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"Danish Government Borrowing and Debt 2001"

Special-Topic Section

Chapter 7
Consequences of Budget Surpluses for Government Debt Policy

7.1 Summary

In recent years the economic consequences of a declining government debt have been discussed in a number of international fora. This discussion e.g. arose as a consequence of the budget consolidation in Europe and the USA, which has led to a stabilised or declining government debt.

A smaller government debt has a number of positive effects on the government budget and on the national economy, such as lower interest costs for the central government. In overall terms, this helps to widen the national economic scope for manoeuvre.

Lower debt reduces the pressure on government borrowing, giving greater leeway in planning government debt policy strategies. A reduced borrowing requirement can make a number of adjustments to the government debt policy strategy appropriate as the current requirement for issuing diminishes.

In the longer term, if the debt approaches zero, the question arises of whether government bonds should still be issued when there is no immediate borrowing requirement. This depends primarily on whether the existence of government bonds is considered to be a prerequisite to maintaining a well-functioning financial market.

In the Danish financial market, the mortgage-credit market is the obvious successor to the benchmark role of government securities. It is thus not necessary to maintain government-bond issues in the absence of a borrowing requirement. For euro-area member states with little debt there are likewise few arguments to support maintaining issues of government bonds for as long as euro-area member states with high debt maintain the supply of euro-denominated government bonds. Other countries can be expected to continue to issue government bonds even if they have no government debt. This is currently the case for e.g. Norway, whose central government holds net assets, but continues to issue government bonds.

7.2 Background

In recent years, a number of international fora have focussed on the economic consequences of a declining government debt. These discussions have e.g. taken place under EU auspices and within the OECD's government-debt group. Reports published in 2000 included one from the Giovannini Group. The Giovannini Group advises the EU on issues related to financial markets. This report e.g. considers the question of coordinated issues^[1]. Furthermore, the economic consequences of a declining debt have been considered in a number of theoretical articles.

Discussion of the consequences of a diminishing government debt has been based on the following:

The USA has had a government-budget surplus since 1998, and until recently a considerable decline in the government debt within a foreseeable period was estimated in prognoses.
Within the EU government budgets have been subject to significant consolidation in the period up to the introduction of the euro.
In a number of other OECD states, including Canada, Australia and New Zealand, government debt has stagnated or been reduced during the 1990s.
Japan has a substantial budget deficit and a growing debt. From 1992 to 2001 gross debt as a ratio of GDP has more than doubled.

Chart 7.2.1 presents the consolidation of government budgets in the euro area and the USA, as well as for Denmark and Japan. Within the EU, Finland, Sweden, Ireland, the UK and Denmark have achieved government-budget surpluses since the end of the 1990s, while the deficits of the other EU member states have primarily been reduced. With regard to Denmark, the turning point came in around 1997. In the period 1997-2001, the government debt has been reduced by almost DKK 90 billion. In that same period, the nominal outstanding volume in domestic bonds has fallen by around DKK 55 billion.

Chart 7.2.1 Development in government-budget balances

Source:	OECD, Economic Outlook 70, December 2001.

The budget consolidation prompted a number of adjustments to the government debt policies of European countries at the end of the 1990s. The new policies are adapted to the greater competition among issuers and the lower issuing requirement. This increased competition can be attributed primarily to the run-up to and the introduction of the euro, creating a European financial market with a single currency. The core concept is to issue in a small number of series with a large outstanding volume and high liquidity. To a great extent the member states pursue identical strategies.

Besides the design of the government debt policy the diminishing government debt affects the national economy, as well as the functioning of the financial markets. The topics discussed in this area include:

The relation between greater public savings, private savings, interest rates, growth and employment.
The consequences of a reduced supply of government bonds for the efficiency and functioning of the financial markets.
The design of government debt policy in a situation where the issuing requirement is reduced as a consequence of transition from deficit to surplus.
Whether it entails costs for a country to re-enter the market for government bonds after a period with no issues.

The future development in government debt, and thereby in the supply of government bonds, depends on many factors that are mutually related, and is therefore subject to considerable uncertainty.

How the debt develops depends primarily on fiscal policy, and to some extent on the cyclical development, which is generally subject to great uncertainty. Moreover, in most OECD countries, the ageing of the population and a diminishing labour force are predicted to be the trend in coming years. Increased expenditure on measures to provide for the elderly can thus postpone or prevent the reduction of net debt.

A calculation of Denmark's government debt up to 2010 is presented in Chart 7.2.2. It is based on the Ministry of Finance's medium-term projection of the development in government debt and shows an average government-budget surplus of around DKK 12 billion in the period 2002-2010, thereby reducing the debt by around DKK 100 billion.

