Governments selling debt on the markets

NIMAN

We have been hearing a lot of talk in recent years of the cost of auctioning bonds by the likes of Ireland, Spain and Italy to get money in to run themselves.

I was wondering how does this actually work?

OK so I gather that is Spain sells €4bn of debt they will obviously have to pay back more as its at a rate of say 4%.

So if they use that €4bn they got in, it lasts only a certain time, then they will have to sell more in the future. But in the meantime they have to budget to pay back that €4bn + interest.

Obviously the more debt a country sells off the more interest it has to pay back. Its always playing catchup.

Is this not just pushing countries further and further into debt? Or am I missing something?

Victor

NIMAN wrote: »

I was wondering how does this actually work?

Let us say a government (or other borrower) wants to raise money. It is looking for €1,000.

1. In any given auction, the exact details will vary. Some debt will be for months, most of it for a few years, some decades. Often, funds will be for a fixed duration, others will be variable, e.g. the government might offer you a 5% return on a bond that expires between 2022 (10 years) and 2025 (13 years). Every year it will pay you €50 (5% of your €1,000) and at the end of the term pay you back your €1,000. If they hold on to it for the full 13 years, you get the extra three €50 annual payments. If, in 10 years time borrowing money is cheap, the government will try to pay you back as early as it can (this was common in the 1999-2007 era).

2. Some bonds will work on a short fixed term, with no interest payable in the duration.

3. Given the times we live in, some lenders might take a jaundiced view and will look for a good return. They offer to give the government €900 now, in exchange for receiving €1,000 in a year's time. This would give them an 11.1% return ((€1,000/€900)-1). The government might baulk at such a high price.

4. Other lenders, hungrier to get a return, might offer €950. This would give them an 5.2% return ((€1,000/€950)-1). The government might snap at such a price and take any funds it can at this price. This might make lenders look for a better return.

5. Now, you can have a combination of the two (1 and 2-4) concepts above. The government might offer 5% over 10 years.

6. Some people will offer more, some less. Given that here will likely be many people willing to offer funds to governments and each will have different requirements, the exact rate will be set by the market.

---

NIMAN wrote: »

Obviously the more debt a country sells off the more interest it has to pay back. Its always playing catchup.

Is this not just pushing countries further and further into debt? Or am I missing something?

Not necessarily. Economies grow and sometimes governments run surpluses. The objective is to use the money for investment (better trained, healthier workers, improved transport, etc.), such that the economy runs more efficiently, so that the level of borrowing is kept as a sustainable level.

Where problems arise is when borrowing is unsustainable, such as they are now - the tax income is reduced, while current expenditures are increased, so investment is taking a big hit.

There is the matter of the economic cycle - it is useful for government to increase taxes and reduce non-essential expenditure in boom times and vice versa in bad times. However, they often get this wrong.

During our boom, banks borrowed money abroad, loaned it to Irish people and businesses, who all too often spent it on imported goods (cars, TVs, building materials, cocaine, ...), including invisible imports like foreign holidays and imported labour (foreign workers sending money home). The government imposed taxes on these, but it can be argued, not enough.

NIMAN

Thanks for that informative reply. Although complicated for someone like me, a lot of it made sense.

noodler

Just to follow Victor's informative post with an example:

http://www.ntma.ie/business-areas/funding-and-debt-management/debt-profile/historical-information/

You will see on that chart there that Ireland debt to GDP ratio in 1990 was 94.5% but fell to around 25% by 2007.

You can also see that the actual nominal (or euro) value of the debt didn't really change at all, its just that the economy expanded greatly (GDP increased massively) as Ireland 'caught up' with other economies.

The problem with Ireland's high debt this time around is that there will be no such growth like that in the near future (the catch up was a one-off event).

NIMAN

NIMAN wrote: »

Obviously the more debt a country sells off the more interest it has to pay back. Its always playing catchup.

Is this not just pushing countries further and further into debt? Or am I missing something?

Just a point on the above. The amount that a country pays on its debt is a function of the expectation that it will pay it back, so Germany can actually issue tbills (short term debt ~3ms or so normally) at negative rates, which means that people are actually paying money to Germany to be given their debt (sounds mad, but what this signifies is that the market believes that a German tbill is actually safer then putting their euros into a bank).

So, if Ireland gets 5bn away at 4% for 5 years, but over the life of the bond, we fix our fiscal imbalances, we can get the next 5bn away at 2%, so we could actually borrow more and end up paying less interest then we did on the smaller amounts, so when the markets think a country is a sound credit risk, the cost of borrowing will be very low allowing you to borrow more.

Don't forget though, that when a country borrows, it does so to invest in itself (generally), so borrowing 5bn should lead to a return on those funds. If the return is greater then the cost of borrowing, we are 'in the money' and can borrow more next time around. Therefore, if a country has good economic growth and a cheap market funding, it isn't actually playing catch-up.

However, economic growth and credit ratings are highly, positively correlated so in the good times, funds are cheap (when you don't really need them as your economy is growing nicely) but during the bad times (and we are in severely bad times) credit is expensive yet this is the time that we actually need it the most.

You can see some corporates managing this (Ryanair do, I believe) as they pile up cash reserves during the boom times and use this to fuel investment during the 'bust' times. Therefore, the cost of their investment is cheaper (so they get a better return on their investment) and they actually grow while other companies shrink. Ideally, a government would do something similar, but in reality, this isn't popular with voters, especially in this country.