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

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### Crisis impact on sovereign debt management and market functioning
- Crisis revealed additional dimensions of risk in sovereign debt management:
  - managing debt composition to mitigate key risk exposures;
  - ensuring debt market functioning under stress;
  - recognizing feedback effects between financial and fiscal sectors and cross-border spillovers.
- Operational challenges for debt managers:
  - meet increased borrowing needs amid intensely challenging market conditions;
  - adopt creative operational approaches, changes in issuance mix and financing modalities, stepped-up market management activities, and coordinated central bank support.
- Recalibrate risk management frameworks to reflect:
  - potential materialization of contingent liabilities;
  - interaction of sovereign risk with financial sector risk;
  - degree of macroeconomic policy flexibility (exchange rate and monetary policy constraints) and their effect on financing costs under stress.
- Liquidity buffers assumed greater importance, especially for countries with constrained monetary policy or concentrated/fragile investor bases.

### Cross-country differences in financing stress and resilience
- Advanced economies experienced significant and widespread financing challenges; the number of financing operations increased sharply, elevating execution risk.
  - 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 were relatively less affected, aided by reforms over the previous decade (lengthened maturities, reduced floating-rate and foreign-currency exposure, improved institutional arrangements, transparency, investor relations, and local market development).
  - Example policy: Uruguay targets a minimum level of 12 months of debt servicing needs.
- Low-income countries (LICs) were relatively insulated due to low integration into international financial markets; main challenges were donor disbursement shortfalls and constrained access to concessional loans.

### Key statistics: Gross central government financing need (Average 2005-2007 and Average 2008-2010, % of GDP; Ratio)
- Selected advanced economies:
  - Australia: 0.5; 5.4; 11.2
  - Belgium: 14.8; 24.0; 1.6
  - Canada: 8.9; 14.7; 1.6
  - France: 10.6; 18.1; 1.7
  - Germany: 8.8; 12.8; 1.5
  - Italy: 19.2; 24.1; 1.3
  - Japan: 50.9; 50.6; 1.0
  - Netherlands: 6.3; 16.4; 2.6
  - U.K.: 5.7; 13.2; 2.3
  - U.S.: 13.4; 24.8; 1.8
- Selected emerging market economies:
  - Brazil: 25.0; 16.8; 0.7
  - Hungary: 21.4; 26.0; 1.1
  - Korea: 10.8; 10.0; 1.0
  - Mexico: 7.8; 11.5; 1.3
  - Turkey: 3.3; 5.7; 1.7
- 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).
- Sources: WEO; and BIS.

### Debt management responses and operational adjustments
- Three broad approaches used by debt managers to address increased financing needs:
  - Change in instrument mix (e.g., more short-term debt issuance to avoid overwhelming markets).
  - Change in issuance technique.
  - Market management activities to support liquidity and price discovery.
- Policies adopted in practice:
  - Increased issuance of short-term debt in many cases (notably Belgium, the Netherlands, U.K., and U.S.) to accommodate large sudden financing needs and to limit market disruption.
  - Use of liability management operations (LMOs) to lengthen maturity and reduce rollover and liquidity risk where feasible.
  - Maintain operational flexibility to adapt primary issuance techniques and deploy liability management to alleviate secondary market impairments and support liquidity.
- Country examples (selected):
  - Belgium: introduced EMTN program in 2008; temporarily doubled number of auctions in first half of 2009; adapted primary dealer quoting obligations to a peer performance measure.
  - U.K.: initially increased short-term issuance then refinanced with long-term bonds; introduced post-auction option facility (PAOF), mini-tenders, and increased syndication; partnered with Bank of England on Special Liquidity Scheme.
  - U.S.: reintroduced 3-year tenor; from 2009 increased inflation-linked and longer tenors; coordinated with Federal Reserve on bond buyback program.
  - Hungary: stopped issuing long-dated fixed rate bonds; introduced floating-rate notes and inflation-linked instrument; introduced noncompetitive auction facility and more frequent buy-back auctions.
  - Brazil: ad hoc debt buybacks and exchanges; introduced regular buy-back program of longer-term fixed-rate bonds.

### Expansion into non-core markets and borrowing instruments
- Debt managers expanded activity in international capital markets to improve investor diversification and ease the financing burden on domestic markets.
- Instrumental adjustments and reintroductions:
  - Canada and the U.S. re-introduced a three-year maturity.
  - Australia re-introduced inflation-linked bonds.
  - Some emerging markets (e.g., Poland) experienced a temporary resurgence in floating rate notes.
- Supplementary issuance programs and auction innovations:
  - Post-auction non-competitive facility introduced in Hungary and the U.K.
  - Smaller issues of “off-the-run” bonds became more frequent in the Netherlands, Belgium, Italy, Germany, and the U.K.
- Syndication and auction flexibility used to broaden investor participation and adapt to market stress:
  - U.K. syndication accounted for over 13 percent of issuance in 2009-10, and 16 percent in 2010-11.
  - Italy widened the band between minimum and maximum auction size; Hungary cut time between announcement and issue date while maintaining an annual pre-announced calendar.

### Limiting effects of market disruptions and market-support measures
- Market-liquidity operations employed:
  - Liability management operations (debt exchanges, purchases/sales of “off-the-runs”).
  - Repo facilities and market-support mechanisms offered by debt management offices (e.g., Belgium).
  - Targeted bond sales ("taps") and dealer exchange options (examples: Brazil, Turkey).
- Central bank actions supported markets:
  - Coordinated monetary easing and QE programs helped keep interest rates low in benchmark currencies.
  - ECB’s Securities Market Program (SMP) targeted extreme euro-area secondary market conditions.
  - Bank of England attributed a 100 basis point decline in gilt yields to the impact of the Asset Purchase Facility (APF).
- Market fragility persisted:
  - Volatility remained elevated, particularly in higher-spread euro-area countries.
  - Foreign investors reduced exposure to higher-spread euro-area government issuers, with domestic banks often offsetting the reduction.

### Stress testing public debt portfolios and enlarging risk frameworks
- Stress testing recognized in IMF-World Bank Guidelines for Public Debt Management (2001) and the "Stockholm Principles."
- Typical practice: stress test the debt portfolio for standardized shocks to key variables; cost-at-risk models capture standardized shocks often with limited feedback.
- More complete approach: incorporate feedback channels (e.g., higher interest rates → impact on GDP and budget; changes in investor demand) requiring broader economic modeling and cross-agency input.
- Calibration challenges:
  - Extreme-event calibration is difficult; historical analysis may be insufficient.
  - Fund staff developing principles on calibration and use of stress tests (to be discussed at 11th Annual IMF Consultations on Public Debt Management Policy and Operational Issues, Seoul, June 2011).
- Shortcoming: stress tests often conducted standalone by different stakeholders; ideal is a joint stress test of sovereign balance sheet and financial sector.