Chart 7.2.2 Projection of development in the domestic government debt

Note:	Actual figures for the period 1995-2001. For 2002-2010, calculation based on the medium-term projection of the Ministry of Finance of the development in the government debt, Economic Report, January 2002.

The Chart also shows an alternative scenario where the budget is balanced in the period 2006-2008 and thereafter develops in line with the basic scenario. The difference between the two scenarios for the government debt increases over the period from just over DKK 46 billion in 2006 to just over DKK 52 billion in 2010, as a consequence of dynamic interest-rate effects. The larger the surplus, the smaller the debt, and the more interest costs are reduced. This in turn leads to larger surpluses, etc. In other words, a number of years with a balanced budget or deficit can considerably delay the settlement of the debt.

If the targets of the basic scenario are achieved, the Danish government debt will decrease, but still be at a considerable level.

Discussion of government debt policy in a surplus scenario should generally be based on two factors in both Danish and international contexts. Any elimination of the debt will often take place over an extended period, and the surplus scenario will often be subject to a degree of uncertainty.

7.3 Effects on the national economy and financial markets

A lower government debt affects the economy primarily via the government budget and a reduced supply of government bonds. The effects are national economic, but also market-related, due to changes in the composition and supply of instruments in the financial market. Reducing the government debt has a number of positive effects on a country's economy, since it increases the national economic scope for manoeuvre. The national economic effects are described in more detail in a number of articles^[2]. In the following, the focus is on how a declining government debt affects the financial markets.

Impacts on financial markets
Government bonds are often characterised by high liquidity and low credit risk. Government bonds are described as the liquid, "risk-free" asset in the financial markets. The low credit risk is a consequence of e.g. the central government's right to levy taxes.

High liquidity and low credit risk ensure government bonds a key role in the financial markets, thereby helping to increase the efficiency and completeness of the markets.

The most important function of government bonds is as a liquidity and hedging instrument. Government bonds are also the underlying asset used in a number of derivative instruments, and are a key investment object for risk-averse investors. They are also used by central banks in their monetary-policy operations. Finally, via the zero-coupon yield curve, government bonds are used to price privately issued financial instruments.

A situation with a decreasing outstanding volume in government bonds affects the financial markets to the extent that close substitutes do not exist or arise to replace government bonds in the aforementioned areas. The obvious alternatives to government bonds include bond issues from the following sources:

Credit institutions. Freddy Mac, Fanny Mae, Deutsche Pfandbriefe and Danish mortgage-credit bonds.
Business enterprises. Issues of corporate bonds by companies with a high rating and thereby a low credit risk.
Government-guaranteed and supranational entities. Øresundsforbindelsen and Great Belt (Storebæltsforbindelsen) are Danish examples of issuers of government-guaranteed bonds. EIB (the European Investment Bank), NIB (the Nordic Investment Bank) and the World Bank are examples of supranational bond issuers.

These are examples of bond issues which have the potential to take over the role of government bonds in the financial markets, including as pricing instruments.

Pricing can also be based on the swap curve. The swap curve indicates the relation between the interest rate on the fixed leg of an interest-rate swap and the maturity of the swap. The market for interest-rate swaps has been growing in recent years to become a large liquid market. Pricing in the financial markets thus does not necessarily require large underlying government-bond issues.

Due to the low credit risk and large outstanding volumes, mortgage-credit bonds are the most obvious successors to the current role of government securities in the Danish market. If the government debt continues to diminish, it is therefore possible that, at some point, mortgage-credit securities will resume the benchmark role they held up to the start of the 1990s.

It is also possible that the supply of bonds from other issuers will increase in step with the reduction of the supply of government bonds. This primarily relates to a greater supply of highly-rated corporate bonds. In recent years the growth in the international corporate-bond market has made it possible to price corporate bonds on the basis of zero-coupon yield curves derived from other corporate bonds with the same rating.

The debate of whether a country's financial markets are affected by a declining supply of government bonds must consider the development stage of the financial market. The existence of government bonds can play a significant role in a situation where the financial market is still being built up, where government bonds are the "foundation stone" of the market. This will usually be the case in a number of developing countries.

7.4 Adjustments to government debt policy

A declining government debt affects the government debt policy to the extent that the policy requires adjustment to ensure that its objectives are met.

The objectives of government debt policy can often be divided into two areas. One is related to achieving low long-term borrowing costs with due consideration of the risks that the debt entails, and the second is to maintain a well-functioning domestic financial market.

