FIRST DRAFT OF THE WORKING GROUP REPORT ON

THE NEED FOR A MIDDLE OFFICE FOR PUBLIC DEBT

MANAGEMENT

(as circulated in the Fifth Meeting of the Working Group on January 19, 2001)

1
 FOREWORD

The need for a comprehensive strategy for public debt management has been
felt for some time because of high fiscal deficits, the consequent increase in debt
burden of the Central Government and the absence of an integrated approach towards
domestic and external public debt management.

As a major step towards putting in place an effective system for public debt
management, a Working Group has been constituted to examine the need for an
integrated “middle office” for public debt management. The role of the “middle
office” envisaged is to make analysis, provide advisory support and management
information system inputs for debt management decisions. The issue was examined in
the context of effective public debt management of the country keeping in view the
possible long-term requirements. Given the wide array of issues involved, the Group
has restricted its focus on the institutional structure, risk management requirements
and best international practices. The recommendations made in this regard, for setting
up a centralized middle office, should be viewed as the starting point towards creation
of a strong institutional system for prudent public debt management.

The recently introduced Fiscal Responsibility and Budget Management Bill

2000, which encompass stipulating limits on public debt as a proportion of GDP,
besides other ceilings on fiscal indicators, have created conducive conditions for
capacity building for public debt management. The initiative of the Group, as outlined
in its recommendations, is also in tune with recent efforts by international financial
institutions like the World Bank and IMF to identify as to what constitutes sound
practices for sovereign debt management.

The setting up of the Working Group and its Report was made possible by
funding from the Institutional Development Fund Grant of the World Bank, aimed at
strengthening the debt management capacity of the country. The Group is indebted to
the valuable insights provided by Mr. Graeme Wheeler and Mr. Fred Jenson from the
World Bank, Mr. Nihal Kappagoda for his consultancy report on best international
practices, and Dr. Raj Kumar, from the Commonwealth Secretariat, London for
complementing Mr. Kappagoda’s efforts. The Group also had the benefit to be
enriched from different officials of select debt offices visited. The Working Group
would like to acknowledge contributions made by Mrs. Usha Thorat from the Reserve
Bank and Mr. Alok Chaturvedi from the Ministry of Finance. On behalf of the Group,
I would also take this opportunity to place on record special appreciation for the
technical inputs provided on the subject by Mr. Arindam Roy from the Ministry of
Finance. The Group is indebted to officials from External Debt Management Unit in
the Ministry of Finance for rendering valuable assistance and providing secretarial
support for the Group.

(Arvind Virmani)
Tuesday, January 30, 2001

2
 INDEX

Report of the Working Group

1. Introduction 1
2. Debt Position of the Central Government 1
3. Central Government Debt Management 3
4. International Experience 4
5. Recommendations 5

Annexures

I. Constitution of the Working Group

II. Central Government Debt

2.1 Definition of Public Liability
2.2 Debt Position of the Central Government
2.3 Debt Burden of the Central Government
2.4 Net Liability of the Central Government
2.5 Contingent Liabilities of the Central Government
2.6 Legal Ceilings on Central Government Debt

III. Existing Structure for Public Debt Management

III.1 Internal Public Debt Management
III.2 Other Domestic Liability Management
III.3 External Public Debt Management
III.4 Missing Links in Middle Office Functions for Public Debt
Management
III.5 Co-ordination among Debt Management Activities

IV. International Experience and Best Practices in Public Debt Management

4.1 Approach in Study of Best International Practices
4.2 Risk Management Framework for Government Debt
4.3 Institutional Structure for Public Debt Management
4.4 Scope of Role and Functions of Debt Offices
4.5 Organisational Structure
4.6 Governance - Legal Framework and Accountability
4.7 Coordination with Fiscal Policy Authority and Monetary Policy
Authority
4.8 Capacity Building in Sovereign Debt Management

V. Summary Recommendations by the Commonwealth Secretariat on Best

International Practices in Sovereign Debt Management

VI. List of Select Debt Offices Visited by the Working Group

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 Report of the Working Group

1. Introduction

1.1 The importance of public debt management has grown immensely over
the years. In India, the need for a comprehensive strategy for public debt
management has been felt for some time. The concern stemmed from the
accumulation in the stock of Central Government debt, high interest burden on
public debt, absence of an integrated risk-management approach towards
domestic and external public debt management, and the need to manage
contingent liabilities of the Government in a centralised manner.

1.2 As a step towards putting in place an effective system for public debt
management, a Working Group was constituted on July 18, 2000 to examine the
need for an integrated “middle office” for public debt management. The middle
office is usually the entity located within a debt management office, which
serves as the risk manager, formulates and advises on the debt management
strategy and also develops benchmarks for assessing the risk-cost trade off of
the portfolio. The role of the “middle office” envisaged is to make analysis,
provide advisory support and management information system inputs for debt
management decisions in the overall framework of the Central Government debt
portfolio, keeping into perspective the possible long-term requirements. The
Memorandum for setting up the Working Group, including the composition and
terms of reference is at Annex 1.
1.3 The Working Group was given a timeframe of four months i.e. up to
November 17, 2000 for submitting its Report. However, given the limited time
and wide scope of the terms of reference, the term of the Working Group was
subsequently extended up to January 31, 2001.

1.4 To study the need for a middle office, the Group analysed the
indebtedness position of the Government for understanding the scale of risk and
cost associated with it. Simultaneously, a review of the present debt
management structure in India was attempted to identify missing links, if any, in
the area of middle office functions for public debt management. In its endeavor
to make recommendations, the Group also undertook an in-depth analysis of the
international best practices for middle office role.

2. Debt Position of the Central Government

2.1 The mounting debt of the central government due to a long legacy of high
fiscal deficits and the increasing use of financing such debt for current
expenditure has led to a continual deterioration of the indebtedness position of
the central government. The total debt of the central government increased
4
annually at a compound growth rate of 13.4 per cent during end-March 1991 to
end-March 2000. While, the ratio of Central Government debt-GDP ratio stood
at 60.9 per cent during 1999-2000, the debt dynamics was characterised by a
“cross-over” in the growth of nominal debt relative to the growth of nominal
GDP, thus pointing towards further deterioration in the debt-GDP ratio. The
composition of outstanding debt also, underwent a change, with the share of
domestic debt increasing steadily since 1991-92. The growth in the domestic
component of Central Government debt was spurred by a heavy accumulation
of internal debt. The re-emergence of an increasing trend in revenue deficit as a
proportion of GDP since 1996-97 could be attributed to the sharp increase in the
internal debt of the Central Government in recent years. As a result, the ratio of
internal debt to GDP deteriorated significantly from 25.3 per cent in 1996-97 to
37.7 per cent in 1999-2000. A detailed study of the indebtedness position of the
Central Government is at Annex 2.

2.2 The steady accumulation in Central Government debt, particularly

internal debt, resulted in increased interest payments burden. The total outgo on
interest payments on Government debt, which accounted for one-fifth of the
total expenditure by the Government in 1990-91 increased to one-third of the
total expenditure in 1999-2000. Thus, interest payments, which pre-empted one-
half of the tax revenue in 1990-91, pre-empted nearly three-fourth of the tax
revenue of the Central Government in 1999-2000. Similarly, the proportion of
interest payments in total revenue receipts increased from 39.2 per cent in 1990-
91 to 51.9 per cent in 1999-2000. The increase in interest burden, inter alia,
stemmed from larger recourse to market borrowings at market-related rates.
Interest payments on external debt, on the other hand, remained fairly stable,
reflecting the concessional nature of such debt flows.

2.3 The over-hang in internal debt also led to potential for significant roll-
over risks in the medium term. The objective of the internal debt manager to
raise debt at minimum cost coupled with a shift in investor preference towards
short-term paper led to a policy of placing borrowings at the shorter-end of the
market. Given the burgeoning market borrowings, the share in outstanding
market borrowings in shorter maturity securities (with a maturity of less than 5
years) accordingly increased from 7.4 per cent of the total market loans in end-
March 1992 to 45.2 per cent in end-March 1998. Although, since 1998-99, the
maturity structure was lengthened with the introduction of long-term securities
and a conscious policy to avoid placing of short-term securities, the weighted
average maturity creeped up steadily from 5.5 years in 1996-97 to 12.6 years in
1999-2000. This entailed large future redemptions during the next ten years.
The external debt component, on the other hand, is characterised by smooth
redemption profile during the next ten years, reflecting the long-tenor of official
debt flows.

5
2.4 Thus, while the debt of the Central Government has reached
unsustainable limits, there is a potential of significant interest rate and roll-over
risks of the domestic debt component, at least in the medium term. For the
external debt component, there remains significant foreign exchange risk, in the
absence of any hedging or portfolio management strategy. In addition,
contingent liabilities of the Central Government, in the form of guarantees on
both domestic and external debt, which, amounted to 5.9 per cent of GDP in
1998-99, poses further risk for the Central Government’s debt position.

2.5 To redress the growing indebtedness position of the Central Government,

in the past, several public agencies recommended enacting legislation for
controlling the Central Government borrowings. The Constitution of India has
provision for placing a limit on the public debt of the Central Government. Very
recently, in an effort to promote overall fiscal prudence, the government has
introduced the Fiscal Responsibility and Budget Management Bill, 2000 in the
Parliament. If the proposed Bill finds passage in the Parliament, it could clearly
serve as the starting point for improving the indebtedness position of the
government.

3. Central Government Debt Management

3.1. The Indian case of public debt management could, at best, be

characterised by a clear dichotomy – management of internal debt by its central
bank, and the other component of domestic debt and external debt, by the
Government. The focus of internal debt management by the Reserve Bank has
been to manage the refinancing and liquidity risk, while ensuring that
borrowings are raised at minimum cost. Efforts aimed at managing other risk
components in terms of portfolio management policies by the Reserve Bank
have been constrained by the overriding concern of meeting the large scale of
borrowing needs and the government debt market which is still in the process of
transformation towards maturity. Portfolio management exercises for other
domestic liabilities, which has largely been characterised by autonomous flows,
is completely missing and the policy framework has been largely dominated by
budgetary needs. On the other hand, for public external debt management, since
the bulk of the debt came from official sources in the form of aid flows, the
Ministry of Finance focussed solely on retiring expensive debt by prepayments
or refinancing, without any portfolio management exercises. Only recently, a
modelling exercise for risk management of the sovereign external debt portfolio
was initiated, after an initiative by the IBRD to allow borrowers flexibility for
deciding on currency and interest and also to allow hedging instruments on
existing IBRD debt for portfolio management purpose. Annex 3 outlines the
institutional structure for public debt management of Government of India.

3.2 The dispersed nature of public debt functions both across and within
different agencies could be responsible for the lack of an integrated debt
6
management structure, which in turn has led to many a missing links in
Government’s debt management strategy. The pivotal role in this regard, usually
played by a middle office; which formulates the borrowing strategy, establishes
a framework for risk management and periodically advises on debt management
operations in an integrated framework has been largely conspicuous by its
absence. Thus public debt management fell short of developing public debt
sustainability benchmarks; medium and long-term public debt management
strategy; making a choice between domestic and external debt; developing
benchmarks for currency, interest and maturity mix as part of reducing costs and
risks. Another area, where risk management practices are yet to be introduced in
a comprehensive manner is contingent liabilities of the Government. These
missing links in risk management for internal, other domestic debt and external
debt portfolios, as well as for the total portfolio in an integrated framework,
point towards the pressing need for a middle office.

3.3 The issue of conflict in objectives between debt management and

monetary policy has also been an area of concern while reviewing the
institutional structure for debt management.

4. International Experience

4.1 International evidence of debt management practice by leading debt

office bears many valuable lessons for countries in the process of strengthening
their debt management capacity. Many countries - mainly advanced and some
emerging market economies - have set up public debt offices and are
successfully managing their sovereign debts. In some instances, public debt has
been brought down from what were clearly unsustainable levels. There has also
been a significant change since late 1980s in the institutional structure, the role
and style of functions of public debt management towards risk management.
This has been enabled by institutionalisation of the debt office with an in-house
risk management culture, as a specialised institution, staffed with professionals
and market specialists. The role of such debt offices, in many instances,
gradually transformed into treasury operations on the lines of operations
performed by investment banks, corporates and foreign exchange management
by central banks. Within the debt office, middle office emerges as the risk
manager, which formulates and advises on the debt management strategy and
also develops benchmarks for assessing the risk-cost trade off of the portfolio.
Annex 4 summarises the key sound practices in sovereign debt management.

4.2 The primary requirement in any comprehensive debt management

exercise is to bring the size of public debt at sustainable levels. Without
sustainability of debt, risk management would not have much impact towards
insulating the debt portfolio from systemic risks. Thus the primary task of the
middle office is to determine sustainability benchmarks and accordingly advice
the Government to ensure that the debt level is brought to sustainable levels.
7
The main risks that needs to be managed for the sovereign debt portfolio are
foreign currency risk, interest rate risk, credit risk, liquidity risk, refinancing
risk, operational risk and payments and settlement risk. Many debt offices have
addressed management of market risks like currency and interest rate risk by
establishing a risk management framework for the sovereign debt in an asset-
liability management framework.

4.3 A prudential risk management framework is essential for reducing

uncertainty among sovereign debt managers as to the government’s tolerance
for risk, its willingness to trade off cost and risk objectives. Once the risks are
identified, risks and costs for alternative debt strategies are measured in a
scenario-based model under a base case scenario and different market rate
scenarios; or in a simulation-based model under value-at-risk, cost-at-risk or
budget-at-risk approach. The government then chooses the strategy that best
represents the government’s preferences for managing the risk/cost trade-offs
and generally tend to choose it along an efficient frontier, which entails
minimum risk. The process of deciding a debt strategy by debt offices has been
facilitated, by using a “strategic benchmark” portfolio, which represent the
approved strategy. The actual debt portfolio could be then moved closer to
approved designed benchmark by debt managers while deciding on key terms
for new debt issues, by buyback operations, and also by using currency and
interest swaps and other hedging activities.

