## 1cypea2022001

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### Preface and mission scope
- Mission: IMF Monetary and Capital Markets Department (MCM) virtual visit to Nicosia from December 7–18, 2020.
- Objective: provide technical assistance to the Ministry of Finance of Cyprus on strengthening the debt and cash management framework.
- Mission meetings: Public Debt Management Office (PDMO) (Phaedon Kalozois (Director), Yiola Georgiou, Stelios Leonidou, Irene Theocharous), Ministry of Finance (George Panteli and Treasury Department officials), extensive discussions with domestic and foreign banks.
- Mission team: Thor Jonasson (Mission Chief), Shirin Nikaein, Michael Papaioannou, Jim Siracusa.
- Acknowledgement: Yiola Georgiou for managing the mission’s agenda and information requirements.

### Executive summary — key observations
- Market context and investment constraints:
  - Eurozone negative interest rates in 2020 reduced attractiveness of domestic bank deposits for PDMO cash surpluses.
  - Suitable investment alternatives scarce because of negative yields on other Eurozone sovereign and agency issues; scarcity common to most Eurozone peers.
  - Recommendation: establish a framework and set of guidelines governing the PDMO’s investment policy despite short-term scarcity of alternatives.
- Liquidity buffer construction and funding:
  - Predominant buildup via pre-funding in the international capital markets through the EMTN program.
  - Domestic T-bill market has size and structural limitations that preclude using it both to manage liquidity and finance the Republic.
  - Recommendation: address operational limitations to develop the domestic T-bill market and facilitate necessary issuance volumes to attract higher domestic and international investor participation.
- Liability Management Operations (LMOs) and contingent credit:
  - Options include LMOs and establishment of a contingent credit line; caveat: investors may be reluctant to exchange higher coupon debt for lower coupons if the exchange is not cash neutral.
- Assessment of current liquidity buffer sizing:
  - Mission found Cyprus’ current liquidity buffer appropriately sized given current uncertainties.
  - Current PDMO approach uses main quantitative variables:
    - (i) refinancing needs, at the end of every month, for the next 9 and 12 months,
    - (ii) projected budget deficit/surplus,
    - (iii) other contingent liabilities not included in the budget balance, with a reasonable provision included in the annual budget.
- Identified issues:
  - Funding plan is annual, but cash buffer size is determined monthly; AFP requires forecasting determinants for the next 2 years, not just next 12 months.
  - Long reference period combined with increased cashflow uncertainty can produce serious discrepancies between targeted and required cash liquidity.
  - Heavy reliance on volatile fiscal and macro forecasts increases risk of overfunding.

### Executive summary — investment and operational recommendations
- Monitor and manage the level of the cash buffer; develop a cash-management policy framework and necessary infrastructure.
- Determine investment options for excess liquidity.
- As COVID-19 conditions ease, consider gradually reducing the cash buffer to the range provisioned in the PDML.
- Revisit reliance on predominantly long-term (> one-year maturity) debt instruments to fund the cash buffer; shift part of funding toward shorter-term sources, especially T-bills.
  - Advancing the T-bill market may require liquidity-enhancing measures for the money market and institutional changes relating to custodian and settlement systems, particularly to attract foreign investors.
  - Communicate changes in issuing policy appropriately to the public.
- Adopt a more proactive approach to managing the redemption profile with LMOs; LMOs can reduce near-term redemptions and thus the target size of the cash buffer.
- Current investment choices under negative interest rates include depositing funds with the Central Bank of Cyprus (CBC) at -0.50 percent or with commercial banks at a similar rate.
- When market conditions normalize, consider investing excess cash surpluses in instruments from other euro-zone governments offering higher yields, or use excess cash for buybacks or early redemptions.
- Consider external investment managers for investing in other euro-zone instruments or undertaking buybacks, subject to governance and oversight considerations.

### Main recommended milestones (summary)
- Prepare an internal model to calibrate the size of the cash liquidity buffer — Milestone: Internal model completed.
- Improve custody and settlement features of Treasury bills to reach international investors — Milestone: Treasury bills are eligible for settlement with an international central securities depository or a comparable mechanism.
- Conduct LMOs more actively, targeting upcoming maturities — Milestone: LMOs are implemented as and when feasible.
- Invest excess cash surpluses — Milestone: Investment policy is developed.
- Constant monitoring for emergence or elimination of contingent risks — Milestone: New contingent risk(s) identified and/or existing economic/financial risks that no longer necessitate liquidity coverage are eliminated.
- Consider gradually reducing the size of the cash buffer in line with PDML provisions as COVID-19 eases — Milestone: Size of the cash buffer is gradually reduced.

### Macroeconomic outlook and debt trajectory
- Real GDP growth:
  - Projected to be -6.4 percent in 2020 (down from 3.2 percent in 2019).
  - Expected to approach 4.7 percent in 2021 and around 3 percent in the medium term.
- Inflation, unemployment, fiscal balance:
  - Inflation dropped to -0.6 percent in 2020; projected to return to positive territory in 2021.
  - Unemployment projected to decline, reaching 5.2 percent in 2023.
  - Fiscal overall balance: from a surplus of 1.7 percent of GDP in 2019 to a deficit of 5.6 percent in 2020; from 2021 onwards deficit will gradually decrease and reach a surplus of around 1 percent of GDP in the medium term.
- Public debt trajectory:
  - General government debt projected to reach 118.4 percent of GDP (€24 billion) by end-2020 from 95.5 percent of GDP (€21 billion) at end-2019 — an increase of €3.1 billion.
  - Public debt expected to gradually decline and reach pre-COVID levels by 2023.
- Cash buffer and reserves:
  - Cash buffer projected to stand at 17 percent of GDP by end-2020.
  - Cash reserves increased from €0.95 billion at end-2019 to €3.6 billion at end-2020; as of end-December 2020 the cash buffer of €3.6 billion covers the financing needs of the next 9-12 months by a factor of 1.7.

### Debt portfolio composition, cost and risks (end-September 2020 / end-2020 figures)
- Portfolio composition (as of end-September 2020):
  - Externally-placed bonds: 49 percent of total debt.
  - Domestic bonds and bills (including recent T-bill issuance): 17 percent of total debt.
  - Official loans: 30 percent of total debt (down from almost 50 percent at end-2018).
- Weighted average cost of debt portfolio:
  - 4.2 percent in 2012
  - 2.2 percent in 2019
  - Approaching 1.9 percent at end-August 2020
- Key risk metrics (end-September 2020, Table 2):
  - Average life (in years): 8.0
  - Average time to next refixing (in years): 5.8
  - Refinancing risk 1Y: 9.9%
  - Refinancing risk 5Y: 35.8%
  - Refixing risk 1Y: 38.8%
  - Refixing risk 5Y: 63.8%
  - Ratio of non-Euro debt to total debt (before derivatives): 0.0%
  - Ratio of non-Euro debt to total debt (after derivatives): 0.0%
  - Ratio floating debt to total debt (before derivatives): 28.3%
  - Ratio floating debt to total debt (after derivatives): 28.3%
  - Total debt outstanding (billion EUR): 25.38
- Recent issuance and financing operations (2020):
  - January 2020: issued a 10-year and a 20-year EMTN, totaling €1.75 billion.
  - April 2020: issued 7- and 30-year EMTNs totaling €1.75 billion and €1.25 billion in a 52-week Treasury Bill.
  - July 2020: executed €1 billion in tap issues of two existing EMTNs (a 5- and 20-year bond).

### PDMO mandate, current practice, and cash buffer guidance
- Mandate: maintain and monitor a cash liquidity buffer as a precaution against difficult financial market conditions; debt management focuses on prudent financing of sovereign borrowing needs; cash management handles government liquidity via a cash buffer.
- Current PDMO guidelines: liquidity buffer to cover 9‒12 months of sovereign gross financing needs (range extended in June 2020 from prior 6–9 months to 9–12 months).
- Since onset of COVID-19, borrowing requirements increased and authorities raised liquidity surplus to around 20 percent of GDP.
- Current modalities for investing cash balance limited to deposits in the CBC earning a negative interest rate.

