Faculty of Economic and Political Science. Public Administration

PUBLIC DEBT

Presented by: Aminu Mukhtar AnkaID: 20111890

Fall 2014.

What is Public Debt Meaning

Public debt or public borrowing is consideredto be an important source of income to thegovernment. If revenue collected through taxes& other sources is not adequate to covergovernment expenditure government may resort toborrowing. Such borrowings become necessarymore in times of financial crises & emergencieslike war, droughts, etc.Public debt may be raised internally orexternally. Internal debt refers to public debtfloated within the country; While external debtrefers loans floated outside the country.

The instrument of public debt take the form of government bonds or securities of various kinds. Such securities are drawn as a contract between the government & the lenders. By issuing securities the government raises a public loan & incurs a liability to repay both the principal & interest amount as per contract. In India, government issues treasury bills, post office savings certificates, National Saving Certificates as instrument of Public borrowings.

Other definitions

The national debt is broken down into two categories: public debt and intragovernmental debt.

To more accurately define the term public debt,let's first give a brief definition of intragovernmental debt.

Intragovernmental debt is money that the government basically owes to itself.For instance, the government has heavily borrowed from the Social Security fund over thepast years, as the Social Security fund has taken in more money than it has paid out. The government has borrowed trillions of dollars ofthis money to itself.

"Public debt" is money that is owed to any other entity.Public debt includes money that is owed to individuals, mutual funds, hedge funds, pensionfunds, foreign governments, etc.

So, if you decide to buy a $1,000 US governmentsavings bond, then you are considered to be included in the "public debt" tally for the country.

Classification / Types of Public Debt

Government loans are of different kinds, theymay differ in respect of time of repayment, thepurpose, conditions of repayment, method ofcovering liability. The debt may be classifiedinto following types.

1. Productive and Unproductive debts

i. Productive debt :-Public debt is said to be productive when it israised for productive purposes and is used toadd to the productive capacity of the economy.As ‘Dalton’ puts, productive debts are thosewhich are fully covered by assets of equal orgreater value.

If the borrowed money is invested  in theconstruction of railways, irrigation projects,power generations, etc. It adds to theproductive capacity of the economy and alsoprovides a continuous flow of income to thegovernment. The interest and principal amountis generally paid out of income earned by thegovernment from these projects.Productive loans are self liquidating.Generally, such loans should be repaid withinthe lifetime of property.

ii. Unproductive debt :-Unproductive debts are those which do not addto the productive capacity of the economy.

Unproductive debts are not necessarily selfliquidating. The interest and the principalamount may have to be paid from other sourcesof revenue, generally from taxation, andtherefore, such debts are a burden on thecommunity.Public debt used for war, famine relief, socialservices, etc. is considered as unproductivedebt.However, such expenditures are not always badbecause they may lead to well being of thecommunity. But such loans are a net burden onthe community since they are repaid generallythrough additional taxes.

2. Voluntary and Compulsory Debt

i. Voluntary debt :-These loans are provided by the members of thepublic on voluntary basis. Most of the loansobtained by the government are voluntary innature. The voluntary debt may be obtained inthe form of market loans, bonds, etc.The Government makes an announcement in themedia to obtain such loans. The rate ofinterest is normally higher than that ofcompulsory debt, in order to induce the peopleto provide loans to the government.

ii. Compulsory debt :-

A compulsory debt is a rare phenomenon inmodern public finance  unless there are somespecial circumstances like war or crisis. Therate of interest on such loans may be low.Considering the compulsion aspect; these loansare similar to tax, the only difference is thatloans are rapid but tax is not.In India, compulsory deposit scheme is anexample of compulsory debt.

3. Internal and External Debt

i. Internal debt :-The government borrows funds from internal andexternal sources. Internal debt refers to thefunds borrowed by the government from varioussources within the country.The various internal sources from which thegovernment borrows include individuals, banks,business firms, and others. The variousinstruments of internal debt include marketloans, bonds, treasury bills, ways and meansadvances, etc.Internal debt is repayable only in domesticcurrency. It imply a redistribution of incomeand wealth within the country & therefore ithas no direct money burden.

ii. External debt :-External loans are raised from foreigncountries or international institutions. These

loans are repayable in foreign currencies.External loans help to take up variousdevelopmental programmes in developing andunderdeveloped countries. These loans areusually voluntary.An external loan involves, initially a transferof resources from foreign countries to thedomestic country but when interest andprincipal amount are being repaid a transfer ofresources takes place in the reverse direction.

