IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Baseline Projections and Risks in Key Policy Areas: Fiscal, Monetary and Externals Sectors

Joint Vienna Institute, Vienna, Austria

February 23– 27, 2015

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

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Outline

1. What are the links between macroeconomic policy and the formulation of debt management strategy?

2. How do these links operate in detail?– Baseline projections

– Risks

– Structural factors

3. Feedback from MTDS and macroeconomic policy– Risk mitigation

– DM imposes macro policy constraints

– Market development

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IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

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Why do we do this: three country examples• Mexico 1994/5

– Large stock of short-term debt first in DX then as stop gap in FX, and fixed exchange rate regime led to run on reserves/government debt crisis=>IMF bailout to resolve liquidity

• Greece 2010:

– Mainly primary deficit problem but non transparent fiscal/debt accounting and significant reliance on short-term and variable rate funding aggravated situation

• Argentina 2001/2:

– External current account deficit (5% of GDP) high in terms of exports (100%) meant risk of overvaluation and potentially costly gov. FX debt=>200% depreciation/debt restructuring.

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IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

1. Broad linkages between MTDS and the macro policy framework

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

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GDP

Govt Revenue

Fiscal Balance

Govt Expenditure (Cg + Ig)

Domestic Borrowing External Borrowing

BOP

Monetary and Exch.

Rate Policy

Macroeconomic Framework and the MTDS:Overview of Linkages (What)

Rest of

the World

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IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

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Macroeconomic Framework and the MTDS

• Some of the key linkages with the macroeconomic framework

– The primary fiscal balance drives future borrowing volumes. The primary balance in turn depend on the broader macro outlook (i.e., tax revenues, etc.);

– Monetary and exch. rate policies influence the types and costs of available sources of financing – i.e., monetary policy effects the inflation risk premium, roll-over risk is higher under a peg;

– Balance of payment gaps may require external financing.

– High growth and real appreciation may reduce the burden of debt

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IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Concrete links to Macroeconomic Framework (MEF)

• Use MEF for baseline projections of macro variables. – Projections need to be part of a consistent macro framework.

– Source: usually macro unit, sometimes Ministry of Planning.

– The DSA will contain these variables, but these may not be the latest update.

• For strategy analysis it is vital to use a realistic baseline for market variables.– Exchange rate outlook often not realistic but political 7

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Relation to Debt Sustainability Analysis (DSA)

• DSA role is to gauge the level of the debt. Does it lead to future debt servicing difficulties (over indebtedness)? – Derive advice on the (max.) primary fiscal balance based on

DSA.– Inputs on refinancing risks

• MTDS role is to derive the composition of debt– Debt structure, and interest rate structure often crudely

modeled in DSA. This is the role of MTDS

• If MTDS leads to a revision in debt strategy implicit in MEF/DSA this should be fed back into MEF/DSA [when updated].

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IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

2. MTDS: How do these linkages operate in detail and in practice?

- Baseline projections- Risks- Long-term structural factors

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

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Baseline Projections: 4 Sectors- Key Macro and Market Variables

Real Sector

Fiscal policy

External sector

Monetary policy

GDP: denominator in cost

/risk indicators and affects

financing needs (if deficit

projections is ratio to

GDP);

Primary balance =

Revenues – Non-

interest Expenditure

•Nominal and real exchange rates. RER= Real Exchange Rate (nominal exchange rate adjusted for inflation differential)•Assumed public sector net disbursement •Reserves accumulation (roll-over risk)

•Commercial/central bank gross/net credit to the government•Interest rates

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Macro vs Market Variables

• Variables that do not directly affect the relative performance of debt liabilities / instruments

– Fiscal performance

– Growth

• Shocks that affect the relative performance of debt liabilities / instruments (critical for MTDS)

– “Market” variables

• Exchange rate

• Interest rate

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Baseline Projections: Fiscal Sector

• DM should be clear about– Expected path of Primary Balance– Gross Financing Needs: Government Deficit = Primary Balance +

Interest + Debt Repayments– For LICs: grants depend on donor policies and economic prospects; a

declining source of revenues as countries develop (a structural factor to consider)

• From DSA whether there is considerable risk in terms of sustainability=>composition policy should help to reduce risk

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Baseline Projections: Monetary Sector

• Short-term interest rates driven by monetary policy

• Other nominal rates driven by inflation expectations

• Unstable monetary regime and inflation will lead to high inflation risk premiums for medium-long-term fixed rate instruments

– Inflation indexed debt requires trusted index not subject to political “intervention”

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Baseline Projections: External Sector

• Balance of Payment defines the external financing needs (BoP gap) in the short-term (for given exchange rate/reserves target)

• The trend in competitiveness drives the path of the REER which is a key variable in cost-risk of external vs domestic funding

• Capital account regime determines whether non-residents can purchase domestic securities. If highly open then interest rate parity good approach to determine likely exchange rates

• Reserves are key for roll-over risk especially under a fixed exchange rate regime with an open capital account=>residents can move money abroad instead

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Macroeconomic Framework: Main Risks?

