserves and is the government’s paying agentfor foreign currency payments, the depositary for for-eign currency cash deposits, and, together with com-mercial banks, a depositary for domestic currencydeposits.

On completion of the proposal of the annualfinancing program, it is discussed within the scope offiscal policy documents and also shown to the BOSfor (nonbinding) commentary and suggestions. Thecoordination takes place within the framework of amedium-term fiscal scenario.

The MoF and the BOS also discuss general li-quidity conditions in the economy at the time ofpreparation of the annual financing program. Debtmanagers share information on the government’scurrent and future financing requirements as well astheir dynamics during the year. The MoF informs theBOS of borrowing intentions in advance, whereuponthe BoS provides information on market conditions.

There are regular meetings of MoF and centralbank officials to discuss, without formal arrange-ments, the technical scope of their respective poli-cies’ execution.

According to a formal agreement between theMoF and the BOS, the former provides two types ofmonthly forecasts. The first, for three months inadvance, consists of day-by-day cash flows of all rev-enues and expenditures for all items to be received orpaid by the government. The second forecast pro-vides the same information one month in advance,but the information is updated and thus more accu-

Country Case Studies: Slovenia 191

rate. The three-month forecast provides an indica-tion of future developments in the government’saccount movements, and the second forecast con-tains updated and reviewed information.

Within the MoF, a committee on liquidity meetsweekly, monitoring monthly liquidity situations anddetermining necessary activity versus financing andversus budget expenditure management. Budget, taxand customs, debt management, and liquidity man-agement departments are permanent members ofthe committee. The MoF notifies the central bankabout budget liquidity projections and monthlychanges, and the BOS provides the MoF with neces-sary information on market liquidity conditions.


The financing program’s objectives and accomplish-ments are regularly announced. The format ofreports contains a separation of objectives and, forevery objective where possible, statements of devel-opment. Documents are available to the financialcommunity, as well as to the general public. Theobjectives and instruments of the debt managementpolicy are made public through the annual financingprogram and other policy documents, including themacroeconomic and fiscal scenarios. These docu-ments are permanently available on the MoF’s website (http://www.sigov.si/mf/angl/apredmf1.html)and other government web sites. The public financebulletin is also permanently available on the MoF website and is updated monthly. It includes data on gen-eral and central government finance accounts, gov-ernment debt, and outstanding guarantees.

The annual report on debt management is madepublic once the government has accepted it. Thereport includes information pertaining to the execu-tion of strategic objectives of debt management; adescription of the debt instruments issued and costswith a cost analysis; an analysis of developments of thecentral government debt portfolio and dynamics;information on general government and public debtand debt with central government guarantees; data ondebt stock, flows, and instruments; and a brief inter-national comparison of debt. In the form of a publicfinance bulletin, the MoF also publishes monthlyinformation on the structure of the debt portfolio.

Slovenia has a practice of enacting budgets forthe current year and the following year and releasinga midterm fiscal strategy paper to parliament and thegeneral public. The amount of debt and debt-servic-ing projections are regular parts of policy papers.Monthly, the BOS reports a service schedule for totalexternal debt.

The domestic market provides transparency ofoperations through a choice of standardized instru-ments, which are offered in a calendar of issuance ofbonds and bills supported by publicly accessible auc-tion results. Auction results are displayed on the MoFweb site. Issues are quoted on the Ljubljana StockExchange. Quotes on treasury bills that are tradedover the counter (OTC) are available through mar-ket makers. Further efforts to reduce the uncertaintyof players in the domestic market are being madethrough contacts with all the important investors inthe domestic financial market. To stabilize anddeepen the market for government securities, trans-parency in domestic issuance is a strategic objective.

The MoF is striving to maintain the awareness ofthe international investment community by makingavailable the maximum rating information on bondsand through contacts with the investment communitywithin the scope of its resources. Transparency,accountability, and reliability in debt issues, as well asmarket approach, have been the prime policy objec-tives of Slovenia since the start of the dissolution ofthe former Socialist Federal Republic of Yugoslavia.

The tax treatment of public securities is clearlydisclosed in the prospectus of each of the securities,which, besides being available to investors, are beingpublicly disseminated.

Debt management activities are audited annuallyby the court of accounts, an independent auditinginstitution that audits the government and public sec-tor entities. Audit reviews of financing are made pub-lic through parliamentary procedure as part of theregular budget audit. Audit of the budget is legallyrequired for parliament to approve the annual gov-ernment budget execution report.

Legal framework

The legal basis for government borrowing andissuance of guarantees is based on Article 149 of the


Slovenian Constitution, which states, “The state shallonly be permitted to borrow monies or to guaranteecredit on such conditions as are determined by law.”

The framework for central government borrow-ing is determined by the Public Finance Act,2 whichsets out the basis for

• a definition of central government borrowingand liquidity borrowing,

• the method of determining the ceilings on itsborrowing,

• the elements of debt management,• the documents underlying the execution of bor-

rowing transactions or programs, and• The rules on borrowing by local governments,

extrabudgetary funds, and public sector entities.

The annual Budget Execution Law displays nom-inal ceilings (quotas) for borrowing and issuance ofguarantees by the central government and borrowingby public entities.

Once the annual Budget Execution Law isadopted, the government approves the annualfinancing program submitted by the MoF, in whichmajor policy guidelines and borrowing strategy arestated. This includes objectives, operations, choice ofinstruments, dynamics, and market choices. If thereis any serious digression from the anticipated marketmovements or other unexpected events, the programcan be amended by the same procedure establishedfor the financing program. In preparing the pro-gram, which includes the dynamics of borrowing,consideration is given to currency structure anddomestic market capacity, where the goal is to fundthe bulk of the borrowing requirement domesticallyand develop the domestic market to minimizemacroeconomic risk and risk of funding. The financ-ing program also aims toward monetary neutralitywhile optimizing currency risk.

The policy guidelines, included in annual financ-ing programs, have evolved with time from being adocument that identified only the type of instrumentand dynamics of borrowing, to a more strategic doc-ument that states and blends policy goals and policyactions. This development is explained to a greatextent by the fact that the existing legal frameworkgoverning debt management operations does not

specify the debt management policy objectives.Therefore, the yearly borrowing program currentlyaims at filling the legal vacuum and avoiding unde-sirable trade-offs between cost and risks. However,given the time span of the financial program (oneyear), only consistent policy actions can ensure thatthe cost dimension gets preeminence over riskdimension and an appropriate mix is preserved.

Institutional framework and internalorganization

According to the Public Finance Act, the MoF isexclusively responsible for the areas of borrowing anddebt management for the central government.

For debt management, the organizational frame-work is determined within a government decree thatstates functions, responsibilities, departmental orga-nization, and description of basic tasks for every cen-tral government employee. Within the MoF, there arethree departments responsible for contracting ormanaging debt or both:

• The international department is responsible forborrowing from international financial institu-tions (such as the World Bank, EuropeanInvestment Bank, and the European Bank forReconstruction and Development). The impor-tance of this source of financing is diminishingsteadily and in 2002 represent about 1.5 percentof total financing.

• The liquidity management department is respon-sible for contracting and managing short-termdomestic debt and cash management.

• The PDMD is responsible for executing theannual borrowing program and managing centralgovernment debt (long-term domestic and for-eign debt). The PDMD also provides back officefunctions with record-keeping and paymentinstructions. Another task is to maintain debtstatistics and provide long-term and short-termprojections on debt service for budgetary and liq-uidity management uses. The PDMD preparesregular debt reports and reports on the executionof the borrowing program (financing program).Moreover, the PDMD and liquidity managementdepartment maintain MoF Internet information


on their respective portions of debt and debtinstruments, and the PDMD maintains contactsand provides data in regular format to ratingagencies. It also cooperates with these agenciesand receives their reports. Finally, the PDMD is incharge of approving and monitoring all publicsector borrowing and government guaranteesentered into by the minister of finance.

The PDMD is organized into different units withdistinct functions and accountabilities, as well as sep-arate reporting lines. The front office is responsiblefor executing transactions in financial markets,including the management of auctions and otherforms of borrowing, and all other funding opera-tions. The back office handles the settlement of trans-actions and the maintenance of the financial records.A separate middle, or risk management, office hasbeen established to undertake risk analysis and mon-itor and report on portfolio-related risks, as well asassess the performance of debt managers againststrategic benchmarks, but it is not yet in operation. Astatistics unit provides reporting service and neces-sary projections, including debt management–related, short-term liquidity projections and projec-tions for budget preparation, and manages the debtdatabase used by the back office for both settlementand maintenance of debt items records. The liquiditymanagement department is organized into two units,the budget liquidity forecasting unit and the moneymarket unit. The department executes issuance andrepayment of treasury bills and other short-terminstruments and keeps records on them.

Internally, the PDMD management is carried outalong instrument lines in both the debt management(front office) and the transaction management unit(back office). The lines are domestic bonds, foreignbonds, domestic loans, foreign loans, and issuing ofguarantees. Except for guarantees, where there is fre-quent cooperation with line ministries, cooperationoperates in the department from front office to backoffice to statistics and analysis.

Coordination and information sharing betweendebt management departments and other depart-ments within the MoF take place in various forms: inthe formal and internal (committees) organization ofthe MoF and through common work, organized by

project, on establishing and upgrading information,budget execution, debt management, and account-ing software systems. Connection with budget prepa-ration follows the budget preparation schedule.Connection to general accounting is permanent andis based on a generic software application connectingaccounting with budget execution and budget users.Also, the software provides a basis for monitoring thebudget execution with respect to further budgetplanning.

Within the ministry, the PDMD and the liquiditymanagement, budget execution, and taxation andcustoms departments of the MoF survey the short-term (monthly) liquidity situation every week anddecide on precise liquidity management tactics. Inmonthly meetings, these departments analyze thethree-month projections and possible developmentsand propose necessary action(s).

The current division and organization of workare based on the historical development and growthof the MoF. Despite the fact that borrowing functionsare located in three units of the MoF, there is a rea-sonable degree of coordination among them andtheir mandates are fairly clear. Nevertheless, a draw-back of the current institutional arrangement is theabsence of a centralized decision-making authority,which to some extent encumbers the process of debtplanning, the process of debt management, andimplementation of the operations necessary for debtmanagement.

Establishment of a separate debt managementagency to take over all central government debt man-agement is being contemplated, and the MoF isstudying the suitability of setting up an independentagency or an office within the ministry to managepublic debt with the following goals:

• centralization of borrowing and debt manage-ment operations;

• increase in responsibility for the execution ofoperations;

• establishment of a clear and measurable debtmanagement goal, which would become the basisfor the delegation of competencies and responsi-bilities;

• isolation of the debt management function frompolitical and other institutions’ interference;


• simplification of procedures for the provision ofmodern information technologies and humanresources with specific knowledge necessary for aprogressive stage of debt management and mini-mizing the operational risk; and increased flexi-bility of the agency to ensure a response tochanges in the market and market participants.

There is no formal coordination with the BOS.The MoF has observer status with the BOS board. Onthe department (technical) level, both the debt andliquidity management functions hold regular work-ing meetings with appropriate central bank offi-cials—ideally, meetings are held monthly.

Information systems

In Slovenia, the MoF has since 1995 been developinga custom-made database for debt. At present, thebase provides for a safe and reliable debt service andis an accurate tool for registering and managing debtitems and a solid basis for statistics and organizationof data for analysis. The initial building-up of thedatabase has been cosponsored by the World Bank.Plans for upgrading the base—with cash-flow genera-tion, a projections engine, and capabilities for port-folio simulation—are progressing relatively slowly,mainly because of funding constraints. The databasewill be fully integrated into the government’s systemof budget execution and accounting system.

Electronic data preservation is supported by stor-age of hard-copy legal and accounting documenta-tion. The computer system is running a continuousbackup procedure. CD storage of documents, as wellas data, has been made possible and is in partial use.The system has been under scrutiny at every due dili-gence proceeding for issuance of internationalbonds. Operations of the back office are separatefrom those of the front office, and a fixed internalprocedure is in place for document delivery on busi-ness items.

Staff

Within the framework of the general administrationstaff and salary policies and regulations, the MoFand the department are trying to alleviate the prob-

lem of low salary incentive mainly through the extraappeal of functional education available on-site forsenior staff. In addition, there are a promotionalvalue for a debt management professional, an activepolicy of and support to postgraduate educationthrough a time-off allowance, and, in most cases,payment of tuition fees. The MoF and the depart-ment are also doing their best to provide case-spe-cific education through domestic and internationalseminars, workshops, and similar events. In 2001,participation of the PDMD staff in off-site educa-tional activities was 84 days, or about 30 percentabove the average of the MoF, which is not incon-siderable when taking into account an ongoingtechnical training for the European Union (EU)accession process. We are also working toward devel-opment of professional responsibility in junior staffthrough a mentor system. Nevertheless, theturnover of trained staff, specifically the front officestaff, presents a permanent operational and, aboveall, development deterrent.

Staff involved in debt management is subject to ageneral government employees’ code of conduct,which includes conflict-of-interest rules. These arefurther detailed for MoF employees in internal ruleson specific conditions applicable to activities of MoFemployees. These detail the rules for management ofemployees’ personal financial affairs. Within thedepartment, an unwritten code of conduct applicablefor contacts with financial organizations and media ispracticed.

Assessment and Management of Costand Risk

The bulk of central government debt in Slovenia isthe result of the assumption of a share in the externaldebt of the former Yugoslavia, bank rehabilitation,and enterprise restructuring operations. Autono-mous growth of debt as a result of indexation of theprincipal is the second most important factor under-lying growth, followed by the exchange rate changesand the budget deficit financing, contributing theleast to the growth of debt.

Concerning external debt, early recognition ofsovereign succession obligations by the government


allowed reestablishment of the country’s access to inter-national capital markets and the possibility of manag-ing and reducing the risks embedded in the externaldebt portfolio. Reestablishing links with internationalfinancial markets was critical in ensuring a normalfunctioning of the economy (i.e., trade financing andaccess of the private sector to international credit).

External debt operations were targeted torestructure the assumed and nonmarketable, expen-sive debt by issuance of long-term securities (10years) denominated in euros, the eventual domesticcurrency of Slovenia after joining the EuropeanMonetary Union. These operations were aimed pri-marily at reducing the refinancing risk of total debtprofile (public and private sector debt) and the riskof a possible balance of payments crisis. They alsoaimed at setting a benchmark for Slovenian borrow-ers in international market(s).

On the internal side, most of the initially issueddebt was bond issues linked to bank rehabilitationand enterprise restructuring. The governmentadministratively issued inflation- and foreign cur-rency–indexed bonds with a maturity schedule rang-ing from 5 to 22 years. This strategy, which reducedthe refinancing risk and resort to foreign borrowing,took into account the evolving conditions of the smallinternal financial market.

Debt management strategies

Respecting the size of financing set by the annualbudget, the basic principle underlying the debt man-agement activities is harmonization of the goals of (a)minimizing borrowing costs over the long term with amaturity structure that ensures a sustainable level ofrisk of refinancing the debt and (b) a currency andinterest rate structure that minimizes the exposure toexchange rate, interest rate, and other risks.

In deciding on annual financing programs, theMoF takes into account minimizing the rollover riskas well as the optimization of market risk, giving con-sideration to the desired foreign exchange neutralityof borrowing. In foreign borrowing, the MoF is striv-ing to establish a high degree of market presence anda broadening of investor base, primarily through theEuromarket, which has the deepest knowledge ofSlovenia as issuer and socioeconomic entity. At the

same time, with two-thirds of Slovenia’s foreign tradein Europe, and with the euro becoming Slovenia’sprospective currency, it is the most exchangerisk–neutral market.

In deciding where to borrow, the main consider-ation has been to give priority to the domestic marketwithout disrupting market conditions and crowdingout the private sector. External borrowing has alsobeen restricted, to the maximum possible degree, tothe rollover of foreign debt and payments of interestin foreign currency.

The risks inherent in the government’s debt struc-ture are always being carefully monitored and evalu-ated. Organizational and legal steps are being taken,in line with the development of the Slovenian legaland economic system in the transition to the EU, toeliminate or hedge different risks. The MoF is contin-uously moving toward a degree of standardization ofdomestic issues that will provide the market with nec-essary supply. Currently, it is running a series of 3- and5-year variable bonds in Slovenian tolars (where theinflation is the variable part of variable interest rate)and 10-year euro-denominated bonds, as well as 3-, 6-,and 12-month nominal fixed-rate treasury bills in aproportion agreed to by the annual financing pro-gram and under a fixed auction calendar, thus addingtransparency and predictability to the supply. In 2002,the MoF started issuing 15-year euro-denominatedbonds and 3-year tolar-denominated bonds with anominal fixed rate to replace the present 3-year vari-able issue. In both the foreign and domestic markets,the MoF is using the reopening device when appro-priate for benchmark or cost purposes or both.

Domestic financial capacity has been constrainedby the limited depth of the financial market and,until recently, by capital controls (gradually liftedbetween1999 and January 1, 2002). Portfolio inflowswere subject to prohibitive costs, which applied tolong- and short-term securities without exception.Thus, capital controls limited foreign investors’ par-ticipation in the government securities market. It iswithin these limits that operations were aimed atfinancing the borrowing requirement without resort-ing to a significant increase in external debt andmonetization, which could have hampered the cen-tral bank’s meeting its monetary targets (M1 until1997, and then from thereon, M3). In 2002, the cen-


tral bank began following a “two-pillar” approach toconducting monetary policy. The first pillar stillemphasizes control of broad money and its compo-nents, and the second pillar includes various real andfinancial indicators, both domestic and external.

Nonmarket financing channels are being usedfor a smaller portion of the short-term borrowing; thelegal arrangement allows the MoF to request publicinstitutions to place their cash surpluses, at marketrates at a given time, at government disposal throughaccepting promissory notes, rather than the generalmarket. Borrowing from the BOS is not permitted.

The MoF prepares annual, quarterly, monthly,and weekly liquidity forecasts. Liquidity managers anddebt managers form, with the budget execution andtaxation department representatives, a permanentworking body in the ministry, a committee on liquid-ity that monitors the constantly adjusted forecasts anddecides on appropriate actions. In constant consulta-tion with the IMF resident adviser, the MoF is improv-ing its liquidity and budget management technologiesand its revenues and expenditure forecasting.

The MoF policy is to provide a steady supply oflong-term and, in proportion, short-term paper, butthere is no requirement anywhere in financial, fiscal,or other regulations for buying or holding govern-ment paper.

The main risks in the debt portfolio

In the past, the share of external debt has grownslowly but constantly. This is primarily due to the factthat in the succession process, Slovenia assumed partof the debt of the former Yugoslavia, whose structure(in terms of currency, maturity, and interest rate) hadno influence over debt expansion. However, the ratioalso increased because of the limited size of thedomestic financial market, which until 2002 did notoffer the possibility of budget deficit financing andrefinancing the repayment of principal in tolars infull by borrowing in the domestic financial market.

Within the structure of instruments, there hasbeen a steady increase in the share of securities and adrop in the share of loans. The share of debt to for-eign governments and international organizations isalso declining, but debt to commercial banks andother creditors is rising. Both of these steady trends

derive from a change in the strategy and conditionsof financing. These tend to result from the fact that,since 1996–97, Slovenia has been financing itself pri-marily in financial markets by use of market mecha-nisms and instruments.

The structure of the debt is predominantly longterm. By the end of 2000, the long-term debt repre-sented 95.5 percent (term-at-issue) and 91.7 percent(term-to-maturity) of total debt. The structure isshowing a low exposure to refinancing risk, butdomestic short-term debt is growing rapidly.

The main focus of attention is market risk. Inparticular, this means the reduction of volatility ofdebt service in domestic currency and reduction ofthe effect of indexation in debt stock dynamics. Theaim and the policy have been to gradually shift thecomposition of the debt portfolio from inflation-indexed debt (by ceasing to issue such debt from2000 onward) and foreign currency–indexed debt tonominal instruments. A gradual strategy involvingintroduction of fixed-rate debt instruments and shift-ing foreign currency debt to the currency with lessvolatility (the euro) has taken place.

Most of the risk in the internal portfolio is due tothe predominance of debt instruments whose cost indomestic currency varies. The most risky instrumentsare those indexed to inflation. Because of the highvolatility of inflation and its relatively high, single-digit level, they have substantially influenced debtincrease.

In the structure of interest rates and types ofinstruments, there has been a clear trend, since 1997in particular, toward a fall in the share of index-linked instruments, as well as growth in the share ofinstruments with a fixed interest rate. The currencystructure reveals rapid growth in the share of theeuro against a rapid fall in the share of the U.S. dol-lar. The trends revealed in movements in the struc-ture of debt are primarily a consequence ofimplementation of the strategic orientations andgoals in borrowing and debt management, and it isexpected that they will continue in the future.

Risk analysis undertaken to develop the strategy

The MoF relies on a comprehensive definition of cost,which is the basis upon which risk is measured. Cost is


measured as the present value of debt service (princi-pal and interest) valued in domestic currency. Risk ismeasured by the difference between the present valueof the baseline scenario and alternate present valuescenarios based on possible different behavior ofunderlying variables affecting debt service.

The ministry relies on periodic assessment of riskbased on the impact of changes of exogenous vari-ables on the debt portfolio’s structure and cost. Thecost of instruments—with the exception of treasurybills, which are short-term fixed instruments—depends on the evolution of different price variables(inflation, interest rate, or exchange rate).Therefore, the analysis of past and future evolutionof different prices and its impact on the debt portfo-lio structure and cost is important to assess the expo-sure of the portfolio. The MoF relies on its ownforecast and on external forecasts of main price vari-ables and interest rates.

Market risk and refinancing risk are periodicallyquantified. The elasticity of the cost of the portfoliowith regard to changes in various variables is calcu-lated and serves as an input in executing the annualborrowing strategy to reduce market risk. Similarly,various issuing strategies are evaluated against thedesired maturity profile in both the domestic andinternational markets. Buybacks are also part of theoperations executed to reduce market risk andachieve the desired maturity profile. These opera-tions are discretional and can be executed through-out the year. Debt sustainability analysis is carried out,as well as assessment of the impact of external debtservice on current account sustainability.

The evolution of the borrowing requirement andthe maturity profile in a dynamic setting (taking intoaccount redemption and new issuance strategies) isimportant for the assessment of medium-term cost,refinancing risk, and strategy for instrumentissuance. Currently, the existing software does notallow for sophisticated statistical and simulation tech-niques. The analysis consists mainly of simple sce-nario analysis. The MoF is in the process ofupgrading the database applications for assessingrisk. Currently, it relies on simple models on spread-sheets.

Assessments of domestic market capacity and itsevolution and of international market access are also

a critical part in determining cost and risk of thefinancing program.

Operational risk is not assessed, but it is takeninto account as part of the ongoing process of aimingto avoid errors or failures in the various stages of exe-cuting and recording transactions. Efforts to reduceoperational risk are being done through legal unifi-cation of responsibilities in budget execution andregulation of procedures. Responsibility for debtmanagement within the PDMD is separated intofront and back offices, with distinct functions andaccountabilities and separate reporting lines.

Benchmarks for domestic debt

Currently, there are no performance benchmarks.The MoF does not have an explicit benchmark port-folio with targets. However, long-term policy actionsfollow policy guidelines targeted toward achieving aportfolio composition that ensures low cost and lim-its risks. The annual financing program sets theactions in conformity with long-term goals, and theannual debt report discusses whether the result ofpolicy actions was consistent.

Active debt management strategies

Buyback operations and execution of call options arepart of MoF operations to reduce debt-service cost.Until 2002, buyback operations have been conductedmainly in international markets, because the rela-tively small actions of the MoF did not disturb marketconditions there. In the domestic market, the maininstrument has been the execution of call options,taking into account the overall borrowing capacity ofthe MoF. Buybacks were not executed in the domes-tic market, given its relatively modest stage of devel-opment. The law strictly regulates active debtmanagement operations. There are criteria for theirexecution, which include evidencing of cost savingsor improvements in the debt portfolio structure with-out increases in the amount of debt outstanding.


Explicit contingent liabilities are monitored in thesame framework as the central debt. They can be


incurred only on the basis of law; the entities thatwould incur them (e.g., borrowing with governmentguarantee) are monitored throughout the process bythe MoF.

The guarantees that are forecasted to be exe-cuted (because of liquidation, bankruptcy, and soforth of beneficiaries) are a matter of definite bud-getary provisioning, and a set of recovery proceduresis in place. Consistent use of short-term rollover pro-jections prevents occurrence of large unpaid liabili-ties at any point in the system.

