Public Debt Management in a Time of Continuing Fiscal Deficits and Financial Market Integration

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Public Debt Management in a Time of Continuing
Fiscal Deficits and Financial Market Integration

• Bill Witherell
• Director, Financial and Enterprise Affairs, OECD
• EUROPA - AMERICA DUE MODELLI PER LA CRESCITA
• Milan, Italy 21 February, 2005

GIC
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Some introductory remarks on public deficits

• Reducing public spending and government debt is
  politically difficult because the process
  inevitably leaves some groups worse off.
• To overcome these difficulties, several countries
  have adopted formal fiscal rules, such as
  balanced-budget rules or multiyear frameworks
  that limit discretionary fiscal policy.
• However, currently, there are calls for changes
  to the 1997 Stability and Growth Pact (initially
  intended to underpin sound public finances prior
  to the introduction of the euro in 1999) to allow
  greater flexibility.
• In the past there have been a few notable
  episodes of large swings in fiscal stances.

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Outlook for public deficits in the Euro area
Source The OECD Economic Outlook, No. 76,
November, 2004
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Public deficits, debts and long-term interest
rates

• Economic theory does not provide clear answers to
  the question as to whether public debt and
  deficits affect the level of long-term interest
  rates.
• Theory provides different answers depending on
  issues such as whether deficits reflect changes
  in public expenditures or shifts in the timing of
  taxes, and on the planning horizon of households
  who hold public debt and pay taxes.
• Thus, the issue becomes essentially an empirical
  one.

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Some recent empirical work

• Estimating the effects of public debt and
  deficits on long-term interest rates is
  complicated by the need to isolate the effects of
  fiscal policy from other influences, especially
  those from business cycle developments and
  associated changes in the monetary policy stance.
• In a recent study attempting to control for these
  other influences, Thomas Laubach, an OECD Senior
  Economist, estimates that the effect of
  government deficits on interest rates are
  statistically and economically significant a one
  percentage point increase in the (projected)
  deficit-to-GDP ratio in the United States is
  estimated to raise long-term interest rates by
  roughly 25 basis points.
• Laubach, New Evidence on the Interest Rate
  Effect of Budget Deficits and Debt, Board of
  Governors of the Federal Reserve System Working
  Paper May 2003

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Long term rates appear to be unusually low, and
spreads are very compressed, with little
discrimination between various classes of debt.
Are we close to a turning point?
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10-year government benchmark bond yields
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Actual and Predicted Long Term Interest Rates
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Investment-grade corporate bond spreads
Note Daily data until 7 February 2005. Aggregate
corporate BAA bond yields (Lehman indices) minus
government benchmark bond yields. In order to
match the respective average maturities of the
BAA indices, 10-year benchmark bonds are used for
the United States and 5-year benchmark bonds for
Europe. Source Thomson Financial Datastream
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High-yield bond spreads
Note Daily data until 7 February 2005. Aggregate
corporate high-yield bond yields minus aggregate
corporate BAA bond yields (Lehman
indices). Source Thomson Financial Datastream.
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Why the unusually low levels of long-term yields
and low investor discrimination between credit
risks?

• Continued more-than-ample liquidity.
• Confidence that central banks will keep inflation
  in check.
• Balance sheet restructuring and improved risk
  management leading to improved credit quality.
• A structural shortage - an excess demand (e.g.
  from pension funds and insurance companies) over
  supply of long term paper.
• A pervasive search for yield in a low interest
  rate, low volatility environment (together with
  leveraged position-taking).

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A significant decline in Uniqueness, which
reflects the pricing of differences in risk
The portion of total variation in each spread
not explained by the common factor identified
as driving these spreads. See Torsten Sløk and
Mike Kennedy, "Factors driving risk premia", OECD
Economics Department Working Papers No. 385, 2004
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Emergence of a truly pan-euro area government
bond market?

• The emergence of a truly pan-euro-area
  government-bond market would provide benefits
  similar to those that the US government
  securities market provides for US financial
  markets a large and liquid market along the
  entire yield curve.
• The introduction of the euro has taken the
  European financial markets closer towards full
  integration by eliminating currency risk between
  those EU countries that have adopted the
  currency.
• Also, euro area government debt issuing policies
  have converged, as part of a world-wide trend
  towards standardization of government debt
  policies, driven by the international integration
  of financial markets and the resulting increase
  in competitive conditions to achieve the cheapest
  funding.
• See Convergence in the Euro Area Government
  Debt Markets,
• Blommestein and Schich, OECD Financial Market
  Trends, March 2003

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Size of the Euro area government bond market

• The most important immediate effect of the
  introduction of the euro has been on the size of
  the euro area government bond market.
• The market can be considered large on the basis
  of two benchmarks
• First, despite the recent dynamic
  growth of issuance in the non-sovereign segments,
  government bond issuance and not corporate bond
  issuance remains the dominant source of supply in
  the euro-denominated bond market.

