Does debt management matter? YES

The World Bank FEBRUARY 1999 NUMBER 17 ECONOMIC POLICY Does debt management matter? Yes A comprehensive debt management strategy can buffer developing countries from volatile international capital markets. Argentina's strategy provides a useful model. East Asia's recent financial crisis was the a solid banking system that is properly reg- largest and most widespread crisis of the uated and adequately supervised. Debt man- 1990s. Rescue packages ranging from $10 agement can play a particularly important billion to $50 billion were cobbled together role in reducing financial vulnerability by Debt management in months or even weeks to help countries limiting liquidity and rollover risks. Why is facing severe balance of payments prob- thisimportant? Because if investors suddenly can reduce financial lems. Devaluations in the region exposed refuse to roll over debt, the government important weaknesses in domestic financial must pay higher interest rates to attract vulnerability by sectors as banks and other borrowers scram- investment. And if the liquidity crunch lasts bled to make payments. long enough, higher interest rates can dam- limiting liquidity and One distinctive feature of East Asia's cri- age fiscal accounts and threaten to become sis is that most of the vulnerability emerged a solvency problem, increasing country rollover risks from large stocks of short-term debt rather risk-that is, the spread over the risk-free than from more traditional shortcomings interest rate that the country pays for funds- such as fiscal deficits. Short-term debt, pri- and borrowing costs. The less solvent is the vate and public, proved much harder to government, the higher are the costs of service than had been anticipated. Rating financing. This note describes what gov- agencies and other analysts were caught off ernments can do to manage debt and exam- guard because they put too much focus on ines Argentina's strategy. indicators that signal fiscal and debt sus- tainability problems (such as the ratio of debt Argentina's debt management to exports) and too little on indicators that strategy signal financial imbalance (such as the ratio The ultimate goal of Argentina's debt man- of short-term debt to international reserves; agement strategy is to improve the coun- see PREMnote 16). In fact, most of the try's credit rating to investment grade. region's problems were triggered by sudden Argentina's debt is still considered specu- difficulties in rolling over short-term debt, lative, and as a result it pays a higher pre- in either domestic or foreign currency, and mium for funds than do investment grade problems in the banking system. countries. To ease this burden, the debt How can governments stem large capital management strategy tries to minimize long- oufflows that result from sudden changes in term borrowing costs, ensure fluid access market sentiment? Efforts to reduce vul- to domestic and international capital mar- nerability to capital outflows must include kets, and limit vulnerability to shocks in a strategy to manage debt and to establish international markets. FROM THE DEVELOPMENT ECONOMICS VICE PRESIDENCY AND POVERTY REDUCTION AND ECONOMIC MANAGEMENT NETWORK The strategy has five main elements. The lent to one-quarter of annual financial first seeks to develop a sound structure of requirements, to provide flexibility in the amortization payments for long-term debt to timing of transactions and to avoid the need avoid a concentration ofprincipal repayments to issue debt at times of high volatility or in a given year, thus limiting the refinanc- interest rates. Other countries might not ing risk. To achieve this goal, the government need such a mechanism if the central bank has issued most new debt at longer maturi- holds international reserves to provide this ties (five years and more) to take advantage cushion. But in Argentina, which has a cur- of periods when the amortization schedule rency board, international reserves are used is lighter. As a result annual amortization pay to back the monetary base, and the inde- Argentina's strategy ments of long-term debt are converging to pendent central bank is prohibited from $10 billion a year, equivalent to 10 percent financing the treasury. Thus the treasury provides flexibility, of total long-term debt (figure 1). needs its own reserves in addition to those The second element is a deliberate effort of the central bank. liquidity, and to limit short-term debt in an era of high The fourth elementdiversifies sources of volatility in international capital markets. financing to increase the number of domes- opportunity As noted, in recent years there have been tic and foreign investors that hold Argen- many episodes (including a few in Argentina tine debt, thus improving the chances of in the late 1980s) where difficulties in refi- tapping markets at all times. Even with global nancing short-term debt have destabilized financial markets, access varies across cur- domestic financial markets. This problem rencies and across types of investors. Pen- has been particularly acute for domestic cur- sion funds usually prefer long-duration rency debt, where interest rates are more instruments with the potential for capital volatile-especially if there is concern about gains, while money market funds lean toward a possible devaluation or a large increase in debt instruments with low price volatility, inflation that would erode the real value preferably for the short term. In addition, of domestic currency debt. Argentina issues experience shows that there is incomplete all of its short-term debt in the domestic mar- arbitrage between European currencies, the ket in both pesos and dollars. Short-term U.S. dollar, and the yen, perhaps as a result debt accounts forjust 3 percent of total debt, of transactions costs and credit restrictions. or less than 1 percent of GDP-a small bur- As a result there are often attractive oppor- den, especially relative to other emerging tunities for issuers who find it more cost- markets. effective to issue in one currency than The third element of the strategy secures another. a liquidity cushion at the treasury, equiva- Argentina has taken advantage of those opportunities and has diversified its issues FIGUE 1 ATURTY POFIL OFacross currencies (figure 2). The govern- FIGURE 1 MATURITY PROFILE OF ARGENTINA'Sment haswell-developed yield curves in U.S. ARGETINAS PULIC EBTdollars and European currencies, allowing Prinicipal repayments, a comparison of costs for different maturi- in billions of U.S. dollars ties and different currencies. These yield 1998 curves also allow the government to issue 1999 structured deals-that is, deals that use the 2000 2001 yield curve for pricing but have some spe- 2002 