## Gross Central Government Financing Need: Selected Countries (content unit _041811)

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### I. Overview and key messages
- The crisis highlighted the importance of debt management in containing debt-related risks and the associated impact on debt markets.
- Operational challenge: meeting increased borrowing needs amid intensely challenging market conditions required sovereign debt managers to modify issuance mix and financing modalities, step up market management activities, and, in some cases, coordinate with central banks.
- Risk management frameworks need to:
  - Capture contingent liabilities;
  - Incorporate interaction of sovereign risk with financial sector risk;
  - Account for degree of macroeconomic policy flexibility (exchange rate and monetary policy constraints) and its effect on financing costs under stress;
  - Recognize potential cross-border spillovers.
- Desirable recalibration of debt management policies and practices because of: deepening fiscal imbalances, long-term fiscal risks, currently high levels of public debt, weaknesses in sovereign balance sheets, and fuller information on contingent liability risks revealed by the crisis.

### II. Policy recommendations and operational steps for debt managers
- Augment risk management frameworks to capture a wider set of risk considerations, explicitly incorporating:
  - (i) the potential materialization of contingent liabilities;
  - (ii) the interaction of sovereign risk with financial sector risk; and
  - (iii) the degree of macroeconomic policy flexibility and its effect on financing costs under stress.
- Improve resilience of debt structures to financing and macroeconomic shocks:
  - Initiate steps, including liability management operations, to lengthen maturity and reduce rollover and liquidity risk.
  - Emerging markets may have scope to use capital inflows to lengthen maturity of domestic currency debt.
  - Complement with appropriate liquidity buffers.
- Ensure sufficient operational flexibility:
  - Maintain scope to adapt primary issuance techniques and use liability management operations to alleviate secondary market impairments and support liquidity.
  - Recognize systemically important sovereign issuers must be mindful of risks of broader market disruption from unsuccessful market operations.
- Strengthen communication with stakeholders and investors:
  - Better understand investor base and investment philosophies, the impact of regulatory reforms, and factors affecting global asset allocation.
  - Improve investor understanding of macro fundamentals, structural developments, and debt management philosophy to identify market vulnerabilities and inform instrument design.
- Enhance collaboration among debt managers and other policy makers:
  - Ex-ante determination of exposures (e.g., financial sector, demographic pressures) to inform debt management interventions and appropriate liquidity buffers.
  - Ensure consistency of debt management policies with financial sector and macroeconomic policies and facilitate cross-institutional efforts to enhance debt market liquidity.
  - Leverage institutional arrangements for macro-prudential monitoring where appropriate.

### III. Crisis impact on debt management and market operations
- Execution risk and operational strain:
  - Execution risk defined: “the risk that a debt manager will fail to raise the required quantity of financing through a debt operation.”
  - Example: U.K. auctions rose from 34 in fiscal year 2007-08 to 66 in fiscal year 2008-09 and to 77 in fiscal year 2009-10.
- Differential country impacts:
  - Most emerging markets experienced a relatively less severe impact, but many faced stress during the early phase due to capital outflows and effective closure of international capital markets in latter half of 2008.
  - Low-income countries were relatively insulated; main challenges were potential shortfalls in donor disbursements and more constrained access to concessional loans.

### IV. Gross borrowing / financing needs — Selected country statistics (Average 2005-2007 and Average 2008-2010, % of GDP)
- Note: Gross borrowing = overall fiscal balance (WEO data) + maturing debt (BIS data on short-term debt).
- Selected advanced economies (Average 2005-2007; Average 2008-2010; Ratio):
  - Australia: 0.5; 5.4; Ratio = 11.2
  - Belgium: 14.8; 24.0; Ratio = 1.6
  - Canada: 8.9; 14.7; Ratio = 1.6
  - France: 10.6; 18.1; Ratio = 1.7
  - Germany: 8.8; 12.8; Ratio = 1.5
  - Italy: 19.2; 24.1; Ratio = 1.3
  - Japan: 50.9; 50.6; Ratio = 1.0
  - Netherlands: 6.3; 16.4; Ratio = 2.6
  - U.K.: 5.7; 13.2; Ratio = 2.3
  - U.S.: 13.4; 24.8; Ratio = 1.8
- Selected emerging market economies (Average 2005-2007; Average 2008-2010; Ratio):
  - Brazil: 25.0; 16.8; Ratio = 0.7
  - Hungary: 21.4; 26.0; Ratio = 1.1
  - Korea: 10.8; 10.0; Ratio = 1.0
  - Mexico: 7.8; 11.5; Ratio = 1.3
  - Turkey: 3.3; 5.7; Ratio = 1.7

### V. Debt management responses and operational approaches
- Broad approaches used:
  - Adjust issuance mix (including more short-term debt where necessary).
  - Change issuance techniques.
  - Intensify market management activities.
- Observed patterns:
  - Many advanced economies shifted issuance toward more short-term debt to meet sudden increases in financing needs without overwhelming markets (Belgium, Netherlands, U.K., U.S.).
  - Fragile market conditions warranted more short-term debt even where borrowing increases were smaller (Germany, France).
  - Some emerging markets initially increased short-term issuance when foreign investors departed (Hungary, Poland, Mexico).
- Liquidity buffers and maturity extension:
  - Many emerging markets established large liquidity buffers. Example: Uruguay targets a minimum level of 12 months of debt servicing needs.
  - Several emerging markets lengthened maturity of domestic currency debt (example: Mexico).

### VI. Expansion into non-core markets and borrowing instruments (debt managers’ operational adaptations)
- Expansion and instruments:
  - Belgium and the Netherlands had introduced MTN programs pre-crisis to promote investor diversification.
  - Several debt managers expanded activities in international capital markets to diversify investors and ease domestic market burden.
  - Re-introduced or resurgent instruments:
    - Canada and the U.S. re-introduced a three-year maturity.
    - Australia re-introduced inflation-linked bonds.
    - Poland saw a temporary resurgence in floating rate notes.
  - MTN program: umbrella structure with separate tranches across maturities, currencies, and interest structures; flexible issuance often in response to reverse enquiries (private placements).
- Supplementary issuance programs and marginal financing:
  - Post-auction non-competitive facility for primary dealers introduced in Hungary and the U.K.
  - More frequent/smaller issues of “off-the-run” bonds (tap sales) in Netherlands, Belgium, Italy, Germany, U.K.
- Market-support operations and adaptations:
  - Increased use of syndication (e.g., over 13 percent of issuance in 2009-10 and 16 percent in 2010-11 in the U.K.).
  - Auction format adjustments (Italy widened band between minimum and maximum auction size; Hungary cut time between announcement and issue date).
  - Primary dealer market-making obligations relaxed or adapted (e.g., Belgium moved to a relative performance measure).
  - Liability management operations (debt exchanges, purchases or sales of “off-the-runs”) used to support market functioning (example: Italy).
  - Expansion of repo facilities by debt management offices (example: Belgium).
- Investor relations and central bank coordination:
  - Increased non-deal road-shows and direct investor access; attracted new investors from Asia and the Middle East.
  - Coordinated monetary easing and QE programs improved liquidity in benchmark currencies (examples: U.K., U.S.).
  - ECB’s Securities Market Program (SMP) targeted extreme euro area secondary market conditions while being neutral from a monetary policy perspective.
- Crisis-related operational extensions:
  - Debt managers administered government financial sector acquisitions (Sweden, U.S.) and bank-related guarantee schemes (Belgium, U.K.).

### VII. Emerging markets — resilience and remaining vulnerabilities
- Improvements contributing to resilience:
  - Maturity profiles extended; reliance on floating rate and foreign currency debt reduced.
  - Institutional improvements: strengthened debt management arrangements, enhanced transparency, active investor relations, local capital market development (examples: Brazil, Uruguay).
  - Credit rating improvements noted (figure referenced in source).
- Remaining vulnerabilities:
  - Debt structures in emerging markets remain generally weaker than in most advanced economies and vulnerable to macro shocks (inflation, commodity prices, exchange rate).
  - Recommendation: use conjunctural and structural opportunities to further lengthen debt maturity and strengthen resilience.

