11.2 Financing the psncr

Despite all of these possibilities concerning the relationship between the PSNCR,

interest rates and the rate of growth of the money supply, one view has dominated

the nancial world since the 1980s – that increased public sector decits cause either

interest rates to rise or the money supply to grow more rapidly. Higher interest rates

were assumed to reduce private sector investment and consumption; a higher rate of

growth of the money supply was assumed to increase the rate of ination. Thus, a

low or zero PSNCR became a major aim of economic policy. This was to a signicant

extent because of the market response to high PSNCR/GDP and high public debt/

GDP ratios. We have already seen one example of the effect of this market response

in relation to the scal policy of the UK government (see Box 11.2).

A major way in which the view of the nancial markets is imposed is through the

operation of the international credit-rating agencies. Their view of the seriousness of

a large public debt has led them consistently to lower the credit ratings of governments

with high public debt/GDP ratios. Whether this is justied is irrelevant. The simple

fact that the credit rating is lowered increases the interest rate such governments

must offer in order to sell their debt on international markets. We shall, however, see

an exception to this in Box 11.5, which looks at another problem caused for govern-

ments in the sale of their debt by the operation of nancial markets. Exercise 11.1

poses some questions on the contents of this box.

Box 11.5

Liquidity and the sale of government debt

The following extract comes from ‘Small countries pay for lack of liquidity’ by Arkady

Ostrovsky and Eric Frey on page 45 of the Financial Timesof 17 June 1999.

Size certainly matters, at least in the euro-zone government bond markets, as small countries

have discovered to their misfortune. It is a simple rule: the smaller the country, the higher the

premium it has to pay to entice investors to buy its government bonds.

Take Finland, for example, one of the most disciplined members of EMU. Its economy is

growing at a healthy 3.8 per cent, its debt to gross domestic product ratio is half that of Italy or

Belgium. It has the highest credit rating from two of the three agencies, yet its bond yields are

among the highest in the euro-zone. At 24 basis points over the German benchmark, Finland’s

yield spread is closer to Belgium, which has recently been downgraded because of its massive

debts, than to France with whom it shares the same rating.

Observers say small countries get penalised by the markets for the lack of liquidity. Since

the launch of the euro, which has eliminated foreign exchange risk, liquidity has become one of

the overriding factors in the euro-zone bond markets. Matt King, bond strategist at JP Morgan,

says that after the launch of the euro small countries lost some of the domestic investors who

swapped their investment into more liquid assets. Meanwhile, the weight of a credit rating in pric-

ing the bond has been signicantly reduced since many investors believe euro-zone countries

are virtually default-risk free.

According to Satu Huber, director of nance at the Finnish state treasury, only 3 per cent of

all international bond issues, excluding domestic issues, were larger than A2bn. Since the launch

of the single currency about a quarter of all international bond issues have exceeded that

magnitude. ‘When we launched our A2bn issue in May last year it was considered a large one,

now it is considered average,’ says Ms Huber. Last May, Finland was able to launch its 10-year

bond at a spread of about 10 basis points over Germany’s 10-year benchmark. It is now trading

at 24 basis points over Germany.

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Chapter 11 • Government borrowing and nancial markets

But Finland is not alone. Austria is also suffering from the lack of liquidity. Austria currently

pays a premium of about 20 basis points over the German bund for its 10-year government bond

issues solely because of lower liquidity for its debt, says Helmut Eder, director of the Federal

Financing Agency. ‘Our credit rating is the same as that of Germany, but our liquidity gives us a

natural disadvantage,’ he says. ‘If we were competitive in liquidity, however, we would lose our

AAA-rating.’ To improve liquidity, the Federal Financing Agency aims to create a certain critical

market volume for every maturity. ‘When the Republic issues a new bond, the market can be

assured that the volume of this maturity will eventually reach A5bn or A6bn,’ says Mr Eder...

What exactly is the nature of the problem?

Bonds issued for small amounts present two potential problems for their holders:

(a)	changes in demand will produce bigger price changes than would occur if the sup- ply were larger – thus, prices and yields are more volatile and the risk associated with holding the bond is greater;

(b)	bond holders wishing to sell the bonds at short notice will have less chance of obtain- ing an acceptable price than if the market were deeper.

It follows that bonds issued in small amounts are less liquid than those issued in large

amounts (see the denition of liquidity in Chapter 1), and a premium has to be paid on

small issues to persuade the markets to hold them.

Source: Financial Times, 17 June 1999

Exercise 11.1

Answer the following questions on the content of Box 11.5: (a)Why do many investors feel that eurozone countries are ‘virtually default-risk free’? (b)Convert 24 basis points into a percentage.

(c)	What happened between May 1998 and June 1999 to cause the spread over Ger- many’s ten-year benchmark of Finnish ten-year bonds maturing in 2008 to widen from 10 to 24 basis points?

(d)	Did the launch of the euro really eliminate foreign exchange risk?
(e)	Why do German bonds provide the benchmark?

(f)	Why would the Austrian government lose its AAA-credit rating if it became ‘com- petitive in liquidity’?

11.3	Attitudes to public debt in the European Union

Market attitudes also had a good deal to do with the Maastricht convergence condi-

tions for membership of European Monetary Union. Several prospective members,

notably Germany, felt the need to convince the nancial markets that the single

currency would be strong after the establishment of monetary union. This explains

the prohibition on the monetary nancing of government debt by the European

Central Bank (ECB); the requirement for membership of the monetary union of

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