Please ce hs paper as: Blommesen, H. J. and A. Hubg (2012), A Crcal Analyss of he echncal Assumpons of he Sandard Mcro Porfolo Approach o Soveregn Deb Managemen, OECD Workng Papers on Soveregn Borrowng and Publc Deb Managemen, No. 4, OECD Publshng. hp://dx.do.org/10.1787/5k9fdwrf5rvj-en OECD Workng Papers on Soveregn Borrowng and Publc Deb Managemen No. 4 A Crcal Analyss of he echncal Assumpons of he Sandard Mcro Porfolo Approach o Soveregn Deb Managemen Hans J. Blommesen, Anja Hubg JEL Classfcaon: E52, E58, E62, H63
A crcal analyss of he echncal assumpons of he sandard mcro porfolo approach o soveregn deb managemen H.J. Blommesen and A. Hubg JEL Classfcaon: E52, E58, E62, H63
OECD WORKING PAPERS ON SOVEREIGN BORROWING AND PUBLIC DEB MANAGEMEN OECD Workng Papers on Soveregn Borrowng and Publc Deb Managemen provde auhorave nformaon on echncal and polcy ssues n he area of publc deb managemen (PDM) and governmen secures markes. Sudes rack closely srucural ssues, rends and challenges n governmen deb polces and markes. opcs nclude pressng governmen deb polcy ssues such as he measuremen of soveregn rsk; how o conan he cos of governmen borrowng operaons; he use of elecronc sysems; soveregn asse and lably managemen (SALM); lqudy of markes n governmen deb; advances n rsk managemen; he role of dervaves n PDM; lnkages beween PDM and moneary polcy and he role of deb managers n prcng and managng conngen lables. hese sudes are prepared for dssemnaon among soveregn deb managers, fnancal polcy makers, regulaors, fnancal marke parcpans, rang agences, and academcs. By provdng nformaon on hs hghly specalsed feld of governmen acvy and polcy, papers am o smulae dscussons among a wder audence as well as furher analyss. he seres can be searched n chronologcal order or by heme. OECD WORKING PAPERS ON SOVEREIGN BORROWING AND PUBLIC DEB MANAGEMEN are publshed on www.oecd.org/daf/publcdebmanagemen
Absrac A CRIICAL ANALYSIS OF HE ECHNICAL ASSUMPIONS OF HE SANDARD MICRO PORFOLIO APPROACH O SOVEREIGN DEB MANAGEMEN hs paper examnes he analycal underpnnngs of he sandard mcro porfolo approach o publc deb managemen (PDM) ha ams a mnmsng longer-erm cash-flow based borrowng coss a an accepable level of rsk. he sudy concludes ha wo echncal key assumpons need o hold for he sandard mcro porfolo approach o yeld opmal (.e. cos-mnmsng) resuls. We argue ha hese assumpons do no hold n he curren borrowng envronmen characerzed by fscal domnance wh complex lnks beween PDM and moneary polcy (MP). By usng he prncples of porfolo heory we demonsrae ha n hs borrowng envronmen, cos-rsk opmaly requres he use of a broader cos concep han employed n he sandard mcro porfolo approach. hs new concep (referred o as effecve borrowng coss) ncorporaes no only he cash flows of he deb porfolo self, bu also hose relaed o prmary borrowng requremens. he resulng broader cos measure ncludes herefore he neracons wh he budge. Fnally, he paper demonsraes ha he sandard cos-rsk framework of he mcro porfolo approach s nesed whn hs new, broader cos concep. JEL codes: E52, E58, E62, H63 Key words: Governmen borrowng, moneary polcy, cenral banks, fscal polcy, soveregn deb, publc deb managemen, soveregn rsk
A CRIICAL ANALYSIS OF HE ECHNICAL ASSUMPIONS OF HE SANDARD MICRO PORFOLIO APPROACH O SOVEREIGN DEB MANAGEMEN By Hans Blommesen 1 and Anja Hubg 2 ABLE OF CONENS A CRIICAL ANALYSIS OF HE ECHNICAL ASSUMPIONS OF HE SANDARD MICRO PORFOLIO APPROACH O SOVEREIGN DEB MANAGEMEN... 4 1. Inroducon... 5 2. he analycal roos of he sandard mcro porfolo approach... 6 3. echncal condons underlyng he mcro porfolo sraegy... 8 4. Emprcal valdy of echncal assumpons of he sandard mcro porfolo approach... 11 4.1 Evaluaon of assumpons under normal (non-crss) condons (World 1)... 12 4.2 Evaluaon of echncal assumpons under crss condons (World 2)... 13 5. Concludng remarks... 15 ANNEX: Deducon of he key echncal assumpons ha underpn he sandard mcro porfolo approach... 17 erms and defnons... 17 Decsons under uncerany and rsk... 18 Lmaons of he sandard mcro porfolo approach... 19 Effecve borrowng coss... 20 BIBLIOGRAPHY... 22 1 2 Hans J. Blommesen s Head of he Publc Deb Managemen and Bond Marke Un, OECD. he vews expressed are personal ones and do no represen hose of he nsuons wh whch he auhor s afflaed. Emal address; hans.blommesen@oecd.org Correspondng auhor. Emal address: anja.hubg@gmx.de. Anja Hubg s a Docoral canddae a he School of Busness and Economcs a he Humbold Unversy of Berln (Insue for Bankng and Asse Markes). 4
A CRIICAL ANALYSIS OF HE ECHNICAL ASSUMPIONS OF HE SANDARD MICRO PORFOLIO APPROACH O SOVEREIGN DEB MANAGEMEN 1. Inroducon here s a consensus among OECD deb managers ha he prmary sraegc objecves or funcons of governmen deb managemen are 3 : (a) securng connuous (and easy) access o markes, whle (b) mnmsng longer-erm borrowng coss a an accepable level of rsk. hese sraegc cos-rsk objecves consue he bass of he so-called sandard mcro porfolo approach o publc deb managemen (PDM). he recen global fnancal and economc crses, however, have rggered a growng debae on he need for makng possble changes n hs sandard sraegc mandae of PDM. hs polcy debae s also nformed by he (poenal) mplcaons of new and complex neracons beween publc deb managemen (PDM), moneary polcy (MP) and fnancal nsably n he face of serous fscal vulnerables, a perceved ncrease n soveregn rsk and consderable uncerany abou fuure neres raes [denoed as fscal domnance n urner (2011), Blommesen and urner (2011), a suaon ha s lkely o las for he foreseeable fuure]. Alhough boh hese neracons and fscal domnance are he resul of (or were revealed durng) he global fnancal crss and s afermah, srucural changes n (or feaures of) he new fnancal (and busness) landscape may be addonal srucural reasons why some of hese new complex lnks are lkely o perss. hese developmens, n urn, have changed sgnfcanly he polcy envronmen for deb managemen offces (DMOs), cenral banks (CBs) and fscal auhores (FA) 4. he sze of he balance shees of CBs has been expanded sgnfcanly whle her composon has been radcally changed 5. he use of unconvenonal moneary polcy has creaed (poenal) conflcs and new neracons beween MP, PDM and fscal polcy (FP). Several analyss and polcy makers have argued ha governmen deb managers should be more aware of, and/or ake explcly no accoun, he broader (macro) mpac of her polcy decsons on he