## How to Set Up a Cash Buffer: A Practical Guide to Developing and Implementing a Cash Buffer Policy (htnea2020004)

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### Role, scope, and purpose
- Cash buffer definition: “the minimum level of cash balances necessary to be sure of meeting day-to-day cash requirements, at all times, under all circumstances, taking into account the availability of other liquid resources” (Williams 2016).
- Primary objectives:
  - Ensure availability of liquidity in government bank accounts.
  - Mitigate funding/refinancing risk from the debt-management perspective.
  - Manage cash flow volatility and timing mismatches between revenue collections, expenditures, debt inflows, and debt service.
- Typical placement and exclusions:
  - Buffer usually sits within the Treasury Single Account (TSA) or main government bank account in local and foreign currencies.
  - Credit lines, contingent funding arrangements, and overdraft facilities are complementary but not considered cash.
  - Sovereign wealth funds and stabilization funds are distinct (longer-term, separate management).

### Prevalence, typical size, and examples of disclosed targets
- Aggregate statistic:
  - Average central government cash balances at the central bank were 3 percent of GDP at end 2018.
- Examples of disclosed cash buffer targets (as reported):
  - Brazil (2020): Six months of federal public debt service in the market in domestic currency; additionally maintains a foreign currency reserve to service annual foreign currency debt.
  - Canada (2019/20): One month of net projected cash flows, including coupon payments and debt refinancing needs.
  - Denmark (2020): Comparable to the annual refinancing requirement of government bonds.
  - Greece (2019): Next four years of debt service, excluding treasury bills (about €32 billion as of end of September 2019).
  - Hungary (2020): Total of six weeks of financing needs.
  - Portugal (2018): Forty percent of the next 12 months of financing need.
  - Romania (2018): Four months of gross borrowing needs in foreign currency.
  - Turkey (2014): An undisclosed percentage of annual debt service.
  - Uruguay (2014): More than the annual debt service.
  - US (2015): Total of one week of cash outflows.
- Unit-specific figures and examples:
  - 28.6 billion, around 1.3 percent of GDP (presented as an example figure for cash balances/cost of carry discussion).
  - Denmark target example for 2019 cash balance: DKr 50–75 billion (2 to 3 percent of GDP).
  - Portugal (end of 2018): IGCP cash buffer €9.3 billion, or 4.6 percent of GDP.
  - US Treasury cash balances: increased from $400 billion in January 2020 to $1.7 billion by end of June 2020 (reported as historically high).
  - Lesotho central government cash balances at the central bank (year-end): 2014 19% ; 2015 18% ; 2016 10% ; 2017 3% ; 2018 4%.

### Decision factors and sources of liquidity risk
- Key determinants of target size:
  - Types of risks perceived and risk management objectives.
  - Availability of other mitigation mechanisms (overdrafts, credit lines, primary dealer commitments).
  - Cost of carry (borrowing or opportunity cost vs. return on invested buffer).
- Main sources of liquidity risk:
  - Volatility and unpredictability of budgetary cash flows and forecast errors.
  - Risks in the availability of funding (undersubscriptions, auction failures, delayed loan disbursements).
  - Refinancing/rollover risk from concentrated or short maturity profiles.
  - Operational risks to auctions (storms, cyberattacks, electronic system disruptions).
- Causes of forecast errors:
  - Unrealistic fiscal projections (revenues overestimated and/or expenditures underestimated).
  - Model risk: poor calibration of forecasting models.
  - Inadequate exchange of information between central CMU forecasts and bottom-up agency data.
  - Misunderstanding differences between budget process and cash management, causing timing misalignment.

### COVID-19 implications (selected observations)
- Pandemic effects:
  - Increased borrowing needs, market volatility, operational risks, and unpredictability in government cash flows.
  - Weaker auction demand in some jurisdictions and potential increases in borrowing costs.
- Buffer responses and actions:
  - Denmark and Sweden referred to cash reserves or liquid assets in early policy announcements.
  - US Treasury increased cash balances from $400 billion in January 2020 to $1.7 billion by end of June 2020.
  - Uruguay revised financing program to shore up liquidity via faster disbursements and new multilateral loans.
  - Hungary aimed to increase liquidity reserves by early execution of international bond issuances during 2020.
- Role of buffers: provide access to needed cash until long-term financing is available and/or fiscal measures are reintroduced.

### Cost of carry and investment operations
- Cost of carry definition: difference between the cost of holding the cash buffer and the return on funds if invested.
- Typical remuneration and implications:
  - Government cash often kept at the central bank; remuneration tied to policy rate or non-remunerated.
  - Returns linked to very short end of yield curve; cost of carry driven by margin between long- and short-term rates.
  - Low short-term rates plus upward-sloping yield curve create a positive cost of carrying cash when government pays higher yields on treasury bills than returns on deposits.
- Examples of measurement approaches:
  - Denmark: compares future short-term rates and current longer-dated financing cost (term premium).
  - Portugal (IGCP): publishes three different cost measures for the cost of carry.
  - Canada: uses treasury bill rates to estimate cost.
  - Brazil: central bank remunerates buffer at same rate as its portfolio of government securities.
- Example cash investment operations:
  - Two-round daily auctions: morning auctions fully collateralized; afternoon auctions invest 10 percent of the remaining excess liquidity overnight and are not collateralized.
  - Cost of carry computed as difference between (1) return on government cash balances auctioned to financial institutions (typically around the overnight rate), and (2) the weighted average yield paid on treasury bills.

