Understanding Public Debt and State Financing: An Overview
Public debt management refers to the debt that governments owe, which is distinct from private debt such as mortgage debt or debt incurred for education or personal expenses. This means that public debt concerns state financing. The modern state has three main ways to finance itself: taxation, earning money through natural resources like oil, or borrowing money from investors. Across time and place, most modern states have featured a combination of these three ways of financing. The focus of this video is on state borrowing, which is public debt. These days, most states are in debt, with most of the debt of rich countries financed by government bonds. These financial instruments come with different contracts and structures, but they all work in a similar way.
Understanding Public Debt Management in the Wake of COVID-19
To borrow money, the government issues a debt obligation that includes the commitment to pay periodic interest, called coupon payments, and the commitment to repay the face value on the maturity date, which could be in one year, five years, or ten years. In the wake of the COVID-19 crisis, government funding needs have surged dramatically, with OECD governments now borrowing trillions. Servicing this debt is costly, as shown in the graph, and managing it is complicated. This raises the question of how the state borrows money, which is where public debt management comes in. Historically, the management of public debt changed hands numerous times, with the typical succession running from the private offices of rulers to elected or appointed assemblies, to ministers of finance or central banks, and finally, to semi-autonomous debt management agencies.
Modern debt management: the role of autonomous agencies.
By the turn of the century, many countries had changed the way they manage their debt. Notably, by setting up primary dealerships and creating new debt management agencies, the model of autonomous agencies sitting outside or within the Ministry of Finance dominates modern debt management. You may have heard of the National Debt Management Office in London, the Finance Agency in Frankfurt, or the Agence France Tresor in Paris. These agencies do not call the shots on how much money the state borrows or how it is spent; that is the realm of parliamentary budgeting. Instead, they are in charge of deciding how the state borrows money. Debt managers seek to manage debt in the taxpayers’ best interest, which is no small task.A government’s debt portfolio is usually the largest financial portfolio in the country.
Debt Management in the 21st Century: The Primary and Secondary Bond Markets.
Debt management in the 21st century has become more complex and much faster, with financial market development more broadly and bound up with technological innovation. The government bond market has two levels: the primary market and the secondary market. Managers usually put new securities up for sale in the primary market, where they are mainly bought by so-called primary dealers. Primary dealers are a select number of banks given privileged access to debt auctions or debt syndications in exchange for a commitment to buy and sell bonds in the secondary market. The makeup of these primary dealer groups continues to change. Big banks are key players, but smaller regional banks also want to be dealers in the country. Any subsequent trading of bonds (which is indeed the bulk of trading) takes place in this secondary market.
Modernizing Debt Management: Portfolio Optimization and Diversification Strategies
Underlying debt management modernization, such as creating semi-autonomous agencies or issuing debt via auctions, is a change in thinking about that management. Domestic public officials, as well as influential international bodies (notably the World Bank, the IMF, and UNCTAD), began considering debt as a portfolio. Debt management became focused on so-called portfolio optimization, and to achieve this, managers pursued a diversification strategy. First, they diversified debt instruments, and second, they diversified bond investors. Portfolio optimization was then pursued with the use of financial derivatives, such as interest rate or currency swaps, to hedge domestic interest rate risk or currency risk. The everyday practice of debt management can be organized in a variety of ways. Let’s look at a few examples of the many decisions that public debt managers must make.
The Complexities of Public Debt Management: Implications for Policy and Stability
For instance, they must decide whether and, if so, how primary dealers are rewarded and what kind of debt instrument will be issued. For example, how long should the maturity be set? There are trade-offs. Short-term debt is often cheaper for the state but more risky in the long or medium term. Decisions must also be made about whether to issue debt in another currency and whether to cater to the demands of long-term institutional investors like pension funds by linking the coupon payments of bonds to an inflation index, thus inflation-proofing investment. And then there is the question of how best to issue green bonds, the newcomer of government debt securities. Public debt management can pursue many strategies, and these strategies are not neutral and are not apolitical. They have implications for income inequality, monetary policy, fiscal policy, and financial stability. Read More: Caution: Before You Enroll in a Debt Management Plan.