4.4 The institutional structure for public debt management, world wide, could
be broadly characterised into two categories – setting up of a full-fledged public
debt office and scattered debt management responsibilities. Within the former
category of a full-fledged debt office, which is the case for most of the advanced
countries and some emerging market economies, there has been a preference to
locate the debt office as a separate entity under the Ministry of Finance or
within the mainstream Ministry. There are also instances of locating the debt
office outside the Ministry as an autonomous agency. On the other hand,
Denmark is the only country where the debt office has been located within the
central bank. The tendency to locate the debt office outside the central bank has
been largely dictated by the overriding concern of the conflict in objectives that
arise between debt management and monetary management.

4.5 Governance issues promoting sound and professional approach towards

debt management, required debt offices to clearly define and disclose its
objectives for debt management, establishing an organisational structure that
ensures clear accountability and transparency of responsibilities with
appropriate internal controls, and establishment of a legal framework wherever
possible. For enabling sound risk management practices, most debt offices
established prudent risk management strategy and policy, strengthening middle
office analytical capability, and defining a framework for risk management
ensuring consistency with other macroeconomic policies and objectives. Debt
8
offices also accorded priority to recruitment of trained staff, and selection and
implementation of effective management information systems.

4.6 The second category of institutional structure reflects dispersed debt

management responsibility, with the Ministry of Finance responsible for
external public debt management and the central bank responsible for the
internal public debt management. Some of the emerging market economies with
dispersed debt management responsibilities, as a first step towards
strengthening their debt management capacity has started to set up a middle
office under the Ministry of Finance for evolving an over-all risk management
framework for the total public debt. The overall aim, for such countries, is to
establish a full-fledged debt office for effective debt management within a
comprehensive framework of risk management.

5. Recommendations

5.1 The Group recognised the need for a centralised middle office that could
focus on debt management advisory activities in a comprehensive risk
management framework. The middle office should operate on the lines of a
modern “treasury” so that it may impart a professional approach by adopting
modern management techniques for public debt management. Setting up such
an office, however, cannot be done in isolation and is to be seen in the context
of total structure comprising back, middle and front office functions to ensure
that they are in harmony with each other. The middle office role to be
successful, therefore, requires active interaction between concerned agencies
responsible for debt management.

5.2 The scope of the middle office for managing the Government debt should
include domestic debt components like internal debt and other domestic
liability; as well as external debt components like debt on Government Account
from external assistance, defence debt, and other sources of Government debt
like IMF debt and foreign institutional investment in Government securities. In
addition, it was felt that the scope of the middle office could gradually be
expanded to include management of Government contingent liabilities, both
explicit and implicit.

5.3 Thus, as a first step towards building a strong institutional mechanism for
public debt management in India, the Working Group felt it necessary to
establish a centralised Middle Office in the Department of Economic Affairs,
Ministry of Finance. The main reason for locating it in the Ministry of Finance
is that there are strong links between the budgeting and debt management
functions. At the same time, it would help to mitigate conflicts in objectives
between debt management and monetary policy.

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5.4 Operations of the Middle Office could be supervised by a Public Debt
Co-ordination Committee comprising of senior executives from the Ministry of
Finance, the Reserve Bank of India and the functional head of the budget
making entity. This would ensure that advisory role of the Middle Office would
be respected by different entities involved for government debt management.

5.5 The middle office should be staffed with officials from the Ministry of
Finance and drawing professionals on a deputation basis from the Reserve Bank
of India and financial institutions. Investment in infrastructure and human
resource development should be an area of priority for the Government to
promote professional approach towards debt management.

5.6 The Group observed that ceilings for Government debt as determined in
the recently introduced Fiscal Responsibility and Budget Management Bill
2000, would serve as a useful starting point for the Middle Office to develop
debt sustainability benchmarks for bringing the level of Government debt to
sustainable levels.

5.7 At the same time, a comprehensive risk management framework for

portfolio management exercise for the Government debt portfolio should also be
established by the middle office, based on cost-risk tradeoffs and the risk
tolerance limits of the government.

5.8 Based on the risk-management framework and cost-risk trade-offs, the

Middle Office would be expected to determine strategic benchmarks for the
debt portfolio. The strategic benchmarks could be the proportion of domestic
and foreign currency debt; the currency composition, duration, mix of floating-
fixed interest rate debt and maturity structure of foreign currency debt portfolio;
and maturity structure and duration for the domestic debt portfolio.

5.9 Strategic benchmarks, designed by the Middle Office, should have the
approval of the Finance Minister. For this purpose, the Public Debt Co-
ordination Committee should advice the Finance Minister periodically on the
appropriateness of the framework and the strategic benchmarks.

5.10 Once the strategic benchmarks are approved, the Middle Office should
regularly disseminate the relevant benchmarks to the concerned agencies
involved for contracting or issuing government debt. This would enable them to
determine their debt management strategy so as to be consistent with the
strategic benchmarks.

5.11 In essence, the character of the centralised Middle Office would vary in
terms of its responsibilities when viewed against different components of debt
for which debt management responsibilities rest with different agencies. For the
internal debt component managed by RBI, since there is already a middle office
10
in place, the role of centralised middle office would be to provide MIS inputs in
terms of broad strategic benchmarks. Thus, while RBI would continue to have
the flexibility for internal debt management, it could incorporate the strategic
benchmarks while deciding the debt management strategy. For RBI to undertake
active portfolio management consistent with the strategic benchmarks, would
also require middle office capacity to be strengthened at RBI. Active co-
ordination between the centralised middle office in the Ministry of Finance and
middle office in RBI, through sharing of data and necessary information could
also facilitate portfolio management.

5.12 For other debt components like other domestic liability and external debt,
for which debt management responsibility lies with the Ministry of Finance, the
centralised middle office would serve as the sole Middle Office for debt
management. Strategic benchmarks designed for other domestic liability and
external debt should be provided as part of detailed MIS inputs to different front
offices for such debt components like the budget making entity and different
credit divisions respectively. The front offices, in turn could fine-tune its debt
management policy so as to make the debt portfolio consistent with the strategic
benchmarks.

5.13 The Middle Office should be responsible for undertaking a consolidated

review of the portfolio to assess the risk characteristics and to ensure that actual
debt portfolio moves closer to the strategic benchmarks. For this purpose, it is
essential for monitoring, compliance and control functions of the middle office
are respected from the time the Middle Office is established.

5.14 The Middle Office should also act as the central unit for managing the
contingent liabilities. While the budget making entity would continue to take the
policy decisions regarding issuing guarantees and accumulating other
contingent liabilities like pension funds, recapitalisation cost towards public
sector enterprises, the Middle Office would try to shape such policies by
incorporating them gradually into the risk management framework. This would
also require active coordination with the budget making entity.

5.15 Other specific roles of the middle office would involve bringing out an
annual report on public debt, which should enhance the transparency of the debt
position of the central government. The report should clearly define and
disclose the main objectives of debt management, the riskiness of the portfolio
and performance of portfolio management by the relevant agencies as measured
by the cost of the actual debt portfolio relative to the portfolio based on the
benchmark.

5.16 For fair assessment of performance in portfolio management of the

Government debt, by different agencies could be made by annually by an

11
independent auditor. Auditor’s assessment should be based on the cost of the
actual debt portfolio relative to the benchmark portfolio.

5.17 Portfolio management exercises might require hedging activities for the
government debt portfolio. Hedging activities, if undertaken, should be
restricted purely to the need to achieve the strategic benchmarks and not involve
tactical trading.

5.18 The middle office should also act as the apex monitoring unit for central
government debt. Thus, data on government debt should be regularly transferred
by different agencies to the middle office. The middle office should ensure that
it develops a debt data recording system on a centralised platform, which is
amenable for portfolio analysis. The debt data recording system should be
preferably open-ended, so that, data requirements for applying new portfolio
management techniques are easily available.

5.19 Setting up a centralized middle office, should be viewed as the starting

point towards creation of a strong institutional system for prudent public debt
management. For resolving the issue of conflict in objectives between internal
debt management and monetary policy, and to redress the need for striking a
synergy in debt management activities of different functional units may require
setting up of a full-fledged debt office eventually. For this purpose, the Group
felt that the institutional structure of leading debt offices, as outlined in the
international experience (Annex 4) of the Report, could serve as an useful guide
to the Government, as and when, it decides to review the need for setting up a
full-fledged debt office.

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Annex 1. Constitution of the Working Group

O.O.No.F. No.1(3)2000-EDMU
Ministry of Finance
Department of Economic Affairs
External Debt Management Unit
----------------------------------------
New Delhi, July 18, 2000.

Subject: Working Group to examine the need for setting up an integrated debt
management “middle office” for public debt covering both external and domestic debt.

A Working Group is hereby constituted to examine the need for setting up an

integrated debt management “middle office” for public debt covering both domestic and
external debt. The role of the “middle office” envisaged is to make analysis, provide advisory
support and MIS inputs for debt management decisions. If the Working Group finds
justification for such an Office, the Group would make recommendations regarding the
scope, role and structure of the “middle office” and steps for setting up such office for debt
management purposes. The proposal is to be examined in the context of overall effective debt
management of the country keeping into perspective the possible long-term requirements.

The Working Group would comprise the following:

Chairman -Dr. Arvind Virmani, Senior Economic Adviser, DEA,

Member - -Mr. D. Swarup, Joint Secretary (Budget), DEA, MOF
or his nominee.
Member - -Dr. Tarun Das, Economic Adviser,DEA, MOF.
Member - -Dr. J. Bhagwati, Jt. Secretary(ECB),DEA, MOF
Member - -Mr. K. Shankar, Controller of Aid Accounts & Audit,
DEA, MOF
Member - -Dr. T.C. Nair, General Manager, Internal Debt
-Management Cell, RBI.
Member - -Mr. Deepak Mohanty, Director (DIF), DEAP, RBI
Member-Convenor - -Mr. Anil Bisen, Director (EDMU), DEA, MOF

The terms of reference of the Working Group are as under:

a) to examine the need/justification for an integrated debt management “middle

office” for public debt covering both domestic and external debt;
b) If justification is found for setting up an integrated “middle office” for public debt,
the Working Group would define the scope of the “middle office” taking into
consideration Indian requirements and the best international practices;
c) to specify role/functions/operations of the “middle office”;
d) to review the functions of the existing institutional set-up for debt management;
e) to propose structure of the debt office and link/interface with various concerned
institutions/agencies like Ministry of Finance, Reserve Bank of India etc;
f) to recommend steps and formalities for establishing the debt management “middle
office”, and
g) to make such other recommendations as the Working Group may deem
appropriate on the subject;

13
 The Working Group would hold necessary meetings and seek advisory support from
multilateral / bilateral and other institutions, including investment banks, who have expertise
in the area.

The Working Group would submit its Report within 4 months from the day it is
constituted. External Debt Management Unit shall act as the Secretariat for the Working
Group. The Group may co-opt any other person as deemed appropriate.

This issues with the approval of Secretary, Department of Economic Affairs.

s/d
(Tarun Das)
Economic Adviser

14
Annex II. Central Government Debt

2.1 Definition of Public Liability

2.1.1 As per the Government of India’s budgetary practice, there are three sets
of liabilities, that constitute central government debt viz. (a) internal debt, (b)
external debt, and (c) “other liabilities”. Internal debt and external debt
constitute “public debt” of India and are secured under the Consolidated Fund
of India. Internal debt includes market loans, special securities issued to the
Reserve Bank of India (RBI), compensation and other bonds, treasury bills
issued to RBI, state governments, commercial banks and other parties, as well
as non-negotiable and non-interest bearing rupee securities issued to
international financial institutions. External debt represents loans received from
foreign governments and bodies under the external aid window and is usually
classified as external debt on “Government Account”. Debt liabilities other than
internal and external debt, termed as other domestic liabilities, include interest
bearing obligations of the Government such as post savings deposits, deposits
under small savings schemes, loans raised through post office cash certificates
etc., provident funds, interest bearing reserve funds of departments like railways
and telecommunications and certain other deposits.

2.1.2 The “other liabilities” of the Government arise in government’s accounts

more in its capacity as a banker or trustee rather than as a borrower. Hence such
borrowings, not secured under the Consolidated Fund of India, are shown as
part of Public Account. Further more, some of the items of “other liabilities”
like small savings are more in the nature of autonomous flows, which to a large
extent are determined by public preference for relative attractiveness of these
instruments. Nevertheless, it should be emphasised that such liabilities are
contractual obligations of the Government and are economically
indistinguishable from the public debt. Moreover, through a change in the
accounting framework, it is possible to bring these liabilities under the Public
Account within the ambit of public debt under the Consolidated Fund. In fact,
under the new system of National Small Savings Fund (NSSF), with effect from
the fiscal year 1999-2000, a substantial portion of “other liabilities” have been
converted into Central Government securities.

2.1.3 The Report, therefore not only includes the above liabilities as
components of debt of the Central Government, but also includes external debt
incurred by borrowings from official agencies for defence purpose, including
Rupee debt from the former Soviet Union, and also from IMF, which is outside
the purview of the budgetary classification followed by the Government.
External debt of the Government, referred to in this Report, would include
external debt accrued in the “Government Account” as well as other sources of
external debt. The term ‘public debt’ of the Central Government, referred to in

15
this Report would follow the usual budgetary practice, comprising of internal
and external debt of the Central Government. The term ‘Government Debt’,
referred to in this Report, would include internal debt, external debt and “other
liabilities” of the Central Government.

