This new introductory guide, ‘Managing public debt in Europe, reviews the debate and empirical evidence on the problems that high public debt may cause and the policy options for reducing it. To do so, it starts from the basics regarding the determinants of the evolution of public debt over time, explains under what conditions high public debt can lead to a crisis and reviews the theory and evidence on whether high public debt is detrimental for growth. (Free download)

Almost a decade after the onset of the global financial crisis, national debt in advanced economies remains near its highest level since World War II, averaging 104 percent of GDP. In Japan, the ratio is 240 percent and in Greece almost 185 percent. In Italy and Portugal, debt exceeds 120 percent of GDP. Without measures either to cut spending or increase revenue, the situation will only get worse. As central banks abandon the extraordinary monetary measures they adopted to battle the crisis, interest rates will inevitably rise from historic lows. That means interest payments will eat up a growing share of government spending, leaving less money to deliver public services or take steps to ensure long-term economic growth, such as investing in infrastructure and education. Servicing debt will become a major burden.[…]

The authors present a framework of sovereign debt issuances and precautionary capital buffers. In a setting where sovereign debt managers are confronted with budget risk and intertemporal funding is costly, the sovereign may issue debt in excess of expected funding needs - a capital buffer - as a measure of self-insurance. The authors provide an empirical assessment of optimal capital buffers for a panel of European countries and derive policy recommendations. For realistic parameters, their model suggests capital buffers in a range from 0.19% to 1.41% of the gross domestic product if the debt manager’s budget predictions are based on an estimate of the deficit’s unconditional mean. If debt managers can predict future deficits at least to some extent, high budget forecast errors become less likely and capital buffer holdings decrease. Their model suggest that optimal capital buffers remain positive and lie between 0.04% to 0.19% of the gross domestic product.

Between 1776 and 1920, the US Congress designed more than 200 distinct securities and stated the maximum amount of each that the Treasury could sell. Between 1917 and 1939, Congress gradually delegated all decisions about designing US debt instruments to the Treasury. In 1939, Congress began imposing a limit on the par value of total federal debt outstanding. By summing Congressional borrowing authorizations outstanding each year for each bond, we construct a time series of implied federal debt limits before 1939 […]

The authors propose a consumption-based model that allows for an inverted term structure of real and nominal risk-free rates. In the authors’ framework the agent is subject to time-varying macroeconomic risk, and interest rates at all maturities depend on her risk perception, which shapes saving propensities over time. In bad times, when risk is perceived to be higher in the short- than in the long-term, the agent would prefer to hedge against low realizations of consumption in the near future by investing in long-term securities. In equilibrium, this leads to the inversion of the yield curve. Pricing time-varying consumption volatility risk is essential in order to obtain the inversion of the real curve and allows the average level and the slope of the nominal level to be priced.

In this paper the authors examine the holdings of government securities by domestic banks along with those of five other sectors: foreign banks, foreign non-banks, the official foreign sector, the domestic central bank and domestic non-banks. The authors use data for 21 advanced economies from 2004 Q1 to 2016 Q2. The results offer four main insights. First, banks are reluctant to undertake major changes in their holdings of domestic bonds but do accept frequent changes of more intermediate size. Second, the foreign official sector emerges as the clearest example of a contrarian investor, buying when prices fall and selling when prices rise. Third, the greater the holdings by domestic and foreign banks, the lower the yields tend to be on 10-year benchmark sovereign bonds. Finally, in all countries included in the sample the authors find a positive home bias in banks' sovereign holdings while foreign banks hold fewer bonds than predicted by a neutral portfolio measure. These results suggest that banks regard domestic government bonds as a special asset class (hence the positive bias and avoidance of major changes in inventories) which they manage in a flexible manner (hence the frequent intermediate changes and lack of systematic timing of transactions), in all likelihood to meet requests from their customers. All in all, this behaviour by domestic banks provides a positive contribution to the liquidity of the market.

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This paper analyzes the evolution of the banking system sensitivity to cross-border contagion in 2006-2011. The study is performed on the basis of the BIS data on cross-border exposures and the Bankscope data on Tier 1 capital of 20 banking systems (Australia, Austria, Belgium, Canada, Finland, France, Germany, Greece, India, Ireland, Italy, Japan, the Netherlands, Portugal, Spain, Sweden, Switzerland, Turkey, the UK and the US). Since the European sovereign debt crisis took a decisive turn at the end of 2009, markets started looking at its main protagonists - Greece, Ireland, Italy, Portugal and Spain (GIIPS) - with a lot of anxiety. However, unexpectedly, we find that a single failure among GIIPS could be absorbed by the network. Our results reveal that the US, the UK, France and Germany pose the highest threat to the systemic stability. Moreover, the resilience of the banking systems to contagion risks tends to improve over the years.

