Introduction and Summary

Government debt is often a country's largest financial portfolio and entails considerable costs and risk. Management of central-government debt and development of sound principles in this respect have therefore received increasing international attention. In Denmark, central-government debt has been reduced substantially over a number of years. At the same time, the principles for and approach to management of Danish government debt are being developed on an ongoing basis.

The central-government debt is compiled as the domestic and foreign debt, as well as the assets of three government funds and the balance of the central government's account with Danmarks Nationalbank. Government Debt Management at Danmarks Nationalbank manages the central-government debt on behalf of the Ministry of Finance and manages loan guarantees and re-lending to a number of companies.

Danish Government Borrowing and Debt provides an overall description of principles and methods for the management of the central-government debt and reviews the development within the past year. The publication is divided into four sections. Chapter 1 outlines the main principles of government debt management. Chapters 2-8 report on borrowing in 2005 and describe the strategy for 2006. Chapters 9-11 introduce three topics: issuance of long-term government bonds, interest-rate models for Cost-at-Risk analysis, and government cash management. The Appendices present detailed statistics on central-government borrowing and debt.

Chapter 1: Main principles
The overall objective of the government debt policy is to cover the central government's financing requirement at the lowest possible long-term borrowing costs, subject to a prudent degree of risk. Furthermore, the aim is to support a well-functioning domestic financial market and to facilitate the central government's access to the financial markets in the longer term.

The objective of government debt policy implies an ongoing evaluation of the trade-off between costs and risk and is supported by liquid benchmark series.

Government debt management is based on international best practice for good governance of debt management, including openness, credibility, clearly defined objectives and a clear division of responsibilities.

Chapter 2: Government debt and interest costs
A strong government budget surplus reduced the central-government debt by DKK 77.1 billion in 2005, to DKK 417.8 billion. Interest costs fell by DKK 4.1 billion to DKK 20.7 billion in 2005. A combination of falling debt and low market interest rates has entailed that the government's interest costs as a percentage of GDP have more than halved within a period of 10 years. The decrease in interest costs in recent years is primarily attributable to the lower interest rates.

Chapter 3: Government borrowing in 2005
2005 was characterised by low market interest rates and a low borrowing requirement. Sale of domestic government bonds totalled DKK 40 billion, mainly in the 10-year maturity segment. Furthermore, a 5-year euro loan of EUR 1.8 billion was raised. Issuance of government securities was discontinued in the latter part of the year as a consequence of upward adjustment of government budget estimates. Total sale of government securities exceeded the borrowing requirement by approximately DKK 23 billion. The excess sale covers part of the government's financing requirement in 2006.

Chapter 4: Issuance strategy
The prospect of falling central-government debt in the coming years entails a need to adjust the central government's issuance policy. The challenge lies in ensuring liquid government securities during a period with a declining borrowing requirement. Consequently, government borrowing will be concentrated on fewer securities. The strategy is to focus on issuance in the 10-year maturity segment . If the borrowing requirement is sufficiently large, issuance may also take place in a shorter maturity segment, maturing in years when the central government has only few redemptions or none at all. In 2006, the borrowing requirement as of January 2006 is DKK 12 billion, and the strategy is as follows:

• The central government will concentrate issuance in the newly opened 10-year government bond, 4 per cent bullet loans 2017. This series will reach a final outstanding amount of approximately DKK 50 billion, of which around DKK 25 billion is expected to be issued in 2006.
• Issuance in 4 per cent bullet loans 2010 will continue until the loan has reached a minimum of DKK 35 billion and the 10-year issue, 4 per cent bullet loans 2015, has reached a minimum of DKK 60 billion.
• The central government will not raise any euro loans in 2006.
• The central government may buy back domestic and foreign government securities.
• In the event of unusual market conditions, small supplementary issues in the other government securities are possible.

Chapter 5: Market structure
Danish government bonds are primarily issued by tap sale to a group of primary dealers, currently comprising 13 Danish and international banks. Treasury bills are issued at monthly auctions. The primary dealers have an obligation to quote current bid and ask prices within fixed maximum spreads and for minimum amounts. Market making contributes to a transparent and well-functioning market for Danish government securities. Government Debt Management at Danmarks Nationalbank has agreed with the primary dealers that MTSDenmark is the marketplace for issuance of and market making in Danish government securities.

