The Checks of Czechs: Optimizing the Debt Portfolio of the Czech Government

Transcription

1 MPRA Munich Personal RePEc Archive The Checks of Czechs: Opimizing he Deb Porfolio of he Czech Governmen Ales Melecky and Marin Melecky Deparmen of Economics, Technical Universiy of Osrava 15. July 2014 Online a hp://mpra.ub.uni-muenchen.de/57604/ MPRA Paper No , posed 27. July :38 UTC

2 The Checks of Czechs: Opimizing he Deb Porfolio of he Czech Governmen Ales Melecky Deparmen of Economics Technical Universiy of Osrava Marin Melecky * Deparmen of Economics Technical Universiy of Osrava Absrac Sound deb managemen pracices help proec governmen expendiures on deb servicing from aggregae shocks and preven he occurrence of deb crises. Building on Giavazzi and Missale (2004), his aricle examines he opimal allocaion of governmen deb for he Czech Republic. To calibrae condiional expecaions of macro variables and o idenify unexpeced shocks, a vecor auoregression (VAR) model for he Czech macroeconomy is esimaed. The esimaed opimal allocaions across shor-erm deb, inflaion-linked deb, long-erm deb, and foreign currency deb are hen discussed in relaion o he acual allocaions implemened by he governmen deb managers in he Czech Republic. We find ha he manager of Czech governmen s deb allocaes oo much deb ino shor-erm bills and oo lile deb ino inflaion-linked bonds based on he esimaed opimal allocaions. Deepening he marke for inflaion-linked bonds and improving governmen cash managemen are he core policy recommendaions. Key words: Public deb managemen; Opimal deb allocaion; VAR model; Czech Republic, Emerging Marke Economies. * We hank Jan Libich for commens and suggesions on he earlier draf of he paper. Corresponding auhor: mmelecky@worldbank.org, m.melecky@gmail.com, Deparmen of Economics, Technical Universiy of Osrava, Sokolska rida 33, Osrava 1, , Czech Republic.

3 Table of Conens 1. Inroducion Sylized Facs: Managemen of Governmen Deb in he Czech Republic Theoreical Underpinnings Daa Descripion Calibraion of Parameers Discussion of Resuls Sensiiviy Analysis Conclusion Inroducion A governmen s deb porfolio conains complex financial srucures and can creae subsanial balance shee risk for he governmen or cash flow risk for he sae budge. Sound deb managemen pracices can help preven he occurrence of deb crises, reduce vulnerabiliy of governmen finances o macroeconomic and financial shocks, and suppor economic growh. The IMF and he World Bank herefore published, in cooperaion wih naional deb managemen expers, a se of guidelines on public deb managemen for policy makers (IMF and WB, 2001). This work includes formulaion and properies of public deb managemen objecives, he underlying insiuional framework and possible coordinaion challenges, formulaion of he deb managemen sraegy, aribues of a sound risk managemen framework, and oher imporan areas of public deb managemen. Much has been wrien abou public deb managemen and he sraegies for opimal deb allocaion (Sargen and Wallace 1981; Bohn 1990, 1998; Missale 1997; and Missale and Blanchard 1991, among ohers). Also, he recen financial and public deb crises have demonsraed he imporan role of public deb managemen sraegy and deb allocaion for economic growh. From a pracical sandpoin, Melecky (2012a) reviews deb managemen sraegies around he world and sudies possible drivers behind he varying formulaions of public deb managemen sraegies. Hawkesby and Wrigh (1997) adap a ax-smoohing mehodology used in Bohn (1990) and impose realisic - 1 -

4 consrains o public deb managemen o conduc deb allocaion analysis for nine OECD counries. Buera and Nicolini (2002) find ha he size of financial ransacions ha he governmen mus underake each period o replicae sae coningen bonds is very large and increases dramaically wih he number of saes. Gerard and Gilson (2001) show, in a simple wo counry model, how an exchange rae regime can influence he public deb srucure. Because he exchange rae risk is hisorically he mos imporan risk for deb managers in emerging marke economies, Melecky (2012b) provides a review of policy approaches o choosing he currency srucure of foreign-currency deb. In addiion, Melecky (2010) develops a pracical approach ha deb managers can use when deciding on he currency allocaion of public exernal deb across muliple foreign currencies based on synchronizaion indicaors of exchange rae volailiy. This paper focuses on public deb managemen in he Czech Republic, because is experience, of progressing from a ransiion economy o an emerging marke and a high-income economy could be informaive for deb managers and policy makers in developing and emerging marke economies. Alhough numerous sudies have focused on fiscal discipline and deb susainabiliy issues (Bulir 2004; Melecky A. and Melecky M. 2012, EC 2012; IMF 2013; Dybczak and Melecky 2014), only Maalík and Slavík (2005) o our knowledge focused explicily on applied governmen deb managemen in he Czech Republic. They argue ha governmen deb managemen in he Czech Republic wen hrough dynamic developmen during he ransiion period of he 1990s and early 2000s. A very low iniial level of governmen deb, missing fundamenal segmens of he financial marke, and he absence of basic deb insrumens, combined wih small or non-exisen fiscal deficis, impeded developmen of he domesic deb marke in he Czech Republic. The need o esablish a funcioning governmen bond marke o spur domesic capial marke developmen and manage risk from foreign currency exposures, hus arose. Maalík and Slavík (2005) recommend ha public deb managemen be included as par of he sae reasury managemen funcions. This recommendaion conradics ha of Wheeler (2004) who argues for some independence of he deb managemen funcion

