Linking maturity structure of Government Debt with Private Debt

Robin Greenwood, Samuel Gregory Hanson  and Jeremy C. Stein of Harvard have written a superb insightful paper on the topic.

They analyse the maturity structure of government debt with private sector debt. The find that whenever government issues higher short-term debt, the private sector goes slow on short-term debt issuances as there is crowding out at short end of the yield curve. The private sector instead shifts to longer term debt.

What are the implications? They argue that we have seen in this crisis that large number of corporates had issues short-term debt. It was rolled over till times were good and when things went bad, they all fell like pack of cards. So they were not just leveraged but had a huge short-term debt position posing multiple problems.

Hence, to dissuade private sector from taking large short term debt positions, govt should issue more short term papers.

There is a nice interview of Greenwood which helps understand the findings (and also helps skip reading the paper!!)

HBS Working Knowledge: Why did you decide to study the maturity structure of government debt?

Robin Greenwood: We have some earlier research on the determinants of corporate borrowing. In that work, we noticed that the maturity structure of corporate debt responds strongly to changes in the maturity of government debt. So when the government issues longer-term debt, for example, corporations back off and issue short-term instead. We called this “gap-filling,” in the sense that firms fill in the gaps created by government financing policy. In that paper, we had thought about government maturity policy as exogenous, largely in the background.

But we ultimately realized the implications of our findings, which is to say that the government could actively influence the corporate sector’s borrowing decisions by shifting its own financing between T-bills and bonds.

Why should we care about how the private sector finances itself? It is becoming increasingly appreciated that financial institutions in the past ten years have relied excessively on short-term financing. The investment bank Lehman Brothers, for example, collapsed because it could not roll over its short-term financing. More broadly, if we think about the financial sector, most people agree that the financing of large financial intermediaries put the larger financial system at risk. Once you recognize this, it’s easy to argue for more regulation, but regulation is difficult, particularly when banks have figured out ways to shift their financing off-balance sheet.

This is where our “gap-filling” idea comes in–the government can dissuade firms from issuing short-term debt by simply making it less attractive to do so. It can accomplish this by issuing more short-term debt (T-bills), raising the yields on short-term debt relative to long-term debt. Once we recognized the potential for government debt maturity policy to have an impact on private sector financial decisions, we became interested in government debt maturity more generally, and the end result is this paper.

Did it help in crisis?

Q: During the financial crisis, the government issued an enormous amount of new debt, and dramatically changed its maturity structure. Does your paper have anything to say about that?

A: Yes. During the early days of the financial crisis, the private sector’s ability to create short-term, money-like claims became significantly impaired. This required a simple government response: expand the supply of riskless short-term bills. Such reasoning seems to have been borne out in Treasury policy during the height of the financial crisis, when the U.S. Treasury issued $350 billion of short-term bills within a week of Lehman Brothers’ failure, as part of the “Supplementary Financing Program.” The proceeds from this program were lent to the Federal Reserve, which in turn bought long-maturity assets. Following the abrupt shortening, government debt maturity quickly reverted to normal levels in 2009. Thus, when the financial sector’s ability to produce money-like securities disappeared, Treasury quickly ramped up its issuance of money-like claims. However, as the anticipated debt burden grew, concerns about rollover risk eventually trumped the desire to cater to money demand, and maturity structure was once again lengthened. So we think our paper provides a useful framework for thinking about policy, both past and future.

Superb stuff. One usually gets to read papers which look at funding pattern of corporates (called capital structure), But this linkage of government debt structure with private sector is quite insightful.

One could try and replicate the study elsewhere as well.In India, government debt maturity structure can be studied, but we do not have the same kind of data for private sector bonds. Some bit of data can be compiled from NSE and FIMMDA but is going to be a task. The Government borrwoing program has been very large in last 3 years. It has been a mix of short term T-Bills and long term government bonds. So, by looking at the overall funding term, we should be able to come out with some kind of hypothesis.

One Response to “Linking maturity structure of Government Debt with Private Debt”

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