Public Debt Middle Office WG Report

8/14/2019 Public Debt Middle Office WG Report

1/57

FIRST DRAFT OF THE WORKING GROUP REPORT ON

THE NEED FOR A MIDDLE OFFICE FOR PUBLIC DEBT

MANAGEMENT

(as circulated in the Fifth Meeting of the Working Group on January 19, 2001)

1


2/57

FOREWORD

The need for a comprehensive strategy for public debt management has beenfelt for some time because of high fiscal deficits, the consequent increase in debt

burden of the Central Government and the absence of an integrated approach towards

domestic and external public debt management.

As a major step towards putting in place an effective system for public debtmanagement, a Working Group has been constituted to examine the need for anintegrated middle office for public debt management. The role of the middleoffice envisaged is to make analysis, provide advisory support and managementinformation system inputs for debt management decisions. The issue was examined inthe context of effective public debt management of the country keeping in view the

possible long-term requirements. Given the wide array of issues involved, the Grouphas restricted its focus on the institutional structure, risk management requirements

and best international practices. The recommendations made in this regard, for settingup a centralized middle office, should be viewed as the starting point towards creationof a strong institutional system for prudent public debt management.

The recently introduced Fiscal Responsibility and Budget Management Bill2000, which encompass stipulating limits on public debt as a proportion of GDP,

besides other ceilings on fiscal indicators, have created conducive conditions forcapacity building for public debt management. The initiative of the Group, as outlinedin its recommendations, is also in tune with recent efforts by international financialinstitutions like the World Bank and IMF to identify as to what constitutes sound

practices for sovereign debt management.

The setting up of the Working Group and its Report was made possible byfunding from the Institutional Development Fund Grant of the World Bank, aimed atstrengthening the debt management capacity of the country. The Group is indebted tothe valuable insights provided by Mr. Graeme Wheeler and Mr. Fred Jenson from theWorld Bank, Mr. Nihal Kappagoda for his consultancy report on best international

practices, and Dr. Raj Kumar, from the Commonwealth Secretariat, London forcomplementing Mr. Kappagodas efforts. The Group also had the benefit to beenriched from different officials of select debt offices visited. The Working Group

would like to acknowledge contributions made by Mrs. Usha Thorat from the ReserveBank and Mr. Alok Chaturvedi from the Ministry of Finance. On behalf of the Group,I would also take this opportunity to place on record special appreciation for thetechnical inputs provided on the subject by Mr. Arindam Roy from the Ministry ofFinance. The Group is indebted to officials from External Debt Management Unit inthe Ministry of Finance for rendering valuable assistance and providing secretarialsupport for the Group.

(Arvind Virmani)

Tuesday, January 30, 2001

2


3/57

INDEX

Report of the Working Group

1. Introduction 1

2. Debt Position of the Central Government 13. Central Government Debt Management 34. International Experience 45. Recommendations 5

Annexures

I. Constitution of the Working Group

II. Central Government Debt2.1 Definition of Public Liability2.2 Debt Position of the Central Government2.3 Debt Burden of the Central Government2.4 Net Liability of the Central Government2.5 Contingent Liabilities of the Central Government2.6 Legal Ceilings on Central Government Debt

III. Existing Structure for Public Debt ManagementIII.1 Internal Public Debt ManagementIII.2 Other Domestic Liability ManagementIII.3 External Public Debt ManagementIII.4 Missing Links in Middle Office Functions for Public Debt

ManagementIII.5 Co-ordination among Debt Management Activities

IV. International Experience and Best Practices in Public Debt Management4.1 Approach in Study of Best International Practices4.2 Risk Management Framework for Government Debt

4.3 Institutional Structure for Public Debt Management4.4 Scope of Role and Functions of Debt Offices4.5 Organisational Structure4.6 Governance - Legal Framework and Accountability4.7 Coordination with Fiscal Policy Authority and Monetary Policy

Authority4.8 Capacity Building in Sovereign Debt Management

V. Summary Recommendations by the Commonwealth Secretariat on Best

International Practices in Sovereign Debt Management

VI. List of Select Debt Offices Visited by the Working Group

3


4/57

Report of the Working Group

1. Introduction

1.1 The importance of public debt management has grown immensely overthe years. In India, the need for a comprehensive strategy for public debtmanagement has been felt for some time. The concern stemmed from theaccumulation in the stock of Central Government debt, high interest burden on

public debt, absence of an integrated risk-management approach towardsdomestic and external public debt management, and the need to managecontingent liabilities of the Government in a centralisedmanner.

1.2 As a step towards putting in place an effective system for public debt

management, a Working Group was constituted on July 18, 2000 to examine theneed for an integrated middle office for public debt management. The middleoffice is usually the entity located within a debt management office, whichserves as the risk manager, formulates and advises on the debt managementstrategy and also develops benchmarks for assessing the risk-cost trade off ofthe portfolio. The role of the middle office envisaged is to make analysis,

provide advisory support and management information system inputs for debtmanagement decisions in the overall framework of the Central Government debt

portfolio, keeping into perspective the possible long-term requirements. The

Memorandum for setting up the Working Group, including the composition andterms of reference is at Annex 1.

1.3 The Working Group was given a timeframe of four months i.e. up toNovember 17, 2000 for submitting its Report. However, given the limited timeand wide scope of the terms of reference, the term of the Working Group wassubsequently extended up to January 31, 2001.

1.4 To study the need for a middle office, the Group analysed theindebtedness position of the Government for understanding the scale of risk and

cost associated with it. Simultaneously, a review of the present debtmanagement structure in India was attempted to identify missing links, if any, inthe area of middle office functions for public debt management. In its endeavorto make recommendations, the Group also undertook an in-depth analysis of theinternational best practices for middle office role.

2. Debt Position of the Central Government

2.1 The mounting debt of the central government due to a long legacy of high

fiscal deficits and the increasing use of financing such debt for currentexpenditure has led to a continual deterioration of the indebtedness position ofthe central government. The total debt of the central government increased

4


5/57

annually at a compound growth rate of 13.4 per cent during end-March 1991 toend-March 2000. While, the ratio of Central Government debt-GDP ratio stoodat 60.9 per cent during 1999-2000, the debt dynamics was characterised by across-over in the growth of nominal debt relative to the growth of nominalGDP, thus pointing towards further deterioration in the debt-GDP ratio. The

composition of outstanding debt also, underwent a change, with the share ofdomestic debt increasing steadily since 1991-92. The growth in the domesticcomponent of Central Government debt was spurred by a heavy accumulationof internal debt. The re-emergence of an increasing trend in revenue deficit as a

proportion of GDP since 1996-97 could be attributed to the sharp increase in theinternal debt of the Central Government in recent years. As a result, the ratio ofinternal debt to GDP deteriorated significantly from 25.3 per cent in 1996-97 to37.7 per cent in 1999-2000. A detailed study of the indebtedness position of theCentral Government is at Annex 2.

2.2 The steady accumulation in Central Government debt, particularlyinternal debt, resulted in increased interest payments burden. The total outgo oninterest payments on Government debt, which accounted for one-fifth of thetotal expenditure by the Government in 1990-91 increased to one-third of thetotal expenditure in 1999-2000. Thus, interest payments, which pre-empted one-half of the tax revenue in 1990-91, pre-empted nearly three-fourth of the taxrevenue of the Central Government in 1999-2000. Similarly, the proportion ofinterest payments in total revenue receipts increased from 39.2 per cent in 1990-91 to 51.9 per cent in 1999-2000. The increase in interest burden, inter alia,stemmed from larger recourse to market borrowings at market-related rates.Interest payments on external debt, on the other hand, remained fairly stable,reflecting the concessional nature of such debt flows.

2.3 The over-hang in internal debt also led to potential for significant roll-over risks in the medium term. The objective of the internal debt manager toraise debt at minimum cost coupled with a shift in investor preference towardsshort-term paper led to a policy of placing borrowings at the shorter-end of themarket. Given the burgeoning market borrowings, the share in outstanding

market borrowings in shorter maturity securities (with a maturity of less than 5years) accordingly increased from 7.4 per cent of the total market loans in end-March 1992 to 45.2 per cent in end-March 1998. Although, since 1998-99, thematurity structure was lengthened with the introduction of long-term securitiesand a conscious policy to avoid placing of short-term securities, the weightedaverage maturity creeped up steadily from 5.5 years in 1996-97 to 12.6 years in1999-2000. This entailed large future redemptions during the next ten years.The external debt component, on the other hand, is characterised by smoothredemption profile during the next ten years, reflecting the long-tenor of official

debt flows.

5


6/57

2.4 Thus, while the debt of the Central Government has reachedunsustainable limits, there is a potential of significant interest rate and roll-overrisks of the domestic debt component, at least in the medium term. For theexternal debt component, there remains significant foreign exchange risk, in theabsence of any hedging or portfolio management strategy. In addition,

contingent liabilities of the Central Government, in the form of guarantees onboth domestic and external debt, which, amounted to 5.9 per cent of GDP in1998-99, poses further risk for the Central Governments debt position.

