Government Debt Management in Europe: Recent Changes in Debt Managers' Strategies
Wolswijk, Guido, de Haan, Jakob, Public Finance and Management
This paper presents a survey of changes in the strategies of government debt managers in European countries. These changes were introduced in response to alterations in the working environment of debt managers, like the introduction of the euro, declining government debt ratios, the introduction of electronic trading systems, and the changed institutional position of debt managers. An important recent feature of debt management strategies in the euro area is the convergence of practices. There is a clear tendency to issue 'plain vanilla' bonds, while there is less emphasis on issuing foreign currency debt. Debt managers increasingly use interest rate swaps and introduce innovative instruments, such as inflation-indexed bonds.
The working environment of government debt managers in Europe has changed considerably during the last decade. By far the most important factor was the introduction of the euro. After the start of monetary union in 1999, debt managers became small to medium-sized players in a European capital market, instead of the dominant party in national capital markets. Consequently, competition among debt managers increased, fostering transparency and stimulating a more efficient primary market and a deeper, more liquid secondary market.
There have been other changes as well. The fiscal consolidation in the run-up to the Economic and Monetary Union (EMU) implied that government debt-to-GDP ratios started to decline in most countries, although this trend has recently been reversed. Furthermore, the organisation of the trade in securities has altered, notably due to the introduction of electronic trading systems. In many countries the institutional position of the government debt managers has also changed. Although there are still substantial differences across countries, there is a clear tendency to grant more independence to the organisation responsible for the management of government debt.
All these changes have affected government debt management strategies in the euro area countries, aiming at the objective of cost minimisation subject to risk-limits. Interestingly, there is considerable convergence in debt management strategies. It appears that there is a clear tendency to issue 'plain vanilla' bonds, while there is less emphasis on issuing foreign currency debt. Debt managers increasingly use interest rate swaps and introduce innovative instruments, such as inflation-indexed bonds.
This paper describes developments in debt management practices since the adoption of the euro in more detail. The remainder of the paper is organised as follows. Section 2 explains the changes in the environment for government debt managers in the euro area in somewhat greater detail, while section 3 examines how debt management strategies have been altered in light of these changes. Section 4 discusses some future challenges for government debt management, while the final section offers our conclusions.
2. A changing environment for European government debt managers
Introduction of the euro
The advent of the euro in 1999 had significant effects on how debt managers in the euro area strive for cost minimisation. Four years before the launch of the euro, the government debt of Italy, Spain, and Portugal yielded about 500 basis points more than German bunds, while Greece was not even able to issue domestic bonds of 10-year maturity until 1997 (Reszat, 2003). After the decision on the adoption of the single currency had been taken, a clear trend towards the geographical diversification of institutional portfolios into assets issued in prospective euro area countries was observed. As a consequence, government bond yields quickly converged (Santillán et al., 2000).
Before the start of monetary union, debt managers were to some extent "ensured" of a demand for their bonds as securities of other governments were not full substitutes. Exchange rate risks played a major role, but non-standardised market conventions and a lack of efficient pan-European settlement systems also hampered international trade in government bonds. The introduction of the common currency changed this playing field substantially. Exchange rate risks within the euro area no longer exist, market conventions have been harmonised and efficient linkages between European settlement systems have been established. From the investor's perspective, the disappearance of exchange rates implies that the government bonds of various governments have become closer substitutes. The reduction in spreads among the various euro government bonds has slowed the initial diversification process. Liquidity and credit risk have become the main differentiating features among government bonds, with the relative contribution of these factors subject to debate (see e.g. Codogno et al. (2003) and Santillán et al., 2000). The introduction of the euro and the implied tight spreads for government bonds also made portfolio managers diversify into a wider range of corporate bonds. Thus, government debt managers face increased competition, requiring them to cater to the desires of investors.