economc polcy mx and he fnancal sysem as a whole. Several auhors have used hs perspecve as bass for suggesng a revson of he convenonal (mcro porfolo) mandae o PDM, ncludng urner (2011), Hoogdun e al. (2011), Sur e al. (2010) and Goodhar (2010). Agans hs complex, mul-faceed borrowng background, he paper wll address he core queson as o wha exen a concepual reformulaon of he sandard mcro porfolo approach o PDM s needed. In hs conex, we wll focus on he followng specfc quesons relaed o he underlyng echncal assumpons of he mcro porfolo approach: (.) Under whch echncal condons or assumpons s he sandard mcro porfolo approach o PDM an opmal one n he sense ha effecve borrowng coss 6 are ndeed mnmsed subjec o a saed preferred level of rsk? 3 4 5 6 See for furher deals Blommesen (2002), Krener (2002) and oher conrbuors n Deb Managemen and Governmen Secures Markes n he 21 s Cenury, OECD. PDM and fscal polcy are closely lnked, boh from an nsuonal pon-of-vew and from a polcy perspecve and [Blommesen and urner (2011)]. See Ben S. Bernanke, he Federal Reserve's Balance Shee: An Updae, Speech a he Federal Reserve Board Conference on Key Developmens n Moneary Polcy, Washngon, D.C. Ocober 8, 2009. he concep of he cash-flow measure based on he sandard borrowng coss of he soveregn lably porfolo assocaed wh he sandard mcro porfolo approach dffers from a wder measure referred o n hs paper as effecve soveregn borrowng coss. he laer concep s furher explaned n secon 3 and he annex. 5
(.) Do hese echncal (opmaly) condons reman vald n a suaon of susaned fscal domnance, mperfec asse subsuably, and he (paral) loss of rsk-free asses? Our analyss denfes wo echncal key assumpons for he sandard mcro porfolo approach o publc lably managemen o yeld opmal (.e. cos-mnmsng) resuls. In hs conex we also demonsrae ha he sandard cos-rsk framework of he mcro porfolo approach represens a specal case of a general framework assocaed wh an alernave (.e. broader) cos measure based on porfolo heory. he underlyng reasonng demonsraes under whch condons may be desrable o ake a broader vew of cos and rsk han he measure mpled by he sandard mcro porfolo approach o soveregn lably managemen. We shall refer o hs broader measure as effecve soveregn borrowng coss. In essence we show how he use of hs broader measure of soveregn borrowng coss (ha explcly encompasses neracons wh he budge) may be a poenally effecve response o he complcaons assocaed wh suaons of fscal domnance 7. he paper s srucured as follows. Secon 2 provdes a dealed analyss of he analycal underpnnng of he sandard mcro porfolo approach, hereby demonsrang ha hs approach has mporan smlares wh he behavour of prvae fnancal nsuons guded by mcro-economc prncples. By comparng he mcro porfolo approach o well-esablshed asse managemen pracces n secon 3, we are n he poson o deduce he wo key echncal assumpons of he cos and rsk framework assocaed wh he sandard mcro porfolo approach. In secon 4, we closely examne each of hese echncal condons. In dong so, we evaluae he mplcaons of he fnancal-cum-soveregn deb crss for he sandard mcro porfolo approach. o ha end, we are makng an explc dsncon beween normal ( non-crss ) perods and more challengng crss suaons. Our analyss shows ha n a suaon of fscal domnance 8 he sandard mcro porfolo approach does no yeld opmal, cos-rsk resuls. he fnal secon 5 concludes and oulnes he nex seps n our research programme. 2. he analycal roos of he sandard mcro porfolo approach he mcro porfolo approach currenly pursued by mos governmen deb managers s refleced n he basc funcons of PDM (securng marke-based fnancng a lowes cos subjec o rsk preferences). he organsaon of publc deb managemen has undergone major changes n he 1990s, reflecng he move o a mcro porfolo approach o PDM. 9 Deb managemen operaons have been delegaed o separae operaonally auonomous uns (DMOs 10 -- Deb Managemen Offces) somemes ousde he 7 8 9 As noed, hs reflecs a suaon wh challenges and ensons n soveregn deb markes, where polcy makers are facng serous fscal vulnerables, a rapd ncrease n soveregn rsk and consderable uncerany abou fuure neres raes. Characersed by crcal publc deb raos, percepons ha he rsk-free asse condon has been weakened as well as mperfec asse subsuably along he yeld curve he ransformaon process was accompaned by broad fnancal secor deregulaon, produc nnovaons (esp. dervaves) and growng demands by nvesors as well as rapdly ncreasng deb levels combned wh a growng volaly n neres and exchanges raes, callng for a sophscaed porfolo based rsk managemen, as explaned by Blommesen and urner (2011, pp. 8-11). See also Wheeler (2004, pp. 2-9). 6
Mnsry of Fnance (MoF), albe subjec o he polcy responsbly of he MoF. 11 A crucal feaure of hs nsuonal se-up s he separaon beween PDM and fscal polcy on he one hand, and moneary polcy (for whch ndependen cenral banks are responsble) on he oher 12. DMOs operae as professonal and predcable marke players sckng o basc marke rules, hereby supporng lqud and ransparen marke for governmen secures. As a resul of hs nsuonal se-up, an acve suppor by PDM for broader macroeconomc objecves, such as was common n he 1950s and 60s and whch enaled an acve use of he deb porfolo srucure n he conduc of macroeconomc polces, has los ground. 13 Insead, he adopon of a mcro porfolo approach enals a narrow focus on cos and rsk arges drecly lnked o he soveregn deb porfolo. hs mples ha DMOs execue ssuance and fundng sraeges based on a clear se of rules guded by mcro-economc prncples 14. hese prncples are summarzed as he sraegc objecve o mnmse longer-erm borrowng coss a an accepable level of rsk. I should be noed ha he objecves mnmsng borrowng coss and managng he assocaed rsks canno be seen n solaon from each oher. Maures are he man componens or feaures o manage he cos and (neres-rae) rsk profle of he soveregn deb porfolo. 15 he shorer he average erm o maury of he deb porfolo, he more frequenly refnancng a new marke condons wll be necessary. hus, porfolos wh a larger share of shor-erm fnancng nsrumens are subjec o a hgher level of neres-rae rsk han hose wh a larger share of longer-erm nsrumens. On he oher hand, consderng he commonly observed upward-slopng yeld curve, longer maury secures provde on average hgher yelds han shorer-erm secures. In oher words, he basc PDM sraegy enals he need o manage a cos/rsk rade-off n srucurng he (opmal) deb porfolo. 