### Structuring the debt portfolio to mitigate shocks and liquidity buffer trade-offs
- Benefits of a relatively low rollover profile:
  - Example: fiscal year 2008—reflecting an unusually long ATM, the U.K. only needed to refinance GBP 17 billion of bonds (about 1.3 percent of GDP).
  - Longer maturities reduce the risk that an investor strike will drive up yields and provide resilience where exchange rate regimes constrain policy choices.
- ATM context: U.K. ATM at around 14 years is about twice as long as the European average and close to three times as long as the U.S. portfolio.
- Debt-structure instruments:
  - Variable-rate debt: protection when monetary policy lowers interest rates.
  - Fixed-rate debt: protection against negative supply shocks that push up interest rates.
  - Inflation-linked bonds: debt service correlated with government revenue and can reduce rollover risk when lengthening maturities.
- Liquidity buffers:
  - Examples of sovereigns using buffers or macro-stabilization funds: Chile, Ireland, Norway, Russia.
  - Many debt managers pre-fund or buy back shorter-dated maturities (e.g., Belgium, Netherlands, Portugal).
  - Constraints: some fiscal frameworks limit cash buffer establishment (example: Finland—no provision for pre-funding).
  - Trade-off determinants: level of debt; degree of fiscal space; potential flexibility of monetary and exchange rate policy; assessment of scale and likelihood of contingent liabilities; durability of market access.
  - Bank-Fund MTDS Framework provides guidance (IMF-World Bank, 2009).

### Adopting an integrated sovereign ALM framework and investor base considerations
- Integrated sovereign ALM framework:
  - Joint analysis of financial assets and liabilities allows accounting for interrelationships and correlations among sources of risk.
  - Enables more comprehensive stress testing and potentially more cost-effective mitigation via asset investment strategies as well as liabilities.
- Investor base vulnerabilities:
  - Debt-structure changes can attract specific investor classes (inflation-linked and longer-dated debt to pension and insurance companies).
  - Reducing concentration of investor type can reduce rollover risk and enhance liquidity, but increasing domestic investor participation may raise sovereign–financial sector interconnection risk.
  - Targeting investor base composition is difficult, especially in a monetary union with free capital movement.

### Role of derivatives, collateral changes, and market-making
- Derivatives (e.g., interest rate swaps) can help achieve a more favorable risk profile and complement maturity extension efforts.
- Changes in collateral provisions driven by regulatory reform may change the cost-benefit trade-off for derivatives.
- Market-making and liquidity backstops:
  - Debt managers, central banks, and financial stability authorities should consider buyback programs, QE program unwinds, and potential establishment of a more permanent liquidity backstop (a "market maker of last resort").
  - Unwinding of QE programs will release bonds back into the market, raising the prospect of market indigestion and added volatility.
- Monitoring regulatory impacts:
  - Basel III liquidity standards (LCR and NSFR) and associated estimated additional financing need of about EUR1.7 trillion (BCBS estimate as of end-2009) suggest increased bank demand for sovereign debt.
  - Regulation-induced demand for sovereign debt may reduce secondary market liquidity by increasing banks’ propensity to buy-and-hold government debt.
  - Jurisdictions with insufficient stock of debt relative to bank demand (examples cited: Australia and Denmark) face aggravated challenges.

### Liability Management Operations (LMOs): benefits and execution risk
- LMOs (buybacks, exchanges) are normal financing techniques and risk management tools used to:
  - achieve a more desirable portfolio structure;
  - accelerate portfolio transition with a series of LMOs;
  - provide investor liquidation windows and improve secondary market functioning.
- Examples:
  - Standing repurchase of near-maturity bonds—Belgium;
  - Reverse auction events—Portugal;
  - Philippines exchanged nearly $3bn of outstanding debt for longer-dated issues in September 2010—the largest ever LMO in Asia.
- Execution risk considerations:
  - Larger LMOs can be challenging during fragile investor sentiment;
  - Debt managers should tailor speed of portfolio adjustment to market conditions and place short-term emphasis on minimizing execution risk.

### Interconnections between sovereign and banking sector risk
- Domestic channels:
  - Asset side: declines in sovereign debt prices generate losses for banks holding government bonds; sovereign debt used as collateral loses utility when prices fall.
  - Liability side: banks’ wholesale financing costs rise with sovereign spreads, tightening credit conditions and harming growth and tax revenues.
- Feedback loop can amplify vulnerabilities, increasing probability that contingent liabilities materialize.
- Extreme case illustrations:
  - Iceland (2008): financial sector assets expanded to over 1,000 percent of GDP at end-2007; gross fiscal cost of bank support amounted to about 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 (2008–2010): banks’ assets about five times GDP at peak; real GDP fell by nearly 11 percent over 2008-2009; capital injections equivalent to 28 percent of GDP by end-2010; public debt rose from 25 percent pre-crisis to 99 percent of GDP at end-2010; banks’ debt guarantees amounted to 16 percent of GDP by end-2010.
- Cross-border transmission:
  - Differentiated sovereign risk within the euro area produced spillovers to banks with exposures to affected sovereigns (example: French banks’ exposure to peripheral European governments).

### Guiding principles and policy recommendations (Stockholm Principles and VI. Going forward)
- Strengthening risk management:
  - Enhance risk management frameworks and place greater emphasis on stress testing.
  - Adopt comprehensive approaches accounting for:
    - (i) degree of macroeconomic policy flexibility available;
    - (ii) exposure of the sovereign balance sheet to, and interaction with, the financial sector;
    - (iii) extent of contingent liabilities, including quasi-sovereign and sub-national debt;
    - (iv) investor base fragility; and
    - (v) risk of cross-border spillovers.
  - Strengthen debt structures and establish appropriate risk buffers to limit rollover risk; use LMOs to modify debt structures actively.
  - Follow a pragmatic approach on feasible portfolio adjustment; emerging market economies should use opportunities from capital inflows to lengthen maturities.
- Greater collaboration:
  - Strengthen collaboration across debt managers, fiscal authorities and financial sector regulators to enhance risk monitoring and management, including monitoring contingent risks in the financial sector.
  - Include debt managers in macro-prudential monitoring arrangements where appropriate.
- Capital market and operational considerations:
  - Maintain a flexible and comprehensive operational toolkit to address market circumstances, mitigate market and liquidity risks, and improve secondary market liquidity.
  - Benchmark/systemically important sovereign issuers must be mindful of wider market ramifications of their operations.
  - Enhance investor relations programs per the "Stockholm Principles" to overcome primary dealer limitations and reduce volatility.
  - Design issuance to diversify the investor base by residency and type where feasible.