Declining debt ratios
Apart from the creation of a European capital market, the start of EMU had another major impact on government debt management. The absence of excessive deficits was one of the so-called convergence criteria on the basis of which it was decided whether European Union (EU) countries could become members of monetary union. Excessive deficits were measured against the reference values of 3% of GDP for the general government budget deficit and 60% for the general government debt-to-GDP ratio. The Maastricht Treaty stipulates that Member States should also avoid excessive deficits after becoming part of the euro area. According to the Stability and Growth Pact, Member States should achieve and maintain a budgetary position 'close to balance or in surplus' in the medium term (see Eijffinger and De Haan, 2000, and De Haan et al., 2003 for analyses of the Pact). Compliance with these rules implies fiscal discipline, while at the same time providing the necessary room for manoeuvre for automatic stabilisers.
Initially the budget deficit in the euro area declined from 5.7% of GDP in 1993 to 1.0% in 2000. However, during the three years thereafter, the budgetary positions of various euro area countries deteriorated substantially (see table 1). The average deficit reached 2.8% of GDP in 2003. The budgetary positions of Germany and France remained particularly weak, with deficits around 4% of GDP. The European Commission (2004) forecasts that on average the budgetary positions in the euro area will remain unchanged, with a few countries still having deficits close to or above the 3% of GDP reference value in 2005.
Government debt ratios of most countries are substantially lower than at the beginning of the 1990s (see table 2). However, the recent weakening of budgetary discipline in some euro area countries has stopped the continuous decrease in the average debt ratio that had been observed since 1997. On average in the euro area, debt ratios started increasing again in 2003, and are expected to continue increasing slightly to 2005, according to the Commission forecasts. As a result, the majority of euro area countries will have debt ratios above the 60% of GDP reference value, and debt ratios in Greece and Italy will not come below 100% of GDP within the forecast horizon.
Since 1988 trade in government securities in Italy has been organised via an electronic trading system MTS SpA (Mercato Telematico de Titoli di Stato). In the mean time, the number of euro area sovereigns with locally managed MTS platforms has increased to nine. Apart from these local systems, where only government bonds of the country concerned can be traded, since 1999 there has been the possibility to trade at EuroMTS where a selected number of European benchmark bonds are quoted. A requirement for trade at EuroMTS is that the bond issue has a minimum size of EUR 5 bln. Alternatively, some government bonds can be electronically traded at Brokertec, which started in 2000. Government securities of Austria, Belgium, the Netherlands, France, Germany and Spain can be traded here, as well as US government bonds. More recently, besides offering opportunities to trade bonds that have been issued, electronic systems have also been used as a platform to issue bonds.
Electronic trading systems have a number of advantages in comparison with trading via the floor and by telephone. First, electronic systems allow for continuous multilateral interaction between market participants while trade is not restricted to a certain location. Second, the capacity of electronic trading systems can be easily enlarged at relatively low cost. Finally, as electronic trade is integrated, all aspects of transactions from quoting to settlement can be done within the system ('straight through processing') so that processing is much quicker than via more traditional trading systems.
The change to electronic trade systems implies more efficiency and higher liquidity. MTS markets are interdealer markets, where some traders are obliged to give quotes for benchmarks and other highly liquid loans so that there are always possibilities to trade. Apart from the obligation to provide quotes, there are maximum bid-ask spreads, which reduce transaction costs. The effective spread in the market is generally less than the maximum spread.
Changing position of debt managers
Finally, the institutional position of the various debt managers has changed during the last decade. Even though important differences among countries still exist, there is a clear tendency to grant more independence to government debt managers (see annex 1). In Germany and France, debt management offices were given a larger degree of independence in 2001. Such reflects the increasing awareness that higher product complexity and competition among debt managers requires a high degree of operational independence and professionalism. Cost considerations also played a role: in Germany, the centralisation of debt management was expected to save interest payments of up to EUR ¾ bln, or some 2% of central government interest payments per year.
At the same time, governments issue more specific guidelines for debt management. These often take the form of a target (range) for the residual maturity or the (modified) duration, subject to certain restrictions such as limits on the use of derivatives. The modified duration measures the change in the current value of the debt portfolio if the yield curve changes by 1 basis point. The French debt agency, for instance, had a 2003 target for the average maturity (after swaps) of 5.3 years, implying a decline by nearly half a year compared to 2002. The Belgian debt agency operates within limits for the shares of maturity-ranges in total debt, such as a 25% cap for total euro-denominated debt for which the interest rate needs to be reset within a year.