2.2 Central Government Debt

2.2.1 Total stock of public liability of the Central Government has increased by
more than three-fold, at an annual compound growth rate of 13.4 per cent, from
Rs. 380,069 crore at the end of March 1991 to Rs. 1,176,174 crore at the end of
March 2000 (Table 1). The growth in the stock of debt was steeper during the
eighties, increasing at an annual compound growth rate of 19.9 per cent from
end-March 1981 to end-March 1991, or by nearly six-fold.

Table 1 : Total Debt of the Central Government

(Rs. Crore)
1=2+3 2 3 4 5=2+4 6=1+4
Total Other Total
Public Internal External Domestic Domestic Total Public
Debt Debt Debt* Liability Debt Liability
(Rupees Crore)
1980-81 44343 30864 13479 17587 48451 61930
1990-91 251040 154004 97036 129029 283033 380069
1991-92 325270 172750 152520 144964 317714 470234
1992-93 369185 199100 170085 160555 359655 529740
1993-94 420866 245712 175154 184911 430623 605777
1994-95 453732 266467 187265 221215 487682 674947
1995-96 489768 307868 181900 247115 554983 736883
1996-97 520860 344476 176384 276961 621437 797821
1997-98 572997 388998 183999 333964 722962 906961
1998-99 655625 459696 195929 374856 834552 1030481
1999-2000 931660 728627 203033 244514 973141 1176174
(% of GDP)#
1980-81 32.6 22.7 9.9 12.9 35.6 45.5
1990-91 44.1 27.1 17.1 22.7 49.8 66.8
1991-92 49.8 26.4 23.3 22.2 48.6 72.0
1992-93 49.4 26.6 22.8 21.5 48.1 70.9
1993-94 49.0 28.6 20.4 21.5 50.1 70.5
1994-95 44.9 26.4 18.5 21.9 48.3 66.8
1995-96 41.4 26.0 15.4 20.9 47.0 62.3
1996-97 38.2 25.3 13.0 20.3 45.6 58.6
1997-98 37.8 25.7 12.1 22.0 47.7 59.8
1998-99 37.2 26.1 11.1 21.3 47.3 58.5
1999-2000 48.2 37.7 10.5 12.7 50.4 60.9
* : External Debt for end-March 1981 refers to outstanding external debt on “government
account” and does not include other components of government external debt like IMF
and Defence debt.
# : Debt to GDP ratios are based on the New Series of GDP estimates at market prices
published by the Central Statistical Organisation.
Source : India’s External Debt – A Status Report, 2000; RBI Annual Report, 1999-2000; and
Economic Survey; 1997-98.

16
2.2.2 The dynamics of public liability in terms of a “debt-GDP crossover”, as
measured by the annual growth rate in public liability and the nominal GDP
growth, could be broadly identified into three phases during the nineties, i.e.,
1992-93 to 1993-94, 1994-95 to 1996-97, and 1997-98 to 1999-2000 (Figure 1).
The annual growth in public liability by 23.7 per cent during 1991-92 stood
higher than the nominal GDP growth. The first phase (1992-93 to 1993-94)
showed a declining trend in the growth of public liability, growing at an average
annual rate of 13.5 per cent and was marginally lower than the nominal GDP
growth. The growth rate in public liability further decelerated during the second
phase (1994-95 to 1996-97) by 9.6 per cent and was significantly lower than the
GDP growth. There was a reversal in the declining trend in the growth of public
liability, increasing again by 13.8 per cent during the third phase (1997-98 to
1999-2000), with the wedge between debt-GDP growth contracting sharply and
crossed the GDP growth rate during 1997-98 and 1999-2000. As a proportion of
GDP, the total public liability, which stood at 45.5 per cent at end-March 1981,
accordingly declined from a peak of 72.0 per cent during 1991-92 to 58.6 per
cent during 1996-97 before increasing to 60.9 per cent during 1999-2000.

Figure 1 : Nominal Debt Growth - GDP Growth Crossover

25.0

20.0

15.0
(per cent)

10.0

5.0

0.0
1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-2000

Total Govt. Debt Nominal GDP Total Domestic Debt

2.2.3 The debt-GDP growth crossover witnessed during the third phase was
propelled by growth in domestic debt of the central government. Increasing
reliance on domestic sources of borrowing mainly in the form of market
borrowings resulted from the changing nature of the fiscal position with re-
emergence of primary deficit since 1997-98 (Figure 2). While the share of
market borrowings financing the gross fiscal deficit more than doubled from
30.0 per cent in 1996-97 to 70.8 per cent in 1999-2000, the share of internal

17
finance increased steadily from 85.1 per cent in 1990-91 to a high of 99.2 per
cent in 1999-2000. Although the fiscal adjustment process initiated in 1991was
successful in arresting the growth in primary deficits during 1991-92 and 1992-
93, the resurgence in primary deficits since 1997-98 led to a steady
accumulation of domestic debt and market borrowings thereby reversing the
declining trend in the debt-GDP ratio. While the domestic component of the
government liability increased marginally from 45.6 per cent as a proportion of
GDP in 1996-97 to 50.4 per cent in 1999-2000, internal debt, which accounted
nearly half of the market loans, increased its share from 25.3 per cent to 37.7
per cent during the corresponding period. This raises concern about the
sustainability of the central government debt and in particular about the
domestic component and internal debt position.

F ig u re 2 : F in an cin g o f G ro ss F iscal D eficit

100 6

90

5
80
(Borrowings as % of Gross Fiscal Deficit)

70
4

(Primary Deficit as % of GDP)

60

50 3

40

2
30

20
1

10

0 0
1980-81 1985-86 1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-
2000

Market B orrowin g s Total In tern al F in an ce P rim ary Deficit - G DP R atio

2.2.4 The share of domestic component of total public liability increased

steadily from 67.6 per cent at the end of March 1992 to 82.7 per cent at the end
of March 2000, mainly due to a sharp increase in internal debt (Figure 3).
Internal debt increased at an annual compound growth rate of 18.8 per cent
during end-March 1991 to end-March 2000 or by nearly five-fold. Accordingly,
the share of internal debt in the total public liability of the government increased
from 40.5 per cent at end-March 1991 to 44.6 per cent at end-March 1999. The
share jumped to 62.0 per cent at end-March 2000 because of the sharp increase
in the growth of internal debt by 58.5 per cent during 1999-2000. The sharp
increase in internal debt during 1999-2000 was however, due to conversion of
other liabilities amounting to Rs. 1,80,273 crore into Central Government
securities, under the new system of National Small Savings Fund (NSSF), with

18
effect from the fiscal year 1999-2000. Accordingly, the share of other liabilities
in total public liability of the central government increased from 34.0 per cent in
end-March 1991 to 36.4 per cent in end-March 1999 and declined thereafter to
20.8 per cent in end-March 2000.

Figure 3 : Components of Total Government Debt Outstanding

100%

80%

60%

40%

20%

0%
1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-2000

Internal Debt Other Domestic Liability External Debt

2.2.5 On the other hand, total external debt of the government witnessed an
absolute decline from US $ 50.0 billion at end-March 1991 to US $ 46.5 billion
at end-March 2000. However, in terms of the local currency, the external
component of government debt increased at an annual compound growth rate of
8.5 per cent during end-March 1991 to end-March 2000 mainly due to the
depreciation of the rupee. In spite of the modest increase in rupee terms, the
share of the external debt in total public liability declined steadily from a peak
of 32.4 per cent in end-March 1992 to 17.3 per cent in end-March 2000. The
ratio of external debt to GDP also declined from a peak of 22.8 per cent in
1991-92 to 10.5 per cent in 1999-2000.

2.2.6 Public debt, which includes internal and external debt of the government,
also grew in consonance with the phase in growth of total government debt as
identified above (Figure 1). Increasing by 29.6 per cent during 1991-92, the
average growth rate in stock of public debt moderated during 1992-93 to 1993-
94 by 13.7 per cent, further decelerated by 7.4 per cent during 1994-95 to 1996-
97, and finally reversed the trend by increasing during 1997-98 to 1998-99 by
12.2 per cent. The spurt in public debt during 1999-2000 by 42.1 per cent
resulted from the conversion of other domestic liabilities into government
securities under the new system of National Small Savings Fund (NSSF), with
effect from the fiscal year 1999-2000. Accordingly, the ratio of public debt

19
declined from a peak of 49.8 per cent in 1991-92 to 37.2 per cent in 1998-99
before increasing to 48.2 per cent in 1999-2000.

2.3 Debt Burden of the Central Government

2.3.1 The overhang of government debt during the nineties, particularly

domestic debt poses significant risk for medium-term macro-economic stability
of the economy. For internal debt management, the large scale of market
borrowings has constrained the leverage for minimising the borrowing cost due
to increase in yields driven by interest rate premium and a shift in preference for
short-term paper caused by increasing uncertainty about future interest rates.
This has led to a policy of placing borrowings at the shorter end of the market,
so as to minimise the cost of borrowing. Thus the share of market borrowings in
shorter maturity securities (loans maturing within a period of 5 years) was as
high as 50.0 per cent during 1996-97 and 36.9 per cent during 1997-98. As a
consequence, the share of the shorter maturity market loans in total outstanding
market loans increased sharply from 7.4 per cent in end-March 1992 to 45.2 per
cent in end-March 1998.

2.3.2 Recognising the roll-over problems arising from the bunching of

redemption in the medium term, the maturity structure was lengthened with the
introduction of long-term securities (ranging from 11 year to 20 year maturity)
during 1998-99. While borrowing in longer-term maturity accounted for 13.5
per cent of the total market borrowings during 1998-99, the share of the shorter
maturity declined to 31.5 per cent. This was followed by placing all government
borrowings above 5-year maturity and about 65.0 per cent of the borrowings
through issuance of above 10-year maturity during 1999-2000. The weighted
average maturity of market loans thereby increased from 5.5 years in 1996-97,
to 6.6 years in 1997-98, 7.7 per cent in 1998-99 and 12.6 per cent in 1999-2000.

20
 Figure 4 : Residual Maturity of less than 1-year for Market Loans & Govt. Account External Debt

9.0

8.0
7.8

7.0
6.8

6.0
5.9 5.7
4.8
5.0
(per cent)

4.5 4.9
4.1 4.3 5.0 4.9
4.5
4.0 4.2 4.4

3.0

2.0
1.4

1.0
0.9

0.0
1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-2000

Market Loans Govt. Account External Debt

21
2.3.3 Notwithstanding the success in lengthening the maturity structure of
dated securities, the immediate redemption pressure (i.e. market loans maturing
within 1-year) on market loans increased. The share of market loans with
residual maturity of less than 1-year increasing from 0.9 per cent in end-March
1994 to 7.8 per cent in end-March 2000 (Figure 4). The magnitude of the roll-
over problem is also reflected from the future redemption profile of the stock of
market loans as on end-March 2000 entailing large redemptions during the next
ten years (Figure 5).

Figure 5 : Redemption Profile of Domestic Market Loans & External Debt as on 31.03.2000

45000

40000

10807 10329
35000 9411 8907 8254
11247 11186 10951
9898
8024
30000
(Rs. Crore)

25000

20000

31252 31159 30151 30223

15000 28321 28260 28263 29394
27473 26195

10000

5000

0
2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10

Domestic Market Loans External Debt

2.3.4 On the other hand, the maturity profile of external debt of the government
at end-March 2000 is skewed towards long-end maturity with 51.2 per cent of
the debt over 10-year residual maturity and only 26.9 per cent under 5-year
residual maturity. The stock of total external debt with a residual maturity of
less than 1-year amounted to only 5.5 per cent of the total debt stock in end-
March 2000. The stock of external debt on Government Account with a residual
maturity of less than 1-year increased marginally from 4.1 per cent in end-
March 1993 to 4.5 per cent in end-March 2000 (Figure 4). This is mainly due to
the long-tenor of external aid in the form of soft loans and is reflected by the
smooth redemption profile of the portfolio as on end-March 2000 (Figure 5).

2.3.5 The adverse debt burden of the government is also reflected by a

persistent increase in the interest burden on internal debt, the bulk of which, is
attributable due to interest payments on market borrowings (Figure 6). Thus,
while the share of interest payments in total expenditure increased from 19.9 per

22
cent in 1990-91 to 31.7 per cent in 1999-2000, the share in tax receipts
increased from 50.1 per cent in 1990-91 to 76.2 per cent in 1999-2000. The
deterioration was also due to stagnation in the share of tax-GDP ratio. The share
of interest payments also increased from 39.2 per cent of revenue receipts in
1990-91 to 53.7 per cent in 1999-2000. The heavy outgo on interest payments
had serious implications for the fiscal position of the government.

