Medium-Term Debt Management Strategy

Transcription

1 Medium-Term Deb Managemen Sraegy 2013 Minisry of Finance and Public Credi General Direcorae of Public Credi Naional Treasury

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3 y Medium-Term Deb Managemen Sraegy General Direcorae of Public Credi and Naional Treasury Depuy Direcorae of Risk Liberad Orden Minisry of Finance and Public Credi Republic of Colombia. Bogoá, D.C., 2013

4 Liberad y Orden Minisry of Finance and Public Credi Republic of Colombia. Bogoá, D.C., s Ediion March, 2013 Minisry of Finance and Public Credi Publishing and disribuion righs reserved Carrera 8ª No.6-64 Bogoá Colombia, Fax. (57-1) aenció[email protected]; Legal deposi in accordance wih Law 44 of 1993 Parcial reprodicion of he conens of his work are permied, proper ciaion provided. Medium-Term Deb Sraegy ISBN Bogoá D.C., April, 2013 Cover design Camilo Medina Ediorial design Bernardo Arias Blanco Prining Dígios & Diseños Lda. Translaion and ediion Saniago Mora Colombia. Minisry of Finance and Public Credi. General Direcorae of Public Credi and Naional Treasury. Medium-Term Deb Sraegy Bogoá, D.C.: Miniserio, p. ISBN: Medium-Term Deb Sraegy 2. Benchmark porfolio 3. Deb porfolio currency composiion 4. Asse and Liabiliy Managemen 5. Cos-risk analysis 6. Fiscal policy I Melo Hernández, Helber Alonso II Díaz Zulea, Ana Carolina III Gómez Rubio, Germán IV Núñez Trujillo, Carlos Alejandro CDD 20ed CEP. Biblioeca José María Del Casillo y Rada 4

5 Liberad y Orden Minisry of Finance and Public Credi Republic of Colombia. Bogoá, D.C., 2013 Miniser of Finance and Public Credi Mauricio Cárdenas Sanamaría General Vice-miniser Germán Arce Zapaa Technical Vice-miniser Ana Fernanda Maiguashca Olano Secreary General Claudia Isabel González Sánchez Direcor General of Public Credi and Naional Treasury María Fernanda Suárez Londoño Depuy Direcor of Risk Helber Alonso Melo Hernández Wih he paricipaion of: Depuy Direcorae of Financing wih Mulilaeral Organisms and Governmens Depuy Direcorae of Inernaional Capial Markes Depuy Direcorae of Inernal Financing Depuy Direcorae of he Naional Treasury Wih he accompanimen of: World Bank Sae Secrearia for Economic Affairs SECO Medium-Term Deb Managemen March 2013 Technical Team Ana Carolina Díaz Zulea Germán Gómez Rubio Carlos Alejandro Núñez Trujillo In collaboraion wih: Saniago Mora Osorio Juan Guillermo Vélez Carmona 5

6 Minisry of Finance and Public Credi Conens Foreword 11 Inroducion 12 Execuive Summary 13 PART I: Medium-Term Deb Managemen Sraegy Concepual Framework Risks, coss and benefis analysis Benchmark Porfolio Benchmark Porfolio - Definiions Oher ools for deb managemen Hedging insrumens Inegraion of he MTDS wih macroeconomic policy Asse and Liabiliy Managemen approach Developmen and efficiency of domesic markes Colombian Case Sudy Objecives of he MTDS Background Medium-Term Deb Managemen Sraegy Formulaion of he MTDS Objecives Guidelines Public deb managemen reach Public deb managemen responsibiliies for he Naion Srucure of he Governmen of Colombia as deb manager CNG ousanding deb and mauriy profiles CNG oal ousanding deb Risk managemen analysis and he benchmark porfolio Benchmark porfolio Exchange rae indicaor Currency composiion 45 6

7 Mauriy indicaor Deb amorizaion profile Ineres rae indicaor Ineres rae composiion of he porfolio Financing sources of he Naional Governmen Raising deb in domesic capial markes Raising deb in foreign capial markes Foreign Governmen and Mulilaeral Organism Financing Invesor relaions program Naional Governmen Liabiliy Managemen Coordinaion wih fiscal and moneary policy Fiscal Policy Deb perspecives from he Naional Developmen Plan Deb managemen ineracion wih moneary policy Accomplishmens and deb oulooks 86 PART I I: Deb Forecasing Mehodology for MTDS MTDS Models Approaches and Objecives The foreign currency benchmark General assumpions Funding needs Currencies in he deb porfolio Prices and marke raes Fiscal Balance (FB) variables Furher definiions Firs Approach ALM Model ALM-1 Model: Minimizing he defici s presen value volailiy Preliminaries Facor idenificaion Framework Resuls ALM-2 model: Sabilizing fiscal impac (Ineress/Revenues) Preliminaries Objecive defininion Theoreical Framework Resuls ALM generales conclusions Resul summary ALM advanages ALM limiaions 124 7

8 Minisry of Finance and Public Credi 6. RCaR Cos v.s. Risk mehodology Model preliminaries Exchange rae volailiy coss and risks Deerminan Analysis Markowiz Porfolio Theory Deb indicaors Framework Idenifying indicaors Definiion of he remaining benchmarks Primary FB and oher macroeconomic variables Marke Variables Deb issuing Insrumens and financing needs Cos vs. Risk analysis Resuls Simulaed variables Cos vs. Risk Analysis General Resuls, Recommendaions and Perspecives Qualiaive improvemens in modeling Model resuls ALM ALM RCaR End remarks Furher remarks 154 References 155 8

9 Acronyms and Abbreviaions ALM APD BR CAF CBBD CCS CNG CONFIS COP CPI DGCP DGCPTN DGPM DNP FAE FB GCS GRS IDB BIRF Asse and Liabiliy Managemen Aspiring Primary Dealer Banco de la República Cenral Bank of Colombia Corporación Andina de Fomeno Developmen Bank of Lain America Cenral Bank Board of Direcors Cross Currency Swap Cenralized Naional Governmen Council for Fiscal Policy Colombian Peso Consumer Price Index General Direcorae of Public Credi General Direcorae of Public Credi and Naional Treasury General Direcorae of Macroeconomic Policy Naional Planning Deparmen of Colombia Saving and Sabilizaion Fund Fiscal Balance General Conribuion Sysem General Royaly Sysem Iner-American Developmen Bank IInernaional Bank for Reconsrucion and Developmen (IBRD) IMF MHCP MTDS MTFF NDP NFPS NGB PAC PD PDP RCaR SECO SFC SNA USD UVR WB WBT XCCS Inernaional Moneary Fund Minisry of Finance and Public Credi Medium-Term Deb Managemen Sraegy Medium-Term Fiscal Framework Naional Developmen Plan Non-Financial Public Secor Naional General Budge Monhly Basis Annual Cash Schedule Primary Dealer Public Deb Primary Dealers Program Relaive Cos a Risk Sae Secrearia for Economic Affairs Financial Superinendence of Colombia Single Naional Accoun Unied Saes Dollar Real Value Uni World Bank World Bank Treasury Exinguishable Cross Currency Swap 9

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11 MINISTRY OF FINANCE AND PUBLIC CREDIT Foreword Over he pas wo years, he Governmen of Colombia has accomplished considerable advances regarding fiscal policy. These breakhroughs, in hand wih a proper deb policy and a srong commimen o fiscal discipline led he counry o recover is invesmen-grade credi raing in 2011 and o hold a low risk premium when issuing deb ever since. Conscious of he grea responsibiliy and effec ha he Naion s deb managemen has on public finances, on he economy and he marke, he Governmen commied o designing he Medium-Term Deb Managemen Sraegy in line wih he Naional Developmen Plan Prosperiy for All By following hese guidelines over he pas wo years, he Minisry of Finance and Public Credi, led by he General Direcorae of Public Credi and Naional Treasury, creaed he guidelines for adminisraing he Cenralized Naional Governmen s public deb under he scope of efficien and inegral risk managemen. The purpose of his sudy is o deermine he characerisics and goals ha define wha an efficien deb porfolio managemen is. One of he bigges challenges faced in his sudy was o choose a model ha suied Colombia s deb needs and goals. For defining which mehodologies o use for finding efficien deb porfolios, he Minisry of Finance and Public Credi relied on is echnical eam, especially on he Depuy Direcorae of Risk, and on he World Bank s Treasury. Colombia is now considered o have adequae deb policies. This, along wih oher governmen policies and a favorable economic and marke environmen have shielded he Naion agains recen financial volailiy around he world. I is our hope ha his documen conribues o he analysis and debae on governmen deb adminisraion and ha i helps o srenghen Colombia s inernaional saus as an example of sound managemen. María Fernanda Suárez Londoño Direcor General of Public Credi and Naional Treasury 11

12 Minisry of Finance and Public Credi Inroducion This documen defines a new medium-erm deb sraegy, o be applied by he Cenralized Naional Governmen (CNG) and used as a compass on he subjec for he following years. For his purpose, he documen addresses he deb sraegy from a heoreical approach, in erms of objecives, risks, benefis and managemen efficiency. Addiionally, i presens mehodologies and examples ha validae he Naion s chosen deb managemen sraegy presened in he firs secion. In line wih his, he documen is divided in wo secions. The firs secion presens major issues ha governmen auhoriies mus consider in formulaing public deb managemen sraegy. Differen risks o be considered when developing issuance sraegies are analyzed as well as he sraegy s harmonizaion wih he governmen s economic policy. Addiionally, he evoluion and curren sae of Colombia s deb managemen is described. This secion ends wih a horough descripion of he curren design for deb sraegy in Colombia, boh in heory and pracice. Idenificaion of he marke agens involved and heir respecive responsibiliies, markes, funding sources and curren deb profiles are all described as well. The second secion focuses primarily on currency facors ha may hinder Colombia s public deb profile. We firs display wo models under which medium-erm deb managemen sraegies are designed, in accordance o CNG asse and liabiliy managemen guidelines. Aferwards, our analysis focuses on he deb porfolio s dynamic and weighs coss and risks wih he previously deermine ad hoc sraegies. These guidelines are resriced by he fac ha, for every period in ime, implemened sraegies are o mee he CNG s financing needs. Finally, resuls and improvemens in modeling mehodologies are presened, mainly hose regarding he model s reach and robusness. Simulaneously, furher consideraions ha may conribue o srenghen he effeciveness of deb policy are menioned. 12

13 MINISTRY OF FINANCE AND PUBLIC CREDIT Inroducion - Execuive Summary Execuive Summary A deb sraegy is a se of acions execued over a deb porfolio, ha seek for risk, cos, duraion, currency and ineres rae objecives in a specific period of ime. In Colombia, he oucome of fosering deb sraegies is a combinaion of indicaors ha define he srucure of a benchmark deb porfolio. Wihin he guidelines of his reference srucure, he Governmen manages is ousanding deb and deb issues. From he early nineeen nineies, Colombia has worked in improving he level of all deb indicaors, in order o miigae risks faced when raising deb. The aim is o do so a compeiive prices and wih a large, diversified pool of funding sources. The main deb porfolio indicaors used for defining deb sraegies in Colombia are: Marke of issuance Average life of he porfolio BENCHMARK PORTFOLIO Ineres rae Issuance marke class Currency denominaion Marke of issuance (inernal/exernal): This indicaor discriminaes he amouns of deb conraced in domesic markes and hose financed in foreign markes. This follows idenified marke limiaions as well as opporuniies for deepening he yield curve. The new implemened deb sraegy combines higher COP denominaed issuings (as a resul of he ALM model) wih a wide array of opporuniies for finding low cos and low currency risk deb in domesic markes 13

14 Minisry of Finance and Public Credi Ineres rae: This indicaor discriminaes volumes of floaing-rae issued deb securiies from fixed-rae issues. Colombia has been relaively conservaive in managing marke risks, when raising deb. Consequenly, a low percenage of he deb porfolio is ied o floaing-raes, which usually imply risks of higher deb-servicing coss. In fac, he Governmen limied floaing-rae deb o 5% of he oal volume of ousanding deb, in par because of he availabiliy of low cos-risk fixed-rae deb sources. Currency denominaion: This indicaor reveals Colombia s deb porfolio s currency composiion. The curren sraegy ses his indicaor as he main subjec of analysis due o is high risk and impac, given he presen economic environmen. Therefore, a large deal of effor is spen in searching for he appropriae volume of USD denominaed deb. The effecs of currency risk wih he curren mauriy profile of he porfolio are horoughly sudied, as well as how his risk should be managed. Afer having evaluaed hree differen mehodologies for esimaing a proper currency composiion, he sudy concludes ha an opimal disribuion is o hold 75% of he deb porfolio in COP, and 25% in USD denominaed deb securiies. This disribuion minimizes coss and risks in he medium-erm and is coheren wih curren macroeconomic policy. Issuance marke class: This indicaor discriminaes wheher deb is raised in capial markes or elsewhere in he financial sysem. Colombian Governmen has decided o concenrae is effors in raising capial in open markes for wo main reasons: i) here are issuance sraegies for inernal and exernal deb, and giving deph o he yield curve enables fund source diversificaion and cus in coss, and ii) his deepening of he curve makes corporae deb less cosly and more available. This is no, by any means, a resricion o conracing liabiliies wih mulilaeral organizaions, bu raher a search for an adequae balance in funding sources. Average life: This indicaor encompasses mauriy profile indices, which reflec amorizaion concenraions in each fiscal erm. Is srucure is a resul of all of he former indicaors, an upper bound for annual amorizaions of 15% of oal ousanding deb was se and he new sraegy lowers i o 10%. 14

15 MINISTRY OF FINANCE AND PUBLIC CREDIT Inroducion - Execuive Summary To illusrae how his works in Colombia, he following char presens he evoluion of each of hese goal indicaors is presened nex: (Sraegy Oucome) Marke of issuance Inernal 53% 67% 72% 70% Exernal 47% 33% 28% 30% Ineres rae composiion Fixed-rae 90% 94% 94% 95% Floaing Rae 10% 6% 6% 5% Currency composiion COP 50% 67% 72% 75% USD (ohers) 50% 33% 28% 25% Liabiliy class Bonds 69% 69% 87% 90% Credi lines 31% 31% 13% 10% Average life Inernal Exernal Toal These resuls are mean o explain how he new deb managemen sraegy was creaed. For his purpose, his documen was divided in wo pars. The firs describes he curren deb sraegy, synheized under he benchmark porfolio, mauriy profiles, measured risks and he organizaional model for managing deb. The second par goes deeper ino he models ha define currency composiions for he deb porfolio, given Colombia s mining and energy boom; which is currenly leading o appreciaion of he COP. The choice for a paricular currency composiion follows he resuls of wo main approaches ha examine differen deb managemen consideraions separaely. The firs approach is he Asse and Liabiliy Managemen model. The second mehodology, dubbed he Cos- Risk model, addresses ALM limiaions under a cos risk scope, under differen currency and ineres rae composiions scenarios 1. Transparence in he definiion and implemenaion of a medium-erm deb managemen sraegy is key for reducing fiscal risks, in line wih he CNG Fiscal Balance financial srucure. In paricular, he ransparence guidelines have reinforced Colombia as a foreign marke deb issuer and improved invesor perspecive owards Colombian deb in general. 1 ALM resuls are one of hese sudied combinaions. 15

16 Minisry of Finance and Public Credi The medium-erm deb sraegy explained hroughou his documen seeks o saisfy he need for currency maching wihin he Fiscal Balance and i consiues he base on which deb will be managed in following years (in line wih he Naional Developmen Plan, Prosperiy for all ). Resuls from he exercises and proposed policies are framed in a pruden and efficien deb managemen conex. Following hese adminisraion principles guaranees deb susainabiliy and a proper accompanimen o public finance managemen. 16

17 PART I Medium-Term Deb Managemen Sraegy 17

18 Minisry of Finance and Public Credi 1. Concepual Framework A deb sraegy is a combinaion of deb insrumens, srucured as a porfolio. Such sraegy seeks o esablish policy guidelines defined by he Governmen. Before discussing deb sraegy design, i is convenien o firs describe relevan heoreical feaures of managemen mechanisms available o deb issuers. Firs, differen ypes of risks ha derive from deb sraegies are assessed, as well as coss and benefis. Nex, benchmark deb porfolio arge indicaors are described. Finally, oher relevan aspecs concerning deb are sudied, such as he ineracion of deb issues wih oher economic variables and marke indicaors Risks, coss and benefis analysis Public deb managemen is he process of esablishing and implemening sraegies for adminisraing Cenralized Naional Governmen (CNG) deb. The goal of public deb managemen policy is o insure ha he Governmen s financing needs are me and ha paymen of is liabiliies is execued a he leas coss and risks possible. A Medium-Term Deb Managemen Sraegy (MTDS) is an acion plan; developed by he Governmen, for obaining a desired deb porfolio srucure, limied by public preferences regarding coss and benefis. The MTDS design makes emphasis in managing implici risk exposures and enables he idenificaion of possible fiscal cos variaions wih incidence on deb-servicing coss, macroeconomic volailiy, marke volailiy or exogenous shocks ha may hinder he aggregae economy. A proper design adminisraes porfolio risks, minimizes he deb burden on axpayers and maximizes resources availabiliy for oher expendiures (FMI e al., 2009). The hree fundamenal, muually exclusive, defined goals of deb s managemen (García, 2000) are: i. Minimizing average cos of deb ii. Minimizing exposure o marke risk iii. Maximizing he deb s average mauriy, seeking a uniform deb mauriy profile Sraegies wih a relaively shor mauriy profile 2 may be inended for minimizing deb cos by reducing budge burdens associaed wih deb service in fuure ineres paymens. In his manner, a possible opimal deb policy would be only issuing shor-erm deb given ha is coss are lower han longer erm issuing, and fuure ineres paymens are avoided. In consequence, uncerainy coming from facors ha would affec he deb s value is reduced. 2 Perhaps one budge cycle. 18

19 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I Figure 1. Deb managemen goal riangle Minimizing coss Minimizing marke risk Minimizing rollover risk Source: García, Leaving aside possible fuure risks, a narrow ime window for issuing shor-erm liabiliies would limi he governmen s room for resrucuring he deb porfolio owards lower coss. In fac, frequen refinancing leads o greaer risks and he impairmen of he curren ousanding deb profile, as opposed o longer erm deb rollover wih lower ineres raes. Conversely, when exernal ineres raes are lower han domesic ones, long-erm deb issues in foreign currency denominaion would be, a priori, more appealing o deb managers as a resul of lower coss. Even hough his second sraegy would exend he general mauriy profile of he deb porfolio reducing rollover risk, i does no incorporae he greaer currency risk associaed wih foreign currency denominaed deb 3. 3 The selecion of a deermined deb sraegy reflecs domesic marke resricions as well. Counries wih deep fixed income markes, have a large enough worldwide pool of invesors who absorb he governmen s financing needs making i unnecessary o issue deb in oher currencies. Opposie o his, in many developing counries, where financing needs are no enirely me domesically, here is need of foreign currency denominaed issuing. 19

20 Minisry of Finance and Public Credi If he chosen deb sraegy aims o reduce marke risk, hen deb managers should increase he amoun of fixed-rae deb issued on longer mauriies. Thusly, impac of ineres paymens linked o long-erm issued deb on he governmen s budge is no opimized. Alhough hese sraegies end o be cosly, hey are commonly found since hey limi he uncerainy on cash flows resuling from unexpeced marke volailiy. This volailiy on deb-servicing coss has a high poliical cos: he governmen s fiscal policy and is oucome may lead o increased revenues or reduced expendiure (García, 2000). Consequenly, i is convenien ha cos and risk evaluaions of he MTDS consider full business cycles 4, so ha inerconnecions beween he aforemenioned goals are incorporaed in all sages of design 5. Aside from fixed rae long-erm deb porfolios, governmens may use inflaion indexed deb issuing as an alernaive sraegy. These bonds provide invesors wih hedging ools for fuure price volailiy, implying lower ineres raes and longer mauriies on issuance. In fac, he advanages can be significan in cases where he governmen s forecased inflaion is below marke esimaes. The effecive design and implemenaion of a MTDS requires he exisence of financial insrumens and bonds; and financial marke deph. Such insrumens should provide enough capial o saisfy he Naion s funding needs and he Governmen s objecives regarding fiscal and macroeconomic policy, as well as fulfilling all of he porfolio managers ineress Benchmark Porfolio Governmen deb managemen consiss in designing and implemening a deb porfolio ha adequaely balances he following characerisics (in accordance wih previously se policy objecives): I. Currency composiion of he deb porfolio, II. Deb mauriy srucure, III. Ineres rae composiion of he deb porfolio, IV. Index composiion of he deb porfolio (wheher i is inflaion indexed, or linked o oher marke or macroeconomic variables 6 ). Deb managers have oher ools available, which allow hem o modify he menioned characerisics when needed. These do no necessarily imply deb issuance, and seek o improve he general public deb mauriy profile. The porfolio s composiion may be ransformed by he means of swaps and oher hedges, buybacks or deb exchanges. Based on hese four characerisics and wih he use of insrumens, governmens implemen heir deb managemen sraegies. 4 Oher counry s experience shows how hey conemplae 3 o 5 year ime horizons. 5 If full business cycles are aken ino accoun, scenarios wih higher shor-erm ineres raes are incorporaed, as well as srong Exchange rae volailiy, hus increasing cos of deb. 6 I s worh menioning ha in Colombia, here are wo ypes of domesically raded bonds: i) TES B bonds indexed o real value unis (UVR for is acronym in Spanish) where par value is expressed in real erms, and ii) TES indexed o CPI where ineress are indexed o inflaion. 20

21 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I Benchmark Porfolio - Definiions Wih he aim of esablishing ime enduring public deb policies, goal indicaors are inroduced. Four main indicaors are defined as follows: I. Foreign currency. This indicaor deermines he opimal issuace level of foreign currency denominaed deb and is resuling effec on he ousanding deb balance. The indicaor is fundamenal when assessing CNG oal revenue under a relaive deb cos oulook and under an asses and liabiliies managemen view of he FB. II. Mauriy. This indicaor defines he differen ideal ime horizons on which deb is issued 7. III. Ineres Rae. This indicaor represens he disribuion of he deb porfolio beween fixed rae and variable rae issues. IV. Indexing. This indicaor deermines he disribuion of he deb porfolio differen issues indexed o, mainly domesic macroeconomic variables. The mos common among hem is CPI indexing. These indicaors lay guidelines for he ideal srucure of deb porfolios in erms of a risk-benefi equilibrium. Oher desirable benchmark porfolio characerisics include consisency wih governmen financing sraegies and long-erm susainabiliy, offering insigh on sound deb managemen. These indicaors allow he manager o monior he achievemen of he deb managemen sraegy goals. Srucural differences beween he curren deb porfolio and he benchmark porfolio indicae how successful deb managers are in replicaing he sraegy; i.e., he desired deb porfoio composiion. In creaing he benchmark porfolio, i is key for he crieria used o be neural o curren marke condiions. I is cenral ha crierion does no reflec any paricular senimen on macroeconomic or marke variables from he governmen or hose involved in he deb managemen process. In fac, he benchmark porfolio could be exremely harmful, if no specified and implemened carefully (Wheeler, 2004). When designing benchmark porfolios, or specifying and implemening deb issuance sraegy, i is also imporan o acknowledge ha deb s behavior responds differenly o a variey of economic shocks. Esablishing wheher a counry is prone o supply or demand shocks ends o be difficul, bu i is known ha negaive shocks on demand rigger falls in prices and economic downurns. Wih falling prices, inflaion-indexed deb-servicing coss would srenghen he governmen s fiscal sance agains Governmen income drops and surges in public expendiure demand. 7 Concerning bonds and vanilla insrumens, mauriies depend on facors like he desinaion marke, and reflec he governmen s preference in regard o where in he yield curve liquidiy should be provided. As for ailored insrumens like bilaeral deb, finding mauriies ha sui a paricular sraegy is harder, as i is implemening i. 21

22 Minisry of Finance and Public Credi In his manner, a hedge for deb-servicing coss agains negaive supply shocks (characerized by falls in gross produc and rising prices) can be achieved by indexing fixed-rae deb. These price indexed fixed-rae insrumens are counercyclical by naure, meaning hey urn ou o be less cosly in economic crisis scenarios when ax revenue drops (Togo, 2007). As i was explained before, he deailed definiion of goal indicaors, address he macroeconomic and fiscal environmen and he developmen of financial markes as well. The recogniion of needed indicaors is unique o each counry, and each one should idenify wha variables are relevan for is economy and design benchmark porfolios ha answer o he behavior of hese variables, hus achieving sound deb managemen sraegies. This book aims o address his analysis for he Colombian economy Oher ools for deb managemen Hedging insrumens The implemenaion of derivaive ransacions, paricularly currency and ineres rae swaps, is necessary for he MTDS o achieve is objecives. Deb porfolio currency composiion is managed by rebalancing ousanding deb, ransforming i wih currency and ineres rae swaps. The implemenaion of derivaive insrumens makes i possible o draw a clear disincion beween issuance sraegy and risk managemen. If a chosen sraegy incurs in hedging coss, hen combining long-erm bond issues and Cross Currency Swaps (CCS) minimizes marke and rollover risks when increasing shor-erm deb is desired. I also conribues o keeping a sable and predicable issuance sraegy, his being cenral for he Naional Governmen (a crucial agen in he local marke) Inegraion of he MTDS wih macroeconomic policy Defining deb managemen policy and deb sraegies are necessary bu no sufficien for a governmen o have an overall sound managemen of he Naion s liabiliies. On he conrary, policies adoped have o guaranee coherence beween public deb managemen and he general macroeconomic background. In consequence, undersanding he links and coordinaion mechanisms beween he wo is essenial, so ha he effecs of deb managemen sraegies and oher macroeconomic policies are amplified ino he overall performance of he economy (See Figure 2). 8 Denmark s governmen has succesfully implemened CCS for heir deb managemen sraegy for nearly hiry years. These swaps provide he governmen wih deb managemen flexibiliy, drawing a clear line ha separaes issuance policy from ineres rae risk managemen. As a resul, he main arge of deb issuance policy is o creae high liquidiy for ousanding deb, as well as a broad se of insrumens available for invesors and low financing risks for he governmen (Danmarks Naionalbank, 2010). 22

23 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I Figure 2. Links beween MTDS and he macroeconomic policy Cos-Risk Analysis Macroeconomic and marke limiaions Informaion on coss and risks Coherence/ limiaions Marke deph iniciaives Macroeconomic framework/ Deb susainabiliy Informaion on coss and risks Deb Sraegy Demand limiaions/pricing facors Financing sources/ marke developmen Budge forecas Convenien deb insrumen composiion Marke developmen facors Source: IMF e al Financing Plan In developing a deb sraegy, differen marke, governmen and privae agen ensions and incenives are o be kep ino accoun, given heir incidence on decision making. The goal is o achieve policies ha are neural o all ineress and lead o overall soundness of deb managemen. For example, fiscal auhoriies are in charge of managing he Naion s deb, in which case hey prefer o keep he deb-servicing coss a a low level under he principle of creaing fiscal room for oher purposes in he shor-erm. However, doing so would increase fuure deb-servicing cos volailiy, forcing he governmen o cu expendiure or raise axes. Oher scenarios may also raise concern regarding ensions beween deb managers and economic policy. For insance, a governmen wih high fiscal deficis and a high deb-o-gdp raio may wan o reduce deb-servicing cos volailiy by increasing he amoun of fixed ineres rae insrumens wihin he porfolio. Alernaively, he governmen could seek o reduce he burden of deb-servicing by issuing shor erm deb, provided heir belief of low deb rollover risk and coss (Wheeler, 2004). 23

24 Minisry of Finance and Public Credi Anoher cause for concern is compaibiliy of deb managemen policy wih moneary policy. The main goal of moneary auhoriies is o achieve price sabiliy 9, bu when hey also play he role of deb managers some conflics of ineres may rise. They may be inclined o keep ineres raes low so ha deb-servicing coss are kep low as well, wih no regard for inflaionary risks. Conversely, moneary auhoriies may find i convenien o issue CPI index-linked deb o heighen is credibiliy, bu simulaneously inensify deb-servicing cos volailiy (Togo, 2007). Moneary policy regimes, he insrumens used by he auhoriies, and he auhoriy s credibiliy, all affec he deb managemen policy. In his sense, he MTDS conribues o improving credibiliy and reduce counry risk premiums due o inflaion. In fac, credibiliy could be considered relevan for he definiion of deb sraegies, since i somehow affecs inernal deb cos for boh shor and long-erm issues. On he conrary, he absence of credible moneary policy leads o high inflaion risk premiums and makes long-erm mauriy deb excessively expensive. Serilizaion acions underaken o reduce excessive liquidiy originaed by foreign capial flows, have led some cenral banks o consider issuing asses and repo agreemens hemselves. Furher enlargemen of quasi-fiscal deficis and he possibiliy of replacing cenral bank deb for Cenral Governmen deb are some conceps ha mus be aken ino accoun when formulaing MTDS (IMF e al., 2009). Similarly, careful examinaion of he governmen s exchange rae policy and foreign currency benchmarks is advisable. Foreign currency denominaed deb issuing requires a deailed knowledge of Balance of Paymens rends and herefore coordinaion wih exchange rae policy. For example, exchange rae uprends or high volailiy migh raise exernal deb coss and lead deb-service paymens o surge. A more naural way of including exchange rae and oher macroeconomic consideraions ino he opimal deb sraegy design consiss in incorporaing he governmen s asses dynamic ino he deb analysis Asse and Liabiliy Managemen approach One of he approaches for deb sraegy design is he Asse and Liabiliy Managemen (ALM) model. I offers a coheren framework for idenifying and managing he deb porfolio s underlying risks. I also sheds ligh on he linkage beween fiscal policy, moneary policy and deb managemen. The ALM suggess ha FB volailiy risk appears when here is no conformiy beween financial characerisics of asses and liabiliies, and herefore risk is minimized when income srucures mach hose of expenses. As menioned by Wheeler (2004), defining benchmark porfolios ha reduce he risk of governmen balance shee mismaches; considering he characerisics of cash flows mean for servicing deb is viable. In counries where expors represen a large percenage of GDP (as is he case of oil producing counries), he governmen s income is largely denominaed in USD as well. In ha even, exernal deb issued in foreign currency can be serviced wih revenues wih he same denominaion, hus balancing he deb composiion o some degree. In any case, i is common for ax revenue in domesic currency o ake up a larger percenage of Governmen income, and are 9 For his purpose, inflaion argeing, ineres raes, moneary aggregaes and exchange raes are managed wih open marke operaions or regulaory conrols like provisioning requiremens. 10 Obligaions arising from issued deb are classified under Liabiliies, while he funds raised hrough deb serve specific expenses in every fiscal erm. 24