3. Recent changes in debt management strategies
The factors just described have caused debt managers to alter their strategies. The fact that debt managers in surrounding countries amended funding strategies also provided incentives to change (see also Lumpkin, 2000). Below, we describe the main changes that have occurred in the last few years, focussing on the maturity of debt, debt denominated in foreign currencies, the use of interest rate swaps and inflation-indexed bonds, and issuing methods.
Liquidity considerations and decreased cross-border obstacles to trade have increased the interest in issuing standardised - "plain vanilla"- government bonds. Usually, the size of these bond issues is rather large compared to the pre-EMU years, with the aim of achieving a high degree of liquidity. While issues of about EUR 2 bln were standard in smaller countries before EMU, the minimum nowadays is EUR 5 bln, reflecting the lower limit for government securities to be eligible for trading on the EuroMTS electronic platform. The larger countries in the euro area nowadays issue bonds of over EUR 20 bln.
At the start of EMU, issuances concentrated heavily on the 10-year segment: all euro area debt managers were active in this market. At that time, the 3-, 5- and 30-year segments also remained attractive, with about half of the debt managers issuing at least one security in those segments (see table 3). The total share of these plain vanilla bonds of total debt ranged roughly between 50 and 100% (see figure 1).
Substantially lower long-term interest rates compared to pre-EMU years also created incentives for a shift in emphasis to the long-term segment of the bond market. This applies in particular to previously less-disciplined countries, such as Greece and Italy (see table 4). The exchange rate risk premium in interest rates vanished with the adoption of the common currency. It was estimated to have been particularly high in Italy (1.5 %-point), but also significant in Spain (1.0 %-point) and in Finland and Ireland (0.4 %-point) in a study in which Greece was not included (Blanco, 2001). In addition, credit risk premiums may also have decreased because of the limits on the government deficit and debt. Credit ratings awarded by major rating agencies improved, especially in the countries previously characterised by less discipline. From a debt management perspective therefore, joining EMU has been a major contribution to the objective of cost saving.
With government deficits generally lower than some years ago, the possibilities of issuing one or more large 10-year benchmark bonds decreased, especially for the countries with smaller government deficits. Issuing securities only along other parts of the yield curve was restricted to the countries with large deficits and/or debts. With a view to increase borrowing possibilities at benchmark maturities, governments have introduced or extended buy-back operations and bond switching operations. These allow bondholders to switch to new and therefore more liquid government debt. Similarly, governments have cut down on non-tradable debt instruments such as retail debt, allowing a higher portion of the funding requirement to be in benchmark bonds. Easier access of individuals to the primary and secondary market for government bonds via financial intermediaries and the Internet also plays a role in decreasing the volume of retail-debt.
Some additional room for issuing benchmark bonds in the market also came from the decrease in short-term financing. Previously some debt managers, notably those with very high debt levels, were constrained in the amount of long-term debt that could be issued on the national market at favourable terms. At high levels of outstanding nominal debt, financial markets' fears that the government might take recourse to inflation to reduce the real value of outstanding liabilities raised the nominal interest rate, making long-term financing more expensive for the debt manager. After the adoption of the euro, the share of short-term debt fell particularly in Belgium, Greece and Italy, all countries with debt ratios above 100% of GDP.
These developments have resulted in a convergence of the remaining maturity of government debt, to an average of around 5.9 years in 2003 (see table 5). Broadly speaking, the average residual maturity in the large majority of countries is now within a 5.5 to 6.5 years band, with exceptions in a few smaller countries. Dispersion was larger before, though limited data availability and caveats in definitions call for caution in interpretation.
Convergence in remaining maturities can be seen as contributing to a more symmetric transmission channel of monetary policy in the euro area. However, remaining maturities of government debt is a poor indicator of this. As discussed later in this article, several governments actively use interest rate swaps, making the concept of remaining maturities less useful as indicator of the short-term interest rate sensitivity of government interest payments. Furthermore, it has to be taken into account that government debt only plays a minor role in the monetary policy transmission process.
