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Debt Management
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Andrey Zahariev
DEBT
MANAGEMENT
a distance learning
academic course book
© Andrey Zahariev, author, 2003, 2012
© Iglika Angelova, cover design, 2012
© ABAGAR Publishing House, 2012
ISBN 978-954-427-981-3
Andrey Zahariev
DEBT
MANAGEMENT
ABAGAR Publishing House

Veliko Tarnovo, 2012
Debt Management
Second revised and extended edition
Assoc. Prof. Andrey Zahariev, PhD – author

Prof. Radko Radkov, DSc (Econ.) – reviewer
Assoc. Prof. Stoyan Prodanov, PhD – reviewer
Vencislav Dikov – translation
Rosemary Papworth – proofreading
Iglika Angelova – cover design
Format: 70/100/16
Quires: 20
This edition is co-financed by the National Scientific Research Fund at the Ministry
of Education, Youth and Science of the Republic of Bulgaria within the implement-
tation of Project INZ01/0116 and managed by Project Manager, Assoc. Prof.
Andrey Zahariev, entitled: "Complex Support for Scientific Research and the
Transfer of Knowledge in the Fields of Economics, Administration and Manage-
ment within the Educational and Qualification Programmes of Masters degree and
the Educational and Scientific Programmes of Doctor of Philosophy through the
Integrated Scientific Centre: Distance Learning and Research Centre" within the
"INTEGRATED SCIENTIFIC UNIVERSITY CENTRES” Programme of 2008.
INTRODUCTION
At the beginning of August 2011 the global financial system was

shaken to its foundations. The leading rating agency Standard & Poor's cut
the credit rating of the United States. Such an act associated with the
United States has no precedent in global economic history. This decision
not only demonstrated that the leading world power had certain problems,
but also that the fundamental concept of the riskless financial asset is
obsolete. This decision was apparently reached after sufficient evidence
had been sought and found in a single aspect - the U.S. government’s
indebtedness. This decision was followed by a series of reductions in the
ratings of several European Union member states - especially Greece –
which now leads to the conclusion that the global economy faces a
systemic problem related to public debt.
From a theoretical point of view, the review of the development of
financial systems allows us to identify two principal sources of state
revenues: taxes and loans.1 Theoretically, the use of loans is expressed as
a specific movement of money among the state, companies, banks,
financial institutions and households - a movement that is associated with
the activities of governments as borrowers of monetary capitals.2 It could
be argued that the borrowing of money by governments is an activity which
affects all economic agents. This activity has resulted in a new concept of
balancing public accounts - the concept of deficit financing.
Deficit financing of the state budget is directly related to the genesis
of the financial and economic systems. From a theoretical point of view,
deficit financing has been studied by the representatives of numerous
schools. The extreme viewpoints of deficit financing recommend either its
complete avoidance (the Classical School) or its wide-scale utilization (the
Keynesian school.) As in many controversial areas of economic
knowledge, the various scientific schools defend their positions. As a result,
in some countries the political class has embraced the ideas of deficit
financing for the state budget, while in other countries it has supported the
idea of balanced public accounts.
1
Of course, here we may include the issue of money as a third method. Nowadays,
however, its scope may be considered rather limited.
2
ADAMOV, V. Teoriya na finansite (Darzhavni finansi). V. Tarnovo, ABAGAR,
1998, p. 572.
6 Debt management
The application of deficit financing of government budgets leads to

the accumulation of deficits. Government debt emerges. Government debt
(external and/or internal) requires the adoption of new types of solutions
related to debt management. The government itself develops as a
strategic process of vital importance to governments and economic
development.3 This is why we may claim that the precise knowledge of
the theoretical foundations, the macroeconomic consequences and
the practical examples of the application of deficit financing is the
basis for the development of debt management techniques.
Analysis of the specific situation regarding the public sector in our
country emphasises the topicality of research in the field of deficit financing
and debt management. Of course, we have to take into account what has
already been done by certain researchers from leading research centres
and representatives of specialized debt management institutions – the
Ministry of Finance and the Central Bank. Taking the risk of challenging
some of the main theoretical arguments "for" and "against" debt financing
of budget deficits, this academic course defends the concept of the
strategic role of government debt. This role is justified not simply from a
purely macroeconomic point of view, but from the perspective of
companies and their financial managers. It could be argued that
government securities, as a form of securitized debt, are the starting point
for the development of various theories and models within the scope of
corporate finance management. In fact, the management of the treasury
and the management of shareholders’ wealth are directly related. This
relationship allows us to complement the research in the public sector and
corporate finance, and to develop it further.
Considering the above, the object of this academic course is the
public sector, and the subjects of this course are the reasons, arguments
and consequences of applying the policy of deficit financing for state and
local budgets, and related decisions regarding passive and active debt
management.
Through this academic course the author aims to justify a
conceptual framework for the development of government debt mana-
gement tools through a consistent review of the theoretical foundations,
3
A Direct result of that aspect is the development and adoption of three-year
strategies for government debt management, which in Bulgaria covered the periods 2006-
2008, 2009-2011, 2012-2014, etc. These strategic documents include three main sections:
first - analysis of the debt, its key indicators and regulative environment; second - defining
the risks associated with the size and structure of the debt; and third - the policy objectives
and tools for debt management. (For more details see: Government Debt Management
Strategy for the period 2006-2008 of the Ministry of Finance of the Republic of Bulgaria,
www.minfin.bg/document/961:1 )
Introduction 7
macroeconomic effects, relationship with the shadow economy and

empirical evidence for debt financing of budget deficits.
The underlying research for this course was carried out in
accordance with the following main hypotheses that we intend to validate
and verify:
Hypothesis One. Deficit financing is a tool for strategically
influencing public choice and the political cycle.
Hypothesis Two. Budget balancing has a direct impact on the
amount of inter-generational redistribution.
Hypothesis Three. The determination of the state in the external
sector is a function of the cumulative expression of the deficits/surpluses of
the individual analytical currency balances.
Hypothesis Four. The dynamics within the volume of external
deficit financing is a cyclical phenomenon.
Hypothesis Five. There is a proportional relationship between the
size of the shadow economy and the volume of deficit financing.
Hypothesis Six. The accession of Bulgaria to the European Union
resulted in the adoption of management techniques and macroeconomic
constraints which ensured the maintenance of the deficit and debt within
the limits provided for by the Maastricht criteria for EU membership.
In order to prove these basic assumptions, we have to widen the

scope of the study to include a wide range of theoretical models and
empirical evidence for deficits and debt. This certainly supports the efforts
of the research centre we represent in order to aid the processes of
Bulgarian social, cultural, economic and educational integration into
European structures.
This current academic course regarding the issues of debt
management is a natural extension of the 2003 edition. The course is
intended for students undertaking the Master's Degree programme in
"Finance". The structure of the course meets the requirements for a
distance learning academic textbook, but may also be used by full-time
students. Students utilising distance learning to study the Masters Degree
programme use web-based technology based at the Distance Learning
Centre at the D. A. Tsenov Academy of Economics, and have access to an
online module which contains interactive materials, presentations and self-
assessment tests consistent with the content of the textbook, and which
can be found at http://wdo.uni-svishtov.bg4.
In line with the above statements, the main objective of the course
is to provide students with knowledge and skills in the field of deficit
4
Note that guest access to the module is restricted.
8 Debt management
financing and debt management. The role of the course within the
Masters Degree programmes is to develop the competencies of modern
financiers, bankers and government administrators in the field of
financial analysis and debt management, the assessment of deficit
financing and its impact on businesses and other taxpayers, and also
to enable them to provide substantiated forecasts about the future
state of the economy and its external sector.
The course is structured as separate topics which include study
questions. It concludes with an end-of-semester case-study examination in
"Debt Management" with multivariate input data. Students are provided
with several examples of investment analysis of debt instruments in MS
Excel format. This approach fully meets the practice established in 2002 by
the Department of "Finance and Credit" to provide educational courses in
accordance with the current environment of highly developed information
and econometric technologies and products.5
For questions and comments related to the curriculum content,
hypotheses or opinions expressed in the course, as well as any
suggestions for improvement, please contact the author using the following
e-mail address: andrew@uni-svishtov.bg
COURSE STRUCTURE
Chapter І. Introduction to the deficit financing theory

1. The general characteristics of deficit financing
2. Classical concepts of deficit financing
Chapter ІІ. The Keynesian theory of deficit financing

1. J. M. Keynes’ research
2. A. Hansen’s contribution
3. A. Lerner’s approach
Chapter ІІІ. Modern theories regarding the budget deficit

1. The theories of Tobin and Buchanan
2. The model of burden distribution between overlapping generations
3. The neo-classical concept
4. The Ricardo-Barro theorem
5
For more details see: ADAMOV, V., Holst, J., Zahariev., A. Finansov analiz. V.
Tarnovo. ABAGAR, 2002 and 2006.
Introduction 9
Chapter ІV. Theories regarding the strategic role of government debt

1. The theory of governmental policy in circumstances of time-inconsistent
preferences
2. The positive theory of fiscal deficit and government debt
3. The political-economic model of the strategic role of debt
Chapter V. The role of the state in the economy

1. Public goods
2. Club goods
Chapter VI. Anatomy of the state redistribution function

1. The methodology of state redistribution impact
2. Budget balance and intergenerational redistributions
Chapter VII. Instruments for defining the status of the external sector
1. Indices for defining the status of the external sector of the economy
2. International currency balances of payments – a tool for the analysis of
deficit and debt
3. Analytical currency balances in terms of product
4. Analytical currency balances in terms of factor
5. Consequences of deficits in analytical currency balances
Chapter VIII. Macroeconomic analysis of external deficit financing

1. Reasons for deficit financing through external loans
2. Dimensions of debt dynamics and cycles
Chapter IX. The shadow economy and tax evasion

1. The shadow economy and tax evasion – definitions and forms of
manifestation
2. Aspects of taxation effects on the shadow economy
Chapter Х. Concepts of tax evasion and tax fraud

1. Tax evasion as a criminal activity
2. Models of optimal tax “evasion”
3. Concepts of alternative tax “evasion” and tax fraud
Chapter ХІ. Measuring the shadow economy and tools for its
counteraction
1. Tools to counteract the shadow economy
2. Methods of measuring the shadow economy
Chapter ХІІ. Deficit financing in Bulgaria

10 Debt management
1. The origin and development of the debt crisis in Bulgaria

2. Measuring and evaluating deficits and indebtedness
3. Solutions to the deficit and debt problem
Chapter ХІІІ. The contemporary paradigm of debt management

1. General characteristics of debt management
2. Contemporary solutions to the global debt crisis
3. Debt management aims and policies
Chapter ХІV. Investment analysis of debt instruments

1. Fundamental investment indicators
2. Specialised indicators for investment analysis of debt instruments
CHAPTER I
INTRODUCTION TO DEFICIT FINANCING THEORY
Introduction to the chapter

This chapter describes the nature and specific features of deficit
financing. By the end of the chapter you will be able to:
 use basic terminology;
 identify the types of budget deficit;
 identify debt financing instruments;
 identify governmental debt factors.
The chapter includes two subtopics:

1. The general characteristics of deficit financing;
2. Classical concepts of deficit financing.
1. The general characteristics of deficit

financing
In order to define issues associated with deficit financing we must
first consider the issues related to:
 governmental debt;
 the budget deficit;
 debt structure;
 the budgeting process;
 budget discipline;
 the effects of deficit financing.
The issues associated with debt financing are among the main
discussion points in the organizational process of every budget, and
therefore one of the central issues in the field of finance. In its broad sense,
the term “deficit” can be defined as an excess of budget expenditures
compared with the incomes for a specified period. Its application in both
specialized financial theory and practice requires the meaning to be defined
with regards to the following three main areas:
12 Debt management
 budget deficit structure;

 planned and actual deficit;
 deficit scope.
The structure of the budget deficit is classified by four levels of

consequent inclusion of the main debt-related expenditures, and includes
the following basic categories:1
A. Budget imbalance – the mismatch between revenues and
expenditures within the budget period. It is the basis for the determination
of the budgetary situation having particular importance. Often, its value is
positive, i.e. there is a budget surplus, while a deficit is reported after
considering the subsequent elements. Examples abound in our budgetary
law, which is indicative of the structure of debt accumulated in previous
periods.
B. Internal budget deficit – calculated by reducing the budget by
the amounts due in order to service the internal debt throughout the period
(budget year).
C. Current budget deficit – calculated by increasing the amount
of the internal budget deficit by the expenditures for servicing the external
debt over the period.
D. Total budget deficit - calculated by increasing the amount of
the current budget deficit with all outstanding payments from previous
periods.2
Another point of view to consider is when the budget deficit is

related to the processes of its adoption and implementation. In this context,
the deficit forecasted, planned and approved via State Budget Law is
defined as planned deficit. However, the practical implementation of a
budget using planned deficit is often particularly difficult because the actual
deficit is, more often than not, different from the planned one. The actual
result at the end of the budget period is the actual budget deficit. The
latter can be larger or smaller, or (for we should not ignore this theoretical
1
The Annual budgetary procedures and the introduction of budget classifications
used by the EU lead to some changes in basic terminology. For comparability between the
basic research, we use the budget categories introduced and applied by national statistics
and the Ministry of Finance, after the reforms in 1989.
2
For more detailed information see: ADAMOV V., Lilova, R., Zahariev, V. Byudzhet
i byudzhetna politika. V. Tarnovo, ABAGAR, 1997; SIMEONOV, S., Zaharieva., G.Defitsitno
finansirane na byudzheta v: BROWN, C. & Jackson., P. Public Sector Economics (Bulg.
transl. ed.). Sofia, FSSA, 1998.
Chapter I. Introduction to Deficit Financing Theory 13
possibility, although this is practically very hard to achieve) equal to the

planned deficit.3
It should be borne in mind that governments do not include all
activities in the official budget, which is often based on current regulations,
such as the redistribution of income and expenses related to social
activities that are generally off-budget. However, the official distinction and
correct measurement of a government's obligation requires the reporting of
all revenues and expenses. According to the U.S. financial practice, the
deficit structure is represented through the differentiation of the elements
by considering first the amount of the on-budget deficit (which represents
only the activities included in the budget), and then the off-budget deficit
(which represents only the off-budget activities). The sum of these two
elements gives us the aggregate (net) deficit.4
In order to provide more accurate definitions of deficit and debt, we
should also consider the following facts:
 At a certain point, debt is the sum of the deficits from previous
years, reduced by the amount of settled debt;
 Debt is the aggregate amount of the excess of expenses over
the revenues from previous periods;
 Debt is the value of a dynamic variable at a specific moment,
while the deficit covers a defined budget period;
 Debt resulting from credit transactions has certain obligations
for the issuer, expressed mostly in the payment of remuneration in terms of
interest and/or discounts on the face value of the debt security.
Despite the popular belief that debt is a governmental "problem",

we should point out that not only the central government, but also local
governments take out loans.5 This generally leads to an overall increase in
indebtedness.
Of course, the real inflationary effects of the actual reduction of the
debt burden to creditors cannot be ignored, and there are certain
sufficiently reliable tools for their alleviation. A popular method is debt
indexation, without which, lending to the government would be unthinkable
during periods of high and varying inflation levels. We should also point out
3
LILOVA, R., Politicheski i ikonomicheski ramki na byudzheta. Svishtov 1992.
According to preliminary data from the Ministry of Finance, the budget in 2011 is an
exception to the general rule, as the deficit is less than 0.4% of GDP compared to the
planned amount.
4
ROSEN, H. Public Finance. New York, 3 ed. 1993.
5
As a result of the process of fiscal decentralization, and with technical assistance
from USAID, Bulgaria has adopted and enforced the specialized Municipal Debt Act,
promulgated in SG, No. 34 of 19 April 2005.
14 Debt management
that investors tend to shorten the time span and index, even of the most
short-term capital market instruments.
The basis for debt indexation is of particular importance for the
success of a bond issue. Debt management is thus directly related to the
actual profitability and burden of the debt respectively, and we must find a
reasonable balance between sufficient and essential stimulation of
investors on the one hand, and an acceptable burden upon the budget on
the other.
When we consider public debt, we should take into account both its
absolute value and its relation to governmental assets such as
administrative buildings, equipment, gold, rights regarding natural
resources and other factors. It is believed that the exclusion of tangible
assets can be highly misleading when considering debt.
In general, the formation of government debt is based on the
emergence of budget deficits. Therefore, the size of the budget deficit
defines the size and scope of the debt. Debt financing involves the use of
various debt instruments. On a global scale, the most common are:6
a) issues of short-, medium- and long-term securities;
b) direct loans from Central Banks;
c) loans taken through tenders from commercial banks and other
banking institutions;
d) credit from international financial institutions.
The use of any of these instruments is in direct relation to the policy

of deficit financing and debt management.
2. Classical concepts of deficit financing

Deficit financing is a problem as old as the problems related to the
structure and finance of state government. This problem was addressed in
Adam Smith’s “The Wealth of Nations”. Smith believes that national debt
owes it’s origins to three main factors:7
 the willingness of government authorities to spend budgetary
funds;
 the unpopularity of tax increases as a method for collecting
additional state revenue;
 the willingness of capitalists to extend loans.
6
SIMEONOV, S., Zaharieva, G. Op. cit., p. 565.
7
FINK, R. and J. High. A Nation in Debt: Economists Debate the Federal Budget
Deficit. Maryland. 1997 p. xiv.
Smith is explicitly against the use of loans as a method of financing

budget deficit. He predicts that, “The progress of the enormous debts which
at present oppress, and will in the long-run probably ruin, all the great
nations of Europe…” (The Wealth of Nations, p. 753). Based on empirical
evidence of deficit financing, he believes that there is a direct relation
between the ability of governments to borrow money and their willingness
to fight wars. In other words, a budget deficit should be avoided except in
situations of war or other extraordinary events. Smith recommends that the
main principle of public finance management should be the "prudent
owner" principle. The government should be responsible for its
financial affairs with the same prudence as the individual regarding
their personal financial affairs.8
At a later stage in the development of economics, Karl Marx
conjectured that government debt is a derivative of capitalist societies. This
derivative is designed to facilitate the exploitation of labour. According to
Marx, government loans are an easy and convenient way to raise capital
which does not expose the government to the problems and risks that are
inevitable if the capital is used for industrial purposes. The use of deficit
financing and the formation of government debt leads to four major
consequences: first, it creates a class of "lazy annuity holders"; second, it
increases the benefits for central bankers in exchange for their agreement
to extend loans to the state; third, it stimulates an increase in the tax
burden and the collection of taxes for the repayment of government debt;
fourth, it motivates industrialists to find new ways of escalating employee
exploitation.9
In conclusion, we should point out that the two representatives of
the classical school (Smith and Marx) highlight the harmful effects of debt
financing – effects which must be limited, and which must not be accepted
by governments.
Recommended additional sources:

1. ADAMOV, V. Teoriya na finansite (Darzhavni finansi). //
Biblioteka „Obrazovanie i nauka”, Svishtov, Tsenov, 2012.
2. LILOVA, R., V. Adamov, Zahariev, V. Byudzhet i byudzhetna
politika. V. Tarnovo, ABAGAR, 1997.
3. STIGLITZ, J. Economics of the Public Sector. (Russ. Transl. ed)
Moscow, 1997.
4. Municipal Law Act, prom. SG, № 34 of 19 April 2005.
8
SMITH, A. Of Public Debts. in: A Notion in Debt: Economists Debate the Federal
Budget Deficit, Maryland, 1987, p. 1.
9
FINK, R., High, J. Op.cit., p. xiv.
16 Debt management
Keywords
1. Budget deficit structure
2. Budget balance
3. Internal budget deficit
4. Current budget deficit
5. Total budget deficit
6. Deficit scope
7. Planned deficit
8. Actual deficit
9. On-budget deficit
10. Off-budget deficit
11. Net (aggregate) deficit
12. Government debt
13. Debt indexing
14. Debt financing
Questions for self-evaluation and discussion

1. Provide the common definition of the term “deficit”.
2. Which are the elements of the budget deficit structure and how are they
defined?
3. What is the difference between planned and actual deficit?
4. What is the difference between the terms “debt” and “deficit?
5. What is the U.S. practice in terms of calculating the aggregate deficit?
6. Which debt financing instruments are you familiar with?
7. Which are the main causes for government debt?
8. What arguments did Smith and Marx express, opposing deficit
financing?
Chapter summary
The issues related to debt financing are among the main discussion
points in the organizational process of every budget, and therefore one of
the central issues in the field of finance. In its broad sense, the term deficit
means an excess of budget expenditures compared to the incomes for a
specified period. The successful management of a budget deficit requires
knowledge of its structure - the four levels of consequent inclusion of the
main debt-related expenditures - and includes the following basic
categories: budget balance, internal budget deficit, current budget deficit
and total budget deficit.
In terms of the processes of the acceptance and implementation of
the budget, we can distinguish between planned and actual deficits. The
methods used by governments to finance their activities through their
official budgets are also important. The U.S government first considers the
on-budget deficit (which represents only activities included in the budget),
then the off-budget deficit (which represents only off-budget activities) and
then defines the amount of the total budget deficit as the sum of these
deficits. Various debt financing instruments are used in financial practice:
issues of short-, medium- and long-term securities; direct loans from
Central Banks; loans taken through tenders from commercial banks and
other banking institutions; and credits from international financial
institutions.
The success of debt management also depends on knowledge of
the main factors which influence debt. Smith defined three main factors for
growth of government debt. He, himself (and later, other economists as
well), was explicitly against loans as a means of financing the budget
deficit. Smith recommends that the main principle of public finance
management should be the "prudent owner" principle, i.e. that the
government should be responsible for its financial affairs using the same
prudence as individuals regarding their personal financial affairs.
At a later stage, Marx defined government loans as an easy and
convenient way of raising capital which does not expose governments to
the problems and risks that are inevitable if the capital is used for industrial
purposes.
CHAPTER II
THE KEYNESIAN THEORY OF
DEFICIT FINANCING

This chapter describes the key arguments in favour of deficit
financing. By the end of the chapter you will be able to:
 discuss Keynes’ key arguments in favour of deficit financing;
 discuss the main ideas of Hansen regarding the conditions for
the utilization of debt financing;
 discuss the burden of debt financing according to Lerner.
The chapter covers three topics:

1. The research of J. M. Keynes;
2. The contribution of A. Hansen;
3. The approach of A. Lerner.
1. J. M. Keynes’ research
The development of economic thought in the 20th century was
greatly influenced by the ideas of J. M. Keynes. These ideas led to the
imposition of a policy of active state intervention in the economy. This
intervention required the state to utilize various means of financing
government spending, which resulted in specific emphasis on deficit
financing. Although Keynes himself did not advocate any mandatory
recipes for economic development and social welfare, his followers
continued the research into state intervention in the economy, and thus
established Keynesian theory. This theory refutes the arguments of the
classical school to limit the use of deficit financing. Despite the criticism of
Keynes’ fundamental ideas in recent decades, it can be argued that
Chapter II. The Keynesian Theory of Deficit Financing 19
Keynesianism still empowers government institutions with beneficial ideas

and solutions.1
What Keynes achieved through his research was perhaps the most
significant advance in 20th century economic theory. Of course, we should
take into account that his "General Theory" emerged in a period where the
market was affected by the negative effects of the Great Depression. It is
therefore understandable why Keynes set his mind towards harnessing the
mechanisms and instruments through which the economy could operate
more efficiently.
In the "General Theory" he does not provide a direct interpretation
of deficit financing problems. At the same time, the analyses regarding the
relationship between unemployment and inflation indirectly prove that
increased government spending (financed through taxes and/or loans) has
a favorable impact on the economy. This increases the volume of capital.
The aim is to increase capital, "... until it ceases to be scarce, so that the
functionless investor will no longer receive a bonus; and at a scheme of
direct taxation which allows the intelligence and determination and
executive skill of the financier, the entrepreneur, to be harnessed to the
service of the community on reasonable terms of reward”.2 According to
Keynes, in times of unemployment the task of the government is to borrow
money and spend it in the economy. It may be noted that:3
First, the richer the community, the wider the gap is between its
actual and its potential production and, therefore, the more obvious and
outrageous the defects of the economic system.
Second, a poor community will be prone to consume by far the
greater part of its output, so that a very modest measure of investment will
be sufficient to provide full employment.
Third, a wealthy community will have to discover many ample
opportunities for investment, if the saving propensities of its wealthier
members are to be compatible with the employment of its poorer members.
For Keynes, this is why the propensity to consume, the marginal

efficiency of capital and interest rate theory are of crucial importance.
However, these issues do not remain confined within the limits of national
borders. Keynes contended his theory in terms of an open economy where
international trade will be "... a willing and unimpeded exchange of goods
and services in conditions of mutual advantage". Keynes’ concept found a
1
Or, as M. Mladenov said “… Keynesianism proved to be tough!”. For more details
see: Keynes, J. General Theory of Employment, Interest and Money. Sofia, Hr. Botev
Publishing House, 1993, p. 447. (in Bulgarian)
2
Keynes, J. Op. cit., p. 435.
3
ibid., p. 43.
20 Debt Management
practical application in the late 20th century through the mechanisms of

international cooperation between the World Trade Organization and
various regional constituencies, including the European Union.
2. A. Hansen’s contribution
The studies of A. Hansen are considered one of the most
successful attempts to compare the effects of the practical implementation
of classical and Keynesian policies in their pure, scientific form. In his
research “Fiscal Policy and Business Cycles”4, Hansen departs from the
classical school’s principles regarding the use of debt financing of a budget
deficit in times of war or natural disasters. Comparing the theoretical
concept with the empirical results, Hansen demonstrates that the increased
level of lending in times of war stimulates economic growth and the
development of credit institutions. For Hansen, unemployment is the
equivalent of an emergency and, therefore, the government is justified in
using debt as a demand management tool in order to reduce or eliminate
unemployment. Specifically, Hansen’s main ideas can be presented in the
following way:5
First, the development of credit institutions from the Middle Ages to
the present day is the result of increasing social needs. These needs
become extreme in times of war. Therefore, the establishment of capital
markets and the development of large commercial banks is a method of
accumulating the essential capital resources that the government may
resort to using in extreme situations. Moreover, the constantly rising
standard of living requires the government to spend more money on
various infrastructure projects. The scale of these projects often exceeds
the capacity of the fiscal system. Therefore, deficit financing is a way to
stimulate development and ensure a high standard of living for the whole
population.
Second, fiscal policy must include the main objective of ensuring full
employment for factors of production. Such a policy requires a significant
increase in government spending. Some of these expenditures may be
financed by increasing progressive taxation rates, others by progressively
increasing government debt. The natural limitations of this sort of policy are
the instruments used by the Central Bank to control cash flows, by which
unutilized funds may be used for the purchase of short-term bonds. The
4
HANSEN, A. Fiscal Policy and Business Cycle N. Y., 1968.
5
The quoted ideas are presented in: HANSEN, A. Fiscal Policy, New and Old; in
FINK, R. and J. High. Op. Cit., pp. 52-57.
interest accrued on these bonds will be returned to the fund owners as

personal income.
These, and other ideas of Hansen, resulted in a series of
publications launched by other researchers in defense of the policy to
stimulate economic development through debt financing of the budget
deficit.
3. A. Lerner’s approach
A. Lerner (1948) is a prominent proponent of the Keynesian
concept of debt. According to him, loans taken by the government should
not transfer the debt burden to future generations. To implement the
planned expenditure when there is a shortage of funds, the burden must be
shouldered by the current generation. Moreover, cuts in consumption must
also be present-day. Interest payments are a purely transfer-related
problem, i.e. payments are made by some members of society to other
members.
Lerner’s theory that internal debt is not a burden for future
generations dominated economic theory and policy in the 40s and 50s.
Subsequent analyses, however, cast doubt on its plausibility. It may be
noted that:6
First, Lerner’s thesis that, “…internal debt is a debt we owe to
ourselves”, does not answer the question of the specific gravity of its
burden to the taxpayer and government creditors. The existence of a large
internal debt will inevitably require an increase in the tax burden and
therefore will inevitably reduce the level of consumption or taxpayers’
savings. In cases of unexpected inflation, creditors will incur losses
because the real value of the repaid loan will be lower than its real value
prior to the increase in the level of inflation. As a result, the Pareto
optimality (which states that the welfare of some individuals increases at
the expense of others) will deteriorate. This is why we should not ignore the
assessment of debt burden within one generation. Such an assessment,
however, was not taken into account in Lerner’s concept.
Second, internal government borrowing, to a certain extent, limits
loans extended to the private sector. Thus, it reduces the level of private
investment, which leads to loss of benefits for future generations due to
lower productivity levels.
For Lerner, functional finance is the guiding principle for the
implementation of government policy when there is either inflation or
6
SIMEONOV, S., Zaharieva, G. Op. cit., p. 569.
22 Debt Management
unemployment, but never for both of them simultaneously. In cases of

inflation, the government must raise tax rates and cut spending, while in
cases of unemployment, the government should cut taxes and increase
spending. In fact, a free-market economy cannot function without having
inflation or unemployment. Only the government can balance spending and
savings.7
The main notion in Lerner’s concept of functional finance is that the
government’s fiscal policy, spending and taxation, the borrowing and
repayment of loans, and the issuance of new money and withdrawal of
money from circulation must be carried out taking into consideration only
their effects on the economy. This approach contradicts the scholasticism,
according to which, the government determines its actions in terms of their
effect on the economy. On this basis, Lerner formulated two basic rules of
functional finance:8
 Rule One: total government spending should be maintained at a
level that will be sufficient to buy goods produced by all who wish to
work, but not enough to increase inflation through a demand level
(at current prices) which exceeds the volume of production output;
 Rule Two: the government should borrow money only when it is
justified that society should have less money and more government
bonds due to the effect of debt financing of the budget deficit and
vice versa - the government should extend loans (or repay old
debts) only if it is justified in increasing the money or reducing the
weight of government bonds owned by the public.
In response to the arguments against debt financing of budget deficits,

Lerner offers four mutually-derivative hypotheses:9
 Public debt should not increase;
 If public debt increases, the increased interest is not to be paid
by increasing the current level of taxation;
 If the increased interest is paid by increasing the level of current
taxation, these taxes are based only on the portion of benefits obtained
from increased government spending and, therefore, are not considered a
loss to the public, but simply a transfer from taxpayers to bondholders;
 High rates of income tax should not discourage investment,
because the appropriate tax deductions for incurred losses will reduce
investment capital at risk by the same proportion by which net investment
income is reduced.
7
FINK, R. and J. High. Op. Cit., p. xv.
8
LERNER, A. Functional Finance and the Federal Debt; in FINK, R. and J. High.
Op. Cit., pp. 59-60.
9
Ibid, pp. 65-66.

