Roulette with the Czech National Debt

"Your Move, Mr. Bond"

During the 2015-16 period of extremely low interest rates, when speculators were clamoring for Czech Crown denominated assets (betting on an appreciation of the currency once the currency cap ended), the Czech Ministry of Finance (MoF) focused on issuing short to medium maturity debt. While at the time, issuing shorter maturity debt seemed to have the advantage of receiving interest, rather than paying interest, there was a catch. It risked that a sudden rise in interest rates would make refinancing all that debt much more expensive.

With the subsequent rapid rise in Czech interest rates, following the end of the Czech National Bank's currency cap, the failure to lock-in low long-term interest rates, by issuing long-term debt, has proven an expensive blunder. This high risk strategy is likely to cost the Czech taxpayer billions of crowns in higher debt service payments over coming years when this short to medium-term debt matures and needs to be refinanced at today's much higher interest rates. Indeed, according to one analyst's estimate, debt-service costs could rise from CZK 39.9bn last year to CZK 52-60bn this year. While errors of judgement are understandable, it now appears that the Debt Management Dept., at the Czech Ministry of Finance (MoF), breached its own publicly stated risk limits. Once again, the MoF faces issues of accountability, transparency and effective oversight.

Quick Recap

During the period 2015-16, both short and long-term Czech interest rates reached historic lows: Monetary policy, especially the Quantitative Easing related purchases of bonds by central banks, in combination with the currency policy/cap in the Czech Republic, had artificially boosted demand for government bonds generally and for Czech bonds in particular. While most OECD countries took the opportunity to extend the maturity of their debt and lock-in exceptionally low financing costs, the Czech MoF took a gamble that short-term rates would remain low and focused instead on issuing short and medium-term debt at negative interest rates.

Missed opportunity: Shorter Dated Debt Issued Rather than 'Lock-in' Longer Dated Debt

Source: Bloomberg

Betting it ''All In'' on Continued Low Interest Rates

The risk that interest rates might suddenly rise, resulting in higher debt service payments, is known as interest rate risk. Interest rate risk is a concept familiar to anyone who has ever borrowed to buy a property. Homeowners know that they can often borrow at a lower interest rate that isn't guaranteed, or borrow at a higher cost with the rate guaranteed for a number of years. Most borrowers prefer to lock-in the cost of their debt to mitigate the risk of a sudden rise in interest rates. Indeed, Ceska Sporitelna recently noted that fixed-rate periods of eight, 10, 15 and 20 years now account for two-thirds of its new mortgages.

While the average Czech may take a cautious approach to interest rate risk, that hasn't been the case at the MoF's Dept Management Department. As at the end of 2016, the average maturity of the Czech Republic's debt was just 5.1 years, compared to an average among OECD countries of 7.8 years. Only Hungary and oil-rich Norway (which effectively has no debt) had shorter maturities. Almost all OECD countries, including countries which also had negative interest rates, e.g. Switzerland, used the historically low interest rate environment to extend, not shorten, the average maturity of their debt. As the graph shows, through 2015-mid 2017, 10 year debt could be issued at similar interest rates to 5 year debt.

''High Stakes'' Gamble leaves Legacy of Higher Debt Service Payments.

It may have made good political headlines to issue short and medium-term debt at a negative interest rates (Yes, to actually be paid for one's debt) but it was a huge gamble that interest rates would remain low/negative and wouldn't rise anytime soon. It was a gamble that went dramatically wrong in 2017 when the CNB lifted its currency cap and Czech interest rates rose at the fastest rate in Europe. When the short and medium-term debt issued in the 2015-17 period matures, and needs to be refinanced, the full impact of the current higher interest rate environment will be felt. With CZK1,735bn of debt, at YE 2018, the costs of this high stakes gamble, and related breach of risk limits, is likely to be in the order of billions of crowns: With the worst yet to come, as yet more of this short to medium-term debt needs to be refinanced. The short-term budgetary gains enjoyed during Mr Babis's tenure as Finance Minister will likely be dwarfed, over the long-term, by the subsequently higher debt service payments.

Casino Royale: When Andrey Babis was Finance Minister (1/2014 - 05/2017), the MoF gambled interest rates wouldn't rise by issuing shorter-maturity debt at 'negative rates'. It was a gamble that later went dramatically wrong.

Bond Girl: It is now apparent published risk limits were breached in 2018, when Alena Schillerova was Finance Minister.

Refinancing Risk Limits Breached

While errors of judgement are understandable, less comprehensible is the disregard for the MoF's own previously announced risk limits. In the MoF's Funding Strategy for 2016[1], it is stated while ''short-term deviation from established strategic medium-term limits and targets for risk parameters of debt portfolio for refinancing and interest risk is possible. However, the issuance in medium term-term horizon will be planned so that the targets and limits defined in this strategy will be fulfilled in [the] medium-term 2018 horizon.''