Figure 6 : Interest Burden on Government Debt

90.0

80.0
76.2
74.4
72.3
70.0
68.6
65.3
63.5
60.0 61.1

53.2 52.1 53.7

51.9
50.0 50.1
(per cent)

48.4 49.0
47.1
45.4
40.0 39.2 40.4

28.3 31.7
30.0 29.6
28.1 28.1 31.2
27.4 27.9
23.9
20.0 21.2 19.9

10.0 11.3

0.0
1980-81 1990-91 1991-92 1994-95 1995-96 1996-97 1997-98 1998-99 1999-2000 2000-2001

(as % of Tax Revenue) (as % of Revenue Receipts) (as % of Total Expenditure)

2.3.6 While interest payments on internal debt increased by nearly eight-fold

during 1990-91 to 1999-2000, more than the six-fold increase in the stock of
debt during the same period; the total interest payments increased by six times
during the same period. On the other hand, interest payments on external debt
grew moderately, reflecting the concessional nature of such loans. Thus, the
share of interest outgo on internal debt increased gradually from 42.5 per cent of
total interest payments in 1990-91 to 51.1 per cent in 1998-99 (Figure 7). The
share increased sharply to 75.4 per cent in 1999-2000. While the share of other
domestic liabilities in total interest payments remained stable around 45.0 per
cent during 1990-91 to 1998-99, it declined sharply to 20.0 per cent in 1999-
2000. On the other hand, the share of external debt in total interest payments
declined from 8.7 per cent in 1900-91 to 4.6 per cent in 1999-2000.

23
 Figure 7 : Share in Total Interest Payments

100%

80%

60%

40%

20%

0%
1980-81 1990-91 1991-92 1994-95 1995-96 1996-97 1997-98 1998-99 1999-2000

External Govt. A/c Internal Debt Other Liabilities

2.3.7 Interest payments, inter alia, stemmed from larger recourse to market
borrowings at market-related interest rates. Since the interest rates on
government securities were somewhat aligned to the market during the latter
half of the eighties, and market related interest rates were offered on
government securities since 1992-93, the borrowings from the market were
mobilised at higher interest rates. The weighted average interest rates on dated
securities rose from 7.03 per cent in 1980-81 to 11.41 per cent in 1990-91 and
further to 13.75 per cent in 1995-96 (Table 2). However, the internal debt
management operations were successful in stabilising the interest rates at a
relatively low level as reflected in the weighted average interest rate of the
dated securities at 11.77 per cent in 1999-2000 and 11.86 per cent in 1998-99.
The average implicit interest rates on other domestic liabilities, which mainly
comprises of small savings and provident fund, also increased from 7.22 per
cent in 1980-81 to 10.81 per cent in 1990-91 and further to 12.15 per cent in
1997-98. Thus, the implicit nominal interest on overall domestic debt of the
central government increased steadily from 8.65 per cent in 1990-91 to 10.69
per cent in 1999-2000. Thus while the debt structure changed from low cost to
high cost constituents, the rising interest rates on such borrowings also raises
concern about the sustainability of debt. The sustainability of domestic debt
could also be viewed from the perspective of real interest rate on such
components, particularly when the real interest rate exceeds the real growth rate
of GDP as witnessed during 1997-98.

24
Table 2 : Nominal Interest Rate on Domestic Debt of Central Government
Fiscal Year Weighted Average Implicit Nominal Implicit Nominal
Interest Rates on Interest Rates on Interest Rates on
Marketable Securities Small Savings and Total Domestic Debt
Provident Funds
1990-91 11.41 10.81 8.65
1991-92 11.78 11.28 9.09
1992-93 12.46 11.06 9.38
1993-94 12.63 12.38 9.72
1994-95 11.91 12.67 9.72
1995-96 13.75 11.72 9.82
1996-97 13.69 12.70 10.39
1997-98 12.01 12.15 10.22
1998-99 11.86 N.A. 10.45
1999-2000 11.77 N.A. 10.69
Source : RBI Annual Reports.

2.3.8 Internal debt management was till recently characterised by undertaking

the bulk of market borrowing programme during the first six months, when
there would be less pressure on the banks to lend to the commercial sector. In
terms of the magnitude, this implied that the central bank had to manage total
Government borrowing every month to roughly 1 per cent of GDP during the
first half of the year. During the last three years, saddled with bulging
repayment obligations and objective to raise debt at minimum cost, debt
management operations had to maintain balance between changing the maturity
mix of borrowings and deriving maximum benefit of liquidity conditions. The
increasing coordination of debt management and monetary policy resulted in
fairly active open market operations, with the central bank releasing the
privately placed government stocks when interest rate expectations became
favourable.

2.4 Net Liability of the Central Government

2.4.1 For assessing the indebtedness position of the government, net

outstanding debt position is also a useful indicator. The net domestic liability of
the Central Government, has been derived after deducting the book value of the
domestic financial assets from the total domestic debt. Net domestic debt of the
Central Government, increased by more than eight-fold during 1990-91 to
1999-2000 (Table 3). On the other hand, net external debt of the central
government declined by nearly 50.0 per cent during the same period. Net
external debt of the Central Government has been derived by deducting foreign
exchange assets of the central bank from the total external debt of the central

25
government. However, the total net liability registered an increase of 3 fold
during 1990-91 to 1999-2000.

Table 3 : Net Liability of the Central Government

(Rupees Crore)
1990-91 1995-96 1996-97 1997-98 1998-99 1999-2000
Net Total 138941 281458 284323 325680 368010 445594
Liability
Net 46293 158004 188307 244188 297493 395485
Domestic
Liability
Net External 92648 123454 96016 81492 70517 50109
Liability

2.4.2 In terms of liability asset ratio also, while the external liability-asset ratio
improved from 2211.4 per cent in 1990-91 to 132.8 per cent in 1999-2000, the
domestic liability asset ratio deteriorated from 119.6 per cent to 168.5 per cent
during the same period. Accordingly, the total liability-asset ratio increased
from 157.6 per cent in 1990-91 to 161.0 percent in 1999-2000.

Figure 8 : Liability-Asset Ratio for Central Government

350.0

311.2
300.0

250.0

219.5
200.0
(per cent)

179.5 168.5
161.8 156.0 156.2
155.4 161.0
150.0
139.8 151.0 155.6
143.5 155.4
132.8

100.0

50.0

0.0
1995-96 1996-97 1997-98 1998-99 1999-2000

Domestic Liability-Asset Ratio External Liability-Asset Ratio Total Liability-Asset Ratio

2.5 Contingent Liabilities of the Central Government

2.5.1 Contingent liabilities of the Central Government arise because of its role
to promote private sector participation in infrastructure projects by issuing
guarantees. Contingent liabilities of the Central Government could be both
domestic or external contingent liabilities and could also be explicit or implicit
in nature. Domestic contingent liability of the Central Government constitute
26
direct guarantees on domestic debt, recapitalisation costs for public sector
enterprises, or unfunded pension liabilities. External contingent liability
constitute direct guarantees on external debt, exchange rate guarantees on
external debt like Resurgent India Bonds and Indian Millenium Deposits, and
counter-guarantees provided to foreign investors participating in infrastructure
projects. Although from the accounting point of view, the contingent liabilities
do not form part of the Government debt, it could pose severe constraints on the
fiscal position of the Government in the event of default.

Table 4 : Contingent Liability of the Central Government

(Rupees Crore)
Year Domestic Guarantees on Total
(end-March) Guarantees External Debt Guarantees
1994 62834 38159 100993
1995 62468 38830 101298
1996 65573 34922 100495
1997 69748 29576 99324
1998 73877 28810 102687
1999 74606 30050 104656
Source : RBI Annual Report 1999-2000 and Status Report on External
Debt, 2000.

2.5.2 The total outstanding direct credit guarantees issued by the Central
Government both domestic as well as on external debt remained stable around
Rs. 100,000 crore during end-March 1994 to end-March 1999 (Table 4). While
domestic guarantees increased modestly during the corresponding period, there
was an absolute decline in the guarantees on external debt. As a proportion of
GDP, however, both domestic guarantees and external guarantees registered a
declined of 3 per centage points during end-March 1993-94 to 1998-99 (Figure
9). Thus, the total guaranteed debt of the central government declined steadily
from 11.8 per cent of GDP in 1993-94 to 1998-99.

Figure 9 : Contingent Liability of the Central Government

14.0

12.0 11.8

10.0
10.0
(per cent of GDP)

4.4
8.5
8.0 3.8
7.3
3.0 6.8

2.2 5.9
6.0
1.9
1.7

4.0
7.3
6.2
5.5 5.1 4.9
2.0 4.2

0.0
1994 1995 1996 1997 1998 1999

Domestic Guarantees Guarantees on External Debt Total Guarantees

27
2.5.3 In addition, exchange rate guarantee on external debt, also have
implications for finances of the Central Government. For example, for
Resurgent Indian Bonds, as per the agreement, exchange rate loss in
excess of 1 per cent on the total foreign currency raised equivalent to US
$ 4.2 billion, would have to be borne by the Government of India. The
extent of such loss, since August 1998, the time when RIB were raised,
up to August 2000 amounted to Rs. 946 crore. The actual loss on such
liability would depend upon the exchange rate prevailing at the time of
redemption in 2003. Very recently, a similar exchange rate guarantee was
provided on the amount of US $ 5.5 billion raised through India
Millenium Deposits, during October-November 2000. For counter
guarantees provided to foreign investors participating in infrastructure
projects, similar risk arises for the Government exchequer. At the same
time, there is a growing volume of implicit domestic contingent liabilities
in the nature of pension funds.

2.6 Legal Ceilings on Government Debt

2.6.1 The Indian constitution under Article 292 provides for placing a limit on
public debt secured under the Consolidated Fund of India but precludes “other
liabilities” under Public Account. However, through a change in the accounting
framework, it is possible to convert these liabilities under Public Account within
the ambit of public debt under the Consolidated Fund and thereby within the
ambit of Article 292. Given the legacy of huge public debt and interest burden
due to a long history of high fiscal deficits, which has increasingly constrained
the maneuverability in fiscal mangement, the Central Government has recently
introduced a Fiscal Responsibility and Budget Management Bill, 2000 in the
parliament. The proposed bill aims to ensure inter-generational equity in fiscal
management and long-term macro-economic stability. This would be achieved
by achieving sufficient revenue surplus, eliminating fiscal deficit, removing
fiscal impediments in the effective conduct of monetary policy and prudential
debt management consistent with fiscal sustainability through limits on central
government borrowings, debt and deficits, and greater transparency in fiscal
operations. The specific targets for debt management in this regard is to ensure
that the total liabilities of the central government (including external debt at
current exchange rate) is reduced during the next ten years and does not exceed
50 per cent of GDP. Simultaneously, the Central Government shall not borrow
from the RBI since April 1, 2003 in the form of subscription to the primary
issues by the latter. In the meantime, the Government may continue to borrow
from the RBI by ways and means advances to meet temporary excess mismatch
between disbursement and receipts in accordance with the agreements entered
into between them.

2.6.2 The bill also addresses to check the contingent liability by restricting
guarantees to 0.5 per cent of GDP during any financial year. In particular,
28
transparency in budget statements would involve disclosure of contingent
liabilities created by way of guarantees including guarantees to finance
exchange risk on any transactions, all claims and commitments made by the
central government having potential budgetary implications.

29
Annex III. Existing structure for public debt management

At present, public debt management in India is spread between different

divisions/units in the Ministry of Finance (MOF) and the Reserve Bank of India
(RBI). The chart below (Table 3.1) highlights the institutional structure and
major responsibilities for public debt management.

3.1 Internal Public Debt Management: The Reserve Bank of India acts as
the Government’s agent for internal debt management responsibilities as per the
RBI Act, 1934 and the Public Debt Act, 1944.

The main units associated with internal debt management in the RBI are
the Internal Debt Management Cell (IDMC); Public Debt Offices (PDO); and
Securities Department in the Department for Government and Bank Accounts
(DGBA). Front office roles like debt issuance and debt service payments are
performed by Public Debt Offices and by the IDMC for open market operations.
Middle Office roles are mainly entrusted with the IDMC. Such responsibilities
include evolving appropriate policies relating to internal debt management, like
timing, amount of debt issuance or repurchase and fixation of interest rate
according to state of liquidity and expectations of the market; cash and liquidity
management; besides promoting an active and efficient government securities
market. In doing so, the IDMC consults the Budget Division in the Ministry of
Finance on key issues. In addition, periodic analysis on internal debt by the
IDMC is complemented by the Department of Economic Analysis and Policy in
the RBI by contribution in annual publications like the RBI Annual Report and
Report on Currency and Finance and periodic research publications like
Development Research Group and RBI Bulletin.

3.2 Other Domestic Liability Management: As outlines earlier, central

government debt also includes other domestic liabilities like interest bearing
obligations of the government such as post savings deposits, deposits under
small savings schemes, loans raised through post office cash certificates etc.;
provident funds; interest bearing reserve funds of departments like railways and
telecommunications; and certain other deposits. The key agency involved for
policy issues on such components is the Budget Division in the Ministry of
Finance. Front and back office roles are however dispersed across different
Departments/Ministries of the Government of India.

3.3 External Public Debt Management: As far as the external public debt is
concerned, the Government of India has so far borrowed from external
assistance sources only in the form of loans/credits from bilateral and
multilateral sources. The responsibility for management is with the Department
of Economic Affairs in the Ministry of Finance. For this purpose, front office

30
roles are mainly entrusted with various credit divisions within the Department
of Economic Affairs (DEA), Ministry of Finance for negotiating and contracting
loans from different bilateral and multilateral agencies/countries. The O/o
Controller Aid Audit & Accounts in the Department of Economic Affairs,
Ministry of Finance is also partially involved with front office roles in respect of
ensuring disbursement of loans/credits. In addition, the Ministry of Defence also
acts as the front office and back office for defence debt from external sources.
External Debt Management Unit (EDMU) in the Department of Economic
Affairs, Ministry of Finance acts as the middle office for external public debt.
Major functions of EDMU include monitoring of public external debt and direct
contingent liabilities; providing MIS inputs for debt management decisions e.g.,
choice of currency, interest and maturity mix; and bringing out an annual Status
Report on External Debt, which also covers public external debt. Back office
responsibility for data recording and accounting lies with the O/o CAA&A in
the Ministry of Finance for external assistance and with the Ministry of Defence
for defence debt.