### Purpose, sizing and legal framework for cash buffers
- Rationales for a cash buffer:
  - Cover maximum financing needed if capital markets disrupted for several months.
  - Provide comfort to investors that the sovereign can honor obligations.
  - Leave room for inflows from pre-financing.
  - Be used for contingent liabilities and/or buybacks.
- Functional decomposition of buffer:
  - (i) transactions buffer for unanticipated falls in cash balances from volatility and forecasting errors;
  - (ii) safety buffer for unanticipated falls from sudden market disruptions.
- Legal basis and process:
  - Article 20 (3) of the 2012 PDM Law and a Council of Ministers decision on June 3, 2020 (renewed December 22, 2020).
  - Minimum to maximum cash buffer covers next 9 to 12 months, measured monthly; PDMO proposal for size must be updated quarterly and approved by the Council of Ministers.
  - Decision on cash buffer level not published in the Official Government Gazette; communicated to market participants and rating agencies in bilateral meetings.

### Quantitative framework and calibration (Box 1 and specifications)
- Monthly sovereign financing needs formula:
  - y(t) = x(t) + z(t) - w(t) + u(t)[r(t), m(t), c(t), s(t)]
    - x(t): refinancing needs for month t
    - z(t): budget balance in cash terms for month t (deficit positive, surplus negative)
    - w(t): excess cash balance from previous month t-1 (negative sign)
    - u(t): extra precautionary cash liquidity depending on prevailing uncertainties for month t
    - u(t) components:
      - r(t): size of redeemable bonds at month t
      - m(t): mandate of the PDMO to raise an unscheduled amount funds at month t
      - c(t): risk of credit rating deterioration for market access for month t
      - s(t): small size of the issuer and implications for refinancing for month t
- Indicative factor specifications during the COVID-19 pandemic:
  - r(t) = [75] percent of the size of redeemable bonds
  - m(t) = [50] percent of z(t)
  - c(t) = [75] percent of x(t)
  - s(t) = [50] percent of x(t)
- Indicative factor specifications during normal times, after the pandemic:
  - r(t) = [25] percent of the size of redeemable bonds
  - m(t) = [10] percent of z(t)
  - c(t) = [25] percent of x(t)
  - s(t) = [10] percent of x(t)
- Buffer definitions:
  - B(min) = Minimum size of cash buffer = Sum of y (t=1 to 6)
  - B(max) = Maximum size of cash buffer = Sum of y (t=1 to 9)
- Operational rules:
  - If actual liquidity stock > B(max) at month t, PDMO decides on investment options for excess liquidity.
  - If actual liquidity stock < B(min) at month t, PDMO raises additional funding to fill the gap.

### AFP process, forecast challenges and AFP 2021 planned funding
- AFP timing and process:
  - AFP prepared for fiscal year t+1, approved by Minister of Finance not later than end-November of current year t, updated at least twice a year.
  - AFP must account for monthly rolling cash buffer requirements for the next 24 months when annualized.
- AFP 2021 planned sources of funding (amounts in mn €):
  - EMTN: 1,250
  - Treasury Bills: 225 – 300
  - Retail Bonds: 40 – 50
  - EIB/CEB: 100
  - SURE: 249
  - TOTAL: 1,864 – 1,949
- Forecast challenges:
  - Long forecast period combined with uncertainty can lead to serious discrepancies between forecast and actual cash liquidity.
  - European Commission autumn 2020 forecasts cited:
    - Budget deficit for 2020: -6.1 percent of the GDP.
    - Budget deficit expected to decrease to -2.3 percent of the GDP in 2021.
    - Real GDP growth: -6.2 percent for 2020 and 3.7 percent for 2021.

### December 2020 AFP position and short-term coverage (summary figures)
- Balance of cash available 1/12/2020: 4,109 (million euros)
- Remaining long-term debt maturity 2020: 818 (million euros)
- EIB/CEB loans: 20 (million euros)
- Budget Cash deficit Dec. 2020: 203 (million euros)
- Use of available cash: 1,001 (million euros)
- Total financing needs Dec. 2020: 1,021 (million euros)
- Cash balance forecast 31/12/2020 (a-b): 3,108 (million euros)
- Budget Cash deficit (surplus) for 9 months 2021: (364) (million euros)
- Total Financing Needs for 9 months of (Jan.–Sept.) 2021: 1,365 (million euros)
- Percentage of coverage of financing needs for 9 months (Jan.–Sept.) 2021 (c/d): 228%
- Cash balance after meeting the financing needs Jan.–Sept. 2021 (c-d): 1,743 (million euros)
- December 18, 2020 projection: total financing needs for December 2020 projected at €1.02 billion; covered by existing cash by 98 percent and by foreseen financing by 2 percent.

### Investment options, constraints and LMOs
- Investment constraints under Euro-area conditions:
  - ECB deposit facility negative rates increase carrying cost; CBC deposit at -0.50 percent is current option.
  - Commercial bank deposits unlikely beneficial given ample banking liquidity and reported pass-through of negative rates to institutional clients.
  - Other euro-zone sovereign T-bills and bonds offer negative yields; yields remain negative further down the curve until after 7 years, producing maturity mismatch for short-term liquidity.
- LMOs role and instruments:
  - LMOs can adjust maturity profile and reduce near-term refinancing needs, lowering required cash buffer.
  - LMO types:
    - Retiring outstanding debt using liquidity buffer for maturing obligations.
    - Purchasing debt in the secondary market (opportunistic purchases or tender offers).
    - Debt exchanges.
  - Considerations: market communication, investor reinvestment preferences, market-distortion risks, and interaction with market development objectives.
- Investment policy framework needs:
  - Delineate portion of cash surplus that must remain readily available versus investible / retireable amounts.
  - Establish quantitative framework/metrics to identify investible surplus and evaluate performance.
  - If outsourcing to external managers, set minimum criteria, selection system, obligations, monitoring and evaluation procedures.

### Operational and market infrastructure issues (T-bills settlement and market development)
- T-bills issuance and settlement:
  - Issued under Cypriot law, sold through Bloomberg auctioning system, listed on Cyprus Stock Exchange (CSE) which acts as depository.
  - No delivery versus payment system currently in place; Republic faces credit risk in auctions because money may not be paid while securities are delivered to CSE accounts.
  - PDMO limits auction participation to domestic banks and allows banks to bid on behalf of clients with banks solely responsible for funds.
  - Clearstream’s custodian account with the CSE can be used to sidestep direct CSE accounts (one documented primary-market case).
- Clearing and settlement steps (domestic and international cases summarized):
  - Auction → PDMO prepares excel file → CSE checks → DMO final confirmation → banks deposit funds by 9:30 settlement date → CSE distributes securities at 10:30 → (for international investors) allocation via Clearstream custodian flows.
- Repayment: CSE prepares payment instructions electronically to the Treasury (Office of the Accountant-General) which executes repayment.
- Market limitations and bank views:
  - T-bill market perceived as illiquid and operationally cumbersome; sizes too small for market-driven auctions; settlement and custodian arrangements at CSE are expensive and may preclude international investor involvement.
  - Domestic banks welcome more liquid and frequent T-bill issuance subject to resolving operational issues; international banks stress streamlining settlement and widening custodial arrangements.

### Annex findings on DMOs’ cash buffer practices and survey evidence
- OECD survey (2018 respondents):
  - 29 of 35 OECD countries that responded found liquidity buffers important and effective.
  - 93 percent of agencies with a liquidity buffer build cash reserves through over borrowing.
  - Cash part of buffer in >90 percent; common securities include T-bills and T-bonds; precautionary credit lines also used.
  - Most common practice: keep a buffer level sufficient to meet one month of expenditures; targets vary between one week and one year.
  - Almost all participants invest excess cash balances; common investments are demand/time deposits in local currency; only a quarter invest in foreign currency assets.
- Pre-COVID vs COVID behavior:
  - Pre-COVID many DMOs reduced warehousing of liquidity; as COVID-19 unfolded most DMOs increased cash buffers as insurance against market uncertainty.
- Country-specific considerations:
  - No one-size-fits-all; countries with deep domestic markets may not pursue target cash buffer policy; small issuers and those near investment grade may emphasize buffers more.