16 In hs conex, we wll refer o he underlyng concepual framework as he sandard mcro porfolo approach o soveregn lably managemen and argue ha here are mporan analycal 10 11 12 13 14 15 16 he generc erm DMO ncludes no only deb managemen enes ha operae ousde he MoF, bu also deb managemen uns whch are a par of he MoF or a cenral bank, as noed by Kalderen and Blommesen (2002, p. 101). A more comprehensve reamen of he ransformaon process, and also of he role and srucure of DMOs s gven by Kalderen and Blommesen (2002, pp. 109-133). Afer all, hs was one of he reasons for he change n he nsuonal se-up n he 1990s. See Kalderen and Blommesen (2002, p. 110) wh furher references. Han (2004, pp. 113-131) provdes a hsorcal overvew of macroeconomc approaches o PDM (mosly n he 1950s and 1960s), whch n parcular nvolved he use of he maury srucure of governmen deb o nfluence marke neres raes and he level of economc acvy. Mos noable are he sudes of Smons (1944), Musgrave (1959), Rolph (1957) and obn (1963). See also Wolswjk and de Haan (2005, pp. 7 f.) wh addonal remarks on convenonal macroeconomc deb managemen objecves (such as macroeconomc and defc sablsaon as well as ax smoohng). hs s also refleced n he organsaonal srucure of he DMO, resemblng ha of a prvae secor fnancal nsuon, ncludng a fron offce and a back offce and a mddle offce (n parcular for he formulaon of he deb sraegy and rsk managemen funcons). In alerng he cos/rsk profle of deb porfolos, DMOs also make use of neres rae swaps. hese dervave nsrumens enable he governmen o opmse he rsk srucure of he deb porfolo srucure, whle smulaneously proceedng wh a demand-drven ssuance sraegy focused on lowes possble borrowng coss [ see, for example, Daube (2009, p. 79)]. See also Rsbjerg and Holmlund (2005, p. 41) and Bolder (2003, p. 4). he UK DMO provdes an nsghful analyss of he Prncples and rade-offs When Makng Issuance Choces; see OECD (2011). 7
smlares wh asse managemen (allocaon) conceps. 17 Specfcally, boh he mcro porfolo managemen of soveregn lables and he prvae asse (or nvesmen) managemen requre makng decsons under condons of uncerany regardng: (a) he (opmal) srucure of a deb (or nvesmen) porfolo, whch nvolves (b) he opmsaon of he mcro cos (or reurn)/rsk relaonshp, by akng no accoun (c) he exsng porfolo (wh lables or asses) and nohng else. Pon ( c ) mples ha he prmary budge balance s reaed as an exogenous varable n he sandard mcro porfolo approach. Hence, he level of deb s largely deermned by changes n he prmary budge balance. he budgeary balance, reflecng he sance of fscal polcy, consues herefore exogenous npu for smulaons assocaed wh he soveregn deb sraegy (whle paymens for servcng he deb are endogenous). Hence, whn he conex of he analycal framework of he sandard mcro porfolo sraegy, here s a clear funconal separaon beween publc deb managemen and fscal polcy, whle he publc deb managemen sraegy s also funconally separaed from moneary polcy. Consequenly, such an nsuonal se-up mples ha publc deb managemen s n prncple no negraed no he convenonal macro-economc framework. In secon 4 we wll dscuss wheher hs s an approprae approach. 3. echncal condons underlyng he mcro porfolo sraegy In order o denfy he key echncal assumpons assocaed wh he curren cos and rsk framework of publc deb managemen, we wll ake a closer look a he underlyng mcro porfolo managemen sraegy. In essence, a long-erm deb managemen sraegy s broadly smlar o passve prvae nvesmen or asse managemen sraeges (based on he prncples of porfolo heory for managng he rsk/reurn relaonshp 18 ). Insead of replcang a broad marke bond ndex as n a passve asse managemen sraegy, he approach used n sraegc governmen deb managemen s o follow a predefned benchmark porfolo 19 (reflecng he long-erm cos and rsk preference) as closely as possble. he PDM sraegy s characersed by rsk-averson and dversfcaon, hereby mrrorng he spr of rsk opmsaon n passve bond porfolo sraeges. hs usually nvolves also he mplemenaon of a buyand-hold sraegy 20. here are, however, also subsanal dfferences beween sraegc governmen deb managemen and a prvae asse or nvesmen managemen sraegy. A publc deb managemen sraegy: 17 18 19 20 However, we wll also show ha here are fundamenal dfferences beween soveregn lably managemen and asse managemen. he prncples of porfolo heory, nroduced by Markowz (1952, 1959), were furher developed by Sharpe (1964), Lnner (1965) and Mossn (1966) n he Capal Asse Prcng Model (CAPM), whch became he smples sandard for measurng rsk and reurn. Mos governmens wh well-developed fnancal markes, esablsh sraegc porfolo benchmarks o gude he long-erm managemen of her deb porfolo [Jensen and Rsbjerg (2005, pp. 64 f.) and IMF and Worldbank (2001, p. 129)]. A passve nvesmen sraegy mples ha acve radng on marke vews wll no ake place. he counerpar of a buy-and-hold sraegy n deb managemen can be vewed as holdng deb o maury, alhough hese sraeges mgh nclude (accal) buy-back operaons and he use of swaps [see, for example, Rsbjerg and Holmlund (2005, p. 50) and Jensen and Rsbjerg (2005, p. 64)]. 8
(a) focuses on medum-o long-erm borrowng coss vs. shor-erm marke value consderaons n case of prvae asse or nvesmen managemen; (b) canno manan a rsk-free poson (a soveregn deb porfolo s always exposed o changes n neres raes 21 due o he need o underake refnancng acves); (c) requres he formulaon of expecaons abou he evoluon of neres raes (no mplc n curren marke prces) over a longer-erm horzon. 22 Consequenly, DMOs need o alor he analycal bass of passve prvae nvesmen or asse managemen sraeges o her specfc suaon. In shor, DMOs use sophscaed porfolo and rsk managemen echnques, n parcular smulaons of deb sraeges based on a sochasc framework for he developmen of key rsk measures (especally neres raes). 