25 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I grealy used for servicing crediors and deb. For his reason, he beer cos-risk alernaive is finding exernal deb currency composiions ha are highly correlaed wih local currency. This process usually requires finding an exernal deb porfolio currency composiion wih he lowes possible variance relaive o he local currency. This answers o he fac ha in many counries, ax revenue (he bigges source for Governmen deb-servicing funds) is denominaed in local currency. The ALM approach also suggess ha deb should be srucured in a way ha deb-servicing insallmens decrease when facing primary defici and increase wih surpluses. This counercyclical srucuring of deb helps o offse risks derived from surges in ax raes, cus in expendiure or deb defauls during financial crises. When deb is srucured o mach fiscal asses, deb managemen serves as an insrumen for minimizing budge volailiy and fiscal policy acs as an economic sabilizer for he counry. The mehod idenifies which deb insrumens have suiable characerisics for he Governmen o achieve is purposes of reinforcing he FB. Paricularly, deb wih paymens condiioned o he accomplishmen of primary surpluses could srenghen he FB agains negaive shocks o fiscal asses. A clear example of he above is GDP-indexed deb. Wih gross income acing as a proxy for ax revenue, managers insure ha deb service insallmens follow he Naion s income dynamics. Anoher aspec ha could lead o mismaches beween he income and expendiure sides of he Governmen s balance shee is he financial effec of risk premiums. For insance, in emerging economies, crises elevae risk aversion and are associaed wih higher risk premiums, hus leading o procyclicaliy of deb and is coss. These rais of he risk premium are closely relaed o he cyclical properies of foreign capial flows. The implicaions of procyclical risk premiums and capial flows on he deb managing make i appropriae o keep financing needs conrolled during crises. Given he difficuly of forecasing crises, i is clear ha issuing long-erm deb and minimizing concenraion of mauriies in a given fiscal erm is advisable from a risk managemen perspecive. Marke agens in charge of formulaing governmen policy mus have clariy on wha are he objecives and he real exen of heir chosen deb sraegy. As such, deb managers should no expec for he sole implemenaion of a deb sraegy o lead o he accomplishmen of fiscal goals, albei he relaion of he wo Developmen and efficiency of domesic markes The disjuncive for economic auhoriies is ofen beween raising funds domesically or finding financing in foreign markes, and is enwined wih how deep and developed inernal public deb markes are. Governmens inroduce a series of policies and regulaions for consolidaing primary and secondary markes for inernal deb and for promoing adequae condiions for he Naion s funding in capial markes. I focuses is effors in providing a smooh funcioning of secondary markes under differen marke condiions and herefore ries o carry hrough predicable and ransparen primary marke operaions. 25

26 Minisry of Finance and Public Credi Provided ha he deb manager s purpose is o finance is budge a he lowes cos-risk raio, having a deep secondary marke becomes relevan 11. Marke deph also resuls in public financing sraegies and macroeconomic policies ha do no inerfere wih each oher. Moreover, deph improves financial marke dynamics, and amplifies liquidiy while giving relevance o public deb and enabling he idenificaion of a robus and liquid yield curve. Deb managemen sraegy provides a se of ools for analyzing and idenifying challenges faced when addressing marke deph issues. In fac, proper medium-erm deb managemen sraegies may even deepen he marke for securiized public deb by making i ransparen and predicable, bolsering he developmen and implemenaion of new deb based insrumens Colombian case sudy 2.1. Objecives of he MTDS In recen years, muliple facors ook he Colombian economy hrough srucural changes ha moivaed a review and updae of curren deb managemen guidelines (proposed during he nineeen nineies and las revised a he beginning of he las decade). The challenge of reviewing he sraegy guidelines is underaken by he Naional Governmen, led by he Minisry of Finance and Public Credi (MHCP), and falls ino he specific asks se by he Naional Developmen Plan (PND), Prosperiy for All. Accordingly, deb policy draws he rules for opimal managemen of he Naion s asses and risks as well as for he efficien adminisraion of he budge. In accordance wih aricle 334 of Colombia s Consiuion, he Sae is in charge giving direcion o he Naion s economy, assuring fiscal susainabiliy, necessary in a Social Welfare Sae. As such, he MHCP includes he MTDS ino is asks. The Minisry s sraegy is one of he drivers ha lead o economic growh. I makes he Naion s deb susainable by carrying a pruden managemen wih fewer budgeary burdens in each fiscal erm. This ouline is vial for a counry like Colombia, where is FB faces srucural risks associaed wih he size of he deb, ne exernal income volailiy, Terms of Trade volailiy and a dependency on paricular producive secors or oher commodiy producing economies. Deb managers migh make wrong decisions on new issuing if here is no framework or guideline o do so. Therefore, if clear objecives for deb managemen are no se, here is a chance of facing marke volailiy and uncerainy in finding funding sources 13. For he Minisry o develop a MTDS, i firs defines guidelines for sound public deb managemen and se goals for inegral risk managemen. 11 Invesors would raher have governmen bonds wih easily observable prices in a liquid marke. This could reflec securiy finding coss ha make non-sandardized deb insrumens more expensive (Leong, 1999). 12 Incorporaing new nodes o he yield curve is possible when here is cerainy of medium-erm financing susaniabiliy hrough coninuous issuing. 13 By designing pruden deb managemen sraegy wih clear end goals, credi risk premiums, liquidiy, and ineres rae premiums on he Naion s ousanding deb are reduced 26

27 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I 2.2. Background For more han weny years, he governmen has recognized he imporance of adequae managemen of he Naion s deb porfolio and is impac on fiscal and economic sabiliy. In 1993, a process of improvemen of he ools wih which he Naion managed deb began, wih he enacmen of Decree In fac, hese regulaory breakhroughs se Colombia as a pioneer and an example on deb managemen o he inernaional communiy 15. In 1997, he designing sage of he Liabiliy Managemen program ends and so he implemenaion sage begins. The projec; led by he General Direcorae of Public Credi (DGCP) in hand wih consulans from Salomon Brohers, aimed o develop a benchmark porfolio for exernal deb. As a resul, he firs in-house Risk Workgroup was creaed wihin he Minisry of Finance, as well as a Public Deb Advisor Commiee 16 in charge of analyzing and defining exernal and inernal deb policy. In he process, risk guidelines were proposed, and he benchmark porfolio under which public deb would be managed for he following years along wih exernal deb managemen sraegy were pu forward. In 1998, he Primary dealers program was launched by he MHCP and he BR, boosing he developmen of domesic public deb markes. In 1999, he financial risk valuaion mehodology for public deb was esablished. I was named Deb-servicing a Risk SDeR for is acronym in Spanish 17, and i sill serves as a ool for analyzing and supporing he Naion s (and oher eniies) liabiliy managemen. In 2001, benchmark deb porfolios were revised and updaed, hus iniiaing a case sudy on Colombian deb, carried ou wih he aid of he IMF and he WB. The purpose of his sudy was o fashion a new documen where public deb managemen guidelines were delivered. In consequence, he new valid goal indicaors for designing deb sraegy are as follows: Mauriy Profiles: hrough a proper mauriy profile design, risks of high concenraion of annual amorizaions are conrolled. Curren policy considers ha an ideal annual mauriy profile is 10% o 15% of he oal ousanding deb. The average life of he porfolio should be of 5 or more years. Ineres Raes: his indicaor seeks o give direcion on how o conrol ineres rae volailiy, esablishing a limi o variable ineres rae issued deb. This should no overpass 30% of he ousanding deb. 14 This Decree regulaes public credi operaions and deb porfolio managemen operaions, as well as deb issuing. 15 This recogniion is given in he WB and IMF 2003 publicaion: Guidelines for Public Deb Managemen Accompanying Documen and Seleced Case Sudies : In i, Colombia is presened as a success case sudy for he sound managing of deb. 16 The Commiee is composed by he Miniser of Finance and Public Credi, he Vice miniser of Finance and Public Credi, he Direcor General of Public Credi and Naional Treasury, he Cenral Bank s Depuy Manager for Moneary Affairs and Inernaional Reserves, plus advising guess relevan for specific subjecs. The Cenral Bank s presence is due o conjoined managemen of he Naion s Asses and Liabiliies by he wo eniies. 17 The valuaion mehodology was developed by he DGCP and i is very similar o he BaR, Budge a Risk : and he CaR, Cos a Risk. I consiss in esimaing he presen value of he highes expeced surge in deb-servicing coss, given a confidence level and ime horizons of one, hree and en years. 27

28 Minisry of Finance and Public Credi Currency: his indicaor is mean o sugges how o conrol exchange rae volailiy risk. According o i, 83% of he Naional Governmen s exernal deb porfolio should be denominaed in USD, 13% in Euro or oher European currency, and 4% in Yen. Laer, in 2003, risk hedging credi operaions were regulaed wih he enacmen of Decree In 2004, he governmen consuled wih he Colombian Agency for Inernaional Cooperaion and Los Andes Universiy, resuling in he documen Revisión y desarrollo de benchmark de deuda inerna (Review and developmen of an inernal deb benchmark). The consulancy had he aim of proposing a resrucuring of he Naion s deb porfolio composiion favoring inernal deb issuing, following WB recommendaions and adhering o he Colombian Fiscal Srenghening Program. Despie he sudy s recommendaions, he adopion of an inernal deb benchmark porfolio was never subsaniaed as policy. In 2010, he Governmen enaced he Naional Developmen Plan (NDP) Prosperiy for All, wih he purpose of pushing he Naion s five producive engines forward; hese are housing, infrasrucure, agriculure, echnologic innovaion and he mining and energy secor. These engines are mean o drive he economy for he nex four years. In his regard, he MTDS aims o opimize public finance managemen in a highly sophisicaed marke, so ha he engines run. Colombia s deb porfolio of he early nineeen nineies was highly concenraed in domesic deb securiies wih limied liquidiy 18. Noneheless, his srucure is now shifing owards a local currency sandardized bond porfolio, issued boh inernally and exernally, keeping a close look o marke and rolling over risks and cos reducion. To move o a differen porfolio srucure, issue policy, Liabiliy Managemen operaions, hedges and deb rades, among oher sraegies, have aken place. Deb managemen guidelines of he nineies were revised a he urn of he cenury, giving birh o new sandards. These new guidelines gave deb a new framework of susainabiliy, reduced fiscal risk and beer deb porfolio risk managemen, all of which remain valid o dae. In spie of his, he Colombian economy has come across muliple facors ha srucurally changed i in recen years, moivaing he Governmen o updae pas deb managemen mehodologies. Some of he aspecs worh menioning are he financial crisis he Naion wen hrough a he very end of las cenury, he esablishmen of a floaing exchange rae regime, he rapid accumulaion of inernaional reserves of he pas few years, price sabiliy hanks o he BR s inflaion argeing, he deepening of Colombia s financial markes along wih susained economic growh driven by he NPD s rain engines (see Figure 3). Oher exernal aspecs somehow affeced he economy as well. Some of hem were inernaional financial crises, along wih elevaed marke volailiy and a surge in oil prices. 18 The Primary Dealer Program gave liquidiy o local secondary markes of Colombian deb insrumens. This deb issuing program offers clear srucuring condiions o invesors. 28

29 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I Figure 3. Inernaional Reserves (USD Mln), Inflaion YoY and Exchange rae Source: Banco de la República, DANE July 31 s, Before coninuing wih he definiion of new guidelines, some of he curren valid sraegy goals are revised, such as: Formally defining a desired composiion for he deb porfolio, subjec o currency exchange risk. Simulaneously he marke where bonds are issued (inernal or exernal deb) has o be disinguished from is currency denominaion, paricularly when direc exernal deb can be issued and derivaives can be raded. Defining a clear goal for he deb porfolio s composiion in erms of inflaion indexed securiies. Defining a mauriy profile for he deb porfolio, so ha i is smooh and concenraions of mauriies make refinancing risk olerable and curren financing viable. Idenifying he need for financing from differen sources and developing benchmark yield curves ha deepen domesic money markes and derivaive markes. The access o domesic and inernaional capial markes by eniies of subnaional order seeking funding should also be sough afer. As menioned, he behavior of financial variables in he FB may cause fiscal shocks. Because of his, evaluaing he naure of cash flows generaed by he Naion s asses and liabiliies and heir suscepibiliy o ineres rae changes or exchange rae flucuaions is key, as 29

30 Minisry of Finance and Public Credi well as vulnerabiliies o changes in Terms of Trade. The former direcly implies he need for classifying asses and liabiliies according o risk exposures, so ha full hedges can be designed by resrucuring he FB composiion and oher risks and oher risks can be managed. All of hese noions formed he design guidelines for deb managemen sraegies of he pas decades, conceps ha will be deal in more deail in Secion Medium-Term Deb Managemen Sraegy 3.1. Formulaion of he MTDS The review of he CNG s deb sraegy is a necessiy for he curren Adminisraion, in he sense ha i leads o defining new guidelines for global deb porfolio srucures, ending o he adequae financing of budge appropriaions, o diminishing medium-erm deb coss under sensible risk exposures and conribues o he developmen of he local capial marke. (PND, Aricle 257). According o his, he characerisics ha define he MTDS are described nex Objecives The main purpose for conracing deb is o opporunely fund he Naional General Budge (NGB). As such, he design of a MTDS is subjec o: Finance budge needs in every fiscal erm. Minimize medium-erm cos of deb wih reasonable risk exposures. Give deph o domesic capial markes Guidelines Along wih he aforemenioned objecives, addiional elemens srenghen and broaden he MTDS reach. These are: Following explici deb susainabiliy and refinancing crieria. Clearly deermining he objecives for MTDS, and periodically reviewing hem in order o guaranee coherence wih oher public policies. 30

31 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I Esablishing ransparence and informaion disclosure procedures ha guaranee he adequae fulfillmen of responsibiliies and accounabiliy Public deb managemen reach The CNG deb porfolios are composed by inernal and exernal deb, and credi lines wih mulilaeral and bilaeral banking insiuions. These liabiliies are he subjec of managemen for which he MTDS is creaed Public deb managemen responsibiliies for he Naion Deb managemen emphasizes on he following iems: Defining public deb policy ha makes medium-erm deb susainable and fills he deb issue limis approved by Congress. Issuing public deb securiies and negoiaing credi, guaraneeing fund availabiliy in accordance wih curren regulaion. Conracing new efficien public credi operaions ha enable he CNG o manage financial risk and help mainain or improve he deb porfolio mauriy profile. Recommending liabiliy managemen operaions ha comply wih he designed MTDS and allow proper and imely managemen of financial risks of he deb porfolio, and ha cause low fiscal impac on he Naion s Budge. Managing he CNG deb porfolio s risks, following he MTDS. Diversifying funding sources while minimizing currency risk, ineres rae risk and deb refinancing risk. Disclosing public deb policy informaion and economic environmen condiions of domesic markes o invesors. Regisering and following hrough wih he Naion s ransacions and wih Sae Eniy deb warraned by he Naion Srucure of he Governmen of Colombia as deb manager The MHCP, hrough he DGCPTN, is responsible for efficienly and opimally managing NGB liquid asses and adequaely handling public deb. In is role as deb manager, he DGCPTN esablishes public deb policy, prioriizing susainabiliy and adequae balancing 31

32 Minisry of Finance and Public Credi of risks. I advises o he MHCP on public financing, policies regarding mulilaeral organisms, risks policies and procedures for public credi operaions. To successfully fulfill all of hese funcions, he DGCPTN is srucured in a way ha gives clariy o he marke on wha i does. Specifically, in wha regards he MTDS, he Direcorae s organizaion is described in he following subsecions Fron Office Depuy Direcorae of Naional Treasury (SDTN): deparmen in charge of direcing, adminisraing and performing reasury operaions (mainly rades and issues). These operaions are inended o raise funds and issue deb, direcly or hrough inermediaries specialized in managing excess liquidiy for porfolios unrelaed wih Naional Budge, when he budge is earmarked. Depuy Direcorae of Inernal Financing (SFIN): deparmen in charge of srucuring and direcing he Naion s financing sraegies wih local capial marke resources. I gives suppor o oher Sae Eniies searching for resources in domesic capial markes on heir deb sraegy. Depuy Direcorae of Inernaional Capial Markes (SFEN): deparmen in charge of srucuring and direcing he Naion s financing sraegies in exernal capial markes and wih foreign banks. I gives suppor o oher Sae Eniies on how o find capial resources in foreign markes. Depuy Direcorae of Financing wih Mulilaeral Organizaions (SFOMG): deparmen in charge of srucuring and direcing financing sraegies wih resources from mulilaeral banking insiuions, foreign governmens and developmen banking insiuions. I aids oher Sae Eniies in heir credi negoiaions wih he menioned organizaions Middle Office Depuy Direcorae of Risk (SR): deparmen in charge of defining risk guidelines, policies and sraegies concerning he Naion s public credi, marke and liabiliy managemen. I esablishes guidelines for managing he Naion s warranies, couner-warranies and coningen liabiliies. Regarding deb sraegy, he SR is in charge of developing he published MTDS documen and looking afer is fulfillmen, in hand wih he oher depuy direcoraes. The SR is also in charge of he managing risks associaed wih coningen liabiliies, given he grea fiscal impac hey have upon he occurrence of coningencies. Due o his high risk, aciviies aimed o manage hese risks are deal separaely from public deb managemen sraegies Addiionally, he Depuy Direcorae of Invesmen Banking and he Depuy Direcorae of Financing for Oher Sae Eniies give suppor o he oher depuy direcoraes and o he DGCPTN. 20 These guidelines can be found in in Coningen Liabiliies: Mehodologies in Colombia, Minisry of Finance and Public Credi. 32

33 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I Back Office Depuy Direcorae of Operaions: deparmen in charge of coordinaing allocaions and managing he Single Naional Accoun (SNA) wih he Monhly Basis Annual Cash Schedule (PAC for is acronym in Spanish).I also conrols, execues and regisers all he operaions underaken by he DGCPTN. BOX A. Sraegic suppor deparmens Legal Affairs: deparmen in charge of advising and giving legal accompanimen o all of he DGCPTN Depuy Direcoraes, so ha all of he public credi operaions, and relaed operaions, are wihin curren regulaions. Depuy Direcorae for Invesor Relaions: proposes and advises on he Naion s sraegy for approaching marke agens, invesors and oher paries ineresed in concurring in public deb operaions. Is purpose is o improve informaion disclosure; he overall percepion on Colombian public deb, is economy and invesmen opporuniies in he counry. I conribues in broadening Colombia s possibiliies of raising capial and financing CNG ousanding deb and mauriy profiles The DGCPTN deb sraegy is focused on minimizing he deb porfolio vulnerabiliy o inernal and exernal shocks, so ha i becomes sable and he Naion s funding programs are fulfilled wih good managemen indicaors. This secion analyzes he deb porfolio s srucure and is evoluion for a ime span ranging from June 2002 o July 2012 (see Table 1). 33

34 Minisry of Finance and Public Credi Table 1. CNG deb porfolio evoluion (Annual averages) CNG DEBT PORTFOLIO EVOLUTION Marke of issuance Inernal 53% 51% 51% 62% 65% 67% 69% 67% 70% 71% 72% Exernal 47% 49% 49% 38% 35% 33% 31% 33% 30% 29% 28% Currency denominaion Ineres rae Financing source Exernal deb Inernal deb Exernal deb Exernal deb Inernal deb USD 82% 83% 83% 82% 81% 78% 79% 82% 81% 81% 79% Euro* 13% 14% 14% 12% 9% 8% 4% 3% 2% 1% 0% Yen 4% 4% 2% 2% 2% 2% 2% 2% 3% 3% 3% COP 0% 0% 0% 4% 8% 13% 15% 13% 14% 15% 18% COP 69% 68% 70% 74% 76% 77% 76% 75% 77% 76% 75% UVR 27% 28% 28% 25% 24% 22% 24% 24% 23% 24% 24% USD 5% 4% 2% 1% 0% 0% 0% 0% 0% 0% 0% Fixed 78% 80% 80% 81% 83% 83% 82% 85% 82% 80% 80% Floaing 22% 20% 20% 19% 17% 17% 18% 15% 18% 20% 20% Bonds 61% 58% 55% 57% 59% 58% 57% 56% 56% 56% 57% Mulilaeral credi 30% 36% 39% 37% 40% 41% 42% 43% 44% 43% 42% Oher 9% 6% 6% 5% 2% 1% 1% 1% 1% 1% 1% TES 78% 81% 83% 87% 89% 91% 93% 94% 95% 97% 98% Oher** 22% 19% 17% 13% 11% 9% 7% 6% 5% 3% 2% Average porfolio life Exernal deb Inernal deb (TES) * Including deb denominaed in oher currencies. ** Including Law 546/99 bonds, farming bonds, peace bonds, securiy bonds, deb reducion securiies, reasury noes, among ohers CNG oal ousanding deb The CNG ousanding gross deb as of July 31 s 2012 amouned o COP 213 rillion, of which COP 154 rillion are inernal deb and COP 59 rillion are exernal deb (see Figure 4a). Variaions of he Naion s ousanding deb (boh in COP and USD) show dissimilar 34

35 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I behaviors (see Figures 4a and 4b). This is largely a resul of flucuaions in exchange raes, where appreciaions of he local currency lower he value of CNG deb in COP. Figure 4. CNG Gross Ousanding Deb (COP Billion) and Toal Deb variaion (YoY) Figure 4a. Figure 4b. Source: Depuy Direcorae of Risk DGCPTN July During he las decade, he Naional Governmen kep he deb-o-gdp raio around 40% in average, wih a downward rend going from 45% o 35% (see Figure 5). The weigh of inernal deb relaive o oal deb ousanding has remained relaively sable along he decade, amouning o 28.5% of GDP in 2005, bu averaging 25% overall. On he oher hand, exernal deb as a percenage of GDP has shown negaive variaions of up o 11% beween 2002 and 2011, seling a a level of 10.4% a he end of he laer year. Needless o say, his reducion of deb-o-gdp raios is consisen wih he Governmen s fiscal responsibiliy policy and deb susainabiliy crieria. 35

36 Minisry of Finance and Public Credi Figure 5. CNG Deb o GDP (%) Source: DGPM July The pas decade winessed a resrucuring of he CNG deb porfolio. While in 2002, 50% of all liabiliies were inernal deb, by he end of he firs quarer of 2012, 72% of he porfolio was composed by inernal deb and 28% exernal deb (see Figure 6). The proporion of inernal deb in he deb porfolio has increased due o acive policy oriened owards larger domesic issuance, hus reducing currency risk. 36

37 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I Figure 6. CNG Deb marke of issuance (COP Billions) Source: Depuy Direcorae of Risk DGCPTN July 31, 2012 In Colombian markes, inernal public deb securiies TES are he mos commonly used deb securiies. These issues are gaining momenum and are now he Naion s main source for funding (see Figure 7). The majoriy of TES issues are fixed rae, COP denominaed securiies, and sum up o 74% of all issues. In 2011, he CNG raised COP 4 rillion wih his insrumen. Moreover, 59% of ousanding TES bonds have medium o long-erm mauriies and only 3% of hem are due on daes shorer han a year (hese las securiies are issued on discoun 21 ). Exernal deb is composed by Global TES securiies and exernal bonds, and ogeher, hese represen as much as 57% of he Naion s exernal deb, followed by credi lines wih mulilaeral credi insiuions. In spie of his, exernal gross deb in COP has decreased as a resul of wo main facors: i) currency risk reducion sraegies, and ii) he effec currency appreciaion on ousanding deb (see Figure 8). 21 These noes do no consiue an insrumen used in medium-erm deb managemen sraegies. Insead hey are used as shor-erm liquidiy insrumens. 37

38 Minisry of Finance and Public Credi Figure 7. CNG Deb composiion by insrumen Source: Depuy Direcorae of Risk DGCPTN - July Figure 8. USD-COP exchange rae (TRM 22 ) Source: Banco de la República 22 Colombia uses a daily reference index for exchange raes. Is calculaion is based marke prices observed on elecronic rading sysems. 38

39 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I As far as currency composiion goes, CNG deb is largely COP denominaed (59%). A smaller porion is USD denominaed (19%) and UVR denominaed (18%). The remaining porion of he porfolio is denominaed in oher currencies, such as Yen and Euro (see Figure 9). Figure 9. Gross deb currency composiion Source: Depuy Direcorae of Risk DGCPTN July Moving on, since early 2004, he MHCP hrough he DGCPTN decided o modify he deb porfolio s currency composiion, in search of increasing he percenage of COP denominaed deb in he porfolio over he observed 50%. The goal of doing so was o reduce currency risk in he deb porfolio. In more deail, while Global TES securiies are mainly issued a fixed-raes, ineres raes for loans wih mulilaeral banking insiuions are generally floaing. By he end of he firs quarer of 2012, 90% of deb paid ineress a fixed-raes, revealing a preference for ineres rae risk by deb porfolio managers in Colombia (see Figure 10). 39

40 Minisry of Finance and Public Credi Figure 10. CNG Deb composiion by ineres rae Source: Depuy Direcorae of Risk DGCPTN July Risk managemen analysis and he benchmark porfolio The main risks o which he Naional Governemn is exposed when conracing deb are refinancing or rollover risk and marke risk 23 (see Table 2, where he main risks o which he CNG is exposed are defined). Monioring hem properly is essenial for insuring adequae risk managemen and reducing impac on he fiscal balance. Table 2. Public deb managemen associaed risks Marke Risk Rollover Risk The possible variaion in deb-servicing coss and ousanding deb as a resul of ineres rae or exchange rae volailiy or inflaion surges. The limied acces o credi in erms of availabiliy and credi erms. 23 Oher risks o which he Naion is exposed, like operaional or counerpary risks, are no addressed in his work. 40

41 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I The weigh of COP denominaed deb inside he porfolio has increased in pas years, leading o lower currency risk exposures in line wih he Governmen s objecives for deb managemen. In his manner, by he end of 2002, he deb porfolio was composed of 35% COP denominaed deb, 14% UVR, and he remaining 52% of deb denominaed in oher currencies. More recenly, as of July 31 s 2012, 59% of he deb was denominaed in COP, 23% in oher currencies and 18% in UVR. Ineres rae risk, on he oher hand, is he variaion on servicing coss of floaing-rae issued deb on a fiscal year, resuling of ineres rae volailiy plus mauriies under a year of expiraion ha have o be refinanced (see Figure 11). Even hough he deb porfolio is highly concenraed in fixed-rae securiies (see Figure 10), he deb cos refixing indicaor is around 15% in average, as a resul of expiries under a year ime. Lasly, he majoriy of he porfolio has a remaining mean life of 5 years (abou he same percenage of UVR and COP issues, where mos of he porfolio is concenraed). On he oher side of he porfolio, he easiness of issuing wih longer mauriies in foreign markes and prepaymen condiions of loans wih mulilaeral banks srech he lengh of he life of he porfolio (see Table 1). Figure 11. Deb cos refixing indicaor Source: Depuy Direcorae of Risk DGCPTN July

42 Minisry of Finance and Public Credi I is also worh noicing how he average life of he porfolio increased, due o deb porfolio resrucuring operaions and he creaion of new nodes of he yield curve for new mauriies, boh domesically and inernaionally (see Figure 12; and for more deail Secion 3.5). Figure 12. Average Life (yrs) Source: Depuy Direcorae of Risk DGCPTN July As for amorizaion profiles for CNG deb, mauriies of he porfolio are highly concenraed around 2012, implying high rollover risk (see Figure 13). However, in he analyzed ime lapse, due daes of he ousanding deb are sill below he recommended 15% of oal deb. In some cases, hey even res under 10%. Despie he lack of uniformiy of he deb amorizaion profile, improvemens are observed because of higher percenages of he porfolio issued on long-erm mauriies. When analyzing he evoluion of rollover risk exposures classified by ype of deb, he effec of a deeper domesic capial marke. Likewise, greaer accessibiliy o issuing long-erm deb in inernaional markes has shaped inernal and exernal deb porfolio mauriy profiles (see Figure 14 and Figure 15). 42

43 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I Figure 13. Annual CNG deb porfolio amorizaions percenage Source: Depuy Direcorae of Risk DGCPTN July Figure 14. CNG deb porfolio mauriy profile Source: Depuy Direcorae of Risk DGCPTN July

44 Minisry of Finance and Public Credi Deb managemen has posiively affeced domesic marke deph and improved he world s percepion on he risks of invesing in Colombia. Furhermore, he Naion has sreched is yield curve by adding new long-erm deb nodes. On ha accoun, i is now possible o issue 15 year COP denominaed bonds and 20 year UVR denominaed bonds in domesic public deb markes, 20 year COP denominaed bonds and 30 year USD denominaed sovereign deb abroad. Figure 15. CNG exernal deb porfolio mauriy profile Source: Depuy Direcorae of Risk DGCPTN July Benchmark porfolio In accordance wih curren regulaions, he DGCPTN is responsible of developing policy for efficienly managing and adminisraing public deb and is servicing. Hence, i idenifies, quanifies and conrols he porfolio s exposure o financial risk. In virue of his faculy, he SR of he DGCPTN conrols negaive shocks ha ousanding deb and deb-servicing coss may have on he macroeconomic environmen and he Naion s Budge. I is in charge of insuring ha financing requiremens are me and ha obligaions derived from liabiliies are delivered a he leas cos possible, wih reasonable exposures o risk in a medium o long-erm specrum. The SR implemens goal indicaor mehodologies for managing he deb porfolio. These indicaors encompass he desired srucure of he deb porfolio in erms of expeced coss and risk radeoff. They help o hedge and conrol he Naion s risk exposures. Therefore, benchmark porfolios are defined nex. 44

45 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I Exchange rae indicaor Currency composiion Currency composiion of he deb porfolio is a direc indicaor for he magniude of currency risk exposures. The second par of he book elaboraes on his subjec. There, mehodologies for measuring and miigaing his ype of risk are exposed. The echnical exercise ha shows he porfolio s currency composiion under he ALM or he Cos-Risk approach is explained. As a resul, an ideal currency composiion for he deb porfolio of 75% local currency (COP and UVR) and 25% foreign currency (USD) was found. Mainaining said composiion requires he definiion of a specific deb issuance sraegy of 80%-20% local-foreign currency placemen for Mauriy indicaor Deb amorizaion profile As menioned earlier, refinancing risk is one of he larges exposures of he Naion s deb porfolio. As such, in consideraion of fiscal responsibiliy, he SR defines he rollover porfolio, mean for conrolling risk by bounding mauriy concenraions in single fiscal erms. Curren DGCPTN policy assers ha an ideal level for annual mauriy concenraions is 10% of ousanding deb and ses he upper bound a 15%. Under hese assumpions, average life of he Naion s ousanding deb exceeds he 5 year mark, which is he minimum mean mauriy profile lifespan recommended in deb managemen lieraure. For verifying his fac, consider he following definiion for he average remaining life of a liabiliy wih principal P, o be paid back in n periods and insallmens { P :1 i n} : i ML P n i = å i i= 1 P where i is ime in years. Now, assuming scenarios where he principal is repaid during he firs 10 years of life of he liabiliy 24 and annual mauriies do no exceed 10% of he porfolio, hen paymens Pi / P are equal o 10% 25. Wih his, he average life ML would be: n å ML = (10%) = 7 yrs i= 1 Issuance sraegies wih longer mauriy srucures under he 10%-15% hreshold would equae longer average mauriy profiles. 24 This is a sressed scenario for i implies ha he CNG is forced o honor all of is liabiliies in a 10 year imeframe. Noneheless, from previous secions he exisence of longer mauriies is clear (see Figures 13, 14 and 15) % of he liabiliy is paid wihin 10 periods wih idenic amorizaion insallmens, for none of hem can exceed 10% of he oal ousanding deb (in accordance wih he profile rule). i 45