### Key recommendations (condensed)
- Maintain alertness to emerging contingent risks and remove coverage for factors no longer posing economic/financial risks.
- As pandemic eases, consider gradual reduction of cash buffer in line with PDML.
- Prepare and maintain an internal model to calibrate cash buffer size and keep it under review.
- Improve custody and settlement features of T-bills to reach international investors; make treasury bills eligible for international CSD settlement or comparable mechanism.
- Shift part of funding toward shorter-term sources, especially T-bills, while resolving operational and institutional impediments.
- Adopt a more proactive LMO strategy to smooth near-term redemptions and reduce required cash buffer.
- Develop a written investment policy for excess cash that defines authority, size of investible excess, objectives, permissible instruments, reporting and performance metrics.
- Consider outsourcing investment management only with clearly defined selection criteria, mandates, oversight and performance monitoring.

*International Monetary Fund — Cyprus: Debt and Cash Management (Preface and excerpts, mission December 7–18, 2020)*

### Preface ................................................................................................................

### 1cypea2022001 - Preface

### Preface: mission scope and acknowledgements
- A mission from the IMF’s Monetary and Capital Markets Department (MCM) conducted a virtual visit to Nicosia from December 7–18, 2020.
- Objective: provide technical assistance to the Ministry of Finance of Cyprus on strengthening the debt and cash management framework.
- Mission meetings:
  - Public Debt Management Office (PDMO): Phaedon Kalozois (Director), Yiola Georgiou, Stelios Leonidou, Irene Theocharous.
  - Ministry of Finance: George Panteli (Permanent Secretary) and Treasury Department officials.
  - Extensive discussions with domestic and foreign banks.
- Mission team: Thor Jonasson (Mission Chief), Shirin Nikaein (both IMF), Michael Papaioannou, and Jim Siracusa (both IMF external experts).
- Special acknowledgement: Yiola Georgiou for managing the mission’s agenda and information requirements.

### Executive Summary: key observations and high-level recommendations
- Market context and investment constraints:
  - Eurozone negative interest rates in 2020 reduced attractiveness of domestic bank deposits for PDMO cash surpluses.
  - Suitable investment alternatives to central bank deposits are scarce because of negative yields on other Eurozone sovereign and agency issues.
  - This scarcity is common to most Eurozone peers.
  - Recommendation: establish a framework and set of guidelines governing the PDMO’s investment policy despite short-term scarcity of alternatives.

- Liquidity buffer construction and funding:
  - PDMO predominantly builds its liquidity buffer via pre-funding in the international capital markets through its EMTN program.
  - Domestic Treasury bill (T-bill) market has size and structural limitations that preclude using it both to manage liquidity and finance the Republic.
  - Recommendation: address operational limitations to develop the domestic T-bill market and facilitate necessary issuance volumes to attract higher domestic and international investor participation.

- Liability Management Operations (LMOs) and contingent credit:
  - Options to manage upcoming maturities include LMOs and establishment of a contingent credit line.
  - Caveat: investors may be reluctant to exchange higher coupon debt for lower coupons if the exchange is not cash neutral.

- Assessment of current liquidity buffer sizing:
  - The mission found Cyprus’ current liquidity buffer is appropriately sized given current uncertainties.
  - Current PDMO approach to determine the cash buffer uses the following main quantitative variables:
    - (i) refinancing needs, at the end of every month, for the next 9 and 12 months,
    - (ii) projected budget deficit/surplus,
    - (iii) other contingent liabilities not included in the budget balance, with a reasonable provision for contingent liabilities being included in the annual budget.
  - Additional idiosyncratic factors are also taken into account.

- Identified issues with current approach:
  - Funding plan is annual, but cash buffer size is determined monthly. Formulating the Annual Financing Plan (AFP) requires forecasting all factors determining the required cash buffer for the next 2 years, not just the next 12 months.
  - Long reference period of forecasts combined with increased cashflow uncertainty can produce serious discrepancies between targeted and required cash liquidity.
  - Cash-flow projections rely heavily on fiscal and macro forecasts that tend to be very volatile under increased instability, increasing risk of overfunding.

- Investment policy and management recommendations:
  - Closely monitor and manage the level of the cash buffer; develop a cash-management policy framework and necessary infrastructure.
  - Determine investment options for excess liquidity.
  - As COVID-19 conditions ease and forecast uncertainty declines, consider reducing the size of the cash buffer in a gradual manner to the range provisioned in the PDML.
  - Revisit reliance on predominantly long-term (> one-year maturity) debt instruments to fund the cash buffer; shift part of funding toward shorter-term sources, especially T-bills, to provide in-year flexibility.
    - Advancing the T-bill market may require liquidity-enhancing measures for the money market and institutional changes relating to custodian and settlement systems, particularly to attract foreign investors.
    - Communicate changes in issuing policy appropriately to the public.
  - Adopt a more proactive approach to managing the redemption profile with LMOs; implementing LMOs can reduce near-term redemptions and thus the target size of the cash buffer.
  - Investment options are limited under negative interest rates; current choices include depositing funds with the Central Bank of Cyprus (CBC) at -0.50 percent or with commercial banks at a similar rate.
  - When market conditions normalize, consider investing excess cash surpluses in instruments from other euro-zone governments offering higher yields, possibly taking some duration risk, or use excess cash for buybacks or early redemptions.
  - Consider involvement of external investment managers for investing in other euro-zone instruments or undertaking buybacks, with general considerations provided by the mission.

- Main recommendations and milestones (Table 1 summary):
  - Prepare an internal model to calibrate the size of the cash liquidity buffer — Milestone: Internal model completed.
  - Improve custody and settlement features of Treasury bills to reach international investors — Milestone: Treasury bills are eligible for settlement with an international central securities depository or a comparable mechanism.
  - Conduct LMOs more actively, targeting upcoming maturities — Milestone: LMOs are implemented as and when feasible.
  - Invest excess cash surpluses — Milestone: Investment policy is developed.
  - Constant monitoring for emergence or elimination of contingent risks — Milestone: New contingent risk(s) identified and/or existing economic/financial risks that no longer necessitate liquidity coverage are eliminated.
  - Consider gradually reducing the size of the cash buffer in line with PDML provisions as COVID-19 eases — Milestone: Size of the cash buffer is gradually reduced.

### I. Introduction — Recent developments and outlook
- Macroeconomic projections and risks:
  - Real GDP growth:
    - Projected to be -6.4 percent in 2020 (down from 3.2 percent in 2019).
    - Expected to approach 4.7 percent in 2021 and around 3 percent in the medium term.
  - Key downside risks: another COVID-19 wave, geopolitical factors, deteriorating confidence, high percentage of domestic non-performing loans, and pace of recovery in the tourism sector.
  - Growth drivers: consumption and investment; largest sectoral drivers expected to be retail, tourism, professional services, and construction.
  - Inflation, unemployment, fiscal balance:
    - Inflation: dropped to -0.6 percent in 2020; projected to return to positive territory in 2021.
    - Unemployment: projected to decline, reaching 5.2 percent in 2023.
    - Fiscal overall balance: expected to decline from a surplus of 1.7 percent of GDP in 2019 to a deficit of 5.6 percent in 2020; from 2021 onwards deficit will gradually decrease and reach a surplus of around 1 percent of GDP in the medium term.

- Banking sector resilience and pressures:
  - CET1 capital ratios have improved.
  - Non-performing loans fell from €28.4 billion (48 percent of total loans) in 2014 to €6.6 billion (22 percent) by July 2020.
  - Banks’ cash liquidity is high, but new lending in 2020 was limited.
  - Profitability is under intense pressure due to the low interest rate environment.
  - ECB announced measures to support banks’ capital positions and ensure favorable financing conditions.

### I. Introduction — Public Debt Management Office (PDMO)
- Mandate and practices:
  - PDMO is mandated to maintain and monitor a cash liquidity buffer as a precaution against difficult financial market conditions.
  - Debt management focuses on prudent financing of sovereign borrowing needs; cash management handles government liquidity needs via buildup of a cash buffer.
  - Implementing a precautionary cash buffer is costly because interest earned on surplus cash is typically much less than the cost of additional borrowing.

- Current buffer guidance and recent actions:
  - Current PDMO guidelines: liquidity buffer to cover 9‒12 months of sovereign gross financing needs.
  - Since onset of COVID-19, borrowing requirements increased and market predictability declined; authorities raised liquidity surplus to around 20 percent of GDP.
  - Current modalities for investing cash balance are limited to deposits in the CBC earning a negative interest rate.

