UNIT 15

MANAGEMENT OF PUBLIC DEBT

Structure
15.0

Objectives

15.1

Introduction

15.2

Price Level and Public Debt

15.3

Debt Management in Developing Countries

15.4

Debt Servicing and Tax Burden

15.5

Management of Public Debt

15.5.1
15.5.2
15.5.3
15.5.4
15.5.5
15.5.6
15.5.7
15.5.8
15.5.9

Introduction
Meaning of Debt Management
Principles of Public Debt Management
Short- term and Long- term Interest Rates
Maturity Mix
The Need for the Investors
Monetization of Public Debt
Interest Ceiling
Debt Size

15.5.10 Inflation Proof Bonds

15.6

Management of Foreign Public Debt

15.7

Floating Debt

15.8

Refunding of Debt

15.9

Repayment of Public Debt

15.9.1

Advantages of Repayment

15.9.2

Methods of Repayment

15.10 Let Us Sum Up

15.11 Key Words
15.12 Some Useful Books
15.13 Answers/Hints to Check Your Progress
15.14 Exercises

15.0

OBJECTIVES

After going through this unit, you will be able to:

36

understand the relationship between price level, debt and debt management;

understand the concept and meaning of management and repayment of public

debt;

explain various principles of management of public debt;

analyze the debt management in developing countries; and

explain various methods of repayment of public debt.

15.1

INTRODUCTION

Management of Public
Debt

Public debt has an important role to play in making good the deficit whenever the
current expenditure exceeds the aggregate revenues of a government. It helps to
mobilize the savings of the community and keep the inflation under check. Moreover
debt resources are necessary in a developing country to finance economic
development. For instance, the government of India used public borrowing on a
massive scale to undertake planned economic development under the Five-Year
Plans. But Public debt is bound to cause a burden to the economy and the people.
It leads to additional doses of taxation. Also only a very small part of the total
volume of debt is of perpetual nature, the remainder being managed or repaid as per
the maturity. The debt is to be managed by following scientific and economic principles
so that it causes the minimum possible burden and it creates the least economic
disadvantage. This assumes importance as the debt repayment and management of
debt have their own impact on the entire economy.
Before explaining various aspects of debt management let us know briefly about the
composition of public debt. The total volume of public debt comprises both of
internal debt ad external debt. While borrowing, undertaken from the governments
and financial institutions from other nations is external debt, internal debt consists of
various types of loans mobilized by the government within the national boundary.
The components of loans and their relative share in the total internal debt vary from
a country to country. For example, in India, besides external debt, government
borrows directly from households, banks and other financial institutions including
the Reserve Bank of India. In India the Internal Debt consists of market loans,
compensation and other bonds such as National Rural Development Bonds and
Capital Investment Bonds, Special Bearer Bonds, Treasury Bills, Special Floating
and other loans and special securities issued to the Reserve Bank. The other liabilities
of government comprises, which are not secured under the Consolidated Fund of
India but are shown as part of public account, post office savings, deposits, deposits
under small savings schemes, loans raised through post office cash certificates,
provident funds, interest-bearing reserve funds of departmental undertakings like
Indian Railways, Telecommunications etc. What is important is whether an internal
debt or external debt, it needs to be managed by redeeming/ repaying the debt. So
what follows is an attempt to know more about the management of debt issues.

15. 2 PRICE LEVEL AND PUBLIC DEBT

When government undertakes borrowing competing the private sector, the interest
rates tend to rise. Consequently the cost of borrowing in the economy does increase
leading to an increase in the price level. This is one of the reasons why economists
often advise the governments to reduce the fiscal deficit to a rational and reasonable
level.
Price level or inflationary situation has an important relationship with the term structure
of the bonds and securities. According to Musgrave the inflation drives up the rates
because lenders would try to protect themselves against any possible loss in the real
value of their claims as prices rise. For example, if the real rate of return in the
absence of any price rise is 3 per cent, and if the expected price rise or inflation is 6
per cent, the nominal rate of interest will be 9 per cent. So the price rise has lessened
the net gain in real terms. Also if inflation is expected to slow down it will lead to a
fall in long rates relative to short rates and vice versa.

37

Public Debt

Price rise or inflation also amounts to be a method of debt redemption. It means the
real value of public debt depreciates because of a fall in the value of the monetary
standard due to inflation consequent upon a currency expansion. If the government
tries to liquidate the debt by a method of currency expansion it will loose its credibility
and future borrowing may be difficult to the government. The central bank has to
guarantee and provide unlimited support to the government bond market in order to
stabilize the prices of government bonds, in an underdeveloped economy. But such
a policy may have inflationary impact on the economy.
Check Your Progress 1
1)

Write three or four sentences about the relationship of price level and debt
Management.
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15.3

DEBT MANAGEMENT IN DEVELOPING

COUNTRIES

In both the developing countries and developed countries the techniques of debt
management are more or less same. But the maneuverability of using these techniques
widely vary. The objectives of debt management in developed economies are:

38

a)

Attracting adequate funds into government issues

b)

Minimizing interest costs

c)

Having a suitable structure of maturity

d)

Maintenance of economic stability etc.