Historically, sovereign debt in local currency has been considered safer than debt in foreign currency. Yet the literature offers scant theoretical or empirical guidance as to why such a gap exists, or why it appears to have slowly and steadily diminished for all regions over the past two decades, as expressed in the ratings widely used by global investors and regulators to assess credit risk. We suggest and empirically test five hypotheses. We find that differences in inflation do not explain the assessed gaps between local and foreign currency credit risk. The banking sector's vulnerability to sovereign debt problems is a significant determinant of the spread, but does not account for its decline over time. Instead, the surge in global reserves, and to lesser extent the reduced reliance on overseas foreign currency borrowing (ie the decline of original sin), as well as lower global volatility, appear to have lessened the gap. But if these variables were to go into reverse, the gap could again widen.

The debt–growth relationship is complex, varying across countries and affected by global factors. While there is no simple universal threshold above which debt to GDP significantly depresses growth, high and rising public debt burdens slow growth in the long term, data from the past four decades indicate.

This paper provides an overview of sovereign debt portfolio risks and discusses various liability management operations (LMOs) and instruments used by public debt managers to mitigate these risks. Debt management strategies analyzed in the context of helping reach debt portfolio targets and attain desired portfolio structures. Also, the paper outlines how LMOs could be integrated into a debt management strategy and serve as policy tools to reduce potential debt portfolio vulnerabilities. Further, the paper presents operational issues faced by debt managers, including the need to develop a risk management framework, interactions of debt management with fiscal policy, monetary policy, and financial stability, as well as efficient government bond markets.

For over a century, legal scholars have debated the question of what to do about the debts incurred by despotic governments; asking whether successor non-despotic governments should have to pay them. That debate has gone nowhere. This paper examines whether an Op Ed written by Harvard economist, Ricardo Hausmann, in May 2017, may have shown an alternative path to the goal of increasing the cost of borrowing for despotic governments. Hausmann, in his Op Ed, had sought to produce a pricing penalty on the entire Venezuelan debt stock by trying to shame JPMorgan into removing Venezuelan bonds from its emerging market index. JPMorgan did not comply, but there was a pricing penalty. Intriguingly, the penalty hit only one bond; an issue by Venezuela’s state-owned oil company that went on the market two days prior to Hausmann’s piece. That bond then began to carry the name in the market of “Hunger Bond.” Using quantitative data and interviews with investors, we try to understand the causes of the Hunger Bond penalty and ask whether there are lessons for policy makers.

The current debate on the role of public debt and sovereign creditworthiness in the euro area, is an essential piece in the context of the broader reform agenda on how to strengthen EMU resilience. This paper focuses on sustainability: it reviews the risks associated with regimes of high debt and stresses the need for comprehensive solutions to mitigate such risks in the future. In particular, the paper acts as a reminder that further risk reduction is needed - efforts in this respect should not be overlooked and should complement those to strengthen Euro Area (EA) stabilisation and risksharing capacity. Keeping public debt at high levels is a source of vulnerability, especially in EA, as it makes the economy less resilient to shocks and may further restrain a country’s LT growth potential. Reducing the currently high public debt levels may be more difficult than in the past and urgency of task depends on risks to debt sustainability. A menu of reforms, including further consolidation and structural reforms, is needed to reduce the currently high debt ratios in many countries. Looking beyond, further institutional changes are needed to make EMU more resilient to future debt crisis.

In 2016, the ESRB General Board agreed that the pooling and tranching of cross-border portfolios of national sovereign bonds represents an interesting and attractive approach that could contribute to the ESRB’s objectives. On this basis, the General Board commissioned a High-Level Task Force on Safe Assets, chaired by Philip R. Lane, Governor of the Central Bank of Ireland, to investigate the practical considerations relating to sovereign bond-backed securities (SBBS).[…]

We identify an adverse consequence of natural resource windfalls, which is particularly detrimental in advanced democracies. We construct a political economy model with endogenous public debt under exogenous resource windfall shocks, in which political myopia results from reelection prospects. Reelection-seeking politicians, while more accountable toward their electorate, are also more myopic. The latter effect gives rise to a budget deficit bias, with the ensuing debt buildup that is exacerbated by resource windfalls. We find that the positive effect of resource windfalls on debt increases as the restrictions on reelection get laxer. We test the model's predictions using a panel of U.S. states over the period 1963-2007. Our identification strategy rests on constitutionally-entrenched differences in gubernatorial term limits that provide plausibly exogenous cross-sectional and time variation in political time horizon, and geographically-based cross-state differences in natural endowments interacted with the international prices of oil and gas. The empirical findings corroborate the model's predictions. In particular, over a period of five years, a resource windfall equivalent to 1% of state income induces an increase of approximately 0.35% ($4.6) in the average real per capita public debt of states with no gubernatorial term limits.