3.4 The need for a Middle Office also stems from recent developments in the
international financial markets. IBRD borrowers, including sovereigns, are now
required to choose currency, interest and maturity mix of their borrowing on
IBRD debt. IBRD is also going to offer derivative products like currency and
interest swap, caps, collars etc to the borrowers to allow them to actively
manage their IBRD portfolio. ADB is also contemplating similar market
friendly loan products. Therefore, the management of Government external debt
would now require continuous studies on benchmarks regarding currency,
interest rate and maturity mix. For this purpose, a sovereign external debt
modeling exercise has been initiated recently by EDMU, in the Ministry of
Finance.

31
 Table 3.1 : PRESENT STRUCTURE of PUBLIC DEBT MANAGEMENT IN INDIA
Office Levels External Debt Domestic Debt Missing Links / Action
Areas
(1) (2) (3) (4)
FRONT OFFICE: 1) Credit Divisions A. Primary Market-
Carry out all In MOF (like Fund- Public Debt Office in
financial Bank Division, ADB, RBI carries out functions
transactions in the EEC, etc.) negotiate like debt issuance and
money and capital and contract new debt service payment.
markets – loans.
1) Borrow (issue B. Secondary Market-
securities); 2) O/o CAA&A in IDMC, RBI entrusted
2) Make debt MOF is entrusted with with open market
service debt servicing and operations.
payments. disbursements.
MIDDLE OFFICE: EDMU in MOF IDMC in RBI in 1. Developing public debt
Advice on debt monitors public consultation with Budget sustainability benchmarks;
management external debt and direct Division in MOF evolves medium and long-term public
strategy to be contingent liabilities; appropriate policies debt management strategy.
adopted. This brings out an annual relating to internal debt
includes – Status Report on management, like timing 2. Integrate internal and
1) Develop debt External Debt which and amount of debt external debt. This would
sustainability also covers public issuance or repurchase; mean the following :
benchmarks. external debt. cash and liquidity a). Choice between Domestic
2) Determine management; promoting and External debt.
benchmarks for Provides MIS inputs for an active and efficient b). Developing benchmarks
currency, debt management government securities for currency, interest and
interest rate, and decisions e.g., choice of market. maturity mix as part of
maturity mix as currency, interest and reducing costs and risks.
part of risk maturity mix. Also IDMC and DEAP in RBI
management working on a sovereign undertake public debt 3. Debt data management –
strategy. external debt modelling management related a) Comprehensive
3) Decide on exercise. studies (published in RBI computerization
borrowing Annual Report and b) Data analysis
instruments, Report on Currency & c) Scenario exercises and
timing etc. Finance). Economic sensitivity testing.
Division in MOF also
performs the same role 4. Transparency – Reports on
(Economic Survey Public Debt.
Budget).
5. Ready availability of
Public Debt information for
the Parliament and the top
management in Ministry of
Finance.
BACK OFFICE: O/o CAA&A does Central Debt Division,
Record keeping, record-keeping and DGBA in RBI maintains
accounting and accounting functions all figures, acts as a
systems support. for GOI’s external debt. controlling office for
PDOs and extends
general supervision over
their working.

32
3.5 Missing links in middle office functions for public debt management:
An analysis of Existing Structure characterises the “mixed” structure and
responsibilities for the public debt management with several units in the
Ministry of Finance and RBI discharging the responsibility. As mentioned
above, in its effort to raise resources at minimum cost, the focus of internal debt
management by the RBI has been on liquidity management and refinancing risk.
The scale of annual borrowings by the government and the conflicts in
objectives arising between dent management and monetary management
constrained the latter for evolving comprehensive benchmarks and undertaking
necessary risk management exercise for the debt portfolio. This in turn could be
attributed to the fact government debt market is still evolving and there has
often been incidence of devolvement of government securities on RBI. The
secondary market still lacks the depth and breadth for enabling RBI to
undertake active open market operations necessitated by portfolio management
objectives. At the same time, substantial initial subscription of Government
securities by the RBI meant that such securities have to be offloaded
subsequently when the market conditions and investor apetite are conducive.
This often led to potential for wrong signals for monetary management.
Although, through active coordination between debt management and monetary
management, RBI often succeed in striking a fine balance for minimising the
conflicts in objectives, sometimes one of the objective had to be sacrificed.
Thus, while for internal debt management the emphasis has been on front and
back office functions, the middle office role is somewhat lacking, for both
domestic and external debt components. Therefore, what is missing is a debt
strategy so as to maintain public debt at sustainable levels and its management
by developing a comprehensive risk management framework. Also conspicuous
by its absence is an integrated approach – covering both domestic and external
debt - towards public debt management. Thus public debt management fell short
of developing public debt sustainability benchmarks; medium and long-term
public debt management strategy; making a choice between domestic and
external debt; developing benchmarks for currency, interest and maturity mix as
part of reducing costs and risks.

3.6 Co-ordination among debt management activities: Another aspect,

which could have prevented an integrated approach for middle office might be
appointment of different Committees/Groups on an ad hoc basis to look at
different aspects of public debt management. A list of such Groups/Committees
are at Table 3.2.

33
Table 3.2 : List of Working Groups/Committees etc. currently looking at different aspects of
Public Debt Management in India.

A. External Public Debt

1. Steering Committee and Core Group on Sovereign External Debt Modelling Exercise. (Secretariat
at EDMU, MOF).
2. Working Group on Reducing Debt Service Cost of all External Debt on Government Account.
(Secretariat at O/o CAA&A, MOF).
3. Working Group on “Reducing debt service cost of External debt on Govt. Account
(Secretariat at ECB Division, MOF).
B. Domestic Public Debt
1. Standing Committee on Cash and Debt Management. (Secretariat at Budget Division, MOF).
2. Technical Advisory Committee on Money and Government Securities Markets.
(Secretariat at IDMC, RBI).
C. Other Related Committees
1. Steering Committee on External Debt. (Secretariat at EDMU, DEA, MOF).
2. Monitoring Group on External Debt. (Secretariat at DEAP, RBI).
3. Permanent Technical Group on Reconciliation of External Debt Statistics with
International Agencies. (Secretariat at O/o CAA&A).
4. Permanent Group on External Commercial Borrowings data. (Secretariat at
DESACS, RBI).

3.7 Conflict in objectives between debt management and monetary

policy: The issue of conflict in objectives between debt management and
monetary policy has also been an area of concern for macro-economic
management. Accordingly, separation of debt management and monetary policy
functions were recommended by an informal RBI Working Group Report on
Separation of Debt Management from Monetary Management. This issue was
vindicated by a recent RBI Report of the Advisory Group in Transparency in
Monetary and Financial Policies. More recently, the Report of the Committee
on Fiscal Responsibility Legislation, which formed the basis for the introduced
Fiscal Responsibility and Budget Management Bill, 2000; recognised that
participation of RBI in primary issues of Government securities has constrained
the maneuverability of RBI in using the monetary policy instruments,
particularly the open market operations and the bank rate, for pursuing the goal
of macroeconomic stability. The Committee accordingly recommended that
freeing RBI from debt management functions should be pursued to accord
greater operational flexibility to RBI for conduct of monetary policy and as part
of fiscal responsibility. The proposed stance of doing away with borrowings
from the central bank three years hence and limiting such borrowings during the
interim period, in the introduced Bill would also contribute towards reducing
such conflicts. While the central bank, through active co-ordination between
debt management, monetary management and exchange rate policy has
succeeded in maintaining a balance between ensuring that borrowing
requirements are met at a minimum cost and ensuring monetary stability, this
was often at the cost of sacrificing indirect instruments of monetary policy.
3.8 Contingent Liability Management: Although there is no centralised
unit for managing the guarantees provided by the Government of India, the
Budget Division in the Ministry of Finance acts as the Middle Office by

34
monitoring such liabilities and formulating policies relating to such guarantees.
The Budget Division also monitors the total guarantees of the Government of
India on a consolidated basis. Front and back office roles, on the other hand, is
dispersed across several Ministries/Departments of the Government of India.

35
Annex IV. INTERNATIONAL EXPERIENCE AND BEST
PRACTICES IN PUBLIC DEBT MANAGEMENT

4.1 Approach in Study of Best International Practices: International

evidence of debt management practice by leading debt offices bears many
valuable lessons for countries in the process of strengthening their debt
management capacity. While there is no unique answer as to what constitute
sound debt management practice, selective discretion should be used while
ameliorating debt management practice based on international experience. More
importantly, the country specific requirements should be carefully analysed so
that the international best practices could be grafted effectively. For studying the
best international practices, Commonwealth Secretariat, London was appointed
consultant for the project, mainly for providing inputs on “international best
practices” in the area of public debt management. The Commonwealth
Secretariat, hired Mr. Nihal Kappagoda, an international expert, who submitted
a Report on the subject. The summary of the recommendations of the
Commonwealth Secretariat is at Annex 5. Chairman and Members also visited
select public debt offices to get first hand experience of their operations. The list
of debt offices and officials visited by the Indian delegation is at Annex 6. The
specific issues examined by the Group on best international practices related to
the risk-management framework, the institutional and organisational structure
for public debt management, governance issues promoting professional
approach, co-ordination with fiscal and monetary management agency with the
debt management agency, and capacity building in sovereign debt management.
4.2 Risk Management Framework for Government Debt

4.2.1 Sovereign debt management primarily aims to ensure that government

borrowing needs are met efficiently. A second objective is to ensure that the
stock of debt portfolio and incremental flows arising from budgetary and off-
budgetary sources are being managed in a manner consistent with the
government’s preferences for cost and risk. An objective of minimising debt
servicing cost, irrespective of risk, should not be an explicit objective. Risky
debt structures, characterised by excessive exposure to short-term or floating-
rate debt or debt denominated in or indexed to foreign currency can
substantially deteriorate the fiscal position of the government, constrain access
to capital and even propagate financial market instability. This is particularly
important when the government’s debt portfolio is large relative to the
economy’s output. Prudent debt management aimed at reducing risks by
establishing a low risk currency composition, interest structure and maturity
profile of the government’s debt portfolio could make countries less susceptible
to financial risk and contagion. Several OECD governments have accordingly
set government debt management objectives aimed at minimising debts
servicing costs over the medium and longer-term subject to a prudent level of
portfolio risk. On the other hand, for many emerging market economies, debt

36
management objectives appear to be to cover their borrowing needs, lengthen
maturities and diversify funding sources wherever possible. Less attention is
paid to managing market risks and refinancing risk.

4.2.2 Table 4.1 summarises several risks arising from the debt portfolio of the
government, which sovereign debt managers endeavor to manage. Depending
on the characteristic of the debt portfolio, the debt manager might accord
different degree of priority for managing different risks. The portfolio choices
would also depend on the macroeconomic policies given the strong
interlinkages between debt management, fiscal, monetary and exchange rate
policy. Thus, to the extent possible, the day to day implementation of sound
debt management policies should seek to reinforce the objectives of
macroeconomic policies and policy reforms aimed at improving the efficiency
of the domestic financial market. Understanding the interplay of these public
policies and considerations and the technical analysis and market judgement
involved in managing what are often very large and complex portfolios, make
sovereign debt management a highly specialist business within the government.

4.2.3 Usually, governments are risk-averse in their sovereign debt management,

often because governments have strong political incentives to adopt the risk
apetite reflected by the “median voter” decision making. Evidence suggests that
taxpayers or representative voters tend to be risk averse in their decision-
making and expect the government to have similar risk apetite in managing its
financial interests. Thus, while governments generally have preference for more
stable tax rates over time they tend to be risk averse for their financial asset-
liability management.

Table 4.1 : Risks Encountered in Sovereign Debt Management

Risk Description
Market Risk Risks associated with changes in market prices, such as interest rates, exchange rates, commodity
prices, etc. For both domestic and foreign currency debt, changes in interest rates affect debt servicing
costs on new issues when fixed-rate debt is refinanced, and on floating-rate debt at the rate reset dates.
Hence, short- duration debt (short-term or floating-rate) is usually considered to be more risky than
long-term, fixed rate debt. (Excessive concentration in very long-term, fixed rate debt also can be
risky as future financing requirements are uncertain.) Debt denominated in or indexed to foreign
currencies also adds volatility to debt servicing costs as measured in domestic currency owing to
exchange rate movements. Bonds with embedded put options can exacerbate market risks.

Rollover Risk The risk that debt will have to be rolled over at an unusually high cost or, in extreme cases, that it
cannot be rolled over at all. To the extent that rollover risk is limited to the risk that debt might have
to be rolled over at higher interest rates, including changes in credit spreads, it may be considered a
type of market risk. However, because the inability to roll over debt and/or exceptionally large
increases in government funding costs can lead to, or exacerbate, a debt crisis and thereby cause real
economic losses in addition to the purely financial effects of higher interest rates, it is often treated
separately. Managing this risk is particularly important for emerging market countries.

Liquidity Risk There are two types of liquidity risk. One refers to the cost or penalty investors face in trying to exit a
position when the number of transactors has markedly decreased or because of the lack of depth of a
particular market. This risk is particularly relevant in cases where debt management includes the
management of liquid assets or the use of derivatives contracts. The other form of liquidity risk, for a
borrower, refers to a situation where the volume of liquid assets can diminish quickly in the face of

37
 unanticipated cash flow obligations and/or a possible difficulty in raising cash through borrowing in a
short period of time.

Credit Risk The risk of non-performance by borrowers on loans or other financial assets or by a counterparty on
financial contracts. This risk is particularly relevant in cases where debt management includes the
management of liquid assets. It may also be relevant in the acceptance of bids in auctions of securities
issued by the government as well as in relation to contingent liabilities, and in derivative contracts
entered into by the debt manager.

