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Debt Management and Financial Stability: Potential Roles for SAIs. Reviewed Proposal by SAI – Canada June 2011. Outline. Introduction: Financial turmoil Fiscal expansion and impact on public debt Fiscal expansion, ↑ S pending measures ↑ Financial requirements, ↑ Borrowing Trend in D/GDP

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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

  • Introduction: Financial turmoil
  • Fiscal expansion and impact on public debt
      • Fiscal expansion, ↑ Spending measures
      • ↑ Financial requirements, ↑ Borrowing
      • Trend in D/GDP
      • Changes in debt environment
  • Debt Management, financial stability and potential roles for SAIs
    • Relationship between debt management and financial stability
    • New role for debt managers
    • Risk management and funding mix
    • Management of contingent liabilities
    • Debt target and performance measurement
    • Fiscal sustainability of public debt
  • Conclusion
1 0 introduction context to the financial turmoil
1.0 Introduction: Context to the Financial Turmoil
  • Pre 2007: Global economy had a long period of steady growth
  • Low inflation / low interest rate
  • However large imbalances in the world economy
  • Concern 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)
2007 financial crisis and economic downturn
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
us subprime mortgage market collapsed
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 government
  • Inadequate 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
financial markets under pressure
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
potential for insolvency in fi as crisis evolved
Potential for insolvency in FI as crisis evolved
  • Holding subprime mortgages
  • Holding ABS and CDOs as investments
  • Holding of commercial mortgages, loans, credit cards… where borrowers fell into arrears as economy weakened
  • Exposure to CDSè
  • Severe 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
2 0 fiscal expansion context
2.0 Fiscal Expansion: context
  • Liquidity measures, address solvency problems (e.g. Lehman Brothers) and regulatory issues
  • Macro situation declining; accommodating monetary policy
  • With weakening economy: governments turn attention to fiscal policy
  • Fiscal 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)

fiscal deficit
Fiscal deficit
  • Budget 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)
public finance sustainable
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)
borrowing increased after financial crisis
Borrowing increased after financial crisis
  • Financial requirements increased rapidly as government spends more.
    • Gross borrowing requirement in 2009 (OECD) : $16 trillion
  • Government 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)
changes in debt environment
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
3 1 relationship between debt management and financial stability
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)
3 2 sound debt management practices matter
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
sound debt management practices matter cont d
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
new environment for debt managers
New environment for debt managers
  • Implication of debt management strategy are broader than expected
  • Debt management influences the soundness and solvency of balance sheet.
  • Debt management a factor that underpins the credibility and reputation of sovereign
  • Debt management conditions debt capital markets and impacts on FI that hold public debt
  • Financial crises can have significant impact on debt mangers when market conditions and fiscal conditions degrade
new environment for debt managers cont d
New environment for debt managers (cont’d)
  • Combined this can lead to unsustainable public debt situation in the short term
  • SAIs must remember that public debt will impact on financial stability.
  • New challenges for SAIs when auditing the management of public debt
new environment for debt managers cont d1
New environment for debt managers (cont’d)
  • 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
new environment for debt managers cont d2
New environment for debt managers (cont’d)
  • 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)
3 3 risk management
3.3 Risk Management
  • Post financial turmoil: increased emphasis on risk assessment and risk management
  • Risk 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
risk management practices and impact on funding mix
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.
risk management practices and impact on funding mix cont d
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)
risk management practices and impact on funding mix cont d1
Risk Management practices and impact on funding mix (cont’d)
  • 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)
risk management practices and impact on funding mix cont d2
Risk Management practices and impact on funding mix (cont’d)
  • 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
need to audit risk management governance procedures
Need to audit risk management governance /procedures
  • Audit Function plays a crucial role in reviewing
  • Broader policy reform need to integrate: debt and risk management (incl. strategic benchmark)
  • SAI should assess the quality of risk control systems
need to audit risk management governance procedures cont d
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
3 4 contingent liabilities potential financial claims on the government
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
contingent liabilities
Contingent liabilities
  • HanaPolackova-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.
categorisation of fiscal risk
Categorisation of fiscal risk

Source: HanaPolackova-Brixi (1999, World Bank)

contingent liabilities effective management required
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?
contingent liabilities cont d
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
contingent liabilities role for debt managers
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
contingent liabilities role for debt managers cont d
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.
3 5 performance measurement
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
few countries use metrics and even less are reported cont d1
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
3 6 sustainability of public debt
3.6 Sustainability of public debt
  • SAIs should understand the arithmetic of the public debt:


    • 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
debt arithmetic cont d
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
  • pbthe primary budget balance (both in percent of GDP)
  • g represents the annual real GDP growth rate (% p.a.)
debt arithmetic cont d1
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
debt arithmetic debt sustainability cont d
Debt arithmetic: debt sustainability (cont’d)

Lowering debt-to-GDP ratio to target levels

  • In 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)
sustainability of public debt
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
sustainability of public debt cont d
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.
4 0 potential roles for sais
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.
potential roles for sais cont d
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
potential roles for sais cont d1
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

Exposure draft should be completed in time for the next meeting in 2012.

  • Overlap with other WGPD projects?
  • Support of SAIs?



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.

LexHoogduin (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.