23 Neverheless, sraegc deb managemen can o an mporan degree be consdered as he mrror mage of an exended or adaped form of passve porfolo managemen. For hs reason, sraegc PDM, frmly based on he prncples of porfolo heory 24, s prmarly concerned wh he mcro opmsaon of he porfolo srucure based on he cos (reurn)/rsk relaonshp. We wll use hs nsgh o denfy he key echncal assumpons of he sandard mcro porfolo approach o PDM. Porfolo heory s assocaed wh he followng core assumpons: 25 Core assumpon 1: Raonal fnancal decson makers ha ac as rsk-averse expeced uly (or wealh) maxmsers. Core assumpon 2: Perfec or effcen capal markes mplyng perfecly compeve markes 26 ha are frconless 27. Clearly, he frs assumpon can easly be appled o publc secor decsons such as publc deb managemen snce hey are also concerned wh he allocaon of scarce resources, hereby raonally weghng coss agans benefs 28. However, he second assumpon canno so easly be jusfed n he 21 22 23 24 25 26 27 28 he possble mplcaons of a more crcal percepon of soveregn rsk by marke parcpans and s mpac on neres raes s excluded here. However, we come back o hs parcular pon n secon 4.2. Oherwse would no be possble o defne or formulae an opmal long-erm fnancng sraegy (based on nformaon from observed marke prces). hs feaure subsanally dsngushes deb managemen from passve nvesmen or asse managemen sraeges because he laer do no requre he formulaon of marke expecaons regardng he acual developmen of neres raes. See for a comprehensve reamen of deb sraegy smulaons Rsbjerg and Holmlund (2005). hese auhors dscuss also he sandard analycal framework for governmen deb and rsk managemen. See for a smlar vew Jensen and Rsbjerg (2005, p. 66). For a rgorous reamen of hese assumpons, see Fama, 1972, esp. pp. 189 214 (expeced uly maxmzaon) and p. 21 (noon of perfec or effcen capal markes). Where he prces of secures conan all avalable nformaon whle hey are aken as gven by buyers, sellers and ssuers of secures. hs n urn mples nfnely dvsble secures, no ransacon coss or axes, whle nformaon s cosless and avalable o everybody. See, for example, Fugu and Wlcox (1999, esp. pp. 35-42) who provde a comprehensve reamen of cos-benef analyss for publc secor decson makers. 9
publc secor. Governmens have consderable marke power, especally n he marke for governmen secures. hs means ha he prce-aker assumpon needs o be furher scrunzed. We wll reurn o hs parcular pon n he nex secon. In addon o hese wo core assumpons, here s anoher, specfc feaure of he sandard mcro porfolo approach o PDM. As noed, PDM reas he prmary budge balance as exogenous snce fscal polcy s funconally separaed from publc deb managemen. hs mples ha he key opmsaon parameers only refer o he ousandng deb porfolo. he OECD Borrowng Oulook 29 makes a polcy dsncon beween fundng sraegy and borrowng requremens. he oal cenral governmen markeable gross borrowng needs are calculaed on he bass of budge defcs (he oucome of fscal polcy decsons ha deermne he prmary borrowng needs) and redempons. he fundng sraegy of DMOs enals decsons on how oal borrowng needs are gong o be fnanced usng dfferen nsrumens (e.g. long-erm, shor-erm, nomnal, ndexed, ec.) and dsrbuon channels. In sum, oal borrowng requremens, and he assocaed fundng sraegy, are n par ndependenly deermned va he fscal sraegy of he governmen. In oher words, hey are n par exogenous for DMOs. For example, he fundng sraegy of DMOs may be nformed by he cenral governmen s preferences o enhance fscal reslence by seekng o mgae refnancng and rollover rsk 30. However, n parcular by reang he prmary budge balance as exogenous, he sandard mcro porfolo approach o PDM mples ha he neracons beween he deb porfolo on he one hand, and he budgeary poson 31 on he oher, are rrelevan for he sandard mcro porfolo opmsaon framework. In concluson, we have denfed he followng wo (relaed) echncal key assumpons ha drve he opmaly resuls of he sandard mcro porfolo approach o publc lably managemen: (1) echncal assumpon 1: he acons of he governmen (n parcular plannng and execung he fundng sraegy) have no mpac on he marke prces of governmen secures and he erm srucure of neres raes derved from hem (prce-aker assumpon). (2) echncal assumpon 2: he budgeary poson and he deb porfolo are sascally ndependen from each oher (zero dependency or correlaon). hese 2 assumpons or condons are relaed o each oher and need o be sasfed n order for he mcro porfolo approach o PDM o yeld opmal cos-rsk choces, as explaned n deal n he annex. If hey do no hold, decsons based on he assocaed cash flow cos measures do no lead o he same resul as decsons aken on he bass of presen value (or marke value) consderaons derved from porfolo heory. More specfcally, our analyss mples ha cos-rsk opmaly (n he porfolo heorecal sense) can only be acheved f we broaden he cos-rsk perspecve of he sandard mcro porfolo approach by ncludng no only he cash flows assocaed wh he deb porfolo self, bu also hose relaed o prmary borrowng requremens. In hs way, a drec lnk s esablshed beween he deb porfolo (wh s composon deermned by he underlyng fundng sraegy) and he governmen s capacy o servce va 29 30 31 See OECD Soveregn Borrowng Oulook 2012 (forhcomng). See Annex A of OECD Soveregn Borrowng Oulook 2012. he budgeary poson encompasses all publc expendures and revenues mnus he deb servcng paymens, as measured by he prmary budge balance (or prmary borrowng requremens). 10
fuure budge surpluses. he man objecve can hen be formulaed as o mnmse he ne burden of he deb porfolo (as measured by he presen value of he ne fscal poson 32 ) gven a desred level of rsk, va he choce of he fundng sraegy of DMOs. hs adjused fundng perspecve corresponds o he mnmsaon of he effecve neres coss assocaed wh he governmen s ne fscal poson. 33 Clearly, hs oal effecve borrowng cos measure s broader han he sandard borrowng cos measure 34 because, as explaned, also capures he (poenal) mpac of he DMO fundng sraegy on he prmary borrowng requremens of he budgeary poson over he plannng horzon. hs n urn mples ha he sandard mcro porfolo approach represens a specal case of a more general framework based on he oal effecve borrowng coss assocaed wh he ner-emporal fscal poson. 