### VIII. Stress testing public debt portfolios and augmenting cost-risk analysis
- Stress testing purpose and practice:
  - Purpose: assess impact of a shock or extreme event on key cost and risk debt indicators.
  - Common practice: apply standardized shocks to key variables; typical cost-at-risk models capture impacts from stochastic or deterministic standardized shocks.
  - More complete stress tests should factor in feedback effects (e.g., higher interest rates → GDP and budget impacts; changes in investor demand) and may require inputs from other officials.
- Calibration challenges:
  - Statistical measures (e.g., two standard deviation parallel shift) may not capture low-probability, large-impact events.
  - Historical analysis may be inadequate where past extreme scenarios do not exist.
- Institutional coordination:
  - Ideally, stress tests by key stakeholders should converge to a joint stress test of the sovereign balance sheet and financial sector.
  - Fund staff developing principles for calibration and use of stress tests and enhancing stress-testing in the Fund-Bank Debt Sustainability Framework.

### IX. Structuring the debt portfolio, liquidity buffers, and ALM
- Portfolio structuring to mitigate shocks:
  - Variable-rate debt protects against negative demand shocks when monetary policy lowers rates.
  - Fixed-rate debt protects against negative supply shocks that push up rates.
  - Inflation-linked bonds correlate debt service with government revenue and can reduce rollover risk if they lengthen maturities.
  - Long-term fixed-rate debt best protects when rate increases reflect perceived sovereign risk.
- Rollover profile benefits:
  - Lower rollover profile reduces risk of investor strikes, provides resilience when exchange rate regime constrains policy, and eases absorption of reduced tax receipts.
  - Example: fiscal year 2008 U.K. refinanced GBP 17 billion (about 1.3 percent of GDP) due to unusually long ATM.
  - ATM context: At around 14 years, the ATM of the U.K. debt portfolio is about twice the European average and close to three times the U.S. portfolio.
- Recalibrating liquidity buffers:
  - Examples of reliance on buffers: Chile, Ireland, Norway, Russia used macro-stabilization or sovereign wealth funds to offset increased financing needs.
  - Pre-funding/buybacks: used by Belgium, Netherlands, Portugal; fiscal frameworks can constrain pre-funding (example: Finland has no provision for pre-funding).
  - Trade-off influenced by level of debt, degree of fiscal space, monetary and exchange rate policy flexibility, scale and likelihood of contingent liabilities, and durability of market access.
- Adopting an integrated sovereign ALM framework:
  - Allows joint analysis of assets and liabilities on the sovereign balance sheet; natural environment for comprehensive stress testing.
  - Some exposures may be mitigated more cost-effectively via asset strategies rather than solely adjusting debt structure.
- Addressing investor base vulnerabilities:
  - Certain instruments and foreign currency issuances attract particular investor classes (e.g., inflation-linked and longer-dated debt attract pension and insurance companies).
  - Increasing domestic investor participation can provide resilience but may increase interconnection with domestic financial sector.
  - Targeting investor composition is difficult and risks creating captive investor bases; targeting domestic investors is particularly difficult in a monetary union.

### X. Liability Management Operations (LMOs) — benefits and considerations
- LMOs usage and examples:
  - Routine repurchase of near-maturity bonds as part of cash management (example: Belgium).
  - Significant reverse auction events (example: Portugal).
  - Debt exchanges to improve servicing profile or change investor preferences (example: U.K. in 2000s).
  - Regular ongoing LMOs in Brazil and Turkey; ad hoc use elsewhere.
  - Philippines exchanged nearly $3bn of outstanding debt for longer-dated issues in September 2010—the largest ever LMO in Asia.
- Implementation considerations:
  - Meaningful portfolio restructuring may require larger and repeated LMOs; fragile investor sentiment complicates implementation.
  - Systematic reverse auctions or debt exchanges for near-maturity bonds can reduce rollover needs over time.

### XI. Derivatives, market liquidity, and regulatory change
- Role of derivatives:
  - Standard interest rate swaps can provide protection against potentially higher interest rates, complementing maturity extension efforts.
  - Effectiveness depends on country-specific circumstances; frameworks must address institutional, legal and accounting implications.
- Managing execution risk and investor appetite:
  - Tailoring products (e.g., MTN) may secure financing at the margin; core financing should focus on standard benchmark instruments to maximize liquidity.
  - Exploit “preferred habitats” (e.g., pension and insurance companies prefer inflation-indexed debt).
  - Benchmark issuers should consider wider market effects of their operations.
- Restoring market liquidity — tools and coordination:
  - LMOs (debt exchanges, buybacks), targeted taps, and buyback auctions used to relieve liquidity stress (examples: Brazil, Turkey, Belgium, Netherlands).
  - Consider a more permanent liquidity backstop (“market maker of last resort”); some DMOs are active in secondary markets (example: Germany).
  - Unwinding QE programs will release bonds back into the market raising potential volatility; ongoing dialogue between DMOs and central banks required.
- Monitoring regulatory changes:
  - Basel III introduces LCR and NSFR; BCBS estimated additional financing needed to meet the LCR is about EUR1.7 trillion across large internationally active banks (as of end-2009).
  - New capital and risk-weighting rules could shift demand towards safer assets; reforms in nonbank financial sector and greater use of central counterparties may increase demand for government debt for collateral.
  - LCR-induced demand may reduce market liquidity by requiring banks to hold more government debt, lowering the proportion available for sale.
  - Jurisdictions with insufficient stock of debt (examples given: Australia and Denmark) may face aggravated challenges.
  - Regulations disincentivizing repo activity may further reduce liquidity; consequence: government bond markets could become broker markets where market makers neither trade on their own books nor provide continuous pricing.
- Collaboration and institutional arrangements:
  - Debt managers should take a central role in monitoring sovereign exposure to banking sector contingent liabilities and consider inclusion on macro-prudential committees.
  - A wider ALM approach can provide consolidated sovereign balance sheet view and facilitate coordination across policy areas.

### XII. Going forward: Key issues and recommended actions
- Strengthening risk management:
  - Enhance risk management frameworks and stress testing, accounting for:
    - (i) degree of macroeconomic policy flexibility;
    - (ii) exposure of the sovereign balance sheet to the financial sector;
    - (iii) extent of other contingent liabilities (quasi-sovereign, sub-national);
    - (iv) investor base fragility;
    - (v) risk of cross-border spillovers.
  - Strengthen debt structures and establish appropriate risk buffers; use LMOs pragmatically to modify debt structures.
  - Emerging markets should use increased capital inflows to lengthen maturities where feasible.
- Greater collaboration:
  - Strengthen collaboration across debt managers, fiscal authorities and financial sector regulators to enhance risk monitoring and management.
- Capital market considerations:
  - Maintain a flexible and comprehensive operational toolkit to mitigate market and liquidity risks and improve secondary market liquidity.
  - Benchmark issuers must be mindful of market-wide ramifications of their operations.
  - Enhance investor relations programs per the “Stockholm Principles” to overcome primary dealer limitations and reduce volatility.
  - Debt issuance choices should contribute to diversifying the investor base where feasible—both residency and type.

