Public Debt Management Strategies
|✅ Paper Type: Free Essay||✅ Subject: Finance|
|✅ Wordcount: 1825 words||✅ Published: 23rd Sep 2019|
Public Debt Management
Public debt management can be defined as open market operations carried out by the government in order to change the composition of the outstanding stock of government-issued debt instruments (Paalzow, 1992). For the past few years many developed countries have expended their public debts, originally the idea was to use those debts to enable growth of the countries. After the World Wars, state loans where the tools available to most governments to finance different projects and rebuild their countries. However, as time passed the world experienced an explosion of public debts with the emergence of financial markets. The reason for that explosion to occur is mainly because government debts are less risky than other assets. Investors main goal is to maximise their profit while minimise the risk. Which is why public debts from developed countries has become very attractive as the countries were seen credible and offer different technics that will negate the risk attached to certain securities. The purpose f this paper is to analyse the current level of some of the developed countries and discuss the best way for government to issue new government securities in order to maximise their profit.
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The thing that stand out when you look at the figures of the central government debt securities markets is the difference between the USA and the other countries. Where on the chart below you can barely see most of the holdings of the other countries, the US stand out in the mass as, giving a kind of positive skewness to data we have in the chart. The reason for that is from the 1997 to 2017, the us government spent more than it received in tax revenue. For many years and under different leadership the US become addicted to deficit spending, a practice is called expansionary fiscal policy. It was in place in order to provide the economy with more money and boost it. However, where it was manageable during years, something happened and change the curve during 2007.
In 2007, the world witnessed a major financial crisis which lead most countries governments to come to the rescue of most of the banks by bailing them out. During that time most of invesmtent assets that wee making money for investors became so much riskier that most people were looking for an alternatinve.
As (Andolfatto & Spewak, 2018) stated: as financial instability increases, investors replace risky assets with high-quality, safe ones in a so-called “flight to quality”. That is exactly why the figure of the US is extremely high as it is considered as the most powerful country on earth. And also countries like China and Japan purchase Treasuries to keep their currencies low in comparative to the dollar. Although it seems reasonable to do so, from an economic point of view it contradicts the theory of supply and demand.
The law of supply and demand is a theory that explains the interaction between the supply of a resource and the demand for that resource. The theory defines the effect that the availability of a particular product and the desire (or demand) for that product has on its price (Kagen, 2018). Whenever the supply of an object increases, economic theory suggests that—all else equal—its price can be expected to drop (Andolfatto & Spewak, 2018). In fact we noticed from the increase of the quantity of treasury securtities that the opposite to the theory happened. The price and interest paid on U.S. government debt is determined by supply and demand. When there are few bonds and a lot of demand, prices rise and interest rates fall. When there are a lot of bonds and little demand, prices fall and interest rates rise (Financial, 2018).looking at the level of the government debt for developped countries, what is the best strategy for the future? Should governments focus more on short term or long term bond? Or should they go for fix rate instead of floating rates?
The next paragraph will discuss the different options in order to highlight the strenght and weakness of each.
Pros and Cons of Government Bonds
For the general audience, government bonds are generally seen to have a lower risk of default compared to other investment opportunities, such as corporate bonds and stocks. Government bonds also have certain tax advantages, depending on their issuing agency and, to an extent, on the type of bonds they are (Basu, 2017).
Issue of new Govies
in order to finance its public debt, the US government every year put forward for auction trillion of dollars of Treasury securities. In term of risk and return treasury securities are known among investors as conservative investments. The greatest advantage of Treasury securities is that they are, of course, unconditionally backed by the full faith and credit of the U.S. government (CUSSEN, 2018). If you hold your investment till maturity you are guaranteed to get your interest and principal that are due. However, not only the US use auction of their treasury bills but other countries also use it to sell the treasury securities.
The large quantities of Treasury securities issued have led to increased attention on the advantages and disadvantages of various auction formats (Bjønnes†, 2001). Over the years the same questions kept returning: which of the uniform price or discriminatory format of auction give a better return to the government?
In the discriminatory-auction model, the Treasury auctions a quantity of securities to a number of bidders, each of whom gets a noisy signal of the common value of the security. Each bidder bids for one unit at a price that maximizes his expected profit. The highest bidders pay their bids and are awarded the securities (Goldreich, 2003).
