World Bank Debt Management

Questions and Answers

PRMED September 2013

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World Bank Debt Management Questions and Answers September 2013

Question Answer Source General Questions 1 i. How would

one characterize the debt portfolio for the average low-income country?

ii. What changes would have been witnessed since debt relief—on average?

iii. What bilateral

creditors have moved more aggressively into the African field of play? How should this be viewed?

The external debt portfolio for an average low income country- post HIPC/MDRI may be composed largely of concessional credits from multilateral (IDA, AfDB, ADB, etc.) sources, as well as funding obtained from bilateral donors to the country (e.g. Saudi Fund, European Union). The establishment of a domestic debt market would likely be at an early phase of development. It is likely that public pension funds and government state owned companies (SOEs) will be holding a large part of public domestic securities. http://go.worldbank.org/83PZB7FH80 Since debt relief in the early to mid-2000s, under the auspices of HIPC and MDRI, government external debt fell dramatically from ranges of 50-75 percent of GDP to 25-percent or less. Following this encouraging decline, however, central government debt has begun to re-accumulate as a proportion to the economy’s output, while debt service indicators have shown signs of deterioration, notably interest costs to export values. Over the years since 2000, large bilateral developing market creditors (e.g. China, India and others) have moved fairly aggressively into African debt markets, with loans on semi-concessional terms. Often loans are tied to natural resources, infrastructure and other public investment, in which the creditor will (in some cases) establish an inroad to the resource base being exposed in much of sub-Saharan Africa today. Views on semi-concessional borrowing are mixed, with the IFIs negotiating such borrowing for IDA-only countries on a case by case basis.

MTDS

2 i. What instruments are available for government cash management

Treasury Bills are the instrument of choice for cash management in a typical low-income country. The central government manages its cash in-excess of target through investment in the market or with the central bank at market rates—issuance or buyback of T-Bills on a more regular basis—or optimally transacts daily using issuance and buy-back of T-Bills or (less likely) entering into repurchase or reverse repurchase agreements.

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in a typical low-income country?

3 i. What is the role of the Central Bank in debt management, and the need to separate monetary policy implementation from debt management?

ii. What is the content of a Memorandum of Understanding (MoU) between the Ministry of Finance and the Central Bank outlining roles and responsibilities in debt management?

Information sharing between debt management (DeM) entities and the Central Bank on current and future debt transactions and the government’s cash flow is critical to the functioning of both debt management and monetary policy. The central government should avoid borrowing directly from the central bank, except under unusual circumstances (financial emergencies), and even then there should be a limit on the amount and period of repayment. Monetary financing of the budget has adverse consequences in terms of implementation of monetary policy, inflationary effects, and in a developing country also imposes constraints on development of the domestic debt market. Insofar as the central bank acts as a DeM agent for the government, the agency relationship should be spelled out in an MOU and should be published. The expected role of the central bank on behalf of the central government should be made clear. It is highly recommended that such agreement be formulated, approved and published, in order to clarify the objectives and policy interdependencies between monetary policy and debt management. Government debt managers’ operational relationships with central banks can be complex. The central bank often provides a wide range of agency services for debt managers. Many central banks provide registry and fiscal agency services for debt managers by maintaining a registry of owners of government securities and by acting as paying agent for the government in the domestic market. When the government (a) collects taxes or issue bonds/treasury bills; or (b) pays back the public debt or spends money following budget appropriations, the government is changing the level of money supply in the economy. Therefore, the relationship (including sharing of information) between the government and the central bank has to be well established.

Wheeler, Graeme, 2004, “Sound Practice in Government Debt Management”, (Washington, World Bank)

Governance and structure of DM Office 1 i. Is there a There is no standard or recommended size for a debt management office that would be DeMPA

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standard or recommended size for a debt management office?

universally applicable for different countries. Attention should be paid towards designing an effective operational structure of debt unit and the capacity of staff to maintain security and control over government borrowing and debt-related transactions, as well as the use of public funds. The organizational structure should support clear separation between the debt managers with the authority to negotiate and contract on behalf of the central government and those responsible for settlement of the transactions, including arranging of payments, bank account management, and recording in the government accounting system (referred to as “segregation of duties”). In addition, there should be a risk monitoring and compliance function within the principal DeM entity (or the DeM entities) to monitor whether all government DeM operations are within the authorities and limits set by government policies and whether they comply with statutory and contractual obligations. This function could be overseen by an individual staff member or, more ideally, a specialized unit with this role and the associated responsibilities. The organizational structure and management policies should support sound human resource management practices with a sufficient and adequately trained staff, formal job descriptions, individual training and development plans, and performance assessments.

2 i. In terms of staffing, what type of profile does a debt management office require?

Debt office staff must have degrees in Finance, economics and/or management. They should be proficient in the use of computers, and especially worksheet packages e.g., Excel. Front office staff must have trainings in loans negotiation skills, domestic debt, etc. While middle office must be trained in MTDS, cost-risk analysis, forecasting, etc. and any other model used to prepare a debt management strategy. The back office staff must be able to work on the debt recording system.