### Appendix highlights — selected country actions, sovereign-banking linkages, and principles
- Selected country operational actions (summary):
  - Belgium: introduced EMTN in 2008; increased short-term instruments and tapping of long-term debt; adapted PD quoting obligations; treasury administered bank guarantees.
  - Germany: increased tapping of long-term debt and foreign currency issuance; continuous secondary market presence.
  - Italy: moved to issuance ranges in uniform price auctions; offered off-the-run bonds and extended reopening timing.
  - U.K.: initially increased short-term instruments, later refinanced with long-term bonds; introduced PAOF and mini-tenders; partnered with Bank of England on liquidity programs.
  - U.S.: reintroduced 3-year tenor; increased inflation-linked and longer tenors from 2009; coordinated with Federal Reserve on buybacks and toxic asset management.
  - Brazil, Hungary, Korea, Mexico, Turkey: varied combinations of buybacks, exchanges, instrument innovation, auction format changes, and targeted investor outreach.
- Sovereign–banking sector interconnections:
  - Asset-side spillovers: decline in sovereign debt prices generates losses for banks holding government bonds.
  - Liability-side spillovers: banks’ wholesale financing costs rise with sovereign spreads.
  - Examples:
    - Iceland: financial sector assets ~1,000 percent of GDP at end-2007; gross fiscal cost of honoring deposit insurance and recapitalizing commercial banks ≈ 70 percent of GDP; gross government debt rose from 29 percent of GDP at end-2007 to an estimated 100 percent of GDP by end-2010.
    - Ireland: real GDP fell nearly 11 percent over 2008-2009; capital injections ≈ 28 percent of GDP by end-2010; public debt rose from 25 percent before the crisis to 99 percent of GDP at end-2010; bank debt guaranteed ≈ 16 percent of GDP by end-2010.
- Guiding principles for managing sovereign risk (Stockholm Principles):
  1. Define scope of debt management to account for interactions among financial assets, contingent liabilities, and debt structure.
  2. Support strategic and operational decisions with domestic, regional, and global information sharing.
  3. Maintain flexibility in market operations to minimize execution risk and support liquidity.
  4. Maintain proactive and timely market communication strategies.
  5. Properly explain modifications to operational toolkits.
  6. Promote communication among debt managers and monetary, fiscal, and regulatory authorities while preserving agency independence.
  7. Maintain close and continuing dialogue with investors.
  8. Keep debt portfolio risks at prudent levels while minimizing medium- to long-term funding costs.
  9. Align the range of risk factors in medium-term strategies with the broad definition of the debt portfolio.
  10. Adopt and communicate prudent risk management strategies covering the full range of risks.

### Appendix V — Sovereign risk components: definitions and linkages
- Sovereign risk: risk of investor losses due to issuer failing to service nominal payments.
- Fiscal risk: deviation between projected and actual fiscal outcomes; contributes to sovereign risk.
- Sovereign risk components:
  - Solvency component: risk country cannot meet present value of external obligations at commensurate interest rates; usually beyond DMO control; determined by primary balances and willingness to pay.
  - Liquidity component (including rollover risk): risk government cannot discharge obligations due to lack of liquid means despite solvency; under debt manager control but affected by contagion and global risk aversion.
- Linkages:
  - Illiquidity can lead to insolvency if future income streams are heavily discounted.
  - Insolvency can lead to illiquidity via runs anticipating future illiquidity.
  - Both functions depend on interest and exchange rates.

### Appendix VI — Choosing optimal maturity structure: cost–risk tradeoff (stylized example)
- Set-up and assumptions:
  - Debt manager chooses among 15 portfolios with different average time to maturity (ATM); maximum maturity = twice ATM.
  - Portfolios have smooth even annual maturity profiles. Example:
    - P1: ATM = 1 year → two equal principal repayments; maximum maturity = 2 years; short-term debt = 50 percent of portfolio.
    - P15: ATM = 15 years → 30 principal payments, each 3.3 percent; short-term debt = 3.3 percent; maximum maturity = 30 years.
  - Assume debt/GDP = 100 percent (results scalable).
  - Consider a large sustained shock increasing the credit risk premium by 1,000 basis points.
- Illustrative outcomes of a 1,000 basis point shock:
  - If shock sustained over one year:
    - Additional cost of refinancing maturing debt = 5 percent of GDP for P1.
    - Additional cost of refinancing maturing debt = 0.33 percent of GDP for P15.
    - Fiscal adjustment required to keep the deficit unchanged will be 15 times greater for P1 relative to P15.
  - Under a medium-term sustained interest rate shock and balanced budget with same portfolio structure:
    - Cumulative impact is a multiple of the additional first-year interest cost; rolling maturing debt into new maximum maturity bonds can cause debt stock growth if fiscal adjustment is insufficient.
- Cost side — yield curve and marginal cost:
  - Extending maturities increases underlying cost depending on yield curve shape.
  - Upward sloping linear yield curve example: spread between 30-year and 2-year yields = 250 basis points.
  - Comparison spreads reported: 30-year vs 2-year gilts = 380 basis points; U.S. Treasuries = 420 basis points.
  - Marginal benefits of extending maturity decline as starting position improves.
- Policy implication:
  - Cost–benefit tradeoff is country specific and depends on level of debt, maturity profile, and yield curve shape.
  - Crisis experience indicates extreme events are reasonable scenarios to consider.

*Source: IMF staff paper — “Policy and Operational Challenges Facing Public Debt Management” (excerpts) provided in content unit _041811.*

### 1. Gross Central Government Financing Need: Selected Countries ..........................................6

### 1. Gross Central Government Financing Need: Selected Countries ..........................................6

### I. Overview and key messages
- The crisis highlighted the importance of debt management in containing debt-related risks and the associated impact on debt markets.
- Operational challenge: meeting increased borrowing needs amid intensely challenging market conditions required sovereign debt managers to modify issuance mix and financing modalities, step up market management activities, and, in some cases, coordinate with central banks.
- Risk management frameworks need to:
  - Capture contingent liabilities;
  - Incorporate interaction of sovereign risk with financial sector risk;
  - Account for degree of macroeconomic policy flexibility (exchange rate and monetary policy constraints) and its effect on financing costs under stress;
  - Recognize potential cross-border spillovers.
- Desirable recalibration of debt management policies and practices because of: deepening fiscal imbalances, long-term fiscal risks, currently high levels of public debt, weaknesses in sovereign balance sheets, and fuller information on contingent liability risks revealed by the crisis.

### II. Policy recommendations and operational steps for debt managers
- Augment risk management frameworks to capture a wider set of risk considerations, explicitly incorporating:
  - (i) the potential materialization of contingent liabilities;
  - (ii) the interaction of sovereign risk with financial sector risk; and
  - (iii) the degree of macroeconomic policy flexibility and its effect on financing costs under stress.
- Improve resilience of debt structures to financing and macroeconomic shocks:
  - Initiate steps, including liability management operations, to lengthen maturity and reduce rollover and liquidity risk.
  - Emerging markets may have scope to use capital inflows to lengthen maturity of domestic currency debt.
  - Complement with appropriate liquidity buffers.
- Ensure sufficient operational flexibility:
  - Maintain scope to adapt primary issuance techniques and use liability management operations to alleviate secondary market impairments and support liquidity.
  - Recognize that systemically important sovereign issuers must be particularly mindful of risks of broader market disruption from unsuccessful market operations.
- Strengthen communication with stakeholders and investors:
  - Better understand investor base and investment philosophies, the impact of regulatory reforms, and factors affecting global asset allocation.
  - Improve investor understanding of macro fundamentals, structural developments, and debt management philosophy to identify market vulnerabilities and inform instrument design.
- Enhance collaboration among debt managers and other policy makers:
  - Ex-ante determination of exposures (e.g., financial sector, demographic pressures) to inform debt management interventions (including liability management operations) and appropriate liquidity buffers.
  - Ensure consistency of debt management policies with financial sector and macroeconomic policies and facilitate cross-institutional efforts to enhance debt market liquidity.
  - Leverage institutional arrangements for macro-prudential monitoring where appropriate.

### III. Crisis impact on debt management and market operations
- The crisis raised significant challenges for debt managers, especially in advanced economies:
  - Sharp increase in number of financing operations elevated execution risk and put debt management under operational strain.
  - Execution risk defined: “the risk that a debt manager will fail to raise the required quantity of financing through a debt operation.”
  - Example: U.K. number of operations rose from 34 auctions in fiscal year 2007-08 to 66 operations in fiscal year 2008-09, and to 77 in fiscal year 2009-10.
- Most emerging markets experienced a relatively less severe impact on financing operations, partly because they were more insulated from the causes of the crisis; however, many faced stress during the early phase due to capital outflows, changes in investor demand and effective closure of international capital markets in latter half of 2008.
- Low-income countries (LICs) were relatively insulated given low integration in international financial markets; main challenges were potential shortfalls in donor disbursements and more constrained access to concessional loans.