46 Minisry of Finance and Public Credi Ineres rae indicaor Ineres rae composiion of he porfolio This indicaor measures exposure o flucuaion in ineres raes. For conrolling said risk, limis are esablished o he amoun of floaing-rae deb issued. The curren valid indicaor saes ha his se of issues should only amoun up o 30% of oal ousanding deb (see Chaper 2). Currenly, 20% of he exernal deb porfolio is floaing-rae liabiliies. Credi lines wih mulilaeral banking insiuions and oher governmens usually have ailor made srucures and ineres raes ha serve he paricular purpose of he raised deb and each of he credi erms. As for inernal deb porfolios, he percenage of liabiliies indexed o floaing-raes is only 1.3% (see Table 3). Low percenages of floaing-rae deb relaive o curren reference porfolios answer o he fac ha marke condiions opened he possibiliy of low rae deb o he CNG. Table 3. Ineres rae benchmark Marke of issuance Ineres rae Inernal Exerna TOTAL Fixed 71% 22% 94% Floaing 1% 6% 6% TOTAL 72% 28% 100% Source: Depuy Direcorae of Risk DGCPTN 3.5. Financing sources of he Naional Governmen Diversifying sources from where he Naion raises deb has been a cenral goal of deb managemen sraegies. A broad base of deb insrumen invesors, and of course deb insrumens (see Figure 16), is desirable since i makes he balancing of mauriy profile financial risks easier. 46

47 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I Figure 16. CNG financing sources Source: DGPM Raising deb in domesic capial markes Raising capial by efficienly issuing TES deb securiies in domesic capial markes is mean o finance a srech of he Naion s budgeary appropriaions for a given fiscal year. The goal hen is o reduce coss wihin reasonable risk parameers. The DGCPTN has designed and implemened a proacive issuance sraegy o comply wih he funding needs defined in he Naion s Annual Borrowing Plan. Thanks o he aucion bond placemen scheme, and o some degree o consened and forced placemens (see Box B) 26, domesic primary markes and secondary markes for public deb are geing sronger and deeper. Aucions are he main mechanism for TES B securiies (see Figure 17). Consened and forced bond placemen wih Sae Eniies are also largely imporan for meeing annual funding goals. 26 Curren placemen sraegy does no conemplae long-erm USD denominaed or floaing-rae securiy issuing. Recen currency appreciaions and overall price sabiliy ha have led o increases of he local currency (or UVR) denominaed TES porion of he deb porfolio. 47

48 Minisry of Finance and Public Credi Figure 17. TES placemen mechanisms COP Mln. Source: Debuy Direcorae of Inernal Financing DGCPTN. The Naion s credibiliy of responsible fiscal managemen ranslaes ino lower local coss of deb. In his manner, issuance raes in primary markes have regisered in 2012 hisorical lows on 5, 10 and 15 year references (see Figure 18) 27. The mos commonly deb insrumens being currenly issued are: fixed-rae COP denominaed TES and fixed-rae UVR denominaed TES. 27 The decreasing rend of issuance raes also follows marke dynamics, moneary policy and marke expecaions for inflaion, local and inernaional risk aversion senimen, among ohers. 48

49 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I Figure 18. Local deb issuance raes by mauriies Source: Depuy Direcorae of Inernal Financing DGCPTN July These lower coss are a resul of growing demand for sovereign deb as well. Aucion resuls confirm he markes appeie for TES bonds and evidence he local marke s suppor o he Naion s predicable and ransparen issuance sraegy of he MHCP. When comparing approved aucion volumes wih he demand (bid o cover), i is eviden how he laer is significanly greaer, averaging around 3.7 imes he offered volume of securiies (see Figure 19). 49

50 Minisry of Finance and Public Credi Figure 19. Weekly aucions, placemens, bids and bid-o-cover raio (monhly average) COP (Mln). Source: Depuy Direcorae of Inernal Financing DGCPTN Sepember Domesic deb marke paricipans Local marke invesor pools are consiued of banks, insiuional invesors (adminisraed pension funds, fiduciary invesmen porfolios, and insurance company invesmen porfolios) and oher governmen porfolios; mainly public pension funds (see Figure 20). 50

51 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I Figure 20. Local TES bondholders* Source: Depuy Direcorae of Inernal Financing DGCPTN July * The remaining percenage accouns for Public Eniy holdings In paricular, pension fund and commercial bank porfolios have enlarged heir sakes of Colombian public deb, given heir low-risk and highly liquidiy (see Figures 21 and 22). In fac, 50% of mandaory pension funds are allocaed in TES securiies 28. Pension funds are no he only insiuional invesors wih appeie for holding long-erm governmen deb securiies o mauriy for maching asses and liabiliies. Even hough long-erm invesmen sraegies give sabiliy o public deb demand, i also represens an obsacle for public deb marke deph. 28 Oher marke facors impose resricions o he invesmen regimes of hese regulaed pension funds, leading o high concenraions of TES. The difficuly of diversifying porfolios in Colombia, because of a sill limied pool of financial insrumens and a relaively small marke, also direcs capials owards public deb. On his noe, he variey of financial insrumens sill presens a lag relaive o demand for invesmen vehicles, which has grown much faser along wih he pension funds. 51

52 Minisry of Finance and Public Credi Now, wih he aim of lowering liquidiy premiums ha increase issuance raes, he Naion ofen reopens some of he ousanding bond references. This scheme is comprised in he TES Placemen Sraegy (ECT for is acronym in Spanish) which has made reopenings more ransparen (see Secion ). Figure 21. TES holdings in pension fund porfolios Source: Financial Superinendence of Colombia. SFIN calculaions. 52

53 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I Figure 22. TES holdings in Financial and Credi Esablishmens Source: Superinendencia Financiera de Colombia y Cálculos SFIN. Inernaional invesors, in urn, represen less han 3% of all sakes in oal ousanding deb, probably as a resul of enry resricions o foreign capials (see Figure 23). Subsequenly, he laes ax reform reduced income ax, which may creae new incenives for foreign capials o ge ino his ype of securiies. The Governmen is consanly discussing and developing mechanisms wih Primary Dealers (PD) for permanenly enlarging invesor pools, including privae individual or corporae invesors ha currenly have no presence in he TES markeplace. 53

54 Minisry of Finance and Public Credi Figure 23. Foreign TES invesmens COP Mln. Source: Depuy Direcorae of Inernal Financing DGCPTN December Developing he local public deb marke Aside from enhancing he Governmen s capaciy o manage deb and reduce currency risk exposures, public deb marke helps saisfy he Naion s funding needs wih relaively low cos-risk measures. Developed deb markes are generally associaed wih longer mauriies, lowering liquidiy premiums, rollover risk and ineres rae risk 29. As par of he MTDS, wih he aim of vializing he public deb marke, measures have been aken in order o provide deph and liquidiy o all of he yield curve s nodes. The Primary Dealer Program (see Box C) has become an incenive for negoiaing public deb securiies in secondary markes, hus providing deph and liquidiy. In his manner, an average of COP 4 rillion (close o USD 2.2 billion) are raded daily over he Elecronic Negoiaion Sysem (SEN for is acronym in Spanish). This elevaed marke appeie for TES is evidenced in recen higher raded volumes in oher negoiaion plaforms (see Figure 25). 29 On op of having a well disribued average mauriy of he porfolio, anoher advanage of deep markes is greaer flexibiliy in every fiscal erm. During crises, he Governmen may formulae fiscal simulus packages of higher inernal public deb issues. Deph also helps o avoid inerference beween public financing policy and macroeconomic policy, and enhances capial marke developmen having public deb as a reference. 54

55 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I Figure 24. Negociaed volumes and annual urnover Source: Depuy Direcorae of Inernal Financing DGCPTN December 2012 Figure 25. Traded volumes Source: Depuy Direcorae of Inernal Financing DGCPTN December

56 Minisry of Finance and Public Credi As for ransparence in pricing of hese securiies, he Naion has made big effors in implemening sound managemen informaion disclosure pracices. This is crucial since Colombian regulaion obliges managed porfolios o value heir sakes a marke prices 30. The resul of managemen sraegies implemened over he years is he coninuous reducion of bid-ask spreads (see Figure 26); evidence of a more efficien marke. Figure 26. SEN bid-ask-spread evoluion Source: Banco de la República, SFIN calculaions. Furhermore, Colombia has he marke infrasrucure necessary for srucuring a wide arrange of derivaive porfolios, providing invesors wih hedging possibiliies. Presenly, sandardized Fuures are lised in he BVC, and muliple non-sandardized conracs are raded overhe-couner. Among hese las securiies, Non-Deliverable TES Forwards (NDFs), ineres rae swaps and non-sandardized securiy are he mos common. 30 The Primary Dealers Program paricipans are obligaed o quoe boh bid and ask TES securiy posiions over he SEN. The BR guaranees negoiaion informaion disclosure in real ime, free of charge. These quoes are permanenly used as price references. 56

57 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I Figure 27. TES fuures (shor, medium and long-erm) Figure 27a Figure 27b Source: Bolsa de Valores de Colombia BVC- December 2012 Shor, medium and long-erm TES fuures marke has gained liquidiy and efficiency, in erms of pricing, over he pas few years (see Figure 27). Buy and sell inenion margins have drawn closer because of he sharp reducion of he bid/ask spread, bu sill, a preference owards shor and medium erm securiies is observed. As for long-erm TES issues, some marke disorions persis, and ranslae o price differenials in fuure conracs (see Figure 27a). The favorable evoluion of deb markes regarding deph has ranslaed ino higher bid volumes on TES Fuures (see Figure 27b), indicaing a higher number of agens as well. The Governmen is conscious of he imporance of he deb marke and included effors in is agenda for developing local markes and providing insrumens and a regulaory frame ha enable deph. 57

58 Minisry of Finance and Public Credi BOX B. TES PLACEMENT SCHEME Duch compeiive aucions are he mechanism of choice for placing shor and long-erm TES deb securiies. Rules and regulaions for defining cu-off raes are esablished by he MHCP. Depending on he amouns of deb o be issued, bids are honored over or under his se rae. For long-erm TES bonds, addiional allocaion possibiliies are offered hrough noncompeiive opions. These consis in issuing and placing addiional securiies, never surpassing he iniial volume placed hrough compeiive aucions. The opion is exercised 12 days afer he iniial aucion a he closing rae of he day of he compeiive aucion. Forced placemens are mandaory long-erm TES allocaions in primary markes. In his operaion, Public Eniies of naional order encompassed in he Naional General Budge (NGB) are obliged o buy hese securiies wih excess liquidiy coming from managing heir resources and funds. The rae a which hey buy is based on marke condiions. Finally, consened placemens are volunary allocaion mechanisms where Sae Eniies, oher han hose of naional jurisdicion ha form he NGB (regional order eniies as municipaliies, deparmens, indusrial and commercial companies where he Naion holds a sake), rade heir excess liquidiy wih he DGCPTN. The rae a which hey rade hese bonds is based on marke condiions. Secondary Marke rading sysems Secondary public deb markes (or afermarkes) serve as a plaform for rading deb securiies such as TES bonds, amongs marke inermediaries and Primary Dealers (PD). The characerisics of his sysem are shown in he following flow char: 58

59 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I TES placemen sraegy TPS Wih he aim of fulfilling budge necessiies of he Annual Borrowing Plan for every fiscal erm and mainaining an adequae financing cos by minimizing liquidiy premiums, he Governmen ofen uses he reopening of cerain TES securiies. This mechanism is implemened for offering addiional volumes of a paricular ousanding bond in primary markes. From he second quarer of 2012 on, a sandardized mechanism for reopening securiies was esablished. Is purpose was o provide ransparence and predicabiliy o public deb placemens in Colombia. As par of he issuance sraegy, rules are defined for new issuings and reopening of ousanding references, in hopes of seling reference bonds ha faciliae marke analysis and monioring. In his manner, he end goal is o aain he needed financing a adequae coss. New issuance sraegy simulaneously seeks o minimize rollover risk and o provide some conrol over high concenraions of liabiliies on specific due daes. The new issuance sraegy aims o develop he deb marke by srenghening he TES yield curve, giving rise o new nodes in he curve wih on-he-run bond issues (see Figure 28). BOX C. Primary Dealers Program The Naional Governmen has played a crucial role in he developmen of he Naion s financial markes. In paricular, he Primary Dealers Program (PDP) was creaed as a ool for giving deph o domesic public deb markes, wih he aim or guaraneeing primary placemen of TES issues and bringing liquidiy o he marke. The program paricipans are esablishmens such as banks, financial corporaions and brokerage firms, moniored by he Financial Superinendence of Colombia. These insiuions mus comply wih a series of prerequisies ha guaranee financial srengh, for hem o be designaed as Primary dealers (PD) or Aspiring Primary dealers (APD) by he DGCPTN. These esablishmens are in charge of buying, inermediaing and promoing he Naion s deb, enhancing adequae financing condiions for he Naion in capial markes developing public deb securiies. As issuer, he Governmen direcs he Program, while he BR adminisraes and he SFC regulaes and moniors. 59

60 Minisry of Finance and Public Credi Figure 28. Fixed-rae and UVR denominaed TES yield curves Source: Depuy Direcorae of Inernal Financing DGCPTN- June

61 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I Reopening policies allow ousanding deb issues o become benchmark securiies in shorer erms as ime goes by. Thusly, i gives liquidiy o he secondary marke and conribues o he formaion of an efficien deb pricing process ha provides yield curves ha reflec he economy s rue raes, deepening he marke and making i an example for oher markes. Once again, his is a clear reflecion of acive Governmen involvemen in ransparen price building. I shows is commimen o developing an insiuional framework ha enables a deep public deb marke, ha serves as reference for oher deb markes. Figure 29. TES placemen sraegy The sraegy seeks o give liquidiy o he hree COP denominaed on-he-run bonds wih 5, 10 and 15 year mauriies and UVR denominaed bonds wih 5, 10 and 20 year mauriies. New issues will be aucioned following he 2 year esablished aucion schedule for iniial offerings, and will hen be reopened wice in a 2 year ime lapse as well when hey ener he mauriy range of benchmark nodes. Securiies issued in COP are due on even years, while UVR lisings maure in odd years 31. Offered volumes mach hose required by ha fiscal year s Annual Borrowing Plan. Iniial offering TES issued in 2 year aucions. Reopening Securiies are offered for 2 years when heir mauriies coincide wih reference nodes. 31 Given he floaing volume of TES due in 2024, an excepion will be made for 2014 mauriies, mainaining a primary public offering for he 2022 mauriy, making i he 10 year node. 61

62 Minisry of Finance and Public Credi An example of he implemened TES deb issuance sraegy is presened nex: Figure 30. TPS Iniial Issuance A firs lo of 15 year deb securiies are issued. 62

63 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I Firs reopening When hese ousanding issues have 10 years lef, here is a firs 2 year long reopening. 63

64 Minisry of Finance and Public Credi Secong reopening Wih 5 years lef o mauriy, a final reopening begins. Source: Depuy Direcorae of Inernal Financing DGCPTN 64

65 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I The resuls for he issuance sraegy are seen in he deb porfolio mauriy profile. The implemenaion of he sraegy conrols concenraion of mauriies during specific fiscal erms, hus smoohing he mauriy profile (see Figure 31). Figure 31. Mauriy profiles (curren vs. expeced) Source: Depuy Direcorae of Inernal Financing DGCPTN. As of June 25, 2012 The securiy issuance sraegy for domesic deb goes in line wih each erm s Annual Borrowing Plan of each. I also maches wih he desired deb level of he Naion for upcoming years and is coheren wih he MTDS guidelines, desired currency composiions and wih he benchmark porfolio (see Secion 3.4). 65

66 Minisry of Finance and Public Credi Raising deb in foreign capial markes Even hough funding needs are now lower han before; parly because of a shif of he deb porfolio owards local deb, Colombia is sill one of Lain America s mos acive issuers in foreign markes. The counry is highly recognized for he consisency and ransparence of is sraegy. Currenly, here are hireen Global bonds wih USD quoing, hree Global TES bonds and wo Yen denominaed bonds. Two of hese Global bonds are Floaing-Rae Noes (FRN), and hey all roughly amoun o abou USD 19 billion. The four main objecives sough in exernal financing are: i) o raise capial wih he bes erms possible, ii) o guaranee long-erm deb susainabiliy, iii) o manage he differen underlying porfolio risks and iv) o broaden he invesor pool. Taking marke environmen ino accoun, he Adminisraion focuses effors in consolidaing liquid yield curves ha enable marke access, in line wih Colombia s need for diversificaion of deb insrumens and for a larger invesor pool. Global USD bonds are securiies designed o be issued, raded and maured in foreign markes in Europe and he Unied Saes. These are denominaed and paid in foreign currency. Global TES bonds have he same srucure as Global USD bonds do, bu for he fac ha hey are denominaed and paid in COP Building liquid and efficien yield curves Wih he aim of guaraneeing favorable condiions for deb becoming an efficien reference for oher quasi-sovereign and corporae deb issuers, he Governmen seeks o build liquid yield curves hrough benchmark bond issuance policy of relevan volumes. This is mean o reduce he rading imperfecions ha low liquidiy cause, as well as wide bid/offer spreads. Issuance policy largely concenraes in 10 and 30 year quoes, hence following global sandards for frequen sovereign issuers. This policy progressively feeds he yield curve wih liquidiy and increases he volume of issued bonds in cerain nodes so ha he inerpolaed curve may serve as a pricing reference for oher insrumens. By guaraneeing deph in he yield curve s benchmark nodes, he marke will resrain from using less liquid references wih higher coupons, usually raded ouside he curve, as pivos for pricing new issues associaed wih sovereign risk. Furhermore, by being able o issue 30 year noes, he Naion exends he average life of is porfolio in a way no oher inernal or mulilaeral deb insrumen has. Thus, he long-erm nodes of he yield curve help in he building of beer mauriy profile indicaors. Issuance policy is complemened wih public liabiliy managemen operaions. These operaions aim o manage risk bu also conribue o consolidaing he yield curve by absorbing inefficiencies, refinancing noes a low cos and giving volume o benchmark nodes. Secion addresses his subjec in deail. 66

67 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I On his noe, he evoluion of he Naion s USD yield curve shows lower financing coss as well as an increase in volume of reference bonds and an overall exension of he curve (see Figure 32). Figure 32. USD yield curve in Colombia ( ) Source: Depuy Direcorae of Inernaional Capial Markes DGCPTN Broadening invesor pools and diversifying deb insrumens Alhough lower exernal funding needs in deb managemen sraegies lead o less liquid yield curves for a variey of insrumens, he Naion seeks o keep an array of alernaives, differen from exernal financing, hrough is USD yield curve. In his way, and looking ou for miigaing he risk of sauraing USD deb insrumens while aking advanage of presen favorable marke condiions, he Naion consolidaes he exernal Global TES yield curve and holds presence in Japanese markes by privaely issuing Yen denominaed bonds (Shibosai or Samurai bonds) Samurai bonds are Yen denominaed insrumens issued by a non-japanese eniy. Shibosai bonds are jus like Samurai noes, bu are exclusively offered o banks and insiuional invesors, hus resricing access o oher kinds of invesors. 67

68 Minisry of Finance and Public Credi These operaions are highly recognized in oher markes for heir cos efficiency and he degree of diversificaion hey give o he Naion. They also offer several advanages o invesors, such as providing a wider array of insrumens wih differen degrees of exposure o Colombian credi. Colombia is a pioneer in he use of inernaional issued insrumens wih local currency denominaion such as Global TES bonds. The Governmen inroduced hese insrumens in 2004 and 2005, when emerging marke currencies began o appreciae, making Global TES very appealing o foreign invesors for is currency exchange rae exposure. Colombia was also he firs counry o use hese new insrumens in In he afermah of he inernaional financial crisis, grea appeie for hese bonds was shown, boh from naional and inernaional invesors. The relaive success moivaed he issuance of oher sovereign and corporae insrumens (for insance, Empresas Públicas de Medellín EPM and Empresa Generadora y Comercializadora de Energía S.A. EMGESA). Colombia issued Shibosai bonds in 2005 and 2009, wih parial guaranees from Japan s Bank for Inernaional Cooperaion (JBIC). A much more isolaed Japanese marke wih high concenraions in Yen securiies, welcomed his new foreign insrumen (in spie of Japan s risk aversion, derived from he 2002 Argeninian defaul), providing Colombia wih an unexplored invesor pool. The 2005 issue was he firs since 2001, and he one in 2009 was he firs operaion underaken by a non-asian counry wih he JBIC Marke Access Suppor Faciliy scheme, creaed for giving suppor o he marke during he crisis Noable Transacions Specialized insiuions and he media have awarded Colombia wih several recogniions. Opimal and opporune execuions of innovaive operaions have been highlighed wih he following awards: IFR Bes Lain American Bond 2006 for he 2017 Global USD issue Euroweek Lain American Sovereign Bond of he Year 2006 for he 2037 USD Global issue LainFinance Bes Sovereign Issuer 2006 LainFinance Bes Laam Deal 2007 for he 2027 Global TES issue and he repurchase of he shor end of he USD yield curve. LainFinance Bes Laam Local Currency Financing 2010 for he 2021 Global TES issue Exernal deb raising during he inernaional financial crisis The inernaional financial crisis has led o challenges for exernal financing and deb. As consequence of an overall percepion of sabiliy, he general view of Colombia as a srong issuer and despie no having an invesmen degree credi-raing ye (los in he lae nineies and only recovered in 2011), he Naion kep is funding sources in inernaional markes. 68

69 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I The good percepion of Colombian deb led o a hreefold increase in issues in foreign capial markes. In fac, afer accouning for ne funding operaions of up o USD 148 million in 2007 and USD 1 billion in 2008, a USD 3.5 billion lo was issued o fund he 2009 fiscal erm and prefinance 2010 budges. This volume of issued deb is he second larges afer he ousanding amoun of 2001 (see Figure 33). Figure 33. USD denominaed liabiliies during crises (Mln) Source: Depuy Direcorae of Inernaional Capial Markes DGCPTN Marke volailiy and risk aversion cerainly posed difficulies o he accomplishmen of he menioned operaions, and he windows of opporuniy were narrow. This 5 year period was also characerized for having sudden and abrup widening of credi spreads, even when compared o he VIX index (see Figure 34). 69

70 Minisry of Finance and Public Credi Figure 34. VIX Index Exernal deb raising operaions Source: Bloomberg, Depuy Direcorae of Inernaional Capial Markes DGCPTN Exernal deb issuing sraegy For he near fuure, he Naion s issuing policy will remain unchanged, concenraed in he 10 and 30 year nodes of he USD curve. In erms of issue volumes, while oher counries aspire for amouns of up o USD 3 billion, Colombia aims for issues around USD 2 billion, in order o mainain he deph of he yield curve and he volume of ousanding deb relaively unchanged. This poenial volume of issues maches he Naion s capabiliy of execuing liabiliy managemen operaions and wih fuure nominal needs of greaer refinancing when reference nodes of he yield curve reach mauriy. By mainaining his USD 2 billion poenial would preserve he curren 2 year frequency of reference bonds, ime span during which he noes may be reopened if marke condiions are suiing. Moreover, dependen on he marke s appeie, he Naion may open he possibiliy of offshore invesmen opporuniies in COP hrough he Global TES yield curve o inernaional invesors. On his noe, he Colombian public deb marke is gradually opening o foreign insiuional invesors, regardless of some resricion o foreign capials inflows and of preferences owards foreign insrumens and Global TES ha offer beer erms of financing han hose of local TES. This las concep calls for a srucured Global TES yield curve as a sound funding alernaive. However, he inernaional marke environmen ofen leads o changes in exernal issuing policy, alering mauriy profiles and even he insrumen s srucure. Afer a large ineres rae conracion during and afer of he financial crisis, recovery in demand and oupu can lead 70

71 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I cenral banks o implemen expansionary policy, elevaing ineres rae levels around he world and evenually alering invesor preferences in erms of duraion, mauriy and ineres rae. As i has happened before, and being careful of he Naion s necessiies and limiaions when addressing a deb managemen sraegy, he possibiliy issuing shorer erm securiies in foreign currency or floaing ineres raes are no ruled ou Foreign Governmen and Mulilaeral Organism Financing Governmen and Mulilaeral financing are funds disbursed by insiuions such as he Iner-American Developmen Bank (IDB), he World Bank s IBRD, Lain-American Developmen Bank (CAF), among oher developmen agencies and foreign governmens. Colombia s Governmen has kep a varied loan porfolio wih he IDB and he IBRD, and simulaneously enered in new liabiliies wih oher agencies, such as he FIDA, he Korean governmen, EXIM Bank and he French Developmen Agency (AFD). These resources are desined o fund prioriized budgeary appropriaions, and as such, back decenralized economic policy and fund waer resource infrasrucure, as well as financing Sae Eniies of erriorial and decenralized jurisdicion. In he pas, a large percenage of counries had exernal deb consiued only by mulilaeral and bilaeral insiuions credi lines. As counries became more sophisicaed in srucuring and conracing deb, and as heir economies developed, he exernal deb securiy issuing percenage gained some room wihin differen naion s liabiliy porfolios. These ype of easily radable deb noe conribues in developing exernal capial markes while funding he budge. However, loans wih he menioned organisms do presen some advanages relaive o deb issuing. I generally offers lower coss, longer expiraion daes and grace periods, an adjusable amorizaion schedule, an array of deb managemen alernaives (currency conversions, exchange rae and ineres rae fixaion) among ohers 33. The las menioned opions are paricularly convenien for a counry like Colombia, for i helps mainain liquidiy in imes of economic peril and gives a cerain degree of flexibiliy o he liabiliy porfolio 34. Colombian policy regarding liabiliies conraced wih mulilaeral banking insiuions focuses on raising he capial necessary for fulfilling he Cenral Governmen s Borrowing Plan over each fiscal erm, and funding Sae Eniy invesmens under favorable condiions. Policy is oriened o profiing from hese cos-benefi reaions and from he added value of echnical assisance, grans and insiuional srenghening associaed wih specific invesmen desinaion loans. 33 Boh Sae Eniies and he Naion are auhorized o conver floaing-rae deb conraced wih mulilaeral banking insiuions and foreign governmens ino fixed ineres rae liabiliies, hus reducing exposure o ineres rae volailiy. 34 A good example for flexibiliy is he Colombian Governmen s quick reacion afer he financial crisis, o adop an acive negoiaion policy wih mulilaeral banking insiuions for designing mechanisms ha enable resource availabiliy when access o exernal capial markes is limied. This prevens sudden capial from fleeing suddenly due o currency depreciaion expecaions and guaranees access o funds. Forunaely, increases in foreign invesmen flows in emerging markes like Colombia, enabled he Governmen in 2009 o keep on implemening is sraegy of prefinancing budgeary needs for he 2010 fiscal year, o subsiue exernal funding sources wih he Samurai bond issue and o reduce insallmens o mulilaeral organisms for relieving hem of some pressure caused by inernaional financial sress and undercapializaion. 71

72 Minisry of Finance and Public Credi The Naion holds a consan dialog wih mulilaeral organizaions for keeping his funding source available as well as he oher deb and hedging insrumens hese insiuions ofen offer. In order for Sae Eniies of erriorial and decenralized naure o be able o access deb of favorable characerisics, he Cenral Governmen advises and accompanies hem hroughou he process of conracing deb wih being awarded wih grans. In he pas 5 years, he average paricipaion in he mulilaeral deb porfolio of his ype of liabiliies was around 18%, having he remaining 82% of i as specific desinaion or unspecified invesmen credi lines. Generally speaking, mulilaeral organism credi lines and swap insrumens serve as ools for adequaely managing public deb, successfully implemening he deb managemen sraegy and reducing he exernal deb porfolio s exposure o financial risk of Sae Eniies and he Cenral Governmen. The wo main exernal sources of funds available o he MHCP are foreign capial markes, and mulilaeral organisms and governmens, which someimes include desinaion covenans for loaned resources Specific desinaion resources are funds mean for invesmen projecs, given o eniies wih permanen accompanimen from he Naional Planning Deparmen (DNP for is acronym in Spanish). The invesmen projecs are analyzed on heir componens, invesmen caegories, currency disribuion of expenses, financial profiabiliy or social impac and invesmen payback. This analysis deermines he suiable source for financing and he erms and condiions for awarding he credi. Unresriced resources on he oher hand, finance CNG prioriized budge appropriaions wih no specific desinaion. They can be inended for specified secors or programs. The Governmen has also dedicaed some effor o finding alernaive exernal sources of capial. New sources of financing may gran he Naion access o favorable deb erms for funding Naional Governmen programs. The Colombian Minisry of Foreign Affairs, hrough is embassies around he world, consanly explores financing possibiliies wih bilaeral organisms so ha he naion is graned wih credi lines wih foreign governmens and inernaional cooperaion agencies Invesor relaions program Complemening all of he former developmens, he Naion s policy has included he srenghening and formalizaion of invesor relaions, hrough he design of a program for informaion disclosure. This effor will encourage he acquisiion of Colombian inernal and exernal public deb, wih he aim of raising capial a low cos, and improving he naional and inernaional percepion of Colombian deb. 35. A consan dialog wih domesic and foreign invesors is key for srenghening and formalizing he marke. I allows he Governmen o disclose informaion ransparenly, manage is deb porfolio efficienly from boh marke and invesor perspecives and have lower financing coss while growing is invesors pool. 35 Visi us a: hp:// 72

73 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I In his manner, he Depuy Direcorae for Invesor Relaions (Invesor Relaions Colombia, IRC), was creaed wih he purpose of esablishing a channel for informaion exchange wih local and foreign markes. IRC works in hand wih oher Naional Governmen eniies so ha he delivered informaion is unified. The main funcions of IRC are: Formally receive and disclose informaion regarding Colombian public deb wih invesors and oher cliens wih whom he MHCP keeps conac. Unify conens and formas for public deb informaion disclosure. Organizing and planning neworking evens for invesors, such as road shows, meeings wih cliens and mulilaeral banking insiuions, conferences, among ohers. Awarding hese funcions o a Depuy Direcorae shows he Naion s commimen of consolidaing relaions wih invesors and bondholders Naional Governmen Liabiliy Managemen In addiion of managing he deb porfolio hrough issuance sraegies and credi lines, he Naional Governmen works in reducing rollover risk and deb-servicing cos burdens on cash flows. To do so, in accordance wih Law 185 of 1995, regulaed by Decree 2681 of December 29 h of 1993, public liabiliy managemen operaions are carried ou. These operaions do no increase he Naion s ne ousanding deb and conribue o he improvemen of he Mauriy Profile. They do no consiue new deb since he deb ceiling is lef unchanged 36. Refinancing operaions, deb resrucuring, renegoiaion, reordering, exchanges repurchases, replacemens, conversions and rades, subsiuion, paymen agreemens, consolidaion of credi obligaions, hedges and Naional Treasury liquidiy managemen acions are all considered, by law, as liabiliy managemen operaions Exchanges, repurchases and replacemens. Exchanges, repurchase and replacemen operaions are he mos common among all of he liabiliy managemen ransacions. They consis in exchanging shor-erm liabiliies wih ohers of longer mauriy, subsiuing exernal deb for inernal obligaions, and repurchase agreemens. 36 Operaions ha lead o new deb or addiional amouns of ne deb are o comply wih Decree 2681 of

