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


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

Public Debt Management in a Time of Continuing
Fiscal Deficits and Financial Market Integration
  • Bill Witherell
  • Director, Financial and Enterprise Affairs, OECD
  • Milan, Italy 21 February, 2005

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
Public deficits, debts and long-term interest
  • Economic theory does not provide clear answers to
    the question as to whether public debt and
    deficits affect the level of long-term interest
  • 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

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

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?
10-year government benchmark bond yields
Actual and Predicted Long Term Interest Rates
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
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.
Why the unusually low levels of long-term yields
and low investor discrimination between credit
  • 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).

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
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
  • 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
  • See Convergence in the Euro Area Government
    Debt Markets,
  • Blommestein and Schich, OECD Financial Market
    Trends, March 2003

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.

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
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.
Selected markets for highly-rated debt securities
(in billion USD )
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
  • 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

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

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
  • 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.

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
  • 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.

Overview of Issuing Procedures
Increased operational autonomy of debt management
  • 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
  • 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.

Concluding remarks
  • Euro area debt-issuing policies have converged
  • 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
  • As a result, a truly pan-European government
    benchmark yield curve does not exist currently.
  • More available at