As these objectives can also be implemented in the developed economies, they

need to be modified in view of the underdeveloped characteristics of money and
capital markets in the developing economies. In fact the main objectives of fiscal
policy differ in between these countries. For example, stabilizing aggregate demand
at high level of employment is the objective of the developed nation, while accelerated
rate of economic growth is the target of the developing economies. So the differences
continue with reference to debt management also. For instance, the central bank
attempts to bring changes in the structure, interest rates and the liquidity position by
directly buying and selling in money and capital markets in the developed economies.
The developing economies too adopt these techniques. But constraints like size of
national debt backwardness of money and capital market and financial institutions
dampen the effectiveness of debt management. Moreover, several objectives of
debt management in developing countries conflict each other. It is necessary to
adopt flexibility with regard to the policy of debt management in the developing
countries while attempting to stabilize the government bond market in the short-run,
to minimize the cost of servicing public debt, to attract peoples response to
government securities etc., Debt management in these countries is considered to be

a big task as it demands resourcefulness, foresight and judicious planning which may
stain the resources of the monetary authorities to the utmost and which may not be
available in these countries at the required level.

15.4

Management of Public
Debt

DEBT SERVICING AND TAX BURDEN

Public Debt is to be serviced by paying interest charges. Tax raised to pay the
interest payments impose a burden on the economy. The taxes which are necessary
to be imposed to finance the interest payments places a burden on the economy.
Following R.A. Musgrave and P.B. Musgrave the additional tax burden can be
measured with the following equation.
t = idY/(Y+idY) = id/ (1+id)
Where i is the interest rate and d is the ratio of debt of national income Y. If i equals
to 5% and d equals to 40% t equals 2%. If d rises to say 100% t increases to 5%
and if d rises to 500%, t increases to 20%. In an economy having the above mentioned
conditions, if required t for financing other public services is 20% the corresponding
total levels of t would be 22%, 25%, and 40% respectively.
E.D.Domar, an American economists defined the burden of public debt as the ratio
of the total debt to the national income. He stated that the problem of debt is
essentially the problem of achieving a growing national income increase. If the
national income grows, taxation required to finance interest liabilities on public debt
would not impose an unbearable burden on the economy. According to him, the
conditions under which the burden would increase or decrease over time is as follows.
(S.K.Singh, 2004)
Let D = amount of debt outstanding at the beginning of a year.
i = rate of interest paid on debt.
T = amount of taxes necessary to cover the interest charge on debt.
So T = Di
t = fraction of income (Y) taken through tax to pay interest.
t = T / Y = Di / Y =

iD
Y

It may be explained from the above equation that the tax rate necessary to pay
interest on debt depends on the ratio of the size of debt multiplied by the rate of
interest to income. This tax rate may be related to growth of income and the budget
deficit which can be stated in the following equation.
t=

Where

1
b
= 1
G
(1/ i )( a / b )

G = rate of growth of income.

B = ratio of deficit to income.

The increase or decrease of the burden of debt can be shown by the above equation.
In order to understand the above relationship the following examples are given.
39

Public Debt

Case 1
i = 3%
G = 3%
b = 3%
Then the taxes necessary for debt servicing (t) will be 3%
Case 2
i = 3%
G = 6%
b = 3%
If i and b remain constant, then doubling the rate of growth of income (6%) means
having the tax rate, that is, t=1.5.%. It mans that the debt burden is cut by half.
Case 3
i = 3%
G = 3%
b = 1.5%
Then t= 6%.. A fall in the rate of growth of income increases the debt burden.
Case 4
i = 3%
G = 4%
b = 4%
Then t remains at 3% as in Case1. It means that an increase in deficit (so rise in
public debt) followed by an equal rate of increase in income leaves the debt burden
unaltered.
It follows that the borrowed funds need to be invested in productive purposes by
the government, so that it leads to an increase in National income thereby reducing
the burden of debt. However, once the government undertakes loans, they are to
be serviced and repaid. Here lies the importance of public debt management.

15.5

MANAGEMENT OF PUBLIC DEBT

15.5.1 Introduction

40

Public debt management refers to a set of operations relating to the magnitude and
structure of the debt, distribution of ownership of the debt among banks, non-banks
and other institutions, individuals, maturity mix, structure of interest rates, refunding
and repayment. In a liberal sense it refers to a set of operations which are necessary
to maintain the existing debt at a minimum cost. According to C.C. Abbot
Management of debt is meant the choice of debt forms and the proportionate
amounts of the different types used, the selection of the pattern of debt maturities,
the amount of debt placed with the different classes of holders, the decision to repay

or refund maturing obligations, the refunding terms offered, the treatment given to
different classes of debt and different types of bondholders, determination of the
provisions attached to new bond issues, adoption of new issues to the needs of
prospective holders, policies pursued in the retirement or creation of new debt and
the relative weights given to all these matters in the Governments general fiscal
policy. The methods and policies of debt management depends on the objective
economic conditions existing in different countries and at different times in the same
country. The above definition clearly explains the meaning and mechanism of public
debt management.