### IV. Gross borrowing / financing needs — Selected country statistics (Average 2005-2007 and Average 2008-2010, % of GDP)
- Note: Gross borrowing is calculated as the sum of the overall fiscal balance (based on WEO data) and maturing debt (based on BIS data on short-term debt).
- Selected advanced economies:
  - Australia: 2005-2007 = 0.5; 2008-2010 = 5.4; Ratio = 11.2
  - Belgium: 2005-2007 = 14.8; 2008-2010 = 24.0; Ratio = 1.6
  - Canada: 2005-2007 = 8.9; 2008-2010 = 14.7; Ratio = 1.6
  - France: 2005-2007 = 10.6; 2008-2010 = 18.1; Ratio = 1.7
  - Germany: 2005-2007 = 8.8; 2008-2010 = 12.8; Ratio = 1.5
  - Italy: 2005-2007 = 19.2; 2008-2010 = 24.1; Ratio = 1.3
  - Japan: 2005-2007 = 50.9; 2008-2010 = 50.6; Ratio = 1.0
  - Netherlands: 2005-2007 = 6.3; 2008-2010 = 16.4; Ratio = 2.6
  - U.K.: 2005-2007 = 5.7; 2008-2010 = 13.2; Ratio = 2.3
  - U.S.: 2005-2007 = 13.4; 2008-2010 = 24.8; Ratio = 1.8
- Selected emerging market economies:
  - Brazil: 2005-2007 = 25.0; 2008-2010 = 16.8; Ratio = 0.7
  - Hungary: 2005-2007 = 21.4; 2008-2010 = 26.0; Ratio = 1.1
  - Korea: 2005-2007 = 10.8; 2008-2010 = 10.0; Ratio = 1.0
  - Mexico: 2005-2007 = 7.8; 2008-2010 = 11.5; Ratio = 1.3
  - Turkey: 2005-2007 = 3.3; 2008-2010 = 5.7; Ratio = 1.7

### V. Debt management responses and operational approaches
- Broad approaches used by debt managers to address increased financing needs:
  - Adjust issuance mix (including more short-term debt where necessary).
  - Change issuance techniques.
  - Intensify market management activities.
- Context and examples:
  - Many advanced economies shifted issuance toward more short-term debt to accommodate large and sudden increases in financing needs without overwhelming markets; particularly evident in Belgium, the Netherlands, U.K. and U.S. where financing of financial support schemes represented a significant proportion of GDP.
  - Even where borrowing increases were not as large, fragile market conditions warranted more short-term debt (e.g., Germany, France).
  - Some emerging markets initially increased short-term issuance when foreign investors departed or were absent (e.g., Hungary, Poland, Mexico).
- Table 2 summary of cross-country responses (change in instrument mix; change in issuance technique; market management activities):
  - Advanced economies:
    - Belgium: Change in Instrument Mix = X; Change in Issuance Technique = X; Market Management Activities = X
    - Germany: Change in Instrument Mix = X
    - Italy: Change in Instrument Mix = X; Market Management Activities = X
    - The Netherlands: Change in Issuance Technique = X; Market Management Activities = X
    - U.K.: Change in Instrument Mix = X; Change in Issuance Technique = X; Market Management Activities = X
    - U.S.: Change in Issuance Technique = X; Market Management Activities = X
  - Emerging market economies:
    - Brazil: Change in Issuance Technique = X
    - Hungary: Change in Instrument Mix = X; Market Management Activities = X
    - Korea: Change in Issuance Technique = X; Market Management Activities = X
    - Mexico: Change in Issuance Technique = X; Market Management Activities = X
    - Poland: Change in Instrument Mix = X; Change in Issuance Technique = X; Market Management Activities = X
    - Turkey: Change in Instrument Mix = X; Change in Issuance Technique = X; Market Management Activities = X
- Liquidity buffers and institutional examples:
  - Many emerging markets established large liquidity buffers to sustain temporary loss of market access while continuing debt servicing obligations. Example: Uruguay targets a minimum level of 12 months of debt servicing needs.
  - Several emerging markets lengthened maturity of domestic currency debt—for example Mexico.

### VI. Emerging markets — resilience and remaining vulnerabilities
- Improvements over the past decade contributed to relative resilience of emerging markets:
  - Maturity profiles extended; reliance on floating rate and foreign currency denominated (or linked) debt reduced.
  - Institutional improvements: strengthened debt management arrangements, enhanced transparency, active investor relations, and local capital market development (e.g., Brazil and Uruguay).
  - These changes contributed to credit rating improvements (Figure 2 referenced).
- Remaining issues:
  - Debt structures in emerging markets remain generally weaker than in most advanced economies and vulnerable to macro shocks (inflation, commodity prices, exchange rate).
  - Emerging markets should use conjunctural and structural opportunities to further lengthen debt maturity and strengthen resilience.

*Source: IMF staff paper — “Policy and Operational Challenges Facing Public Debt Management” (excerpts).*

### 12.      Debt managers expanded their use of non-core markets and borrowing instruments.

### 12.      Debt managers expanded their use of non-core markets and borrowing instruments.

### Expansion into non-core and international markets
- Before the crisis, both Belgium and the Netherlands had introduced a medium-term note (MTN) program to promote investor diversification and to secure some cost advantages.
- Several debt managers expanded the scale of activities in international capital markets to improve investor diversification and help ease the financing burden on domestic markets.
- Presence in non-core markets was seen as a complement to core issuance programs that could be exploited in better times.
- Examples of re-introduced or resurgent instruments:
  - Canada and the U.S. re-introduced a three-year maturity.
  - Australia re-introduced inflation-linked bonds.
  - In some emerging markets, there was a temporary resurgence in the use of floating rate notes (e.g., Poland).
- A medium-term note program provides an overall umbrella structure under which separate tranches with a wide range of maturities, currencies, and interest rate structures can be sold to investors; often new tranches are issued in direct response to a reverse enquiry from an investor (private placement), illustrating the mechanism’s flexibility.

### Supplementary issuance programs and marginal financing
- Supplementary issuance programs complemented core issuance programs and helped raise additional financing at the margin.
- Specific measures:
  - Post-auction non-competitive facility for primary dealers introduced in Hungary and the U.K.
  - More frequent and significant smaller issues of “off-the-run” bonds (tap sales) in the Netherlands, Belgium, Italy, Germany, U.K.
- These supplementary programs provided incremental financing capacity and flexibility.

### Limiting effects of market disruptions and operational adaptations
- Market perceptions of sovereign risk intensified as sovereign balance sheets deteriorated and the financial sector weakened; the interconnectedness between sovereign risk and the financial sector was highlighted (Iceland and Ireland cases referenced).
- Market sensitivity to differences in credit quality increased; AAA-rated issuers benefited from “safe haven” flows while less creditworthy issuers experienced greater volatility, especially where ratings approached or breached investment-mandate thresholds.
- Cross-border spillovers aggravated market conditions, with concerns about sovereign credit risk in one country spreading to others perceived to have similar vulnerabilities.
- Primary and secondary market fragility forced operational changes:
  - Issuance mechanisms were modified to support the primary market and facilitate larger investor participation given primary dealer balance sheet vulnerabilities.
  - Increased use of syndication (e.g., accounted for over 13 percent of issuance in 2009-10, and 16 percent in 2010-11 in the U.K.).
  - Auction formats were adjusted; Italy widened the band between minimum and maximum auction size, Hungary cut the time between announcement and issue date (calendar still pre-announced annually).
  - Primary dealer market-making obligations were relaxed or adapted; in some instances changes became permanent (e.g., Belgium moved to a relative performance measure to assess quotation obligations).
- Market-support operations undertaken by debt managers:
  - Liability management operations such as debt exchanges and purchases or sales of “off-the-runs” (often initiated at dealers’ request, e.g., Italy).
  - Expansion of repo facilities offered by debt management offices (e.g., Belgium).
- Despite efforts, liquidity in secondary markets, particularly for non-benchmark issuers, remained relatively poor.

### Investor relations and coordination with monetary authorities
- Investor relations were refocused to restore market confidence:
  - Increased non-deal road-shows and activities giving investors direct access to debt managers and policy officials.
  - Efforts contributed to attracting new investors, particularly from Asia and the Middle East.
- Actions by central banks improved market conditions:
  - Coordinated and sustained monetary easing helped keep interest rates low in benchmark currencies.
  - Quantitative easing (QE) programs contributed to improving market liquidity in some cases, requiring enhanced coordination across debt managers and central banks (e.g., U.K., U.S.).
  - ECB’s Securities Market Program (SMP) targeted extreme secondary market conditions in the euro area while being neutral from a monetary policy perspective.
- Market fragility persisted: volatility remained elevated in higher spread euro area countries, constraining investor appetite; foreign investors reduced exposure to higher spread euro area issuers with domestic banks often offsetting the reduction.