Settlement Risk Refers to the potential loss that the government could suffer as a result of failure to settle, for
whatever reason other than default, by the counterparty.

Operational Risk This includes a range of different types of risks including transaction errors in the various stages of
executing and recording transactions; inadequacies or failures in internal controls, or in systems and
services; reputation risk; legal risk; security breaches; or natural disasters that affect business activity.

Source: Draft Guidelines for Public Debt Management produced by the World Bank and the IMF.

4.2.4 For evolving a risk management framework for the government’s debt
portfolio, establishing the risk tolerance limits of the government can be a
difficult process. The government’s implicit risk preferences may need to be
interpreted by debt managers, by exploring the preferences implied by earlier
government policy decisions and also by assessing the risk management culture
in the Ministry of Finance, other leading Ministries and the Central Bank.
Important indicators of risk preference could include whether the government is
scaling down the size of its balance sheet, its approach in managing its public
sector enterprises and contingent liabilities, and its attitude towards risk-sharing
proposals emanating from the private sector. A prudential risk management is
essential for reducing uncertainty among sovereign debt managers as to the
government’s tolerance for risk, its willingness to trade off cost and risk
objectives and, consequently, which transaction to accept and reject. Without an
integrated debt management strategy in terms of strategic guidelines, portfolio
management decisions can end up lacking coherence and being based on
particular individual’s speculation about market trends or key relative prices.

4.2.5 In designing a debt management strategy, the sovereign debt manager is

faced with several choices regarding the financial characteristic of the debt. The
key decisions in this regard include:

• the desired currency composition of the debt portfolio, including the mix
between domestic currency debt and foreign currency debt;
• the desired maturity structure and liquidity of the debt;
• the appropriate duration or interest rate sensitivity of the debt;
• whether domestic currency debt should be in nominal terms or indexed to
inflation or a particular reference price; and
• whether the portfolio composition should be transformed through swaps and
other hedges or through new issuance.

38
 Common examples of risk-cost tradeoff associated with such decisions
involve:
• Although ex ante, foreign currency debt may appear to be cheaper vis-à-vis
domestic debt mainly due to inflation risk, on an ex post basis foreign
currency debt may prove to expensive when domestic economic policy
settings and market conditions have forced the government to devalue.
• Excessive reliance on short-term paper to take advantage of lower short-term
interest rates, in a positively-sloped yield curve environment, may leave a
government vulnerable to volatile and possibly increasing debt service costs
if interest rates increase, besides increasing refinancing risk and risk of
default in the case that a government cannot rollover its debt at any cost.
• Although hedging costs for foreign currency debt might be expensive,
particularly where past exchange rate volatility have been very high or
country risk is substantial, excessive unhedged foreign currency debt may
leave governments vulnerable to volatile and possibly increasing debt
service if exchange rate depreciate.
• Spreading out borrowing in the capital market enables borrowers to sample
market conditions and possibly develop greater recognition in the market
where as concentrating borrowing in a smaller number of issues enables the
borrower to meet their borrowing needs more quickly and creates larger,
more liquid, benchmark issues.
• In order to build up greater market knowledge, portfolio managers may be
allowed to manage tactical positions and thereby entail the risk of not
generating acceptable risk-adjusted returns, vis-à-vis the portfolio
management policy of aiming to move the portfolio closer to the strategic
benchmark.
• In order to reduce its debt service cost, debt managers may build benchmark-
sized debt issues at key points along the yield curve. Reopening previously
issued securities can also enhance market liquidity, thereby reducing the
liquidity risk premia in the yields on government securities. However,
concentrating the debt in benchmark issues may increase refinancing risk.

4.2.6 A key issue for developing a risk management framework for the debt
manager is to decide whether the debt structure should be examined in isolation
or whether risk management is better served by considering the nature of
government’s assets and cash flows. Linking the risk management framework to
a asset-liability framework (ALM) would involve identifying and managing
market risks by examining the risk characteristics of the cash flows available to
the government to service its borrowings, and choosing a portfolio of liabilities
which matches these characteristics as much as possible. Although it may be
difficult to produce a full balance sheet of the government, unlike a corporate
entity, conceptually all governments have such a balance sheet. The objective of
the ALM approach is not to produce a balance sheet, which quantify all its
39
assets. Instead, the main objective is to consider the various types of assets and
obligations the government manages, besides its tax revenue and direct debt
portfolio, and explore whether the risk characteristics associated with those
assets can provide insights for reducing the cost and risk of government’s
liabilities. This, in turn, could provide a benchmark for quantifying the costs and
measuring the risks of the debt portfolio. This quantification of cots and risks
provide a basis for developing a strategy for managing the debt portfolio. The
ALM approach also provides a useful framework for considering governance
arrangements for managing the government’s balance sheet.

4.2.7 Two variants of the ALM approach are possible. The first approach is to
use a simplified balance sheet framework where the only assets are government
revenues, measured as the present value (PV) of future revenues, and the only
liabilities are government debt and the present value of future expenditures,
excluding debt service. In this framework, risk is measured by the volatility of
differences between the debt servicing costs and the future primary surpluses
(i.e., the excess of asset over liability) as a result of market price movements.
By comparing the costs and risks of different debt management strategies, the
debt manager can then choose the strategy that reflects the government’s
tolerance for risk.

4.2.8 The other approach of ALM framework is a balance sheet with multiple
assets and liabilities. Assets are foreign exchange reserves and the PV of future
tax revenues and in some cases, equity investment in state owned enterprises;
while liability constitute foreign exchange debt, domestic currency debt and in
some cases, explicit contingent liabilities like guarantees and deposit insurance
or even implicit contingent liabilities. In this case, it is often simplest to
manage the overall balance sheet on a sub portfolio basis, i.e., by “match
funding” the various asset portfolios, which have different financial
characteristics with sub-portfolios of debt which match those characteristics.
Thus market risks on the foreign currency debt would be minimised by
matching the currency and interest mix of the foreign exchange reserves with
the stable portion or target level of foreign exchange debt, thereby creating a
natural hedge. Such an approach should ensure that the central bank would be
free to design and manage its intervention and investment portfolios of reserves
according to its own objectives. To preserve the liquidity objectives of the
foreign exchange reserves, the debt manager should issue debt with longer
maturities than the liquid reserves, and match the interest rate characteristics by
issuing floating rate debt or by using interest rate swaps to match the duration of
the reserves. For reserves held for investment purposes, risk would be
minimised by matching the currencies and interest rate sensitivities of the
reserves and the foreign currency debt. The choice of currencies for the debt
portfolio matched with investment portfolio should take into account the cost of
funding since, the spread of investment returns over the cost of debt might differ
across countries. Debt and assets are fully matched in foreign currency financial
40
characteristics when countries solely borrow in foreign currency only to the
extent they hold foreign exchange reserves.

4.2.9 For the remainder of foreign exchange debt, for countries, which borrow
in foreign currency in excess of the foreign exchange reserves they hold, the
risk is minimised by matching it with the domestic currency assets, which has
the highest correlation with the domestic currency. Another option is to create
shadow foreign exchange assets for the remainder of foreign exchange debt. For
a pegged exchange rate regime, this could be done by issuing debt in foreign
currency in accordance with the trade-weighted basket of currencies for the peg,
which is most closely integrated in terms of trade and capital flows. For a
floating rate regime, the shadow asset can be created by undertaking a statistical
analysis of historical variances and covariances of foreign currencies relative to
the domestic currency to find the portfolio of debt which has the minimum
variance to the domestic currency. In some countries, where data limitations or
comprehensive policy reforms may make past statistical relationships irrelevant,
the shadow asset could be constructed on the basis of the country’s trade pattern
and sources of capital flows. Similarly, financial characteristics of domestic
currency debt are matched with the structure of domestic currency assets.

4.2.10For sovereign debt management, risk is measured as the volatility of debt

service and other expenditures relative to the volatility of tax and other
revenues. In present value terms, it can also be measured as the volatility of the
value of the government’s assets relative to the liabilities. The risk measurement
process quantifies the risks and costs of alternative debt strategies. This is
usually done with financial models, ranging from relatively simple, scenario
based models, to more complex models using sophisticated statistical analysis
and techniques, like simulation-based models. While use of sophisticated and
complex models can improve the degree of precision to the cost and risk
estimates, it should not change the cost/risk rankings of a well-specified simple
model significantly. Most models in use by sovereign debt managers are based
on simulations of future debt servicing flows for the debt portfolio under a
variety of different assumptions regarding the strategy for managing the
composition of debt and path of future market variables.

4.2.11 In practice, most debt managers simplify the scenario-based model by

comparing the range of debt servicing costs against a notional benchmark. Thus,
the first step is to project debt servicing costs under a specific strategy for
managing the structure of the debt portfolio, and using a “base case” set of
assumptions for future market variables. This gives the expected cost of the debt
strategy being evaluated over the time horizon specified. The risk of the strategy
is measured as the potential increase in debt servicing costs over the same time
horizon under the worst case scenarios of market prices. The next step is to
project debt servicing costs under different debt strategies by using different
proportions of fixed-floating rate debt or currency mix, and also using different
41
assumptions for market risk i.e. a wide range of alternative market price
assumptions. This would give estimates of costs and risks of different strategies
under the same base case and risky scenarios.

4.2.12The time horizon used by most debt managers is a medium-term time

horizon, for example five years, since budget projections become increasingly
uncertain the further out they are projected. In this case, risk is measured as the
potential increase in cumulative costs relative to the base case over this time
horizon, and corresponds to a notional volatility in debt servicing costs relative
to the revenue flows of the underlying assets. The choice of the numeraire
currency is also crucial for analytical purpose. Costs are usually measured in the
domestic currency where the portfolio of debt being modeled funds domestic
currency assets. A sub portfolio of debt funding foreign currency assets can be
modeled separately for which a foreign currency can be used as the numeraire.
Similarly, the base case assumption is also critical for the output of the model. A
poorly selected base case can bias the choice towards strategies which might
appear to be optimal under such assumptions, but could actually be riskier or
higher cost strategy than expected. One way of avoiding this type of bias is to
introduce “market neutral” assumptions for the base case.

4.2.13Simulation-based models, used by most debt managers, involves Monte

Carlo simulations to generate a wide variety of different market risk scenarios
and then to project different debt service costs for a particular debt strategy
under different market scenarios. This generates a distribution of different cost
outcomes for that debt strategy. The expected cost of each strategy can then be
represented by the mean of the distribution, and the risk of the strategy can be
represented by a measure of the upper range of costs above the mean, such as
the variance or standard deviation of the distribution. Most debt offices use
“value-at-risk” (VAR) approach for measuring risk, a variant of this approach.
VAR measures the confidence interval of the range of possible risks measured
by the volatility of the marked-to-market, or present values of the liability
portfolio. The Denmark Nationalbank, on the other hand, adopted a “cost-at
risk” (CAR) approach to calculate a confidence interval of the upper range of
costs using the standard deviation from the distribution. The risk of a particular
strategy is then measured by the confidence interval. The specification of the
currency and time frame to use for cost and risk measures should be made on
the basis of the same type of considerations used for scenario-based models.

4.2.14Once the costs and risks of alternative debt have been measured, an
efficient frontier, which is an envelope of all those strategies that are “efficient”
in the sense that there are no other strategies that have a lower risk for a given
expected cost, could be constructed. The government should choose the strategy
that best represents the government’s preferences for managing the risk/cost
tradeoffs. In general, debt managers select a debt strategy that lies along the
efficient frontier, and tend to be risk averse by selecting a strategy on the
42
frontier that represent higher cost but lower risk. Sometimes, other objectives,
such as desire to issue debt at uniform points on the yield curve in order to
promote the development of a pricing benchmark for private sector issues could
lead to the debt manager choosing a strategy that does not lie on the frontier.
This could entail a cost relative to the most efficient strategies.

4.2.15The process of deciding a debt strategy by debt offices, has been

facilitated, by using a “strategic benchmark” portfolio, which represent the
approved strategy. Such a benchmark is typically comprised of targets for the
key risk characteristics of the approved strategy, such as the mix of fixed-
floating debt, currency composition, or duration. The actual debt portfolio could
be then moved closer to designed benchmark by debt managers while deciding
on key terms for new debt issues, by buyback operations, and also by using
currency and interest swaps and other hedging activities. The benchmark also
serves as a control mechanism to ensure that the debt manager implements the
approved strategy. For debt managers that actively manage debt to reduce costs,
the benchmark can serve as the basis for measuring the performance of the debt
manager by comparing the actual cost of the debt portfolio to what the cost
would if the exact benchmark was attained. For governments permitting debt
managers to undertake tactical trading within well-defined position and loss
limits, these operations can also be assessed as to whether they have contributed
net cost savings relative to the benchmark. Benchmarks should also reviewed
from periodically to access their appropriateness and revise it if the
government’s objectives change or there are significant changes in economic
relationships.

4.2.16Benchmarks are usually set by debt offices for portfolio management for
the foreign currency debt, and in some case, for the entire debt portfolio. Table
4.7 shows the different benchmarks in use by selected debt offices. For foreign
currency debt, benchmarks should preferably be derived for the government’s
net foreign currency debt portfolio rather than the gross debt portfolio. This
implies that, whenever possible, part of the foreign currency debt should be
matched against the financial characteristics of the foreign exchange asset. Debt
managers would then be free to concentrate on their risk management activities
on the remaining net foreign currency exposure. The usual benchmarks for
foreign currency debt are modified duration and/or interest rate mix for
managing the acceptable interest rate risk; currency composition along with the
proportion of domestic and foreign currency debt for managing exchange rate
risk; and the maturity profile, usually indicated by a ceiling on the amount of
debt maturing at any given point, for managing the refinancing risk.