74 Minisry of Finance and Public Credi Domesically, hese operaions have been of key imporance due o he fac ha hey enable an acive managemen of he deb profile of he CNG, exending he average life of he porfolio and leading o savings in deb-servicing coss, while reducing TES mauriy concenraions in specific fiscal erms. Addiionally, elevae he deb s liquidiy in secondary markes and favor large volume issues wih a larger invesor pool. Hence, hese exchanges of push domesic ineres raes down due o lower deb-servicing coss. All in all, his makes a flaening of he TES yield curve relaively predicable in inermediae mauriies. Exchange operaions seek o acively include he insiuions regisered in he PDP in public deb rades. In his way, exchange operaions have conribued o develop he local deb marke by consolidaing deb insrumens and enlarging he number of ineresed invesors under clear capial supply and demand guidelines. The resuls of recen deb exchange operaions are presened in Table 4. Table 4. Execued exchange ransacions Raised Delivered Average life Average coupon Nominal* Average life Average coupon Nominal* Ousanding deb reducion Feb % 1, % 1, Feb % 2, % 2, Mar % 4, % 4, May % 1, % 1, Nov % 3, % 3,694 23, Dec % % Dec % % Dec % % Toal ,596 13, Feb % % Apr % % Apr % 3, % 3,293 0 Toal ,137 4, Sep % 5, % 5, Toal ,962 5, * Nominal values in COP Bln 74

75 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I Furhermore, deb securiy replacemen operaions subsiue exernal deb for domesic TES deb securiies. In fac, he CNG has largely replaced is funding sources for aking advanage of he domesic marke s environmen and he effec of credi resricions imposed o emerging markes in he lae nineies. The firs operaion was carried ou in 2002, where exernal deb was exchanged for inernal deb, amouning COP 1.3 rillion. This was followed in 2005 by anoher similar operaion for an amoun of COP 1.5 rillion. These operaions had he aim of managing risk while simulaneously allowing he rolling of coming mauriies, reducing currency risk and he concenraion of mauriies, hrough he replacemen or repurchase of securiies in foreign currency denominaion wih ones of COP denominaion. These operaions also open he possibiliy of profiing from curve inefficiencies and reduce refinancing coss in hand wih elevaing benchmark bond liquidiy (see Figure 35). Figure 35. Exernal public liabiliy managemen (USD Mln) Source: Depuy Direcorae of Inernaional Capial Markes DGCPTN Prepaymens The anicipaed paymen of ousanding liabiliies is also considered a public deb managemen operaion. Prepaymens effecively reduce ousanding deb and consequenly generae savings in fuure fiscal erms. For doing so, capial sources differen from credi, such as 75

76 Minisry of Finance and Public Credi reasury excess liquidiy or selling asses, are required. Domesically, hese operaions aim o reduce he concenraion of TES mauriies in deermined fiscal erms wihou increasing ineress and amorizaions in oher periods. One recen prepaymen operaion ha lowered currency risk exposures was he anicipaed paymen of USD 1.25 billion o he IDB for an emergency credi awarded in Oher operaions were prepaymen of USD 313 million in 2006, USD 625 million in 2007 and USD 313 million in Anoher noeworhy operaion was he 2006 COP 2 rillion prepaymen of differen deb quoes. In 2007, abou COP 800 billion were paid in advance Hedging program The SFEN has underaken liabiliy managemen operaions in order o reduce he currency risk exposure of USD denominaed deb. These operaions allowed he Governmen o adjus he deb s profile closer o he benchmark profile esablished by he SR. Addiionally, he DGCPTN srucures hedges wih he aid of widely acceped financial insrumens. Deermining wheher a hedge is needed follows his process: 1. Idenifying deviaions from he benchmark porfolio: Comparing he anual deb-servicing composiion of he porfolio o goal indicaors (currency, ineres rae, and refinancing) as o idenify excessive risk. 2. Analyzing mauriy profiles: Idenifying fiscal years where amorizaion limis are overpassed. 3. Defining flows o pay off: Idenifying which credis are o be fully paid ou, hose overexposed ha exceed amorizaion limis, and are due in he near fuure. 4. Deb-Servicing Risk (DSR): Afer hese firs hree seps, deb-servicing risks are analyzed in order o deermine which of he benchmark porfolio variables show more marke risk exposure and are a hedging prioriy. 5. Marke perspecive: Marke perspecives are analyzed o insure ha he liabiliy managemen ransacion or deb hedging insrumen is adequaely used in erms of lower coss and imely implemenaion. Afer his is carried ou, he Direcor General of Public Credi and Naional Treasury, afer reviewing he favorable concep of he Depuy Direcorae of Risk, auhorizes he effecive execuion of he hedge. Among he used hedging insrumens available o he Naion, Cross Currency Swap (CCS) insrumens are common. They consis in he agreemen of exchanging paricular deb relaed flows. The counerpary in he conrac agrees o pay he Naion s foreign currency insallmens in floaing-raes, and he Naion is responsible for paying more appealing fixed-rae obligaions in domesic currency 76

77 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I denominaion. Normally, obligaions for boh paries in he agreemen cease when all hedge relaed paymens are insalled, generally o he liabiliy s mauriy. The Naion frequenly uses, however, a special kind of CCS dubbed Exinguishable CCS (XCCS). Under hese conracs, paries agree o condiion he mauriy of he swap conrac, no o when he deb is due, bu o he possible defaul of he Naion s obligaions. If such circumsance maerializes, he conrac exinguishes wihou generaing any furher paymen obligaions among he paries 37. When a pary defauls, is counerpary is no obliged o assume he operaion s marked-o-marke paymens, and may hus offer a more aracive swap rae 38. However, he Naion is confiden of having very low defaul probabiliy, making exinguishable clauses very unlikely o be exercised 39. In his manner, XCCS have conribued o generae savings in plain vanilla CCS (wih raes beween 10% and 20% or lower, depending on marke condiions). Throughou 2008, various CCS hedges were execued, amouning o USD 500 million, and by he end of 2011 reached a nominal hedge of USD 1,000 million Deb renegoiaion programs Very similar o swap conracs on vanilla floaing-rae deb securiies, liabiliy renegoiaions wih he WB and IDB, help he Governmen o aain beer erms for servicing is deb. These renegoiaions do pose some advanages when compared wih markeable hedges: hey generae a synheic ineres rae swap wih no furher coss on he deb, since he mulilaeral agency (e.g., BIRF, IDB) execues a AAA raed deb swap in derivaive exchanges. When The Republic of Colombia execues such operaions, i would have o assume a credi spread associaed o is credi raing and credi risk merics (Credi Defaul Swaps). Consequenly, his deb erm renegoiaion could be financially beer han swap derivaives. This renegoiaion modifies he erms and condiions seled in he conrac wihou esablishing any kind of ransacion wih a hird pary. This implies ha no furher counerpary risk exposures or any of he hassle of a derivaive operaion. The resul is a reduced currency and ineres rae risk exposure and a beer deb profile of lower fiscal burdens and impac. 37 Beween 2005 and 2008, he Naion played an acive role in using derivaive insrumens for currency and ineres rae risk hedges, wih he use of XCCS. 38 This mehod has approved for convering floaing-rae USD long-erm credis ino fixed-rae CPI indexed ones. 39 Given an exchange rae overshooing scenario due o deb evens, where he closing value of deb favors he Naion, he Governmens financial counerpary is in capaciy o communicae savings derived from no paying fuure expeced M2M. 40 In May 6, 2008, he Naion announced hey were saring a hedge program, consising on changing USD 2 billion USD denominaed exernal deb o COP denominaion. Wih his, he Naion sough o reduce risk exposure of a credi porfolio made up of floaing-rae USD denominaed liabiliies conraced wih he WB. By he means of swaps, he aforemenioned credi obligaions were subsiued by fixed-rae COP denominaed ones. In December 31, 2008, The Governmen carried ou hedging operaions worh USD 500 million. 77

78 Minisry of Finance and Public Credi IDB renegoiaion In 2009, he CNG acceped a erm renegoiaion proposal from he IDB. I modified he condiions of a USD 500 million currency indexed liabiliy, urning i ino fixed-rae USD denominaed. Table 5. IDB erm renegoiaions 2009 IDB currency conversion Afer erm Before erm renegoiaion renegoiaion Currency Ineres Currency Ineres Ousanding liabiliy paymen* Ousanding capial disbursemen* Currency Pooling Sysem Credi Uni of Accoun Ajusable USD Fixed Single Currency Faciliy Credi USD Ajusable USD Fixed 3, Toal USD Fixed 3, * USD Mln WB renegoiaion Also wih he aim of reducing ineres rae risk, and aking advanage of hisorically low inernaional ineres rae levels, raes of ousanding liabiliies wih he WB, worh USD billion, were fixed in Deails on his operaion are presened in Table 6. Table 6. WB erm renegoiaions * USD Mln 2009 WB rae fixing Currency Volume* February USD 1,609.3 March USD July USD Toal 2,596.6 Ineres rae fixing renegoiaions also resemble ineres rae swaps, bu presen some addiional advanages o hose of a plain vanilla derivaive 78

79 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I 3.6. Coordinaion wih fiscal and moneary policy In order o guaranee coheren public deb and macroeconomic policy, i is key o ake ino accoun he links beween coordinaion mechanisms (see Figure 36). Figure 36. Ineracion beween deb managemen, moneary policy and fiscal policy Deb srucure affecs deb-servicing coss and migh pu fiscal susainabiliy a risk. High expendiure levels migh increase deb values and generae inadequae deb srucures if i s no susainable. Fiscal Policy Deb managemen Moneary Policy Exchange rae and ineres rae policy have an effec over he deb porfolio in erms of currency and ineres rae risk. Inadequae deb srucures migh pu he Cenral Banks abiliy o adjus ineres raes and exchange raes a risk. High inflaion and volaile ineres raes migh reduce governmen revenue and slow he economy down. Serilizaion and quasifiscal defici can direcly increase he vaue of deb. Bad fiscal managemen and high deb o GDP raios migh increase inflaionary expecaions, lead o surges in ineres raes and currency depreciaion. Source: Togo (2007) 79

80 Minisry of Finance and Public Credi I is crucial for he MTDS design and implemenaion o be decenralized or ha he Naion s deb policy is limied by is moneary and fiscal policy (see Figure 37). Figure 37. MTDS, fiscal and moneary policies. Goals and conrol variables Deb managemen DGCPTN Fiscal policy CONFIS Moneary policy Banco de la República Goals Minimizing deb-servicing coss under pruden risk exposures Implemening adequae Budge policy Improving resource allocaion and wealh disribuion under susainable and pruden deb leveles Conrolling inflaion, for guaraneeing Price sabiliy Conrol Variables Deb porfolio composiion Expendiure and ax revenue composiion Defici and deb levels Ineres rae, exchange rae and moneary aggregaes Fiscal Policy Deb perspecives from he Naional Developmen Plan 41 The DGCPTN designs he deb sraegy for Naional Governmen, as already menioned. This sraegy is published semiannually along wih he Annual Borrowing Plan in hopes of giving ransparence o all marke agens on how he Governmen manages is liabiliies and finances. The sraegy is debaed and approved by he CONFIS (he Naion s Superior Council for Fiscal Policy). Led by he Miniser of Finance, his organism is in charge of direcing he Naions fiscal policy and coordinaing he budgeary sysem. Since he goal of fiscal policy is o generae fiscal surpluses and insure susainable deb levels, in he early nineies, Colombia sared srenghening is fiscal insiuions. To do so, he Naion commied o having reforms focused on seing he building blocks for macroeconomic sabiliy, passed by Congress. These consiuional reforms enable he counry o face boh inernal and exernal shocks o he economy, for he Fundamenals of macro sabiliy are coordinaed moneary, fiscal and deb Managemen policies, based on a solid financial sysem and flexible exchange rae regimes. 41 For furher deail, see he Medium-Term Fiscal Framework: Marco Fiscal de Mediano Plazo 2011 : hp:// and Marco Fiscal de Mediano Plazo 2012 : hp:// 80

81 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I On his noe, fiscal managemen is based on he Fiscal Responsibiliy and Transparence Law (Law 819 of 2003). I saes ha he Governmen is o se annual Non-Financial Public Secor (SPNF) primary surplus goals for he following fiscal year, as a se of goals for he following 10 years. Consequenly, deb is managed under prudency and coordinaion crieria. Accomplishmens on deb susainabiliy are evidenced by improved defici o GDP and public deb o GDP raios. The laer indicaor (ne SPNF financial asse deb as a percenage of GDP) decreased from 41.8% in 2002 o 28.4% in 2011, and i is expeced o reach 10% levels by he end of he Moreover, CNG public finance adjusmens were accomplished because of wo main reasons. Firs, by aaining higher revenues due o ax reforms and he DIAN s (Naional Direcorae of Taxes And Cusoms) more efficien ax raising and managemen; and second, by conrolling expendiure growh raes. From 2002 o 2011, public expendiure (leaving ou Social Securiy Insiue pension ransferences) grew around a 5% real annual rae, in line wih curren poenial GDP growh raes. Beween 2010 and 2011, real expendiure growh sayed below he 6% mark, even when facing large unexpeced disbursemens due o he effecs of rainy season emergencies. Wih his, CNG ne deb amouns o 35% of GDP and Consolidaed Public Secor deb reached 26% in This reflecs he Governmen s commimen o fiscal susainabiliy and a responsible managemen of is finances. Similarly, a large percenage of he CNG s deb is fixed-rae COP denominaed deb securiies, wih relaively smooh amorizaion srucures. This has helped in reducing he effec of inernal and exernal shocks on deb-servicing coss and hence on he budge. Pruden managemen of he CNG deb porfolio associaed risks ranslaed o fiscal savings due o lower deb-servicing coss. This, in hand wih fiscal discipline and conservaive moneary policy measures, has led o lower inernal and exernal deb coss. Lower raes also keep a close relaion wih lower coss of capial, and incenive o invesmen, somehow making projecs more profiable and generae higher income ax revenues for he Naion. I is also imporan o acknowledge ha good fiscal managemen derived from he proper pricing and adminisraion of coningen liabiliy risks has posiively affeced he Naion s financial siuaion. Idenified coningen liabiliies are: i) Naion warrans awarded o public credi operaions of governmen insiuions oher han Sae Eniies; ii) Naion warrans awarded o Sae conracing projecs; iii) selemens and conciliaions derived from lawsuis agains he Naion; iv) coss derived from naural disasers 42 ; and v) Mulilaeral Banking Insiuion uncalled capial. In his sense, coningen liabiliy managemen is a reflecion of fiscal policy ha guards public finances from possible shocks coming from he aforemenioned sources 43. Even hough hese accomplishmens are noeworhy, he Governmen recognizes a long way o go regarding fiscal discipline and public finance susainabiliy. Reaching i will guaranee a sable economic growh pah for he medium-erm. In consequence, he Naional Governmen has idenified he necessiy of considering fiscal ransparency and responsibiliy regulaion. I s inended o reach hese goals by designing and implemening a quaniaive rule ha leads CNG finances hrough a viable and credible pah and conribuing o macroeconomic sabiliy and an ever more solid and susainable deb policy. 42 The MHCP leads a projec for defining financial sraegies ha reduce fiscal vulnerabiliy o naural disasers. A mehodology wih he opimal sraegy for managing hese risks was published, esablishing he use he Reserve Fund, coningen liabiliies, insurance, among oher insrumens. 43 The Sae Eniy Coningency Fund is he chosen mechanism for miigaing coningency risk and avoiding fiscal volailiy when risks maerialize. 81

82 Minisry of Finance and Public Credi Saring in Augus of 2010, several reforms oriened owards fiscal susainabiliy, were enaced. As such, he ax reform eliminaed some capial draining disorions. Simulaneously, enaced Legislaion Acs incorporaed fiscal susainabiliy crieria ino he Consiuion 44, inroduced a fiscal rule over he CNG finances 45 for he firs ime in Colombian hisory and creaed he General Royaly Sysem (GRS) for he more efficien managemen of regional royalies. This se of reforms is he new framework for medium-erm fiscal policy design, which will allow public finance managers o generae savings and sabilize he business cycle. This new ouline for adminisraing public finance aims o reduce he NFPS defici from 4.1% in 2011 o 2.4% in 2014, and as consequence, ne deb o GDP raio drops are expeced o go from 38.7% of GDP in 2011 o 27.1% in 2021 (see Box A). This srenghens curren fiscal responsibiliy regulaion (Law 358 of 1997, known as red-ligh law ; Law 617 of 2000, knows as Terriorial fiscal responsibiliy law ; and Law 819 of 2003 known as Fiscal responsibiliy law ) 46. Figure 38. New Insiuional Fiscal Framework in Colombia General Royaly Sysem Redligh Lay (1997) Law 617 for fiscal responsibiliy (2000) Fiscal rule Medium-Term Fiscal Framework Medium-erm Expendiure Framework Source: DGPM 47 Fiscal susainabiliy 2011 reforms 44 Aside from Colombia, only Germany has incorporaed fiscal susainabiliy crieria in is Consiuion. 45 Facoring in expeced foreign invesmen, forecased GDP growh and he conribuions of mining o economic growh, i is necessary o coordinae economic policy, paricularly wih he fiscal rule. The rule consiues an economic policy insrumen for beer fiscal discipline, auseriy and macroeconomic sabiliy. 46 This complemens local eniy fiscal consolidaion effors, enforced by Law 358 of 1997 and Law 617 of Law 617 of 2000: The erriorial fiscal rule defines limis for erriorial expendiure, specifying a scaled cap for operaional expendiure of curren free allocaed revenues for caegorized municipaliies and deparmens, hus linking curren expendiure wih srucural income. Law 819 of 2003: The fiscal ransparency and responsibiliy law creaed he MTFF, an imporan ool for planning susainable shor and medium-erm fiscal policy. The MTFF publishes he Naional Governmen s Annual Borrowing Plan primary surplus goals, desired public deb levels and a horough analysis of deb susainabiliy, along wih fiscal and macroeconomic resuls for he pas fiscal year. Law 1473 of 2011: I defines a fiscal rule for CNG public finances, included in he MTFF. I mus be coheren wih all of he oher budge design, deb and public finance managemen insrumens. 82

83 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I In order o achieve Prosperiy for all, i is necessary for fiscal policy and moneary policy o adap. In his way, he NDP offers differen deb managemen relevan poins, wih he aim of building srong fiscal policy and susainable long-erm deb. In accordance wih Aricle 344 of Colombia s Poliical Consiuion, he Naion mus seek o give deb a proper, susainable managemen. For his purpose, and following he NDP guidelines, he MDTS is defined, evaluaing CNG revenue and is FB. Aricle 257 of he NDP esaes ha: The MHCP is in charge of designing and managing a Medium-Term Deb Sraegy (MTDS) wih he objecive of defining guidelines for he srucure of he global deb porfolio, guarding he adequae financing of Naional Governmen Budge appropriaions, reducing he medium-erm coss of deb under pruden risk limis and o conribue in deepening he local capial marke. The former requires: i) a horough evaluaion of he Naion s asses and liabiliies, ii) o carry ou a componen and correlaion analysis of he Naion s revenue, iii) o define he opimal composiion of he deb porfolio, iv) o define and implemen insrumens for managing he Naion s Balance, and v) building a legal framework for welding i all ogeher. In his sense, he MTFF, and financing sources and revenue generaion esablished in Budge laws every year mus all be consisen. The design and credibiliy of he Governmen s sraegy has been priced in by markes and raing agencies, resuling in 2011 in an upgrade of Colombian deb, back o is long los invesmen grade rae (Colombia was downgraded in 1999 due o is inernal financial crisis). The posiive effec of his upgrade and following posiive oulooks has he direc effec of lowering he coss of financing for he Naion and for companies regisered in Colombia. This lower cos of capial is paricularly consrucive in imes wih excess liquidiy and worldwide risk aversion. Furhermore, he MTFF preserves and guaranees invesor confidence, avoids macroeconomic unbalances, simulaes social invesmen and conribues o wealh redisribuion. The new insiuionalism of he MTFF will lead o mechanisms ha guide he Naion s fiscal policy in a predicable way, isolaing social expendiure and public invesmen from economic variaions, making i easier for agens o allocae heir capial. The design of a medium-erm fiscal pah also considers invesmens in infrasrucure and large liabiliies; such as healhcare and liigious obligaions as well as sae pension fund liabiliies. I also links he balance wih he mining and energy secor boom. The mining boom will come wih higher and more sable ax revenue as a resul of enaced reforms and ax collecing efficiency from he DIAN and a more dynamic economic growh, wondering around 4.8%. Some of his new higher income will have o be saved in line wih he fiscal rule and he GRS Lasly, in addiion o he aforemenioned benefis of sound public finance managemen, his new pah of fiscal discipline will lower deb raios and, consequenly, lower ineres paymens. These resources may be redireced owards social welfare invesmen. 83

84 Minisry of Finance and Public Credi Box D. Legislaion Acs Considering all of he medium-erm fiscal policy challenges, he Governmen successfully passed hrough Congress, beween Augus 2010 and Sepember 2011, several reforms for complemening he Naion s insiuional fiscal framework. The aim of hese reforms was generaing bases for susained medium-erm economic growh, higher produciviy and employmen, all in favor of fiscal and macroeconomic susainabiliy. The hree main savings and fiscal susainabiliy reforms are: The fiscal rule, he creaion of he General Royaly Sysem and Fiscal Susainabiliy Consiuional principle (hese las wo acs modified he Naion s Poliical Consiuion). Fiscal Rule Law (June, 2011) The fiscal rule was designed as he main ool for public finance managemen, wih he aim of implemening counercyclical fiscal policy and enforcing public deb susainabiliy. I ses a fixed defici goal of 1% of GDP wihin a decreasing medium-erm pah. The implemenaion of he rule will ensure a sable growh rend for public expendiure, financed by permanen income sources as well as generae savings from ransiory excess income for downurns in he business cycle, boh naionally and regionally (in par due o he regional royaly law). Moreover, he fiscal rule will enable a counercyclical sance for facing flucuaions of he business cycle, and even increase invesmen and give simulus o he economy. All in all, he benefis of fiscal discipline ranslae ino benefis for he mos vulnerable segmen of sociey. The Law creaed he Savings and Macroeconomic Sabiliy Fund. I will accumulae a percenage of CNG surplus capial, along wih is reurns and furher capial oulays. These funds will be sricly desined o deb amorizaion paymens, counercyclical expendiure and unexpeced expendiure obligaions ha may call for he emporary defermen of he rule. The reach of he fiscal rule is only limied by he exen of he CNG, aking ino accoun ha i is no necessary o incorporae all of he public secor eniies ha are governed by fiscal responsibiliy rules of heir own, which oblige hem o regulae expendiure and deb (Law 358 of 1997 and 617 of 2000), and have proven o be posiive for local and erriorial eniy fiscal planning. Sabilizaion of public expendiure derived from he fiscal rule will be fundamenal in consolidaing public deb susainabiliy and srenghen invesor rus in public finance managers. Addiionally, coordinaion beween moneary and fiscal regulaors (he CNG and he BR) will be faciliaed wih he implemenaion of he rule, due o more informed decision making by he moneary auhoriy ha allows he policymaker o beer deal wih he effec of negaive shocks. Legislaion Ac for creaing he General Royaly Sysem (June 2011) This reform seeks o equally redisribue he income generaed by he exracion and use of non-renewable resources in Colombia, and generae preservaion mechanisms ha ensure sound public managemen while srenghening compeiiviy in he regions. This 84

85 MINISTRY OF FINANCE AND PUBLIC CREDIT Medium-Term Deb Managemen Sraegy PART I legislaion creaed he Savings and Sabiliy Fund, which consiues he main mechanism he Royaly Sysem uses for promoing fiscal and macroeconomic sabiliy. Two addiional funds were consiued, desined o enforce adequae invesmen for srenghening adequae disribuion of invesmen resources wih royaly funds. These are: he Regional Compensaion Fund and he Regional Developmen Fund. Royaly Law and he fiscal rule consiue sabilizing insrumens for he economy, giving boh regions and he Cenral Governmen, ools for saving capial during he mining boom for spending when mining and energy resources become scarce, hus avoiding sharp currency appreciaions This reform of he royaly sysem seeks afer a more equal disribuion of royalies beween all erriorial Sae Eniies. I aims o spread resources across all of he Colombian populaion, insead of he curren, low, 17%. This does no mean in any case, ha he Naion will finance is budge wih mining royaly revenue or even dispose of such funds. In his sense, he Legislaion Ac projec suggess ha royalies are no o be included in he Naion s General Budge, even hough hey are o be managed under budgeary crieria, approved by Congress. Fiscal Susainabiliy Legislaion Ac (June 2011) This Legislaion Ac incorporaes fiscal susainabiliy principles for public finance in Colombia s Poliical Consiuion, o be aken ino accoun by all Sae Eniies of any order. In his manner, planned or designaed expendiure would no pu he Naion s financing programs or medium-erm public secor obligaions a risk a any ime. Budge limiaions are recognized by he principles, and are linked o business cycles Deb managemen ineracion wih moneary policy The MHCP coordinaes macroeconomic policy in Colombia. I defines and execues fiscal policy and manages he Naion s public resources from a financial and budgeary perspecive. On he oher hand, he BR (Colombia s Cenral Bank), is he moneary auhoriy, regulaing currency and credi policy. I is worh noing ha Colombia s Poliical Consiuion esablished independence of he BR from all oher Eniies of he execuive branch of poliical power. In fac, he Bank will only award loans o he Governmen if here is unanimiy o do so in he Board of Direcors (JDBR). In 1999, Colombia implemened an inflaion argeing regime as he frame for is moneary policy 48. The BR s objecive is o keep low and sable inflaion so ha GDP may follow is long-erm growh pah. The reason for his is ha having a sable purchasing power of he 48 Beween 2010 and 2011, he BR se a long-erm inflaion arge range beween 2% and 4%, wih he purpose of anchoring inflaionary expecaions. Aiming o keep inflaion wihin he range, inervenion ineres raes se by he Bank sayed unchanged in 3% hroughou I is worh noing ha he JDBR ses quaniaive inflaion arges derived from CPI measuremens. These guidelines are consisen wih he counry s growh policy and aim o reduce price uncerainy. Specifically, he BR enforces is consiuional mandae of guaraneeing macroeconomic sabiliy in he counry, publishing inflaion arges, analyzing he economic indicaors ha influence price dynamics, analyzing risk managemen sensiiviy, frequenly elaboraing economic research and keeping an open dialog wih oher cenral banks from around he world in order o end o global needs. 85

86 Minisry of Finance and Public Credi COP insures susainable growh, job creaion and welfare for Colombian populaion. In his way, low inflaion is associaed wih lower price uncerainy and incenivizes invesmen. Looking back, when Colombia experienced high inflaion raes, inernal deb issuance policy was highly concenraed in USD and UVR indexed insrumens, raher han having fixed-rae asses. Now, wih a sable inflaion rae wondering in he 2%-4% range, i is considerably easier o issue fixed-rae deb securiies. These developmens were accompanied by sysemaic cus in fiscal deficis as a resul of conservaive fiscal policy. Independence beween moneary and poliical auhoriies in Colombia guaranees consisency and credibiliy of economic policy, and improves Governmen macroprudenial inervenion mechanisms. Despie oal independence of he BR, here is a high degree of coordinaion beween he moneary auhoriy and he DGCPTN, which makes he execuion of moneary and fiscal policy simpler. In Colombia, he adequae implemenaion of moneary policy and coordinaion of he MHCP and he BR revolves around forecass of cash flows ha he Naional Treasury wishes o execue, and ha are periodically forwarded o he BR. On his noe, he Naional Governmen and he BR have agreed o hold excess liquidiy in ineres-bearing deposis in he Cenral Bank. The erms for hese deposis (volumes and raes) answer he Naion s liquidiy needs and are seled and approved in he Self-Regulaed Inerinsiuional Treasury Commiee, joinly conformed by he BR and he DGCPTN. As for currency managemen policy, and given ha mos of Colombia s exernal deb is USD denominaed, i is necessary for he MHCP o propose currency risk managemen ransacions. I is also relevan o coordinae BR and MHCP sraegies in order o keep a sound, flexible exchange rae regime 49, leaving inernaional reserve levels and inflaion arges unouched Accomplishmens and deb oulooks During he pas few years, Colombia has been recognized for is grea breakhroughs regarding moneary and fiscal policy. This is why in 2010 he Naion was awarded wih he recogniion of he bes exernal, local currency denominaed financing ransacion. In March and May 2011, Colombia regained is invesmen grade credi-raing from Sandard & Poor s, Moody s and Fich, los 12 years prior. Figure 39 compares credi raings for USD denominaed deb wih he EMBI+ index and 5 and 10 year CDS spreads. The Figure illusraes how risk premiums have dropped in spie of former negaive raing oulooks. The reason behind his is Colombia s known coheren and orhodox macroeconomic policy and an implacable credi honoring slae ha has kep risk premiums a low levels. This solid and responsible view of Colombia, has led o lower issuance raes and a longer mauriy profile, boh locally and abroad. BR ofen inervenes currency markes following he JDBR macroprudenial guidelines, so ha he BR is able o manage inernaional reserves, smoohens exchange rae volailiy and influences nominal exchange rae adjusmen speed. 86

87 Figure 39. Credi raings, EMBI+, 5 and 10 year CDS s - Colombia Source: Raing agencies, Bloomberg, Depuy Direcorae of Risk and Depuy Direcorae of Inernaional Capial Markes calculaions However, he Naion does no sele wih wha i has accomplished so far, and hus seeks for new ways o improve is adminisraion by being involved in inernaional deb managemen workshops and developing new projecs oriened owards opimizing is managemen. As par of he coninous effor for improving deb managemen sandards and sraegy designs, he Minisry has developed ools and insrumens for echnically assesing proper benchmark deb indicaors. The second half of he book presens he approach o benchmark indicaors, paricularly showing resuls for he currency composiion of he deb porfolio. 87