DeMPA

3 i. What should be the content of communication between the debt office and investors?

The content of such communication should cover forthcoming issuance of domestic securities; and plans, if any, regarding introduction of new series of T-bills, bonds etc. the full information on these should be transmitted with transparency. The DMU for its part should enquire of market participants concerning the confidence in which government financial policy is held and what impediments to investment are seen in the domestic market. Regular meetings between debt managers (usually together with central bank officials) and investors should be organized and used to clarify government public debt

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policies and instruments. 4 i. Reporting-

what reports should a debt office produce?

The Unit responsible for debt management policies and implementation should make sure that there is sufficient- and quality- information to discharge this responsibility effectively. Typically this is done through periodic reporting by the debt manager on progress on the implementation of the medium-term debt management strategy and the associated annual borrowing plan. This reporting should provide information on the evolution of the portfolio and the key cost and risk indicators, so that those accountable for decisions are able to adequately monitor developments vis-à-vis the expected evolution of these indicators. The government should report both central government and total nonfinancial public sector debt and loan guarantees outstanding to meet statutory- or contractual- reporting obligations or both. Externally, this will include reporting to international financial institutions, stock exchanges, and foreign regulatory authorities, where applicable. A debt statistical bulletin (or its equivalent) covering domestic and external central government debt and loan guarantees should be prepared. This bulletin could be in the form of regular central bank publications, statistical tables produced by the bureau of statistics, or tables published in the government financial accounts. The bulletin should be published at least annually (preferably semiannually or quarterly) and provide information on central government debt stocks (by creditor, residency classification, instrument, currency, interest rate basis, and residual maturity); debt flows (principal and interest payments); debt ratios and indicators; and basic risk measures of the debt portfolio.

DeMPA/ MTDS

5 i. What is a good debt recording system? What are minimum requirements for a good system?

A good debt recording system would readily provide the following: • An accurate break-out of outstanding debt by various characteristics, including

currency composition, creditor composition, concessionality and instrument composition (including by interest rate type).

• Aggregate debt servicing schedules across various categories of debt. • Some basic portfolio indicators, such as average maturity, proportion of foreign

currency debt, etc. • Payment schedules for interest and amortization of individual loans and securities,

along with the associated payment notices. This can be decentralized if management is spread across different contracting entities.

• The potential to handle domestic debt, on-lending, and to a degree, contingent liabilities.

Ideally, the debt recording system would also interface with other key systems including (i)

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ii. What is a registry for government securities, and why is it not a replacement for a debt recording system?

the payments system used to make debt servicing payments; (ii) the transaction management system (where relevant for example, if the debt management unit engages directly in financial market transactions); (iii) the auction system (if separate from the transaction management system), and (iv) the government’s financial management information and accounting system(s). In addition, it should be important to ensure the integrity of the system by imposing appropriate security controls. Sound practice requires comprehensive debt management systems that record, monitor, settle, and account effectively for all central government debt and debt-related transactions, including past debt relief and debt restructuring (Paris Club rescheduling). These systems should provide for an accurate, consistent, and complete database of the domestic, external, and guaranteed debt. Ideally, the debt recording or management system should interface with the government’s financial management information and accounting systems. Government securities issued in the domestic market require an accurate recording of the holders of each security. This requires having in place an efficient and secure central depository (registry) system. The registry system should provide accurate and timely information on all holders of government securities. A registry agreement between the issuer and registrar is a normal practice. Most registry systems allow nominee accounts (that is, accounts in the name of a local custodian bank holding the securities on behalf of its clients). For these nominee-registered securities, beneficial ownership can be determined only from the books of the custodian. For reporting and statistical purposes, someone (normally the central bank) must possess the power to require the domestic custodians to share information on the amounts held by foreign investors. In the following indicator, “holders of government securities” do not include the end investors in the case of nominee accounts.

6 i. What are the roles and functions of a “back office”?

ii. How should the office be organized?

There needs to be a clear separation between debt managers with the authority to negotiate and transact on the behalf of the central government (front office staff), and those responsible for settlement of the transactions, managing bank accounts and recording the transactions in the government accounting system (segregation of duties). The “Back Office” is usually charged with loan entry into secure databases, compilation of data which feed into reports generated by “middle-Office” staff, and other like duties. Back-office (treasury operations) responsibilities usually include confirming trades, issuing payment instructions for transactions, accounting for trades, arranging collateral transfers, administering loan documentation, and managing relationships with fiscal agents (which, for

Wheeler, Graeme, 2004, “Sound Practice in Government Debt Management”, (Washington, World Bank)

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domestic debt, may be the central bank) and with registrars and paying agents. Responsibility for managing the systems needs of the debt office, including systems planning, implementation of new systems, and maintenance and updating of existing applications is also usually assigned to this office. Compilation of debt statistics and reporting on operational risk or vulnerabilities—often, with the help of the middle office—is frequently a back-office responsibility.