1. ADAMOV, V. Teoriya na finansite (Darzhavni finansi). //
Biblioteka „Obrazovanie i nauka”, Svishtov,Tsenov, 2012.
2. KEYNES, J. The General Theory of Employment, Interest and
Money. (Bulg. transl. ed.) Sofia, Hr. Botev, 1993.
3. KANEV, M. et al.. Obshta teoriya na ikonomikata
(Makroikonomika). Svishtov, 1995.
Keywords
1. Government spending
2. Capital volume
3. Keynes’ concept of unemployment
4. Hansen’s ideas
5. Fiscal policy objectives
6. Interest payments
7. Lerner’s thesis
8. Functional finance
9. Lerner’s first rule
10.Lerner’s second rule
11.Lerner’s hypotheses in favour of debt financing

1. What is the influence of government spending on the economy,
according to Keynes?
2. According to Keynes, how should the government act in cases of
unemployment?
3. What arguments did Hansen provide in favour of deficit financing?
4. What is Lerner’s view of the consequences of debt financing?
5. How is Lerner’s theory criticised?
6. Define the essence of Lerner’s rules of functional finance and
determine their current feasibility.
7. How would you comment on Lerner’s main hypotheses regarding deficit
financing?
8. In the case of the public debt crisis in the period 2011-2012, which of
the theories described is “to blame” for national and global debt-related
problems?
24 Debt Management
Chapter summary
The period of increased state intervention in the management of the
economy affected the principles of budget organization and management.
During this period, a number of theoretical concepts appeared which
refuted the classical school’s arguments for the limited use of deficit
financing. One of the most popular theories is that of J. M. Keynes.
What Keynes achieved in his research is perhaps the most
significant advance in economic theory in the 20th century. Although in his
"General Theory" he does not provide a direct interpretation of the
problems of deficit financing, the analyses regarding the relationship
between unemployment and inflation indirectly prove that increased
government spending (financed through taxes and/or loans) has a
favourable impact on the economy. For Keynes, the propensity to
consume, marginal capital efficiency and interest rate theory were the most
important issues.
Further research in this field was conducted by A. Hansen. He
defined deficit financing as a means to stimulate development and
establish a high standard of living for the whole population. Another
prominent proponent of the Keynesian concept of debt was A. Lerner
(1948), who tackled the problem of transferring the burden of debt to future
generations. According to him, in order to carry out planned expenditure
when there is a shortage of funds, loans should be taken by the current
generation. Consumption must also be cut in the present day, and interest
payments are simply transfers from some members of society to other
members. Hence, the burden of debt is not shifted from one generation to
another. Lerner's ideas have been criticized in terms of the debt burden for
taxpayers and state creditors, and the limitations they cause for the private
sector. For Lerner, functional finance is the guiding principle for the
implementation of government policy when there is either inflation or
unemployment, but never for both of them simultaneously. In cases of
inflation, the government must raise the tax rates and cut spending, while
in cases of unemployment, the government should cut taxes and increase
spending.
CHAPTER III
MODERN THEORIES REGARDING THE BUDGET DEFICIT

This chapter describes modern interpretations of the budget deficit
issue. By the end of the chapter you will be able to:
 discuss the various macroeconomic management tools;
 discuss the moral aspects of debt financing;
 analyse the debt financing burden;
 estimate the effects of debt financing on the national economy.
The chapter covers four topics:

1. The theories of Tobin and Buchanan;
2. The model of burden distribution between overlapping
generations;
3. The neo-classical concept;
4. The Ricardo-Barro theorem.
1. The theories of Tobin and Buchanan

The arguments of the classical and Keynesian schools regarding
deficit financing of governmental budgets established the historical basis
for the development of modern interpretations of this issue. Many of them
reject the arguments of both Smith and Keynes by trying to offer a third
alternative. This alternative is usually developed within narrow limits of
overlap between the classical and Keynesian schools.
J. Tobin’s theory of budget deficit assumes that the government has
two main macroeconomic management tools - fiscal policy and monetary
policy. In a critique of the causes of the 1980-81 recession in the U.S.
economy, Tobin claimed that the major recessionary factor was the anti-
inflationary policy of the Federal Reserve system. He recommended the
implementation of a balanced combination of a tight fiscal and a loose
monetary policy. Moreover, Tobin recommended an expansion of credit in
order to reduce interest rates and stimulate economic recovery which
would lead to an increase in fiscal revenue and, possibly, reduce the
Chapter III. Modern theories regarding the budget deficit 27
deficit. Thus Tobin falls into the mainstream of the Keynesian concept of
using credit expansion as a factor to stimulate the economy. He claimed
that, "...the budget deficit is more a result rather than the cause of higher
interest rates and economic depressions caused by these rates."1
Besides research which weighs the arguments "for" and "against"
deficit financing, economic development theory contains some concepts
which define the above groups of arguments as harmful. According to J.
Buchanan (1983), debt financing of public consumption is, "...eating up the
national capital.”2 Buchanan believed that citizens’ and politicians’ natural
propensity to consume encourages the use of deficit financing.
"Voters welcome the receipt of benefits from public spending, but
complain about paying taxes. The eligible politicians are trying to meet
voters’ expectations”.3 According to Buchanan, what withholds this
propensity is regard for national capital, respect that is a product of the
cultural evolution. This status quo, however, was altered by Keynes, who
can be described as a "revolutionary success", and who brought about the
destruction of the Victorian economic model. Despite the economic logic in
Keynes’ concept, Buchanan believed that it destroyed the moral barriers
that protected national capital, which would be eroded unless these moral
barriers were restored. Buchanan recommends that only a constitutionally
provided budget balance is the best way to restore these moral barriers.
2. The model of burden distribution between

overlapping generations
The model of burden distribution between generations resulted from
the scientific research of A. Lerner. In this model, the term "generation"
includes each citizen of a particular nation, at an age between specified
minimum and maximum limits. Since current average life expectancy is
now 75 years of age, this model can now be developed based on the
assumption of the coexistence of three generations:
 the generation of youth;
 the generation of middle-aged people, and
 the generation of elderly people.
1
For more details see: FINK, R. and J. High. Op. Cit., p. xvi. and TOBIN J. A
Keynsian View of the Budget Deficit., California management review, 1984, vol. 26 , no.2 ,
pp. 7-14.
2
FINK, R. and J. High. Op. Cit., p. xvii.
3
Ibid.
28 Debt Management
The overlapping-generations model includes precisely these three

generations. It also demonstrates how the fiscal policy of the state is able
to transfer the debt burden from one generation to another.
The overlapping-generations model is based on the following
assumptions:4
 that the population consists of equal numbers of young people,
middle-aged people and elderly people;
 that the time span of each generation within each of the three
categories (young, middle-aged and elderly) is 25 years;
 that each member of a certain generation earns a fixed income
of $24,000 throughout the 25-year period;
 that there are no private savings – each person consumes his or
her income in full;
 that the situation is repeated at regular intervals.
The income generated by each representative of the three

generations is shown in Row 1 of Fig. 3-1. Here, we analyze the effect on
the three co-existing generations in a situation where the government
decides to take an internal loan of $24,000, provided that the budgetary
revenue which has been additionally accumulated (by taking the loan) is
channelled into the financing of public consumption. We assume that the
loan must be paid off in full as a lump sum in 2015. According to this
model, only young and middle-aged people will be willing to extend credit
to the government. If we assume that the loan is extended proportionally by
only the young and middle-aged generation, then each member of these
two generations will reduce their consumption by $12,000 for the period
between 1990 and 2015. This effect is shown in Row 2. With the funds
raised from the loan, the government can provide the same level of
consumption for all citizens - everyone gets an extra $8,000 (Row 3).
At the maturity of the loan, each generation shifts to the next
generational category. A new young generation replaces the elderly
generation from Row 1 of the model. The government has to provide
$24,000 to pay the face value of the Government Bonds issued 25 years
ago. This is accomplished by increasing taxation rates. Thus, each
generation bears a new tax burden of $8,000 for each member (Row 4).
With the tax revenues of $24,000 collected, the government is able to pay
the face value of the Government Bonds issued 25 years ago. In this case,
the new elderly and middle-aged generations bear the burden of debt
4
Similar examples can be found in: ROSEN, H. Public Finance, New York, 3 ed.
1993; as well as in: SIMEONOV, St., Zaharieva, G. Defitsitno finansirane na byudzheta, v:
BROWN, C. and Jackson, P. Public Sector Economics. (Bulg. transl. ed.), Sofia, FSSA,
1998, pp. 569-572.
financing (Line 5). For the purposes of the model, we assume that the
interest rate is zero and that there is no inflation.
The overlapping-generations model

Period 1990-2015 / generation
No. Position Middle-
Young aged Elderly
1. Income generated $24,000 $24,000 $24,000
Refusal of current
personal consumption
2. and investment in 25- -$12,000 -$12,000 Х
year Government
Bonds
Consumption provided
3. by the government due +$8,000 +$8,000 +$8,000
to the loan
… … … … …
2015
Middle-
Young aged Elderly
Accumulation of funds
for the maturity
4. payment of the 25-year
-$8,000 -$8,000 -$8,000
GBs through taxation
Payment of the face
5. value of the GBs
+$12,000 +$12,000
Figure 3-1
The results of the above model are:

a) Due to the loan and related taxation policy, the elderly
generation of 1990 has a lifetime consumption level until the end of their
lives in 2015 - $8,000 higher than it otherwise would have had.
b) The young and middle-aged generations of 1990 did not
experience any changes in their consumption levels until 2015.
The young generation of 2015 has a lifetime consumption stream

that is $8,000 lower than it would have been in the absence of the debt and
accompanying fiscal policies. Thus, the government loan of $24,000 results
in the transfer of $8,000 from the young generation of 2015, to the elderly
generation of 1990.
The difference between the present value of taxes and transfers is
the net tax paid by every member of this generation. When we compare the
net taxes paid by the separate generations, we can see how income is
redistributed amongst them. This redistribution is a direct result of the
30 Debt Management
government’s debt policy. Most calculations using this framework suggest

that older generations benefit at the expense of younger generations. The
main positive result of debate regarding the overlapping generations model
is that it focuses our attention on the lasting effects of government fiscal
policies which affect the life of a generation and disregard the
considerations of the common annual budget cycle. The recommendation
is that the size of the deficit, as well as the specific taxation methods,
should take into account all effects.
3. The neo-classical concept

The generational model shown above does not allow for the fact
that economic decisions can be affected by government debt policy, and
changes in these decisions can have consequences for whoever bears the
burden of the debt. This fact suggests that the taxes levied to pay off the
debt affect neither work-related nor savings behaviour when they are
imposed. The implication is that, although taxes affect the decisions of
economic agents, the real costs are imposed on the economy.
More importantly, we have ignored the potentially important effect of
debt financing on capital formation. In the neo-classical model of debt
financing, when the government initiates a project, whether financed by
taxes or borrowing, resources are removed from the private sector. We
usually assume that when tax finance is used, most of the resources
removed come at the expense of consumption. At the same time, when the
government borrows, it competes for funds with individuals and companies
who want the money for their own investment projects. Hence, it is
generally assumed that debt has the greatest effect on private
investment. This is proven by the fact that debt finance leaves future
generations with a smaller capital stock (all other conditions being
unchanged), and therefore its members are less productive and have
smaller real incomes than otherwise would have been the case. In scientific
research literature, the mechanism through which the debt burden works is
called the reduction of capital formation.
Note, however, that one of the things held equal here is public
sector capital stock. As suggested earlier, to the extent that the public
sector undertakes productive investments with the resources it extracts
from the private sector, the total capital stock increases. The assumption
that government borrowing (deficit financing) reduces private investment
plays a key role in neo-classical analysis. It is sometimes referred to as the
crowding out hypothesis. According to this hypothesis, when the public
sector draws on the pool of resources available for investment, private

investment is crowded out. (See Figure 3-2).
In other words, with deficit budget financing, the increase in
government spending will move the economy from point a to point b. Within
this process the output of production in the private sector (h1 - h2) is pushed
to provide resources for the increase (g2 - g1) of the production output in the
public sector. It should be emphasized that the crowding-out hypothesis is
valid only when all available resources are used. In the opposite situation,
when the economy is not operating on the verge of its production capacity
(e.g. when the economy is in point c), the crowding-out effect cannot be
observed.
Crowding-out effect
Public sector production output
(annual)
b
g2 Increase of
government
spending a
g1
c
Crowding-out of
private investments
h2 h1
Private sector production output
(annual)
Source: Schiller, B. The Economy Today, N.Y, McGraw-Hill, 1994, p.235 (with changes).
Figure 3-2
The crowding-out effect can be avoided via the external financing of

the budget deficit. This is due to foreign loans leading to an increase in the
production output of the public sector without any reduction in the
production from the private sector. In other words, external funding moves
32 Debt Management
the economy (see Figure 3-3) beyond the limit of its production capacity
(from point a into point d).
External funding and production capacity

Public sector production output
(annual)
b d
g2 Additional production output
(import) funded with
external debt
g1 a
h2 h1
Private sector production output
(annual)
Source: Schiller, B. Op. Cit., p. 244.
Figure 3-3
Considering the two options illustrated in Figure 3-2 and Figure 3-3,
it is clear that the type of government funding can influence private sector
production factors and private spending. Therefore:5
 tax-based financing creates a tax burden by reducing the
current consumption in favour of raising capital and future generations
receive a higher real income and the corresponding consumption level;
 vice versa – loan-based financing results in an increase in the
current consumption level at the expense of a decrease in capital formation
and hence, future real income.
In cases of loan-based financing, the members of future

generations will be less productive and will have lower real incomes than
5
Brumerrhoff, D. Finanzwissenschaft. Munchen, 1996, p. 388.
they would have had in the case of tax-based financing. Thus, the burden
is transferred to future generations and capital formation is reduced.
Debt crowding-out of private capitals
Sector А: Debt-free Sector B: Capital market with

i capital market i government debt
Real Interest rate (annual percentage)

Real Interest rate (annual percentage)
9 9
8 8
7 7
6 6 S’
5 5
S B
1500
S
4 4
А А
3 3
2
D 2 D
1 1
0 3000 4000 5000 0 3000 4000 5000
DC
Volume of capital Volume of capital
Source: Samuelson, P. and W. Nordhaug, Economics, N.Y., McGraw-Hill, p. 403.

(modified)
Figure 3-4
The crowding-out effect illustrated previously is caused by changes

in interest rates which are brought about by an increase in the interest rate
due to a loan taken by the government. As a result, the cost of capital
increases. Along with the rise in interest rates, private investment becomes
more expensive and, hence, unattractive (see Figure 3-4). The graphs
show the curves for the demand and supply of capital (C). The intersection
between the supply curve (S) and the demand curve (D) represents the
level of the real interest rate. Sector A above shows the equilibrium price of
capital in the absence of government debt, respectively, i = 3%, and C =
4,000 units.6 Sector B shows a situation in which the government has
6
Samuelson, P. and W. Nordhaug, Economics, N.Y., McGraw-Hill, p. 403.
34 Debt Management
adopted a policy of deficit financing for 1,500 units of capital. When the
additional debt securities are offered on the capital market, investors
include them in their investment portfolios. Consequently, the net supply of
capital will be shifted to the left due to the additional demand for the 1,500
units of capital.
The equilibrium price on the capital market along supply curve D
will shift from point A to point B.7 The new interest rate level will rise from
3% to 4%, as, due to the competition from the government, companies will
be discouraged from issuing debt securities and, thus, the overall capital
volume will be reduced from 4,000 to 3,500 units of capital. Therefore, the
1,500 units of capital borrowed by the government will result in the
crowding-out of 500 capital units in the economy and will reduce its total
production output.
We should also note the following: due to the international mobility
of capitals, the increase in the interest rate will lead to the inflow of foreign
capitals. This, in turn, will increase the demand for local currency and the
resulting increase in price will result in a relative increase in export prices.
Consequently, net exports will be crowded-out (suppressed) in a similar
manner to (and, in this case, to a greater extent than) private investments.
This relates directly to the analysis of the crowding-out hypothesis.
A simple example is the historical relationship between interest rates and
budget deficits and their relation to gross domestic product. A positive
correlation between the two variables supports the crowding-out hypothesis
and vice versa. In fact, things are not that simple, because other factors are
also likely to influence interest rates. For example, during a recession,
investment declines and thus lowers the interest rate. At the same time,
deteriorating business conditions reduce tax revenues and thus increase
the deficit. However, these factors may occur in the inverse relationship,
which does not provide direct information on the effects of crowding-out. As
a consequence, the problem of identifying the separate effects of deficits
on interest rates remains unsolved.
Despite the ambiguity of the econometric arguments, the theoretical
basis for the crowding-out effect is so convincing that most economists
believe that a large budget deficit reduces investments. However, the
precise degree of the reduction and subsequent decline in the welfare of
future generations cannot be estimated with absolute accuracy.8
7
Ibid.
8
Note that the degree of crowding-out is smaller than the degree of attracting
foreign investments due to higher interest rates. However, the burden on future generations
is almost the same due to the interest payments on external loans.
4. The Ricardo-Barro theorem

Our discussion so far has ignored the effects of increased tax rates
or the issuance of government securities in order to finance government
spending.9 This issue was analysed by R. Barro in his classic paper, “Are
Government Bonds Net Wealth?” Here, he proves the Ricardian
equivalence theorem (named after the nineteenth-century economist David
Ricardo), which states that deficit financing of public spending and an
increase in tax rates have the same effect on the economy.
Under these conditions, assuming that the government reduces the
tax revenue by 100 units of capital and also issues government bonds for
the same amount to finance its budget deficit, they will be bought by
households at the expense of the income available due to tax cuts. If
households feel richer as holders of government bonds, they will reduce
their savings and increase their consumption. From this, the Keynesian
thesis can be derived regarding the stimulating effect of deficit budget
financing on aggregate demand and economic activity.
According to Barro, the above assumption ignores the effect of the
future tax burden. Each rational economic agent is aware that when the
government finances a deficit by issuing government bonds, it will raise
taxes in the future in order to pay the interest on them and their face value.
Therefore, through deficit financing the government only postpones the
increase in taxes.
What is the rational response of households in terms of debt
financing of government spending? To prepare for the future payment of
higher taxes, households save part of their income and purchase
government bonds. Therefore, the total amount of savings remains the
same in level as it was before the reduction of taxes and the issuance of
government securities. This means, however, that the level of consumption
also remains the same, and private investment is not crowded out because
the interest rate does not change. This is because the supply of money is
unchanged (since the total savings do not change) and government bonds
are purchased with the money left over from tax cuts.
From the analysis above, Barro concludes that budget deficit
financing does not affect economic activity. Therefore, deficit financing
does not create a burden for future generations. Barro also applies the
theorem to the generational model. He believes that parents are rational in
the long run. They realise that, in conditions of budget deficit, their
9
This section is based on the interpretation of this problem in: SIMEONOV, S.,
Zaharieva, G. Defitsitno finansirane na byudzheta, in: BROWN, C. and Jackson, P. Public
Sector Economics. (Bulg. transl. ed.) Sofia, FSSA, 1998, pp. 574-576.
36 Debt Management
successors will have to pay the interest and principal on the government
bonds issued by paying higher taxes. This will reduce their consumption
and level of prosperity. Parents are worried about such a fate befalling their
children and grandchildren. What can they do to prevent this scenario? A
rational solution is to increase their wealth and to bequeath it to their
children. Parents invest the surpluses in income due to the reduced taxes
in different assets. In the broader sense, these assets can be in various
forms of wealth (corporate shares, real estate, bank deposits, jewellery,
etc.). Barro perceives government bonds specifically as liquid wealth.
Due to the wealth inherited from their parents, the heirs will pay
higher future taxes without reducing their consumption. For example, let us
assume that parents have bequeathed a house to their children. In this
case, the children won’t have to save in order to purchase a house and
therefore will have greater disposable income. However, after they pay
higher taxes, they will have the same disposable income as their parents
used to have. When parents bequeath their government bonds to their
children, the latter will obtain additional income in the form of interest and
principal. This will be used by the children to pay the higher taxes in order
to repay the loan borrowed during their parent’s lifetime. However, the level
of consumption will not fall, i.e. it will remain the same as before the
imposition of higher taxes.
Therefore, deficit financing actually does not change anything. The
parents’ generation retains its level of consumption. At the same time, it
bequeaths some of its wealth (as government bonds or other assets) to
their children. The income from this wealth is used to pay higher taxes to
repay the debt accumulated in previous years. In effect, then, the rational
behaviour of parents eliminates the future burden on their children caused
by debt financing of the budget. Therefore, the general conclusion is that
fiscal policy regarding the budget deficit is unnecessary and useless.

1. ADAMOV, V. Teoriya na finansite (Darzhavni finansi). Svishtov,
2012.
2. SIMEONOV, S., Zaharieva, G. Defitsitno finansirane na
byudzheta, in: BROWN, C. and Jackson, P. Public Sector
Economics. (Bulg. transl. ed.) Sofia, FSSA, 1998.
3. ROSEN, H. Public Finance. New York, 3 ed. 1993.
Keywords
1. Macroeconomic management tools
2. The views of J. Tobin
3. Credit expansion
4. Fiscal revenue
5. Ricardo’s moral considerations regarding his research
6. “Eating up” national capital
7. Generations
8. Overlapping generations model
9. Assumptions regarding the overlapping generations model
10.Generational accounting
11.Current tax value
12.Transfers
13.Net tax
14.Care amongst generations
15.The neo-classical debt pressure model
16.Effects on private investment
17.The crowding-out hypothesis
18.The crowding-out effect
19.Shifting of the economy
20.Full utilization of the resources available
21.External financing and production capacity
22.Private supply of factors
23.Tax and credit financing
24.The equilibrium price of the capital market
25.Dependence between the interest rate and budget deficit
26.The Ricardian equivalence theorem
27.Government bonds
28.Reaction of rational households
29.Burdens for future generations
30.The views of R. Barro
31.Parental transfer of wealth
32.The rational behaviour of parents

1. Which are the main macroeconomic management tools according to J.
Tobin’s theory?
2. How, according to Tobin, could the deficit be reduced?
38 Debt Management
3. What, according to J. Buchanan, encourages the use of deficit

financing?
4. How would you discuss the model of burden distribution among
overlapping generations? Does it have any disadvantages and what are
they?
5. Is the hypothesis that the young generation bears the burden of debt
valid? Provide arguments to support your opinion.
6. What are the effects of government loans according to the neo-classical
concept?
7. Explain the mechanism or the relationship between external financing
and production capacity.
8. Define the Ricardian equivalence theorem and state your own opinion
regarding this.
9. Do you agree with Barro’s opinion that deficit financing does not create
a burden for future generations? Provide arguments to support your
opinion.
Chapter summary
The arguments of the classical and Keynesian schools regarding
deficit financing of the government’s budget established the historical basis
for the development of modern interpretations of this issue. According to J.
Tobin, the budget deficit is more as a result of, rather than the cause of,
higher interest rates and the resultant economic depression. It is a
consequence of the misuse of the two main macroeconomic management
tools by the government: fiscal policy and monetary policy. Economic
literature also discusses the moral aspect of this issue. This was studied by
J. Buchanan, according to whom debt financing of public consumption is,
"...eating up the national capital." Buchanan believes that citizens’ and
politicians’ natural propensity to consume encourages the use of deficit
financing. Voters welcome the receipt of benefits from public spending, but
complain about paying taxes. Eligible politicians are trying to meet voters’
expectations. What withholds this propensity is regard for national capital.
According to Buchanan, the economic logic in Keynes’ concept destroys
the moral barriers that protect the national capital, which will be eroded
unless these moral barriers are restored.
Besides the moral aspect, modern theories also tackle the problem
of transferring the burden of deficit financing amongst generations. A.
Lerner’s model attempts to compare the benefits and burdens of state
fiscal policy for different generations in the long term.
The neo-classical view of deficit financing ignores the effect of tax
increases, or the issuance of government bonds to finance government
spending. This effect is analysed by R. Barro, who proved the Ricardian
equivalence theorem which states that deficit financing of government
spending and tax increases have the same effect on economic activity. He
reached the conclusion that deficit financing does not affect economic
activity and also does not create burdens for future generations.
CHAPTER IV
THEORIES REGARDING THE STRATEGIC ROLE OF
GOVERNMENT DEBT

This chapter presents contemporary research into the relationship
between government decisions and public debt. By the end of the chapter
you will be able to:
 analyse the applications of deficit financing as a tool for
strategic influence over the political cycle;
 interpret the main characteristics and hypotheses of modern
budget deficit theories.
The chapter includes three subtopics:

1. The theory of governmental policy in circumstances of
time-inconsistent preferences;
2. The positive theory of fiscal deficit and government debt;
3. The political-economic model of the strategic role of debt.
1. The theory of governmental policy in

circumstances of time-inconsistent
preferences
The emergence of theories regarding the strategic role of debt is a
modern answer by researchers within the context of public choice theory.
Unlike earlier theories, where fiscal inefficiency is usually explained by the
political conflict between various forces operating at the same moment in
time, they assume a single-factor dependency by the fiscal policy of a
single political ideology at a certain period of time. This single-factor
dependency is interpreted as the right of governments to set fiscal policy
without taking into account the opinion of other political forces. For this
purpose, researchers examined the fiscal behavior of governments with
different ideological preferences in a competitive political environment. This
would mean that political decisions would be consistent with the political
Chapter IV. Theories Regarding the Strategic Role of Public Debt 41
cycle and the will of voters. In other words, regardless of the government’s
political ideology, the preferences of voters will actually determine whether
it should resort to deficit financing or not. Therefore, we must take into
account that the preferences of voters could lead to the use of debt as a
strategic instrument.1 Scientific literature discerns two main strategic
aspects of debt:
 Each fiscal decision has long-term consequences. Debt is a
typical example of governmental decisions with long-term
consequences as the servicing and repayment of it affects future
governments. In other words, by leaving a legacy of debt, the
indebted government determines the behavior of successive
governments as well.
 The indebted government (and the respective political party)
can use debt to improve its image in the eyes of voters, therefore
improving its chances to win at the next elections. This denotes a
strategic influence on voters’ attitudes.
Of course, the specific actions of the indebted government will

depend on the ideological preferences of its electorate. This means that
every political party has ideological constraints regarding the type of
strategic instruments it would use and the way in which they should be
used. Such an approach can be seen to be based on the "political
divergence hypothesis." An alternative view is stated in the "political
convergence hypothesis." According to this hypothesis, given a certain
distribution pattern of voters’ preferences and expectations, and a certain
economic structure in a bipartisan system, both parties will have as their
primary goal the creation of an election platform that meets the
expectations of the average voter. In other words, their primary objective
will be to remain in power by fulfilling the expectations of the average (resp.
mass) voter. However, the political convergence hypothesis conflicts with
the ideological resistance of political forces. This is due to governmental
policy being optimal only for certain conditions and for a specific period of
time. This policy should change according to changes in conditions.
However, these changes may conflict with ideological restraints and the
political force may lose its identity. Under these conditions, the decisions of
the indebted government can:
 pre-define the policies for successive governments according to
the preceding government’s policy;
 change the attitudes of voters.
1
De WOLFF, J. The Political Economy of Fiscal Decisions. N. Y., Physika-Verlag,
1998, p. 28.
42 Debt Management
A comprehensive review of the publications regarding the issue of

the strategic role of debt has allowed us to consider in more detail:
a) the theory of governmental policy in circumstances of time-
inconsistent preferences, developed by T. Person and L. Svensson in
19892,
b) the positive theory of fiscal deficit and government debt, developed
by A. Alesina and G. Tabellini in 19903,
c) the political-economic model of the strategic role of debt, developed
by P. Aghion and P. Bolton in 19904.
The above works are new developments in deficit financing theory.