- Technical assistance history and PDMO objectives:
  - PDMO has previously received MCM technical assistance on debt management strategy, market development, and institutional issues.
  - PDMO is considering LMOs to better manage near-term debt profile and wants to identify relevant risk indicators.
  - If PDMO manages a share of liquid financial resources, it seeks metrics to evaluate investment performance (including potential external fund managers) and compliance with investment policies.

- Report structure:
  - Section 2: debt portfolio and debt management strategy.
  - Section 3: cash management practices and interaction with debt management.
  - Section 4: methodology to monitor and assess the liquidity buffer.
  - Section 5: options for mitigating refinancing risk and improving investment efficiency.

*International Monetary Fund — Cyprus: Debt and Cash Management (Preface and Executive Summary, mission December 7–18, 2020)*

### 9.      Public debt in Cyprus has increased due to fiscal pressures and contraction of

### 9.      Public debt in Cyprus has increased due to fiscal pressures and contraction of

### Public debt trajectory and cash buffer
- General government debt projected to reach 118.4 percent of GDP (€24 billion) by end-2020 from 95.5 percent of GDP (€21 billion) at end-2019, an increase of €3.1 billion.
- Cash buffer projected to stand at 17 percent of GDP by end-2020, sufficient to cover gross financing needs of more than the next nine to twelve-months.
- Cash reserves increased from €0.95 billion at end-2019 to €3.6 billion at end-2020; as of end-December 2020 the cash buffer of €3.6 billion covers the financing needs of the next 9-12 months by a factor of 1.7.
- Public debt expected to gradually decline and reach pre-COVID levels by 2023.

### Recent issuance and financing operations (2020)
- January 2020: PDMO issued a 10-year and a 20-year EMTN, totaling €1.75 billion, completing the Cyprus yield curve and increasing cash reserves.
- April 2020: PDMO issued 7- and 30-year EMTNs totaling €1.75 billion and €1.25 billion in a 52-week Treasury Bill to boost cash reserves and cover loss of fiscal revenues.
- July 2020: PDMO executed €1 billion in tap issues of two existing EMTNs (a 5- and 20-year bond) to further boost cash reserves and improve bond liquidity.

### Debt portfolio composition and cost
- As of end-September 2020:
  - Externally-placed bonds: 49 percent of total debt.
  - Domestic bonds and bills (including recent T-bill issuance): 17 percent of total debt.
  - Official loans: 30 percent of total debt (down from almost 50 percent at end-2018).
- Weighted average cost of the debt portfolio:
  - 4.2 percent in 2012
  - 2.2 percent in 2019
  - Approaching 1.9 percent at end-August 2020
- Cost reduction drivers: improvement in Cyprus’ credit rating, low interest rate environment, liability management transactions, replacement of high-cost debt with lower-cost issuance.

### Key debt portfolio risks and indicators (as of end-September 2020)
- Refinancing risk:
  - Average time to maturity increased from 7.4 to 8 years from end-2019 to end-September 2020.
  - Debt maturing within one year increased from 8.3 to 9.9 percent of total debt from 2019 to end-September 2020.
  - Share of debt maturing within five years dropped from 41.2 to 36 percent over the same period (post early IMF loan repayment on February 27, 2020).
- Interest rate risk:
  - Share of debt with a floating interest rate decreased from 38 to 28 percent of total debt from end-2019 to end-September 2020.
- Currency risk:
  - Foreign exchange risk eliminated after early repayment of the IMF loan of €717 million in February 2020.
  - As of end-August 2020, no outstanding debt in foreign currency.
- Liquidity risk:
  - Cash reserves increased to €3.6 billion by end-2020, covering next 9–12 months; short-term insufficient funds risk mitigated.
- Table 2 risk metrics (end-September 2020):
  - Average life (in years): 8.0
  - Average time to next refixing (in years): 5.8
  - Refinancing risk 1Y: 9.9%
  - Refinancing risk 5Y: 35.8%
  - Refixing risk 1Y: 38.8%
  - Refixing risk 5Y: 63.8%
  - Ratio of non-Euro debt to total debt (before derivatives): 0.0%
  - Ratio of non-Euro debt to total debt (after derivatives): 0.0%
  - Ratio floating debt to total debt (before derivatives): 28.3%
  - Ratio floating debt to total debt (after derivatives): 28.3%
  - Total debt outstanding (billion EUR): 25.38

### Debt management strategy (objectives and framework)
- Overriding objective: ensure financing needs are always met in time and borrowing cost is the lowest possible in the medium term within an acceptable level of risk.
- Medium-term debt management strategy (3–5 years) prepared and updated at least once a year by the PDMO; provisionally approved by the Minister of Finance and submitted for final approval to the Council of Ministers.
- Annual financing program (AFP) prepared for every fiscal year, updated at least twice a year and approved by the Minister of Finance.
- Financing operations implemented within a 3-pillar framework:
  - Refinancing risk:
    - Maintain a balanced debt maturity profile with gross financing needs below 10 percent of GDP.
    - Majority of new borrowing expected to have fixed interest rate and to be in euros.
    - Maintain cash buffer to meet gross financing needs throughout the year with a 24-month forward-looking approach.
  - Development of the government securities market:
    - Grow stock of government securities via international bond issuance replacing other borrowing (e.g., loans).
    - Issue benchmark bond in the primary market on a regular basis through the EMTN program.
    - Enhance pricing, transparency, and liquidity in the secondary market via international banks and MTS BondVision, LSE.
  - Development of investor relations:
    - Maintain contacts with existing investors and find new investors to extend and diversify the investor base geographically.

### MTDS 2021–23 targets and progress (progress as of end-September 2020)
- A1. Short-term debt structure: ≤5 percent — Target status: 5.7 percent.
- A2. Maturity of marketable debt: >7 years — Target status: 7.8 years.
- A3. Refinancing risk: Maintain total liquid funds of the 9-12 months needs throughout the year — Achieved.
- A4. Gross financing needs: Maintain annual GFN up to 10 percent of GDP — Target status: 10.1 percent.
- A5. Foreign exchange risk: Upper limits on total outstanding debt (<5 percent) foreign currency exposure — Total debt: 0 percent.
- A6. Interest rate risk: Upper limit on total outstanding debt (<35 percent) floating interest rate exposure — Total debt: 28 percent.
- A7–A9. Market structure, price discovery, longer yield curve — In progress: market group of international investment banks formed; MTS platform operational; yield curve extended up to 30 years.
- A10–A12. Investor relations, market intelligence, expansion of investor base — Ongoing actions include regular publications, investor presentations, non-deal road shows to core and non-core European markets and US East Coast market.

### Cash management practices and sound practices
- Overriding objective of cash management: ensure government can fund expenditures in a timely manner while minimizing costs, reducing risks, and improving efficiency.
- Three development phases of modern cash management:
  - Develop Treasury Single Account (TSA) and integrate government bank accounts.
  - Build cash flow forecasting capability to monitor and forecast TSA balances.
  - Move to active cash management, borrowing and lending in money markets to smooth net daily cash flows.
- Instruments and operations:
  - T-bills as typical instrument for active cash management and core instrument in domestic financial markets; useful for smoothing cash flows and as collateral.
  - Repos and reverse-repos for fine tuning cash management; collateralized lending reduces credit risk and offers execution flexibility.
- Trade-off: building a liquidity buffer has an opportunity cost because sovereign funding cost is typically higher than return on the buffer (negative cost of carry); use of a cash buffer implies a cost-risk tradeoff.

*I M F | CYPRUS Debt and Cash Management*

### 27.      The size of the cash buffer should, inter alia, be based on the debt manager’s

### 1cypea2022001 - 27.      The size of the cash buffer should, inter alia, be based on the debt manager’s

### Purpose and sizing of cash buffers
- Cash buffer rationales:
  - To cover maximum financing needed if capital markets were disrupted for several months and no issuance could take place.
  - To provide comfort to investors that the sovereign will be able to honor its debt obligations.
  - To leave room for inflows from possible pre-financing (necessitating a flexible buffer).
  - To be used for contingent liabilities and/or for buybacks of outstanding securities.
- Common functional decomposition:
  - (i) transactions buffer for an unanticipated fall in cash balances stemming, inter alia, from the combination of volatility and forecasting errors in the cash forecasting;
  - (ii) a safety buffer for an unanticipated fall in cash balances stemming, for example, from sudden disruptions in capital markets for a period when no bond/bill issuances would be possible.