### Crisis-related operational extensions
- Debt managers took on other operational roles:
  - Managing government financial sector acquisitions (e.g., Sweden, U.S.).
  - Administering bank-related guarantee schemes (e.g., Belgium, U.K.).
  - Supporting market liquidity in other sectors in some instances (e.g., Sweden).

### Implications for debt management strategies and risk management
- The crisis underscored interconnections between debt management and macroeconomic policy constraints, particularly the sovereign’s vulnerability to financial sector contingent liabilities and the importance of actively managing liquidity risk.
- Imperatives for debt management policies and strategies going forward include the need to:
  - Have in place a strong risk management framework.
  - Actively use the structure of the debt to mitigate shocks.
  - Maintain access to a liquidity buffer.
  - Adopt an integrated asset-liability (ALM) management framework to monitor and mitigate risk on the sovereign balance sheet.
  - Address vulnerabilities in the investor base.
- Liquidity support constraints within a monetary union can aggravate sovereign financing difficulties by limiting policy responses and exacerbating rollover and liquidity risk; timely provision of robust liquidity support mechanisms for individual countries is important.
- Enhancing risk management frameworks:
  - Traditional cost-at-risk analysis may fail to capture the full range of risk factors and interactions between macroeconomic vulnerabilities and debt structures; models calibrated on historical outcomes would not have captured an event as extreme as the crisis.
  - Nontraditional risk exposures need to be captured, including financing shocks from implicit financial sector contingent liabilities, large quasi-sovereign and sub-national debt, and sudden withdrawal of investors (a particular issue highlighted by the euro area crisis).
  - Excessive reliance on nonresident investors can aggravate financing risk if those investors withdraw in response to sovereign balance sheet deterioration or credit rating downgrades.

*Source: _041811 - 12.      Debt managers expanded their use of non-core markets and borrowing instruments.*

### 28.      Overall, the importance of augmenting traditional cost-risk analysis with

### _041811 - 28.      Overall, the importance of augmenting traditional cost-risk analysis with

### Stress testing public debt portfolios
- Stress testing complements traditional cost-risk analysis and was recognized in the Guidelines for Public Debt Management (IMF-World Bank, 2001).
- Purpose: assess impact of a shock or extreme event on key cost and risk debt indicators (e.g., timing and scale of debt servicing cash flows).
- Common practice: stress tests apply standardized shocks to key variables; typical cost-at-risk models capture impacts from stochastic or deterministic standardized shocks.
- More complete stress tests should factor in feedback effects (e.g., higher interest rates → GDP and budget impacts; changes in investor demand) and may require inputs from other officials (e.g., central bank research).
- Calibration challenges:
  - Statistical measures (e.g., two standard deviation parallel shift) are useful but may not capture low-probability, large-impact events.
  - Historical analysis helps when past extreme scenarios exist, but recent crisis showed extreme events can exceed past experience.
- Institutional coordination:
  - Ideally, stress tests by key stakeholders should converge to a joint stress test of the sovereign balance sheet and financial sector.
  - Currently, stress tests are often standalone (debt managers, bank supervisors, sovereign wealth funds); subjecting elements to a common shock allows a more holistic vulnerability assessment.
- Ongoing work: Fund staff developing principles for calibration and use of stress tests and enhancing stress-testing in the Fund-Bank Debt Sustainability Framework.

### Structuring the debt portfolio to mitigate shocks
- Portfolio structures can provide insurance against various shocks (demand, supply, terms of trade, balance of payments).
- Examples of debt structure effects:
  - Variable-rate debt protects against negative demand shocks when monetary policy lowers rates.
  - Fixed-rate debt protects against negative supply shocks that push up rates.
  - Inflation-linked bonds correlate debt service with government revenue and can reduce rollover risk if they lengthen maturities.
- Crisis lessons on sovereign credit/default risk:
  - Long-term fixed-rate debt best protects when rate increases reflect perceived sovereign risk.
  - Variable-rate and short-term fixed-rate debt can aggravate costs if credit quality deteriorates.
- Rollover profile benefits:
  - A relatively low rollover profile reduces risk of investor strikes raising yields; provides resilience when exchange rate regime constrains policy; reduces servicing cost increases from deteriorating creditworthiness; and eases absorption of reduced tax receipts and accommodative fiscal policy.
  - Example: in fiscal year 2008 the U.K., with an unusually long ATM, only needed to refinance GBP 17 billion of bonds (about 1.3 percent of GDP).
  - ATM context: At around 14 years, the ATM of the U.K. debt portfolio is about twice as long as the European average and close to three times as long as the U.S. portfolio.

### Recalibrating liquidity buffers
- Liquidity buffers reduce rollover risk by providing resources for redemptions.
- Examples of reliance on buffers: Chile, Ireland, Norway, Russia used macro-stabilization or sovereign wealth funds to offset increased financing needs.
- Pre-funding/buybacks used by some debt managers (Belgium, Netherlands, Portugal); fiscal frameworks can constrain pre-funding (e.g., Finland has no provision for pre-funding).
- Large buffers can affect government cash management and central bank liquidity management; coordination across stakeholders needed.
- Policy trade-off: determining appropriate cost-risk trade-off in light of risk exposure; key influencing factors include level of debt, degree of fiscal space, monetary and exchange rate policy flexibility, scale and likelihood of contingent liabilities, and durability of market access.
- Appendix IV and the Bank-Fund MTDS Framework provide stylized guidance on this trade-off.

### Adopting an integrated sovereign ALM framework
- A comprehensive sovereign asset and liability management (ALM) framework allows joint analysis of financial assets and liabilities on the sovereign balance sheet.
- Benefits:
  - Better account for interrelationships and correlations among risk sources.
  - Natural environment for comprehensive stress testing.
  - Potential to achieve desired balance sheet risk exposures more efficiently and cost-effectively.
  - Some exposures may be mitigated more cost-effectively via asset strategies rather than solely adjusting debt structure.

### Addressing vulnerabilities in the investor base
- Debt structure can be used to strengthen investor base resilience and diversification:
  - Certain instruments and foreign currency issuances or specific transaction sizes can attract particular investor classes.
  - Inflation-linked and longer-dated debt tend to attract institutional investors (pension and insurance companies); banks may prefer other instruments.
- Benefits of diversifying investor types:
  - Reduces rollover risk exposure, enhances market liquidity, and contributes to financial stability.
- Domestic investor participation:
  - Increasing domestic investor participation can provide resilience to sudden stops, but may increase interconnection between domestic financial sector and sovereign.
  - Targeting investor composition is difficult and risks creating captive investor bases; targeting domestic investors is particularly difficult in a monetary union.

### Challenges for debt management practices and market functioning
- Inter-related priorities for debt managers:
  - (i) achieving over time more robust debt structures while meeting immediate financing needs;
  - (ii) restoring market liquidity;
  - (iii) managing the impact of new regulations;
  - (iv) contributing to more effective sovereign risk management.
- Relevance: these issues are acute for advanced economies but remain relevant for emerging markets and LICs as non-concessional and market-based borrowing rises for infrastructure and investment needs.

### Ensuring sufficient operational flexibility
- Debt managers must retain flexibility to tailor financing operation sizes to market conditions while maintaining transparency and predictability.
- Tools to preserve predictability while allowing flexibility: issuance ranges.
- Debt managers should adopt proactive and timely market communication strategies as per the "Stockholm Principles."

