Debt Management and Financial Stability: Potential Roles for SAIs

Debt Management and Financial Stability: Potential Roles for SAIs

Reviewed Proposal by SAI – Canada

June 2011

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Outline1. Introduction: Financial turmoil2. Fiscal expansion and impact on public debt

1. Fiscal expansion, ↑ Spending measures2. ↑ Financial requirements, ↑ Borrowing3. Trend in D/GDP 4. Changes in debt environment

3. Debt Management, financial stability and potential roles for SAIs1. Relationship between debt management and financial stability2. New role for debt managers3. Risk management and funding mix4. Management of contingent liabilities5. Debt target and performance measurement6. Fiscal sustainability of public debt

4. Conclusion

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1.0 Introduction: Context to the Financial Turmoil

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1.0 Introduction: Context to the Financial Turmoil

Pre 2007: Global economy had a long period of steady growthLow inflation / low interest rateHowever large imbalances in the world economyConcern over the quality of economic expansion Large Current Account deficits Low i / low ∆p: more risks as investors searching for

higher yield Assets price bubble (housing, commercial real estate)

Concerns over the growing household debt (e.g. US)

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2007 Financial crisis and economic downturn

Until recently crises focussed on Emerging Markets (EM) (e.g. southeast Asia, Latin American debt crisis)

Most recent crisis epicentered in the United States with global consequences

Through complex interactions and relationships: affected Advanced Economies more than Emerging Economies

Many elements in explanation

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US Subprime mortgage market collapsed

Poor lending standards Borrowers encouraged into variable rate mortgages Teaser rate

Financial institutions taking risks (assume housing prices ever increasing)Homeownership encouraged and subsidized by governmentInadequate Regulation / Supervision in Large Economies Light regulatory regime (poor implementation of Basel II) Liquidity levels not robust Too big to fail Too complex to fail Too interconnected to fail Moral hazard reducing market discipline

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Financial markets under pressure

Housing prices started to fall / default rate rose sharply

Value of complex derivatives based on mortgages uncertain

Markets dried up as market for derivatives because uncertain – bad assets

Originating institutions stuck with mortgages that had intended to sell

Short-term financing / interbank lending markets dried up as: FI desire to hold liquid assets Concern over counterparties’ solvency (questioned value of assets)

Concern about quality of household and business loans on balance sheets of FI

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Potential for insolvency in FI as crisis evolved

Holding subprime mortgagesHolding ABS and CDOs as investmentsHolding of commercial mortgages, loans, credit cards… where borrowers fell into arrears as economy weakenedExposure to CDSèSevere downturn in housing prices Decline in stock prices Psychological worries as financial sector under pressure, as unemployment

began to rise Pressure on household spending (especially big ticket items: auto, housing)

Banks reluctant to make new loans (because of liquidity pressure, shortfall in capital, balance sheets problems, concern over quality of loans and effects on future losses)Growth in emerging economies slowed down (reduced exports, capital markets tight, financial sector problems)Exceptions: China, India

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2.0 Fiscal Expansion and Impact on Public Debt

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2.0 Fiscal Expansion: contextLiquidity measures, address solvency problems (e.g. Lehman Brothers) and regulatory issuesMacro situation declining; accommodating monetary policyWith weakening economy: governments turn attention to fiscal policyFiscal stimulus measures introduced (however fiscal space was often limited and poor fiscal credibility) New stimulus measures announced by G-20 countries $US 820 B (2009), $US 660 B (2010)G-20 support for the financial sector totalled 32% as a percentage of 2008 GDP(49% for advanced economies, 2% for emerging economies)

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Fiscal deficitBudget deficit for the OECD as a whole is estimated to have peaked at 7.5% GDP $US 3.3 Trillion (est. 6.5% of GDP in 2011)

For the G-20, the increase in the average overall fiscal deficit is estimated at 5.4 percent in 2010

Net borrowing requirements are estimated to fall from $US3T (2010) to $US2.9T (2011).