Issuing policy in a situation with a declining debt
For the central government, a smaller debt generally reduces the pressure to borrow, thereby giving greater scope in planning government debt policy. This leads to lower costs and fewer risks. Moreover, a reduced borrowing requirement can make it reasonable to carry out a number of adjustments to the government debt policy strategy in step with the reduction of the current issuing requirement.

International practice is to base the issuing policy on liquid benchmark issues in order to reduce the average borrowing costs via a liquidity premium.

When a country turns a budget deficit into a surplus, the outstanding volume in each on-the-run issue will be negatively affected, making it necessary to adjust the policy in order to maintain the benchmark strategy. Key adjustments and instruments used for maintaining the benchmark strategy in the scenario of a declining debt are:

Concentration of issues in fewer bond series and instrument types
Longer issue periods for individual securities
Buy-back and switch operations
Market making schemes
Lending facilities
Interest-rate and currency swaps
Consolidation of public borrowing

Box 7.1 presents the individual items in relation to Danish government debt policy.

Box 7.1 Adjustments to Danish government debt policy for a lower government debt

Concentration of issues on fewer bond series and instrument types. Since the start of the 1990s Denmark's government debt policy has focused on issues in a small number of series and maturity segments. Bonds are issued only in the 2-, 5- and 10-year segments. In the period 1997-99 only very few issues took place in the 30-year segment. At the close of 2000 the 30-year paper became an off-the-run issue. Previously, several different types of loan were used, including serial loans, premium bonds and floating-rate loans. In the current strategy, only bullet loans are used.

Longer issue periods. Currently, issues are made in the 5- and 10-year bonds for approximately 2 years. The 10-year bond traditionally opens with a remaining maturity of e.g. 11-12 years, and closes when the remaining maturity is around 10 years. In the 2-year segment, the securities are open for issue for approximately 1 year. Moreover, the series can be re-opened at a later time.

Greater use of buy-back and switch operations. Buy-backs have been used actively for several years. Buy-back of securities before normal redemption makes it possible to move the financing requirement to the buy-back year where issues in a small number of series can be made. Switch auctions were launched as part of Danish government debt policy in 2001.

Use of interest-rate and currency swaps. Domestic interest-rate swaps were introduced in Danish government debt policy in 1998. To some extent, interest-rate swaps separate the duration objective from the issuing policy. In this way, the issues can be concentrated in e.g. the 10-year segment, and duration is managed independently thereof by transacting interest-rate swaps. In 2001 currency swaps from kroner to euro were introduced in Danish government debt policy. Via currency swaps, foreign loans can be raised by issuing domestic bonds and then swapping the proceeds to foreign currency. Currency swaps from kroner to euro thereby increase the domestic borrowing requirement.

Lending. A alternative method to support liquidity is to lend government securities against collateral. This supports turnover and thereby liquidity, since a shortfall in a given bond is prevented. It can be argued that the required outstanding volume in a given series (critical level) becomes lower if there is an efficiently functioning lending facility. As part of Danish government debt policy, two lending facilities have been established under the auspices of respectively the central government and the Social Pension Fund (SPF). The two facilities together cover most of the domestic government bonds.

Re-lending to government-guaranteed entities. As from 2002, the government-guaranteed entities Øresundsforbindelsen and Storebæltsforbindelsen have had access to a re-lending facility in government loans, cf. Chapter 5. Re-lending entails that the government-guaranteed entities borrow via the central government, which finances the loans by issuing bonds. In a number of other countries, government borrowing has been consolidated, by e.g. including the financing of local-government debt in overall general-government borrowing.

The aforementioned instruments and adjustments can help to maintain the benchmark strategy in a situation where the debt is declining, thereby ensuring low average borrowing costs, while some of the initiatives, viewed separately, at the same time can entail an increase in the risk on the debt. Examples are a concentration of issues and longer issuing periods since fewer securities reduce the government's issuing opportunities, and moreover can result in a less even redemption profile. Increased disparity of the redemption profile can subsequently be set off via active use of buy-backs. All in all, a lower government debt reduces the absolute risk on the debt, i.e. the risk measured in kroner, as the central government has to borrow less, cf. Chapter 6.

Most countries are expected to maintain a prolonged benchmark strategy via active use of the aforementioned instruments, even though their debt is declining.

An alternative to adjustments to the individual countries' government debt policy would be closer cooperation between countries with a relatively small issuing requirement, in order to maintain liquidity in on-the-run issues.

