Is the Standard Micro Portfolio Approach to Sovereign Debt Management Still Appropriate?

This paper examines the analytical underpinnings of the standard micro portfolio approach to public debt management (PDM) that aims at minimising longer-term cash-flow based borrowing costs at an acceptable level of risk. The study concludes that two technical key assumptions need to hold for the standard micro portfolio approach to yield optimal (ie cost-minimising) results. We argue that these assumptions do not hold in the current borrowing environment characterised by fiscal dominance with complex links between PDM and monetary policy. By using the principles of portfolio theory we demonstrate that in this borrowing environment cost-risk optimality requires the use of a broader cost concept than employed in the standard micro portfolio approach. This new concept incorporates not only the cash flows of the debt portfolio itself, but also those related to primary borrowing requirements. The resulting broader cost measure includes therefore the interactions with the budget. Finally, the paper demonstrates that the standard cost-risk framework of the micro portfolio approach is nested within this new, broader cost concept. Full publication: Threat of fiscal dominance?