### Survey findings and common practices (OECD survey, 2018 respondents)
- 29 of 35 OECD countries that responded found liquidity buffers important and effective to mitigate refinancing risk and liquidity risk.
- Primary benefits cited:
  - Immediate access to liquidity increases financial flexibility, cushions market stress or temporary loss of market access, supports predictability of borrowing programs, enhances market confidence.
- How liquidity buffers are built:
  - 93 percent of the agencies with a liquidity buffer build cash reserves through over borrowing.
  - Slightly more than half of respondents indicate budget surpluses as a source of their liquidity buffer.
- Composition and instruments:
  - Cash is part of the liquidity buffer in more than 90 percent of agencies that hold one.
  - After cash, the most commonly used securities are highly liquid assets (e.g., T-bills and T-bonds), followed by precautionary credit lines.
- Target levels and design:
  - DMOs target minimum levels to cover financing needs to withstand severe liquidity strains for a certain period (e.g., one week to one year).
  - The most common practice is to keep a buffer level sufficient to meet one month of expenditures.
  - About half of the countries carry only domestic currency in their liquidity buffer; an asset liability management model is commonly applied to determine currency composition.
- Costs and investment:
  - Less than half of participants measure the cost of maintaining a liquidity buffer; most who measure it compare it with the cost of funding.
  - Almost all participants invest excess cash balances.
  - Investment policies: often invested in demand and/or time deposits in local currency; only a quarter invest in foreign currency assets.
  - Most countries have deposits at the central bank; half of countries with a cash buffer have deposits at local private banks.
  - To manage investment risk, common measure is to create limits based on counterparty ratings.

### Cyprus: Assessment of PDMO cash buffer management during COVID-19
- The PDMO’s management during heightened uncertainty due to COVID-19 is assessed as prudent.
- Rationale for build-up and maintenance:
  - Uncertainty about severity and duration of COVID-19 crisis.
  - Sovereign had recently exited a financial crisis.
  - Cyprus is a small issuer.
- Mission assessment: adequate liquidity should be maintained until the pandemic is totally under control, despite significant carry costs.
- Accumulation achieved by issuance of medium-term bonds in addition to the T-bill program.
- Authorities’ investment constraints and options:
  - Current euro-zone liquidity circumstances limit beneficial investment options.
  - Authorities contemplate:
    - Depositing all or part of cash surpluses with the CBC at a rate of -50 basis points.
    - Deposits with commercial banks if better rates could be offered (unlikely due to excess-liquidity environment).
    - Investment in other euro-zone assets with higher-than-zero yields, especially with some duration exposure.
    - Liability management operations (LMOs), such as debt buybacks.

### Recommendations (PDMO cash and debt management integration)
- The mission recommends that the PDMO:
  - (i) Maintains alertness towards new contingent risks that may be emerging and/or eliminating other factors that may have ceased to constitute economic or financial risks necessitating liquidity coverage.
  - (ii) As the present COVID-19 pandemic conditions ease, consider reducing the size of the cash buffer in a gradual manner in line with the provisions of the PDML.

### Determining liquidity buffers in Cyprus debt management (Legal and procedural framework)
- Legal basis and policy decisions:
  - Levels based on Article 20 (3) of the 2012 PDM Law and a Council of Ministers decision on June 3, 2020, renewed on December 22, 2020.
  - Minimum to maximum cash buffer covers financial needs of the next 9 to 12 months, measured on a monthly basis within the financial year (January–December).
  - Prior to June 2020 the cash buffer coverage period was 6 months (min) to 9 months (max). In June 2020 this was lengthened to 9 months (min) to 12 months (max).
  - Decision on cash buffer level is not published in the Official Government Gazette due to confidentiality; communicated to market participants and rating agencies in bilateral meetings.
- Process and factors (Article 20(1)(a)-(d) of PDM Law):
  - PDMO prepares proposal for desired level and minimum-maximum range to be held in the General Government Account (TSA), considering:
    - (i) level of market volatility,
    - (ii) current credit facilities of the government,
    - (iii) accuracy of forecasts of cash reserves and cash flows,
    - (iv) any other relevant factors.

### Procedures, monitoring, and operational implications
- Quarterly update and approval:
  - By law, the PDMO’s proposal for the size of the cash buffer must be updated on a quarterly basis and approved by the Council of Ministers.
- Rolling sufficiency:
  - The cash buffer to be held at any point should be sufficient to cover gross financing needs of the next 9 to 12 months on a rolling basis.
  - Council decision: the cash buffer by the end of each month must be sufficient to meet gross financing needs of the following 9 to 12 months.
- Quantitative variables assumed known:
  - Refinancing needs, at the end of every month, for the next 9 and 12 months (this is known with almost 100 percent accuracy).
  - Fiscal needs, i.e., projected budget deficit/surplus (under normal conditions, budget-balance forecasts for a horizon of two years ahead). These projections are typically accurate, with a margin of error that is manageable; under uncertain conditions additional cash is necessary.
  - Contingent liabilities not included in the budget balance, with a reasonable provision included in the annual budget; under severe economic instability budgeted amounts may prove insufficient.
- Impact on Annual Funding Plan (AFP):
  - According to Article 10 of the PDML, the PDMO prepares the AFP for the next fiscal year (t+1).
  - AFP is approved by the Minister of Finance not later than the end of November of the current year (t) and updated at least twice a year.
  - The AFP’s annual basis versus cash buffer’s monthly rolling basis necessitates forecasting determinants of the required cash buffer for the next two years, not just next 12 months.
  - Example: AFP for 2021 had to make provision for the necessary cash buffer by end-December 2021 to cover financing needs up to end-December 2022.

### AFP 2021: Planned sources of funding (amounts in mn €)
- EMTN: 1,250
- Treasury Bills: 225 – 300
- Retail Bonds: 40 – 50
- EIB/CEB: 100
- SURE: 249
- TOTAL: 1,864 – 1,949

### Forecast challenges and macro context
- Forecast volatility:
  - Long forecast period combined with uncertainty can lead to serious discrepancies between forecast and actual cash liquidity needs.
- European Commission autumn 2020 forecasts (as cited):
  - Budget deficit for whole year of 2020: -6.1 percent of the GDP.
  - Budget deficit expected to decrease to -2.3 percent of the GDP in 2021.
  - Real GDP growth: -6.2 percent for 2020 and 3.7 percent for 2021.

### Additional Cyprus-specific factors affecting buffer sizing
- Retail securities subject to short-notice redemption:
  - Currently, there are €636 million in Retail Bonds outstanding, redeemable in 1-3 months on request by the holder; potential redemptions can increase cash buffer needs.
- PDMO’s limited authority over cash outflows:
  - PDMO cannot stop or slow down cash-outflows resulting from supplementary budget expenditure even when liquidity stock falls below minimum; PDML assigns PDMO task to raise additional funding to fill the gap, creating pressure to propose higher cash levels and higher AFP funding.
- Sovereign rating position implications:
  - S&P, Fitch, DBRS Morningstar: investment grade with stable outlook (before outbreak of COVID-19 outlook was positive).
  - Moody’s: two notches below investment grade with positive outlook.
  - Sovereign rating heavily dependent on banking system performance and legacy NPLs; progress interrupted by pandemic.
- Small issuer dynamics and market issuance:
  - Main source of funding: European EMTN market (issued under English Law).
  - Need to issue at least €1.0 bn nominal per bond to achieve benchmark size; small issuer status leads to an additional premium and potential liability management challenges.

### Monitoring rules and actions (PDML Article 21)
- If cash buffer falls below projected financing needs of next 9 months, PDMO must raise additional funding to complete the liquidity gap (Article 21(1)).
- If cash buffer exceeds projected financing needs of next 12 months, the excess cash must be used for early redemptions of outstanding debt or invested based on a written investment policy (Article 21(2)-(3)).
- Necessitates a cash-management policy framework and infrastructure for implementation.