Management of Public
Debt

15.5.2 Meaning of Debt Management

Public debt management refers to certain methods which are adopted by governments
with reference to the process of floating, refunding and repayment of public debt.
According to Prof. Abbot, public debt management is mainly concerned with
z

The form of issue of public securities,

The terms on which new bonds and securities are sold

Maturing debts are redeemed or refunded

The pattern of maturities of debt and its ownership.

It follows that the management of public debt is concerned with the determination of
the structural features of public debt like maturity period, rate of interest etc. The
debt policy or management of public debt has a lot of significance as the changes in
the stock of public debt and its portfolio may cause significant effects on the
functioning of the economy. These changes may promote or contradict the existing
monetary and fiscal policies. Therefore, there is greater need for close coordination
between these policies. Such an important mechanism of management of debt should
be governed by some principles.

15.5.3 Principles of Public Debt Management

According to Philips E.Taylor, public debt management should sub-serve three
important principles:
a)

The policies pursued must be able to extract from the public, without undue
coercion, the necessary loans to finance a deficit or to replace maturing securities,
and this should be done at the lowest feasible interest cost,

b)

The entire transactions should serve the economic objectives of stable growth.

c)

The debt should be so placed as to minimize the need to enter the market when
it is inconvenient or unpropitious to do so.

However, we should admit that there exist conflicts among these objectives.
It may be noted from the above first principle that debt management should be
capable of providing the required amount from the lending market. Also, loan amount
need to be procured at reasonable cost as interest payments have a bearing on
revenue account of the budgets. The first principle also requires a number of debt
instruments capable of tapping the loanable funds in the economy. It also implies the
freedom and maneuverability to offer the terms like maturities and interest rates. Of
course, this requires cooperation from the monetary authorities to create favorable
money conditions.

41

Public Debt

With regard to the second principle, debt management policy requires flexibility to
achieve stable economic growth. If the debt management policy, along with other
economic policies, fails to achieve the price stability, it amounts to detracting the first
principle also. The third principle stated above can best be served by lengthening
maturities like the British Consols which never mature. In such a case retiring and
refunding of debt takes place at the choice of the Treasury. The above mentioned
principles of public debt management may be discussed in more detail below.
Check Your Progress 2
1)

Explain the meaning of debt management in three sentences.

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2)

Write two principles of public debt management as stated by Philip E. Taylor.

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15.5.4 Short-Term and Long-Term Interest Rates

This principle states that government should be in a position to create and redeem
the public debts but only at a lower interest costs. The term, structure and the interest
rate will have a bearing on debt management. Evidence shows that short term rates
are either close to or above the long-term rates. However, during the 1930s
depression the short-term rates were below the long-term rates and all rates declined.
In order to reduce the cost of war debt during and post World War II, the government
tried to keep the rates low. This could be possible by undertaking borrowings from
the commercial banks on a large scale by which the money supply has increased.
This policy was continued in the post-war period and which is contrary to the monetary
policy followed in 1950s. At one stage the debate relating to long-term versus
short-term issues assumed importance. But the contention that short term issues
would minimize interest costs and so a large part of debt should consist of such
instruments has no longer been valid. It cannot also be said that interest cost is
minimized by selling those bonds which can be sold at the lowest current interest
rates. Therefore, it is necessary that expectation of rates need to be considered
along with current rates.

42

The implications of the term structure of interest rates for debt management suggest
asking whether interest cost is minimized by selling those bonds which can be placed
at the lowest cost to maturity. Possibly the answer is no. Following Musgraves, for
example that the Treasury borrows for one year at 5 per cent and for 20 years at 7
per cent. It may not be advisable to take one-year issue because by year end the

opportunity to borrow at 7 per cent may be lost if the level of rates has risen. On the
other hand suppose the treasury can borrow for 20 years at 5 per cent and for one
year at 7 per cent. The former choice need not necessarily be preferable as the
rates may decline before the 20 years have passed. Here what is important is the
direction in which the Treasury expects the interest rates to change. If the Treasury
expects the rates to rise, the choice is long-term bonds and if the rates are expected
to decline, the choice would be short-term issues. What one has to observe here is
that once interest cost contracted for should have to be carried for the entire period
even though rates do fall. Similarly the benefits of a low rate would continue even if
the rates do rise. For example, if the Treasury borrows Rs. 1000 in the market in
which a 20 year bond, if selling at par, must carry a coupon rate of 6 per cent.
Suppose after one year the market yield on a 19 year bond falls to 5 per cent. As
a result, the price of the old bond will rise to Rs. 1,117, i.e., the present value of
Rs. 1000 due in 19 years plus 19 annual coupon payments of Rs. 65 as discounted
at 5 per cent. In such a case, if the Treasury were to retire the old bond and to
issue a new 19 year bond at 5 per cent, it would have to raise Rs. 1117 rather
than Rs. 1000 to replace the outstanding issue. This would leave its position unchanged
as the present values of the two cash flows i.e., Rs. 1000 in 19 years plus nineteen
annual payments of Rs. 65 or Rs. 1117 in 19 years plus 19 annual coupon payments
of Rs. 61.40 discounted at 5 per cent are the same and each is equal to Rs. 1117.
The same type of reasoning applies in a situation where interest rates rise and bond
prices fall. It follows that nothing would be lost by replacing the old bond with a new
one. It may also be noted that though the former could be retired at a lower price,
the latters coupon rate would have to be correspondingly higher. Musgraves further
opine that debt management is a fine art of which requires a shrewd appraisal of
market prospects for a considerable time ahead.