7 i. What are the roles and functions of a “middle office”?

ii. How should the office be organized?

The middle office is often changed with analytic work grounded in the figures produced by back-office staff. Research work related to debt management, and production of a series of comprehensive reports on the country’s debt situation falls within the mandate of this office. The middle office--often called the “risk management team”-- is normally responsible for establishing a cost and risk management strategy or framework for the government’s debt portfolio, researching and analyzing policy alternatives, and monitoring compliance with the portfolio and risk management policies. In some countries these responsibilities cover broad obligations on the government’s balance sheet, including guarantees and other contingent liabilities and the monitoring of private sector foreign currency debt (which can represent a possible contingent liability). A key output from the middle office is the formulation of the debt management strategy.

Wheeler, Graeme, 2004, “Sound Practice in Government Debt Management”, (Washington, World Bank)

MTDS, Reform Plan, DeMPA, DSA 1 i. What is a

medium term debt management strategy (MTDS) and how should it be expressed?

An MTDS is a plan that the government intends to implement over the medium-term1 in order to achieve a desired composition of the government debt portfolio, which captures the government’s preferences with regard to the cost-risk tradeoff. It operationalizes country authorities’ debt management objectives—e.g., ensuring the government’s financing needs and payment obligations are met at the lowest possible cost, consistent with a prudent degree of risk. An MTDS has a strong focus on managing the risk exposure embedded in the debt portfolio—specifically, potential variations in the cost of debt servicing and its impact on the budget. In particular, an MTDS identifies how cost and risk vary with the composition of

MTDS

1 The medium-term is typically defined as 3–5 years. If the time horizon is too short, e.g., the budget cycle, there is a risk that short-term expediency will dominate, turning the focus on short-term costs and away from risks that could materialize later. The evaluation of the cost and risks underlying the strategy should aim to capture the full economic cycle, allowing potentially higher short-term interest rates and substantive movements in the exchange rate to emerge—elements of “shocks” to the system- both of which may significantly increase the cost of debt.

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ii. And how is it different from an MTDS report?

the debt. While a sound MTDS can be developed without the use of a quantitative tool, especially where countries are constrained in their choices, the use of scenario analysis provides useful information, enabling the DM to quantify the potential risks to the budget of alternative debt management strategies. The strategy document should preferably include the following:

• Description of the market risks being managed (currency, interest rate, and refinancing or rollover risks) and historical context for the debt portfolio

• Description of the future environment for DeM, including fiscal and debt projections; assumptions about interest and exchange rates; and constraints on portfolio choice, including those relating to market development and the implementation of monetary policy

• Description of the analysis undertaken to support the recommended DeM strategy, clarifying the assumptions used and limitations of the analysis

• Recommended strategy and its rationale

The recommendations should specify targets and ranges for key risk indicators of the portfolio and the financing program over the projected horizon. As an interim step, it would be sufficient to express the strategy as guidelines to indicate the direction in which certain key indicators are expected to evolve (for example, a statement that ―the amount of local currency debt maturing within 12 months shall be reduced). In addition, if one of the DeM objectives is to promote the development of the domestic debt market, the strategy should include measures to support such development.

2 It is important to maintain coherence between a reform plan and a strategy. For example, if an MTDS points to an increase in domestic borrowing, it may be that a reform plan needs to remove institutional obstacles or provide a legal framework.

The consistency between a Reform Plan, MTDS and DeMPA should be strongly emphasized. After identification of strengths and weakness in DeM activities through application of the DeMPA, (and prospectively an MTDS), a follow-on activity moving into reform plan territory would be an evaluation of why the organization is not performing as well as it should--consideration of recently completed reforms – are these helpful or a headwind to further progress-- and discussion of the possible sequencing of reforms. In the question posed to the left, it is clear that if MTDS and the country’s formal Debt Management Strategy point to an objective of encouraging an increase in domestic borrowing, the reform plan will need to address obstacles in the way of this hoped for achievement—starting with the legal framework and other issues related to domestic debt management.

Reform-Plan Primer

3 When during the Given the goal and time coverage of MTDS (building a desired debt composition within the MTDS

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annual fiscal cycle is the best time to formulate an MTDS? Is it during budget negotiations, after, or before? If a large portion of fiscal expenditure is on investment projects with financing tied to these projects, then a strategy is perhaps needed during the negotiations of the public investment plan (otherwise a strategy cannot have influence). In other cases, if most financing is untied, perhaps once the Medium-term fiscal framework (MTFF) is in place?

medium term) one would suggest having an MTDS approved at the time when the fiscal authority proceeds to budget negotiations. If so, an MTDS can be developed within the MTFF framework. Moreover it is worth formulating MTDS before the budget negotiations commence since it may offer a degree of “protection” from the dominance of short-term policy expediency. The MTDS should be also the basis for preparing the annual borrowing plan which would be finalized together with budget formulation.