### Investment policy and liquidity surplus management
- PDMO responsibilities:
  - Prepare a written investment policy for liquidity surplus (PDML Article 21(3)), with consultations before Minister of Finance approval.
- Investment considerations:
  - Maintain cash buffer for next 9–12 months before investing excess.
  - If choosing redemption of public debt instead of investments, consider:
    - (i) risk metrics not being affected negatively (weighted average maturity, interest rate and FX risk, counter-party risk),
    - (ii) a net fiscal benefit resulting or at least no net fiscal cost.
- Available investment options:
  - Deposits in domestic commercial banks.
  - Investments in T-bills or medium-term bonds of other sovereigns (denominated in euro).
  - Domestic commercial bank deposits unlikely to be beneficial given ample banking liquidity.
- Past frameworks and risk controls:
  - Previously: investments in domestic commercial banks with caps per bank, minimum credit rating, collateral in form of T-bills or government bonds; criteria adjusted several times.
  - Earlier attempts to develop a credit scorecard for banks using liquidity, capital adequacy, credit, interest and market ratios, and credit rating; availability lags of data were an issue.

### Cyprus assessment on investment and policy stance
- Key factors in forecasting liquidity buffers:
  - Split investment grade/non-investment grade ratings of the Sovereign and contingent liabilities from domestic banking sector.
  - Cyprus’ small issuer profile and investor requirement to issue individual tranches of €1 billion.
- Current modalities and constraints:
  - Investing cash balance is limited to deposits in the CBC earning a negative interest rate plus carry cost.
  - Options for placing deposits or investing domestically or internationally exist but are limited by abundant banking sector liquidity domestically and in the Euro area.
- Policy appropriateness and considerations:
  - Present PDMO policy to maintain 9-12 months in gross financing needs seems broadly appropriate.
  - PDMO could consider liability management operations to better manage near-term debt profile and better identify relevant risk indicators.
  - If PDMO moves to actively managing a share of liquid financial resources, it should consider metrics to evaluate investment performance (for PDMO and any external fund managers) and ensure compliance with investment policies.

*Source: Excerpt from IMF | CYPRUS Debt and Cash Management*

### 51.      Since the onset of the COVID-19 pandemic the borrowing requirement has

### Since the onset of the COVID-19 pandemic the borrowing requirement has

### Changes in borrowing requirement and forecasting during COVID-19
- The PDMO considers its 24 month-ahead forecasts of fiscal budget deficits reasonably accurate in normal times, but forecast quality has deteriorated during COVID-19 due to emergency spending responses and falls in revenue.
- The effects of extreme instability from COVID-19 are viewed as placing upward pressure on the size of the liquidity buffer.
- Projected government financing needs for 2020 were revised upwards from €2.3 billion to €5.6 billion, necessitating revisions of the Annual Financing Plan (AFP) for 2020; the AFP was revised three times during 2020 (last revised in August 2020).
- AFP 2021 was approved in October 2020 and revised periodically given continued uncertainty.

### AFP December 2020 – September 2021 (summary figures from Table 5)
- (a) Balance of cash available 1/12/2020: 4109 (million euros)
- Remaining long-term debt maturity 2020: 818 (million euros)
- EIB/CEB loans: 20 (million euros)
- Budget Cash deficit Dec. 2020: 203 (million euros)
- (b) Use of available cash: 1001 (million euros)
- Total financing needs Dec. 2020: 1021 (million euros)
- Total remaining funding 2020: 1021 (million euros)
- Debt maturity for the 9 months of 2021: 1729 (million euros)
- (c) Cash balance forecast 31/12/2020 (a-b): 3108 (million euros)
- Budget Cash deficit (surplus) for 9 months 2021: (364) (million euros)
- Percentage of coverage of financing needs for 9 months (Jan.–Sept.) 2021 (c/d): 228%
- (d) Total Financing Needs for 9 months of (Jan.–Sept.) 2021: 1365 (million euros)
- Cash balance after meeting the financing needs Jan.–Sept. 2021 (c-d): 1743 (million euros)
- Source: PDMO, Ministry of Finance.

### December 2020 position and short-term coverage
- As of December 18, 2020, total financing needs for December 2020 projected to amount to €1.02 billion:
  - €818 million relates to long-term debt
  - €203 million relates to projected budget cash deficit for December
- These financing needs will be covered by existing cash available by 98 percent and by foreseen financing by 2 percent.
- Remaining state funding for 2020 expected to be implemented within the second fortnight of December 2020.
- Cash available at end-2020: €3.1 billion exceeds total financing needs for whole year 2021 of €2.2 billion (by €900 million), enabling consideration of early repayment (liability management) in 2021.

### Quantitative framework for liquidity buffers (Box 1 and related specification)
- Monthly sovereign financing needs y(t) formula:
  - y(t) = x(t) + z(t) - w(t) + u(t)[r(t), m(t), c(t), s(t)]
    - x(t): refinancing needs for month t
    - z(t): budget balance in cash terms (deficit positive, surplus negative) for month t
    - w(t): excess cash balance from previous month t-1 (with a negative sign)
    - u(t): extra (supplementary) cash liquidity for precautionary purposes depending on prevailing uncertainties for month t
    - u(t) composed of:
      - r(t): size of redeemable bonds at month t
      - m(t): mandate of the PDMO to raise an unscheduled amount funds at month t
      - c(t): risk of credit rating deterioration for market access for month t
      - s(t): small size of the issuer and its implications for refinancing (availability of funds) for month t
- Indicative factor specifications during the COVID-19 pandemic (adjustable by the PDMO):
  - r(t) = [75] percent of the size of redeemable bonds
  - m(t) = [50] percent of z(t)
  - c(t) = [75] percent of x(t)
  - s(t) = [50] percent of x(t)
- Indicative factor specifications during normal times, after the pandemic (adjustable by the PDMO):
  - r(t) = [25] percent of the size of redeemable bonds
  - m(t) = [10] percent of z(t)
  - c(t) = [25] percent of x(t)
  - s(t) = [10] percent of x(t)
- Definitions for cash buffer sizes:
  - B(min) = Minimum size of cash buffer, i.e., liquidity stock for next 6 months = Sum of y (t=1 to 6)
  - B(max) = Maximum size of cash buffer, i.e., liquidity stock for next 9 months = Sum of y (t=1 to 9)
- Operational rules:
  - If actual liquidity stock > B(max) at month t, PDMO decides on investment options for excess liquidity (positive difference).
  - If actual liquidity stock < B(min) at month t, PDMO decides on additional funding options to fill the gap (negative difference), taking into account existing sovereign debt portfolio.

### Factors influencing calibration of the cash buffer
- Factors placing upward pressure on buffer size:
  - Split investment grade/non-investment grade sovereign ratings from contingent liabilities imposed by the domestic banking sector and potential effects on market access.
  - Cyprus’ profile as a small issuer combined with investor requirement to issue individual tranches of €1 billion, potentially leading to liability management challenges and limited secondary market options.
- The PDMO can calibrate the framework based on COVID-19 experience and updated public finance forecasts.

### Recommendations regarding the AFP and liquidity buffer
- It is recommended that the macroeconomic scenario prepared by the Ministry of Finance be reviewed at regular intervals to strengthen validity and reliability of budget forecasts and forecasts for government liquid assets for the next year.
- Specific mission recommendations for AFP preparation and cash buffer sizing:
  - (i) modify procedures for the development of the AFP to ensure it fully captures information to calibrate the cash liquidity buffer
  - (ii) update the internal model for quantifying the cash liquidity buffer and keep it under review

### Management of the cash liquidity buffer — investment options and considerations
- Pre-funding is the predominant source of DMO cash buffers; prudently dimensioning buffers and managing cost of carry is important to minimize all-in debt service cost.
- Investment instruments and considerations:
  - Central bank/ECB deposits:
    - ECB deposit facility rate has been negative for some years, increasing carrying cost; nevertheless, a significant level of central bank deposits remains necessary for immediate availability.
  - Commercial bank deposits:
    - Require credit risk management and a risk framework for amounts, tenors, and products.
    - Private sector banks are increasingly passing on the cost of placing liquidity at the central bank to institutional clients; negative rates for institutional clients have been reported in the Cypriot banking system.
    - While less attractive, commercial bank deposits could spur demand for an expanded T-bill issuance and require possible adjustments (settlement arrangements, establishment of a repo program).
  - Investments in other Eurozone sovereign obligations:
    - Eurozone sovereign T-bills and bonds currently offer negative yields; yields remain negative further down the curve until after 7 years, producing material maturity mismatch for a short-term liquidity buffer.