Long-term interest rate expected to rise to 5.1% (2011) from 3.7% (2009)

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Public Finance: Sustainable?

Public finances unsustainable in some countries – interest rates will further augment as D/GDP ratio increase (4bps for every percentage point > 75%)

Debt sustainability : “Ability to service debt without large adjustments to revenue and/or expenditure as well as the lack of an ever-increasing debt burden”

Debt sustainability is a bigger problem for advanced economies.

Risk of sovereign default (e.g. Ireland, Portugal, Greece)

Debt downgraded by Credit Rating agencies (e.g. reduced outlook for US, Japan)

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2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 20160

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80 Debt/GDP for Emerging Countries (%)Argentina, B, StableBrazil, BBB-, StableBulgaria, BBB, StableChile, A+, PositiveLithuania, BBB, StableMexico, BBB, StableUkraine, B+, Stable

Source: Standard & Poor's (long-term credit & outlook); International Monetary Fund (debt), Wall Street Journal

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2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 20160

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40

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80

100

120

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160 Debt/GDP for Countries with a Negative Outlook (%)

Greece, BB-, NegativeIceland, BBB-, NegativeIreland, BBB+, NegativeSpain, AA, Negative


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2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 20160

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100

150

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300 Debt/GDP for G-7 Countries (%)

Canada, AAA, StableFrance, AAA, StableGermany, AAA, StableItaly, A+, StableJapan, AA-, StableU.K., AAA, StableU.S., AAA, Negative


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2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 20160

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80 Debt/GDP for other OECD countries (%)

Austria, AAA, StableKorea, A, StableNorway, AAA, StableRussia, BBB, StableSweden, AAA, Stable


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Borrowing increased after financial crisis

Financial requirements increased rapidly as government spends more. Gross borrowing requirement in 2009 (OECD) :

$16 trillionGovernment in advanced and emerging economies need to borrow more funds USD 16 trillion (2009) USD 17.5 trillion (2010), USD 19 trillion (2011 -- nearly twice that of

2007)

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Changes in debt environment

Impact on debt managers: reported that issuance condition worsened (weaker auctions)Debt managers modified their borrowing strategies in terms of maturity, currency and type of instruments.Debt program more opportunistic for some sovereigns

Challenges for borrowing programs: 1) Significant increase in short-term debt issuance (short notice and

lowest borrowing cost possible for capital injections or for recapitalisation of banks)

2) Liquidity pressures in secondary markets 3) Record volume of sovereign issuance 4) Crowding-out effects (especially if above benchmark): risk premia E.g In early April 2011Portugal sold 1B Euros 6mths T-Bills @ yield 5.11%

(compared to 2.98). One year rate = unsustainable 10 year bonds

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Recent changes in financial markets: selected countriesRecent changes in issuing procedures and debt instruments: selected countriesAustria More emphasis on investor relations.

Canada Re‐introduction of 3‐year maturity. Reduction in the regular buy‐back programme but maintained switch operations in long-end to support market liquidity. Introduction of additional benchmarks for 2‐year and 5‐year sectors.

Hungary More flexible auction calendar (bi‐weekly bond auctions with dates but without tenors in calendars). More flexibility in the amounts offered. Introduction of top‐up auctions (non‐competitive subscription) and auction fees. More frequent use of reopeningof off‐the‐run bonds and buy‐back auctions. Planned introduction of exchange auctions. Introduction of direct, regular meetings with institutional investors.

Korea Since September 2009, single price format of auctions was changed to a multiple price format. Introduction of conversion offers

Mexico Tap issues of both short and long term bonds.

United Kingdom Mini tenders were introduced in October 2008 as a more flexible supplementary distribution method alongside with the core auctions programme. In 2009‐10 the DMO is using syndicated offerings to supplement its auction programme (as of 1 October2009, three syndicated offerings have been held). Introduction of a post‐auction option facility.

OECD, 2009

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3.0 Debt Management, financial stability and potential roles for SAIs

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3.1 Relationship between debt management and financial stability

Debt structure and sound debt management practices are essential complements to fiscal consolidation and financial stability in a post crisis environment.