They complement research on the philosophy of deficit financing.
The basic assumption of the theory of governmental policy in
circumstances of time-inconsistent preferences is a simplified bipartisan
political model in which two political parties (having left- and right-wing
orientation) alternate in office, differ in their levels of public consumption
and are uncertain of electoral attitudes. Person and Svensson apply the
model to a small open economy assuming that the interest rate is zero.
During different periods the country is ruled by governments that can
increase taxes in order to provide sufficient resources in order to finance
the production of public goods. Part (or all) of the fiscal revenues from the
first period can be transferred to the second period, where they can be
used to supply public goods. Taxes are assumed to have a distortive effect,
which means that they induce a deadweight loss to society. The
government generates public benefits beyond those that are generated in
the production of public goods. The presence of a deadweight loss,
however, means a reduction in the benefits generated by the government.
In order to present the main points in Person and Svensson’s study, let us
consider the following example of a situation in which public consumption is
affected only in the second period:
2
The theory is presented as the author’s interpretation of the original ideas
described in: PERSON, T. and L. Svensson. Why a Stubborn Conservative would run a
Deficit: Policy with Time-Inconsistent Preferences. Quarterly Journal of Economics, 1989,
May, pp. 325-345.
3
described in: ALESINA, A. and G. Tabellini. A Positive Theory of Fiscal Deficits and
Government Debt. Review of Economic Studies, 1990, vol. 57, pp. 403-414.
4
described in: AGHION, P. and P. Bolton. Government Domestic Debt and the Risk of
Default: A Political-Economic Model of the Strategic Role of Debt, in: Public Debt
Management: Theory and Practice, ed. by R. Dornbush and M. Draghi, Cambridge, pp. 315-
345.
First, periodic limitation requires that all consumption tax revenues

from the first period should be transferred to the second period. This
creates significant problems in terms of time-inconsistent preferences. If
either party is in power in both periods, this party will have to form a budget
in period one (for both periods), which will include the collection of tax
revenues in the first period and their expenditure during the second period
(with the expenditure in the second period exactly equal to the tax revenue
from the first period). To optimize the effects of the budget on the economy,
the government would construct a budget to equalize the marginal cost of
tax distortion in relation to the marginal benefit from the production of public
goods. At the beginning of the second period, the government may revise
this budget.
Second, in choosing the optimal ex-post budget which will have
certain tax revenues transferred from the first period, the government will
try to equalize the marginal benefits of public goods with the marginal cost
of tax distortion (thus all costs from the first period will be depreciated). The
ex-post budget will differ from the ex-ante budget, not by the marginal
benefits (which will be the same), but by the cost of tax distortion. An
alternative situation will occur when the government opts for a time-
consistent budget. Thus, in determining the taxes in the first period, the
government will take into account the fact that the budget during the
second period will depend on the fiscal decisions from the first period, in
order to avoid subsequent budget updates.
Third, the time-consistency problem arises when the government in
office during the second period is different from the one which was in office
during the first period. Initially, Person and Svensson analysed a case of
fiscal behaviour by a conservative government, who would rather reduce
government spending in the knowledge that, in the second period, they will
be replaced by a government that relies on increased budget spending.
Under these conditions, the conservative government would opt for a low
level of public goods in the second period, and would have to increase
some taxes in the first period to ensure that the resulting revenues are
transferred to the second period. On the other hand, knowing that during
the second period the office will be held by a liberal government, the
conservative government would prefer to allocate less budget revenue for
the second period. This is why the liberal government in the second period
will be forced to increase taxes in order to ensure the higher level of public
goods envisaged. Thus, with lower taxes in the first period, the
conservative government would reduce the expansion of the provision of
public goods planned by the liberal government. However, it is clear that
the behaviour of the conservative government in the first period causes an
44 Debt Management
increase of tax distortion – tax rates are too low in the first period and too
high during the second period.
Fourth, the exact amount of reduction caused by the conservative
government depends on the level of the importance of public goods
compared to the reduction in the government’s usefulness due to tax
distortions. If the government is more persistent than necessary, the
reduction in its usefulness as a result of too many public goods will be
relatively high compared to the reduction of its usefulness caused by tax
distortion. Thus, the conservative government will achieve a higher level of
restriction regarding the activities of the liberal government by
accumulating less money in the state budget. On the other hand, if the
conservative government is more flexible, the level of taxes in the first
period will be modified more easily and smoothly to the level projected by
the liberal government for the second period. This means that the
conservative government will determine its fiscal policy based on the
anticipated changes during the term of office of the liberal government. The
main reason for this behaviour is that the level of tax distortion is lower than
the level in the previous situation. Both situations do not assume the use of
debt financing to ensure the provision of public goods. In fact, the
conservative government restricts the success of the liberal government
only by limiting the increase of tax rates to a greater extent than the
economy can endure.
Fifth, the theory of Person and Svensson has new areas of
application when we include borrowing as a factor which may limit the
success of the liberal government in the second period. This means that
loans taken during the first period will have to be paid by the government
during the second period. One weakness in the Person and Svensson’s
theory is the fact that both authors do not analyse a situation in which the
resources accumulated via the budget during the first period (from taxes
and loans) are used for the production of public goods in the second
period. This means that:
 if the conservative government transfers the entire amount to
the second period, the liberal government can use the accumulated
resources directly to repay the debt. In this case, the constraining effect will
not be achieved (because the interest rate model has assumed a zero
interest rate);
 if the conservative government distributes the money among the
consumers in the first period, the tax (respectively the tax distortion) will be
significantly greater during the second period.
The main finding of Person and Svensson’s study can be defined as

follows: any conservative government can complete their mandate by
imposing lower-than-optimal taxes if they are to be replaced in office by a

liberal government who intend to increase government spending. This
would result in governments choosing time-inconsistent preferences. To
prove their theoretical concept, Person and Svensson analysed the effects
of the Reagan government’s first fiscal policy, where the main strategic
objective was to reduce tax rates during their term of office in order to
reduce the spending of subsequent governments. Another example is the
privatisation policy adopted by the Thatcher government in the UK. In
general, Person and Svensson’s theory instigated further research into the
analysis of the strategic role of government debt.
2. The positive theory of fiscal deficit and

government debt
The positive theory of fiscal deficit and government debt developed
by Alesina and Tabellini was influenced by New Keynesian ideas at a time
when conservative governments in the leading economies were being
replaced by liberal governments. The theory’s assumptions are comparable
to the initial assumptions in Person and Svensson’s model. Like them, the
authors consider an economy with two political parties having different
preferences regarding the desired composition of government spending
between two public goods (e.g. defence and welfare). In this case, unlike
Person and Svensson’s model, the volume of the provision of these goods
does not vary. The two parties have ideological differences and represent
the interests of different constituencies. The government in office provides
both public goods via a specific composition. The goods provided may be
financed through tax revenues (the proportional taxation of labour incomes)
or by issuing government bonds. Since this is a closed-type of economy,
the interest rate is determined entirely by the influence of internal
conditions and factors. Alesina and Tabellini developed their model using a
temporally indefinite, two-period horizon. The mechanism of electing a
government is not peremptorily defined and the parties alternate in office
according to an externally defined pattern regarding the probability of being
elected. There is a constant populace of individuals who work, consume
and save. They are born at the beginning of the first period and have the
same time horizon (two periods or an infinite time horizon). They are
identical in all respects except in their preferences regarding the
composition of the two public goods supplied by the government. The utility
function for these individuals can be expressed as:
46 Debt Management
(4-1) U  U (ct )  V ( xt )  h( gt )  (1   )h( f t ) ,

where:
c is private consumption;
x is leisure time;
g is public good one (e.g. defence);
f is public good two (e.g. welfare);
 is the coefficient of the individual preference regarding the
composition of the two public goods ([0;1]);
t is the time period.
The overall utility for the period is a discounted sum of the utilities
derived throughout the period. Alesina and Tabellini use a model of random
distribution of preferences to define the uncertainty regarding future policy.
At any moment each consumer is endowed with one unit of time that may
be used for either labour or leisure. One unit of labour is transformed into
one unit of public goods. Labour income taxation affects the level of
consumers’ supply of labour and hence the level of individual consumption.
Since consumers are identical in every aspect but for their preference
regarding the composition of the two public goods, we can assume that all
consumers will choose the same levels of consumption and leisure under
the same fiscal policy. In their analysis, Alesina and Tabellini point out that:
First, the government remains in office during all periods and
maximises the weighted average of the utility of all voters. The optimal
solution would be to balance the budget for every period. However, in this
situation the government in office would define the supply level and the
composition of the public goods, as well as the alternative method of
financing their supply (loans or taxes), according to its objective for
maximising the long-term utility of its electorate (in terms of an average,
representative voter). Under these conditions, the government conforms to
the likelihood of being replaced in office by another government supported
by another political force. To simplify the analysis, the authors assume that
the preferences of the two parties regarding the supply of public goods vary
dramatically: only one good will be supplied in any period – the first party
will supply only good g (e.g. wealth, =1) while the second party will
supply only good f (e.g. defence, =0).
Second, the analysis of the two-period model requires reverse
induction. Under these conditions, the government in office during the
second period will have to impose a level of taxation and also a level of
supply and composition of the public goods which will be in compliance
with the debt inherited from the previous government, because, during this
period, the debt has to be repaid. Thus, the government in office during the
first period, being aware of the consequences of deficit financing for the
government in office during the second period, will determine the tax rates,
the budget deficit and the level and composition of public goods supplied
during the first period. Due to the simplification of the characteristics of the
two political parties, the situation during the second period will be perfectly
symmetrical: at a certain volume of inherited debt, during the second period
both parties would choose the same tax rates and level of supply of public
goods regardless of their different preferences regarding the composition of
the supplied goods.
Third, long-term decisions made by the government in office during
the first period depend on the probability of its re-election. The problem of
optimising fiscal policy and deficit financing is solved according to the
marginal cost of the inherited debt (which depends on the probability of re-
election) and the marginal utility of generated public debt to be bequeathed
to the next government in office (which depends on the possibility of
supplying larger volumes of the preferred public good). Therefore, the
lower the probability of re-election, the higher will be the preferred optimal
level of deficit financing. Consequently, policy choices for the next
government in office will be constrained proportionally to the size of the
inherited debt and the corresponding reduction of government spending for
provision of public goods.
The main conclusion which can be derived from Alesina and
Tabellini’s theory is that public debt plays a strategic role in determining the
restraints of the fiscal policy of future governments.
3. The political-economic model of the strategic

role of debt
The theories mentioned above regarding the strategic role of deficit
financing and public debt related only to the influence that a certain
government may have on the decisions of the subsequent government.
They did not consider the possible effects of a government on voters’
behaviour. A study conducted by P. Aghion and P. Bolton in 1990 fills this
gap by developing a political-economic model of the strategic role of debt,
which demonstrates how the over-accumulation of debt can have a
strategic influence on voter’s behaviour and attitudes.
The model considers a closed economy in which two political
powers are trying to win elections in two successive periods. Elections are
held at the beginning of each period. The government provides a public
good during either period. In period one the government can choose
48 Debt Management
between proportional income tax5 and issuing government bonds to be sold

to other economic agents (deficit financing). The interest rate is determined
by internal factors in the economy. During the second period, only taxes
are available to finance both debt repayments and expenditure on the
public good. The rate of transformation between the private and the public
good is equal to one, i.e. one unit of private good produces one unit of
public good. Aghion and Bolton’s analysis covers two scenarios:
a) that the government does not default on outstanding public debt
in period two;
b) that the government decides when and how much of the
inherited debt they will repay.
The consumers live throughout both periods. Within each period

they earn a fixed amount of income according to a given normal histogram
of income distribution. Therefore, consumers are heterogeneous in terms
of their incomes. The public good is supplied to each consumer at equal
rates. Under these conditions the utility function for a consumer who
consumes a private ( c ) and a public ( g ) good throughout the two periods
is represented as:
(4-2) U c1, c2 , g1, g 2   log c1  g1    log c2  g 2  ,
where:
 is the discount factor.
This utility function is rather specific since the private and public
goods are completely interchangeable. Consumers choose the volume of
consumption in both periods and also the amount of savings in the first
period in light of the budgetary constraints in each period and in order to
maximize the utility function above. Between the two periods the two
parties compete with each other to win the elections. The left-wing party
represents primarily the interests of those individuals whose income is
below the average in the economy. The right-wing party represents
primarily the interests of those whose income is above the average. The
electorate vote for the party that guarantees them a higher value with
regards to the utility function in the second period. The party which
receives at least fifty percent of the votes is elected.
Initially, Aghion and Bolton assumed a model having no default on
the debt. Their analysis starts with a comparison of the optimal fiscal policy
for the two periods from the point of view of a left-wing and a right-wing
5
Hence we have a distortive effect of income taxation.
“dictator”.6 After that, they analysed a situation having alternating

governments. The equilibrium in their model (like those in Alesina and
Tabellini’s analysis) is solved using the method of backward induction.
Thus, the optimal fiscal policy in the first period is determined by the known
amount of inherited debt. The first government decides on the optimal
amount of debt and the level of supply of public goods for this period. In
Aghion and Bolton’s model the key fiscal policy decisions are taken by the
Minister of Finance who bears the political responsibility to his party for the
success of its term in office and electoral victory. Under these conditions it
may be noted that:
First, at a certain volume of mature debt, the Minister of Finance will
be indifferent with regards to the high level of expenditure on public goods.
This indifference is in terms of:
 a policy for determining a level of tax rates during the second period
2 in order to ensure revenue which would cover only debt servicing
expenditure and not the finance for the provision of the public good
g 2 ; and
 a policy of higher tax rates during the second period in order to
provide the resources for the supply of the public good.
The reason for this indifference is clear. Since private and public
goods are completely interchangeable and the average consumer gets an
exact equivalent of public good in exchange for his private good, the
feasible utility level will be the same for any composition of consumption of
private and public goods. Such a relation, however, is valid only for the
average consumer - those with average incomes. Consumers with lower
incomes will generate less fiscal revenues than the value of the public good
they receive. For consumers with higher than average incomes, this
proportion will be the inverse. Similar results can also be obtained for the
first period. Without the distorting effect of taxes, and with two completely
interchangeable goods, the Minister of Finance will be indifferent not only
to the choice between the composition of debt and taxation financing the
provision of public goods, but also between the probable volume of debt.
Aghion and Bolton define this situation as Ricardian super
indeterminacy. The authors point out that the indeterminacy is in terms
not only of the composition of the expenditure for financing the provision of
public goods (as in the Ricardian equivalence theorem), but also of the
feasible level of government spending. For the average consumer a greater
6
For Aghion and Bolton the term “dictator” means a party which has a government
in office in both periods.
50 Debt Management
present day public debt motivates agents to save more in order to pay the
future increase in income taxes in the second period.
Second, fiscal decisions during the second period will vary
according to the political affiliation of the government in office. A right-wing
government would choose to cease the provision of public goods during
the second period and the tax rate will correspond to the minimum level
required to repay the debt. A left-wing government will try to maximize the
provision of public goods and will therefore set a tax rate  2  1 and provide
the maximum possible volume of public goods once the debt is repaid.
During the first period, a right-wing government will try to minimise
expenditure – it will stop the provision of public goods and, hence, will not
have the grounds to collect taxes or issue bonds. As a result, consumers
will not save. A left-wing government, on the other hand, will maximize the
level of government spending, impose the maximum tax rate 1  1 and
issue bonds for a specific maximum value (the value of the discounted
aggregate income during the second period). However, this leads to a
confusing situation – bonds will not be purchased because the whole
income of consumers will be transferred to the budget as tax revenues.7 In
order to avoid such controversy, Aghion and Bolton additionally assume
that   [0 ; 1], the criterion being an efficient income tax. At this stage of
the analysis we may summarize that:
 a country with a right-wing “dictator” may be described as a country
having a zero level of state interference in the economy8; during
both periods in such an economy, no public goods will be provided
and no public debt will be incurred; consumers will dispose of all
their income and will be able to spend it on purchasing private
goods;
 a country with a left-wing “dictator” may be described as a country
having total state interference in the economy. During both periods,
taxation will claim all income and only public goods will be
consumed.9
Third, the alternation of the government in office results in changes

in the fiscal policy.
Aghion and Bolton analysed the optimal fiscal policy in two
situations – first, when a left-wing government is replaced by a right-wing
7
The model will be even more confusing if we assume that consumption can have
a negative value.
8
i.e. the classical ideal of a laissez-faire world.
9
This description strongly resembles the imagined communist society (author’s
note).
government (LR), and vice versa (LR). Following the inverse induction
method, the analysis started with the second period. The results were
identical to those described above: for a given level of inherited debt, a
right-wing government will not provide any public goods and will impose the
lowest possible tax rate that would allow them to repay the debt; a left-wing
government, on the other hand, will maximise budget revenues (1),
repay the debt and use the remaining budget revenue for the provision of
public goods. Which party will win the elections depends on the distribution
of incomes – as we have already mentioned, consumers (i.e. the voters)
are heterogeneous in terms of their incomes. The voters with average
incomes will be indifferent – all voters with incomes below the average will
be worse off, and this is why they will vote for a left-wing party; all voters
with incomes above the average will be better off and will therefore vote for
a right-wing party. In this situation, the outcome of the elections depends
on the direction of the income distribution asymmetry. If the median voter is
worse off than the average voter, the elections will be won by the left-wing
party and vice versa – if the median voter is better off than the average
one, the elections will be won by the right-wing party. Therefore the
outcome of the elections is a function of the position of the median voter.
Fourth, if the left-wing party is in power in the first period in an
economy where the income distribution is such as to ensure victory for the
right-wing party, the left-wing party would prefer a maximum level of public
spending whilst in office. Things get much worse when we take into
account that the right-wing successor will have radically different
preferences - a minimum level of supply of public goods. In this case, the
left-wing party will impose tax rates of 1  1 in an attempt to constrain the
policy choices of the succeeding right-wing government by taking a
substantial loan, thus reducing the disposable incomes during the second
period. During the first period this will provide poorer consumers with
greater benefits compared to the benefits for the average consumer,
because their disposable income does not allow them to purchase any
quantity of the public good provided. Moreover, this will have a
redistributive effect during the second period, as the richer consumers will
bear a relatively higher tax burden to service the debt.
Fifth, if a right-wing government is in office during the first period
and it is obvious that it will not be re-elected plus it will be succeeded by a
left-wing government, the former will not collect any taxes because it is
aware that the latter will collect all incomes as taxes and is therefore
indifferent to the actual volume of debt. For example, if a right-wing
government bequeaths a substantial debt to the succeeding left-wing
government, the latter will have to cut its spending because its priority will
be to repay the debt. In fact, the large debt results in a higher level of
52 Debt Management
savings by rational consumers since they will try to avoid future losses of
income due to the imposition of higher tax rates. Under these conditions, it
can be argued that the debt cannot have a strategic impact on the outcome
of the election. In their analysis, Aghion and Bolton further examined the
likelihood of default on a part of, or the full amount of, the debt during the
second period. Their first assumption related to the behaviour of the
Minister of Finance once again, who is indifferent to the alternatives:
 repaying the debt, and
 defaulting.
If the Minister of Finance defaults during the second period, this will
result in lower taxes and, respectively, a higher income for the average
user. If the Minister does not want to default and repays the debt,
consumers will recover their bond holdings from the first period, which will
also automatically increase their income. The average consumer benefits
in both cases.
Sixth, if both the left- and the right-wing governments choose to
default, the initial equilibrium will change. As already noted, the structure of
the utility function induces a preference for the party left with the highest
possible level of public expenditure. Thus, by defaulting on the outstanding
debt payments, a left-wing government will ensure the achievement of the
above preference. In fact, a government like this redistributes income in
favour of poorer voters. Since savings are a function for increasing income,
wealthy consumers are assumed to recover a much greater amount than
the poorer, who will recoup smaller volumes of savings. They will be better
off at a higher level of provision of public goods. What is surprising here is
that a right-wing party will choose to default on the debt as well. As we
already noted, the right-wing will increase tax rates during the second
period only to repay the inherited debt, and will not attempt to provide any
public goods. If the right-wing government defaults on a part of, or the full
amount of, the debt, this will maximise the benefits for voters who support
the party. This can easily be proved via mathematical means. A right-wing
government will impose a zero tax rate during the second period and a
complete moratorium (on principal and interests) on the debt. In these
circumstances, Aghion and Bolton take into account that consumers with
incomes above the average will pay more in taxes to finance debt
repayment than the value of their bond holdings. In other words, for every
dollar of savings return, the rich will have to pay more than a dollar as
income tax.
Seventh, costless default on the debt leads to the impossibility of
establishing a rational-expectations political equilibrium where government
expenditures are financed through debt. This is logical, because no one will
agree to lend to the government if they anticipate a default on the debt. In

fact, the initial assumptions and limitations of the model (a non-distortional
effect of taxation, rate of transformation between the private good and the
public good of “one”, etc.) result in one where small changes in the
parameters yield non-linear changes in the results. Any modifications to the
initial assumptions and limitations also results in changes in the results. At
this stage of their model’s development, Aghion and Bolton changed the
rate of transformation by assuming that it takes more than one unit of
private good to produce one unit of public good. In these circumstances,
the provision of public goods becomes more expensive. This changes the
results of the model, and now the right-wing government will have to resort
to deficit financing as an instrument of strategic influence on voters’
attitudes in order to be re-elected.
Eighth, the new logic of the model results in a change of income
distribution. This establishes a new middle class which would prefer
repayment of the debt during the second period. Moreover, the size of the
middle class is a function of the volume of the debt accumulated. Thus, due
to the modification of the model, we can analyse the behaviour of a
marginal (indifferent) consumer. For a substitution rate of one, marginal
consumers will be those with average incomes. These average consumers
were indifferent to both alternatives in the second period due to the fact
that one unit of private good could be exchanged for exactly one unit of
public good. When the rate of substitution changes, average-income
consumers will change their behaviour as well: if all their incomes are taxed
away, the volume of public goods they will get in return is smaller than the
volume they would be able to purchase with their disposable income. This
is why the average consumer will be better off with a right-wing
government. The new marginal consumer is poorer than the average-
income consumer (see Figure 4-1).10
10
The figure is based on: De VOLFF, Op. Cit., p. 42 (with modifications).
54 Debt Management
Optimal default policy
Poor Middle-class Affluent

voters voters voters
0 Marginal Average 1
income income
2=1 2=annuity 2=0
during the 2nd period

Preferred policy
Maximum Zero Zero
volume of volume of volume of
public good public good public good
Default Without default Without default
Figure 4-1
The group of voters with incomes between the marginal and

average level form a new political class of voters – the middle class. They
differ from affluent voters in one thing only – they tend to tolerate the
taxation of income. The new marginal voter may change their behaviour
depending on the amount of debt to be repaid. Therefore, their voting
attitudes can be influenced using public debt as a strategic instrument:
 the smaller the amount of debt, the closer the marginal and the
average voters will be;
 a small amount of debt means a lower level of savings during
the first period (a limited issue of government bonds) and, therefore, a
lower level of repayment expenditure during the second period;
 a higher level of consumption of public goods during the first
period which results in electoral support for the left-wing party.
Hence, the conclusion that debt as a strategic instrument can be

used to influence the behaviour and size of the middle class, and therefore
the outcome of the elections. In defence of the right-wing government’s
policy, Aghion and Bolton prove that such a government will issue bonds
for electoral purposes only. Intuition suggests that the existence of a
majority of voters who hold a significant proportion of the income saved in
government bonds will reduce their support for the left-wing party, which is
likely to default.

1. ADAMOV, V. Milinov, V. Teoriya na finansite (metodichesko
rakovodstvo). V. Tarnovo. ABAGAR, 2002.
2. ALESINA, A. and Tabellini, G. A Positive Theory of Fiscal
Deficits and Government Debt. // Review of Economic Studies,
1990, vol. 57.
3. BOLL, S. Intergenerationale Umverteilungswirkungen der
Fiskalpolitik in der BRD. Frankfurt, 1994.
4. De WOLFF, J. The Political Economy of Fiscal Decisions. N. Y.,
Physika-Verlag, 1998.
Keywords
1. Strategic aspects of debt
2. The political divergence hypothesis
3. The political convergence hypothesis
4. Basic assumptions of the theory of governmental policy in
conditions of time-inconsistent preferences
5. Distortionary effect of taxation
6. Periodic restriction of consumption
7. Time-inconsistency of preferences
8. Optimal ex-post budget
9. Fiscal behaviour of conservative governments
10.Behaviour of liberal governments
11.Reduction of government’s utility
12.Weaknesses in Svensson and Person’s theory
13.The result of Svensson and Person’s research
14.Basic assumptions regarding the positive theory of fiscal deficit
and government debt
15.Utility function
16.The mechanism of political elections
17.Maximisation of voters’ long-term utility
18.Reverse induction method
19.Optimisation of fiscal policy and debt financing
20.Basic assumptions regarding the political-economic model of the
strategic role of debt
21.Heterogeneity of consumers
22.Inter-periodic utility function
23.Left-wing party
24.Right-wing party
56 Debt Management
25.Expenditure for the provision of public goods

26.Conditions for indifference regarding the expenditure for the
provision of public goods
27.Ricardian super indeterminacy
28.Behaviour of average-income consumers
29.Behaviour of right-wing governments
30.Propositions in Aghion and Bolton’s theory
31.Indifferent voter
32.Right-wing successor in office
33.Protection against future loss of income
34.Consequences of debt aging
35.Consequences of debt default
36.Middle class
37.Marginal consumer
38.Average-income voter

1. What is new in the theories regarding the strategic role of public debt?
2. What is the feasibility level of the “political divergence hypothesis” and
the “political convergence hypothesis” in the existing political and
economic conditions of Bulgaria?
3. What are the basic assumptions of governmental policy theory in
conditions of time-inconsistent preferences?
4. What are the key elements in, and the main results from, Svensson and
Person’s research?
5. Comment on the validity of the functional dependencies in Alesina and
Tabellini’s theory (equation 4-1).
6. What are the weaknesses in Svensson and Person’s theory?
7. What are the differences between the positive theory of fiscal deficit
and government debt, and Svensson and Person’s theory?
8. What are the basic assumptions of the political-economic model of the
strategic role of debt and how does it differ from the first two theories?
9. What are the main situations and the key elements in Aghion and
Bolton’s analysis? Do you agree with them?
Chapter summary
Modern public debt theory includes the use of debt as a strategic
instrument to influence voters’ decisions on the one hand, and to improve
the image of the government in office on the other. Governmental actions
also depend on the ideological preferences of its electorate. They can be
based on two main hypotheses: the “political divergence hypothesis” and
the “political convergence hypothesis”.
An in-depth knowledge of debt financing philosophy requires that
we should consider:
а) Governmental policy theory in conditions of time-inconsistent
preferences,
b) The positive theory of fiscal deficit and government debt, and
c) The political-economic model of the strategic role of debt.
The theory of governmental policy in conditions of time-inconsistent

preferences was developed by Person and Svensson. It assumes a
simplified two-period model in which the two political parties (having left
and right orientation) alternate in office, differ in their levels of public
consumption and are uncertain regarding electoral attitudes. The positive
theory of fiscal deficit and government debt developed by Alesina and
Tabellini is influenced by New Keynesian ideas. Its basic assumptions are
similar to those of Person and Svensson. The government in office
provides a particular composition of two public goods. The supply of public
goods can be financed either from tax revenue or from the issue of
government bonds. It is a closed-type economy and therefore the interest
rate is determined entirely by internal factors and conditions.
Aghion and Bolton coined the terms “middle class” and “marginal
consumer”. The size of the middle class is a function of the volume of the
debt accumulated. The marginal consumer is worse-off than the average-
income consumer. The marginal voter may change their behaviour
depending on the amount of debt to be repaid. The authors prove that a
right-wing government will issue bonds for electoral purposes only.
CHAPTER V
THE ROLE OF THE STATE IN THE ECONOMY

This chapter describes the types of public goods and the role of the
state in the process of their production and supply. At the end of the
chapter you will be able to:
 identify the various types of public goods;
 use the instruments for control of production of such goods;
 discuss the advantages and the specific features of club goods.

1. Public goods;
2. Club goods.
1. Public goods
Apart from purely public goods such as national defense, which are
non-rivalrous and cannot comply with the principle of excludability
(otherwise their compliance to this principle would be too expensive) and
the purely private goods, which are rivalrous and excludable, there are also
mixed types of goods. These goods are neither purely public nor purely
private. Brown and Jackson (1992, 1998) classify them into two groups
according to the following criteria:1
 Consumption rivalry;
 Possibility for application of the excludability principle.
1. The first group includes goods consumed collectively and are

at the same time subject of overconsumption. These goods are
provided by private companies or by the public sector. They are
supplied by means of the market, of the state budget and are
financed with either sales incomes (e.g. fees charged for the use of
1
For more details see: BROWN, C. and P. Jackson. Public Sector
Economics. 4th ed., BLACKWELL, 1994.
Chapter V. The role of the state in the economy 59
a service) or tax revenues. Examples for such goods are public

parks, public swimming pools, etc. In other words these goods are
rivalrous and non-excludable (i.e. the excludability principle cannot
rationally be applied).
2. The second group includes goods which are non-rivalrous and
excludable. These are the so-called “goods with external effects”.
They are produced by private companies, distributed by means of
the market with subsidies or adjustment fees and financed with
sales incomes. Examples for such goods are schools, private
swimming pools, cable TV, etc.
More generally, mixed goods are goods with personalised benefit

(i.e. the individuals benefit from the goods) that can also be beneficial for
the society as a whole. Consider education: the state is interested in its
citizens to be better-educated and better-qualified and therefore participate
in the production and provision of this good. On the other hand, individuals
receive personal benefits from the consumption of that good.
Under the conditions of equilibrium and perfect rivalry, where the
optimal quantity of each type of good is produced, the conditions for
marginal costs are identical to the equations for purely private and public
goods. This means that the marginal cost for the joint good is equal to the
amount that all individuals are willing to pay for the benefit of private and
public goods consumption.
Fees must be charged for the consumption of private values of the
mixed goods, because:
1. No groups of individuals should be privileged in the
consumption of a good paid for by the whole society;
2. The demand corresponding to such fees provides an index for
the desired level of investment and monetary expenditures for the
provision of such goods.
3. When the cost of providing additional capacity are proved to
result from those who demand the good, the consumption fees
serve as a rationalisation tool to limit the demand for this particular
good. This stimulates the demand for alternative goods as well as
to channel supply in areas that best meet the economic needs of
each buyer. In other words, if the government acts as a distributor
or a supplier of private goods, its aim is to compete with the free-
market providers, i.e. goods and services must be produced only if
consumers are willing to pay the price asked for them.
Where this is not done, the provision will be very expensive, i.e.
there is no effective constraint on the demand for these goods. (Of course
60 Debt management
there may be reserves. Without consumption fees and some clear demand
indicators, the government may not be willing to provide expensive goods
or services for which consumers are willing to pay in full). The supply of
public goods further raises the question of the private spending to finance
public funds. According to Keynes “… government is not to do things which
individuals are doing already, and to do them a little better or a little worse;
but to do those things which at present are not done at all.”2
Government itself is one of the most important public goods: a
capable and efficient government benefits all. A good government has the
two main characteristics of public goods:
 everyone benefits from it;
 it would be difficult and unnecessary to exclude any individual
from it.
The analysis of the efficient provision of public goods assumes that

any redistribution carried out by the government in connection with the
equitable distribution of income is achieved through the method of lump
sum taxes. Such taxes do not distort the relative prices and therefore are
neutral in terms of the efficient allocation of resources. These taxes are not
used in practice. This means that the current tax system is associated with
the so-called deadweight loss, i.e. the price paid by the taxpayer to obtain
one unit of income through taxation is usually greater than one unit.
This imperfection in the tax system means that when purely public
goods are financed using the distorting taxes method, the Pareto optimality
condition derived by Samuelson should be modified to:
EMRSi + E (private spending on public funds) = MRT
This means that private spending on public funds includes the price
system distortions caused by the tax, the cost of the state to collect taxes
and the costs incurred by the taxpayer to determine and pay the tax. This
rule can be applied in the analysis of public benefits and costs, where the
costs will include the costs of government. If these costs are included in the
analysis, we shall see that the effective size of the public sector will be
smaller than that defined with the traditional analysis of Samuelson, who
has ignored these costs.
2
ROSEN, H. Op. cit.
2. Club goods
The analysis of the non-pure public goods led to the development of
the club theory. According to this theory, the club is an association of
people who collectively consume a good which none of them could
consume individually. Thus they aim to exploit the economy of scale – to
share the costs with the other club members or to satisfy the need for
interpersonal communication. The size of the club plays an important role.
Each additional member reduces the average cost of the club good.
Another question is to what extent the size of the club can increase without
sacrificing the quality of services or benefits that members receive.
Basically the problem of the excessive large number of club members may
be solved by introducing a membership fee or restriction. Examples of such
club goods are swimming pools, language courses etc. Typical here is that
those who are not members of the club may be excluded from the benefit
of good. The main feature of such goods is that those who are not
members of the club can be excluded from the consumption of the goods.
The classical club model of Buchanan included the following
propositions:
 the club can exclude the non-members of the club at no cost;
 there is no discrimination among the club members as all
benefits and costs are shared equitably.
Buchanan’s club is a voluntary association and his analysis is

focused on the development of a representative individual club member
denoted as I, the consumption of the i-th individual of of private goods - yi,
the non-pure public good X and the size of the club - s. Thus the
individual’s utility function can be expressed as: max Ui (yi, X, s). The
analytical problems are related to determining the:
 optimal conditions for the club good;
 the volume of good that can be provided;
 the optimal size of the club.
From the point of view of the debt management concept, the club
theory generates valid solutions at municipal level, where the decisions
regard the deficit financing of the local budget.
62 Debt management