5 This paper focuses specifically on he allocaion sraegy for governmen deb in he Czech Republic. I builds on he heoreical approach of Giavazzi and Missale (2004) o empirically analyze he opimal governmen deb allocaion for he Czech Republic. The idenificaion of unexpeced shocks in his approach draws on condiional expecaions from an esimaed VAR model for he Czech macroeconomy. Moreover, he paper discusses he esimaed opimal allocaion shares in relaion o he acual ones implemened by he governmen deb managers in he Czech Republic. I also sudies he robusness of he deermined opimal deb allocaion using a sensiiviy analysis. Based on he conduced analysis he paper aims o propose implemenable policy recommendaions o improve he deb managemen sraegy of he Czech Minisry of Finance (CMoF), respecively is deb managemen uni. We find ha he deb manager of Czech governmen s deb should opimally allocae abou 7% of he deb ino shor-erm CZK bills, abou 16% of he deb ino foreign currency bonds, 25% ino CZK inflaion-linked bonds, and 52% of he deb ino long-erm CZK bonds. The acual deb allocaions implemened by he CMoF in end-2012 differ from he esimaed opimal ones, paricularly for he shares allocaed o shor-erm bills and inflaion-linked bonds. In paricular, he CMoF allocaes abou 23% ino shor erm bills compared wih he suggesed opimal allocaion of 7% based on our esimaes. The acual allocaion could be viewed as more speculaive and opporunisic o generae savings. However in pracice, greaer allocaions o shor-erm bills could reflec oher consrains such as inefficiencies in cash managemen or implemenaion of budgeary plans ha he governmen will have o ackle firs before i can move oward he opimum allocaion. Moreover, because of underdeveloped inflaion linked bond markes, he CMoF does no allocae any significan share of is deb ino his insrumen. 1 Our esimaed opimal allocaions for he Czech governmen s deb sugges ha he Czech governmen should deepen he marke for inflaion linked bonds. In addiion o proecing he governmen deb porfolio agains macroeconomic shocks, effors o develop he marke 1 In June 2012, he CMoF issued for he firs ime CPI inflaion linked bonds for reail invesors and coninued o issue his ype of securiies since hen. To dae, he overall allocaion of deb o his insrumen remains negligible a 0.12% of he oal governmen deb. See also: hp://

6 for inflaion indexed bonds could have addiional posiive effecs on he developmen of he insiuional invesor base and enhance savings mobilizaion in he Czech Republic. The remainder of he paper is organized as follows. Secion 2 provides sylized facs abou he developmen of governmen deb, is allocaion, and servicing. Secion 3 oulines heoreical underpinnings of he applied approach. Secion 4 describes he employed daa. Secion 5 discusses he calibraion of individual parameers of he model o deermine opimal allocaion of he Czech governmen deb. Secion 6 discusses he empirical resuls. Secion 7 conducs a sensiiviy analysis. Secion 8 concludes. 2. Sylized Facs: Managemen of Governmen Deb in he Czech Republic Afer he Czech Republic s spli from Slovakia in 1993, he deb of he Czech governmen grew subsanially and increased 10.5 imes by Srong growh of he Czech governmen deb occurred also in relaion o GDP, albei wih a bi more volailiy. The governmen deb relaive o GDP increased from 15.6 o 45.7 percen, i.e. roughly ripled beween 1993 and 2012 (Figure 1; panel 1,1). Governmen deb managers in he Czech Republic were hus busy rying o raise he needed amoun of funds while minimizing he cos and risk associaed wih he chosen funding sraegy. Toal deb servicing coss increased almos four imes wih he increasing level of he deb. Neverheless, he governmen deb managers succeeded in seadily decreasing he deb servicing coss per Czech koruna of governmen deb from 9.5% o 3.4% over he period. Noe ha his declining rend has been subjec o noiceable volailiy around he 1997 banking crisis and he 2008 global financial crisis (Figure 1; panel 1,2). More explicily, he volailiy of deb servicing coss (3-year and 5-year rolling sandard deviaion; Figure 1; panel 2,1) decreased from 1997 o 2003 and hen increased again, wih he 5-year rolling measure of volailiy reaching is peak in This developmen in he volailiy of deb servicing coss raises a quesion wheher he savings on deb servicing charges observed in panel 1,2-4 -

7 were indeed achieved a he same level of risk or governmen deb managers in he Czech Republic became much more opporunisic in heir deb allocaion and increased heir risk aking. Alhough global and domesic facors may have played an imporan role, he allocaion of governmen deb ino more risky insrumens may have been parly responsible as well. The allocaion of Czech governmen deb across shor-erm CZK deb, long-erm CZK deb, and long-erm foreign currency deb changed subsanially over (Figure 1, panel 2,2). Around 1993, he deb managers relied on he combinaion of shor-erm CZK paper and long-erm foreign currency paper because of underdeveloped domesic markes for governmen deb. This combinaion exposed hem o foreign currency and liquidiy risks ha realized mosly afer he 1997 financial crisis when deb servicing coss spiked (Figure 1; panel 1,2 and panel 2,1). Aware of hese risks, deb managers of Czech governmen deb focused on he developmen of domesic governmen bond marke and allocaing more deb ino medium and long-erm governmen bonds as of This reallocaion was done a he expense of allocaions o shor-erm bills and foreign currency insrumens, and helped proec deb servicing coss from shocks and decrease heir volailiy. However, since 2006, his rend and pruden allocaion has been reversed and replaced by greaer and more opporunisic allocaion o shor-erm bills followed by a slowdown and a sligh reversal in he decreasing allocaion o foreign currency deb. The laer migh have been done for sraegic reasons o preserve he presence and access o inernaional financial markes. [Figure 1 Here] 3. Theoreical Underpinnings As in Giavazzi and Missale (2004), we consider he siuaion in which a governmen implemens a budge consolidaion plan. Furher, he responsibiliy for financing public deb hrough various deb insrumens is assigned o a public deb manager. His objecive is o minimize he - 5 -

