Fiscal policy, public debt management and government bond market: issues for central banks

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1 Fiscal policy, public debt management and government bond market: issues for central banks BIS CEMLA Roundtable Mexico City, November 2012 Ramon Moreno The opinions expressed in these slides are my own and do not necessarily reflect the views of the BIS.

2 Financial stability and public debt (Vargas et al, Colombia) Starting early 2000s government relied increasingly on domestic debt market. Banks reluctant to lend to private sector were willing to hold increasing amounts of public paper (called TES) in the domestic financial sector without much impact on lending rates. Private pension funds portfolios also increased demand for TES. Domestic public debt increased by (i) swaps of foreign debt for domestic currency debt, in addition to the direct placement of TES in the domestic market; (ii) sterilization of central bank intervention in the foreign exchange market 2

3 Financial stability and public debt (Colombia) Result: growing exposure of the financial system to nondiversified market risk (large fraction of its TES holdings are long term, fixed rate bonds that are valued mark-to-market). Concerns: an underestimation of market risk measures or moral hazard (the expectation of a bail-out) may explain growing demand for public debt B In 1997 to 2005 securities holdings by credit institutionsrose from around 12% of their assets to 32%. 3

4 Financial stability and public debt (Vargas et al) Stress test to Colombian financial system s holdings of public securities revealed important effects a 100 bps. parallel increase in the TES spot curve could cause losses close to 17% of the profits obtained by credit institutions (at the time historically high), and 2.5% of the value of their portfolios as of May Note: not implausible, in 2002 electoral uncertainty in Brazil in led Colombian sovereign spreads to rise by 490 bps with a corresponding increase in domestic long interest rates of 430 bps.. It subsequently took six months for the spread to return to its previous levels. Pension funds exposure to market risk is also significant 4

5 Session III Issues for discussion 1. To what extent have central banks become major issuers of domestic debt securities? What considerations guide the choice of maturity of central bank bills and bonds? 2. Do changes in maturity structure of debt have implications for monetary policy? Do governments and central banks actively adjust their issuance strategy to changing demand for different maturities by different investors? 3. To what extent is short-term debt issued by the government and the central bank a close substitute for bank reserves? What are the implications for the lending behaviour of banks? 4. How is central bank debt issuance coordinated with government debt management. 5

6 Day 2 Session 3 (Item 1) To what extent have central banks become major issuers of domestic debt securities? What considerations guide the choice of maturity of central bank bills and bonds?

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9 Stylised facts for Latin American debt Public debt/gdp In 2010 ranged from under 10% in Peru, to 24% in Colombia and Mexico and 65% in Brazil Increased in Brazil and Mexico, stable/falling or low elsewhere. Average maturity has risen from around 2 years to 10 years or higher Central bank securities 2010 ranged from less than 1% in Peru to 3% in Mexico and 9% in Chile (more outside Latin America) fell (Chile) or was low and stable Maturity: largest share one year or less (eg 100% share in Peru, vs 61% and 88% for Mexico and Argentina respectively. 1-3 yr maturity (over 1/3) important in Chile and Mexico 9

10 Choice of maturity of central bank bills and bonds Central bank bills: monetary policy objectives; short maturities may be preferred in order to more easily adjust liquidity to meet the policy rate target Government bonds: trade off: longer maturities might reduce liquidity/refinancing risks but may imply higher costs. 10

11 Choice of maturity of central bank bills and bonds Two types of public debt management goals have a bearing on the choice of maturity Minimise costs to avoid perception that debt is unsustainable while taking into account tolerance for risk. provide fiscal insurance against budget risk, ie structure debt to provide a hedge against macroeconomic shocks to the budget. Returns on a government securities portfolio are negatively correlated with government consumption and positively with the tax base and, thus, output. For example, a well designed borrowing strategy will seek to reduce the government s repayment burden during cyclical downturns, when tax revenues decline temporarily and interest rates tend to fall. 11

12 Day 2 Session 3 (Item 2) Do changes in maturity structure of debt have implications for monetary policy? Do governments and central banks actively adjust their issuance strategy to changing demand for different maturities by different investors?

