Download Lecture 1.Principles of Public Debt

Lecture outline
 What means debt sustainability?
 Ponzi scheme and the government debt
 Maastricht criteria
 Internal and external government debt
 Ways to minimize government debt servicing costs
What means debt sustainability?
 How big should the government debt be in order to destabilize
economy?
 If the debt is used to cover the budget deficit, Debt/GDP ratio
will be increasing and may even turn into large debt burden.
The government may not be able to serve the debt and
eventually announce default.
 The increasing volume of the public debt in the US has lead
scientists to think of sustainability issues.
 The term sustainability with respect to public debt is used to
mean the ability of debtor to remain solvent and avoid defaults
What means debt sustainability?
 Budget constraint serves as starting point ensuring debt
sustainability. Budget constraint can be one period, long
term and multiple period.
 Debt sustainability can analyzed with the help of simple
model: assume that economy has only one sector, GDP per
capita and capital, interest rate and growth are constant;
interest is greater than growth and there is no inflation;
 When interest rate is greater than growth, the government
cannot create financial pyramids such as “Ponzi scheme”
Ponzi scheme and government debt
 In 1919 Charles Ponzi opened business which offered depositors the
return of 100% in 90 days. Around 40 thousand people deposited in
the company of Ponzi which amounted to 150 million dollars (at
present prices).
 Depositors received the promised return on time, but these funds
were simply deposits attracted from new clients. New depositors
paid returns of the old depositors. This was financial pyramid later
named as Ponzi scheme
 In August of 1920 this pyramid collapsed because there were
rumors that no funds left to pay back deposits. This rumor caused
panic among depositors and the old and new depositors claimed their
deposits back.
Ponzi scheme and government debt
 Is government debt similar to Ponzi scheme?
 The answer is no because:
 Unlike Ponzi, the government can print money or raise taxes to
pay back its debt
 If the government behaved like Ponzi, there will be at least one
bond holder who will be refused to get his interest payments at
some point in the future. This would eliminate further functioning
of the government bond market. Therefore, it is not possible to
refinance infinitely.
Impossibility of infinite refinancing
 Refinancing becomes impossible after real interest rate in
the country will exceed growth.
 This is because real interest rate serves as payment to
bondholders in Ponzi scheme while growth as inflow of
new customers
 Since at some point of time, interest rate exceeds growth,
refinancing like in Ponzi scheme becomes impossible.
Maastricht criteria
 1997 EU members made agreements on sustainable growth. These
agreements originated from proceeding of 1993 meeting in
Maastricht.
 The EU members agreed upon setting up constant fiscal monitoring
and sanctions against countries which break fiscal discipline.
 Countries which adopted Euro should maintain budget deficit to
GDP ratio below 3 percent and debt to GDP ratio at around 60
percent.
 These and other limits (e.g. inflation rate, foreign currency exchange
regime) are known as Maastricht criteria or convergence criteria
Maastricht criteria
 Maastricht criteria may limit the ability of the government
to make short run adjustments to economy because the
main priority is long term economic sustainability
 Proponents of Maastricht criteria claim these short run
adjustments are not associated with significant economic
costs and there can be sacrificed.
Internal and external government debt
 Why do developing countries have their government debt
primarily from external sources?
 This is because these countries have very weak internal
government bonds markets and therefore the governments
in these countries have to rely on external markets
 It is possible to have a choice between internal and
external bond markets if there is an alternative- well
functioning internal market for government bonds
If choice between internal and external markets
exist
 When choosing between internal and external markets it is
necessary to consider the following points:
 Impact of debt on economy
 Debt expenditures
 Hidden risk in debt
 External debt market is associated with exchange rate
risks
Gross debt or net debt?
 Gross debt is simply debt accumulated by the
governments
 Net debt is gross debt netted from government assets
which are liquid enough to pay back its debt
 So should the government focus on the gross debt or net
debt?
Public debt management strategies
 What purpose should the government pursue given that taxes have
distortionary effect?
 Classical answer of Barro- to stabilize tax rates over time through
debt.
 However, this is too academic view on debt. Public finance officials
claim that the need for government debt comes from the fact that the
government should not be left without money even for a single day.
 Attracting debt is necessary when even if the government plans to
have budget surplus and there are no payment arrears between
budgets of different levels. This is mainly because there is constant
need to refinance debt
Public debt management strategies
 However, constant debt inflow to the government budget
generates constant outflow of funds in the form of cost of
servicing debt
 For this reason, the main target in the public debt
management- to minimize cost of servicing debt at the
given level of risk
 In OECD countries too, 72 percent members of this
organization define their public debt management targets
in the way to link cost of servicing to risks.