Debt stock will affect the government’s balance sheet

Weak debt structure can be a source of financial instability (high debt stock, large proportion of short-term debt stock with low term to maturity, large foreign currency debt,…).

Higher volatility could result as refinancing large debt stock can lead financial instability.

Can also put pressure on FI balance sheets where marking to market of government securities increase risk and impact on capital requirements

For financial markets, a poor debt structure will lead to market pessimism and reduced liquidity (incl higher interest rates)

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Strong interrelations between debt management and financial stability (DNB Working Paper, 2010)

Financial Stability

Debt Management

Monetary Policy

Financial Regulation & Supervision

Fiscal Policy

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3.2 Sound debt management practices matter

Inappropriate debt structure can lead to fiscal vulnerability and financial instability

Lower cost debt strategy (short-term, foreign denominated debt) are subject to higher risk in the event of unexpected shocks

Financial crises of the ‘90s illustrate how the debt portfolio impact on resilience to external shocks

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Sound debt management practices matter (cont’d)

Currency exposure (e.g. Argentina, Brazil, Indonesia, Russia) Mexico (1994) issued Tesobonos – bonds linked to US dollars. The next year

the currency was devalued, increasing the debt stock and financial instability). Mexico (early 2000) improved debt structure: domestic financing of deficit, lengthening of maturity structure, liquid yield curve for domestic debt, increase predictability and transparency of debt issuance

Exposure to imp-licit contingent liabilities (e.g. Turkey, Korea, Thailand)

Debt structure that are too short can generate confidence crises Short ATM entail high rollover and refinancing risk : if interest rates increase

large fiscal impact

Concern that government will not have sufficient funds to redeem maturing bonds on due date. Lower demand for debt instruments, higher yield, increase debt charges

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New environment for debt managers

Implication of debt management strategy are broader than expectedDebt management influences the soundness and solvency of balance sheet.Debt management a factor that underpins the credibility and reputation of sovereignDebt management conditions debt capital markets and impacts on FI that hold public debtFinancial crises can have significant impact on debt mangers when market conditions and fiscal conditions degrade

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New environment for debt managers (cont’d)

Combined this can lead to unsustainable public debt situation in the short termSAIs must remember that public debt will impact on financial stability.New challenges for SAIs when auditing the management of public debt

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SAIs need to revisit the soundness of debt management practices: SAIs should audit debt management practices to determine if debt managers opted for debt structure that supports financial stability. Need for debt managers to develop strategic benchmark to help determined desired l.t. structure of liability (currency, interest, maturity, liquidity, indexation)

SAIs could examine processes / tools in place to support funding mix decisions

SAIs may also want to include in its audit scope the need to maintain large liquidity levels in order to build cash buffers to meet sudden shock on financial markets

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Increasing foreign currency liquidity needed: for multiple episodes to protect value of

currency, to cover financial requirements during

funding disruptions to demonstrate the government’s ability to

support market confidence (benchmarked against other sovereigns reserves-to-debt ration)

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3.3 Risk ManagementPost financial turmoil: increased emphasis on risk assessment and risk managementRisk associated to assets (e.g. , liquidity for cash management, FX reserves) and liabilities (bond/bills program) management.Importance of Risk management: key for achieving debt management objectives. Market Risks (interest and currency) Credit Risks Liquidity Risks Refunding Risks (rollover)

Operational Risks + legal risks + risks associated with contingency liabilities less likely to be managed

Define a framework for assessing portfolio performance in relation to cost, risk and return

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Risk Management practices and impact on funding mix

Strategic benchmark (SB) plays a key role in the control of risk. SB is a management tools that requires the government to specify: risk tolerance and portfolio preferences between expected cost and risk trade-off.

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Risk Management practices and impact on funding mix (cont’d)

Debt managers need to have a view on optimal debt structure of portfolio.

