Government Bonds: No Longer a World Without Risk
IMF Blog, March 24, 2011
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- Authors: JosVials
- Published: March 24, 2011
Overview and central message
- "The risk free nature of government bonds, one of the cornerstones of the global financial system, has come into question as the global crisis unfolds."
- "One thing is now very clear: government bonds are no longer the risk-free assets they once were."
- This shift has "far reaching implications for policymakers, central bankers, debt managers, and how the demand and supply sides of government bond markets function."
- Author and date: José Viñals, March 24, 2011.
Three key aspects highlighted
- In a world without a risk free rate, the health of the financial sector and the government are closely interconnected.
- "We need to better understand the linkages between sovereign and financial risks, and conduct a thorough analysis of the channels of cross-border spillovers."
- "Policies to help manage sovereign risk will have a positive impact on financial stability, and measures to stabilize the banking sector will have a favorable impact on sovereign balance sheets."
- Countries with large potential liabilities from their banking sectors need to identify, assess, monitor, and report related risks closely.
- "The impact of these contingent liabilities on the government’s financial position, including its overall liquidity, needs to be assessed when making borrowing decisions."
- The risks involved call for stronger emphasis on stress tests.
- "There is anecdotal evidence that some debt managers are complementing existing analytical approaches with a greater focus on stress scenarios, including extreme financing shocks."
- Policymakers could contemplate "the role for a joint stress test for systemically important financial institutions and sovereigns."
- Outcomes of such stress tests could "help inform crisis preparedness, debt strategies, as well as financial supervision and regulation."
Implications for demand-side dynamics
- Government bonds are being treated less like pure interest rate products and more like credit products.
- Their prices "mainly provide measures of borrowers’ probabilities of default."
- Many bonds "are not as liquid as before and their investor base is not as diversified as it used to be."
- "During phases of risk aversion, they do not benefit from flight to quality flows. On the contrary, they correlate with risky assets."
- Credit rating downgrades have procyclical effects and can exacerbate adverse dynamics.
- Central banks accept government bonds as collateral, but "below certain thresholds, lower ratings could trigger sizeable haircuts, in other words, revaluing the bonds substantially below their market value."
- Regulators could assign "a non-zero risk weight under the standardized approach" so that these bonds "are not risk-free rates any longer."
- Even where some sovereigns retain many risk-free characteristics (for example, "United States Treasuries and German Bunds"), "the once solid dividing line between interest rate and credit products has become blurred."
- Long-run investor behavior shifts:
- "More capital may flow towards emerging markets."
- Emerging economies have "been able to absorb the recent inflows, but the increase in corporate and financial leverage, rising asset prices, and building inflationary pressures may soon translate into growing imbalances and open the door to a new set of challenges to financial stability."
Implications for supply-side and debt management
- Debt managers in advanced economies are adopting practices similar to emerging market peers.
- Faced with greater economic and financial risks, they emphasize "risk mitigation strategies, well beyond what traditional debt management objectives would indicate."
- On the trade-off "between being predictable or flexible, most of them have erred on the side of flexibility."
- Annual programs need "sufficient flexibility to cope with the challenges of issuing and managing larger amounts of debt."
- Debt managers are prioritizing "proactive and timely communication" and understanding "the evolving nature of the investor base."
- These elements align with the "‘Stockholm Principles’ IMF facilitated with the debt managers in September 2010."
Policy implications and recommendations
- Strengthen analysis of sovereign–financial sector linkages and cross-border spillovers to better manage systemic risk.
- Identify, assess, monitor, and report contingent liabilities stemming from banking sectors when making government borrowing decisions.
- Expand use of stress testing, including joint stress tests for systemically important financial institutions and sovereigns, to inform:
- crisis preparedness,
- debt strategies,
- financial supervision and regulation.
- Debt managers should build flexibility into issuance programs, maintain proactive communication, and monitor changes in the investor base to mitigate heightened market and liquidity risks.
- Regulators and central banks should reassess collateral frameworks, haircut policies, and risk-weight assignments that may amplify procyclical dynamics.
Source: Government Bonds: No Longer a World Without Risk — José Viñals, March 24, 2011.