Development of the market for private sectordebt

The MoF is aware of the importance of the govern-ment securities and a benchmark yield curve as thebasic reference for pricing private sector debt. In theinternational market, continued effort is placed onexpanding the investor base and keeping a represen-tative yield curve for enhancing the access of domes-tic investors to those markets, with a clear pricereference available for pricing of their transactions.In the domestic market, to build a domestic yieldcurve, the target has been shifting from issuance ofindexed debt to fixed-rate instruments. The processhas been gradual. It consisted first of introducingvariable instruments as an intermediate step towardfixed-rate instruments, standardizing maturities, andintroducing short-term fixed-rate instruments. Thenext step consists of issuing long-term fixed-rateinstruments and extending their maturities. A 10-yeareuro-denominated bond is issued in the domesticmarket and will be followed by a 15-year, euro-denom-inated bond, which helps to price other long-terminstruments.


Slovenia’s government securities market is framedon the background of a hyperinflationary environ-ment inherited from the former Yugoslavia and astrong policy stance until 1997, where the budgetwas either balanced or in surplus. As a consequenceof the hyperinflation scenario inherited from the

former Yugoslavia, all financial contracts in theeconomy were indexed to inflation, the indexexpressed as the basic interest rate (the average ofthe last three months of inflation and, later, the last12 months) calculated by the BOS. Only in 1998 didtreasury bills with maturities of 6 and 12 monthsappear as the first nominal instruments denomi-nated in domestic currency. Issuance of treasurybills before 1997 was only sporadic because of therelatively comfortable fiscal position. The bulk ofdomestic debt corresponds to the bank rehabilita-tion and enterprise restructuring that followed inde-pendence in 1991. The instruments issued for thesepurposes were inflation-indexed bonds or foreigncurrency–indexed bonds with different maturities.These instruments were issued administratively (notin the market) and were the only long-term instru-ments available until 1997.

In 1997, as the budget deficit emerged, inflation-indexed bonds started to be issued sporadically with-out a preannounced calendar. Sporadic issuance ofindexed bonds continued in 1998 and 1999 withoutstandardized maturities. Since 2000, bonds have beenregularly issued according to a preannounced calen-dar. Maturities were standardized as 3- and 5-year vari-able-rate bonds (where indexation is the variable partof variable interest rate) as part of the strategy tomove toward introduction of fixed-rate instrumentsdenominated in domestic currency, and a 10-yearfixed-rate foreign currency–denominated bond. Thebonds aimed at spreading the stock of debt across theyield curve to minimize rollover risk. Different inter-est calculation formulas used earlier were unified toenhance secondary trading and transparency.Enhancement of the market structure—includingimprovements in the auction mechanism, standard-ization and issuance of simple instruments, andannouncement and calendar of funding needs—con-tributes to developing the market and helps tobroaden the investor base.

The 10- and 15-year bonds were introduced tosatisfy the demand of institutional investors. They aredenominated in foreign currency and payable indomestic currency as an intermediate step towardnominal rates. In the event Slovenia becomes an EUcountry, the euro-denominated bonds will be repaidin euros.


In 2002, the MoF issued, for the first time, athree-year fixed-rate bond denominated in domesticcurrency, and the ministry will gradually shift othermaturities to fixed-rate instruments. The shift tofixed-rate instruments not only aims at reducing mar-ket risk, but also at developing an identifiable yieldcurve and enhancement of trading. The MoF alsobelieves that a liquid secondary market in govern-ment securities can be built only by means of fixed-rate instruments. When investors buy variable orinflation-indexed instruments, they are hedgedagainst inflation risk, which deters trading of infla-tionary expectations. Inflation-indexed bonds are theleast traded instrument in the secondary market.

The MoF reopens on-the-run issues several timesduring the year, according to a preannounced calen-dar, until it reaches a desired level (benchmark). TheMoF has resorted to such a technique because of lim-ited subscription in a single auction.

The issuance of treasury bills also became sys-tematic in 1998. First, a three-month bill was intro-duced in May 1998, then a 6-month bill in October1999, and a one-year bill in May 2000. These bills aimat establishing a flexible and cost-effective source ofshort-term borrowing to finance liquidity shortages,and they have contributed decisively to the movetoward nominal rates in the economy and creation ofa money market yield curve.

The MoF and the BOS issue their respectiveinstruments. The MoF issues treasury bills and bonds,and the central bank issues its central bank bills. TheMoF issues securities through an auction mechanismand accepts the market price, and the BOS, by meansof a tap and recently through the use of auctions.There is no conflict in issuing different instrumentsand pricing them differently. However, there mightbe competition of securities in the secondary market.

Auctions

Securities are issued through auctions. Bonds areissued by means of a multiple-price auction, and trea-sury bills, through a fixed-price auction. Auctions are,in legal form, public auctions. The MoF executes theauctions.

For short-term paper, all sectors except the BOScan participate. All participants bid through primary

dealers, the commercial banks that are registeredsecurity dealers.

In auctions of long-term paper, banks, securitiesdealers and other firms, and funds, including publicand government agencies—all sectors except thecentral bank—can participate; interested entitiesthat possess adequate technical and other means canparticipate in the auctions directly by agreementwith the MoF (the PDMD). Other market partici-pants, including households, participate throughthose commercial banks that are registered securitiesdealers.

Secondary market

To develop an efficient secondary market of govern-ment securities, the first task has been to provideinstruments that can be easily marketable and willhave simple features and clearly identifiable cashflow. To achieve this goal, the MoF is implementing astrategy toward nominalization of the main borrow-ing instruments. This includes the introduction oftreasury bills with different maturities and a shiftfrom inflation-indexed instruments, first, toward vari-able-rate instruments and, then, to fixed-rate instru-ments. Changing to variable-rate bonds also involveda gradual simplification of bond formulas in an effortto avoid disrupting the market. This development hasalso fostered similar development in the productsoffered by the domestic banking system.

In Slovenia, the central bank conducts open mar-ket operations exclusively with central bank bills,which can deter secondary trading of governmentsecurities. However, the BOS had a catalytic role incontributing to establishment of OTC trading inshort-term government securities in November 2001.In particular, the BOS designed its regulatory frame-work. OTC transactions in government bonds alsostarted recently, in August 2001, and activity hasincreased steadily in both types of instruments. TheBOS is also contributing to the design of the regula-tory framework for repo operations with short-termgovernment securities in the OTC market. The rapidincrease in OTC transactions is due to lower costsresulting from the absence of brokerage fees and lowcommissions charged by the Depository andSettlement Company.


Keeping access to domestic and internationalfinancial markets

To keep access to domestic and international finan-cial markets, the MoF maintains frequent contactwith investors and monitors financial markets’ devel-opments and investors’ preferences. There has alsobeen a strategy to issue debt instruments with stan-dard maturities and, within the limits of borrowingneeds, a size that enhances investors’ appetite. In theinternational market, the PDMD has aimed at estab-lishing a yield curve, which helps to price transac-tions. The PDMD strives to establish a size thatensures a certain degree of liquidity for investors butat the same time does not represent a refinancing riskfor the portfolio. In the domestic market, investorsare informed in advance about the issuing plans, toavoid any surprises or advantage. The PDMD aims atbeing reliable in its strategy and pricing of transac-tions. The investors’ preference for particular instru-ments is also taken into account in preparation of theannual financing program.


Slovenia uses an electronic system to settle and clearall security transactions occurring on the LjubljanaStock Exchange. All trades conducted on thatexchange are automatically transmitted to the

Depository and Settlement Company, a clearing andsettlement corporation. Settlement is T+2 on a deliv-ery-versus-payment basis. Depository and SettlementCompany rules comply with the Group of 30 interna-tional standards and all nine recommended actionsin 1989 for clearing houses. Compliance with theCPSS-IOSCO recommendations adopted inNovember 2001 is under assessment.

Taxation

Interest income and capital gains from governmentsecurities is at present taxed under the broad cate-gory of corporate income tax. Interest income fromgovernment securities is tax exempt for personalincome tax purposes. Any profit arising from appre-ciation in the price of the security, when a security issold within three years of the date of its acquisition,is treated as a capital gain for personal income taxpurposes. There are no differences between finan-cial and nonfinancial corporations in the treatmentof government securities for taxation purposes.There is also no distinction between current incomeand capital gains for corporate income tax pur-poses. No withholding tax is applied on incomederived from government securities for residentsand nonresidents. Primary and secondary transac-tions with securities and shares are exempt fromvalue-added tax.


Appendix

Legal Framework

The outlines of the legal framework, given in Articles81 through 84 of the Public Finance Act, are as follows:

The central government may incur debt bothlocally and abroad and up to the level stipulated bylaw (i.e., to the sum necessary for financing thedeficit and for repayments of debt in the currentyear). During a period of temporary financing, thecentral government may incur debt up to the amountnecessary for current debt repayments.

If, because of mismatches in flows, budget expen-ditures cannot be covered with current budgetreceipts, the central government may borrow for liq-uidity purposes, however not in excess of 5 percent ofthe last regular budget.

By drawing loans and issuing securities, the cen-tral government may raise funds necessary either torepay the public debt before falling due or to pur-chase its own securities, provided that:

1. Measures to establish economic stability are sup-ported;

2. Cost of central government debt is reduced; or3. The quality of debt portfolio is improved without

increasing the central government debt.

The central or local government may also enterinto other debt transactions in order to manageexchange and interest risks related to the centraland/or local government debt (transactions withderivatives). The central government may buy andsell its own securities either on or outside the orga-nized securities market. The funds for the purchaseof securities shall be included in the central govern-ment budget.

Decisions regarding transactions in relation tocentral government borrowing, central governmentdebt management, and interventions in securitiesmarkets are made by the minister responsible for

finance on the basis of the annual FinancingProgram adopted by the Government.

The debt operations are concluded by the minis-ter responsible for finance or another person autho-rized by the minister in writing.

Decisions regarding liquidity borrowing aremade and executed by the minister responsible forfinance or another person authorized in writing bythe minister.

Article 85 specifies financing rules for local gov-ernments:

Local governments may borrow and managedebt on the basis of prior approval of theminister responsible for finance and underthe terms and conditions laid down by theact regulating the financing of local govern-ments. Borrowing transactions for which noprior approval has been given by the ministryresponsible for finance shall be deemed nulland void. Should it be impossible to balancethe implementation of the budget due touneven inflow of receipts, local governmentsmay borrow for liquidity, however no morethan 5 percent of the last regular budget.Unless otherwise stipulated in a special law,incomes from cash management are budgetrevenues, whereas the expenses of liquidityborrowing of the budget are budget expen-ditures. Local governments are obliged toreport to the ministry responsible for financeon the borrowing and repayments of debt ina manner determined by the ministerresponsible for finance.

Note

1. The case study was prepared by Stanislava Zadravec C.,Gonzalo Caprirolo, and Andrej Klemencic from the Public DebtManagement Department of the Ministry of Finance.

2. A more detailed outline of the framework is described inthe Appendix to this report.


The South African government securities market hasgone through various phases since the late 1970s. No for-mal and prevailing market rate existed before this period.The government periodically issued bonds at par, whenneeded. As the market started to develop, the govern-ment realized the importance of creating benchmarkbonds across the yield curve to increase liquidity. By theearly 1990s, a debt trap was looming, and the governmentintensified its focus on debt management. The govern-ment’s macroeconomic framework under the growth,employment, and redistribution program was designedto, among other economic challenges, bring the totaldebt to manageable levels. As a result, the department offinance developed a framework of philosophies and prin-ciples to manage its debt. This led to guidelines andstrategies to manage debt more actively.

Today the central government, state-owned enti-ties, and local governments in South Africa are respon-sible for issuing more than 95 percent of the totalfixed-interest-rate securities in the market. The gov-ernment has taken great care to prove itself a reliableand responsible borrower, domestically as well asabroad. The funding is concentrated in large, liquidbenchmark bonds to provide liquidity to the market.

Currently, the government is able to finance thetotal funding requirement in a sophisticated, liquid,and well-regulated domestic market. Much attentionhas been paid to the structural, legal, and infrastruc-tural sides of supporting market development. There isregular interaction with the Bond Exchange of SouthAfrica (BESA), the Financial Services Board, and theSouth African Reserve Bank (SARB) to help with theproper control of the domestic market. The govern-ment has also maintained a transparent relationshipwith the market. Quality information has been madeavailable, particularly on key budgetary figures andfunding strategies. As a result, South Africa’s debt man-agement strategy has moved beyond the stage that char-acterizes most emerging markets, and it is closer to thatof developed markets in the industrial countries.

The Domestic Market Before 1990

In the 1970s, new government bond issues were sold asperiodic public issues. Typically, the secretary offinance would issue bonds at par three or four times ayear, usually to coincide with the date of a maturing

203

15South Africa1

bond. There was no active secondary market and,therefore, no prevailing market rate. However, sev-eral investigations of and reports on future develop-ments in the capital market of South Africahighlighted the need for changes, among others theDe Kock Commission, the Stals report, and theJacobs report. In 1978, a broad consensus among allmarket participants was formed, pointing out the realneed for market development.

In 1981, Eskom (the Electricity SupplyCommission) was the first public entity to issue abond at a discount to the market. The governmentsoon followed. During the early 1980s, the govern-ment issued bonds on an open-ended tap basis untilthe allotted nominal amount, as specified in theprospectus, was fully issued. For each amount issued,a new bond was introduced to the market. Duringthis period, there was no clear separation betweenmonetary and fiscal policies. Primary issues were usedfor both financing government spending and openmarket transactions.

In the mid-1980s, important participants in thecapital market established a forum with the SouthAfrican government to discuss matters of mutualinterest. The investment community was partly con-cerned about the Act on Prescribed Assets. This actwas introduced in 1958 to create funds for semigov-ernmental institutions (such as universities and theSouth African Broadcasting Corporation) and devel-opments in the former homelands. To fund theseinstitutions, pension funds and insurance companieswere obliged to invest part of their funds as pre-scribed assets in government bonds, governmentguarantee bonds, and bonds approved and specifiedby the registrar of pensions (e.g., homeland bonds).Moreover, the investment community was concernedabout the small amounts of holdings being kept in aparticular bond, some of which were illiquid.

The prescribed assets were a serious stumblingblock in the development of financial markets. Noprevailing market rate could be determined becauseof such requirements. The act was finally done awaywith in October 1989. When prescribed assets werelifted, the scene was set for further market develop-ments in the South African capital market.

In 1989, the then department of finance consoli-dated several smaller issues to create benchmarks in

5-, 10-, 15-, and 20-year maturities. Furthermore, Eskomand other public entities began making two-way prices(i.e., quoting bid and offer prices) in their bonds.

Developments 1990–98

Developments in the domestic market

Development of the BESA

The development of a formal bond exchange inSouth Africa originated from recommendationsmade in the Stals and Jacobs reports. The authoritiesrecognized that self-regulation by the market partici-pants was more desirable and acceptable thanimposed control. As a result, bond-trading firms whohad run a voluntary association called the BondMarket Association since 1989 were licensed in 1996as a formal exchange called BESA (the BondExchange of South Africa).

To develop the clearing operations, BESAadopted the Group of 30 recommendations on clear-ing and settlement. The exchange also established arecognized clearinghouse, UNEXcor (UniversalExchange Corporation). Today, BESA members areable to benefit from electronic trade reporting,matching, and settlement. Electronic net settlementtakes place each trading day and is facilitated by foursettlement agent banks and their Central Depositoryof South Africa.

Introduction of auctions and market making

In the early 1990s, the SARB had been appointed asthe agent to issue, settle, and make a market in gov-ernment bonds. In September 1996, the departmentof finance conducted a survey among members ofBESA and certain foreign banks to obtain their viewson how to improve issuance and secondary mar-ket-making activity in government bonds. As a resultof the problems experienced with selling primaryissues to the market on demand, South Africadecided to adopt the international practice of usingregular auctions as a method of selling primary issuesof government securities to the market. To ensureefficiency, liquidity, and transparency of the sec-


ondary market for government bonds, market partic-ipants also agreed with the principle of movingtoward formal systems of market making. As a result,primary dealers were appointed, and their mainresponsibility was to make a market (quoting of two-way prices) and provision of liquidity in the sec-ondary market for government bonds.

Auctions

Since 1998, the responsibilities of the SARB changedfrom being an issue, settle, and market-making agentin government bonds to conducting auctions ofbenchmark bonds according to a fixed program onbehalf of the national treasury. The treasury, in atimely manner, informs all market participants aboutthe year’s public sector borrowing program, includ-ing the extent of the borrowing requirement, auctiondates through an auction calendar, the maturitystructure and size of issues, and the instruments to beissued. Seven days before the weekly auction, anannouncement is made on what instrument will beissued. The auctions of benchmark bonds are openonly to primary dealers.2

Appointment of primary dealers

In 1998, the national treasury appointed a panel of12 primary dealers, consisting of 6 local banks and 6foreign banks. The reasons for appointing primarydealers were to reduce refinancing risk for the gov-ernment, improve the liquidity and efficiency of thegovernment bond market, and create clear and trans-parent price formation. The introduction of a pri-mary dealer system also supported the developmentof regulations for trading and investor protection andestablishment of a more efficient clearing and settle-ment procedure. Other benefits of primary dealer-ship include improved market analysis and research.

The criteria to be a primary dealer, set out by thenational treasury, require both the local and nonresi-dent market makers to hold a specified minimumamount of rand-denominated capital in South Africa.This held capital is a demonstration by market makersof the capacity to deal with the inherent risks associ-ated with market making. In addition, it shows a firmcommitment toward developing the domestic market.

Some requirements were identified to be put inplace before the appointment of market makers. Itwas also decided that a gradual approach to changewas necessary to avoid undue disruptions in the mar-ket. Two main areas for measures were identified,necessary structural improvements and liquidityenhancing issues.

• Structural improvements included– creation of an efficient legal framework,– market surveillance of primary dealers by the

SARB and the national treasury,– introduction of minimum capital require-

ments of banks wanting to operate as marketmakers,

– introduction of an auction system to sell gov-ernment bonds to formal market makers,

– dematerialization of bond certificates,– shortening of the settlement period to T+3,

and– introduction of the risk management system

in the treasury.• Liquidity enhancing issues referred to measures

aimed to provide sufficient liquidity to thebroader market, for example, in ensuring thatthere is continuous provision of market-relatedbid and offer prices in appropriate volumes andunder all market conditions. These objectiveswere achieved through introducing benchmarkbonds and establishing the repo market.

Other developments

Other developments in the 1990s were, among oth-ers, the issuance of the first corporate bond in theSouth African market by SA Breweries, the establish-ment of the South African Futures Exchange, and thedevelopment of a register, payment, and debt record-ing system in the debt operation division of thedepartment of finance.

The framework of philosophies and principles

In the early and mid-1990s, an ever-increasing budgetdeficit, a rising stock of debt, and a rising cost of ser-vicing the debt caused an intensive public debate onthe sustainability of the government’s debt-servicing

Country Case Studies: South Africa 205

costs. Interest rates were high in both nominal andreal terms, and the average maturity of the debt port-folio was just below 10 years, about 60 percent ofwhich had to be refinanced within 5 years. Thismeant that besides the net new deficit that had to befinanced, a high percentage of the existing debt alsohad to be refinanced in an environment of highinterest rates. The threat of falling into a debt trap,and the uncertainty of potential liabilities, triggered afocus on prudent debt management.

In March 1996, an announcement was made inthe Budget Review that the entire debt managementpolicy would be reviewed. Following this measure, aframework of philosophies and principles to managepublic debt, cash, and risk was developed andapproved by parliament to promote a proper under-standing of what was to be achieved and further abroad base of support. The framework identified riskareas, as well as the strategies to follow. Following sug-gestions in this framework, a public debt office wasalso established. This office was named the asset andliability management (ALM) branch of the depart-ment of finance (the department of finance is todaycalled the national treasury). The following chartillustrates the current structure of the ALM branch.

The Evolving Debt ManagementStrategy Since 1999

The performance of the South African capital marketsduring the 1997–98 financial crises proved that theSouth African government bond market was no longerat a nascent stage. However, at the same time, it was evi-dent that debt management objectives had to changeto face new challenges. The willingness of the investorsto commit their funds at the long end of the curve (27-year maturity) and the active participation of foreigninvestors signified the need to change the debt man-agement approach. A research paper titled “Compre-hensive Debt Management Framework” identifiedcertain policy gaps that had to be addressed. Thepaper proposed that debt management objectivesshould be changed, including recommendations for atactical debt management approach.

Identifiable policy and instrument gaps

• Design and use of instruments: Although low-costdebt instruments such as inflation-linked bondswere introduced, there was a need to considerintroducing the low-coupon, fixed-rate bond. The


ALM Branch Structure

Division Head: Asset and Liability Management

Chief Director: Liability Management

Chief Director:Asset Management

Chief Director: Financial Operations

Chief Director: Strategy and Risk

Management

Director: Foreign Debt

Director:Restructuring(Energy & Telecomms.)

Director: Cash Management

Director: Market Risk

Director: Domestic Debt

Director: Restructuring (Transport & Defense)

Director: Accounting & Information

Director: Country Risks (Financial Modeling Contingent Liabilities)

Director:Back Office

Director: Corporate Governance (PFMA implementation)

Director: Systems Integration

Director: Credit Risk a

a. Public Finance Management Act.

design and use of low-coupon instruments is inline with the government’s policy of introducinginflation targeting, which has helped to reduceunreasonable expectations about the future of theinflation rate. New low-coupon bonds have beensuccessfully used as a destination bond in switches.

• Use of derivatives: Derivatives were not usedwhen South Africa was still developing a riskmanagement framework. However, this couldchange in the near future. Discussions are goingon regarding the use of derivatives, such as sepa-rate trading of registered interest and principalof securities (STRIPS)3 and interest rate swaps.

• Maturities: The capacity at the short end was lim-ited. Switches between different maturities havebeen offered to the market to restructure thematurity profile of outstanding debt.

• Proper coordination of the funding activities ofstate-owned enterprises (SOEs): To ensure asmooth, efficient, and predictable securities mar-ket, there was a need to harmonize governmentborrowing with the SOEs. The public sector bor-rowers forum was launched on May 31, 2001, toorganize the funding activities of the public sec-tor issuers. The forum consists of the parastatals,the Financial Services Board, the SARB, and thenational treasury.

• Coordination of liability management and mone-tary policy: There was no coordination betweenliability management and monetary operations.Consequently, a detailed work plan for the publicdebt management committee, which consisted ofhigh-level decision makers from the nationaltreasury and the SARB, had to be formulated.

Change in the hierarchy of debt managementobjectives

Based on the analysis in “Comprehensive DebtManagement Framework,” debt management objec-tives were changed. Before 1999, the primary objec-tive of debt management was to develop the domesticcapital market, and the secondary objective was topromote a balanced maturity structure. Developmentsin the domestic market changed the emphasis ofthese objectives. The primary objective shifted tofocusing on the reduction of the cost of debt within

acceptable risk limits, and the secondary objective, toensuring government access to financial markets anddiversifying funding instruments.

A shift from strategic to tactical debtmanagement

The national treasury acknowledged that while theobjectives of South African debt management were nowprudent; developments in the global sovereign capitalmarkets necessitated a change from strategic to tacticaldebt management in South Africa. The strategic debtmanagement policy looked at the overall design andimplementation of the debt management program.This includes how primary issuance is designed andmanaged, how debt instruments are designed andtraded, and how liquidity is provided. Tactical debt man-agement policies concentrate on actively managing theoutstanding stock of debt and its composition to reducethe cost of debt to within acceptable risk limits.

Achievements

Notable achievements in implementing new debtmanagement approach cover improved domesticbond market liquidity. The total South African bondmarket turnover increased from R 5 trillion in 1997to about R 11 trillion in 2000. The government bondproportion of total market turnover has alsoincreased, from about 55 percent in 1995 to 91 per-cent in 2000. Moreover, investor confidence hasrisen, as has the participation of foreign investors inthe domestic bond market. Meanwhile, the perceivedrisk associated with foreign investment in SouthAfrica has continued to decrease with rising effi-ciency, sophistication, and openness in the SouthAfrican capital market. Evidence of this was the factthat South Africa was one of the few countries to issueand fund in the longer-dated bonds during the1997–98 financial market crises.