### Operational flexibility, lengthening maturities, and constraints
- Operational flexibility:
  - Tailor financing operation sizes to market conditions and exploit opportunities to secure more robust portfolio structures while preserving transparency and predictability (e.g., issuance ranges).
  - Proactive and timely market communication strategies recommended (Stockholm Principles).
- Lengthening maturities—opportunities and constraints:
  - Constraints: elevated medium-term financing needs; volatile market conditions; competition for long-term funding from banks; rising interest rates as monetary conditions tighten.
  - For countries with deep inflation-linked debt markets, consider expanding issuance of inflation-linked instruments.
  - Advanced economy gross financing needs projected to remain at around 25-30 percent of GDP over the next two years.

### Institutional recommendations and Fund support
- Enhanced institutional arrangements:
  - Debt managers should monitor sovereign exposure to banking sector contingent liabilities and participate in cross-institutional arrangements and macro-prudential committees where appropriate.
  - Adopt wider ALM approaches requiring consolidated sovereign balance sheet views and cross-policy coordination.
- Fund support and technical assistance:
  - Fund staff can assist with stress-testing methodologies, risk monitoring frameworks, and facilitating multilateral consensus through surveillance and technical work.

*IMF staff paper drafted by a team led by Udaibir S. Das.*

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

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

### Crisis impact on sovereign debt management and market functioning
- The crisis revealed additional dimensions of risk in sovereign debt management, increasing the importance of:
  - managing debt composition to mitigate key risk exposures;
  - ensuring debt market functioning under stress;
  - recognizing feedback effects between financial and fiscal sectors and cross-border spillovers.
- Debt managers faced an operational challenge: meeting increased borrowing needs amid intensely challenging market conditions, requiring creative operational approaches, changes in issuance mix and financing modalities, stepped-up market management activities, and coordinated support from central banks.
- Risk management frameworks need to be recalibrated to reflect:
  - potential materialization of contingent liabilities;
  - interaction of sovereign risk with financial sector risk;
  - degree of macroeconomic policy flexibility (exchange rate and monetary policy constraints) and their effect on financing costs under stress.
- Liquidity buffers assumed greater importance, especially for countries with constrained monetary policy or concentrated/fragile investor bases.

### Cross-country differences in financing stress and resilience
- Advanced economies experienced significant and widespread financing challenges; the number of financing operations increased sharply, elevating execution risk.
  - Example: in the U.K. the 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 were relatively less affected, in part due to enhanced resilience from reforms over the previous decade (lengthened maturities, reduced floating-rate and foreign-currency exposure, improved institutional arrangements, transparency, investor relations, and local market development).
  - Uruguay targets a minimum level of 12 months of debt servicing needs.
- Low-income countries (LICs) were relatively insulated because of low integration into international financial markets; their main challenges related to donor disbursement shortfalls and constrained access to concessional loans.

### Key statistics: Gross central government financing need (Average 2005-2007 and Average 2008-2010, % of GDP; Ratio)
- Selected advanced economies:
  - Australia: 0.5; 5.4; 11.2
  - Belgium: 14.8; 24.0; 1.6
  - Canada: 8.9; 14.7; 1.6
  - France: 10.6; 18.1; 1.7
  - Germany: 8.8; 12.8; 1.5
  - Italy: 19.2; 24.1; 1.3
  - Japan: 50.9; 50.6; 1.0
  - Netherlands: 6.3; 16.4; 2.6
  - U.K.: 5.7; 13.2; 2.3
  - U.S.: 13.4; 24.8; 1.8
- Selected emerging market economies:
  - Brazil: 25.0; 16.8; 0.7
  - Hungary: 21.4; 26.0; 1.1
  - Korea: 10.8; 10.0; 1.0
  - Mexico: 7.8; 11.5; 1.3
  - Turkey: 3.3; 5.7; 1.7
- Sources listed: WEO; and BIS.
- 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).

### Debt management responses and operational adjustments
- Three broad approaches used by debt managers to address increased financing needs:
  - Change in instrument mix (e.g., more short-term debt issuance to avoid overwhelming markets).
  - Change in issuance technique.
  - Market management activities to support liquidity and price discovery.
- Table 2 sample of responses (change in instrument mix / change in issuance technique / market management activities):
  - Advanced economies:
    - Belgium: X / X / X
    - Germany: X /   /
    - Italy:   X / X
    - The Netherlands: X /   X
    - U.K.: X / X / X
    - U.S.: X /   X
  - Emerging market economies:
    - Brazil:   / X /
    - Hungary: X /   X
    - Korea: X /   X
    - Mexico:   X / X
    - Poland: X / X / X
    - Turkey: X / X / X
  - Note: See Appendix I for more detail of the changes.
- Policies adopted in practice:
  - Increased issuance of short-term debt in many cases (notably Belgium, the Netherlands, U.K., and U.S.) to accommodate large sudden financing needs and to limit market disruption.
  - Use of liability management operations to lengthen maturity and reduce rollover and liquidity risk where feasible.
  - Maintenance of sufficient operational flexibility to adapt primary issuance techniques and deploy liability management to alleviate secondary market impairments and support liquidity.

### Policy recommendations and lessons for debt managers
- Augment risk management frameworks to explicitly incorporate:
  - contingent liabilities;
  - interaction between sovereign and financial sector risk, including cross-border spillovers;
  - degree of macroeconomic policy flexibility and its impact on financing costs under stress.
- Improve resilience of debt structures:
  - lengthen maturity profiles;
  - reduce rollover and liquidity risk;
  - where possible, emerging markets should use capital inflows to lengthen the maturity of domestic-currency debt;
  - maintain appropriate liquidity buffers.
- Ensure operational flexibility:
  - preserve scope to adapt issuance techniques;
  - use liability management operations to improve market functioning and reduce execution risk;
  - systemically important sovereign issuers must be aware of the risk of broader market disruption from unsuccessful market operations.
- Strengthen communication with investors and stakeholders:
  - better understand investor base and investment horizons;
  - assess impact of regulatory reforms on investor behavior;
  - identify potential capital market vulnerabilities to inform instrument design and mitigate sudden loss of market access.
- Enhance collaboration among debt managers and other policymakers:
  - determine ex-ante exposures (financial sector, demographics) to inform interventions and liquidity buffer sizing;
  - ensure consistency between debt management, macroeconomic, and financial sector policies;
  - leverage institutional arrangements for macro-prudential monitoring to support debt market liquidity.

*IMF staff paper drafted by a team led by Udaibir S. Das.*

### 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 markets and instruments
- Debt managers expanded activity in international capital markets to improve investor diversification and ease the financing burden on domestic markets.
- Before the crisis, Belgium and the Netherlands had introduced a medium-term note (MTN) program to promote investor diversification and to secure some cost advantages.
- In some instances, increased borrowing needs were met by re-introducing debt instruments:
  - Canada and the U.S. re-introduced a three-year maturity.
  - Australia re-introduced inflation-linked bonds.
  - Some emerging markets experienced a temporary resurgence in the use of floating rate notes (e.g., Poland).
- Supplementary issuance programs complemented core issuance:
  - Post-auction non-competitive facility for primary dealers was introduced in Hungary and the U.K.
  - Smaller issues of “off-the-run” bonds became more frequent and significant in the Netherlands, Belgium, Italy, Germany, and the U.K.