An impression of the differences with respect to government debt among the European countries is given in Chart 7.4.1. This was part of the background to the discussion in the Giovaninni Report of the need for coordinated government issues in Europe. The overall objective of coordination is to enhance liquidity in the different countries' securities, and thereby reduce the interest costs to the participating countries.

Chart 7.4.1 Debt, gross and net issues in 2000

Source:	Central Government Debt, Statistical yearbook, 1980-2000, OECD

The Giovannini Report concludes that especially the small euro-area member states would benefit from coordinated issues. The report outlined four different proposals with varying degrees of coordination, cf. Box 7.2.

Box 7.2 The Giovannini Report on coordinated issues

The Giovannini Report outlines four initiatives entailing varying degrees of greater coordination of the government debt policy. The four initiatives can be summarised as:

Coordination of technical aspects. This proposal entails the smallest degree of integration and concerns exchange of information concerning issuance calendars, identical coupon and maturity dates, a common primary dealer system, and a common clearing and settlement system. Coordination of technical aspects already takes place among issuers in Europe. One example is the exchange of information on auction dates under the auspices of the EU's Brouhns Group. Information is available at www.europa.eu.int/comm/economy_finance/efc_en.htm.

Shared debt instruments with country-specific tranches. A number of countries join forces to issue e.g. a 10-year loan. The proposal entails that each country is allocated one tranche of the loan, which is guaranteed by that country. A precondition for the proposal is that the participating countries have the same rating.

A common debt instrument with a common guarantee. The participating country guarantees the entire issue ("joint and several guarantees"). One problem with this proposal is that it is in conflict with Article 103 of the EU Treaty which prohibits bail out.

Supranational issues. A supranational government-debt unit is established which grants loans in its own name and re-lends to the member states.

Financial market considerations in a situation with no government debt
The need for a well-functioning domestic financial market can be a vital parameter determining whether a country ceases to issue government bonds when the government debt has fallen to a very low level or been eliminated completely.

Whether a small outstanding volume in government bonds or a situation without government bonds presents a challenge to the functioning of the financial market depends, as previously stated, on whether close substitutes to government bonds exist, Section 7.3.

A smaller euro-area member state with little or no government debt will not experience any scarcity of a "risk-free" asset for as long as the overall euro market for government bonds is intact. Hedging and investment, etc., can take place in euro-denominated bonds issued by other euro-area member states.

In situations where the government debt is reduced and has perhaps lapsed completely, the outstanding volume can be maintained by the central government continuing to issue government bonds, placing the proceeds in a portfolio of government assets. An example of a country that uses this strategy is Norway, whose central government holds net assets but nonetheless issues government bonds.

Even if the government debt disappears for a transition period, it may be necessary to increase the debt at a later time. Re-entering the bond market can impose extraordinary costs, however. The re-establishment costs can be related to several factors. Firstly, the market may require a premium due to uncertainty concerning the expected liquidity in the new securities. Rebuilding market making and primary dealer schemes, inaccurate pricing, etc., can also entail additional costs.

Transition periods where the debt is very low might e.g. arise as a consequence of large non-recurring revenue or due to demographic shifts.

The weighting given to the financial market and the possible costs of re-establishment vary between countries. This is natural in view of the large variations in the development stages of the financial markets of the various countries, and the variations in the extent to which the existence of government bonds is critical to the functioning of the financial market. A vital consideration in this respect is whether the country has its own currency.

If Denmark's government debt continues to decrease, making it necessary at some point to consider whether the issue of government bonds should continue or not, financial market considerations are not expected to justify continued issue. Danish mortgage-credit bonds will be able to take back from government bonds the role of benchmark in the Danish bond market, cf. Section 7.3.

Furthermore, it is assumed that any re-establishment costs will be relatively moderate, in view of the rapid development of the financial markets in recent years, with greater integration among the national markets, e.g. following the establishment of multinational trading platforms for bonds and greater use of other financial products. It is therefore the impression that problems with e.g. correct price setting of a new issue will not arise on any future re-entry to the bond market by the central government. All in all, it is therefore very likely that in a situation with no Danish government debt, there will be no requirement to issue Danish government bonds.

Footnotes

^[1]The Giovannini Report can be downloaded at www.europa.eu.int/comm/economy_finance/publications/giovannini/giovannini081100en.pdf.

^[2] See e.g. "The Economic Consequences of Disappearing Government Debt" by Reinhart and Sack in Brookings Papers on Economic Activity, 2:2000.

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	Version 1.0 March 2002 Nationalbanken. Published by Danmarks Nationalbank March 2002, http://www.nationalbanken.dk/