### Practical approaches to determining the target buffer
- Two perspectives and corresponding formulations:
  - Debt-management perspective (cover portion/whole of debt service over period t to t+n):
    - Target CB_t = D_t,t+n * (1 - C%) (1)
      - CB_t = target cash buffer at beginning of month t.
      - n = duration of potential stress period in months.
      - D_t,t+n = ∑_{i=t}^{t+n} D_i (projected debt service).
      - C = ratio of debt service that can be rolled-over/covered with primary dealer commitments and/or other resources.
    - Alternative: Target CB_t = D_t,t+n - C_nom (C_nom = nominal amount of mitigation).
    - Smoothing options:
      - Target CB_t = D_max * (1 - C%) (2) where D_max = Max(D_t,t+n), t=1,...,N.
      - Target CB_t = D_avg * (1 - C%) (3) where D_avg = average(D_t,t+n), t=1,...,N.
    - Numerical example: potential stress period n = 3 months with C = 0.5.
  - Cash-management (daily transactions) perspective (cover transactional outflows excluding borrowing/redemptions):
    - Target CB = [ max_j ∑_{i=1}^{m_j} (Net outflow in day i ) ] * (1 + x%) - OD (4)
      - m_j = duration of stress period j in days.
      - x = historical daily forecast error (scaling factor).
      - OD = level of cash available through existing mechanisms (overdraft).
    - Alternative average: Target CB = [ average_j ∑_{i=1}^{m_j} (Net outflow in day i ) ] * (1 + x%) - OD (5)
    - Practical simplification: replace net flows with outflows for prudence (US example: buffer to cover one week of outflows).
  - Inventory-modeling / safety-stock analogy:
    - Target CB = z * m * σ_d - OD (6)
      - m = desired period of coverage (in days).
      - z = z-score (z-score for a 95 percent confidence level is 1.65).
      - σ_d = standard deviation of daily changes in the TSA.
- Operational considerations:
  - Choose rolling horizon (moving target) vs. fixed level based on risk perception and ability to actively manage balances.
  - Transactional buffers will be withdrawn more frequently in smaller amounts; debt-service buffers used less often but in larger sizes.

### Two-tiered and joint buffer design
- Two-tiered structure:
  - Tier-1 (“safety”): infrequently used, meant to meet debt service in market stress; can be invested longer term.
  - Tier-2: for transactional daily cash flow volatility.
  - Total buffer = Tier-1 + Tier-2; Tier-1 based on formulas (1), (2), or (3); Tier-2 on (4), (5), or (6).
- Joint cash buffer target:
  - Unify cash and debt management perspectives by including financing and repayments in buffer analysis.
  - Canada example: overall liquidity maintained to cover at least one month of net projected cash flows, including coupon payments and principal.

### Governance, coordination, and public communication
- Governance framework should address coordination, transparency of target policy, legal/regulatory issues, and investment strategy.
- Regulatory implications:
  - Legal constraints (debt rules, annual borrowing limits) may require legal or operational adaptations to accumulate buffers.
  - Ringfencing: define conditions for usage, permissible deviations, and remedial measures.
- Coordination and information flows:
  - CMUs, DMUs, central bank, and spending/revenue agencies require timely, frequent information sharing.
  - Formal arrangements (MOUs, committees) can institutionalize coordination; examples: Canada, Poland, Turkey.
- Public disclosure:
  - Public disclosure of policy and actual buffer levels enhances credibility and fiscal transparency (examples: Canada, Denmark, Italy, US).
  - Some countries disclose policy but not numeric targets/levels to avoid misperceptions.

### Balance sheet, fiscal strategy, and market implications
- Building buffers affects the sovereign balance sheet and borrowing strategy:
  - Options to build buffer: issue additional debt, sell financial/fixed assets.
  - Over-borrowing risk: borrowing to accumulate buffers can pressure market liquidity and interest rates and may require phased approaches.
  - Market absorption capacity and communication are essential when front-loading issuance.
- Using fiscal windfalls or one-off revenues to build buffers requires political commitment and adjustment of spending or borrowing.

### Investment policy and credit risk
- Investment choices should match liquidity needs and risk tolerance:
  - Common instruments: money market instruments, repo, deposits with central bank or commercial banks.
  - Longer-term investments appropriate for Tier-1 funds intended for debt service coverage.
- Credit risk mitigation:
  - Holding buffer at central bank reduces credit risk but may lower remuneration.
  - Counterparty limits and credit-quality restrictions are typical policy tools.

### Country cases and operational examples
- Canada:
  - Two-round daily auctions (morning fully collateralized; afternoon 10 percent of remaining excess liquidity, overnight, not collateralized).
  - Maintains Can$ 20 billion callable demand deposit for prudential liquidity (callable deposits maintained at fixed level unless otherwise needed).
- Hungary (ÁKK):
  - Minimum TSA balance evolved post-crises; from four to six weeks of issuance to a percentile-based rule (98th percentile of one-day budgetary expenditures of previous two years).
  - Uses optimal balance calculation based on six weeks of financing needs and contingency credit lines.
- Portugal (IGCP):
  - Initial target 100 percent of next 12 months’ gross borrowing needs (excluding treasury bills), later reduced to 50 percent then 40 percent as Investment Grade status returned.

### Special cases and interactions with monetary policy
- Building or maintaining buffers affects central bank liquidity and monetary policy operations.
  - Government withdrawals to build buffers can assist central bank sterilization when excess liquidity exists.
  - Over-borrowing in scarce liquidity conditions amplifies shortages and can be costly.
  - If buffers include foreign currency holdings, they directly affect central bank international reserves.
- Lesotho example:
  - Peg to South African Rand achieved by maintaining NIR; central bank reserves moved in parallel with government cash balances due to cross-border liquidity flows.
  - Quarterly movements documented across 2015: Q1 to 2019: Q4.