2.5 To redress the growing indebtedness position of the Central Government,in the past, several public agencies recommended enacting legislation forcontrolling the Central Government borrowings. The Constitution of India has

provision for placing a limit on the public debt of the Central Government. Veryrecently, in an effort to promote overall fiscal prudence, the government has

introduced the Fiscal Responsibility and Budget Management Bill, 2000 in theParliament. If the proposed Bill finds passage in the Parliament, it could clearlyserve as the starting point for improving the indebtedness position of thegovernment.

3. Central Government Debt Management

3.1. The Indian case of public debt management could, at best, becharacterised by a clear dichotomy management of internal debt by its central

bank, and the other component of domestic debt and external debt, by theGovernment. The focus of internal debt management by the Reserve Bank has

been to manage the refinancing and liquidity risk, while ensuring thatborrowings are raised at minimum cost. Efforts aimed at managing other riskcomponents in terms of portfolio management policies by the Reserve Bankhave been constrained by the overriding concern of meeting the large scale of

borrowing needs and the government debt market which is still in the process oftransformation towards maturity. Portfolio management exercises for otherdomestic liabilities, which has largely been characterised by autonomous flows,is completely missing and the policy framework has been largely dominated by

budgetary needs. On the other hand, for public external debt management, sincethe bulk of the debt came from official sources in the form of aid flows, theMinistry of Finance focussed solely on retiring expensive debt by prepaymentsor refinancing, without any portfolio management exercises. Only recently, amodelling exercise for risk management of the sovereign external debt portfoliowas initiated, after an initiative by the IBRD to allow borrowers flexibility fordeciding on currency and interest and also to allow hedging instruments onexisting IBRD debt for portfolio management purpose. Annex 3 outlines theinstitutional structure for public debt management of Government of India.

3.2 The dispersed nature of public debt functions both across and withindifferent agencies could be responsible for the lack of an integrated debt

6


7/57

management structure, which in turn has led to many a missing links inGovernments debt management strategy. The pivotal role in this regard, usually

played by a middle office; which formulates the borrowing strategy, establishesa framework for risk management and periodically advises on debt managementoperations in an integrated framework has been largely conspicuous by its

absence. Thus public debt management fell short of developing public debtsustainability benchmarks; medium and long-term public debt managementstrategy; making a choice between domestic and external debt; developing

benchmarks for currency, interest and maturity mix as part of reducing costs andrisks. Another area, where risk management practices are yet to be introduced ina comprehensive manner is contingent liabilities of the Government. Thesemissing links in risk management for internal, other domestic debt and externaldebt portfolios, as well as for the total portfolio in an integrated framework,

point towards the pressing need for a middle office.

3.3 The issue of conflict in objectives between debt management andmonetary policy has also been an area of concern while reviewing theinstitutional structure for debt management.

4. International Experience

4.1 International evidence of debt management practice by leading debtoffice bears many valuable lessons for countries in the process of strengtheningtheir debt management capacity. Many countries - mainly advanced and someemerging market economies - have set up public debt offices and aresuccessfully managing their sovereign debts. In some instances, public debt has

been brought down from what were clearly unsustainable levels. There has alsobeen a significant change since late 1980s in the institutional structure, the roleand style of functions of public debt management towards risk management.This has been enabled by institutionalisation of the debt office with an in-houserisk management culture, as aspecialised institution, staffed with professionalsand market specialists. The role of such debt offices, in many instances,gradually transformed into treasury operations on the lines of operations

performed by investment banks, corporates and foreign exchange management by central banks. Within the debt office, middle office emerges as the riskmanager, which formulates and advises on the debt management strategy andalso develops benchmarks for assessing the risk-cost trade off of the portfolio.Annex 4 summarises the key sound practices in sovereign debt management.

4.2 The primary requirement in any comprehensive debt managementexercise is to bring the size of public debt at sustainable levels. Withoutsustainability of debt, risk management would not have much impact towards

insulating the debt portfolio from systemic risks. Thus the primary task of themiddle office is to determine sustainability benchmarks and accordingly advicethe Government to ensure that the debt level is brought to sustainable levels.

7


8/57

The main risks that needs to be managed for the sovereign debt portfolio areforeign currency risk, interest rate risk, credit risk, liquidity risk, refinancingrisk, operational risk and payments and settlement risk. Many debt offices haveaddressed management of market risks like currency and interest rate risk byestablishing a risk management framework for the sovereign debt in an asset-

liability management framework.

4.3 A prudential risk management framework is essential for reducinguncertainty among sovereign debt managers as to the governments tolerancefor risk, its willingness to trade off cost and risk objectives. Once the risks areidentified, risks and costs for alternative debt strategies are measured in ascenario-based model under a base case scenario and different market ratescenarios; or in a simulation-based model under value-at-risk, cost-at-risk or

budget-at-risk approach. The government then chooses the strategy that best

represents the governments preferences for managing the risk/cost trade-offsand generally tend to choose it along an efficient frontier, which entailsminimum risk. The process of deciding a debt strategy by debt offices has beenfacilitated, by using a strategic benchmark portfolio, which represent theapproved strategy. The actual debt portfolio could be then moved closer toapproved designed benchmark by debt managers while deciding on key termsfor new debt issues, by buyback operations, and also by using currency andinterest swaps and other hedging activities.

4.4 The institutional structure for public debt management, world wide, couldbe broadly characterised into two categories setting up of a full-fledged publicdebt office and scattered debt management responsibilities. Within the formercategory of a full-fledged debt office, which is the case for most of the advancedcountries and some emerging market economies, there has been a preference tolocate the debt office as a separate entity under the Ministry of Finance orwithin the mainstream Ministry. There are also instances of locating the debtoffice outside the Ministry as an autonomous agency. On the other hand,Denmark is the only country where the debt office has been located within thecentral bank. The tendency to locate the debt office outside the central bank has

been largely dictated by the overriding concern of the conflict in objectives thatarise between debt management and monetary management.

4.5 Governance issues promoting sound and professional approach towardsdebt management, required debt offices to clearly define and disclose itsobjectives for debt management, establishing an organisational structure thatensures clear accountability and transparency of responsibilities withappropriate internal controls, and establishment of a legal framework wherever

possible. For enabling sound risk management practices, most debt offices

established prudent risk management strategy and policy, strengthening middleoffice analytical capability, and defining a framework for risk managementensuring consistency with other macroeconomic policies and objectives. Debt

8


9/57

offices also accorded priority to recruitment of trained staff, and selection andimplementation of effective management information systems.

4.6 The second category of institutional structure reflects dispersed debtmanagement responsibility, with the Ministry of Finance responsible for

external public debt management and the central bank responsible for theinternal public debt management. Some of the emerging market economies withdispersed debt management responsibilities, as a first step towardsstrengthening their debt management capacity has started to set up a middleoffice under the Ministry of Finance for evolving an over-all risk managementframework for the total public debt. The overall aim, for such countries, is toestablish a full-fledged debt office for effective debt management within acomprehensive framework of risk management.

5. Recommendations

5.1 The Group recognised the need for a centralised middle office that couldfocus on debt management advisory activities in a comprehensive riskmanagement framework. The middle office should operate on the lines of amodern treasury so that it may impart a professional approach by adoptingmodern management techniques for public debt management. Setting up suchan office, however, cannot be done in isolation and is to be seen in the contextof total structure comprising back, middle and front office functions to ensurethat they are in harmony with each other. The middle office role to besuccessful, therefore, requires active interaction between concerned agenciesresponsible for debt management.

5.2 The scope of the middle office for managing the Government debt shouldinclude domestic debt components like internal debt and other domesticliability; as well as external debt components like debt on Government Accountfrom external assistance, defence debt, and other sources of Government debtlike IMF debt and foreign institutional investment in Government securities. Inaddition, it was felt that the scope of the middle office could gradually be

expanded to include management of Government contingent liabilities, bothexplicit and implicit.

5.3 Thus, as a first step towards building a strong institutional mechanism for public debt management in India, the Working Group felt it necessary toestablish a centralised Middle Office in the Department of Economic Affairs,Ministry of Finance. The main reason for locating it in the Ministry of Financeis that there are strong links between the budgeting and debt managementfunctions. At the same time, it would help to mitigate conflicts in objectives

between debt management and monetary policy.

9


10/57

5.4 Operations of the Middle Office could be supervised by a Public DebtCo-ordination Committee comprising of senior executives from the Ministry ofFinance, the Reserve Bank of India and the functional head of the budgetmaking entity. This would ensure that advisory role of the Middle Office would

be respected by different entities involved for government debt management.

