Public Debt MgtPublic debt is the result of govt borrowing from private individuals and financial institutions with the promise of paying back the money borrowed plus interestPurposes of Public Debt - Managing the national economy - Making expenditures that exceed revenues over a long period - Making exp. that exceed revenues over a short term period - Financing specific capital expenditures(Public Capital- large components such as highways, airports, roads, transit systems, and railways; local, municipal components such as public education, public hospitals, police and fire protection, prisons, and courts; and critical components including water and sewer systems, public electric and gas utilities, and telecommunications)

Characteristics of Public Debt 1.Form of Debt Bearer form and registered debt contracts2. Obligation Bases Debt contracts are also called securities. The term indicates that repayment is secured by the contract. The obligation based may be general obligation, limited liability obligation and moral obligations

Characteristics Contd3. Tax Status Public debt may have special tax treatment4. Time Periods The debt contracts specify time periods Short,Intermediate, and Long5. Amounts Total amount, Face value, and One time borrowing amount are the three types.

Characteristics Contd6. Rates It refers to interest (also effective) rates7. Ratings It shows the creditworthiness of the issuing organization.8. External guarantees Govt guarantees may be given for local govt, if they are allowed to borrow. Financial institutions or insurance companies may give guarantee

External guaranteeExternal guarantee loan is a letter of guarantee issued to a principal(Bank) in a foreign country guaranteeing that international trade commitments will be fulfilled by the banks customer.If the contractual obligation is not fulfilled in due time and as specified, the bank/Govt pays the principal the agreed amount of money.

Characteristics Contd9.Special features - Call Option - Put Option : It allows debt holders to demand the payment (It is opposite to Call option) - Rollover option: It allows the borrower to extend a debt contract in time beyond the maturity date with a higher interest rate

Exercise of calls

Exercise of Puts

Characteristics Contd10. Innovation. Innovative forms of debt should be within the legal provisions of public debt and tax provisions. E.g: Variable rate instruments Instruments with foreign currency denominations Lease agreements

Public Debt ProcessPD process involves all the steps from borrowing money to payments of debt.The process involves the following steps:Step 1. The decision to borrow money -identify the purpose -consider the cost of borrowing

Public Debt Process ContdStep 2. Provide legal advice to the officials responsible for issuing debt - It minimizes possible errors

Step 3. Decide the amount to borrow - Borrow the lowest reasonable amount - The amount should be the required amount

Public Debt Process Contd.Step 4: Design a debt issue - Design features which are attractive for both the borrower and the lenders - Design features for minimizing costsStep 5 & 6 : Marketing Efforts and the development of debt contracts - Ads for issuing bonds - Debt contracts should be accompanied by a Prospectus

Public Debt Process ContdStep 7: Exchange of ownership of debt contracts for money - A debt issuer signs a contract with the underwriter, transferring ownership Step 8: Administration of debt - The administration includes handling the debt proceeds, maintaining records, fulfilling debt contract requirements, handling call options

Cost of Capital Public SectorAs there is no specific model available, a number of possible discount rates are used.However, there are two main approaches:Social Opportunity Cost Rate - Pub. Sector funds comes from private sector. So, the social opportunity cost is the pre-tax rate of return in private sector

Social Opportunity Costthe opportunity cost to the society of making a certain good or service, at the expense of using the factor of production for a different good or service

Social Opportunity CostEconomicsThe opportunity cost to the society of making a certain good or service, at the expense of using the factor of production for a different good or service

Cost of Capital Public Sector2. Social Time PreferenceIt is the after tax rate of return required by society to induce it to sacrifice present consumption for the promise of future consumption as generated by the investmentFactors such as the age structure of the population, growth prosperity etc should be considered

Time preference

Inclination of a consumer towards current consumption (expenditure) over future consumption, or vice versa. What may induce a consumer to delay consumption is called Rate of Time Preference amount of money (expressed as a proportion of the consumer's current income) that will compensate him or her for forgoing current consumption.