More recently, some reversion to issuing short-term securities can be observed. Some countries aim at establishing benchmarks over the entire yield curve, requiring issuing activity in the short-term segment as well. France and Italy in particular are active in this segment, with France currently setting the benchmark. Furthermore, higher-than-anticipated deficits in many countries required additional financing at short notice, which is easier in the short-term market segments. Finally, low short-term interest rates have made it cheaper to borrow short-term. Thus, Ireland financed its entire gross borrowing requirement (EUR 4 bln) short-term in 2001. Other countries, however, continue to emphasise long-term borrowing, and did not deviate from previously announced borrowing programmes, also with a view to maintaining credible relationships with investors.
The "battle of the benchmarks", allowing financing at lowest interest rates, was won by the German government bonds, the Bund. Thus, the Bund sets the standard for other countries' rates and the German government can normally borrow at best rates in the market. The Bund benefited from the German government being a major issuer in the euro area and having an outstanding financial reputation, although the recurrence of significant deficits has reduced the linked advantage in 2002/2003. The benchmark role of the Bund is also very much helped by the well-developed market in derivatives, allowing market participants to hedge against interest rate risk.
Decreased emphasis on foreign-exchange denominated debt
With the advent of the euro, the largest part of euro area countries' debt denominated in foreign currencies automatically turned into domestic debt. An amount of close to 4½ % of euro area government debt was redenominated into domestic debt by the start of 1999. The share of debt in non-euro denominated currencies, standing at 2% of total euro area government debt at the end of 2002, shows a slightly declining tendency. The main currencies in which this type of debt nowadays is denominated are US dollars, UK pound, Japanese Yen, and Swiss Francs, as is shown in table 6. The share of foreign exchange denominated debt exceeds 10% of total central government debt only in Austria (12%) and Finland (13%). Its level had been much higher previously: in 1995, for instance, the share of non-domestic currencies in total debt exceeded 25% in Belgium, Finland and Ireland.
Potential reasons for issuing debt in non-domestic currencies include avoiding overburdening the domestic capital market, supplementing official foreign exchange reserves, increasing international ownership of bonds and taking advantage of better financing conditions abroad.
The relevance of the first three motives has diminished in recent years in the euro area. Integrated European capital markets and improved public finances imply that fears of the crowding out of private capital demand have relaxed. As for foreign exchange reserves, national central banks participating in the euro area have not expanded their holdings of foreign exchange reserves, thus not providing additional demand for foreign currency denominated debt. Likewise, with the advent of the euro, countries no longer need to issue securities in another currency to attract international investors.
The significance of the fourth argument, taking advantage of better financing conditions abroad, is much debated among debt managers. As regards the cost perspective, the Austrian debt management office has indicated that long-term cumulative saving from using foreign currency markets ranges between 1½ and 2% of GDP (Hauth and Kocher, 2001). Most countries concerned use foreign exchange swaps to substantially reduce the exchange rate risk they run.
Countries have different attitudes towards funding part of the borrowing requirement in foreign currency debt. Reducing the foreign currency denominated debt is explicitly stated as part of the debt management strategy in some countries (Belgium, Greece, Ireland and Italy). A few other debt managers, in search of favourable financing conditions, continue to use this possibility (Austria), or do not exclude this option if conditions turn favourable (Spain). Italy continues issuing US dollar denominated securities with a view to maintaining the benchmark status among non-US sovereign issuers. This programme of minimum size $10 bln can be expanded to other currencies on the basis of arbitrage possibilities, although the trend remains downward. A few countries, such as Germany and the Netherlands, explicitly excluded financing part of government debt in foreign currencies. This was mostly related to prestige-considerations, with recourse to foreign currencies regarded as a token of financial weakness. The relevance of this argument however, has now decreased as access to the euro area financial markets strongly reduces the likelihood of such a limit to financing possibilities. In this respect, France lifted the prohibition on borrowing in foreign currencies in 2003 and Germany is considering issuing this type of debt. Although outside this paper's scope, the introduction of the euro also affected the operations of debt managers outside the euro area. Denmark and Sweden, but also the ten countries that joined the European Union in 2004 denominate a substantial part of their debt in euro, or issue debt in the domestic currency and then swap it to euro.
