Financial Risk Manager: World Financing: Rollover Roulette

World Financing: Rollover Roulette
Friday, October 22, 2010

How governments borrow matters as well as how much.

WHEN financial turmoil threatened to engulf Ireland last month, the government took an unusual step: it scrapped bond auctions for the rest of the year. The move was possible because the country has enough cash to last until next May.

Over the past two years Ireland's National Treasury Management Agency (NTMA), which manages the state's debt, has maintained a cash cushion of €20 billion ($27.7 billion), equivalent to 12% of GDP. It did the bulk of its borrowing through long-term bond auctions, resulting in a relatively long average maturity for the national debt. The IMF reckons that next year Ireland must finance the rich world's largest budget deficit as a share of GDP. But it needs to refinance only a modest amount of maturing debt (see chart). In contrast, huge refinancing needs helped drive Greece into the arms of the fund and of its euro-zone peers in May.

Ireland's prudence in debt management has not come cheaply. It costs more to issue long-term than short-term debt. Anthony Linehan of the NTMA notes that a cash cushion entails increased interest charges and a higher debt-to-GDP ratio on the books of Eurostat, the European Union's statistics agency. But "it reassures the market to know Ireland is pre-funded."

The mechanics of how countries borrow receive far less attention than how much they borrow. Sovereign-debt managers in rich countries used to focus on borrowing as cheaply as possible. No longer. Many are now more preoccupied with ensuring uninterrupted access to funds. Some, for example, are reducing short-term borrowing and the associated "rollover risk". America relied heavily on shorter-term Treasury bills to finance a rocketing deficit in 2008. Since then, it has shifted most of its borrowing to long-term bonds. The share of the United States' debt maturing in the next 12 months has dropped from more than 45% in 2008 to barely 30%, an historic low.

A sovereign-debt manager's greatest fear is a failed auction, in which bids fall short of the debt on offer. The actual cash shortfall is usually not that important: the borrower can simply raise the additional money at a later date. But a failed auction can look like a damaging vote of no confidence. In March 2009 an auction of British gilts failed. Though it proved an anomaly, it still rattled stockmarkets and generated unflattering headlines.

Sovereigns usually prefer auctions because they result in lower borrowing costs. Paying fees to a syndicate of banks to market a deal directly to investors is politically unpopular, too. But Britain's auctions have become so large that they entail far more risk for primary dealers, the banks that purchase government securities at auction and then sell them on. That is particularly true for long-term bonds, whose prices are more volatile. Because that increases the risk of failure, last year Britain started supplementing its debt auctions with syndicated deals.

Dealers themselves face more pressure to support the market. Earlier this year America's Federal Reserve notified primary dealers that they would have to bid in auctions for a share of issuance that was in proportion to their size and number. Treasury officials say the guidance formalised existing expectations. But Dino Kos, a former head of markets at the Federal Reserve Bank of New York (and now a strategist for Portales Partners, a broker), says the new requirement almost guarantees that an auction will not fail.

Sovereign borrowers are also trying to expand their base of investors. Banks, for example, have habitually treated their governments' debt as risk-free. This has led to potentially dangerous concentrations of sovereign debt. The IMF notes in its latest "Global Financial Stability Report" that some 24% of Japanese banks' assets consist of government bonds. Moreover, Japan borrows inordinately through short-term debt. If banks suddenly lost confidence in government debt, the result could be both a systemic banking crisis and a funding crisis for the Japanese government.

Finance ministers and debt managers are spending more time on the road, in particular courting sovereign-wealth funds in Asia and the Middle East. Sweden's debt manager is exploring the American private-placement market. Inflation-indexed bonds are experiencing a surge in popularity, both from investors worried about inflation and from borrowers who think they attract a different type of buyer. South Korea and Australia have reactivated inflation-indexed bond programmes in the past year, and America will almost double its annual issuance from $58 billion in 2009 to over $100 billion in 2011.

Ultimately, of course, the most careful debt management cannot stop a country's solvency coming into question if its deficits keep rising. But as Ireland is finding, a bit of wiggle-room can be invaluable.

Source: The Economist , A service of YellowBrix, Inc.

Labels: Economy, World Financing