The Main Challenge Facing the NationalTreasury

The government’s budget deficit as a percentage ofGDP decreased from 5.1 percent in fiscal year


1994/95 to 1.5 percent in the 2001/02 fiscal year.The main challenge facing the national treasurytoday is to find ways to uphold an efficient, transpar-ent, and liquid government bond market in an envi-ronment with declining borrowing needs. Thedecline in the supply of government paper is ofteninterpreted as a decrease in the liquidity of the bondmarket, especially in those countries whose securitiesmarkets are still at a nascent stage. However, SouthAfrica has reduced its supply of paper in line with thegovernment’s lower financing needs, without sacrific-ing liquidity in the bond market. The country hasmanaged to achieve this by carrying out active debtmanagement strategies with use of tools such as debtconsolidation (switches) of bonds and debt buybacks.Inflation-linked bonds have also been introduced,and a facility to strip government bonds has beenestablished. Swap derivatives will be introduced indue course.

Debt consolidation (switches)

Debt consolidation was introduced to reduce thefragmenting of bonds on the yield curve and therebyimprove the liquidity of the benchmark issues. Debtconsolidation has also helped to smooth out thematurity profile and reduce the refinancing risk, eas-ing the pressure at the short end of the curve. Thenumber of outstanding issues of small amounts andhigh coupons has been converted (switched) intolarger liquid bonds with low coupons. To execute thedebt consolidation (switches), exchange auctionshave proved to be a powerful tool. Exchange auctionshave also been used as a cash management tool. As atthe end of 2001/02 fiscal year, a total of R 52 billionin bonds had been switched.

Debt buybacks

With the objective of reducing the government’sdebt-servicing costs in the medium to long term—and strengthen the integrity of the government secu-rities market—small, illiquid, high-coupon bonds ofless than R 1 billion as well as ex-homeland bondshave been bought back from the market. At the endof the 2001/02 fiscal year, R 4.5 billion of illiquidbonds had been bought back.

Inflation-linked bonds

To reduce the long-run cost of debt, the ALM branchhas embarked on the design of instruments that canlower the overall cost of debt for the government,such as the issuance of inflation-linked bonds.Inflation-linked bonds give institutional investors achance to match long-term assets and liabilities,while also providing an objective measure of infla-tionary expectations and acting as a benchmark forother issuers. These bonds were considered a mech-anism for unlocking the liquidity of the long-termfixed-rate bonds, because inflation-linked bondstend to attract the buy-and-hold investors. By switch-ing into inflation-linked bonds, institutional inves-tors released long-term fixed-rate bonds in thesecondary market to trade, thereby increasing liq-uidity on the long end of the curve for long-term,fixed-rate nominal bonds.

South Africa has developed a full inflation-linkedbonds curve with 2008, 2013, and 2023 maturities.These bonds had an average yield of 4percent as ofMay 20, 2002. However, as in other similar markets,the liquidity in the South African inflation-linkedmarket is low, because these bonds mostly are boughtby investors who tend to hold the bonds to maturity.The primary dealers do not have any price-makingresponsibilities on inflation-linked bonds.

Stripping of government bonds

The ALM branch undertook a project of discoveringwhether the STRIPS system improves the liquidity ofthe underlying instruments. The project pointedout that STRIPS could increase demand for theunderlying instrument and encourage active portfo-lio managers to take advantage of arbitrage oppor-tunities through stripping and reconstitution.Under conditions of declining government funding,the project discovered that it was clear that it wasnecessary to introduce a STRIPS program to main-tain the liquidity and integrity of the domestic capi-tal market. Trading in STRIPS began at the end ofJanuary 2002 through primary dealers acting as mar-ket makers. The Central Depository of South Africaacts as a government agent in stripping governmentbonds. By introducing a strip facility, the national


treasury discouraged investment banks from creat-ing their own special purpose vehicles, whose soleresponsibility is to strip government bonds for mar-ket participants.

Swaps

To manage the duration of the government’s debtportfolio, the national treasury’s liability manage-ment division is introducing interest rate swaps asinstruments for cost and risk management. Moreover,with government participation in the swap market, itis assumed that the liquidity of both the swap marketand the underlying bond market will improve.

Foreign Borrowing

Political unrests due to apartheid system in 1984 and1985 resulted in sizable capital outflows. The fiscaland monetary decision makers were forced to enterinto a partial debt standstill.4 According to a SARBcensus, South Africa’s indebtedness on August 31,1985 was US$23.7 billion (41.4 percent of GDP),US$13.6 billion of which was deemed to fall underthe debt standstill. The repayment of this part of thedebt was executed under four debt standstill agree-ments starting in 1985. The final repayment underthese agreements was made in August 2001.

After a period of restricted access, the SouthAfrican government was able to return to the foreignmarket in 1994 after the election of the first demo-cratic government. The first issue after this return wasa U.S. dollar global bond issue, followed by a yenbond issue in 1995. The government also set up anEMTN (euro medium-term note) program.

Since then, an integrated strategic approach hasbeen followed when entering the foreign market tofund the budget deficit, as stipulated in the BudgetReview each year. Usually, foreign funding hasamounted to US$1 billion per fiscal year. However,the prime focus has not been for funding purposes,but to create benchmarks in specific foreign mar-kets for other South African entities to follow. Thisis mainly because South Africa is capable of fundingits total budget deficit from the domestic capitalmarket only.

The strategy of borrowing in the foreign marketso far has been to exploit perceived pricing anoma-lies to obtain cost-effective funds. Moreover, in thefuture, the foreign debt management will also focuson promoting the rand market by taking advantageof the South Africa’s positive credit-rating develop-ment whenever possible.


From 1996 to 1999, three financial risk managementobjectives drove the ALM branch, namely controllingthe quantum of capital, optimizing the return on cap-ital, and managing the cost of capital, each describedin the following.

Controlling the quantum of capital

As mentioned before, the debt issued by the state,and the cost of servicing this debt, were at a high levelin the mid-1990s. In this light, a distinction was madebetween two different broad areas of risk:

• Risk of ever-increasing deficit: This risk was notseen as the primary responsibility of the ALMbranch. The primary responsibility for managingthis risk was guided by the implementation of thegovernment’s macroeconomic framework, thegrowth, employment, and redistribution pro-gram.

• Risk of ensuring cash availability to meet thestate’s expenses: The liability manager was givendirect responsibility for– ensuring the state’s continued access to

financial markets, both domestic and for-eign;

– contributing to the absorption capacity of statedebt within these markets through ongoingmarket development, product innovation, andproper coordination of activities with theSARB’s monetary management operations;

– developing efficient secondary markets forits securities; and

– establishing the state’s name as a fair and effi-cient borrower in the financial markets throughthe active marketing of its debt instruments.


Optimizing the return on capital

The ALM branch was interested in investments relat-ing to surplus cash arising because of overall fundingrequirements and ensuring liquidity needs. The levelof surplus cash was largely affected by cash manage-ment activities. However, from a risk managementperspective, a certain level of investment was kept asa liquidity buffer. The return on capital invested inprograms and projects through the budgetary pro-cess did not concern the ALM branch.

Managing the Cost of Capital

An integrated strategy was followed for domesticand foreign borrowing. It was accepted that savingsin the cost of debt service could be achieved fromthe ongoing development of the depth and widthof the domestic financial markets, rather thanthrough efforts to borrow more cheaply in foreignmarkets. Because of the size of South Africa’sdomestic debt, limited scope existed for activelymanaging the debt portfolio and reducing debt-ser-vicing costs. The focus of existing domestic debtmanagement aimed, therefore, at addressing thematurity structure to avoid unwanted bundlingacross the debt profile. Although funding of thenew gross financing need (new issues) was man-aged actively, cost savings were not achieved by tak-ing interest rate views.

The principles regarding individual risk cate-gories concentrated on these risk areas:

• Liquidity risk: The management of this risk, con-sidered by the ALM branch to be the most impor-tant, involved ensuring that the minimumamount of cash was always available to meet thestate’s expenses. Further explanation of liquidityrisk will be covered under the section on cashmanagement.

• Interest rate risk: This risk meant that adversechanges in interest rates could cause an increasein borrowing costs. It was accepted that the state’sminimum risk position was in long-term, rand-denominated debt. A duration target was estab-lished to control the interest rate risk. No interest

rate view was taken as a means of achieving costsavings.

• Credit risk: In the course of managing cash bal-ances and derivatives positions, the guiding phi-losophy and principle was that the role of theALM branch, in managing the state’s market risk,involved a transfer of that risk to the marketplacein return for the credit risk of the counter-party.The state’s size in the financial markets necessi-tated accepting credit risk from a far wider rangeof counter-parties. With the exception of liquid-ity, no counter-party or issuer was exempt fromthe process of having a credit limit imposed.Transactions could be conducted only after for-mal limits were set with counter-parties andissuers that satisfied soundly based and accept-able assessment processes.

• Foreign exchange risk: It was accepted that it wasnot appropriate for the ALM branch to hedgeforeign loans raised by the state through therand, because the foreign currency debt repre-sents just a small part of the total debt. Instead,the national treasury regards controlling thelevel of foreign currency debt as essential.

• Market-making risk: It was accepted that this riskshould be limited and confined to debt markets.Market-making activities in South African bondswere removed from the government (the rolethat was played by the SARB as an agent of thegovernment) and transferred to the market whenprimary dealers were introduced in 1998. Thus,the risk of fluctuations in the market was shiftedto the market participants, where it was deemedto belong.

• Trading and ethical risk: Primary dealers tookresponsibility for trading and ethical risk. A codeof conduct was drafted, documented, and signedbetween primary dealers and the ALM branch.The code of conduct addressed the issues of busi-ness ethics, relationships, due diligence, confi-dentiality, controls, and trading rules.

Setting up the capacity to assess and managecost and risk

In 1999, a risk management project was introduced.Its purpose was to set up a separate section within the


ALM branch that would be solely responsible formanaging risks of the government portfolio. In 2000,a risk management team was put in place to run theproject. The chief directorate of the strategy and riskmanagement controls and manages risks that areidentified and debt it is exposed to. Specific risk man-agement responsibilities within the context of theALM branch are to

• create and maintain a risk management frame-work for general government bodies and publicenterprises,

• develop an ideal benchmark for governmentdebt, and

• monitor and manage credit risk exposure.

Risk management today

Because of the developments that have taken place inboth the domestic and foreign markets, the nationaltreasury has resolved that the risk managementframework adopted in 1996 needs to be realigned.This is mainly due to the fact that debt managementpractices have evolved, and more emphasis is nowplaced on advanced tactical and quantitative models,rather than just on policies. Although the risks iden-tified are still the same, the new model in each caseensures that policies and procedures to quantify, con-trol, and manage risk exposure are now put in place.Table II.15.1 summarizes the types of risk and themanagement of these risks.


Table II.15.1. Management of Risk

Type of risk Management of risk

1. Liquidity and refinancing riskShort-term liquidity • Monitor exchequer cash balance and flows.

• Maintain a certain minimum cash balance.• Maintain access to short-term borrowing.• Limit size of short-term debt.• Prefinance maturing debt.

Long-term liquidity • Smooth the maturity profile.• Extend portfolio maturity.• Develop liquid benchmarks.

2. Interest rate risk • Manage ratio of fixed- vs. floating-rate debt.• Manage ratio of short-term vs. long-term debt.• Manage nonparallel yield curve shifts.• Use interest rate swaps.

3. Currency risk • Domestic vs. foreign debt.• Use of currency swaps. • Manage short-term vs. long-term debt.• Composition of currencies.

4. Budget risk • Modest short-term borrowing.• Reduce volatility of short-term interest rates.• Monitor actual vs. debt service costs.• Stress-testing (implemented in 2002).

5. Credit risk • Set overall counter-party credit status, for example, rating (implementation started in 2002).

• Set individual counter-party credit limits (implementation started in 2002).• ISDA mitigation clauses (implemented in 2002).

6. Downgrade risk • Identify key factors that are important in the credit-rating process.• Develop a culture of consistent messages between other departments and

the international community.

7. Operational risk • Put policies and measures in place to control back office operations and payments.

Benchmark for management and performance

To ensure accountability and the delegation of risk,the government has approved a benchmark thatshould reflect and establish an acceptable level of riskand target costs. The benchmark reflects the defineddebt management objectives and acceptable quantifi-able risks, and it expresses the government’s strategicdebt position and aligns debt policy to economic pol-icy. Altogether, the benchmark provides appropriaterisk management and control and forms a baseline formeasuring the performance of debt managers. Thebenchmark was formulated under these principles:

• Robustness: A conclusion should rely on fewassumptions.

• Efficiency: The government should be able totake the least possible risk for a certain cost.

• Mark-to-market valuation: The governmentshould be able to measure savings and cost overthe lifetime of the debt.

• Risk context: Risks should be constrained to theannual debt-service expense.

• Transparency: There should be an open basis forperformance measurement.

Cash Management

Both the cabinet memorandum of February 1997 andthe Public Finance Management Act require cashmanagement in the ALM branch to provide a frame-work for creating awareness in all spheres of the gov-ernment of the need for proper cash-flowmanagement. The responsibility to plan and managethe government’s daily cash-flow needs was officiallytaken over from the SARB in June 1999.

To ensure enough funds are available for thestate to meet all expected and unexpected financialcommitments, it is necessary and prudent to keep anappropriate level of cash and near-cash. It is there-fore important to optimize returns on cash balances.Therefore, the cash manager’s responsibilities are to

• manage liquidity by ensuring that the rightamount of funds are available in the right cur-rencies, at the right time, and in the right place;

• plot projected flows and monitor the actual flowsagainst projections: Timely and accurate futurecash-flow projections are critical to plan the fund-ing of the national revenue fund effectively, min-imizing the required liquidity buffer andmaximizing returns on surplus cash;

• create an appropriate organizational structure; and• engineer the required linkages between the tax and

loan accounts, the paymaster general accounts, andthe departmental accounting systems.

During the early 1990s, the then department offinance introduced a tax and loan account system. Itopened four tax and loan accounts with each of thefour major domestic banks in South Africa. Surplusfunds in the exchequer account, kept at the SARB,are deposited into these accounts daily. When spend-ing occurs, funds flow back via the exchequeraccount to the various departmental accounts. Thisestablishes daily outflows from the accounts.

Since June 1998, the difference between pro-jected daily cash flows and actual cash flows has beenmaintained daily. Taking control over cash-flow esti-mates, and more accurate information on projectedmonthly and daily cash flows, have made it possible toplan and draw up proposals on financing needs moreaccurately. Also, the active use of treasury bills, issu-ing of short-term (one-day) treasury bills to financecash-flow peaks, and investments by the Corporationfor Public Deposits (an organization that managesshort-term public funds and is part of the SARB) hascontributed to cash-flow management carrying lowercash balances ahead of cash-flow peaks.

Managing Investor Relations

The national treasury also attaches greater signifi-cance to managing investor relations and has set upan annual investor relations program, which includesroad shows, primary dealer meetings, and one-on-one meetings with investors and other market partic-ipants, such as banks, fund managers, and the like.

The annual road shows are intended to promotethe exchange of ideas between the national treasuryand investors (foreign and domestic) on issues ofmutual interest. This could, for example, involve dis-


cussions on funding needs, new instruments and pro-jects proposed by the ALM branch, and any concernsabout the market.

At the establishment of the primary dealership,the national treasury, the SARB, market makers, andthe BESA agreed to coordinate their responsibilitiesto ensure a transparent and efficient bond market.All new strategies have been discussed with marketparticipants, and they have been encouraged to sub-mit their comments. The national treasury hasadhered to its annual funding strategy, and anyunplanned events have been avoided. Furthermore,the ALM branch within the national treasury and themoney and capital market division of the SARB havehad a formal program of meeting primary dealers todiscuss their performance in the primary and sec-ondary markets and capital market issues of mutualinterest.

The ALM branch and the money and capitalmarket division of the SARB have also held discus-sions with the top management of various capitalmarket participants.

Legal Framework for IssuingGovernment Debt Instruments

The Public Finance Management Act forms the basisfor financial administration in the South African gov-ernment. The act

• regulates financial management in the nationaland provincial governments;

• ensures that all the revenue, spending, assets,and liabilities of those governments are managedefficiently and effectively;

• provides for responsibilities of people entrustedwith financial management in those govern-ments; and

• incorporates the regulations on borrowing bypublic entities (It does not allow provinces toborrow from abroad.).

The act also stipulates the limits on borrowing,guarantees, and other commitments. To improveaccountability of debt management, the act settleswho should

• borrow for the government;• issue a guarantee, indemnity, or security; and• enter into any other transaction that binds the

government.

The act also lists the purposes for which the min-ister of finance, as an executive authority, may borrowmoney. These are to

• finance the national budget deficit,• refinance maturing debt or a loan paid before

the redemption date,• buy foreign currency,• maintain credit balances on a national revenue

fund bank account,• regulate internal monetary conditions should the

need arise, and• for any other purpose approved by the national

assembly by special resolution.

Concluding Remarks

South Africa has gained valuable experience andlearned important lessons in public debt manage-ment. The most significant lesson the governmenthas learned was the importance of having a debtmanagement framework to deal with the mountingdebt that was threatening South Africa. The frame-work identified risk areas, as well as the strategies tofollow. Of special importance in the implementationof the framework have been

• the development of liquidity in both financialinstruments and the capital market;

• the development of a yield curve and the issuingof bonds over the spectrum of the yield curve;

• the diversification of fixed-income instrumentssuch as floating- and variable-rate bonds, fixed-interest bonds, and inflation-linked bonds;

• market making, trading, and investment riskswere transferred to the market through theappointment of primary dealers;

• the opportunity to issue bonds in a proper, well-structured (regulated), and developed market; and

• introduction of cash management, with anemphasis on actively managing cash balances


(This entails the daily monitoring of actual flowsagainst projections.).

Today, the inherent conflict between debt man-agement and monetary policies is now well under-stood. A clear separation of activities has beenintroduced, and existing conflicts have now beendealt with in the appropriate manner.

To reduce costs, a gradual approach has been fol-lowed, from emphasizing market development toactively taking positions in the market. This enables thegovernment to actively manage its outstanding stock ofdebt and the composition of this debt. It also hasbecome critical to identify, control, and manage thegovernment’s risk exposure. The national treasury’sALM branch has actively managed these risks, guidedby a comprehensive risk management framework.

Establishing and maintaining a good relationshipwith investors, both locally and internationally, hasbeen one of the priorities in promoting the South

African bond market. The investor relations pro-gram, run by top management in the national trea-sury and the SARB, has increased the transparencyand openness of the bond market and encouragedinvestor confidence in the government’s ability tomanage debt.

Although all of these issues are important, it iscrucial to note that the South African bond marketcould not have been so efficient without a prudentmacroeconomic framework and a well-constructedlegal framework.

Notes

1. The case study was prepared by the National Treasury ofthe Republic of South Africa.

2. Information is available on the web site,www.treasury.gov.za.

3. The interest and principal components of a security aresplit into separately tradable instruments.

4. Deferred of government debt.


Sweden has had a separate agency, Riksgäldskontoret(the Swedish National Debt Office [SNDO]), for gov-ernment debt management since 1789. Inevitably, theprinciples and practices of debt management havechanged repeatedly over the years. A major reform ofthe governance system was enacted in 1998. As a result,debt management decisions are made within a moreclearly structured framework. There is also a morestructured approach to evaluate the decisions after thefact. The outline of this system and the experiences sofar are presented in the first section, which also dis-cusses the organization of the debt office.

The new governance system has created a frame-work for more focused analysis of the debt manage-ment strategy and the risks involved. The secondsection discusses the key features of debt managementstrategy and the analyses undertaken to get a betterunderstanding of the costs of government debt andthe associated risks.

The third section discusses measures for develop-ing the government securities markets.


Statutory rules

The core principles and rules for central governmentdebt management in Sweden are given in the Act onState Borrowing and Debt Management.2 The currentlegislation was enacted by parliament in 1998. The gov-ernment’s right to borrow is based on an annual autho-rization from parliament, which is given as part of thedecision on the state budget for the subsequent fiscalyear. There is no fixed limit on the annual amount ofborrowing. Instead, the act specifies the purposes forwhich the government may borrow, in particular, tofinance the budget and refinance maturing debt.3 Thegovernment invariably delegates the mandate to bor-row to the SNDO.

The objective of debt management is also formu-lated in the act. It stipulates that the state’s debt shallbe managed so that the long-term costs are minimized

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while taking risks into account. Debt managementshall also respect the demands of monetary policy.This is basically the same rule that governed debtmanagement before the reform in 1998. The differ-ence is that the objective now is stated in a lawenacted by parliament, whereas it previously was setout in documents issued by the government.

Finally, the act contains procedural rules. First, itstipulates that the government each year shall decideguidelines for debt management. This decision shallbe based on a proposal submitted by the SNDO. Theproposal shall be sent to the Riksbank, the centralbank for comments, to ensure that the demands ofmonetary policy are taken into account. Second, theact instructs the government to submit an annualreport to parliament in which it makes an evaluationof the management of the debt. The SNDO’s pro-posal, the Riksbank’s comments, and the govern-ment’s guidelines, as well as the evaluation report,are all public documents.

The statutory rules create a framework for dele-gation, reporting, and evaluation. Parliament—at thetop of the system—has established the objective. Onthe basis of this objective, the government is man-dated to set guidelines. In preparing the guidelines,the SNDO assists the government. This reflects thefact that the SNDO staff work full-time with debt pol-icy, whereas the government (the ministry of finance)has many other obligations and is confronted withdebt policy issues infrequently.4

The implementation of debt management on thebasis of the guidelines is then delegated to the SNDO.The guidelines define in broad terms how the debtshould be structured. They typically include rangesaround target values, leaving scope for the SNDO tomake more detailed decisions on the management ofthe debt.5 There are two decision levels within theSNDO. The first level is the board, which is made upof external members (with the exception of the direc-tor general).6 For example, it makes strategic deci-sions on how to use the ranges given in thegovernment guidelines and benchmark portfolios.The second level is the operative management of thedebt within the frame set by the board, which is in thehands of the SNDO’s staff, led by the director general.

The governance system also puts emphasis onevaluation. Each decision level is evaluated by its

immediate superior body. This means that the boardmonitors and evaluates operative debt managementand reports to the government. At the next level, thegovernment evaluates the overall result of theSNDO’s decisions. Finally, parliament evaluates debtmanagement as a whole, including the government’sguidelines. This evaluation is in the form of anannual written statement, adopted after a debate andvote in parliament. This statement is published intime for the SNDO to consider comments and rec-ommendations from parliament when preparing thenext guideline proposal, closing the loop of delega-tion and monitoring.

This governance framework applies to centralgovernment gross debt, or the debt portfolio man-aged by the SNDO. The Swedish government sectoralso has financial assets, for example, in funds in thepublic pension system and in equity holdings.Indeed, at end-2001, the general government netfinancial debt was negative, despite a central govern-ment debt-to-GDP ratio of about 54 percent. There isno debt management strategy at the level of generalgovernment, partly because the public pension fundsare managed separately from the state budget, basedon objectives derived from their role in securingfuture pensions, and because local authorities have asignificant degree of independence. However,attempts are made to broaden the perspective toinclude the central government’s balance sheet inthe analysis of risks relevant to central governmentdebt management.

The governance framework in practice

The first guidelines constructed within the newframework were adopted in 1998, covering debt man-agement in 1999. When the guidelines for 2002 wereadopted in November 2001, it was thus the fourthtime the exercise was repeated. It was recognizedwhen the new system was put in place that the objec-tive was vague and that further analysis was needed totranslate it into a practical framework for debt man-agement. In the preparation of the guideline propos-als, emphasis has been put on complementing thestatutory target with appropriate definitions of costsand risks. In addition, the SNDO has presented anal-yses of how the composition of the debt portfolio can


be expected to affect costs and risks. The main con-clusions and the resulting debt management strategyare summarized in the second section.

The changes in the way debt policy is governedhave not, at least so far, altered the practices of debtmanagement. The most significant effect is perhapsthat the time perspective in the guidelines has beenextended from one year to include tentative plans forrolling three-year periods, consistent with the timeframe used in the budget process. However, theimportance of the form and structure of governanceshould not be underestimated.

First, the new system has increased the attentiongiven to debt policy in both the government and par-liament. Considering the size of the annual debtcosts, this attention is justified.

Second, the procedure surrounding the annualguideline decision has affected the perception ofdebt policy. All strategic proposals and decisions mustbe explained to the public in terms of their impact oncosts and risks. The decisions are then evaluated interms of their impact on costs, and the results aremade available to the public. The transparency of thesystem helps to commit the policymakers to thestated objective of long-term cost minimization withdue regard to risks. In particular, borrowing strategiesthat reduce short-term costs, but also significantlyraise medium- or long-term costs or the risk of thedebt are difficult to implement.

Third, the system provides a clearer distributionof responsibilities between the parties concerned.The government (the ministry of finance) delegatesdebt management to the SNDO for one year at atime. The government can change the guidelinesduring the year if the circumstances underlying thedecision have changed materially, but this has to bedone in the form of an amended guideline, that is, ina public document.

