Perspectives 2019 2020 Public Sector

62 Conducting Sovereign Liability Management: An Indispensable Step to Building Up Economic Strength Any government is exposed to several risks that may have direct influence on the cost of their debt service. On a global scale, shifts in international markets can cause increased volatility in the exchange rate, drive terms of trade shocks, or significantly move commodity prices, all of which is outside the influence of an individual government. At a domestic level, countries can be affected by changing interest rates, inflation rates, or be exposed to more systemic shocks driven by a specific industry, such as the banking sector. Any of these risks can expose the vulnerabilities a sovereign faces and translate into stress when it comes to debt repayment. The perception of stress by external market participants can in turn lead to restricted funding access for a government, which in worst cases, may end up using its international reserves to service debt repayments, further weakening its macro stability. However, these risks can be preemptively addressed through the adoption of regular liability management transactions that can easily be executed opportunistically on smaller outstanding debt portions in a country’s government debt portfolio. These operations can in turn have positive effects on the fiscal profile, help fortify the domestic financial system, and create a positive reinforcement that supports the macroeconomic fundamentals of any emerging market economy. These types of operations also ensure the sustainability of servicing debt and appropriately manage its related risk. It is worthwhile to note that regular LM transactions alleviate the need to do so under stress situations. Waiting to execute an LM operation until it is absolutely necessary, rather than taking an opportunistic view, defeats the positive effect of regular executed LM operations. Executing an LM under stress may lead to elevated refinancing costs, as investors will understand that the government, at that point, may not have any alternative funding options. 2. Identifying risks covered by regular LM operations The risks sovereign debt management offices need to take into account relate to the total stock of debt, its maturity and currency composition, as well as its interest rate composition. External and domestic shocks can exacerbate these risks associated with a government’s debt portfolio. Below is a list of the most common challenges sovereign debt management may seek to address with an LM operation 1 : 1 Extracts from the IMF Policy Paper, A Primer on Managing Sovereign Debt Portfolio Risks , April 2018 Risk Description Interest Rate Risk Higher interest rates increase the cost of debt. Increases in interest rates occur when fixed rate debt is refinanced, or when interest rate changes occur on floating rate debt. Short term and floating rate debt is traditionally considered riskier than long term, fixed rate debt. Exchange Rate Risk Changes in exchange rates may increase the servicing cost of foreign denominated debt. Measures of exchange rate risk include the share of domestic currency debt as percentage of a government’s total debt, and the ratio of short term external debt to international reserves. Refinancing Risk This measures the ability to refinance maturing debt under current market conditions and takes into account investor appetite for a country’s government bonds. Refinancing risk is typically a major concern for countries with volatile and/or rapidly deteriorating economic indicators, lower credit rating, perceived poor governance, and high political risk, as well as for highly indebted countries and countries under financial distress. Liquidity Risk Refers to a situation where the volume of liquid assets diminishes quickly as a result of unanticipated cash flow obligations and/or a possible difficulty in raising cash through borrowing in a short period of time. Credit Risk Traditionally reflected in a country’s sovereign credit rating and the sovereign credit default swap (CDS) spreads that reflect market concerns. These indicators are difficult for debt managers to control; however, they determine respective bond yields and borrowing costs.