### Limiting the effects of market disruptions and dislocations
- Market perceptions of sovereign risk intensified as sovereign balance sheets deteriorated, highlighting interconnectedness between sovereign risk and the financial sector (Iceland and Ireland cited as vivid examples).
- AAA-rated issuers benefited from “safe haven” flows, while less creditworthy issuers experienced greater market volatility, especially where ratings approached or breached investment-mandate thresholds.
- Cross-border spillovers amplified market deterioration; contagion from concerns about one sovereign spread to others perceived to have similar vulnerabilities.
- Primary and secondary market fragility forced operational adaptations:
  - Greater use of syndication to broaden investor participation (in the U.K. syndication accounted for over 13 percent of issuance in 2009-10, and 16 percent in 2010-11).
  - Auction formats and sizes were made more flexible (e.g., Italy widened the band between minimum and maximum auction size; Hungary cut the time between announcement and issue date while maintaining an annual pre-announced calendar).
  - Primary dealer frameworks were adapted; market-making obligations were relaxed or adjusted during the crisis (Belgium moved permanently to a relative performance measure for dealer quotation obligations).
- Debt managers used market-liquidity operations:
  - Liability management operations, such as debt exchanges and purchases or sales of “off-the-runs,” were deployed (often at dealer request, e.g., Italy).
  - Repo facilities and other market-support mechanisms offered by debt management offices were expanded (e.g., Belgium).
  - Despite these efforts, liquidity in secondary markets—particularly for non-benchmark issuers—remained relatively poor.
- Investor relations were refocused to restore confidence:
  - Increased emphasis on keeping investors and stakeholders informed.
  - Stepped-up non-deal road-shows and direct access to debt managers and policy officials to attract new investors, particularly from Asia and the Middle East.
- Central bank policy actions supported markets:
  - 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.
  - The European Central Bank’s Securities Market Program (SMP) was designed to directly target extreme conditions in euro-area secondary debt markets while being neutral from a monetary policy perspective.
  - Example: the Bank of England attributed a 100 basis point decline in gilt yields to the impact of the Asset Purchase Facility (APF).
- Market conditions remained fragile:
  - Volatility, especially in higher-spread euro-area countries, remained elevated and constrained investor appetite.
  - Foreign investors reduced exposure to higher-spread euro-area government issuers, with domestic banks often offsetting the reduction.

### Taking on other crisis-related functions
- Debt managers’ responsibilities broadened into other policy areas, requiring new institutional mechanisms:
  - Active roles in managing government financial-sector acquisitions (e.g., Sweden, U.S.).
  - Involvement in bank-related guarantee schemes (e.g., Belgium, U.K.).
  - Support for market liquidity in other sectors in some instances (e.g., Sweden).

### Implications for debt management strategies and risk management
- The crisis highlighted interconnections between debt management and macroeconomic policy constraints, including sovereign vulnerability to financial-sector contingent liabilities and the importance of managing liquidity risk within a monetary union.
- The experience underlined several imperatives for debt management policies and strategies going forward:
  - (i) have in place a strong risk management framework;
  - (ii) actively use the structure of the debt to mitigate shocks;
  - (iii) maintain access to a liquidity buffer;
  - (iv) adopt an integrated asset-liability (ALM) management framework to monitor and mitigate risk on the sovereign balance sheet;
  - (v) address vulnerabilities in the investor base.
- Enhancing the risk management framework:
  - Traditional cost-at-risk analysis may not capture the full range of risk factors or important interactions between macroeconomic vulnerabilities and debt structures.
  - Models calibrated on historical outcomes may fail to capture extreme events like 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—issues highlighted by the euro-area debt crisis.
  - Excessive reliance on nonresident investors can exacerbate financing risk if nonresidents are more sensitive to sovereign-balance-sheet quality and react to downgrades or perceived vulnerabilities.

*Source: IMF staff; references include Fiscal Monitor (April 2011) and IMF analyses cited in the text.*

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

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

### Stress testing public debt portfolios
- Stress testing was recognized in the Guidelines for Public Debt Management (IMF-World Bank, 2001) and reiterated in the "Stockholm Principles" (Appendix III).
- Purpose: assess the impact of a shock or extreme event on key cost and risk debt indicators (for example, indicators of liquidity risk, such as the timing and scale of debt servicing cash flows).
- Typical practice: stress test the debt portfolio for standardized shocks to key variables, often with limited feedback to other variables; a typical cost-at-risk model captures the impact of these standardized shocks.
- More complete approach: factor in feedback (e.g., higher interest rates → impact on GDP and the budget position; changes in investor demand) requiring broader economic modeling and input from other officials.
- Calibration challenges:
  - Extreme-event calibration is difficult; historical analysis helps but may be insufficient as extreme events can be larger than past experience.
  - Fund staff are developing principles on calibration and use of stress tests to be discussed at the 11th Annual IMF Consultations on Public Debt Management Policy and Operational Issues (Seoul, June 2011).
- Current practice shortcoming: stress tests are often standalone by different stakeholders (debt managers, bank supervisors, sovereign wealth funds); ideally they should converge to a joint stress test of the sovereign balance sheet and financial sector to allow a holistic assessment of vulnerabilities.
- Note: Much subsequent work focused on stochastic cost-at-risk models rather than on defining specific extreme scenarios (OECD, 2005); anecdotal evidence suggests some debt managers are beginning to place greater focus on specific stress scenarios, including extreme financing shocks.

### Structuring the debt portfolio to mitigate shocks
- Crisis lessons: portfolio structures can provide insurance against a range of shocks; many emerging markets emphasized mitigating rollover risk and external vulnerabilities since the 1990s, contributing to resilience in the crisis.
- Benefits of a relatively low rollover profile:
  - Example: fiscal year 2008—reflecting an unusually long average term to maturity (ATM), the U.K. only needed to refinance GBP 17 billion of bonds (about 1.3 percent of GDP).
  - Other benefits: (i) reduces risk that an investor strike will drive up yields; (ii) provides resilience where the exchange rate regime constrains policy choices; (iii) reduces cost of servicing debt as creditworthiness deteriorates; (iv) makes it easier to absorb financing impact of reduced tax receipts and an accommodative fiscal policy.
- ATM context: U.K. ATM at around 14 years is about twice as long as the European average and close to three times as long as the U.S. portfolio.
- Debt-structure instruments and their protections:
  - Variable-rate debt: protects against negative demand shocks when monetary policy lowers interest rates.
  - Fixed-rate debt: protects against negative supply shocks that push up interest rates.
  - Inflation-linked bonds: provide debt service correlated with government revenue and can reduce rollover risk if used to lengthen maturities.
- Sovereign credit/default risk: long-term fixed-rate debt minimizes transmission of market-perceived sovereign risk into debt service costs; variable-rate and short-term fixed-rate debt can aggravate this risk.
- Liquidity risk: a longer and smoother maturity profile limits principal payments in any period and creates financing space to absorb other fiscal needs.