### Lengthening maturities: opportunities and constraints
- Challenges:
  - Elevated financing needs in the medium term and volatile market conditions make lengthening maturities difficult.
  - Debt managers must balance meeting investor needs to ensure absorption of new issues against containing targeted risks and avoiding aggravating financial sector fragility.
  - Sovereign competition for long-term funding will rise as banks demand long-term financing due to regulatory capital buffer increases.
- Cost constraints:
  - Rising nominal interest rates as monetary conditions tighten will constrain the pace of lengthening maturity.
  - Entrenched inflation expectations risk significant increases in nominal fixed-rate yields, raising costs of extending maturities through nominal debt and making inflation-indexed debt relatively more attractive.
  - Countries with deep markets for inflation-linked debt should consider expanding issuance.
- Emerging markets:
  - Recent capital inflows present an opportunity to lengthen domestic currency debt maturity.
  - Pre-crisis, some emerging markets (e.g., Brazil, Mexico) increased issuance of longer-term fixed-rate and inflation-linked instruments to improve debt profiles and market efficiency.
  - Going forward, debt managers should, to the extent possible, resume and consolidate longer-term domestic currency debt issuance.
- Example macro figure: advanced economy gross financing needs are expected to remain at around 25-30 percent of GDP over the next two years.

### Potential benefits and considerations for Liability Management Operations (LMOs)
- LMOs (buybacks or exchanges of outstanding debt) have been used as financing techniques and risk management tools for two decades.
- Use cases:
  - Routine repurchase of near-maturity bonds as part of cash management (e.g., Belgium).
  - Significant reverse auction events (e.g., Portugal).
  - Debt exchanges to improve debt servicing profile or change investor preferences (e.g., U.K. in 2000s).
  - Regular ongoing LMOs in some countries (e.g., Brazil, Turkey); ad hoc use elsewhere for specific objectives.
  - Philippines exchanged nearly $3bn of outstanding debt for longer-dated issues in September 2010—the largest ever LMO in Asia.
- For meaningful portfolio restructuring, larger and possibly repeated LMOs may be necessary; fragile investor sentiment can complicate implementation.
- As part of a portfolio transition, systematic reverse auctions or debt exchanges for near-maturity bonds can reduce rollover needs over time.

*Source: _041811 - 28.      Overall, the importance of augmenting traditional cost-risk analysis with*

### 42.      Derivatives will also continue to play a role in helping debt managers achieve a more

### _041811 - 42.      Derivatives will also continue to play a role in helping debt managers achieve a more

### Derivatives and debt managers’ risk profiles
- Derivatives will continue to play a role in helping debt managers achieve a more favorable risk profile.
- Example: the use of standard interest rate swaps can provide some protection against potentially higher interest rates, complementing efforts to reduce interest rate exposure through maturity extension.
- The overall effectiveness of these tools will depend on country specific circumstances.
- Ongoing changes in collateral provisions—driven to a large extent by the regulatory reform agenda—may significantly change the market environment for some debt managers and change the cost-benefit trade-off.
- Note: appropriate debt management frameworks that adequately address the institutional, legal and accounting implications are required.

### Managing execution risk and investor appetite
- Investor appetite, including for new instruments, will be critical to achieving desired financing targets.
- Tailoring products to meet specific investor needs (as with an MTN) may help secure financing at the margin; however, focusing the core financing program on standard benchmark instruments, which maximizes liquidity, will likely remain most effective.
- There is scope to exploit ―preferred habitats‖ to secure a more robust investor structure (e.g., pension and insurance companies have a preference for inflation-indexed debt).
- Debt managers should tailor the speed of portfolio adjustment to market conditions and, in the short-term, place greater emphasis on minimizing execution risk.
- “Benchmark issuers” (systemically important sovereign issuers) should consider how their operations affect wider debt capital markets through their role as a market reference.
- Positive steps to enhance investor relations programs and improve transparency, including through enhanced data provision, will be critical to minimizing investor uncertainty and containing costs.
- An effective investor communications strategy will play a vital role in restoring confidence and improving market liquidity.

### Restoring market liquidity: tools and coordination
- Debt managers need to consider steps to mitigate market volatility and restore liquidity; there may be an effective role for LMOs.
- Examples of instruments and operations:
  - Debt exchanges that allow investors to lock in a desired relative price can help liquidity move from an “off-the-run” bond to a new benchmark bond (used by Brazil and Turkey).
  - Buybacks and debt exchanges to address market dislocations (used during the crisis in several emerging markets, e.g., Brazil, Korea).
  - Targeted bond sales (―taps‖) to relieve market liquidity at specific points of the curve (used by Belgium, Netherlands).
- Debt managers, central banks, and financial stability authorities should identify mechanisms to restore market liquidity, review effectiveness of buyback programs, QE programs, and the SMP, and consider a more permanent liquidity backstop (a “market maker of last resort”).
- Precedents and practices:
  - Some debt managers (e.g., Germany) are active participants in the secondary market, effectively providing a market making service.
  - Brazil conducts regular buyback auctions to provide liquidity windows.
  - Such facilities were more prevalent in the 1990s and early 2000s (e.g., Poland, U.K.), fell into disuse as markets developed, but may be meritorious given relaxed market making obligations in extreme conditions.
- The unwinding of QE programs will release bonds back into the market, raising the prospect of market indigestion and added volatility; ongoing dialogue between debt managers and central banks will be critical.

### Strengthening sovereign balance sheets and market confidence
- Improving market liquidity requires restoring market confidence and strengthening sovereign balance sheets.
- Strengthening sovereign balance sheets requires:
  - Credible fiscal policies over a sustained period.
  - Strengthened fiscal institutions to support these policies (Fiscal Monitor, November, 2010).
  - Enlarged insurance buffers in the debt structure, especially for countries with structural risk factors (e.g., large financial sectors or limited means to deal with rollover risk).
  - Focus on making financial institutions safer to mitigate and manage the sovereign‘s exposure to contingent liabilities.
- Debt managers will experience whether policies are perceived to be credible; enhanced credibility can create a virtuous circle: reduced perception of sovereign risk → lower financing costs → reinforcement of credible policies.

### Monitoring regulatory changes and market impacts
- Regulatory changes (strengthened capital and liquidity buffers; improvements in quality of capital and transparency) should reduce sovereign contingent exposure to the banking sector.
- Specific proposals—especially liquidity coverage and leverage ratios—may create problems for some countries (those with low debt relative to the size of the domestic banking sector) or for some operations (notably repo operations) (Box 6).
- Potential effects:
  - Demand for government bonds may rise for some countries.
  - New regulations may have detrimental effects on secondary market liquidity by increasing banks’ propensity to buy and hold sovereign debt securities, changing demand-supply dynamics and reducing market liquidity.
  - Effects aggravated where the supply of debt securities is small relative to the size of the banking sector.
- Debt managers, central banks, and financial stability authorities should closely monitor the impact of new regulations on secondary market liquidity and primary market participation.

### Collaboration, ALM approach, and institutional arrangements
- Debt managers should play a more central role in monitoring and possibly measuring the sovereign‘s exposure to banking sector contingent liabilities and assessing the likelihood of their materialization.
- Countries with large contingent liabilities, especially outsized banking sectors, will need to monitor such risk closely.
- Enhanced sovereign risk monitoring requires collaboration and information sharing across key institutions and may necessitate new cross-institutional arrangements (e.g., including debt managers on macro-prudential committees).
- A wider ALM (Asset-Liability Management) approach can facilitate these efforts by providing a consolidated view of the sovereign balance sheet and its risk exposure, drawing information from a broad range of policy areas, and coordinating portfolio strategies. Designing an operational ALM framework will require further work and entail significant institutional challenges.
- Establishing effective dialogue between debt managers and financial sector regulators can mitigate unintended consequences of regulatory changes; debt managers can contribute early to discussions on proposed regulatory changes (e.g., proposed ban on short-selling of sovereign debt).

### Box 6 highlights: New regulatory initiatives and sovereign debt markets
- Several new regulations are expected to increase demand for sovereign debt:
  - Basel III establishes two liquidity standards—a liquidity coverage ratio (LCR) and a net stable financing ratio (NSFR) to be introduced after an observation period.
  - As of end-2009, the Basel Committee on Banking Supervision (BCBS) estimates that the additional financing needed to meet the LCR ratio is about EUR1.7 trillion across large and internationally active banks.
  - New regulations on capital and risk weighted assets could incentivize banks to shift demand towards safer assets with lower risk weight.
  - Regulations for the nonbank financial sector (e.g., money market funds in the U.S., insurance companies in Europe) may also increase demand.
  - Reforms encouraging greater use of central counterparties for repos and derivatives are anticipated to increase demand for government debt for collateral purposes.
- Liquidity risks and market functioning:
  - The LCR-induced demand for sovereign debt may reduce liquidity by requiring banks to hold more government debt on their balance sheets, lowering the proportion available for sale and reducing secondary market trading, impeding price discovery and distorting market signals.
  - Jurisdictions with insufficient stock of debt to cover increased demand (e.g., Australia and Denmark) may face aggravated challenges; other countries with a low stock of sovereign debt could face similar challenges.
  - Other regulations on trading and leverage that disincentivize repo activity may further reduce liquidity in debt markets by making collateralized lending costly under an outright leverage ratio that includes repos.
  - Consequence: government bond markets could become broker markets where market makers neither trade on their own books nor provide continuous pricing.