### Governance checklist and concluding considerations
- Quantitative analysis: cash flow volatility, forecast errors, and potential stress duration are key inputs.
- Qualitative assessment: existing mitigation mechanisms and market access depth.
- Trade-off: sufficient buffer to cover liquidity strains versus minimizing carry costs.
- Practical design steps:
  - Analyze historical stress episodes and forecast errors.
  - Factor in mitigation mechanisms and market access.
  - Select appropriate formula and horizon (debt vs. transactional perspective).
  - Define governance, investment policy, coordination arrangements, and disclosure strategy.

*International Monetary Fund | December 2020*

### 1. Introduction ........................................................................................................

### 1. Introduction

### Role and definition of a cash buffer
- Maintaining a cash buffer is a risk management tool for government cash and debt management to address cash flow volatility and timing mismatches concerning revenue collections and expenditures, debt inflows, and debt service.
- Cash balance management aims to ensure availability of liquidity in government bank accounts and, from a debt management perspective, to mitigate funding risk.
- The cash buffer is defined as “the minimum level of cash balances necessary to be sure of meeting day-to-day cash requirements, at all times, under all circumstances, taking into account the availability of other liquid resources” (Williams 2016).
- The governance structure for a cash buffer covers coordination, communication, and investment strategies for managing cash balances.

### Scope and relationship to other instruments
- The cash buffer, as used in this note, typically sits within the Treasury Single Account (TSA) or main government bank account under the treasury’s control and includes funds in local and foreign currencies available for daily short-term liquidity needs and medium- to long-term financing requirements.
- Credit lines, contingent funding arrangements, and overdraft facilities are not considered as cash; they are complementary to the cash buffer.
- The cash buffer is distinct from sovereign wealth funds or stabilization funds (funds of structural cash surpluses), which are usually managed separately with longer-term investment policies.

### Purpose of the note
- The note provides policy and technical recommendations for setting up a cash buffer target, drawing on country practices.
- Structure of the note:
  - Section 2: Overview of country practices for cash buffers.
  - Section 3: Decision factors for setting the target cash buffer level.
  - Section 4: Practical approaches to determining the target buffer.
  - Section 5: Other issues to consider when developing a cash buffer policy.
  - Annexes: Central government cash balances at the central bank; templates for cash buffer targets for debt management and cash management.

---

### Overview of Cash Buffer Practices

### Prevalence and typical size
- Many countries, from developing to advanced economies, hold consistent cash balances in their central bank accounts.
- Average central government cash balances at the central bank were 3 percent of GDP at end 2018.
- Not all countries have systematically and explicitly identified the minimum amount of cash reserves needed, embedded a target cash balance level in policy frameworks, or structured cash and debt management operations to achieve a target.

### Adoption and objectives
- Over the past decade, more governments have adopted cash buffer policies to support cash and debt management and budget execution.
- An OECD survey found that most member countries (29 out of 35 respondents) maintain cash buffers to mitigate timing mismatches, risks of deviations in cash flow forecasts (revenue and expenditure), and refinancing risks.
- Cash buffers are part of policy frameworks in countries including Canada, Portugal, and the United States.
- Country experiences during the 2008–09 crisis and the European debt crisis prompted several OECD countries (Denmark, Hungary, Mexico, Poland) to adapt cash buffer policies to boost market confidence and provide flexibility in funding options.
- Example: In Greece, cash reserves were sufficient to cover the debt service for the next four years (about €32 billion as of end of September 2019), assuming treasury bills are rolled over.

### Methods and adjustments
- There is no one-size-fits-all methodology to determine the optimal size of the cash buffer; governments utilize different methods.
- Cash buffers are intended to be held for extended periods, although targets can be reviewed occasionally as underlying factors change (cash flow forecasting capacity, debt repayment profile, cost of carry, external market conditions).
- Several governments reviewed or recalibrated cash buffer targets in response to the COVID-19 pandemic.

### Examples of disclosed cash buffer targets (as reported)
- Brazil (2020): Six months of federal public debt service in the market in domestic currency; additionally maintains a foreign currency reserve to service annual foreign currency debt.
- Canada (2019/20): One month of net projected cash flows, including coupon payments and debt refinancing needs.
- Denmark (2020): Comparable to the annual refinancing requirement of government bonds.
- Greece (2019): Next four years of debt service, excluding treasury bills.
- Hungary (2020): Total of six weeks of financing needs.
- Portugal (2018): Forty percent of the next 12 months of financing need.
- Romania (2018): Four months of gross borrowing needs in foreign currency.
- Turkey (2014): An undisclosed percentage of annual debt service.
- Uruguay (2014): More than the annual debt service.
- US (2015): Total of one week of cash outflows.

---

### Decision Factors for Setting the Target Cash Buffer Level

### Inputs and considerations
- Determination of the target level depends on a combination of factors: types of risks perceived, objectives of risk management, availability of other risk mitigation mechanisms, and the cost of carrying the buffer.
- Core focus: management of liquidity risk (risk of insufficient cash to satisfy obligations on a given day).

### Sources of liquidity risk
- Volatility and unpredictability of budgetary cash flows, leading to forecast errors.
- Risks in the availability of funding, e.g., less borrowing than planned due to undersubscriptions in auctions or delays in loan disbursements.