5.5 The middle office should be staffed with officials from the Ministry ofFinance and drawing professionals on a deputation basis from the Reserve Bankof India and financial institutions. Investment in infrastructure and humanresource development should be an area of priority for the Government to

promote professional approach towards debt management.

5.6 The Group observed that ceilings for Government debt as determined inthe recently introduced Fiscal Responsibility and Budget Management Bill

2000, would serve as a useful starting point for the Middle Office to developdebt sustainability benchmarks for bringing the level of Government debt tosustainable levels.

5.7 At the same time, a comprehensive risk management framework forportfolio management exercise for the Government debt portfolio should also beestablished by the middle office, based on cost-risk tradeoffs and the risktolerance limits of the government.

5.8 Based on the risk-management framework and cost-risk trade-offs, theMiddle Office would be expected to determine strategic benchmarks for thedebt portfolio. The strategic benchmarks could be the proportion of domesticand foreign currency debt; the currency composition, duration, mix of floating-fixed interest rate debt and maturity structure of foreign currency debt portfolio;and maturity structure and duration for the domestic debt portfolio.

5.9 Strategic benchmarks, designed by the Middle Office, should have theapproval of the Finance Minister. For this purpose, the Public Debt Co-ordination Committee should advice the Finance Minister periodically on the

appropriateness of the framework and the strategic benchmarks.

5.10 Once the strategic benchmarks are approved, the Middle Office shouldregularly disseminate the relevant benchmarks to the concerned agenciesinvolved for contracting or issuing government debt. This would enable them todetermine their debt management strategy so as to be consistent with thestrategic benchmarks.

5.11 In essence, the character of the centralised Middle Office would vary in

terms of its responsibilities when viewed against different components of debtfor which debt management responsibilities rest with different agencies. For theinternal debt component managed by RBI, since there is already a middle office

10


11/57

in place, the role of centralised middle office would be to provide MIS inputs interms of broad strategic benchmarks. Thus, while RBI would continue to havethe flexibility for internal debt management, it could incorporate the strategic

benchmarks while deciding the debt management strategy. For RBI to undertakeactive portfolio management consistent with the strategic benchmarks, would

also require middle office capacity to be strengthened at RBI. Active co-ordination between the centralised middle office in the Ministry of Finance andmiddle office in RBI, through sharing of data and necessary information couldalso facilitate portfolio management.

5.12 For other debt components like other domestic liability and external debt,for which debt management responsibility lies with the Ministry of Finance, thecentralised middle office would serve as the sole Middle Office for debtmanagement. Strategic benchmarks designed for other domestic liability and

external debt should be provided as part of detailed MIS inputs to different frontoffices for such debt components like the budget making entity and differentcredit divisions respectively. The front offices, in turn could fine-tune its debtmanagement policy so as to make the debt portfolio consistent with the strategic

benchmarks.

5.13 The Middle Office should be responsible for undertaking a consolidatedreview of the portfolio to assess the risk characteristics and to ensure that actualdebt portfolio moves closer to the strategic benchmarks. For this purpose, it isessential for monitoring, compliance and control functions of the middle officeare respected from the time the Middle Office is established.

5.14 The Middle Office should also act as the central unit for managing thecontingent liabilities. While the budget making entity would continue to take the

policy decisions regarding issuing guarantees and accumulating othercontingent liabilities like pension funds, recapitalisation cost towards publicsector enterprises, the Middle Office would try to shape such policies byincorporating them gradually into the risk management framework. This wouldalso require active coordination with the budget making entity.

5.15 Other specific roles of the middle office would involve bringing out anannual report on public debt, which should enhance the transparency of the debt

position of the central government. The report should clearly define anddisclose the main objectives of debt management, the riskiness of the portfolioand performance of portfolio management by the relevant agencies as measured

by the cost of the actual debt portfolio relative to the portfolio based on thebenchmark.

5.16 For fair assessment of performance in portfolio management of theGovernment debt, by different agencies could be made by annually by an

11


12/57

independent auditor. Auditors assessment should be based on the cost of theactual debt portfolio relative to the benchmark portfolio.

5.17 Portfolio management exercises might require hedging activities for thegovernment debt portfolio. Hedging activities, if undertaken, should be

restricted purely to the need to achieve the strategic benchmarks and not involvetactical trading.

5.18 The middle office should also act as the apex monitoring unit for centralgovernment debt. Thus, data on government debt should be regularly transferred

by different agencies to the middle office. The middle office should ensure thatit develops a debt data recording system on a centralised platform, which isamenable for portfolio analysis. The debt data recording system should be

preferably open-ended, so that, data requirements for applying new portfolio

management techniques are easily available.

5.19 Setting up a centralized middle office, should be viewed as the startingpoint towards creation of a strong institutional system for prudent public debtmanagement. For resolving the issue of conflict in objectives between internaldebt management and monetary policy, and to redress the need for striking asynergy in debt management activities of different functional units may requiresetting up of a full-fledged debt office eventually. For this purpose, the Groupfelt that the institutional structure of leading debt offices, as outlined in theinternational experience (Annex 4) of the Report, could serve as an useful guideto the Government, as and when, it decides to review the need for setting up afull-fledged debt office.

12


13/57

Annex 1. Constitution of the Working Group

O.O.No.F. No.1(3)2000-EDMUMinistry of Finance

Department of Economic AffairsExternal Debt Management Unit----------------------------------------

New Delhi, July 18, 2000.

Subject: Working Group to examine the need for setting up an integrated debt

management middle office for public debt covering both external and domestic debt.

A Working Group is hereby constituted to examine the need for setting up anintegrated debt management middle office for public debt covering both domestic andexternal debt. The role of the middle office envisaged is to make analysis, provide advisory

support and MIS inputs for debt management decisions. If the Working Group finds justification for such an Office, the Group would make recommendations regarding thescope, role and structure of the middle office and steps for setting up such office for debtmanagement purposes. The proposal is to be examined in the context of overall effective debtmanagement of the country keeping into perspective the possible long-term requirements.

The Working Group would comprise the following:

Chairman -Dr. Arvind Virmani, Senior Economic Adviser, DEA,Member - -Mr. D. Swarup, Joint Secretary (Budget), DEA, MOF

or his nominee.

Member - -Dr. Tarun Das, Economic Adviser,DEA, MOF.Member - -Dr. J. Bhagwati, Jt. Secretary(ECB),DEA, MOFMember - -Mr. K. Shankar, Controller of Aid Accounts & Audit,

DEA, MOFMember - -Dr. T.C. Nair, General Manager, Internal Debt

-Management Cell, RBI.Member - -Mr. Deepak Mohanty, Director (DIF), DEAP, RBIMember-Convenor - -Mr. Anil Bisen, Director (EDMU), DEA, MOF

The terms of reference of the Working Group are as under:

a) to examine the need/justification for an integrated debt management middleoffice for public debt covering both domestic and external debt;

b) If justification is found for setting up an integrated middle office for public debt,the Working Group would define the scope of the middle office taking intoconsideration Indian requirements and the best international practices;

c) to specify role/functions/operations of the middle office;d) to review the functions of the existing institutional set-up for debt management;e) to propose structure of the debt office and link/interface with various concerned

institutions/agencies like Ministry of Finance, Reserve Bank of India etc;f) to recommend steps and formalities for establishing the debt management middle

office, andg) to make such other recommendations as the Working Group may deem

appropriate on the subject;

13


14/57

The Working Group would hold necessary meetings and seek advisory support frommultilateral / bilateral and other institutions, including investment banks, who have expertisein the area.

The Working Group would submit its Report within 4 months from the day it is

constituted. External Debt Management Unit shall act as the Secretariat for the WorkingGroup. The Group may co-opt any other person as deemed appropriate.

This issues with the approval of Secretary, Department of Economic Affairs.

s/d(Tarun Das)

Economic Adviser

14


15/57

Annex II. Central Government Debt

2.1 Definition of Public Liability

2.1.1 As per the Government of Indias budgetary practice, there are three sets

of liabilities, that constitute central government debt viz. (a) internal debt, (b)external debt, and (c) other liabilities. Internal debt and external debtconstitute public debt of India and are secured under the Consolidated Fundof India. Internal debt includes market loans, special securities issued to theReserve Bank of India (RBI), compensation and other bonds, treasury billsissued to RBI, state governments, commercial banks and other parties, as wellas non-negotiable and non-interest bearing rupee securities issued tointernational financial institutions. External debt represents loans received fromforeign governments and bodies under the external aid window and is usually

classified as external debt on Government Account. Debt liabilities other thaninternal and external debt, termed as other domestic liabilities, include interest

bearing obligations of the Government such as post savings deposits, depositsunder small savings schemes, loans raised through post office cash certificatesetc., provident funds, interest bearing reserve funds of departments like railwaysand telecommunications and certain other deposits.