Allows the pricing of risks against expected cost of debt service

Funding mix = f (structure of economy, economic shock, preference of investors)

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Crisis situation: deviation for strategic benchmark

Eg. May issue more s.t. maturity instruments that previously announced. When normal conditions return DM need to return to earlier announced debt strategy (e.g. reduce floating debt, increase maturity of domestic debt)

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Designing and implement strategic benchmarks: complex /challenging; in particular in emerging economies Limited domestic currency borrowing Quantitative risk management tools are harder

to implement (e.g. models are less stable) Cost-risk tradeoffs more difficult. Hence difficult

for EM debt managers to construct optimal debt portfolio for performance measurement

Risk of default is such that EM debt managers aim for lower D/GDP ratios

Less foreign debt and more reserves

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Need to audit risk management governance /procedures

Audit Function plays a crucial role in reviewingBroader policy reform need to integrate: debt and risk management (incl. strategic benchmark)SAI should assess the quality of risk control systems

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Need to audit risk management governance /procedures (cont’d)

SAI could examine the risk management framework that support debt management decisions: How risks are identified, monitored, mitigated How risk tolerance levels are established The use by debt managers of benchmarking and stress

testing to set risk limits Use of quantitative models (stochastic models,

robustness, stress testing, use of model in debt strategy, use of model for benchmarking, performance measurement,…)

How risks are integrated in modeling exercise Governance structure in place / Mandate of risk

committees Reporting on risk operations to Treasury operations /

Minister / Parliament /Legislature / Overall risk management of the balance sheet

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3.4 Contingent liabilities: potential financial claims on the government.

Refer to obligations that may become government liabilities whose size and timing = f(uncertain future events outside the control of government)

Contingent Liabilities: significant risks on the balance sheet

In fact, main risk to fiscal sustainability come from contingent liabilities (including publicly guaranteed debt)

Contingent debt such as guarantees is latent form of government debt

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Contingent liabilities

Hana Polackova-Brixi (1999, World Bank) published a tool that provides a snapshot of a country’s fiscal exposures. Bank failure is considered an implicit contingency (ie. that there is a moral obligation to intervene in the case of a bank failure or default of a private entity on nonguaranteed debt). Collapses in the financial services sector can seriously damage the fiscal position of governments and can be a major source of fiscal vulnerability.

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Categorisation of fiscal risk

Source: Hana Polackova-Brixi (1999, World Bank)

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Contingent liabilities: effective management required

Need principles for reporting and pricing contingent liabilities

Need measures of cost and risks that encompass both guarantee portfolio and regular debt portfolio: debt managers well positioned to manage both

Need rules and procedures so that costs of guarantee are made explicit and reported

Design/ management of contingent debt/guarantees Guarantees may entail higher financial risks Are risks management processes in place? Is government sharing risks?

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Contingent liabilities (cont’d)

Failures in the financial system of a country can lead to both explicit and implicit contingent liabilities. The same is true for collapses of major non-bank corporations (e.g. automobile manufacturing sector in the United States and Canada). Guarantees to support the financial sector totalled 28% of 2008 GDP (2009 average advanced economies)Guarantees totalled only 0.1 % for emerging economies

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Contingent liabilities: role for debt managers

Monitoring of contingent liabilities by debt managers How are debt managers integrating risks associated to contingent liabilities in conventional debt management (including probability of default when conducting national debt management strategy analysis as well as strategies for financing contingent liabilities which are likely to become actual liabilities in the short-to – medium term)Accounting principles for off-balance sheet commitments

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Contingent liabilities: role for debt managers (cont’d)

SAI could examine the role played by debt managers in managing explicit and implicit contingent liabilities. Attention should be given to contingent liabilities and impact on balance sheet.SAIs could audit the need for government to compile and publish accurate and timely date on all government guarantees and other contingent liabilities – as well as disclose and report of loan guarantees as part of the budget process.

