Debt Management - in the UK and Overseas

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

25. UK DMO Governance Framework

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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