13 Maturity structure of debt and monetary policy (1) Perfect certainty about future short-term rates, implies debt of different terms would be perfect substitutes for one another. In this case, control of the overnight interest rate is sufficient for central banks to affect the near end of the yield curve. But uncertainty about the path of future interest rates (which could be caused by high public debt) will make debt of different maturities imperfect substitutes. Changes in the mix of short-term and long-term bonds will change relative prices, and so influence the shape of the yield curve. Monetary policy based on setting the policy rate becomes less effective as transmission to other interest rates is reduced. Hence central bank purchases or sales of bonds become more effective exactly when classic monetary policy reliant on the overnight rate works less well. 13

14 Maturity structure of debt and monetary policy (2) Do not need to be at zero lower bound. Even when the policy rate is above zero, imperfect asset substitutability along the yield curve means that monetary policy can be made to work more surely and more rapidly by central bank action in longerdated markets. This may become particularly relevant in the years ahead as central banks seek to reduce their bond holdings when government financing needs are still large. 14

15 Maturity structure of debt and monetary policy (3) Imperfect substitutability of assets at various maturities may be more relevant in EMEs, where financial markets are thinner EME domestic investor base is often quite small and dominated by a few large, local banks. Implication: local bonds are less reliable as collateral at times of market stress (Fostel and Geanakopolos, 2008). Need additional measures for monetary policy to work. Example: Following Sep 2008 Lehman bankruptcy, Mexico with well developed domestic debt markets faced loss of confidence in bond markets. Lowering policy rates not enough as would not pass through to long-term rates. Responses: A shortening of the maturity of new debt issuance; Official purchases of long-term government bonds in the market; The creation of a central bank facility for interest rate swaps which allowed bond holders to reduce their exposure to the long-term interest rate. 15

16 Adjusting issuance strategy to changing demand by investors Public debt management: Data suggest that over the medium term, demand for long-term assets (and also for domestic currency bonds) has been accommodated through issuance policies Central banks: the data indicate issuance concentrated at very short maturities 16

17 Day 2 Session 3 (Item 4) How is central bank debt issuance coordinated with government debt management.

18 Issues of coordination of central bank and public debt Public debt management can complicate monetary policy eg issuance at short maturities may affect ability to achieve the policy rate target Central bank debt issuance can crowd out public debt issuance Central bank debt issuance can also make it harder to use public debt management to provide a hedge against macroeconomic shocks to the budget (eg seeking to ensure that interest payments of the government decline during cyclical downturns). 18

19 Solutions to conflict between central bank and public debt (complications for monetary policy, crowding out of public debt) Government issue the debt securities needed for monetary regulation (Mexico). Arrangements for the central bank to issue debt at short maturity while the government issues public debt at longer maturities Korea : central bank issues debt up to 2 year maturity, while the government issues debt from 3 to 20 years. Still there are cases where maturities may overlap; in Chile 38% of the central bank debt has maturity exceeding three years 19

20 Fiscal insurance A central bank that issues debt will usually do so because it does not have public debt available for its monetary options. If monetary policy is countercyclical, the fiscal insurance role can be preserved the cost of debt will indeed It will then structure its own debt to achieve its interest rate target and not necessarily to provide fiscal insurance that minimises the government debt service burden in response to shocks. Nevertheless, the central bank may play an important fiscal insurance role that is not necessarily emphasised in the public debt management literature, by providing cover for currency mismatches of the public sector (and the rest of the economy). 20

21 Day 2 Session 3 (Item 3) To what extent is short-term debt issued by the government and the central bank a close substitute for bank reserves? What are the implications for the lending behaviour of banks

22 Short-term debt and bank credit Conventional monetary transmission mechanism, bank credit is determined primarily by demand factors. Issuance of short-term debt (or bank reserves) should play little role in determining the level of financial intermediation. When banks increase their holdings of government bonds, they may crowd out credit to the private sector (Kuttner and Lown (1998)). Under imperfect market conditions, however, debt maturity can affect banks lending behaviour. For example, banks may face financing constraints. Short-term government and central bank bills could then act as liquidity buffers, relaxing these constraints and enhancing banks capacity to lend. 22

23 Likely impact depends on the sensitivity of banks holdings of bills and securities to the level of interest rates. Low interest rates imply banks have a greater incentive to seek finance by liquidating their holdings of short-term paper rather than by borrowing from the central bank. Liquid assets provide an easy way for investors to leverage up their balance sheets. Banks and other investors may use their bond holding to build riskier exposures (see Borio and Zhu (2008)). Liquidity and risk-taking may interact in a mutually reinforcing way, increasing the strength of the monetary transmission mechanism and creating a destabilising credit boom. 23

24 Desired asset maturity may matter maturity structure, and if the government does not supply enough long maturity assets banks may create them by making loans, even though such lending may not be a perfect substitute; ie, the shorter debt maturity of sovereign bonds may lead banks to finance a greater amount of long-term projects. Some support from emerging market economies: strong growth in short-term official sector debt is associated with credit growth. 24