Lecture outline What means debt sustainability? Ponzi scheme and the government debt Maastricht criteria Internal and external government debt Ways to minimize government debt servicing costs

What means debt sustainability? How big should the government debt be in order to destabilize economy? If the debt is used to cover the budget deficit, Debt/GDP ratio will be increasing and may even turn into large debt burden. The government may not be able to serve the debt and eventually announce default. The increasing volume of the public debt in the US has lead scientists to think of sustainability issues. The term sustainability with respect to public debt is used to mean the ability of debtor to remain solvent and avoid defaults

What means debt sustainability? Budget constraint serves as starting point ensuring debt sustainability. Budget constraint can be one period, long term and multiple period. Debt sustainability can analyzed with the help of simple model: assume that economy has only one sector, GDP per capita and capital, interest rate and growth are constant; interest is greater than growth and there is no inflation; When interest rate is greater than growth, the government cannot create financial pyramids such as “Ponzi scheme”

Ponzi scheme and government debt In 1919 Charles Ponzi opened business which offered depositors the return of 100% in 90 days. Around 40 thousand people deposited in the company of Ponzi which amounted to 150 million dollars (at present prices). Depositors received the promised return on time, but these funds were simply deposits attracted from new clients. New depositors paid returns of the old depositors. This was financial pyramid later named as Ponzi scheme In August of 1920 this pyramid collapsed because there were rumors that no funds left to pay back deposits. This rumor caused panic among depositors and the old and new depositors claimed their deposits back.

Ponzi scheme and government debt Is government debt similar to Ponzi scheme? The answer is no because:  Unlike Ponzi, the government can print money or raise taxes to pay back its debt  If the government behaved like Ponzi, there will be at least one bond holder who will be refused to get his interest payments at some point in the future. This would eliminate further functioning of the government bond market. Therefore, it is not possible to refinance infinitely.

Impossibility of infinite refinancing Refinancing becomes impossible after real interest rate in the country will exceed growth. This is because real interest rate serves as payment to bondholders in Ponzi scheme while growth as inflow of new customers Since at some point of time, interest rate exceeds growth, refinancing like in Ponzi scheme becomes impossible.

Maastricht criteria 1997 EU members made agreements on sustainable growth. These agreements originated from proceeding of 1993 meeting in Maastricht. The EU members agreed upon setting up constant fiscal monitoring and sanctions against countries which break fiscal discipline. Countries which adopted Euro should maintain budget deficit to GDP ratio below 3 percent and debt to GDP ratio at around 60 percent. These and other limits (e.g. inflation rate, foreign currency exchange regime) are known as Maastricht criteria or convergence criteria

Maastricht criteria Maastricht criteria may limit the ability of the government to make short run adjustments to economy because the main priority is long term economic sustainability Proponents of Maastricht criteria claim these short run adjustments are not associated with significant economic costs and there can be sacrificed.

Internal and external government debt Why do developing countries have their government debt primarily from external sources? This is because these countries have very weak internal government bonds markets and therefore the governments in these countries have to rely on external markets It is possible to have a choice between internal and external bond markets if there is an alternative- well functioning internal market for government bonds

If choice between internal and external markets exist When choosing between internal and external markets it is necessary to consider the following points:  Impact of debt on economy  Debt expenditures  Hidden risk in debt External debt market is associated with exchange rate risks

Gross debt or net debt? Gross debt is simply debt accumulated by the governments Net debt is gross debt netted from government assets which are liquid enough to pay back its debt So should the government focus on the gross debt or net debt?

Public debt management strategies What purpose should the government pursue given that taxes have distortionary effect? Classical answer of Barro- to stabilize tax rates over time through debt. However, this is too academic view on debt. Public finance officials claim that the need for government debt comes from the fact that the government should not be left without money even for a single day. Attracting debt is necessary when even if the government plans to have budget surplus and there are no payment arrears between budgets of different levels. This is mainly because there is constant need to refinance debt

Public debt management strategies However, constant debt inflow to the government budget generates constant outflow of funds in the form of cost of servicing debt For this reason, the main target in the public debt management- to minimize cost of servicing debt at the given level of risk In OECD countries too, 72 percent members of this organization define their public debt management targets in the way to link cost of servicing to risks.

