2. Lecture outline Risk factors in public debt management Diversification Liquidity and transparency Structure of public debt management unit

3. What are risk factors? Types of risks involved in public debt management:  Market risk  Refinancing risk  Liquidity risk  Credit risk  Transaction risk  Operational risk

4. Market risk Market risk arises when there is a chance of unpredictable volatility of market prices: price of credit or interest rate and exchange rate. For this reason short term debt with floating interest is supposed to be riskier than long term debt with fixed interest. Similarly, debt in foreign currency bears risk of losses due to exchange rate variations. Government bonds sold with right to sell back to the government (so called put options) leads to increasing market risk.

5. Refinancing risk Refinancing risk is associated with the need to refinance under very high interest rates or refusal by creditors to prolong debt. Refinancing risk may be attributed to market risk, but it has one distinctive feature: refusal to prolong debt may lead to defaulting on debt and subsequently to economic crisis.

6. Liquidity risk Liquidity means that the government should have enough assets to meet its current liabilities. It may also arise when the government imposes penalties on investors who want to quit market because market does not have enough players. This implies exiting market is costly and may serve a signal to potential investors.

7. Credit risk Credit risk- there is risk that the government or its counteragents cannot meet their obligation on time. This risk increases when the government uses interest and currency swaps while government assets are used as collateral

8. Transaction and operational risks Transaction risk – possibility of losses due to inability of the counteragent to transfer funds to government accounts Operational risk – failure of systems and operator mistakes, reputational risks, breaking professional ethics or natural disasters affecting business activities

9. Transaction and operational risks Transaction risk – possibility of losses due to inability of the counteragent to transfer funds to government accounts Operational risk – failure of systems and operator mistakes, reputational risks, breaking professional ethics or natural disasters affecting business activities

10. Diversification Investors are aware that if one puts all eggs into one basket, the risk to loose all investments and to get maximum profit is equal to one. In the modern theories in portfolio this risk is known as unique risk of the company and varies across companies. Even slight diversification of portfolio decreases this risk significantly. In the case of the public debt, unique risk would be issuing only short term or long term debts. Short term debt and long term debt bear different types of interest rate risks.

11. Diversification Short term government securities offer lower interest payments and long term securities offer higher. However, short term securities have higher interest rate volatility, which may cause liquidity risk For this reason, the government diversifies its portfolio with both short and long term securities. Normally, that share of short term securities is much larger than that of the long term ones.

12. What is acceptable level of risk? Graeme W. in his “Sovereign Debt Management in New Zeland” (in Kari Nars, ed., Excellence in Debt Management: The Strategies of Leading International Borrowers. Euromoney Publications, 1997.) claims that the government should act like average voter who is normally risk averse person. Marcel C. and others ( “Risk Management of Sovereign Assets and Liabilities”, IMF Working Paper WP/97/166, December 1997.) propose to take the maximum level of risk as the level of interest volatility which the government can tolerate without deviating from budget targets. Some authors advocate to remove debt in foreign currency from portfolio because exchange rate volatility adds to overall volatility of government budget

13. Proceedings from literature Literature proceedings can be summed as follows:  First step- creation of liquid and effective market for Government bonds  Public debt management should be predictable and transparent. This will decrease risk of uncertainty around real price of the government securities  If the market is effective, then there is fair balance between risks and costs of debt servicing. Investors agree to buy securities with lowest risk even if they pay lowest interest  The government should keep debt in foreign currency to minimum

14. Liquidity and transparency Treasury has two main targets in debt management- cost and risk minimization Cost minimization requires well functioning security market, which, in turn requires, large number of investors and funds. Investors enter market only if the market has enough liquidity and they pay for liquidity by accepting low interest payments Liquidity- key to both large funds and cost minimization

15. Liquidity and transparency Shortest way to liquidity- regular issue of large amounts of short term Treasury bills. They bear minimum risk for investors. For example, Treasury of the US has been issuing Treasury bills since 1929 on a regular basis. It did not increase or decrease issue based on immediate changes in demand on market. This increased predictability and transparency of public debt management By publishing calendar of security issuance the government signals that it does not have some insider information regarding future interest rates and does not plan to take advantage over other market players. If there is need to change the calendar, then the government consults the necessary changes with other market players in order to keep transparency.

16. Liquidity and transparency Treasury faces interest rate risk on constant basis and diversifies portfolio accordingly Normally Treasury has to choose between two options- to pay more on debt or to risk more with stability of public finances. Cost of debt may be decreased by issuing more short term debt while volatility of expenditures can be decreased by issuing more long term debts. In the former, the share of debt refinanced in the current year under current interest rate will be greater, in the latter- lower.

17. Repurchase operation Government repurchases its debt when budget is in surplus Repurchase operation increases the liquidity of the market. It also decreases debt service costs There are three methods of repurchase-  Auction  Repurchasing outside stock exchange  Conversion

18. Structure of public debt management unit Institutional aspects of managing public debt:  Treasury – fiscal policy: help to the government in macroeconomic management; solving wide range of macroeconomic and regulatory issues,  Central bank- monetary policy: achieving price level stability  Public debt management: risk minimization in the portfolio of government bonds and debt servicing costs However, it is not possible to provide independence to Public debt management unit entirely. Treasury and Central bank both have valuable experience which can be utilized in the activity of public debt management unit.

19. Two structures of public debt management unit Pros for independence of Public Debt Management unit:  Treasury may use public debt management unit in manipulations serving fiscal policy  Public debt management unit should not be governed as if it were commercial company  Independent unit would be more transparent Cons for independence of Public Debt Management unit :  It is difficult to make deals with independent debt management unit  Treasury can impose additional necessary liabilities on the unit  Treasury professionals know all accounts of the government and therefore can help increase effectiveness of unit

20. Rational organizational structure Independent of where public debt management unit is located, there are some general views on its structure:  Public debt management unit resembles security company  It has front office, which is responsible for financial management, relations with investors, underwriters and banks, debt management strategy, portfolio management and cash management  It has also middle office, which is responsible for risk management and strategy design, as well as, linking them to macroeconomic elements. The middle office has greater importance when dealing with public debt in foreign currency

21. Rational organizational structure Middle office has the following functions:  Consistency analysis  Sustainability analysis  Cost and risk analysis  Monitoring and detailed analysis of new financial instruments  Cooperation with rating agencies  Coordination with Treasury, Central Bank and others

22. Rational organizational structure Back office responsibilities:  Transaction regarding public debt  Accounting  Debt books management The well functioning of back office requires modern technology systems Front, middle and back offices of public debt management unit should have clear targets and responsibility structure.

23. Thank you for your attention!