What Does “Proper Public Debt Management” Mean in the Presence of Derivatives?
Because Mexico had issued large amounts of short term tesobonos that could not be rolled over in the aftermath of the devaluation, subsequent analyses have pinpointed improper public debt management as a major cause of the crisis. The consequent policy prescription has been to restructure the public debt to longer maturities in a modern version of the nineteenth century British prescription for virtuous public debt management—’’all consols-no bills.”
The example of the tesobono swaps, however, indicates that such a prescription can easily be circumvented. Even in the case of the relatively short term tesobonos, the yield apparently was not sufficient to encourage foreign lenders to hold Mexico risk. Only the income-hungry Mexican banks wanted to hold the risk and were willing to accept the yields on tesobonos that were unacceptable to foreign lenders. Thus, vis-a-vis the rest of the world, the Mexican national balance sheet was a borrower of call dollars through the tesobono-tesobono swap operation. The tesobonos canceled out, and the sudden calls on the Mexican banking system to deliver dollars to restore margin were equivalent to calls to deliver official reserves so.
Suppose that instead of tesobono issues, the Mexican government had structured its debt by issuing ten-year peso or even dollar denominated bonds. Foreign buyers, even more reluctant to absorb these issues than to absorb tesobonos, would have required very high yields. Mexican banks, however, proved that they would have been willing to take the risk at lower yields.
Again, they would have entered into swaps that converted these long term claims against the Mexican government into short term, perhaps callable dollar claims against the national balance sheet.
If the foreign lenders view of the risks is that they warrant only short term lending, a prescription to lengthen the debt is an irrelevancy. Even if it is undertaken on-balance sheet, it will be undone off-balance sheet.
Of course, if the government is strongly committed not to bail out the banking system, the construction of a national balance sheet is irrelevant; tesobono risk or the risk of government securities with any particular features would then be priced properly by the domestic banks, and their dollar margin requirements would not be met by the central bank. The public debt could then be truly lengthened, if that is desirable.