Similarly, the central bank’s views are broughtinto the process in a formalized way when theRiksbank is invited to comment on the annual pro-posal. This is in contrast to the situation 10 or 15years ago, when debt management often was used asan instrument of monetary and exchange rate policy.Now it is clear that monetary policy, at most, acts as aconstraint on the cost minimization problem, and itis not part of the objective. An objection from the

Riksbank to a proposal from the SNDO must belinked explicitly to “the demands of monetary pol-icy”(i.e., the suggested guidelines would interferewith the Riksbank’s ability to reach its statutory objec-tive or price stability). In an economy with well-devel-oped financial markets, this will only rarely be thecase. A gradual separation between monetary policyand debt policy had begun before the governance sys-tem was reformed, but the new process has con-tributed to an even clearer decoupling of monetarypolicy and debt policy.

In summary, the governance framework intro-duced in 1998 makes it clear that debt managementis a policy area in its own right, with its own objective.The government is answerable to parliament forachieving this target, but major responsibilities aredelegated to the SNDO, in both the preparation ofguideline proposals and operative debt management.As a result of the guideline procedure, the operativeindependence of the SNDO has increased. However,through the reporting and evaluation mechanisms,there has been a corresponding increase in the pos-sibilities to hold the SNDO accountable for its deci-sions. As is appropriate, delegation andaccountability go hand in hand.

The arguments for delegating the implementa-tion of monetary policy to an independent centralbank are well known, and the practice of doing so iswide spread. The Swedish governance framework fordebt management illustrates how debt policy can bedelegated in a similar fashion to an independent debtoffice. However, the degree of delegation is less farreaching than in monetary policy.

First, the debt management objective is two-dimensional, in that there may be trade-offs to makebetween cost and risk. Second, the attitude to risk ispresumably not invariant to the overall fiscal positionof the country. Debt must be seen as part of the over-all balance sheet of the government. It must beassessed in relation to expenditure commitments,defining another class of liabilities, and future taxrevenues, which are the most important assets on thebalance sheet. It seems inevitable that an optimaldebt policy is state contingent in that the attitude torisk will vary depending on the overall outlook forgovernment finances. Strategic decisions on debtmanagement are thus closely linked to fiscal and bud-

Country Case Studies: Sweden 217

get policies, which fall within the realm of the gov-ernment and parliament. An independent debt officemay not have the necessary information to make suchassessments. Moreover, and more important, it is notbe possible to make a separate debt office account-able for decisions that are ultimately political innature. It is therefore difficult to delegate strategicdecisions to an administrative agency to the sameextent as the implementation of monetary policy canbe delegated to an independent central bank.

The organization of the SNDO

Background

For the first 200 years, the SNDO was responsibledirectly to parliament. This meant, for example, thatit had an external board appointed directly by parlia-ment. However, in 1989, it was turned into an agencyof the government. This reflected primarily theassessment that parliament’s influence was securedvia the budget process and that the implementationof debt policy was handled more efficiently by anagency reporting to the government.

Internal organization

The operative responsibility for the SNDO is in thehands of the director general and the deputy directorgeneral, both appointed by the government. Thedirector general is also the chairman of the board.The government also appoints the other board mem-bers, none of whom is employed by the SNDO.Reflecting the previous link to parliament, four of theeight board members are also members of parlia-ment. The board decides on strategic issues related todebt management (e.g., guideline proposals and riskcontrol).

Within the SNDO, there is a clear organizationalseparation between front, middle, and back officeresponsibilities. Front office activities, such as auc-tions, debt, and cash management transactions, areexecuted within the debt management department.The head of the debt management departmentreports to the director general.

Debt management is monitored by the risk con-trol department, the middle office. Its responsibilities

include monitoring positions relative to benchmarksand observance of credit limits on counter-parties.The risk control department is also responsible formonitoring operative risks.

Confirmation and settlement of debt manage-ment transactions are handled by the back officedepartment. Reports on the results of debt transac-tions are handled by the accounting department. Theheads of risk control, back office, and accountingreport to the deputy director general to achieve a fur-ther separation between operative debt managementand follow-up activities.

In addition, there is the internal auditing depart-ment. It reports directly to the board on results ofaudits of the activities of the SNDO.7

Financial and human resources

The SNDO is funded by the state budget. The SNDOsubmits budget proposals to the government, cover-ing rolling three-year periods, that explain its financ-ing needs. Current expenditures for salaries, rents,and similar expenditures are covered by one budgettitle, interest payments on the debt by another.Consequently, the SNDO cannot use savings on inter-est costs, for example, to hire additional staff.

Within the limit set in the budget, the SNDO hasconsiderable flexibility in allocating funds betweenuses, including hiring decisions. Swedish governmentagencies, in general, are controlled not by detailedspecifications on how they may use their funds, but bywhether they manage to achieve the objectives set upfor them. The evaluation system for debt manage-ment is thus unusual only in that it is more elaborateand formalized than in other areas.

This affects, for example, decisions on salaries.The government appoints the director general andthe deputy director general and sets their salaries.The SNDO, ultimately the director general, makeshiring decisions and establishes the salaries of allother employees. There is no fixed salary structure,based on seniority or other set criteria, within theSwedish central government. Instead, merit anddegree of competition from the outside for a particu-lar skill are key factors. This means that salaries canbe adjusted to the SNDO’s need to recruit or retain aparticular individual—that is, of course, within the


limits in any organization to maintain a wage struc-ture perceived to be fair and reasonable.

Still, the SNDO cannot directly outbid privatefinancial firms in terms of wages. The key to recruit-ing and retaining staff with appropriate financialmarket skills is to offer challenging and interestingtasks to work with. In particular, it is important toinvolve also relatively junior staff in discussion anddecisions on policy issues. Even though debt man-agement involves portfolio decisions analogous tothose made in private financial institutions, there areconnections to broader economic policy issues notpresent elsewhere. By building on this aspect, a debtoffice can create an advantage relative to the privatesector, offsetting some of the differences in salary lev-els. In areas such as the back office and informationtechnology, the differences between working in a pol-icymaking institution and a private firm are less pro-nounced. The SNDO therefore tends to meettougher competition when it comes to retaining staffin administrative functions than in the core policyareas.


Background

The statutory objective—long-term cost minimizationwith due regard to risk—is obviously sound. However,more precise concepts are needed to translate theobjective into a strategy for actual debt management.An important element in the analyses conductedwithin the new governance framework has been todefine what one should mean by costs and risks.

The next question is how the debt portfolioshould be structured. The SNDO has concluded thatthe composition of Sweden’s current debt portfolio,in particular in terms of the share allocated to foreigncurrency debt, differs from what is desirable. The dis-crepancy is so significant in relation to the speed withwhich the debt composition can be modified that ithas been deemed unnecessary at this stage to definea target portfolio in terms of percentage shares. Theguidelines have instead pointed out the desired direc-tions in which to move the portfolio. The resulting

debt portfolio strategy is discussed in this section, asare various aspects of active debt management.

The concepts of costs and risks

It was acknowledged when the new law was enactedthat additional analyses were required to give theconcepts of costs and risks more concrete interpreta-tions. Although much remains to be done, some ten-tative conclusions have been drawn by the SNDO andconfirmed in the government’s guideline decisions.

The first step in the process was to considerwhether costs (and related risks) should be measuredon the basis of a complete mark-to-market of the debtor using interest rates set when bonds were issued.The conclusion was that market value changes domatter. However, the bulk of the debt is not—andindeed cannot be—refinanced at short notice. As afirst approximation, therefore, it is reasonable toassume that debt instruments are left outstandinguntil maturity. This means that short-term fluctua-tions in market values resulting from changes in mar-ket interest rates are of little consequence for therealized costs of the debt. This view is also reflected inthe accounting practice of not revaluing the debt onthe basis of current market interest rates.

It should be noted, however, that the foreign cur-rency debt is consistently valued in terms of currentexchange rates. One reason to treat interest rate andexchange rate movements differently is that the lattercan be expected to lead to realized losses or gainseven if the bond is left outstanding to maturity,because payments are made in foreign currency.Moreover, the current exchange rate is probably thebest available indicator of the rate at maturity.

In the bill presenting the new legislation, the gov-ernment indicated that real (as opposed to nominal)measures of costs seemed appropriate from a generaleconomic perspective. However, the governmentnoted that the understanding of real measures offinancial risk was limited and that nominal costs there-fore would be used pending further analysis. A secondstep in the analysis has dealt with the question of howto go beyond nominal measures of costs and risks.

In its simplest form, a real measure could beobtained by deflating nominal costs with a priceindex, for example, the Consumer Price Index. This


would, for example, make the cost of an inflation-linked bond predetermined and, hence, risk free. Itis intuitively clear, however, that there is more to “realrisk” than inflation adjustment, and, more concretely,that an inflation-linked bond is not in general riskfree for the government. This line of thinking led toa broadening of the perspective beyond the govern-ment debt as usually defined. Inspiration also camefrom the practice, in particular in financial firms, ofmaking risk analyses in terms of the entire balancesheet, leading to a perspective akin to asset and lia-bility management (ALM).

The starting point is to note that debt is just oneitem on the government’s balance sheet, broadlydefined. First, there are nondebt obligations of allkinds, including entitlement programs and otherfuture expenditures. Second, the government hasassets. The most important of these is the right tocharge taxes, which in balance-sheet terms could bemeasured as the present value of future tax revenues.

Risks arise when assets and liabilities are not per-fectly matched. To manage its risks, the governmentmust therefore consider the entire balance sheet andtry to limit the mismatch between assets and liabili-ties.8 A complete balance-sheet analysis of the gov-ernment is an inordinately complicated undertaking.An ALM-based approach to debt management canalso be helpful if one does not have a complete quan-titative picture, however. In particular, it becomesclear that the risk of government debt should beassessed on the basis of whether it exacerbates or mit-igates strains on the balance sheet.

One simple measure of the (current) strains onthe balance sheet is the budget balance. For example,a debt portfolio that typically has high costs in reces-sions, that is, when public finances are strained forother reasons, must be considered riskier than a port-folio for which the opposite is true. This translatesinto treating deficit smoothing as an operative objec-tive of debt management.

An ALM perspective also modifies the assessmentof inflation-linked bonds. Debt costs linked to infla-tion mitigate swings in public finances as long asinflation is high when tax bases are high and expen-ditures low, that is, if inflation is positively correlatedwith the business cycle. However, if the economy is hitby a supply shock leading to stagflation—high infla-

tion combined with low growth—inflation-linkeddebt adds to the strains on public finances.

Acknowledging that ALM provides an appropri-ate frame for thinking about debt management risksis one thing; translating it into a complete debt man-agement strategy is quite another. The most visibleeffect so far on Swedish debt management is that inqualitative and quantitative analyses, debt costs are setin relation to GDP. GDP is here seen as a measure ofother business cycle–related influences on the budget,or a debt portfolio perceived as having a relatively sta-ble cost-to-GDP ratio is regarded as less risky. Usingthe cost-to-GDP ratio as the criterion for ranking debtportfolios is a step in the direction of ALM.

The SNDO has built a stochastic simulationmodel, which is used, jointly with qualitative reason-ing, in the work on guidelines for debt management.The model generates paths for interest rates,exchange rates, GDP, and the borrowing require-ment for up to 30 years. These time series are thenused to simulate the costs of a set of debt portfolioswith different characteristics, making it possible torank portfolios on the basis of their expected costsand the variability of costs. The primary metric usedis the cost-to-GDP ratio. Because GDP is generated inthe model, it is possible to capture correlationsbetween interest rates, exchange rates, and GDP inan internally consistent manner.9

Debt portfolio strategy

Background

For the purpose of discussing debt strategy at theportfolio level, the Swedish central government debtcan be broken down into three parts, nominal kronadebt, inflation-linked krona debt, and foreign cur-rency debt. Figure II.16.1 shows how the debt and itscomposition have developed since 1992.10

The current debt portfolio is dominated by nom-inal loans in domestic currency, made up of bondsand bills, but less so than in most Organization forEconomic Cooperation and Development countries.First, Sweden has an unusually large share of infla-tion-linked loans, although still less than 10 percentof total debt. Second, and more significant, morethan a third of the debt is in foreign currencies. The


foreign currency debt is largely a legacy from theearly 1990s. As can be seen in Figure II.16.1, totaldebt more than doubled between 1990 and 1995,when Sweden experienced the deepest recessionsince the 1930s. With an annual net borrowingrequirement corresponding to 14 percent of GDP atthe peak, it was useful to divert some of the borrow-ing to foreign capital markets. This reduced the pres-sure on long-term interest rates in the domesticmarket and diversified the debt portfolio.

The duration of the combined nominal kronaand foreign currency debt is approximately 2.7 years.The inflation-linked debt has a duration (measuredin terms of real rates) of close to 10 years.

Conclusions concerning the debt portfolio

The key question in the analyses conducted withinthe new governance framework has been how a port-

folio consistent with the objective of long-term costminimization with due regard to risk should be struc-tured. Special attention has been given to foreigncurrency debt, reflecting that this is the aspect inwhich the Swedish debt portfolio stands out, and toinflation-linked debt, as a relatively new instrument.

Foreign currency debt

Based on qualitative and quantitative analyses, theSNDO has concluded that it is desirable to reduce theshare of foreign currency debt.11 It adds risk withoutoffering expected long-term cost savings. First, thegovernment has few foreign currency assets (i.e., theforeign exchange exposure is basically unhedged).12

Second, it is not unlikely that the domestic currencyweakens in recessionary periods, because the costs offoreign currency debt would tend to add to swings inthe deficit-to-GDP ratio. Third, at a somewhat subtler


Figure II.16.1. Central Government Debt, 1990–2001 (In billions of Swedish kronor)

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level, the simulations model illustrates that (underflexible exchange rates) domestic short-term interestrates are negatively correlated with the business cycle,because the central bank will vary short rates in acounter-cyclical manner. This tends to stabilize theratio of debt costs to GDP. For a small country, foreigninterest rates will be unaffected by domestic events,making foreign currency debt less attractive thandomestic currency debt, other things being equal.

In the guidelines for 2001, the governmentdecided that the share of foreign currency debtshould be reduced.13 No percentage target was set,partly because the desired share is so far below thecurrent one that a decision on this point was noturgent. Instead, the government established a plan ofannual amortizations corresponding to SKr 35 bil-lion. Annual repayments could be varied within aninterval of ±SKr 15 billion. The governmentinstructed the SNDO to take account of the value ofthe krona when deciding the actual rate of repay-ment. If the krona is seen as significantly underval-ued, it is rational—given a cost minimizationtarget—to reduce repayments until the kronaexchange rate has returned to more normal levels. Inthe guidelines for 2002, the government decided tolower the long-term rate of repayment to SKr 25 bil-lion. Moreover, it set the 2002 target rate to SKr 15billion, citing the weakness of the krona.

Also pointing to the depreciation of the krona,the SNDO used its mandate to hold back amortiza-tions of close to SKr 15 billion in 2001. It has alsoannounced that repayments will be made at a lowerpace than the targeted rate from the start of 2002. Incombination with a significant reduction in thekrona-denominated debt and the depreciation of thekrona, this has led to an increase in the foreign cur-rency share during 2001 (Figure II.16.1). The long-term ambition is still to gradually decrease theforeign currency debt to achieve a debt portfoliomore in line with the objective of debt management.

Inflation-linked debt

In the guideline proposal for 2002, the SNDO focusedon the role of inflation-linked debt.14 The quantitativeresults from the simulation model were less clear cutthan in the analysis of foreign currency debt. The

model indicates that there is little difference in termsof costs and risks between nominal and inflation-linked domestic currency debt. One potential expla-nation is that the model assumes the economy is notsubjected to severe shocks. For example, budgetaryand monetary policy targets are met on average in allsimulations. The debt portfolios are thus not sub-jected to any stress-tests, because these are hard tohandle in a long-term simulation model. In such anenvironment, there is little reason to expect inflation-linked debt to differ markedly from nominal debt.

Using qualitative reasoning, the SNDO points toother possibilities. For example, in an environmentwith low growth and low inflation, perhaps even defla-tion, inflation-linked bonds are helpful for deficitsmoothing. Conversely, during a period of stagflation,having a large inflation-linked debt is undesirable.The observation that neither deflation nor stagflationcan be ruled out before the fact. is then sufficient toindicate that a portfolio made up of several types ofdebt is preferable from the point of view of reducingrisk. As long as inflation-linked bonds are notmarkedly more costly than nominal bonds, this diver-sification effect thus argues for including inflation-linked debt in the portfolio. The tentative assessmentis that the share should be higher than the current 8percent for inflation-linked debt to make an appre-ciable difference in an actual stress test.

In the guidelines for 2002, the governmentinstructed the SNDO to increase the share of infla-tion-linked debt in the long term.15 However, giventhe cost minimization objective, the rate of increasemust be weighed against the costs of other types ofdebt. As in other countries, the inflation-linked bondmarket has periodically been characterized by limitedinvestor demand and high liquidity premiums. Animportant task for the SNDO is therefore to continueits efforts to improve the functioning of the market sothat the benefits in terms of reduced portfolio riskscan be achieved at acceptable costs. (See also thethird section.)

Duration

The choice of duration involves a trade-off betweencosts and refinancing risks. Experience indicates thatnominal short rates, on average, are lower than long


rates. Strict cost minimization would thus argue forhaving a debt with short duration. As noted before,domestic short rates may also be negatively correlatedwith the business cycle, which contributes to deficitsmoothing. However, a short duration would makedebt costs more sensitive to current interest rate lev-els. Moreover, short rates tend to be more volatilethan long rates.

The duration of the nominal part of Swedishdebt is 2.7 years, which has been concluded to repre-sent a reasonable trade-off between the considera-tions discussed. The current guidelines thus indicateunchanged duration over the three-year planninghorizon.

The inflation-linked debt is significantly longer,as is appropriate for an instrument aimed at protect-ing investors from inflation uncertainty. The guide-lines state that inflation-linked debt should have atleast five years’ maturity at the time of issuance andpreferably longer. Inflation-linked debt thereforeextends average maturity and helps reduce refinanc-ing risks for the debt portfolio as a whole.

Maturity profile

A duration target does not limit refinancing risks. Inprinciple, a mixture of just two maturities can achieveany duration target. In practice, the rollover risk islimited by the SNDO’s overall borrowing strategy,based on a set of nominal benchmark bonds extend-ing to at least 10 years and a set of inflation-linkedbonds, some of which have an even longer time tomaturity. For the purpose of clarity, the guidelinesstill set a limit on the permissible extent of refinanc-ing over the short term. The stipulation is that theSNDO should plan its borrowing in such a way thatno more than 25 percent of the debt matures overthe next 12 months.

Summary

Sweden has decided that the concept of risk in thestatutory objective shall be interpreted in terms ofhow debt costs affect the overall stability of govern-ment finances. In this regard, Swedish authoritieshave adopted an ALM approach as the starting pointfor debt portfolio analysis. Given the time perspec-

tives involved in government debt management,potentially spanning generations, genuine uncer-tainty will always be a key element in debt manage-ment. One should therefore not expect to reachrobust, once-and-for-all quantitative conclusionsabout what is an optimal debt portfolio. The maincontribution of the ALM approach is probably asmuch in the questions it raises as in the formalanswers. In particular, the debt manager is forced toaddress issues related to risk taking in a more consis-tent manner than if debt costs are seen in isolationfrom the rest of the government balance sheet.

Active debt management

Background

It is useful to distinguish between two types of activedebt management. The first type includes actionsallowing a separation between funding decisions, onthe one hand, and decisions on the characteristics ofthe debt portfolio, on the other, achieved primarilythrough derivatives. Such activities are motivated by adesire to use low-cost methods of funding without nec-essarily accepting the risks attached to those instru-ments. The resulting debt portfolio should have lowerfunding costs or risk or both than an identical portfo-lio created by direct borrowing. This form of activemanagement is driven by strategic considerations.16

The second type of active debt managementrefers to positions taken on the basis of views on thefuture paths of interest rates or exchange rates. Thisrequires a defined benchmark. A position is then cre-ated by modifying the actual portfolio so that it devi-ates from the benchmark. The result of the positioncan be evaluated by comparing the (market) value ofthe actual portfolio to the value of the benchmark.This form of active management is typically driven bytactical considerations.

The SNDO uses both forms of active debt man-agement. The following explains the motivations andframeworks used in each.

Portfolio management strategies

The separation between funding and portfolio deci-sions originates from how the foreign currency debt


has been managed. Traditionally, the SNDO pursuedan opportunistic borrowing strategy, seeking out low-cost funding sources without regard to currency ormaturity. To achieve the desired composition of theforeign currency debt portfolio, expressed in abenchmark portfolio, it used derivatives to transformthe cash flows.

Given this experience of working with derivatives,it was not a major step when the SNDO in 1996 beganborrowing in Swedish krona and converting the debtinto synthetic foreign currency obligations by use offoreign currency swaps.17 This transformationinvolves several steps. First, the SNDO issues a long-term krona bond. Second, it does an interest-rateswap (IRS) in kronor in which it receives paymentsbased on a fixed interest rate and pays based on afloating interest rate. Third, the floating krona cashflow is converted to euros, say, via a foreign currencyswap. Finally, there is an IRS in foreign currency toachieve the desired duration of the foreign currency

exposure. At the end of 2001, about 45 percent of theforeign currency exposure, equivalent to SKr 180 bil-lion, was in the form of krona/currency swaps. As canbe seen in Figure II.16.2, annual swap volumes havevaried between SKr 20 billion and SKr 40 billion,depending partly on the perceived depth of the mar-ket. In recent years, at least half of the krona bondsissued have been swapped.

Krona/currency swaps have for several years beenthe cheapest method for creating foreign currencyexposure. The reason is that the SNDO—as a repre-sentative of the state—has a comparative advantage inlong-term borrowing in kronor. In other words, thelong-term swap rate is higher than the SNDO’s long-term funding cost. This swap spread is partly offset bythe fact that the floating swap rate is higher than thetreasury bill rate, which determines the cost for directshort-term funding. As long as the average short-termspread over the term of the swap is lower than the ini-tial long-term swap spread, the SNDO obtains cheaper


Figure II.16.2. Bond Issuance and Swap Volumes, 1996–2001

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funding by using swaps than by issuing bills. Moreover,it avoids the refinancing risk.18

The SNDO has announced that IRSs can be usedas an alternative to short-term funding, that is, as acomplement to bills. This enables the SNDO to bor-row in the long end of the yield curve withoutincreasing the duration of the debt. Swaps thus alsoresult in larger issue volumes in the Swedish bondmarket, which should support liquidity. This aspecthas been important in recent years, when gross bor-rowing needs, following an improved budget situa-tion, have decreased.

It is important that large-scale derivates transac-tions are handled in a transparent manner to avoidany confusion in the marketplace about the motivesfor using them. As in the bond market, the SNDOtherefore announces its yearly planned swap activi-ties. The volumes are decided based on previousexperiences and following comments from marketplayers. The actual volumes can change dependingon market conditions. Moreover, a swaps book of thesize built up in Sweden presupposes that swaps mar-kets have sufficient depth, so that shrinking swapspreads do not erode the benefits. A gradual expan-sion of the program, with due regard to the costs ofswaps relative to other funding techniques, is there-fore advisable.

Swaps and other derivatives give rise to counter-party risks, which must be carefully managed. TheSNDO uses credit support annex agreements as amethod for reducing credit risks. This is a system ofbilateral exchange of cash based on the current mar-ket value of the net position. Such a system limits thecredit exposure to the daily changes in market value,allowing the SNDO to transact with the counter-par-ties that offer the best prices at each point basicallywithout regard to the previous contracts written withthose intermediaries.19

Tactical debt allocation

Foreign currency debtThe SNDO takes tactical positions to benefit frommovements in exchange rates and interest rates onlyin the management of the foreign currency debt. Theframework for this activity is a benchmark portfoliodetermined by the SNDO’s board. The board defines

a neutral portfolio in terms of currency and maturitycomposition and the maximum permissible devia-tions from this portfolio. Within these boundaries,the SNDO management has the mandate to takepositions. The observance of these limits is moni-tored by the risk control department, which is sepa-rate from the debt management department.

The SNDO also engages external portfolio man-agers (currently five) working with the same man-date, scaled down to a fraction of the total foreigncurrency debt. This practice gives an additional mea-suring rod for evaluation of the SNDO’s debt alloca-tion decisions.