### Liability Management Operations (LMO) — using the cash buffer to influence liquidity requirements
- Role and appraisal:
  - LMOs allow debt managers to respond to market condition changes and funding program needs; for Cyprus, LMOs would be refinements to the MTDS objectives.
  - LMOs can assist in achieving optimal access to liquidity, acceptable borrowing costs, and optionality to minimize liquidity buffer size.
- LMO types and considerations:
  - Retiring outstanding debt:
    - Using a share of the liquidity buffer to repay maturing obligations as they fall due; requires consideration within overall debt management and communication to markets and rating agencies.
    - 2021 redemptions are limited to decisions regarding the 12-month T-bill maturity in April 2021.
  - Purchasing debt in the secondary market:
    - Opportunistic purchases should be relatively small to avoid market distortion; achieving material nominal amounts may be challenging amid investor reinvestment concerns.
    - Tender offers provide higher liquidity to investors but may be less cost effective under current conditions focused on HQLA; costs must be weighed against program objectives.
    - Debt repurchases are more typical when amassing liquidity via budget surpluses rather than pre-funding; repurchases reduce nominal amounts of marketable securities and affect future market development and funding requirements.
  - Debt exchanges (mentioned as an LMO category for consideration).

*IMF | CYPRUS Debt and Cash Management*

### 83.      DMOs often consider the use of LMOs to actively manage their refinancing risk

### 1cypea2022001 - 83.      DMOs often consider the use of LMOs to actively manage their refinancing risk

### Use of LMOs to manage refinancing risk
- DMOs often consider the use of LMOs to actively manage their refinancing risk by adjusting their maturity profile with debt exchanges.
- One characteristic of such a debt swap is that debt maturities can be transformed into maturities more attractive to the DMO.
- Current markets conditions are potentially conducive for DMOs as higher average duration of debt can be achieved at historically low costs, sometimes even negative rates.
- If higher average duration is of interest, such LMOs could lower the required/desired liquidity buffer size by lessening refinancing requirements in the near term.

### Towards an Investment Policy Framework
- To decide on whether a part of the cash buffer could be invested in instruments other than deposits, a determination needs to be made on the part of the cash surplus that should be readily available.
- The remaining amount could be invested in longer-term instruments or be considered for retirement.
- It is important to have a quantitative framework/metrics in place to generate the level of cash surplus that could be invested or bought back.
- Metrics to assist the PDMO to evaluate its own performance, i.e., to allow a self-assessment of the earnings or losses from undertaking such investments, should also be in place.
- These frameworks/metrics are missing and are identified as key gaps by the mission.

- The mission looked at conceptual aspects of developing a basic scenario for the PDMO’s investment policy addressing the current COVID-19 situation. These aspects include:
  - (i) delineation of the objective of setting up a liquidity surplus investment policy (i.e., a cash-management framework),
  - (ii) determination of the infrastructure needed at PDMO for implementing the above-mentioned cash-management framework,
  - (iii) identification of the necessary procedures required by the PDMO personnel to execute all related actions for implementing this project,
  - (iv) identification of necessary resources in terms of infrastructure and personnel,
  - (v) setting up a related framework with specific quantifiable metrics,
  - (vi) setting up necessary governance and control policies,
  - (vii) development of a system to assist with monitoring cash liquidity (Box 2).

- If the necessary infrastructure for managing FX risk is considered insufficient at the PDMO, the mission offered general considerations for potential outsourcing the management of the cash-buffer funds, including:
  - (i) the identification and adoption of minimum criteria requirements for recruiting such fund managers,
  - (ii) setting up a system for their selection, that is in line with international best practices,
  - (iii) identification and setting up of their obligations,
  - (iv) development of procedures to monitor and evaluate their performance.

### Box 2 — Investment Guidelines for Excess Cash (summary)
- A more sophisticated investment activity would require the PDMO to adapt an investment framework encompassing current conditions as well as perhaps a return to a more normalized rate and yield curve environment.
- The investment strategy of the excess cash reserves should be consistent with the cash and debt management strategies set by PDMO and supported by an appropriate audit system and suitable reporting and accounting frameworks.
- The PDML should be appropriately modified to allow the investment of the excess cash reserves, where:
  - the authority to undertake such investment should be established,
  - the determination of the size of the excess cash to be invested should be clearly defined,
  - the objectives of the invested funds should be explicitly stated,
  - the permissible instruments for investment, including currency, tenor, and credit quality, and the investment performance be reported.
- Institutional and organizational frameworks for investing excess cash should be developed with sound institutional and governance arrangements covering delegation of authority, decision processes, clearly stated roles, responsibilities and accountabilities, resolution of differences, breaching of responsibilities, and specified reporting systems.
- Investment management activities should be based on published investment mandates and investment frameworks that specify the risk tolerance of the investment entity (PDMO).
- Internal operations would require appropriately qualified and well-trained staff subject to a code of conduct and conflict of interest requirements.
- If external investment managers are used, a clearly stated selection process and a detailed oversight framework should be in place.

*Source: Mission Team.*

### Recommendations
- A more flexible and reliable short-term financing tool would be complementary and, in general, would reduce the need for a large cash buffer.
- The reliance to predominantly long-term (greater than one-year maturity) debt instruments to fund the cash buffer may need to be revisited by the PDMO, with a view to shift to shorter-term financing sources, especially T-bills.

*Source: Mission Team.*

### 88.      When the pandemic comes to an end, and conditions start normalizing, there are

### 1cypea2022001 - 88.      When the pandemic comes to an end, and conditions start normalizing, there are

### Options to expand investments for the cash surplus
- When the pandemic ends and conditions normalize, investment options for the cash surplus can expand beyond domestic and international bank deposits to include:
  - Instruments from other euro-zone governments that may offer higher yields than commercial-bank deposits, possibly by taking some duration risk.
  - Paying back maturing debt by undertaking liability management operations (see Table 1 in source).

### Annex 1 — T-bills settlement procedures (Cyprus PDMO)
- Legal and market setup:
  - T-bills are issued under Cypriot law, sold through auction using the Bloomberg auctioning system, and listed on the Cyprus stock exchange (CSE), which acts as the depository.
- Participation and credit risk:
  - No delivery versus payment system is currently in place; the Republic faces credit risk in auctions because money may not be paid while securities are delivered to CSE accounts.
  - PDMO limits auction participation to domestic banks and allows banks to bid on behalf of clients provided banks are solely responsible for funds.
- Custody alternative:
  - Holders need accounts with the CSE or a custodian; Clearstream’s custodian account with the CSE can be used to sidestep direct CSE accounts (one documented primary-market case).
- Clearing and settlement — domestic investors/domestic custodians:
  - i. Auction takes place – results are notified to participants
  - ii. PDMO prepares (with input from the banks) an excel file with details to set up the securities in the depository
  - iii. The excel file is sent to the CSE which checks it and sends it back to the DMO for final confirmation
  - iv. Final confirmation is given by the DMO to the CSE
  - v. The banks deposit the necessary funds by 9:30 in the morning of the settlement date. This is monitored by the DMO.
  - vi. Unless otherwise informed by the DMO the CSE distributes the securities to the holders at 10:30 in the morning
- Clearing and settlement — international investors/Clearstream account (one such case):
  - i. Auction takes place – results are notified to participants
  - ii. PDMO prepares (with input from the banks) an excel file with details to set up the securities in the depository
  - iii. The excel file is sent to the CSE which checks it and sends it back to the DMO for final confirmation
  - iv. Final confirmation is given by the DMO to the CSE
  - v. The bank that input the bid for the international investor notifies Clearstream and the controller of its account with the CSE about the coming transaction
  - vi. The banks deposit the necessary funds by 9:30 in the morning of the settlement date. This is monitored by the DMO
  - vii. Unless otherwise informed by the DMO the CSE distributes the securities to the holders at 10:30 in the morning
  - viii. Once the securities are in the Clearstream custodian account they are allocated to the bank’s own Clearstream account and then the bank transfers the securities to the Clearstream account of the investor who bought the T-bills.
- Repayment:
  - The CSE prepares payment instructions based on depository data and sends them electronically to the Treasury (Office of the Accountant-General). The Treasury executes the repayment.