8 probabiliy of unsuccessful deb consolidaion owing o unexpeced increase in deb service charges and deb revaluaion hrough pruden and inexpensive deb financing. The public deb manager faces a policy radeoff, however. Less risky deb wih low volailiy of deb servicing charges is more expensive, and less expensive deb is more risky and has more volaile deb servicing charges. In our model, he deb manager can use four possible bonds o finance governmen deb: he shor-erm ineres rae bond, inflaion-indexed bond, foreign currency bond, and fixed ineres rae bond. In view of is policy radeoff, he deb manager selecs he proporion of governmen deb ha will be raised hrough shor-erm local-currency deb, hrough foreign-currency deb, hrough price-indexed deb, and hrough long-erm local-currency deb. Governmen deb grows wih increasing servicing coss of shor-erm public deb in local currency, public deb in foreign currency, public deb indexed o prices, long-erm public deb, and a primary fiscal defici. Governmen deb also grows wih is posiive revaluaion due o changes in exchange raes, prices, and economic performance. The consrained opimizaion problem of he deb manager oulined above is formally described in Appendix 1. Solving his opimizaion problem under he employed assumpions gives he following resuls for he opimal shares of shor-erm deb, price-indexed deb, * h. 2 * s, of foreign currency deb, * q, and of s B Cov i ( B ) Cov( y i ) B Var( i ) B Var i * y T ( ) 2Pr E A 1B 1 Cov e i Cov i ( ) ( ) ( ) * 1 1 * 1 1 q h TP Var i 1 Var i 1 1 2Pr BVar i 1 B Cov e ( B ) Cov( y e ) q B Var( e ) B Var e * y T ( ) 2Pr E A 1B 1 Cov e i Cov e ( ) ( ) ( ) * 1 1 * 1 1 s h FP Var e 1 Var e 1 1 2Pr BVar e 1 (1) (2) 2 Noe ha because risk and expeced coss of deb service boh influence he probabiliy of deb sabilizaion, he objecive of deb sabilizaion offers a soluion independen of he governmen s risk preferences, as Giavazzi and Missale (2004) argue

9 ( * y B ) Cov( y 1 1) B h B Var( ) B 1 T ( ) 2Pr E A 1B 1 Cov e Cov i ( ) ( ) ( ) * 1 1 * 1 1 q s IP Var 1 Var 1 1 2Pr BVar 1 (3) * * * Noe ha he opimal share of long erm deb is given by 1 s q h. In (1)-(3), and y are elasiciies of governmen budge o GDP wih respec o oupu growh and inflaion respecively. B denoes he percenage value of he governmen deb-o-gdp raio. Pr denoes probabiliy ha he adoped sabilizaion plan fails, and E (A ΔB T ) is he planned reducion in he deb-o-gdp raio over period T. TP, FP and IP represen he erm risk premium, he foreign exchange risk premium on he local relaive o he foreign currency, and he inflaion risk premium respecively. Cov(.) sands for covariance and Var(.) for variance of corresponding variables condiional on informaion available a ime. compued as: More specifically, he condiional covariance of wo random variables U 1 and V 1 can be cov ( U, V ) E U E ( U ) V E ( V ) U E ( U ) U E( U ) u V E ( V ) V E( V ) v cov ( U, V ) cov( u, v ) (18) where y,, i,e, y,, i * * * and * denoes foreign economy variables. The condiional variance of wo random variables U 1 and V 1 can hen be compued analogously. We use a vecor auoregression model of order p (VAR(p) model) o esimae he condiional covariances and variances: W B DZ (19)

10 1 y,, i,e, B is a marix of coefficiens, and Z is a vecor of forecas errors which where W are serially uncorrelaed and have zero mean and uni variance. Noe ha B E W 1 hen conains esimaes of he condiional covariances and variances of unexpeced shocks:. D i var ( y 1) cov ( 1, y 1) cov ( 1, y 1) cov ( e 1, y 1) cov ( y 1, 1) var ( 1) cov ( i 1, 1) cov ( e 1, 1) D cov ( y 1, i 1) cov ( 1, i 1) var ( i 1) cov ( e 1, i 1) cov ( y 1, e 1) cov ( 1, e 1) cov ( i 1, e 1) var ( e 1) (20) The nex secion links he discussed model variables o observables ha is he daa on he funcioning of he macroeconomy of a given counry, he Czech Republic in his case. 4. Daa Descripion Our sudy focuses on he Czech Republic and works wih he daa from he Czech economy. The foreign economy (res-of-he world) variables are approximaed by daa from he Euro Area. To calibrae he model, including compuaion of he condiional covariances and variances, we use daa on real GDP for he Czech Republic from he Czech Saisical Office, whereas nominal GDP for he Euro Area from he Eurosa, harmonized CPI, he nominal CZK/EUR exchange rae, he 3-monh money marke raes for he Czech Republic and he Euro Area are from he Eurosa. These daa series are quarerly and span from he firs quarer of 1996 o he second quarer of For he calibraion of model parameers, we use he general governmen deb o GDP raio in he second quarer of 2013 from he Eurosa. Furher, o calibrae difference in he yields for Czech governmen bonds issued in domesic and foreign currency, we use he yields on 10 year governmen bonds in CZK and EUR in 2012 from he Czech Naional Bank s ARAD sysem and Bloomberg respecively. Governmen revenues and expendiures were obained from he Czech Saisical office and span from he firs - 8 -

11 quarer of 1999 o he second quarer of 2013, because earlier daa on he wo variables are no publicly available. All daa are described in deail in Table A1 of Appendix 2. Table A2 of Appendix 2 repors daa summary saisics on all variables employed in he calibraion of he model saring a he earlies available observaion and ending in he second quarer of Calibraion of Parameers of Condiional Covariances and Variances This secion explains in deail how individual parameers enering he compuaion of he opimal shares of differen bonds in he governmen deb porfolio in equaions (1)-(3) are calibraed. Recall ha he assumed opions for he deb manager are o raise governmen deb using shor-erm bonds, foreign currency bonds, price-index bonds and long-erm bonds Calibraing parameers The semi-elasiciies of he governmen budge o GDP raio o oupu growh,, and o y inflaion,, were esimaed as he respecive correlaions over 1999Q1-2013Q2. In paricular, we calculaed η y as he correlaion beween quarerly real GDP growh and he governmen budge o nominal GDP raio, and η π as he correlaion beween he quarerly inflaion rae and he governmen budge o nominal GDP raio. Noe ha equals 0.15 (Table 1), suggesing ha he raio of y governmen budge o GDP improves when he economy is growing in real erms. The elasiciy of he governmen budge o GDP raio o CPI inflaion,, is esimaed a 0.2. Ineresingly, boh calibraed parameers happen o be similar o he calibraions used by Giavazzi and Missale for Brazil. The governmen deb o GDP raio, B, was se o 46.5 percen in line wih he Czech governmen s indebedness in 2013Q2. [Table 1 Here] - 9 -