Innovations: interest rate swaps
Increasingly, euro area debt managers use interest rate swaps, whereby the government receives the long-term interest rate from the counter-party and pays the short-term interest rate. This effectively reduces the duration of outstanding debt as the remaining maturity until the next interest rate fixing decreases (Ladekarl and Svennesen, 1999
The increasing popularity of interest-rate swaps has to be seen mainly in the light of reduced government financing needs. Given this, and the wish to issue high volumes of benchmark bonds to obtain liquidity in these markets, little choice is left over for steering the risk-profile of government debt. Swaps introduce more flexibility in debt management by separating the question of liquidity from the risk profile. While these swaps are nothing new to the market, the European swap market had so far been too small for governments to actively use swaps without disturbing markets, but with the euro this risk has seized. Yet, governments' increasing activity in the swap market has not gone unnoticed. Remolona and Wooldridge (2003) observe a ceiling on euro swap spreads, as governments enter the market to receive flexible interest rates when differences between government interest rates and swap rates become large.
Employing interest rate swaps contributes to reducing financing costs as it enables debt management agencies to continue concentrating on issuing in the favourite 10 year bond segment, while at the same time reaping the cost advantages of short-term interest rates. Assuming an upward sloping yield curve, this reduces financing costs. A few debt managers have published cost savings from swaps' use. In France, where swaps have been introduced in 2002, the gain has been 0.5% of central government interest payments. The Dutch public debt manager has calculated that in the period 1999-2001, it has annually saved some 0.4% of central government interest payments due to the use of interest rate swaps.
While contributing to the objective of cost saving, the intensified use of interest rate swaps also includes risks (Piga, 2001). The counter-party risk relates to the possibility that the counter-party in the swap-arrangement can no longer fulfil its obligations. Permission for debt managers to use these swaps is therefore accompanied by several restrictions regarding the minimum rating of counterparties, maximum risks per counter-party and overall maximum risks. Only few government debt managers provide (non-standardised) information on swap operations undertaken and the risks involved.
Innovations: inflation-indexed bonds
Inflation-indexed bonds are bonds where the principal and the interest payment are linked to a price index, thus compensating bondholders for inflation. The discussion on the pros and cons of inflation-indexed bonds is a long-standing issue in the area of public finance, both theoretically and practically (De Cecco et al., 1997.) From the cost perspective, proponents usually emphasise that governments have to pay nominal-bond holders an inflation premium, as investors are uncertain on future inflation. This premium lapses when issuing inflation-indexed bonds. Those less favourable to this type of bonds highlight the possibility of governments having to pay an additional liquidity premium because of the usually small market for indexed bonds. Apart from cost considerations, issuing indexed bonds is also taken up by governments to broaden the investor base. An interesting by-product of inflationindexed bonds is that it allows inferring markets' perception of expected inflation. Comparing the yield on an index-linked bond with the yield on a nominal bond with the same maturity and from the same issuer produces an estimate of expected inflation. However, this is an imperfect measure to the extent that yield spreads are also affected by a liquidity premium.
While cost saving has been a major motivation for issuing this type of bond, the primary reason for investing in it was protection against inflation risks. Nowadays, a shift towards other purposes is observed. This partly follows from a number of safeguards that have been introduced in the Maastricht Treaty to avoid recurring periods of high inflation. The European Central Bank (ECB) has been given a very high degree of independence, there is a prohibition of monetary financing, and there is a no-bail-out clause. In addition, the ECB has adopted a clear definition of its ultimate objective of price stability (see De Haan et al. , 2004, for a discussion).
With high inflation concerns lessened, portfolio diversification emerges as the main motivation to invest in index bonds (European Commission, 2003). Indexed bonds are of particular interest for pension funds, whose future obligations are linked to nominal developments because of the price or wage linking of pension benefits. Investing in inflation-indexed bonds therefore offers these investors the opportunity to match their liabilities by nominal claims, reducing mismatches in the growth of assets and liabilities due to inflation.
