Posted by Yasemin Hurcan and Fatos Koc
A recent paper by Fatos Koc discusses the benefits and challenges of adopting a sovereign asset and liability management (SALM) framework in debt management. The paper draws on the experience of countries such as New Zealand, Denmark and Turkey, all of which have adopted the SALM approach, in various forms.
The SALM framework is based on a balance-sheet approach. It is designed to identify and effectively manage the key financial exposures of the public sector as a whole. SALM entails monitoring and quantifying the impact of movements in exchange rates, interest rates, inflation, and commodity prices on both sovereign assets and liabilities in a coordinated way. On the liability side, the aim is to minimize debt service costs subject to a prudent level of risk. On the asset side, the aim is to accumulate an adequate level of net foreign assets, including foreign exchange reserves, in order to conduct effective monetary and foreign exchange policies, and provide a buffer against external shocks.
Uncoordinated management of sovereign assets and liabilities may cause significant mismatches on the government’s balance sheet. For example, balance sheet risk will increase if foreign currency reserves are invested in short-term dollar deposits and financed with long-term borrowing in local currency. This in turn will cause maturity and currency mismatches on the balance sheet. SALM provides comprehensive data on a government’s assets and liabilities, together with methods to detect sources of financial mismatches and tools to reduce detected vulnerabilities to external shocks.
In light of the global financial crisis, and the consequent deterioration in the sovereign balance sheet in many countries, the SALM approach looks increasingly attractive. Many countries today perceive the need to take balance sheet risks into account when designing their borrowing strategies. In addition, the so-called Stockholm Principles underline that the importance of taking into account relevant interactions between the nature of financial assets, explicit and implicit contingent liabilities, and the structure of the debt portfolio. These principles, in essence, reflect a move towards a broader definition of risk than is adopted in traditional approaches to debt management.
In line with these developments, Koc’s paper underlines that the SALM approach can reveal important vulnerabilities that are hidden when considering sub-portfolio balance sheets.An examination of the nature of sovereign assets and liabilities as a whole can be a guide for managing the risks of government balances. Undertaking tests of the impact of different types of macroeconomic risk provides valuable evidence that can significantly improve the efficiency of debt management policies.
Despite its potential benefits, the adoption of SALM faces several challenges. These include the compilation of financial statistics on public sector balance sheet, the measurement of non-financial assets, and risk analyses of the sovereign asset and liability portfolio. Other challenges include the need to centralize the financial risk management function and to build institutional capacity for risk management. The paper suggests that, while aspects of SALM can be applied in emerging markets and some developing countries, a gradual approach is recommended. As a first step, key areas of the balance sheet should be identified and assessed from a vulnerability and management perspective. Country experiences suggest that the management of liquid financial assets (e.g., cash reserves and state funds) by debt management offices (DMOs) can be a practical starting point for introducing a SALM framework that initially takes a more limited form, and can be expanded later.
Another challenge faced by developing countries with low capacity is the selection of appropriate debt indicators that are relatively simple to analyze. A leading debt indicator in many developed and developing countries is net debt, which entails the deduction of cash-like liquid assets from gross debt. The IMF, the World Bank, and the OECD also use this definition for providing accurate comparison of countries’ indebtedness.
In some countries, active and natural hedging strategies can be used to mitigate currency risk, interest-rate risk, and re-financing risk exposures of balance sheets. The paper argues that the adoption of such strategies depends on several factors including a country’s capacity to analyze risk and the development of financial markets. Natural hedging strategies are considered more suitable for developing countries.Issuing inflation-indexed bonds against budget risk, creating natural hedges for currency risk, and establishing liquidity buffers for re-financing risk should be relatively easy to apply in most developing countries. On the other hand, domestic financial markets are unlikely to be sufficiently developed to use active hedging instruments in achieving a preferred and optimal portfolio.
Natural hedging methods are quite straightforward and do not require to be applied on a day-to-day basis. In this regard, simple strategies can be used to mitigate the currency risk exposure of the balance sheet. The country experiences referred to in the paper indicate, for example, that accumulating international reserves to match foreign currency debt can be very effective in addressing balance sheet vulnerabilities. On the other hand, active hedging instruments, such as interest and currency swaps, are much more complicated to implement both from an operational and a technical perspective.
Another example of a natural hedge strategy is the use of a “liquidity buffer”. This policy can be helpful in reducing the pressures on debt and cash management during periods of financial stress. Issuing short-term securities carries a lower cost than issuing long-term securities. On the other hand, over-reliance on short-term debt exposes debt management to a significant re-financing risk. In addition, a benchmark issuance policy may result in massive redemptions in certain months of the year, thus disturbing the repayment profile. In that case, maintaining a liquidity buffer serves as a cushion against short-term market volatilities. It also provides flexibility to DMOs during their regular debt auctions.
Centralization of management of all these financial risks and the building of institutional capacity are important elements in creating a SALM framework for debt management. Credit risks stemming from derivative agreements and treasury guarantees are another area of centralized risk management. Some DMOs, including in Denmark and South Africa, provide financial risk management guidance to government-owned companies. Such practices can be useful in promoting good governance and the sovereign’s risk tolerance. Recently, the use of PPPs in financing large infrastructure projects, such as highways and bridges, has become common in some developing countries since they offer governments a different approach for alleviating fiscal constraints, though the fiscal risks associated with such contracts need to be carefully managed. Introducing a standard contract for PPPs can be an effective way to mitigate credit risk exposure of the sovereign balance sheet, as is implemented in the U.K., New Zealand, South Africa and Canada.
Finally, the paper develops some useful strategies for building the institutional capacity of developing countries in relation to debt management. Although there is no straightforward answer to the “best institutional arrangement” for the efficient development and management of SALM, country experiences suggest that the establishment of a dedicated unit responsible for strategic decisions and coordination across government agencies could be effective. However, such an arrangement does not need to be established from the beginning. Initially, the focus should be on building the capacity of DMOs—for example through training opportunities and study tour visits to more advanced countries—together with reinforcing the DMO’s position as the principal advisor to the government on issues such as financial risk management and development of the capital markets.
 Yasemin Hurcan is aTechnical Assistance Advisor, PFM1 Division, Fiscal Affairs Department, IMF; Fatos Koc is a Head of the Market Risks Department, the Undersecretariat of Treasury in Turkey.
 Fatos Koc, Sovereign Asset and Liability Management Framework for DMOs, published by UNCTAD.
 These principles emerged from the 10th annual IMF Consultations on “Policy and Operational Issues facing Public Debt Management” co-hosted by the Swedish National Debt Office in Stockholm, June 2010.
 Active hedging is a method to mitigate risk in the underlying financial instrument, by entering into a derivative contract - e.g., a swap, option and forward contract - whose value moves in the opposite direction to their underlying position and cancels out part or all of it. A natural hedge is a financial activity that reduces risk by matching cash flows (i.e., revenues and expenses) without using sophisticated financial products.
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