### Recalibrating liquidity buffers
- Liquidity buffers reduce rollover risk by providing access to resources to meet redemptions.
- Examples of sovereigns using buffers or macro-stabilization funds to offset financing needs: Chile, Ireland, Norway, Russia.
- Many debt managers actively pre-fund or buy back shorter-dated maturities as part of operations (e.g., Belgium, Netherlands, Portugal).
- Constraints: some fiscal frameworks limit cash buffer establishment (example: Finland—no provision for pre-funding).
- Large buffers can affect government cash management and central bank liquidity management; buffer decisions need coordination across stakeholders.
- Trade-off: building resilience via buffers entails costs; debt management must determine appropriate trade-off between cost and risk given:
  - level of debt,
  - degree of fiscal space,
  - potential flexibility of monetary and exchange rate policy,
  - assessment of scale and likelihood of contingent liabilities materializing,
  - durability of market access.
- Appendix IV presents a stylized representation of this trade-off; Bank-Fund MTDS Framework provides guidance (IMF-World Bank, 2009).

### Adopting an integrated sovereign ALM framework
- A comprehensive and integrated sovereign asset and liability management (ALM) framework can be useful.
- Joint analysis of financial assets and liabilities on the sovereign balance sheet allows decision makers to account for interrelationships and correlations among sources of risk.
- An integrated ALM provides a natural environment for more comprehensive stress testing and can achieve desired balance sheet risk exposure more efficiently and cost effectively.
- Some exposures might be mitigated more cost-effectively via asset investment strategy rather than adjusting the debt structure alone.

### Addressing vulnerabilities in the investor base
- Debt-structure changes can strengthen investor diversification; certain instruments attract specific investor classes (e.g., foreign-currency issuance, minimum transaction sizes).
- Inflation-linked debt and longer-dated debt tend to appeal to institutional investors (pension and insurance companies); banks may prefer other instruments.
- Reducing concentration of investor type can:
  - reduce rollover risk,
  - enhance market liquidity,
  - contribute to financial stability.
- Increasing domestic investor participation might provide resilience to sudden stops but could increase sovereign–financial sector interconnection risk.
- Targeting investor base composition is difficult; care needed to avoid creating a captive investor base that harms market functioning and financial stability.
- Targeting domestic investors is particularly difficult in a monetary union where capital movement is free and foreign currency risk is absent.

### 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 management of sovereign risk.
- Relevance: While issues may be more acute for advanced economies, they remain relevant for emerging markets and LICs as non-concessional and market-based borrowing increases to meet investment needs.

### Ensuring sufficient operational flexibility
- Debt management operations must remain flexible given continuing financing needs and elevated sovereign balance sheet and market risks.
- Flexibility includes tailoring the size of financing operations to market conditions and exploiting opportunities to secure a more robust portfolio structure.
- Flexibility must not reduce transparency or predictability; issuance ranges can preserve predictability while allowing scope to adjust size to revealed market demand.
- Debt managers should adopt proactive and timely market communication strategies so operational framework changes are quickly and clearly communicated (Stockholm Principles).

### Lengthening maturities: opportunities and constraints
- Challenges to lengthening maturities:
  - overall financing needs remain elevated into the medium term;
  - market conditions likely volatile until confidence is restored.
- Debt managers must weigh meeting investor needs to ensure smooth absorption of new issues against the risks they aim to contain, including potential increased financial sector fragility.
- Competition for long-term funding: sovereigns face increased competition from banks seeking long-term financing due to regulatory efforts to increase capital buffers.
- Rising interest rates as monetary conditions tighten will constrain the pace of lengthening maturities; rising nominal fixed-rate yields (if inflation expectations become entrenched) increase relative costs of extending maturities via nominal debt and make inflation-indexed debt more attractive.
- Countries with established, deep markets for inflation-linked debt should consider expanding issuance of these instruments.
- Emerging market opportunity: recent capital inflows prior to the crisis allowed some emerging markets (e.g., Brazil, Mexico) to increase issuance of longer-term fixed-rate and inflation-linked instruments, improving debt profile and market efficiency; debt managers should, to the extent possible, resume and consolidate longer-term domestic currency debt issuance.
- Example financing needs projection: advanced economy gross financing needs are expected to remain at around 25-30 percent of GDP over the next two years.

### Potential benefits and use of Liability Management Operations (LMOs)
- LMOs (buybacks or exchanges of outstanding debt) have been used as normal financing technique and important risk management tool over the last two decades.
- LMOs can help achieve a more desirable portfolio structure; a series of LMOs spread over time can accelerate portfolio transition.
- Small-scale tools: systematic reverse auctions or debt exchanges for near-maturity bonds can reduce rollover needs (examples: standing repurchase of near-maturity bonds—Belgium; reverse auction events—Portugal).
- Larger operations may be necessary for significant portfolio impact but can be challenging when investor sentiment is fragile.
- Debt exchanges can:
  - achieve a more favorable debt servicing profile,
  - facilitate changes in investor preferences (examples: U.K. in 2000s; Philippines exchanged nearly $3bn of outstanding debt for longer-dated issues in September 2010—the largest ever LMO in Asia).
- Some debt managers use LMOs regularly as ongoing business (e.g., Brazil and Turkey); others use them ad hoc to meet portfolio objectives.

*Source: IMF staff analysis and cited IMF-World Bank frameworks and related references in the provided content.*

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

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

### Role of derivatives and collateral changes
- Derivatives can help debt managers achieve a more favorable risk profile by, for example, using standard interest rate swaps to provide protection against potentially higher interest rates and complementing maturity extension efforts.
- The overall effectiveness of derivatives depends on country specific circumstances. 33
- Ongoing changes in collateral provisions related to the use of these instruments—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: associated risks of greater capital inflows include potential to destabilize the debt market via sharp reversals, inflationary pressures, and exchange rate appreciation. 31
- Facilities allowing investors to exchange shorter remaining maturity bonds for longer-dated bonds could be useful. 32
- Appropriate debt management frameworks must address institutional, legal and accounting implications. 33

### Managing execution risk and investor appetite
- Investor appetite, including for new instruments, is critical to achieving financing targets.
- Product design can increase investor diversification; tailoring products to specific investors (as with an MTN) can secure marginal financing, but focusing on standard benchmark instruments that maximize liquidity will likely remain the most effective approach.
- There is scope to exploit "preferred habitats" (e.g., institutional investors such as pension and insurance companies preferring inflation-indexed debt) to diversify the investor base.
- Debt managers should tailor the speed of portfolio adjustment to market conditions, placing greater short-term emphasis on minimizing execution risk.
- "Benchmark issuers" (systemically important sovereign issuers) should recognize their operations’ wider market repercussions. 34
- Enhancing investor relations programs and improving transparency, including through enhanced data provision, is critical to minimize investor uncertainty and contain costs. 35
- An effective investor communications strategy is vital to restore confidence and improve market liquidity.