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Euro-denominated bond markets volumes issued by
type of issuerIn millions of euros
Note Issues of a maturity of 1 year or more.
Government comprises bonds of agencies, central
governments, municipals, regions, cities, and
supra-nationals. Financial comprises
asset-backed securities, financials bonds, and
Pfandbriefe. The latter includes Pfandbrief-style
paper issued in EU-countries, like for instance
French Obligations foncières, Spanish Cedulas
hipotecarias, etc. Source European Commission
(DG ECFIN).
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Second, It is large by international comparison.
Looking at most recent data, the combined
outstanding volume of the three major euro area
sovereign bond issuers in the euro area stands
broadly on par with US Treasury marketable
government debt.
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Selected markets for highly-rated debt securities
(in billion USD )
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Challenges for debt management

• However, even though the re-denomination into a
  common currency of all individual euro area
  government debt has meant that an important
  distinguishing feature of government securities
  their currency denomination has ceased to
  exist, the euro debt market seems to have
  characteristics that make it different from debt
  markets in the United States or Japan.
• Specifically, market participants still
  differentiate between issues of different
  governments in terms of credit risk and other
  factors.
• Moreover, euro area government debt policies
  remain decentralized, while competition between
  market practices has also been mentioned as an
  obstacle in the creation of a truly euro
  area-wide government debt market.
• As a result, a truly pan-European benchmark yield
  curve has not yet emerged.
• While some argue that the benchmark role is split
  among different issuers and varies with the
  maturity segment, others argue that effectively
  the swap curve has become the benchmark yield
  curve.

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Benchmark yield differentials in the euro
area 10-year benchmark bond yield differentials
to Germany, in basis points
Source Thomson Financial Datastream.
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Convergence in public debt management

• Driven in part by attempts to achieve the
  cheapest funding under increasingly competitive
  conditions and as part of an OECD-wide trend
  towards standardization of government debt
  policies, EU debt management policies and
  procedures have converged.
• This has been reflected in convergence of the
  composition of debt by type of instrument and
  maturity, issuing procedures, the harmonization
  of market conventions, the greater use of
  electronic markets, more sophisticated risk
  management procedures, more transparent policies,
  and greater operational autonomy of debt
  management offices (DMOs).

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Increased use of buy-back operations

• Euro area countries have used buy-back operations
  to concentrate debt in fewer, larger series and
  have stopped issuing instruments covering the
  entire maturity spectrum and, instead, focus on a
  limited number of benchmark maturities.
• The principal reason for buy back operations
  among EU countries is to build-up cheaper, large
  liquid benchmark series. In particular, in the
  smaller euro-zone countries it was difficult to
  maintain liquid series across the entire maturity
  spectrum.
• Other motives are to improve management of
  interest-rate and refinancing risk -- buy-back
  operations can be used to smooth the redemption
  profile within the year or between years, thereby
  reducing the refinancing risk and to achieve
  direct fiscal savings by buying back illiquid
  bonds that are undervalued in the market.

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Enhancing liquidity

• In the attempts to enhance liquidity of their
  issues, debt issuing procedures have converged
  substantially both in the euro area and the
  European Union.
• The principal issuing procedures are auction and
  tap. After the introduction of the euro, a number
  of countries have added syndication.
• Auctions are the issue method most commonly used
  among the EU member states.
• The publication of auction calendars has
  increased transparency.
• The smaller countries, in particular, combine
  auctions with the syndication of benchmark bonds,
  in order to provide a quick build-up of
  outstanding volume and greater certainty of
  issue.
• In all EU member states high priority is given to
  the 10-year segment, with outstanding volumes of
  between EUR 5 and 24 billion, depending on the
  borrowing requirement of the issuer.

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Overview of Issuing Procedures
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Increased operational autonomy of debt management
offices

• Convergence of debt management policies is also
  reflected in the increased operational autonomy
  of debt management offices (DMOs).
• In spite of the diversity in terms of location
  and other institutional features , there is
  general agreement that DMOs should have
  sufficient autonomy from the political sphere,
  and that they should be principally concerned
  with the operational aspects of the management of
  sovereign debt.
• It is especially during the last few years that
  we are witnessing the establishment of an
  increasing number of autonomous DMOs in EU
  countries.
• In addition to Sweden ( whose debt office dates
  back to the 18th century ) and Finland (from the
  19th century), there are now such DMOs in
  Austria, Belgium, France, Germany, Greece,
  Iceland, Ireland, the Netherlands, Portugal, and
  the United Kingdom.

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Concluding remarks

• Euro area debt-issuing policies have converged
  significantly.
• The creation of a truly pan-European
  government-bond market would provide benefits
  similar to those of the US government securities
  market a large and liquid market along the
  entire yield curve.
• However, there are different issuers in the euro
  area and investors distinguish between those
  different issuers of government debt in the euro
  area, even though most issuers are rated
  triple-A.
• As a result, a truly pan-European government
  benchmark yield curve does not exist currently.
• More available at www.oecd.org.