### Cash flow volatility and forecast errors
- Governments face considerable cash flow volatility during budget execution due to timing mismatches between cash inflows and outflows; this can lead to temporary cash surpluses or shortfalls independent of fiscal stance.
- Cash flow forecasts are central to planning; forecast errors measure discrepancies between forecasts and outturns and reflect inherent volatility.

### Causes of forecast errors
- Unrealistic fiscal projections (budget preparation not credible—revenues overestimated and/or expenditures underestimated) make deviations from initial cash flow forecasts inevitable.
- Poor calibration of forecasting models and tools (“model risk”), especially when cash flow patterns are unstable or changing over time.
- Inadequate exchange of information among government agencies—central CMU forecasts (top-down) need timely bottom-up information from spending and revenue collection agencies; inefficient communication can lead to omission or underestimation of infrequent but large flows.
- Lack of proper understanding of differences between the budget process and cash management, producing timing differences and misalignment.

---

### COVID-19: Implications for cash buffers (selected observations)
- The COVID-19 pandemic increased borrowing needs, market volatility, operational risks, and unpredictability in government cash flows.
- Surges in funding needs with adverse market conditions led to weaker auction demand in some jurisdictions and potential increases in borrowing costs.
- Existing cash buffers have served as a first line of defense:
  - Denmark and Sweden referred to cash reserves or liquid assets in early policy announcements addressing COVID-19.
  - The US Treasury increased cash balances from $400 billion in January 2020 to $1.7 billion by end of June 2020 (reported as historically high) to maintain prudent liquidity.
  - Uruguay revised its financing program to shore up liquidity buffers via faster disbursements from existing arrangements and new loans from multilateral institutions.
  - Hungary disclosed an objective to increase liquidity reserves by early execution of international bond issuances during 2020.
- As the impact of COVID-19 continues, cash buffers provide access to needed cash until long-term financing becomes available and/or fiscal measures are reintroduced.

---

*International Monetary Fund | December 2020*

### Box 1. Responding to COVID-19 Challenges: The Case for Cash Buffers

### Box 1. Responding to COVID-19 Challenges: The Case for Cash Buffers

### Forecast errors and liquidity risks
- Cash flow forecast errors arise from:
  - Timing differences between when revenues and expenditures are recorded in the budget and the actual date that the corresponding funds are deposited in or withdrawn from the TSA.
  - Realization of contingent liabilities (both explicit and implicit), including calls on guarantees or government insurance schemes that lead to unforeseen cash flows in timing and magnitude.
- Cash flow forecasts should ideally include estimates for contingent liability outflows based on expected losses, but actual outturns can differ, producing forecast errors.
- Even with realistic fiscal aggregates and reasonably reliable forecast models, inherent volatility in cash flows makes some variation between actual data and forecasts inevitable.
- The magnitude of historical or potential forecast errors is important in assessing risk:
  - More volatile cash flows imply a wider range of forecast errors.
  - Institutional constraints may limit the CMU’s capacity to generate forecasts within a reasonable margin of error.
- Purpose of the cash buffer: provide cash availability in case of deviations from forecasts.

### (Re)Funding risks
- Re(‑)funding risks stem from borrowing assumptions in the budget and cash flow forecasts, covering external debt and domestic market financing to meet deficits and refinance maturing debt.
- Debt management objectives (often run by a Debt Management Unit, DMU) aim to meet funding needs considering costs and risks.
- Refinancing or rollover risk: debt may need to be rolled over at unusually high interest cost or may not be rollable at all.
- Refinancing risk increases when the maturity profile is short and/or concentrated around particular periods.
- Factors exacerbating refinancing risk include: volatile market conditions, rapidly deteriorating economic indicators, lower credit rating, perception of poor governance, high political risk, high indebtedness, and financial distress (Jonasson and Papaioannou 2018).
- Access to swift cash avoids disruption of funding plans (for example, auction calendars) and supports predictability in public debt management.
- Lower-than-expected inflows from debt issuance reduce available cash for other spending; delays in disbursements of foreign loans have similar effects to undersubscriptions in domestic auctions.
- Divergent objectives between debt and cash managers can cause concentrated funding needs (e.g., benchmark bond issuance via reopenings on a regular auction calendar) that require management via short-term borrowing programs and/or the cash buffer.
- Operational risks to auctions (storms, cyberattacks, electronic system disruptions) can cause auction failures; these risks motivate maintaining buffers even in advanced economies.
- Speed of government reaction to market developments and time needed to revise borrowing plans and market-communicate new instruments are important determinants of target buffer size.
- Historical examples and policy responses:
  - The 2008–09 financial crisis showed markets can dry up even in advanced economies.
  - Market disruptions coinciding with high debt service days can leave governments unable to meet obligations; example: October 29–30, 2012 (US markets closed because of “Superstorm Sandy”), prompting US Treasury to revise its cash buffer policy.

### Availability of other mitigation mechanisms for risk management
- Central bank overdraft lines and ways-and-means facilities can reduce needed buffer size but are often prohibited or restricted; legal return periods (for example, a month) must be considered.
- Market-based short-term financing options (repurchase agreements, pre-agreed credit, overdraft lines with commercial banks) reduce cash buffer needs by offsetting financing deviations.
  - Example: In the Slovak Republic, primary dealers are obliged to set up a money market credit line to the government for trades worth at least €100 million, with a minimum tenor of 14 days (AFME 2017).
- Primary dealership systems and participation requirements can support continuity of funding:
  - Spain: each primary dealer must submit bids for a minimum nominal value of 3 percent of the amount allotted by the treasury for each security auctioned (AFME 2017).
  - France: primary dealers required to purchase a predetermined amount of securities over a certain period.
- Sinking funds vs. cash buffers:
  - Sinking funds are usually targeted to specific bonds and loans of higher volume and typically cannot be used for timing mismatches in regular budgetary cash flows; they are depleted after designated debt service.
  - Cash buffers are intended to be maintained at target levels for extended periods.
  - From a cash management perspective, sinking funds are less flexible and may lead to accumulation of idle cash in different accounts.