Within the euro area, only a few countries issue inflation-indexed bonds. France has issued this type of flation-indexed bonds. France has issued this type of bonds since 1998, linked to a domestic price index. Since 2001 bonds linked to the euro area wide harmonised consumer price index (excluding tobacco) have also been offered with a view to broadening the investor base. Issuance statistics confirm that ownership of inflation-indexed bonds is widely spread; some 75% of the first French bonds linked to the European price index were sold to non-residents, of which more than half were investors outside the euro area. To ensure that sufficient liquidity prevails in this market segment, the issuance programme is scheduled to be speeded-up; some 10% of net bonds issued will be inflation-indexed. Italy and Greece have taken up issues of inflation-indexed bonds of 5-year, respectively 25-year maturity in 2003, while Germany and the Netherlands are studying this option. Although growing rapidly, the share of inflation-indexed bonds in total debt is still relatively minor. In France it currently represents around 4% of total tradable central government debt.
Broadening the investor base
With the euro now being the domestic currency for twelve countries and exchange rate risks and costs having disappeared, the degree of national bias in investors' preferences has decreased. Thus, national debt managers are less 'assured' about national demand for their debt securities, forcing them to enter into competition with other debt managers. To attract foreign investors, all euro area countries but Germany use primary dealers to distribute government bonds. These primary dealers mediate between the debt agency and the market and operate on both the primary and secondary market. Tasks for primary dealers usually include the obligation to bid at auctions or to buy a certain amount of newly issued bonds, promotion of government debt and market making (Economic and Financial Committee, 2002b). The latter function implies continuous offering of buying and sale prices, thus increasing the liquidity of the market.
On average, debt agencies operate with some 15 primary dealers, though there are substantial variations between countries, ranging from 8 in Ireland to 24 in Austria. In all countries concerned, foreign financial institutions dominate in number, reflecting the wish to spread ownership of government securities widely. Large financial institutions like ABN AMRO, Salomon/Citybank and Deutsche Bank are active as primary dealers in the majority of euro area countries.
Another way of distributing government bonds that has gained importance is the use of a bank syndicate (see table 7). While initially mainly used by small euro area countries, also large issuers have started to use syndicated placements, mainly for launching instruments aimed at new market segments. In France, it was used for the launch of euro-area inflation-linked bonds and in Italy and Spain for the launch of their new 15-year benchmarks. An advantage of this approach is that banks can actively select foreign investors. Furthermore, the method allows for placing a large volume at once, thus increasing the liquidity of the bond and making it immediately eligible for electronic trading. Naturally, the banks that are responsible for placing a new bond receive adequate compensation for the risks they run.
On average in the euro area, foreign ownership of government debt increased from 19% of GDP in 1997 to 32% of GDP in 2003, with domestic ownership decreasing (see figure 2). Increased spreading of bonds' ownership occurred in most countries, but in the smaller ones in particular. Thus, in the Netherlands, foreign ownership of long-term government debt doubled in the period 1997-2001 to 51%, in Spain it increased from 18% (1997) to 41% (2002) in 2002, while in France non-residents' share of marketable government debt increased from 15% (1997) to 36% (2002).
4. Challenges ahead
The forces changing the environment in which euro area debt managers must achieve their goals of cost minimisation have changed and are still changing.  Adjusting debt structures to this new environment takes time as long maturities reduce the possibilities of adapting instantaneously. The environment is expected to continue changing. We mention two specific challenges.
Diminishing sovereign bond supply
Government budget deficits in the euro area have come down substantially in the last decade with a view to qualifying for the fiscal convergence-criteria for adopting the euro, as outlined in the Maastricht Treaty. Although current fiscal developments in a number of euro area countries are troublesome, all countries still subscribe to the stated goal of balanced budgets in the medium-term. One particular reason for doing so is that population ageing will have a major upward impact on fiscal deficits in the decades ahead (Economic Policy Committee, 2002).
