Sovereign debt management and fiscal vulnerabilities

A wide consensus has emerged on the role of debt management in reducing fiscal vulnerability by providing insurance against macroeconomic shocks to the government budget. Whether this goal is better accomplished by nominal or inflation-indexed debt, by a short or a long maturity structure, remains however controversial. In this paper we review the issues of indexation and debt maturity, discussing in particular the role of the maturity structure in light of integrated financial markets and the risk of default. We argue that the role of inflation-indexed debt as a hedge against demand and inflation shocks is less important when price stability is ensured by a Ricardian fiscal policy and an independent central bank. A strong case can instead be made for a long maturity structure to reduce interest-rate risk and, more importantly, the risk of default. The maturity of the debt is a key variable to assess the vulnerability of the government fiscal position and should deserve greater attention in debt sustainability analysis. Finally, we compare the theory of fiscal insurance to the debt managers’ practice of minimizing the cost and risk of the interest expenditure. A concern forthe cost of debt service is justified only if expected return differentials between debt instruments are determined by mispricing, market imperfections or liquidity, but not if higher risk premia reflect a fair price for insurance. Our analysis points to the danger of minimizing the interest expenditure over a short horizon as may happen in times of crisis, when the government strives to achieve budget balance. More generally, fiscal insurance cannot be evaluated using national accounts figures, such as the interest expenditure and the book value of the debt. The lack of a more theory-based accounting framework is indeed a major obstacle to optimal debt management