### The cost of carry
- Definition: “Cost of carry” = difference between the cost of holding the cash buffer and the return on these funds if invested.
- Cash buffers are often debt-financed (associated borrowing cost) or accumulated from primary surpluses (opportunity cost of not reducing debt or investing elsewhere).
- Carrying a cash buffer can be used to reduce future financing needs (like a sinking fund); the opportunity cost is akin to an insurance premium.
- Typical remuneration of government cash balances:
  - Often kept in the central bank; remuneration rate often relates to the policy rate or is non-remunerated.
  - Returns are linked to the very short end of the yield curve (policy or market rate); borrowing or opportunity cost is generally determined by longer-term borrowing rates, in line with average borrowing maturity.
- Yield curve implications: in usual market environments the yield curve is positively sloped; the cost of carry depends on the margin between long and short-term interest rates rather than the absolute level of rates.
- Cost of carry calculation approaches:
  - Approximate by average cost of borrowing.
  - Detailed analysis may compare borrowing cost for instruments to be dropped from the issuance plan (assuming reduced borrowing).
  - Denmark: comparison of future short-term rates and current longer-dated financing cost (term premium) used to estimate medium-term cost.
  - Portugal (IGCP): publishes three different cost measures for the cost of carry based on three different sets of assumptions.
  - Canada: uses treasury bill rates to estimate the cost.
  - Brazil: central bank remunerates the buffer at the same rate as its portfolio of government securities, offsetting borrowing cost to the extent the portfolio composition reflects government debt.
- Benefits of holding a cash buffer are difficult to quantify; main benefit is improved ability to meet unexpected cash needs and better market perception of sovereign capacity to service liabilities.
- Countries measure carrying cost to judge cost and relative changes across years (Portugal tracks carrying cost over a three-year period).

### Practical approaches to determining the target buffer
- Target level aligns with government risk management objectives in cash and debt management and depends on perceived risks and authorities’ priorities.
  - If buffer is to cushion market stress affecting borrowing auctions, it will be used less frequently but in larger sizes.
  - If buffer guards against budgetary cash flow forecast errors, it will be transactional, with smaller but more frequent withdrawals.
- Buffer targeting methods: rolling horizon basis (moving target) or fixed level, chosen based on risk perception and ability to actively manage cash balances.

### Country examples and policy changes
- US Treasury:
  - Adopted a cash buffer policy in 2015 to protect against potential loss of market access for auctions while continuing to make forecasted fiscal outflows.
  - In August 2014, Treasury announced plans to revise cash balance management policy citing effects of September 11, 2001, and Superstorm Sandy.
  - TBAC recommended reviewing cash balance policy as part of overall risk management.
  - Policy revised in June 2015; a minimum balance target was adopted to hold cash sufficient to cover one week of outflows in the Treasury General Account.
  - In 2018, average cash balances of the US Treasury amounted to around 1.5 percent of GDP.
  - In 2020, the cash balance policy was again revised as part of the policy responses to COVID-19.
- Canada:
  - Implements cash buffer policy under prudential liquidity management.
  - Holds liquid financial assets including domestic cash deposits and foreign exchange reserves.
  - Cash with the Bank of Canada includes operational balances and a Can$ 20 billion callable demand deposit held for the prudential liquidity plan; callable deposits are maintained at this fixed level unless otherwise needed.
  - Operational balances fluctuate; the average level of balances in fiscal year 2017/18 stood at a level of Can$ [text truncated in source].

*Source: Box 1 from "How to Set Up a Cash Buffer: A Practical Guide to Developing and Implementing a Cash Buffer Policy," International Monetary Fund | December 2020.*

### 28.6 billion, around 1.3 percent of GDP.

### htnea2020004 - 28.6 billion, around 1.3 percent of GDP.

### Cash investment operations and cost of carry
- Governments invest excess cash balances via short-term deposits allocated to banks and other financial institutions through auctions conducted in two rounds: one in the morning and one in the afternoon.
- Morning auctions are fully collateralized to mitigate counterparty risk.
- Afternoon auctions concern 10 percent of the remaining excess liquidity, which is invested overnight and is not collateralized.
- The cost of carry of the cash balances is computed as the difference between:
  - (1) the return on government cash balances auctioned to financial institutions (typically around the overnight rate), and
  - (2) the weighted average yield paid on treasury bills.
- Due to low short-term interest rates and an upward sloping yield curve, there is a positive cost of carrying cash for the government because financial institutions pay rates of interest for government deposits that are lower than the rate the government pays on treasury bills.
- Example figures from the unit:
  - 28.6 billion, around 1.3 percent of GDP.