A number of papers have found underpricing in the older discriminatory auctions
for U.S. Treasury securities (Goldreich, 2003). Friedman 1991 argued that the treasury could reduce the cost of financing by switching to the uniform-pricing model. And also other put forward the arguments that discriminatory auctions can be manipulated. He put forward the argument when talking about discriminatory auction that: the present method involves payment of different prices by different purchasers, which tends to limit the market to specialists and to establish a strong incentive for collusion among bidders (Friedman, 1991).
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Uniform-price (Dutch) auction
In a uniform-price auction, bidders submit demand functions to a seller who awards m units of a homogeneous good to the highest m bids at a single clearing price that applies to all bids (Burkett & Woodward, 2018). In order word, all bidders pay the same stop-out price. Buyers who have bid more than the clearing price get their orders filled at the clearing price and the buyer who bid the clearing price gets the remainder (Hull, 2015). The uniform price auction is fair, in the sense that bidders never pay less than other bidders for the same number of units won (Burkett & Woodward, 2018). Going further, Uniform price auctions decrease the fear of the Winner’s Curse since all the bidders pay the bid of the first looser, which makes their bid closer to their real expectations of the secondary-market price an leads to an overall more aggressive bidding strategies.
Many authors have argued that uniform price auctions generate higher expected revenues to
the Treasury than discriminatory price auctions because they alleviate the winner’s curse by
linking the auction price to the lowest winning bid, or alternatively, to the highest loosing bid (e.g. Bikchandani and Huang, 1993; Friedman, 1991) (Bjønnes†, 2001). Bikhchandani
and Huang (1989) argue that uniform-price auctions are more susceptible to overbidding
as participants try to send signals to the secondary market (Goldreich, 2003).
Government agencies cannot issue stock to meet funding shortfalls, which leaves debt financing as their only option to raise money for essential services and long-term capital projects, such as bridges, hospitals and schools (Basu, 2017).
- Andolfatto, D., & Spewak, A. (2018, Mar 09). On the Supply of, and Demand for, U.S. Treasury Debt. Retrieved from research.stlouisfed: https://research.stlouisfed.org/publications/economic-synopses/2018/03/09/on-the-supply-of-and-demand-for-u-s-treasury-debt/
- Basu, C. (2017, April 19). Pros & Cons of Government Bonds. Retrieved from Pocket Sense: https://pocketsense.com/pros-cons-government-bonds-6020.html
- Bjønnes†, G. H. (2001). Winner’s Curse in Discriminatory Price Auctions: Evidence from the Norwegian Treasury Bill Auctions. the Journal of Economic Literature (JEL).
- Burkett, J., & Woodward, K. (2018, Dec 7). Uniform-Price Auctions with a Last Accepted Bid Pricing Rule. Retrieved from kylewoodward: https://kylewoodward.com/research/auto/burkett+woodward-2018A.pdf
- CUSSEN, M. P. (2018, Jan 01). Introduction to Treasury Securities. Retrieved from investopedia: https://www.investopedia.com/articles/investing/073113/introduction-treasury-securities.asp
- Financial, S. (2018, Dec 16). U.S. Treasuries: Supply and Demand. Retrieved from skygatefinancial: https://skygatefinancial.com/u-s-treasuries-supply-demand/
- Goldreich, D. (2003). Underpricing in Discriminatory and Uniform-Price Treasury Auctions. Retrieved from semanticscholar: https://www.semanticscholar.org/paper/Underpricing-in-Discriminatory-and-Uniform-Price-%C2%A4-Goldreich/e3a974e84aaa142960ba172d5befef4412d61045
- Hull, J. C. (2015). In J. Hull, Options, futures, and other derivatives (p. 362). New Jersey: Pearson.
- Kagen, J. (2018, Feb 7). Law of Supply and Demand. Retrieved from investopedia: https://www.investopedia.com/terms/l/law-of-supply-demand.asp
- Paalzow, A. (1992). PUBLIC DEBT MANAGEMENT. Stockholm: EFI RESEARCH REPORT.
- Parker, M. (2018, November 29). longterm-vs-shortterm-treasury-bonds. Retrieved from finance.zacks.com: https://finance.zacks.com/longterm-vs-shortterm-treasury-bonds-3374.html
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