Management of Public
Debt

15.5.5 Maturity Mix

Maturity mix has an important bearing on management of public debt. It was well
established that the public debt should be well funded. It implied public debt should
have bonds/securities with long-term maturities. For example, the British debt during
the 19th century was mostly in the form of consols or perpetual securities as stated
earlier. As there is no fixed maturity date for these consols, they can be retired at the
government option if it is willing to pay the market price. This protects the
government from the creditors who demand payment of money at an inopportune
time. But the views of the government to-day are totally different. The most important
assumption of public debt management is that maturing issues are all refunded. The
size of national debt may increase or decrease depending upon the governments
stabilization policy. Moreover, if some issues mature, they will be refunded in terms
of other issues. It may also be noted that if the average debt outstanding is shorter,
the larger will be the size of refunding operations, though it does not influence the
maturity structure. So the important underlying guideline for the choice of the maturity
mix or structure is to choose a term structure so as to minimize the interest cost. As
the cost of borrowing differs with the maturity of the debt, those bonds need to be
chosen which the investors would be willing to absorb at the lowest cost. In other
words, the government should borrow from the lowest-cost lender.
Another issue to be considered while choosing the maturity mix is the inflation. It is
a well established fact that long term securities are less inflationary as they reduce
the problem of frequent and continuous refunding. It has been held that government
can reduce the annual rate of inflation just by lengthening the average maturity of
debt. The maturity needs to be linked to indexation of public debt. Debt indexation

43

Public Debt

always suggests long term maturities. This is mainly because debt indexation
neutralizes effects of inflation on debt. In the absence of indexation, shorter maturities
are better as longer maturities tend to exacerbate expectations of high inflation.

15.5.6 The Need of the Investors

It is opined that debt should be managed in such a way that the type and the terms
of issues need to be suitable to the investors. Otherwise it would be difficult to the
government to manage its debt. For example, if the government plans converting of
the short-term securities into a long term debt, it will have to offer the terms in such
a way to attract the bondholders and the investors to see that the general liquidity of
the public debt remains more or less the same. If the debt management does not
cater the needs of the investors; it may lead to disturbances in the security market.
At the same time, if the interest of the investors is protected by keeping the rates
high, the cost of public debt becomes high.

15.5.7 Monetization of Public Debt

Public debt is monetized by increasing the money supply. In other words, debt
monetisation results in an increase in circulating currency. The government can regulate
the level of interest rates in the market as it controls the money supply in the economy.
Though debt monetization is the cheapest way of borrowing as it is not without
excessive aggregate demand and inflation.. Debt monetization is an easy way to
raise revenue and is likely to be misused through excessive increase. While the
choice of the term structure of issues needs to be judged in terms of their effects,
debt monetization should not be undertaken during inflationary period. It has been
felt that lengthening the debt at the time of refunding the issues tends to be restrictive
and shortening the issues would be expansionary. Lengthening the debt issues raises
the long-term rates as shown in the following diagram 15.1.

Length of
Debt

Money
Demand

Interest
Rate

Fig. 15.1
Source: S.K. Singh, Public Finance in Theory and Practice
44

In the diagram demand for money is represented on the horizontal axis and length of
debt and interest rate is represented on the vertical axis. It may be observed from
the diagram that an increase in the length of debt from OD to OD' results in an
increase in the money demand from OM to OM'. As a result, the rates of interest
rise from r to r'. This is because of the fact that holding of debt instead of money
means purchasing liquidity. The investors will accept such a situation if they are
offered higher rates. But higher rates in turn may exert restrictive influence on private
investment which is welcome during a period of boom. But very long term debt too
would inject rigidity into the financial structure and may lack adequate liquidity in the
economy which may have adverse effects. If the economy is experiencing a fall in
employment, shortening the debt is the right policy. It all depends upon the immediate
objectives of the stabilization policy which largely decides the debt management
policy.

Management of Public
Debt

15.5.8 Interest Ceiling

Interest ceiling is also considered to be one of the methods of debt management. In
U.S.A soon after the World War I, an interest ceiling of 4 per cent on securities in
excess of five years, excluding those issued to government securities was imposed.
But this ceiling remained ineffective for long period and the congress allowed the
Treasury to issue bonds at above ceiling gave rise to several controversies and has
been proved to be an ineffective measure. Moreover, it places an undesirable
constraint in adopting a stabilization policy may not be rational and advisable.

15.5.9 Debt Size

This implies an imposition of an upper limit by the legislature on the size of the debt
a government can borrow. In U.S.A the congress authorizes a set limit which the
Treasury cannot exceed. Fixing a limit on the size of debt has been considered as an
indirect way of controlling unnecessary and unproductive expenditure of the
governments. In India, the recently enacted Fiscal Responsibility and Budget
Management (FRBM) Act can be stated as a similar exercise. According to this
Act the Government of India should bring down its Gross Fiscal Deficit at 3 per cent
of Gross Domestic Product by the year 2008 09. The Twelfth Finance Commission
while recommending debt relief and incentive grants-in-aid to states insisted that
those states which would enact the FRBM Acts are only eligible to get the relief.
Such a measure has been appreciated as it may help manage the debt levels of the
center and state governments at sustainable level.