1. BROWN, C. and Jackson, P. Public Sector Economics. (Bulg.
transl. ed.) Sofia, RSSA, 1998 (ed. G. Manliev).
2. STIGLITZ, J. Economics of the Public Sector . (Bulg. transl. ed.).
Sofia, Stopanstvo, 1996.
3. ZAHARIEV, A. Fiskalna detsentralizatsiya i finansovo upravlenie
na obshtinite v Balgariya. Tsenov, // Biblioteka „Obrazovanie i
nauka”, book. 13, Svishtov, 2012.
Keywords
1. Mixed goods
2. Excludability principle
3. Consumption rivalry
4. Pure public goods
5. Pure private goods
6. Equilibrium conditions
7. Marginal costs for mixed goods
8. Private spending financing public funds
9. Good government
10.Lump-sum taxes
11.Club goods
12.Club
13.Club size
14.Buchanan’s classical model
15.Analytical problems related to provision of public goods
16.Optimal conditions for provision of club goods

1. What are the differences between mixed and the pure goods?
2. Describe the main types of mixed goods.
3. Describe the main reasons for imposing fees for the consumption of
goods.
4. What is the role of the state in the process of the production and supply
of public goods?
5. What methods for the efficient supply of public goods are you aware of
and what is the level of their efficiency?
6. Comment on the main idea of Buchanan’s classical club model and

define the level of its feasibility today?
7. What are the main problems related to club goods?
64 Debt management
Chapter summary
Pure public goods are those goods which are non-rivalrous and
either cannot comply with the principle of excludability or their compliance
would be too expensive. Unlike the pure public goods, the pure private
goods are rivalrous and excludable in terms of their consumption. Apart
from the pure goods, there are also mixed types of goods that are neither
purely public nor purely private. They can be classified into two groups
according to the above criteria. The first group includes goods consumed
collectively and are at the same time subject of overconsumption. These
goods are provided by private companies or by the public sector, are
supplied by means of the market of the state budget and are financed with
either sales incomes (e.g. fees charged for the use of a service) or tax
revenues. The second group includes goods which are non-rivalrous and
excludable. Therefore mixed goods are goods with personalised benefits
(i.e. the individuals benefit from the good) that can also be beneficial for the
society as a whole.
Under the conditions of equilibrium and perfect rivalry, where the
optimal quantity of each type of good is produced, the conditions for
marginal costs are identical to the equations for pure private and public
goods. This means that the marginal cost for the joint good is equal to the
amount that all individuals are willing to pay for the benefit of private and
public goods consumption.
We should not disregard the issue of financing the provision of
goods. Individual consumers must be charged fees for the consumption of
private values of the mixed goods. It is believed that if the government acts
as a distributor or a supplier of private goods, its aim will be to compete
with the free-market providers, i.e. goods and services must be produced
only if consumers are willing to pay the price asked for them. Otherwise
there will be no effective constraint on the demand for these goods. The
supply of public goods further raises the question of the private spending to
finance public funds.
Government itself is one of the most important public goods. A good
government has the two main characteristics of public goods: everyone
benefits from it and it is difficult and unnecessary to exclude any individual
from it.
The analysis of the efficient provision of public goods assumes that
any redistribution carried out by the government in connection with the
equitable distribution of income is achieved through the method of lump
sum taxes. Such taxes do not distort the relative prices and therefore are
neutral in terms of the efficient allocation of resources. These taxes are not
used in practice. This means that the current tax system is associated with
the so-called deadweight loss, i.e. the price paid by the taxpayer to obtain
one unit of income through taxation is usually greater than one unit.
The analysis of the non-pure public goods led to the development of
the club theory. The club is an association of people who collectively
consume a good which none of them could consume individually. Thus
they aim to exploit the economy of scale – to share the costs with the other
club members or to satisfy the need for interpersonal communication. The
size of the club plays an important role - each additional member reduces
the average cost of the club good or reduces the quality of the services or
benefits that members receive. Basically the problem of an excessively
large number of club members may be solved by the introduction of a
membership fee or another restriction. According to Buchanan’s classical
club model, the club can exclude the non-members of the club at no cost
and there is no discrimination among the club members as all benefits and
costs are shared equitably.
CHAPTER VI
ANATOMY OF THE STATE REDISTRIBUTION FUNCTION

This chapter describes the problems related to the intergenerational
effects of the governmental financial policy. At the end of the chapter you
will be able to:
 analyse the effects of governmental decisions in the field of
deficit financing;
 discuss the relationships and dependencies between the budget
balance and the volume of intergenerational distribution.

1. The methodology of state redistribution impact;
2. Budget balance and intergenerational distributions.
1. The methodology of state redistribution

impact
The intervention of the state on the economy is a process, the

knowledge of which is a prerequisite for sound decision-making in the field
of deficit financing and debt management. As a form of financing the
budget deficit, public debt raises some questions as to the nature and
extent of the intergenerational impact of governmental financial policies.
For this purpose a two-generation model based on the neoclassical growth
model is used. The starting point for such research is to analyse the
general economic importance of the state tax and its transfer policy in
terms of its impact on macroeconomic stability and economic growth. The
common redistribution method of global transfer, results in a minimum
macroeconomic capital base as well as a low overall level of social welfare
(even in long-term equilibrium). In fact, a redistributive policy that leads to
major economic consequences, such as the state budget balance, is
difficult to describe with a single variable. For this purpose, we should look
for another option which would allow a more objective evaluation of the
effects of the government’s intergenerational redistribution. The theoretical
Chapter VI. Anatomy of the state redistribution function 67
basis for such a measure is the fiscal balance rule, which provides clear
criteria for the implementation of an unbiased but efficient financial policy
by the state.
Research into the general-economic effects of the intergenerational
distribution led to the following results:1
First, the economic activity within the generation’s model of a
representative individual is characterised with individual distribution of their
income at the time of its acquisition among the current consumption flows,
and, by means of his savings – among future ones as well. Under these
conditions, the labour supply of an individual household will depend on the
wage level (i.e. the income of an economic agent at a certain time t
amounts to wt.) His consumption at a young and an old age is denoted
1 2 1
respectively with c t and c t 1 and his savings at a young age with s t . The
personal savings of the individual generate interest at the current interest
rate rt 1 in such a way that his liquid assets and income from interest are
available to cover his current consumption spending. The adopted
redistribution policy provides for a uniform tax rate (z) for all economic
agents and a common transfer in favour of retired agents. For each period
the population growth is n. Throughout the lifetime of each young individual
the state collects from taxes at the tax rate of z and transfers the whole
amount to the old generation in the same period. Thus each retired
economic agent receives a transferred amount of 1 n z . Therefore the
budget constraints for the young and the old generation are respectively:
(6-1) w t  c1t  s1t  z
(6-2) s1t 1  rt 1   z1  n   c 2t 1
The equations above are converted to yield the intergenerational

budget constraint equation:
c 2t 1 z1  n  r n
(6-3) c1t   wt  z   w t  z t 1
1  rt 1 1  rt 1 1  rt 1
Therefore the aggregate expression of the value of consumption

spending should be equal to the net income. This is actually an expression
of the net salary after the deductions for the net transfers paid by the state
throughout the life cycle. Notwithstanding the planned transfer payments to
1
The equations are adopted from: BOLL, S. Intergenerationale Umverteilung-
swirkungen der Fiskalpolitik in der BRD, Frankfurt, 1994.
68 Debt management
the old generation, the economic agents are taxed as the interest is
foregone due to reductions in income capacity not paid. There is a parallel
decrease in the taxation of the individual agents because as the population
grows the transfer amounts per capita increase more than the per capita
payment transfers for each generation. If the rate of population growth is
lower than the interest rate, then the accrued interest on the contributions
within this redistribution model will not be enough to compensate for
foregone interest income of the payers of social security contributions.
Therefore, the net value of the net payments of each employee to the state
budget will be positive, and will accordingly decrease his purchasing
 
power. In the opposite situation rt 1  n , population growth will contribute
to the effect that the implemented policy of redistribution will actually not
burden any generation. These correlations do not actually concern the
retired generation at the time of the introduction of such a policy, as it
receives the same transfers without having to pay any contributions. Thus,
in all cases, this generation takes advantage of all social benefits. The
consumption of this age group will comply with the budget constraint (6-2)
and use the total amount of the transfer 1 n z above the initially planned
level.
 1
Second, each household maximises its utility function u t  c t , c t 1
2

This function is based on the Cobb Douglas methodology:
  c 
u t  c1t
 2 1
t 1 for (0<<1). Thus it is clear that the current consumption
demand corresponds to a  share of the incomes within the individual life
cycle. With equation (6-1) for the savings of the young generation we arrive
at the following relationship:
 r n
s1t  1  w t  z1   t 1 
 1  rt 1 
(6-4)
 1 n 
 1  w t  z1     
 1  rt 1 
This equation shows that regardless of whether the state

redistribution policy causes an actual decrease in the resources of the
economic agents or not, the changes in their savings volume are
insignificant. This is due to the fact that both the contributions paid during
their youth (period z), and the transfers they receive when they are retired
1 n z reduce their material interest to save. This applies to each
separate type of payment, and thus such payments can be expected in
both periods. The impact of the fiscal policy on savings is also independent
of the relationship between growth rate and interest rate.
Third, the periodic capital market equilibrium is the result of the
alignment between the savings of younger at a certain time t and the need
for capitals for the subsequent period k t 1 . In per capita terms, for the
young people in the t period the equilibrium can be expressed as:
(6-5) s1t  1  n k t 1
Combining this macroeconomic presentation of the result of the

individual utility maximisation, as in equation (6-4), we obtain the equation
for the temporary development of general-economic capital resources:
1  1  
(6-6) k t 1  w t z z
1 n 1 n 1  rt 1
Factor prices are determined in terms of the general economic

production activities. It expresses the relationship between the per capita
gross domestic product - y t and the capital supply level of labour k t

represented as a Cobb-Douglas function: y t  k t , for (0<<1). According
to the traditional concepts of the neoclassical equilibrium theory, factor
prices depend on the marginal efficiency of labour and capital:
w t  1   t

(6-7)
(6-8) rt  k t 1
These correlations allow us to derive the effects of the redistributive

policies already described. The long-term equilibrium capital resource
obtained without government activity is determined by equality 16-6 for
к t 1  k t  k and z  0 . Thus equation 6-8 is transformed as:
1
 1  1    1
(6-9) k 
 1 n 
Deriving equation (6-6) for the value of z in long-term equilibrium

results in:
70 Debt management
    
  
k 1  wk 1    1  r  k 
(6-10)    z 
z 1  n k z 1  n 1  r k z 
 
 
For z=0 this equilibrium is solved by modifying equilibrium 6-7 and

6-9:
k  1   1     1 k 1   
 k   
z 1 n z 1  n 1  r
 1   1     1   1    k
1
1  
     
(6-11) 1 n 1 n z 1 n 1 r
1 1    
   
1  1 n 1 r 
The meaning of this equilibrium reflects the fact that the taxation and
transfer mechanism reduces the capital resources in the long term,
irrespective of the ratio between the rate of growth - n and the interest rate
- r. This is because the applied policy does not constrain the individual
incomes r  n  . The redistribution, resulting from the adopted fiscal policy,
causes a general-economic increase of consumption in favour of the older
generation without changing the capital resource. The reason for this lies in
the fact that the older generation has a marginal propensity to consume, in
terms of income available equal to the unit, thus saving. There can be no
question that this is due to the the older generation exhibiting a marginal
propensity to consume its disposable income, ruling out the possibility for
saving. At the same time the younger generation reduces its consumption
in the period of the implementation of the policy, but only to the amount of
zrt 1  n  / 1  rt 1  , and thus the general-economic consumption is
growing. The actual decline in savings in all subsequent periods causes a
long-term reduction of capital resources. The resulting changes of factor
prices in each year after the period of implementation have a negative
effect on savings. However, according to equation 6-4, saving is a positive
correlation of interest and the care for the old will decrease at the rate of
increase of the expected net transfer value. Conversely, a higher discount
rate of future transfer payments will result in higher levels of savings in the
future. Therefore, the effect on savings resulting from factor costs only
cannot be determined separately.
2. Budget balance and intergenerational

distributions
Considering the above relationships, issues arise regarding the
relationship between the budget balance and the level of intergenerational
distribution. However, the state policy described above, results in
redistribution and overall economic change in several aspects. The
scenarios of state redistributive effects show an obvious preference in
favour of the older generation at the expense of the younger generation.
This is because during the life cycle of each working generation the pattern
of taxation remains the same - the tax burden is borne by the young and
the retired receive cash transfers. Moreover, future generations have to
bear the loss of welfare at the expense of those living today, as the
reduced capital volume leads to lower consumption levels and therefore
lower standards of living. The effects of such redistributive influences and
their magnitude can only be understood for a certain time period. A
negative budget balance may require government financing through deficit
spending (which means by accumulating debt). This obviously transfers
liabilities onto the future as part of the tax burden is borne by future
economic agents.
Such transfers through time can be considered reasonable when
the budget deficit is used to finance investment projects which provide
benefits for the future. The above hypotheses shows that the level of
budget imbalance cannot be used as a reliable indicator to determine
which redistributive effects are related to the adopted fiscal policy. This is
because budget balance reflects the financial flows used to affect the
volume of capital, therefore simply changing the name of a financial flow
can change not only the level but also the polarity of the balance (deficit or
credit). Nevertheless, the effects of the fiscal policy remain constant. In
particular, these arguments are used to justify measuring-type concepts
which are, essentially, conscious attempts of financial flows to be given
incorrect names. Under these circumstances the feasibility of a gradual
implementation of the above-described policy of non-progressive income
taxes and transfers combined with various levels of budget balance should
be approbated. When calculating the budget balance, the assumption is
that only the state itself redistributes wealth and does not take any further
intervention in the economy. Thus the public sector is reduced to a pension
security scheme. If the size of a generation in a given period t t is L t , the
state will register payments at the amount of zLt . This amount will be
transferred to the retired generation and if the generation increases at the
72 Debt management
rate of n , the transferred amount will be calculated as 1  n   L t 1 . This

relationship is obvious when the actual financial flows in circulation are
considered. If the changes in income levels are considered, then the
results will be different, as will be seen below.
In terms of the relationships and dependencies in the public sector
of the economy (see the Example), the financial flows may be classified as
tax payments and transfer payments. These flows, to and from the state
budget, result in equivalent changes in liquid wealth in terms of saved
incomes. If we denote the period of implementation of the fiscal policy with
t and the current period with s , the tax revenue collected from the young
generation at any time will be Ls z . They increase the budget revenues and
receivables and therefore – the overall wealth of the state. This is equally
valid for the payments transferred to retired people expressed as
Ls 1 1  n z . Since these two amounts should be equal by definition, the
changes in revenues in any period will result in equivalent changes in
expenditures, i.e. the budget is self-balanced (See Table 6-1).2
However, the above relationship is indicative of the state budget,
where all revenues are compared to expenditures. In the following table -
the left side includes operations that increase the amount of revenues
accumulated by the state and the right one – those which reduce it. By
definition, in the example, the revenues match the government spending in
each period. This reveals the first proof of the inefficiency of using budget
balance as an instrument of redistributive effects, since, according to the
common concept, the shifting of the tax burden to future generations is a
phenomenon associated with budget deficit.
Table 6-1
Example of a balanced budget following a redistribution policy
st
Increase in budget resources Decrease in budget resources
Tax revenues from the young Transfers to retired people
generation
Ls z Ls 1 1  n z
Budget balance = 0
Source: BOLL, S. Op. Cit.
2
The example is adapted from: BOLL, S. Op. Cit..
Instead, the example actually proves that such a policy may result
in a balanced budget after all.

1. ADAMOV, V. Teoriya na finansite (Darzhavni finansi). V.
Tarnovo, ABAGAR, 1998.
2. BOLL, S. Intergenerationale Umverteilungswirkungen der Fiskal-
politik in der BRD. Frankfurt, 1994.
Keywords
1. State redistribution function
2. Ordinary redistribution
3. Global transfers
4. State budget balance
5. State inter-generational redistribution
6. The fiscal balance rule
7. Individual distribution of income
8. Individual personal saving
9. Liquid assets
10.General taxation
11.General transfers
12.Inter-generational budget constraints
13.Cobb-Douglas approach
14.Cobb-Douglas function
15.Periodic equilibrium of the capital market
16.Long-term equilibrium capital resource
17.Long-term suppression of capital resources
18.State redistribution scenarios
19.Measure-based concepts
20.Policy of constant general tax rates and transfers
21.Balancing the budget through a redistribution policy
22.Hypothesis for altering the budget balance
23.Designation of financial flows
24.Internal interest charged on “government loans”
74 Debt management

1. What are the effects of a redistribution policy of general taxation of the
employed and general transfers to the retired?
2. What is the effect of a redistribution policy on the individual savings
within the overlapping generation’s model?
3. Discuss the effects of the taxation and transfer mechanism on capital
resources?
Chapter summary
The use of deficit financing raises some questions regarding the
nature and intensity of its intergenerational effects. For this purpose we use
a two-generation model. The starting point for such research is to analyse
the general economic importance of the state tax and transfer policy in
terms of its impact on macroeconomic stability and economic growth. The
common redistribution by means of global transfers result in a minimum
macroeconomic capital base and a low overall level of social welfare.
A redistributive policy that leads to major economic consequences,
such as the state budget balance, is difficult to describe with a single
variable. For this purpose, we should look for another option, which would
allow a more objective evaluation of the effects of the government’s
intergenerational redistribution. The theoretical basis for such a measure is
the fiscal balance rule, which provides clear criteria for the implementation
of an unbiased but efficient financial policy by the state.
The main stages of the research on the general economic effects of
the inter-generational redistribution are:
а) the relationship between the economic activities of a certain
representative individual and the individual redistribution of income;
b) the utility function of a single household;
c) the capital market equilibrium.
Another important issue is the relationship and dependency

between the budget balance and the size of the intergenerational
redistribution.
CHAPTER VII
INSTRUMENTS FOR DEFINING THE STATUS OF THE
EXTERNAL SECTOR

This chapter describes instruments for the analysis and evaluation
of the external debt. By the end of the chapter you will be able to:
 discuss the indices and coefficients reflecting the ability to
service foreign debt;
 comment on the status of international currency ratios;
 distinguish the separate types of currency ratios.
The chapter includes five subtopics:

1. Indices for defining the status of the external sector of the
economy;
2. International currency balances of payments – a tool for
the analysis of deficit and debt;
3. Analytical currency balances in terms of product;
4. Analytical currency balances in terms of factor;
5. Consequences of deficits in analytical currency balances.
1. Indices for defining the status of the external

sector of the economy
The foreign sector of the economy refers to business transactions
between the residents of a certain country and residents of other countries.
Such deals may result in three scenarios:
 net cash flow leaving the country;
 net cash flow coming into the country;
 balanced outgoing and incoming cash flows.
While the second and third scenarios are associated with positive
effects for the national economy, the first situation can be described as
negative. It usually leads to a correction in the exchange rate parity of the
Chapter VII. Instruments for defining the status of the external sector 77
national currency against other currencies. The correction in the exchange

rate fundamentally changes the parameters of macroeconomic policy.
Therefore, knowing the consequences of a deficit in the external sector is
the basis for rational decisions regarding the debt management of an open
economy.
In this context, we shall analyse two working hypotheses:
First, the status of the external sector is a function of the
cumulative expression of individual currency balances.
Second, the dynamics of the volume of foreign deficit financing is
cyclic.
Using macroeconomic aggregates and debt data, we can establish

certain ratios and coefficients which asses the ability of developing
countries to service their foreign debts. Such an assessment requires
complex analysis of the situation in each individual country, rather than the
mechanical application of a certain financial ratio. Some of the most trusted
and reputable debt indicators are presented in the methodology of World
Debt Tables in accordance with the procedures and data from the World
Bank and the International Monetary Fund. The ratios offer various
measures of the cost or the potential for debt servicing. Foreign debt is
used in the following indicators:
 Ratio of Total External Debt to the Import of Goods and Services
(EDT/MGS);
 Ratio of Total External Debt to Gross National Product (EDT/GNI);
 Ratio of Total Debt Service to the Export of Goods and Services
(TDS/XGS) – also known as the Debt Service Rate;
 Ratio of Total Interest Payments to the Export of Goods and
Services (INT/XGS) - also known as the Interest Service Ratio;
 Ratio of Total Interest Payments to Gross National Product
(INT/GNI);
 Ratio of International reserves to Total External Debt (RES/EDT);
 Ratio of International reserves to the Import of Goods and Services
(RES/MGS);
 Ratio of Short-term Debt to Total External Debt (STD/EDT);
 Ratio of Concessional Debt to Total External Debt (CD/EDT);
 Ratio of Multilateral Debt to Total External Debt (MD/EDT).
The most commonly used indicator for the degree of public

indebtedness is the external debt of GDP percentage. This indicator is part
of the convergence criteria monitored for EU accession. The volume of
debt is often indicative of the state of public finances, their structure and
the scale of budgetary difficulties. However, evaluation of the external
78 Debt management
sector of the economy is inevitably related to the issue of the tools used to
analyse deficit and debt.
National practices for the management and monitoring of external
debt (as part of government debt) offer additional criteria and indicators,
which include:1
First, monitoring of the following main interest rates for debt stocks
in EURO and USD:
 LIB6MEUR - 6-month LIBOR in EURO;
 LIB6MUSD - 6-month LIBOR in USD;
 EURIBOR6M - 6-month EURIBOR.
Risks related to changes in interest rates are subject to specific

monitoring. This is due to the specific importance of the “fixed interest rate
debt to floating interest rate debt ratio. An increase in the portion of fixed
interest rates reduces the risk exposure of the debt.”2 The same monitoring
is applied to the average time to re-fix the (ATR) index. “The higher ATR
value is an indication that a relatively significant portion of the debt is
neutral to the change in interest rate coupons in the short-term and
suggests lower risk.”3
Second, monitoring and analysis of the risk of exchange rate
changes. This risk is generated as a result of changes in the prices of
instruments included in the government debt portfolio and denominated in
currencies other than the Euro and the Lev, which leads to changes in both
the nominal value of the debt and the financial resources intended to
service it. The "internal-to-external debt" ratio provides information on the
debt portfolio’s foreign currency exposure. The greater proportion of debt in
national currency (internal debt and also, under the currency board, the
portion of the foreign debt denominated in the reserve currency - the Euro),
the more independent the economy is from foreign currency exchange rate
fluctuations.4
The World Debt Tables mentioned above are commonly accepted
as a universal tool for monitoring the level of indebtedness. They also
provide data on the external debt of mostly low- and middle-income
countries. Below are information and instructions corresponding to the
1
This section is based on the indicators used by the Ministry of Finance of
the Republic of Bulgaria implemented through, and described in detail in:
GOVERNMENT DEBT MANAGEMENT STRATEGY 2009-2011 (http://www.
minfin.bg/bg/page/68).
2
Ibid, p. 20.
3
Ibid.
4
Ibid, p. 20.
numbering of the individual sections in the tables. The designations

correspond to the original designation of the various debt indicators.
I. STRUCTURE OF THE WORLD DEBT TABLES

Section One. General debt indicators for the size and structure
of debt:
“TOTAL DEBT STOCKS (EDT)” refers to the total value of
government debt, debt guaranteed by the government, private non-secured
debt (reported or evaluated by the IMF bodies), credits extended by the
IMF and reported short-term debt. The outstanding interest payments are
added to the short-term debt and reported as a separate item. Export
credits and outstanding long-term debt principals are reported as a
memorandum item.
“TOTAL DEBT FLOWS” refers to consolidated data regarding
borrowed loans, principal payments, long-term debt interest payments and
IMF purchases.
“NET FLOWS ON EXTERNAL DEBT” are disbursements on long-
term external debt and IMF purchases, minus principal repayments on
long-term external debt and IMF repurchases up to 1984. Beginning in
1985, this line includes the change in stock of short-term debt (including
interest arrears for long-term debt). Thus, if the change in stock is positive,
a disbursement is assumed to have taken place; if negative, a repayment is
assumed to have taken place.
“TOTAL DEBT SERVICE (TDS)” is the sum of the principal
repayments and interest actually paid in foreign currency, goods, or
services on long-term debt, interest paid on short-term debt, and
repayments (repurchases and charges) to the IMF.
Section Two. Series of data on the aggregate net resource flows
and net transfers (long-term):
“NET FLOWS ON EXTERNAL DEBT (LONG-TERM)” is the amount
of net flows on long-term debt (other than IMF purchases) plus net foreign
direct investments and official aid (other than technical support). Technical
support aid is reported as a separate memorandum item.
“NET LONG-TERM TRANSFERS” are net long-term resource flows
minus long-term debt payments and profits from direct investments abroad.
Section Three. Series of data on the main economic aggregates.
The Gross National Product (GNP) series uses the average annual
exchange rate of the national currency to USD.
Section Four. Debt indicators: debt and debt-servicing indicators
as a percentage of some of the economic aggregates.
Section Five. Detailed information about the size and flows
related to long-term debt and its components.
80 Debt management
Section Six. Information about the currency composition of

long-term debt. The six major currencies in which the external debt of low
and middle- income countries is contracted are separately identified, as is
debt denominated in Special Drawing Rights and debt repayable in multiple
currencies.
Section Seven. Information about the restructuring of long-term
debt beginning in 1985. Shows the size and flow on debt in any given
year. It also presents the amounts written off or forgiven in any given year
(interests forgiven are shown as memorandum items) as well as the
amount of debt stock reduction (e.g. through buybacks).
Section Eight. Presents a reconciliation between the stock and
flow data on total external debt for each year, beginning with 1988.
This is designed to illustrate the changes in stock that have taken place
due to five factors:
 Net flows on debt;
 Net change in interest arrears;
 Interest capitalised;
 Debt forgiveness or reduction by means of debt restructuring;
 Cross-currency revaluation of debt.
The residual differences, i.e. the changes in stock are not explained
by any of the factors identified above, is also presented as a separate item.
The residual is calculated as the sum of identified accounts minus the
change in debt stock. The presence of significant differences often
illustrates a discrepancy in the reported data. However, they are more often
explained via specific circumstances related to the loans borrowed by the
national governments.
Section Nine. Provides information about the average terms
and new commitments on publicly guaranteed debt, and information
about the level of commitments of public and private sources.
Section Ten. Provides information about revenues spent in
advance and obligations on outstanding debt at the end of December
1992.
II. SOURCES
The time series data in the tables are based on information reported
to the World Bank through the Bank's Debtor Reporting System (DRS),
which includes member states who have received credits from the
International Bank for Reconstruction and Development (IBRD) and loans
from the International Development Association (IDA). Additional
information is obtained from files held at the World Bank and the IMF.
The reporting countries provide detailed (by individual loans)

information through the DRS about the annual status, transactions and
terms of long-term external debt of public bodies and publicly guaranteed
private debts. This information provides the core content of the tables. The
aggregated data for private non-guaranteed debt is presented, subject to
the level of information accessibility.
Data for short-term debt is reported by the debtors, or estimated
based on information provided by the creditors. The main sources of up-to-
date information are the claims of commercial banks to developing
countries published by the Bank for International Settlements (BIS), and
data on publicly guaranteed provisional credits provided by the
Organisation for Economic Cooperation and Development (OECD). Interest
in arrears on long-term debt are added to short-term debt and displayed as
a separate line in Section One. Interest arrears owed to public and private
creditors are shown separately. Export credits are shown as a
memorandum item in Section One. They include official export credits,
provisional credits and bank credits that are publicly guaranteed or insured
by export credit agencies. The tables include data for long- as well as
short-term export credits. The source of the information is the Creditor
Reporting System of the OECD.
III. DEFINITIONS
А. External debt, debt service, and debt flows
Long-term external debt is defined as debt that has an original or
extended maturity of more than one year, is due to non-residents and
should be repaid in foreign currency, goods or services. Long-term external
debt has three main components:
 Public debt - An external obligation of a public debtor (the
national government, a political subdivision, and autonomous
public bodies).
 Publicly guaranteed debt - An external obligation of a private
debtor that is guaranteed for repayment by a public entity.
 Private non-guaranteed external debt - An external obligation of
a private debtor that is not guaranteed for repayment by a
public entity.
The tables present public and publicly guaranteed debt as

aggregate values.
Short-term external debt is defined as “debt that has an original
maturity of one year or less.” The data in the tables does not distinguish
between public and private non-guaranteed short-term debt.
82 Debt management
Export credits are reported in section one of the tables and include
official export credits, suppliers' credits, and bank credits officially
guaranteed or insured by an export credit agency. Both long-term and
short-term credits are included here. The information is provided through
the CRS of the OECD.
Debt structure and components
Total External Debt
Short-term Long-term IMF

debt debt credits
By debtors
Private Public and
nonguaranteed Publicly
debt Guaranteed debt
By creditors
Public creditors Private creditors

Commercial banks
Multilateral
Bilateral
Bonds
Other
Source: World Debt Tables

Figure 7-1
Interest arrears on long-term debt are defined as interest

payment due but not paid, calculated on a cumulative basis.
Total debt volume is defined as the sum of public and publicly
guaranteed long-term debts, private non-guaranteed long-term debt,
credits extended by the IMF and short-term debt. The relationship between
the total debt and its components is illustrated by Figure 7-1.
B. Debt flows
Aggregate long-term net resource flows and

net transfers of developing countries
Disbursements
minus
Loan
depreciation
Debt Servicing
equals Official
credits,
equals
Net resource foreign Aggregate net

plus
debt flows direct and resource flows

portfolio
minus minus
investments
Interest payments
Interest repayments on loans and profits
from FDIs
equals equals
Aggregate
Net debt transfers
net transfers
Source: World Debt Tables

Figure 7-2
Disbursements are expressed as withdrawals on outstanding

commitments during the year specified.
Principal repayments are the actual amounts of principal (i.e. its
depreciation) paid in foreign currency, goods, or services in the year
specified.
84 Debt management
Interest repayments are the actual amounts of interest paid in

foreign currency, goods, or services in the year specified.
Net flows (net lending or net borrowing) are disbursements minus
principal repayments.
Net transfers are net flows minus interest payments (or
disbursements minus total debt service payments).
The structure of, and relations between, net debt flows, net transfer
flows and aggregate net flows and transfers are illustrated by Figure 7-2.
C. Transactions with the IMF