12 The erm premium, TP, is calculaed as he las year (2012Q2-2013Q2) average of he difference beween he yield of 10-year governmen bonds and he yield of 3-monh money marke rae (assumed o rack he 3-monh Treasury bill rae). The foreign exchange premium on he Czech koruna vis-à-vis he euro, FP, is compued as he las year is average of he difference beween he yields on 10 year governmen bonds issued in CZK and EUR in domesic and euro markes respecively, less he expeced percenage change in he CZK/EUR nominal exchange rae. The laer was se o zero in line wih he random walk hypohesis for he exchange raes. 3 The inflaion premium, IP, is calculaed as he las year s average of he difference beween acual CPI inflaion a ime and he expeced CPI inflaion condiional on an informaion se daed -1. The AR(1) process was used o generae expeced inflaion for simpliciy. This approach was used because daa on inflaion expecaions are no readily available and inflaion linked bonds are no commonly raded. 4 We analyze he sensiiviy of our resuls o each of hese parameers laer in he paper. The probabiliy ha a given sabilizaion (fiscal consolidaion) plan may fail is iniially se a 2 percen following Giavazzi and Missale (2004, p. 9). The probabiliy ha a fiscal adjusmen in he Czech Republic will fail could be slighly elevaed as broadly illusraed in Appendix 3, Table B1. From 2002 o 2013, a period for which numerical arges of fiscal adjusmen plans are available, mos fiscal adjusmen plans could be judged successful, alhough some of hem (2006, 2007, 2009) only parly. Furher research could focus on more careful assessmen of he rack record of he Czech governmen in adhering o is announced sabilizaion plans, mos noably hose involving significan fiscal consolidaion. The consolidaion plan, he planned reducion in he deb-o-gdp raio, T E A B 1 1, is iniially se o 1 percen. This calibraion is consisen wih he Czech governmen s plan o gradually decrease fiscal deficis and slowdown deb accumulaion, and achieve 3 Pas year averages a differen poins in ime suggesed swiching signs (from appreciaion o depreciaion) for he average rend of he exchange rae, concurring wih he random walk hypohesis. 4 Noe ha anoher simple approximaion of inflaion expecaions could be achieved by using he Czech Naional Bank (CNB) inflaion arge a a given ime, assuming perfec credibiliy of CNB s moneary policy and is inflaion arge. Alernaively, fas learning of economic agens would need o be in place o ensure ha his approximaion holds during a moneary policy-driven disinflaionary period, as experienced by he Czech Republic

13 a balanced budge in We analyze he sensiiviy of our resuls o he wo parameers laer in he paper Calibraion of condiional variances and covariances The process of compuing condiional covariances and variances consiss of he following seps. Firs, we esimae an unresriced VAR model wih four lags (VAR(4)), as suggesed by he Akaike informaion crierion (see Table A3 in Appendix 2). This longer lag is also heoreically required because of he year on year differences in variables ha we use for he esimaion and forecass. The year on year differencing inroduces up o hree quarer auocorrelaion by consrucion. The VAR conains, as endogenous variables, domesic oupu growh, inflaion, he ineres rae, and he percenage change in he CZK/EUR exchange rae. We use year on year changes in he variables o ensure ha he variables are saionary. In addiion, he VAR conains exogenous variables, namely he consan, ime rend, as well as he foreign (Eurozone) oupu, inflaion, and ineres rae. The variables y, i, π and e are hen calculaed as he forecas errors of he VAR model s saic (one period ahead) forecass of oupu growh, inflaion, he ineres rae, and he change in he exchange rae. The esimaion resuls for he VAR(4) model are repored in Table A4 in Appendix 2. The plos of residuals from he esimaed VAR are also repored in Appendix 2 in Figure A1. The residuals are well behaved apar from wo large ouliers. Firs, we can observe an oulier for he ineres rae equaion a he beginning of he sample ha corresponds o he period before he financial crisis. Second, we can observe an oulier for he real GDP corresponding o he onse of he 2008 global financial crisis. Shorening he sample or using a dummy variable o ake ou he ouliers does no maerially change he VAR esimaion resuls. We also inspec he acual and prediced values of he VAR variables o make sure he VAR performs well for forecasing purposes (Figure A2 in Appendix 2). The esimaed VAR performs reasonably well in forecasing wih he bes fis produced for he ineres rae and inflaion variables

14 (Table A5 in Appendix 2). The relaively worse fi for he exchange rae could be explained by he radiionally high volailiy of exchange rae series ha applies also o he CZK/EUR rae. The calibraed condiional covariances and variances based on he esimaed VAR are repored in Table 2: [Table 2 Here] The condiional variances correspond o he variances of forecas errors for individual variables from he esimaed VAR(4). The condiional variance for he exchange rae (he e,e cell) is much larger compared wih oher variables whereas he ineres rae variance (he i,i cell) is he smalles. Also he esimaed condiional covariances reveal ineresing observaions for governmen deb managers in he Czech Republic ha seek o exploi naural hedges for efficien deb porfolio allocaion. Consider he covariances of GDP growh wih oher variables firs. The covariance of GDP growh and inflaion is negaive and significan suggesing ha business cycles could have been driven more by supply shocks han demand shocks. This conjecure is consisen wih he presence of wo crisis periods ha involved deep recessions, in which producion capaciy diminished, and srong recoveries followed. This negaive covariance could imply ha nominal revenues for he Czech governmen could be more sable han in oher counries in which he business cycle is primarily driven by demand shocks. The covariance of GDP growh wih he ineres rae is posiive bu insignifican, and is small magniude suggess a weak ransmission channel of moneary policy from ineres raes o GDP growh. The negaive sign on he covariance beween GDP growh and changes in he exchange rae is consisen wih he covariance beween GDP growh and inflaion. If GDP growh is primarily driven by supply shocks, posiive supply shocks such as produciviy increases should resul in appreciaion of CZK vis-à-vis EUR as suggesed by he esimaed covariance. Consider he addiional covariances of inflaion wih he remaining variables. The covariance of inflaion wih he ineres rae is posiive and significan in line wih he expecaion ha moneary policy raes increase when inflaion increases. The covariance of inflaion wih changes in he exchange rae is esimaed negaive bu insignifican. Alhough he purchasing power pariy