Some examples of debt strategies
 Marvin Anthony in his “The Design and Use of Strategic
Benchmarks – some findings in OECD markets,” ( 14th OECD
Global Forum on Public Debt Management and Emerging
Government Securities Markets, December 7-8, 2004,
Budapest) gives an overview of debt strategies of certain
countries
 Australia – main strategy is to attract debt with minimum long
term expenditures and acceptable risk hedging
 Ireland – to refinance debt due and provide funds to the
government keeping short and long term liquidity, avoiding
fiscal expenditures volatility and minimizing risks
Some examples of debt strategies
 New Zealand – maximize income on financial assets and
debt of the government given the risk averse strategy
 Sweden- minimize cost of servicing debt in the long run.
Debt management should comply with targets of monetary
policy and cabinet of ministers
 Great Britain – to sustain the annual trade volume of
government obligations set by Treasury with the focus on
the minimizing long term expenditures and risk
Types of debt expenditures
 Interest payments- for government bond worth 1000 dollars with 10
percent annual interest rate and semiannual payments, interest
payments amount to 50 dollars
 Discount (or negative) premiums – discount implies that at the
moment of selling the security the government gives discount. For
example, in the face value is 1000 dollars, the government sells this
security for 950 dollars giving 50 dollar discount. This means the
government loses 50 dollars since it has to pay 1000 dollar to
investor at the time of maturity.
 Positive premium- government pays extra to the face value of the
security when it purchases back its debt before it matures. For
example, 1000 dollar worth bond purchased back at 1050 dollars.
Interest rate or discount?
 Treasury Bills are normally sold with discount.
 Government bonds are subject to both interest payments
and discounts. For example, let us assume that the
government sells USD 1000 worth bond with 10 annual
interest payments. However, if the interest rate on the
market is 5 percent and perfectly competitive, the market
players will buy this bond infinitely until its market price
will equal to USD 2000. Mathematically,
USD100/0.05=USD 2000. So the government can receive
USD 1000 premium by selling this bonds to public.
Summing up debt service expenditures
 The government bears the following expenditures on debt
service:
 Payments to primary dealers
 Cost of printing and other technical activities related to
issuing debt
 Discounts
 Premiums
 Interest payments
 Annual principal payments
Cost minimization policies
 Good policies for cost minimization
 Yield curve manipulations
 Indexing
 Information asymmetry
 Segmenting
 Micro-structured finances
 Bad policies for cost minimization
 Printing money
 Increasing taxes
 Defaulting on debt
Yield curve manipulations
Yield, %
Time (years)
Yield curve manipulations
 Long term bonds bear greater risk than short term
securities and therefore offer higher return
 However, when the situation is stable over long run yield
on the long term bonds is the average of both current and
future interest rates. This implies that longevity of
holdings does not cost of debt service. For example,
interest on 10 years bonds will be the same as for 5 years
bonds after its refinancing for the next 5 years.
Indexing debt
 Indexing debt by certain macroeconomic volatility- GDP
growth, government expenditures, exchange rate or
inflation rate
 Indexing in order to secure against inflationary risk can
decrease or increase expenditures. This depends on how
rate of inflation will behave in the long run. Since indexed
bonds offer nominal return + compensation for inflation,
nominal return is lower than in the non-indexed bonds. It
follows that at times of low inflation the government
decreases its cost of debt servicing.
Information asymmetry
 The government can use its access to more accurate information than
that is available to private sector in order to decrease debt servicing
expenditures.
 One instance when the government is better informed that the private
sector is the forecast of future interest rates. If, for example, the
governments knows that future interest rates will be lower while the
market expects high interest rate, it may issue more short term bonds
that long term securities. Alternatively, the government may be
aware of some insider facts before market will get to know them and
take convenient position when issuing securities.
 However, playing on the market equipped with insider information
might be dangerous for the government since it faces the risks of
lowering investor confidence.
Segmenting
 Some market player may prefer to fill in certain segments
of the market and pay for this by accepting lower interest
payments on governments bonds
 These bonds are issued as specially tailored for the
investors in the segment. However, specially tailored
bonds have lower liquidity.
 On the other hand, continuously decreasing liquidity may
cause the government to pay compensation in the long
run.
Micro-structured finances
 Another way to decrease debt servicing cost – through micro-
structured finances
 Market players do not want to buy big bulks of government
debt because it is associated with increased risk. To overcome
this, the government uses primary dealers who buy and keep
big amount of government bonds on their accounts.
 Two targets of micro-structured finances:
 Increasing the profitability of entire market
 Increasing the share of government in this profitability
Thank you for your attention!