### Restoring market liquidity
- Debt managers should consider steps to mitigate market volatility and restore liquidity; LMOs (liquidity management operations) can play an effective role.
- Debt exchanges allowing investors to lock in a desired relative price can help shift liquidity from "off-the-run" bonds to new benchmark bonds. 36
- Examples: Brazil and Turkey provide an exchange option to primary dealers as part of regular auction frameworks.
- Buybacks and debt exchanges have been used to address market dislocations (e.g., Brazil, Korea); targeted bond sales ("taps") were used by many during the crisis (e.g., Belgium, Netherlands).
- Debt managers, central banks and financial stability authorities should collaborate to review buyback programs, QE programs, and SMP effectiveness and consider establishing a more permanent liquidity backstop (a "market maker of last resort").
- Some debt managers (e.g., Germany) act as active secondary market participants to provide market-making services; others (e.g., Brazil) conduct regular buyback auctions to provide investor liquidation windows.
- Such facilities were more prevalent in the 1990s and early 2000s (e.g., Poland, U.K.) but fell into disuse as markets developed and market-making obligations tightened; relaxing market-making obligations in extreme conditions suggests possible merit in wider use of these programs.
- Unwinding of QE programs will release bonds back into the market, raising the prospect of market indigestion and added volatility spilling into other asset markets; ongoing dialogue between debt managers and central banks is critical. 47

### Strengthening sovereign balance sheets and credibility
- Restoring market confidence and strengthening sovereign balance sheets requires credible fiscal policies over a sustained period and strengthened fiscal institutions (Fiscal Monitor, November, 2010).
- Insurance buffers in the debt structure need enlarging, especially for countries with structural risk factors (large financial sectors or limited means to deal with rollover risk).
- Authorities should focus on making financial institutions safer to mitigate sovereign exposure to contingent liabilities.
- Debt managers will directly observe whether policies are perceived as credible; improved credibility can reduce perceived sovereign risk, lower financing costs, and reinforce credible policies.

### Monitoring the impact of regulatory changes
- Regulatory changes (e.g., enhanced capital and liquidity buffers, improvements in capital quality and market transparency) should reduce sovereign contingent exposure to the banking sector. 37
- Specific proposals—particularly liquidity coverage and leverage ratios—may create problems for some countries or operations (notably repo operations) and change the cost-benefit trade-off for debt managers. (See Box 6.)
- New regulations may increase demand for government bonds but could have detrimental effects on secondary market liquidity by increasing banks' propensity to buy-and-hold sovereign debt, reducing the proportion available for sale and trading. 38
- Effects are more acute where the stock of debt 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.

### Box 6 — New regulatory initiatives and sovereign debt markets (key points)
- 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 BCBS estimates that the additional financing needed to meet the LCR ratio is about EUR1.7 trillion across large and internationally active banks.
- The financing gap is expected largely to be closed through increased purchases of sovereign debt by banks.
- New regulations on capital and risk-weighted assets could incentivize banks to shift demand towards safer assets with lower risk weights, further increasing demand for sovereign debt.
- Regulatory changes for the nonbank financial sector (e.g., money market funds in the U.S., insurance companies in Europe) and reduced reliance on credit rating agencies may also increase demand for sovereign debt.
- Encouraging greater use of central counterparties for repos and derivative transactions is anticipated to increase demand for government debt for collateral purposes.
- Regulation-induced demand for sovereign debt (in particular the LCR) may reduce market liquidity by requiring banks to hold more government debt on their own balance sheets, reducing the amount available for sale and impeding secondary market trading, price discovery and market signals. 2,3
- Jurisdictions with insufficient stock of debt relative to increased bank demand (e.g., Australia and Denmark) face aggravated challenges; the Basel process allows for exceptions and country-specific solutions, though formal rules for exceptions have not yet been formulated.
- Regulations disincentivizing repo activity (e.g., an outright leverage ratio that treats repos as leverage) could make repo lending costly and potentially lead government bond markets to become broker markets where market makers neither trade on their own books nor provide continuous pricing.

### Enhanced 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 likelihood of materialization, particularly in countries with large contingent liabilities or outsized banking sectors.
- Enhanced sovereign risk monitoring requires collaboration and information sharing across key institutions and may necessitate new cross-institutional arrangements; including debt managers on macro-prudential committees may be efficient in some circumstances. 39,40
- Adopting a wider ALM approach to sovereign risk management would require a consolidated view of the sovereign balance sheet and risk exposure, drawing across policy areas and coordinating portfolio strategy decisions; operationalizing such a framework entails further work and significant institutional challenges.
- Establishing effective dialogue between debt managers and financial sector regulators can mitigate unintended consequences of regulatory changes (e.g., proposed bans on short-selling sovereign debt).

### Fund support and technical assistance
- Fund staff can: 
  - Help illuminate the nature and extent of key risks to be considered in debt management strategies.
  - Contribute technical work on stress-testing methodologies and risk monitoring frameworks. 41
  - Facilitate consensus through multilateral interactions with debt managers, drawing on ongoing bilateral and multilateral surveillance.

### VI. Going forward — Key issues and policy recommendations
- Strengthening risk management
  - Enhance risk management frameworks and pay greater attention to stress testing.
  - Adopt a more comprehensive approach that accounts 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 from quasi-sovereign and sub-national debt;
    - (iv) investor base fragility; and
    - (v) the risk of cross-border spillovers.
  - Strengthen debt structures and establish appropriate risk buffers, notably to limit rollover risk. LMOs can be used to modify debt structures actively.
  - Follow a pragmatic approach to determine feasible extent of 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
  - Strengthen collaboration across debt managers, fiscal authorities and financial sector regulators to enhance risk monitoring and management, including monitoring contingent risks in the financial sector, and to better inform fiscal and financial stability assessments.
- Capital market considerations
  - Maintain a flexible and comprehensive operational toolkit to address market circumstances, mitigate market and liquidity risks, and improve secondary market liquidity.
  - "Benchmark issuers" or systemically important sovereign issuers must be mindful of wider ramifications of their operations on debt capital markets.
  - Enhance investor relations programs along the lines suggested by the "Stockholm Principles" to overcome limitations in primary dealer networks and reduce market volatility. 42
  - Design debt issuance to diversify the investor base where feasible—both by residency and type.