4. Short-Term, Medium-Term & Long-Term Debts ↓

i. Short-Term debt :-Short term debt matures within a duration of 3to 9 months. Generally, rate of interest islow. For instance, in India, Treasury Bills of91 days and 182 days are examples of short termdebts incurred to cover temporary shortages offunds. The treasury bills of government ofIndia, which usually have a maturity period of90 days, are the best examples of short termloans. Interest rates are generally low on suchloans.

ii. Medium-Term debt :-Long term debt has a maturity period of tenyears or more. Generally the rate of interestis high. Such loans are raised for

developmental programmes and to meet other longterm needs of public authorities.

iii. Long-Term debt :-The Government may borrow funds for medium termneeds. These funds can be used for developmentand non development activities. The period ofmedium term debt is normally for a period aboveone year and up to 5 years. One of the mainforms of medium term debt is by way of marketloans.

5. Redeemable and Irredeemable Debts

i. Redeemable debt :-The debt which the government promises to payoff at some future date are called redeemabledebts. Most of the debt is redeemable innature. There is certain maturity period of thedebt. The government has to make arrangement torepay the principal & the interest on the duedate.

ii. Irredeemable debt :-Such debt has no maturity period. In this case,the government may pay the interest regularly,but the repayment date of the principal amountis not fixed. Irredeemable debt is also called

as perpetual debt. Normally, the governmentdoes not resort to such borrowings.

6. Funded and Unfunded Debts

i. Funded debt :-Funded debt is repayable after a long period oftime. The period may be 30 years or more.Funded debt has an obligation to pay fixed sumof interest subject to an option to thegovernment to repay the principal. Thegovernment may repay it even before thematurity if market conditions are favourable.Funded debt is Undertaken for meeting morepermanent needs, say building up economic &industrial infrastructure. The governmentusually establishes a separate fund to repaythis debt. Money is credited by the governmentinto this fund & debt is repaid on maturity outof this fund.

ii. Unfunded debt :-Unfunded debts are incurred to meet temporaryneeds of the governments. In such debtsduration is comparatively short say a year. Therate of interest on unfunded debt is very low.Unfunded debt has an obligation to pay at duedate with interest.

Governments with strong economies, who are welltrusted in the world, are able to raise fundsby issuing their own securities, usually calledgovernment bonds. Individuals, other nations,and groups buy these bonds, and the governmentpromises to pay them back at a certain, usuallyfairly good, interest rate. governments, who donot have the trust from the world to be able toissue bonds and expect people to buy them, mayturn to international institutions, or evennormal banks, to give them loans, usually atless favorable rates.Some people use the term public debt to refernot only to money directly owed in the form ofsecurities that can be collected on by agovernment, but also on the pool of money owedin the form of services and payments promised.For example, pension payments the governmentmay owe to its employees, or contracts thegovernment has entered into but has not yetpaid, may also be included in somecalculations.

Implicit debtGovernment "implicit" debt is the promise by a government of future payments from the state. Usually this refers to long term promises of social payments such as pensions and health expenditure; not promises of other expenditure such as education or defense. A problem with these implicit government insurance liabilities is that it is hard to

cost them accurately, since the amounts of future payments depend on so many factors. First of all, the social security claims are not open bonds or debt papers with a stated time frame, time to maturity.

Impact of the public debt on inflation

An increase in the public debt may, heighten the risk of inflation. If the public debt grows strongly, the government may in fact be tempted to reduce the value of that debt by generating inflation. That happens if the public debt is monetized. In that case, the government issues debts which are bought by the central bank, that purchase usually being mandatory. The money which the government receives from the central bank is used to finance the budget deficit. The money supply expands substantially as a result, and thereis inflationary pressure which may lead to hyperinflation.

All periods of hyperinflation which have occurred in the past have originated from a budget crisis which may be due to war, extremely negative economic shocks, or bad policies. A budget crisis may prevent the government from raising finance on the capital market, or force it to borrow at very high interest rates, so that it resorts to monetization of the public debt.

If the public debt increases, and if the economic

agents take account of a greater likelihood of monetization of the debt, inflation expectations – and hence also current inflation may rise.

Why Public Debt Management Matters?

1.1.1 Terms of Trade and Risk: the 1980s crisis

Debt crisis have been observed since long time ago and are part of the economic historyof countries. However, the crises were isolated cases confined to one specific country in one point in time. The 1980s debt crisis witnessed a special historical situation that lead to major external debt payment problems for a large number of developing countries at the same time.