This paper uses high-frequency data to analyze the effects of US monetary policy—during the conventional and unconventional policy regimes—on foreign government bonds markets in advanced and emerging market economies. The results indicate that an expansionary US monetary policy steepens the foreign yield curve—denominated in local currency—during a conventional US monetary policy regime and flattens the foreign yield curve during an unconventional policy regime. The passthrough of unconventional US monetary policy to foreign bond yields is, on balance, comparable to that of conventional policy. In addition a conventional US monetary easing leads to a significant narrowing of the credit spreads on dollar-denominated sovereign bonds that are issued by countries with a speculative-grade sovereign credit rating. However, during the unconventional policy regime, yields on speculative-grade sovereign debt denominated in dollars move one-to-one with yields on comparable-maturity US Treasury securities.

We examine economic convergence among euro area countries on multiple dimensions. While there was nominal convergence of inflation and interest rates, real convergence of per capita income levels has not occurred among the original euro area members since the advent of the common currency. Income convergence stagnated in the early years of the common currency and has reversed in the wake of the global economic crisis. New euro area members, in contrast, have seen real income convergence. Business cycles became more synchronized, but the amplitude of those cycles diverged. Financial cycles showed a similar pattern: sychronizing more over time, but with divergent amplitudes. Income convergence requires reforms boosting productivity growth in lagging countries, while cyclical and financial convergence can be enhanced by measures to improve national and euro area fiscal policies, together with steps to deepen the single market.

This paper investigates the welfare and economic stabilization properties of a fiscal transfers scheme between members of a monetary union subject to sovereign spread shocks. The scheme, which consists of cross-country transfer rules triggered when sovereign spreads widen, is incorporated in a two-country model with financial frictions. In particular, banks hold government bonds in their portfolios, being exposed to sovereign risk. When this increases, a drop bank’s equity value forces them to contract credit and to raise lending rates at the same time as they retain funds to build up their net worth. I show that, when domestic fiscal policy is not distortionary, fiscal transfers improve welfare and macroeconomic stability. This is because fiscal transfers can reduce banks’ exposure to government debt, freeing credit supply to the private sector. On the contrary, when domestic fiscal policy is distortionary, fiscal transfers cause welfare losses, despite stabilizing the economy. This result arises because the distortions caused by funding the scheme outweigh the positive effects of fiscal transfers in smoothing the adjustment of the economy hit by the shock.

The paper argues that private deleveraging episodes trigger increases in public debt (mutualization). The key mechanism is not so much explicit bail-outs but the private deleveraging episode hinders economic growth and subsequent countercyclical fiscal policy increases the public debt ratio. Whether total debt ends up increasing or decreasing depends on the extent of the growth slowdown and the reaction of fiscal policy during the deleveraging spell. Total debt increases only in a slow growth and strong fiscal policy reaction scenario. Implications for monitoring public finance developments: we should take into account these apparent implicit guarantees when analyzing public debt sustainability (see Berti et al (2013) or Hernández de Cos et al (2014)). The topic is timely and the econometric analysis well-executed. The database is impressive and very useful.

As a new year begins, governments around the world are poised for another cycle of debt disputes and missed payments. Venezuela is stumbling into default after starving its people for years to pay foreign creditors. Its hard currency reserves are drying up under pressure from US sanctions as the government battles hyperinflation, runs out of things to sell to China and Russia, and tries to buy time with a wacky virtual currency scheme. Meanwhile, Ukraine and Puerto Rico will each go to court in January to fend off debt collectors. Ukraine has appealed an English court decision that would enforce its debt to Russia as if it were an ordinary commercial contract, despite Russia’s annexation of Crimea, crippling trade sanctions, and sponsorship of separatist conflict in eastern Ukraine. A fund known for making a fortune from suing Argentina has challenged a US federal law enacted in 2016 that promised bankruptcy-style debt relief for Puerto Rico. If the fund wins, hopes for a fresh start for the hurricane-battered commonwealth and an equitable resolution for its creditors would dim.[…]

Sovereign bond-backed securities (SBBS) are defined as securities with varying levels of seniority backed by a diversified portfolio of euro-denominated central government bonds. Because they are created through private contracts, SBBS do not mutualise sovereign risks, as each government would remain responsible for servicing its own debt obligations. This report summarises the findings of an ESRB High-Level Task Force on the feasibility and impact of creating a market for SBBS as a tool to enhance financial stability. The technical findings are based on analytical work and insights from market participants and other stakeholders. The Task Force’s report represents the outcome of these analyses and discussions, without necessarily reflecting individual views on all aspects or pre-judging future decision-making on SBBS. This volume of the report conveys the Task Force’s main findings; Volume II contains the analysis underpinning those findings.[…]