Expert Opinions on Cost of Capital1.Zero cost as the donors do not expect return2. Zero cost , but expects return for replacing assets3. The cost is low, which is equivalent to the return available from short term securities4. Capital has the same cost as the cost of capital in the private investments

Types of DebtShort Term Bills, Notes, Bank Loans, A/c Payable, Unpaid bills and claims, Cash discounts

Intermediate Debt The period is usually 1-5 years

Types of Debt Contd.Long Term Debt: is appropriate where (for)the project will not require replacement for many years (E.g.city hall, heath facility)The project can be financed by service charges to pay off the debt commitmentsNeeds are urgent for public health or other emergency reasons

Long Term Debt Contd- Intergovernmental revenues may be available on a continuous basis to guarantee the security of the debt

- (For)Financing projects in areas of rapid expansion where the demand on resources are comparatively large and unforeseen

BONDSIt is the most common long term debtIt is a Prom. Note ensuring that the lender will receive periodic payments of interest and at maturity repayment of the original sum invested.Face value is the amount that the issuer pays on maturityCoupon rate is the interest rate

Types of BondsGeneral Obligation Bonds: are backed by full faith, credit and taxing power of the issuing authority. Govt can levy taxes to meet debt service requirementsSpecial Tax or Spe. Assessment Bonds: are payable only from the proceeds from a special tax levied from the beneficiaries (Highway bonds)

Types of BondsRevenue Bonds : are issued to finance a revenue-producing enterprise such as the construction of a toll road or bridgeStepped Coupon Bonds: use a serial maturity schedule, with coupon rates that start at lower levels and progressively increase to higher levels

Types of BondsZero-Coupon Bonds: are not eligible for any interest, but sold at a deep discount.Capital Appreciation Bonds: are compound interest bondsTender Option Bonds:allows the investor to submit for redemption before maturity.

Types of BondFlexible Interest Bonds: The yield changes over the life based on some interest index issued by reliable authoritiesDetachable Warrant Bonds: the holder can buy more securities at the same price and rate of returnInflation Protection Bonds: The Principal will be adjusted for inflation without changing the interest.

EXTERNAL BORROWINGExternal debt is defined as the amount of disbursed and outstanding contractual liabilities of residents of a country to nonresidents to repay the principal with or without interest, or to pay interest with or without principal.

Factors to be considered in borrowingBorrowing Policy -Develop well thought- about policies -Assess the requirement for capital -Look for foreign capital and then design projects - Select a reasonable period - Terms, repayment, interest etc should be considered in borrowing

Factors Contd..Central Borrowing Authority - As a result, the total national borrowing is recorded at one place - Second, the borrowings can be controlled well - Third, the community knows the liability - Finally, it helps better planning of future borrowings

Factors ContdLimits and Guarantees - Can fix the upper limit keeping the repayment capacity in mind - Guarantees may be given by the Govt or financial institutions

Factors ContdForeign Exchange Controls - Free flow of foreign capital affects many aspects of the economy including balance of payments. - So strict control on foreign exchange is necessary. - Exchange control regulations influence the Public Debt Management

Factors Contd.Proper deployment of external resources - should not be used for luxuries - should be utilized for proper purposes - if the purpose is not specified, use it in industries to increase production or infrastructure facilities.

Factors Contd..Prompt Debt Servicing - Develop a habit of prompt payment of interest and the principal on time.Timely Implementation of Projects -Some countries are fast in designing projects and borrowing,but slow in implementing projects - If the loan is not used on time, the lenders may charge a commitment fee

Factors ContdTransparency - Ensure transparency to all transactions and avoid corruption

Expanded World Trade (Export) - The loan has to be paid back. So find place in foreign markets to earn foreign exchange

Factors Contd..Encouragement to foreign Private Investments - Offer incentives such as repatriation of profits and capital etc

Investment Preferences - Investment of foreign capital should be in areas vital to the devt of the country.

Factors Contd.Import Substitution - Reduce the imports to save foreign exchange

Citizens Remittances - Encourage the Diaspora to remit their income to the country.

Factors Contd.Adoption of a sound negotiation strategy - A team of multi-disciplinary professionals including lawyers, accountants, economists should negotiate with the lending institutions. - They should be aware of the international laws and practices of borrowing

Public debtAnalyzing PDPD Outstanding= total debt level a govt carries at a specific time.Debt service = annual payment of principal and interest. Debt capacity =the level of debt a govt can affordPossible measures of debt capacity1. Debt outstanding a s a percentage of taxable property values = Debt outstanding / taxable property values. (Or) Debt outstanding / personal income

Public debt2. Debt outstanding per capita = Debt outstanding / Population 3. Debt service as a percentage of revenue = Debt service / revenue (1) and (2) are called debt outstanding ratios and (3) is called debt service ratio Additional debt capacity is available if the current debt level of government does not exceed its benchmark debt ratio.

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