Domestic currency debtThe SNDO makes no corresponding debt allocationdecisions based on views on interest rates in the man-agement of the krona debt. The main reason is thatthe SNDO is so dominant a player in the krona fixed-income market that its reallocations could move inter-est rates. Opportunistic behavior by such a borrowerwill raise the overall level of interest rates as investorsdemand compensation for the added risks they face.Given its typical dominance of the domestic currencybond market, a predictable and transparent borrow-ing strategy is a better means to lower debt costs for asovereign issuer. (See also the third section.)

As noted, the SNDO bases decisions on the rateof repayment of the foreign currency debt partly onexchange rate assessments. This is also a form ofactive debt management, affecting the compositionof the debt, although there is no defined benchmarkfor the overall debt portfolio.

It should be emphasized that from the point ofview of securing low costs and acceptable risks, activedebt management relative to a benchmark portfoliois of secondary importance compared with the deci-sion on the benchmark portfolio itself. For example,it is obvious that choosing a duration target of 2 yearsinstead of 5 years affects costs and risks far more thanvariations within an interval of ±0.3 years aroundeither central value. Still, the savings from successfulactive debt management can be significant in abso-lute numbers. Moreover, instruments used for posi-tion taking can be applicable also in conventionaldebt management, for example, on the use of deriva-tives instruments, thus giving positive side effects.


Cash management and the links to the centralbank

The state payment system in Sweden is based on thesingle-account principle, that is, all payments arechanneled through a system with a single topaccount, managed by the SNDO. Up until 1994, thebalance on this account was held with the Riksbank.This meant that the SNDO was not engaged in cashmanagement. Instead, the Riksbank had to sterilizethe changes in bank reserves resulting from swings inthe balance on the government’s account.

In connection with Sweden’s entry into theEuropean Union (EU), it was decided that the SNDOshould manage the top account outside the Riksbank.One reason was that EU rules prohibit the centralbank from lending directly to the government, that is,the SNDO could no longer have a negative balance onits account overnight. Because the government’s cashposition fluctuates strongly over the month, it wouldhave had to deposit a sizable sum with the Riksbank tocreate a buffer that would prevent the balance fromever turning negative. This was deemed to be an inef-ficient form of cash management.

In the current framework, the SNDO uses itsRiksbank account for participation in the paymentclearing system, but the balance on the account is setto zero at the end of each day. This is achieved viatransactions in the short-term interbank market withsuch instruments as overnight loans and deposits, aswell as repos. Typically, the balance is brought to zeroby such interbank market transactions. On occasion,there is a remaining balance (positive or negative),rarely exceeding a few million kronor, at the end ofthe day. This is then transferred automatically to anaccount held by the SNDO with a commercial bank.In this way, the SNDO has responsibility for all aspectsof government debt management, from overnightloans to 30-year inflation-linked bonds.

This arrangement also means that the Riksbankdoes not have to offset the swings in the governmentcash position via market operations. Because theSNDO is part of the interbank market, the reservesavailable to the banking system are not affected bythe government’s cash position. Separation of gov-ernment cash management from the central bankthus also simplifies the Riksbank’s task of managing

its balance sheet to set the overnight interest rate atthe target level.

Although the SNDO has been responsible fordomestic currency cash management since 1994, ithas continued to make all exchanges between kronorand foreign currencies with the Riksbank. TheRiksbank makes the exchanges needed to cover theSNDO’s purchases of foreign currencies in a prede-termined pattern to avoid confusion with interven-tions for exchange rate policy purposes. Specifically,the bank buys a preannounced sum of foreign cur-rency during a certain period on each trading day.

As of July 1, 2002, the SNDO will also have theright to make such exchanges with other counter-par-ties. The motivation for the government’s decision isthat this will allow greater flexibility in the handlingof the transactions. Although the SNDO is alsoinstructed to act predictably and transparently in theforeign exchange market—that is, short-term specu-lative transactions are ruled out—it need not adhereto such a strict calendar as the Riksbank, thus makingit possible to also use the timing of purchases of for-eign currency as an instrument for reducing the costsof the debt.

Management of contingent liabilities

Contingent liabilities in the form of guarantees canbe issued only on the basis of authorization from par-liament. Four government agencies are in charge ofspecial guarantee programs related to export credit,housing, international aid, and deposit insurance.The SNDO issues other guarantees based on specificauthorizations by parliament in each case. The bud-get law stipulates that a risk-related fee should becharged for guarantees. If parliament decides thatthe recipient of the guarantee does not have to pay,budget means must be reserved to cover the fee. TheSNDO sets the fee, that is, there is a clear separationbetween the decision to issue the guarantee and thepricing. The accuracy of the SNDO’s pricing deci-sions can be evaluated after the fact by checkingwhether the fees accumulated over long periodsmatch the payments made to cover guarantee claims.

With an ALM approach to debt management, it isclear that guarantees (and other contingent liabilities)must be considered in analyses of the risks in public


finances. In a consistent risk management framework,it should be possible, for example, to consider whethera risk reduction should be achieved via a change in thegovernment debt portfolio or by transferring a guar-antee to a guarantor in the private sector.

Again, this principle is easier to state than toimplement. A first step would be to present consis-tent aggregate information on government guaran-tees. This should include expected losses on the totalguarantee portfolio, but also capture the magnitudeof unexpected losses. Reports on the guarantee port-folio should be presented to parliament in connec-tion with the budget proposal. If the expected orunexpected guarantee losses increase, this should beconsidered before decisions on expenditures andtaxes are taken, because this would be equivalent to aweakening of the underlying budget position. Such aframework is not in place in Sweden, but steps in thisdirection are being taken to improve the analysis andmanagement of contingent liabilities.


Introduction

In addition to a well-balanced allocation among typesof debt, a smoothly functioning market for govern-ment securities is important to achieve the objectiveof minimizing costs. As a dominant borrower andparticipant in the Swedish fixed-income market, theSNDO has a responsibility for ensuring the efficiencyand development of the market. The SNDO hastherefore taken an active role in the discussions anddevelopment of the market place. This includes mea-sures to improve the secondary market to enhanceliquidity and transparency. Some examples of mea-sures taken in the different market segments are dis-cussed in this section.

Nominal bonds

Primary market

The overall strategy is to concentrate borrowing in afew fairly large issues. Currently, there are around 10

such benchmark bonds. Large issues make tradingeasier, and the risk of short squeezes in specific issuesis lowered. The SNDO previously aimed at ensuringthat there were bonds maturing every year. This strat-egy was slightly changed during 2000, when a new 10-year issue was introduced, maturing in 2011, leaving2010 without any maturity. Considering the largebudget surpluses, it was more important to concen-trate borrowing to support liquidity than to haveyearly maturities of benchmark bonds. The maturityprofile at the end of 2001 is illustrated in FigureII.16.3.

When a new issue is introduced, normally with a10-year maturity, switches from old issues are carriedout to quickly build up the new issue. In addition, aspecial repo facility of some SKr 20 billion is in placeimmediately after the first auction of the new bond.The repo rate is typically 15 basis points below theRiksbank’s target for the overnight interest rate. Thisrepo facility ensures that no single investors cansqueeze the market for a new issue. As a result, theSNDO has not set any limitation on how large a sharea single investor may hold of a single bond or on theshare allocated to a single dealer in an auction.

Bond auctions are held biweekly. The issue forauction and the volume are announced one week inadvance. The authorized dealers are committed toenter bids on behalf of investors and for their ownaccount. The result is presented 15 minutes after theauction is closed.

Secondary market

One important way to enhance liquidity in the sec-ondary market is to offer repo facilities to the autho-rized dealers. This lowers the risk of shortages and,hence, supports liquidity. To ensure that the SNDOdoes not assume too dominant a position in the repomarket, these activities are limited. The SNDO has seta maximum repo volume of SKr 500 million, whichthe authorized dealers can use at a penalty rate of 60basis points below the Riksbank’s target for theovernight rate. This spread ensures that the facility isregarded as a “repo of last resort.” Although theserepo facilities are rarely used, they are importantbecause they make it impossible to create a squeeze.With a penalty rate as high as 60 basis points, supply


and demand in the market still govern pricing in nor-mal circumstances, without interference from theSNDO.

In addition, repos are a natural instrument in theSNDO’s liquidity management. When the SNDOneeds to borrow in the short term, it might, forinstance, lend a security to an investor in a repo to getshort-term funds. In this case, the repo rate is 15–25basis points below the targeted overnight interest rate.Other alternatives are to borrow directly in the depositmarket or issue short-term treasury bills on tap.

Treasury bills

The Swedish treasury bill market is relatively large inan international perspective. About 20 percent of thetotal debt is in treasury bills. This market is builtaround the same principles as the bond market.Borrowing is made through biweekly auctions and is

concentrated in eight bills, normally of up to 12months’ maturity (see Figure II.16.4). The repo mar-ket is less liquid and deep than the bond market, butthe SNDO has similar repo facilities as those in thebond market, with slightly more generous conditions.

When a bond has less than one year to maturity,investors are offered opportunities to switch into apackage of three or four bills. The package is con-structed so that the exchange is duration neutral.The operation leaves the investor with more liquidsecurities and lowers the refinancing risk of theSNDO, because the redemption is spread over sev-eral dates.

Inflation-linked bonds

Inflation-linked bonds were introduced in 1994. Theshare of the total debt is some 8 percent. This makesthe Swedish inflation-linked market one of the largest


Figure II.16.3. Maturity Profile for Nominal Bonds, December 2001

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2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

in the world in relative terms. There are currentlyseven inflation-linked bonds ranging from 2 to 26years in maturity.

Two main arguments have been put forward tosupport issuance of inflation-linked bonds. First, thelong-term funding cost should be lower, because thestate assumes the inflation risk. If the inflation riskpremium is higher than other premiums that mightwork in the other direction, such as liquidity premi-ums, the funding cost of inflation-linked bondsshould be lower than for nominal bonds. The secondargument—discussed in the second section—is thatinflation-linked bonds contribute to diversification ofthe debt portfolio.

In the first years of the program, the cost argu-ment seems to have been valid because investorsbought inflation-linked bonds at breakeven levelshigher than the official inflation target set by theRiksbank. Probably the inflation target at that time

did not have full credibility, which made it rational forinvestors to pay to avoid the inflation risk. Inflationfell below the inflation target, and, as a consequence,the SNDO has calculated that so far the inflation-linked borrowing has saved some SKr 8 billion in accu-mulated funding cost since 1994. However, in recentyears, the credibility for the 2 percent inflation targethas been established, and breakeven inflation pricedby the market has been below 2 percent. This hasraised the question whether issuance of inflation-linked bonds is cost efficient.

The government and the SNDO have concludedthat the cost saving might vary substantially over time.When inflation risks are regarded as small, it mightbe less favorable to issue inflation-linked bonds andvice versa when inflation risks rise. Also, it is impor-tant for the SNDO to support an efficient market forinflation-linked bonds to bring down the liquiditypremium.


Figure II.16.4. Maturity Profile for Treasury Bills, December 2001

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Jan-02 Feb-02 Mar-02 Apr-02 May-02 Jun-02 Jul-02 Aug-02 Sep-02 Oct-02 Nov-02 Dec-02

Developing a market for a new type of instru-ment is a challenge. Theoretical arguments supportinclusion of inflation-linked bonds in long-term assetportfolios. However, most large asset portfolios inSweden still have small shares of inflation-linkedassets. There are several reasons behind this. One isprobably that many investors use nominal accountingand benchmarking, making inflation-linked instru-ments appear more, rather than less, risky. Fundmanagers also have a tendency not to deviate verymuch from their competitors, implying that theremay be thresholds that need to be passed to increaseaggregate holdings of inflation-linked bonds.

One lesson from Sweden’s experience is that apragmatic approach is warranted. For example, theSNDO has issued inflation-linked bonds throughboth auctions and on tap. On-tap issuance—issuanceof securities at the request of authorized dealers—worked well when the large domestic investors werebuilding up strategic holdings in inflation-linkedbonds. The on-tap method made it possible to meetthis demand in a flexible way. As the market grew,auctions were introduced, because this methodincreased transparency and predictability.

Although inflation-linked bonds are soldthrough auctions, the SNDO offers authorized deal-ers an on-tap switching facility in the secondary mar-ket, making it possible for authorized dealers toswitch between two bonds on a duration-neutralbasis. The SNDO sets the price in a way that makesswitches expensive for the dealers. Like repo facilitiesfor nominal bonds, the switching facility should beregarded as a “last resort” offer. In addition, theSNDO has repo facilities for inflation-linked bonds.Each authorized dealer can repo SKr 200 million 25basis points below the Riksbank overnight rate.

Ahead of auctions, the SNDO takes advice fromauthorized dealers. The SNDO is more inclined to lis-ten to advice in the inflation-linked market than inthe nominal bond market; dialogue with investorsand dealers is more important in a new market.

Naturally, when deciding what and how much toissue, the SNDO also takes prices into account. Inparticular, the it tries to avoid funding at breakeveninflation rates, which are too low. However, theSNDO finds it important to support the market byalso issuing at least small volumes when funding costs

seem less favorable. In the longer run, this shouldhelp bring down liquidity premiums and, hence,make inflation-linked funding less expensive.

Authorized dealers

The SNDO has three separate dealer agreements:one for nominal bonds, one for treasury bills, andone for inflation-linked bonds. The reason for havingformal agreements is that it enables the SNDO toform dealer groups committed to take part in boththe primary and secondary markets on an ongoingbasis. A commitment from dealers is of added impor-tance in Sweden, given its fairly small market.

The agreement for nominal bonds was changedin 2001, when an electronic trading platform wasstarted. The SNDO used the agreements as an instru-ment to make a uniform change of the market struc-ture possible. According to the new agreement, theauthorized dealers will, apart from taking part in theprimary market, quote binding two-way prices in 2-, 5-, and 10-year bonds in the electronic system. Theagreement specifies minimum volumes and maxi-mum bid-offer spreads. As part of the new agree-ment, the SNDO began to pay commissions todealers to encourage participation in the electronictrading system. One part is fixed, and one is relatedto how active the dealer has been in the primary andsecondary markets. In total, commissions amount tobetween SKr 15 million and SKr 20 million per year(equivalent to less than US$2 million).

An advisory board governs the new electronictrading platform. The authorized dealers, the SNDO,and the exchange are represented on that board.

The SNDO does not pay commissions in the trea-sury bill market, because the commitment needed—especially in the secondary market—from the dealersis not regarded as important as in the bond market.However, the authorized dealers have the advantageof being the only ones allowed to bid in the auctionsand have access to repo facilities.

The agreement for inflation-linked bonds ismore extensive in the sense that it requires the can-didates to apply once a year and present a businessplan for their activities. By requiring business plans,the SNDO wants to stress that it is important thatdealers are active in promoting inflation-linked


bonds to help broaden the investor base.Commissions are also paid to authorized dealers inthe inflation-linked market—in total, about SKr 12million per year.

Investor relations

As the fixed-income markets become more globaland integrated, the importance of investor relationsincreases. Previously, the debt policy of a country wasof interest for only a limited number of mostlydomestic investors. Now, investors can and willchoose from a number of fixed-income markets.Consequently, sovereign borrowers are in competi-tion with each other and with other large issuers.

The main element in the SNDO’s investor rela-tions strategy is to have a transparent and predictableborrowing strategy. When investors understand theframework for debt management and know what vari-ables are important, there will be less uncertainty andrisk premiums will be lower. However, transparencyand predictability do not exclude changes in borrow-ing plans or the set of instruments used. The issuermust have the opportunity to adjust its plans, forexample, to unforeseen changes in the borrowingrequirement. Therefore, the objective should be tocommunicate strategic principles—for example,duration of the debt and the desired debt composi-tion—and explain what factors are important whenformulating policies.

In this respect, the guideline system serves as agood basis. In the guidelines, investors and otherscan find the motives behind a certain strategy. Thefact that all documents in the guideline process arepublic also allows dealers, investors, and other con-cerned parties to offer their comments.

The SNDO publishes a report three times a yearin which it presents the latest forecast for the bor-rowing requirement as well as plans for futureissuance. In addition, the report discusses differenttopics related to debt management. This may includearticles about swap strategies, proposals for changesof the market structure, and similar topics. The pur-pose is to provide information and stimulate thedebate on debt management. The Internet(www.rgk.se) is used extensively to make informationavailable.

Apart from written material, the SNDO finds itimportant to be available to investors who want to dis-cuss debt policy. The SNDO also takes initiatives tomeet investors both in Sweden and abroad.


All tradable debt instruments used by the SNDO areregistered electronically with the Swedish CentralSecurities Depository and Clearing Organization(VPC), which is a corporation controlled by themajor domestic banks. VPC handles the clearing andsettlement of all transactions in government securi-ties, as well as interest payments and repayment onmaturity. The normal settlement date for treasurybills is T+2, and for bonds, it is T+3.

Clearing in the Swedish system is done on a netbasis, making it sensitive to unwinding problems inthe event of a major player failing to pay or deliversecurities. To cope with this problem, all market play-ers, including the SNDO and the Riksbank, haveagreed to support the market through repo arrange-ments. However, this is not binding, that is, there isstill a risk that unwinding problems would occur,which implies that the system does not fully complywith international standards. There is a systemic riskthat is implicitly covered by the state. The Riksbank,as responsible for the payment system in Sweden, hasdemanded that the system be changed. At present,the introduction of a central counterpart seems themost likely solution, but other options, such as grosssettlement, have been discussed.

Trends shaping the future market forgovernment securities

Looking ahead, debt management and funding strat-egy in Sweden will continue to focus on broadeningthe investor base. This includes attracting new inter-national institutional investors to offset the interna-tional diversification by domestic portfolio managers.However, it also involves making government debtinstruments available to smaller investors, includingretail. In recent years, such a development has tosome extent been hindered by the extreme stockmarket performance; for private individuals inSweden, fixed-income instruments have not seemed


attractive. Following the correction in the stock mar-ket, the SNDO has noticed an increased appetite forfixed-income savings.

This raises issues related to how to reach retailinvestors. More efficient distribution channels mightchange the role of the authorized dealers and otherintermediaries. One scenario could be that investors,retail as well as institutions, enter bids in auctionsdirectly through the SNDO’s web site. The advantagefrom the investors’ point of view would be that theycould enter bids without intermediaries and withoutrevealing information to other market participants.Moreover, intermediaries might not find it worth-while to invite retail investors to the primary marketfor government securities, because this may be lessprofitable than selling other products.

Therefore, the SNDO believes that to reachsmaller investors, it is important to develop direct dis-tribution channels. The drawback with such a strategyis that it might be costly to handle small lots. Thetrend toward straight-through processing shouldbring down this cost in the coming years, however.Also, the costs involved need to be valued againstcosts of using intermediaries, such as commissionsand underwriting fees. In the more competitive envi-ronment faced by sovereign issuers, the fees requiredfor such services may tend to rise.

It is far from certain what rapid technologicalchange will mean for the distribution of debt instru-ments. However, the SNDO considers it important tobe prepared in the event that new distribution chan-nels, for example, based on Internet solutions, turnout to be attractive to investors. Changes are hard toanticipate, making it all the more important not torely on only one strategy.

If the primary market changes with more directselling to investors, what will then happen to the sec-ondary market? Today, the secondary market is builtaround a market-maker system, with banks quotingtwo-way prices. With a less central role in the primarymarket, some intermediaries might not find it prof-itable to commit resources to secondary market activ-ity. Either such a development will go hand in handwith a trend where debt markets, similar to the equitymarkets, are primarily order driven and market mak-ers are less important; or the issuers will have to findnew ways to get support from intermediaries in the

secondary market. In either case, it is rational to havealternative distribution channels. However, thesealternatives should be developed taking into accountthe effects on the secondary market. Also, for retailinvestors, it is important that their bond holdings canbe converted to cash at reasonable costs.

Continued technical change is bound to changefixed-income markets as it is changing other financialmarkets. The separation of the primary and sec-ondary markets, and the strong role for intermedi-aries in both segments, are two areas where newsolutions might come up. Therefore, it is advisablefor debt managers to make possible changes in thetraditional market structure into account when form-ing strategies for how to improve the functioning ofgovernment securities markets.

Notes

1. The case study was prepared by Lars Hörngren and ErikThedéen from the Swedish National Debt Office.

2. This report deals with central government debt manage-ment. For brevity, the term “central” will be left out, unless it isneeded to avoid confusion with other aspects of public debt.

3. Expenditures are controlled via the budget, not by ceil-ings on government borrowing or the size of the debt.

4. This also reflects a long-standing tradition in Sweden ofworking with small ministries, which are responsible for policydecisions, and delegating operative functions to agencies thathave separate management and are at arm’s length from the min-istries.

5. Concrete illustrations of the contents of the guidelinesare presented in the second section.

6. For more on the organization of the SNDO, see the sec-ond section.

7. The national audit office, an independent agency for cen-tral government auditing, also audits the activities and accountsof the SNDO.

8. The ALM perspective was introduced in the guidelineproposal presented in October 2000, available at the SNDO’s website (http://www.rgk.se/files/upl497-Guidelines_2001.pdf).

9. The model and the simulation results are described inpapers available at the SNDO’s web site(http://www.rgk.se/files/upl553-Teknisk_Rapport.pdf).

10. The SNDO has used derivatives and other debt manage-ment instruments actively for a number of years. The numbers inFigure II.16.1 refer to the exposures when account has beentaken of derivatives.

11. The analysis is presented in the guideline proposal for2001, available at the SNDO’s web site(http://www.rgk.se/files/upl497-Guidelines_2001.pdf).

12. The foreign exchange reserves are owned and managedby the Riksbank, reflecting its responsibility for implementing for-eign exchange policy. Because the foreign exchange reserves areset aside for a special purpose, they give no hedging effect from


the point of view of the central government. The foreign cur-rency debt and the foreign exchange reserves are therefore man-aged separately.

13. The government’s decision for 2001 can be found at theSNDO’s web site (http://www.rgk.se/files/upl546-statsskuld_eng.pdf).

14. The guideline proposal for 2002 is available at theSNDO’s web site (http://www.rgk.se/files/upl1037-Riktlinjer_Eng.pdf).

15. The government’s decision for 2002 can be found at theSNDO’s web site (http://www.rgk.se/files/upl1115-riktlin-jebeslut_2002_eng.pdf).

16. One could include exchanges and buybacks of outstand-ing debt in active debt management, because they imply devia-

tions from a plain “issue-and-leave-outstanding” strategy. Theseinstruments are discussed in the third section, because they arealso meant to enhance market liquidity.

17. For an in-depth review of the use of swaps by debt man-agers (including the SNDO), see Gustavo Piga, Derivatives andPublic Debt Management (Zurich: International Securities MarketAssociation), 2001.

18. A long-term bond combined with an interest-rate swap isequivalent to a (synthetic) floating-rate note.

19. The SNDO works with symmetrical credit support annexagreements, that is, the it also transfers cash if a counter-party hasa net claim, in line with market practice.



Objectives of debt management policy

The government’s current debt management policywas first outlined in the Report of the Debt ManagementReview in 1995. The debt management policy objectiveis: “to minimize over the long term the cost of meetingthe government’s financing needs, taking into accountrisk, whilst ensuring that debt management is consis-tent with the objectives of monetary policy.”

This policy objective is achieved by

• pursuing an issuance policy that is open, pre-dictable, and transparent;

• issuing conventional gilts that achieve a bench-mark premium;

• adjusting the maturity and nature of the govern-ment debt portfolio by means of the maturity andcomposition of debt issuance and other marketoperations, including switch auctions, conversionoffers, and buybacks;

• developing a liquid and efficient gilts market; and• offering cost-effective retail savings instruments

through national savings.

Before the 1995 review, the formal objective fordebt management was to

• support and complement monetary policy;• subject to this, avoid distorting financial markets; and• subject to this, fund at least cost and risk.

However, it was felt these objectives were not anappropriate description of the way that debt manage-ment policy functioned in practice. In particular:

• Funding at least cost subject to risk is the primaryobjective of debt management policy.

• An efficient and liquid gilts market lowers yieldsand, hence, reduces funding costs, thus helping toachieve the primary objective.

• Debt management is not the major tool of mone-tary policy, nor is monetary policy the main objec-tive of debt management.

234

17United Kingdom1

• The objective did not mention the importantspecific roles of the gilts market and national sav-ings.

The current objective focuses on the long term.This avoids the government seeking short-term gainby, say, reducing the debt interest bill over the pub-lished forecast period. The long-term nature of manyof the instruments used in the debt market plus theimportance of maintaining an issuer’s reputationmean that it is preferable to focus on long-term aimsrather than seek short-run gains.