Compliance with the rules agreed in the Stability and Growth Pact, requiring balances to be close to balance or in surplus in the medium-term implies declining debt ratios. Thus, the supply of government bonds will shrink. While on a macroeconomic level this will have positive effects, it may impact on the functions that these bonds currently perform in the capital market as benchmark, safe haven and for monetary policy. Government bonds perform these roles because of their special combination of low credit risk and high liquidity.
* Benchmark. As to the role of setting the benchmark for the pricing of other bonds, a high degree of liquidity is essential. This allows government securities to be used as the standard for setting prices in other bond market segments. A reduced supply of government bonds could affect this market function and result in other securities having the opportunity to form the benchmark, such as highly-rated international organisations like the European Investment Bank, or internationally active financial institutions such as Freddie Mae (Wooldridge, 2001).
* Safe haven. Government bonds of industrialised countries are a safe haven in times of financial crises, in view of the very low credit risk and the continued high degree of liquidity. Whether a reduced supply will cause problems depends on the degree to which other securities could perform the same function.
* Monetary policy. Regarding monetary policy, government bonds form the main element of collateral for central bank credit operations. A reduced supply of government bonds however, can easily be absorbed by allowing private bonds to be used as collateral, as is currently already the case in monetary policy operations in the euro area if certain eligibility conditions are fulfilled.
At the same time, from the demand side of the bond market, the interest in government bonds could well be increasing. In particular, pension funds in the euro area are expanding and are being rapidly introduced in a number of countries in addition to the pay-as-you-go financing system of pensions. Demand from these institutions focuses on long maturities and on inflation-indexed bonds, in view of the long-term inflation-linked pension liabilities. Thus, as a reduced supply probably implies shorter maturities, a serious mismatch between the maturities of assets and liabilities of pension funds could occur (Bishop, 2000).
It is as yet too early to tell whether less government debt will hinder the sound functioning of financial markets. The development of alternatives is partly an endogenous development. A crucial issue is whether the alternative is a close substitute for government debt. In this context, it is worth recalling that the securities market in the euro area is less of a source of corporate finance than in the United States. Thus, the government securities market in the euro area is not as important as in the United States for corporate finance (International Monetary Fund, 2001). This implies that close substitutes are less likely to be available. Finally, while the United States experienced a short period of budget surpluses around the turn of the century, such an event is still to occur in the euro area.
Further debt management co-ordination
Debt management practices in the euro area have strongly converged but have not yet been fully harmonised, creating obstacles to a single bond market (International Monetary Fund 2001). Attention now focuses on removing the remaining impediments. Certain technical items on which further co-ordination could be possible include the issuing calendar. Thus far, no formal arrangements have been made between debt managers to spread issuances, which has occasionally resulted in debt managers issuing bonds at the same time. In addition, identical coupon and maturity dates have been called for, as well as a common primary dealer system. Differences in market structure and legal and regulatory differences also prevent the euro area debt market from being fully integrated. Non-co-operative issuing practices may reduce transparency and cause disturbances to markets if issuing dates are set in a discretionary manner.
Though these ideas for 'technical' co-operation are not undisputed, much discussion focuses on further ideas for the co-operation of debt management in the euro area. Calls for co-operation partly arise from cost concerns. Debt managers in the smaller euro area countries face liquidity premiums that could be avoided if debt issuances were bundled. This could eliminate the natural disadvantage of the smaller countries, which could be aggravated if borrowing requirements decrease further due to declining deficits. Further co-ordination could take many forms, such as issuing a joint security with country-specific portions, issuing such a security with a joint guarantee and issuing a bond by a single issuer (Giovannini Group 2000).