IMF credit denotes repurchase obligations to the IMF with respect
to all uses of IMF resources, excluding those resulting from withdrawals in
the reserve tranche calculated at the end of the year specified. They
include purchases and withdrawals under Stand-By, Extended, Structural
Adjustment, Enhanced Structural Adjustment, and Systemic
Transformation Facility Arrangements, together with Trust Fund loans.
Purchases are total withdrawals from the General Resources
Account of the IMF during the year specified, excluding withdrawals in the
reserve tranche.
Repurchases are total repayments of outstanding withdrawals from
the General Resources Account during the year specified, excluding
repayments due in the reserve tranche.
For comparison of data on the use of IMF credit and reported long-
term debt, the unutilised IMF credit data is converted at the end of the year
specified from special drawing rights (SDRs) in accordance with the
method of currency conversion. The purchase and repurchase flows are
converted using the average SDR rate for the year specified. Net
purchases usually do not affect the utilization of IMF credit from one year to
another. The valuation effects of using different exchange rates frequently
explains many of the differences recorded. Other factors that influence
change in quotas (which automatically adjusts the size of the reserve
tranche) are authorised currency purchases of one country by another
Member State with funds disbursed from the "General Resources" account,
and the use of the currency of the country for various administrative
purposes by the Fund.
D. Non-debt flows
Direct foreign investment is defined as an investment that is
made to acquire a lasting management interest (usually of 10 percent of
voting stock) in an enterprise operating in a country other than that of the
investor, the investor's purpose being an effective voice in the management
of the enterprise. It is the sum of equity capital, reinvestment of earnings,
other long-term capital, and short-term capital as shown in the balance of

payments.
Profit on direct foreign investment is the sum of reinvested
earnings on direct investment and other direct investment income.
Portfolio equity flows is the sum of national funds, depository
receipts (American or global), and direct purchases of shares by foreign
investors.
Grants are defined as legally binding commitments that obligate a
specific value of funds available for disbursement for which there is no
repayment requirement.
Technical cooperation grants comprise of two basic types of
grants:
 Free-standing technical cooperation, which is the
provision of resources aimed at the transfer of technical
and managerial skills or of technology for the purpose of
increasing general national capacity without reference to
the implementation of any specific investment projects;
and
 Investment-related technical cooperation, which denotes
the provision of technical services required for the
implementation of specific investment projects.
E. Categories of creditors
The data from the individual reports is aggregated according to the
type of creditors.
Official creditors. Debt from official creditors includes:
 Loans and credits from international organizations
(multilateral). Loans from funds administered by an
international organization on behalf of a single donor
government are excluded; such lending is classified as
bilateral;
 Loans from governments (bilateral): loans from
governments and their agencies (including central
banks), loans from autonomous public bodies, and direct
loans from official export credit agencies.
Private creditors. Debt from private creditors include:
 Bonds - Publicly issued and privately placed bonds;
 Commercial banks - loans from private banks and other
private financial institutions;
 Other private credit: Credits from manufacturers,
exporters or other suppliers of goods; commercial credits
guaranteed by official creditor agencies.
86 Debt management
F. Long-term debt
The tables include the following types of debt-related data:
 Debt outstanding and disbursed: total outstanding
debt at year end;
 Undisbursed debt: the cumulative undisbursed portion
of contracted debt at year end;
 Commitments: the volume of debt for which contracts
were signed in the year specified;
 Disbursements: withdrawals from outstanding
commitments during the year specified;
 Principal repayments: amounts of principal paid in the
year specified;
 Net flows: disbursements minus principal repayments;
 Interest payments from the borrower during the year
specified;
 Net transfers: Net flow minus interest payments (or
disbursements minus total debt service payments);
These may have negative values when the borrower
transfers money to the creditor;
 Debt service: the sum of principal repayments and
interest payments actually made.
G. Loan terms
Provides information about the average terms regarding public and
publicly guaranteed debt during the year specified.
H. Memorandum positions
National debt is characterised by two indices:
 Concessional loans (grant loans) - Loans with a grant
element of 25% or above;
 Variable interest rate loans - Loans repayable at spread
over one or more key short-term market rates (e.g.
LIBOR).
Additionally, the tables take into account:

 Specific debt-restructuring programmes;
 Main economic indicators;
 Main debt indicators;
 Currency exchange rates.
2. International currency balances of payments –

a tool for the analysis of deficit and debt
The international currency balance of payments is a record of a

nation's international monetary (currency) transactions with the rest of the
world, i.e.:
 It is a method for the reporting of international cash flows using
statistical data;
 It is equivalent to business and financial transactions between
residents of a country and non-residents;
 International transactions are recorded in the corresponding
national currency.
Being the principal macroeconomic indicator, the international
currency balance of payments transactions between residents of a country
and non-residents are recorded by a double-entry system of book-keeping.
Thus, each export transaction is considered in terms of the export of a
certain amount of goods in monetary terms (currency) and the
corresponding import of its monetary equivalent.
In terms of currency, the transactions included in the international
currency balance of payments generate two main currency flows:
 credit currency flows to resident economic agents – reported
with positive values;
 debit currency flows to non-residents - reported with negative
values.
As an accounting tool, the international balance of payments allows

us to:
 analyse economic and other relations of a country with other
countries and characterise the principles which define them;
 define the current account position of a country compared to the
rest of the world, and thus classify the country as either a debtor or a
creditor (either globally or in relation to a certain country);
 evaluate, compare, forecast and balance the volume,
composition and structure of receivables and payables according to the
specific overall socio-economic environment (reality);
 forecast the development of the various sectors of the national
economy according to the country’s role in the development of
international economic relations.
Currency balance of payments may be analysed using two
completely different, and yet interrelated, approaches:
88 Debt management
 analysis, and
 synthesis.
The analytical approach for the construction of foreign currency

balance accounts decomposes the economic, financial and credit relations
between separate national economic agents into homogeneous and
uniform groups of foreign currency transactions. Thus, when the criterion
for decomposition is the volume of goods as a result of combinations of
various basic production factors, we distinguish:
 foreign trade accounts;
 services and non-trade operations accounts.
When the criteria for decomposition are the factors of production,
we can also distinguish between:
 foreign capital (investments) and credit accounts;
 factor income accounts and cash transfers accounts.
The imperfect method for determining the value of labour (human

capital) does not allow us to define a separate currency account for the
movement (migration) of labour, which is perhaps the most important
production factor. The changes in the third factor of production - land (real
estate resources) are generally accounted within the balance of foreign
trade operations, because the movement of primary resources (raw
materials) abroad is subject to foreign exchange transactions.
The synthetic approach for defining currency accounts takes into
consideration the whole range of operations and foreign exchange
transactions in a single balance account – the balance of payments. The
main advantage of the synthetic currency balance (BoP) compared to the
analytical balance accounts is the possibility to carry out a comprehensive
comparative analysis of the economic relations of an economy.
3. Analytical currency balances in terms of

product
The foreign trade balance (also referred to as "balance of trade") is
the difference between the financial flows of exports and imports. This
account reflects foreign trade transactions undertaken by national
economic agents. The scope and nature of foreign trade transactions are
determined by the absolute and relative competitive advantages of the
national economy compared to the rest of the world in terms of
international trade. The balance of trade is expressed in monetary terms
because it reflects the monetary value of the imports and exports of output
in an economy over a certain period. Therefore, when national economic
agents export goods, the balance of trade account is credited (incoming
financial flow) and vice versa - when national economic agents export
goods, the balance of trade account is debited (Figure 7-3).
Imports Exports
BALANCE
Dt (–) Ct (+)
OF TRADE
Outgoing Incoming
financial flow financial flow
Figure 7-3
Unlike the balance of trade, which accounts for the so called “visible
goods”, the balance of services records the currency flows related to
provision of services (also referred to as “invisible goods”) among the
separate economies (Figure 7-4).
Import Export
of services of services
BALANCE
of services
Dt (–) Ct (+)
and financial
transfers
Outgoing Incoming
Figure 7-4
90 Debt management
Like the import and export of goods, the import of services from
other countries results in an outgoing financial flow and reduces (debits)
the account balance. The export of services creates an incoming financial
flow which increases the account balance (credits the account). The
transactions related to imports and exports of services may be grouped into
three main groups:
 transportation;
 tourism;
 other services.
The transportation services group includes financial flows related to

the transportation of people and goods, and the transfer of energy sources
(natural gas, electricity, etc.)
The tourist services group includes financial flows related to
international tourism. They are subdivided into two groups:
 primary;
 complementary.
The main financial inflows related to international tourism include

incomes from sales of package tourist services. Simultaneously, during
their stay in the country, foreign tourists purchase various goods and
services offered on the domestic market. These purchases create
complementary financial flows related to international tourism. The group of
financial inflows related to international tourism also includes the transfers
of tuition fees, healthcare services and the sustenance of students and
patients abroad.
The third group includes the so-called “other services”. These
include credit and debit financial flows related to communication,
insurance, leasing, financial and other similar services.
4. Analytical currency balances in terms of

factor
The change in a certain production factor directly affects the frontier
of production possibilities for the national economy. An increase in the
human factor (employment) will shift the frontier of production possibilities
upwards (from РРF0 to РРF1) and thus, with all other factors remaining the
same, will result in an increase in the national product (see Figure 2-5).
This is why the (quantitative) increase of a certain production factor may be
accounted for as a credit. Alternatively, a decrease of a certain production
factor will shift the frontier of production possibilities upwards (from РРF0 to
РРF2). Such a reduction is accounted for as debit.
Quantity of product B
PPF1
PPF0
PPF2
Quantity of product A
Legend: credit; debit
Figure 7-5
Unlike the analytical currency balance accounts described above,

the capitals and credits balance account describes essentially different
financial flows – capital flows. Due to the fact that it accounts for factors
rather than goods, the incoming and outgoing financial flows are described
as debits and credits on the capital balance account. This is because the
import of capitals and credits results in an increase of the “capital”
production factor (a credit operation accounted for with a positive “+” sign)
and their exports decreases the available capital (a debit operation
accounted for with a negative “” sign).
92 Debt management
Import Export
of capital of capital
and credits and credits
BALANCE
Ct (+) of capitals Dt (–)
and credits
Incoming Outgoing
Figure 7-6
This account includes the capital and credits flowing into and out of
the national economy. Thus, there is a positive balance (surplus) when the
flow of imported capital and credits is greater than the volume of capital
and credits flowing out of the country, and a negative balance when the
outgoing flow is greater than the incoming one.
According to the purpose of the financial flows included in the
capital and credit account, we can distinguish:
 investment flows;
 debt (credit) flows.
Additionally, depending on the period for which capital and credits

are transferred abroad, we distinguish between short- and long-term
operations. It is generally assumed that monetary credit transfers have a
clearly defined, specific temporal characteristic (the loan period).
Consequently, at a certain moment in the future, the credit currency
flow (the provision of loans abroad) will be followed by a reciprocal debit
flow (the repayment of such loans). Moreover, the movement of currency
funds for investment purposes implies a relatively greater time period
between the time of investment and the repatriation of the money invested
abroad.
Depending on the instruments used to manage international debt,
the international currency flow may become:
 unidirectional (gratuitous) (i.e. external debt forgiveness);
 investment (e.g. with debt restructuring and its exchange for
“Brady” bonds, which may be consequently swapped for assets).
An integral part of the balance account of capitals and credits is the

balance account of incomes from investments abroad. This balance
shows the ratio of the incoming currency flow of incomes generated abroad
(interest, profits and dividends) from exported capitals and credit, and the
outgoing currency flow of repatriated returns on foreign investments in the
national economy.
Import Export
repatriation repatriation
of income of income
BALANCE
of incomes
Ct (+) from Dt (–)
investments
abroad
Incoming Outgoing
Figure 7-7
Since the incomes from investments abroad are derived from a

prior movement on investments and credits, these two balance accounts
are interrelated.
5. Consequences of deficits in analytical

currency balances
Where the volume of debit transactions in the foreign trade balance
exceeds the volume of credit operations, the balance is passive (negative).
In this case, the excess amount is defined as a "passive balance", i.e.
there is a deficit on the analytical balance account. In the opposite
situation, when the volume of credit transactions (export) is greater than
the volume of debit (import) transactions, the foreign trade balance is
considered active, i.e. there is a "surplus". A situation of equilibrium
between export and import commodity flows in terms of currency (i.e. a
zero balance on the foreign trade account) is only theoretically possible.
94 Debt management
The imbalance (active or passive) of credit and debit transactions in

the foreign trade account may be analysed in four aspects:
 temporal;
 geographical;
 economic;
 liquid.
In terms of time (temporal) aspects, the imbalance may be:

 chronic, related to long-term discrepancies between import and
export transactions;
 cyclic, which is a function of economic development fluctuations
and follows the economic cycle curve;
 incidental, due to the effects of short-term and incidental factors.
In terms of geographical distribution of foreign trade relations, the

balance of trade with certain countries, regions or organisations may be
active and with others, passive. The imbalance (surplus or deficit) on the
foreign trade account is a function of the country’s position in the
international markets.
In terms of liquidity and liquid reserves, there is a direct relation
between imbalance and overall currency liquidity. The distinction between
a “general” and “pure”5 liquidity allows us to define two types of economies:
 economies which raise their real currency reserves mainly from
their foreign trade operations (economies with “general” currency
liquidity);
 economies which raise their real currency reserves both from
their foreign trade operations and taxation (economies with “pure”
currency liquidity).
On a global scale, the negative balance on the foreign trade

accounts of economies with internationally convertible currencies provides
other economies with liquid currency reserves. This generally improves the
level of international currency liquidity. Therefore, countries with "general"
currency liquidity should have positive balances on their foreign trade
accounts.
5
For more details see RADKOV. R., Adamov, V., Zahariev, A. Valuti i
valutni sistemi. V. Tarnovo, ABAGAR, 2000, pp. 148-150.

1. RADKOV. R., Adamov, V., Zahariev, A. Valuti i valutni sistemi
(Sbornik s testove I zadachi). V. Tarnovo, ABAGAR, 1999.
2. PILBEAM, K. International Finance. Sofia, FTP, 1995.
3. RADKOV. R., Adamov, V., Zahariev, A. Valuti i valutni sistemi. V.
4. STRATEGIYA za upravlenie na darzhavniya dalg 2006-2008.
5. STRATEGIYA za upravlenie na darzhavniya dalg 2009-2011.
6. http://www.federalreserve.gov/rnd.htm
7. http://www.bradynet.com/
8. http://www.mscidata.com/
9. http://www.imf.org/
10.http://www.worldbank.com/
11.http://www.bnb.bg/
12.http://www.ecb.int/
13.http://www.bundesbank.de/
14.http://www.odci.gov/cia/di/products/hies/index.html
Keywords
1. Net outgoing currency flow
2. Net incoming currency flow
3. Balanced incoming and outgoing flows
4. Currency parity correction
5. Debt evaluation, coefficients and ratios
6. Debt indicators
7. IMF transfers
8. Non-debt flows
9. Official creditors
10.Private creditors
11.Long-term debt
12.Loan terms
13.Memorandum positions
14.International currency balance accounts
15.International currency flows
16.Trade and financial operations
17.Currency aspect of operations
18.Credit currency flows
19.Debit currency flows
96 Debt management
20.National balance of payment accounts

21.Analytical approach
22.Synthetic approach
23.Foreign trade balance account
24.Balance of services and financial transfers
25.Balance of capitals and credits abroad
26.Balance of incomes from investments abroad
27.Export and import flows
28.Export and import of services
29.Main currency flows
30.Complementary currency flows
31.Analytical balance accounts in terms of factor income
32.Capital currency flows
33.Investment currency flows
34.Debt-related currency flows
35.Repatriation of investments abroad
36.Passive balance
37.Active balance
38.Zero balance
39.Chronic imbalance
40.Cyclic imbalance
41.Incidental imbalance
42.Economies with “general” currency liquidity
43.Economies with “pure” currency liquidity

1. Which of the main foreign debt indicators refer to overall foreign debt?
2. How should disposable liquid reserves be structured?
3. What causes the declining role of gold as a liquid resource component?
4. At the beginning of 2010, Hungary’s gold reserves amounted to USD
2100 mln. and its currency reserves (including SDR) were USD 13 bln.
The expected volume of export was USD 56 bln. and the volume of
import was USD 75.5 bln. Total external debt volume was USD 50 bln.,
18% of which the country had to repay during the same year. Analyse
Hungary’s international currency liquidity, taking into account that the
expected annual net national product of the country was USD 130 bln.
5. In a specific year, Bulgaria has contracted foreign debt repayment
transfers of USD 1.2 bln. The expected gross national product amounts
to USD 32 bln. The volume of export is expected to account for 50%,
and the volume of import 45% of the annual GDP. а) Define the
absolute volume of the imports and exports expected; b) Analyse

Bulgaria’s currency liquidity for that year.
6. In a specific year, Bulgaria has contracted foreign debt repayment
transfers of USD 989 mln. The volume of export is expected to account
for 48% of the gross national product of the country. In the previous
year, the gross national product of the country was USD 29.5 and for
the current year it is expected to increase by 4%. Analyse Bulgaria’s
currency liquidity for the current year.
7. Define the term ‘international currency accounts’.
8. What are the principal types of international currency accounts?
9. What are the consequences of deficits in the analytical balance of
payments accounts?
10.What is the effect of export and import operations on the various types
of analytical balance accounts?
11.What is the difference between a corporate balance and an international
currency balance?
12.What are the consequences of a chronic imbalance on the foreign trade
account, provided that the credit transfers exceed the debit ones?
13.Perform a comparative analysis of the advantages and disadvantages
of an increase in foreign direct investments on the one hand, and an
increase of portfolio investments on the other.
14.What will the balance of the services and financial transfers account be
if the volume of imported services exceeds the volume of exported
ones?
15.In what direction will the production possibilities frontier shift if the
volume of exports exceeds the volume of imports on the analytical factor
accounts?
16.Define the total balance on the account of payments of a given
economy if, within a certain year, it had foreign trade relations only in
terms of its factor accounts and the volume of imports exceeded the
volume of exports with USD 100 mln.
17. Define the balance on the account of payments of a given economy if
the volume of export operations exceeds the volume of import
operations by USD 235 mln. for each analytical account of the foreign
trade balance and the balance of incomes from investments abroad.
the volume of import operations exceeds the volume of export
operations by USD 850 mln. for each analytical account of the foreign
trade balance, the balance of services and the balance of investments
and credits.
the volume of import operations exceeds the volume of export
98 Debt management
operations by USD 432 mln. for each analytical factor account, and by
USD 234 mln. for each analytical product account of the foreign trade
balance, the balance of incomes from investments abroad, the balance
of services and the balance of investments and credits.
foreign trade balance exports are USD 2,145 mln. and imports are USD
1,015 mln., the balance of services exports are USD 920 mln. and
imports are USD 1,215 mln.; the balance of investments and credits
exports are USD 980 mln. and imports are USD 1,045 mln.; and the
balance of incomes from investment abroad exports are USD 645 mln.
and imports are USD 548 mln.
21.Define the balances on the various analytical accounts and then the
total balance on the account of payments of a given economy if foreign
trade balance exports are USD 2,560 mln. and imports are USD 1,475
mln., the balance of services exports are USD 540 mln. and imports are
USD 1,160 mln.; the balance of investments and credits exports are
USD 400 mln. and imports are USD 1,250 mln.; and the balance of
incomes from investment abroad exports are USD 405 mln. and imports
are USD 550 mln.
22.Define the balance on the account of payments of a given economy if
the foreign trade balance exports are USD 13,456 mln. and imports are
USD 12,398 mln., the balance of services exports are USD 5,670 mln.
and imports are USD 4,350 mln.; the balance of investments and credits
exports are USD 12,980 mln. and imports are USD 10,045 mln.; and the
balance of incomes from investment abroad exports are USD 3,,645
mln. and imports are USD 4448 mln.
23.Define the balance on Bulgaria’s account of payments for 2010
providing that foreign trade balance exports are EUR 13,456 mln. and
imports are USD 12,398 mln., the balance of services exports are USD
5,670 mln. and imports are EUR 4,350 mln.; the balance of investments
and credits exports are EUR 12,980 mln. and imports are USD 10,045
mln.; and the balance of incomes from investment abroad exports are
EUR 3,645 mln. and imports are USD 4,448 mln. Assume a currency
exchange rate of 1$ = 1.40 BGN.
24.Define the balance on Bulgaria’s account of payments for 2011 in USD,
providing that foreign trade balance exports are EUR 9,456 mln. and
imports are USD 11,212 mln., the balance of services exports are USD
6,670 mln. and imports are EUR 4,350 mln.; the balance of investments
and credits exports are EUR 6,980 mln. and imports are USD 8,000
EUR 1,645 mln. and imports are USD 1,558 mln. Assume a currency
25.Define the balance on Bulgaria’s account of payments for 2009 in USD,

providing that foreign trade balance exports are USD 9,456 mln. and
imports are EUR 11,212 mln., the balance of services exports are EUR
6,670 mln. and imports are USD 4,350 mln.; the balance of investments
and credits exports are USD 6,980 mln. and imports are EUR 8,000
USD 2,645 mln. and imports are EUR 1,558 mln. Assume a currency
100 Debt management
Chapter summary
Knowing the consequences of a deficit in the external sector is the
basis for making rational decisions on the debt management of an open
economy. In this context, it is essential to define the situation in the
external sector. For this purpose we can use a number of factors and ratios
by which to assess the possibilities for servicing debt. Some of the most
trusted and reputable debt indicators are presented in the methodology of
the World Debt Tables in accordance with the procedures and data from
the World Bank and the International Monetary Fund. The ratios offer
various measures of the cost or the potential for debt servicing.
The international currency balance of payments is a record of a
country's international monetary (currency) transactions with the rest of the
world. In terms of currency, the transactions included in the international
currency balance of payments generate two main currency flows: credit
currency flows and debit currency flows.
Currency balance of payments may be analysed using two
completely different, and yet interrelated, approaches: analytical and
synthetic. The analytical approach can be used in the following manner:
А) When the criterion for decomposition is the volume of goods as
a result of combinations of various basic production factors: the
foreign trade account and the services and non-trade operations
account.
B) When the criterion for decomposition are the factors of
production: the foreign capital (investments) and credits account
and factor income and cash transfers account.
Depending on the relative volumes of exports and imports, the

foreign trade account balance may be passive (negative), active (positive)
or neutral (zero balance). The imbalance (active or passive) may be
analysed in four aspects: temporal, geographical, economic and liquid.
The synthetic approach for defining currency accounts takes into
consideration the whole range of operations and foreign exchange
transactions in a single balance account – the balance of payments.
CHAPTER VIII
MACROECONOMIC ANALYSIS
OF EXTERNAL DEFICIT FINANCING

This chapter discusses aspects of foreign debt management. By the
end of the chapter you will be able to:
 discuss the objectives of external deficit financing;
 discuss external financing techniques;
 comment on the reasons for borrowing external loans;
 analyse debt dynamics and cycles.

1. Reasons for deficit financing through external loans;
2. Dimensions of debt dynamics and cycles.
1. Reasons for deficit financing through

external loans
The increase in government debt accumulated as a result of
external funding complicates its management. Government debt
management is a system of activities by the state including analysing
needs, negotiating and borrowing loans, complying with the terms of the
loan transaction, changing terms and interest rates, maintaining bond
rates, and repaying loans at their maturity dates. In short, government debt
management includes all operations related to the efficient and proper
maintenance for servicing the public debt. The main objectives of foreign
debt management are1:
 to avoid liquidity and maturity crises related to debt management;
 to maintain the current account deficit within reasonable limits
(e.g. 4-5% of GDP);
1
Creditanstalt Investment Bank, Vienna, An institutional report presented at the
th th
“Government Debt Management” seminar in Sofia on 19 and 20 October 1995.
102 Debt management
 to use external debt for investment rather than consumption;

 to maintain monetary and fiscal discipline;
 to control the ratio between portfolio capital flows and foreign
direct investments;
 to maintain or establish trust by depositors, creditors and
investors;
 to strengthen the national banking system.
The process of debt management includes activities undertaken at

two main stages: borrowing and repaying debt. At the borrowing stage,
activities are undertaken in the following sequence:
1. Analysis of the need for additional debt financing.
2. Assessment of loan terms – the most important stage of the
preparation of the loan deal, when the borrower has to define:
 the type of the creditor:
- whether to borrow from specialised financial institutions or
commercial banks, or to issue securities on the stock
market and thus borrow from corporations and private
households;
 the capital market to borrow from:
- the domestic or a foreign capital market (this is often
identified with the nationality of the creditor, but we
should not rule out the possibility of the participation of
national residents on capital markets abroad as well as
the participation of foreign residents on the domestic
capital market); 2
 the type of loan:
- in cash – from issues of stocks
- in credit;
 the method of borrowing and placement:
- through auctions (among commercial banks);
- through direct negotiations with the creditor (international
financial institutions);
- with or without subscription.
3. Negotiating the terms: amount; repayment term; price (discount,
fixed or floating interest rate); repayment schedule (gratis period, coupon
payments). Additional terms – lump sum or instalments, security,
convertibility, redemption, etc.
4. Loan borrowing, respectively the sale of securities.
2
This decision also depends on additional assessments of currency risk related to
exchange rate fluctuations in the currency of the loan.
Chapter VIII. Macroeconomic analysis of external deficit financing 103
The above algorithm is by no means imperative. However, it is

indicative of the numerous problems and difficulties related to public debt
borrowing and servicing. Repayment of debt, however, raises the need to
examine in depth the financial and economic nature of external deficit
financing and the possible reasons for taking such decisions.
At various stages in the course of their economic development,
most countries have resorted to external debt.3 There are several main
reasons for external borrowing:
 external loans enable the borrowing governments to reduce the
difference between the levels of domestic saving and investments;
 external loans solve problems related to shortage of resources;
 external loans modify the temporal model of consumption;
 external loans are used to finance deficits in previous balances
of payment.
In a closed economy, investments are limited by the availability of

domestic savings. When the economy is opened, this limitation can be
overcome by borrowing external loans to supplement domestic savings
and, therefore, the borrowing government will have more disposable
resources to increase the rate of economic growth. The effect of external
borrowing is illustrated by Figure 8-1, where the marginal efficiency of
investment (MEI) is affected negatively, while the level of domestic savings
(S-S) is affected positively by the change in the interest rate. In a closed
economy the investments Od will be equal to domestic savings at an
equilibrium interest rate of i0. In an open economy, the government can
borrow external loans at the current international interest rate of i*.
An open economy will no doubt benefit from a loan to the amount of
dc, and the corresponding increase in investments to 0c, where the
marginal efficiency of investments will be equal to the cost of the loan at an
interest rate of i*. As a result, future income will increase with the volume of
bcde, of which abcd is the interest burden, and the triangle abe represents
the net gains to the economy. Until the return on projects financed via
loans exceeds the cost of these loans, the country will keep improving its
wealth by borrowing and investing the funds borrowed.
The time pattern of income and absorption as a result of external
loans is shown in the upper part of Figure 8-1, where the income Y is equal
to the absorption A in the absence of external loans. The increase in
investment financed by external loans will allow Y to grow faster (and reach
the level of Y') compared to a scenario having no borrowing. In addition,
3
IQBAL, Z. and A. Yousef. External debt - analysis and policy issues. 1998,
(unpublished working paper), pp. 7-11.
104 Debt management
capital inflows will allow the absorption A' to exceed the income Y', so long
as capital inflows exceed the cost of debt servicing. Otherwise, if the cost
of debt servicing exceeds the capital inflows, the net transfer of resources
will become negative and absorption A' will fall below income Y', but will
still remain higher than A - the absorption without borrowing.
A dynamic model of the

“Investments-Savings” equilibrium
i
MEI
S
i0 e
a b
i*
S
0 d c I,S
Figure 8-1
External loans are also used by governments to smooth the time

pattern of consumption with income fluctuations. External borrowing may
also be substantiated by some demographic factors which determine the
propensity to save. The most important variations in income are the ones
resulting from changes in trading conditions or exogenously caused
declines in the volume of exports (e.g. the increase of oil prices in the 70’s
had a negative effect on the trade of countries importing oil, and resulted in
greater deficits in their current accounts.) These external imbalances are
considered mostly as short-term and are financed by loans or reserves.
Similarly, exporters of raw materials may face changes in their terms of
trade resulting from changes in the prices of their main export products.
The economies may also be faced with poor harvests, which deprive them
of some major export products, or create the need to import substitutes of

the product which would have been produced domestically. If such an
event is proved to be only temporary, this would be a sound reason for
financing it with external debt, instead of allowing absorption to follow the
fluctuations of income. Smoothing the costs over time will serve as a built-
in stabiliser, dampening the impact of temporary shocks in economic
activity. Indeed, there is evidence that a number of countries exporting raw
materials try smoothing the costs by accumulating foreign resources when
prices are high. However, external loans used to finance non-productive
activities, and the balance of payments deficit caused by constant factors,
as well as having to compensate for the outflow of capitals may delay the
adjustments necessary and exacerbate the problems with balance of
payments. In these conditions, external borrowing can result in endless
refinancing by taking new loans, and eventually cause a debt crisis.
2. Dimensions of debt dynamics and cycles

The dynamics of external debt financing may be expressed by the
following equation: 4
(8-1)a D  CA  DFI  GCO
Alternatively, equation (8-1)а may be transformed into:

(8-1)b D  iD  NCA  DFI  GCO
or:
(8-1)c   iD  G ,
D
where:
D is the external indebtedness of a country expressed as
its gross (total) debt minus its currency reserves;
D is the derivative of D in terms of time;
i is the average nominal interest rate;
DFI are foreign direct investments;
GCO is the gross capital outflow;
CA is the external current account;
NCA is the external current account minus interest transfers;
G is the deficit/surplus of resources, which is equal to the
external account balance (without interests) minus foreign
direct investments plus the gross capital outflow.
4
IQBAL, Z. and A. Yousef. Op. Cit. pp. 7-11.
106 Debt management
In fact, equation (8-1)с may be considered equivalent to the

balance of payments. It shows that the increase in net external debt results
in an increase in the interest payments account (iD) and a deficit of
resources.5 If we assume that I is constant, then the debt accumulation
model shall be defined by the changes in G, which defines the specific
features of macroeconomic policy and, hence, the phases of the debt
cycle. When countries borrow external loans with the intention to raise
funds, from a theoretical point of view, they may go through three distinct
debt cycle phases.
Debt phases of external loans

for purposes of production investment
A, Y Y’ with borrowing
Deficit of А (Absorption)
Y (Income)
А’ with borrowing
Y=А without borrowing
Net payments
Net capital
incoming flow
resources
G t (Time)
0 T0 t (Time)
D
D (Net debt)
Phase I Phase III
Phase II
t (Time)
Source: IQBAL, Z. and A. Yousef. External debt - analysis and policy issues. 1998,
(IMF working paper).
Figure 8-2
5
This means that the current net debt at a certain moment Т is equal to the sum of
the past resources deficits.
The phases are illustrated in the lower part of Figure 8-2. During
phase I, the debt used to alleviate the resources deficit grows faster than
the interest rate. During Phase II there is a surplus of resources, but they
are not sufficient to cover the interest payments, i.e. to service the debt.
During this phase the debt keeps growing, although its growth rate is
slower than the growth of the interest rate. During Phase III the surplus of
resources (the excess of savings over investments) is sufficient to cover
the interest payments in full and the nominal debt decreases until it is paid
off completely.
However, according to some researchers there is an additional
fourth phase, when the country, having paid its debt in full, becomes a
creditor. The development of phase four requires the country to be
exporting capital long enough to repay the debt accumulated and to
become a creditor.6
The longer the outgoing capital flows exceed interest receipts, the
longer resource transfers will be negative. However, the country will
become a net creditor when its interest receipts exceed outgoing capital
flows. Phase five of the debt cycle occurs when the country becomes a
developed creditor and is able to reinvest part of its income from
investments abroad and use the remainder to increase domestic
consumption. The final phase of the debt cycle occurs when the developed
creditor starts to repatriate its capitals lent abroad consuming not only the
income from interest, but also the repayment on the principal of loans
extended to other countries. There are a number of factors that determine
whether the country needs to go through all six phases of the complete
debt cycle or if it can resist the additional phases of the cycle. The most
important of these factors are the relative share of the debtor country in the
world economy, the rate of growth of exports and the GDP of the debtor,
and the level of interest rates in the international markets. In short,
economies are expected to stay for extended periods of time in two of the
phases. These are phases 2 and 5, which are characterised respectively
by a negative balance (deficit) in resources and a positive balance
(surplus) in resources.
In practice, the interest rate cannot be considered a constant value
and a shortage of resources is not a constantly decreasing function of time.
When i and G have more complex patterns of development over time, the
dynamics of the debt may not be the type represented by Figure 8-2. There
6
ZAHARIEV. A. Bulgarian External Debt-macrostability aspects and evidences.
International Conference "Financial Stabilization and Economic Growth" (26-27.X.2000).
Conference proceedings, p. 125.
108 Debt management
are numerous examples of debtor countries that are constantly in phases

one and two. This is mainly due to the difference between the percentage
growth in exports and the interest rate on its outstanding debt. If:7
 is X  / X (the rate of growth in the export of goods and
services);
z – D/X (the debt/export ratio)
g – G/X (the ratio of the deficit of resources to exports),
then the equation (8-13)с may be transformed into:
(8-2) z  i  z  g
This equation is also known as the sustainability condition: if the

rate of export growth exceeds the interest rate, the constant positive deficit
in resources may be compensated by a low value in the debt/export ratio.8
If z remains constant in time, we will have:
z  0
and then:
(8-3) g    iz
which is positive for >i. If >I, then the deficit of resources cannot be
sustained indefinitely because this would mean that the ratio D/X would
have to increase indefinitely. If exports grow at a rate lower than the
interest rate, an increasingly large part of export incomes must be set aside
for debt servicing if we do not want the ratio D/X to increase indefinitely.
This condition must be determined by creditors’ confidence

regarding the expected behaviour of i over time, their uncertainty about
the effectiveness of policies and perceptions about "over-indebtedness". If
i<0, creditors may call for the suspension of future growth of the ratio
D/X (or D/GDP). At this stage, the growth rate of debt should be lower than
the growth rate of exports.
Conversely, the proportion of the exported product should increase.
Thus, a larger volume of domestic production would substitute part of the
imports, or the burden of servicing the debt should be reduced by means of
debt restructuring techniques. Otherwise, the government must loosen the
restrictions on the exchange of foreign currency by adopting an appropriate
policy. Therefore, in order to maintain the required solvency, we must
observe the condition 0I.
7
The equilibria are adopted from: IQBAL, Z. and A. Yousef. Op. Cit. pp. 7-11.
8
Ibid.
Exhibit
Theoretical model of the origin
of debt crisis
a) Common liquidity country b) Net liquidity country
A, Y Y’ with borrowing A, Y
А (Absorption)
Y=Аwithout lending
Y (Income)
А’ with borrowing
А (Absorption)
Y (Income)
Y=А without borrowing А’ with lending
Net payments Net capital Y’ with lending

Net capital Net receipts
outgoing flow
incoming flow
resources
Deficit of
G t (Time)
resources
G t (Time)
Deficit of
0 T0 0
t (Time) T0 t (Time)
D D
D (Net debt)
Phase V
D (Net debt)
Phase I Phase III
Phase IV Phase VI
Phase II
t (Time) t (Time)
Source: Zahariev. A. Bulgarian External Debt-macrostability aspects and evidence.

International Conference "Financial Stabilization and Economic Growth"
(26-27.X.2000). Conference proceedings, p. 125.

2012.
2. DARZHAVEN dalg. Mesechno izdanie na MF i BNB, 1998, 1999,
2000, 2001, 2002, 2003, 2004, 2005, 2006, 2007, 2008, 2009,
2010, 2011.
3. YOTSOV, V. Makroikonomicheski problemi pri obsluzhvaneto na
vanshniya dalg. Sofia, 19-20 October 1995.
4. MINASYAN G., Nenova, M., Yotsov., V. Parichniyat savet v
Balgariya. Sofia, 1998.
110 Debt management
Keywords
1. Public debt management
2. Objectives of public debt management
3. Borrowing
4. Debt repayment
5. Need for debt financing
6. Loan terms
7. Creditor’s status
8. Capital market
9. Types of loan
10.Debt negotiations and placement
11.Debt acceptance
12.Reasons for deficit financing via external loans
13.Marginal efficiency of investment
14.Interest burden
15.“Investments-Savings” equilibrium model
16.Temporal model of income and absorption
17.Debt servicing
18.Temporal consumption model
19.Levelling of expenditure over time
20.Debt dynamics
21.Debt cycles
22.Debt cycle phases
23.Outgoing capital flows
24.Negative resource transfers
25.Net creditor
26.Developed creditor
27.Sustainability condition
28.Over-indebtedness
29.Debt restructuring techniques

1. Define the essential characteristics of debt management.
2. What are the objectives of external debt management?
3. What is the algorithm of debt acceptance?
4. Discuss the main reasons for lending and borrowing external loans.
5. Discuss the dynamic model of the “investments-savings” equilibrium.
6. Describe the main equilibria for defining the dynamics of external debt
financing.
7. Discuss the phases of the debt cycle.

8. Estimate the gross outflow/inflow of capitals providing that the current
account balance is minus USD 1 bln., foreign direct investments amount
to USD 548 mln. and the volume of external debt is USD 8.245 bln.
Discuss the effects of the equation: D   iD  G
9. Under what circumstances would the following modification of the
sustainability condition for external debt financing be valid: g    iz ?
account balance is minus USD 2.65 bln., foreign direct investments
amount to USD 1.82 bln. and net external indebtedness is USD 15.123
bln. Discuss the effects of the equation: D   iD  G
11.Compare the terms “net creditor” and “developed creditor”.
account balance is USD 2.15 bln., foreign direct investments amount to
USD 1.82 bln. and net external indebtedness is USD 21.2 bln. Discuss
the effects of the equation: D  iD  G
112 Debt management
Chapter summary
Government debt management includes all operations related to the
efficient and proper maintenance, and servicing of public debt. Its main
objectives are: to avoid liquidity and maturity crises; to maintain the current
account deficit within reasonable limits; to use external debt for
investments; to maintain monetary and fiscal discipline; to control the ratio
between portfolio capital flows and foreign direct investments; to maintain
or establish the trust of depositors, creditors and investors; to strengthen
the national banking system.
The process of debt management includes activities undertaken at
two main stages: the borrowing and the repayment of debt. At the
borrowing stage, activities are undertaken in the following sequence:
а) analysis of the need for additional debt financing;
b) assessment of loan terms;
c) negotiation of the terms;
d) borrowing the loan, respectively the sale of securities.
The above algorithm is indicative of the numerous problems and

difficulties related to public debt borrowing and servicing. Repayment of
debt, however, raises the need to examine in depth the financial and
economic nature of external deficit financing.
The main reasons for external borrowing are: external loans enable
the borrowing governments to reduce the difference between the levels of
domestic saving and investments; external loans solve issues related to the
shortage of resources; external loans modify the temporal model of
consumption; external loans are used to finance deficits from previous
balances of payments. The reasons for external deficit financing are
explained by the model of dynamic “investments-savings”.
The successful management of external deficit financing is closely
related to the analysis of debt dynamics and cycles. It facilitates accurate
managerial decisions related to the external sector of the economy and the
movement of debt and non-debt capital flows.
CHAPTER IX
THE SHADOW ECONOMY AND TAX EVASION

This chapter describes the nature and form of the shadow economy
and the possibilities of affecting it. By the end of the chapter you will be
able to:
 use the basic terms and definitions;
 distinguish the various forms of manifestation of the shadow
economy;
 discuss the possible ways of affecting the shadow economy.

1. The shadow economy and tax evasion - definitions and
forms of manifestation;
2. Aspects of taxation effects on the shadow economy.
1. The shadow economy and tax evasion -

definitions and forms of manifestation
The inability of governments to collect taxes very often makes them
resort to deficit financing. On the other hand, taxpayers often try to reduce
the taxes they have to pay. Therefore, the main objectives of taxation in
terms of achieving social equality are often unachievable due to the impact
of factors and events that make theoretical concepts and formulations
impossible. In this aspect we have to consider the phenomena of "tax
evasion" and "tax avoidance". Both of these cannot be perceived as
independent fiscal phenomena. This is due to the fact that, when we
discuss tax evasion and tax fraud, we are analysing the broader
phenomenon of the "shadow economy".
114 Debt management
The term “shadow economy” is often substituted with other

synonymous terms.1 However, the various synonyms denote the same
meaning - a situation when various activities are carried out and incomes
are generated in the economy, but are not registered in official statistics
and therefore reduce the fiscal revenue for national budgets.
According to V. Tanzi (1980) the development of the shadow
economy is due to two groups of factors:2
1. Those related to the taxpayer’s desire to avoid legal taxation.
2. Those related to the taxpayer’s desire to disobey regulations and
restrictions imposed by the government. Restrictions on legal
activities are related to the taxpayer’s consent to pay social security
contributions, while restrictions on illegal activities include the sale
of stolen goods, prostitution, narcotics trafficking, etc. The
resources invested in such activities could be used for generating
income in the legal economy and therefore reduce the volume of
tax revenue.
On the other hand, according to J. Cullis and P. Jones (1992)

without taxation the rational distribution of labour output among the
economic agents would be impossible. In short, taxation is a universal
instrument for the accumulation of revenues for the state and, without
taxation, the movement of money would be difficult. Taxation is a
phenomenon which presumes imminent payment. Tax evasion is a
violation of tax laws and, therefore, it is considered a criminal offence. At
the same time, taxpayers’ doubts about the advisability of the taxes
imposed generate resistance. In practice, resistance against taxation
materializes as tax evasion.3
National legislations provide various definitions of taxpayers’
activities that are considered tax evasion. Generally, they all define tax
evasion as:
The taxpayer’s activity (or inactivity) intended to conceal
certain facts and information in order to avoid payment of
taxes or to unlawfully reduce the amount of tax liability.
Therefore tax evasion reduces the budget revenue.4
1
Some of the synonyms are “black” (noire), “unofficial” (inofficielle), “irregular”
(irreguliere), “underground” (sousterrienne), “hidden” (cachee), “cash” (enmonnaie), “dual”
“unrecorded” (irregistree), etc.
2
For more details see: TANZI, V., The Underground Economy in the United States:
Estimates and Implications, Banca Nationale del Lavoro Quarterly Review, 33, 135, 1980,
pp. 427-54.
3
CULLIS, J. and P. Jones, Public Finance and Public Choice, McGRAW- HILL,
London, 1992, p. 217.
4
Ibid.
Chapter IX. The shadow economy and tax evasion 115
Obviously, tax evasion includes many different types of activities.

These activities have both a hidden and explicit nature. From the
perspective of taxpayers, the most common form of tax evasion is the
demands for larger discounts or exemptions which are guaranteed by law,
or the deliberate reduction of declared income. However, it would be fair to
say that the behaviour of individuals regarding the taxation of their income
is just a form of defence. "Taxpayers seek to avoid the fiscal deduction of
their wealth or at least to reduce its size.”5
In terms of the methods used to avoid deduction, there are several
groups of taxpayers, depending on their behaviour, regarding paying taxes
and benefiting from the potential of the national insurance system. These
are:
1. People who work entirely in the legal economy, i.e. declare all
their income and, respectively, have full rights to use the services of the
social security system;
2. People who work both in the legal economy and in the shadow
economy: they declare all their incomes from the legal economy and pay all
the due taxes on them and at the same time have a side job in the shadow
economy receiving their incomes in cash and thus evading taxation on
these incomes;
3. People who work entirely in the shadow economy and who, due
to weaknesses in the social security system, may or may not receive social
security benefits.
Thus, according to Cullis and Jones (1992), people from the third
group (those who work entirely in the shadow economy and receive social
security benefits through fraud) are most often subjected to criticism. This
criticism is based on the assertion that they are allowed to live reasonably
well without contributing to the social security system and have fewer
working hours than the standard working week. The press considers
people committing social security payments fraud as thieves from the state
which provides social security and, therefore, this group has the worst
image.
Public opinion, on the other hand, demonstrates a selective
approach to assessing the behaviour of those who evade taxes. The fact is
that people with higher incomes do not always receive as much
disapproval. This is partly due to the belief that people with higher incomes
5
GAUDEMET, P.M., J. Moline, Finances Publiques, Politique Financiere, Budget et
Trezor, P., 1983, p. 322.
116 Debt management
do not necessarily evade taxation, but can avoid taxes via professional
legal and accounting advice.
There are certain difficulties in determining the borderline between
tax evasion and tax avoidance. One of the acceptable and correct answers
is that the difference is in lawfulness - while tax avoidance is legal, tax
evasion is not. However, we must admit that the legal boundaries are not
always precisely defined and there are many loopholes in fiscal laws.
Some types of tax avoidance are almost indistinguishable from tax
evasion.6
According to F. Cowell (1985), these differences, which are based
on moral concerns, are quite blurred and inefficient in terms of economic
analysis.7 He considers security and insecurity as criteria for differentiation,
i.e. tax avoidance provides the economic agent with some security, while
tax evasion is characterised by a certain degree of ambiguity in terms of
the actual amount of taxes which must be paid.
A. Lewis (1982) describes some additional aspects of tax avoidance
and tax evasion, which are summarized in Table 9-1 below:8
Table 9-1
1. Evasion: 1.1 By commission
- intentional;
- unintentional;
1.2 By omission:
- intentional;
- unintentional;
2. Avoidance: 2.1 legal “loopholes”;
2.2 tax expenditures as part of approved
government policy;
V. Adamov (1992) describes the following differences between tax

evasion and tax avoidance:9
First, tax avoidance – tax circumvention which is not in breach of
state regulations. Depending on its scale it may be:
 avoidance provided for by law, which includes two main
groups of techniques: the underestimation of the tax base, and the
overestimation of tax-deductable expenses;
6
CULLIS, J. and Jones, P. Op. cit., p. 217.
7
COWELL, F. The Economic Analysis of Tax Evasion.// Bulletin of Economic
Research, 37, 3, 1984, pp. 169-93.
8
LEWIS, A. The Psychology of Taxation. Oxford, Martin Robinson, 1982.
9
ADAMOV, V. Teoriya na finansite. Svishtov, 1992, pp. 144-5.
 avoidance ignored by the law, which is generally due to some

imperfections and loopholes in fiscal legislation;
Second, tax evasion (tax fraud).
Regardless of scientific stipulations, taxpayers should be aware that

legislative bodies and governments have tools sufficient in scope and
impact to combat such negative phenomena as tax evasion and tax fraud.
However, there are some limitations to taking tougher measures against
the circumvention of taxes which are related to the perception of taxation
as a form of active intervention by the state in the economic and social life
of society. This is why the possibilities for the reduction of the tax base and
the exemptions provided for by fiscal legislation, as well as existing
loopholes, are either results of imperfections and errors in the existing
legislation, or due to intentional taxation policy aiming to support a certain
economic activity X. Figure 9-1 illustrates both cases.10
The effect of non-taxation of good X

Units Y
3 I2
7
10
I0
6
I1
5
0 4 9 2 Units Õ
Source: CULLIS, J. and P. Jones. Public Finance and Public Choice. London, McGRAW-
HILL , 1992, p. 218.
Figure 9-1
10
Figures 1 through 7 and the comments on them are based on: CULLIS, J. and
Jones, P. Op. cit., pp. 218-227; and BROWN, C. V., and Jackson, P.M. Public Sector
Economics, 4th ed., BLACKWELL, 1994, pp. 429-9.
118 Debt management
The line 1-2 is the initial budget restriction. If Y (all other goods and
services) are X taxed, the budget restriction line is shifted to the left (and
becomes the parallel line 3-4.) After taxes are paid, the equilibrium
consumption curve is in point 5. If good X is depleted intentionally or
unintentionally, the budget restriction shifts to the line 3-2 (i.e. if an
economic agent consumes the whole volume available of X, he will not pay
any taxes at all). In this case, when the whole volume of X is consumed,
equilibrium is set at point 6. The change in taxation is represented by the
vertical line 6-7. The budget restriction 8-9 at point 6 allows for a higher
indifference curve (I2 compared to I1) at point 10, provided that taxation
revenue remains the same.
As shown, the result may be caused deliberately or by error. If X
were a good which generates positive external effects, its use should be
recommended. E. Browning and D. Browning (1983) suggest that this is
the result of questionable fiscal policy instruments as the lack of a clear
statement could mean that tax benefits primarily those people who are well
informed or, most likely (in cases of "loopholes" in the law), those who
employ the services of special law or accounting firms.11 Another important
issue is that the exemption of good X may be legalised only after some
heated public debates.
Some of the typical forms of tax avoidance are: intensive
depreciation; tax credits; investment premiums; tax-exempt profits spent on
charities, priority scientific research, etc.12
2. Aspects of taxation effects on the shadow

economy
Obviously, the taxes imposed have certain effects on the behaviour
of each economic agent who acts rationally. Therefore, the taxes imposed
significantly change the parameters of the informal economic characteristic
of the perfect market.
In Figure 9-2(а), the transformation curve ТТ’ shows the number of
rest hours that may be used to increase production. The gradient of ТТ’
shows the rate at which reduced rest hours may be used for production. If
we assume that the initial choice of economic agents is made at point 1:
then the ratio of rest hours to informal production hours is as shown in the
11
For more details see: BROWNING, E. and J. Browning, Public Finance and the
Price System, NY, Macmillan, 1983.
12
CULLIS, J. and P. Jones, Op.Cit., p. 218.
figure. The existing market allows individuals to “trade” their time along the
w line (which represents the level of remuneration).
Taxation and informal production

Rest
T
Informal
hours 1
Hours of
Legal
production 2
Possibilities for
home-based
I1 production
Rest hours
Hours w
of
rest
0
T’ Production
Shadow economy Legal economy
a) output output
Rest
(1 - t)w
T
1
Informal
hours
2
3 I1
Hours of
legal
production 4
I0 w
Hours
of
rest
0 T’ Production
Shadow economy Legal economy
b) output output
Source: CULLIS, J. and P. Jones. Op. Cit., p. 219.

Figure 9-2
120 Debt management
If legal production is an available option, economic agents will

achieve equilibrium at point 2 of I1 with the corresponding volumes of
informal production, legal production and rest hours. In particular, the shift
from 1 to 2 represents the allocation of working hours to legal production.
Figure 9-2(b) shows the effect of an imposed tax. The w line (which
represents the cost of labour) shifts its (1 - t)w position along the ТТ’ curve,
and thus reflects the effect of tax on wages received for hours of legal
production, compared to those spent for informal (shadow-economy)
production (t is the tax rate). Economic agents will achieve equilibrium at
point 4 on the lower indifference curve of I0. Thus, point 3 represents the
borderline between the hours of shadow-economy production versus the
hours of legal production and rest.
The change in the number of rest hours and hours of legal
production is a function of the change in the number of hours allocated to
shadow-economy production, but it is obvious that the tax imposed results
in a greater increase in shadow-economy production compared to legal
production. Thus, the increase in the volume of shadow-economy
production proves the restrictive effect of taxation and lowers the level of
legal production (GDP).13
In general, the model of reaction of the shadow economy to the
imposition of a tax illustrated in Figure 9-2 only demonstrates some loss of
wealth due to distortion in the pattern of production. This cannot be
considered a valid reason for taking tough measures against tax evasion
and the shadow economy. In practice, informal production hours can be
used to generate taxable income, but they may not be used in addition.
Obviously, to develop a rigorous and ruthless policy against tax evasion
and tax fraud we have to develop further the theoretical models exploring
the nature of tax evasion as an illegal activity.

1992.
2. STOYANOV, V. Osnovi na finansite. S., 1999.
3. FISHER, S., Dornbush, R., Shmalenzi, R. Ekonomika. Moscow,
Delo, 1999.
4. BELEV, B., Schneider, Fr., Zahariev, A. et al. The Informal
Economy in the EU Accession countries (Size, Trends and
13
Ibid, p. 220.
Challenges to the Process of EU Enlargement. Sofia, Center for

the Study of Democracy). 2003.
5. CULLIS, J. and Jones, P. Public Finance and Public Choice.
Oxford, 1998.
Keywords
1. Purposes of taxation
2. Tax evasion
3. Tax avoidance
4. The shadow economy
5. Factors for the development of the shadow economy
6. The views of J. Cullis and P. Jones
7. Taxpayers’ behaviour
8. Taxpayer categories
9. The views of F. Cowell
10.The views of A. Lewis regarding the differences between tax
evasion and tax avoidance
11.The views of V. Adamov
12.Tax exemption effects
13.Legal tax avoidance
14.Tax avoidance stipulated by law
15.Tax avoidance ignored by law
16.Illegal tax avoidance
17.Tax changes
18.The views of Е. Browning and D. Browning
19.Forms of tax avoidance
20.Rational economic agents
21.The informal economy
22.Transformation curve
23.Legal production
24.Effects of taxation on wages
25.Market production
26.Hidden production
27.Reaction of the informal economy
28.Loss of wealth

1. Define the term “shadow economy”.
122 Debt management
2. Discuss the factors behind the shadow economy.

3. What are the differences between “tax avoidance” and “tax evasion”?
4. Discuss the possibilities of affecting the phenomena of “tax avoidance”
and “tax evasion”.
5. What forms of tax avoidance are you aware of?
6. What is the effect of taxation on the activities and decisions of economic
agents?
Chapter summary
The phenomenon of the "shadow economy" is inherent in any
economy. It is associated with the implementation of activities and the
generating of incomes which are not reported to official statistics and
reduce by various degrees the fiscal revenue in national budgets.
Tax evasion includes many different types of activities which have
both a hidden and explicit nature. Such are the demands for larger
discounts or exemptions which are guaranteed by law, or the deliberate
reduction of declared income. There are several groups of taxpayers
according to the tax circumvention methods they use:
1. People who work entirely in the legal economy, i.e. declare all
their income;
2. People who work both in the legal economy and in the shadow
economy;
3. People who work entirely in the shadow economy.
There is a specific difference between tax evasion and tax

avoidance. While tax avoidance is legal, tax evasion is not. A. Lewis
distinguishes the two categories of tax circumvention as follows:
 Evasion through omission or error;
 Avoidance through “loopholes” in fiscal laws or tax exemption as
a part of government fiscal policy.
V. Adamov (1992) describes the following differences between tax

evasion and tax avoidance:
First, tax avoidance
 avoidance provided for by law (through underestimation of the
tax base or overestimation of tax-deductable expenses);
 avoidance ignored by the law.
Second, illegal tax evasion (tax fraud).
Levying a new tax has certain effects on the behaviour of each

economic agent who acts rationally. Therefore, the taxes imposed
significantly change the parameters of the informal economic characteristic
of the perfect market.
CHAPTER Х
CONCEPTS OF TAX EVASION AND TAX FRAUD

This chapter describes the factors that stimulate taxpayers to
engage in tax evasion activities. By the end of the chapter you will be able
to:
 discuss the individuals propensity to evade taxes
 analyse the relations between levels of tax rates, incomes and
tax evasion
 discuss the main concepts related to tax evasion.

3. Concepts of alternative tax “evasion” and tax fraud

Various studies1 indisputably prove that the effects of tax evasion
can be measured and compared in monetary terms. Moreover, they have
identified the taxpayers’ desire and motivation to take action in order to
evade taxes.2 What is not clear is how prevalent these desires are and
under what specific conditions taxpayers will undertake action to evade
their taxes. In order to clarify the principal reasons for deciding to evade
taxes we shall develop the following model to study the nature of tax
evasion as a criminal activity.
Tax evasion offers the risk-neutral individual the following type of
choice:3 If we assume that taxable income is Y and that the rate of tax is t,
1
For more details see: SMITH, S., Britain’s Shadow Economy, Oxford University
Press, 1986.
2
BROWN, C. and P. Jackson, Public Sector Economics, 4th ed., BLACKWELL,
1994, p. 429.
3
The equilibria and examples are based on: CULLIS, J. and P. Jones, Op.Cit., pp.
220-1.
Chapter Х. Concepts of tax evasion and tax fraud 125
then, with certainty, the individual will have the benefit of (1 - t)Y by
declaring and paying tax due. If the individual evades taxes, then we
assume that there is a probability p that he will get caught and face a fine
or punishment whose monetary value is F. The expected value of the
evasion strategy is expressed as:4
(10-1) E(V)=p(Y - F) + (1 - p)Y
If E(V) exceeds (1 - t)Y in value, the individual will evade taxes. For
example, if Y = $12000, р = 0,5, t = 0,33 and F = $5000, the comparison
would be:
(10-2) (1 - t)Y = 0,66 х 12000 = $8000
as compared to
(10-3) p(Y - F)+(1 - p)Y = 0,5(12000 - 5000) + 0,5(1200)= $9500
The expected outcome exceeds the monetary value of the actual outcome
and the individual is almost certainly predicted to evade. We have to note
that the source of the additional expected income does not affect the
decision.
A common assumption adopted in financial theory is risk aversion
on the part of most individuals and its inclusion reduces the number of
outcomes where “evasion” is a utility-enhancing strategy. This uncertain
prospect has to be differentially attractive to compensate the individual for
bearing the risk. If we include risk aversion, the relevant calculation for the
expected utility of evasion becomes:
(10-4) E(U) = pU(Y - F) + (1 + p)U(Y)
This new situation is illustrated by Figure 10-1, where Y is pre-tax

income and U0 is the level of utility associated with it. If the individual
declares his income, the actual legal income he will get is (1 - t)Y. Let us
assume that, initially, the monetary value of punishment upon detection is
F1, so that (Y - F1) is the level of income and U2 is the utility level enjoyed at
the time of detected evasion. For tax evasion to be attractive, the act must
offer at least as high a level of utility as not evading. This is the case when
the probability of detection indicates an expected income level of Y*.
Depending on the curvature of the total utility curve, which indicates the
extent of risk aversion, Y* will be greater than (1 - t)Y. The greater the
curvature, the greater the risk aversion. Given F1, this amounts to having a
low probability of detection. As р takes values from 0 to 1, the expected
income level migrates from Y to (Y - F1). The general point here is that if
4
Ibid.
126 Debt Management
people are risk-averse, evasion will be much less than if they are risk-
neutral.
Tax evasion as a crime
Expected
pF
utility
P=0 U0 Total
utility
3’ U1 1 2
V 3
2’
F1 U2
p=1
F2
p=1
0 0
Value of (Y-F2) (Y-F1) (1-t) Y* Y** Y
Income
certainty
a) b)
Source: CULLIS, J. and P. Jones, Op.Cit., p. 219.

Figure 10-1
Figure 10-1(а) displays half-moon shapes that indicate the

individual’s value of certainty. It is the horizontal distance between the total
utility curve and the line indicating expected value. The distance V,2’ in
Figure 10-1(а) equals 1-2 in Figure 10-1(b) and represents the amount of
money that compensates for bearing the uncertainty of a fine F1, with
probability р (at the utility level U1) associated with the certain income (1 -
t)Y. The upper intercept of the curve F1 in Figure 10-1(а) occurs when р=0,
and the lower when р=1 and the level of detection has reached 100%.
Based on the above calculations, J. Cullis and P. Jones formulate
the following implications:5
1. The more risk averse people are, the less evasion there will be;
5
CULLIS, J. and P. Jones, Op.Cit., p. 222.
2. For a given fine F1, the higher values of р will result in less
evasion;
3. For a larger fine F2, Figures 10-а and 10-b need amending and
Y** becomes the expected income needed to make evasion
attractive. Thus V,3’ = 1,3 is now the appropriate value of certainty
and implies that for a larger fine, a lower probability of detection will
suffice to deter a given decision to evade tax.