By taking account of risk, the government doesnot follow a purely cost-minimizing strategy. Rather,the government seeks to ensure that it is robustagainst a variety of economic results. The main way ofdoing this is by considering the effect of issuance onthe ensuing government debt portfolio. Broadlyspeaking, the government will not be able to predictwhich particular gilt will prove to be cheaper thanany other, because they will seldom be any betterinformed than the market on the future path of keymacroeconomic variables. Indeed, the market willprice any relevant information into the gilt yieldcurve. Therefore, it would seem futile for the govern-ment to attempt to beat the market systematically bytrying to anticipate the future path of the economythat differs from that embodied in market expecta-tions. It is therefore preferable for the government toselect a portfolio that would protect it from as wide arange of economic shocks as possible.

In terms of operational delivery of the new debtmanagement objective, the 1995 review heralded amove away from a highly discretionary debt manage-ment policy. The review rejected the thesis that dis-cretion benefited the government in that it could sellappropriate debt at advantageous prices. It was feltthat under such arrangements, the governmentwould pay an unnecessary premium, because it wouldbe systematically attempting to beat the market andthere would be no certainty over or transparency inthe path of issuance policy. Therefore, the reviewadvocated a change to a policy that would promote amore efficient, liquid, and transparent market. It rec-ommended a move toward a policy of annual pub-lished remits that would set out in advance issuancein terms of type and maturity of gilt, a preannounced

auction calendar, and a movement toward more giltsales by auction and less by tap.

Institutional framework for debt management

On May 6, 1997, the chancellor of the exchequerannounced that he was granting operational controlof interest rate policy to the Bank of England. Amongthe other changes announced were that operationalresponsibility for debt and cash management shouldpass to Her Majesty’s Treasury. Following a consulta-tion exercise in July 1997, treasury ministersannounced the creation of a new executive agency,the United Kingdom Debt Management Office(DMO), which would be charged with carrying outthe government’s operations in the debt and cashmarkets. The DMO became officially operational asof April 1, 1998, and took over responsibility for debtmanagement from the Bank of England from thatdate. Full responsibility for cash management wasassumed on April 3, 2000.

Before April 1998, the Bank of England acted asthe government’s agent in the debt and cash markets.The transfer to Her Majesty’s Treasury helped miti-gate any perception that the government’s debt andcash operations might benefit from inside knowledgeover the future path of interest rates and avoided apotential conflict of interest, or perception of con-flict, between the objectives of the government’s debtand monetary policy operations. This separation ofresponsibilities allows the setting of clear and sepa-rate objectives for monetary policy, debt manage-ment, and cash management, with benefits in termsof reduced market uncertainty and, hence, lowerfinancing rates. The Bank of England’s monetary pol-icy committee is able to raise any issues about theimplications of debt management for monetary pol-icy with the treasury’s representative at monetary pol-icy committee meetings.

As with all executive agencies, the DMO’s rela-tionship with the treasury is outlined in a frameworkdocument.2 The basic structure for debt manage-ment is that treasury ministers advised by officials inthe debt and reserves management team will set thepolicy framework within which the DMO will makeoperational decisions within the terms of the annualremit is set for them by treasury ministers. The

Country Case Studies: United Kingdom 235

DMO’s business objectives include a requirement forthe DMO to advise the treasury about the appropri-ate policy framework, but strategic decisions rest withthe respective ministers. The Bank of England acts asthe DMO’s agent for gilt settlement and retainsresponsibility for gilts registration.

Legal framework for borrowing

The government’s overall policy on debt manage-ment is set out in “The Code for Fiscal Stability,”which has statutory effect by virtue of Section 155 ofthe Finance Act, 1998. Paragraph 12 of the codestates that:

the primary objective of debt managementpolicy shall be to minimize—over the longterm—the costs of meeting theGovernment’s financing needs whilst:• taking account of risk; and • ensuring that policy does not conflict

with monetary policy.

All central government borrowing is donethrough the treasury (including the DMO) ornational savings, although the Bank of England actsas agent for foreign currency borrowing for the offi-cial reserves. National savings is responsible for pro-viding personal savings products to members of thepublic (mainly small investors).

The treasury has wide discretion as to how toraise money by borrowing, and it does so through twostatutory funds, the National Loans Fund and thedebt management account. Its main power to borrowfor the National Loans Fund is conferred by Section12 of the National Loans Act, 1968, which was subse-quently amended in 1998 to establish the debt man-agement account. This provides that the treasury canraise any money that it considers expedient to raisefor the purpose of promoting sound monetary con-ditions in the United Kingdom, and this money maybe raised in such manner and on such terms and con-ditions as the treasury thinks fit. Section 12(3) of thesame act makes it clear that the treasury’s power toraise money extends to raising money either withinor outside the United Kingdom, and in other curren-cies. There are no set limits on the extent to which

the treasury may borrow from outside the UnitedKingdom. The treasury’s power to borrow for thedebt management account is conferred by Paragraph4 of Schedule 5A of the National Loans Act, 1968,and this paragraph, like Section 12 of the act, givesthe treasury a wide discretion as to how to raisemoney. Paragraph 4(3) is similar in terms to Section12(3) of the act, and it provides that the treasury’spower to raise money under Paragraph 4 extends toraising money either within or outside the UnitedKingdom, and in other currencies. Again, there isnothing in Schedule 5 of the act to limit the amountof money the treasury may borrow from outside theUnited Kingdom.

In practice, treasury borrowing takes a widerange of forms and ranges from the issuing of long-term securities (gilts) to the issuing of short-termtreasury bills (12 months maximum) under theTreasury Bills Act, 1877.

Organizational structure within the DMO3

The chancellor of the exchequer, under advice fromtreasury officials, determines the policy and financialframework within which the DMO operates and dele-gates to its chief executive operational decisions ondebt and cash management and day-to-day manage-ment issues. The chief executive is appointed by thetreasury and variously reports to the permanent sec-retary (on expenditure and related issues), treasuryMinisters (on policy issues), and parliament (in theformal presentation of accounts). In particular,he/she is responsible to treasury ministers for theoverall operation of the agency and delivering theremit (which may include a confidential element thatexpands on the published remit) in a way that he/shejudges will involve the least long-run cost to theexchequer, subject to being compatible with otherpolicy considerations.

The DMO is organized around eight businessunits (see Appendix) and has a structure of corporategovernance in place to assist the chief executive incarrying out his responsibilities. This comprises ahigh-level advisory board, advising the managingcommittee, which is the senior decision-making bodyfor the office. The managing committee is in turnsupported by a credit and risk committee and strategy


groups for each key business area (debt, cash, invest-ments). There are currently two external nonexecu-tive directors on the advisory board, both of whomare also on the office’s audit committee, togetherwith a member of the treasury. The advisory board,however, is an informal arrangement, and its pro-ceedings are not published.

The DMO is an on-vote agency of the treasury, isfinanced as part of the treasury, and operates underarrangements that control its administrative cost.The DMO is subject to an internal audit functionthat reviews the systems of internal control, includ-ing financial controls, and to external audit by thenational audit office. The chief executive is theaccounting officer for both the office’s administra-tive accounts and the accounts of the debt manage-ment account, through which all its markettransactions pass.

The chief executive of the DMO is responsiblefor setting the DMO’s personnel policies and manag-ing staff. The office has delegated authority for pay,pay bargaining, training, and setting terms and con-ditions to recruit, retain, and motivate staff.Nonetheless, personnel policies are designed to beconsistent with wider public sector pay policy and theCivil Service Management Code. The DMO achievedInvestors in People accreditation in June 2000.

An important issue for debt managers is theneed to control operational risk, which can entaillarge losses for the government and tarnish thereputation of debt managers. The DMO has devel-oped a corporate governance framework to ensuresound risk monitoring and control practices toreduce operational risk (see the DMO’s functionalstructure in the Appendix). The “Statement onInternal Control” in the DMO’s Annual Report andAccounts (ARA) 2001-02 (available on the DMO’sweb site) describes the DMO’s approach to manag-ing its operational risk. A risk management unithas been established within the DMO. A businesscontinuity plan is also being developed with keymarket participants to mitigate the impact of asevere disruption to the market’s infrastructure.The adequacy of the DMO’s management of riskand internal controls is regularly reviewed by theDMO’s audit committee, which is chaired by anexternal nonexecutive director.


Coordination of debt management and fiscaland monetary policy

The separation of debt management from monetarypolicy responsibility was part of the changesannounced to the operation of monetary policy onMay 6,1997. However, the debt management objec-tive still has a reference to monetary policy. It ensuresthat the Bank of England’s monetary policy responsi-bilities will not be undermined by the DMO or thetreasury (e.g., “printing money” to meet the cashrequirement or DMO cash market operations inter-fering with the Bank of England’s money marketoperations).4 This constraint on debt managementreflects the institutional changes made in 1997.However, the Debt Management Review in 1995 notedthat debt management no longer played a major rolein the delivery of monetary policy objectives.5

The credibility of the United Kingdom’s fiscal pol-icy is underpinned by the government’s fiscal frame-work6 that was introduced in 1997 as part of themacroeconomic reforms of the current administra-tion. In addition, “The Code for Fiscal Stability”(1998) sets out the principles that guide the formula-tion and implementation of fiscal policy. The rela-tionship between debt management and fiscal policyis an area where there is an ongoing program of work.The treasury will shortly be producing work that willlook at the linkages between fiscal policy and the debtportfolio. This work includes the development of acomprehensive asset and liability risk monitor to aidthe quantification of the risks faced by the central gov-ernment on its balance sheet. A preliminary versionwas published in the Debt and Reserves ManagementReport 2002–03, as a precursor to the publication ofthe whole of government accounts in 2005–06. Otherrisks related to the central government’s contingentliabilities are currently being published annuallywithin the “Supplementary Statements” that accom-pany the publication of the Consolidated Fund andNational Loans Fund Accounts. A list of contingent lia-bilities and their maximum values is also available.Quantification and assessment of the risks that giverise to these liabilities will also be further developed.



As previously noted, the 1995 Debt Management Review(as subsequently updated) established the primaryobjective of U.K. debt management policy as “to min-imize over the long term the cost of meeting the gov-ernment’s financing needs, taking account of risk,whilst ensuring that debt management policy is con-sistent with the objectives of monetary policy.” Thisprimary objective has been reaffirmed in subsequentdebt management reports, which are publishedannually with the budget papers. On the cost side,the main elements include nominal/cash-flow costscommitted to when borrowing, real interest costs,accrual/net present value costs that include changesin capital costs on redemption, and the cost ofissuance, which is relatively small for sovereignissuers.

These costs expose the balance sheet of the gov-ernment to various risks, which are not as tractable asthose of the private sector because governments tendnot to match their financial liabilities with financialassets. Risks therefore need to be placed in the con-text of the overall government balance sheet andinclude

• default risk: the risk that the government will beunable to meet its nominal cash-flow commit-ments for interest and redemption payments;

• refinancing risk: the risk that government will beunable to refinance its maturing borrowingthrough further borrowing (or in doing so, it isfaced with a high cost of finance);

• cash-flow risk: the risk that interest rate shockscause large fluctuations in the debt interest bill;and

• mark-to-market/ex post financing risk: the riskthat the government will regret its choice of bor-rowing instrument after the event because ofnominal and real interest rate shocks.

Given the longevity of the government’s balancesheet and the long maturity of its potential borrow-ings, these costs and risks need to be traded off overa relatively long time horizon. The optimal debt port-folio, comprising different types of securities andmaturities, will depend primarily on which type of

risk the fiscal authorities are trying to contain andtheir preferences over any cost implications of a riskmitigation strategy. The focus could be on either vari-ations in the debt-servicing cost alone (cash-smooth-ing/cost- at-risk) or in government spending as awhole (tax-smoothing). If considering the latter, therelationship among different economic variables andtheir effect on the level of the government’s annualdeficit (e.g., on government revenues and the returnson government assets) also needs to be considered.


The treasury, with the DMO, determines the desiredstructure of new issuance over the year ahead, takinginto account the financing requirement and consid-erations of the various costs and risks. This account-ing structure is outlined in the annual Debt andReserves Management Report (DRMR) and is expressedin terms of the percentage of issuance across eachclass of gilt and overall financing to be raised throughthe issuance of treasury bills. In consultation with thetreasury and market participants, the DMO makesfurther decisions about specific issuance instrumentsand timing during the year in line with the overall tar-get. Significant changes in the public finances fore-casts may lead to a revision in the remit. TheChancellor’s Pre-Budget Report (generally available inNovember) provides an opportunity to revise thisstructure, if necessary in light of revised treasury fore-casts for the economy.

It is currently the policy of the U.K. governmentto issue debt across a variety of instruments. At 7.83years (by end-December 2001), the average modifiedduration of the gilts portfolio is longer than most ofits peers among Organization for EconomicCooperation and Development member govern-ments. This partly reflects the desire to minimize refi-nancing and cash-flow risks inherent in the highpostwar debt-to-GDP ratios. It also prevents govern-ment financing from having a major impact on liq-uidity conditions for monetary policy and latterly hasbeen a response to the high institutional demand forlong-maturity paper from U.K. pension funds. Alongwith a relatively smooth redemption profile, thishelps to add additional certainty to projections offuture debt-servicing costs. Long duration will also


limit the effect of any negative supply-side shock onthe government’s fiscal position.

By end-December 2001, 24.6 percent of the mar-ketable debt portfolio was made up of index-linkedgilts and treasury bills. In the event of a demandshock, this proportion should allow the changes inthe debt-servicing cost relating to this particular partof the national debt to mitigate the resulting move inthe government’s budget balance. Of this, index-linked gilts also provide protection against a “nomi-nal” shock. U.K. governments have not used foreigncurrency debt to finance the domestic borrowingrequirement in peacetime, reflecting the belief thatforeign currency risk to the balance sheet was neitherdesirable nor cost effective.

U.K. issuance of foreign currency debt in recentyears has been used to augment the foreign currencyreserves rather than for domestic funding reasons.Issuing liabilities in the currency in which the UnitedKingdom wished to hold foreign currency assetsallowed exchange rate exposures to be hedged.However, the development of the swaps market hasmeant that the currency the debt is issued in, and thecurrency in which assets are held, do not necessarilyhave to be the same. Value for money is the primaryconcern when deciding whether to fund the foreigncurrency reserves from debt issued in pounds sterlingswapped into foreign currency, or from the issuanceof foreign currency–denominated debt, with thecomparison being made on a swapped basis.

The government is conducting further work onmanaging risk in the debt portfolio by determiningthe resilience of cost and tax-smoothing properties ofdifferent debt structures to a range of economic con-ditions and shocks. This should help to quantify amore optimal debt portfolio against which anissuance strategy and long-term performance couldbe assessed.

The treasury select committee’s report on debtand cash management7 recommended, “that theTreasury considers adopting a benchmark approachto debt management … [that] … would help pro-duce a clear published assessment of the costs andrisks faced by the DMO.” Responding to the commit-tee, the government accepted that greater trans-parency in performance measurement would bedesirable if it could be achieved without compromis-

ing other strategic debt management objectives, butexpressed reservations about the extent to which thiswas possible. The DMO’s aim has not been developedinto an all-embracing quantitative target, or set ofbenchmarks, for four reasons:

• Minimizing debt interest costs over a shortperiod could encourage opportunistic behaviorwith potential damage to the long run-objective.(A nonopportunistic approach to debt manage-ment reduces the long-term risk premium pricedinto gilt yields.)

• It is not straightforward to decide the interestrate risk that the exchequer should take in its lia-bility portfolio, given that it is not being matchedagainst a portfolio of financial assets.

• Any benchmark is not independent of theDMO’s own actions, as monopoly supplier ofU.K. government bonds, and so it could bealtered to a degree by the DMO’s decisions.

• The DMO and the treasury do not want to beconsidered to be taking short-term views on inter-est rate changes, to maintain the separation ofmonetary policy decision making and debt andcash management.

The DMO does not seek to manage the debt port-folio actively to profit from expectations of movementsin interest rates and exchange rates, which differ fromimplicit market prices. This would risk financial loss aswell as potentially sending adverse signals to the mar-kets and conflicting with monetary or fiscal policies orboth. It would also add to market uncertainty.

However, a target duration for the portfolio isimplicit in the financing structure agreed annuallywith the treasury, in that it sets out clear parameterswithin which the DMO must operate is.

Developing the markets for governmentsecurities

Since the comprehensive review of debt managementin 1995, there have been a number of advances inissuance techniques, the range of debt instrumentshas been refined and expanded, and numerous struc-tural changes to the debt markets have taken place.The overall aim of the reforms has been to help lower


the cost of public financing over the long term,responding to both endogenous and exogenous fac-tors that have influenced the U.K. debt market dur-ing the period. In recent years, these factors haveincluded budget surpluses, the rapid rise of the U.K.corporate bond sector, institutional changes (particu-larly those relating to pension funds), increasingtechnological and other advancements (which haveenhanced systems), market structures, and debtinstruments around the world.

The process of reform has been continued by theDMO, whose published objectives include “to con-duct its market operations, liaising as necessary withregulatory and other bodies, with a view to maintain-ing orderly and efficient markets and promoting aliquid market for gilts.” All the changes to the markethave involved considerable consultation with marketparticipants and other stakeholders to develop broad-based support and promote predictability.

Issuance transparency

Although the benefits are difficult to quantify, trans-parency and predictability should reduce the amountthe government is charged for market uncertainty (the“supply uncertainty premium”). Predictability shouldalso allow investors to plan and invest more efficiently(in the knowledge of when and in what maturity bandsupply will occur) and thus reduce the liquidity riskpremium. This is particularly the case in the UnitedKingdom, where government debt constitutes a rela-tively significant proportion of fixed-income debt andopportunistic trading on the part of the governmentwould have a significant influence on the market.

The government’s borrowing plans for the yearahead are announced before the start of each finan-cial year in the DRMR published by the treasuryalongside the budget, usually each March.8 TheDRMR details the financing requirement, the forecastsales of gilts, their breakdown by maturity and instru-ment type, and the gilt auction calendar for the com-ing year, along with planned short-term debt sales,including treasury bills. An auction calendar is alsoissued at the end of each quarter by the DMO, whichconfirms auction dates for the coming quarter andstates which gilts are to be issued on which date.Normally, eight calendar days before an auction, the

amount of stock to be auctioned is announced (andif it is a new stock, the coupon). At this point, thestock is listed on the London Stock Exchange (LSE)and when-issued trading commences. (This is the for-ward trading of the stock to be sold at the auction.When-issued trades settle on the auction’s settlementdate, and the process helps reveal price informationin the run-up to the auction.)

Market makers and end-investor groups are con-sulted during the formulation of these plans (andalso quarterly before the DMO announces specificauction stocks for the quarter ahead).

Gilts are now issued entirely by auction unlessthere are exceptional circumstances. The DMOretains the ability to buy back or issue gilts in smallerquantities (by tap) at short notice for market man-agement reasons only. Buybacks can be done eitherbilaterally or by reverse auction. The DMO alsoundertakes a range of market management opera-tions, which are essentially neutral in terms of gov-ernment financing and include the conversion orswitching between specified stocks and repurchase(repo) activities. A gilt repo involves one party sellinggilts to a counter-party with an agreement to repur-chase equivalent securities at an agreed price on anagreed date. In June 2000, the DMO introduced anondiscretionary standing repo facility, whereby theDMO may temporarily create upon request a gilt forrepo, for the purpose of managing actual or potentialdislocations in the gilt repo market. Operationaltransparency is enhanced through close coordinationwith market participants and agreed announcementand publication requirements.9

Portfolio operations and instruments

The U.K. securities market incorporates a range ofdebt instruments, including treasury bills, conven-tional gilts, double-dated gilts, undated gilts, index-linked gilts, and gilt strips.10 The distribution of theportfolio and the main holders of gilts are detailed inthe Tables II.17.1 and II.17.2 and Figure II.17.1.

Treasury bills

The DMO took over full responsibility for exchequercash management on April 3, 2000.11 The transfer of


cash management to the DMO was delayed from theearliest possible date in October 1998 by technical,capacity, and administrative issues (including con-cerns over systems during the millennium period).

The DMO’s main strategic objective in carryingout its cash management role is to “offset, through itsmarket operations, the expected cash flow into or outof the National Loans Fund (NLF),12 on every busi-ness day; and in a cost effective manner with dueregard for credit risk management.”13 An importantpart of the DMO’s approach is to seek to ensure thatits actions do not distort market or trading patternsand as such, in its bilateral dealings with the market,the DMO is a price taker. The DMO also has to take

account of the operational requirements of the Bankof England for implementing its monetary policyobjectives.

The DMO carries out its cash management objec-tives primarily through a combination of weekly trea-sury bill tenders conducted on a competitive biddingbasis, bilateral operations with DMO counter-parties,and repo or reverse repo transactions.

Treasury bill tenders are currently held on thelast business day of each week for settlement on thenext working day. Following the final tender at theend of each calendar quarter, the DMO issues anotice broadly outlining the maturities of treasurybills available in each week of the next quarter. The


Table II.17.1. Details of the Debt Portfolio at December 31, 2001

Figure II.17.1 Composition of Debt Stock Gilt portfolio summary statistics

Nominal value of the gilt portfolio (including inflation uplift) £274.92 bn

Market value of the gilt portfolio £302.76 bn

Weighted average market yields:

Conventional gilts 4.90%

Index-linked gilts 2.44%

Portfolio average maturity 11.28 yrs

Portfolio average modified duration 7.83 yrs

Portfolio average convexity 115.35

Average amount outstanding of largest 20 gilts £9.80 bn

Undated1.1%

Index-linked24.6%

T-bills3.9%

Conventional70.3%

Source: DMO quarterly review (October–December 2001).

Table II.17.2. Distribution of Gilt Holdings as of end-December 2001 (Market values)

End-Dec. 2001 £bn Percentage

Insurance companies and pension funds 183.7 63Banks and building societies 3.1 1Other financial institutions 29.6 10Households 18.8 6Public sector holdingsa 4.4 2Overseas sector 53.4 18Total 292.9 100

a. Local authorities, public corporations, and charities. Net of central government holdings.Source: Office for National Statistics.

precise quantities of bills on offer and the maturity ofbills on offer in each week are announced one weekbefore the relevant tender.

To facilitate a significant increase in the stock oftreasury bills, the DMO changed the arrangementsrelating to the issuance by tender of treasury billsfrom October 5, 2001. As part of these changes, theDMO recognized a list of primary participants in thetreasury bill market. These are banks or financialinstitutions that have agreed to place bids at treasurybill tenders on behalf of other parties, subject to theirown due diligence and controls. On request, the pri-mary participants will also provide their customerswith secondary dealing levels for treasury bills. TheDMO’s cash management counter-parties and a lim-ited number of wholesale market participants whohave established a telephone bidding relationshipwith the DMO are also eligible to bid directly in trea-sury bill tenders.

The DMO publishes the tender results on the wireservices pages. The DMO will announce, at the sametime, the amounts on offer at each maturity at the nexttender, together with an outline of any planned ad hoctenders to be held in the following week.

The DMO may also issue shorter-maturity trea-sury bills (up to 28 days) at ad hoc tenders. Theobjective of ad hoc tenders will be to provide addi-tional flexibility for the DMO in smoothing theexchequer’s cash flows, which the regular tenderprogram may not provide.

Gilts

Conventional gilts are the simplest form of govern-ment bond and constituted 70.3 percent of the debtportfolio as of end-December 2001. There are eightundated gilts still in issue, making up about 1 percentof the portfolio. Their redemption is at the discretionof the government, but because of their age, they allhave low coupons and there is little current incentivefor the government to redeem them. The last float-ing-rate gilt (whose coupon was set with reference tothe three-month Libid [London interbank bid])rate] was redeemed on maturity in July 2001. Toavoid periodic price fluctuations related to couponpayment dates, gilt prices are now quoted clean, thatis, without accrued interest, although the “dirty”

price (including accrued interest) is used for conver-sion offers.

The United Kingdom was one of the earliest gov-ernments to introduce index-linked bonds, with thefirst issue in 1981. Index-linked bonds now accountfor about 25 percent of the government securitiesportfolio.

Gilt strips14

The U.K. gilt STRIPS market was launched onDecember 8, 1997. “Stripping” a gilt refers to break-ing it down into individual cash flows that can betraded separately as zero-coupon gilts. Not all giltscan be stripped, although it is the DMO’s intention tomake all new gilts strippable. The STRIPS market wasintroduced to permit investors to

• closely match the cash flows of their assets(strips) to those of their liabilities (e.g., annu-ities),

• enable different types of investment risk to betaken, and

• bring the range of products offered in the U.K.market in line with other large markets, such asthe United States, Japan, Germany, and France.