88 88 Minisry of Finance and Public Credi

89 PART II Deb Forecasing Mehodology for MTDS 89

90 Minisry of Finance and Public Credi Deb Forecasing Mehodology for MTDS As par of he effors for furher improvemen in Colombia s credi raings and is deb managemen performance and design, he MHCP has invesed iself in building new ools for seing and discussing deb managemen porfolio benchmarks. This second secion of he book, made up of four chapers, akes on echnical aspecs of opimal deb sraegy design given he pariculariies of Colombian economy. Wih his in mind, wo separae approaches are addressed, from which hree analyical models rise. Chaper 5 showcases he basics for he wo models encompassed under our firs modeling asses and liabiliies managemen approach. Chaper 6 focuses on our second cos-risk approach, only resriced by fulfilling budgeary needs on a fiscal erm. The firs addressed approach, inroduced in Chaper 5, considers wo separae bu similar models for opimal sraegy design. These models link he Governmen s revenue wih he CNG asses and liabiliies, and conceives he MTDS as a ool for reaching fiscal equilibrium, provided a pah for revenue behavior. The second approach, akes on analyzing deb dynamics of a variey previously deermined of ad hoc sraegies, in erms of coss and risks. In Chaper 7, resuls for all hree models are presened and global conclusions are reached. Findings, boh empirical and mehodological (regarding proper definiion, reach of he model and robusness of resuls), are lised, along wih some addiional remarks on deb policy effeciveness. 4. MTDS Models Approaches and Objecives This chaper defines he common elemens mehodological approaches o deb sraegy design have. Firs, he reach of he models is addressed. Then, general assumpions for he modeling are explained and oher exogenous componens of MTDS are described The foreign currency benchmark Colombia s economy is vulnerable o foreign economies given is rade ies wih oher naions and is ever growing openness o rade during he pas wo decades. Like so, commerce is increasingly imporan and has o be kep in noice by policy makers. For insance, mining and energy secors are a consanly growing source of income for he CNG; eiher hrough axaion or expors (e.g. Ecoperol). Consequenly, good dynamics of his secor may indirecly boos oher producive indusries of he economy (boh publicly and privaely), hrough exernaliies or job creaion. On his noe, i s naural for he governmen o incorporae exchange rae consideraions o policy design since hey closely affec rade. Regarding deb managemen and acknowledging he incidence of exchange rae behavior on deb and he Colombian economy, he models developed in Chapers 5 and 6 aim o find he ideal currency composiion of he deb porfolio subjec o he models resricions and assumpions, hus building he benchmark. 90

91 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II The remaining benchmarks (namely mauriies and rae indexaion) are aken as parameers in each of he models. In his way, subjec o each of he model s objecives, hese oher benchmarks are devised so ha hey have no major incidence in currency composiion of he deb porfolio resuls General assumpions The definiion of a foreign currency benchmark is bu one of he muliple aspecs ha configure a MTDS. Therefore, since he modeling in his book is oriened owards currency composiions of he deb porfolio, i is imporan o poin ou how hese oher facors are deal wih wihou hem being endogenously modeled Funding needs Governmens issue deb answering o heir poliical and economic goals and needs in every fiscal erm, in order for he governmen o operae. The Colombian governmen is no excepion o his rule. In accordance o his, he rule ha deermines he needed volume of deb issues on each fiscal erm is ha capial raised hrough deb issuing (in COP) has o be equal o funding needs. For example, deb issues for 10 year horizons, subdivided ino quarers, have o mach he Naion s funding needs for he same ime span. Based on his principle, deb volumes o be issued on each quarer are deermined and have o mee accuraely each quarer s financial needs Currencies in he deb porfolio For simpliciy, given he significance in paricipaion of USD in he deb porfolio 50, all foreign currency denominaed deb is expressed in USD. Hence, boh ousanding deb and new issuing recommended by he models are expressed in USD. Besides he high proporion of USD denominaed deb wihin he porfolio, he general rule of expressing resuls in USD also answers o he fac ha revenues coming from mining and energy secors are also denominaed in USD (resuling on high USD o COP raios in he balance shee). To express every foreign currency deb issue in USD resuls convenien for implemening he ALM model explained in Chaper 5. As for he second model under he ALM approach 51, an excepion o he rule is made, given ha wihin he porfolio s composiion, a high paricipaion of WTI crude oil indexed deb is considered. Oherwise, all oher foreign currency denominaed issues are expressed in USD, for which saying USD or foreign currency are indifferenly alike % of he oal ousanding exernal deb (COP). 51 See Secion

92 Minisry of Finance and Public Credi Prices and marke raes As menioned in Chaper 2, here is a high incidence of marke risk on he deb porfolio. Broadly speaking, marke volailiy affecs he deb porfolio in wo possible ways: 1. By increasing deb-servicing coss of previous issuances: For insance, bonds where coupons are indexed o marke raes or when deb issuances are denominaed in foreign currency, marke volailiy may affec servicing coss. 2. Because of deb issuing coss: When ineres raes surge, he price ha invesors are willing o pay for public deb are lower. Therefore, he volume of deb issued has o be larger han ha when ineres raes are low, in order o saisfy he Governmen s financial needs. As such, hree basic groups of variables are reaed separaely: ineres raes, Exchange raes and Price indexes (see Table 7). Table 7. Marke Variables Variable COP Ineres rae UVR Ineres rae USD Ineres rae 3M LIBOR rae 6M LIBOR rae TRM (COP/USD) UVR exchange rae WTI (USD/barrel) Class Ineres rae Ineres rae Ineres rae Ineres rae Ineres rae Exchange rae Exchange rae Price The simulaion for hese variables varies, depending on he model and he differen objecives se for each of he mehodologies. Based on hese, a suiable esimaion for marke values is chosen Fiscal Balance (FB) variables Coherence beween all he models developed hroughou his book and esimaions on he behavior of Naional Accoun Sysem variables is necessary. For his reason, he Medium-Term Fiscal Framework (MTFF) along wih oher reliable sources available o he DGCPTN, 92

93 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II were chosen as he main sources from where macroeconomic and fiscal forecass were drawn. Paricularly, variables ha mos affec he dynamics of deb and beer reflec fiscal policy assumpions and FB informaion are: CNG s Primary Surplus [Source: MTFF]. Forecased deb issues for he remaining fiscal year (e.g., from when ousanding deb was las quanified o he 31s of December of ha fiscal year) and for he following erm [Source: Cash Flow Saemen - MHCP]. Volume of effecive yearly amorizaion insallmens, regarding he deb porfolio s regisered invenory dae [Source: Effecive ransacion consulaion Depuy Direcorae of Operaions, DGCPTN]. The incorporaion of forecased deb issues and amorizaions is mean o be consisen wih shor-erm economic policy regarding he fulfillmen of he Governmen s financial needs. Similarly, fuure rajecories for inflaion raes and UVR are drawn from he MTFF in order o mainain consisency wihin he daa and avoid disorions in he modeling. As for exchange raes (TRM) and WTI prices, forecass from he MTFF are used Furher definiions Iniial deb porfolio Sraegies resuling from simulaions and modeling are dependen on fuure paymen and mauriy srucures, based on curren invenories of ousanding liabiliies and deb issued by he CNG. For accuracy, oal fuure expendiure associaed wih deb is deermined by volumes and curren sae of he ousanding deb porfolio. For models where iniial ousanding deb is included, he closing dae for measuring hese socks is he 30h of June of Forecas ime horizon Differen ime horizons are considered for each one of he wo approaches. The wo ALM models work on a 10 year ime span, in accordance wih he MTFF. As for he Cos-Risk approach a 5 year ime horizon is considered due o he fac ha longer ime inervals lead o elevaed volailiy in he simulaion, boh for marke and macroeconomic variables (ax revenues, ineres raes, exchange raes, ec.). This follows he WB recommendaions o he DGCPTN of reducing ime horizons o 5 years. The descripion of he elemens needed for modeling provide a clear perspecive of he ools available for defining CNG deb managemen sraegies. I provides insigh on he curren environmen for public deb and on he objecives and reach of he hree quaniaive models developed in his book. Wih his informaion a hand, he nex sep is o coninue wih deailed analysis of boh he srucure and he resuls of each of he menioned models. 93

94 Minisry of Finance and Public Credi 5. The ALM Model The CNG s income and expendiure usually comes in various currency denominaions oher han he domesic one, being USD he main one. From he governmen s poin of view, exchange rae volailiy could significanly hinder income and expendiure, deerioraing he balance and hus hreaening fiscal susainabiliy. Consequenly, wih he aim of idenifying an ideal currency composiion of he deb porfolio, his firs approach seeks o mach CNG expendiure and income in accordance o he currency denominaion of each side of he FB. Therefore, in developing he wo models ha fall under he ALM approach, wo differen currency full hedging sraegies are considered. The firs is o look for level-maching hedges, where he paymens derived from he deb porfolio composiion equae income and expendiure for each of he currencies. A second alernaive is o conceive deb managemen as a mechanism ha ensures fiscal susainabiliy; measured as CNG deb-servicing o oal income raio. Accordingly, he second model arges a sraegy where his raio remains unouched; even while facing exogenous shocks o currency markes or o he Naion s revenue. The oucome of such sraegy is a CNG balance srucure ha will remain unchanged despie abrup currency depreciaions or negaive shocks o naional income accouns ALM-1 Model: Minimizing he defici s presen value volailiy Under his firs rial of he ALM model, he selecion of a deb sraegy consiss in deermining a deb porfolio composiion ha minimizes volailiy on he CNG defici s presen value (Toal Income Toal Expendiure). The procedure is applied for a ime horizon ha comprehends he remaining of he fiscal year from he ime of modeling and he 5 following erms. Since variaions in deb-servicing coss (ineres paymens) impac he fiscal balance, deb-servicing is chosen as he model s free variable Preliminaries Facor idenificaion The kind of defici volailiy ha his ALM approach inends o minimize derives from exchange rae (TRM) flucuaions. As such, i is worh noing ha a large percenage he of USD porion of he Governmen s income corresponds o Ecoperol inernaional crude oil sales. In aggregae, he impac exchange rae flucuaions have on he Governmen s income increases as he amoun of USD denominaed income rises 53. Following his argumen, currency depreciaion leads o higher revenues (in COP) while appreciaion makes hem drop. The same behavior is seen in expendiure: variaions of TRM hi expendiure depending on is foreign currency composiion. 52 Amorizaions are no facored in given ha hese are below he line capial paymens and are no included in he FB. 53 For example, revenues may reac more violenly o cerain TRM flucuaions if hey are largely denominaed in USD, say 80%, han if only 50% are denominaed in foreign currencies. 94

95 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II I is herefore undersood ha sound managemen focused on srenghening he FB and making i solven consiss in reaching equilibrium in erms of currency composiion. If his is accomplished, foreign exchange shocks on revenues and expendiure will cancel ou naurally, hus avoiding FB mismaches due o currency volailiy Deb in he Fiscal Balance The effec of ousanding deb on he FB is ransmied via deb-servicing expenses (ineres paymens). Under his premise, full currency hedges would imply higher percenages of deb denominaed in USD, generaing annual ineres paymen obligaions in his currency. However, doing so migh no be so convenien, since migraions o deb porfolio wih higher USD composiions imply higher unnecessary Governmen expendiure (wih new foreign currency deb issues), generaing excessive burdens o he fiscal erm s budge. On he conrary, when he proporion of USD denominaed expendiure is reduced, he MTDS needs o generae deb porfolios wih higher COP denominaed deb, increasing ineres paymens in local denominaion and herefore raising he aggregaed expendiure in domesic currency Reach and limiaions of he MTDS The exen o which a MTDS can balance he currency composiion of he deb porfolio is largely influenced by iniial condiions imposed by he currency composiion of he FB. In his way, some paricular FB srucures make i easier o find full currency hedges using deb as an insrumen for such purpose. A grea way o undersand he concep of FB full currency hedges is o conras wo differen balance srucures, as Figure 40 shows. Figure 40. Deb effec on he FB Fiscal Balance 1 (o he lef) shows an iniial mismach beween he currency composiions of he wo sides of he balance. Fiscal Balance 2 (o he righ) shows equilibrium of currency composiions in he balance shee. However, balancing FB1 hrough deb managemen sraegies urns o be easier han i is for FB2. 95

96 Minisry of Finance and Public Credi FB1 reaches currency composiion equilibrium when deb-servicing coss amoun o ha 10% on which he saemen is unbalanced. This means ha a deb porfolio wih ineres of up o 20% of he FB has o be equally disribued beween COP and USD. In his way, if 10% of ineres paymens is denominaed in COP and he remaining 10% in USD, hen a currency composiion of he deb porfolio wih a 70/30 raio of COP/USD denominaion is achieved hus maching he income currency disribuion. On he oher hand, FB2 only hedges he balance mismach when he enire deb porfolio is denominaed in USD, as well as all of he ineres and he USD percenage of expendiures reach 40% (20% previously denominaed in ha currency and an addiional 20% coming from deb-servicing coss). Wih his currency composiion, he COP/USD raio of he balance is now 60/40. In his way, he sraegy implemened o FB1 is more feasible given ha wih i all of he Naion s financial needs will no rely on exernal deb issuing. As a resul, fully hedging he currency mismach risk of he balance is easier on he firs example han for FB2, even hough FB1 has an iniial currency dispariy. On ha noe, on he ALM-1 model, a porfolio currency composiion ha generaes ineres coss ha are equally disribued beween domesic and foreign currency does no necessarily imply a 50/50 currency composiion of he deb porfolio. For example, if USD denominaed deb ineress are lower han hose in COP, hen he ousanding composiion should award more han 50% o USD denominaed deb so ha larger deb a lower raes lead o equivalen COP ineres paymens. Anoher aspec worh menioning in he analysis of he former example is ha boh FB1 and FB2 show he same fiscal susainabiliy condiions, in he way ha he wo show no defici and deb-servicing coss represen 20% of oal expendiure. Consequenly, he effeciveness of he hedging abiliy of a deb porfolio does no only depend direcly on he fiscal balance of he Governmen, bu on is currency composiion. Summarizing, he objecive of his secion, was o emphasize how he channel hrough which a MTDS immunizes he porfolio agains currency depreciaion is he generaion of an ineres paymen flow derived from a chosen currency composiion. Likewise, he imporance of he income/expendiure srucure of he FB o he design of a MTDS is highlighed as well as he limied exen o which he sraegy works given he iniial sae of he variables defined and he balance srucure. The nex sep is o address specific characerisics of he model Framework The ALM approach seeks afer a sraegy ha manages o balance he COP/USD composiion in he FB. Wih his purpose in mind, he ALM-1 model defines he MTDS in five sages. This secion describes he mehodology of hese five seps while resuls are presened aferwards. This being said, he five sages are: 1. Classifying he FB by currency composiions. 2. Forecasing he CNG revenues and expendiure. 96

97 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II 3. Deb issuing filling fiscal erm financing needs. 4. Marke variable forecasing. 5. Idenificaion of he opimal sraegy Fiscal balance composiion by currency The purpose of firs classifying he currency composiion of he FB is o idenify iniial condiions and resricions imposed by he srucure of he CNG balance (Figure 40). A ime span of 10 years (in accordance wih he MTFF) is chosen, as i enables he evaluaion of FB mismaches across all of he fiscal erms in order o capure variaions in he currency composiion. Unlike he examples above, for hese cases only one fiscal erm is considered. During his chosen year, USD and COP percenages are mached on boh sides of he FB. As menioned in Chaper 4, he source from where FB variables are drawn is he MTFF. These fiscal variables are hen classified by currency since he framework does no originally consider his division. The porion of income denominaed in USD coming from mining and energy is idenified given is imporance wihin he Naion s finances. In fac, in simulaions and in he opimizaion process, oal income is modeled as a funcion of one fixed parameer and one free variable ha depends of TRM and WTI behavior. The parameer measures curren revenues no ied o USD or linked o he mining and energy secor while he variable capures he porion of he balance ied o USD and WTI prices Forecasing he CNG revenues and expendiures In order o minimize fiscal defici volailiy by using an adequae currency composiion of he deb porfolio, he ALM-1 model needs some inpu variables ha allow he model o deermine he CNG oal fiscal defici o be financed on each of he fiscal years under analysis over he chosen 10 year span. As such, based on he MTFF, forecass for revenues and expendiures are forecased. As for revenue, he COP/USD currency disribuion is calculaed for each period of ime (i.e. he wo currency caegories conemplaed), so ha objecive quaniies of he expendiure porion of he FB o be seled are idenified. This is equivalen o decomposing he income porion of he FB for each, as follows: " : Revenue = COP + USDTRM 97

98 Minisry of Finance and Public Credi Based on hese FB forecass and he resuling currency pariion of he revenue srech of he balance, he volumes of liabiliies o be hedged are deermined. Each annual fiscal defici is expressed in erms of CNG income and expendiure and of deb-servicing coss. In his way, he oal defici for ime is calculaed wih he following equaions: Where: FB = Primary Balance -Ineress Primary Balance = Curren.Income -Curren.Expendiure The reason for forecasing curren expendiure insead of oal expendiure is ha he laer is made up of he curren expenses firs wih deb-servicing coss added (again, only ineres paymens): Toal.Expendiure = Curren.Expendiure + Ineress Now, even hough he examples of las secion considered equilibraed fiscal balances ( BF = 0), his does no rule ou he need for an acive MTDS in order o immunize he FB agains exchange rae flucuaions. When fiscal deficis are winessed ( BF < 0 ), underaking acion wih he design of an MTDS becomes necessary. To illusrae, le he FB combine boh primary surpluses ( Primary Balance > 0) and overall fiscal defici ( BF < 0 ) 54. This implies ha income in overpasses curren expendiure (see Figure 41) bu he difference of he wo is ye no large enough o offse deb-servicing coss (he dark grey area in Figure 41). Consequenly, in order o minimize defici volailiy, having an idea of how revenue and expendiure behave in is key. Figure 41. Primary Surplus and Toal Fiscal Defici 54 This is he case of Colombia. However, his subjec will be addressed in deail furher along he chaper when he model s resuls for Colombia are presened. 98

99 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II Deb issuing Fiscal balances are funded wih deb issuing over each fiscal erm, hus creaing ineres cos ha spread along he 10 year ime span considered by he model. Wih all oher variables unchanged, new issuings increase fuure deb-servicing-coss 55 and generae larger han expeced fiscal deficis (see Figure 42). Figure 42. Defici and Fiscal Susainabiliy This relaion can, off course, hreaen he Governmen s fiscal susainabiliy. As such, accuraely esablishing he deb issuing model parameers, enables an annual quanificaion of ineres paymens and he sudy of he effec of deb-servicing coss in he year s fiscal defici presen value (he laer is he variable under analysis). In his way, simple condiions for deb issuance in following fiscal erms are defined so ha he model s resuls are easily inerpreable and he fundamenal relaions beween he variables are observed. These condiions are: Mauriies over 10 years: Wih his mauriy profile he deb manager inends o isolae he effec of ineres paymens on he CNG fiscal accouns, given ha mauriy for new issues is longer han ha of 10 years conemplaed by his model 56. Lending rae: Bonds are issued a par value, for which here are no premiums or discouns. The issue raes are defined by forecass of marke raes (he mehodological deails of he modeling are addressed in Secion ). Currencies: For simpliciy, only issues in COP or USD are considered. Wih his, he erms USD and foreign currency are indifferenly used. I is worh noing ha he percenage of issues in foreign currencies oher han USD only amoun o 5% of oal exernal deb as of June Deb insrumens: For simpliciy, and o keep he number of variables and parameers low, only bulle bonds are considered as new deb insrumens in he model. Addiionally, hey are fixed rae securiies ha pay annual ineres. These issues follow he srucural scheme of Colombia s Class B COP denominaed TES bonds issued annually. 55 Ineres rise for all unil new deb is fully covered. 56 The Cos-Risk approach does no include his assumpion and amorizaions are incorporaed. 99

100 Minisry of Finance and Public Credi Marke variables The incidence of marke facors (prices, ineres raes and exchange raes among ohers) on he deb s behavior is self-eviden. More precisely, marke variables affec deb in wo ways when designing a MTDS: i) hey aler he coss of new deb (for insance, in scenarios where higher ineres raes lead o higher risk premiums for new CNG issues), and ii) by modifying deb-servicing coss of index-linked issues, wheher i is via principal or ineress 57. Addiionally, he forecass for paymens of ousanding deb and he dynamics of fuure issues require he esimaion of a variey of ineres raes and exchange raes (COP/USD and COP/UVR). These variables are ou of he reach of he MTFF. Table 8 summarizes he se of variables modeled and he source from where he inpus are obained. Table 8. ALM-1 marke variables Variable COP Ineres rae UVR Ineres rae USD Ineres rae 3M LIBOR rae 6M LIBOR rae TRM (COP/USD) UVR exchange rae WTI (USD/barrel) Source Rae daa base (Infoval) Rae daa base (Infoval) Rae daa base (Bloomberg) Rae daa base (Bloomberg) Rae daa base (Bloomberg) TRM daa base + MTFF rend UVR daa base + MTFF rend Price daa base (Bloomberg) Variables are divided ino wo groups: Ineres raes: raes on yield curve -CEC in COP, USD, or UVR and LIBOR raes for 90 days and 180 days Exchange raes and WTI barrel prices Separae mehodologies are implemened for each of he groups. For ineres raes he LIBOR Marke Model 58 is used, and a Geomeric Brownian moion for he oher marke variables (TRM, UVR and WTI). 57 See Chaper 4 for more deail. 58 This model is also known as he BGM (Brace Gaarek Musiela) model, named afer is auhors. 100

101 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II Ineres raes The LIBOR Marke Model (LLM) was designed for forecasing marke raes used in derivaive insrumens (spread opions, swapions, and ohers). For his reason, esimaions are based on risk-neural probabiliy measures. One of he advanages of using his model is ha i esimaes fuure raes based on observed forward raes, forcing volailiy and expeced values o reflec he curren financial environmen. Anoher advanage of using his model is ha he yield curve is fully fied (for all of he mauriy srucure of deb), insead of jus having shor erm raes or forward raes. In fac, he model s resul for each ime node is a series of forward raes which deermine he enire yield curve. The LLM considers lognormal disribuions for he forward raes on differen mauriies of he modeled yield curve. In oher words, if { rj = 1, 2, ¼, n} is he se of n esimaed forward raes, where T j is he rae for he ime inerval T j y T j + 1, hen each one of hem follows he following equaion: Q ( ) ( ) ( ) Tj = s ( ). dr r dw j j j Q Tj Where dw is he measure 59 associaed wih he rae r j. Even hough a measure is defined for each of he n inervals ha compose he yield curve, he Girsanov Theorem guaranees he exisence of a sysem of equaions wih which a single measure can be found for all n inervals, herefore finding a curve defined by his only measure. However, deails on he procedure used for calculaing such measure are ou of he reach of his book, and are herefore omied. Summarizing, he LLM approach is used for each of he five ineres raes o be modeled, under a en year imeframe. The resul for each rae is a se { r = 1, 2, ¼, n} for each ime. From hese ses, deb-servicing and issue raes for every fiscal erm are calculaed. Exchange raes and prices j The remaining marke condiions are individually modeled implemening a Geomeric Browninan moion. Aferwards, correlaions beween he variables and heir respecive mulivariae normal probabiliy disribuion funcion are generaed. In deail, a Geomeric Brownian moion model is a coninuous sochasic process in which he logarihm of he modeled variable follows a rending Wiener process. The possibiliy of including rends in he model is very useful since fiscal and macroeconomic forecas are drawn from he MTFF. The evoluion of he TRM process is described in he following equaion: ( ) = m + s. d TRM TRM d TRM dw 59 Inuiively, a measure is a way o assign he size of he probabiliy se, from which associaed even probabiliies are calculaed. 101

102 Minisry of Finance and Public Credi Where W represens he Wiener process, and ( m, s ) are consan parameers for rend and volailiy in percenage unis. The drif m is aken from he MTFF and volailiy s is esimaed wih an EWMA 60 char. As a resul, he TRM evoluion is described as: TRM = TRM e æ 2 s ö ç m ç - d+ sw çè 2 ø -1. The oher wo marke variables (WTI and UVR) follow he Brownian moion models wih MTFF rends. Moreover, flucuaions of marke variables are no independen. These movemens are ofen preceded or followed by variaions in oher marke and economic variables. In order o model he ineracion of hese hree variables, correlaions are inroduced hrough shocks o he esimaed mulivariae normal disribuions 61. Broadly speaking, modeling shocks wih a given correlaion marix is sufficien for aaining a comprehensive correlaion dynamic amongs variables. For insance, for n independen variables, he correlaion marix is he n n ideny marix I n n.. If some degree of ineracion beween variables is desired for he n variables, hen a non-idenical marix would incorporae such correlaions. Marix A is found as follows: 1. Firs, an array of n independen normally disribued random variables are generaed (hey represen he shocks inroduced o he model) 62. Le X = { X1, ¼, X n } be a normally disribued process: X ~ N(0, I n n) Where 0 is a null vecor, I n n. is a n n uni marix and X is a n 1 vecor. 2. Then, he n n correlaion marix A for he n variables is esimaed. To force he correlaion on he variables, he posiivesemidefinie marix is facored wih Cholesky s decomposiion algorihm. The algorihm decomposes A ino wo riangular marices: A= L L As follows, L is lower riangular and is ranspose is upper riangular. 3. Finally, o calculae a correlaed se of random variables, Y is defined as: T 60 Exponenially Weighed Moving Average: saisical model ha esimaes a variable s volailiy by exponenially weighing he observaions, making recen ones more relevan han long pas ones. The modeling assumes he variables behave exponenially wih a fixed decay rae. 61 The random variables incorporaed in he model are hose ha define he Wiener Process { W } for TRM, WTI prices and UVR. 62 In his manner, shock variables number he same amoun of marke variables in he model. 102

103 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II T Y = X L ~ N(0, A) The n 1 vecor Y denoes a se of n new variables, normally disribued wih correlaion A Opimal deb sraegy idenificaion Afer carefully modeling he variables ha affec he behavior of deb securiies; boh poliical (new deb issue condiions) and a marke variables (forecasing raes and prices), he deb sraegy ha bes minimizes defici volailiy is sough afer. For his reason, deb-servicing is a defining variable for esimaing he opimal deb sraegy. In oher words, he model uses ineres paymen flows in each fiscal erm as an inpu, hus deermining he sraegy. In a sric sense, he opimizaion process firs idenifies he ineres flows necessary o even ou he FB year afer year. From here, respecive ousanding deb balances are obained (wih new deb issue ineres raes provided, hus condiioning annual ineress of he deb porfolio o hose values). Insead of opimizing oal ousanding deb balances, his model seeks o minimize ineres paymens. Once hese opimal ineres levels are idenified and fiscal accouns are balanced ou, he model deermines he corresponding ousanding deb balance (i.e. he deb porfolio). Drawing conclusions from deb sraegies based on he deb porfolio (ousanding deb balance) is clearer, bu resuls are sill presened combining boh ineress and he deb balance for each fiscal erm Resuls For implemening he ALM-1 model, he layer scheme menioned in he framework is followed, and he resuls shown follow he same order Fiscal Balance by currency and income and expendiure forecasing Currency denominaion segregaed fiscal accouns were drawn from MTFF projecions of fiscal variables for he erm. For presenaion effecs, he following daa is shown in percenages in order for i o be comparable hroughou he 10 year erm. 103

104 Minisry of Finance and Public Credi Figure 43. CNG revenue currency composiion As in he examples of Secion 5.1.1, he average percenage of he USD denominaed revenue sources condiions he opimal sraegy o generae USD denominaed ineres paymens. These deb-servicing insallmens, along wih already USD denominaed expendiure, mus balance ou he wih USD quoed revenue, of around 30% of oal revenue (see Figure 43). Moreover, currency composiion of oal expendiure shows high concenraions of local currency expenses. This comes as no surprise since mosly all of he Governmen s operaional expendiure is obviously denominaed in COP. Figure 44. CNG expendiure composiion 104

105 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II The purpose of segregaing COP denominaed deb-servicing and ousanding amorizaions from USD servicing and remaining insallmens, is o deermine he weigh of he deb porfolio relaive o oal expendiure. Average percenages of USD deb-servicing coss relaive o oal servicing cos are included in order o evidence deviaions from he rend. As expeced, average USD denominaed deb-servicing coss seadily remain under 5% of oal expendiure (see Figure 44). The currency composiion of expendiures is much more sable hrough ime han is revenue counerpar. This means ha he flucuaions of he foreign currency denominaed expendiure coincide wih he dynamic of he COP/USD exchange rae (see Figure 8 in Secion 3.2.1). This suggess ha USD volumes of expendiure are sable and ha he percenage of his expenses relaive o he oal follow exchange rae dynamics. The imporance of oil derived revenues is he high degree of uncerainy hey inroduce o he model. Because of his, flucuaions of he USD denominaed porion of he FB also follow oil prices and he mining secor s performance. Tha is, he beer mining and energy secors, he greaer he paricipaion of he USD revenues (and vice versa) Idenificaion of Opimal Deb Sraegy A he beginning of he chaper, examples where he srucure of he CNG s FB indicaed wha he model s opimal sraegy should be. These conceps, applied o he Colombian case, lead o an opimal deb porfolio, capable of generaing around 30% of revenue in deb-servicing cos wih USD denominaion. This percenage is exacly he amoun of expenses subjec o exchange rae risk. However, he analysis conduced in Secion regarding he implicaions and resricions ha differen FB srucures impose on he MTDS s 63 design, lead o an immediae conclusion: in order for issued deb o generae a USD servicing coss equivalen o 30% of he income, i is necessary o considerably increase he USD denominaed percenage of he deb porfolio. The reason for his is ha curren levels of he deb-servicing only make up abou 5% of expendiure. The average composiion for he FB for he period in Figure 45, is analyzed in erms of he exen o which he MTDS immunizes he FB from flucuaions in he exchange rae. The daa is scaled aking oal expendiures of each period as a measure The MTDS covers muliple aspecs, including he opimal currency composiion of he deb porfolio. For purposes of his exercise, he erms MTDS and opimal sraegy are equivalen. 64 This assumpion is valid as long as he period s FB always shows fiscal defici. 105

