Improving Public Debt Management
In the OIC Member Countries
180
Furthermore, development and economic aid grants may be subject to constraints regarding
prespecified investment projects, thereby limiting the government’s policy space (see Panizza
2010). Therefore, in order to increase spending flexibility, it might be beneficial to increase the
share of debt held domestically. However, domestic debt tends to be more expensive than
external debt in developing countries. Insufficient transparency or a challenging political
environment increases the interest rates when governments turn from external (concessional)
financing to domestic debt financing.
Some countries may consider converting or rolling over Eurobonds into longterm domestic
currency liabilities, preferably in close cooperation and communication with their
international partners. Such a changeofstrategy could help in establishing muchneeded
domestic accountability channels to replace the weaker external accountability channels
resulting from a streamlining of conditionality of international financial institutions. The key
challenge here is resolving the time inconsistency problem associated with nominal debt
contracts. However, this may be innovatively resolved by allocating a share of the bonds for
civil servants as part of a civil service pay increase.
(3) Domestic borrowingDomestic debt markets are an important source of financial funding for governments. A wellfunctioning domestic market for public debt helps to reduce the risks linked to public debt,
because it provides additional diversification opportunities. For domestic creditors it is easier
and less expensive to buy sovereign bonds if they are traded on the domestic market. Domestic
creditors, in turn, are a source of funding that reacts less to global market conditions and may
be less volatile than external sources. The domestic debt market might be strengthened by e.g.
improving legal and regulatory frameworks, promoting market infrastructure, maintaining
political stability and developing a predictable public debt management. Low and stable
inflation rates as well as an independent central bank may help to keep savings in the domestic
financial market. A high share of securities in the total domestic debt sector and a high share of
fixed vs. floating bonds usually describe a good quality of the domestic bond market (see also
Abbas und Christensen 2010).
Some OIC member countries are heavily indebted in the domestic banking sector. High interest
rates on government debt and preferences for safe lending reduce the incentives of banks to
provide credit to the private sector in these countries, leading to a crowdingout of bank loans
to the private sector. Since banks manage only a limited amount of savings, buying government
debt decreases their liquidity which otherwise could have been used to finance domestic
investment via credits to local firms or consumers. Banks tend to invest in shortterm
instruments to avoid asset and liability mismatches with shortterm bank deposits. This
increases interest rate risks and refinancing risks of the government’s debt portfolio.
When a substantial part of public debt is held by domestic banks, a vicious link between public
finances and the banking sector exists: public default would damage the banking sector and
difficulties in the banking sector endanger government’s success in placing its bonds on the
domestic market. Given that the domestic investor base is often limited, access to foreign
investors helps to break the vicious link between domestic commercial banks and the public
sector.
A domestic creditor composition with a large share of nonbanking investors is favorable
(Christensen 2005, Abbas and Christensen 2010). The investors’ base can be broadened by
reforming the legal framework to grant pension funds, insurance companies and foreign
investors access to the domestic debt market (Christensen 2005, Maana et al. 2008, Panizza