The debt problems of the 1980s affected all types of developing countries andalltypesofdebt. Theamountofoutstandingpublicmedium-andlong- term debt held by developing countries rose from about USD 270 billion in 1977 to USD 470billion in 1981. Short-term and non-guaranteed debts are believed to have grown even more rapidly. Countries borrowed heavilyin this period as interest rates were low (even negative in real terms at some points),

international private credit was readily available, and financing needs were substantial.1

The build up of external debt was premised onthe assumption that interest rates and commodity prices would move within their historical range. When these assumptions proved inaccurate, the international capital market lending practically collapsed. By end-1981 the annual lending flow from banks to developing countries reached almost USD 50 billion, when in October 19822 it was runningonly at USD 15 billion. The change in the Banks behaviour, from anti-cyclical (continuing rolling over debt service) to pro-cyclical (stopping further rolling over of debt service due), accelerated the crisis.

The borrowing became unsustainable as the 1980s arrived. The crisis was triggered by the following developments:

1. The precipitous rise in interest rates tounprecedented levels after 19793 and the associated swings in exchange rates, as developed countries sought to roll back inflation;

2. The sharp slackening of import demand in

developed countries resulting from the steep and then prolonged recession that started in 1980;

3. The collapse of primary commodity prices,including oil, beginning in 1980;

4. The rapid increase in the relative pricesof imported manufactured goods, which together with the fall in export prices entailed a deterioration of developing countries’ terms of trade; and

5. Last but not least, the growing wave of protectionism that characterised foreign economic policy in the 1980s in developedmarket economy countries.

The Importance of Sovereign Debt Management

The two examples provided in the two previoussections show the importance of Public Debt Management (PDM). Regarding the 1980s crisis,the conclusion that should be drawn is that acountry should implement a Debt Management Office (DMO) that would implement:

6. An overall public indebtedness strategy that is consistent with macroeconomic priorities;

7. Accurate and up-to-date records of all public and publicly guaranteed external loans;

8. Fully awareness of both the timing and the amounts of debt servicing obligationsincluding contingent liabilities;

9. Ability to project the impact of the borrowing decisions of various domestic entities on the country’s overall debt profile, national budget and balance-of-payments; and

10. Capacity to benefit from innovations and instruments available in the financial markets to reduce the costs and the risksto the debtor.

11. External and Domestic Debts 12. The “Grey Book” 23 defines Gross24 External Debt as:

13. Definition of Gross External Debt. 14. Gross External Debt, at any given time, is the outstanding amount of those actual current, and not contingent, liabilities that require payment(s) of principal and/or interest by the debtor at some point(s) in the future and that are owed to non-residents by the

residents of an economy. 15. It is very important to understand the differences and the similarities between these two definitions. The publicdebt definition would include contingent liabilities originated through guaranteesprovided to domestic borrowers, whereas the external debt definition seems to exclude them. The public debt definition does not mention the “residence” criteria, whereas in the gross external debt definition it is a crucial point. The following paragraphs will deal with these differences and similarities.

Evolution of Public Debt

Evolution of public debt can be linked with the basic premises of economics that human needs and wants are unlimited whereas the ways and means to accomplish these needs and wants are limited. Ever since the origin of the state its role has beenincreasing though the nature and types of involvement have marked

change especially in the twenty firstcentury. At the beginning security was the prime concern. Governments used to collect contributions and borrowings from citizens to finance war and security. With the increased role from security to development andwelfare, financing requirements of the governments increased tremendously. The ballooning of public expenditure could not be financed solely by public revenue. Thus domestic borrowings became a major source of deficit financing. With limited scope of domestic savings and borrowings to finance reconstruction and development of war-torn economies and the emergence of international financial institutions the governments began toreceive foreign aid in grants and loans. Foreign aid is primarily aimedto help overcome investment limitations caused by domestic saving

constraints, to overcome foreign exchange constraints in financing development inputs and to help technology transfer from developed and advanced countries. Of the total foreign aid inflow, share of loan hasbeen increasing significantly since the establishment of international financial institutions like The WorldBank and International Monetary Fund and the regional development banks like Asian Development Bank and African Development Bank.At present borrowings, both external and domestic, have become a major source of resource mobilization and deficit financing and an important instrumentof monetary and financial management.