### Fund support and next steps
- Fund staff can:
  - Help illuminate the nature and extent of key risks for debt management strategies.
  - Contribute to technical work on stress-testing methodologies and risk monitoring frameworks.
  - Facilitate consensus through multilateral interactions with debt managers, drawing on bilateral and multilateral surveillance.

### VI. Going forward: Key issues and recommended actions
- Strengthening risk management
  - Risk management frameworks should be enhanced, and greater attention paid to stress testing.
  - A more comprehensive approach should account for:
    - (i) the degree of macroeconomic policy flexibility available;
    - (ii) the degree of exposure of the sovereign balance sheet to, and interaction with, the financial sector;
    - (iii) the extent of other contingent liabilities, including those arising from quasi-sovereign and sub-national debt;
    - (iv) investor base fragility; and
    - (v) the risk of cross-border spillovers.
  - Debt structures need to be strengthened and appropriate risk buffers established, notably to limit rollover risk. LMOs can be used to modify debt structures more actively. A pragmatic approach is needed to determine the extent of feasible portfolio adjustment.
  - Emerging market economies should use the opportunity of increased capital inflows and renewed investor risk appetite to further lengthen the maturity of their debt structures.
- Greater collaboration
  - Collaboration should be strengthened across debt managers, fiscal authorities and financial sector regulators to enhance risk monitoring and management, including monitoring contingent risks in the financial sector, and better inform fiscal and financial stability assessments.
- Capital market considerations
  - The operational toolkit for debt management should remain flexible and comprehensive to deal with a variety of market circumstances. This includes techniques to mitigate market and liquidity risks and operations to improve secondary market liquidity.
  - “Benchmark issuers” (systemically important sovereign issuers) need to be mindful of how the effectiveness and success of their operations carry ramifications for broader debt capital markets.
  - Debt managers need to focus on enhancing investor relations programs along the lines suggested by the “Stockholm Principles.” This will help overcome limitations in primary dealer networks and reduce market volatility.
  - Debt issuance choices should contribute to diversifying the investor base where feasible—both in terms of residency and type.

*Source: IMF chapter/section text provided in content unit _041811 - 42.      Derivatives will also continue to play a role in helping debt managers achieve a more*

### APPENDIX I: SUMMARY OF DEBT MANAGERS’ RESPONSES—SELECTED COUNTRIES

### APPENDIX I: SUMMARY OF DEBT MANAGERS’ RESPONSES—SELECTED COUNTRIES

### Debt managers’ operational responses — selected country actions
- General overview:
  - Three broad approaches: (i) changing the issuance mix; (ii) adaptation of financing modalities; and (iii) stepping up market management operations.
- Advanced economies (selected actions as reported):
  - Belgium:
    - Introduced an EMTN program in 2008; initially increased issuance of short-term instruments (including in FX).
    - Increased tapping of long-term debt. Increased proportion of syndication and private placements (including through greater issuance of State notes and BTBs). Temporarily doubled number of auctions in first half of 2009.
    - Adapted primary dealers quoting obligations, initially under the provisions for ―exceptional market circumstances‖, but then moved to a permanent adoption of a peer performance measurement.
    - Treasury made responsible for administering State guarantees of banks; regular meeting of a monitoring committee established to assess the risk that the guarantees will be called.
  - Germany:
    - Increased tapping of long-term debt; increased foreign currency issuance.
    - Maintains a continuous presence in the secondary market that allows it to mitigate temporary market dislocations on an ongoing basis.
  - Italy:
    - In the uniform price auctions the Treasury moved from announcing a fixed size to be issued to an issuance range. The width of this auction range is calibrated according to market conditions.
    - Off‐the run bonds offered as a response to highly volatile market conditions. The timing of reopening of bonds to PDs at non-competitive prices also extended.
  - U.K.:
    - Initially increased the proportion of short-term instruments, but has subsequently refinanced these with long-term bonds.
    - Introduced a post-auction option facility (PAOF); introduced mini-tenders to supplement the core auction program; increased the proportion of issuance through syndication.
    - Partnered with the Bank of England on implementing the Special Liquidity Scheme; coordinated with the Bank on the bond purchase scheme.
    - Coordinated with the U.K. Treasury on the implementation and operation of the credit guarantee scheme and asset-backed guarantee scheme for banks.
  - U.S.:
    - Reintroduced the 3-year tenor; initially increased the proportion of short-term instruments; from 2009 has increased the proportion of inflation-linked and longer tenors.
    - Coordinated with the Federal Reserve on the bond buyback program.
    - Coordinating with the Federal Reserve on the management of the toxic assets acquired from AIG and Bear Stearns.
- Emerging markets (selected actions as reported):
  - Brazil:
    - Engaged in ad hoc debt buybacks and exchanges. Introduced regular buy-back program of longer-term fixed-rate bonds.
  - Hungary:
    - Stopped issuing long-dated fixed rate bonds; introduced floating-rate notes; introduced new inflation-linked instrument targeted at retail investor; increased proportion of FX issuance.
    - More flexibility in the amounts offered and in the auction calendar (bi‐weekly bond auctions with dates but without tenors in calendar).
    - Noncompetitive auction facility introduced. More frequent buy-back auctions, particularly in longer-dated bonds. More frequent reopening/ taps of off‐the‐run bonds.
    - Introduction of direct, regular meetings with institutional investors.
  - Korea:
    - Stopped issuance of inflation-linked bonds; initially limited issuance of long-term bonds.
    - Single price format of auctions was changed to a multiple price format.
    - Offered buy-back facility for inflation-linked instruments. Conversion offers also introduced.
  - Mexico:
    - Engaged in market management operations through buybacks and debt exchanges.
  - Turkey:
    - Initially reduced issuance of nominal fixed rate bonds; introduced innovative revenue-linked bond to broaden the investor base; subsequently introduced a new 10-year fixed rate bond (2009).
    - Revenue linked bond sold through private placements.
    - Increased scale of debt exchange program, i.e. bonds made available to primary dealers for switching at time of new issues.

### Sovereign and banking sector risk — key interconnections
- Domestic interlinkages:
  - Mechanisms of spillovers:
    - Asset side: a sharp decline in sovereign debt prices generates losses, especially for banks holding large portfolios of government bonds.
    - Liability side: banks‘ wholesale financing costs tend to rise in tandem with sovereign spreads.
    - Rising bank financing costs tighten credit conditions, reducing economic growth and tax revenues, which increases sovereign spreads and further raises financial sector risk.
  - Illustrative country experiences:
    - Iceland:
      - Financial sector assets expanded annually at about 100 percent of GDP to over 1,000 percent of GDP at end-2007, with about half consisting of foreign assets funded through external debt.
      - The gross fiscal cost of honoring deposit insurance obligations and recapitalizing commercial banks amounted to about 70 percent of GDP.
      - Gross government debt increased from 29 percent of GDP at end-2007 to an estimated 100 percent of GDP by end-2010.
    - Ireland:
      - Before the crisis Ireland had a fiscal surplus, relatively low public debt, and high growth; assets of domestic banks amounted to five times Ireland‘s GDP at the height of the boom.
      - Real GDP fell by nearly 11 percent over the period 2008-2009.
      - By the end of 2010, the Irish authorities had injected capital into the banking sector equivalent to 28 percent of GDP.
      - Public debt increased from 25 percent before the crisis to 99 percent of GDP at end-2010.
      - Debt issued by banks was guaranteed to the tune of 16 percent of GDP by end-2010.
- Cross-border aspects:
  - Financial sector linkages across borders transmit one country’s sovereign and banking concerns to other regional economies; markets differentiated among sovereigns within the euro area from April-May 2010 onward.
  - Example: French banks carry significant exposure to peripheral European governments, which may explain increases in CDS spreads of French banks since January 2010.
- Box 7 — Feedback channels between sovereign and banking sector risk (summarized):
  - Sovereign risk impacts banks via asset holdings of sovereign debt, collateral values for transactions (e.g., repos), and derivatives.
  - Sovereign debt valuation affects bank market value and provision needs; lower sovereign debt value reduces collateral value and can alter derivative positions.
  - Sovereign debt liquidity affects banks that use it to manage liquidity.
  - Banks often act as the de facto demander of last resort for sovereign debt by transforming short-term deposits into longer-term government debt holdings.
  - Governments provide deposit guarantees and loan guarantees, creating contingent liabilities.
  - Banks affect governments through the tax base and potential need for costly capital support or guarantees.