15.5.10

Inflation Profit Bonds

In order to overcome the inflationary effects of yield of bonds and securities especially
to protect the small investors, inflation profit bonds have been suggested. These
are also known as stable purchasing or constant power purchasing bonds. The
significance of these bonds is that the redemption value would vary according to the
cost of living index which protects the small investors against any loss of purchasing
power from inflation as well as depriving of a gain if prices should fall. Countries like
Austria, France, Finland and Israel besides U.S.A used this method either in private
or public lending operations. It was supported on the ground that it would defeat
inflation and provides an escalator clause to the small saver and investor. However,
this innovative method has been criticized on the ground that it would generate
pressure for adopting such an escalator clause in other sectors also.
45

Public Debt

Check Your Progress 3

1)

Write four sentences about minimizing the interest costs as part of debt
management.
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2)

Explain about imposing an upper limit on the national Debt Size in five sentences.
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3)

What is the main purpose of the inflation-proof bonds?

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15.6

MANAGEMENT OF FOREIGN PUBLIC DEBT

Sound macro economic management of a country requires efficient and effective

foreign debt managements also. It is necessary to forecast and plan the requirement
or quantum of external borrowing and the consequent debt service payments or
obligations. The governments especially the developing nations should take into
consideration the external borrowings and resultant service obligation while designing
the monetary and fiscal policies. It has been observed by the International Monetary
Fund that only one fifth of the developing nations are systematically managing their
foreign debt. The two important issues concerning foreign debt are:

46

1)

The extent of regulation of foreign debt and

2)

Its composition.

With regard to regulation, in several countries including India, the Central government
controls and regulates the external borrowings. Not only the individuals, even the
sub central governments do not have access to the external borrowings directly. In
India only in recent years the regulations of external borrowing by the state
governments have been liberalized. Regarding the composition of foreign debt,
debt management would be easier as a larger proportion of foreign debt is institutional

and non-commercial. External debt can be repaid or serviced only through foreign
exchange earnings which is possible by increasing the export earnings. If foreign
borrowings are invested in such industries and activities which bring foreign exchange
so that the foreign loans can be repaid and serviced effectively. On the other hand
if the foreign loans are utilized for unproductive purposes repayment of the loans
become difficult. The size or aggregate level of foreign debt depends on the growth
rate of the economy and its export performance. It is necessary that the growth rate
of the economy should be faster than the rate of interest on long term borrowing to
keep the country solvent. Also it is necessary that the rate of growth of exports
exceed the rate of interest to avoid any liquidity crisis. In some countries the debt
service exports ratio limit is fixed for efficient debt management. For instance in
Philippines a 20 per cent limit is fixed since the balance of payments crisis in
1969- 70. In some countries statutory limits are imposed on the quantum of external
borrowing itself. Of course, its not the volume of debt alone that matters but the
efficient management of it is important.

15.7

Management of Public
Debt

FLOATING DEBT

Floating debt here means debts made by the government of temporary nature like
that of the Ways and Means Advances from the Reserve Bank of India (RBI) in
India. They may be in the form of special securities issued to Reserve Bank of
India. For example, the Central Government takes loans of temporary nature from
the Reserve Bank of India and issues special securities which are non-negotiable
and non-interest bearing (generally issued for not more than 12 months). This type
of floating debt aims at providing short-term debt to the government to bridge the
gap between revenue and expenditure. Such debt needs to be redeemed at the
specified dates/time of maturity. Many a time, the floating debt carries either nil or
less rate of interest if the debt is redeemed. When the government fails to redeem,
it may be converted as permanent debt and becomes a burden due to an increase in
the interest rate. So the floating debt should be repaid as per the maturity of the
loan. The Central Bank of the country generally stipulates the amount of floating
debt that can be undertaken by government. For example, the Reserve Bank of
India fixes limits on the amount of Ways and Means Advances (which is an important
component of floating debt) that the Central and State Governments borrow. Such
a measure will help in the effective debt management of the governments. For instance,
the limits of Ways and Means Advances (WMA) to the Central Government for the
fiscal year 2005-06 were retained at Rs.10000 crore during the first half of the year
(April-September) and Rs.6000 crore during the second half of the year (OctoberMarch). The interest rate on WMA has been the bank rate and that on overdraft at
2 per centage points above the bank rate.

15.8

REFUNDING OF DEBT

Sometimes the government replaces the short-term loans by long-term loans.

Government borrows funds to meet current expenditure with shot-term loans which
will be replaced later on by obtaining or raising fresh loans of long-term nature from
the public. In other words, refunding is a method in which the maturing bonds are
replaced by new bonds. Government bonds sometimes be reduced before heir
maturing date if the government intends to change the terms of bonds like changing
the rate of interest, maturity period etc. Though this method provides a temporary
relief to the government, it gets tempted and finds it easy to postpone the repayment
of the debt. Traditionally refunding operation involves highly complicated procedures

47

Public Debt

but adequate techniques are developed in recent time simplified the matters.
Refunding operations rather face a management problem that it is necessary to
estimate the yields precisely as demanded by the market.

