"The overall strategy is more important than individual instruments"

Researchers and practitioners discuss the benefits and strategies of public debt management at Goethe University

The debt management of the public sector is a recurrent topic of discussion. The federal and the state governments of Germany (Bund und Länder) use financial products like derivatives to hedge against interest rate risks. If the interest rate develops differently than expected, this can potentially lead to losses. Therefore, there are already some callings for a ban on derivative financial products for public debt management. On 27 May 2019, at an event of the LOEWE Center SAFE researchers discussed with representatives from politics and practice at Campus Westend of the Goethe University Frankfurt how efficient public debt management should look like.

Thomas Schäfer, State Minister for Finance in Hesse, said that the primary objective of public debt management is to ensure the solvency of the state at all times. Three aspects are of great importance for the strategic orientation of Hesse's debt management. "The future must be calculable", said Schäfer. According to him, government programs run continuously and must remain financially viable without the tax burden changing significantly over time. Secondly, a debt strategy could only be assessed ex-ante – and not with information that was only available later. Thirdly, the portfolio could only be assessed as a whole. "The overall strategy is more important than individual instruments," said Schäfer.

Less leeway for the federal government

Tammo Diemer, Managing Director of the German Finance Agency and thus responsible for financing the federal government of Germany, emphasized the conflict of objectives between cost-effective financing and planning security. Compared to 30-year federal bonds, short-term debt instruments with a two-year maturity are very inexpensive, he said. With this option, however, the federal government would have to refinance itself after expiry, with uncertain financing conditions. In each financial year, Germany reissues about 18 percent of its debts, Diemer said. The result of the conflict of objectives is a product portfolio that is optimally diversified: in addition to the five standard bonds (with maturities ranging from six months to 30 years), the federal government also uses financing instruments as inflation-linked bonds and interest rate derivatives, which would make a valuable contribution to greater diversification of the debt portfolio. In addition to costs and planning security, the federal government must also take into account that all relevant maturities in the issuance calendar are used sufficiently to keep them liquid. Besides, the Finance Agency could not use certain insurance products strategically: "We are failing because the market is too small for such transactions," Diemer said.

From an academic perspective, this kind of products would indeed make sense, explained Alfons Weichenrieder, Professor of Public Finance at Goethe University. In a closed economy, the public sector's risk of increasing interest rates is at the same time the citizen's opportunity of rising interest rates as an investor. Nevertheless, according to Weichenrieder, it is advantageous to smooth out both the tax burden and government expenditure over time. This is economically more beneficial than increasing or decreasing the tax rate depending on financing requirements, he said. Furthermore, according to Weichenrieder, the state should incur less debt in low-interest phases.

Christian Schlag, Professor of Derivatives and Financial Engineering at Goethe University, emphasized that the right methodological approach is necessary to assess a strategy ex ante, i.e. at the time of the decision. Therefore, various scenarios with all conceivable interest rate paths would have to be simulated. Based on the model-based simulations, debt managers could then derive a strategy from the distribution of opportunities and risks, said Schlag. With regard to public debt management, Schlag recommended making the decision for a particular strategy more accessible to the public and thus verifiable.