Concept of Debt Management Borrowing allows a country to invest and consume beyond its current level of revenue mobilization and capacity to save and produce. However, no

country can borrow indefinitely sinceunsustainable level of borrowing results in debt crisis. If not managed properly, it can be a huge burden to the economy and future generation. Therefore, we need to achieve the benefits of borrowing without creating difficult problems of macro-economic and balance of payments stability. International debt crisis of early 1980s signified the need and importance of an effective public debt management. Debt repudiation of some highly indebted countries put the international community in an awkward situation. Similarly, Asian financial crisis of 1990s unveiled the complexities of debt management risks. Excessive short term volatile capital inflow coupled with some financial speculations is believed tobe the main culprit of Asian financial crisis which caused Asian

miracles to melt down though it did not last long. Public debt management, in general, is the process of establishing and executing a strategy for managing thegovernment’s debt in order to raise necessary funds from the lending markets with minimum cost and prudentrisk and keeping the debt liabilitiesat sustainable level and paying back the loan without hampering in credibilityand the prospect of necessary borrowings in the future.The main objective of public debt management is to ensure that the government’s financing needs and its payment obligations are meet at the lowest possible cost over the medium to longrun, consistent with a prudent degreeof risk (IMF & World Bank 2003, p6). Debt management today is not merely the act of borrowing necessary debt

at the cheapest interest rate and paying it off as early as possible. Informed decision to seek financing requirements, strategic view of risk management, sensitivity analysis and the act of refinancing, rescheduling and restructuring of debt are coveredby it.

Why Debt Management? Debt management supports public budgeting by providing debt service projections. It helps to avoid bunching up of repayments. It also indicates for weeding out of existingexpensive loans. Similarly, it provides necessary data and information to keep public debt at a sustainable level. Use of modern management strategies and techniques help to maximize benefits and minimize the costs and risks of public borrowing. It also supports macro-economic policies by providing

various debt scenarios against macro-economic aggregates. It assists in loan negotiation by providing basic data and information to compare two or more loan offers. It provides necessary data and information to negotiate for debt restructuring. It creates various scenarios to carry out sensitivity analysis of various terms and conditions as well as other situational factors. Regular monitoring of the level of indebtedness provides early warning signals of possible problems. It alsoassists in developing and maintainingefficient capital market in the country.

Debt Management Functions The ambit of debt management extends from resource forecast and planning to debt policy making. The organizational procedure for loan

negotiation, issuance of securities, market operations, debt servicing, debt accounting and reporting, control and co-ordination of borrowing decisions, risk management and loan administration fall within the domain of debt management. Different writers divide debt management functions into various categories. Manual on Effective Debt Management (2006) of UN ESCAP has grouped debt management functions into three broad categories namely resource mobilization, debt and risk management, loan operations and management information system. It covers external and domestic debt as well as on lending arrangements to public corporations and other entities. It is quite comprehensive and covers functions ranging from resource forecast and borrowings policies and plans to the assessment and movement to domestic capital market, development of debt

management system and monitoring and control of all sorts of public debt. Debt management functions can be changed in accordance with the changing perspective of debt management. However, for the purpose of this article we briefly describe debt management functi

ons based on a

World Bank publication authored by Mr. Thomas M. Klein (M. Klein 1994) as follows: a) Executive Debt Management: - It ishigher level of debt management. It gives over all direction to public debt management. This typology consists policy, regulatory, and resourcing functions.Policy function involves the formulation of national debt policies and strategies in co-operation with different agencies andunits within the government with prime responsibility

for the economic management of a country.The regulatory function involves legal, institutional and administrative arrangements for public debt management. It includes the establishment of a well-defined regulatory environment and continuousreview of administrative and legal framework that specifies organizational responsibilities, rules and procedures among debt management units. The resourcing functions deals basically with administrative management and provides adequate resource requirements, human and others, for debt management. b) Operational Management: - It includes recording, analytical, operational and controlling functions.The recording function needs clear understanding of requireddata elements, data sources and accounting procedures. It requires

collecting detail information on a loan-by-loan basis. The data collected on a loan-by-loan basis is aggregated to provide statistics for analytical purposes. The analytical function undergoes analysis of debt information on both aggregated and disaggregated level from different angles. It also observes trends of international and domestic financial markets. It analyses and appraises different debtinstruments for their relevance and applicability to the country. It monitors the country’s market access,market trends, borrowing level, lender characteristics, loan availability in domestic as well as international markets, impact, volumeand cost of borrowing and new debt management techniques. The operation function involves loan negotiating, loan utilization and debt servicing. It monitors the

implementation of loan agreements to ensure timely and appropriate utilization of loan amount and repayment without any arrears. It also monitors all types of contingentliabilities. It prepares debt serviceforecasts and processes for timely debt service payments. The controlling function measures debt-servicing capacity, involves in risk management and monitors and coordinates among debt management institutions to ensure effective debtmanagement. Controlling function is essential to ensure that operational debt management is in line with executive debt management. It also ensures that borrowing is kept withinthe statutory limits.