106 Minisry of Finance and Public Credi Figure 45. FB srucure implicaions on MTDS As previously menioned, balancing he paricipaion of currencies on boh accouns of he FB implies increasing he percenage of USD denominaed deb o a level where he porfolio generaes deb-servicing coss go up from 3% o an equivalen o 29% of he expendiures 65. This is almos enfold he amoun of curren USD ousanding deb, assuming hisorical raes for new USD issues (which are higher han he curren ones) will no change, so ha annual ineres flows generaed are unchanged relaive o ousanding volume 66. The MTDS resuling from he opimizaions model is a corner soluion, i.e. he ALM-1 model s recommendaions consiss on convering he enire deb porfolio o USD denominaion. I is worh noicing ha even if his resuls were implemened, FB revenue and expendiure composiion would sill no balance off given ha oal deb-servicing ascends in average o 14% of he oal expendiures (3% correspond o he USD deb-servicing coss and he remaining 11% COP servicing). Wih his, here would sill be a 15% gap in he expendiures ha 14% of he oal deb-servicing coss will no cover (associaed wih having 29% of revenue in he fiscal balance in USD denominaion). The presen analysis leaves ou resuls on specific aspecs of issuing and forecased marke raes. In fac, he analysis focuses on aspecs ha cover he mos relevan feaures of he MTDS, mainly revenues, expendiures and deb. Resuls give a ligh reamen o marke variables. Regardless of he levels of ineres raes and marke facors, he fundamenal conclusion of he model revolves around he srucure of he FB in erms of currency. Acually, CNG revenue and expendiure currency composiion is indifferen o variaions in ineres raes, so furher analysis of hese variables is somewha irrelevan. The conclusion o conver he enire deb porfolio o an USD denominaion is no a poliically viable sraegy since i will hinder inernal marke developmen and does no fulfill he objecive of immunizing he deb porfolio agains exchange rae volailiy Even wih sable fiscal deficis, which is he case shown here. 66 Curren posiive circumsances of he Colombian economy, refleced in he low risk perspecive of foreign markes, indicae ha fuure raes could be even lower. This implies ha i would be necessary o increase he USD volume in he deb porfolio even more o generae he same deb-service flows generaed by pas higher. 67 Remember ha even in he bes scenarios, he deb porfolio sill lef an amoun of USD uncovered equivalen o 15% of oal expendiures. 106

107 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II On his noe, new mehodological approaches encompassed by he ALM model are sough in order o guide he MTDS owards viable deb policy excecuions. Consequenly, a second model is developed nex ALM-2 model: Sabilizing fiscal impac (Ineress/Revenues) The ALM-1 model addresses deb as a policy insrumen guard he FB from drasic or unexpeced exchange rae flucuaions. However, one of he conclusions ha his model reached was he impossibiliy of making a perfec currency composiion mach in erms of revenue and expendiure of he FB. These limiaions are addressed by he ALM-2 model, by exploring new possibiliies for minimizing he fiscal impac generaed by exchange rae risks, under he ALM approach. To do his, he focus of he ALM-1 is modified by augmening he opimal sraegy wih fiscal sabiliy objecives agains exchange rae volailiy. In his sense, he firs modificaion resides he effec of maerialized currency risk is adressed. Insead of minimizing he volailiy of he presen value of he defici (ALM-1), he new model conemplaes he sabilizaion of deb-servicing cos impac on CNG revenue for each fiscal year. Concreely, he purpose is o sabilize he ineress/revenue raio agains exchange rae variaions ha increase he weigh of USD ineres paymens (he COP equivalen) relaive o revenues of each period. The second modificaion is he incorporaion of an addiional volailiy facor o he TRM simulaion: WTI oil prices. The ALM-1 idenified WTI as a deermining componen of he CNG s oal income. This new approach includes on he expendiure side of he FB hrough ineres paymen of synheic deb insrumens. These deb insrumens are issued in WTI synheic unis (conceived for he purposes of he model) in he same way ha TES can be denominaed in UVR. In his way, WTI can be considered as a new currency under his approach. A hird aspec in which he ALM-2 model differs from he ALM-1 is he mehodology implemened for simulaing he considered marke and macroeconomic variables. While he ALM-1 sochasically simulaes he variables and hen formulaes he opimal sraegy as a resul of an opimizing process, he ALM-2 idenifies he opimal deb porfolio srucure by finding hose sraegies ha mainain ineres/revenue raio sable, even under ad hoc sressed scenarios for TRM and WTI Preliminaries Objecive defininion The ALM-2 model seeks o immunize he fiscal impac of deb-servicing in he FB agains shocks o exchange raes or oil prices, by accomplishing o keep he ineres paymen o revenue raio as sable as possible. This does no mean ha revenues and he ineress are 68 Shocks on he UVR are no incorporaed since his variable responds o inflaion, so volailiy is no significan as here are insiuions wihin he governmen in charge of keeping i sable making use of specific moneary policies (i.e. Banco de la Republica) 107

108 Minisry of Finance and Public Credi consan, and in order for his o occur, deb managers use deb-service as a mechanism for imprining sabiliy, i.e., by deermining he deb porfolio. In fac, he objecive is o reduce uncerainy in fiscal accouns associaed o increases in deb-servicing as a resul of exreme devaluaions or adverse shocks o oil prices. Therefore, he objecive of he exercise is o undersand deb, no as a source of fiscal mismaches, bu as a ool for srenghening decisions and sraegies regarding oher policies The equaion The ALM-2 model aims for fiscal susainabiliy in each fiscal erm, and for i o endure exchange rae volailiy. According o his, if ineress I and revenues Y are funcions of exchange raes (TRM), among oher facors, hen he objecive would be: d æi ö " : = 0. d(trm ) ç Y çè ø The previous equaion indicaes ha for each period, he impac deb-servicing coss on CNG revenue remains, regardless of variaions of he exchange rae, wih which fiscal accouns become immune o exogenous exchange rae flucuaions hroughou he analyzed period. This is no unpresedened, and in fac, Calvo, Izquierdo, and Talvi (2003), aemp o deermine he adequae currency composiion of he deb balance so ha exogenous flucuaions of he exchange rae do no modify he deb o GDP raio, given a currency composiion of he gross producion in he economy. Moreover, he purpose of he ALM-2 model is very similar o ha of Calvo e. Al. (2003), bu he difference is ha fiscal susainabiliy is evaluaed period by period (i.e. as a flow and no as sock), he reference uni is no Deb/GDP bu Ineress/Revenues, and ha he exchange rae is expressed in real erms and no in nominal erms. This way, he opimal deb porfolio currency composiion is ha which leaves he I / Y raio immune o TRM flucuainos in period. In his way, he effeciveness of he sraegy is measured in erms of is capaciy o mainain he I / Y raio as sable as possible. This measuremen allows idenifying he ideal currency composiion of he oal ineress and he CNG s oal income. To equae he raio, le ineress I and revenue Y be: I I I TRM = COP, + USD,, Y Y Y TRM = COP, + USD,. 108

109 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II Where I USD, and Y USD, correspond o he amoun of USD denominaed oal ineress and oal income in. I COP, and Y COP, represen he COP percenage of his figures. Therefore, he basic condiion given by he previous equaion in he period is: d æi ö ç I Y - Y I = 0 Û = 0. d( TRM ) Y Y USD, USD, ç 2 çè ø Reorganizing he equaion on he righ side and muliplying boh sides by TRM, hen: I TRM Y TRM = I Y USD, USD, These equaions describe he paricipaion of he USD in oal ineress and oal income volumes. Therefore, in order o immunize he fiscal impac of deb on CNG income in each fiscal erm (in erms of flows), he percenage of each currency denominaion in he oal ineres and oal income mus be he same Oher volailiy sources - Oil Up o now, only TRM has been modeled o have effecs on fiscal susainabiliy. However, as menioned in Secion 5.1, Colombian revenue depends (boh public and privae) on he mining and energy secor. Consequenly, he ALM-2 model aims o reduce he impac of WTI volailiy marke risk on CNG fiscal susainabiliy. The conclusions obained for TRM before are valid for he WTI analysis. Le ineress and revenue be: I I I TRM WTI = COP, + WTI,, Y Y Y TRM WTI = COP, + WTI,. Where IWTI, and Y WTI, are WTI unis of ineress and revenue. Accordingly; WTI represens he price of he WTI oil barrel in USD during he period.these equaions assume TRM as consan during he period. Finally, he relaion beween ineres paymens and revenues currency composiions is: I WTI Y WTI = I Y WTI, WTI,. 109

110 Minisry of Finance and Public Credi As he equaions clearly show, income depends on TRM in wo ways: revenues associaed o oil producion and he remaining USD denominaed revenues. Since sressed scenarios incorporae individual ad hoc schocks o he variables, furher analyzing he double effec of he TRM is no relevan for he analysis. Summarizing, he ALM-2 addresses ALM-1 limiaions by incorporaing he following argumens o he model: 1. Considering ha i is no possible o balance currency paricipaions in he FB, he ALM-2 seeks o immunize he I / Y raion agains variable volailiy. This guaranees fiscal susainabiliy, undersood as he capaciy of he CNG o honor is deb obligaions (ineress) on every fiscal year. 2. Oil prices are incorporaed boh on he asse and he liabiliy sides of he FB (income and ineress). This is done by assuming he issue of synheic WTI denominaed deb securiies ha generae WTI based ineres paymens. 3. Insead of sochasically simulaing correlaed marke variables, his model analyzes ad hoc sressed scenarios. Up o now, links beween some of he variables of he model have been described. However, he formal heoreical consideraions are presened nex Theoreical Framework The ALM-2 model divides he procedure in he following sages. 1. Classificaion of he FB figures by currency. 2 Forecas CNG revenue and curren expendiure. 3. New deb issuance Saisfying he Naion s financing need on each period. 4. Marke variables reamen. 5. Idenificaion of an opimal deb sraegy. 6. Analysis of sressed scenarios TRM and WTI shocks. As you can observe, alhough he firs hree sages are common in boh models, he deails involved in each of hem makes he wo models differen. 110

111 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II Fiscal balance currency composiion This firs sage of he model follows he ALM-1 procedure given ha boh models incorporae he FB asses and liabiliies o he analysis. However, he WTI facor is included in CNG expendiures hrough deb-servicing paymens indexed o oil prices CNG revenue and curren expendiure forecas The MTFF forecass for FB variables in his new ALM-2 model follow he same procedure as in ALM-1. However, he incorporaion of WTI prices o FB liabiliies (as a resul of he WTI denominaed synheic deb issuing) consiues a major difference wih he firs model. In his way, for each year, he paricipaion of each denominaion in oal revenues is calculaed as follows: " : COP + UVR + USD + WTI = 100%. Segregaing income ino four differen denominaion caegories is necessary for idenifying he opimal sraegy. Similar segregaion for expendiure is also excecued. This is done for he ALM-1 model as well. However, he UVR caegory includes inflaion indexed deb securiies in ha model Issuing of new deb From his poin on, he ALM-2 model is subsanial differen from ALM-1, paricularly because he array of deb insrumen used for financing fiscal defici (during he 10 years ime span, in line wih MTFF) is broader under he ALM-2 approach. This is a resul of he inclusion of WTI denominaed bonds. In line wih his, he issuing erms for he new deb are: 10 year or longer mauriies: As wih he ALM-1 model, he purpose is o isolae he effec of ineres paymen concenraions on he CNG fiscal accouns. None of he models addresses he mauriy benchmark in a deailed way, since new issuings are assumed o exceed he 10 year mauriy horizon. Issue rae: Securiies are issued a par value, so here are no premiums or discouns in he issuing (as wih ALM-1). However, issue raes are no longer defined by marke rae forecass obained from sochasic modeling. Insead, he model analyzes differen sressed scenarios wih only one issuing rae for each insrumen. This rae is he resul of averaging primary marke aucion issuance raes (weighing by nominal volumes placed). Daa included aucions saring on June 2004 and ending in January This implies ha here is only one issue rae for each ype of insrumen. The specific mehodological deails involved in his process are explained furher in Secion

112 Minisry of Finance and Public Credi Deb porfolio denominaion: As i is menioned in he beginning of he secion, his model assumes ha all foreign currency issues are USD denominaed. Addiionally, UVR, WTI and COP currency denominaions are considered These WTI bonds are srucured in he same way UVR indexed securiies so ha heir nominal value of is expressed in WTI unis and coupons are calculaed a a fixed WTI rae. In his way, coupon and principal paymens o bond holders are calculaed as he COP equivalen o WTI unis on he insallmen dae. Ineress are calculaed from he coupon fixed on issuance. The deails coupon raes are described in Secion Deb insrumens: The erms of he deb securiies considered in his model are he same as hose in ALM-1. Ineress are paid annually, a a fixed rae and wih a mauriy longer han 10 years. For WTI denominaed bonds, he same mauriy, ineres rae and coupon insallmen condiions of oher denominaed bonds hold Marke variables Raes and prices The scenario oriened analysis makes i necessary o give marke variables a differen reamen from ha in ALM-1, where hey were esimaed wih sochasic modelling. These scenarios focus on measuring he implicaions of sressed conrol variables on he model s objecive indicaor (Ineress/Revenue). Table 9. ALM-2 marke variables Variable Source Class COP Ineres rae Rae daa base (Infoval) Parameer UVR Ineres rae Rae daa base (Infoval) Parameer USD Ineres rae Rae daa base (Bloomberg) Parameer WTI Ineres Rae 10 yr oil fuures Parameer UVR exchange rae UVR daa base + MTFF rend Parameer WTI (USD/barrel) Sressed scenario Conrol TRM (COP/USD) Sressed scenario Conrol Table 9 summarizes he models inpus. As already menioned, TRM and WTI variables are sressed, while all he oher variables are esimaed wih simple mehods and are reaed as parameers. 112

113 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II Local issuance raes COP, UVR and USD Before going in deph wih he calculaions, i is worh recalling ha when securiies are issued a par value, marke ineres raes mach issuance raes. The specific consan values of each of hese hree raes in a 10 year span are he average raes observed in deb securiy aucions, weighed by nominal issued value 69. The equaion for calculaing he model s ineres raes is a recursive formula, idenically implemened for all hree denominaions (COP, UVR and USD). r COP n = å å VN s= 1 n s= 1 r COP, s COP, s VN COP, s. Where rcop, s and VN COP, s are ineres raes and nominal volume of issued COP denominaed securiies in placemen aucion s. As for s, i represens placed securiies in aucions. For example, if he firs aucion places hree securiies, hen s would ake a leas values 1, 2, 3. For he second aucion, s would sar on 4 and so on. Combining aucion raes in a single variable, for such a long ime span and such a wide variey of securiies wih differen mauriies is a large simplifying assumpion. However, his assumpion does no lead o any deviaions from he model s objecive, since differences in mauriies are encompassed by he mauriy profile indicaor, no by oal deb cos measuremens of ineres raes. Addiionally, since new issues are due in ime spans longer han 10 years, mauriy consideraions may be excluded (amorizaions are insalled afer he period of sudy is over) and he main subjec of analysis is sill he fiscal impac of deb, measured as ineres paymens for every fiscal erm. WTI bonds As menioned before, he ALM-2 model conemplaes WTI indexed securiy issues. These bonds have a synheic WTI uni denominaion, and he face rae (coupon) is calculaed in wo seps: 1. For each day in he defined ime period, an implici ineres rae is calculaed as a weighed diference beween spo WTI 10 prices ( WTI ) and WTI 10 year fuures ( WTI + ), ", as follows r WTI 1/10 æ + 10 WTI ö, = -1. ç WTI çè ø 69 The aucions observed are hose held in he period of analysis. Chaper 4 esablishes ha his period is he imelapse beween June 2004 and June

114 Minisry of Finance and Public Credi 2. Issue raes for WTI bonds are also reaed as consans in he model, for which here is a single r WTI rae for he 10 year span. This rae is esimaed by aking a simple average of all he r, as follows: WTI, r WTI 1 = år WTI, T < T. Where Î T are day of he ime inerval where r WTI, raes are available. TRM and WTI reamen Based on TRM and WTI variables, an array of sressed scenarios are formulaed and evaluaed in erms of he efficiency of an opimal sraegy. The opimizaion rials vary he percenages of he deb porfolio denominaed in all for caegories 70, ulil a combinaion ha fis he fiscal impac sabilizaion objecives is found. In oher words, for every poin in he TRM and WTI simulaions, a se of weighs is found, hus consiuing an opimal sraegy. Since simulaed pahs are variable, porfolio composiion resuls are valid only for specific pahs Opimal sraegy idenificaion As menioned before, resuls for opimizaion rials are deb porfolio denominaion composiions, wheher i is COP, UVR, USD or WTI. Jus as wih ALM-1 sraegies, he ALM-2 derives he porfolio composiion ha beer fis ineres paymen flows, for esablishing issuing condiions and saisfying he model s objecive funcion. In spie of having similar objecives, he role ha he deb-servicing cos variable plays in each of hem is differen. The ALM-1 seeks o mach i wih he USD volume of asses (income) in he FB, while he ALM-2 seeks o immunize he I / Y raio for each period agains adverse exogenous shocks o exchange raes and oil prices. Addiionally, ineres raes, fiscal variables and oher variables are reaed differenly in each of he mehodologies. Formally, idenificaion of he opimal sraegy in boh modes is equivalen o solving a bounded opimizaion problem: finding a se of * * * * * * opimal percenages w COP, w UVR, w USD and w WTI, where å w i = 1 y " i : w i > 0, ha make he I / Y raio as sable as possible. All i pahs for prices and marke raes are provided as parameers, esablishing a baseline for disurbing he pahs of TRM and WTI variables. I is imporan o remember ha weighs, and herefore porfolio composiions, are consan for he enire 10 year span and are independen of ime. Mahemaically, a sraegy S = [ wcop, wuvr, wusd, wwti ] is defined, where all w i, : i Î { COP, USD, UVR, WTI} are consan, i.e. " : w i, = w i. 70 Percenages remain consan in he 10 year ime span. 114

115 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II Before geing ino he opimizaion problem, here are sill some inerconnecions and relaions behind he dynamics of he issuing model and variable pah assumpions and he fuure behavior of marke and macroeconomic facors 71. Ineremporal relaions Issuance dynamics Given ha he model assumes he percenages ha define he porfolio composiion are consan hrough ime, new issues herefore leave he porfolio s srucure unalered, wih he fixed w i. In oher words, " S, = [ wcop, wuvr, wusd, wwti ] sraegies, he following mus hold: OD w + NV wi = OD i i, + 1 Where OD is ousanding deb in and NV i, + 1 is he nominal COP value of new deb wih : i Î { COP, USD, UVR, WTI} denominaions in ime + 1. Noice ha his equaion links he porfolio s composiion in and + 1, so ha for = 0 (2012), he porfolio is insanly recomposable implemening w i percenages " i. The model assumes ha in = 0, he porfolio currency (denominaion) composiion is given by sraegy S = [ wcop, wuvr, wusd, wwti ] and ha oal ousanding deb OD is equal o oal curren (observed) CNG ousanding 0 deb. The resul when solving for w i, is ha denominaion percenages are saic in ime and independen of, where w i represens he porfolio percenage of he i-h denominaion in COP, in ime + 1, as a funcion of he i-h denominaed ousanding deb ( OD wi) and new issues NV i, + 1 (in COP). Even hough i is no done explicily, his equaion does ake ino accoun marke facors. In fac, he equaion for UVR, USD y WTI exchange raes is: + 1 w i = OD w e i, i + e NV OD e i, + 1 i, i, + 1 Where e i, + 1 is he COP o i-h denominaion exchange rae for ime, making sraegy s dependan of currency flucuaions for he forecased ime horizon 72 { ei, :1 i 3, 1 10}. This Exchange rae vecors serve as parameers for he model, no conrol variables. 71 The main requisie for new deb issues is ha i mus saisfy financing needs in each fiscal erm, which depend on assumpions for he behavior of he economy and marke variable pahs. 72 * For he opimal sraegy S. 115

116 Minisry of Finance and Public Credi As for ineres raes, hey are implicily incorporaed ino he model hrough he valuaion of new issues ND i, + 1, since he model requires for funding needs o be fulfilled in every fiscal erm. The mahemaical equaion ha links ineres raes r i, wih required issue volumes ND +, where i = 1, ¼, 4, is: i, 1 ND " r = BFP + I 4 i, : å i,. i= 1 TCi, Where PFB is he primary fiscal balance and I represens ineres paymens in. Ineres rae r i, in he prior equaion is consan for all imes. As such, here are only four raes in he model: " : ri, = ri. Hence, noaion for ineres rae r i is a reflec of he unvariable characerisic of ineres raes across al forecased imes 73 and i Î { COP, USD, UVR, Overall, his equaion links ineres raes, exchange raes and new deb issues wih he primary fiscal balance for all denominaions i hroughou in every period he seleced ime span, as a funcion of prior issues as well. This evidences he close relaion all of he menioned variables have wih chosen sraegies S = [ wcop, wuvr, wusd, wwti ]. The Chaper has shown, so far, he relaionship beween he w i percenages ha define he MTDS wih oher relevan fiscal and marke feaures of he model (i.e., he FB equaion and marke raes and prices), o deermine he sraegies evoluion and is impac in fiscal accouns. The opimizaion problem * * * * * The deb sraegy S = [ wcop, wuvr, wusd, wwti ], is he porfolio srucure ha bes balances he I / Y raio, when srong flucuaions in * exchange raes and oil prices are experienced. Sraegy S does no always fi perfecly since he I / Y raio is no always unchanged due o variaions of economic and marke facors ha affec he COP equivalen of oal ousanding deb. * In his sense, he objecive funcion mus quanify how efficien sraegy S is in erms of I / Y raio sabiliy. In her words, le f () be he objecive funcion over he se of S = [ wcop, wuvr, wusd, wwti ] sraegies, ha aggregaes all individual deviaions of he I / Y raio, relaive o a seady sae (where variable volailiy does no affec I / Y). Formally, f is defined as: Where i { USD, UVR, WTI} Î and: ( ) å( USD, WTI, UVR, ) f S = D +D +D D = I - Y " i i, i, i,,, I Y 73 In he case of WTI prices, he equivalen rae is esimaed by adding a spread o he model s USD exchange rae. For more deail, see Secion

117 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II These variables capure he relaion beween he hree exchange rae denominaions. The objecive funcion f is defined over deviaions ok I / Y (see Secion ). Immunizaion for he i-h denominaion is compleely reached when in, D i, = 0. Formally, his is equivalen o he following condiion: d æi ö If D i, 0, hen 0 dx ç Y çè ø Where X is he TRM or WTI exchange rae in. See ha D i, impliciy includes he relaions esablished beween sraegy s and he model s fiscal and marke variables. Therefore, funcion f over he se of D i, elemens, capures all of he elemens considered so far. Since hese D i, elemens capure deviaions of he I / Y raio reaive o a se rend, he opimizaion problem becomes a minimizaion rial for hose divergences. Wih he objecive función is idenified, he complee specificaion of he problem only requires he definiion of resricions on he percenages so ha: å "Î i { COP, USD, UVR, WTI} w i = 1 w i Where " i : w i ³ 0. There are oher addiional policy resricions and (inernal and exernal) marke deph consideraions ha affec he w i weighs. For example, as menioned in Secion 5.1.3, w COP = 0 is no a plausible resul, given ha exernal funding sources canno absorb all of he CNG s financing needs. However, hese resricions are evaluaed ex pos. In consequence, he opimizaion problem is: ( ) min f S subjec o : w = 1, ( w ³ 0) S å i i i The soluion for his problem is a combinaion of percenages S = [ wcop, wuvr, wusd, wwti ] ha se he porfolio s srucure, valid for he enire 10 year ime frame. 117

118 Minisry of Finance and Public Credi Sressed scenario analysis The goal of hese excercises is o deermine he degree of efficiency of he opimal sraegy and WTI shocks, in erms of FB sabiliy. * S, and is endurance o exogenous TRM The sressed scenario is defined as a seing in which he I / Y raio is alered by q shocks in any of he variables 74. The procedure for disressing boh TRM and WTI variables is very much alike, for which only he exchange rae case will be elaboraed, and only a few noeworhy remarks on he oil price will be made. Sressed scenario inpus Since resuls are being sressed by alering TRM and WTI raes, i is necessary o firs deermine he USD volumes and oil barrels assumpions of MTFF 10 year forecass. The purpose is o generae ad hoc shocks o prices ha lead o fi fiscal accoun reacions. The following formula esimaes how many QWTI, oil barrels are sold abroad by he Governmen in ime > 2012 : Q WTI, Y = TRM WTI, WTI Where Y WTI, is he COP denominaed CNG income generaed from he sale of oil, and TRM and WTI are he observed raes in. The formula for deermining anual USD volumes is similar. The remaining impus needed for designing hese sressed scenarios are ousanding deb for four all denominaion caegories for he 10 * year period of sudy. These volumes are obained afer applying he S opimal sraegy (so I and Y are acually * * I and Y 75 ). Quanificaion of Impac For consrucing he USD sressed scenario, ineres * * I and revenue Y equaions are reconsidered as he sum of he variable and saionary componens of he currency s evoluion (he procedure for he oher denominaions follows he same logic). Le a = a( TRM ) * * and le I / Y be he opimal ineres o revenue raio. Then, he firs equaion can be rewrien as: a ( TRM ) I I + I TRM = = Y Y Y TRM * * * COP, USD, * * * COP, + USD,. 74 Prices are given by MTFF forecass. 75 The definiion of opimal Y revenue is exogenous o he model. However, for noaion simpliciy, Y is Governmen income once he opimizaion problem has been solved. * * 118

119 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II In his manner, he impac SS q of a shock q o TRM on fiscal susainabiliy in is defined as: ( ) ( ). SS TRM TRM q º a - a + q This equaion is simply a formal quanificaion of how currency depreciaions ( q > 0) or apreciaions ( q < 0) aler he weigh of debservicing coss relaive o CNG revenue. Designing diferen scenarios for a single period of ime is he same as calculaing SS q for differen q values. However, even hough i is posible o aggregae he effec of disressing all variables, i is bes o analyze shocks separaely so ha reacions are no overesimaed or underesimaing when summing he ne effec Resuls Currency composiion of he Fiscal Balance and revenue and expendiure forecass Jus as for he ALM -1 model, baseline variable forecass are sough. In his case, esimaions for exchange raes and oil barrels sold abroad are needed for designing sressed scenarios. Neverheless, deb-servicing is forecased following he model assumpions: i) iniial * oal ousanding deb (in COP) can be redisribued as esablished by he oupu of he opimal sraegy S, and ii) ha deb is payed back a esimaed issue raes. As saed before, forecass for macroeconomic, fiscal and some marke variables are drawn from he MTFF. Resuls for he procedures used are presened in Secion , and are no longer adressed. Anoher aspec worh menioning is ha denominaion composiion resuls do no immediaely rule ou he model resuls, due o how resricions over iniial condiions of he FB composiion are defined (paricularly for revenue srech of he balabce). The ALM-2 model seeks afer fiscal susainabiliy ha only requires a mach beween he currency composiions of ineres paymens and revenue. Hence, i is no necessary, under his scope, o balance ou all of he FB, bu jus he menioned porions of i New deb issues and marke variables The mechanics on deb issuance are described in deail in Secion hereby only resuls for esimaions in Colombia are presened. The values of issuance ineres raes for all denominaions are compiled in Table 10, and resuls show ha WTI ineres raes are 100 bps below USD denominaed bond raes. Inuiively, his spread is he resul of a risk premium ha compensaes invesors for high oil price volailiy 119

120 Minisry of Finance and Public Credi Table 10. Issuance ineres rae Ineres rae Value COP 8.80% UVR 8.56% USD 5.20% WTI 6.20% Idenifying he opimal sraegy Afer describing he forecased FB, issue raes and oher variables involved in he modeling, he problem for finding he * opimal sraegy S is: The opimal CNG deb porfolio srucure ( ) å(,,, ) min f S = D +D +D subjec o : w = 1, w ³ 0 S å USD WTI UVR i i i * S for he period is: * * * * * S = éwcop, wuvr, wusd, w ù ë WTI û = 45%,15%,30%,10% [ ] Thus, he opimal ALM-2 sraegy grans inernal deb 60% of he porfolio (UVR and COP), while he remaining 40% is exernal deb (USD and WTI). This soluion suggess an increase in exernal deb paricipaion relaive o he curren composiion of he deb porfolio (75% inernal deb and 25% exernal deb): Curren S = [ 57%,18%, 25%,0% ] According o he sraegy, inernal deb is reduced by 15% of he oal balance (a he beginning of he period). The redisribuion of he porfolio would be noed as follows: S [ 12%, 3%, 5%, 10% ] * Curren - S = To analyzie changes of WTI and USD paricipaions in his resuling MTDS implemenaion, i is necessary o evaluae he COP equivalen implicaions of hese percerage changes in ousanding deb balance. Wih June 2012 numbers for he deb porfolio, where ousanding deb amouned o COP 212 rillion and he impac of a hypoheical ransiion owards he opimal sraegy suggesed by he model is: 120

121 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II Table 11. Transiion o ALM-2 opimal sraegy Marke Denominaion Curren Opimal sraegy Difference Paricipaion COP equivalen Paricipaion COP equivalen Paricipaion COP equivalen Inernal deb COP 57% 120,725,412 45% 95,309,536-12% -25,415,876 UVR 18% 38,123,814 15% 31,769,845-3% -6,353,969 Toal inernal deb 75% 158,849,227 60% 127,079,381-15% -31,769,845 Exernal deb USD 25% 52,949,742 30% 63,539,691 5% 10,589,948 WTI 0% 0 10% 21,179,897 10% 21,179,897 Toal exerna deb 25% 52,949,742 40% 84,719,588 15% 31,769,845 PORTFOLIO 100% 211,798, % 211,798,969 0% 0 Due o he magniude of modificaions o he porfolio, if his deb sraegy were adoped, i would be imperaive for he CNG and he policy auhoriies o define plans of adjusmen during he ransiion period. These plans should minimize he effecs significanly reducind he COP and UVR denominaed porion of he porfolio, in favor of higher foreign currency and WTI percenages. The Governmen would have o assure ha i does no impose oo much pressure o any of he wo markes (inernal and exernal), and cause an increase in raes or a reducion of inversor pools Sressed scenarios * Besides consideraions of recomposing he deb porfolio, he opimal MTDS ( S ) minimizes he effecs of exogenous shocks, like exchange raes and oil prices flucuaions, on he deb-servicing (ineress)/cng oal revenue relaion. For = 2012, exchange rae flucuaions of ± 50% and oil price shocks of 25 USD were considered. I is worh noing ha he base scenario corresponds o he MTMF, which considers an annual average TRM of COP 1800 and an average oil price of USD 92. The resuls of such sressed scenario are as follows: 121

122 Minisry of Finance and Public Credi Table 12. TRM and WTI sressed scenarios Opimal sraegy vs Curren composiion % TRM Ineres Revenue % Ineres % Revenue Raio USD WTI Ineres Revenue % Ineres % Revenue Raio Opimal sraegy Curren -50% 14,235 84, % % 16.92% ,789 90, % -6.02% 17.53% Base 16,269 95, % Base 16,269 95, % 50% 19, , % 18.13% 17.11% 25 16, , % 5.68% 16.68% -50% 16,236 84, % % 19.30% ,336 90, % -6.02% 19.24% Base 17,336 95, % Base 17,336 95, % 50% 19, , % 18.13% 16.70% 25 17, , % 5.68% 17.12% * The resul of disressing he economy over he S sraegy, in erms of vulnerabiliy of he FB for he 2012, is ha ± 50% flucuaions of he exchange rae do no aler he deb-servicing o oal income raios ( I2012 / Y 2012) in more han 11bps (when q < 0 and here is an appreciaion). In conras, he same variaion applied o he curren deb porfolio shows an increase of 118bps in a devaluaion scenario * (close o 12 imes he effec of he sressed scenario buil from S ), while in an appreciaion scenario, SS q is equal o 142bps (again, * close o 12 imes he effec under S ). * As for WTI, he effecs of a USD 25 movemen are much sronger ha hose of TRM. When esing he S sraegy, hese flucuaions resul Curren in 53bps and -32bps reacion for q =- USD25 and q = USD 25. The resuls for he curren porfolio composiion S reacions of 112bps and 100bps o WTI price variaions, respecively. * As a whole, sraegy S is sill more efficien ha he curren one, in erms of keeping I / Y sable agains shocks in he WTI. Table 13 summarizes he variaions in he I 2012 / Y 2012 resuling from applying he menioned shocks o he baseline (MTFF figures) Table 13. Sressed scenario summary TRM ( q = ± 50 %)) WTI ( q = ± 25 USD) ) MTDS Curren Porfolio MTDS Curren Porfolio q < q >