4.2.17Benchmarks for domestic debt are used only when the debt manager has
considerable scope and the domestic capital market is sufficiently developed to
adjust the composition of its debt portfolio through new borrowings, buyback
trades and/or through derivative transactions. The domestic currency benchmark
43
usually focuses on the acceptable ranges for interest rate risk and the maturity
profile for the domestic debt portfolio. However, given their dominant role as an
issuer in the domestic bond market, most governments prefer not to purchase or
trade their domestic securities, other than what is needed for normal liquidity
management.

4.3 Institutional structure for public debt management

4.3.1 The institutional setting for public debt management in different
countries, could be broadly classified into five categories i.e., (i) a full-fledged
debt office either in the mainstream Ministry of Finance; (ii) under the Ministry
of Finance as a separate entity like the Treasury or a Debt Management Agency;
(iii) autonomous institution outside the Ministry; (iv) in the Central bank; and
(v) the debt office is dispersed between the Ministry of Finance and the central
bank.

4.3.2 The first four categories refer to a full-fledged debt office and could be
differentiated by the location and the degree of autonomy accorded to the debt
office. Table 4.3, which lists the institutional setting for full-fledged debt offices
in place shows that the bulk of the debt offices are located as a separate agency
under the Ministry of Finance with sufficient degree of operational
independence (i.e. second category). In terms of the degree of independence
accorded to the debt office, the institutional setting for the above category
resembles the third category, i.e., where the debt office is located as an
autonomous entity. Although, in the first three cases, the debt office may be
located under the Ministry of Finance or as an autonomous agency, the central
bank still retains some agency services for debt management and in some cases
undertake foreign exchange operations for its foreign currency debt and cash
management. Denmark is the only country, where its central bank,
Nationalbanken houses the debt office for the government.

4.3.3 International experience suggests that centralised debt offices in most

countries are located under the Ministry of Finance. Within this institutional
structure, in most of the advanced countries, the debt offices are set up as an
autonomous or separate entity within a Treasury or as a statutory unit. This
enables the debt office to assume sufficient degree of operational independence
Thus, for thirty countries for which data is available, twenty-four have their debt
offices under the Treasury/ Ministry of Finance. This includes all the emerging
economies for which information is available. The main argument for entrusting
sovereign debt management responsibility within the Ministry of Finance or
Treasury is the proximity of location, which enables the senior management
within the Ministry of Finance to review and assess the performance of the
entity more easily. This issue of geographical proximity is particularly important
when a full-fledged centralised debt office is being set up and management
competencies are unproven. Another factor, which have prompted many

44
governments to locate the debt office within the Ministry of Finance is that
since public debt has budgetary implications, co-ordination between budget
making and the debt office is facilitated. This arrangement thereby minimises
chances of any conflict arising from the budgetary process wherein the annual
borrowing requirements are determined and the management of such liabilities.
The downside risk of unsustainable borrowing has been obviated in most of the
cases, by legal enactment of authorising annual borrowing with a preset limit
(Table 4.4) and practising policies of fiscal prudence.

4.3.4 Few debt offices (e.g., Australia, Austria, Ireland, Portugal and Sweden)
have also been set up as an autonomous debt agency or corporation outside the
Ministry of Finance giving it a distinct institutional presence. This was
established with legislation (e.g. Ireland and Portugal) or without legislation
(e.g. Australia and Sweden). Very recently, Germany have decided to take out
the debt management functions from the Ministry of Finance to an autonomous
set up as a private corporation. The overriding reason for creating an
autonomous institution emanated from the concern of conflicts in objective
between fiscal policy and debt management. Thus, an autonomous debt office
would be less likely to engage in risky strategies designed to maximise short-
term political gains. Another common concern has been the influence on interest
rate. Thus, any perception of insider trading or market manipulation would
undermine the credibility of the government, the debt office and the market. The
risk of debt management and cash management being downplayed by a large
institution like the Ministry of Finance could result in the commercial needs of
the business being inadequately funded. This issue was also factored in while
taking the debt office outside the Ministry of Finance and setting it up as an
autonomous agency. In order to build a sound risk management culture, an
autonomous structure, under the supervision of a board of directors responsible
for managing the government’s interests is likely to adopt a more commercial
approach in reviewing the need for additional expenditure on systems, training,
salary compensation and recruitment of skilled staff. In particular, an
autonomous agency could maintain a flexible management and career path
structure, and link the pay scale of its staff to that of private sector practitioners.
Such flexible pay structure would allow the debt office to attract highly
qualified staff, that are, knowledgeable in the increasingly complex financial
instruments and markets.

4.3.5 The degree of autonomy in such debt offices, vary from country to
country. Although the debt offices are autonomous in nature, most of them
either report to the Minister of Finance or to the Parliament. Thus, while the
formulation of debt policy like level of the debt, limits on domestic and foreign-
currency borrowing is a political decision and therefore should rest with the
government, the actual management of sovereign debt can be extracted from the
political domain by assigning such responsibility to an autonomous institution.
Under this arrangement, the Ministry of Finance, based on its objectives, risk
45
preferences and macroeconomic and institutional constraints of the country,
defines the medium-term strategy for debt management; while the debt office
implements that strategy and administers the issuance of domestic and foreign
currency debt.

4.3.6 The issue of conflict in objectives between debt management and

monetary management has led to many central banks, transfer its debt
management responsibility back to the government or to an autonomous agency
outside the Ministry of Finance. Instances of such conflicts are as under:
o A central bank may be reluctant to raise interest rates to control
inflationary pressures to avoid any adverse effect on its domestic
liability portfolio.
o A central bank may be tempted to manipulate financial markets to
reduce interest rates at which government debt is issued or to inflate
away some of the value of the nominal debt.
o A central bank may also be tempted to inject liquidity in the market
prior to debt refinancing, or to bias the maturity structure of the debt
profile according to the stance of its monetary policy.

4.3.7 Management of public debt by the central bank is further constrained due
to conflict in objectives between debt management and exchange rate
management. Such instances include:
o Daily management of the liquidity of the foreign currency debt by
the central bank in the foreign exchange market i.e. converting
foreign debt proceeds into local currency or converting local
currency funds into foreign currency debt repayments, may conflict
with the intervention policy of the central bank.
o Similarly, the central banks sale and purchase of securities to meet
foreign currency debt requirements could also be perceived by
financial markets as having a signalling effect on its exchange rate
policy, thereby undermining its effectiveness.

4.3.8 In view of the potential conflicts in objectives between debt management,

monetary policy and exchange rate management, Austria, Hungary and United
Kingdom have recently shifted their debt management responsibility out of the
central bank. In New Zealand, all debt management functions carried out by the
central bank, as agent of the debt office, have been conducted without reference
to monetary policy considerations since 1988. Moreover, in South Africa, after a
thorough review of debt policy, the central bank, which until recently, has been
the government’s agent for marketing its debt instruments, was made
accountable to the Department of Finance on all matters related to debt
management. Funding activities undertaken by the central bank on behalf of the
government were ring-fenced from monetary policy operations.

46
4.3.9 Denmark is the only exception, where in 1991 the Danish government
decided to regroup assets and liabilities management under the central bank’s
authority. The rationale behind the decision was to improve the coordination of
the management of the public debt and the foreign exchange reserves, and to
reduce the net exposure of the government to exchange rate risk. Some
governments recognise the fact that the central bank has more staff with market
transaction experience. The efficiency advantage has led to some central banks
(United Kingdom and Brazil) undertake the government’s foreign currency
borrowing. For countries, which have already established their debt offices, the
central bank, still retains some debt management functions like book-keeping,
registry services etc under an agency agreement between the Ministry of
Finance and the central bank. For some countries, cash management and foreign
exchange transactions related to foreign currency debt are also undertaken by
the central bank.

4.3.10Internationally, independent set-up and the Ministry of Finance are

regarded as somewhat watertight compartments for locating the debt office. In
reality, however, there is a very thin line between an independent set-up and the
Ministry of Finance. The Ministry of Finance always exercises some measure of
control over the operations of the debt office, irrespective of its location. This is
unavoidable because it is the liability of the Government that is to be managed
by the debt office. Therefore, even among the most independent set-ups like
National Treasury Management Agency of Ireland and the Swedish National
Debt Office which are entrusted with day-to-day management responsibilities,
the Ministry of Finance determines the policy, sets the operational guidelines
and the benchmarks under which the debt office is required to operate. This
institutional mechanism is usually, safeguarded, by public debt legislation or
legal statutes.

4.3.11On the other hand, in many countries, the Ministry of Finance recognised
the need to build professionalism and capacity for debt management, by
locating the debt office outside the mainstream Ministry as a separate entity.
The main objective is to accord sufficient degree of autonomy to the debt office,
even though it is located within the Ministry. The degree of freedom varies
across countries with respect to its own budget provision, recruitment policy,
salary structure and legal framework.

4.3.12For the fifth category of debt offices, public debt management

responsibilities are typically split, with the Ministry of finance in charge of the
public external debt management and the central bank is responsible for
domestic debt management. Table 4.5 shows the split nature of debt
management responsibilities for some emerging market economies till recently.
Among the emerging market economies, some countries like Colombia,
Hungary, Mexico and South Africa have already established a full-fledged debt
office under the Ministry of Finance. Further more, some countries like
47
Argentina, Brazil, China and Thailand have started initiatives to set up a debt
office under the Ministry of Finance. To establish a public debt office, the
starting point for all these countries has been to strengthen the capacity building
of the debt office by establishing a middle office.

48
Table 4.3. Institutional Location of Sovereign Debt Management Responsibility

Under the Ministry of Located within Located elsewhere as an

Finance or Treasury* the Central Bank autonomous entity
Advanced Economies
Australia 
Austria 
Belgium 
Canada 
Denmark 
Finland 
France 
Germany 
Greece 
Ireland 
Italy 
Japan 
Netherlands 
New Zealand 
Portugal 
Spain 
Sweden 
Switzerland 
United Kingdom 
United States 

Emerging Economies
Argentina1 
Brazil 1 
China1 
Colombia 
Hungary 
Korea 1 
Mexico 
South Africa 
Thailand1 
Turkey 
1: Establishment of sovereign debt management offices is currently underway in these countries.
* : In many countries, although debt offices are under the Ministry of Finance or Treasury, the
debt office is set up as an autonomous entity with sufficient operational independence.
Source: Draft document on “Sound Practices in Sovereign Debt Management”, FPS Department,
The World Bank, March 2000; OECD as mentioned in “Risk Management of Sovereign Assets and
Liabilities”, Working Paper, WP/97/166, IMF, December 1997 and national authorities.

49
 Table 4.5 : Institutional Framework for Foreign Currency Debt
Management in Emerging Economies
Countries Central Govt. State & Local Govt. State Owned
Enterprises
China MOF Not allowed SOEs
India MOF Not allowed SOEs
Indonesia MOF Not allowed
Korea MOF Own responsibility SOEs
Singapore None
Thailand DMO under MOF None MOF
Argentina MOF Own responsibility
Chile MOF Not allowed MOF
Colombia MOF State Govts./MOF SOEs/MOF
Mexico MOF State Owned banks MOF
Peru DMO under MOF DMO under MOF MOF
Venezuela MOF Not allowed Not allowed
Czech Republic None MOF SOEs
Hungary DMO under MOF None
Poland MOF Own responsibility
Russia MOF Regional agencies
Israel MOF Own responsibility SOEs
South Africa DMO under MOF Not allowed MOF

Source: “Managing foreign debt and liquidity risks in emerging economies : an

overview”, John Hawkins and Philip Turner, as excerpted in “Managing Foreign Debt
and Liquidity Risks”, BIS Policy Papers, No. 8, September 2000.

Table 3.3 : Degree of Autonomy for Debt Offices

Countries Degree of Autonomy
Ministry of Finance
Belgium Not independent
Canada -
Germany Independent except for independent matters
Greece -
Japan Dependent
Mexico Independent within the broad objectives of the Development Plan
Netherlands Independent
New Zealand No specific independence
Switzerland Independent, except for restriction on some type of institution
Turkey Independent under normal circumstances
United Kingdom Independent within limits set by the remit
Autonomous Agency
Australia Highly independent
Austria Highly independent
Ireland Independent in some broad guidelines drawn by the MOF
Sweden Independent except for foreign exchange
Central Bank
Denmark Borrowing program is approved by the MOF
Source: OECD as mentioned in “Risk Management of Sovereign Assets and Liabilities”,
Working Paper, WP/97/166, IMF, December 1997.

50
 Table 3.4 : Institutional Arrangement of Debt Offices and Annual
Borrowing Authority or Debt Ceiling Limit
Institutional Countries Limit on Annual Debt Ceiling Limit
Arrangement Borrowing Authority
Ministry of Finance
Belgium  ×
Canada  ×
Finland  ×
France  ×
Germany  ×
Greece  ×
Hungary  ×
Italy  ×
Mexico  ×
Morocco  ×
New Zealand  ×
United States × 
United Kingdom  ×
Autonomous Agency
Australia  ×
Ireland  ×
Portugal  ×
Sweden  ×
Central Bank
Denmark × 
Source: Draft Guidelines for Public Debt Management, SM/00/135, IMF.