4 What is the optimal horizon for a strategy? If a country has a 5-year MTFF, does this imply that we should formulate a 5-year strategy? In the case of Cote d’Ivoire, the main risk (domestic refinancing) was surfacing over the coming three years, so

The medium-term for MTDS is typically defined as 3–5 years. If the time horizon is too short, e.g., the budget cycle, there is a risk that short-term expediency will dominate, turning the focus on short-term costs and away from risks that could materialize later. The evaluation of the cost and risks underlying the strategy should aim to capture the full economic cycle, allowing potentially higher short-term interest rates and substantive movements in the exchange rate to emerge, both of which may significantly increase the cost of debt in the “outer” years of the projections. The choice of time horizon over which costs and risks are evaluated should take account of the stability of the economy. For example, if the economy is quite stable, evaluating these factors over a shorter time horizon may be fully representative; however, if the economy is not stable, it may be necessary to consider a longer time horizon. For example, if commodity

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we decided to limit the strategy to the shorter period to highlight this risk.

export prices are in a downward trend, a longer time period may need to be chosen so that an eventual upward turn in prices is also captured in the analysis.

5 i. Do we include IMF loans in the MTDS?

ii. How do we find out if an IMF loan is formally meant as budget support?

We include IMF loans in the MTDS if the lending is part of budget support, and the central government is paying the interest bill on the loan—not the central bank. Otherwise the IMF loans may be viewed as constituting foreign exchange reserves, on which the central bank is paying the interest bill, and should not be included as government debt in the MTDS. Article IV reports, readings of other recent IMF documents, and talking to counterparts at the IMF and authorities at the Ministry of Finance of the country concerned.

MTDS

6 i. What is a DeMPA?

ii. Should a government pursue “A” scores for all DeMPA indicators?

iii. For which purposes is the DeMPA used?

The DeMPA highlights strengths and weaknesses in government DeM practices. Performance assessment facilitates the design of plans to build and augment capacity and institutions tailored to the specific needs of a country. The DeMPA also facilitates the monitoring of progress over time in achieving the objectives of government DeM in a manner consistent with international sound practice. The DeMPA tool is a methodology for assessing Debt Management performance through a comprehensive set of indicators spanning the full range of government debt management functions. The indicator set is intended to be an internationally recognized standard in the government debt management field and may be applied in all developing countries. A government should not set its sights on obtaining all “A” scores in its DeMPA review, but rather assist the DEMPA team to understand the state of play in the debt management unit, its strength and weaknesses, thereby targeting areas for reforms and an eventual improvement of performance in the Unit.

DeMPA

7 i. What is debt sustainability analysis?

ii. How is sustainability analyzed,

The DSA provides a framework for assessing the state of a country in terms of its risk of longer-term debt distress. Under the World Bank-IMF Debt Sustainability Framework (DSF) a debt sustainability analysis (DSA) should be prepared annually for all IDA-only, PRGF eligible countries jointly with the IMF. Sustainability is analyzed by a comparison of debt burden indicators to indicative debt-burden thresholds. The indicative debt burden thresholds are in turn grounded in a country’s quality of policies and institutions, as

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under which time horizon, and what are the main drivers of the results?

iii. How is sustainability analysis different from an MTDS analysis?

measured by the World Bank’s CPIA exercise. (This classification is often used to determine the share of grants and loans in IDA assistance). MTDS and the DSF are both frameworks that address debt issues, but, given their different focus, they are complements rather than substitutes. The DSF provides the analytical tool to undertake debt sustainability analysis. It focuses on the long-term sustainability of debt, which is influenced by both its level and composition. To assess debt sustainability, the DSF considers a baseline macroeconomic framework that outlines a country’s fiscal and balance of payments stance under certain assumptions and conditions, and then considers the robustness of key debt burden indicators - usually the ratio of the NPV of debt to GDP, exports or tax revenue—to various macroeconomic shocks, such as to GDP, the exchange rate, revenues, etc. Overall, its primary objective is to gauge if the level and terms of current and expected future borrowing may lead to future debt servicing difficulties over the longer-term. However, certain simplifying assumptions are generally made, e.g., the term structure for market debt is not explicitly modeled, which limits its ability to provide some of the detailed analysis that would be of interest to the debt manager. The MTDS is a more targeted debt management framework, focusing on the specifics of how the composition of debt should be managed over the medium-term. Determining an effective MTDS requires the performance of various financing strategies to be evaluated under a given path for key macroeconomic variables, which should be consistent with that used in the DSF. Similarly, it requires the robustness of each alternative strategy to be evaluated under various shocks. Again, the DSF should inform the stress tests to be applied. Here, variables that capture market risk, such as the interest rate sensitivity of cash flows, other determinants of the term structure, and the exchange rate, may be explicitly modeled. This means that more detailed information on the specifics of the debt portfolio can be assessed more readily. The DM needs to recognize that MTDS may have important consequences for the DSA. Where testing of the alternative debt strategies under the various stress tests suggests that key debt sustainability indicators may be at risk, this should be discussed with the fiscal authorities. At this point, the preferred strategy, and its associated cost and risk implications, could be fed into an updated DSA.