2.1.2 The other liabilities of the Government arise in governments accountsmore in its capacity as a banker or trustee rather than as a borrower. Hence such

borrowings, not secured under the Consolidated Fund of India, are shown aspart of Public Account. Further more, some of the items of other liabilitieslike small savings are more in the nature of autonomous flows, which to a largeextent are determined by public preference for relative attractiveness of theseinstruments. Nevertheless, it should be emphasised that such liabilities arecontractual obligations of the Government and are economicallyindistinguishable from the public debt. Moreover, through a change in theaccounting framework, it is possible to bring these liabilities under the PublicAccount within the ambit of public debt under the Consolidated Fund. In fact,under the new system of National Small Savings Fund (NSSF), with effect fromthe fiscal year 1999-2000, a substantial portion of other liabilities have beenconverted into Central Government securities.

2.1.3 The Report, therefore not only includes the above liabilities ascomponents of debt of the Central Government, but also includes external debtincurred by borrowings from official agencies for defence purpose, includingRupee debt from the former Soviet Union, and also from IMF, which is outsidethe purview of the budgetary classification followed by the Government.External debt of the Government, referred to in this Report, would include

external debt accrued in the Government Account as well as other sources ofexternal debt. The term public debt of the Central Government, referred to in

15


16/57

this Report would follow the usual budgetary practice, comprising of internaland external debt of the Central Government. The term Government Debt,referred to in this Report, would include internal debt, external debt and otherliabilities of the Central Government.

2.2 Central Government Debt

2.2.1 Total stock of public liability of the Central Government has increased bymore than three-fold, at an annual compound growth rate of 13.4 per cent, fromRs. 380,069 crore at the end of March 1991 to Rs. 1,176,174 crore at the end ofMarch 2000 (Table 1). The growth in the stock of debt was steeper during theeighties, increasing at an annual compound growth rate of 19.9 per cent fromend-March 1981 to end-March 1991, or by nearly six-fold.

Table 1 : Total Debt of the Central Government(Rs. Crore)

1=2+3 2 3 4 5=2+4 6=1+4Total

PublicDebt

InternalDebt

ExternalDebt*

OtherDomesticLiability

TotalDomestic

DebtTotal Public

Liability

(Rupees Crore)

1980-81 44343 30864 13479 17587 48451 61930

1990-91 251040 154004 97036 129029 283033 380069

1991-92 325270 172750 152520 144964 317714 470234

1992-93 369185 199100 170085 160555 359655 529740

1993-94 420866 245712 175154 184911 430623 605777

1994-95 453732 266467 187265 221215 487682 674947

1995-96 489768 307868 181900 247115 554983 736883

1996-97 520860 344476 176384 276961 621437 797821

1997-98 572997 388998 183999 333964 722962 906961

1998-99 655625 459696 195929 374856 834552 1030481

1999-2000 931660 728627 203033 244514 973141 1176174

(% of GDP)#

1980-81 32.6 22.7 9.9 12.9 35.6 45.5

1990-91 44.1 27.1 17.1 22.7 49.8 66.8

1991-92 49.8 26.4 23.3 22.2 48.6 72.0

1992-93 49.4 26.6 22.8 21.5 48.1 70.9

1993-94 49.0 28.6 20.4 21.5 50.1 70.5

1994-95 44.9 26.4 18.5 21.9 48.3 66.81995-96 41.4 26.0 15.4 20.9 47.0 62.3

1996-97 38.2 25.3 13.0 20.3 45.6 58.6

1997-98 37.8 25.7 12.1 22.0 47.7 59.8

1998-99 37.2 26.1 11.1 21.3 47.3 58.5

1999-2000 48.2 37.7 10.5 12.7 50.4 60.9

* : External Debt for end-March 1981 refers to outstanding external debt on governmentaccount and does not include other components of government external debt like IMFand Defence debt.

# : Debt to GDP ratios are based on the New Series of GDP estimates at market pricespublished by the Central Statistical Organisation.

Source : Indias External Debt A Status Report, 2000; RBI Annual Report, 1999-2000; andEconomic Survey; 1997-98.

16


17/57

2.2.2 The dynamics of public liability in terms of a debt-GDP crossover, asmeasured by the annual growth rate in public liability and the nominal GDPgrowth, could be broadly identified into three phases during the nineties, i.e.,1992-93 to 1993-94, 1994-95 to 1996-97, and 1997-98 to 1999-2000 (Figure 1).The annual growth in public liability by 23.7 per cent during 1991-92 stood

higher than the nominal GDP growth. The first phase (1992-93 to 1993-94)showed a declining trend in the growth of public liability, growing at an averageannual rate of 13.5 per cent and was marginally lower than the nominal GDPgrowth. The growth rate in public liability further decelerated during the second

phase (1994-95 to 1996-97) by 9.6 per cent and was significantly lower than theGDP growth. There was a reversal in the declining trend in the growth of publicliability, increasing again by 13.8 per cent during the third phase (1997-98 to1999-2000), with the wedge between debt-GDP growth contracting sharply andcrossed the GDP growth rate during 1997-98 and 1999-2000. As a proportion of

GDP, the total public liability, which stood at 45.5 per cent at end-March 1981,accordingly declined from a peak of 72.0 per cent during 1991-92 to 58.6 percent during 1996-97 before increasing to 60.9 per cent during 1999-2000.

2.2.3 The debt-GDP growth crossover witnessed during the third phase waspropelled by growth in domestic debt of the central government. Increasingreliance on domestic sources of borrowing mainly in the form of market

borrowings resulted from the changing nature of the fiscal position with re-emergence of primary deficit since 1997-98 (Figure 2). While the share of

market borrowings financing the gross fiscal deficit more than doubled from30.0 per cent in 1996-97 to 70.8 per cent in 1999-2000, the share of internal

17

Figure 1 : Nominal Debt Growth - GDP Growth Crossover

0.0

5.0

10.0

15.0

20.0

25.0

1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-2000

(percent)

Total Govt. Debt Nominal GDP Total Domestic Debt


18/57

finance increased steadily from 85.1 per cent in 1990-91 to a high of 99.2 percent in 1999-2000. Although the fiscal adjustment process initiated in 1991wassuccessful in arresting the growth in primary deficits during 1991-92 and 1992-93, the resurgence in primary deficits since 1997-98 led to a steadyaccumulation of domestic debt and market borrowings thereby reversing the

declining trend in the debt-GDP ratio. While the domestic component of thegovernment liability increased marginally from 45.6 per cent as a proportion ofGDP in 1996-97 to 50.4 per cent in 1999-2000, internal debt, which accountednearly half of the market loans, increased its share from 25.3 per cent to 37.7

per cent during the corresponding period. This raises concern about thesustainability of the central government debt and in particular about thedomestic component and internal debt position.

2.2.4 The share of domestic component of total public liability increasedsteadily from 67.6 per cent at the end of March 1992 to 82.7 per cent at the endof March 2000, mainly due to a sharp increase in internal debt (Figure 3).Internal debt increased at an annual compound growth rate of 18.8 per centduring end-March 1991 to end-March 2000 or by nearly five-fold. Accordingly,the share of internal debt in the total public liability of the government increasedfrom 40.5 per cent at end-March 1991 to 44.6 per cent at end-March 1999. Theshare jumped to 62.0 per cent at end-March 2000 because of the sharp increasein the growth of internal debt by 58.5 per cent during 1999-2000. The sharpincrease in internal debt during 1999-2000 was however, due to conversion of

other liabilities amounting to Rs. 1,80,273 crore into Central Governmentsecurities, under the new system of National Small Savings Fund (NSSF), with

18

Figure 2 : Financing of Gross Fiscal Deficit

0

10

20

30

40

50

60

70

80

90

10 0

1 9 80 -8 1 1 9 85 -8 6 1 9 90 -9 1 1 99 1 -9 2 1 9 92 - 93 1 9 93 -9 4 1 9 94 -9 5 1 9 95 -9 6 1 9 96 -9 7 1 99 7 -9 8 1 99 8 -9 9 1 99 9 -

2000

(Borrowing

sas%o

fGrossFiscalDeficit)

0

1

2

3

4

5

6

(Prim

aryDeficitas%o

fGDP)

Market Borrowings Total Internal Finance Primary Deficit - GDP R atio


19/57

effect from the fiscal year 1999-2000. Accordingly, the share of other liabilitiesin total public liability of the central government increased from 34.0 per cent inend-March 1991 to 36.4 per cent in end-March 1999 and declined thereafter to20.8 per cent in end-March 2000.

2.2.5 On the other hand, total external debt of the government witnessed anabsolute decline from US $ 50.0 billion at end-March 1991 to US $ 46.5 billionat end-March 2000. However, in terms of the local currency, the externalcomponent of government debt increased at an annual compound growth rate of8.5 per cent during end-March 1991 to end-March 2000 mainly due to thedepreciation of the rupee. In spite of the modest increase in rupee terms, theshare of the external debt in total public liability declined steadily from a peakof 32.4 per cent in end-March 1992 to 17.3 per cent in end-March 2000. Theratio of external debt to GDP also declined from a peak of 22.8 per cent in

1991-92 to 10.5 per cent in 1999-2000.

