The Market for Government Debt

In advanced economies, governments fund their financing needs by issuing securities. The amount issued within a given year has to cover the deficit of the year and the reimbursement of debt coming to maturity.

Debt securities can be either short-run (Treasury bills, for example with a three-month or a one-year maturity) or long-run (government bonds, up to a 50-year maturity).

The interest rate paid on debt is usually fixed. It can also be variable: in particular, some countries issue inflation-protected bonds (the return of which is indexed on inflation).

In advanced countries, the average maturity of public borrowing typically lies between 5 and 10 years, but it is somewhat shorter in the United States and longer in the United Kingdom.

Governments in advanced countries generally borrow in their domestic currency, while those of emerging countries with less-developed financial markets often borrow in US dollars and, to a lesser extent, in euros.

Foreign currency borrowing may be cheaper but carries an exchange rate risk since the repayment is heavier if the home currency depreciates.

Its repayment is also made riskier due to the material impossibility for the central bank to act as a lender of last resort to the government (the central bank only lends its own currency).

Government bonds are traded by investment banks and eventually purchased by institutional investors such as asset managers and pension funds which manage household savings, insurance companies, central banks, and sovereign wealth funds.

Governments are usually considered more solvent than any private agent and the interest rate that they pay on their debt is thus considered as the risk-free interest rate, on the basis of which all financial securities are valued.

However, not all governments are equal, and their borrowing costs depend on their credit quality; that is, the likelihood assigned by investors that they will remain able to repay their debt in full.

Investors often rely on the assessments provided by rating agencies, independent institutions which evaluate the creditworthiness of borrowers. A government’s borrowing rate includes a risk premium that depends on its rating and compensates the bond holder for the risk incurred.

Central banks typically hold treasury bonds as one of the counterparts of money; they buy (or accept as collateral in repurchase agreements) government securities from banks in exchange for providing them with liquidity.

This mechanism differs from an outright monetization of the deficit to the extent that the government does not mandate the central bank to buy these securities. Amounts bought by independent central banks derive from monetary rather than fiscal policy considerations.