From the issuer’s perspective, a STRIPS marketcan result in slightly lower financing costs if the mar-ket is willing to pay a premium for “strippable” bonds.As of September 28, 2001, there were 11 strippablegilts in issue, totaling £115.18 billion (nominal). Ofthese, £2.4 billion of stock was held in stripped form.All issues have aligned coupon payment dates. Thismeans that coupons from different strippable bondsare fungible when traded as strips. However, couponand principal strips paid on the same day are not fun-gible, that is, a specific bond cannot be reconstitutedby substituting the relevant principal strip with acoupon strip with the same maturity. This featureprotects the overall size of any issue and thus main-tains the integrity of various benchmarking indices.

The first series of strippable stocks were issuedwith June 7/December 7 coupon dates; however, in2001, the DMO issued two new conventional stockswith coupon dates aligned on March 7/September 7.These stocks will become strippable from April 2002.


The second series of coupon dates was introduced toavoid cash flows becoming too concentrated on justtwo days in the year.

Although anyone can trade or hold strips, only agilt-edged market maker (GEMM), the DMO, or theBank of England can strip (or reconstitute) a strip-pable gilt through the CREST electronic settlementsystem. GEMMs are obliged to make a market forstrips.

The market in gilt strips has grown slowly since itsinception. Factors that have contributed to this slowtake-off have been the need for pension fund trusteesto give appropriate authority to fund managers toinvest in strips and the inversion of the yield curveover the period since the inception of strips, whichmakes strips appear expensive relative to conven-tional gilts. Retail demand for strips has also beenhampered by the necessary tax treatment, wherebysecurities are taxed each year on their accrued capi-tal gain or loss, even though no income payment hasbeen made. However, the ability to hold strips withinsome tax-exempt savings products will reduce the taxdisincentives to personal investment in strips.

GEMMs

The U.K. government bond market operates as a pri-mary dealer system. As of end-December 2001, therewere 16 firms recognized as primary dealers(GEMMs) by the DMO. Each GEMM must be a mem-ber of the LSE and must undertake a number of mar-ket-making obligations in return for certain benefits.

In broad terms, the obligations of a GEMM are toparticipate actively in the DMO’s gilt issuance pro-gram, make effective two-way prices on demand in allnonrump gilts and non-index-linked gilts, and pro-vide information to the DMO on market conditions.As September 28, 2001, 10 of the 16 recognizedGEMMs were also recognized as index-linked gilt-edged market makers (IG GEMMs). Their market-making obligations extend to cover index-linked gilts.

The benefits of GEMM status are exclusive rightsto competitive telephone bidding at gilt auctions andtaps, either for the GEMM’s own account or on behalfof clients; exclusive access to a noncompetitive bid-ding facility at outright auctions; the exclusive facilityto trade or switch stocks from the DMO’s dealing

screens; exclusive facilities to strip and reconstitutegilts; an invitation to a quarterly consultation meetingwith the DMO15 (allowing the GEMMs to advise onthe stock(s) to be scheduled for auction in the follow-ing quarter and discuss other market-related issues);and exclusive access to gilt interdealer broker (IDB)screens. In addition, any transactions undertaken bythe DMO for market management purposes are car-ried out only with or through the GEMMs.

Since early 2002, the GEMMs have been requiredto provide firm two-way quotes to other GEMMs in asmall set of benchmark gilts. These quotes are to bemade on a near-continuous basis on any of the recog-nized IDB screens. The purpose of this new obligationis to enhance liquidity in the intra-GEMM market forthe benefit of the entire secondary market for gilts.

Gilt IDBs

As of end-December 2001, there were three specialistgilt IDBs operating in the gilt market. Their servicesare limited to the GEMM community. Their main pur-pose is to support liquidity in the secondary marketsby enabling the GEMMs to unwind anonymously anyunwanted gilt positions acquired in the course of theirmarket-making activities. All but a few inter-GEMMtrades are executed through an IDB. Non-index-linked GEMMs have no access to index-linked screens.

Each IDB is registered with the LSE andendorsed by the DMO. The DMO monitors this seg-ment of the market on an ongoing basis to ensurethat an IDB service is available to all GEMMs on anequitable basis and the market-maker structure iseffectively supported by the IDB arrangements. TheIDBs are also subject to specific conduct-of-businessrules promulgated by the LSE. For example, they areprohibited from taking principal positions or fromdisseminating any market information beyond theGEMM community.

Mechanisms used to issue gilts

Auctions are the exclusive means by which the gov-ernment issues gilts as part of its scheduled fundingoperations. However, the government retains theflexibility to tap or repo both index-linked and con-ventional gilts for market management reasons. The


move to reliance on a preannounced auction sched-ule reflects the government’s commitment to trans-parency and predictability in gilt issuance.

The government uses two different auction for-mats to issue gilts:

• conventional gilts are issued through a multiple-price auction, and

• index-linked gilts are auctioned on a uniform-price basis.

The two different formats are used because ofthe different nature of the risks involved to the bid-der for the different securities.

Conventional gilts are viewed as having less pri-mary issuance risk. There are often similar giltsalready in the market to allow ease of pricing (or, ifmore of an existing gilt is being issued, there is priceinformation on the existing parent stock); auctionpositions can be hedged using gilt futures; and thesecondary market is relatively liquid. This suggeststhat participation is not significantly deterred by bid-ders not knowing the rest of the market’s valuation ofthe gilts on offer. A multiple-price auction format alsoreduces the risk to the government of implicit collu-sion by strategic bidding at auctions.

In contrast, positions in index-linked gilts cannotbe hedged as easily as conventional gilts. The secondarymarket for index-linked gilts is also not as liquid as forconventional gilts. Both of these factors increase theuncertainty of index-linked auctions and increase the“winner’s curse” for successful bidders—that is, the costof bidding high when the rest of the market bids low.Uniform price auctions thus reduce this uncertainty forauction participants and encourage participation. Inaddition, there are fewer index-linked bonds than con-ventionals in issue, so pricing a new index-linked issuemay be harder than for a new conventional.

GEMMs also have access to a noncompetitive bid-ding facility under both formats. They can submit anoncompetitive bid for up to 0.5 percent of theamount of stock on offer in a conventional gilt auc-tion. The proportion of stock available to each index-linked GEMM in an index-linked auction is linked totheir performance in the previous three auctions.

The DMO allots stock to individual bidders at itsabsolute discretion. In exceptional circumstances, the

DMO may choose not to allot all the stock on offer, forexample, where the auction was covered only at a levelunacceptably below the prevailing market level. Inaddition, the DMO may decline to allot stock to anindividual bidder if it appears that to do so would belikely to lead to a market distortion. As a guideline,successful bidders, either GEMMs or end-investors,should not expect to acquire at the auction for theirown account more than 25 percent of the amount onoffer (net of the GEMM’s short position in the when-issued market or parent stock or both) for conven-tional gilts and 40 percent for index-linked stock.

Tap issues

The DMO will use taps of both conventional andindex-linked gilts only for market management rea-sons in extreme conditions of temporary excessdemand in a particular stock or sector. The last tapwas in August 1999.

Conversion offers and switch auctions

In addition, the DMO will occasionally issue stockthrough a conversion offer or a switch auction, inwhich stockholders are offered the opportunity toconvert or switch their holding of one gilt intoanother at a rate of conversion related to the marketprices of each stock. In both cases, the main purposesof these operations are to

• build up the size of new benchmark gilts morequickly than can be achieved through auctionsalone (This is particularly important in a periodof low issuance.); and

• concentrate liquidity across the gilt yield curve byreducing the number of small, high-coupon giltsand converting them into larger, current-coupongilts of broadly similar maturity.

Conversion candidates will not have fewer thanabout five years to maturity or more than £5.5 billionnominal outstanding. In addition, conversion offerswill not be made for a stock that is “cheapest-to-deliver,” or has a reasonable likelihood of becomingcheapest-to-deliver, for any gilt futures contracts withany outstanding open interest.


The price terms of any conversion offer will bedecided by the DMO, using its own yield-curve modelto provide a benchmark ratio for the offer. The DMOwill then (at its own discretion) adjust this ratio totake some account of the observed cheap/dear char-acteristics of the source and destination stocks.Conversion offers remain open for a period of threeweeks from the date of the initial announcement ofthe fixed dirty-price ratio. The appropriate amountof accrued interest on both gilts is incorporated intothe calculation of the dirty-price ratio for forward set-tlement. The conversion itself will involve noexchange of cash flows.

Acceptance of such offers is voluntary, and stock-holders are free to retain their existing stock.However, this is likely to become less liquid (i.e.,traded less widely, with a possible adverse impact onprice) if the bulk of the other holders of the giltchoose to convert their holdings. Should the amountoutstanding of a gilt be too small to expect the exis-tence of a two-way market, the DMO is prepared,when asked by a GEMM, to bid a price of its ownchoosing for the gilt. In addition, the DMO wouldrelax market-making obligations of GEMMs in this“rump” gilt. The DMO would announce if a gilt tookon this “rump” status.

In addition to the main purposes identified forconversion offers, switch auctions were introduced in2000 to

• allow the DMO to smooth the immediate giltredemption profile by offering switches out oflarge ultra-short issues into the current five-yearbenchmark (or other short-term instruments), and

• facilitate switching longer by index-trackingfunds as a particular stock is about to fall out of asignificant maturity bracket, thus contributing tomarket stability.

Switch auctions are held only for a proportion of alarger stock that is too large to be considered for anoutright conversion offer. The DMO ensures that a suf-ficient amount of the source stock remains for a viable,liquid market to exist following a switch auction.Hence, the DMO will not hold a switch auction for aconventional stock that would reduce the amount inissue to below £4.5 billion (nominal). Switch auctions

are held only when both the respective stocks arewithin the same maturity bracket, although here thematurity brackets overlap (short and ultra-short, 0–7years; medium, 5–15 years; long, 14 years and more).In addition, the DMO will not hold a switch auctionout of a stock that is cheapest-to-deliver, or has a rea-sonable likelihood of becoming cheapest-to-deliver,into any of the “active” gilt futures contracts. TheDMO might, however, switch into such a stock.

Switch auctions are open to all holders of thesource stock, although non-GEMMs must route theirbid through a GEMM. They are conducted on a com-petitive bid-price basis, where successful competitivebidders are allotted stock at the prices they bid.There is no noncompetitive facility, and the DMOdoes not set a minimum price.

The same principles apply to index-linked switchauctions with the following exceptions. First, index-linked switches will be held only when both therespective stocks have longer than four and one-halfyears to maturity and when the source stock has notbeen auctioned in the previous six months. Second,the (nominal) size of any single index-linked switchauction is limited to £250 million to £750 million ofthe source stock, and the DMO will not hold a switchauction that would leave an index-linked stock with aresultant amount outstanding of less than a nominal£1.5 billion. Third, the auctions are conducted on auniform bid-price basis, whereby all successful bid-ders will receive stock at the same price. Where aGEMM’s bids are above this price, it will be allotted inthe full amount bid, but allotments for bids at thestriking price may be scaled. Published results willinclude the common allotment price, the pro ratarate at this price, the real yield equivalent to thatprice and the inflation assumption used in that cal-culation, and the ratio of bids received to the amounton offer (the cover). Only one index-linked switchauction has been held up until end-2001.

Gilt repo

The gilt repo market was introduced in January 1996.After 1986, a limited market in stock borrowingexisted in which GEMMs (and discount houses forshort-dated stocks) were allowed to cover short posi-tions by borrowing stock in the stock-lending market


and approved stock lenders were allowed to lend.However, the introduction of an entirely open trad-ing market in gilt repos has enabled market partici-pants to borrow or lend gilts more easily. This hasimproved market liquidity and the ease with whichgilt positions can be financed. A Bank of England sur-vey put the size of the gilt repo market as ofNovember 2001 at £130 billion (equivalent to one-fourth of the pound sterling money market at thattime), with an additional £48 billion of stock lending.

Gilt repos now account for the majority of Bankof England monetary policy operations and a signifi-cant proportion of the DMO’s dealing to manage theexchequer’s cash flow. It is estimated that gilt reposnow account for about half of all overnight transac-tions in the pound sterling money market. Conductin the gilt repo market is guided by the Gilt Repo Codeof Best Practice, as published by the stock lending andrepo committee chaired by the Bank of England (lat-est version, August 1998).

The DMO has the ability to create and repo spe-cific stocks to market makers, or other DMO counter-party, under a special repo facility if, for example, aparticular stock is in exceptionally short supply anddistorting the orderly functioning of the market. Inresponse to a previous consultation exercise, the DMOintroduced, in June 2000, a nondiscretionary standingrepo facility, for the purpose of managing actual orpotential dislocations in the gilt repo market. Any reg-istered GEMM, or other DMO counter-party, mayrequest the temporary creation of any nonrump stockfor repo purposes. The DMO charges an overnightpenalty rate, and the returned stock is canceled.

Recent Factors Shaping the U.K. BondMarkets

As in other currencies, the pound sterling credit mar-ket has seen increased annual private issuance in

recent times, at a time when the United Kingdom hasbeen running a budget surplus. Thus, the govern-ment’s percentage of the overall outstanding poundsterling debt market had been steadily reducing.Decreasing government funding requirements haveled to gilts acquiring a scarcity premium, especially inlonger-dated stocks, which in turn has lead to areduction in yields. At the same time, the UnitedKingdom has enjoyed a low-inflation, low-interestrate environment recently (relative to the 1970s and1980s), so a need to enhance returns has led investorsto increase their appetite for (credit) risk.

As the U.K. government’s budgetary positionimproved, gross issuance of gilts declined from apeak of £54.8 billion in financial year 1993–94, reach-ing a minimum of £8.1 billion in 1998–99. However,given that the government’s borrowing needs arecyclical, there is a benefit in maintaining a minimumlevel of issuance so that market infrastructure is sus-tained and the market remains sufficiently liquid andretains the capability to absorb future larger grossissuance. Table II.17.4 summarizes the government’sforecast for the central government net cash require-ment over the next few years. The medium-term fore-casts point to a prudent level of borrowing, reflectingplanned investments in public services that are fullyconsistent with the fiscal rules.

In view of the limited amount of gilt issuance inrecent years, the DMO has adopted a number ofstrategies to concentrate debt issuance into largerbenchmark issues, currently at three maturity points,with a 5-, 10-, and 30- year term to maturity. Theselarger issues allow governments to capture a liquiditypremium across the yield curve. The DMO has alsoused conversion and switch auctions to build upbenchmark issues.

The government also decided to launch a struc-tured gilt buyback program in fiscal year 2000/01 toadd to gross issuance and thus help to maintain li-quidity in the market during a time of strong demand.


Table II.17.3. Changing Levels of Debt (Absolute terms and relative to GDP)

2000/01 1999/00 1998/99 1997/98

Market value of debt £287 bn £348 bn £374 bn £343 bnNet debt/GDP (percent) 31.8 36.8 40.8 43.3

Following market consultations, reverse auctions werereintroduced in fiscal year 2000/01 while the DMObought in, direct from the secondary market, short-dated index-linked gilts and double-dated gilts. TheDMO also buys in near-maturity gilts (with less than sixmonths’ residual maturity) as part of its regular opera-tions to smooth the cash-flow impact of redemption.

In general, these operations have been very suc-cessful. There was more than 90 percent take-up ofthe conversion offers, apart from the one conductedin November 1998. The switch auctions have all beencovered with a comfortable margin, and the threelonger-dated switches have secured very attractive for-ward-dated funding rates. The rates at which theDMO has repurchased stock in the reverse auctionwas at yields, which were predominantly “cheap” rel-ative to the DMO’s fitted yield curve.

During fiscal year 2000/01, the DMO (in consul-tation with the Bank of England, the treasury, theRadio Communications Agency, and market partici-pants) put in place arrangements to facilitate thesmooth handling of much larger than expectedreceipts from the third-generation mobile phonelicense auction. Total receipts of £22.5 billion ampli-fied the fiscal surplus in fiscal year 2000/01. The gov-ernment subsequently decided to maintain aminimum level of gross gilts issuance to sustain giltmarket liquidity and investor interest in light of theforecasts of an increase in the financing requirementover the next few years. As a consequence of thesepolicy decisions, the DMO held a short-term net cashposition of £11 billion at the end of fiscal year2001/02. Partly to assist the management of this, therange of high-quality, short-term money marketinstruments in which the DMO may transact on abilateral basis for cash management purposes was

extended in October 2000. It is expected that thecash position will be run down over the three finan-cial years to end-March 2004.

As part of its continuing commitment to encour-age liquidity and transparency of the gilts market, theDMO consulted widely in 2000 about the possibleimpact of electronic trading systems on the secondarymarket for gilts and how the DMO’s relationship withthe GEMMs might change as a consequence. Thatwork continued during 2001, with a view to introduc-ing early in 2002 inter-GEMM mandatory quote obli-gations in the more liquid gilts, as outlined in theresponse document published in June 2000.

To promote further transparency in the gilts mar-ket, in September 2000, the DMO introduced a real-time benchmark gilt price screen on its wire servicesshowing indicative midprices for a series of giltsderived from GEMMs’ published quotes.

Tax

In 1995–96, the basis for taxation of gilts wasreformed. Essentially, this meant that capital gains orlosses on gilts experienced by corporate investorswould be taxed similarly to income from gilts. Thiseliminated most of the tax-driven pricing anomaliesin the market by making the tax system neutral withregard to holding high- or low-coupon bonds, whichwas a necessary precondition to launching theSTRIPS market to avoid tax-based incentives for strip-ping all or none of a bond. In addition, since April1998, all gilt interest has been paid gross, unless therecipient has preferred net, to reduce the compli-ance obligations for custodians and make the giltmarket more accessible and attractive to investors.


Table II.17.4. April 2002 Public Borrowing Requirement Forecasts for the Central Government Net CashRequirement(£ billion)

2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 projection projection projection projection projection projection

3 14 18 16 21 24


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Notes

1. The case study was prepared by the U.K. DebtManagement Office and the Debt and Reserves ManagementTeam of the U.K. Treasury.

2. A full description of all the DMO’s responsibilities, objec-tives, and lines of accountability is set out in the current versionof its Framework Document (July 2001, www.dmo.gov.uk/publication/f2spc.htm). Other relevant documents can be foundon the DMO’s web site: www.dmo.gov.uk.

3. The following information reflects the situation as of June30, 2002. However, effective July 1, 2002, the DMO took on twoadditional business units: the public works loans board and thecommissioners for the reduction of the national debt. This led toan increase in the number of staff at the DMO to about 80 employ-ees. Before July 1, 2002, another government department—thenational investment and loans office—had carried out the func-tions of the public works loans board and commissioners for thereduction of the national debt. The staff were transferred from thenational investment and loans office, which no longer exists.

4. The DMO Handbook: Exchequer Cash Management in theUnited Kingdom (February 2002) details the interaction of cashmanagement with U.K. monetary policy and can be found on theDMO’s web site.

5. Further detailed discussion can be found in K.AlecChrystal, ed., Government Debt Structure and Monetary Conditions(London: Bank of England), 1999.

6. A detailed discussion of the fiscal framework can be foundin HM Treasury, Analysing U.K. Fiscal Policy, 1999, available atwww.hm-treasury.gov.uk/mediastore/otherfiles/90.pdf. A full dis-cussion of recent developments in macroeconomic and financialpolicy can be found in HM Treasury, Reforming Britain’s Economicand Financial Policy—Toward Greater Economic Stability, 2001, avail-able at www.palgrave.com/catalogue/catalogue.asp?Title_Id=0333966104.

7. “Government’s Cash and Debt Management” (HC 154)(available at www.publications.parliament.uk/pa/cm199900/cmselect/cmtreasy/154/15402.htm) was published on May 22,2000. It provides a comprehensive guide to the government’scash and debt management arrangements as well as records ofthe oral evidence provided by officials and expert witnesses.

8. The Debt Management Report was first published in1995–96. It was retitled the Debt and Reserves Management Report in2001–02, when it outlined for the first time the annual frameworkfor the management of official foreign currency reserves.

9. Full details of all these instruments and operations areavailable in the “Gilt Operational Notice” and “Cash OperationalNotice” on the DMO web site.

10. Full details of all these instruments and operations areavailable in the “Gilt Operational Notice” and “Cash OperationalNotice” on the DMO web site.

11. The DMO Handbook: Exchequer Cash Management in theUnited Kingdom (February 2002) details the cash managementoperations and can be found on the DMO’s web site.

12. The National Loans Fund is the account that consoli-dates all government lending and borrowing.

13. The strategic objective for cash management is con-tained in a remit “Exchequer Cash Management Remit,” pub-lished in HM Treasury, Debt and Reserve Management Report2002–03 (London), March 2002.

14. A full description of the separate trading of registeredinterest and principal of securities (STRIPS) market is given in theinformation memorandum, “Issue, Stripping and Reconstitutionof British Government Stock,” July 2000, on the DMO web site.

15. The DMO also holds quarterly meetings with the repre-sentatives of end-investors. Minutes of these meetings are pub-lished shortly afterwards on the DMO’s web site. In addition,there are annual meetings with the economic secretary to thetreasury for both groups in January as part of the preparationsfor the annual remit, published in March.


The U.S. Treasury enjoys several advantages over othercountries in managing debt. Federal debt issuance is arelatively small percentage of total domestic debtissuance, so financial markets easily absorb changes inthe government’s borrowing needs. The depth of privatemarkets also allows the government to borrow solely indomestic currency. The sophistication of domestic finan-cial markets allows the government to rely on the privatesector for a range of activities that increase the liquidityof treasury securities. The wide breadth of participationin treasury auctions makes uniform-price auctions feasi-ble. Underlying these advantages is the additional advan-tage of a large, diverse economy that assures investorsthat debt will be repaid. Many of these advantages havebecome self-reinforcing: As market depth and breadthhave increased, more market participants have been will-ing to rely more on treasury securities.

The advantages enjoyed by the United States haveinfluenced the development of the treasury marketand U.S. debt management techniques. The result is asystem that has unique characteristics and constraints.Consequently, the following outline of U.S. gover-nance, strategy, and market development may havelimited applicability to other countries.

Governance Framework

The power of the U.S. government to borrow is autho-rized by the U.S. Constitution. Congress has delegatedthe secretary of the treasury the power to issue

• certificates of indebtedness and bills: debt obliga-tions maturing not more than 1 year from the dateof issue,

• notes: debt obligations maturing at least 1 year andnot more than 10 years from the date of issue,

• bonds: debt obligations of more than 10 years, • savings bonds: retail debt obligations maturing not

more than 20 years from the date of issue, and• savings certificates: retail debt obligations matur-

ing not more than 10 years from the date of issue.

The secretary of the treasury is authorized to pre-scribe the terms and conditions of the debt obligationsissued by the treasury and the conditions under whichthe debt obligations will be issued. For this and otherduties, the secretary may delegate duties and powers toanother officer or employee of the U.S. Department ofthe Treasury. In practice, this means that a political

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18United States of America1

appointee under the secretary generally makes debtmanagement decisions with the advice of career staff.

The Secretary of the treasury can invest in thetreasury’s own securities or in commercial bankdeposits secured by a broad range of pledged collat-eral acceptable to the treasury, including obligationsof the U.S. government and private issuers. As part ofits cash management, the treasury maintains rela-tionships with a large number of commercial banksthat help to absorb its large seasonal swings in cashbalances.

Congress sets a limit on the total face amount ofdebt obligations issued by the secretary of the trea-sury. This limit is changed periodically as provided bylaw, either through the congressional budget processor otherwise. Until late 1917, congressional approvalwas required every time the treasury needed to bor-row. During World War I, this approach to debtissuance became unduly cumbersome, and congressgave the treasury the authority to borrow, while main-taining authority over the total amount of debt out-standing. This practice has allowed the treasury toissue debt for a period, often one or two years, with-out having to seek congressional approval.

The secretary of the treasury is required to sub-mit to congress an annual report that includes cer-tain statistics about the treasury’s past and projectedpublic debt activities. These reports are based on theadministration’s annual budget projections andincrease the accountability of government debt man-agers. In addition, the government auditing agencymay investigate the treasury department’s debt man-agement activities.

Administrative structure

The department of the treasury is organized into twomajor components: the departmental offices and theoperating bureaus. The departmental offices are pri-marily responsible for the formulation of policy andmanagement of the treasury department as a whole,and the operating bureaus carry out the specificoperations assigned to the department.