15 hypohesis suggess ha (oher hings equal) increasing inflaion should resul in depreciaion of local currency and an increase in he exchange rae, he esimaed negaive covariance implies differen ransmission mechanism. We conjecure ha as inflaion increases and ineres raes rise, capial inflows due o he increased ineres rae differenial could cause he exchange rae o appreciae, a leas in he shor erm. Consider he remaining covariance of he ineres rae and changes in he exchange rae. The esimaed negaive covariance is only marginally significan. The esimae conradics he hypohesis of uncovered ineres pariy. The esimae implies ha an increasing ineres rae differenial on CZK vis-à-vis EUR shall resul in fuure appreciaion of he koruna wihin he one year horizon presumably because of higher capial inflows. This is however in line wih empirical research suggesing ha uncovered ineres pariy has a mixed performance and ends o only hold in he medium erm (he 2-5 years horizon) (Chinn and Quayyum, 2012). We furher compare our calibraion of he raio of he covariances and variances enering equaions (1)-(3) wih hose used by Giavazzi and Missale (Table A6 in Appendix 2). Overall, our calibraions differ from hose of Giavazzi and Missale. Alhough he relaive magniudes of our calibraion are in some cases similar (Cov(eπ)/Var(e), Cov(ie)/Var(i), Cov(ie)/Var(e)) o hose of Giavazzi and Missale, in oher cases, hey are in absolue values nine imes larger (Cov(yπ)/Var(π)) or en imes smaller (Cov(eπ)/Var(π)) or bear a differen sign alogeher (Cov(yi)/Var(i); Cov(ye)/Var(e)). 6. Discussion of Resuls Using he baseline calibraion of he parameers presened in Tables 1 and 2, and equaions (1)-(3), Malab s fsolve funcion s soluion produces opimal shares for governmen deb allocaion ha are presened in Table 3. [Table 3 Here]

16 The esimaed resuls sugges ha he manager of Czech governmen s deb should allocae 7.28% of he deb ino shor-erm CZK bills (T-bills), 15.98% of he deb ino foreign currency bonds, 25.16% ino CZK inflaion-linked bonds, and 51.58% of he deb ino long-erm fix-rae CZK bonds. Managing liquidiy risks, repaymens of longer erm bonds, and cash requiremens for reasury operaions forces he deb manager o allocae a leas a small share of governmen deb ino shor-erm bills. We esimae his allocaion o be abou 7%. We will discuss his number in more deail shorly when comparing our opimal esimaes wih he acual allocaions implemened by Czech deb managers. The allocaion of abou 16% o foreign currency bonds could be possibly higher given he negaive foreign currency premium and he implied poenial savings. The poenial cos savings from a greaer allocaion of deb ino foreign currency are, however, miigaed by he relaively high condiional variance of he CZK/EUR exchange rae (he size of unexpeced change in he exchange rae), and he significanly negaive condiional covariance of he exchange rae wih GDP growh. The former increases overall risk of allocaing deb ino foreign currency while having revenues in local currency. The laer suggess ha when governmen revenues decline he CZK ends o depreciae, hus increasing deb service charges and increasing he CZK equivalen of he EUR denominaed deb. Despie he negaive inflaion premium (Table 1, IP), he allocaion o inflaion-linked bonds is subsanial of abou 25% of oal deb. This resul arises mosly because he condiional variance of unexpeced changes in inflaion is high and dominaes he influence of he negaive inflaion premium. Noe ha he negaive inflaion premium alone would sugges allocaion of Czech governmen s savings (reserves) in CZK inflaion-linked paper. In pracice, such allocaion could be implemened by he Czech governmen holding savings (reserves) in inflaion-linked paper issued by he Czech Naional Bank (CNB). Apar from benefiing from he negaive inflaion risk premium ha is, acual inflaion lower han he expeced one priced in by he marke he inflaion-linked paper issued by he CNB would also hold he bank accounable for sysemaically undershooing is inflaion arge and discipline i furher o adhering o i

17 In heory, an increasing probabiliy ha he governmen will fail o fully implemen is deb consolidaion program increases he desired allocaions o long-erm deb. Because an increase in he probabiliy of fuure failure of he consolidaion program will resul in increasing financing coss for he governmen, locking ino a lower fixed rae enables deb managers o proec he governmen budge from unexpeced increases in fuure deb service charges. For he Czech governmen, he probabiliy of failure o implemen is consolidaion program could be slighly elevaed (Appendix 3). This shows up in he esimaed opimal allocaion of abou 52% in medium o long-erm CZK deb. Table 3 also shows he laes available daa from 2012 on he acual allocaion of Czech governmen deb across he considered opions. The acual allocaions are in some cases noiceably differen from he esimaed opimal ones. As discussed, one facor ha could explain he mismach beween he acual and he opimal deb allocaions is he underdeveloped marke for inflaion-linked bonds. Bu oher facors could also play a role. Deb managers in he Czech Republic could be raher opporunisic in deb allocaion overweighing perceived savings from larger allocaion ino shor-erm deb over he refinancing risk ha derives from such allocaion. However, one consideraion ha we have ignored, and ha could jusify larger allocaions o shor-erm bills, are possibly larger cash managemen needs of he Czech governmen hroughou he fiscal year o smooh he differences beween he collaion of governmen revenues and execuion of governmen expendiures. Such needs could arise, for example, because of expeced seasonaliy in governmen revenues ha mismach he governmen expendiure plans or from an overall inefficien implemenaion of governmen budge plans. Finally, he near zero acual allocaion of governmen deb o CZK denominaed inflaionlinked insrumens is due o he fac ha hese insrumens are no commonly issued by MoF, or oherwise commonly raded in he marke. However, he esimaed opimal allocaion for Czech governmen deb implies he Czech governmen should furher develop he marke for inflaion index bond o beer proec is deb porfolio and he governmen budge from unexpeced changes in deb servicing coss; nowihsanding he addiional posiive effecs his developmen could have on he insiuional invesor base and savings mobilizaion

