Academic journal article Public Finance and Management

Borrowing Short- or Long-Term: Does the Government Really Face a Trade-Off?: A Stochastic Macro Framework for Public Debt Management

Academic journal article Public Finance and Management

Borrowing Short- or Long-Term: Does the Government Really Face a Trade-Off?: A Stochastic Macro Framework for Public Debt Management

Article excerpt

Abstract

This paper considers public debt management as a component of a more general problem involving fiscal planning under uncertainty. This approach has the potential to result in a new optimal debt maturity structure. Using a stochastic simulation macro-econometric model, we show that a shorter debt maturity structure is generally less expensive and may also contribute to stabilize the budget balance as interest rates tend to decline when the economy is weak.

(ProQuest Information and Learning: ... denotes formulae omitted.)

0. Introduction

Different perspectives exist on the choice of the maturity structure of public debt. Debt managers have traditionally analysed this choice as a trade-off between low and stable debt service cost. The policy implication is that a risk-averse government should issue a "prudent" (i.e., longterm) debt maturity structure to limit exposure to ongoing refinancing requirements and unexpected interest rate changes.

However, debt management can be analysed from another perspective as a component of a more general problem involving fiscal planning under uncertainty. Under this approach the preferred debt maturity structure is determined by its influence on the overall budget balance, rather than on debt service cost alone.

There is indeed a growing interest among sovereigns toward a better integration of debt management into fiscal planning, with the aim of smoothing budget balance (or reducing probabilities of deficit outcomes) over the business cycle. The idea behind budget balance smoothing is to establish a debt structure that ensures that the risk of high debt costs is reduced in situations when the budget is tight.

Although the paper is meant to describe the Canadian context, this issue is of relevance for countries that are trying to hit budget targets while also trying to optimally structure a large public debt. Since the governments under the European Economic and Monetary Union and the "Stability and Growth Pact" are committed to avoid "excessive" budget deficits, debt management can be used in the interest of that goal. Indeed, Missale (2001) considers that the Stability and Growth Pact introduces deficit stabilization as a new objective of debt management where interest payments on public debt may serve as a hedge against the budget consequences of cyclical downturns.

We show in this paper that a shorter debt maturity structure is less expensive on average and may be less risky from the point of view of the overall budget balance if demand shocks prevail over the business cycle. The policy implication is that a fiscal planner is likely to favour a debt maturity structure shorter than the one chosen by the debt manager if he/she believes that demand shocks are likely to prevail relative to other shocks (e.g., interest rate, inflation, and supply shocks).

We assume throughout this study that the government of Canada does not engage in opportunistic borrowing through a financing strategy that attempts to pick ideal market conditions. The government of Canada does not attempt to save by shortening debt maturity when the yield curve is particularly steep and by lengthening maturity when the yield curve is flat or inverted. It is assumed in this paper that once the government selects a debt maturity structure, it maintains it for the remaining fiscal planning horizon (ten years). This assumption seems to be supported by a variety of public documents (e.g., Department of Finance-Canada, 2001) which stress that the general debt management strategy is not based on a particular interest rate outlook.

This paper should not be viewed as an attempt to contrast "debt managers" with "fiscal planners" but to emphasize that a broader macroeconomic view of debt management may shed a new light that could serve the field of debt management. The plan of this paper is as follows. Section 1 reviews some key features of the stochastic simulation macro-econometric model of the Canadian economy that we have used for this study. …

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