123 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II Opposie o he ALM-1, his model does no resul in corner soluions for he currency composiion of he porfolio bu are in fac feasible. However, consideraions presened in Secion indicae ha coss of migraing from he curren porfolio srucure o he MTDS suggesed by ALM-2 are no o be underesimaed. Consequenly, resuls of he ALM-2 mus be inerpreed along wih he oher relevan aspecs of he design and wha is mos convenien as a deb sraegy for he CNG ALM generales conclusions This secion presens he resuls, advanages and he limiaions of he wo implemened models under he ALM approach. Discussion of hese resuls is framed in a wide conex ha includes he conceps and hypohesis developed in Chaper Resul summary In his firs approximaion o finding an opimal sraegy, an ALM approach was adoped ha aligned deb managemen sraegy wih FB principles (boh on he asses as on he liabiliies side). Firs, he FB is covered from exchange rae variaions by maching revenue and expendiure USD volumes for every fiscal year considered by he MTFF. However, as he paricipaion of USD denominaions in he revenues is over 30%, on average, for he analyzed period, i impossible o reach a proper mach of fiscal accouns hrough he deb managemen solely. I is also found ha even if he whole deb porfolio was denominaed in USD, deb-servicing coss would no compensae USD denominaed revenue volumes. For his reason, a second approach was considered. I ries o miigae he effecs, over deb-servicing cos paricipaion and fiscal susainabiliy, of marke volailiy for exchange raes and oil prices (ha is, sabiliy of he ineres/revenue raio for every fiscal year). The resuls for his second approach are a more viable deb porfolio currency composiion, in erms of implemenaion. Neverheless, he model sill suggess a large migraion o USD denominaed deb, relaive o he curren porfolio. The ALM-2 model o elevae he foreign currency denominaed porion of he porfolio o 40%, and curren levels are a only 25% (as of June 2012) ALM advanages One of he mos aracive aspecs of his approach, idenified by governmens all over he world, is ha i allows hem o manage he FB s risks hrough coordinae policies on fiscal, moneary, and currency exchange frons (see Chaper 2). Under he ALM approach, he deb sraegy works as a ool o link revenues and liabiliies of he governmen s FB, making heir currency composiion similar so ha idenified risks can be effecively hedged and miigaed. 76 These aspecs were deal wih in Chaper

124 Minisry of Finance and Public Credi In fac, despie he ALM-1 resuls, maching boh sides of he FB by using hese deb managemen sraegies comes as a naural choice for sabilizing governmen finances, even when facing exogenous macroeconomic shocks o he economy. In his sense, he model recognizes and incorporaes he governmen s asses srucure in he design of a deb managemen sraegy. The ALM-2 is profiable in he way ha uncerainy around volumes of CNG revenues desined for deb-servicing are reduced. Firs auhoriies have more room for assigning he remaining resources o oher expendiures since here is confidence ha addiional financing for ineres paymens will no be necessary (a leas no because of exernal marke behaviors). Likewise, he CNG benefis from reduced deb coss, given ha fiscal susainabiliy srenghens risk perspecives in domesic and foreign markes, and hus reduces risk premiums paid on issuance. Achieving a deb srucure ha maches revenue srucure wih paymen obligaions is appealing for he CNG. However, her are cerain risks relaed o managing deb under ALM guidelines ha need o be considered ALM limiaions Even hough coordinaion beween differen governmen macroeconomic policies, offered by he ALM approach, is one of he Governmens objecives, some underlying dangers of using deb as a sabilizing ool for public finances are no be forgoen Model limiaions The ALM-1 model ries o mach he currency composiion of CNG revenue and expendiure in he FB, for every fiscal erm. However, he model s specificaion does no consider he size of he balance in a sric sense 77. For example, an increase of he CNG forecased revenue, anbove curren expendiures, makes i is necessary for he Governmen o increase expendiure and generae higher ineress. Since higher ineress are only achieved wih new deb, fresh issuings are in order. However, since his new liabiliies are no mean for financing CNG expendiure bu raher for immunizing he FB agains exogenous shocks, his new deb is considered inefficien and unnecessary. Thereby, he model ignores prudence and susainabiliy principles in is specificaion and in fac recommends increases in deb-servicing coss when unexpeced surges in he revenues come along 78. This would lead o large and unmanageable FB when he economy downurns. If revenues in cerain denominaion drop, he model would recommend o immediaely liquidae he percenage of deb porfolio in ha denominaion 79. Reducing he deb porfolio is no an easy ask 80 and i leads o very high moneary and repuaional coss for 77 The example presened in Secion ignored nominal moneary volumes of he FB and only focused in porfolio composiion. 78 Noice ha MTFF forecass consider fiscal primary surpluses saring in 2013, and would herefore no be unexpeced. 79 If shocks are inernal, he prion of he porfolio o liquidae would be he COP denominaed srech. Foreign shocks would demand USD denominaed deb liquidaion. 80 Liabiliy managemen operaions (exchange managemen ransacions, repurchases, ec.) which modify he erms of he ousanding deb porfolio a a moderae cos are no only a CNG decision, bu also depend he macroeconomic enviromen and on marke agen perspecives. Furher explanaion of hese operaions is found in Secion

125 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II which governmens are in general renuen o apply hese measures 81. Ahough ALM-1 ries o minimize fiscal defici vulnerabiliy agains exogenous variaions in he exchange rae and oil prices, is implemenaion could lead o high levels of expendiures ha hreaen he Governmen s fiscal susainabiliy. The ALM-2 on he conrary, only ses ou o guaranee fiscal susainabiliy in line wih defined fiscal forecass. Therefore, he model gives feasable resuls in erms of implemenaion. Alhough more realisic, he ALM-2 shares he srong dependency o revenue srucures of he ALM-1. This is, if he denominaion composiion of forecased revenues is modified { Yi, : ³ 2012}, hen he resuling opimal sraegy will ' ' also differ. For example, if here is new revenue forecas { Y : ³ 2012} considered, where YUSD, > YUSD, ", hen he opimal sraegies ' would also differ: wusd > wusd, i.e., he model recommends deb porfolio srucures wih higher foreign currency paricipaion. Consequenly, if he revenue s fuure behavior is significanly deviaes from he MTFF s forecass incorporaed in he ALM-2, hen he opimal sraegy would no only no be inefficien, bu could also lead o procyclicaliy and high rollover coss (previously idenified in he ALM-1 model). Finally, i is worh noicing ha boh ALM models ignore ransiion coss of migraing from he curren deb porfolio o he resuling opimal sraegy. These models sugges an ideal srucure where differen FB risks (mainly generaed by exchange raes volailiy) are miigaed by choosing an adequae MTDS. However, he coss of recomposing (refinancing) he deb porfolio are very high, for which hese should be del wih wih more deph and be incorporaed in he model Approach limiaions The ALM approach o deb managemen reflecs he will of Governmen insiuions o define coordinaed policies oriened owards fiscal susainabiliy. The approach implies ha deb sraegy is defined as a funcion of CNG revenue and no he oher way around, hus making deb sraegies passive insrumens of fiscal managemen. Accordingly, deb only accompanies ohe expendiure policies aimed o give sabiliy o CNG asses and liabiliies. Even hough CNG revenue dynamics are affeced by similar ses of variables o hose ha disress deb porfolios, addiional consideraions are aken ino accoun by policy makers when designing sraegies for managing each one of hese separaely. Hence, i is fundamenal o explore oher mechanisms ha broaden he analysis. 81 For deails on refinancing risk see Secion Coss of refinancing deb are porfolio recomposiion coss every ime forecass do no mach real oucomes. 125

126 Minisry of Finance and Public Credi Alernaives and perspecives The message his Secion wans o deliver so far is no ha differences beween deb, revenue and oher expendiure behavior rule ou he possibiliy of defining coordinaed economic policies ha seek a common fiscal objecive. Insead, i means o highligh he risks of using deb managemen sraegies as a ool for accomplishing objecives ou of he deb managemen s reach 83. Following his argumen, many counries have adoped anoher series of policies for managing revenues and sabilizing fiscal accouns, independen from deb managemen sraegies. A good example is Denmark, a counry whose exensive use of financial derivaives for almos 30 years has allowed he governmen o successfully manage exchange rae risks in is deb porfolio 84. Anoher example, closer o he Colombia, is Mexico. This an oil producing counry wih high levels of USD denominaed income in is revenue, very much like Colombia. Consequenly, he governmen has implemened oil revenue sabilizing mechamisms by implemening derivaive hedging sraegies. In paricular, heir sraegy consiss in purchashing pu opions o be execue when he oil barril prices fall below he value negoiaed by he governmen (defined according o he mexicam oil producion condiions). Wih his, he effecs of adverse shocks o he oil prices on Mexican fiscal accouns are hedged. In fac, in 2009, he Mexican governmen was able o hedge 330 million barrels (close o 23 billion USD) wih a premium cos of only 1,5 billion USD. The effeciveness of implemening similar hedges in Colombia depends on regulaory and echnical developmens in he counry. Such sraegies are only possible when here are comprehensive legal frameworks for rading derivaives, as well as echnical sudies ha deermine hedging requiremens, srike prices, and derivaive pricings. These derivaive managemen ools, differen from deb managemen sraegies, can sabilize he revenue dynamics, providing business cycle and FB managemen alernaives o deb adminisraors. Wih he implemenaion of such hedges, a MTDS design could concenrae on conrolling risks only relaed o he deb porfolio, insead of aiming o miigae risks ha belong o oher fields. In his sense, he Relaive Cos a Risk model (RCaR) comes as an alernaive ha quanifies he Cos vs Risk relaion. The model addresses currency risk wihou considerind is implicaions on fiscal accouns. Consequenly, he only objecive of deb managemen under his scope is o saisfy CNG financing needs on each fiscal erm. 6. RCaR Cos v.s. Risk mehodology The ALM approach capured he CNG revenue srucure dynamics, bu had several limiaions. One of he mos imporan ones is he impossibiliy of analyzing differen sraegies under risk/cos crieria, which would allow he manager o decide on opimal economic policies. 83 Secion discusses hese elemens from he perspecive of inegraing Governmen exchange rae, moneary, and fiscal policies. 84 See Secion for more deails. 126

127 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II This limiaion rises from considering marke, fiscal and macroeconomic variables as an inpu, and oupuing a sole opimal deb sraegy, mean o saisfy he model s objecives. In his sense, resuling sraegies are only opimal under he specific scenerios on which hey were modeled bu are no comparable if addiional or differen crieria are inroduced. For his reason, he DGCPTN adops he following approach, which allows he incorporaion of explici fiscal cos and risks measures derived from a paricular deb sraegy. In a way, he Cos vs Risk mehodology rises as an answer o he limiaions of he ALM approach Model preliminaries Exchange rae volailiy coss and risks The significa effec ha foreign marke behavior has on Colombian economy; in par beacause of is commercial agreemens wih oher governmens and o access o exernal financing sources, make i necessary o include exchange rae consideraions in deb and fiscal accoun managemen. Some of he idenified coss and risks of variaions in he USD denominaed porion of he deb porfolio are: Cos: coupon spreads beween USD denominaed bonds and COP denominaed deb (currenly around 200bps and 300bps), imply ha USD deb has, a priori, lower ineres raes. Therefore, more USD denominaions in he deb porfolio mean lower ineres raes and lower deb-servicing coss for he CNG. Risk: ineres rae adjumens for USD denominaed deb, due o currency depreciaion can easily offse savings derived from higher USD conraced deb volumes 85. Therefore, he purpose of his mehodological approach is o quanify fiscal risk he effec of TRM volailiy. The model means o evaluae he coss and risks of following a paricular sraegy insead of seeking afer specifical fiscal susainabiliy objecives Deerminan Analysis Markowiz Porfolio Theory Hisorically, COP denominaed deb issues are more expensive han USD denominaed ones. This fac was evidenced by he esimaed issue raes in he ALM-2 model: 8.80% for COP, 8.56% for UVR, and only 5.20% for USD denominaed deb (see Secion 5.2.1). In reurn, USD quoes resuls riskier bu less cosly (he USD), while oher are less risky bu more expensive (COP). 85 Increasing USD percenages of ousanding deb affecs he enire new USD denominaed porfolio, while savings only rise wih new issues. 127

128 Minisry of Finance and Public Credi This argumen is similar o Markowiz Porfolio Theory, where in a porfolio consiued by wo asses of he same naure, profiabliliy comes in hand wih higher risks. This paricular approach o he analysis is useful when implicaions for he presen value of deb servicing coss are discussed Deb indicaors Cos and risk measuremens mus be defined based on cerain variables ha reflec and/or measure deb performance. The model s flexibiliy for selecing an indicaor ha suis paricular economic policy represens an advanage over he ALM approach. For he effecs of hese exercises, he following deb indicaors were chosen: 1. Toal ousanding deb (measured a he end of he fiscal year). 2. Deb-servicing presen value 87 (during he 10 year ime window 88 ). The reason for choosing hese indicaors is ha hey capure shor and long-erm feaures of public deb Framework This model individualy evaluaes each sraegy, and oupus a (Cos, Risk) vecor, in six basic sages: 1. Idenifying indicaors and defining implied coss and risks. 2. Defining addiional benchmarks, oher an currency composiion. 3. Forecasing primary FB and oher macroeconomic variables Forecasing marke variables. 5. Defining new issue characerisics Insrumens and financing needs Cos vs risk analysis. 86 See he resuls subsecion for more deail. 87 Deb-servicing coss are ineres and amorizaion paymens. 88 The opens when he model is firs implemened and closes 5 fiscal years aferwards, o he day. 89 Resuls consider a 5 fiscal year ime frame for modeling. If modeling sars on Augus , he ime span will end on December The RCaR considers he las measured deb invenory volumes, before modeling. This allows o measure financing needs in erms of fiscal assumpions and ousanding deb. 128

129 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II Idenifying indicaors The definiion of he wo used indicaors is moivaed by he need o rea medium and long-erm feaures of he deb porfolio separaely. Aferwards, measures for quanifying coss and risks are seled, and he reasoning for choosing hese wo indicaors is presened nex Toal ousanding deb (long-erm indicaor) This indicaor evaluaes CNG capaciy of mainaining a susainable deb porfolio hrough ime, given ha final ousanding deb volumes are he saring poin for calibraing he MTDS every fiscal erm. Ousanding volumes are shown un nominal curren COP. Noneheless, his indicaor does no capure fiscal variaions coming from cashflow oulays on each period. As such, he oal ousanding deb indicaor for ime T = December expressed curren COP (here on ousanding deb ) is noed as OD Presen value of deb-servicing coss (medium-erm indicaor) This indicaor measures he medium-erm fiscal effecs of new deb issuings, in erms of generaed periodical paymen obligaions of iniial ousanding deb invenories. In his way, his indicaor complemens ousanding deb indicaors by incorporaing cash flow and financing need consideraions. As such, he presen value of deb-servicing coss is Indicaor = åpv ( ineress + amorizaions) where PV denoes he presen value 0 T of flows in = 0 (when he model is firs implemened, inhis case June ) Cos and risk measures Firs of all, since indicaors are dependen of sochasically simulaed marke variables, hey are random variables hemselves. Now, he cos of a given deb issuance sraegy is defined as he expeced value of he chosen indicaors while risk is measured as he difference beween he 95h percenile and he expeced value of he indicaor. Formally, his is: [ ] Cos = E Indicaor [ ] [ ] Risk = P Indicaor - Indicaor 95 E 129

130 Minisry of Finance and Public Credi For example, he cos measure of presen value deb-servicing coss in 2017 would be: Cos = E[ DPV 2017 ] Moving on, he selecion of he 95h percenile ( P 95) as a risk measure aims o incorporae sufficienly sressed scenarios o he model. In fac, his is a sressed risk measure in erms of cos measuremens 91. Figure 46 he probabiliy disribuion for ousanding deb in a 5 year ime frame given a specific issuing sraegy, from which measures are calculaed. Figure 46. Relaive Cos a Risk (RCaR)* *COP Tln Definiion of he remaining benchmarks The srucure of he remaining porfolio benchmarks is based on currenly DGCPTN implemened pracices for new deb issues. In consequence, he model s resuls gain relevance in erms of idenifying policy ha bes suis esablished and implemened regulaions. The srucure of each benchmark is oulined as follows: 91 This is why he model is dubbed a Relaive Cos a Risk (RCaR) model. 130

131 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II Ineres rae benchmark: Local currency issuances, boh in COP and UVR, are currenly issued a a fixed rae, which is why his benchmark is only relevan for issuances in foreign currency. For he laer, a share of 20% of he issuances are floaing-rae securiies and 80% are fixed-rae asses. Variable rae issuances are indexed a 3 monhs LIBOR, according o he curren bonds in he governmen s deb porfolio o he dae. Mauriy benchmark: several srucures of differen mauriies are considered according o he ype of insrumen being deal wih. Issuances in COP: 5, 10 and15 years mauriies. Issuances in UVR: 5, 10 and 20 years mauriies. Issuances in foreign currency: 5, 10 and 30 years mauriies. As menioned in previous chapers, exernal markes allow longer mauriy issuings han local ones do. This fac is observed in he way he Colombian deb porfolio is srucured. On he oher hand, UVR issuances allow slighly longer erms han COP noes, since here is no risk of real value los in high inflaion scenarios for hese invesmens. Index benchmark: since price variaions lead o deb-servicing volailiy, UVR indexed securiies mean o miigae inflaion risks. As such, 80% of inernal deb is COP denominaed, while 20% UVR indexed bonds 92. Table 14 summarizes he srucure of he previously described benchmarks. Table 14. Benchmark summary Benchmark Class Descripion Ineres rae Fixed 80% Floaing 20% COP 5, 10 y 15 Mauriy UVR 5, 10 y 20 USD 5, 10 y 30 Index COP 80% Inflaion 20% 92 When his documen was las reviewed, UVR was a a COP Unless here is deflaion in he economy, UVR has an uprend. 131

132 Minisry of Finance and Public Credi Primary FB and oher macroeconomic variables The Cos-Risk approach focuses on deb issues and leaves ou paricular consideraions of CNG fiscal asses. On his noe, he main purpose of deb issuing is o saisfy he CNG s financial needs, given by deducing deb service from he Primary FB. This is summarized in he following equaion: Financial needs = Primary Balance -(Ineress + Amorizaions ) In order o appropriaely define required deb issuance amouns, Primary FB are considered exogenous inpus o he model and are aken direcly from he MTFF. This model acknowledges ha expendiure behavior is no consisen hroughou every budgeary cycle. On he conrary, i recognizes here are periods where he governmen is obliged o incur in addiional expendiure and ohers where fewer expenses execued. Thus, a quarerly division of he fiscal year, and annual financial needs are mean o be saisfied quarerly. For example, a 20/20/20/40 scheme may be adoped in he percenage division of he expendiure during each erm, which means concenraing a 40% of he oal annual expendiure in he fourh quarer of he year, and 20% in each of he oher quarers. I should be noed ha, in spie of he fac ha primary bond aucions are held in he middle of every quarer, fiscal variables are aken as of he end of he quarer (March 31, June 30, Sepember 30 and December 31). Therefore, he amoun of deb required in each aucion corresponds o he needed volume a he end of he quarer. Finally, he Governmen defines every currency denominaion share in he deb porfolio in line wih he chosen MTDS. Therefore, he previous equaion only defines he amoun in COP of he oal issuance for each period Marke Variables The se of variables o be esimaed should be aken ino accoun before formally inroducing he model. In line wih his, Table 15 shows he six analyzed marke variables, along wih he inpus required for simulaing each variable. 132

133 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II Table 15. RCaR marke variables Variable Inpu COP Ineres rae Hisoric β 0, β 1, β 2 & COP CEC UVR Ineres rae COP CEC + inflaion adjusmen USD Ineres rae Hisoric Curva + β Calibraion 3M LIBOR rae Hisoric Curva + β Calibraion 6M LIBOR rae Adjused 3M LIBOR rae + Correcion TRM (COP/USD) Hisoric TRM + MTFF rend UVR exchange rae MTFF forecass These variables, modeled hough sochasic simulaion rials, enable he analysis of deb composiions under several possible scenarios. This procedure is crucial for esimaing he risks associaed o issuance sraegies, since appreciaion, depreciaion and differen fuure ineres rae curves affec he erms of fuure deb issuings. In order o avoid unnecessary volailiy, variables wih daily quoes are normalized o monhly enrie. The corresponding daa is rewrien on a monhly basis wih he following equaion 93 : x i, 1 = å xj. M i, j Î M i, Where x i, is he value of he variable i in monh, M denoes he days of he monh on which here is available daa for variable i, i, and M i, denoes he number wih available daa. Therefore, x i, is a simple average of he available observaions of a variable. Ineres and exchange raes were esimaed separaely bu in order o incorporae marke rae ineracions, correlaions beween he wo variables were incorporaed and esimaed. 93 Variables convered o a monhly basis were: COP and USD ineres rae (is beas) and 3 monh LIBOR raes. UVR and 6 monh LIBOR raes are modeled based on he firs raes, and herefore have monhly periodiciy by definiion. 133

134 Minisry of Finance and Public Credi COP ineres rae The simulaion of he COP ineres rae consiss in building a yield curve for each momen in ime. The forcas of a paricular fuure COP ineres rae requires deermining raes for every momen in ime afer he firs dae. For conveniency, he Nelson & Siegel model (1987) is implemened o simulae COP yield curves. The model esimaes he complee yield curve (CEC) as a liquid, smooh funcions for every node 94, robus agains small marke variable flucuaions. This model is able o oupu all sors of yield curves (seep, invered, verically displaced, among ohers) wih only four inpus: b, 0 b, 1 b and. Accordingly, by modeling he behavior of hese four parameers, he 2 model produces a complee forecas of he yield curve for each momen in ime. Before moving forward wih he RCaR mehodology, some useful rae consideraions of Nelson & Siegel (1987) are explained. Nelson & Siegel Relevan conceps This model does no only have he advanage of producing yield curves wih he desired characerisics menioned above, bu i also allows drawing conclusions from basic correlaions beween parameers. In fac, he model suggess some degree of ineracion beween variables, and he specificaion is summarized as follows: ( ) rm= b + b e + b e - m / [( m ) - m / ] In his equaion, m is he mauriy for which ineres rae is evaluaed (measured in years) and is known as he decay parameer (his parameer does no affec any oher erm in he equaion, oher han mauriies). Values b 0, b 1, and b 2 are he parameers ha direcly affec he value of ineres raes, given an iniial mauriy m. Now, o find he long and shor erm nodes of he yield curves, i is necessary o solve he following equaions: Long - Term Rae : lim rm ( ) = b m 0 Shor - Term Rae : lim rm ( ) = b + b m Afer solving for parameers, he model generaes he following expressions are found: Shor Term Rae: b0 + b1. 94 I does no have pronounced changes and is firs derivaive is coninuous. 134

135 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II Long-erm Rae: b 0. In hese soluions, b 1 (shor erm) represens he curve s slope and b 2 (medium erm) represens is curvaure. In he model, he decay parameer is lef unchanged hroughou he whole simulaion. As i will be saed laer, he idenificaion of he shor erm raes based on he model parameers is fundamenal, bu he deails on he procedure ha leads o hese conclusions are no deal wih since hey are no relevan for he developmen of he RCaR. Esimaion of RCaR raes Single facor model Using a single facor model for esimaing ineres raes means ha, insead of deermining he fuure behavior of he four Nelson & Siegel parameers, only one parameer is modeled, while naural (consan) seady saes are assumed for he oher hree. In his sense, b 0 has been chosen as he deermining facor for yield curve simulaions. The reason for doing so is ha b 0 is he long-erm componen of he curve an i ouweighs all of he oher parameers. In fac, Diebold & Li (2006) esablish ha he difference beween wo idenical CEC yield curves in differen momens in ime, may be aribued o he long-erm componen of he curve ( b ) and b 0 1, b 2, and can be assumed as consans in he model. In order o reduce he uncerainy derived from working wih such a wide ime horizon, he use of he CKLS model 95 for shor-erm raes is recommended. Therefore, he CKLS model is implemened for esimaing shor-erm marke raes r in COP, where r = b0 + b1. For calculaing he seady saes values for b 1 and b 2, AR(1) 96 models are used, based Infoval 97 daa bases. The decay facor is lef consan, according o Diebold & Li assumpions 98. The seps for modeling he raes, following Nelson & Siegel (1987) and Diebol & Li s (2006) are: 1. Obaining hisorical daa b 0, b and b 1 2 ( consan hroughou he analysis). 2. Modeling shor erm rae r based on he hisorical b0 + b1. The ineres rae CKLS approach resuls in a forecas for r. The equaion ha describes he sochasic process used in he CKLS approach is: ( ) g. dr = l m- r d + s r dz 95 See Chan e al. (1992) for furher deail. 96 Firs order auo-regresive model: x = a0 + a1x 1 +. For furher deails see Wooldridge (2006). 97 Infoval is he Eniy in charge of providing prices for domesic fixed income markes in Colombia. For furher references, go o 98 Following Diebold & Li s (2006),» 1,3684. This value is esimaed by maximizing he facors weigh in he equaion for he medium-erm. In Nelson-Siegel, = 1/, bu given ha Diebold y Li use a monhly-basis version of Nelson-Siegel, hen = 1/ ( 12 l). 135

136 Minisry of Finance and Public Credi Where r is he shor-erm rae in ime ; dr and d are differenial increases of raes and ime; dz is he Wiener process 99 associaed o variance d ; l is he mean reversion velociy; m is he drif; and g is a weighing facor ha links shor-erm rae wih annual shor-erm volailiy s. The fi and consisency of hese COP ineres raes curve esimaions depends on appropriae calibraions of parameers l, m, s and g. For esimaing hese parameers, a Generalized Momen Mehod (GMM) 100 based on b s hisorical series. 3 Obaining long-erm esimaions for parameers b 1 and b 2 (naural seady saes). Long-erm values for b 1 and b 2, are denoed as b and 1 b 2 and are obained using an AR(1) model. 4. Forecasing b 0. In his sep, resuls of seps 2 and 3 are combined: r = b0 + b1. Then, he ideniy is rewrien as b0 = r - b1. Once he model for r is calibraed (sep 2), b 1 is replaced by b 1 found (sep 3), and finally esimae b 0. Nelson & Siegel parameers for every insan s in he 5 year imeframe can be expressed as b 0,s, b 1,s, b 2,s and s, as follows: s» (Diebold & Li, 2006). b = b. Where b 1 is esimaed wih an AR(1). 1, s 1 b 2, s = b2 1. Where b 2 is esimaed wih an AR(1). b0, s = r0 - b1. Where r 0 is he resul of evaluaing he sochasic process r in = 0. Under he model s assumpions, r = b + b is he CKLS esimae for shor-erm insananeous raes I is worh menioning ha, even hough aribuing all of he curves variaion o b 0 may seem resricive, he assumpion is aligned wih long-erm policy objecives 101 of MTDS design making curvaure and slope feaures less concerning. Noneheless, i is acknowledged ha seepenings and flaenings of yield curves are commonly observed due o marke circumsances on a daily or weekly basis. Rae scenario simulaion The procedure presened so far indicaes ha, in order o simulae various pahs for ineres rae variables (meaning, generaing COP yield curves (CEC) randomly), i is enough o randomly disress he values for b 0 for as many simulaions as needed. This means ha if you wish o simulae n ineres raes (n Nelson-Siegel yield curves), hen n Wiener processes, as he one indicaed in he CKLS equaion, should be generaed. 99 This erm gives randomness o he model. Implicaions of his feaure will be addressed laer. 100 For deails, see he Apendix. 101 The 5 year imeframe is longer han he one facored by privae marke agens, whose ineress are focused on shor o medium-erm flucuaions (2 years a he mos). 136

137 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II This is: n processes : dz ~ N(0,d) Having simulaed ineres rae variables, he esimaed chosen pah is calculaed as he mean value of all of he ineres rae random walks. The resul is a se of yield curves for each monh of chosen 5 year imeframe UVR ineres rae Theoreic consideraions menioned for he COP yield curve apply o his variable, meaning ha simulaions of complee yield curves for each momen in he imeframe are needed. Accordingly, he resuling curves mus be smooh funcions wih lile sensiiviy o volailiy, described in erms of few parameers. In his regard, UVR is a variable ha, by definiion, reflecs and correcs variaions in level prices of he economy. As such, UVR flucuaions capure volailiy in real erms, which are subsequenly adjused and incorporaed nominal flucuaions. Therefore, he baseline for building UVR yield curves is he respecive COP yield curve, adjused wih Fischer s equaion on every node wih forecased MTFF inflaion daa. The real ineres rae ( i R ) is relaed o nominal ineres raes ( i N ) and o inflaion (p ) as follows: ( + i ) = ( + i ) ( + p) N R Thus, real raes (in fac, raes for UVR yield curves) are based on he nominal COP curve and are calculaed wih he following equaion: i R 1+ in = p These moneary ideniies rule ou he need of oher models for calculaing UVR ineres raes or generaing model simulaions USD bond raes Ineres raes for USD denominaed bonds, issued by he Governmen of Colombia, are esimaed using he same mehodology applies for COP raes. This is, esimaing Nelson-Siegel parameers, where hree of hem ar long-erm seady saes and he fourh is esimaed wih he CKLS model. 137