### Annex 2 — Experiences of PDMOs in managing cash buffers (overview and recent practices)
- Purpose and trade-offs:
  - Cash management mitigates refinancing risk. Building a cash buffer has opportunity cost because sovereign funding cost is typically higher than return on the buffer when the yield curve is upward sloping.
  - Cash buffers commonly comprise:
    - (i) a transactions buffer for unanticipated falls in cash balances from volatility and forecasting errors;
    - (ii) a safety buffer for unanticipated falls in cash balances from sudden disruptions in capital markets.
- Sizing and rationales:
  - Size should reflect debt manager’s needs for debt and liability management operations.
  - Some countries size buffers as the maximum financing needed if capital markets were disrupted for several months.
  - Buffer also provides investor comfort for honoring debt obligations, leaves room for inflows from pre-financing, and can be used for contingent liabilities or buybacks — all related to liability management operations (LMOs).
- Survey results and common practices (2018 OECD respondents):
  - 29 of 35 OECD countries that responded found liquidity buffers important and effective to mitigate refinancing and liquidity risk.
  - 93 percent of agencies with a liquidity buffer build up cash reserves through over borrowing.
  - Slightly more than half of respondents cite budget surpluses as a source of their liquidity buffer.
  - Cash is part of the liquidity buffer in more than 90 percent of agencies holding one; next most common holdings are highly liquid assets (e.g., T-bills and T-bonds), followed by credit lines.
  - Most common practice is to keep a buffer sufficient to meet one month of expenditures; targets vary (e.g., one week to one year) and scenario analyses are often conducted.
  - About half of countries carry only domestic currency in their liquidity buffer; asset liability management models commonly determine currency composition.
- Costs and investment policy:
  - Less than half of participants measure the cost of maintaining the liquidity buffer; most who measure compare it with the cost of funding.
  - Almost all participants invest excess cash balances to mitigate carry cost; common investments are demand/time deposits in local currency. Only a quarter invest in foreign currency assets.
  - Most have deposits at the central bank to mitigate credit risk; half of countries with a cash buffer have deposits at local private banks.
  - Counterparty rating limits are commonly used to manage investment risk.
- Pre-COVID and COVID-period behavior:
  - Prior to COVID-19 many DMOs reduced warehousing of liquidity as markets exhibited exceptional liquidity and falling interest rates increased carry costs; those with less consistent market access maintained larger buffers.
  - As COVID-19 unfolded, most DMOs increased cash buffers as insurance against market uncertainty.
- Country-specific considerations:
  - No one-size-fits-all methodology; even within the Euro-area approaches differ.
  - Countries with deep and liquid domestic markets (e.g., Germany and the Netherlands) do not pursue a target cash buffer policy.
  - Countries near an investment grade rating, with small issuance programs and less developed domestic money markets may place greater emphasis on refinancing risk and thus on buffers.

### Annex 3 — Views of domestic and international banks
- Debt issuance track record:
  - Banks were uniformly complimentary of the PDMO since the Global Financial Crisis and highlighted international investor participation despite a limited borrowing program.
  - Use of English Law for Cyprus securities was noted positively versus a trend of onshoring domestic law in the EZ.
  - Presence of a cash buffer provided comfort to investors by largely obviating near-term refinancing risk.
- Liquidity in Cypriot banking system:
  - Cypriot banks have high levels of liquidity; demand for HQLA is muted by high liquidity coverage ratios. Main source is retail deposits.
  - Major Cypriot banks have begun to pass through negative rates to institutional clients, including the public sector, which reduces the PDMO’s ability to use domestic commercial bank deposits for its cash buffer and pushes PDMO toward more expensive central bank deposits.
  - Upward pressure on liquidity is likely to continue given ECB policy and the need for Cypriot banks to restart wholesale funding by issuing senior unsecured debt.
- T-bill market:
  - Both international and domestic banks perceive the T-bill market as illiquid and operationally cumbersome.
  - Reported issues: sizes too small for market-driven auctions; settlement and custodian arrangements at CSE are expensive and may preclude international investor involvement.
  - Domestic banks would welcome more liquid and frequent T-bill issuance subject to resolving operational issues; international banks stress streamlining settlement and widening custodial arrangements beyond the CSE.
  - Domestic banks forecast higher demand for their own portfolios given negative commercial bank deposit rates. International banks expect international investor interest post-operational improvements but note potential size constraints versus large investors’ liquidity thresholds.
- Committed or contingent credit lines:
  - Banks, subject to pricing, were comfortable with Cypriot credit for providing contingent credit lines as an unfunded replacement for part of a funded cash buffer.
  - International banks questioned investor perception of such facilities, viewing them as more consistent with emerging market credits and possibly inconsistent with the Republic’s EZ sovereign profile.
- Suitable investments for the liquidity buffer:
  - Given current Euro-area liquidity, banks recognized challenges in identifying appropriately yielding instruments with suitable credit, maturity and liquidity for a DMO liquidity buffer.

### Annex 4 — PDMO procedures for developing the Annual Funding Plan (AFP)
- Legal basis and alignment:
  - Pursuant to Article 10 (1) of the PDM Law, the PDMO prepares an AFP every fiscal year covering projected government financing needs for the next year, based on Medium-Term Debt Management Strategy (MTDS) guidelines approved by the Council of Ministers.
- Step-by-step AFP preparation (example AFP 2021; approval not later than end-November 2020):
  - Step 1: Projections of total funding needs for next year (2021)
    - Total amount = annual fiscal surplus/deficit 2021 (in cash/money terms) plus scheduled debt redemptions 2021.
    - Fiscal surplus/deficit projections prepared by Directorate of Economic Policy (DEP) of Ministry of Finance, aligned with Stability Program and Draft Budgetary Plan under Regulation EU 473/2013; projections are both annual and monthly.
    - Scheduled debt redemptions and refinancing needs are estimated by PDMO for short-term and long-term debt.
  - Step 2: Projection of cash balance by end of 2020
    - PDMO considers current 2020 cash balance, monthly fiscal surplus/deficit 2021 (DEP series), monthly debt redemptions 2021, and scheduled remaining borrowing for 2020.
    - PDMO compares projected end-2020 cash balance with total 2021 funding needs and checks whether the cash buffer target is satisfied.
    - Cash buffer target is determined such that cash must be enough to cover financing needs of the next 9-12 months on a rolling basis (e.g., by end-2020 ensure cash sufficient to cover January–September 2021).
    - Excess cash by end-2020 can be used for partial funding of 2021.
  - Step 3: Determining the funding plan for 2021
    - Takes into account MTDS 2021–2023 guidelines and the cash balance target for end-2021.
    - Objective: cover total funding needs of 2021 using borrowing tools (mainly EMTNs in international capital markets), considering any excess cash buffer.
    - PDMO also forecasts 2022 funding needs on a monthly basis.
    - Factors considered include:
      - Cyprus being a small issuer with limited market access frequency;
      - Uncertainty of market conditions (reason to maintain liquid funds for 9–12 months);
      - Credit rating profile of the Republic of Cyprus;
      - Risk of temporarily losing market access;
      - Monitoring EU policies and interest variations.
  - Step 4: Finalizing cash buffer size and AFP for 2021
    - PDMO finalizes results from step 3, accounting for prevailing uncertainty.
    - Example adjustment: due to the pandemic, PDMO increased pre-funding period from range of 6 – 9 months to range of 9 months – 12 months ahead.
- Box 1 — Mathematical equation used for the AFP:
  - y_{t+1} = x_{t+1} + z_{t+1} – w_{t} + u_{t+1}
  - where:
    - y = financing needs
    - x = refinancing needs
    - z = budget deficit in cash terms (if surplus it takes a negative sign)
    - w = Excess cash balance (cash exceeding the financing needs of the next 12 months)
    - u = extra (supplementary) cash buffer for precautionary purposes depending on prevailing uncertainty

*IMF | CYPRUS Debt and Cash Management (excerpts from content unit 1cypea2022001)*

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_Source: https://www.imf.org/-/media/files/publications/cr/2022/english/1cypea2022001.pdf_