4. Emprcal valdy of echncal assumpons of he sandard mcro porfolo approach Afer havng denfed he wo key echncal condons supporng he sandard mcro porfolo approach, we wll analyse n hs secon her emprcal valdy. o ha end, wo general suaons wll be explored. In world suaon one (World 1 for shor) we have n mnd he normal 35 crcumsances such as hose ha exsed n he wo decades or so pror o he 2008-2009 crss: low volaly and srong lqudy n fnancal markes (ncludng governmen secures markes), prmary dealers wh srong balance shees and excellen capacy o make markes, relavely low borrowng coss, moderae governmen borrowng requremens, low soveregn rsk 36, perfec or hgh asse subsuably across maures, and low or moderae governmen deb levels. he frs key queson can hen be formulaed as follows: consues he sandard porfolo approach wh s creron of mnmsng he long-erm borrowng coss subjec o rsk (usng he cash flows assocaed wh he porfolo of exsng and planned governmen lables) an adequae bass for he soveregn deb and fundng sraegy n World 1? Specal aenon wll be pad n hs conex o he praccal mplcaons for DMOs of he assumpon of exogenous prmary borrowng requremens. World suaon wo (World 2 for shor) represens crss condons, n parcular serous fscal vulnerables, a perceved ncrease n soveregn rsk and consderable uncerany abou fuure neres raes. 37 Anoher feaure of he curren crss suaon are he (poenal) mplcaons (for he underpnnng 32 33 34 35 36 37 he ne fscal poson of he governmen equals he ne presen value (NPV) of all cash flows. hs means ha we ake no accoun he cash flows of boh he exsng (and he planned or expeced) fuure soveregn deb porfolo and hose assocaed wh he prmary borrowng requremens. Noe ha he porfolo of governmen lables does no only nclude he sock wh already ssued secures, bu also hose ha wll be ssued n he fuure (.e. over he lfe me of hs porfolo). See for furher deals he annex. he mahemacal dervaon of hs and also he sandard cos measure s gven n he annex. As noed, hs s he measure assocaed wh he sandard mcro porfolo approach (based on he cash flows of he deb porfolo self). hs saemen s no as sraghforward as seems. I has been argued ha hese crcumsances were no normal (herefore he use of expressons such as he Grea Moderaon) and ha, ndeed, hey lad he bass for asse bubbles and macroeconomc mbalances ha ulmaely rggered he Grea Crash [see Blommesen, Hoogdun and Peeers (2009); Blommesen (2010)]. We wll gnore hs complcaon and smply assume ha he wo decades or so pror o he crss represen he normal condons for PDM. We refer here o percepons of low (or hgh) soveregn rsk whou gong no he complcaons assocaed wh he fac ha here are que dfferen vews on wha exacly soveregn rsk s (see Blommesen, H. J., Guzzo, V., Holland, A., Mu, Y., 2010). Denoed as fscal domnance n urner (2011), Blommesen and urner (2011). 11
of he sandard mcro porfolo approach) of new and complex neracons beween publc deb managemen (PDM), fscal polcy, moneary polcy (MP) and fnancal nsably wh (ulra-)hgh borrowng coss. 4.1 Evaluaon of assumpons under normal (non-crss) condons (World 1) he normal condons of World 1 are characersed by low or moderae governmen defcs and deb levels (mplyng susanable deb levels and percepons of low soveregn rsk) and well-funconng lqud deb markes wh effcen access by DMOs o borrow funds a normal ( rsk free ) coss. Under World 1 condons publc deb managers alhough hey (and cenral bankers) have poenally subsanal marke power can be reaed as prce-akers. However, hs presupposes a specfc nsuonal se-up of DMOs and cenral banks. In many counres, he core of hs nsuonal arrangemen consss of nsuonally ndependen cenral banks wh srong an-nflaon mandaes and operaonally auonomous DMOs. I was furher assumed ha poenal polcy conflcs beween moneary polcy and soveregn deb managemen could be avoded by followng wo separably prncples 38 : Cenral banks should no operae n he markes for long-daed governmen deb, bu should lm her operaons o he blls marke. Governmen deb managers should be guded by a mcro porfolo approach based on cos-mnmsaon mandaes, whle keepng he ssuance of shor-daed deb o a pruden level. In World 1, hese nsuonal arrangemens and prncples convenenly smplfed he lves of polcymakers n cenral banks and deb managemen offces. More mporanly, cenral banks and DMOs were judged as beng farly successful n execung her respecve mandaes. Moreover, hey allowed each nsuon o be held accounable for her dsnc mandaes. And hey provded consderable nsulaon from shor-erm polcal pressures. In such an envronmen, governmen deb managers do no (need o) moblse her power o move markes. Insead, DMOs ac as professonal and far marke players (largely by followng he marke rules of prvae fnancal nsuons). In addon, he drec neracons beween DMOs and cenral banks (seng moneary polcy condons and conrollng neres raes 39 ), are mnmal. Hence, n he non-crss condons of World 1, publc deb managemen acves can be expeced o have a mnmal mpac on marke prces (and, hence, on he yeld curve derved from hem). Moreover, gven exogenous prmary budge balances (known wh cerany), he frs echncal precondon ha acons of he governmen have no mpac on he yeld curve, s ceranly me n he sandard mcro porfolo approach. he dependence beween echncal condons 1 and 2 mples ha also he second condon of zero correlaon beween he budgeary and he deb poson s vald 40. Hence, n World 1, he sandard porfolo approach mnmses longer-erm borrowng coss (beng equvalen o mnmsng he NPV 41 of he deb porfolo) and herefore provdes n prncple an approprae bass for he soveregn fundng sraegy. 38 39 40 41 See Blommesen and urner (2011) for a comprehensve dscusson In World 1, shor-daed and long-daed nsrumens are close subsues and conrol of he overngh neres rae s suffcen for CBs o affec he near end of he yeld curve (Blommesen and urner, 2011). hs feaure follows drecly from reang he prmary borrowng requremens as an exogenous varable n he sraegc framework for fundng and deb managemen. NPV = ne presen value. 12
4.2 Evaluaon of echncal assumpons under crss condons (World 2) he prevous secon shows ha n normal crcumsances he neracons beween he budgeary and he deb posons are assumed o be neglgble. hs assumpon s clearly no vald n crss perods wh hghly volale governmen secures markes wh fscal domnance perods and soveregn balance shees very vulnerable for shocks. In ha case, a soveregn asse-lably managemen (SALM) approach becomes more mporan. Pu dfferenly, he more lkely ha he srucure of he governmen deb porfolo may help n provdng an effecve proecon of he soveregn balance shee agans possble shocks, he more mporan an negraed managemen of soveregn asses and lables becomes. Moreover, SALM 42 s closely relaed o (he macro-economc objecves of) ax smoohng and budge sablsaon 43. Bu even ousde he framework of an negraed managemen of he balance shee has o be acknowledged ha boh he budge and soveregn deb poson are bascally drven by he same macroeconomc varables (nflaon, GDP and economc growh). hs perspecve pu pressure on mananng he zero-correlaon assumpon even n perods ha canno be classfed as exreme crss perods 44. World 2 condons are assocaed wh a srucurally reshaped moneary, fnancal and fscal envronmen, noably fscal domnance characersed