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Technical questions 1 How to deal with SDR

debt? Do we convert it to USD, or break it down into USD, EUR, JPY and sterling?

It is important to decompose the SDR into its constituent currencies, e.g. USD, Euro, GBP and the JPY.

MTDS

2 How to deal with expected large disbursements, which constrain strategy? For example, if a bilateral donor is financing the construction of an airport, then any strategy can only be applied to the remaining free funds. Do we ask the country to provide information on all still-disbursing loans or just the major projects?

DM should be clear about the expected path of the primary balance, and the key drivers underlying this projection, including anticipated government revenues and expenditures, and economic growth. An issue that may be particularly pertinent for LICs is the appropriate treatment of project loans and associated spending. The planned spending, as reflected in the fiscal framework, is typically dependent on the receipt of specific project loans. Thus the DM may wish to take the path of expected disbursements as a given, as they will be offset by changes in spending. Nevertheless, it will be important to assess from time to time strategic choices in a more unconstrained manner, which will enable the authorities to determine the relative costs and benefits of project-based versus general budget financing.

MTDS

3 How to calculate T-bill interest rate profiles? We usually assume that the T-bill is rolled over sufficient times to make up a full year (a weekly T-bill is assumed to rolled over 52 times), but is the face value kept constant or does it snowball? This does not make much of a difference, practically,

The compilation of annualized T-bill interest rate profiles from higher frequency figures—monthly; six-monthly, etc.—could go forward as an interpolation of expected annual data for the year—given actual outturns to date within the year. Alternatively, expectations for the remainder of the year may be built from the higher-frequency data accumulated over the period to date. Under these assumptions we have an explicit change in annual interest rate (price) without having to use assumptions regarding rollover. In a case of exceptional short-term volatility in markets, such as during the nadir of the global financial crisis government interest rate assumptions will need be more carefully constructed, for example looking at developments in private sector rates, notably Libor, and conditions affecting interbank liquidity. Consultations with experts in the financial markets could pay a dividend under such circumstances.

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but an agreed approach would be helpful.

4 What are the broad characteristics of Sharia law facing a country that wishes to issue a “bond” into the Islamic market?

Sharia law bans the sale and purchase of debt contracts, profit taking without real economic activity, as well as activities that are not considered halal (Sharia compliant). Only interest-free forms of finance associated with investments that do not involve any association with pork, alcohol, firearms, adult entertainment or gambling are considered permissible in Islamic finance. Contractual relationships between financiers and borrowers and not governed by capital-based investment gains, but by shared business risk (and returns) from investment in lawful activities. The Islamic finance market advanced by 15% per year over the three years to 2008, spurred by demand for investments that comply with Islamic law. Sukuk, which are wholesale asset-based capital market securities have enjoyed the largest gain. Global issuance has largely been denominated in U.S. dollars and concentrated in parts of Asia (e.g. Malaysia) and the countries of the GCC. Despite the strong potential for the sukuk market, a number of hurdles remain:

o Identification of underlying assets that meet sharia requirements; and absence of structural features that are standard in conventional securities

o Limited historical performance data; potential illiquid secondary markets, tax disincentives (double taxation)

o Regulatory standards pertaining to sharia compliance vary considerably.

Jobst, Andreas, P. Kunzel, P. Mills and A. Sy, 2008 “Islamic Bond Issuance—What Sovereign Debt Managers need to Know” IMF Policy Discussion Paper 08/3. (Washington: International Monetary Fund)

5 What are the main types of risk that the debt manger should be concerned with?

1. Market Risk: refers to the risks associated with changes in market prices, such as interest rates, exchange rates, commodity prices, on the cost of the government’s debt servicing. For both domestic and foreign currency debt, changes in interest rates affect debt servicing costs on new issues when fixed rate debt is refinanced, and on floating rate debt at the rate reset dates. Hence, short-duration debt (short-term or floating rate) is usually considered to be more risky than long-term, fixed rate debt. (Excessive concentration in very long-term, fixed rate debt also can be risky as future financing requirements are uncertain.) Debt denominated in or indexed to foreign currencies also adds volatility to debt servicing costs as measured in domestic currency owing to exchange rate movements. Bonds with embedded put options can exacerbate market and rollover risks. (http://treasury.worldbank.org/bdm/pdf/PDM_Guidelines_2001_english.pdf) 1.1. Interest rate risk: refers to the vulnerability of the debt portfolio, and the cost of

government debt, to higher market interest rates at the point at which the interest

Wheeler, Graeme, 2004, “Sound Practice in Government Debt Management”, (Washington, World Bank)

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rate on variable rate debt and fixed rate debt that is maturing is being re-priced. http://siteresources.worldbank.org/INTDEBTDEPT/Resources/468980-1238442914363/MTDSGudianceNoteCA.pdf

1.2. Exchange rate risk: relates to the vulnerability of the debt portfolio, and the government’s debt cost, to a depreciation/devaluation in the external value of the domestic currency.