• Having established the baseline we need to ask what are the most likely risks (deviations from the realistic baseline)

• What risks are primarily for DSA?– GDP (growth shocks)– Primary balance (revenue/expenditure surprises)=> affects funding size

but not typically funding priority

• What are risks for MTDS:– Sharp increase in interest rates (external/domestic)

• Driven by inflation shocks or real interest rates?

– Exchange rate realignment– Changes in REER path, Terms of Trade shocks– Sudden stops of flows (or reversals),

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IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

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Macroeconomic Framework and Debt Strategy:Contingent Liabilities and Financial Crises: 2007-08

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IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Exchange rate shock impact

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IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Interest rate Shock impacts

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IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Longer-term Structural Factors

• Real exchange rate and real interest rates are the long term drivers of the cost of debt funding

– Note in DSA the debt dynamics for Debt/GDP is broken down into key drivers:

• Primary deficit

• Automatic debt dynamics: (i) real interest effect; (ii) real growth rate effect; and (iii) real exchange rate effect

• Special “below the line” debt events (debt forgiveness; privatization; recapitalization/bail-outs)

• Residual (picks up inertia because of fixed nominal rates)

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IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

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Longer-term Structural Factors

• Examples of structural factors:– structural changes in monetary policy (inflation targeting)– development of domestic debt markets (reforms)– changing trends in prices of commodities– trends in real effective exchange rate (productivity)– trade or other macro reform

• Long-term structural factors influence the debt strategy through their effects on the baseline macro scenario (notably RER and real interest rates) and on the mix of available instruments

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

3. Feedback from MTDS and macroeconomic policy

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

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The Challenge

• Public debt management should be an integral part of a country’s comprehensive policy agenda, including among others:

– prudent fiscal policy measures– appropriate policy mix, with a consistent monetary policy framework– adequately regulated and supervised financial system, in particular

the banking sector

• Public debt management should be an additional policy tool, consistent with the general macroeconomic policy framework.

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IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

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Link to Mitigating Fiscal Vulnerabilities

• Choice of strategy can reduce liquidity risk and therefore, reduce the likelihood of crisis

– Longer debt maturity helps reduce fiscal vulnerabilities: reduces roll-over risk and slows the pass through of increasing spreads / interest rates

– More domestic funding reduces foreign exchange rate risk exposure

– Similarly, reducing variable rate debt can reduce budgetary uncertainty and exposure to shifts in market’s assessment of credit risk

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IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Link to Balance of Payments Vulnerabilities

• Lengthening external debt maturities reduces roll-over and potential drain on reserves/balance of payments vulnerabilities through capital flight especially under a peg.

• Switching to domestic can lower REER and promote exports. Shifts crowding out from export to domestic sector. Crowding out domestic sector can be mitigated by developing savings market.

• Public debt management should coordinate with monetary authorities e.g. before engaging in buybacks of external debt or switching funding, given the impact on exchange rates/reserves

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Link to Effective Implementation of Monetary Policy

• Longer domestic debt maturities may help reduce the conflict between monetary and debt management objectives– CB can more freely set high nominal short-term interest rates to

achieve monetary objectives

• Public debt management can help develop efficient fixed-income markets– Improves transmission mechanism of monetary policy– Facilitates move to indirect instruments of monetary policy

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IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

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Link to Effective Implementation of Monetary Policy (cont.)

• However, public debt management should be coordinated with overall monetary policy in order to avoid inconsistency of policies.

• For example, the debt manager should take account of the impact of its operations on domestic (and external) liquidity conditions –and coordinate them with the central bank

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IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Link to Financial System, in particular Banking System Vulnerabilities

• Given the typically large holdings of public debt by banks, public debt management can influence the robustness of the financial system

• Improving the overall robustness and ease with which the government can meet its debt obligations, will improve the quality of the banks’ balance sheets– Reducing government’s liquidity risk, e.g. through longer maturity

structures would help reduce financial system vulnerabilities

– Operations targeted at containing the probability of a sovereign default through, e.g., a debt structure that is robust, would help reduce financial system vulnerabilities

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IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

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Link to Financial System

• More generally, public debt management can effectively support the development of more robust financial markets, improving the functioning of the financial system

– Facilitating corporate debt markets• Providing a benchmark for the private sector• Providing scope for securitization of banks’ assets

– Facilitate repo market development• Improving liquidity of banks’ balance sheets

– Facilitate development of derivatives markets• Allowing for more effective risk management within the economy

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IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Conclusions

• The overall aim of public debt management is to minimize costs to the budget, taking account of potential vulnerabilities

– Composition of debt stock can help mitigate vulnerability of budget to shocks – thus enhancing macroeconomic stability

– Reducing rollover risk is an important mitigating factor to address broad range of vulnerabilities

• To achieve its intended objectives, public debt management should be performed in close coordination with the rest of the macroeconomic policy

• Despite public debt management’s policy impact on macroeconomic stability, financial stress and crisis may still occur

– However, if public debt management is appropriately performed, the amplitude and length of such events would tend to be reduced (as opposed to exacerbated).

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