*IMF staff paper*

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

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

### Operational responses of debt managers: three broad approaches
- Three broad approaches were identified: (i) changing the issuance mix; (ii) adaptation of financing modalities; and (iii) stepping up market management operations.
- Specific country actions varied and included instrument innovation, adjustments to primary issuance techniques, and market-support steps.

### Selected Advanced Economies — key measures taken
- Belgium
  - Adjusted instrument mix: Introduced an EMTN program in 2008; initially increased issuance of short-term instruments (including in FX).
  - Adapted primary issuance technique: 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.
  - Steps to support market functioning: Adapted primary dealers quoting obligations, initially under provisions for "exceptional market circumstances", then moved to a permanent adoption of a peer performance measurement.
  - Other: 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
  - Adjusted instrument mix: Increased tapping of long-term debt; increased foreign currency issuance.
  - Steps to support market functioning: Maintains a continuous presence in the secondary market that allows it to mitigate temporary market dislocations on an ongoing basis.
- Italy
  - Adapted primary issuance technique: In 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. Timing of reopening of bonds to PDs at non-competitive prices also extended.
- U.K.
  - Adjusted instrument mix: Initially increased the proportion of short-term instruments, but subsequently refinanced these with long-term bonds.
  - Adapted primary issuance technique: Introduced a post-auction option facility (PAOF); introduced mini-tenders to supplement the core auction program; increased the proportion of issuance through syndication.
  - Steps to support market functioning / Other: 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.
  - Adjusted instrument mix: Reintroduced the 3-year tenor; initially increased the proportion of short-term instruments; from 2009 increased the proportion of inflation-linked and longer tenors.
  - Steps to support market functioning / Other: 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.

### Selected Emerging Markets — key measures taken
- Brazil
  - Adjusted instrument mix / Market operations: Engaged in ad hoc debt buybacks and exchanges. Introduced regular buy-back program of longer-term fixed-rate bonds.
- Hungary
  - Adjusted instrument mix: 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.
  - Adapted primary issuance technique: 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.
  - Steps to support market functioning: 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
  - Adjusted instrument mix: Stopped issuance of inflation-linked bonds; initially limited issuance of long-term bonds.
  - Adapted primary issuance technique: Single price format of auctions was changed to a multiple price format.
  - Market operations: Offered buy-back facility for inflation-linked instruments. Conversion offers also introduced.
- Mexico
  - Market operations: Engaged in market management operations through buybacks and debt exchanges.
- Turkey
  - Adjusted instrument mix: 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).
  - Adapted primary issuance technique: Revenue linked bond sold through private placements.
  - Steps to support market functioning: Increased scale of debt exchange program, i.e. bonds made available to primary dealers for switching at time of new issues.

*Source: National authorities, Euroweek (2009).*

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### APPENDIX II: SOVEREIGN AND BANKING SECTOR RISK—KEY INTERCONNECTIONS

### Overview
- Interlinkages between sovereign balance sheets and the banking sector have both domestic and cross-border aspects.
- Domestic sovereign credit deterioration can quickly spill over to the financial sector through multiple channels on both asset and liability sides of banks' balance sheets.

### Domestic interlinkage channels and dynamics
- Asset side:
  - Sharp decline in sovereign debt prices generates losses, especially for banks holding large portfolios of government bonds.
  - Sovereign debt is used as collateral for transactions (e.g., repos) and via derivatives; lower sovereign debt values reduce collateral value and can require provisioning.
- Liability side:
  - Banks' wholesale financing costs tend to rise in tandem with sovereign spreads.
  - Rising bank financing costs tighten credit conditions, negatively affecting economic growth and tax revenues, further worsening sovereign balances and increasing sovereign spreads.
- Feedback loop:
  - Deterioration in sovereign spreads increases probability that financial sector contingent liabilities will materialize, further weakening sovereign balance sheets.

### Extreme outcomes and case illustrations
- Iceland (2008)
  - 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.
  - Gross fiscal cost of honoring deposit insurance obligations and recapitalizing commercial banks amounted to about 70 percent of GDP (net cost expected to be somewhat lower as assets are gradually recovered).
  - Gross government debt rose from 29 percent of GDP at end-2007 to an estimated 100 percent of GDP by end-2010.
- Ireland (2008–2010)
  - Before the crisis: fiscal surplus, relatively low public debt, high growth; property prices tripled between 2000 and 2008.
  - At the height of the boom, assets of domestic banks amounted to five times Ireland‘s GDP.
  - From 2008, real GDP fell by nearly 11 percent over 2008-2009.
  - By end-2010, Irish authorities had injected capital into the banking sector equivalent to 28 percent of GDP.
  - Public debt rose from 25 percent before the crisis to 99 percent of GDP at end-2010.
  - Banks‘ debt guarantees amounted to 16 percent of GDP by end-2010.

### Cross-border transmission
- Financial sector linkages transmit sovereign credit and banking sector concerns across borders; differentiated sovereign risk within the euro area since April-May 2010 produced spillovers to banks with exposures to affected sovereigns.
- Example: French banks’ significant exposure to peripheral European governments may have contributed to increases in CDS spreads of French banks since January 2010.

### Feedback channels summarized (Box 7)
- Sovereign risk → banking system:
  - Banks hold sovereign debt as liquid/low-risk assets, collateral, or via derivatives.
  - Sovereign debt value affects banks’ market/book values and collateral utility.
  - Domestic banks often act as demander of last resort for sovereign debt.
  - Banks rely on governments for deposit and loan guarantees.
- Banking system → sovereign:
  - Banking sector contributes to tax base directly (wages, profits, value added) and indirectly via credit provision.
  - Banking sector failures may require costly capital support and guarantees, affecting the sovereign balance sheet.

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### APPENDIX III: GUIDING PRINCIPLES FOR MANAGING SOVEREIGN RISK AND HIGH LEVELS OF PUBLIC DEBT (“Stockholm Principles”)

### Framework and operations
- Principle 1: Define the scope of debt management to account for interactions among financial assets, explicit and implicit contingent liabilities, and debt portfolio structure.
- Principle 2: Support strategic and operational debt management decisions with relevant information sharing at domestic, regional, and global levels; information sharing should occur among relevant public authorities and, where appropriate, with the private sector.
- Principle 3: Maintain flexibility in market operations to minimize execution risk, improve price discovery, relieve market dislocations, and support secondary market liquidity; be prepared to use liability management operations to alleviate secondary market impairments.

