Rise in government debt brings challenges

The surge in Organisation for Economic Co-operation and Development budget deficits and borrowing needs is creating unprecedented challenges in government bill and bond markets.

Amid continued uncertainty about the pace of recovery, as well as the timing and sequencing of exit strategies, gross borrowing needs of OECD governments are expected to reach almost $16,000bn in 2009, up from an earlier estimate of about $12,000bn. In 2010, the OECD area-wide fiscal deficit is projected to peak at a post-war high of about 8.25 per cent of GDP, while the tentative borrowing outlook for 2010 shows a stabilising picture at about $16,000bn.

Another marker for the scale of the challenge is the size of outstanding debt. In 2007, for example, total marketable debt of the central governments in Japan, the US and eurozone stood at nearly $21,000bn, more than double the level a decade before. In 2009, it is projected to be more than $27,000bn. Raising large volumes of funds at the lowest possible cost has therefore become a tough challenge. Debt managers had to deal with the consequences of increased competition in raising funds, extreme volatility in markets and (potential) market absorption problems. They have therefore introduced changes in issuance procedures, including more flexible auction calendars and more flexibility in the amounts offered. The compass of debt managers is aimed at balancing the cost and increasing risk of rapidly growing debt portfolios, including refinancing, repricing and interest rate risks.

In response, OECD debt managers have sought to rebalance the profile of their debt portfolios by issuing more long-term instruments. For the OECD area as whole, the share of short-term issuance to total gross issuance peaked at nearly 70 per cent in 2008. This year it is estimated that it will decrease to about 63 per cent, with a projected further decline in 2010.

Most OECD debt managers have been very successful in financing the surge in funding needs. Less successful auctions can be viewed as “single market events” and not as evidence of systemic market absorption problems.

A looming additional challenge is the risk that, when the recovery gains traction and risk aversion falls further, yields will start to rise. Market stress may be further aggravated by exit implications of monetary policy shifts, creating additional complications for the debt management strategy. Thus far, investor demand in many OECD countries and across a variety of asset classes (including government securities) was and is (largely) driven by the central bank’s low interest rate policy (in some cases zero rates) and asset purchase and quantitative easing programmes. Exit measures, via unwinding of non-standard monetary policy measures, reverse repos, or raising official rates, must therefore be carried out with great prudence, especially in situations where significantly greater government debt issuance can be expected in future.

The termination of central bank purchase programmes and selling assets acquired by central banks during quantitative easing schemes could see greater government issuance needs but without market support, leading to an upward pressure on market rates (which may of course be desirable from a monetary policy point of view).

However, it could also rock (government) securities markets by pushing up strongly longer-term rates on government bonds (and perhaps also long-term mortgage rates). This quite complex situation requires a clear understanding by the monetary authorities of the market impact of exit programmes, a proper communication strategy, and an effective two-way exchange of information between the government issuer and central bank. With proper planning asset sales do not need to be disruptive.

Although clever debt management strategies could potentially reduce government borrowing costs, sound public debt management is no complete substitute for sound fiscal policy. Over time, a return to a prudent medium-term fiscal strategy is an essential element of any credible exit strategy to bring debt service costs under control.

Hans Blommestein is head of public debt management at the OECD