2. Refinancing or Rollover Risk: The risk that debt will have to be rolled over at an unusually high cost or, in extreme cases, cannot be rolled over at all. To the extent that rollover risk is limited to the risk that debt might have to be rolled over at higher interest rates, including changes in credit spreads, it may be considered a type of market risk. However, because the inability to roll over debt and/or exceptionally large increases in government funding costs can lead to, or exacerbate a debt crisis and thereby cause real economic losses. In addition to the purely financial effects of higher interest rates, it is often treated separately. Managing this risk is particularly important for emerging market countries. (http://treasury.worldbank.org/bdm/pdf/PDM_Guidelines_2001_english.pdf)

3. Liquidity Risk: There are two types of liquidity risk. One refers to the cost or penalty investors face in trying to exit a position when the number of actors has markedly decreased or because of the lack of depth of a particular market. This risk is particularly relevant in cases where debt management includes the management of liquid assets or the use of derivatives contracts. The other form of liquidity risk, for a borrower, refers to a situation where the volume of liquid assets can diminish quickly in the face of unanticipated cash flow obligations and/or a possible difficulty in raising cash through borrowing in a short period of time.

(http://treasury.worldbank.org/bdm/pdf/PDM_Guidelines_2001_english.pdf) 4. Credit Risk: The risk of non- performance by borrowers on loans or other financial

assets or by a counterparty on financial contracts. This risk is particularly relevant in cases where debt management includes the management of liquid assets. It may also be relevant in the acceptance of bids in auctions of securities issued by the government as well as in relation to contingent liabilities, and in derivative contracts entered into by the debt manager (http://treasury.worldbank.org/bdm/pdf/PDM_Guidelines_2001_english.pdf)

5. Settlement Risk: Refers to the potential loss that the government, as counterparty could suffer as a result of failure to settle, for whatever reason other than default by counterparty... (http://treasury.worldbank.org/bdm/pdf/PDM_Guidelines_2001_english.pdf)

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6. Operational Risk: This includes a range of different types of risks, including transaction errors in the various stages of executing and recording transactions; inadequacies or failures in internal controls, or in systems and services; reputation risk; legal risk; security breaches; or natural disasters that affect business activity. (http://treasury.worldbank.org/bdm/pdf/PDM_Guidelines_2001_english.pdf)

6 i. What is an annual borrowing plan? How is this plan related to the medium-term debt management strategy?

ii. How should this plan be expressed?

An annual borrowing plan should be developed, consistent with the MTDS and taking account of the underlying volatility in government cash flows. The specifics on size and timing of new borrowing are determined in conjunction with the forecast of cash needs given the expected implementation of the budget, and taking account of any specific market characteristics or creditor behavior, and objectives of regular and stable issuance in the domestic market. An important factor in determining the effectiveness of the borrowing plan will be the quality and robustness of government cash management and forecasting. An annual borrowing plan should be expressed with great transparency, communicating plans and other market activities well in advance. This approach can lead to lower costs by providing investors with a degree of certainty, increasing liquidity and serving to broaden the investor base.

DeMPA

7 i. What is asset-liability management for a government?

ii. What role does the debt office play in managing the overall balance sheet of the government?

Asset-Liability Management (ALM) comprises a range of risk management techniques designed to look at an entity’s (central government’s) asset and liability portfolios in combination, with a view to reducing the effect of market-related volatility on the balance sheet. In many respects ALM for government’s are comparable to those of a large diversified private sector corporation The key elements for the DMU in managing the overall balance sheet of the government is (first), the effectiveness and accuracy of forecasts of government debt servicing and government cash flows, particularly to determine the aggregate level of cash balances in government bank accounts; and (second) the extent to which the management of the aggregate level of cash balances is integrated with DeM activities such as issuance or buy-back of T-bills.

Treasury

8 i. How does a government forecast cash

Normally “cash-in” projections would be sourced from the Revenue/Taxation Authority, Customs, and other government units following services/ trade, to account for royalties, commissions, and further, remittances, taxable FDI income flows and other portfolio income

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in-and outflows?

ii. How can

forecasts be improved and lead to better cash management (lower debt)?

iii. What is the role of the debt manager in effective cash forecasting and cash management?

accrued under government accounts. Cash outflows would be sourced from the Authorities’ budgetary unit which has the responsibility to collate projections of recurrent expenditure items and capital outlays from various federal agencies. To the degree that the frequency at which these steps are undertaken are moved from annual to quarterly or semi-annual, is a step can familiarize staff with the vagaries (or seasonality) of data flows, and get a better handle on the dynamics of the forecast. Close monitoring of the macro economy and its potential effects on inflows and outlays should receive strong management support to boost the usefulness of the forecasting exercise. Improved forecast accuracy, and stepped-up use of investment of surplus funds, or management of excess liquidity can help to underpin a more efficient system, and in turn, help to lower debt. For cash forecasting and management activities the DMU is responsible for providing to the Budget Unit and others the best estimate of total government debt service—domestic and international. Improvement in the accuracy of such projections for the budget should remain an outstanding objective for the Unit.