18 7. Sensiiviy Analysis As in any calibraion or esimaion approach, here is some uncerainy around he calibraed parameers. This uncerainy could be even more imporan for resuls obained from a non-linear model like ours. For ha reason, we conduc a sensiiviy analysis regarding he calibraed parameers. Such analysis shall also es he robusness of our resuls and gain furher insighs ino he applicabiliy of he resuls in various circumsances ha he deb manager can be faced wih in he fuure. More specifically, we vary he model parameers wihin a plausible range around heir calibraed values, and examine how he esimaed opimal shares of foreign currency, shor-erm local currency, inflaionindexed, and long-erm local currency deb change in response. The resuls of such sensiiviy analysis are ploed in Figure A3 in Appendix 2. Overall, our resuls are raher insensiive o changes in single parameers, excep for he foreign currency and inflaion risk premiums (FP, IP), and he exen of he consolidaion plan (he size of budge adjusmen). An increasing foreign exchange premium implies progressively greaer opimal allocaions o foreign currency bonds and inflaion-indexed bonds and smaller allocaions ino long-erm bonds. The sensiiviy resuls sugges ha if uncerain abou he FP value, deb managers should graviae o more conservaive allocaions ino local currency. The baseline resuls are also sensiive o changes in he IP. Negaive IP suggess ha fuure acual inflaion will be on average greaer han expeced, and encourages allocaion of governmen savings (reserves) in inflaion-linked papers. In conras, posiive IP encourages some borrowing in CZK denominaed, inflaion-linked bonds. The opimal deb allocaion is similarly sensiive o how ambiious he fiscal consolidaion plan is. A more ambiious consolidaion plan implies greaer allocaions owards long-erm fixed rae deb. This resul could seem couner-inuiive if deb managemen is par of he fiscal savings effors and is forced o cu cos a he expense of greaer risk aking, because he probabiliy of failure of such

19 plan will likewise increase. However, if deb managemen is independen and no par of he fiscal consolidaion plan, as argued by Wheeler (2004), he implicaions are differen. The resuls sugges ha in a risk neural environmen governmen consolidaion may require sable deb service charges ha do no inroduce an unexpeced cos o he budge. 5 A greaer allocaion o fixed rae bonds is hen jusified. 8. Conclusion Sound deb managemen pracices can help avoid unexpeced increases in deb services charges, reduce deb vulnerabiliy o macroeconomic and financial shocks, and hus preven he occurrence of deb crises. This paper carried ou an empirical analysis of he opimal deb allocaion for he Czech Republic using he approach of Giavazzi and Missale (2004) and an esimaed VAR model for he Czech macroeconomy. The esimaion resuls sugges ha he Czech governmen should allocae mos of is deb (abou 52%) o long-erm fixed-rae bonds. This is a smaller share han he Czech Minisry of Finance (CMoF) allocaed o his insrumen by end-2012 (65.9%). Furher, he CMoF should allocae abou 25% of is deb o inflaion-linked bonds. Currenly, such insrumen is no widely used by deb managers in he Czech Republic and he corresponding marke is underdeveloped. The resuls subsaniae considerable effors ha he deb managers in he Czech Republic should devoe o developing he marke for inflaion-linked bonds. The CMoF can draw on examples of oher counries ha have developed markes for inflaion-linked bonds such as France, Germany, Ialy and Sweden. The CMoF s allocaion ino foreign currency bonds of 11% is broadly aligned wih he suggesed opimal allocaion of 16%, given he uncerainy abou he foreign currency premium. In conras, he CMoF s allocaion o shor-erm bills of 23% is significanly above he suggesed opimal 5 Sraegic ineracions beween he governmen and he cenral bank (he moneary-fiscal mix) as well as longerm demographic facors may also play a role in deermining he feasibiliy of a planned fiscal consolidaion (Libich and Sehlik, 2012)

20 allocaion of abou 7% and could be inroducing excessive risks o he deb porfolio under he assumed risk neural preferences. In pracice, he CMoF allocaion o shor-erm bills could be driven by inefficiencies ha are ou of he deb manager s conrol, and could sem from inefficien cash managemen or implemenaion of budge plans, including ax collecion and governmen expendiures. More research is needed o aid formulaion of robus governmen deb managemen sraegies in he Czech Republic, and his paper is one of he firs aemps in his direcion. More broadly, furher research is warraned on he opimal allocaion of deb in emerging marke economies ha ypically face a broader se of challenges han advanced economies, including hose due o poliical economy facors

21 References BOHN, H., 1990, Tax Smoohing wih Financial Insrumens, American Economic Review, vol. 80 No. 5, pp BOHN, H., The Behavior of U.S. Public Deb and Deficis, The Quarerly Journal of Economics, MIT Press, vol. 113(3), pp , Augus. BUERA, F., NICOLINI, J. P., Opimal Mauriy of Governmen Deb wihou Sae Coningen Bonds, Universidad Torcuao Di Tella, DoE Working Papers 016. BULIR, A., Exernal and Fiscal Susainabiliy of he Czech Economy: A Quick Look Through he IMF s Nigh-Vision Goggles, CNB Inernal Research and Policy Noe, 4/2004. CHINN, M. D., QUAYYUM, S., Long Horizon Uncovered Ineres Pariy Re- Assessed,Naional Bureau of Economic Research, Inc., Cambridge, NBER Working Paper No DYBCZAK, K., MELECKY, M., EU fiscal sance vulnerabiliy: Are he old members he gold members? Economic Modelling, Elsevier, vol. 38(C), pp EUROPEAN COMMISION, Fiscal Susainabiliy Repor 2012, European Economy 8/2012, Economic and Financial Affairs 2012, Available from: hp://ec.europa.eu/economy_finance/publicaions/european_economy/2012/pdf/ee _en.pdf. GERARD, M., GILSON, N., Public deb srucure and exchange rae regime, Diparimeno di Economia Poliica dell'universià di Milano Bicocc Working Paper. GIAVAZZI, F., MISSALE, A., Public Deb Managemen in Brazil, Naional Bureau of Economic Research, Inc., Cambridge, NBER Working Paper No HAWKESBY, C., WRIGHT, J., 1997, The Opimal Public Deb Porfolios for Nine OECD Counries: A Tax-Smoohing Approach, Universiy of Auckland Working Paper. IMF AND THE WORLD BANK, Guidelines for Public Deb Managemen, Washingon D.C., Available from: hp://