In 2005, six of the primary dealers in government bonds took up 70 per cent of the bonds sold. The average daily turnover in Danish government securities on MTSDenmark was almost DKK 2 billion in 2005.

The market structure for Treasury bills was modernised in 2005. A new and improved MTS auction system has been implemented, and a primary dealer system has been introduced for Treasury bills, with 12 Danish and international banks as participants.

Chapter 6: The government funds
The assets of the three government funds – the Social Pension Fund (SPF), the High-Technology Foundation and the Financing Fund for increased distributions from the Danish National Research Foundation (the Financing Fund) – are included in the central-government debt and are managed together with the central government's other financial assets and liabilities within government debt management. At the end of 2005, SPF's bond portfolio had a nominal value of DKK 133.2 billion. In 2005, DKK 8.7 billion was transferred from SPF to the Ministry of Social Affairs to cover pension improvement measures. The central government contributed DKK 2.9 billion and DKK 1.0 billion to the High-Technology Foundation and the Financing Fund, respectively. The subsequent build-up of capital and disbursements from the funds are stipulated in the annual Finance Acts.

Chapter 7: Government loan guarantees and re-lending
Government loan guarantees and re-lending derive from the political intention to support the financing of certain projects. Most of the government loan guarantees and re-lending managed by Government Debt Management at Danmarks Nationalbank are issued to government-owned companies involved in large infrastructure projects.

At the end of 2005, government guarantees managed by Government Debt Management totalled DKK 75.4 billion, and re-lending totalled DKK 23.1 billion.

Chapter 8: Risk management of central-government debt
The central-government debt and related interest costs are exposed to the development in interest rates (interest-rate risk) and exchange rates (exchange-rate risk), as well as the counterparties' ability and willingness to honour their payment obligations (credit risk). In addition, there is operational risk. Management of the various risk types reflects the objective of low long-term borrowing costs, subject to a prudent degree of risk.

Interest-rate risk related to central-government debt is managed via a strategic benchmark for the duration of the debt portfolio. The target band for the duration in 2006 remains unchanged at 3.0 years ± 0.5 years. The foreign government debt is primarily denominated in euro. As a result of Denmark's fixed-exchange-rate policy vis-à-vis the euro, the exchange-rate risk is limited.

Credit risk related to the central government's swap portfolio is limited via requirements of the credit ratings of counterparties, as well as unilateral collateral requirements. At end-2005, 98 per cent of the central government's swap portfolio, measured in terms of principal, was covered by unilateral collateral agreements.

Operational risk is limited e.g. via the use of standardised financial instruments, clear procedures and a clear division of functions.

Chapter 9: Issuance of long-term government bonds
During 2005, several government issuers resumed or commenced the issuance of ultra-long fixed-rate nominal or inflation-linked government bonds with maturities of 30 years or more.

Issuance of ultra-long bonds should be viewed against the background of falling interest rates and flattening yield curves in several countries in recent years. Some market participants have indicated that the life insurance sector and pension funds have underpinned the structural demand for ultra-long government bonds, which may have contributed to the flattening of the yield curve.

In view of the very low borrowing requirement, Government Debt Management has no current plans to change its issuance strategy to include more instruments with longer maturities.

Chapter 10: Interest-rate models
In the management of interest-rate risk related to central-government debt, the development in future interest costs is analysed under different assumptions regarding the level of interest rates. The analyses are performed using the Cost-at-Risk (CaR) model on the basis of simulations of the interest-rate development in an interest-rate model.

So far, the one-factor Cox-Ingersoll-Ross (CIR) model has been used to generate the interest-rate scenarios in the CaR model. Now the interest-rate model has been extended to include two explanatory factors.

The extension improves the explanatory power of the model and allows for the decoupling of short-term and long-term interest rates that are observed historically for several periods. Simulation of the interest-rate development in the two-factor model indicates that the results are relatively robust to the choice of estimation period.

Chapter 11: Government cash management
The Danish central government holds liquid funds in order to handle current payment flows. The funds are held in the central government's account at Danmarks Nationalbank, and the central government's large receipts and disbursements are settled via this account. The account accrues interest on market terms. The overall management of the liquid funds is handled by Government Debt Management by aiming at a specific balance on the account at year-end, as well as ensuring that the balance is always positive.

In the management of costs and risk, the central government's account is an integral part of the government debt portfolio. This means that the overall duration of the government debt, as well as the issuance and buy-back policies, are subject to coordinated management with the balance of the central government's account.