''For average time to maturity of the state debt, the target value of 6.0 years is stipulated for the 2018 medium-term horizon with the possibility of deviation of 0.25 years. The Ministry will consider achieving this medium-term target if favourable market conditions remain.'' Therefore, while the MoF would appear to have given itself some flexibility around achieving the target of 6 years, the risk limits explicitly state a minimum average maturity of 5.75 years and a maximum maturity of 6.25 years.

This is reiterated in the MoF's Second half Update[2]: "In case of refinancing and interest risk indicators, the Ministry allows their short-term deviation from stipulated medium-term targets and limits with the fact, that they will be met by the end of medium-term horizon, i.e. by the end of 2018.''

So was the refinancing risk limit met by the end of 2018?Fast forward, two years, to the end of 2018, we find the actual average time to maturity is 5.4 years, significantly below the stated risk limit of a minimum average maturity of 5.75 years.

A request to the MoF for a comment has, as at time of publication, not received a response.

Average Maturity of Czech State Debt (Years) Breaches Published Risk Limit

Note: Year end data. Dashed lines show minimum and maximum risk limits applicable from end 2018 onwards as stipulated by Czech MoF in 2016.

Off Limits

Comparing the Average Maturity chart with the earlier chart of interest rates we can see ahead of the rapid rise in interest rates in 2017/18 the MoF was positioned with relatively short-term debt (and in breach of the risk limit). Then after the rapid rise in interest rates, by end Q2 2019, the average maturity had been extended to 5.9 years (within the lower limit) and by the end of 2019, the maturity of the average debt had been extended to 6.2 years, near the top of the allowable range. A case of ''shutting the stable door, after the horse has bolted''. Had the MoF acted earlier to bring the average maturity within the published risk limits, this expensive fiasco could have been avoided.

''It's Hush-Hush''

Mysteriously, while the MoF's 2018 Funding Strategy report[3] reiterated the Refinancing Risk limits, the expected average maturity of the State debt for 2018 was discreetly omitted from this particular section of the report. In the prior 2016 and 2017 Funding Strategy reports, to aid comparison, alongside the target and limits, the expected maturity figure had been given. It is perhaps worth noting that by the time the 2018 Funding Strategy report was published Czech interest rates had already started to rapidly rise (Chart) and the enormity of the blunder would have been apparent. Even now, The Czech Republic Government Debt Management Annual Report 2020 conveniently charts[4] the Average Maturity of State Debt against Declared Targets but not against the Declared Risk Limits (as we have shown).

'Active' Breach Rather Than 'Passive' Breach of Limits

Regulators and market participants often distinguish between active and passive breaches of risk limits. Active breaches result from decisions by managers while passive breaches result from movements in market prices without any active intervention by the portfolio/debt management team. Generally speaking, passive breaches are regarded as less serious so long as managers take immediate action to bring a portfolio back in line with stated limits. Active breaches are generally regarded as much more serious. Active breaches indicate ineffective controls and a reckless disregard for risk limits.

Unfortunately, the MoF's breach, though possibly well-intentioned, looks very much an 'active' breach to take advantage of what were perceived as ''extraordinary savings'' and in mid- 2017[5], immediately prior to the rapid rise in interest rates, for ''utilizing favourable market conditions''.

Rogue Traders?

While Finance Minister (2014-17), Andrej Babis tried to cultivate a reputation of fiscal prudence. However, as we have seen, the lower debt service payments (receipts) were achieved by accepting a high level of refinancing risk. Allowing the average maturity of State debt to decline; falling to just 5 years in 2017, contributed to the budget surplus that was recorded in that election year. However, the flip-side now is that as the short to medium-term debt issued under his tenure as Finance Minister now matures, it now needs to be refinanced at much higher interest rates contributing to the current budget deficit. The fact Alena Shillerova, who succeeded Andrej Babis as Finance Minister, was slow to extend the average maturity of State debt, to within the previously announced risk limits, has compounded the problem. By the time the MoF did act, in 2019, it was too late, both long and short-term interest rates had already moved sharply higher.

Lack of Accountability, Transparency and Effective Oversight

With a massive Covid-19 related budget deficit almost certain to be recorded this year, little attention is likely to be placed on that part of the deficit by the MoF's reckless approach to refinancing risk (culminating in the MoF breaching its own stated risk limits in 2018). That said, just prior to the Covid-19 pandemic, the underlying deterioration in the state budget was already apparent with tough questions beginning to be asked.

That publicly stated risk limits were able to be breached highlights, once again, the lack of accountability, transparency and effective oversight at the Ministry of Finance.

Jeremy Monk
Investment Director,
AKRO investiční společnost, a.s.
Prague. 30th March, 2021

[1] The Czech Republic Funding and Debt Management Strategy for 2016, page 16, 18th Dec., 2015. 

[2] The Czech Republic Funding and Debt Management Strategy for 2016 - Second Half Update, page 15, 24th June, 2016

[3] The Czech Republic Funding and Debt Management Strategy for 2018, page 14, 22nd December, 2017. 

[4] The Czech Republic Government Debt Management Annual Report 2020, page 34, 12 February 2021 

[5] The Czech Republic Funding and Debt Management Strategy 2017 Second Half Update, page 12, 30 June 2017.