Tuesday, December 29, 2009

Strategies for financing government debt

The rising government deficits across many countries and deep uncertainty about economic prospects raises questions about the approach to be adopted towards financing these debts, specifically the maturity choices of financing government debts. The dilemma is over the expected costs of debt service and the risk of facing a situation in which costs are much greater than forecast. Further, apart from determining the cost of financing the debt, it also determines the "shape of the yield curve, the extent of private sector maturity transformation, and the value of the currency (for instance if foreign lenders have different preferences over maturities relative to domestic lenders)".

The US treasury has been adopting a strategy of "exchanging short-term borrowings for long-term bonds", also in an effort to lower the real long term interest rates, to finance its deficits. Given the prevailing higher than expected long term rates (given the zero-bound in nominal short term rates), Paul Krugman has advocated that in addition to the Fed buying more long-term debt,the government can issue more short-term debt (T-Bills). He points to the fact that the overall borrowing by the non-financial sector hasn’t risen (and hence long term rates have not risen), since the surge in government borrowing has less than offset a plunge in private (long-term) borrowing (in view of the uncertain economic circumstances the private sector is fleeing into short-term securities).

In uncertain times, as Rajiv Sethi points out, since short-term debt becomes the preferred habitat for lenders, their rates typically tend to be lower than long term rates, which are inflated by their liquidity premium. This is another reason for preferring the financing of deficits with short term debt over long-term obligations. He also writes, "Other things equal, greater uncertainty (about future rates) should lengthen maturities. However, greater uncertainty will also steepen the yield curve and raise the expected costs of long-term (relative to short-term) financing, and this effect should reduce desired maturities."

Andy Harless (see also Rajiv Sethi's comments) too argues in favor of financing government debt through issuance of Bills by the Treasury. He makes an interesting case against borrowing long-term, so as to hedge against the possibility of unexpected increases in short term rates, and thereby reduce its risk of default. Any such unexpected increases would arise out of greater demand for short-term financing by private businesses and/or inflationary expectations taking hold, both of which would be signalling a sudden (unexpected!) economic recovery and therefore a welcome development. The recovery would also generate higher than expected revenues and reduced expenditure on fiscal stabilizers and other stimulus spending, thereby mitigating the higher costs of financing government debt.

In this context, Rajiv Sethi also draws attention to a paper by Joseph Gagnon, who advocates that the Fed purchase long term securities. Further, the Fed's purchases of long term securities, coupled with the Treaury's issuances of short term T-Bills, will ensure greater maturity diversification and also reduce the "vulnerability to unexpected fluctuations in interest rates".

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