2.2.6 Public debt, which includes internal and external debt of the government,also grew in consonance with the phase in growth of total government debt asidentified above (Figure 1). Increasing by 29.6 per cent during 1991-92, theaverage growth rate in stock of public debt moderated during 1992-93 to 1993-94 by 13.7 per cent, further decelerated by 7.4 per cent during 1994-95 to 1996-97, and finally reversed the trend by increasing during 1997-98 to 1998-99 by12.2 per cent. The spurt in public debt during 1999-2000 by 42.1 per centresulted from the conversion of other domestic liabilities into governmentsecurities under the new system of National Small Savings Fund (NSSF), witheffect from the fiscal year 1999-2000. Accordingly, the ratio of public debt

19

0%

20%

40%

60%

80%

100%

1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-2000

Figure 3 : Components of Total Government Debt Outstanding

Internal Debt Other Domestic Liability External Debt


20/57

declined from a peak of 49.8 per cent in 1991-92 to 37.2 per cent in 1998-99before increasing to 48.2 per cent in 1999-2000.

2.3 Debt Burden of the Central Government

2.3.1 The overhang of government debt during the nineties, particularlydomestic debt poses significant risk for medium-term macro-economic stabilityof the economy. For internal debt management, the large scale of market

borrowings has constrained the leverage for minimising the borrowing cost dueto increase in yields driven by interest rate premium and a shift in preference forshort-term paper caused by increasing uncertainty about future interest rates.This has led to a policy of placing borrowings at the shorter end of the market,so as to minimise the cost of borrowing. Thus the share of market borrowings inshorter maturity securities (loans maturing within a period of 5 years) was as

high as 50.0 per cent during 1996-97 and 36.9 per cent during 1997-98. As aconsequence, the share of the shorter maturity market loans in total outstandingmarket loans increased sharply from 7.4 per cent in end-March 1992 to 45.2 percent in end-March 1998.

2.3.2 Recognising the roll-over problems arising from the bunching ofredemption in the medium term, the maturity structure was lengthened with theintroduction of long-term securities (ranging from 11 year to 20 year maturity)during 1998-99. While borrowing in longer-term maturity accounted for 13.5

per cent of the total market borrowings during 1998-99, the share of the shortermaturity declined to 31.5 per cent. This was followed by placing all government

borrowings above 5-year maturity and about 65.0 per cent of the borrowingsthrough issuance of above 10-year maturity during 1999-2000. The weightedaverage maturity of market loans thereby increased from 5.5 years in 1996-97,to 6.6 years in 1997-98, 7.7 per cent in 1998-99 and 12.6 per cent in 1999-2000.

20


21/57

21

Figure 4 : Residual Maturity of less than 1-year for Market Loans & Govt. Account External Debt

5.7

7.8

4.8

5.9

6.8

4.2

0.9

1.4

4.1 4.34.5 4.9

4.95.04.5

4.4

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-2000

(percent)

Market Loans Govt. Account External Debt


22/57

2.3.3 Notwithstanding the success in lengthening the maturity structure ofdated securities, the immediate redemption pressure (i.e. market loans maturingwithin 1-year) on market loans increased. The share of market loans withresidual maturity of less than 1-year increasing from 0.9 per cent in end-March

1994 to 7.8 per cent in end-March 2000 (Figure 4). The magnitude of the roll-over problem is also reflected from the future redemption profile of the stock ofmarket loans as on end-March 2000 entailing large redemptions during the nextten years (Figure 5).

2.3.4 On the other hand, the maturity profile of external debt of the governmentat end-March 2000 is skewed towards long-end maturity with 51.2 per cent ofthe debt over 10-year residual maturity and only 26.9 per cent under 5-year

residual maturity. The stock of total external debt with a residual maturity ofless than 1-year amounted to only 5.5 per cent of the total debt stock in end-March 2000. The stock of external debt on Government Account with a residualmaturity of less than 1-year increased marginally from 4.1 per cent in end-March 1993 to 4.5 per cent in end-March 2000 (Figure 4). This is mainly due tothe long-tenor of external aid in the form of soft loans and is reflected by thesmooth redemption profile of the portfolio as on end-March 2000 (Figure 5).

2.3.5 The adverse debt burden of the government is also reflected by apersistent increase in the interest burden on internal debt, the bulk of which, is

attributable due to interest payments on market borrowings (Figure 6). Thus,while the share of interest payments in total expenditure increased from 19.9 per

22

28321

11247

28260

11186

28263

10951

31252

10807

31159

10329

27473

9898

29394

9411

30151

8907

30223

8254

26195

8024

0

5000

10000

15000

20000

25000

30000

35000

40000

45000

(Rs.

Crore)

2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10

Figure 5 : Redemption Profile of Domestic Market Loans & External Debt as on 31.03.2000

Domestic Market Loans External Debt


23/57

cent in 1990-91 to 31.7 per cent in 1999-2000, the share in tax receiptsincreased from 50.1 per cent in 1990-91 to 76.2 per cent in 1999-2000. Thedeterioration was also due to stagnation in the share of tax-GDP ratio. The shareof interest payments also increased from 39.2 per cent of revenue receipts in1990-91 to 53.7 per cent in 1999-2000. The heavy outgo on interest payments

had serious implications for the fiscal position of the government.

2.3.6 While interest payments on internal debt increased by nearly eight-foldduring 1990-91 to 1999-2000, more than the six-fold increase in the stock ofdebt during the same period; the total interest payments increased by six timesduring the same period. On the other hand, interest payments on external debtgrew moderately, reflecting the concessional nature of such loans. Thus, theshare of interest outgo on internal debt increased gradually from 42.5 per cent oftotal interest payments in 1990-91 to 51.1 per cent in 1998-99 (Figure 7). Theshare increased sharply to 75.4 per cent in 1999-2000. While the share of other

domestic liabilities in total interest payments remained stable around 45.0 percent during 1990-91 to 1998-99, it declined sharply to 20.0 per cent in 1999-2000. On the other hand, the share of external debt in total interest paymentsdeclined from 8.7 per cent in 1900-91 to 4.6 per cent in 1999-2000.

23

Figure 6 : Interest Burden on Government Debt

28.1

50.153.2

65.3

61.163.5

68.6

74.476.2

72.3

21.2

39.2 40.4

48.4 45.4 47.1 49.0

52.153.7

51.9

11.3

19.9

23.927.4 28.1

28.329.6

27.9

31.731.2

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

90.0

1980-81 1990-91 1991-92 1994-95 1995-96 1996-97 1997-98 1998-99 1999-2000 2000-2001

(percen

t)

(as % of Tax Revenue) (as % of Revenue Receipts) (as % of Total Expenditure)


24/57

2.3.7 Interest payments, inter alia, stemmed from larger recourse to market borrowings at market-related interest rates. Since the interest rates ongovernment securities were somewhat aligned to the market during the latter

half of the eighties, and market related interest rates were offered ongovernment securities since 1992-93, the borrowings from the market weremobilised at higher interest rates. The weighted average interest rates on datedsecurities rose from 7.03 per cent in 1980-81 to 11.41 per cent in 1990-91 andfurther to 13.75 per cent in 1995-96 (Table 2). However, the internal debtmanagement operations were successful in stabilising the interest rates at arelatively low level as reflected in the weighted average interest rate of thedated securities at 11.77 per cent in 1999-2000 and 11.86 per cent in 1998-99.The average implicit interest rates on other domestic liabilities, which mainly

comprises of small savings and provident fund, also increased from 7.22 percent in 1980-81 to 10.81 per cent in 1990-91 and further to 12.15 per cent in1997-98. Thus, the implicit nominal interest on overall domestic debt of thecentral government increased steadily from 8.65 per cent in 1990-91 to 10.69

per cent in 1999-2000. Thus while the debt structure changed from low cost tohigh cost constituents, the rising interest rates on such borrowings also raisesconcern about the sustainability of debt. The sustainability of domestic debtcould also be viewed from the perspective of real interest rate on suchcomponents, particularly when the real interest rate exceeds the real growth rateof GDP as witnessed during 1997-98.

24

0%

20%

40%

60%

80%

100%

1980-81 1990-91 1991-92 1994-95 1995-96 1996-97 1997-98 1998-99 1999-2000

Figure 7 : Share in Total Interest Payments

External Govt. A/c Internal Debt Other Liabilities


25/57

Table 2 : Nominal Interest Rate on Domestic Debt of Central Government

Fiscal Year Weighted AverageInterest Rates onMarketable Securities

Implicit NominalInterest Rates onSmall Savings and

Provident Funds

Implicit NominalInterest Rates onTotal Domestic Debt

1990-91 11.41 10.81 8.65

1991-92 11.78 11.28 9.09

1992-93 12.46 11.06 9.38

1993-94 12.63 12.38 9.72

1994-95 11.91 12.67 9.72

1995-96 13.75 11.72 9.82

1996-97 13.69 12.70 10.39

1997-98 12.01 12.15 10.22

1998-99 11.86 N.A. 10.451999-2000 11.77 N.A. 10.69

Source : RBI Annual Reports.