22 IMF, Czech Republic, 2013 Aricle IV Consulaion, IMF Counry Repor No. 13/243, Washingon D.C., Available from: hp:// LIBICH, J., STEHLIK, P., Moneary Policy Facing Fiscal Indiscipline under Generalized Timing of Acions, Journal of Insiuional and Theoreical Economics, vol. 168(3), pp MATALIK, I., SLAVIK, M., Deb Managemen in he Czech Republic (formaion in he 1990s and he curren sae). Prague Economic Papers vol. 1, pp MELECKY, A., MELECKY, M., The Impac of Macroeconomic Shocks on he Governmen Deb Dynamics: How Robus is he Fiscal Sance of he Czech Republic?, Poliická ekonomie, Universiy of Economics, Prague, vol. 2012(6), pp MELECKY, M., 2012a. Formulaion of Public Deb Managemen Sraegies: An Empirical Sudy of Possible Drivers, Economic Sysems, Vol. 36, pp MELECKY, M., 2012b. Choosing The Currency Srucure Of Foreign Currency Deb: A Review Of Policy Approaches, Journal of Inernaional Developmen, Vol.24, pp MELECKY, M., Currency Allocaion of Public Exernal Deb and Synchronizaion Indicaors of Exchange Rae Volailiy, Comparaive Economic Sudies 52 (2010), pp MISSALE, A., Managing he Public Deb: The Opimal Taxaion Approach, Journal of Economic, Surveys vol. 11 (3). MISSALE, A., BLANCHARD, O. J. (1991). The Deb Burden and Deb Mauriy, NBER Working Paper, No SARGENT, T. J., WALLACE, N., 1981, Some Unpleasan Monearis Arihmeic, Quarerly Review, Vol. 5, No. 3. Federal Reserve Bank of Minneapolis. WHEELER, G., Sound Pracice in Governmen Deb Managemen, Inernaional Bank for Reconsrucion and Developmen: World Bank USA

23 Table 1: Calibraion of inpu parameers Parameer Tables in he Main Tex Descripion Baseline Calibraion Giavazzi & Missale (2004) Calibraion η y Elasiciy of governmen budge o GDP wih respec o oupu η π Elasiciy of governmen budge o GDP wih respec o inflaion B Governmen deb o GDP (2 nd quarer 2013), (in %) TP Term premium (las year average), (in %) FP Foreign Exchange Premium on CZK (las year average), (in %) IP Inflaion premium (las year average), (in %) Pr Probabiliy ha sabilizaion plan fails, (in %) 2 2 E (A -delhab T ) Planned reducion in deb-o-gdp raio over T, (in %) 1 1 Source: Auhors calculaions Table 2: Calibraion of condiional covariances and variances Variance - Covariance marix y Π i e y (0.040) (0.018) (0.161) π (0.015) (0.158) i (0.069) e Source: Auhors calculaions Noe: Sandard errors in he parenheses Table 3: Esimaed opimal deb allocaion and acual allocaion of Czech Governmen Deb Deb Allocaions s* q* h* Fix Esimaed Opimal Acual (December 2012) 22.8% 11.3% 0.0% 65.9% Source: Auhors calculaions; CMoF Developmen of he Governmen deb. 6 Noe: s* - shor-erm floaing-rae deb, q* - foreign-currency denominaed deb, h* - inflaion-indexed deb, and fix - long-erm fixed-rae deb, which is compued as 1-s*-q*-h* 6 Available a: hp://

24 Figures in he Main Tex Figure 1: Czech governmen deb (op panels) and Deb servicing coss (boom panels) % 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% % 10% 8% 6% 4% 2% 0% Governmen deb, bln. CZK Toal (lef axis, CZK bln.) Deb/GDP, % Deb service cos per CZK of deb 25% 20% 15% 10% 5% 0% y rolling S.D. 5-y rolling S.D. 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% s q h (1-s-q-h) Source: CMoF and auhors calculaions

25 APPENDIX 1 The Opimizaion Problem of he Governmen Deb Manager problem: As in Giavazzi and Missale (2004), he deb manager ries o solve he following opimizaion A. Objecive Funcion T (1) Min E Prob X>A B Min E X dx s, q, h s, q, h T A1B1 By choosing he proporion of public deb o be raised hrough shor-erm deb, s, foreign currency deb, q, price-indexed deb, h, and long-erm deb (1-s-q-h), i minimizes he probabiliy ha he inended fiscal adjusmen will fail due o unexpecedly high deb service charges or deb revaluaion. E is expecaion condiional on informaion available a ime. A+1 is he expeced adjusmen, X T denoes he uncerain componen of he fiscal adjusmen, B 1 is he deb-o-gdp raio, and B 1 is he rend deb raio ha is, he deb raio ha would exis in period + 1 in he absence of he fiscal correcion. B. Consrains The deb raio rises if ineres paymens increase, primary budge surplus decreases, nominal GDP grows, or domesic currency depreciaes, which affec he value of foreign currency deb. The nominal rae of reurn on fixed rae bonds is known a he ime of issuance and equals o he long-erm ineres rae (R): T T T B B B I B e qb S y B. (2)