15.9

REPAYMENT OF PUBLIC DEBT

Generally governments borrow huge amounts to finance expenditure both of

developmental and non-developmental nature. A government, which borrows, has
to repay the debt by imposing taxes. Even if it postpones the repayment of the
principal amount, it does require paying the interest amount from time to time as
per the prescribed terms at which it issued the bonds. The fact is that the government
may postpone the repayment of the public debt once or twice but not indefinitely. As
repayment and servicing of the debt demands imposition of additional doses of
taxation, governments often defer the repayment of public debt. The government
generally makes provisions for redemption of the debt when the bonds are issued.
Now let us know briefly the meaning of such words as the refunding, redemption
and repudiation before explaining various measure of repayment. Refunding is a
method in which the maturing bonds are replaced by new bonds. This process of
refunding involves no liquidation of the money burden of public debt. This type of
repayment gives the government temporary relief. On the other hand redemption
means the outright repayment of a loan. Repudiation is altogether different from
redemption, though it is also one way of getting rid of the burden of a debt. In this
case neither the interest nor the principal amount would be paid by the government.
In other words, government in this case just refuses to honor the post debts. As
repayment of the debts will have to be undertaken by rational government, the
advantages of repayment and methods of repayment are explained below.

15.9.1 Advantages of Repayment

1)

It raises the credit of the government

2)

It will produce salutary effects on the people if simultaneously repayment efforts

are made

3)

It saves the cost of debt administration.

4)

Debt repayment is a deflationary measure

5)

It reduces the scope for extravagant expenditure of the government.

6)

Repayment also saves the future generations from paying additional doses of
taxation

7)

It helps the government to raise loans in future

After understanding various advantages from the repayment, let us now know about
the methods of repayment.

15.9.2 Methods of Repayment

Repudiation

48

Repudiation means refusal to pay a debt. But this is not a common practice or
method of repayment. However, there are some countries which have resorted to
this practice such as the Soviet Government in 1917 which repudiated the debt
similarly some States in the USA before the civil war (1861-65) which repudiated

the debts owed to the English citizens. Under this method the government refuses to
repay the public debt and the liability for public debt is extinguished. In fact this
amounts to confiscation of the property of debt holders to the extent of their size of
debt. If the government adopts this method, it will be penalizing the wealthier and
relatively wealthier class compared to other categories of people. In other words, it
leads to inequity. In fact, other category of people, the non-bondholders, will be
benefited through a possible reduction in taxation, as the governments obligation to
pay interest will be reduced to the extent of repudiation. Moreover people invested
their savings in Government bonds would suffer and people having equal amount in
other forms of wealth would be benefited. The governments credit suffers and it
would be very difficult to loans in future when government repudiates its debt.

Management of Public
Debt

If the government repudiates an external debt, it may lead to problems like facing
economic sanctions by the creditor nation and even a war besides losing its credit at
the international level. Under normal circumstances, no rational government will be
resort to this method as it reflects the insolvency of the government. Generally
governments use this method following social or political revolution when they feel
that it is almost impossible to honor the debt obligations.
Conversion
Conversion is also considered as another method of debt redemption. Governments
occasionally use this method when they have an immediate obligation to pay the old
debts and when resources are not readily available. Under such circumstances the
government issues conversion loans or fresh bonds to the existing bondholders. In
fact, this is not exactly debt redemption and does not lead to any reduction in the
total debt obligation of the government. But if the government manages the fresh
loans at lower interest rates, servicing burden of public debt will decline. Government
generally try to convert their high cost loans with low rates of interest when the rate
of interest is falling. Such an arrangement will minimize the burden on the government
though there is no change in the debt stock of the government as such.
According to Hugh Dalton conversion method does not really reduce the debt burden
as reduction in interest rates reduces the ability of the bondholders to pay taxes
resulting in loss of government revenues thereby reducing the capacity of government
to redeem or repay the loans. A successful use of this method ensures efficient
management of public debt.
Here, it is necessary to note that the methods of refunding and conversion are often
used interchangeably . Refunding is the postponement of debt payment while
conversion is the change or rearrangement of interest rates and other terms of the
debt except the postponement of debt maturities. Often, both the methods can be
used in a combined way.
Sinking Fund
Sinking fund is a fund which aims at sinking the debt obligation. It facilitates for
regular retirement of public debt. It operates in such a way that the government
deposits a fixed amount of revenues into this fund every year aiming at the regular
retirement of public debt. Many economists believed that this is best method of debt
redemption. Under this method, the Fund accumulates over a period of time by
setting aside a small amount every year from the revenue budget which increase at
compound interest rate. So that it will be useful by the time the debts mature. Sinking
fund is accumulated from the beginning until the debt is matured. But now it is not a