Each taxpayer faces a serious dilemma when it comes to answering
the question: "How much income to declare to the taxman?" The answer to
this question defines the three main categories of taxpayers:
 completely honest taxpayers, who diligently declare the full
amount of their incomes;
 partially honest taxpayers, who use a set of instruments to
legally avoid taxes plus some tax evasion techniques in order to reduce
their taxable incomes;
 completely dishonest taxpayers, who either do not declare their
incomes or declare incomes only up to the threshold of tax-exempt
amounts.
Figure 10-2 illustrates the optimal tax evasion combination. The
amount of income legally liable for tax is given by ОY and is liable to
proportional tax rate t. The probability of detection is р, and the detected
undeclared income is subject to a surcharge at a rate of s. Both axes tell
you something about the income; with the imposition of a 45o angle it is
easy to move from one axis to the other in order to achieve equal distance
between both axes. With ОY as pre-tax income on the x axis, all the
“action” takes place in the wedge below the 45o line because the individual
does not receive a reward from the tax authorities for evasion. If the
economic agent is completely honest and declares Y, his income will be (1
- t)Y. If he is completely dishonest and remains undetected, his income will
remain Y. If, on the other hand, he is completely dishonest and is detected,
his income will be (1 - t - ts)Y (the distance Y-1 in the figure). The
individual can settle for honesty and finish with the income level associated
with point 2, or can be an undetected evader and enjoy income OY, or a
detected evader and have the “penal” income of Y-1.
However, perhaps most realistically, he might declare some, but not
all, tax-liable income. Thus, the utility is maximized on I0 at point 3. This
point involves a declared income Y* which is less than Y and implies an
after-tax income of Y - tY*, tax payment of tY*, and tax evaded being equal
128 Debt Management
to t(Y - Y*). We have to point out that this situation is possible only for
undetected tax evasion.
Optimal tax evasion model

Income if
caught
Tax Tax due plus

slope due surcharge on
=-s
concealed
Income if all is I0
income
undeclared and 2
undetected
3
Y(1 - t - ts) + tsY*
Income with 1 Income if
declared caught and
optimal penalised
4
evasion = (1 - t - ts)Y
45 o
0 (1 - t - ts)Y (1 - t)Y Y - tY* Y Income
=Y-1
Income
Tax Tax
evaded paid
Income with undetected

optimal evasion
Source: CULLIS, J. and P. Jones, Op.Cit., p. 223.
Figure 10-2
The particular form given to the utility function by F. Cowell6 means

that an increase in the probability of detection rotates the indifference
curves anticlockwise, reducing the optimal amount of evaded tax and
raising the amount of tax paid. Increasing the penalty surcharge rate on
detection will move the “trade-off” segment 2,1 to a position resembling 2,4,
which indicates that more tax will be paid and less evaded.
D. Alm (1988) presents a model of tax evasion (Figure 10-3) which
involves two stages.7 The first - the selection of how much to evade - can
6
For more details see: COWELL, F. The Economic Analysis of Tax Evasion.
Bulletin of Economic Research, 37, 3,1985, pp. 163-93.
7
For more details see: ALM, J., Compliance Costs and the Tax Avoidance: Tax
Evasion Decision, Public Finance Quarterly, 16, 1, 1988, pp. 31-66.
be taken from F. Cowell’s analysis (so that income net of evaded income
equals ОО’).
Declaration versus avoidance on legal income
T’ C’
Marginal shelter cost Marginal tax rate on
of an additional $ of an additional $ of
taxable income taxable income
C’ T’
0 q* 0’
Declared income Shelter income
Figure 10-3
Increasing legal income and the effect on declaration and avoidance
T’ C’
C’ C’ T’
À A
0 q* q* * 0’ 0”
Source: ALM, J., Op. Cit.

Figure 10-4
130 Debt Management
The second is the division of legal income into taxable and shelter
income, a choice that is independent of that made at stage one. An
increase in the probability of detection increases legal income so that ОО’
becomes ОО” (Figure 10-4) due to the shifting of the indifference curve
from the optimal tax evasion model. This model uses variables based on
the proportional rate of tax levied on legal incomes (hence its shape of
ОТ’). In the case illustrated, positive and increasing marginal costs of
avoidance are incurred (АС’). Declared income is measured from О and
sheltered income from О’ with q* being the optimal decision point.
Here is how the model works:8
1. An increase in the probability of detection increases legal income at
stage one (by flattening the indifference map in Figure 10-4).
2. Curve АС’ is moved rightwards by the shift in the vertical axis to О”,
and the new optimal decision is in the vicinity of Оq** with both declared
and avoided income being raised.
3. The effect on the proportions declared is impressive and the proportion
of the income declared changes from Оq*/OO to Оq**/OO”.
4. The proportion will be higher if the marginal shelter cost rises faster
than the increases in the marginal tax rate, as can be seen from the
relative gradients of ОТ’ and АС’.
3. Concepts of alternative tax “evasion” and tax

fraud
The tax evasion models above explore the relationship and
dependence between the size of tax evasion and the evader’s utility
function for various surcharge (penalty) rates and probabilities of detection.
However, some financiers and economists have slightly different views on
tax evasion and tax avoidance. Some of the most significant criticisms and
alternatives come from:
 M. Spicer’s “norms of compliance” model;
 A. Lewis’ economic approach;
 Laffer’s theory regarding the relation between the tax rate and the
volume of fiscal revenue;
 The concept of tax evasion as a form of protecting returns on
investments in human capital.
8
CULLIS, J. and P. Jones. Public Finance and Public Choice. London, McGRAW-
HILL, 1992, pp. 223-4.
M. Spicer (1986) offers two general criticisms of the traditional “tax

evasion” model:9
1) Tax evasion decisions appear to be governed, not by maximizing
strategies, but by ‘rule of thumb’ heuristics. In this way, penalty calculations
based on the probability of detection and the size of punishment are
unlikely to be made – therefore, available heuristic principles are more
appropriate. Research indicates that past experience with audits will bias
the estimates of audit probabilities. Decision-makers are calculating not the
true probability of detection, but the most straightforward and accessible
conjecture as to how to order their affairs instead.
2) М. Spicer draws attention to the so-called “norms of compliance”.
The decision to evade tax will be influenced by factors such as perceptions
of the justice of the fiscal system and the number of an individual’s friends
who evade tax themselves. In order to incorporate a more “realistic” model
of evasion, Spicer amends the decision-making rule to include “psychic
costs”. A taxpayer will evade tax only as long as the expected gains from
taxes exceed the expected losses from fines and the “psychic costs”
associated with evasion. To tax evade:10
(10-5) (1 - p)tQY - pstQY - c >0,

where:
t is the tax rate;
Q is the fraction of unreported taxable income;
Y is the taxable income;
s is the fine rate imposed on evaded taxes;
р is the probability of detection;
с is the psychic costs of tax evasion.
The question is then: What influences the psychic costs, and how
important are they in the decision to tax evade? Here, Spicer notes
psychological relationships such as cognitive dissonance, whereby, when
an individual acts in a way that is not consistent with his beliefs, feelings of
discomfort are created which then stimulate changes in beliefs. If tax
evasion is committed more often, the taxpayers themselves will erode the
social norms and reduce the psychic costs of evasion.
A. Lewis (1982) proposes a broader model of tax evasion, which is
illustrated in Figure 7.11 Box (i) contains the elements that economists
would term broadly defined “tastes” or “preferences”. It includes sympathy
9
SPICER, M. Civilization at a Discount: The Problem of Tax Evasion. National Tax
Journal, 1986, pp. 13-20.
10
SPICER, M.W., Op. Cit.
11
LEWIS, A., The Psychology of Taxation, Blackwell, Oxford, 1982.
132 Debt Management
or antipathy towards the government, feelings of control over political

agents’ actions and the ability to influence those actions, and views on the
equity of the taxation system.
Those attitudes both influence, and are influenced by, the perceived
opportunity to evade, and the perceived probability of detection and
punishment (ii). Perceived opportunities and enforcement in turn influence,
and are influenced by, the characteristics of taxpayers – age, sex,
education, religion, culture, class, past experience of the cost of
compliance with taxation, etc. In short, three broad factors predetermine
compliant or evasive behaviour: attitudes towards tax, perceptions of tax,
and individual personal characteristics. Individuals may need to rationalize
their behaviour or alter their attitudes in the light of their experience of
evasion. The ovals in the figure contain connections to a broader approach
with regard to economic-political science. Circle (iv) might be interpreted as
capturing government attitudes and perceptions, and (v) – governmental
actions. There is a two-way causality between the ovals and the boxes.
A. Lewis’ broadened approach to modelling tax evasion
(iv) (i)
Government fiscal stance, Attitudes and perception
reliance on direct versus
ff fiscal policy and
indirect taxes; individual
influence over tax policy constitutional structure
making, etc.
(v) (ii)
Tools used to enforce a Perceived Rationalization or
particular tax structure change of attitudes
enforcement and
and their variability with as a consequence
choice of structure opportunity
of experience
(iii) Characteristics of
taxpayers (including
demographic and
background variables)
Tax compliance or
evasion behaviour
Source: LEWIS, A. The Psychology of Taxation. Oxford, Blackwell, 1982.

Figure 10-5
Ovals (iv) and (v) are seen by Lewis as capturing the actual world
and the dotted lines are indicative of fiscal policy actors willing to use their
view of taxpayer-voter perceptions based on meagre investigation.
Any analysis of taxation theory would not be complete if it did not
take into account a direct link between tax rates and the volume of tax
revenues. In this field, Arthur Laffer’s research takes centre stage, as it
resulted in a theoretically complete curve of taxation known as the Laffer
curve.
In short, the Laffer curve leads to the following conclusions:12
 Increased taxation causes a decrease in actual wages;
 Heavy taxation results in the reduction of the supply of labour;
 Heavy taxation causes individuals to escape from industry and
to orientate towards activities which are not subject to taxation.
The last conclusion demonstrates the relationship between Laffer’s

theory and tax evasion. On the basis of the concept of diminishing marginal
utility and the decisions of individuals to evade at certain levels of tax
burden, the Laffer curve model is modified by having its left side
constructed based on the curve of an individuals’ propensity to bear the tax
burden in view of expected social welfare. Thus, individuals achieve a level
of ultimate satisfaction with the services of the social security system so
that each new unit of social welfare not only induces an increase in the
amount of wealth, but in the utility function of this wealth. The right side of
the Laffer curve is based on the projection of the curve indicating the
increasing resistance of taxpayers opposed to the increase in tax burden,
i.e. this is the section in where individuals gradually reduce and eventually
cease all legal economic activities, as the ratio of the price of the public
goods supplied against disposable wealth (income) cancels the benefit of
these goods. In other words, at one extreme, a lack of taxation (when the
tax rate is 0%) would mean an economy without a state, while at the
other extreme total taxation (a tax rate of 100%) would mean a state
without an economy. Obviously, the optimal level of taxation will be
achieved at the apex of the curve, where individuals would achieve
equilibrium and the state will generate the highest level of budget revenue.
Last, but not least, we shall consider the concept of tax evasion as
a form of protection of return on investments in human capital made by a
rational investor. Using this concept, the public has rights of individuals on
income, only to the extent of public supplies realised through the
12
For more details see: АДАМОВ, В., Теория на финансите, Свищов, 1992, pp.
295-298.
134 Debt Management
production of human capital via good education. In this respect, let us

assume that the cost of education is shared equally between individuals
and society. Therefore, we can establish the existence of the following two
theoretical situations: The state has a legitimate claim on individuals’
incomes, but only to the extent of public investment utilised for the creation
of human capital through the provision of public education. We are
assuming that the expenses for public education are shared equally
between the individuals and the society. Therefore, we should identify the
following two theoretical models:
1. If the financial benefits gained from the education of a certain
individual - which is measured in terms of the difference in income from a
position which requires higher education, and a position which does not
require this level of education - are shared equally between the individual
and society, the return period will also be equal for the individual and
society;
2. If the financial benefits gained from the education of a certain
individual – which is measured in terms of the difference in income from a
position which requires higher education and a position which does not
require this level of education - are not shared equally between the
individual and society, the return period will be shorter for the individual in
proportion to the excess revenue allocated to them and vice versa.
Based on the assumptions above, we may construct a matrix

describing the possible combinations regarding the distribution of the
financial burden (the costs associated with the provision of a single
individual having the public good of higher education) and the financial
benefits (the increase of personal income) of education. If we denote:
1. the financial costs for the individual as EFCi, and the financial
costs for society regarding the provision of a unit of good as EFCs;
2. the financial benefits for the individual as EFBi, and the
financial benefits for society regarding the provision of a unit of good as
EFBs, we can construct the following matrix of possible combinations: (see
Table 10-1).
As we can see from the matrix, the combinations along the diagonal
line from left to right (the first, fifth and ninth cells), express states of
equilibrium. The other combinations result in an imbalance, which goes to
extremes in the third cell (an extreme imbalance beneficial to society) and
in the seventh cell (an extreme imbalance beneficial to the individual). We
should also point out that:
First, the combinations of non-equilibrium in the second, the
third and the sixth cell are most typical when the state is in a superior
position vis-à-vis that of its citizens. Under these circumstances, any
rational individual will be tax-averse because of the excessive claims of the

state on the income generated by individually owned human capital.
Second, the combinations of non-equilibrium in the fourth, the
seventh and the eighth cell are most typical when the state is in an inferior
position vis-à-vis that of its citizens.
Table 10-1
Distribution of the financial costs and benefits of human capital formation
Distribution of Distribution of benefits
costs EBi>EBs EBi=EBs EBi<EBs
1 2 3 4
Imbalance to the Imbalance to the
ECi>ECs Balance benefit of society benefit of society
ECi=ECs benefit of Balance benefit of society
individuals
ECi<ECs benefit of benefit of Balance
individuals individuals
Moreover, when we consider the characteristics of education as a

specific type of public good, we should take into account that:
First, according to classic concepts in the field of economics and
public finance (e.g. in Brown and Jackson (1992)), education is a mixed
non-competitive good. Some individuals may decide not to take
advantage of it. The reason for such a decision may be a mismatch
between the actual investor in education and the actual beneficiary. In
other words, since the beneficiaries of education are individuals, it may be
considered a private good with externalities.
Second, the assumption of education as a private good with
externalities is the starting point for the development of a model of optimal
distribution of the costs of investment in human capital formation
among all beneficiaries.
Third, theoretically, such a model will determine the point of
competitive equilibrium between educational supply and demand. In other
words, it will identify the point at which the requirements for Pareto
optimality are satisfied, or more precisely, where marginal public benefits
equal marginal public costs. But, as the marginal public benefits are a
cumulative expression of all benefits generated by the "provision" of
education as a public good, then finding the Pareto optimality allows us to
136 Debt Management
determine the optimal allocation of costs for investment in human capital

formation. (see Figure 10-7).13
Non-equalities in the model of the optimal distribution of costs

of investment in human capital formation
Price
(MC) Social
Private demand (SD) -
demand (PD) MSB
P S MC=const.=MSC
C
Public
EBp subsidy
P*
Private
ExtB fee
0 Q*p Q*s EBq Quantity

(private) (public) (Q)
Fig. 10-7
If we assume that society provides 30% of all funds needed to

produce a single unit of human capital (line F*C), then it could later reclaim
through income taxes no more than the share of the increase of individual
incomes generated due to prior investments in human capital. If political, or
other reasons, lead to a situation where the state tries to use the fiscal
system to extract revenues in excess of this accepted proportion, then the
ordinary taxpayer has every reason to take action to evade or avoid taxes.
In other words, when the imposition (or the increase) of a tax
increases the time for return on investment in human capital formation,
then individuals will take a number of measures to re-establish the initial
ROI rate (in a perfect market.)
13
ZAHARIEV, A. Finansovo upravlenie na choveshkite resursi. V. Tarnovo,
ABAGAR, 1998, pp. 155-157.

1. ZAHARIEV, A. Tenevaya Ekonomika - Teoreticheskie Modeli i
Empiricheskie Svidetelystva. Ternopoly, 2000
2. ZAHARIEV, A. Byagstvo ot danaka i danachna izmama -
teoretichni modeli i fiskalni resheniya. // Ikonomicheski
izsledvaniya, Sofia, II na BAN, Vol. 9, 2000, book. 1, pp. 103-
125.
3. ALM, J. Compliance Costs and the Tax Avoidance: Tax Evasion
Decision. // Public Finance Quarterly, 16, 1, 1988.
4. BELEV, B., Schneider, Fr., Zahariev, A. et al. The Informal
Challenges to the Process of EU Enlargement). Sofia, Center for
the Study of Democracy. 2003.
5. CULLIS, J. and Jones., P. Public Finance and Public Choice.
Oxford, 1992.
6. DILNOT, A. and Morris, C. What Do We Know about the Black
Economy? Fiscal Studies, 1981, 1981, 2, 1, pp. 58-73.
7. FIEGE, E. The Underground Economies: Tax Evasion and
Information Distortion. Cambridge, 1989.
Keywords
1. Tax evasion as crime
2. Tax-exempt income
3. Utility level
4. Total utility curve
5. Risk aversion level
6. Degree of curvature
7. Curvature probability
8. Individual safety
9. J. Cullis and F. Jones’ applications and findings
10.Optimal tax evasion model
11.Completely honest taxpayers
12.Partially honest taxpayers
13.Completely dishonest taxpayers
14.Undetected tax evasion
15.F. Cowell’s utility function
16.Tax-liable income
17.Non-taxable income
18.Legal income
138 Debt Management
19.Progressive tax rate

20.Effects of the change in income rates
21.Relationships between the level of tax evasion and incomes
22.M. Spicer’s “norms of compliance” model
23.A. Lewis’ economic approach
24.Laffer’s theory
25.Maximising factors
26.Fiscal system fairness
27.Psychic costs
28.Rationalisation of behaviour
29.Taxation curve
30.Taxpayers’ resistance
31.Economy without a state
32.The state without an economy
33.Financial benefits
34.Return period
35.Individual financial costs
36.Public financial costs
37.Imbalanced groupings

1. Which conditions would cause a risk-indifferent economic agent to
evade tax?
2. Analyse the income-utility-risk relationship.
3. Comment on J. Cullis and F. Jones’ concepts.
4. Which are the main categories of taxpayers?
5. Comment on the optimal evasion model and the degree of its validity.
6. Compare the optimal evasion model and Alm’s model.
7. What are the differences between the traditional tax evasion model and
Spicer’s “norms of compliance” model?
8. Comment on A. Lewis’ extended tax evasion model.
9. Compare the main concepts of Laffer’s theory with theories regarding
the strategic impact of government debt on the political cycle.
10. Under what circumstances - within the model for the optimal allocation
of costs of investment in human capital - will individuals have reason to
evade or avoid taxes?
Chapter summary
In order to reduce the level of tax evasion we should be aware of
taxpayers’ motivation to evade, i.e. their reasons and the specific
conditions which make them evade taxes. In order to understand the
origins and development of the decision-making process to evade, we
apply a model which describes tax evasion as a crime. The model explains
the relation between the individual’s decision to evade or not and the size
of tax rate, the degree of probability of detection, the level of penalty on
detection of the offense, financial benefits and the benefits of tax evasion. If
people are risk-indifferent, they would tend to evade if the financial benefits
from implementing such a strategy exceed the amount of tax they must pay
if caught. The other main argument is that when people are risk-averse, the
level of tax evasion would be lower than if they are risk-indifferent.
Each taxpayer is facing a serious dilemma as to how much income
to declare to the taxman. The answer to this question defines the three
main categories of taxpayers:
 completely honest taxpayers;
 partially honest taxpayers;
 completely dishonest taxpayers.
Tax evasion opportunities are also illustrated by other models, such

as the “optimal tax evasion” model and the tax evasion model proposed by
Alm. These models study the relationship and dependence between the
size of tax evasion and the evader’s utility function for various surcharge
(penalty) rates and probabilities of detection. However, some financiers
and economists have slightly different views on tax evasion and tax
avoidance. Some of the more significant concepts are:
 M. Spicer’s “norms of compliance” model;
 A. Lewis’ economic approach;
 Laffer’s theory regarding the relation between the tax rate and
the volume of fiscal revenue;
 The concept of tax evasion as a form of protection of return on
investment in human capital.
CHAPTER XI
MEASURING THE SHADOW ECONOMY
AND TOOLS FOR ITS COUNTERACTION

This chapter develops your competences related to the
measurement of the shadow economy and ways in which to counteract it.
By the end of the chapter you will be able to:
 distinguish between the main methods of counteracting tax
evasion;
 discuss the advantages and disadvantages regarding the main
sources of information used to estimate the volume of the black
economy.

1. Tools to counteract the shadow economy;
2. Methods of measuring the shadow economy.
1. Tools to counteract the shadow economy

The need to counteract tax evasion and the shadow economy is
undisputed and pressing. There are two main methods of fighting tax
evasion:1
1) Preventive – used to “fill in” the gaps and loopholes in current
fiscal regulations by removing unjustified tax deductions, refunds and
exemptions.
2) Administrative - audits, determining tax and the primary costs on
site, the adoption of surcharge rates.
It is also necessary to take stringent measures to limit the size of

the shadow economy. We need clearer and stricter legislation as well as an
impartial and incorruptible judiciary.
1
ADAMOV, V. Teoriya na finansite. Svishtov, 1992, pp. 146-7.
Chapter XI. Measuring the shadow economy and tools for its counteraction 141
Based on research conducted in Bulgaria, Prof. I. Stoykov and Prof.

B. Dimitrova propose that administrative measures against the shadow
economy should be included in long-term programmes for socio-economic
development.2 In fact, for Bulgaria as a country with a significant debt
burden, the implementation of effective measures against tax evasion and
tax fraud is critical. Generally, there is a direct relation between the shadow
economy and deficit financing. This relation results in a decrease in fiscal
revenues while the demand for public goods remains constant. Eventually,
an increase in the level of detection and strict criminal prosecution of
detected tax evasion would result in an increase in the tax base. This
increase in the tax base would provide greater fiscal revenues and
therefore, will decrease the need for deficit financing and result in an
internally-balanced state budget.
2. Methods of measuring the shadow economy

Cullis notes that, by definition, every area of concern that contains a
significant illegal element is going to be deficient in reliable statistics. Such
is the case with the extent of shadow economies. On top of this inherent
data weakness is the fact that different observers have “axes to grind”. For
some, the apparent failure of Keynesian expansionary policies to stimulate
GNP can be blamed on the expansion of the shadow economy. For others,
the existence of an extensive black economy in which everyone has
alternative sources of money justifies the curtailment of social security
programmes. For the tax authorities it may represent missing millions and a
decline in taxation morality. The figures quoted for the black economy are
as varied as the methods used to generate them.
The theory of cost-benefits analysis defines a limited number of
sources for valuation information. These sources are market data,
behavioural approach, direct enquiry via questionnaires or experiments,
and (in exceptional circumstances) the views of experts. In this context:3
First, market data covers a number of official sources of
information. In particular, national income accounting offers two
approaches. At the macro level, K. MaCaffee (1980) has considered the
gap between the income approach to national income calculation and the
2
The authors define several groups of problems which need effective
administrative solutions. For more details see: STOYKOV, I., Dimitrova, P. Skritata
ikonomika v Balgariya. // Ikonomicheski izsledvaniya. vol. 1, 1999, pp. 72-75.
3
CULLIS, J. and Jones, P. Public Finance and Public Choice. Oxford, 1998, pp.
205-6.
142 Debt management
expenditure approach.4 Information about the former comes from tax

returns, and the argument is that income from the black economy will not
show as income but will appear as expenditure. A. Dilnot and C. Morris
(1981) are critical of this approach on the grounds that the basic argument
is not entirely correct.5 One example they offer is the renting out of
premises that are used as brothels. The rent paid will probably be included
in the income estimate of GDP, but the expenditure involved is unrecorded
so that the inclusion/exclusion “goes the wrong way” for the MaCaffee
approach. They note that, even if all transactions were entirely legitimate,
errors in the sampling used to collect data and timing inconsistencies would
cause the income and expenditure figures to diverge. Therefore, they
argue that the error between the two approaches is significant and
advocate the much more disaggregated approach that they themselves
follow. They use disaggregated income and expenditure figures using the
Family Expenditure Survey and find the black economy to be some 2-3 per
cent of GNP. O’Higgins (1981) similarly resorts to official statistics.6 He
notes that there is a discrepancy in the Family Expenditure Survey
between the expenditure recorded for the self-employed and others
employed sharing a similar recorded income. But there is a question over
whether the correct comparisons have been made because employee
incomes are recorded on a current-period basis, whereas details for the
self-employed are for earlier accounting periods. It is, of course, possible to
use data that is available to the tax authorities. He suggests that 6-7 per
cent of legal income goes unreported. O’Higgins is doubtful about a related
approach of using tax enforcement data on the grounds that these will vary
with the investigative and prosecution efforts undertaken from period to
period.
Second, behavioural approach – studies listed under this heading
are those that rely on the observation that (under certain circumstances)
black transactions due to the behaviour of black economy agents, may be
recorded. Such an “indirect” monetary approach relies on the increased
circulation of large-denomination notes in the UK. Two US studies depend
on the cash-in-hand view of the black economy. Guttman (1977) suggests
that legitimate activities involve a fixed ratio between cash and current
account payments, so that an increase in this ratio reflects the growth of
4
MaCAFFEE, K. A Climbs of the Hidden Economy in the National Accounts.
Economic trends, 1980, vol 316. pp. 81-87.
5
DILNOT, A. and C. Morris. What Do We Know about the Black Economy? Fiscal
Studies, 1981, 1981, 2, 1, pp. 58-73.
6
O’HIGGINS, M. Measuring the Hidden Economy. British Tax Review, 1981, nos. 5
and 6, 37, 2, pp. 269-78.
the black economy.7 Similarly, Feige (1981; also see 1989) supposes that
multiplying the average velocity of circulation with the volume of currency
and bank deposits yields the value of total transactions, and if the resulting
figure bears a constant relationship to national income, then this predicted
nominal GDP can be compared with that in the actual national accounts to
give a measure of the black economy.8 However, more efficient use of
money gives the unexpected result of a shrinking black economy for the
UK (see Dilnot and Morris).9
Third, direct sociological enquiry. Economists have been wary of
evidence from both questionnaires and experiments due to the strategic
and hypothetical elements involved. Most people will underestimate tax
evasion on their part when asked. However, to ignore the use of
questionnaires and experiments is to ignore a growing body of relevant
literature. Lewis (1982) details the major studies involved, noting that social
surveys concerned with tax attitudes and perceptions have as yet been
concerned only indirectly with the extent of tax evasion.10 If low and
declining tax morals were combined with an environment in which evasion
was thought justifiable, the prediction would be of extensive tax evasion.
Research conducted in the summer of 2001 on tax evasion
techniques employed by Bulgarian private companies11 provided the
results shown in the table below, summarizing the tax evasion technique of
officially reporting lower wages than actual (i.e. a lower taxable income)
and therefore paying lower social security and pension contributions and
income taxes (Table 11-2).
Table 11-2
Payment of pension security contributions based on reported
taxable incomes (exceeding the minimum non-taxable base)
Small Medium Medium Medium Large
(up to 49 (50-199 (200-349 (350-499 (over 500
Response: employees) employees) employees) employees) employees)
Yes 32% 51% 63% 75% 83%
No 68% 49% 38% 25% 17%
7
GUTTMAN, P. The Subterranean Economy. Financial Analyst’s Journal, 1977, 33,
pp. 26-7.
8
FIEGE, E. The UK’s Unobserved Economy: A Preliminary Assessment Economic
Affairs, 1981, 1, 4, pp. 205-12; Fiege, E. The Underground Economies: Tax Evasion and
Information Distortion. Cambridg, 1989.
9
DILNOT, A. and C. Morris. Op. Cit.
10
LEWIS, A. The Psychology of Taxation. Oxford, 1982.
11
BELEV, B., Fr. Schneider, A. Zahariev et al. - The Informal Economy in the EU
Accession countries (Size, Trends and Challenges to the Process of EU Enlargement).
Sofia, Center for the Study of Democracy. 2003, pp. 225-238.
144 Debt management
Main results from the research:

The research confirms the intensity of the use of strategic tax and
insurance avoidance in Bulgaria. This is particularly obvious for small and
medium-sized enterprises. The main reasons behind this trend are:
 employees agree with the introduction of corporate policy for tax and
insurance avoidance due to the unemployment risk. Such a risk
directly reduces the return rate from investments in human capital
formation through education.
 the lack of trade unions allows management and accounting staff to
increase the use of tax avoidance with or without employees’
consent.
 reduced payments to the state and social insurance funds free
resources for new corporate investments and for certain increases in
the disposable income of personnel (e.g. via cash-on-hand instead of
PAYE payments), ceteris paribus.
 due to the small size of the companies, the local tax offices perform
tax audits quite rarely, thus reducing the probability of tax-avoidance
revealing a risk level acceptable to corporate management.
Otherwise, larger taxpayers (enterprises with more than 350
employees) are very often surprised by fiscal audits. As a result,
large companies prefer to fairly report the actual amounts of salaries,
income taxes and social insurance contributions rather than pay
penalty surcharges.
Tax and insurance evasion in Bulgarian private companies varies

from 17% in large enterprises (with more than 500 employees), through
37% in medium-sized enterprises (with 50 to 499 employees), to 68% in
small enterprises (with up to 49 employees).
Fourth, expert opinion. Recourse to expert opinion is distrusted as a
source of valuation in economics but may well be relevant as a source of
information. In this context, one of the best documented opinions is that of
Sir William Pile, who is the former chairman of the Board of Inland
Revenue and in 1977 ‘guesstimated’ the black economy as 7.5 per cent of
GNP.
Exhibit:
The Informal Economy in the EU Accession Countries: Size, Scope,
Trends and Challenges to the Process of EU Enlargement,
18-19.04.2002 – Sofia
“Tax Avoidance in Bulgaria: the Human Capital Approach”

Assoc. Prof. Andrey Zahariev, PhD
/Summary of the research/
“...
3. Methodology
The research methodology is based on the establishment of the relationship
between:
a) The distribution of fixed term contracts according to the hierarchical status of
the employee in certain small, medium and large companies in Bulgaria:
(1) YFTC  a  bX HIERARCHY ,
where: Y = application of fixed term contracts (FTC);
X = hierarchical status;
b) The distribution of fixed term contracts according to the existence of local
trade unions:
(2) YFTC  a  bX UNION ,
where: Y = application of fixed term contracts (FTC);
X = the percentage of registered unions at the companies from the
sample;
c) The size of the company according to the number of employees and the
official taxable income according to the corporate policy on labour contracting
and social insurance:
(3) YINCOME  a  bXSIZE ,
where: Y = official taxable income established on insurance bases;
X = size of the company according to the number of employees;
In order to test the above hypothesis for our sample of Bulgarian firms, we
apply correlation and regression analysis. Initially, the enterprises in the sample
were distributed in five groups according to the number of employees:
I Small enterprises (up to 49 employees)

II Medium-sized enterprises 1 (50-199 employees)
III Medium-sized enterprises 2 (200-349 employees)
IV Medium-sized enterprises 3 (350-499 employees)
V Large enterprises (over 500 employees)
146 Debt management
4. Analysis of key results

The key results from the survey are related to the three main relationships
indirectly expressing the size and reasons for tax avoidance in Bulgaria. From
figures 5 and 6 it can be seen that distribution of fixed term contracts is a
function of the size of the company and the hierarchical status of the
employees.
Distribution of Fixed Term Contracts at Bulgarian
Medium- Sized and Large Companies
Large (over 500

Workers employees)
Medium (350-499
Support personnel employees)
Medium (200-349
Employees
employees)
Medium (50-199
Specialists
employees)
Small (up to 49
Managers
employees)
0% 10 20% 30% 40% 50% 60% 70% 80%

Figure 5
Distribution of Fixed Term Contracts for Managers, Specialists and
at the Bulgarian Small, Medium-Sized and Large
80%
Managers:
70% y = 0,021x + 0,189
R2 = 0,0537
60%
50%
Specialists:
40% y = -0,016x + 0,376
R2 = 0,0583
30%
20% Workers:
y = -0,046x + 0,562
10% R2 = 0,493
0%
Small (up to 49 Medium (50-199 Medium (200-349 Medium (350-499 Large (over
employees) employees) employees) employees) employees
Managers Specialists Employees Supp.