2.3.8 Internal debt management was till recently characterised by undertakingthe bulk of market borrowing programme during the first six months, whenthere would be less pressure on the banks to lend to the commercial sector. Interms of the magnitude, this implied that the central bank had to manage totalGovernment borrowing every month to roughly 1 per cent of GDP during the

first half of the year. During the last three years, saddled with bulgingrepayment obligations and objective to raise debt at minimum cost, debtmanagement operations had to maintain balance between changing the maturitymix of borrowings and deriving maximum benefit of liquidity conditions. Theincreasing coordination of debt management and monetary policy resulted infairly active open market operations, with the central bank releasing the

privately placed government stocks when interest rate expectations becamefavourable.

2.4 Net Liability of the Central Government

2.4.1 For assessing the indebtedness position of the government, netoutstanding debt position is also a useful indicator. The net domestic liability ofthe Central Government, has been derived after deducting the book value of thedomestic financial assets from the total domestic debt. Net domestic debt of theCentral Government, increased by more than eight-fold during 1990-91 to1999-2000 (Table 3). On the other hand, net external debt of the centralgovernment declined by nearly 50.0 per cent during the same period. Netexternal debt of the Central Government has been derived by deducting foreign

exchange assets of the central bank from the total external debt of the central

25


26/57

government. However, the total net liability registered an increase of 3 foldduring 1990-91 to 1999-2000.

Table 3 : Net Liability of the Central Government(Rupees Crore)

1990-91 1995-96 1996-97 1997-98 1998-99 1999-2000Net TotalLiability

138941 281458 284323 325680 368010 445594

NetDomesticLiability

46293 158004 188307 244188 297493 395485

Net ExternalLiability

92648 123454 96016 81492 70517 50109

2.4.2 In terms of liability asset ratio also, while the external liability-asset ratioimproved from 2211.4 per cent in 1990-91 to 132.8 per cent in 1999-2000, thedomestic liability asset ratio deteriorated from 119.6 per cent to 168.5 per centduring the same period. Accordingly, the total liability-asset ratio increasedfrom 157.6 per cent in 1990-91 to 161.0 percent in 1999-2000.

2.5 Contingent Liabilities of the Central Government

2.5.1 Contingent liabilities of the Central Government arise because of its roleto promote private sector participation in infrastructure projects by issuing

guarantees. Contingent liabilities of the Central Government could be bothdomestic or external contingent liabilities and could also be explicit or implicitin nature. Domestic contingent liability of the Central Government constitute

26

Figure 8 : Liability-Asset Ratio for Central Government

139.8

311.2

219.5

179.5

132.8

161.0

168.5

155.4143.5151.0

156.2

155.6

161.8155.4 156.0

0.0

50.0

100.0

150.0

200.0

250.0

300.0

350.0

1995-96 1996-97 1997-98 1998-99 1999-2000

(percent)

Domestic Liability-Asset Ratio External Liability-Asset Ratio Total Liability-Asset Ratio


27/57

direct guarantees on domestic debt, recapitalisation costs for public sectorenterprises, or unfunded pension liabilities. External contingent liabilityconstitute direct guarantees on external debt, exchange rate guarantees onexternal debt like Resurgent India Bonds and Indian Millenium Deposits, andcounter-guarantees provided to foreign investors participating in infrastructure

projects. Although from the accounting point of view, the contingent liabilitiesdo not form part of the Government debt, it could pose severe constraints on thefiscal position of the Government in the event of default.

Table 4 : Contingent Liability of the Central Government

(Rupees Crore)Year

(end-March)Domestic

GuaranteesGuarantees onExternal Debt

TotalGuarantees

1994 62834 38159 1009931995 62468 38830 101298

1996 65573 34922 1004951997 69748 29576 993241998 73877 28810 1026871999 74606 30050 104656Source : RBI Annual Report 1999-2000 and Status Report on External

Debt, 2000.

2.5.2 The total outstanding direct credit guarantees issued by the CentralGovernment both domestic as well as on external debt remained stable aroundRs. 100,000 crore during end-March 1994 to end-March 1999 (Table 4). While

domestic guarantees increased modestly during the corresponding period, therewas an absolute decline in the guarantees on external debt. As a proportion ofGDP, however, both domestic guarantees and external guarantees registered adeclined of 3 per centage points during end-March 1993-94 to 1998-99 (Figure9). Thus, the total guaranteed debt of the central government declined steadilyfrom 11.8 per cent of GDP in 1993-94 to 1998-99.

27

Figure 9 : Contingent Liability of the Central Government

7.3

6.25.5

5.1 4.94.2

4.4

3.8

3.0

2.21.9

1.7

11.8

10.0

8.5

7.3

6.8

5.9

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

1994 1995 1996 1997 1998 1999

(percentof

Domestic Guarantees Guarantees on External Debt Total Guarantees


28/57

2.5.3 In addition, exchange rate guarantee on external debt, also haveimplications for finances of the Central Government. For example, forResurgent Indian Bonds, as per the agreement, exchange rate loss inexcess of 1 per cent on the total foreign currency raised equivalent to US$ 4.2 billion, would have to be borne by the Government of India. The

extent of such loss, since August 1998, the time when RIB were raised,up to August 2000 amounted to Rs. 946 crore. The actual loss on suchliability would depend upon the exchange rate prevailing at the time ofredemption in 2003. Very recently, a similar exchange rate guarantee was

provided on the amount of US $ 5.5 billion raised through IndiaMillenium Deposits, during October-November 2000. For counterguarantees provided to foreign investors participating in infrastructure

projects, similar risk arises for the Government exchequer. At the sametime, there is a growing volume of implicit domestic contingent liabilities

in the nature of pension funds.

2.6 Legal Ceilings on Government Debt

2.6.1 The Indian constitution under Article 292 provides for placing a limit onpublic debt secured under the Consolidated Fund of India but precludes otherliabilities under Public Account. However, through a change in the accountingframework, it is possible to convert these liabilities under Public Account withinthe ambit of public debt under the Consolidated Fund and thereby within theambit of Article 292. Given the legacy of huge public debt and interest burdendue to a long history of high fiscal deficits, which has increasingly constrainedthe maneuverability in fiscal mangement, the Central Government has recentlyintroduced a Fiscal Responsibility and Budget Management Bill, 2000 in the

parliament. The proposed bill aims to ensure inter-generational equity in fiscalmanagement and long-term macro-economic stability. This would be achieved

by achieving sufficient revenue surplus, eliminating fiscal deficit, removingfiscal impediments in the effective conduct of monetary policy and prudentialdebt management consistent with fiscal sustainability through limits on centralgovernment borrowings, debt and deficits, and greater transparency in fiscal

operations. The specific targets for debt management in this regard is to ensurethat the total liabilities of the central government (including external debt atcurrent exchange rate) is reduced during the next ten years and does not exceed50 per cent of GDP. Simultaneously, the Central Government shall not borrowfrom the RBI since April 1, 2003 in the form of subscription to the primaryissues by the latter. In the meantime, the Government may continue to borrowfrom the RBI by ways and means advances to meet temporary excess mismatch

between disbursement and receipts in accordance with the agreements enteredinto between them.

2.6.2 The bill also addresses to check the contingent liability by restrictingguarantees to 0.5 per cent of GDP during any financial year. In particular,

28


29/57


30/57

Annex III. Existing structure for public debt management

At present, public debt management in India is spread between differentdivisions/units in the Ministry of Finance (MOF) and the Reserve Bank of India

(RBI). The chart below (Table 3.1) highlights the institutional structure andmajor responsibilities for public debt management.

3.1 Internal Public Debt Management: The Reserve Bank of India acts asthe Governments agent for internal debt management responsibilities as per theRBI Act, 1934 and the Public Debt Act, 1944.

The main units associated with internal debt management in the RBI arethe Internal Debt Management Cell (IDMC); Public Debt Offices (PDO); and

Securities Department in the Department for Government and Bank Accounts(DGBA). Front office roles like debt issuance and debt service payments are

performed by Public Debt Offices and by the IDMC for open market operations.Middle Office roles are mainly entrusted with the IDMC. Such responsibilitiesinclude evolving appropriate policies relating to internal debt management, liketiming, amount of debt issuance or repurchase and fixation of interest rateaccording to state of liquidity and expectations of the market; cash and liquiditymanagement; besides promoting an active and efficient government securitiesmarket. In doing so, the IDMC consults the Budget Division in the Ministry of

Finance on key issues. In addition, periodic analysis on internal debt by theIDMC is complemented by the Department of Economic Analysis and Policy inthe RBI by contribution in annual publications like the RBI Annual Report andReport on Currency and Finance and periodic research publications likeDevelopment Research Group and RBI Bulletin.