### Communication
- Principle 4: Maintain proactive and timely market communication strategies to support a transparent and predictable operational framework for debt management.
- Principle 5: Properly explain modifications to operational toolkits; communicate changes clearly and in a timely fashion and undertake prior consultation with investors and stakeholders where appropriate.
- Principle 6: Promote communication among debt managers and monetary, fiscal, and financial regulatory authorities, while preserving each agency’s independence and accountability.
- Principle 7: Promote close and continuing dialogue with the investor base to understand characteristics and preferences, identify vulnerabilities and opportunities, and design instruments matching investor needs.

### Risk management
- Principle 8: Keep debt portfolio risks at prudent levels while minimizing funding costs over the medium to long term; place stronger emphasis on risk mitigation given increased macroeconomic and financial risks.
- Principle 9: Ensure medium-term debt management strategies consider the broadest definition of the debt portfolio and relevant stress scenarios; identify main risk sources and establish a clear risk management framework.
- Principle 10: Adopt and communicate prudent risk management strategies covering the full range of risks facing sovereign debt managers; maintain debt portfolios that reduce exposure to refinancing risk and contingent liabilities and clearly communicate strategies to limit these risks.

*These principles emerged from discussions at the 10th Annual IMF consultations on “Policy and Operational Issues facing Public Debt Management,” co-hosted by the Swedish National Debt Office in Stockholm, June 2010.*

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### APPENDIX IV: DEBT STRUCTURES AND CRISES OF THE 1990’S—ORIGINAL SIN AND ITS ABSOLUTION

### Evolution since the Tequila crisis (1994/95)
- Emerging market policymakers have reduced "original sin" by addressing fiscal dominance and inflation, lowering risk premia and facilitating lengthening of domestic currency debt maturities and reduced reliance on variable-rate and foreign currency debt.
- Inflation-indexed bonds were effectively used in several countries (Chile, Brazil, Peru) to help lengthen domestic maturities where policymakers pursued disinflationary policies.

### Performance during the global financial crisis
- The relatively limited impact on emerging markets during the global financial crisis reflects improved macro policies and stronger debt structures.
- Capital inflows created excess demand for emerging market currencies and debt instruments, enabling further strengthening of debt structures, though many emerging markets still lag advanced countries in resilience.

### Empirical patterns (1999–2009)
- Over 1999–2009:
  - Average maturity of domestic debt increased (charted by region: Asia, Europe, Latin America, Total EM).
  - Floating rate share of domestic debt decreased (charted by region).
- Note on regional composition used for the charts: Asia comprises China, Hong Kong, India, Indonesia, Malaysia, Philippines, Singapore, Korea and Thailand; Europe comprises Czech Republic, Hungary, Poland, Russia and Turkey; Latin America comprises Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela. Total EMs also includes South Africa.
- Source of charts: BIS, staff estimates.

*End of appended content.*

*Source: APPENDIX I–IV, IMF document.*

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

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

### Definitions and core concepts
- 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; regarded as a contributing factor to sovereign risk.
- Sovereign risk decomposed: logically split into two components—solvency and liquidity (including rollover) risk—since inability to discharge contractual obligations can stem from either.

### 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.
- Determinants and control:
  - Solvency is usually considered beyond the control of the debt management office.
  - Solvency is determined by primary balances and the willingness to pay.
- Cross-reference: solvency definition consistent with IMF (2002) for deriving a definition of liquidity.

### Liquidity and rollover risk
- Liquidity risk: 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 commensurate with the debt stock and primary balance.
- 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.
- Control and exogenous influences:
  - Liquidity risk is under the control of the debt manager.
  - Liquidity risk is affected by outside factors such as contagion and global risk aversion.

### Interaction between solvency and liquidity
- Bidirectional links:
  - Illiquidity can lead to insolvency: a solvent but illiquid entity with highly positive future income streams may need to sell or borrow against those future streams; insolvency can result if the future income stream is discounted so heavily that it does not yield sufficient liquid assets.
  - Insolvency can lead to illiquidity: current liquidity can be exhausted by runs if investors/depositors anticipate future illiquidity.
- Note: both solvency and liquidity risk are functions of interest and exchange rates.

### APPENDIX VI — Choosing the optimal maturity structure: cost–risk tradeoff (stylized illustration)
- Setup and assumptions:
  - A debt manager chooses among 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; maximum maturity = twice the ATM.
    - Example: P1 has ATM = one year, maximum maturity = two years, with two equal principal repayments—one in the first year and one in the second; short-term debt = 50 percent of the portfolio.
    - Example: P15 has ATM = 15 years, maximum maturity = 30 years, with 30 principal payments each of 3.3 percent of the portfolio; short-term debt = 3.3 percent of the portfolio.
  - Debt level assumed high at debt / GDP = 100 percent (results scale with deviation from 100 percent).
- Interest-rate shock exposure example:
  - Assume a credit risk premium increase of 1,000 basis points sustained over one year.
  - Additional cost of refinancing maturing debt in Year 1:
    - P1: additional cost = 5 percent of GDP.
    - P15: additional cost = 0.33 percent of GDP.
  - Fiscal adjustment implication: the fiscal adjustment required to keep the deficit unchanged will be 15 times greater for P1 relative to P15.
- Medium-term dynamics:
  - If the interest-rate shock is sustained over the medium-term and the country runs a balanced budget while maintaining the same portfolio structure (rolling maturing debt into a new bond at the portfolio’s maximum maturity), cumulative impact is a multiple of the Year 1 additional interest cost.
  - Example: in P1 the debt maturing in Year 1 is rolled into a new 2-year bond; insufficient fiscal adjustment scope implies debt stock will grow as additional interest payments are financed with new debt.
- Nonlinearity and diminishing returns:
  - The relationship between maturity and interest-rate sensitivity is nonlinear.
  - Relative benefits of extending maturity decline as the starting ATM position increases.
- Cost side of the tradeoff:
  - Extending maturities increases underlying funding cost depending on the shape of the yield curve.
  - Illustration uses an upward sloping linear yield curve with spreads between 30-year and 2-year yields:
    - 250 basis points (close to the current bund spread).
    - 380 basis point spread for 30-year and 2-year gilts.
    - 420 basis points for U.S. Treasuries.
  - Figure 10 (illustrative) shows marginal cost of each portfolio relative to P1 and the interest-rate sensitivity (riskiness) of each portfolio—typical cost–risk tradeoff.
- Country specificity and policy choice:
  - Actual cost–benefit tradeoff depends on:
    - (i) the level of debt;
    - (ii) the maturity profile;
    - (iii) the shape of the yield curve.
  - Policy placement along the tradeoff is influenced by policymakers’ assessment of likelihood/vulnerability to a significant negative shock to creditworthiness.
  - Crisis experience indicates extreme events are possible and constitute reasonable scenarios to consider.

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_Source: https://www.imf.org/-/media/websites/imf/imported/external/np/pp/eng/2011/_041811pdf.pdf_