### Country examples and practices
- Canada
  - Uses two-round daily auctions (morning fully collateralized; afternoon for 10 percent of remaining excess liquidity, overnight and not collateralized).
  - Source: Canada Department of Finance 2018 (as cited in the unit).
- Portugal (IGCP)
  - IGCP adopted a conservative cash buffer policy starting in 2011.
  - Initial target: cover 100 percent of the government’s gross borrowing needs in the following 12 months, excluding the rollover of treasury bills.
  - Target later reduced to 50 percent and then to 40 percent of the next 12 months’ financing needs as Portugal regained Investment Grade status.
  - At the end of 2018, the IGCP cash buffer stood at €9.3 billion, or 4.6 percent of GDP.
  - IGCP estimates the cost of carrying the cash buffer using three approaches:
    - (1) the implicit interest rate on the overall debt stock (implied by rates on current outstanding debt);
    - (2) the marginal cost of new funding in the year of consideration;
    - (3) the marginal cost of funding only using treasury bills.
- Hungary (ÁKK)
  - ÁKK is responsible for cash management operations; Hungarian State Treasury provides cash flow forecasts.
  - Historical evolution:
    - After 1997–98 crises, a minimum cash buffer policy was implemented.
    - Initially set as the sum of four to six weeks of issuance of bonds and 12-month bills.
    - Post-2008–09, buffer increased to cover several months of planned financing needs.
    - Beginning in 2013, modified to cover 50 percent of bond and loan redemptions in the first quarter.
    - Revised in 2017: minimum TSA balance set at the 98th percentile of one-day budgetary expenditures of the previous two years (equal to the 90th percentile of two-day expenditures).
  - Implements an “optimal balance” calculated based on six weeks of financing needs for drawing up financing plans.
  - Uses contingency tools including credit lines with commercial banks in foreign currency.
- Denmark
  - Example target level for 2019 cash balance: DKr 50–75 billion (2 to 3 percent of GDP), corresponding to annual refinancing of government bonds in the coming years.
- United States
  - Held a cash buffer to cover one week of outflows from the government’s account until recently (as an example practice).

### Cash buffer target design — debt management perspective
- General approach: target cash buffer set to cover whole or portion of debt service for a given period ahead.
- Steps summarized:
  - Step 1: Analyze potential duration of periods of stress (historical market/auction data; example stress in developing/emerging markets can be two to four months).
  - Step 2: Factor in existing risk mitigation mechanisms (precommitted funds from primary dealers, expected primary surplus, overdraft facility, credit lines).
  - Step 3: Formulate the target cash buffer level using calculated inputs.
- Formulae presented:
  - Target CB_t  =  D_t,t+n  *  (1-C%)                             (1)
    - Where: CB_t is the target cash buffer level at the beginning of month t.
    - n is duration of potential stress period in months.
    - D_t,t+n is the projected level of debt service within the timeframe (t,t+n), i.e. D_t,t+n = ∑_{i=t}^{t+n} D_i where D_i is the debt service in month i.
    - C is the ratio of debt service that can be rolled-over/covered with PD commitments and/or other resources.
  - Alternatively:
    - Target CB_t  =  D_t,t+n  -  C_nom
      - where C_nom is a nominal amount referring to the total magnitude of risk mitigation mechanisms.
  - Smoothing options:
    - Target CB_t  =  D_max  *  (1-C%)                               (2)
      - D_max = Max (D_t,t+n), t=1,...,N
    - Target CB_t  =  D_avg  *  (1-C%)                                (3)
      - D_avg = average (D_t,t+n), t=1,...,N
- Numerical example used in illustrative Figure:
  - Potential stress period n = 3 months with C = 0.5 (50 percent needs covered through available resources).

### Cash buffer target design — cash management (daily transactions) perspective
- Objective: mitigate extended periods of net cash outflows from the TSA balance by creating a buffer for budget execution needs (excluding borrowing and redemptions).
- Steps summarized:
  - Step 1: Analyze potential duration and magnitude of stress periods using reconstructed hypothetical TSA balances (excluding borrowing and debt repayments) or daily first differences adjusted for financial flows.
  - Step 2: Factor in forecast errors by calculating average and highest margin of errors comparing forecasts with outturns.
  - Step 3: Factor in existing risk mitigation mechanisms (overdraft facilities, short-term borrowing capacity).
  - Step 4: Formulate the target cash buffer level.
- Formulations presented:
  - Target CB  =  [ max_j  ∑_{i=1}^{m_j} (Net outflow in day i ) ]. (1+ x%)  -  OD                             (4)
    - Where: m_j is duration of stress period j in days.
    - x is the historical daily forecast error (or scaling factor).
    - OD is the level of cash available through existing mechanisms (such as overdraft).
  - Alternative (average):
    - Target CB  =  [ average_j  ∑_{i=1}^{m_j} (Net outflow in day i ) ]. (1+ x%)  -  OD                             (5)
  - Practical simplification: replace net flows with outflows for prudence; United States example: buffer to cover one week of outflows (historical practice).

### Inventory-modeling analogy and statistical approach
- Safety-stock analogy from logistics:
  - Simple safety stock formula: z-score * lead time * standard deviation of demand.
  - Cash management analogy:
    - Lead time = desired period of coverage (in days).
    - Demand volatility = standard deviation of daily changes in TSA balances.
  - Formula presented:
    - Target CB  =  z * m * σ_d  -  OD                       (6)
      - Where: m is the desired period of coverage (in days).
      - Z is the z-score (z-score for a 95 percent confidence level is 1.65).
      - σ_d is the standard deviation of daily changes in the TSA.
- Practical considerations:
  - Daily changes in TSA balances often show a symmetrical distribution around zero, but tails may be fatter than a standard normal distribution due to infrequent high-volume transactions (capital expenditure, salary payments).
  - In the presence of fat tails, use higher z-scores or alternative distributions depending on the government’s risk tolerance and data fit.
  - The cash buffer maintained for debt management is typically not used daily and can be invested for longer periods; measure cost of carry for different target levels and scenarios and weigh against benefits.

