Running Government Finances Like a Bank

Many investors are concerned about the increase in public debt of Asian countries since the Asian Financial Crisis. As justification, governments need to issue debt to support the financial markets, jump start the economy, and develop infrastructure, etc. Sovereigns with large outstanding debt are seen to be more credit risky and more more susceptible to something going wrong. Thus, the IMF issued guidelines on Public Debt Management (PDM).

In a nutshell PDM takes Asset-Liability Management best practice from banks and insurance companies and applies them in managing government debt. This makes sense since the biggest financial portfolio in a country is the government's finances anyway.

Governments should focus on ALM issues like liquidity and interest rate risk management. It should analyze the cost-benefit trade off of borrowing in the short term - which is cheap but risky and volatile, as opposed to borrowing long term - which is expensive but predictable. They should also focus on minimizing unhedged foreign exchange exposures, debt with embedded put options (unpredictable maturities), and implicit contingent liabilities.

Governments should also push for the development of their domestic currency capital markets. A developed capital market would mean that there are a lot of investors and variety of issued securities. Development of derivatives markets will also be beneficial as investors are more willing to take and hedge risks. A developed capital market will also allow the government to issue longer-dated debt since there are willing investors.

Having a large public debt portfolio is not such as bad thing as it can be a catalyst for economic growth. The key here is proper risk management. All they (governments) have to do is to look at what the banks and other financial institutions are doing.

Sources:

International Monetary Fund
Financial Engineering News

Tags: finance derivatives risk management alm government debt bonds capital markets