Debt Management - in the UK and Overseas International Consulting Economists’ Association London, May 2004

Debt Management in 2004 Debt management objectives The debt management “office” Policy framework Governance Building the office “Challenges” for the Consultant

What is Sovereign Debt Management? “The process of establishing and executing a strategy for managing the government’s debt in order to: Raise the required amount of funding Achieve its cost and risk objectives Meet related goals – e.g. developing an efficient market for government securities.” IMF/World Bank, Guidelines for Public Debt Management, March 2001

Why is it Important? Fiscal sustainability; problems include Size and growth of indebtedness (debt/GDP) Poorly structured - maturity, currency or interest rate composition (excessive focus on short-term or FX debt) Large and unfunded contingent liabilities Exposure to economic shocks (lack of liquidity) Asymmetry of risk Weaknesses exacerbate economic crises Contagion and feedback effects Sound debt management policies not a substitute for good economic policies – but reduce feedback effects and provide resilience

No shortage of examples…. The emerging market debt crises of the 1990s… Mexico 1994 Asia 1997-98 Russia 1998 Brazil 1998-99 …were characterised by vulnerabilities arising from poor debt structures crystallisation of contingent liabilities

Building Debt Management Capacity Establishing objectives and priorities Developing the analytical framework for risk management – and the necessary capability Ensuring consistency with macro-economic policies financial market development policies Establishing an organisational structure with clear accountability and transparency of responsibilities a relevant legal and governance framework Recruitment of trained staff, systems investment etc

Objectives “The main objective of public debt management is to ensure that the government’s financing needs and its payment obligations are met at the lowest possible cost over the medium to long term, consistent with a prudent degree of risk… It should encompass the main financial obligations over which the government exercises control.” IMF/World Bank, Guidelines for Public Debt Management, March 2001

Portfolio Risk Objectives In 1990s models focussed on optimising liability portfolio Historical distributions of interest and exchange rate to generate efficient cost risk frontier associated with different issuance strategies Stochastic simulations - Markowitz models, VAR, Cost at Risk etc In 2000s focus on whole government balance sheet – ALM framework – main government asset is power to tax Matching financial characteristics of assets and liabilities Direct matching or e.g. currency assets and liabilities Debt servicing ratio to annual budget or GDP (proxy for power to tax) Integrate with macro models to create internally consistent scenarios Include contingent liabilities, on-lending to SOEs etc Importance attached to “tax smoothing” Fiscal resilience in face of adverse economic shocks Develop stress tests, or upward bounds

Other Debt Management Objectives Developing a liquid and efficient government bond market Ensure ability to borrow in size at short notice Issuance policy open predictable and transparent Generating a benchmark premium Maturity and composition taking account of : Investors’ demand Government's attitude to risk Shape of the yield curve Need for liquid Treasury bill market Adjusting maturity by issuance, also switch auctions, conversions, buy-backs and , in some cases, derivatives

Performance Measurement Risk models underpin strategic target Often expressed as duration target (although maturity profile important) Derivatives allow separation between funding decision and portfolio decisions Eurozone countries issuing at 10 years, and using IRS to reduce duration (France, Finland, Belgium) Reinforced through performance benchmarks Assumes active trading Measures cost of actual portfolio against strategic target (Ireland) or a short-term optimised portfolio (Quebec) Strategic target may in practice become performance benchmark – Austria, Portugal Active trading may be confined to FX portfolio where Government is a price taker – Denmark, Sweden

[No] Performance Benchmark in the UK Risk of Active trading Limited inside information (and no wish to capitalise on it) Concern to avoid actions being interpreted as market signals Concern to avoid opportunistic behaviour – adding to market uncertainty Benchmark not independent of DMO’s actions Status as part of HM Treasury risks adding to market uncertainty and damaging DMO’s credibility A strategic target remains a relevant indicator - for explanatory and monitoring purposes Formal targets for secondary measures – efficiency and service

A Debt Management “Office” Clarity and transparency Internally, with focus on the debt management task Externally, in the perception of the markets in relation to objectives and intent Linked with accountability and governance Improving capacity, efficiency and effectiveness Getting decisions right Emphasis on portfolio risk management Integrating dispersed functions Expertise, professionalism

Autonomous Offices: Objectives Kalderon & Blommerstein, OECD 2002 Motives for Separate office Autonomy from political sphere Emphasises separation between debt management & monetary policy Greater transparency between government functions Ability to concentrate expertise Staff recruitment and retention (pay flexibility) Linked with improved transparent and accountable framework Accountability must be supported by governance framework Needs high level political support for transparency and accountability But: major administrative task – beware of diversion of effort

Different Institutional Arrangements Operational independence from MoF & Central Bank Responsibilities often include cash management, also asset management, contingent liabilities and on-lending Spectrum of institutional arrangements Part of Treasury / MoF (Italy, Greece) or another ministry (Spain) “Bureau” within Treasury / MoF (Finland, USA) Independent agency within Treasury or MoF (Australia, New Zealand, Netherlands, UK, Belgium, France) Agency within central bank (Denmark) Autonomous agency within government (Sweden, Austria, Portugal, Ireland - Irish Agency manages structural investment funds) Company owned by Government (Germany) Some use Central Bank as agent; all use Bank for some services

Formation of the UK DMO Established in April 1998 - an Agency of HM Treasury Corollary of interest rate setting responsibilities for the Bank of England announced in May 1997 Legally part of HM Treasury some operational and managerial independence but a strong governance framework With the aim “…to minimise the Government’s debt financing costs over the long term, taking account of risk, and manage the aggregate cash needs of the Exchequer in the most cost-effective way, while being consistent with monetary policy objectives.”