Debt Management and Risk Debt management involves a number of risks that can be reduced but cannot be eliminated. There are inherent

risks associated with debt managementoperations related to the structure and composition of debt in terms of maturity, currency and interest rate and liquidity position of the government that can be managed by restructuring debt stock and changingloan conditionality and, using a number of financial instruments such as currency and interest rate swap, hedging and derivatives. The major risk includes:a) Market Risk: - It is associated with the fluctuations in interest and foreign exchange rates. It largely depends on the structure of debt and volatility of domestic and international market. Short-term loanwith floating interest rate is riskier than the long-term fixed interest rate. Similarly, emerging market and transition economies are prone to frequent fluctuations in debt management cost.

16. b)  Operational Risk: Operational risk includes transaction errors or omissions, internal management weaknesses and non-compliance or breach of law and loan conditionality. It mainly occurs in issuance, trading and redemption of debt. It often happens because of the negligence or inadvertent behavior and lack of expertise of debt management staff and lack of proper coordination, ineffective control or oversight mechanism among debt management institutions.

17. c)  Liquidity Risk: This occurs when the government has excessive pressure of bunching up of debt service payments where capacity for immediate repayment is considerably low. It occurs when there is an unanticipated cash flow. Similarly, when the

bondholder's band wagons to exit from the market, it creates a serious liquidity risk. Credit risk, settlement risks and roll-over risks are some other risks that a debt manager has to face efficiently and effectively to avoid unnecessary and undesirable cost of debt management. In addition to these there may be country risks associated with the financial, economic and political condition of the country. While initiating for risk management debt manager should consider the vulnerability of risks since some risks are more vulnerable than others.

Keeping risks at an acceptable level and minimizing borrowing cost is an important objective of public debt management. Therefore, a sound debt management should include an effective risk management system to

avoid unexpected and unwanted variations in the level of debt service payments. Debt managers should ensure consistency between dept policy and operational practicesin order to minimize uncertainties and unpredictability. They should strive to maintain balance between cost minimizing devices and associated risks of public debt portfolio. Debt managers should undertake .

. Good public debt management can help reduce borrowing cost in many ways. A well- designed and implemented borrowing program can give confidence to investors and thus reduce the lending spread. A carefully balanced composition of securities can contain risk—which are harder to manage in countries having few alternative sources of finance.

. Good public debt management can also helpdevelop the domestic financial market. Domestic financial institutions benefit from having available public debt instruments in which to invest and which

can provide benchmarks for the pricing ofother instruments. Moreover, firms and individuals also benefit for similar reasons. In turn, a well-developed domestic financial market can facilitate economic development, and make the economy more resilient to external shocks, such as capital outflows.

. In light of these benefits, it is important to define more specifically theobjectives, components, and the principles that constitute a sound publicdebt management strategy, and how such a strategy can be designed and implemented.To illustrate this, this paper discusses key issues in debt management, focusing on recent developments in country practices, and experiences of reform in developing countries.

. What is public debt management? Public debt management is the process of establishing and executing a strategy for managing public debt in order to raise the required amount of funding at the desired risk and cost levels. It should encompass the main financial obligations over which governments, central, regional and local, exercises control. Public debt management isimportant for a number of reasons:

to ensure that the level and rate of growth of public debt is sustainable in a wide range of circumstances;

to lower public borrowing costs over the long term, thusreducing the impact of deficit financing and contributing to debt and fiscal sustainability;

to avoid economic crises because of poorly structured debt;

the public debt portfolio is often the largest financialportfolio in the country and can have a far-reaching impact on financial stability – consequently, effective management is essential.1.2 How is public debt management facilitated? There is a range of measures that governments may introduce to help ensure the effective management of public debt. This includes the development of a legal framework toprovide the overall parameters for public debt management activity, for example, in respect of the authority to issue debt and the types of instruments that can be used. The legal framework manifests itself through organizational arrangements. These arrangements should be clear and transparent. The allocation of responsibilities between a country’s Finance Ministry, Central Bank, or a separate

References

David Ricardo. Chapter 29 in On the Principles of Political Economy and Taxation.

Boundless. “The Public Debt.” Boundless Political Science. Boundless, 14 Nov. 2014. Retrieved 10 Dec. 2014Reinhart, C M and K S Rogoff , “Debt and Growth Revisited”, VoxEU.org, 11 August, 2010.

Public sector debt statistics : guide for compilers and users. — Washington, DC : International Monetary Fund, 2011.

Blanchard O. (2009), Macroeconomics, Pearson Prentice Hall, 5th edition.

IMF (2010a), From stimulus to consolidation: Revenue and expenditure policies in advanced and emerging economies, Fiscal Affairs Department, April 30.