Some examples of debt strategies Marvin Anthony in his “The Design and Use of Strategic Benchmarks – some findings in OECD markets,” ( 14th OECD Global Forum on Public Debt Management and Emerging Government Securities Markets, December 7-8, 2004, Budapest) gives an overview of debt strategies of certain countries Australia – main strategy is to attract debt with minimum long term expenditures and acceptable risk hedging Ireland – to refinance debt due and provide funds to the government keeping short and long term liquidity, avoiding fiscal expenditures volatility and minimizing risks

Some examples of debt strategies New Zealand – maximize income on financial assets and debt of the government given the risk averse strategy Sweden- minimize cost of servicing debt in the long run. Debt management should comply with targets of monetary policy and cabinet of ministers Great Britain – to sustain the annual trade volume of government obligations set by Treasury with the focus on the minimizing long term expenditures and risk

Types of debt expenditures Interest payments- for government bond worth 1000 dollars with 10 percent annual interest rate and semiannual payments, interest payments amount to 50 dollars Discount (or negative) premiums – discount implies that at the moment of selling the security the government gives discount. For example, in the face value is 1000 dollars, the government sells this security for 950 dollars giving 50 dollar discount. This means the government loses 50 dollars since it has to pay 1000 dollar to investor at the time of maturity. Positive premium- government pays extra to the face value of the security when it purchases back its debt before it matures. For example, 1000 dollar worth bond purchased back at 1050 dollars.

Interest rate or discount? Treasury Bills are normally sold with discount. Government bonds are subject to both interest payments and discounts. For example, let us assume that the government sells USD 1000 worth bond with 10 annual interest payments. However, if the interest rate on the market is 5 percent and perfectly competitive, the market players will buy this bond infinitely until its market price will equal to USD Mathematically, USD100/0.05=USD So the government can receive USD 1000 premium by selling this bonds to public.

Summing up debt service expenditures The government bears the following expenditures on debt service:  Payments to primary dealers  Cost of printing and other technical activities related to issuing debt  Discounts  Premiums  Interest payments  Annual principal payments

Cost minimization policies Good policies for cost minimization  Yield curve manipulations  Indexing  Information asymmetry  Segmenting  Micro-structured finances Bad policies for cost minimization  Printing money  Increasing taxes  Defaulting on debt

Yield curve manipulations Time (years) Yield, %

Yield curve manipulations Long term bonds bear greater risk than short term securities and therefore offer higher return However, when the situation is stable over long run yield on the long term bonds is the average of both current and future interest rates. This implies that longevity of holdings does not cost of debt service. For example, interest on 10 years bonds will be the same as for 5 years bonds after its refinancing for the next 5 years.

Indexing debt Indexing debt by certain macroeconomic volatility- GDP growth, government expenditures, exchange rate or inflation rate Indexing in order to secure against inflationary risk can decrease or increase expenditures. This depends on how rate of inflation will behave in the long run. Since indexed bonds offer nominal return + compensation for inflation, nominal return is lower than in the non-indexed bonds. It follows that at times of low inflation the government decreases its cost of debt servicing.

Information asymmetry The government can use its access to more accurate information than that is available to private sector in order to decrease debt servicing expenditures. One instance when the government is better informed that the private sector is the forecast of future interest rates. If, for example, the governments knows that future interest rates will be lower while the market expects high interest rate, it may issue more short term bonds that long term securities. Alternatively, the government may be aware of some insider facts before market will get to know them and take convenient position when issuing securities. However, playing on the market equipped with insider information might be dangerous for the government since it faces the risks of lowering investor confidence.

Segmenting Some market player may prefer to fill in certain segments of the market and pay for this by accepting lower interest payments on governments bonds These bonds are issued as specially tailored for the investors in the segment. However, specially tailored bonds have lower liquidity. On the other hand, continuously decreasing liquidity may cause the government to pay compensation in the long run.

Micro-structured finances Another way to decrease debt servicing cost – through micro- structured finances Market players do not want to buy big bulks of government debt because it is associated with increased risk. To overcome this, the government uses primary dealers who buy and keep big amount of government bonds on their accounts. Two targets of micro-structured finances:  Increasing the profitability of entire market  Increasing the share of government in this profitability

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