9 i. Issuance of global bonds—what is the role of debt offices?

The DMU together with legal and economic/financial advisors will interface with the underwriter of a premier issue for a global bond. Governments/DMU should plan their actions within a timeframe that extends well beyond the date of first-time market access, and contemplate a bond issue within a wider, medium-term debt sustainability framework. These considerations are especially important for LICs, given the small size of their economy http://www.imf.org/external/pubs/ft/wp/2008/wp08261.pdf If the debt issuer wishes to establish its presence in international markets (more likely for emerging market economies, but also recently an increasing trend among selected LICs), it should opt for a bond with characteristics that would insure a large investor base, liquidity in the secondary market, and if possible, inclusion in at least one of the major bond indices used by investors and asset managers. Under favorable external economic conditions, many African, Asian and European LICs are becoming debut issuers; but should such positive conditions not prevail in the international context, sovereign bond issuers with unfamiliar profiles or lower credit ratings will likely face increased scrutiny and possible worsening of issuance terms (e.g. smaller sizes and higher spreads, if not a total inability to access markets).

Das, U. M. Papaioannou, (2008) “Strategic Considerations for first-time Sovereign Bond Issuers”. IMF Working Paper 08/261

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ii. How can a global bond issuance be prepared?

iii. How are cash proceeds from global bond issuance managed?

Countries needing to borrow internationally generally do not do so publicly unless the borrowing is sufficiently large to justify the costs involved. To prepare for global bond issuance, underlying legal and procedural documentation are sound, and are contracted on the most beneficial or cost-effective terms. Because issuance of a dollar/or euro denominated bond can carry high foreign exchange rate risk, it is also important that the principle Dem entity responsible for external borrowings carefully assess and manage the risks associated with foreign currency debt. “All-in-costs” should be evaluated for each form of external borrowing, but especially for global bonds. http://treasury.worldbank.org/services/financial+products+lending+rates+and+loan+charges/ The preparation of a terms sheet (physical or electronic) by the relevant front office staff without undue delay is a minimum requirement to satisfy concerns over the time taken (especially in LICs) to capture bond or loan recording into the debt management system If the international bond issue is a “bullet”—i.e. one-off repayment at a term of 10 years, it would be prudent, following the set off of funds designated for special projects or other support to (i) create a “sinking fund”, supporting by proceeds generated by the “project” to prepare for eventual repayment; (ii) if the bond used is based upon coupon payments, with a medium-range term, earlier buy-backs could be initiated to smooth the retirement process.

10 i. Contingent liabilities- what are they, and what is the role of the debt manager in identifying, monitoring and managing them?

ii. How do you price the risk related to contingent liabilities?

Contingent liabilities (CL) are the taking on by government of guarantees for loans contracted by other entities normally within the public sector (SOES or parastatals) but also for private sector players in the economy. Credit risk is an important element here, and the debt manager can take a number of steps to identify, monitor and manage such risks and uncertainties. The DMO, on the basis of its work for government debt, can be allocated responsibilities for these tasks. This, as it is also naturally concerned about the government’s creditworthiness, which can be eroded by taking on more risk in the form of guarantees. The DMO can help give management of contingent liabilities a degree of market disciple through: centralizing CL data to help the Budget Office maintain current information of the sources and users of guarantees, so that they can be properly charged as expense (if so needed); helping to estimate default risk on the guarantee; quantifying the expected cost and risk of the guarantee; charging a premium for the beneficiaries; establishing risk-sharing mechanisms as partial guarantees, and helping to manage or monitor a special purpose fund created to provide for the expected payouts of explicit contingent guarantees

Curry, Elizabeth (2002) “The Potential Role of Government Debt Management Offices in Monitoring and Managing Contingent Liabilities”. CEPAL (January 2002)

11 i. What is on- On-lending is, for example, a borrowing by the central government, the proceeds of which DeMPA

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lending, and how can a portfolio of on-lent loans be managed?

ii. What are the risks?

are passed on to a second entity (e.g. SOE or other parastatal). In management of on-lending, it is important to monitor risks (especially credit risks). To cover credit risk and administrative charges, the government can seek to mitigate risks by charging a guarantee fee or adding an on-lending fee or risk premium to the cost of borrowing. It is also important that documented policies and procedures exist for on-lending. And monitoring of development post-lending is critical – the people tasked with the assignment, and methods employed. Credit risk is the single largest uncertainty facing the central government in on-lending—what is the creditworthiness of the “on-lendee” and how might this evolve over the course of the loan. To mitigate credit risk and administrative charges the government can, as noted above, charge an on-lending fee, or risk premium to the cost of borrowing.

Domestic/foreign borrowing and debt 1 What are the common

impediments to expanding the domestic market for T-bills (eventually bonds) in a typical low-income country?