*Source: htnea2020004 - 28.6 billion, around 1.3 percent of GDP.*

### Annex 3 includes a template for a simplified exam-

### htnea2020004 - Annex 3 includes a template for a simplified exam-

### A Joint Cash Buffer Target
- Cash and debt management perspectives can be unified; a sufficiently sized cash buffer helps mitigate cash flow volatility and forecast errors and secures debt service and financing.
- Governments should have a unified cash buffer management policy to avoid over-borrowing and minimize cost of carry.
- One approach: include cash flows from financing and repayments in the cash management buffer analysis.
  - Example: In Canada, in 2017–18, the government’s overall liquidity levels were maintained to cover at least one month of net projected cash flows, including coupon payments and principal.
  - In this case, cash flows used in formulas (4) and (5) are inclusive of debt service and borrowing; for formula (6), net TSA changes should include effects of debt flows.
- Two-tiered structure option:
  - Tier-1 (“safety”): resorted to less frequently (e.g., meeting debt service in market stress); can be invested in longer-term instruments.
  - Tier-2: used to meet transactional needs from regular daily cash flow volatility.
  - Total cash buffer = Tier-1 + Tier-2; Tier-1 calculated based on one of formulas (1), (2), or (3); Tier-2 based on formulas (4), (5), or (6).

### Balance Sheet Management: Fiscal Policy and the Borrowing Strategy
- Cash balances form an important portion of the government’s financial assets; switching to or increasing a cash buffer target changes the balance sheet composition.
- Options to build buffer:
  - Issue additional debt (may expand both sides of the balance sheet).
  - Sell other financial or fixed assets (privatization).
- Risks and considerations:
  - Over-borrowing (borrowing more than required by the fiscal deficit) is common practice to accumulate buffers.
  - Over-borrowing may necessitate adjustment to the borrowing strategy and choice of instruments; a phased approach may be needed to avoid pressuring market liquidity and interest rates.
  - Market absorption capacity must be analyzed and additional communication with market participants may be required.
  - Front-loaded over-borrowing affects debt service costs and should be weighed against medium-term benefits.
- Country examples and measures:
  - Portugal and Turkey adopted cash buffer policies within IMF-supported programs with extra funding to mitigate over-borrowing pressure.
  - Hungary increased the cash buffer target after the 2008–09 financial crisis using IMF and EU funds (Rez 2018).
  - In 2011, Canada announced plans to borrow an additional amount of Can$ 5 billion over the following three years for prudential liquidity management (cash buffer policy).
- Fiscal windfalls and one-off revenues:
  - Can be saved to build cash buffers but may require adjustment of non-discretionary spending and political commitment.
  - Diverting budgetary resources without adjustment will require additional borrowing to meet prevailing funding gaps and means foregoing opportunities to reduce borrowing.
- Governance:
  - Availability of cash buffer funds should not generate incentives to increase spending; ringfencing buffer resources and high-level commitment are preconditions for success.

### Monetary Policy
- Cash buffer policy must be communicated to the monetary authority because government balance flows affect monetary liquidity in financial markets.
- Building and maintaining buffers are important considerations for the central bank’s monetary policy design and implementation; the government must understand central bank policy framework and planned operations.
- Additional borrowing to build buffers drains financial market liquidity if balances are held at the central bank; the ministry of finance and central bank should harmonize liquidity management policies to avoid conflicting market signals.
- In scarce liquidity periods, over-borrowing to build buffers amplifies shortages and can be costly; ministries need to understand market liquidity conditions and central bank desired liquidity levels.
- When excess liquidity exists, government withdrawal to build buffers can assist central bank sterilization operations; this does not compromise central bank independence when government pursues its own target.
- The government’s commitment to maintaining its buffer affects the central bank’s liquidity projections; deviations from buffer targets may require central bank action.
- Fluctuations in government cash balances can move central bank balance sheet components, including international reserves; if part of the buffer is held in foreign currencies, changes directly affect reserves.
  - In some policy settings, movements in local currency balances can influence reserves (see Lesotho case).

### Investment Policy
- Investing the cash buffer can yield cost savings since unremunerated balances increase cost of carry.
- Most OECD countries with cash buffer policies have an investment policy to achieve returns on cash balances within prudent risk limits.
- Common instruments and considerations:
  - Money market instruments, repo, and deposits with the central bank or commercial banks are common.
  - Funds held for debt service over longer periods are more suitable for longer-term investments.
  - Investment horizon, instruments, and currency composition should reflect market and cash flow profiles.
  - Asset-liability management approaches often determine currency composition; most OECD liquidity buffers contain only local currency.
- Example practice:
  - Canada maintains an important portion of its reserves as “callable” demand deposits at the Bank of Canada.

### Lesotho: Interaction with Net Foreign Assets (Box example)
- Lesotho pegs the Loti to the South African Rand; the peg is achieved by maintaining net international reserves (NIR) sufficient to back Loti issuance.
- In practice, central bank reserves have moved almost concurrently with government cash balances at the Bank of Lesotho due to close integration with South African markets.
- Mechanism: cash flows leaving government accounts increase banking system liquidity; that liquidity is invested in the neighboring market by exchanging local currency into Rand, causing foreign currency liquidity to leave the central bank balance sheet and moving net foreign assets in parallel with government cash balances.
- Periodicity of cash inflows from the South African Customs Union increases fluctuation frequency, complicating central bank operations.
- Box Figure 7.1 shows Central Bank liabilities to central government versus Central Bank net foreign assets (Billion LSL) across quarterly periods (2015: Q1 through 2019: Q4).