26 T T where B 1 B 1 B is he deb accumulaion, I 1B are he nominal ineres paymens, e is he log T of nominal exchange rae, q is he share of euro denominaed bonds, S 1 is he rend primary surplus, y 1 is he log of oupu, and 1 is he rae of inflaion. The ineres paymens are as follows: * I I B i sb R RP qb R hb R s q h B. (3) * I where R is he foreign ineres rae, R is he real ineres rae known a he ime of issuance and π +1 is he rae of inflaion in he following period. i +1 is he average ineres rae beween period and +1 * known a ime. The reurn on euro denominaed bonds 1 is approximaed by he sum of he foreign ineres rae and he risk premium (R +RP ). R RP e 1 The raio of he rend primary surplus o GDP is uncerain, since i depends on cyclical developmens of GDP and inflaion: T. (4) T 1 1 y S E S y E y E T where S 1 is he raio of rend primary surplus o GDP, y is he semi-elasiciy of governmen budge (relaive o GDP) wih respec o oupu, is he semi elasiciy of budge wih respec o he price level and E are he expecaions condiional on he informaion a ime. C. Firs Order Condiions The governmen selecs shares of deb insrumens wih respec o he firs order condiions (5)-(7). The deb srucure is opimal only if increased probabiliy of failure is equalizes across deb insrumens. T E A B i R (5) T * E A B R RP e e R (6)

27 E A B R R T I (7) T where A1 B1 s, q and h. T is he planned reducion in he deb o GDP raio and A1 B1 is a funcion of D. Assumed Behavioral Relaionships Based on he Giavazzi and Missale s framework, he following behavioral relaionships are assumed. The difference beween ineres coss of shor rae bonds and fixed rae bonds is given by he deviaion of he average shor rae from is expeced value and he erm premium (TP ) on fixed rae bonds: i R i E i TP. (8) The erm premium is calculaed from he rue erm premium ( TP ) and informaional spread: I I 1 1 TP TP E i E i, (9) I where I E are invesor s expecaions. The difference beween he reurn on he euro denominaed bonds (expressed in Czech koruna) and he reurn on fixed rae bonds is influenced by he deviaion of average exchange rae from he expeced exchange rae and he exchange rae risk premium: * R RP e e R e E e FP. (10) spread: The foreign premium is calculaed from he rue erm premium ( FP ) and informaional I I I 1 1 FP FP E e E e, (11) where I E are invesor s expecaions

28 The difference beween ineres coss of price-indexed bonds and fixed rae bonds is given by he deviaion of he average inflaion rae from he expeced inflaion rae and he inflaion risk premium (IP ): I R R E IP. (12) The inflaion premium is calculaed from he rue premium ( IP ) and informaional spread: I I I 1 1 IP IP E E. (13) where I E are invesor s expecaions. E. Triangular Approximaion of Disribuion To esimae he probabiliy disribuion funcion ( X ), Giavazi and Missale ake a linear approximaion of ( X ) across bad realizaions of he fiscal adjusmen X>0. This approximaion yields he riangular probabiliy densiy funcion described in (14). Greaer bad realizaions are hus less likely o occur han smaller ones X X X. (14) 2 X F. The Soluion Using (14), subsiuing (8)-(13) ino (5)-(7), and rearranging gives he following soluions for he opimal shares of shor-erm deb, s*, foreign currency deb, q*, inflaion-linked bonds, h*, and fixed rae deb (1-s*-q*-h*): s B Cov i ( B ) Cov( y i ) B Var( i ) B Var i * y T ( ) 2Pr E A 1B 1 Cov e i Cov i ( ) ( ) ( ) * 1 1 * 1 1 q h TP Var i 1 Var i 1 1 2Pr BVar i 1, (15)

29 B Cov e ( B ) Cov( y e ) q B Var( e ) B Var e * y T ( ) 2Pr E A 1B 1 Cov e i Cov e ( ) ( ) ( ) * 1 1 * 1 1 s h FP Var e 1 Var e 1 1 2Pr BVar e 1 ( * y B ) Cov( y 1 1) B h B Var( ) B 1 T ( ) 2Pr E A 1B 1 Cov e Cov i ( ) ( ) ( ) * 1 1 * 1 1 q s IP Var 1 Var 1 1 2Pr BVar 1, (16). (17)

30 APPENDIX 2 Tables Table A1: Descripion of daa and daa sources Variable Characerisic Source Nominal GDP EA GDP in curren prices, seasonally adjused and adjused daa by working days, millions of euro (from )/millions of ECU (up o ), for CR and EA EUROSTAT Real GDP - CR GDP in consan prices (2005=100), billions of CZK CNB s ARAD HCPI Exchange rae 3M Money Marke ineres rae Harmonized consumer price index, 1996=100, seasonally adjused, index, all-iems HICP, for CR and EA Calculaed as 3-monh average from monhly daa Nominal bilaeral exchange rae CZK/EUR (ECU), quarerly average 3-monh Money marke ineres rae, for CR and EA Series are based on naional mehodologies. EONIA and Euribor (see: hp:// follow a European mehodology. Boh use he same panel of banks. EUROSTAT EUROSTAT EUROSTAT 10Y bond yield 10-year mauriy reasury bond yield (Maasrich crierion) CNB s ARAD Governmen revenues Toal general governmen revenues CSO Governmen expendiures Toal general governmen expendiures Deb o GDP raio General governmen gross deb as % of GDP EUROSTAT Noe: CR = Czech Republic, EA = Euro Area (EA , EA , EA , EA , EA , EA17). CNB = he Czech Naional Bank, CSO = he Czech Saisical Office. Governmen revenues and expendiures were obained from: hp://apl.czso.cz/pll/rocenka/rocenkavyber.gov_p?mylang=cz. CSO

31 Table A2: Daa summary saisics Daa availabiliy 1996Q1-2013Q2 1999Q1-2013Q2 2000Q Q1-2013Q2 Variable 3M ineres rae CR 3M ineres rae EA nominal exchange rae CZK/EUR HCPI CR HCPI EA real GDP CR nominal GDP EA governmen expendiures CR governmen revenues CR 10Y bond yield CR deb o GDP raio CR Mean Median Maximum Minimum Sd. Dev Skewness Kurosis Jarque-Bera Probabiliy Sum E Sum Sq. Dev E E E Observaions Source: Auhors calculaions

32 Table A3: VAR lag lengh selecion Lag LogL LR FPE AIC SC HQ NA * * * * * Source: Auhor s calculaions Noe: * indicaes lag order seleced by he crierion; LR: sequenial modified LR es saisic (each es a 5% level); FPE: Final predicion error; AIC: Akaike informaion crierion; SC: Schwarz informaion crierion; HQ: Hannan-Quinn informaion crierion