3.2 Other Domestic Liability Management: As outlines earlier, centralgovernment debt also includes other domestic liabilities like interest bearingobligations of the government such as post savings deposits, deposits undersmall savings schemes, loans raised through post office cash certificates etc.;

provident funds; interest bearing reserve funds of departments like railways andtelecommunications; and certain other deposits. The key agency involved for

policy issues on such components is the Budget Division in the Ministry ofFinance. Front and back office roles are however dispersed across differentDepartments/Ministries of the Government of India.

3.3 External Public Debt Management: As far as the external public debt isconcerned, the Government of India has so far borrowed from externalassistance sources only in the form of loans/credits from bilateral and

multilateral sources. The responsibility for management is with the Departmentof Economic Affairs in the Ministry of Finance. For this purpose, front office

30


31/57


32/57

Table 3.1 : PRESENT STRUCTURE of PUBLIC DEBT MANAGEMENT IN INDIA

Office Levels

(1)

External Debt

(2)

Domestic Debt

(3)

Missing Links / Action

Areas

(4)

FRONT OFFICE:

Carry out allfinancialtransactions in themoney and capitalmarkets 1) Borrow (issue

securities);2) Make debt

servicepayments.

1) Credit Divisions

In MOF (like Fund-Bank Division, ADB,EEC, etc.) negotiateand contract newloans.

2) O/o CAA&A inMOF is entrusted withdebt servicing anddisbursements.

A. Primary Market-

Public Debt Office inRBIcarries out functionslike debt issuance anddebt service payment.

B. Secondary Market-IDMC, RBI entrustedwith open marketoperations.

MIDDLE OFFICE:

Advice on debt

managementstrategy to beadopted. Thisincludes 1) Develop debt

sustainabilitybenchmarks.

2) Determinebenchmarks forcurrency,interest rate, andmaturity mix as

part of riskmanagementstrategy.

3) Decide onborrowinginstruments,timing etc.

EDMU in MOFmonitors public

external debt and directcontingent liabilities;

brings out an annualStatus Report onExternal Debt whichalso covers publicexternal debt.Provides MIS inputs fordebt managementdecisions e.g., choice ofcurrency, interest and

maturity mix. Alsoworking on a sovereignexternal debt modellingexercise.

IDMC in RBI inconsultation with Budget

Division in MOF evolvesappropriate policiesrelating to internal debtmanagement, like timingand amount of debtissuance or repurchase;cash and liquiditymanagement; promotingan active and efficientgovernment securitiesmarket.

IDMC and DEAP in RBIundertake public debtmanagement relatedstudies (published in RBIAnnual Report andReport on Currency &Finance). EconomicDivision in MOF also

performs the same role(Economic SurveyBudget).

1. Developing public debtsustainability benchmarks;

medium and long-term publicdebt management strategy.

2. Integrate internal andexternal debt. This wouldmean the following :a). Choice between Domesticand External debt.

b). Developing benchmarksfor currency, interest andmaturity mix as part ofreducing costs and risks.

3. Debt data management a) Comprehensivecomputerization

b) Data analysisc) Scenario exercises andsensitivity testing.

4. Transparency Reports onPublic Debt.

5. Ready availability ofPublic Debt information forthe Parliament and the topmanagement in Ministry ofFinance.

BACK OFFICE:

Record keeping,accounting andsystems support.

O/o CAA&A doesrecord-keeping andaccounting functionsfor GOIs external debt.

Central Debt Division,

DGBA in RBI maintainsall figures, acts as acontrolling office forPDOs and extendsgeneral supervision overtheir working.

32


33/57

3.5 Missing links in middle office functions for public debt management:

An analysis of Existing Structure characterises the mixed structure andresponsibilities for the public debt management with several units in theMinistry of Finance and RBI discharging the responsibility. As mentioned

above, in its effort to raise resources at minimum cost, the focus of internal debtmanagement by the RBI has been on liquidity management and refinancing risk.The scale of annual borrowings by the government and the conflicts inobjectives arising between dent management and monetary managementconstrained the latter for evolving comprehensive benchmarks and undertakingnecessary risk management exercise for the debt portfolio. This in turn could beattributed to the fact government debt market is still evolving and there hasoften been incidence of devolvement of government securities on RBI. Thesecondary market still lacks the depth and breadth for enabling RBI toundertake active open market operations necessitated by portfolio managementobjectives. At the same time, substantial initial subscription of Governmentsecurities by the RBI meant that such securities have to be offloadedsubsequently when the market conditions and investor apetite are conducive.This often led to potential for wrong signals for monetary management.Although, through active coordination between debt management and monetarymanagement, RBI often succeed in striking a fine balance for minimising theconflicts in objectives, sometimes one of the objective had to be sacrificed.Thus, while for internal debt management the emphasis has been on front and

back office functions, the middle office role is somewhat lacking, for both

domestic and external debt components. Therefore, what is missing is a debtstrategy so as to maintain public debt at sustainable levels and its management

by developing a comprehensive risk management framework. Also conspicuousby its absence is an integrated approach covering both domestic and externaldebt - towards public debt management. Thus public debt management fell shortof developing public debt sustainability benchmarks; medium and long-term

public debt management strategy; making a choice between domestic andexternal debt; developing benchmarks for currency, interest and maturity mix as

part of reducing costs and risks.

3.6 Co-ordination among debt management activities: Another aspect,which could have prevented an integrated approach for middle office might beappointment of different Committees/Groups on an ad hoc basis to look atdifferent aspects of public debt management. A list of such Groups/Committeesare at Table 3.2.

33


34/57

Table 3.2 :List of Working Groups/Committees etc. currently looking at different aspects ofPublic Debt Management in India.

A. External Public Debt

1. Steering Committee and Core Group on Sovereign External Debt Modelling Exercise. (Secretariatat EDMU, MOF).

2. Working Group on Reducing Debt Service Cost of all External Debt on Government Account.(Secretariat at O/o CAA&A, MOF).

3. Working Group on Reducing debt service cost of External debt on Govt. Account(Secretariat at ECB Division, MOF).

B. Domestic Public Debt

1. Standing Committee on Cash and Debt Management. (Secretariat at Budget Division, MOF).2. Technical Advisory Committee on Money and Government Securities Markets.

(Secretariat at IDMC, RBI).

C. Other Related Committees

1. Steering Committee on External Debt. (Secretariat at EDMU, DEA, MOF).2. Monitoring Group on External Debt. (Secretariat at DEAP, RBI).3. Permanent Technical Group on Reconciliation of External Debt Statistics with

International Agencies. (Secretariat at O/o CAA&A).4. Permanent Group on External Commercial Borrowings data. (Secretariat at

DESACS, RBI).

3.7 Conflict in objectives between debt management and monetarypolicy: The issue of conflict in objectives between debt management andmonetary policy has also been an area of concern for macro-economicmanagement. Accordingly, separation of debt management and monetary policyfunctions were recommended by an informal RBI Working Group Report onSeparation of Debt Management from Monetary Management. This issue wasvindicated by a recent RBI Report of the Advisory Group in Transparency inMonetary and Financial Policies. More recently, the Report of the Committeeon Fiscal Responsibility Legislation, which formed the basis for the introducedFiscal Responsibility and Budget Management Bill, 2000; recognised that

participation of RBI in primary issues of Government securities has constrainedthe maneuverability of RBI in using the monetary policy instruments,

particularly the open market operations and the bank rate, for pursuing the goalof macroeconomic stability. The Committee accordingly recommended thatfreeing RBI from debt management functions should be pursued to accordgreater operational flexibility to RBI for conduct of monetary policy and as part

of fiscal responsibility. The proposed stance of doing away with borrowingsfrom the central bank three years hence and limiting such borrowings during theinterim period, in the introduced Bill would also contribute towards reducingsuch conflicts. While the central bank, through active co-ordination betweendebt management, monetary management and exchange rate policy hassucceeded in maintaining a balance between ensuring that borrowingrequirements are met at a minimum cost and ensuring monetary stability, thiswas often at the cost of sacrificing indirect instruments of monetary policy.

3.8 Contingent Liability Management: Although there is no centralisedunit for managing the guarantees provided by the Government of India, theBudget Division in the Ministry of Finance acts as the Middle Office by

34


35/57

monitoring such liabilities and formulating policies relating to such guarantees.The Budget Division also monitors the total guarantees of the Government ofIndia on a consolidated basis. Front and back office roles, on the other hand, isdispersed across several Ministries/Departments of the Government of India.