Table 3.5 : Legal Framework for Debt Offices

Countries Limit for Domestic Borrowing Decides new limits
Ministry of Finance
Belgium Limit on the cost of borrowing The Parliament
Canada Yes, Borrowing Authority Act The Parliament
Germany Yes, a limit is set by federal legislative The Parliament
authorisation (Budget Law)
Greece No, except for the limit to T-Bills
Japan Yes, a limit is set by Budget Law The Parliament
Mexico Yes, a limit is set according to the Federal The Congress
Budget
Netherlands Implicit limit (budgeted borrowing -
requirement)
New Zealand No legal limit MOF may alter the program
Switzerland No legal limit -
Turkey Only for govt. bonds the limit is twice the For govt. bonds, the
budget deficit Parliament
United Kingdom Limit by the funding remit -
Autonomous Agency
Australia Yes, financial year budgetary need DMO and the Treasurer
Austria Yes, the limit is set by the Financial Law The Parliament
Ireland No -
Sweden Limit only for foreign exchange funding -
Central Bank
Denmark Limit on the level of debt outstanding The Parliament

51
Source: OECD as mentioned in “Risk Management of Sovereign Assets and
Liabilities”, Working Paper, WP/97/166, IMF, December 1997.

4.4 Scope of role and functions of a debt office

4.4.1 In a number of countries, the scope of debt management operations of the
central government broadened in recent years. The scope of a debt office
involves all contractual liabilities of the central government, including
contingent liabilities, in some cases. Few debt offices also attend to manage the
pension liabilities of the government. Thus, while the public sector debt, which
is included or excluded from the central government’s mandate over debt
management varies from country to country depending on the nature of the
political and institutional framework, some debt offices include publicly-
guaranteed debt in the sovereign debt management policy. Debt management by
a public debt office, often involves, the oversight of liquid financial assets and
potential exposures due to off-balance sheet claims on the government,
including contingent liabilities such as state guarantees. On the other hand,
some debt office exclude publicly-guaranteed debt from their debt management
policies until the guarantee is invoked. It is, however, desirable that all public
debt is centralized under the management structure of the debt office so that the
risk exposure of the sovereign debt is adequately reflected and managed as a
single portfolio.

4.4.2 For a public debt agency, the main tasks or responsibilities involved
generally include:
 issuance or contracting debt obligations

 redeem or service debt obligations

 manage the day-to-day risk exposure like liquidity risk, market risk and

credit risk of the sovereign debt portfolio,

 secondary market operations

 cash management

 issue and manage guarantees

 evaluate performance

 report periodically to the authority through publication or data

dissemination
 book-entry and record keeping

 clearing and settlement system

4.4.3 Where debt management office exist within the Ministry of Finance or
Treasury, the roles of the debt office has sometimes been merged into a broader
organisational structure, expanding the role of debt offices to manage both asset
and liability of the government. Debt offices in New Zealand and South Africa
have been established as part of the asset-liability management office. In
addition, the debt offices may also advice on a range of public sector financial
management issues including privatisation and restructuring of state-owned
52
enterprises; and management of a wide range of commercial, contractual and
litigation risks on behalf of the government. The main benefits from such a
merged structure enables the debt office to better understand the risks of the
government’s balance sheet and identify natural hedges.

4.5 Organisational Structure

4.5.1 Sound governance considerations suggest that debt management

functions should be organised as separate units given their different objectives,
responsibilities and staffing needs. Accordingly, the business of sovereign debt
management has changed rapidly since the late 1980’s, with many governments
investing heavily to create a specialised debt management office by adopting an
organisational structure similar to that found in leading corporate and banking
treasuries and in the reserve management departments of central banks. The
usual practice has been to divide functional responsibilities and accountabilities
by establishing a separate front, middle and back office, and maintain separate
reporting lines to the Chief Executive of the debt agency. Although all the debt
offices might not have achieved such a complete structure, most debt offices
have established the main elements of such functional entities.

4.5.2 The front office is typically responsible for executing transactions in

financial markets, including the management of auctions and other forms of
borrowing, and all other funding operations. For most of the debt offices, the
front office is normally responsible for the analysis and efficient execution of all
portfolio transactions, consistent with the portfolio management policy of the
agency. These transactions usually include short and medium term borrowing in
domestic and foreign currencies, management of trading positions and hedging
transactions, the investment of foreign currency liquidity and any excess cash
balances associated with the government’s daily departmental cash
management. Within the front office, individual portfolio managers are assigned
different functional responsibilities usually on an instrument, market, or
currency basis. Given the market-related nature of operations of portfolio
managers, they can also provide a wide range of portfolio management services
like designing funding and pricing strategies, assessing fair value on individual
transactions and exploring market opportunities to help move the actual debt
portfolio closer to the strategic benchmarks. The latter could be achieved
through terms for new borrowing, hedging strategies and buyback operations.
They can also provide advice on government initiatives to foster the
development of the primary and secondary government bond market and
possible market reaction to new fiscal information.

4.5.3 A separate middle office has been set up both within a full fledged debt
office as well as where debt management responsibilities are split between the
Ministry of Finance and the central bank. The key role of the middle office is to
develop a debt management strategy by establishing a cost and risk
53
management framework for the central government’s debt portfolio. For this
purpose, the middle office could report to the head of the management operation
on the objectives for sovereign debt management and on the cost and risk
tradeoffs of different portfolio management strategies. Based on the
government’s preferences in respect of expected cost and risk, middle office
staff would develop a set of portfolio management policies and seek approval of
the Minister of Finance for these. This is usually done through evolving
strategic benchmarks for the portfolio for managing different risks. The main
policies developed by the middle office to address different portfolio risks
include:
• For managing market risk, the middle office identifies the preferred currency
composition, duration of the portfolio, along with the decision rules for
transacting to transform the actual portfolio closer to the strategic portfolio
over time. Questions as to whether tactical trading should be permitted
would need to be examined and, if undertaken, position limits and loss limits
need to be established.
• For management of refinancing risk, the middle office is required to develop
policies specifying the acceptable maturity profile of the portfolio and the
degree of refinancing risk in any single year.
• Similarly, management of credit risk would require establishing limits on the
government’s exposure to individual counterparties through swap
transactions or the investment of excess liquidity. Acceptable limits for credit
exposure are often based on the credit rating assigned by sovereign credit
rating institutions, the marked-to-market exposure of the position, the type of
instrument involved and the time to maturity. Sub-limits for specific
transactions may also be established.
• Liquidity risk management policies specify minimum levels of foreign
currency liquidity, the instruments and currencies that this liquidity can be
held in, and tactical trading benchmark for the investment of this liquidity.
Liquidity levels may also need to be established for domestic currency debt
portfolio if the government is not able to borrow domestically at short notice
to meet day-to-day liquidity needs.
• Settlement risk management policies involve designating acceptable
transaction bankers, custodians, clearing brokers and fiscal agents and the
setting maximum amount of exposure to any settlement institution. Provision
of overdraft facility up to specified limit may also be necessary for situations
where timing mismatches means that the funds may be few hours late in
arriving while the loan agreements specify that the foreign currency debt
servicing payments must be made early in the business day. Since
settlements payments could be very large, debt offices should have a detailed
settlements procedures manual.
• Operational risk management policies should include policies, through cross-
reference to an operations manual, to manage operating risk around
transactions, management information systems, the legal framework and
54
 other threats to the organisation’s business continuity and reputation. While
the most common operational risks tend to lie on the transaction side through
errors in confirming and settling trades, even with comprehensive
management controls, the most serious operating risks generally relate to
fraudulent breaches of controls and systems failure. This is why a sound risk
management culture, well-defined controls and separate reporting lines are
so important.

4.5.4 The middle office is also responsible for monitoring compliance against
strategic benchmarks. This separation helps to promote the independence of
those setting and monitoring the risk management framework and assessing
performance (the middle office) from those responsible for executing
transactions (the front office). Debt offices in some countries like Belgium,
Ireland and Sweden also have a legal office inside the middle office.
Information technology functions, which tend to be located in the back office,
are sometimes a middle office responsibility. Some middle offices (e.g., in
Belgium, Brazil, Colombia and New Zealand) also carry out investor relation
functions, which are usually the front office responsibilities.

4.5.5 Although separation in responsibilities between the front and middle

office helps to promote the independence of those setting and monitoring the
risk management framework and assessing performance (the middle office)
from those responsible for executing transactions (the front office); tensions
may arise between them while discharging their duties. Tension may arise in
deciding the appropriate types of transactions or new instruments to introduce,
the setting of benchmarks, and measuring and reporting value added. It is
therefore, essential to ensure that the middle office functions are not
constraining the initiative of the front office staff in their search for various
ways to add value to the debt management operation, lower debt servicing costs,
increase returns from their liquidity management, and reduce risk. Similarly, the
integrity of the middle office staff and their capability in their risk management
design and monitoring and control functions can be seriously compromised if
this group is not given sufficient freedom to develop their professional capacity.
Such tensions could also be resolved by ensuring that there is an agreement on
the essential roles of the two offices, and their capacity to develop strong
synergies within a clear set of accountabilities.

4.5.6 Back Office

4.6 Governance: Legal Framework and Accountability

Sound governance practices are an integral part of sovereign debt

management. In order to establish appropriate accountability for managing the
sovereign debt portfolio, most governments have in place legislation pertaining
to powers to borrow, invest, issue guarantees and undertake transactions on
55
behalf of the government. This overcomes the need to request specific
authorisations from the Parliament or the constitutional authority for individual
transactions, which can introduce and a range of political factors into the
decision making and considerable delay the execution of transactions. For e.g.,
a study by IBRD suggests that more than three-fourth of the member countries
surveyed, on an average, took more than a week to obtain approval to execute a
foreign borrowing transaction. This implies that such countries, in their
endeavour to manage the debt portfolio, can only operate with a lag to achieve a
transaction in case there are any desirable market movements in the
international financial market. Such impediments, in a volatile international
financial market, could ultimately prove to be imprudent decision finally when
the transaction is entered into or entail a loss in terms of opportunity cost for not
being able to execute a transaction at the opportune moment. The authority to
issue new debt is normally stipulated in the form of either borrowing authority
legislation with a pre-set limit or a debt ceiling.

Legal arrangements should also be supported by delegation of appropriate

authority to debt managers. A common feature of this type of legislation is that
the authority for borrowing or financial transaction decision rests with the
Minister of Finance or Treasury and requires the Ministry to be accountable for
these decisions to the Parliament. The Minister, in turn, delegates the decision-
making authority to the head of the debt office. All delegations pass through the
head of the debt agency to individual portfolio managers and any other staff
with operational responsibility. For example, in Portugal, a statue specifies
responsibilities, administrative and supervision framework, delegation of
powers, distribution of tasks and the overall financial structure.

Objectives for government debt management should be clearly specified,

publicly disclosed and included in legislation, wherever possible in order to
reduce uncertainty as to the government’s willingness to trade-off cost and risk.
Unclear objectives can often lead to poor decisions on how to manage the
existing debt resulting in a potentially risky and expensive portfolio. Lack of
clarity might also create uncertainty within the financial community leading to a
higher risk premia. Thus many debt offices have made disclosure of their
primary objective in terms of cost-risk tradeoff (Table 4.6). Disclosure may also
be made in respect of secondary objectives like such as maintaining the liquidity
of government issues at various points on the yield curve so as to provide a
pricing benchmark for private issuers, or for emerging market economies, to
promote the development of domestic debt market through a gradual extension
of the maturities of government debt and development of new instruments.

The above arrangement should be supplemented with establishment of a

risk management framework. The strategic benchmarks for portfolio
management of the sovereign debt, in terms of the currency, interest and
maturity mix, produced by the debt office needs to be approved by the Minister
56
of Finance on an annual basis. For countries where the debt agency is outside
the Ministry of Finance or Treasury, the recommendations made to the Minister
of Finance should be made by the Ministry of Finance in conjunction with the
debt office. This requires a counterpart unit in the Ministry of Finance, which is
usually compact, to supplement the recommendations of the debt office while
approving the strategic benchmarks. Once the benchmarks are approved, the
debt office would be independent to operate for achieving such strategic
benchmarks. For few debt offices pursuing active portfolio management,
tactical trading limits are imposed on the portfolio manager. The Table below
provides arrangement for countries enacting legislation for clearly specifying
debt management objectives and strategic benchmarks.

The legislation should also ensure that there is appropriate auditing of

the financial transactions undertaken by the debt office to ensure that they
comply with generally accepted accounting practices and the portfolio
management policies of the debt office. There should also be comprehensive
reporting of financial performance to the Minister of Finance and/or Parliament.

Irrespective of the institutional structure of the debt office, legal

arrangements should clearly specify the organisational framework for debt
management including the mandated and roles of the debt office. Authorising an
outside body of advisors (constituting of a board of directors, advisory bodies
etc.) are used frequently to provide quality assurance on debt management on a
regular basis to the head of the debt office and the minister of finance or the
head of the finance ministry. Thus, autonomous debt agencies in countries like
Sweden and Portugal, are managed by boards, appointed by the government and
chaired by the head of the debt office. Advisory boards with mainly non-
governmental members work with the autonomous debt agency in Ireland. In
countries like Belgium, Colombia, Hungary and South Africa where the debt
office is located within the Ministry of Finance, committees staffed mainly from
the Finance Ministry; other government agencies, including the central bank;
meet regularly with the government debt managers to discuss broader
government debt and asset management issues. On the other hand, for the debt
office in New Zealand, which is located in the Treasury, the Advisory Board
comprises mainly of non-governmental members. Such members are experts in
risk-management theory and practice, meets four times a year to provide advice
and oversight across a broad range of strategic and operational risk management
issues and to establish greater transparency in the decision making and
supervision process.
4.6 Co-ordination with fiscal policy authority and monetary policy
authority
4.7 Capacity Building in Sovereign Debt Management

57