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3.5 Performance Measurement Metrics should be used by debt managers to support debt strategy decisions and to assess their performance relative to debt management objectives Debt Costs: low-cost funding Budgetary risk: minimize volatility in budgetary

outcomes and provide stability to the fiscal planning process

Debt Rollover: refinancing needs and ability to meet these needs in the event that markets cease to function

Market Impact: maintaining a well-functioning government securities market to keep debt costs low and to foster efficient capital markets

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Metrics and Performance Measurement

Debt Costs Budgetary Risk Debt Rollover Market Impact

Average term premium

Average term to maturity

Duration

Fixed/Floating ratio

Average term to maturity

Duration

Fixed/Floating ratio

Floating share as % of GDP

Maturity profile

Maturing share of debt

Maturing amount as a percentage of GDP

Refinancing coverage

Size of treasury bill stock

Size of bond benchmarks

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Few countries use metrics and even less are reported (*)

Country MetricsAustralia Duration *

Fixed-Rate Share of Debt *Belgium Fixed-Rate Share of Debt *

Maturing Share of Debt *ATMDuration

Canada Fixed-Rate Share of DebtATMDuration

Denmark ATM *Fixed-Rate Share of DebtRe-fixing share of GDPDebt Composition

Finland Average Term-to-Re-Fixing *DurationFixed-Rate Share of Debt

France ATM *

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Few countries use metrics and even less are reported (cont’d)

Country Metrics

Germany Average Term-to-Re-Fixing *Nominal Debt Charges *Duration

Italy ATMDurationAverage Term-to-Re-Fixing

Japan Average Term-at-IssuanceMaturity

Netherlands Re-fixing Share of GDP *ATM

Sweden Debt Composition *Duration *ATM

UK DurationATMMaturing Share of Debt

USA ATMDurationMaturing Share of Debt

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Few countries use metrics and even less are reported (cont’d)

Large issuers such as the US, Japan, and the UK do not communicate any debt structure targets to the public. Smaller issuers do tend to communicate targets

SAIs could audit if and how debt management metrics are used by debt managers for monitoring and reporting performance.

SAIs could also examine how targets and results could be communicated to Parliament, Legislature, Congress and the public

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3.6 Sustainability of public debt

SAIs should understand the arithmetic of the public debt:

(1)

where D represents a country’s gross public debt stock

r captures the real interest rate paid on public debt outstanding

PB represents the government’s primary balance, i.e. the government’s fiscal balance before net debt interest payments

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Debt arithmetic (cont’d)

The above identity can also be expressed in percent of GDP, which puts the public debt stock in relation to the size of the economy (government’s underlying potential tax base):

(2)

After rearranging we obtain:

(3)

where d denotes the public debt stock pb the primary budget balance (both in percent of GDP) g represents the annual real GDP growth rate (% p.a.)

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Debt arithmetic (cont’d)

Stabilizing the current debt-to-GDP ratio (4)

Where pb, represents the required primary balance to stabilize the debt-to-GDP ratio

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Debt arithmetic: debt sustainability (cont’d)

Lowering debt-to-GDP ratio to target levelsIn order to lower the current debt-to-GDP ratio to a target level d* over the next T years, the required permanent primary balance pb** is given by:

(5)

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Sustainability of public debt (Deutsche Bank Research, March2010)

Required Primary Balance

To lower 2010 debt stock to 2007 level

Pre-crisis debt, % of GDP

Current debt, % of GDP

Baseline Scenario, % of GDP

To stabilize 2010 debt stock, % of GDP

Achievement of debt reduction (% of GDP in:

2007 2010 2020 5 Years 10 YearsArgentina 56 49 25 -0.7 -2.0 -1.4Brazil 73 62 49 1.8 0.0 0.8Canada 65 86 89 0.4 4.3 2.4Chile 15 23 0 -1.0 0.8 0.0France 70 92 114 0.4 5.1 2.6Germany 65 82 97 1.2 4.8 2.7Greece 104 123 171 2.4 6.8 4.0Ireland 28 81 118 1.3 11.7 6.0Italy 112 127 131 1.9 5.2 3.1Japan 167 197 246 -0.5 5.3 2.4Korea 26 37 20 -0.8 1.5 0.4