by hgh deb levels, a more crcal percepon of he underlyng soveregn rsk (leadng o a weakenng / loss of he rsk free rae assumpon) and, assocaed wh hese feaures, greaer uncerany abou he (fuure) developmen of neres raes. In World 2, he acons of governmen deb managers may become a crcal elemen n he overall conduc of macroeconomc polcy 45. For hese reasons we wll ake a closer look how World 2 condons mgh affec he key echncal assumpons underlyng he sandard mcro porfolo approach. Frs, he prce-aker assumpon s unlkely o hold n World 2, alhough prce-makng may no be he nenon of deb managers. However, under less lqud and hghly volale marke condons, marke operaons by he DMO ( a very large player vs-à-vs he marke) may lead o de faco shfs n markes 46. Moreover, also sraegc decsons (n parcular abou he poron of shor-erm vs. long-erm borrowng amouns) may have a sgnfcan mpac on relave marke prces of governmen secures and, 42 43 44 45 46 SALM s concerned wh he managemen of he overall rsk exposure of he enre soveregn balance shee, comprsng fnancal asses (manly ax-payng capaces) and fnancal lables (governmen deb porfolo). See also Rsbjerg and Holmlund (2005, pp. 42 f.) and Blommesen and Koc (2007). hese heores are focused on lowerng he varably of he budge balance, hereby avodng flucuaons n ax raes n responses o economc developmens. Such a polcy framework s welfare-mprovng because changes n ax raes may creae economc dsorons. See he early conrbuons by Barro (1979) and Mssale (1997). More recen conrbuons nclude Mssale (2011), Bernasch e al. (2009), Faragla e al. (2008,2010), Lusg e al. (2008), Nosbusch (2008), Bacchocc and Mssale (2005), Buera and Ncoln (2004), Barro (2003), Angeleos (2002). Neverheless, reang he prmary budge balance as an exogenous varable known wh cerany may be a good sarng pon for deb sraegy smulaons under farly normal marke condons. As noed by Rsbjerg und Holmlund (2005, p. 48), a general lesson from buldng smulaons models s o sar ou smple and gradually expand he model (e.g. allowng for he sochasc modellng of he budge balance). Such an approach, however, s ceranly no approprae n World 2. hs s he reason why several auhors sugges a revson of he convenonal or sandard mcro porfolo approach, ncludng Hoogdun e al. (2011), Sur e al. (2010), Goodhar (2010) and Blommesen and urner (2011). Also he accumulaed (borrowng) effecs of DMOs are lkely o conrbue o a mes sgnfcan marke moves. 13
as a resul, nfluence he shape of he yeld curve 47. hs also apples o deb levels havng reached a crcal lm (e. g. 90% of GDP and above 48 ), whch could pu an upward pressure on neres raes (due o ncreased supply and crowdng-ou effecs) and a downward pressure on economc growh. In such an envronmen and n spe of he separaon of mandaes publc deb managemen and moneary polcy may sar o have a drec nfluence on each oher. 49 he man reasons are decreased subsuably along he yeld curve and he exsence of llqud and dysfunconal marke segmens, whch may hamper he moneary ransmsson process. As a consequence, he cenral bank s use of he overngh rae o conrol he shape of he yeld curve n order o nfluence economc acvy becomes less effecve. 50 A he same me, purchases and sales of governmen bonds by CBs become more effecve. However, by shfng her emphass from he shor end o he longer-erm segmen of he yeld curve, he moneary auhores nevably nerac drecly wh governmen deb managemen decsons. hese operaons also change he maury of governmen bonds n he hands of he publc. 51 DMOs (and he fscal auhores) need herefore o have greaer awareness ha her operaons may also affec economc acvy hrough new and a mes complex nerdependences wh moneary polcy measures. 52 Fnally, he percepon ha soveregn rsk has ncreased and he assocaed weakenng of he safe (or rsk free) asse assumpon has resuled a mes n a sgnfcan cred rsk premum mplc n he yeld curve for governmen secures. hrough hs new channel, acual and expeced changes n soveregn lables (or changes n fscal polcy) can drecly affec he erm srucure of neres raes. hs may also enal conagon o hrd counres, n parcular among counres whn a moneary unon 53. Furhermore, changes n percepons abou soveregn rsk may be ransferred o he holders of he governmen deb whn and across borders (n parcular by affecng he balance shees of fnancal nsuons 54 ). hs mples ha he neracons beween he deb porfolo and he budgeary poson need o be ncorporaed n he analycal framework of publc deb managemen. Pu dfferenly, he second echncal assumpon needs o be dropped. he prevously descrbed lnk beween fscal polcy (refleced n he prmary budge balance) and he developmen of neres raes needs o be aken no consderaon whn he smulaon framework of he deb sraegy (for example, va specfc macro-economc /fscal scenaros). Moreover, hgh deb levels (e.g. above he crcal level of 90%) drecly feed back no he governmen s 47 48 49 50 51 52 53 54 See Blommesen and urner (2011, pp. 16). Based on an emprcal sudy, ncorporang daa on 44 counres and coverng he me perod 1946 o 2009, Renhar and Rogoff (2010, p. 577) demonsrae ha across boh advanced counres and emergng markes, hgh deb/gdp levels (90% and above) are assocaed wh consderably lower growh. See also he more recen BIS sudy by Cecche e al. (2011). See Blommesen and urner urner (2011, pp. 19-30) and also Hoogdun e al. (2010, pp. 15-17) for addonal deal. For he same reasons, publc deb managemen operaons become more effecve. In hs conex, he ncreasng use of shor-erm borrowng by governmen deb managers o secure addonal fundng durng he global fnancal crss s vewed crcally. See, for example, Blommesen and urner (2011, pp. 26 f.) and Hoogdun e al. (2010, p. 2). Shor-erm ssuance has he same effec as moneary expanson, and herefore mgh complcae he conrol of he polcy rae by he moneary auhores. As argued by urner (2011, pp. 5 f). See Blommesen and urner (2011, pp. 28-30). For example, rang changes n counry X may have a sysemc mpac on oher counres, even when he laer counres are no formally downgraded; for example, n he form of hgher fundng raes. See also Hoogdun e al. (2010, pp. 14 f). 14