The goals for government borrowing in local currency in the domestic market are to achieve transparency and predictability, providing the government with a means to finance its expenditures in a cost-effective manner while minimizing the risks. To the extent possible debt issuance should use market based mechanisms, including competitive auctions, tap issues and syndications. Common impediments for expanding the market for domestic T-bills (eventually bonds) include several issues, among which: (i) lack of final private sector demand for domestic government securities, grounded in “mistrust” of the level of transparency in auction pricing, or lack of tradition of private holding of public securities; (ii) overwhelming holdings of government paper by the public sector (a function of (i) above), with frequent financing actions between the central bank and the central government—muddying the waters regarding the purpose of T-bill sales (for government finance—or for monetary policy (OMO)); (iii) earlier unsuccessful attempts at extending the yield curve without sufficient prerequisites to prepare the markets.

MTDS / DeMPA

2 How do foreign investors contribute or add risk to the local markets?

Foreign participation in domestic security markets contributes or adds to risk in several manners. First, foreign exchange rates now enter the equation for investment by overseas agents, and capital in- or outflows will be driven to a degree by actual or anticipated movements in FEX-cross rates. So foreign exchange risk (or uncertainty) emerges to be mitigated. Second, liquidity risk will also now play a role if foreign inflows are large, with the potential for an “in-out” dynamics that can roil the underlying fundamentals of domestic market conditions, and influence monetary policy and foreign reserve management.

MTDS

3 How often and how predictable should debt

Auctions in the domestic market should be held as frequently as the underlying management apparatus will allow without a compromise of principles. Operations in the domestic

DeMPA

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auctions be in the domestic market?

primary market should be transparent and predictable, including publishing borrowing plans well in advance, and acting consistently when issuing new securities into the wholesale market, regardless of the mechanism used for borrowing. Terms and conditions of new issues should be publicly disclosed and clearly understood by investors. And documented procedures for DMU/Treasury borrowing in the T-bill market should exist. All borrowing in the domestic market should be done in accordance with the government’s DeM strategy.

4 How often do debt markets use derivatives? In which cases should they be recommended?

In low income countries use of derivatives for hedging various exposures is at a fairly primitive stage, through use of such instruments by “Emerging Markets” has advanced at a fairly rapid pace over recent years. The key requirement for derivatives use is to ensure the presence of a risk management framework and documented procedures and policies for the use of such. Even with these safeguards in place, derivatives used as hedging instruments (for example, swaps, caps and futures) will normally entail market and credit risk, and should be recommended cautiously for any purpose.

DeMPA/ MTDS

5 What are the typical tradeoffs between issuing bonds abroad or in the domestic market?

Foreign exchange risk comes to the fore when an international (global, euro etc.) bond is issued, while sale of a local currency bond on the domestic market does not entail such risks. One must also examine carefully the loads, advisory fees, and other payments required of international underwriters, not generally a feature of domestic debt issuance.

MTDS

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6 i. What is a primary market for government securities?

ii. How can the primary market be improved, and what is the role of the debt manager in the development of an active primary market?

The need to develop domestic securities markets has, following the international financial crisis, increasingly attracted the attention of national and international policy makers. For many governments this presents immense challenges, as the problems that inhibit securities market development run deep into the economy. For most countries, particularly for LICs, standard marketable treasury bonds will be the main funding instrument (though T-bills are referenced here as a building block toward a fully functioning government bond market). Selling and distributing government securities to investors efficiently involves the choice of sales procedures (auctions, retail schemes, tap sales and/or syndication, and the possible use of primary dealers). The method chosen for the primary market—auctions the most common method—or where there is not a liquid secondary market—syndications (or other underwriting arrangement) can be used to minimize placement risk and ensure allocation. The use of primary dealers—financial intermediaries selected by the government to promote activity in government bonds and the securities market generally—can often entail risk of collusion, especially for countries with a small financial sector. DMU’s can help ensure that the use of a larger number of primary dealers can set the stage for development of the secondary market. Needless to say, before undertaking a full-fledged primary dealer system, the DMU should carry out an extensive review of the most effective ways to sell and distribute government securities.

Developing a Government Bond Market—a Handbook (2010) IMF and World Bank. (Financial Stability Forum 2008)

7 i. What is a secondary market for government securities?

ii. What are the preconditions for an active market, and what is the role of the debt manager in developing an active secondary market?

The secondary market, also called the aftermarket, is the financial market in which previously issued instruments, such as stocks, bonds (government and corporate), options and futures are bought and sold. After initial issuance, for example of government bonds through the Treasury and or a group of primary dealers, investors can purchase from other investors in the secondary market. Promoting a vibrant secondary market for government securities has proved to be one of the most difficult aspects of government securities market development. It requires the active participation of many groups, the commitment of government to refrain from policy changes affecting the value of government securities. Questions facing the DMU include: (i) which transactions and market practices should be allowed? (ii) which type of intermediaries to participate in the markets, and (iii) what is the appropriate level and form of transparency.