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Required Primary Balance

To lower 2010 debt stock to 2007 level

Pre-crisis debt, % of GDP

Current debt, % of GDP

Baseline Scenario, % of GDP

To stabilize 2010 debt stock, % of GDP

Achievement of debt reduction (% of GDP in:

2007 2010 2020 5 Years 10 YearsMexico 21 24 13 -0.1 0.5 0.2Portugal 71 91 132 1.8 5.7 3.5Russia 7 10 0 -0.5 0.0 -0.2Spain 42 68 93 1.0 6.2 3.3Sweden 48 55 39 -0.7 0.9 0.0United Kingdom

47 83 124 0.6 7.7 4.0

United States

62 92 133 0.5 6.4 3.5

Sustainability of public debt (Deutsche Bank Research, March2010)

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Sustainability of public debt

SAIs could report on the impact of rising public debt considering the pressure on sovereign financing capacity as well as inter-generational impact.

SAIs should examine measures taken to restore fiscal credibility. Difficulty of achieving required primary balance to stabilize or reduce debt /GDP

SAIs should examine whether debt targets have been established and review the measures taken to reach a sustainable debt level

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Sustainability of public debt (cont’d)

SAIs need to ensure governments comply with the WB/IMF guidance on Medium-Term Debt Management Strategy (MTDS- 2009))

SAIs need to ensure governments consider long-term fiscal sustainability issues and its impact on public debt – this is aligned with IPSASB proposal on the need for government to report on long-term fiscal sustainability.

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4.0 Conclusions and Potential Roles of SAIs

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4.0 Potential Roles for SAIs

Recent financial crisis has highlighted the benefits of developing and implementing a sound debt management strategy to meet the related financing and fiscal challenges

Close relationship between debt management and economic recovery Borrowing needs will remain high. Crowding-out effect: sovereign issuers are facing

increased competition on markets and need to accept higher/expensive risk premia.

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Potential Roles for SAIs (cont’d)

SAIs could audit for: Soundness of debt strategy and funding

mix is key to ensure sustainable public debt Effective Risk management Need to establish performance

management and metrics Reporting and management of contingent

liabilities Sustainable public debt level to reduce

vulnerability

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Potential Roles for SAIs (cont’d)

In addition to debt management practices, SAIs may want to address the need for initiatives to reduce fiscal vulnerability and restore credibility : fiscal rules, expenditure management, broaden/protect tax base, fiscal transparency, institutional reforms…

Challenge: SAIs need competency and capacity; clear mandate

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Exposure draft should be completed in time for the next meeting in 2012.Overlap with other WGPD projects?Support of SAIs?

QUESTIONS ?

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Hans Blommestein, How to Integrate Contingent Liabilities in Public Debt Management Strategies, OECD, 2008.

Hans Blommestein, Responding to the Crisis, Changes in OECD Primary Market Procedures and

Portfolio Risk Management, OECD, 2009. Hans Blommestein (et al), OECD Sovereign Borrowing Outlook, No. 3,OECD, 2010. Hans Blommestein (et al), Debt markets: Policy Challenges in the Post-Crisis Landscape, OECD, 2010. Udaibir S. Das (et al), Public Objectives and the Influence of Marco-economic Policies and the Quest

for Financial Stability, 20th ECD Global Forum on Public Debt management, OECD, 2011. Development Finance International, Fiscal Sustainability of Debt, Joint Ministerial Forum on Debt

Sustainability, Commonwealth Secretariat, 2009. Deutsche Bank Research, Public Debt in 2020, 2010. Lex Hoogduin (et al), Public Debt managers’ Behaviour: Interactions with Macro Policies, De

Nederlandsche Bank, 2010 Marc Robinson, Accrual Budgeting and Fiscal Policy OECD, 2009. Allen Schick, Post Crisis Fiscal Rules : Stabilizing Public Finance while responding to Economic

Aftershocks, OECD, 2010. World Bank/ IMF, Developing a MTDM Strategy – Guidance for Country Authorities, 2009.

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