The DMO’s Functions The Government’s debt manager issuing gilts (and Treasury Bills), managing the gilts market The Government’s cash manager balancing daily the net cash flow into/from Government issuing Treasury bills; borrowing and lending in the money markets The Government’s (short term) asset manager managing of cash surpluses (inc from 3G licences) DMO also manages Government lending to local authorities and investments of certain public sector funds.

Identifying the Policy Framework: Interaction with Monetary Policy Separation of debt management from monetary policy clarifies objectives and reduces uncertainty Essential in Eurozone, and most developed countries More difficult where debt management operations affect interest rates and the capital market Currency boards adds risk to fiscal and financing policy Important in UK avoids given Bank a conflict of interest – or a market perception of conflict – reducing market uncertainty only a weak link between financing policies and monetary conditions; and money supply growth & inflation

Identifying the Policy Framework: Co-ordination with Central Bank Central Bank’s input to policy Drawing on market knowledge Wider market development influencing, and influenced by, debt and cash management policies Identifying services required Fiscal agent for auctions etc Settlement services; debt registration services Cash account manager (banking services) [Investment manager – investing structural and longer-term surpluses] Agree service levels Backed-up with MOUs or service level agreements

Establishing the Governance Framework: Three Levels High-level policy formation Setting the debt (and cash) management strategy Delegations to the Debt Office for meeting that strategy – and its accountability “External” governance of the Debt Office Information flows – reporting to Ministers, officials and Parliament Performance assessment and external audit “Internal” management and governance structures Facilitated by (or subject to) the domestic legal framework

High-level Policy Formation Development of the debt management strategy Taking account of relevant views and responsibilities, especially macro-economists (also Central Bank?) Benefits of a formal Debt Management Committee Strategy set for the year ahead, with explicit provision for review Approved by Ministers Published (as necessary) approved by National Assembly/Parliament Implemented within the agreed institutional framework by the responsible body (the Debt Office) Agreed co-ordination arrangements with other bodies, including fiscal agent Operating within the same framework supported by memoranda of understanding (MOUs) etc. Outlaw second-guessing.

Delegating Operational Policy Ministers delegate implementation to Debt Office Specified parameters or objectives, e.g. portfolio or duration benchmarks, targets for cash balances Related objectives (e.g. for Treasury bills, contingent liabilities) Identifying Decisions that Must be taken by Ministers Can be taken by officials Circumstances that require a revision, e.g. unanticipated changes in fiscal position or wider economy Parameters of delegation widen as confidence and capacity builds

Delegating Managerial Policy Policy delegation backed by: Longer term management objectives (capacity, administrative costs, investment) Preparation of an annual business plan Agreed operational and managerial delegations – subject to legislation and government service practice Management reports, publications and other information Benefits from defined delegation in terms of Transparency and accountability Faster decision-making Less risk of challenge from other bodies Increase sense of purpose and authority within Debt Office, contributes to capacity building

External Accountability Reporting outturns against the published objectives Managerial and operational reports Within the Ministry of Finance Formally to Parliament To market, on website etc Performance assessment High-level – is it the right objective Achievement of portfolio objectives Meeting management objectives External Audit Both propriety and cost-effectiveness

UK DMO’s Relationship with Ministry of Finance (HM Treasury) Ministers set objectives and targets Co-ordination with macro policy within HM Treasury Set annual strategy objectives (“remit”) Approve Business Plan and targets Chief Executive responsible for operational decisions within parameters of remit Reports direct to Parliament on expenditure and accounts DMO advises on its remit and portfolio objectives; but HM Treasury integrates with wider economic advice (on fiscal and balance sheet policies)

UK DMO Governance Framework

Building the Office Building a professional and committed team Developing debt management strategy Procuring systems and establishing business processes Controlling operational risk Managing stakeholder relationships Employees Central Bank, regulators, Market-makers, investors, exchanges Others in Ministry of Finance and government Reform must be “seamless” to market

Internal Specialisation Separate front, middle and back-office Allows specialisation Avoids duplication Contributes to risk management Distinguish between key responsibilities Senior management Front Office: primary issuance and execution, internal and external, secondary market transactions (debt and cash) Middle office: policy and portfolio strategy development and accountability reporting Middle office: risk management: policies, processes and controls Back-office: transaction recording, reconciliation, confirmation and settlement Internal audit and compliance – reporting to CEO / Head of Office