cial features such as calls, puts, or adjust- 2002 2003 ing spreads-for specific investors, thus 2004 broadening the investor base. 2005 The final element of the debt manage- 2006 ment strategy seeks to develop a domestic 2007-10 201 1-27, treasury market, including T-bills (Letes) and 0 5 10 15 20 T-bonds (Bontes) in pesos and dollars, respec- PREMNOTE 17 FIGURE 2 SOURCES OF INTERNATIONAL experience shows that limiting the size of FUNDING FOR ARGENTINA, 1996 short-term debtand generating a sound pro- Argetinefile of amortization payments for long-term Argentine debt greatly reduce rollover risk. These Other pesos Euro 6% 4% Lire efforts have also helped Argentina access 9% 13%financial markets even at the worst times of the East Asian crisis. Indeed, because of k kYen this strategy Argentina has had smaller over- Deutsche 8% all (foreign plus domestic) refinancing needs marks than Brazil, Russia, or other emerging mar- 24% ket countries. The risks of One important lesson of the Asian cri- sis is that in today's globalized markets the refinancing can risks of refinancing can be larger for domes- U.S. dollars tic currency debt than for foreign currency be targer for 37% debt. Since the onset of the crisis the cost of refinancing domestic currency debt has domestic currency tively. Instruments denominated in both cur- increased up to eight times, generating a rencies are a distinctive feature of Ar- domestic currencydebt trap that threatened debt than for gentina's market and reflect the bimonetary fiscal accounts. nature of the economy, where the long end With concerns about short-term debt on foreign currency of the capital market functions primarily the rise, some economists have favored in dollars. Letes and Bontes are intended to the imposition of capital controls. But debt accommodate the recent growth in domes- Argentina's experience suggests that volatile tic capital markets as four groups of insti- flows can be dealt with through pruden- tutional investors-pension funds, mutual tial regulation in the banking sector and funds, insurance companies, and banks- overall sound policies in capital markets. become bigger players in fixed-income The Central Bank's prudential regulation instruments. for banks is stricter than international stan- The development of Argentina's treasury dards and has ensured adequate liquidity market was based on the successful expe- for it to act as a lender of last resort to the riences of industrial countries such as banking system by negotiating a standby France, Italy, Spain, and the United States. borrowing facilitywith international banks Instruments are issued through Dutch auc- (box 1). tions, and most bids are submitted through Avoiding the conversion of private debt the 12 banks that are the primary dealers or into public debt also helped Argentina market makers. These banks guarantee the overcome the crisis. During the tequila cri- success of the auction by ensuring the sub- sis of 1994-95, despite continuous pres- mission of enough bids to cover the size of sure from investors, the government stayed the auction. They also provide adequate liq- out of private contracts. Problems in ser- uidity to these instruments to make them vicing private, provincial, and municipal attractive to investors. In addition, the gov- debts had to be solved by the parties ernment has adjusted the financial infra- involved without the participation of the structure to minimize the settlement risk, federal government. This approach helped and is taking steps to increase transparency establish discipline and avoid losses in trading and to reduce the bid-ask spread because there was less moral hazard and in the secondary market. hence more prudent behavior by private borrowers. Lessons Looking forward, perhaps the biggest Debt management matters and can help challenge is to develop new indicators of reduce country vulnerability. Argentina's financial vulnerability. These new indicators FEBRUARY 1999 Box 1 THE CENTRAL BANK OF ARGENTINA'S REPO FACILITY In 1996 the Central Bank ofArgentina nego- the program is extended under the same tiated a contingent repo program with top- terms and conditions to ensure access to the rated international banks. This line of credit facility for a long enough period. was intended to increase systemic liquidity The repo has a 20-28 percent haircut, to the banking system while preserving the depending on the security. The margin is Central Bank's capacity to act as a lender of based on mark to market, and the Central last resort. The credit line originally repre- Bank has to provide an additional margin sented about 10 percent of deposits, and it (either in securities or in U.S. dollars). If has been growing to reflect the increase in the prices of the financial instruments fall deposits in the banking system. by more than 5 percent, the Central Bank will Under the program the Central Bank has provide sufficient margin to cover 125-140 the option of selling Argentine dollar-denom- percent of the amount of the transaction. The inated bonds subject to a repurchase agree- repo program costs $7.2 billion, with $6.7bil- ment. Depending on the bank, the program lion coming from government bonds and $0.5 lasts from two to five years. Every three months billion from mortgage-backed securities. should put more weight on stocks of debt lic sector; instead they insist on using indi- and other financial assets rather than on cators of dubious usefulness, such as ratios flow indicators such as the current account of debt to exports. deficit. Domestic and foreign currency debt have become more fungible (especially This note was written by MigelA. Kguel, under- under fixed exchange rates), and banking secretary offinancing and chief of the Cabinet system liabilities need to be monitored more ofAdvisers ofArgentinas Ministry ofEconomy closely so that they do not become a pub- and Public Works and Services. lic sector liability in a crisis. In this light it Ifyou are interested in similar topics, consider is surprising that many officials responsi- joining the Managing Capital Flow Volatility ble for evaluating country risk do not have Thematic Group or Strategic Debt Management a good diagnosis of domestic currency debt Thematic Group. Contact Sara Calvo, x3633 7, or of the contingent liabilities of the pub- or click on Thematic Groups on PREMnet. T his note series is intended to summarize good practice and key policy findings on PREM-related topics. PREMnotes are distributed widely to Bank staff and are lt f also available on the PREM website (http://prem). If you are interested in writing a PREMnote, email your idea to Asieh Kehyari. For additional copies of this PREM- ave note please contact the PREM Advisory Service at x87736. Prepared for World Bank staff