### Guiding principles for managing sovereign risk and high public debt (―Stockholm Principles‖)
- Framework and operations:
  1. The scope of debt management should be defined in a way that also accounts for any relevant interactions between the nature of financial assets, explicit and implicit contingent liabilities, and the structure of the debt portfolio.
  2. Strategic and operational debt management decisions should be supported by relevant information sharing at the domestic, regional, and global levels.
  3. Flexibility in market operations should be maintained to minimize execution risk, improve price discovery, relieve market dislocations, and support secondary market liquidity.
- Communication:
  4. Proactive and timely market communication strategies should be maintained to support a transparent and predictable operational framework for debt management.
  5. Modifications to the operational toolkits of debt managers should be properly explained.
  6. Communication among debt managers and monetary, fiscal, and financial regulatory authorities should be promoted, given greater inter-linkages across objectives, yet with each agency maintaining independence and accountability for its respective role.
  7. A close and continuing dialogue with the investor base should be promoted to keep abreast of its characteristics and preferences.
- Risk management:
  8. Debt portfolio risks should be kept at prudent levels, while funding costs are minimized over the medium to long term.
  9. When determining medium-term debt management strategies, the range of risk factors considered should be consistent with the broadest definition of the debt portfolio and the associated range of potential scenarios.
  10. Prudent risk management strategies covering the full range of risks facing sovereign debt managers should be adopted and communicated to investors.

### Debt structures and crises of the 1990s — original sin and its absolution
- Progress since the Tequila crisis of 1994/95:
  - Emerging market policymakers reduced fiscal dominance and inflation, lowering risk premia and lengthening the maturity of domestic currency debt.
  - Reliance on variable rate and foreign currency debt declined in many cases; inflation-indexed bonds were used to lengthen domestic maturities in countries including Chile, Brazil, Peru.
- Crisis-era resilience:
  - The relatively limited impact on emerging markets during the global financial crisis reflects improvements in macro policies and stronger debt structures.
  - Many emerging markets faced excess demand for their currency and debt instruments, allowing further strengthening of debt structures, though some still lag advanced countries.
- Figure-related note (as reported):
  - Evolution of Debt Composition, 1999-2009 highlighted that over time domestic maturities lengthened while variable rate debt decreased, with regional aggregations covering specified emerging markets reporting data to the BIS.

*APPENDIX I: SUMMARY OF DEBT MANAGERS’ RESPONSES—SELECTED COUNTRIES*

### APPENDIX V: SOVEREIGN RISK AND ITS COMPONENTS—DEFINING SOLVENCY AND

### APPENDIX V: SOVEREIGN RISK AND ITS COMPONENTS—DEFINING SOLVENCY AND LIQUIDITY/ROLLOVER RISK

### Definitions
- Sovereign risk: the risk of losses by an investor due to the failure of the issuer to service the nominal stream of payments agreed in a credit contract.
- Fiscal risk: the deviation between the projected and actual results of a country‘s fiscal stance and can be regarded as a contributing factor to sovereign risk.

### Determinants of sovereign risk
- Sovereign risk is logically split into two components:
  - A solvency component.
  - A liquidity component (including rollover risk).

### Solvency risk
- Definition: the risk that a country is not able to meet the present value of its external obligations evaluated at interest rates that are commensurate to the debt stock and primary balance.
- Characteristics:
  - Solvency is usually considered beyond the control of the debt management office.
  - Determined by the primary balances and the willingness to pay.

### Liquidity risk (including rollover risk)
- Definition: the risk that the government is unable to discharge its obligations due to a lack of liquid means, despite being solvent as evaluated at interest rates that are commensurate with the debt stock and primary balance.
- Characteristics:
  - Under the control of the debt manager but affected by contagion and global risk aversion.
  - Rollover risk: the risk that the government is unable to refinance debt falling due because new borrowing rates are exceptionally high or investors are unwilling to purchase the debt.

### Linkages between solvency and liquidity
- Illiquidity can lead to insolvency:
  - A solvent but illiquid entity can sell shares in future income streams or borrow against them to survive until cash flows turn positive.
  - Insolvency can occur if future income streams are discounted so heavily that they do not yield sufficient liquid assets to overcome liquidity constraints.
- Insolvency can lead to illiquidity:
  - Current liquidity can be exhausted by runs if investors/depositors anticipate future illiquidity.
- Note: solvency and liquidity risk are functions of interest and exchange rates.

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### APPENDIX VI: CHOOSING THE OPTIMAL MATURITY STRUCTURE: THE COST–RISK TRADEOFF

### Stylized set-up and assumptions
- A debt manager can choose between 15 different portfolios, each with a different average time to maturity (ATM).
- Each portfolio has a smooth and even maturity profile on an annual basis; the maximum maturity of each portfolio is twice the ATM.
  - Example P1: ATM = 1 year → two equal principal repayments (one in the first year, one in the second); maximum maturity = 2 years; short-term debt = 50 percent of the portfolio.
  - Example P15: ATM = 15 years → 30 principal payments, each of 3.3 percent of the portfolio; short-term debt = 3.3 percent of the portfolio; maximum maturity = 30 years.
- Assume the level of debt is high: debt / GDP ratio = 100 percent (results can be scaled by deviations from 100 percent).
- Consider exposure to a large and sustained shock to interest rates (e.g., contingent liability or fiscal shock) that increases the credit risk premium by 1,000 basis points.

### Illustrative outcomes of a 1,000 basis point shock
- If the shock is sustained over one year:
  - Additional cost of refinancing maturing debt = 5 percent of GDP for P1.
  - Additional cost of refinancing maturing debt = 0.33 percent of GDP for P15.
  - Consequently, the fiscal adjustment required to keep the deficit unchanged will be 15 times greater for P1 relative to P15.
- Under a medium-term sustained interest rate shock, assuming a balanced budget and maintaining the same portfolio structure by rolling maturing debt into a new bond at the maximum maturity of the portfolio:
  - The cumulative impact is a multiple of the additional interest cost incurred in the first year.
  - Example: for P1, debt maturing in the first year is rolled into a new 2-year bond; insufficient fiscal adjustment to maintain a balanced budget would cause the debt stock to grow as additional interest payments are financed with new debt.

### Cost side: yield curve and marginal cost
- Extending maturities increases underlying cost, depending on the shape of the yield curve.
- Assumed upward sloping linear yield curve examples:
  - Spread between 30-year and 2-year yields = 250 basis points.
  - Spread examples for comparison: 30-year vs 2-year gilts = 380 basis points; U.S. Treasuries = 420 basis points.
- The relationship between maturity and interest rate sensitivity is nonlinear; relative benefits of extending maturity decline as the starting position improves.
- The marginal cost of extending ATM beyond 1 year should be weighed against the reduction in interest rate sensitivity (risk exposure).

### Policy implication
- The actual cost–benefit tradeoff is country specific and depends on:
  - (i) the level of debt;
  - (ii) the maturity profile;
  - (iii) the shape of the yield curve.
- Choosing where to locate on the cost–risk trade-off is a key policy decision, influenced by the assessed likelihood or vulnerability to significant negative shocks to creditworthiness.
- Crisis experience indicates extreme events are possible and constitute reasonable scenarios to consider.

*Source: IMF staff estimates; content from the appendix text provided.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2011/_041811.pdf_