Within the departmental offices, the secretary ofthe treasury has primary responsibility for debt man-agement activities of the federal government, is theprincipal economic adviser to the president, and

plays a critical role in policymaking by bringing aneconomic and government financial policy perspec-tive to issues facing the federal government.Departmental staff formulate and recommenddomestic and international financial, economic, andtax policy. Debt management responsibilities include

• determining the treasury’s financing needs, plan-ning schedules of security issues and amountsneeded, and analyzing alternative types of securi-ties and sales techniques;

• soliciting private sector advice in carrying outtreasury financing and debt management policy,and preparing reports containing such recom-mendations;

• analyzing current economic and securities mar-ket conditions and their potential effects on trea-sury financing on a regular basis;

• coordinating with the Federal Reserve Bank ofNew York, part of the central banking system,regarding its fiscal agent responsibilities;

• participating in an interagency market surveil-lance group; and

• coordinating and approving market borrowing offederal agencies and government-sponsoredenterprises.

Debt administration is conducted by the bureauof the public debt (BPD), which reports to the trea-sury. Specific functions of the BPD include

• borrowing the money necessary to operate thefederal government and accounting for theresulting public debt;

• issuing, keeping records of, and redeeming gov-ernment securities; servicing registered accounts;and paying interest when due;

• maintaining accounting and audit control overpublic debt transactions and publishing state-ments;

• processing claims for physical securities that arelost, stolen, or destroyed; and

• promoting the sale and retention of retail instru-ments, U.S. savings bonds.

Cash is managed by the financial managementservice (FMS), which also reports to the treasury. The

Country Case Studies: United States of America 251

FMS receives and disburses all public monies, main-tains government accounts, and prepares daily andmonthly reports on the status of governmentfinances. The FMS is the government’s primary dis-bursing agent, collections agent, accountant andreporter of financial information, and collector ofdelinquent federal debt.

The FMS manages the collection of federal rev-enues, such as individual and corporate income taxdeposits, customs duties, loan repayments, fines, andproceeds from leases, and maintains a network ofabout 18,000 financial institutions to collect theserevenues. The FMS also oversees the federal govern-ment’s central accounting and reporting system,keeping track of its monetary assets and liabilities.The FMS works with federal agencies to help themadopt uniform accounting and reporting standardsand systems.

In addition to the operating bureaus, the FederalReserve Bank of New York acts as the treasury’ fiscalagent in carrying out debt management activities.Fiscal agency services performed include

• maintaining the treasury’s funds account,• clearing treasury checks drawn on that account,• conducting auctions of treasury securities,• maintaining treasury’s securities electronic book-

keeping system, and• issuing, servicing, and redeeming treasury securi-

ties.

The Federal Reserve System (the Fed) is an inde-pendent government entity. Debt policy and mone-tary policy are conducted independently. Althoughthe treasury and the Fed have independent policies,the Fed acts as the treasury’s fiscal agent, carrying outvarious operational activities for the treasury, andsenior staff meet weekly to discuss policy issues.

The relevant web sites for current informationare

• http://www.treas.gov/domfin for treasury debtmanagement,

• http://www.publicdebt.treas.gov for the BPD,• http://www.fms.treas.gov for the FMS, and• http://www.newyorkfed.org for the Federal

Reserve Bank of New York.


The treasury’s debt management objective is toobtain the lowest possible cost of financing over time.In achieving this goal, the treasury’s debt manage-ment strategy is guided by five interrelated principles.

The first principle is maintaining the “risk-free”status of treasury securities. This is accomplishedthrough prudent fiscal discipline and timely increasesin the debt limit. Ready market access at the lowestcost to the government over time is an essential com-ponent of debt management.

The second principle is maintaining consistencyand predictability in the financing program. Thetreasury issues securities on a regular schedule withset auction procedures. This reduces uncertainty inthe market and helps minimize overall cost of bor-rowing. In keeping with this principle, the treasurydoes not seek to time markets, that is, it does not actopportunistically to issue debt when market condi-tions appear favorable.

The idea of regular and predictable auctionschedules began in the 1970s. Starting in 1970, thefederal government began financing generallyincreasing deficits, and most of the treasury’s debtmanagement tools were well-suited for the task. Newauction cycles were added, frequencies of issuanceincreased, and auction sizes rose over time. By thelate 1970s, the magnitude of the treasury’s financingneeds led to the introduction of a “regular and con-sistent” debt issuance schedule.

The third principle of debt management is thetreasury’s commitment to ensuring market liquidity.Liquidity promotes efficient capital markets by pro-viding an underlying security for a wide range offinancial transactions and lowers borrowing costs forthe treasury by increasing demand for its securities.

Fourth, the treasury finances across the yieldcurve. A balanced maturity structure mitigatesrefunding risks and appeals to the broadest range ofinvestors. In addition, providing a pricing mechanismfor interest rates across the yield curve further pro-motes efficient capital markets.

Fifth, the treasury employs unitary financing.The government’s financing needs are aggregated sothat borrowing across agencies is conducted through


the treasury. Thus, all programs of the federal gov-ernment can benefit from the treasury’s low borrow-ing rate. Otherwise, separate programs with smaller,less liquid issues would compete with one another inthe market. There are some exceptions to unitaryfinancing, amounting to less than 1 percent of allpublic debt securities outstanding.

These principles frequently act as constraints onthe treasury as it works to meet its objective. Regularissuance across the yield curve may occasionally leadto relatively high short-term borrowing costs—coststhat we believe are more than offset by the premiuminvestors are willing to pay for a predictable supply oftreasury securities. The most significant constraint,however, is that the future can be seen only imper-fectly and, therefore, the treasury constantly works toforecast our likely borrowing needs, anticipate howwe should alter our borrowing pattern when thefuture does not fit our forecast, and anticipate whatwill prove to be the lowest-cost means of financing inthe future.

The treasury’s long-term financing decisions aremade quarterly after advice is solicited from the pri-vate sector through interviews with market partici-pants and advice from a private sector advisorygroup. The group is composed of about 20 individu-als who come from broker/dealer firms and invest-ment firms and who are active participants in thegovernment securities market. They meet at the timeof each treasury midquarter refunding to advise thetreasury on their recommendations for the currentrefunding operation and debt management policymatters. The group’s formal recommendations andthe minutes of the group’s meetings are available onthe Internet at http://www.treas.gov/domfin. Thetreasury also solicits advice from individuals throughan e-mail address: [email protected].

Risk management

Financial liabilities are denominated only in localcurrency. Domestic currency liabilities are viewed asappropriate for the treasury’s balance sheet, giventhe very high proportion of its domestic currencyassets. Aside from appropriate, a portfolio solely ofdomestic currency liabilities is feasible because of thelarge size of domestic financial markets that can read-

ily absorb fluctuations in the treasury’s borrowingneeds.

The treasury issues benchmark securities across awide range of maturities to reduce refinancing risk.Expected borrowing needs are announced quarterly.Changes in schedules or amounts are announcedwith sufficient lead-time for price discovery and dis-tribution to investors. Underlying this approach is thetreasury’s large presence in the market, which meansthat policy changes are likely to lead to price changes.

Management of liability risk is concentrated onmaintaining a stable average maturity through bal-anced issuance of short-, medium-, and long-termsecurities and ensuring high liquidity through a reg-ular and predictable issuance of benchmark securi-ties. The average length of privately held, marketabletreasury debt at the end of 2001 was 5 years and 6months, excluding inflation-indexed securities, and 5years and 10 months, including inflation-indexedsecurities.

Borrowing programs are based on the fiscal andeconomic projections contained in the annual bud-get established by congress. The treasury uses theadministration’s most recent projections of the fed-eral government’s budget position as inputs in thesemodels. New budget projections are made annuallyand published early in the calendar year. Projectionsare then revised five or six months later.

Based on the administration’s projections, thetreasury creates long-term debt projections usinginternally developed models. These models are usedto monitor rollover risk and ensure a relativelysmooth maturity profile. Short-term debt issuancepatterns are based on cash management projectionsthat incorporate both the administration’s long-termforecasts and the most recent estimates of short-termexpenditures and revenues.

The treasury ensures a high level of liquiditythrough a large, regular, and predictable issuancepattern. The Fed’s primary dealer system for debtissuance, which helps to ensure the success of trea-sury auctions, further reduces liquidity risk. The fre-quency and large scale of treasury operations helps toprovide assurances that allow for frequent testing ofsettlement systems.

The treasury is responsible for the operation andmanagement of the commercial book entry program,


which includes the announcement, auction, issuance,and buyback of marketable treasury securities as wellas regulating, servicing, and accounting for thesesecurities. The Federal Reserve Bank of New York,working as the treasury’s fiscal agent, has the day-to-day responsibility for identifying, monitoring, andmitigating operational risk associated with thenational book entry system, a safekeeping and trans-fer system for the treasury’s marketable securities.The identification and monitoring of risks associatedwith the announcement, auction, issuance, and buy-back of marketable treasury securities rests with theBPD. These risks are mitigated by contingency plansand associated with various points of failure through-out the automated systems required to perform thesefunctions.

Operational risk is minimized through the deliv-ery-versus-payment feature of the commercial bookentry program and by separate agencies handlingauctions and settlements. As an additional assurance,annual audits are conducted by the accountingagency of the legislative branch of government.

Recent policy changes

Because of recent budget surpluses, the treasury hadbeen paying down its outstanding debt by issuing lessdebt than the amount of maturing debt, decreasingboth its short- and long-term debt issuance. Payingdown debt is inherently asymmetrical, with the pay-down occurring at the short end of the maturity spec-trum, leading to an increase in average length.

The treasury instituted policies to help mitigategrowth in the average length, including regular,smaller reopenings of longer-term debt and buybacksof outstanding long-term debt. Also, it recently sus-pended issuance of 30-year bonds. This decision wasbased, in part, on a need to reduce longer-term debtissuance. It also reflected market experience, whichindicates that financing with 30-year bonds is expen-sive relative to 10-year financing.

Continuing economic sluggishness, reduced taxrevenue, and the fiscal response to the tragic eventsof September 11 have led to an increase in the trea-sury’s near-term financing needs. These needs areexpected to be temporary and largely met throughincreased treasury bill and shorter-term note

issuance, which in turn has helped to decrease theaverage length of the privately held marketable debt.

Asset management

The U.S. government’s holdings of financial assets(including foreign reserves) are small compared withits financial liabilities. Cash is largely held in com-mercial banks that are required to post substantialcollateral. The Fed, as fiscal agent for and at thedirection of the treasury, has primary operationalresponsibility for investment of cash in participatingcommercial banks. These responsibilities includeaccepting, valuing, safekeeping, monitoring for col-lateral deficiencies, and releasing collateral. The Fedis also the primary point of contact for the depositaryfinancial institutions that participate in the program.

Cash management operations are reviewed andaudited both internally and externally. Operations,including both the Fed and commercial banks partic-ipating in cash management, employ coordinatedand comprehensive risk management procedures toensure that processes and operations are available.Such management ensures that the objectives of theprogram are achieved and safeguarded.

The Government Securities Market

Debt management has evolved as the U.S. financialmarkets have become more sophisticated. As recentlyas World War II, retail instruments provided animportant role in debt issuance. In the 1950s and1960s, the dominant bond issuers were corporaterather than government. Regular issuance of all debtinstruments did not occur until the 1970s. Rules onparticipation continue to evolve in response tochanges in the number of treasury market partici-pants and changes in technology.

The major increase in government debt issuancein the United States took place in financial marketsthat were already well developed. However, given thatready market access is essential to the government’sdebt management program, the treasury does focuson how to broaden the market for its securities.Broad distribution of treasury securities enhances liq-uidity and efficiency of the market for government


debt, while minimizing the impacts of governmentdebt management activities on the economy andmoney markets and increasing the distribution of thebenefits of government borrowing.

Because of the treasury market’s size, security,and demand by other investors, treasury securitiesrepresent the most liquid capital investment in theworld. For investors looking for safety, predictability,and easy liquidity, treasury securities offer a range ofbenefits suited to those objectives.

The treasury issues fixed-rate nominal and infla-tion-indexed securities. They are direct obligations ofthe U.S. government and are known commonly asmarketable securities because they can be boughtand sold in the secondary market at prevailing mar-ket prices through financial institutions, brokers, anddealers in government securities. Except for a fewspecific issues of treasury bonds that were issuedbefore 1985 that are callable, marketable treasurysecurities are not redeemable before maturity. Allmarketable treasury securities are issued only inbook-entry form, with a minimum purchase amountof $1,000 and in multiples of $1,000. SinceSeptember 1998, customers who have establishedaccounts with the treasury have been able to pur-chase securities via the Internet at the BPD’s web site(www.publicdebt.treas.gov).

The treasury currently offers fixed-rate nominalsecurities with maturities ranging from 4 weeks to 10years on a regular basis. Bills with maturities of 4, 13,and 26 weeks are auctioned weekly, with Thursday set-tlement dates; 2-year notes are offered monthly forsettlement at month-end; and 5- and 10-year notes areauctioned quarterly with midmonth settlement dates.This wide range of maturity dates allows an investor tostructure a portfolio to specific time horizons.

In an effort to expand the types of securities itoffers and broaden the base of direct investors in itssecurities auctions, the treasury began auctioninginflation-indexed securities in January 1997. Thesesecurities help to protect investors from inflation,and their auctions have had broader direct participa-tion relative to treasury fixed-rate nominal securityauctions by appealing to investors that have not pre-viously invested in treasury securities and encourag-ing other portfolios to invest more. This increasedparticipation should help to lower overall financing

costs. The treasury also issues a retail inflation-indexed savings bond.

The treasury initially offered 5- and 10-year infla-tion-indexed notes and 30-year inflation-indexedbonds, but market interest has largely focused on the10-year note, so 5-year inflation-indexed notes werelast issued in October 1997 and 30-year inflation-indexed bonds were suspended in October 2001. Theprincipal of the security is adjusted daily for inflation.The inflation adjustment is subject to federal incometax in the year it is earned, and the inflation-adjustedprincipal is paid at maturity. Semiannual interest pay-ments are a fixed percentage of the inflation-adjustedprincipal. The security uses the nonseasonallyadjusted consumer price index for all urban con-sumers as the inflation index. The treasury currentlyoffers the 10-year inflation-indexed note on a regular,semiannual schedule.

Before the early 1970s, the traditional methodsfor selling notes and bonds were subscription offer-ings, exchange offerings, and advance refundings.Subscriptions involved the treasury setting an interestrate on the securities to be sold and then selling (ortaking subscriptions for) them at a fixed price. Inexchange offerings, the treasury allowed holders ofoutstanding maturing securities to exchange themfor new issues at an announced price and couponrate. In some cases, new securities were issued only toholders of the specific maturing securities; in others,additional amounts of the new security were issued.Advance refundings differed from exchange offer-ings in that the outstanding securities could beexchanged before their maturity date.

A fundamental difficulty with fixed-price sub-scription and exchange offerings was that marketyields could change between the announcement ofthe offering and the deadline for subscriptions.Increased market volatility in the 1970s made fixed-price offerings very risky for the treasury.

A modified auction technique was introduced in1970, in which the treasury preset the interest rate(coupon rate) and bids were made on the basis ofprice. The treasury started to auction coupon issueson a yield basis in 1974. Bids were accepted on thebasis of an annual percentage yield, with the couponrate based on the weighted-average yield of acceptedcompetitive tenders received in the auction. Yield


auctions free the treasury from having to set thecoupon rate before the auction and ensure that theinterest costs of new note and bond issues accuratelyreflect actual market demand and supply conditionsat the time of the auction.

Today, all marketable treasury securities are soldin uniform-price auctions, and all treasury auctionsare conducted on a yield basis. The terms and condi-tions for offerings of treasury securities are governedby the terms and conditions set forth in the “UniformOffering Circular for the Sale and Issue ofMarketable Book-Entry Treasury Bills, Notes, andBonds” (in the United States Code of Federal Regulations,available at www.publicdebt.treas.gov/gsr/gsruo-cam.htm). A separate announcement is made foreach auction, providing the dates of the auction andsettlement, the amount offered for sale, the maturityof the security, and other details. The treasury sellsthe entire announced amount of each securityoffered at the yield determined in the auction.

The treasury permits trading during the periodbetween announcement and settlement on a when-issued basis that provides for price discovery andreduces uncertainties surrounding auction pricing.Potential competitive bidders look to when-issuedtrading levels as a market gauge of demand to deter-mine how to bid at an auction. Noncompetitive bid-ders, to whom securities are awarded at theauction-determined yield, can use the quotes in thewhen-issued market to assess the likely auction yield.

Until late 1998, the method for selling mar-ketable treasury securities generally had been multi-ple-price auctions. In a multiple-price auction,competitive bids were accepted from the lowest yield(discount rates in the case of treasury bills) to thehighest yield required to sell the amount offered tothe public. Competitive bidders whose tenders wereaccepted paid the price equivalent to the yield (ordiscount rate) that they bid. Noncompetitive bidderspaid the weighted-average price of accepted compet-itive bids.

The treasury adopted the use of single-price auc-tions for all marketable treasury securities inNovember 1998. All auctions of inflation-indexednotes and bonds have been on a single-price basissince the Treasury began selling inflation-indexedsecurities. As with multiple-price auctions, single-

price auctions are conducted in terms of yield (bankdiscount rate in the case of treasury bills). Bids areaccepted from the lowest yield (or discount rate) tothe highest required to sell the amount offered. Incontrast to multiple-price auctions, all awards are atthe highest yield (or discount rate) of accepted bids.

The treasury has found that single-price auctionshave some advantages over multiple-price auctions.First, they tend to distribute auction awards to agreater number of bidders than multiple-price auc-tions. Second, auction participants may bid moreaggressively in single-price auctions. Successful bid-ders are able to reduce the so-called winner’s curse,the risk that a successful bidder will pay more thanthe common market value of the security and, there-fore, will be less likely to realize a profit from sellingit. There is evidence that more aggressive bidding haslowered treasury borrowing costs somewhat.

Any entity may submit a bid in a treasury auctiondirectly to a federal reserve bank, which acts as thetreasury’s fiscal agent, indirectly through a dealer, ordirectly to the treasury department. The treasury per-mits all dealers registered with the Securities andExchange Commission and all federally regulatedfinancial institutions to submit bids in treasury auc-tions for their own accounts and for the account of cus-tomers. All bidders in treasury auctions—not justprimary dealers and financial institutions—may bid intreasury auctions without a deposit, provided the bid-der has a payment mechanism in place (an“autocharge agreement”) with its federal reserve bank.

Primary dealers are firms through which theFederal Reserve Bank of New York conducts its openmarket operations. They include large diversifiedsecurities firms, money center banks, and specializedsecurities firms, and they are foreign owned and U.S.owned. Over the last decade, the number of primarydealers has declined from 46 to 22. Among theirresponsibilities, primary dealers are expected to par-ticipate meaningfully in treasury auctions, make rea-sonably good markets in their trading relationshipswith the Federal Reserve Bank of New York’s tradingdesk, and supply market information to the Fed.Formerly, primary dealers were also required to trans-act a certain level of trading volume with customersand thereby maintain a liquid secondary market fortreasury securities. Customers include nonprimary


dealers, other financial institutions (such as banks,insurance companies, pension funds, and mutualfunds), nonfinancial institutions, and individuals.Although trading with customers is no longer arequirement, primary dealers remain the predomi-nant market makers in U.S. Treasury securities.

The treasury has facilitated purchases of treasurysecurities by small investors by awarding securities ona noncompetitive basis for up to $5 million through a

book-entry system. Through this system, the investorholds treasury securities directly on the books of thetreasury, without using the services of a financial insti-tution or a dealer.

Note

1. The case study was prepared by the Office of MarketFinance of the U.S. Treasury.


1. Debt management objectives andcoordination

1.1 Objectives

The main objective of public debt management is toensure that the government’s financing needs and itspayment obligations are met at the lowest possible costover the medium to long run, consistent with a pru-dent degree of risk.

1.2 Scope

Debt management should encompass the main finan-cial obligations over which the central governmentexercises control.

1.3 Coordination with monetary and fiscalpolicies

Debt managers, fiscal policy advisers, and centralbankers should share an understanding of the objec-tives of debt management, fiscal, and monetary poli-

cies given the interdependencies between their differ-ent policy instruments. Debt managers should conveyto fiscal authorities their views on the costs and risksassociated with government financing requirementsand debt levels.

Where the level of financial development allows,there should be a separation of debt management andmonetary policy objectives and accountabilities.

Debt management, fiscal, and monetary authori-ties should share information on the government’scurrent and future liquidity needs.

2. Transparency and accountability

2.1 Clarity of roles, responsibilities, and objectivesof financial agencies responsible for debtmanagement

The allocation of responsibilities among the ministryof finance, the central bank, or a separate debt man-agement agency for debt management policy advice,and for undertaking primary debt issues, secondary

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Appendix

Summary of the Debt Management Guidelines1

market arrangements, depository facilities, and clear-ing and settlement arrangements for trade in govern-ment securities, should be publicly disclosed.

The objectives for debt management should beclearly defined and publicly disclosed, and the measuresof cost and risk that are adopted should be explained.

2.2 Open process for formulating and reportingdebt management policies

Materially important aspects of debt managementoperations should be publicly disclosed.

2.3 Public availability of information on debtmanagement policies

The public should be provided with information onthe past, current, and projected budgetary activity,including its financing, and the consolidated finan-cial position of the government.

The government should regularly publish infor-mation on the stock and composition of its debt andfinancial assets, including their currency, maturity,and interest rate structure.

2.4 Accountability and assurances of integrity byagencies responsible for debt management

Debt management activities should be audited annu-ally by external auditors.

3. Institutional framework

3.1 Governance

The legal framework should clarify the authority toborrow and issue new debt, invest, and undertaketransactions on the government’s behalf.

The organizational framework for debt manage-ment should be well specified and ensure that man-dates and roles are well articulated.

3.2 Management of internal operations

Risks of government losses from inadequate opera-tional controls should be managed according to

sound business practices, including well-articulatedresponsibilities for staff, and clear monitoring andcontrol policies and reporting arrangements.

Debt management activities should be supportedby an accurate and comprehensive managementinformation system with proper safeguards.

Staff involved in debt management should besubject to code-of-conduct and conflict-of-interestguidelines regarding the management of their per-sonal financial affairs.

Sound business recovery procedures should be inplace to mitigate the risk that debt management activ-ities might be severely disrupted by natural disasters,social unrest, or acts of terrorism.

4. Debt management strategy

The risks inherent in the structure of the govern-ment’s debt should be carefully monitored and eval-uated. These risks should be mitigated to the extentfeasible by modifying the debt structure, taking intoaccount the cost of doing so.

In order to help guide borrowing decisions andreduce the government’s risk, debt managers shouldconsider the financial and other risk characteristicsof the government’s cash flows.

Debt managers should carefully assess and man-age the risks associated with foreign currency andshort-term or floating-rate debt.

There should be cost-effective cash managementpolicies in place to enable the authorities to meetwith a high degree of certainty their financial obliga-tions as they fall due.

5. Risk management framework

A framework should be developed to enable debtmanagers to identify and manage the trade-offsbetween expected cost and risk in the governmentdebt portfolio.

To assess risk, debt managers should regularlyconduct stress tests of the debt portfolio on the basisof the economic and financial shocks to which thegovernment—and the country more generally—arepotentially exposed.


5.1 Scope for active management

Debt managers who seek to manage actively the debtportfolio to profit from expectations of movements ininterest rates and exchange rates, which differ fromthose implicit in current market prices, should be awareof the risks involved and accountable for their actions.

5.2 Contingent liabilities

Debt managers should consider the impact that con-tingent liabilities have on the government’s financialposition, including its overall liquidity, when makingborrowing decisions.

6. Development and maintenance of anefficient market for governmentsecurities

In order to minimize cost and risk over the mediumto long run, debt managers should ensure that theirpolicies and operations are consistent with the devel-opment of an efficient government securities market.

6.1 Portfolio diversification and instruments

The government should strive to achieve a broadinvestor base for its domestic and foreign obligations,

with due regard to cost and risk, and should treatinvestors equitably.

6.2 Primary market

Debt management operations in the primary marketshould be transparent and predictable.

To the extent possible, debt issuance should usemarket-based mechanisms, including competitiveauctions and syndications.

6.3 Secondary market

Governments and central banks should promote thedevelopment of resilient secondary markets that canfunction effectively under a wide range of marketconditions.

The systems used to settle and clear financialmarket transactions involving government securitiesshould reflect sound practices.

Note

1. The IMF–World Bank Guidelines for Public Debt Managementcan be found on the IMF and the World Bank web sites in 5 lan-guages:http://www.imf.org/external/pubs/cat/longres.cfm?sk=15113.0andhttp://www.worldbank.org/pdm/pdf/guidelines_2001_final.pdf.

Appendix: Summary of the Debt Management Guidelines 261

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