CHAPTER 2

Government Debt Policy Trends in 2009

The slowdown in the world economy combined with the financial rescue packages led to a surge in government borrowing requirements. At the be ginning of 2009 considerable uncertainty still characterised the finan cial system, causing concern as to whether the market would be able to absorb the increased supply of government bonds without yields rising strongly. Against that background, government debt management offices increased the flexibility of their issuance strategies.

The uncertainty in the financial markets and increased risk aversion among investors meant that government bonds were still in demand. How ever, investors took a more selective approach to investment, which widen ed spreads between government issuers. Risk aversion among in vest ors led to concentration of issuance in short-term government se cur ities.

Conditions in the financial markets improved during the spring, re flect ing accommodative monetary and fiscal policies. Although govern ment borrowing requirements were adjusted further upwards, gov ern ment debt management offices no longer paid a premium when open ing new series, and issuance was once again distributed more evenly across maturity segments. However, liquidity and price transparency in the secondary markets remained low.

Continued Financial Turmoil in Early 2009 2.1

The turmoil in the global financial markets culminated after the collapse of Lehman Brothers in September 2008. Governments in most countries introduced financial rescue packages in order to restore confidence in the financial system. The measures had an impact, but at the beginning of 2009 the financial system was still characterised by great uncertainty, leading to high volatility in the money and credit markets.

The financial rescue packages entailed a higher government issuance requirement, partly as a result of government capital injections into banks. Moreover, banks in many countries were given the opportunity to is sue bonds with government guarantees, which led to increased com petition to attract investors among high-rated issuers. The financial rescue packages gave rise to concern as to whether the market would be able to absorb the increased supply of bonds without yields rising strongly.

Uncertainty in the financial markets and increased risk aversion among investors meant that government bonds were still in demand as they are associated with low risk. This was one of the reasons why government bond yields for most euro area member states remained low in early 2009, cf. Chart 2.1.1.

10-year government yields	Chart 2.1.1
Note: Yields adjusted for maturity differences. Source:: Bloomberg.

Larger country differences in financing conditions
Owing to the widespread uncertainty, international investors took a more selective approach to investment, and yield spreads between government issuers widened. Investors focused more on the creditworthiness of coun tries, including their levels of indebtedness and future budget deficits. In ad dition, investors were particularly interested in liquid government securities, cf. Box 2.1.

Widening of yield spreads to germany	Box 2.1
The special status of German government bonds as a result of their high liquidity is illustrated in the Chart below. The Chart shows that in the period when the financial turmoil peaked, the yield spread between German and French government bonds widened considerably. This is primarily attributable to liquidity differences between French and German government bonds. If the widening of the yield spread had been attributable to a change in credit risk, the spread between German and French government-guaranteed bonds would have increased correspondingly. However, this spread remained more or less constant during the peak turmoil.
10-year yield spreads between french and German bonds
Note: Average for 31 days. Government-guaranteed securities are illustrated by the spread between Cades and KfW. Source:: Bloomberg.

More flexible issuance strategies
In early 2009, investors focused on reducing the risk on their portfolios. This meant that demand was concentrated on government bonds with short maturities. Against that background, borrowing requirements were to a large extent financed by issuing T-bills and short-term bonds, cf. Chart 2.1.2. The more flexible issuance strategies also meant that more government securities were issued outside the key on-the-run issues, and various issuance methods were used. In addition, auctions were held more frequently and adapted to market conditions.

Issuances in the euro area of government securities	Chart 2.1.2
Note: Short-term borrowing primarily covers issuances with maturity up to one year. Source: ECB Statistical Data Warehouse (sdw.ecb.europa.eu).

Due to accommodative monetary policies and focus on government issues in the short-term maturity segment, borrowing requirements were met at low rates of interest. However, issuance in bonds with short maturities meant that the refinancing risk increased. Refinancing risk was in focus among rating agencies due to the turmoil in the financial markets and prospects of large budget deficits.

Issuance premiums to attract investors
The concentration of demand on government securities with short ma tur ities entailed that government debt management offices paid an issuance premium for long-term government securities around the turn of the year in order to attract investors, cf. Chart 2.1.3.

Opening premiums on 10-year government bonds	Chart 2.1.3
Note: Opening premiums are calculated as differences in asset swaps between existing and new securities. Observations from Belgium, Denmark, France, Germany and The Netherlands are included. Source: Bloomberg.

In addition, increased volatility in the market for government securities meant that in a few instances at the beginning of the year it was difficult to obtain sufficient demand at auctions and when issuing syndicated loans. As market conditions improved from the 2nd quarter onwards, issuance premiums normalised and volatility in government bond yields stabilised at a lower level, cf. Chart 2.1.4.

Volatilities in german 2- and 10-year government yields	Chart 2.1.4
Note: Annualised volatility. Standard deviation for a 60-day period. Source: Bloomberg.

Improvement of Financial Markets From the 2nd Quarter 2.2

Higher risk appetite among investors and lower volatility in the financial markets meant that the markets for government securities improved in the 2nd quarter. As the markets picked up, most yield spreads to Germany nar rowed. The improved sentiment in the government bond market spread to other bond markets, such as mortgage bonds and corporate bonds. The increased risk appetite caused the spread between govern ment bonds and corporate bonds to narrow, cf. Chart 2.2.1.

Yield spread between european corporate and government bonds	Chart 2.2.1
Note: Spreads indicate the difference between the yield of European corporate bonds with various credit standing and the yield of European government bonds. Source: Bloomberg.

Upward Adjustment of Borrowing Requirements 2.3

A stronger-than-expected contraction of the global economy led to the introduction of not only financial rescue packages, but also fiscal stimulus packages in a number of countries in the 1st half of 2009. Against that background, borrowing requirements were adjusted upwards in mid-2009, cf. Chart 2.3.1.

net Government borrowing in OECD countries	Chart 2.3.1
Source:OECD statistics, SourceOECD (www.stats.oecd.org).

The estimated borrowing requirements for 2009 and the coming years were adjusted upwards, but nevertheless the improved conditions in the mar kets for government securities meant that government debt manage ment offices became less concerned about whether they would be able to cover their borrowing requirements than they had been at the beginning of the year.

Lower risk aversion among investors led to a broader distribution of de mand for government securities across maturities. Against that back ground, government debt management offices returned to more trans par ent and normal issuance strategies focusing on building up issues in key benchmark segments.

In spite of the increasing borrowing requirement, central-government financing costs remained low, also reflecting central banks' extraordinary monetary-policy measures.

Focusing on secondary markets
The improvements in the primary markets in the 1st half of 2009 were not reflected in the secondary market to the same extent. Liquidity in the secondary market was still considerably lower than before the financial tur moil, and consequently activity on electronic trading platforms was also lower, cf. Chart 2.3.2.

Average daily turnover on three European MTS platforms	Chart 2.3.2
Source: www.MTSData.com.

To support liquidity in the secondary markets, a number of countries have introduced new market-making requirements that automatically adapt to changing market conditions, cf. Chapter 12. These requirements are based on market making by primary dealers relative to each other.

Outlook for 2010
At the beginning of 2010, conditions in the markets for government se curities are significantly better than one year ago. This is to a large extent at tributable to monetary- and fiscal-policy initiatives. However, there is con siderable uncertainty linked to a roll-back of the expansionary monetary and fiscal policies. If these policies are rolled back too late, fear of a debt spiral and inflation may push up interest rates. On the other hand, if they are rolled back too early, the economy and the financial markets may, once again, come under pressure.