35


36/57

Annex IV. INTERNATIONAL EXPERIENCE AND BEST

PRACTICES IN PUBLIC DEBT MANAGEMENT

4.1 Approach in Study of Best International Practices: Internationalevidence of debt management practice by leading debt offices bears many

valuable lessons for countries in the process of strengthening their debtmanagement capacity. While there is no unique answer as to what constitutesound debt management practice, selective discretion should be used whileameliorating debt management practice based on international experience. Moreimportantly, the country specific requirements should be carefully analysed sothat the international best practices could be grafted effectively. For studying the

best international practices, Commonwealth Secretariat, London was appointedconsultant for the project, mainly for providing inputs on international best

practices in the area of public debt management. The CommonwealthSecretariat, hired Mr. Nihal Kappagoda, an international expert, who submitteda Report on the subject. The summary of the recommendations of theCommonwealth Secretariat is at Annex 5. Chairman and Members also visitedselect public debt offices to get first hand experience of their operations. The listof debt offices and officials visited by the Indian delegation is at Annex 6. Thespecific issues examined by the Group on best international practices related tothe risk-management framework, the institutional and organisational structurefor public debt management, governance issues promoting professionalapproach, co-ordination with fiscal and monetary management agency with thedebt management agency, and capacity building in sovereign debt management.

4.2 Risk Management Framework for Government Debt

4.2.1 Sovereign debt management primarily aims to ensure that governmentborrowing needs are met efficiently. A second objective is to ensure that thestock of debt portfolio and incremental flows arising from budgetary and off-

budgetary sources are being managed in a manner consistent with thegovernments preferences for cost and risk. An objective of minimising debtservicing cost, irrespective of risk, should not be an explicit objective. Risky

debt structures, characterised by excessive exposure to short-term or floating-rate debt or debt denominated in or indexed to foreign currency cansubstantially deteriorate the fiscal position of the government, constrain accessto capital and even propagate financial market instability. This is particularlyimportant when the governments debt portfolio is large relative to theeconomys output. Prudent debt management aimed at reducing risks byestablishing a low risk currency composition, interest structure and maturity

profile of the governments debt portfolio could make countries less susceptibleto financial risk and contagion. Several OECD governments have accordingly

set government debt management objectives aimed at minimising debtsservicing costs over the medium and longer-term subject to a prudent level ofportfolio risk. On the other hand, for many emerging market economies, debt

36


37/57

management objectives appear to be to cover their borrowing needs, lengthenmaturities and diversify funding sources wherever possible. Less attention is

paid to managing market risks and refinancing risk.

4.2.2 Table 4.1 summarises several risks arising from the debt portfolio of the

government, which sovereign debt managers endeavor to manage. Dependingon the characteristic of the debt portfolio, the debt manager might accorddifferent degree of priority for managing different risks. The portfolio choiceswould also depend on the macroeconomic policies given the stronginterlinkages between debt management, fiscal, monetary and exchange rate

policy. Thus, to the extent possible, the day to day implementation of sounddebt management policies should seek to reinforce the objectives ofmacroeconomic policies and policy reforms aimed at improving the efficiencyof the domestic financial market. Understanding the interplay of these public

policies and considerations and the technical analysis and market judgementinvolved in managing what are often very large and complex portfolios, makesovereign debt management a highly specialist business within the government.

4.2.3 Usually, governments are risk-averse in their sovereign debt management,often because governments have strong political incentives to adopt the riskapetite reflected by the median voter decision making. Evidence suggests thattaxpayers or representative voters tend to be risk averse in their decision-making and expect the government to have similar risk apetite in managing itsfinancial interests. Thus, while governments generally have preference for morestable tax rates over time they tend to be risk averse for their financial asset-liability management.

Table 4.1 : Risks Encountered in Sovereign Debt Management

Risk Description

Market Risk Risks associated with changes in market prices, such as interest rates, exchange rates, commodityprices, etc. For both domestic and foreign currency debt, changes in interest rates affect debt servicingcosts on new issues when fixed-rate debt is refinanced, and on floating-rate debt at the rate reset dates.

Hence, short- duration debt (short-term or floating-rate) is usually considered to be more risky thanlong-term, fixed rate debt. (Excessive concentration in very long-term, fixed rate debt also can berisky as future financing requirements are uncertain.) Debt denominated in or indexed to foreigncurrencies also adds volatility to debt servicing costs as measured in domestic currency owing toexchange rate movements. Bonds with embedded put options can exacerbate market risks.

Rollover Risk The risk that debt will have to be rolled over at an unusually high cost or, in extreme cases, that itcannot be rolled over at all. To the extent that rollover risk is limited to the risk that debt might haveto be rolled over at higher interest rates, including changes in credit spreads, it may be considered atype of market risk. However, because the inability to roll over debt and/or exceptionally largeincreases in government funding costs can lead to, or exacerbate, a debt crisis and thereby cause realeconomic losses in addition to the purely financial effects of higher interest rates, it is often treatedseparately. Managing this risk is particularly important for emerging market countries.

Liquidity Risk There are two types of liquidity risk. One refers to the cost or penalty investors face in trying to exit aposition when the number of transactors has markedly decreased or because of the lack of depth of aparticular market. This risk is particularly relevant in cases where debt management includes themanagement of liquid assets or the use of derivatives contracts. The other form of liquidity risk, for aborrower, refers to a situation where the volume of liquid assets can diminish quickly in the face of

37


38/57

unanticipated cash flow obligations and/or a possible difficulty in raising cash through borrowing in ashort period of time.

Credit Risk The risk of non-performance by borrowers on loans or other financial assets or by a counterparty onfinancial contracts. This risk is particularly relevant in cases where debt management includes themanagement of liquid assets. It may also be relevant in the acceptance of bids in auctions of securitiesissued by the government as well as in relation to contingent liabilities, and in derivative contractsentered into by the debt manager.

Settlement Risk Refers to the potential loss that the government could suffer as a result of failure to settle, forwhatever reason other than default, by the counterparty.

Operational Risk This includes a range of different types of risks including transaction errors in the various stages ofexecuting and recording transactions; inadequacies or failures in internal controls, or in systems andservices; reputation risk; legal risk; security breaches; or natural disasters that affect business activity.

Source: Draft Guidelines for Public Debt Management produced by the World Bank and the IMF.

4.2.4 For evolving a risk management framework for the governments debt portfolio, establishing the risk tolerance limits of the government can be a

difficult process. The governments implicit risk preferences may need to beinterpreted by debt managers, by exploring the preferences implied by earliergovernment policy decisions and also by assessing the risk management culturein the Ministry of Finance, other leading Ministries and the Central Bank.Important indicators of risk preference could include whether the government isscaling down the size of its balance sheet, its approach in managing its publicsector enterprises and contingent liabilities, and its attitude towards risk-sharing

proposals emanating from the private sector. A prudential risk management isessential for reducing uncertainty among sovereign debt managers as to the

governments tolerance for risk, its willingness to trade off cost and riskobjectives and, consequently, which transaction to accept and reject. Without anintegrated debt management strategy in terms of strategic guidelines, portfoliomanagement decisions can end up lacking coherence and being based on

particular individuals speculation about market trends or key relative prices.

4.2.5 In designing a debt management strategy, the sovereign debt manager isfaced with several choices regarding the financial characteristic of the debt. Thekey decisions in this regard include:

the desired currency composition of the debt portfolio, including the mix

between domestic currency debt and foreign currency debt;

the desired maturity structure and liquidity of the debt;

the appropriate duration or interest rate sensitivity of the debt;

whether domestic currency debt should be in nominal terms or indexed to

inflation or a particular reference price; and

whether the portfolio composition should be transformed through swaps and

other hedges or through new issuance.

38


39/57


40/57

assets. Instead, the main objective is to consider the various types of assets andobligations the government manages, besides its tax revenue and direct debt

portfolio, and explore whether the risk characteristics associated with thoseassets can provide insights for reducing the cost and risk of governmentsliabilities. This, in turn, could provide a benchmark for quantifying the costs and

measuring the risks of the debt portfolio. This quantification of cots and risksprovide a basis for developing a strategy for managing the debt portfolio. TheALM approach also provides a useful framework for considering governancearrangements for managing the governments balance sheet.

4.2.7 Two variants of the ALM approach are possible. The first approach is touse a simplified balance sheet framework where the only assets are governmentrevenues, measured as the present value (PV) of future revenues, and the onlyliabilities are government debt and the present value of future expenditures,

excluding debt service. In this framework, risk is measured by the volatility ofdifferences between the debt servicing costs and the future primary surpluses(i.e., the excess of asset over liability) as a result of market price movements.By comparing the costs and risks of different debt management strategies, thedebt manager can then choose the strategy that reflects the governmentstolerance for risk.

4.2.8 The other approach of ALM framework is a balance sheet with multipleassets and liabilities. Assets are foreign exchange reserves and t

Documents

Public Debt Middle Office WG Report