49

Public Debt

very effective instrument as the stock of debt has exceeded number of times than the
real size of the sinking fund.
According to Hugh Dalton sinking fund should be financial and accumulated out of
current revenues of the government and should not be financed from borrowing
sources. If the sinking fund is financed with borrowing resources, it does loose its
purpose and cannot be called as sinking fund. In many countries sinking fund is not
accumulated from year to year over a period of time. Generally some amount of
resources from the revenue account is allocated from the current year budget
allocations which are used for repayment of debt in the same year. But the existence
of such fund with small annual accrual has become irrelevant in view of the
mountainous and fast growing debt obligation in India as well as in several other
countries in the world.
Theoretically, sinking fund is a good means for orderly retirement of public debt. But
this is a slow process of repayment of debt and there is every chance of diverting the
resources from the fund for other uses at the time of resource crunch. The sinking
fund was in practice as early as in 1934-35 when the government of India made a
provision of Rs.3 crores annually from the revenue budget for reduction or avoidance
of debt. Subsequently this amount was raised to Rs.5 crores from 1946-47 in view
of the growth of public debt due to the World War II. This arrangement in India at
the central Government continued until 1969-70 and discontinued from 1970-71
onwards.
Surplus Budget
It has been argued that a surplus budget on revenue account may be used to clear
off or reduce public debt gradually instead of creating a separate fund like the sinking
fund. Of course, the use of this method depends upon the state of the revenue
budget. In other words, this method is less certain than making a fixed amount every
year to the sinking fund which aims at reduction of debt. But in the modern times
surplus budget is a rare phenomenon due to the fast growth of revenue expenditure.
Moreover, surplus budget policy cannot be followed at all economic situations. In
other words, surplus budget cannot be followed when deflationary conditions prevail
in the economy and so this is the limitation of the present method.
Terminal Annuities
This is also considered as an important method wherein the government issues terminal
annuities maturing every year a part of the debt in the serial order announced or
decided by the government by a lottery system. Under this method the debt burden
is cleared besides a reduction in the interest. This is something like repaying the debt
amount in installments. Consequently, the burden of debt diminishes year to year
and the amount would be paid by the maturity time.
Capital Levy

50

Capital levy is a heavy levy imposed once for all on property, wealth or any of the
capital assets above a certain fixed value. Capital levy is generally imposed after
war to liquidate the unproductive war debts. According to R.N.Bhargava the
government may redeem its public debt by levying a heavy additional tax only once,
or at the most twice. This special heavy tax to repay public debt is generally called
a capital levy; asset is assessed on the value of capital held by the people. Sometimes
it is called a special levy, when the heavy tax is imposed on an index of ability other
than capital. After World War I in the UK it was proposed to impose a capital levy

to repay the heavy debt incurred while waging the war. The Labour Party in the
U.K. in election manifesto in October 1922 made a promise that Labour recognized
the urgent need of lifetime from the trade and industry of the country to receive the
country from the dead weight burden of the National debt. It, therefore, proposes
the creation of a war debt redemption fund by a special graduated levy on fortunes
exceeding 500 (Bhargava R.N.)

Management of Public
Debt

Justification for Capital Levy

It is opined that the huge deadweight and unproductive war debt be liquidated by a
heavy once for all tax to repay the debt. A special levy is also justified on the premise
that those who made large amount of profits during war should pay the government
in order to enable it to clear off the debts. Moreover, during war the poorer sections
of the society, the soldiers make sacrifices while the business and capital class earn
windfall profits. Therefore, it is quite rational to impose a heavy dose of tax on the
capitalists. A capital levy can also be justified, as it is anti-inflationary due to taking
away of the surplus purchasing power from the rich business and investor class.
Capital levy is justified on equity ground also. The enhanced inequalities due to and
during the War can be reduced by imposing a capital levy. The real burden of public
debt would increase if a depression follows the war. Under such circumstances, the
government bondholders will gain. Therefore, it is logical to levy a special levy like
the capital levy to liquidate the debt once for all. The outright repayment of the
national debt by imposing a capital levy would provide a psychological relief to the
people as they need not pay additional doses of taxation in future to repay the debt.
In the absence of such a heavy levy, the people have to pay taxes for years together
which may cause adverse effects on incentives to work, save and invest. Hugh
Dalton strangely justified the imposition of capital levy both on the grounds of social
justice and also from the point of view of relieving the debt burden of the posterity.
Further, he commended the use of capital levy because of its deflationary character.
Disadvantages of Capital Levy
The foremost problem of capital levy is that it is very difficult to identify and estimate
a fair value of the property accumulated during war time. So it s difficult to assess
and administer the tax. This tax may act as a disincentive to save and invest which
are subject to tax. It looks like imposing a tax on thrift. Within the domestic economy
it discourages savings and investment and may also prevent the inflow of foreign
direct investment thus effecting adversely commerce and industry in the long run.
Such a heavy dose of tax, even though once-for-all, may affect badly the confidence
and faith of the business and investor class and also may encourage tax evasion.
Given the opportunity, the capital may take a flight from the domestic economy to
where there is no such tax.
No doubt, capital levy can be chosen in specific circumstances due to its quick and
equity consideration. But alternative methods of repayment are also suggested as
this heavy levy has its own adverse effects on the people and economy. For example,
U.K.Hicks states that A levy thus amounts to a major surgical operation on the
body politic, it will either kill or cure and is very different in its effects from regular
dosage or massage applied by the normal tax structure

51

Public Debt

Check Your Progress 4

1)

Write three important advantages of debt redemption.