*htnea2020004 - Annex 3 includes a template for a simplified exam-*

### Box 7. Volatility in the Central Bank Balance Sheet: The Case of Lesotho

### Box 7. Volatility in the Central Bank Balance Sheet: The Case of Lesotho

### Investment framework and credit risk
- Investing a government cash buffer creates exposure to credit risk, defined as the risk that a counterparty will default or be downgraded.
- Holding cash in central banks mitigates such credit risks but usually generates lower remunerations than accounts at private banks.
- Several countries—including Denmark, Hungary, Mexico, and the US—maintain cash buffers at the central government’s account at central banks to avoid credit risk associated with investing.
- To manage credit risk arising from cash buffers, restrictions can be imposed by means of a guideline or policy document:
  - restrictions on the credit quality of institutions; and
  - restrictions on the size of the credit risk exposure to a single counterparty.

### Impact of excess liquidity and negative interest rates
- Excess liquidity and negative interest rates in some countries’ money and debt markets have affected the cost of carry and investment opportunities for governments’ cash accounts.
- In the Eurozone, investment opportunities have shrunk in an environment of negative interest rates, although borrowing costs also declined.
- Revisions to cash buffer policies in some countries (examples cited: Latvia, Portugal, and Slovenia) have included:
  - redefinition of the target level (especially where the discrepancy between short and medium-long-term interest rates is high);
  - increased focus on active liquidity management; and
  - diversification of investment options and counterparties.

### Governance framework for a cash buffer
- A cash buffer policy should be based on a well-defined governance framework addressing coordination, transparency of target policy, and regulatory issues.
- Regulatory considerations:
  - Introducing a cash buffer may require adapting the legal framework where legal constraints (for example, a debt rule or an annual borrowing limit) limit prefinancing.
  - The design of the buffer (target level and sources) can reflect existing legal and operational requirements; e.g., borrowing requirement projections can cover the target amount, or the buffer can be accumulated through short-term financing instruments such as treasury bills.
  - The ringfencing of the cash buffer should be made part of the regulatory framework by defining conditions under which the cash buffer can be used, permissible deviations from the target, and measures when deviations occur.
- Coordination and information flows:
  - Efficient management of cash balances requires timely flow of information and effective coordination among central bank, treasury, and/or ministry of finance.
  - CMUs and DMUs should coordinate with the central bank on liquidity management to ensure the monetary authority is aware of cash entering or leaving the financial system.
  - DMUs should liaise with CMUs and other departments to receive up-to-date cash forecasts to determine borrowing requirements.
  - Regular meetings and ad hoc interactions, including formalized arrangements (legal document or memorandum of understanding) or committees, can reinforce communication and sustained coordination; examples given: Canada, Poland, and Turkey.
  - Committees can be timed around key milestones, such as announcements of government funding plans; in some cases committees have decision-making power over size and investment activities (example cited: Canada).
- Public communications:
  - Public disclosure of the cash buffer policy has a positive signaling effect and enhances credibility; disclosing the actual level of the cash buffer further increases fiscal transparency and market confidence (examples cited: Canada, Denmark, Italy, and US).
  - Policymakers should be mindful of volatility in government cash accounts due to seasonal and idiosyncratic patterns; some countries disclose the policy without providing actual and target levels to avoid misperceptions.

### Concluding remarks and design considerations
- A cash buffer is a tool to manage liquidity and refunding risks:
  - mitigates adverse impacts of mismatches in cash flows and errors in cash flow forecasts; and
  - addresses funding risk from unanticipated increases in borrowing needs or temporary interruptions to funding sources.
- Since the early 2000s, a growing number of countries have adopted cash buffer policies; existing buffers served as a first line of defense during the COVID-19 pandemic.
- Design of the cash buffer should consider sources and potential impacts of risk in cash and debt management:
  - quantitative analyses of cash flow volatility and forecast errors, and potential duration of stressed periods, are key;
  - quantitative analyses should be complemented by qualitative assessments (existing risk mitigation mechanisms and access to money markets);
  - countries with limited access to deep financial markets should be more cautious.
- There is a trade-off between costs and risks:
  - buffer should be sufficient to meet financing needs during liquidity strains; but
  - excess cash balances should be avoided given the cost of funding;
  - the cost-risk trade-off changes with discrepancies between short- and medium-long-term interest rates.
- Cash buffer targets:
  - can be formulated by accounting for potential duration of stress periods and existing risk mitigation mechanisms, and enhanced using scenario analyses;
  - country practices indicate buffer levels are often calculated as a percentage of net or gross cash flows and/or of debt maturing in the short-term;
  - buffer formulations can fine tune targets by factoring in existing risk mitigation measures and potential forecasting errors.
- Implications for the sovereign balance sheet:
  - target level, composition, and investment policy of the cash buffer may entail adjustments in the size and timing of financing programs and the use of fiscal revenues, including one-off inflows such as privatization.
- Coordination and communication:
  - effective coordination mechanisms and public communication are key for managing government bank accounts and funding transactions, and for monetary policy implementation.
  - forming committees among relevant institutions can support strategic work on funding and investment activities.

### Annex finding: Central Government Cash Balances at the Central Bank (Percent of GDP) — Lesotho
- Lesotho: 2014 19% ; 2015 18% ; 2016 10% ; 2017 3% ; 2018 4%
- Note: IMF’s Monetary and Financial Statistics. Select countries with cash balances over 1 percent of GDP at the end of 2018. Figures depict year-end balances. Several governments also hold cash balances at commercial banks, which are not captured in the figure.

*International Monetary Fund | December 2020*

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_Source: https://www.imf.org/-/media/files/publications/howtonotes/2020/english/htnea2020004.pdf_