138 Minisry of Finance and Public Credi However, someimes hisorical b daa is no available. In order o keep consisency wih how oher raes were obained, b s and are inferred from hisorical yield curves published in Bloomberg. This means ha for each dae wih available USD yield curves, b 0, b 1, b 2, and are calculaed ex pos in order o creae a hisorical parameer daa base. Having consruced such base, he yield curve is esimaed wih a single facor model and under he CKLS for shor erm raes monh LIBOR The 3M LIBOR rae is he reference rae for loans and deb securiies issued in USD denominaion. I is also he rae a which shor erm USD denominaed deb is indexed. For his reason, i is an indispensable inpu for he RCaR model. For simulaing his rae, he same procedure of USD yield curves is implemened: a Nelson-Siegel parameer daa base is creaed (based on 3M LIBOR curves found in Bloomberg) and hen he same modeling seps are followed monh LIBOR Even hough he new deb issued is no indexed o 6M LIBOR raes, some ousanding mulilaeral loans have his reference. Therefore, esimaing his rae is necessary for he calculaion of fuure flows. Exercises carried ou by he DGCPTN aimed a evaluaing he 6M rae s behavior in relaion o he 3M LIBOR rae. Resuls show a high correlaion beween hese wo erms, for which he 6M rae is esimaed based on he 3M reference. Using a simple linear regression model: Libor 6 = a Libor. 0 + a 1 3, he 6M quoe is found Exchange rae Randomly simulaed exchange raes mus incorporae MTFF forecased TRM rends for calculaing he 95% confidence inervals used in he RCaR model. For his purpose, and in line wih TRM modeling of ALM-1, he BGM mehodology was implemened, since i incorporaes specific ad hoc rends and volailiy parameers. The process is formally represened by he following equaion 102 : ( 2 /2) d TRM = TRM e m - s + s W -1. Where m is TRM depreciaion (or appreciaion) rend in,d represens change in ime as a fracion of a year, s is annual TRM volailiy and W represens a Geomeric Brownian Moion process for TRM. 102 For deails see Secion

139 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II Correlaions beween raes Jus as in he ALM-1 model in Secion 5.1, he RCaR capures ineracions beween prices and raes. However, while ALM-1 only considers some of hese relaions, he RCaR broadened he model and incorporaed correlaions beween all variables. Jus as before, a correlaion marix is facored wih Cholesky decomposiions, hus inroducing randomness o he model Deb issuing Insrumens and financing needs For defining issuing condiions, esablishing he desired characerisics of he securiies and how cash flows are esimaed is key. Therefore, he following specificaions of he model are clarified: Bulle bonds: These are securiies wih no inermediae amorizaions implying ha he enire par value is paid upon mauriy. Mauriy benchmarks: Condiions on he daes when principals are repaid follow he guidelines of he prior Secion for all issues (see Table 14). Ineres rae composiion: Jus as for mauriy benchmarks, hese follow he same srucure of he prior Secion (see Table 14). All bonds are issued wih fixed raes excep for hose wih 5 year mauriies, denominaed in USD. These las bonds use 3M LIBOR as a rae benchmark, and correspond o 20% of oal exernal deb. Currencies: Local currencies are COP and UVR 103, while he only foreign currency considered is USD, given he low percenage of ousanding deb in oher currencies. Ineres rae benchmark: coupon rae are marke benchmark raes for each insrumen, For insance, he COP denominaed yield curve is used as benchmark for bond issues in COP, and USD yield curves for USD denominaed bond issues. Issue raes: For simpliciy, and o avoid unnecessary noise in he simulaions, new bonds are issued a par value 104. This assumpion allows he model o value, in a fairly simple way, he coupon wih which fixed rae deb is issued and he margins for floaing rae bonds. Moreover, firs consider a bulle bond wih annual coupons c issued a par. From he basic bond valuaion formula, he price (equal o 1 since he bond was issued a par) mus be equal o he presen value of all fuure cash flows: T å = 1 [ ] DF ( c d ) + DF = 1 T 103 In his conex, UVR is par of he indexing benchmark. 104 Bond are a par value when is pricing is equal o he value of he principal. If he price is below (above) he principal, hen i is issued on discoun (a premium). 139

140 Minisry of Finance and Public Credi Where T is he number of paymens o mauriy, relaive o he bond s paymen srucure 105. Equaing for coupons, he equaion becomes: DF is he discoun facor for ime and d is he frequency of coupon insallmens c = å 1- DF T = 1 T DF ( d ) I is worh noing ha discoun facors calculaed wih simulaed yield curves are differen for every ineres rae simulaion rial, hus creaing a disribuion for every bond s coupons. For floaing-rae bonds, where margins are esimaed insead of coupons, he valuaion formula is: Where L 3, is 3M LIBOR in. 1- DFT m = - T DF d å T å å L = 1 3, T DF DF = 1 = 1 Aucion periodiciy: The models incorporaes 4 issues per year. The firs comes righ in he middle of he firs quarer, in February 15, he following in May 15, hen anoher Augus 15 and a final one in November 15. Bond aucion reopening: When bonds are issued, hey are placed hrough a limied number of consecuive aucions. When all of hese securiies are placed, he issue is closed o mauriy. In his way, reopening are ruled ou so no bond can be placed in more han one aucion. On his noe, he number of aucions for a paricular securiy depends on is mauriy. For example, for securiies wih 15 year mauriies, a reasonable period for placemen would be wo years. However, if he bond in quesion is due in 5 years, a wo year placemen period would be exaggeraed. Even hough he number of aucions for each mauriy profile is a flexible parameer wihin he model, exercises consider he following aucion srucure, in accordance wih he defined benchmarks: 105 For insance, if he securiy has quarerly paymens, hen d = 1/4. 140

141 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II Table 16. Aucion dynamics New issuings Denominaion Term Mauriy (years) Aucions (years) Ineress COP UVR USD Shor 5 1 Annual Medium 10 1 Annual Long 15 2 Annual Shor 5 1 Annual Medium 11 2 Annual Long 21 2 Annual Shor 5 1 Quarerly Medium 11 2 Semi-annual Long 32 4 Semi-annual Accordingly, long-erm issues wih 32 year mauriies consider a 4 year placemen period; so ha he 30 year benchmark node is reached when half he securiies are placed hrough aucion (see Table 16). The model incorporaes UVR issues wih 1, 5, 11 and 21 year mauriies. Alhough only bulle bonds were inroduced in he modeling, his does no mean ha oher ousanding credi lines wih mulilaeral banking insiuions, or exernal funding vehicles oher han bonds issuance by he Depuy Direcorae of Inernaional Capial Markes, may be modified in heir ineres paymen schedules, amorizaions or insallmens. Moving on, i is worh recognizing ha advancemens in erms of deb issue modeling relaive o he ALM-1 and ALM-2 models branch from wo main facors. Firs, he RCaR considers a higher issue frequency (quarerly insead of annually) and raes are esimaed wih models ha have beer marke fis (CKLS in RCaR vs. LLM in ALM-1). By doing his, fuure ineres paymens are more precise and he overall model provides beer insigh. Breakhroughs also come from he use of differen approaches. The wo ALM models mean o idenify an ideal deb porfolio, based on a given behavior for revenue and expendiure and oher fiscal and marke variables. Therefore, iniial deb invenories only included ousanding liabiliies bu ignore mauriy profiles. Conversely, he RCaR recognizes an iniial deb porfolio and all of is specific mauriy profiles, hus deermining he need for new financing on each fiscal erm as a funcion of ineress and amorizaions. 141

142 Minisry of Finance and Public Credi Cos vs. Risk analysis The resul of his model is a vecor ( CosS, Risk S) for each probable s sraegy. Wih his, plausible a priori chosen sraegies can be evaluaed from an implemenaion perspecive. Addiionally, sraegies are defined according o COP/USD composiions; following foreign currency denominaed issuance assumpions, for which deb indicaors are affeced by sochasically modeled variables; mainly exchange and ineres raes (see Secion 6.2.4) Noaion Formally, he indicaor (a random variable) is a funcion of he chosen sraegy and sochasically modeled parameers. Le IdT Î { OD, DPVT} be a deb indicaor in ime = T and le s be a valid long-erm sraegy in he ime inerval Î (0, T), = T, hen: Id = Id S = Id S r e ( wcop, wusd ; Î(0, T ), Î(0, T )) ( ) ( ) Where sraegy s resuls from he combinaion of USD and COP weighs. and e Î (0, T) w COP and USD w and ineres and exchange raes r Î (0, T ) To illusrae, oal ousanding deb in 2017 ( OD 2017), is he resul of choosing one paricular currency benchmark and specific rajecories for ineres and exchange raes in ha imeframe, spanning from he momen of modeling o In hose erms, coss and risks would be: [ ( )] Cos = E OD S T ( ) ( ) Risk = P éod S ù- éod S ù 95 ë T û E ë T û E OD S is calculaed based on he mean of n simulaions ha ake from he MTFF 95 ë T û is he mean of 5% of he simulaions furhes from he MTFF rend. For his reason, his las erm differs significanly from figures in his documen. Since TRM rends are given by he MTFF, hen [ T ( )] rajecory. On he oher hand, he TRM pah used for compuing P éod ( S) ù As for ineres raes, here are no predeermined pahs o use as rends in he model. However, in calculaing he P é 95 ODT ( S) ù ë û, 5% of he rajecories furhes from he mean are used. In fac, all raes are sressed o a 95% level simulaneously, boh for ineres and currency. 142

143 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II Evaluaed sraegies The RCaR model inegraes sophisicaed echnical and mehodological procedures ha allow incorporaing marke behavior. The objecive of his approach is fairly simple: evaluaing a paricular sraegy in order o assess is coss and risks. In his way, a small se of feasible deb policy sraegies is considered for evaluaion, looking for a clear perspecive on he implicaions of changing percenages of USD denominaed deb in he porfolio. The five chosen schemes are hose ha beer fi all of he desired condiions of a deb sraegy. The upper bound for foreign currency denominaed deb is he opimal sraegy calculaed by he ALM-2 (60% COP denominaed deb and 40% USD 106 ). From here, he oher rial sraegies are proposed by gradually decreasing by 10% he amoun of USD denominaed deb unil he lower bound of no USD deb paricipaion is reached (he leas exposure o currency risk). Formally he se enclosing all of he sraegies is: {( w, w ) = ( 60% + 10%, 40% - 10% ): = 0, ¼,4 } COP USD Sraegies wih a weigh of USD denominaed deb greaer han 40% are lef ou of he analysis, for hey are no a viable poliical choice for he Governmen. These sraegies may hinder he domesic marke s deph and, according o he ALM resuls, may lead o procyclicaliy of he balance, increasing risks when revenue forecass are no me. 6.3.Resuls Having already assessed he deails of he sochasic modeling and a comprehensive framework for developind deb sraegies, he book moves on o presen concree resuls Simulaed variables Giving paricular aenion o TRM forecass because of his variable s impac in deb indicaors, resuls for he simulaions are presened briefly. Here, 10 year average levels for he hree variables ha deermine he characerisics of new issues are presened: Table 17. Average issuance raes Ineres rae Value bps vs COP COP 7.27% 0 bps UVR 4.15% 312 bps USD 4.32% 295 bps 106 For he purpose of his book, USD encompasses all foreign currency denominaions. 143

144 Minisry of Finance and Public Credi The UVR rae is calculaed from nominal raes of COP yield curves (7.27%) and forecased inflaion for he 5 following fiscal years (3% YoY). This gives rise o a 312 bps spread of he UVR relaive o COP ineres rae. The ineres rae-usd spread of 295 bps means ha COP denominaed deb issuance ineres raes cos 68% more han hose of USD issues 107. As for TRM, he average calculaed value unil 2017 is, in probabiliy, equal o he forecass drawn from he MTFF (calculaed by he end of 2012) wih a 1,831 COP/USD exchange rae and 1,800 for he 5 remaining fiscal erms. Neverheless, he P 95 percenile for his variable ses a COP/USD exchange rae of 2,719 by December 31s of 2017, evidencing large deviaions from he rend (see Figure 47). This resul is equivalen o a consan 7.73% COP depreciaion (YoY). Depreciaion is, off course, a sressed scenario where deb deerioraes due o incremens in ousanding deb value in COP for USD denominaed deb, even when he weigh of his issues remains unouched. Figure Exchange rae (TRM) scenarios 107 See Markowiz analysis in Secion

145 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II Cos vs. Risk Analysis Of he proposed deb managemen sraegies, hree are of paricular ineres o he CNG and o deb adminisraors and herefore analyzed in deail: % COP vs 0% USD sraegy ( S ): I evaluaes he risk reducion effec of eliminaing currency risk in new issues. Deb indicaors will only be affeced by TRM flucuaions in prior issues. This sraegy increases COP paricipaion in he porfolio o 90% in % COP vs 20% USD sraegy ( S ): I mainains he curren porfolio composiion unil 2017 (75% COP y 25% USD); for which i is possible o idenify implici coss and risks in he curren porfolio % COP sraegy ( S ): This disribuion of he porfolio is accomplished by implemening he ALM-2 approach. I reduces he ousanding percenage of 60% COP denominaed deb in The sraegies lef ou of his deailed analysis also conribue o building he Cos-Risk curve for each of he indexes, since hey resul from gradually alering he s and generaing he ( CE, R E) objecs in he (Cos,Risk) plane. The resuls for he implemenaion of he firs hree sraegies are as follows: Table 18. Sraegy oucomes Sraegy (COP+UVR/USD) 2017 Porfolio composiion Ousanding deb (2017) Deb-servicing PV ( ) Cos P 95 [ ] Risk %Risk Cos P 95 [ ] Risk %Risk I. 100/0 85/ % % II. 80/20 75/ % % III. 50/50 60/ % % Sraegies Cos Risk/Cos Risk Risk% Cos Risk/Cos Risk Risk% I vs. II % % II vs. III % % I vs. III % % COP Trlln. Table 18 shows he risks and coss of each of he hree seleced issuance sraegies (i.e. I. 100%/10%, II. 80%/20% y III. 60%/40%). For insance, and analyzing under he opic of 2017 ousanding deb, he risk of issuing all of he deb in COP denominaion is valued a COP 27.4 rillion. The las hree rows in Table 18 (i.e., I vs. II, II vs. III y I vs. III), conras he differen proposed sraegies. Numbers in gray depic desirable resuls of cos or risk reducion, while numbers in red mean incremens in hese figures. For example, in he II vs. III 145

146 Minisry of Finance and Public Credi sraegy, he resuling risk increase of shifing from he curren sraegy o a 50%/50% COP-USD sraegy is valued in COP 11.8 rillion (in red) while savings in coss amoun o COP 12.4 rillion (in green). Daa in column %Risk represens he Risk-Cos raio for he differen sraegies, so ha heir performance is compared. Similarly, daa in column Risk/Cos on he lower righ corner of he Table, shows he gains or losses in exposure in Risk-Cos raios when sraegy changes, hus porraying cos risk rade-off. The resuls for he six sraegies in Secion sugges differen currency weighs for he designed MTDS, depending on he conrolled indicaor. Figure 48.a shows he resuls for when oal amoun of ousanding deb OD 2017 were opimized. To he righ, in Figure 48.b, shows resuls for when he variable is he presen value of deb-servicing coss DPV Figure 48. Cos vs Risk resuls As for resuls for final ousanding deb, i is clear how issues wih higher percenages of USD denominaed issues have a larger Risk-Cos raio. Concreely, for every addiional COP 1 rillion reducions in cos derived from sraegy shifs, here is an approximae increase in risk of COP 2 rillion. This clearly illusraes high exposures o currency risk. Analyzing he DPV indicaor, i is clear how porfolios wih higher USD denominaion are riskier and sraegies wih COP percenages higher han 80% are inefficien for here are oher composiions wih more USD paricipaion and equal underlying risk In his sense, he RCaR model is very similar o Markoviz efficien froniers, wih he suble difference of having he efficien srech of he curve in he lower porion of he parabola. 146

147 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II As a maer of fac, cos risk radeoffs indicae ha for porfolios wih more han 75% of COP denominaed liabiliies, COP 1 rillion cos 80 reducions derived ranslae in risk increases valued in COP 0.8 rillion or less. Deails on his ransiions from he curren sraegy ( S ) o he oher sraegies ( S ) and ( S ) are presened nex Toal Ousanding Deb Indicaor: OD Resuls of comparing implemened sraegy scenarios are as follows: Sraegy II Sraegy I ( S S ): Transiioning from he curren sraegy o all COP denominaed issues incurs in an cos increase of COP 3.8 rillion and resuls in a COP 6.6 rillion valued risk drop. In oher words, every addiional COP 1 rillion in coss leads o a COP 1.7 rillion risk drop Sraegy II Sraegy III ( S S ): Transiioning from he curren sraegy o a 50%/50% currency composiion of he issuing sraegy, following he srucure recommended by he ALM-1 wih a final composiion of he porfolio of 60% in COP denominaed deb and 40% USD, would lead o a cos reducion of COP 5.4 rillion and an increase of COP 11.8 rillion in valued risks. This variaions equae a COP 1 o 2.2 rillion raio. Consequenly, resuls confirm ha, even hough USD liabiliies are less cosly for he CNG budge, TRM volailiy exposures may deeriorae he overall deb ouline afer convering o COP, o he poin where iniial savings could urn ino he real coss. However, a deb porfolio denominaed in only local currency implies high rollover risks, and he effors of making Colombia a good issuer wih sound moneary and macroeconomic policy o he eyes of he world would be los. The following analysis of he VPS 2017 indicaor esablishes oher reasons for keeping an acive percenage of USD denominaed deb in CNG porfolios Deb-servicing presen value indicaor: DPV When sudying his new DPV indicaor, resuls urn o be highly dependen of he analyzed ime inerval (in his case ). The effec of some sraegy migraions (II I) reveals he menioned behavior Sraegy II Sraegy I ( S S ). This ransiion leads o increases in boh coss and risks (COP 8.1 rillion and COP 1.1 rillion respecively). I indicaes ha migraing o corner soluions (100% COP deb), would no generae benefis ha make i an opimal decision. In fac, he (Cos, Risk) curve shows ha for every sraegy locaed on he upper segmen of he curve, here is a sraegy on he lower segmen wih he same risk level and lower coss. Thereby, a sraegy Sx in which COP (or UVR) denominaed deb sands around 70% o 80% of he porfolio, represens he same risk level as sraegies wih 100% COP issues (Sraegy I). In fac, sraegy Sx implies a cos reducion ha makes i a dominan sraegy over Sraegy I (see Figure 49). 147

148 Minisry of Finance and Public Credi Figure 49. Deb-servicing sraegy efficiency Sraegy II Sraegy III ( S S ). The migraion causes a cos drop of COP 12.4 rillion; bu a risk increase of COP rillion. Overall, here is a rade-off effec similar o he one of ransiion ( S S ). The reason for i is explained by he Markowiz wo asse porfolio framework (see Secion 6.3.1). One of he asses is highly profiable and risky and he oher one is hardly profiable and safe Now, suppose here is ineres of ransiioning from sraegy ( S ) o sraegy ( S ). As Figure 49 clearly shows, boh coss and risks increase from such a ransiion. The increase in coss is eviden, since MTFF rends used are sable 109 and here is no anicipaed TRM volailiy ha migh lead o depreciaions and impacs on he deb porfolio s value. Consequenly, he dominan effec over he servicing indicaor is he addiional cos of issuing in COP insead of USD denominaed deb since spreads beween he local and foreign raes range around 295bps. Therefore, wih a seady TRM and higher ineres raes in COP, his ransiion (i.e. ( S S )) will lead o higher COP issues a higher coss. Regarding risks, increases are aached o he sressed P 95 scenarios where TRM is volaile and causes exreme depreciaion. As he currency devalues, he COP equivalen of USD denominaed servicing-coss becomes more expensive, hus negaively affecing DPV. Noneheless, his negaive effec will only be relevan when he deb porfolio conains a significan volume of USD deb. For example, if he DPV only conained a USD 1 obligaion, hen depreciaion effecs would be insignifican. On he conrary if i conains he equivalen o COP 100 rillion, even he smalles depreciaion would hinder he DPV indicaor. 109 TRM indicaor is equal o $1800 COP/USD all along he esimaion window, as indicaed on Figure

149 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II 80 According o he prior saemens, resuls show ha if ( S ) is aken as he saruing sraegy, and USD denominaions are gradually 100 replaced by COP servicings in he DPV unil reaching ( S ), a some poin he remaining USD percenages of he porfolio would be so low ha any TRM flucuaion would no harm he indicaor. Formally, consider he differenial in risk as a resul of ransiioning from 100 S and ( S ): 80 ( ) D Risk = R - R = P é 95 DPV ù SéDPV ù (P é 95 DPV ù SéDPV ù ë û - ë û - ë û - ë û ) By definiion, ( S S ) SéDPV ù= C ë û. Reorganizing he erms of he equaion we find an equivalen condiion o he risk increase in scenario D Risk > 0 º P édpv ù P édpv ù ë û - ë û > C - C =DCos Now, i was already proven ha C porfolio, for which: - C > 0, since coss increase from smaller paricipaions of USD denominaions in he deb D Risk > 0 º P é 95 DPV ù P é 95 DPV ù ë û > ë û The previous condiion indicaes ha depreciaions only affec he DPV indicaor when more han 20% of he new issuings are USD denominaed. This means ha ( S ) is riskier han ( S ), only when he firs scenarios are increasingly sressed. Now, Figure 49 shows how, for larger USD paricipaions ha reac o induced TRM depreciaions, and impac he DPV indicaor (deermined by Sraegy Sx), he previous inequaliy is invered. The OD does no behave as servicing cos do, given ha new issues affec he porfolio s oal nominal value afer placemen and DPV is only alered by ineres paymen obligaions. Thus, he speed a which USD issues aler OD causes ha low volumes of his denominaions are able o inver his inequaliy General analysis The RCaR analysis shows, in erms of ousanding deb a he end of he period, an inverse relaion where higher coss implies lower risks for every deb issue sraegy, regardless of is currency composiion or mauriy profile. On he oher hand, in erms of presen value of deb-servicing coss, a horizonal risk-cos curve shows a segmen where coss offse risks more efficienly, very much like Markoviz efficien froniers, in he lower porion of he parabola. Alogeher, aking ino accoun boh indicaors exposed in hese exercises, TRM volailiy significanly impacs deb srucures. Neverheless, here are oher consideraions such as cos efficiency and rollover risk ha are o be incorporaed ino he MTDS design. 149

150 Minisry of Finance and Public Credi 7. General Resuls This chaper summizes he general conclusions of all he exercises developed hroughou he sudy. DGCPTN qualiaive and mehodological breakhroughs are colleced and resuls of he hree developed models are gahered, making emphasis on each of he model s srenghs, limiaions, and weaknesses. Finally, i menions some deb managemen relaed argumens ye o be improved in he following years Qualiaive improvemens in modeling In order o deermine he deb sraegy ha bes fis he Colombian macroeconomic environmen, differen approaches and mehodologies ha capure all he relevan elemens of deb in he analysis were reviewed and he following achievemens were gahered: Reducion on he forecasing ime horizon, from 10 o 5 years: The argumen is based in he fac ha high volailiy of marke variables (ineres rae and exchange rae), causes excessive insabiliy due o increased significance of he random componen on he forecased variables. Idenificaion of local econominc condiions ha migh resric or limi he model s performance 2. This enables he incorporaion of new elemens ino he analysis and complemens laer conclusions of he differen mehods. Developmen of he Cos-Risk approach. Using he RCaR model i is possible o evaluae he individual performance of an ad hoc defined sraegy. This consiues a breakhrough on quaniaive modeling. Under his framework, all examined sraegies represen realisic deb managemen policy alernaives. Linking cos and risk esimaes. This aspec was absen on he ALM approach, where he wo models worked wih he sraegies ha bes fied model objecives defined a prior. Model flexibiliy regarding deb indicaors. As he risk measuremens are more consisen, i is possible o accuraely define indicaors ha capure fiscal feaures. Even hough he only used deb managemen insrumen is he currency composiion of he porfolio, here are oher mechanisms ha help define deb sraegies (e.g. mauriy benchmarks and ineres rae benchmarks). Resuls on exernal deb showed in Chaper 3, display success of placemen sraegies and liabiliy managemen ransacions. These operaions have increased he average life of he porfolio wih liquid 10 year and 30 year nodes and made he yield curve more sable agains inermediae nodes ha prin noise o he model. 110 The bes example for his is he CNG income currency composiion (COP, UVR, USD, WTI). I opens a possibiliy of analyzing oher hedge alernaives from he asse perspecive of he FB (see Secion 5.3). 150

151 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II 7.2. Model resuls This work has esablished guidelines for designing an opimal deb sraegy in Colombia. These guidelines are based on he foreign currency composiion srucures of he deb porfolio. Resuls for he hree separae models are lised nex ALM-1 This model esimaes a deb porfolio composiion ha minimizes he presen value of fiscal defi ci volailiy. One of he main conclusions was ha income currency composiion (around 32%) made i impossible o generae deb sraegies ha balance revenues and expendiures (which represens 17% of revenues), for he period and 2022 forecass ALM-2 The ALM-2 model addresses limiaions of ALM-1 approach. This model aims o immunize he ineres/revenue raio. Jus as for ALM-1 resuls, his model suggess a ransiion o deb porfolios wih higher USD denominaion percenages (up o 40%), making he sraegy more feasible. However, he opimal deb sraegy has some procyclical feaures, since i dependens on he performance of he mining and energy secor. In his sense, if performance expecaions are no fulfiled, he deb sraegy migh become problemaic3. In oher words, refinancing risks derived of he 60%/40% currency composiion of he deb porfolio arise from he need of consanly recomposing he srucure when mining revenues vary RCaR Alhough he wo former models lead o imporan conclusions hey do no incorporae cos and risk consideraions derived from a deermined deb sraegy. This hird model addresses hese consideraions. In his way, he RCaR model arises as an analyical insrumen for assessing implici sraegy risks; leaving aside concerns for oal defi ci. This new approach evaluaes coss and risks in erms of deb-servicing coss and ousanding deb. Resuls sugges reducing he USD denominaed percenage of he porfolio, due o exchange rae risk concerns (currency depreciaion) exceeding benefis of larger USD paricipaions (lower financing coss of USD denominaed deb). 111 This hesis suppors Calvo, Izquierdo, and Talvi resuls (2003) appoined on Chaper

152 Minisry of Finance and Public Credi 7.3. End remarks The recommendaions of boh approaches (ALM and Cos-Risk) are complemenary. On one hand, he ALM mehod suggess an increase of USD paricipaion in he deb porfolio, while he RCaR suggess lower USD percenages (under 25%). However, he las mehodology does no inend o compleely eliminae USD denominaed liabiliies. Conclusions of he hree models are summarized nex: I. For cash flows saemens purposes, i is necessary o hold a percenage of he deb porfolio in USD denominaed liabiliies. The reason for his is ha CNG income, wih which deb is serviced, is largely affeced by he USD volailiy. II. Corner soluions (100% COP) are no efficien porfolio srucures 4. These sraegies lead o rollover risks, since redesigning a deb marke ha saisfies all of he CNG financing needs domesically would urn ou o be cosly. Even hough corner soluions do fulfill some deb sraegy fiscal objecives, hey lead o oher risk levels: Figure 50. Deb managemen objecives vs Model resuls Minimizing coss ALM approach Cos-Risk approach Low risk in boh approaches Minimizing marke risk Minimizing rollover risk 112 Currency denominaion concenraions. 152

153 MEDIUM-TERM DEBT MANAGEMENT STRATEGY Deb Forecasing Mehodology for MTDS PART II In his manner, deb placemen coss are reduced when he enire deb porfolio is on foreign currency denominaion (ALM) since USD raes are lower bu marke risk increased via exchange rae depreceiaion. Currency risk would be somehow miigaed wih high domesic currency concenraion, bu his would lead o higher deb coss. III. High USD paricipaion leads o procyclicaliy of he deb porfolio. The required amoun of USD denominaions in he deb porfolio increases during economic surges and consequen currency appreciaion, raising he need for USD issues. These USD issuances come wih large USD capial infl ows ha generae furher currency appreciaion pressure. IV. Presen deb invenories are fundamenal. The RCaR model displayed he iniial deb invenories imporance in erms of coss and risks, even hough boh OD and DPV resuls are noably differen5. In he firs place, DPV direcly dependends on mauriy concenraions; whereas OD indicaors are long-erm oriened. V. Differen currency denominaions imply differen marke condiions. I is essenial o realize ha each currency has is own dynamic, for which coss and esimaed yield curves are differen. For example, ineres raes in foreign markes, where he Colombian Governmen has placed deb, are usually lower (around 300bps according o ALM-2 and RCaR models). Likewise, he COP/ USD exchange rae migh show depreciaions of around 7.73% in suffi cienly sressed scenarios. VI. The DPV 2017 indicaor has a minimum risk infl ecion poin. Concenraed COP denominaed mauriies (83% agains 17% of foreign currency) for he period, reduce TRM vulnerabiliy of he DPV 2017 indicaor. Min If sraegy S is aken as a saring poin, from which USD denominaed issues are gradually increased in D %, hen boh coss and risks will increase. The reason for such surge in boh variables is ha TRM volailiy offses savings derived of issuing an addiional D % of USD denominaed deb 6, making S = (100%,0%) an ineffi cien sraegy. * VII. The deb managemen objecive riangle is bes equilibraed by sraegy S = (80%,20%). According o Secion 6.3, following his sraegy would lead o a deb porfolio currency composiion of (75%, 25%) by he end of The reasoning behind his saemen is: a. This sraegy does no aler CNG curren financing source srucure. Addiionally, i displays he lowes cos and risk rade-off levels for he ousanding deb indicaor. b. I is no procyclical wih economic behavior. The suggesed USD paricipaion in he deb porfolio offers moneary auhoriies a wide room for policy making and for miigaing he effec of exogenous shocks ha lead o currency depreciaions and deeriorae he ousanding deb porfolio. c. The porfolio does no concenrae risks measuremens. The sraegy ha bes balances marke risks and issuing coss incorporaes a USD deb percenage beween 0% (minimum marke risk- maximum cos relaion) and 40% (high marke risk-low coss relaion). 113 See Secion Risk indicaors are relaive o cos indicaors, for which risks are facored in savings calculaions derived from larger USD issuings. 153

154 Minisry of Finance and Public Credi Consequenly, following he findings lised in a. and b., a (80%,20%) sraegy balances all hree deb managemen objecives bes. This work recommends a foreign currency denominaed deb percenage of 20% over he deb porfolio; his is, o follow he (80%, 20%) sraegy. This srucure oupus a (75%,25%) ousanding porfolio composiion by he end of Furher remarks Addiional o deb sraegy recommendaions menioned above, deb managers should also frequenly and acively monior he medium-erm deb managemen. Sraegies should be opporunely adjused afer an updaed comprehensive analysis and he insiuions in charge of managing deb should be designed in accordance wih he CNG organizaional srucure and hierarchy. In his way, as a resul of consan he dialog beween he DGCPTN and he World Bank regarding racking and monioring of he deb sraegy, a special commiee was creaed for reviewing deb policy a leas wice a year. Some of he advanages of having his new managemen insrumen are: The exisence of an insiuionalized room for debae over deb policies alernaives. The possibiliy of evaluaiong policy coherence in a medium-erm framework. The possibiliy of evaluaing coherence beween deb managemen policy and macroeconomic policy (for insance, deb sraegy consisency wih Cenral bank policy) Finally, even hough his sudy incorporaes asse and liabiliy managemen consideraions o he deb sraegy design, effors sill have o be made in order o include oher governmen policy concerns such as fiscal balance machings and oher cos consideraions. 154

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