Debt (& Cash) Office: Systems Government Expenditure Monitoring and Control disbursement authority receipt collection monitoring cash flow Published Financial Accounts Government cash flow Forecasting and Reporting Bank Accounts central bank other Government Cash Management Forecasting flow profiles modelling Debt Management Modeling and analytics Securities Issuance Treasury bills Bonds Repos Transaction Processing and Recording Database Links to settlement Debt Database Market Feeds Market Notices Published transactions Account

Capacity and Resources Staff recruitment and retention Even without pay flexibility, greater authority and accountability improves job satisfaction. Delegation allows greater flexibility to respond to changes in the economic environment Greater visibility as a centre of excellence, with the support of Ministers, helps improve the status of staff Secondments can close gaps Importance of Training May be only route to closing gaps Means to professionalism – link to business plan Enhance individuals’ commitment [along with golden handcuffs] Make skills available to others in Government

Some Lessons from the UK Establish respective roles and responsibilities (in relation to rest of MoF, Central Bank etc) and publish them Manage stakeholders (Ministers, market, BoE, Parliament) Manage as a project: dedicated manager, business plan Involve staff Horizontal decision-making structures Communication, including through change and integration processes “Rewarding” professionalism Change programme Signal what matters Delivery Professionalism Risk management, inc operational risk Effective internal project management

“Challenges” for the Consultant Relevance of OECD experience to emerging economies The legal framework How separate is the Debt Office? Cash management and budget execution Interaction with Central Bank Operational risk

Emerging Economies Additional Problems High fiscal deficits and high levels of indebtedness Balance sheets more exposed to shocks <= less diversified economies, weak capital markets, low savings, and susceptibility to contagion effects Transition countries: inexperienced MoF and Central Bank (but want to join Eurozone) Lack of instrument independence Poor accountability and transparency; inadequate legal framework Failure to account for contingent liabilities Poor systems, poor operational risk management Greater salary differentials between MoF & Central Bank and MoF & private sector => difficult to retain staff

Emerging Economies Solutions: Debt management policies take into account public policy dimension – development of domestic debt market, co-ordination with fiscal and monetary policy Avoid conflict with Central Bank – co-ordination mechanisms Suspend debt issuance by Bank Principal-agent problems and need for co-ordination implies location of Debt Office in or close to MoF Minimise political pressure with long-term objectives and benchmarks, and public reporting Avoid active trading – reduce operational risk and save resources Need to be creative with incentive compatible pay structures in line with skill needs!

Legal Framework Problems Best international practice; the legislation Laws say only what you can do, not what you can’t Institutionalised job descriptions Restrictive limits (gross v net) Lack of delegated authority; Parliamentary involvement in operational decisions Best international practice; the legislation Addresses the state’s authority to borrow and to issue guarantees Sets appropriate limits and reporting & accountability requirements Authorises the Minister of Finance to set explicit objectives to be followed [….finance the government’s borrowing needs efficiently … ensure debt servicing obligations are met…ensure debt portfolio is managed according to cost and risk objectives.]

How Separate is the Office Advantages of a separate office Signals new status to Ministers and officials Forces rationalisation, and encourages professionalism Allows pay flexibility Risks Principal-Agent problems, especially inadequate accountability, transparency and governance Cronyism Diversion of effort Adds to skill staff requirements (in both purchaser and provider) Seen an end in itself

Debt and Cash Management: Benefits of Integration Co-ordinating issuance strategies across the full range of instruments Funding (overview of full risk-free yield curve) Financial market development Market signalling Debt issuance decisions taken in the context of the government’s overall cash flows Weakens the link between the timing of bond sales and the timing mismatch between receipts and payments Allows pattern of bond sales to be announced in advance

Cash Management: Issues Integration in debt office risks losing focus on debt management Linkage with what? Macro-forecasting Budget planning and control Accounting functions Budget execution – the main problem in practice Central Bank concerns about monetary policy ops “market confusion”, “cutting across”, “interference” Confusion over role of Treasury bills Debt management, cash management, monetary policy Perceived need for central bank bills

Interaction with Central Bank Problems Different objectives Bank resentment at formation of Debt Office MoF staff jealousy of higher Bank pay, better systems etc Solutions Identify respective roles Distinguish policy from services High-level co-ordination and fire fighting Backed by regular operational level contact and information flows Suspend Issuance of Central Bank Bills At request of Central Bank, Debt Office should issue extra Treasury Bills for monetary policy purposes, sterilising proceeds

Operational Risk Lack of skilled risk specialists understanding of operational risk Business Continuity Plan & Disaster Recovery Site acceptance of responsibility Less important when Central Bank is fiscal agent main argument for leaving agency function with Bank

Internal Control Strategies Culture Public sector ethos Open (‘no blame’) - no personal financial targets ‘Profit’ not an objective Best Market Practice Policy and operational control of transactions and projects Risk polices and appetite regularly reviewed Separate operational and processing areas; ‘4-eyes’ approvals Procedure and control manuals “owned” by line mangers Embedded monitoring, “exception logs” Management “certification” Facilitated and analysed by “risk champion” – operational risk specialist – reporting to Board/CEO

Conclusion Debt management matters! There is a recognised international best practice But no single template More challenging in emerging and transition countries than in the OECD (although some useful blank slates) Effectiveness mixes: Economic policy Policy execution Good governance and management