fscal poson due o ncreasng deb servcng coss. In exreme cases, hs chan of evens may lead o a negave deb-defc spral. o preven hese negave feedback suaons, he governmen needs o manan conrol over he rsks assocaed wh he enre balance shee. hs can be accomplshed by usng a SALM approach, because, as noed, n hs way polces can be denfed o nsulae n par or fully he fscal poson agans supply and demand shocks. In sum, he wo key echncal assumpons underpnnng he sandard mcro porfolo approach o publc deb managemen do no hold n World 2. Mcro-opmsaon of cos and rsk usng he sandard approach would resul n fundng decsons ha are subopmal. We beleve ha he followng World 2 condons wll reman n force for a consderable perod of me: (a) hgh deb raos, (b) percepons of elevaed soveregn rsk levels, and relaed o hs, (c) greaer uncerany abou fuure neres raes, accompaned by crcal neracons beween publc deb managemen and moneary polcy. 5. Concludng remarks Alhough he sandard mcro porfolo approach o publc deb managemen has worked well for a long me, rapdly changng condons assocaed wh he curren perod of fscal domnance has promped a major re-hnk of he underlyng framework. Our paper draws he followng man conclusons: a) he wdespread use of he sandard mcro porfolo approach s assocaed wh governmen deb managemen havng become a dsnc dscplne, operaonally ndependen, and guded by ransparen mcro-economc prncples and rules, whch seeks o ensure ha he governmen s able o secure he requred fundng a lowes possble coss subjec o a preferred or accepable level of rsk. he sandard approach s well-anchored n he prncples of porfolo heory. b) he underlyng core objecve o mnmse longer-erm (cash-flow based) borrowng coss a an accepable level of rsk leads o opmal fnancng decsons, provded he followng wo key echncal assumpons hold: 1. Acons by he governmen (ncludng he execuon of s borrowng and fundng programme) have no mpac on marke prces of governmen secures and he erm srucure of neres raes derved from hem (prce-aker assumpon) and 2. he budgeary and deb posons are sascally ndependen from each oher (zero dependence or correlaon) c) he denfcaon of hese wo key echncal assumpons allows us o make a dsncon beween: World 1: Normal (non-crss) perod. Mnmsng sandard cos measures (.e. cash-flows based on he borrowng coss of he soveregn lably porfolo as n he sandard mcro porfolo approach) yelds opmal resuls. World 2: Crss perod (fscal domnance). Mnmsng sandard cos measures leads o sub-opmal resuls. More specfcally, volaons of assumpons 1 and 2 are caused by crcal publc deb raos, percepons ha he rsk-free asse condon has been weakened as well as mperfec subsuably along he yeld curve. Especally he weakenng and (paral) loss of he rsk-free asse condon has profound 15
mplcaons. In reponse, we sugges o mnmse a broader cos measure so as o acheve opmal resuls durng crss perods. Wha are he praccal mplcaons of hese conclusons for PDM? he answer s less sraghforward han one would perhaps hnk. On he one hand, can be noed ha he sandard borrowng cos measure can be drecly nfluenced by he deb manager hrough he choce of he fundng sraegy. On he oher hand, we have shown ha when World 2 condons deermne he borrowng envronmen, hen we may need a broader cos objecve for ensurng opmal fundng decsons 55. However, he adopon of a broader borrowng framework may also have mplcaons for he curren nsuonal se-up. Clearly, he pros and cons of any nsuonal change need o be carefully examned so as o avod mplemenaon decsons ha may carry oo much rsk. We wll assess carefully hese nsuonal ssues n follow-up research. 55 I was also shown ha he cos/rsk objecve of he sandard mcro porfolo approach s nesed whn hs broader borrowng framework ha uses a cos concep ha ensures opmal fundng decsons n World 2. 16
Annex: Deducon of he key echncal assumpons ha underpn he sandard mcro porfolo approach erms and defnons Our analycal framework s based on he projecon of all fuure cash flows assocaed wh he deb porfolo over he lfe me of hs porfolo 56. hs mples ha we do no only nclude he cash flows of he governmen deb secures porfolo self, bu also ake no accoun he relaed cash flows of prmary borrowng requremens of he soveregn (whch comprse all oher publc expendures and revenues (excludng deb servcng paymens) 57. We assume (a) a fne me horzon or nerval 0, for he deb porfolo and (b) a sarng dae of he deb porfolo ha concdes wh he begnnng of he evaluaon dae ( 0 ); hs means ha here are no cash flows o be aken no accoun before he evaluaon dae. Key varables wll be defned as follows: 0 sarng dae of he deb porfolo end of he lfeme of he deb porfolo (represens he pon n me where governmen deb has been compleely repad) NPV ne presen value (NPV) of he deb porfolo a me NFV ne fuure value (NFV) of he deb porfolo a he end of he me horzon a me C accumulaed borrowng coss over he me nerval 0, Cf 0,,Cf 0,, ncludng cash flows from prmary and secondary marke operaons (paymens receved hrough ssung or sellng governmen secures, paymens made for purchasng or redeemng secures and neres paymens on secures) as well as neres paymens on swaps. cash flows of he deb secures porfolo over he me nerval B B cash flows assocaed wh prmary borrowng requremens; hs represens he 0,, 1 dfference beween revenues and publc expendures (excludng deb servcng paymens) n he me nerval ; when he cash flow s posve he balance can be used o repay deb and 0, 1 when s negave he balance ndcaes new borrowng 58. 56 57 58 hs assumpon mples ha all governmen deb wll be compleely repad. hs assumpon can be relaxed by allowng for a consan deb level from some pon of me n he fuure. hs analycal framework s very smlar o he one used for he evaluaon of fnancng decsons n longerm nvesmen projecs of corporaons such as he fnancng of new machnery or a new plan, ndusral projecs, envronmenal projecs, ec. hs fnancng framework s also referred o as capal budgeng and deals wh he allocaon of nernal and exernal resources among poenal nvesmen projecs wh a long-erm me-horzon. Noe ha only he borrowng requremen cash flows up o one perod before he end of he horzon (ha s, up o me 1 ) are relevan for our analyss. 17