Increased co-operation would allow the establishment of one single benchmark for the euro area over the entire maturity structure, enabling euro area government debt to fulfil many or all of the functions its US counter-part currently performs. Discussions focus, amongst others, on the expected cost savings. These could turn out to be small and are uncertain, depending also on the creditworthiness financial markets assign to a common bond, compared to the ratings of the underlying issuers (Bishop, 2000). At present the largest countries in particular seem to have little to gain from further co-operation, facing as they are liquid markets and top credit ratings. More importantly, the no-bail-out clause limits the degree of co-operation. This clause, which is included in the Maastricht Treaty, forbids financial assistance in the case of one of the euro area countries running into financial problems. The background for this clause is that countries have to solve their own financial problems, avoiding negative spillover effects to those countries that pursue sound policies. Weakening this rule implies the increased likelihood of spreading unsound fiscal polices and at the same time decreases incentives for sound fiscal behaviour. Debt management co-ordination should continue to take this backbone of the European policy constellation into account.
We have described to what extent the strategies of government debt managers in European countries have changed due to developments such as the introduction of the euro, declining government debt ratios, the introduction of electronic trading systems and the changed institutional positions of debt managers. Financing debt at low costs in this new environment required changes in strategy.
An important recent feature of debt management is the convergence in debt management strategies; there is a clear tendency to issue 'plain vanilla' bonds and the size of these bond issues is rather large compared to pre-EMU years. After the adoption of the euro, the share of shortterm debt fell particularly in highly indebted countries like Belgium, Greece and Italy. The average remaining maturity of debt in euro area countries has converged to about 6 years on average.
Although countries have different attitudes towards funding part of the borrowing requirement in foreign currency debt, the share of debt in non-euro denominated currencies is gradually declining.
On the other hand, 'innovative' products such as swaps and inflation-indexed bonds have gained in importance. Swaps introduce more flexibility in debt management, by separating the issue of liquidity from the risk profile. As to inflation-indexed bonds, three countries now issue bonds linked to a euro area price index. Portfolio diversification is emerging as the main motivation for investing in indexed bonds.
All euro area countries but Germany use primary dealers to distribute government bonds. On average, debt agencies operate with some 15 primary dealers, but there are substantial differences among countries. Another way of distributing government bonds that has gained importance, especially among the smaller euro area countries, is the use of a syndicate. Domestic ownership of total government debt decreased from 75% in 1997 to 54% in 2002 in the euro area. Increased spreading of bond ownership occurred notably in the smaller Member States.
Finally, we have discussed two challenges that debt managers may face. First, declining debt ratios may impact on the functions that these bonds currently perform in the capital market as benchmark, safe haven and for monetary policy. These roles stem from the special combination of the low credit risk and high liquidity of government bonds. We conclude that it is not yet certain whether lower government debt will hinder the sound functioning of financial markets, as the development of alternatives is partly an endogenous development. A crucial issue is whether alternatives are a close substitute for government debt.
Second, we discussed the co-operation of debt managers in the euro area which may lead to lower costs, especially for smaller countries. However, the no-bail-out clause of the Maastricht Treaty limits the degree of cooperation.
We would like to thank Richard Jong-A-Pin for research assistance, and two anonymous referees for useful comments. The opinions expressed are those of the authors and do not necessarily reflect the views of the European Central Bank.
(1) See Favero et al. (1999) and Missale (1999) for comprehensive studies on government debt management pre-EMU.
(2) The most common definition of liquidity refers to the extent to which market participants are able to conduct sufficiently large transactions without producing major price movements. In the bond market, the liquidity of issues depends on matters such as issue size, maturity (recent issues tend to be more actively traded) and secondary market making conditions (Santillán et al., 2000).
(3) We assume here the objective of cost minimisation to remain the central objective of European debt managers. Favero et al. (1999) have suggested that, in the light of the fiscal rules in Europe, an alternative objective of debt management may be to stabilise the deficit-to-GDP ratio, with the aim of reducing the likelihood of breaching the 3% of GDP deficit reference value.
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Fiscal Policies Division, European Central Bank
Jakob de Haan
Faculty of Economics, University of Groningen and CESifo,
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Publication information: Article title: Government Debt Management in Europe: Recent Changes in Debt Managers' Strategies. Contributors: Wolswijk, Guido - Author, de Haan, Jakob - Author. Journal title: Public Finance and Management. Volume: 6. Issue: 2 Publication date: April 1, 2006. Page number: 244+. © Southern Public Administration Education Foundation 2009. Provided by ProQuest LLC. All Rights Reserved.
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