...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................

2)

Explain the usefulness of Sinking Fund in retiring debt in two sentences.

...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................

3)

What is the main objective of Capital levy?

...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................

15.10 LET US SUM UP

Public Debt causes burden in terms of additional doses of taxation to both the present
and future generations. Also there is a two-way relationship between public debt
and price level. As a large part of the debt is to be repaid or managed some scientific
principles are to be followed to minimize the burden and disadvantages on the
economy. While various issues like minimization of interest costs, maturity period,
interest ceiling, upper limits on debts etc. assume importance in debt management,
sinking fund, conversion, refunding, capital levy etc. methods need to be used for
repayment of debt. A rational policy of debt management and repayment need to
be designed comprehensively taking into account the relevant macro-economic
objectives. The efficiency and the success of public debt management depends
upon the level of coordination among debt policy, fiscal policy and monetary policy
of the Government.

15.11
Consol

52

KEY WORDS
: A consol is an obligation of the Government
to pay a fixed amount of interest annually
without any maturity.

Deflation

: It is a situation where aggregate demand falls

short of aggregate supply. Falling down of
prices, employment and purchasing power of
individuals.

Inflation

: It is a situation of rising prices where

aggregate demand exceeds aggregate supply.
Increasing trend of prices.

Maturity

: Maturity is the time period when the bond or

security is to be redeemed by the Government.

Bond Holder

: A bondholder is a person who owns

Government debt issue or security. He will
hold the bond or security till its maturity.

Debt Swapping

: It means Government converting their high

cost debt with relatively low cost debt
instruments like small savings collections;
Government of India recently introduced this
Scheme to enable the stocks to prepay their
high cost debt with market borrowings and
small savings over a period of three years
ending 2004-05.

Management of Public
Debt

15.12 SOME USEFUL BOOKS

Musgrave R.A. & Musgrave P.B., Public Finance in Theory and Practice
(1980 &1989) McGrawhill. Third & Fifth Edition, New Delhi.
Phillip E. Taylor Economics of Public Finance (1961) Third Edition Macmillan,
New York.
Prest A.R. Public Finance in Under-developed Countries (1962) Allied,
Bombay.
Tripathy R.N. Public Finance in Under-developed Countries (1978) The World
Press, Calcutta.
Bhargava R.N., Theory and Working of Union Finance in India (1974)
Chaitanya Pub. House, Allahabad.
Singh, S.K., Public Finance in Theory and Practice (2004) Sixth Edition,
S.Chand & Co., New Delhi.
Government of India Economic Survey 2004-05

15.13

ANSWERS/HINTS TO CHECK YOUR

PROGRESS

Check Your Progress 1

1)

Study Section 15.2 carefully and get your answer.

53

Public Debt

Check Your Progress 2

1)

See Sub-section 15.5.2

2)

See Sub-section 15.5.3

Check Your Progress 3

1)

Study Sub-Section 15.5.4 and get your answer.

2)

See Sub-Section 15.5.9 for the answer.

3)

The main purpose is to protect the small investor.

Check Your Progress 4

1)

Write any three from Sub-section 15.9.1.

2)

For regular and orderly retirement. Retiring the debt on maturity with resources
of revenue budget.

3)

To liquidate the war debt with a once for all heavy dose of tax.

15.14 EXERCISES

54

1)

Explain the objectives and meaning of public debt management.

2)

Discuss various issues of debt management.

3)

Explain the important principles of debt management and discuss the

implications of debt magnetization.

4)

Explain various aspects of debt management in under developed countries.

5)

Discuss the advantages of debt repayment and explain the methods of

repayment.

6)

What is capital levy? Give justification for its imposition to liquidate the debt.

Notes

MEC- 006 : PUBLIC ECONOMICS

Block 1

Public Economics: The Basic Concepts

Unit 1

Welfare Foundations of Economic Policies

Unit 2

Theory of Market Failure

Unit 3

Voting and Local Public Goods

Block 2 Social Choice and Collective Decision making

Unit 4

Arrows Impossibility Theorem: Social Choice and Individual

Values

Unit 5

Normative Models : Equity and Justice

Unit 6

Spatial Voting Models

Block 3

Public Policy : Mechanism Design, Agenda Setting

and Information

Unit 7

The Basics of Public Policy

Unit 8

Mechanism Design

Unit 9

International Policy Coordination

Block 4

Economics of Taxation

Unit 10

Commodity Taxes

Unit 11

Direct Taxes

Unit 12

Introduction to Optimal Taxation

Block 5

Public Debt

Unit 13

Theory of Public Debt

Unit 14

Sources of Public Debt

Unit 15

Management of Public Debt

Block 6

Fiscal Federalism

Unit 16

Fiscal Federalism and Fiscal Policy

Unit 17

Equity and Efficiency Issues

Unit 18

State and Local goods

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