R fnal deb repaymen cash flow (ncludng prncpal and accumulaed neres) a he end of he horzon r deermnsc rsk-free dscoun rae; only applcable under condons of cerany (he f gven rae a whch an eny can freely borrow or, alernavely, nves) z z, sochasc neres rae for he me perod characerscs o he correspondng zero-coupon neres rae, comparable n s rsk Z for ha me perod E expecaon operaor condonal o he nformaon se avalable a me. Decsons under uncerany and rsk Under condons of uncerany we have o accoun for he fac ha he forecasng process for cash flows s mperfec (subjec o error). Fuure varables are herefore characersed by a probably dsrbuon wh possble oucomes. In hs framework he dsperson (or varably) of unexpeced oucomes funcons as a measure of rsk (forecasng error) 59. Assumng ha he underlyng rae of reurn z 60 evolves n a sochasc (non-deermnsc) fashon hrough me, he expeced ne presen value (NPV) can hen be wren as: 1 z z NPV E Cf e B e E (1) 0 0 Governmen deb managemen s bascally concerned wh he fnancal burden (or cos) of he deb porfolo for fuure generaons. For hs reason he ne fuure value (NFV) a he end of he horzon of he deb porfolo a me s of crucal mporance for governmen deb polcy decsons. he NFV can be obaned by compoundng he NPV of hs porfolo over he me nerval, a he approprae dscoun rae (ha s, he sochasc neres rae z over he me nerval, ). he expeced NFV can hen be expressed as follows 61 : he expeced ne fuure value E NFV E z NFV E NPV e represens he expeced amoun of cash needed a me o repay he deb (ncludng prncpal plus accumulaed neres). hs wll be referred o as he expeced (2) 59 60 61 See Joron (2007, p. 75). hs rae of reurn wll be denoed as he neres rae z for he me perod, (wh z z, and ). I essenally reflecs he concep of he yeld curve, whch capures he relaonshp beween he rae of reurn Z Z, and s relaed me o maury. (.e. expeced by he marke on a zero-coupon bond held unl maury) In he corporae fnance leraure on capal budgeng he NFV of an nvesmen s usually referred o as he fuure (or ermnal) value of hs nvesmen; see, for example, Solomon (1969, p. 134), Hrshlefer (1970, p. 57) and Berman and Smd (1988, p. 19). See also Hansen and Moven (2007, pp. 589 f.). 18
fnal deb repaymen cash flow, denoed by E R. Now we are n he poson o deduce he followng key deb susanably condon 62 : NFV E R E R E NFV rf 0 E E NPV e (3) We shall use he NFV of he deb porfolo o formulae a cash-flow based cos measure. Frs, he NFV s decomposed no wo componens 63 : NFV Prncpal Accumulaed Ineres (4) sumof borrowngrequremens borrowngcoss Second, he neres of he deb porfolo accumulaed over he perod, wll be referred o as borrowng coss and denoed by C (.). Expeced borrowng coss can hen be expressed as: E z C E NFV B E NPV e 1 0 1 B (5) 0 We can conclude from he equaons (1), (2) and (5) ha he NPV, he NFV and expeced borrowng cos creron C(.) do no necessarly yeld he same resuls. he mplcaons of hs concluson for he concepual underpnnng of he sandard cos concep assocaed wh he sandard mcro porfolo approach are furher explored below. Lmaons of he sandard mcro porfolo approach As explaned n secon 3, he sandard mcro porfolo approach s based on a sraghforward applcaon of cos (reurn n he case of asses) and rsk measures from porfolo heory. hese measures, however, are calculaed from presen value fgures and do no represen cash-flow based coss (or revenues). Snce he sandard mcro porfolo approach o PDM nvolves he mnmsaon of cash-flow based borrowng coss (subjec o rsk consrans), NPV (equaon 1) and he sandard cos creron needs o be equvalen n order for he soveregn deb sraegy o be enrely conssen wh he underpnnngs of porfolo heory. For hs o be he case, we need, frs, o place he expecaons operaor E before each varable. Secondly, he cash flows flows Cf of he deb secures porfolo and he borrowng requremen cash B have o be sascally ndependen from each oher (zero dependence or correlaon). Equaon (2) can hen be rewren as: E ~ ~ z z wh e E e z NFV E NPV e (6) Equaon (6) mples ha he expeced NFV equals he expeced NPV compounded a he deermnsc neres rae z~ for he me perod, (wh ~ z ~ z, and ). hs mples ha he decson measures NPV and NFV are also equvalen under uncerany. I should be emphassed, z hough, ha hs condon only holds f he expeced compound facor E e depends solely on he 62 63 Equaon (3) reflecs he key deb susanably condon ha he presen value of lables s no greaer han he presen value of asses (.e. he value of cash flows avalable o pay down he deb); see, for example, Gammarol e al. (2007, p. 5). See, for example, Berman und Smd, (1988, p. 19). 19
expecaons for he erm srucure of he (sochasc) neres raes z and herefore becomes sascally condonal on ha nformaon. hs n urn mples also ha he budgeary and ax decsons of he soveregn (fscal polcy for shor) have no mpac on he erm srucure of neres raes. Fscal polcy decsons ac as exogenous npu for he publc deb manager n he form of boh cash flow- based borrowng requremens B and cash flows Cf of he deb secures porfolo (deermned by he fundng sraegy). In oher words, s assumed ha B and Cf have no mpac on he erm srucure of neres raes (.e. echncal assumpon 1 n secon 3). Only n ha case, he expeced compound facor behaves z z deermnscally wh respec o ha condonal expecaon, so ha E e e ~. 20 A smlar reasonng apples wh respec o he expeced borrowng coss he expeced borrowng coss equaon (5) can hen be rewren as: E 1 ~ z C E NPV e E B 0 ndependen of hefundngsraegy E C n equaon (5). (7) Provded ha he cash flows B and Cf (deermned by he fundng sraegy) are sascally ndependen from each oher (zero correlaon, see echncal assumpon 2 n secon 3), he second erm 1 0 B E n (9) s equal for all fundng sraeges. In sum, when boh echncal assumpons hold, mn expeced NPV and mn expeced NFV are equvalen o mnmsng he expeced cash-flow based borrowng coss of he sandard mcro porfolo approach. Effecve borrowng coss We concluded ha n World 2 (a crss perod wh fscal domnance), he mnmsaon of sandard cos measures (.e. cash-flows solely based on he borrowng coss of he soveregn lably porfolo) leads o sub-opmal resuls. Insead, we sugges o mnmse a broader cos measure so as o acheve opmal resuls. hs means ha no only he cash flows of he deb porfolo self are ncorporaed, bu also he relaed cash flow-based borrowng requremens assocaed wh all oher publc expendures and revenues (summed up n he prmary budge balance). he resulng broadened cos measure referred o as effecve borrowng coss s equvalen o he NPV measure (see equaon (1)) and can hen be expressed as follows: eff Where C E NPV NFV eff z C E NPV e E denoes he expeced effecve borrowng coss accumulaed over he me perod,. I can be seen from equaon (8), ha our broadened borrowng cos measure represens he effecve neres coss assocaed wh he ne fscal poson (.e., he ne deb poson as measured by he NPV). Hence, he proposed new cos measure capures also he mpac of he fundng sraegy on he budge. In oher words, by focusng on he ne fscal poson, we esablsh a drec lnk beween he deb porfolo and he budge. (8)