Workers Linear (Workers) Linear (Specialists) Linear
Figure 6
Application of Fixed Term Contracts Policy according

to the existence of Trade Unions at the Company
70%
y = 0,1166x + 0,0461
R2 = 0,7016
60%
y = -0,0216x + 0,426
50%
R2 = 0,0822
40%
30%
20%
10%
0%
Small (up to 49 Medium (50-199 Medium (200-349 Medium (350-499 Large (over 500
employees) employees) employees) employees) employees)
Fixed Term Contracts Trade Union Linear (Fixed Term Contracts) Linear (Trade Union)
Figure 7
Does your company offer pension insurance (public & private)

to its employees on a taxable income basis?
100%
90% 83%
y = -0,1271x + 0,7736 75%
80%
R2 = 0,9764
70% 63%
60% Yes
51% No
50% Linear (Yes)
Linear (No)
40%
32%
30%
20%
10%
0%
Small (up to 49 Medium(50-199 Medium(200-349 Medium (350-499 Large (over 500
employees) employees) employees) employees) employees)
Figure 8
According to the size of the company for the categories of specialists

and workers, the regression line has a negative beta (= -0,016 for specialists
148 Debt management
and = -0,046 for workers). Otherwise for the category of managers, the
regression line has a positive slope. The explanation is related to the
enlargement of the use of the JSC legal form for registration relative to the size
of the company. All governing bodies are usually contracted under fixed terms.
The existence of a trade union is also an important factor in introducing
a policy for fixed term contracting as a tax-avoidance factor. The larger the
company, the better represented the trade unions are, and vice-versa (the
trendline confirms our hypothesis by R2=70%).
The final, and most representative, figure for the purposes of this
research is fig. 8. Upon asking the question “Does your company offer
pension insurance (public & private) to its employees on a taxable income
basis?” we were able to confirm the relationship between the size of the
company and the policy of insuring company employees on a non-taxable
basis. The intensity of such policies of tax avoidance declines by 13% for
every subsequent category of companies according to the criterion,
“number of employees”. 98% of the variation in the observed trend can be
explained by changes in company size. The remaining 2% of the variation
cannot be expressed by the above factor influences.
…”

1. BELEV, B., Schneider, Fr., Zahariev, A. et al. - The Informal
Challenges to the Process of EU Enlargement). Sofia, Center for
the Study of Democracy. 2003.
2. CULLIS, J. and Jones, P. Public Finance and Public Choice.
Oxford, 1998.
3. GUTTMAN, P. The Subterranean Economy. Financial Analyst’s
Journal, 1977, 33.
4. MaCAFFEE, K. A Climpse of the Hidden Economy in the
National Accounts. Economic trends, 1980, vol 316. pp. 81-87.
5. O’HIGGINS, M. Measuring the Hidden Economy. British Tax
Review, 1981, nos. 5 and 6, 37, 2, pp. 269-78.
Keywords
1. Prevention of tax evasion
2. Administrative methods against tax evasion
3. Extensive black economy
4. K. MaCaffee’s approach
5. Disaggregated income and expenditure
6. O’Higgins’ approach
7. Market data
8. Behavioural approach
9. Black transactions
10.Indirect monetary approach
11.Average circulation speed
12.Direct sociological surveys
13.Expert opinion

1. Define the principal characteristics of the methods used to counteract
tax evasion.
2. Perform a comparative analysis of the possible ways in which to
measure the shadow economy.
3. To what extent is the shadow economy a problem for central and the
local governments? Provide arguments and express your own opinion.
4. What are the main reasons for individuals to evade their income tax?
5. Comment on the main means and methods to counteract tax evasion
and tax fraud in terms of their effectiveness and feasibility.
6. Estimate the size of the shadow economy in your municipality.
7. In today's economic reality in Bulgaria, which are the most frequently
used methods for the legal concealment of taxable income?
150 Debt management
Chapter summary
Reducing the size of the shadow economy requires certain
measures. In this context, there are two main methods of fighting tax
evasion:
1) Preventive – used to “fill in” the gaps and loopholes in current
fiscal regulations by removing unjustified tax deductions, refunds and
exemptions.
2) Administrative - audits, determining tax and the primary costs on
site, adoption of surcharge rates.
We also need clearer and stricter legislation as well as an impartial

and incorruptible judiciary.
Generally, there is a direct relation between the shadow economy
and deficit financing which results in a decrease in fiscal revenues while
the demand for public goods remains constant. An increase in the level of
detection and strict criminal prosecution of detected tax evasion would
result in an increase in the tax base, which in turn would provide greater
fiscal revenues and therefore, will decrease the need for deficit financing
and result in an internally-balanced state budget.
In order to accurately estimate the size of the shadow economy we
have to consider the reliability of the data and methods used to collect it.
The theory of cost-benefits analysis defines the following sources of
valuation information:
 Market data which covers a number of official sources of
information;
 Behavioural approach – studies that rely on the observation that
black transactions due to the behaviour of black economy
agents, may be recorded;
 Direct sociological enquiry;
 Expert opinion.
CHAPTER XII
DEFICIT FINANCING IN BULGARIA

This chapter reviews the relationship between deficit financing and
debt management solutions. By the end of the chapter you will be able to:
 comment on the causes of the debt crisis;
 discuss the possibilities for reducing the indebtedness of our
economy.

1. The origin and development of the debt crisis in Bulgaria;
2. Measuring and evaluating deficits and indebtedness;
3. Solutions to the deficit and debt problem.
1. The origin and development of the debt crisis

in Bulgaria
The development of financial systems is a process for which the
complexity and scope can hardly be covered within a single study.
Moreover, when applied to empirical data, the theoretical models often do
not match reality. This is because public debt and deficit financing models
are based on certain necessary conditions and limitations, within which the
model works. Taking these limitations into account, we shall try to
determine if, and to what extent, accumulated public debt and deficit
financing act as instruments of strategic impact by applying the hypotheses
we discussed in the previous chapters to the specific conditions in our
country.
During the period 1878-1944, the actual loss for the Bulgarian
economy in external liabilities amounted to 6296.5 million gold levs: 31% of
this amount was received by Germany and Austria, 23.8% by France, 20%
by the UK, 19 2% by Italy and the remaining 6% was paid to Russia,
Turkey, Yugoslavia, Romania, the United States, Belgium and other
countries (according to Prof. S. Cholakov’s calculations). Some of these
152 Debt management
debts were incurred via loans taken by the government and the rest
(including some war reparations) were imposed by international
organisations. An interesting fact regarding these debts is that only 10 per
cent of them were principal payments and the remaining 90 percent were
payments of interests, other expenses and reparations.
In the period after 9th September 1944, when all production factors
were owned by the state, demand for credit was considered unnecessary
because the state (in terms of DSK and BNB) disposed of the public’s free
cash. Part of the population's savings, in the form of an almost free credit
resource, were used to balance the budget which officially was always
without deficit. During this period of a centrally planned economy only a few
internal government loans were concluded, the last one being in 1955.
Undoubtedly, the use of external loans is a factor which can further
stimulate economic growth. It can compensate for an insufficient savings
rate in the national economy, or provide foreign currency resources for the
import of modern technologies. However, Bulgaria’s foreign debt policy was
determined by the second argument.
External loans resulted in an accumulation of debts to foreign
creditors. By the mid-80s they were not a particular problem for the
Bulgarian economy. At that time, external debt amounted to 5 billion US
dollars. The country had no particular difficulties in servicing its foreign debt
with the foreign currency it received from the export of goods and services.
However, in the late 80s the situation changed. The national economy
showed some symptoms of crisis that significantly slowed its growth rate
down. In order to offset the decline in economic development, the
government resorted to more external loans. They were used to import
grain, fuel, industrial raw materials and advanced technological equipment
for the development of new industries. For a short period of time, foreign
debt increased substantially. Meanwhile, export receipts were not overly
large, making it difficult to pay interest and principal on external loans.
Bulgaria entered a stage of refinancing its external debts – the country had
to take new loans out in order to pay the old ones.
Information regarding external government loans and accumulated
foreign debt was not officially announced for a long time. The data
published by international institutions did not reach Bulgarian society. The
official version was that Bulgaria did not have excessive government loans
and had negligible debt. In the period 1985-1989, however, that “negligible”
external debt amounted to about $ 11 billion.
The period of transition to a free-market economy, which started at
the end of 1989, led to significant changes in the national economy. The
possibilities for servicing foreign debt deteriorated:
 the volume of exported goods and services decreased;
Chapter XII. Deficit financing in Bulgaria 153
 large financial resources were transferred abroad;

 a significant part of the country’s external debt was due in that
period;
 Bulgaria’s credit risk increased significantly due to the political
and economic instability of the country.
All of these negative factors together with a severe economic crisis
resulted in a drastic decrease in Bulgaria’s foreign exchange reserves and
in 1990 the country declared a moratorium on foreign payments. Thus, the
country fell into complete international isolation which further aggravated
the economic situation. Only the IMF and the World Bank were willing to
help the country to overcome the crisis. At the same time, Bulgaria entered
into negotiations with its creditors for the reduction and restructuring of
external debt. It turned out that there were many creditors which were
mostly private financial institutions and most of them were members of the
London Club and the Paris Club. The negotiations started in 1992 and led
to the conclusion of a preliminary agreement with the London Club
creditors at the end of 1993, and a final agreement (signed on 28th
November 1994) known as the Debt and Debt Service Reduction (DDSR)1.
It covered the reduction and restructuring of a debt of $ 6.2 billion principal
and $ 1.9 billion in arrears and unpaid interest. The agreement provided for
two basic methods of reducing the original debt: buy-back and replacement
of part of the debt with securities:2
 Debt buy-back. Under this “repurchase” option, Bulgaria offered
to buy 20% of its debt from its creditors at a certain price (25.8125
cents per one dollar of debt and the related interests). About 12.9%
of the original debt was restructured using this option.
 Discount Bonds (DISC) issued by Bulgaria to its creditors
against outstanding debt. The bonds had 50% discount on their
nominal value and an annual interest of LIBOR + 13/16. The
principal is secured with 30-year American Treasury Bonds with
zero coupons. The interest payments for the next 12 months were
secured with short-term, low-risk stocks in US dollars. 63.3% of the
original debt was restructured using this option. There is a clause
for the recovery of the nominal value of the bonds.
 Front Loaded Interest Reduction Bonds (FLIRB) – Treasury
Bonds with a nominal value equivalent to 1 USD of the original
debt, but with a significantly lower interest rate for the first seven
years. This bond had a gradually increasing interest rate of 2%
1
STOYANOV, V. Osnovi na finansite, S. 1999, p. 461.
2
YOTSOV, V. Makroikonomicheski problemi pri obsluzhvaneto na vanshniya dalg.
Sofiya, 19-20 October, 1995.
154 Debt management
during the first two years, 2.25% during the following two years,
2.50% for the fifth year, 2.75% for the sixth year and 3.00% for the
seventh year until it reached the six-month LIBOR+13/16 annually.
The payment is guaranteed with collateral (18-year American
Treasury Bonds) equivalent to the amount of a twelve-month
interest payment on the principal at an annual rate of 2.6%. This
option was used to restructure 26.8% of the original debt. There is a
clause for the recovery of 50% the nominal value of the bonds.
 The fourth instrument issued to compensate debt-holders for the
period of moratorium on debt payments was the Interest-Arrears
Bond (IABs).
The agreement obliged the government to resume the payment of

interests in arrears amounting to 1.9 bln. USD and to pay a lump sum of
715 mln. USD prior to, or at the date of, the agreement. The interests were
to be repaid as follows:
 63.8 mln. USD paid in cash;
 223.3 mln. USD through the buy-back option;
 1614.7 mln. USD in Interest Arrears Bonds.
The interest on these bonds is six-month LIBOR+13/16. The

principal and the interest are not secured and the bonds cannot be
exchanged for assets. These bonds are the only option through which
Bulgaria does not receive any reduction in the debt (see Table 12-1).
The main advantage for the indebted country is the reduction of its
debt and the increase in investments. Hence, the improvement in the
balance of payments: the reduction of outstanding interests in the current
account and the reduction of outstanding principal in the capital account.
This will stimulate investors who will invest in advanced technologies and
will provide access to new markets and new sources of financing. The
substitution of debt for equity is a useful tool for attracting capitals
transferred abroad and the successful launch of this programme lead to an
increase in the price of bonds on the secondary capital market, raised the
country's credit rating and stimulated the inflow of fresh money.
Table 12-1
Investment characteristics of
Bulgarian Brady Bonds (BBB)
Type of bond DISC FLIRB IAB
Issued volume 1,85 bln. USD 1,658 bln. USD 1,611 bln. USD
Series А: 1,685 Series А: 1,489
Series B: 0,165 Series B: 0,169
Issue date 28 July 1994 28 July 1994 28 July 1994
Maturity date 28 July 2024 28 July 2012 28 July 2011
Repayment of Repayment of 8 years of gratis period; 21 7 years of gratis
principal principal in full at equal semi-annual payments period;
th
maturity starting from 9 July 2002 21 equal semi-annual
payments starting
th
from 30 July 2001
Interest Series А: Series А: LIBOR+13/16%
coupon LIBOR+13/16% 1-2 г. - 2.00% Payable every 6
Payable every 6 3-4 г. - 2.25% months;
months; 5 г. - 2.50%
Series B: 6 г. - 2.75%
LIBOR+15/16% 7 г. - 3.00%
Payable at each 6 8-18 г.- 6 мес.
months; LIBOR+13/16%, Payable
every 6 months;
Series B: the same as Series
А + 0.5%;
Interest Actual number of 30/360 for the period of fixed Actual number of
coupon days/360 coupon and actual number of days/360
calculation days /360 for the period of
base floating interest
Collateral 1. 30-year US
1. Principal: Treasury Bonds with
2. Interest zero interest rate None
coupon: 2. 1 year of 2. 1 year of redeemable
redeemable collateral collateral up to an interest
up to an interest rate rate of 3%
of 7%
As well as the advantages described above, there are also certain

disadvantages:
 The positive effect on the balance of payments can be
exhausted very quickly. Foreign investors sooner or later begin
to repatriate profits, dividends, and in some cases, the capital
itself. When the amount of profits and dividends exceeds the
amount of interest payments on the debt, the balance of
payments will deteriorate without being compensated
adequately by improving the capital account.
156 Debt management
 The debt to equity exchange has a lower efficiency than other

tools due to the fact that, for these operations, most of the profit
generated by the discounted price of the bonds on the
secondary market goes into the hands of investors and
intermediaries, while the other instruments benefit the borrower
country.
 Possibilities for the legalisation of capitals transferred illegally
abroad, corruption and speculative transactions.
 Risk of an increase in the inflation rate due to the increased
supply of money.
 Foreign investors are given various opportunities to invest in
the country, which will be met with resistance by local
entrepreneurs.
It is considered that debt to equity exchange should be avoided
where there may be direct investment, i.e. fresh money is always
preferable to the settlement of old debts.
Undoubtedly, servicing of external debts in the long run reduces
public wealth. The question is then: why did we take external loans, since
we know their burden and their effects? In the second half of the 80s they
were a means to mitigate the crises in planned economies. After this
period, external loans were taken to partially finance deficits in the national
balance of payments and to temporarily stabilise the slowly reforming
economy. This shows that there are always reasons for external financing.
The problem, however, is how to reduce the debt burden in order to free
more resources for development.
2. Measuring and evaluating deficits and

indebtedness
The high degree of the indebtedness of our country since the early
90s and the weak economy determined trends of permanent debt financing
of the budget deficit (see Table 12-2).
Table 12-2
Budget deficit of Bulgaria in the 90’s
(in % of GDP)
1991 1992 1993 1994 1995 1996 1997 1998
Deficit: -4.5 -4.9 -12.1 -4.6 -5.2 -15.4 -0.4 0
Source: MF ofRB
Gross and net external debt of Bulgaria (1991-1998)
Source: Държавен дълг, Издание на МФ и БНБ, January 1999.

Figure 12-1
As is known, however, all economic problems have their solutions.

The question is the size of their price. The following charts and tables
provide a comprehensive picture of the macroeconomic situation,
developments and trends related to the national debt for the Republic of
Bulgaria in the period 1991-1999 (see Table 12-3 and Figure 12-1).
Table 12-3
Foreign debt by year (1991-1999)
1991 1992 1993 1994 1995 1996 1997 1998
Total amount 11802 12548 13890 11411 10229 9660 10095 9300
Minus reserves 11471 11613 13235 10409 8993 9177 7936 6650
Source: Държавен дълг, Издание на МФ и БНБ, January 1999
158 Debt management
Particularly significant external financing during this period was

obtained via agreements concluded with the IMF. “The nature of the socio-
economic development of Bulgaria in the second half of the twentieth
century and the difficult and inconsistent adaptation of its business to the
conditions of the market economy made the country seek active financial
support mainly from the IMF. This is why we purchase more SDRs per
capita than the countries of Central and Eastern Europe.”3
The payment of foreign debt interest and principal is a real burden
on the economy and the population of any country when external loans are
used for consumption, or invested in inefficient investment projects. Sadly,
both factors are present in the case of the Bulgarian foreign debt.4
The burden of the long-term leakage of foreign exchange resources
is borne by the whole society: the ordinary citizen gets lower wages and
pays higher taxes; businessmen are forced to pay higher corporate tax and
to borrow at higher interest rates; delayed modernisation of production
factors decreases the competitiveness of Bulgarian goods and they lose
their market positions; pensions and old-age benefits are reduced;
investments in human capital formation in terms of education, healthcare,
sports and tourism are also reduced.
Table 12-5
Bulgaria’s foreign debt burden in the 90’s
1991 1992 1993 1994 1995 1996 1997 1998
Foreign debt/GDP 157.4 145.6 128.3 117.5 78.1 98.3 96.9 68.9
Foreign debt /Export 431.7 317.2 372.7 290.1 191.4 197.5 205.1 --
Debt service ratio -- 38.1 33.7 19.3 15.4 19.3 15.5 --
Source: Darzhaven dalg, Izdanie na MF i BNB, January 1999
However, the relative debt burden gradually decreased, mainly due

to economic recovery and structural reforms, the successful rescheduling
of loans with the London Club and successful cooperation with the IMF and
the World Bank.
Share of the external debt Share of the internal debt

1999 83.0 17.0
2002 88.8 11.2
3
MINASYAN G. Balgariya i MVF. // Ikonomicheska misal, N 4,1999.
4
BROWN, C. and Jackson, P. Public Sector Economics. (Bulg. transl. ed.) Sofia,
FSSA, 1998.
According to the statistics, in the first half of 1999 the total

government debt of Bulgaria was structured as follows:5
 83% external debt;
 17% internal debt.
At the end of 2002, the amount of external debt in the debt structure
was 88.8%. That is why external debt management was of primary
importance for our country. We need changes in medium-term economic
policy in order to gradually reduce the external debt burden and to find
more opportunities for investment and consumption in the country.
3. Solutions to the deficit and debt problem

The European Council’s decision in December 1999 to invite
Bulgaria to start negotiations for full membership in the European Union
radically changed the priorities and objectives of our macroeconomic
policy. In fact, the debt was originally the only macroeconomic indicator
that Bulgaria did not initially fulfil the economic criteria for accession.
Therefore, the possible solutions to the problem of debt have a strategic
importance for the future development of our country. In this respect it
should be noted that:6
First, within the process of re-financing we have to improve the
structure of the external debt. Most of the external loans should be
medium-term. This was the primary objective of the agreement with the
London Club creditors, which substituted the old long-term debts with
Brady bonds. Further, the government must take foreign loans only in
extreme situations such as natural disasters, poor harvests, epidemics, etc.
Business loans should be negotiated by commercial banks. They take
responsibility for their service and not the state.
Second, a positive balance on the current account of the balance of
payments is the healthiest way to reduce the burden of external debt for
the country. It is associated with greater penetration of Bulgarian goods
and services on the international markets which depends to a large extent
on their competitiveness. This requires an effective restructuring of
business, which requires more time.
Third, the government should finance capital projects in the public
sector through a system of concessions. Thus, it will give exclusive rights
to foreign private investors to build highways, bridges, ports, wharves, etc.
5
Vanshen dalg, Izdanie na MF i BNB, January 1999, p. 49.
6
Ibid.
160 Debt management
for certain periods of time and will not have to take loans and bear the
business risks associated with these type of investments.
Fourth, more foreign investments should be attracted to the
country. This can be done through direct and portfolio investments. For this
purpose we need to accelerate the sales of state-owned assets to
Bulgarian citizens and foreign investors. These sales would ensure the
foreign currency resources the country needs to repay its debts to foreign
creditors and would eliminate the need for external re-financing and
therefore would reduce the total volume of national debt. The increasing
globalization of the world economy in recent years has led to a rapid
expansion of cross-border direct investments. Between 1980 and 1990
world exports increased by 72%, while cross-border direct investments
increased fourfold. Not only large, but also small and medium-sized
companies set up subsidiaries and joint ventures abroad to handle fierce
international competition. The liberalization of Eastern European countries’
economies allowed them to also benefit from this process. Compared to
portfolio investments, foreign direct investments have some obvious
advantages for the beneficiary country:
 they generate urgently needed cash inflows;
 they provide production, financial and marketing expertise;
 they create higher-paid jobs and so reduce the unemployment
level and prevent the emigration of highly qualified specialists.
Fifth, in recent years the practice of reducing external debts by

replacing them with assets has become increasingly popular worldwide.
Debt instruments such as Brady bonds are admitted as legal tender in the
privatisation of state-owned assets. "The substitution of debt to equity
benefits all participants. Creditor banks recover part of their loans by selling
them on the secondary market, or become owners if they are also
investors. The main advantage for the debtor country is the reduction of its
debt and the increase in investments. Hence the improvement of the
balance of payments, which improves both the current account (due to less
interest payments) and the capital account (due to reduction of principal
payments). Another important advantage is the sharp increase in
investments.”7
Sixth, the state may repurchase part of its debt (through active
operations) like any other investor in the international capital market. All it
needs is to establish a special capital fund and to find the right moment for
the buy-back transaction. In this way it may reduce both the principal and
the interests on its external debt.
7
MINASYAN G., Nenova, M., Yotsov, V. Op. cit., p.164.
The process of reducing external debt principal and interests is a

long one. The first step in this direction is to prevent a further increase in
debt. After that, the choice of approaches and tools by which to reduce it is
a matter of a specific assessment of the economy and the willingness of
society to bear reasonable restrictions. We should always comply with the
primary objective of debt-reduction policies - to reduce the interest burden
to a level that will not have a negative impact on savings and foreign
currency reserves. These instruments may ensure economic growth, which
itself becomes an instrument for reducing the burden of foreign debt.
Exhibit
Debt and deficit, trends and status in Bulgaria and the EU
Figure 12а-1. Forecast payments to service

external government debt in the period 2002-2017
Source: Zamyana na breydi obligatsii (09. 09. 2002). Doklad na Ministerstvo na

finansite, http://www.minfin.government.bg/bg/index.html
162 Debt management
Source: MF
Legend: Left scale – government debt in mln. EUR
Right scale – government debt /GDP (%)
Figure 12а-2. Government debt dynamics
Source: MF
Legend: Basic component – government debt in BGN;
Second component – government debt in USD;
Third component – government debt in EUR;
Fourth component – government debt in other currencies.
Figure 12а-2. Currency structure of governmental debt
Source: MF
Legend: Basic component – government debt with fixed interest rate;
Second component – government debt with floating interest rate.
Figure 12а-3. Interest structure of governmental debt
Source: MF & NSI

Legend: ––––––– interest payments/GDP (%);
– – – – – interest payments/tax revenues (%)
Figure 12а-4. Interest payments

164 Debt management
Source: Преглед на фискалните тенденции в ЕС (2010-2012 г.), МФ, ФСАП, 2011
Figure 12а-5. Budget deficit (2010-2012)
Source: Ibid.
Figure 12а-6. Government spending as a share of GDP (2010-2012)
Source: Ibid.
Figure 12а-7. Government debt as a percentage of GDP (2010-2012)

Source: Ibid.
Figure 12а-8. Economic growth rate (2010-2012)

1. ALEKSANDROV, S. Za ili protiv privatizatsiyata s breydi
obligatsii. // Banki, investitsii, pari. 1995, br. 4.
2. ANGELOV, I. Makroikonomicheski izmereniya na sdelkite po
dalga. // Pari. 29.07.94.
3. DIMITROVA, G. Zamyana na dalg sreshtu sobstvenost. //
Ikonomika, book 3,1996.
4. ZAHARIEV, A. Upravlenie na vanshniya dalg v usloviyata na
ikonomichesko konvergirane. // Narodnostopanski arhiv, book 2,
Svishtov, 2001.
5. KASIDOVA, S. Balgarskiyat variant na shemite za zamyana na
dalg sreshtu sobstvenost. // Bankov pregled, book 2, 1995.
6. MINASYAN G., Nenova, M., Yotsov, V. Parichniyat savet v
Balgariya. Sofia, 1998.
7. PILBEAM, K. International Finence (Bulg. transl. ed.). Sofia,
FTP, 1995.
8. PREGLED na fiskalnite tendentsii v ES (2010-2012 g.), MF,
FSAP, 2011.
Keywords
1. External debt in the 80s
2. Conditions for servicing external debt
166 Debt management
3. Agreements for debt reduction and restructuring

4. Buy-back
5. Discount bonds
6. Front loaded interest reduction bonds
7. Interest arrears bonds
8. Investment characteristics of Bulgaria’s Brady bonds
9. Debt restructuring benefits
10.Debt restructuring drawbacks
11.Budget deficit of the Republic of Bulgaria
12.Gross debt of the Republic of Bulgaria
13.Net debt of the Republic of Bulgaria
14.External debt burden of the Republic of Bulgaria
15.“Debt-assets” agreements
16.Debt problem solutions

1. Define the causes for the moratorium on debt servicing declared in
1990.
2. Describe the main advantages and disadvantages of debt restructuring
using Brady bonds.
3. To what extent are the “debt-for-equity” swaps applicable compared to
cash privatisation?
4. Define the causes of Bulgaria reporting positive balances on its current
account and balance of payments in 1994 and 1997.
5. Evaluate the effect of the Brady-to-global swaps made in 2002 for an
exchange rate of 1.83 BGN/USD (17 Jan. 2003). Use the official
statistics published by the Ministry of Finance.
6. Using the official statistics published by the Ministry of Finance,
evaluate the effect of the Brady-to-global swaps made in 2002 for an
exchange rate of 1.10 EUR/USD.
7. Evaluate the effect of a swap of DISC with floating interest rate coupons
to global bonds with a fixed annual interest rate of 7% (see Table 12-1)
for an external debt of USD 1 bln. into an external debt in Euro for an
exchange rate of 1.10 EUR/USD. Using additional macroeconomic and
currency exchange information, evaluate the effect of the DISC-to-global
swap at:
a) the end of 2007;
b) the end of 2008;
c) the end of 2009;
d) the end of 2010;
e) the end of 2011.

168 Debt management
Chapter summary
The use of external loans is undoubtedly a factor which stimulates

economic growth. It may be used to compensate for the insufficient level of
spending in the national economy, or to provide additional foreign currency
resources for the import of advanced technologies. However, Bulgaria’s
foreign debt policy was determined by the second argument.
In 1990, Bulgaria declared a moratorium on all payments related to
servicing its foreign debt. In order to solve its debt problem, in 1992 the
government entered into negotiations with its creditors. In 1994 the
negotiations led to an agreement for the reduction and restructuring of a
debt of $ 6.2 billion principal and $ 1.9 billion in arrears and unpaid interest.
The agreement provided for two basic methods of reducing the original
debt: the buy-back and replacement of part of the debt with securities.
Due to the 1994 agreement and the resulting financial support from
leading financial institutions, Bulgaria gradually normalised its external
sector operations. Through a series of active operations in foreign debt
bonds since 2001, Bulgaria has gradually reduced the size of its external
debt. Since the accession of the country to the European Union in 2007,
foreign debt has become a macroeconomic indicator which ranks Bulgaria
among the leading EU member states and also among the Euro zone
countries. Therefore, the solution to the foreign debt problem is of strategic
importance for the future development of each EU member state.
CHAPTER XIII
THE CONTEMPORARY PARADIGM OF DEBT
MANAGEMENT

This chapter describes the main characteristics and specifics of
debt management. By the end of the chapter you will be able to:
 discuss contemporary solutions to the global debt crisis;
 interpret the objectives of debt management policies.

1. General characteristics of debt management;
2. Contemporary solutions to the global debt crisis;
3. Debt management aims and policies.
1. General characteristics of debt management

Governments are major borrowers on the domestic and
international capital markets. Governmental debt instruments are included
in the portfolios of many institutional and individual investors. The ways in
which governments finance their budget deficits and manage large
amounts of existing debt significantly affect the structure and performance
of national financial markets.1 This is why debt management has become
an important and challenging field of economics. Its importance is due to
the significant long-term consequences of debt management decisions.2 It
is challenging because it demands extremely high requirements of the debt
1
In fact the effects are reciprocal. Debt is growing due to budget deficits and vice
versa – budget surpluses are used by governments to reduce the debt burden. The second
case is widely discussed in scientific circles because of the importance of government
securities as investment instruments. For more details, see POSNER, P. Federal debt - debt
management in a period of budget surplus. FDCH Government Account Reports,
29.09.1999. Business Source Premier.
2
The decisions which aim to increase budget revenues are subject to certain
economic and political limitations. For more details, see HOLCOMBE, R. and J. Mills.
Politics and Deficit Finance. Public Finance Quarterly. October 1995, Vol. 23, pp. 448-466.
170 Debt management
manager regarding accurate knowledge of macroeconomic equilibrium

laws and the rules for making financial and investment decisions by other
economic agents.
This chapter is based on the opinion that "government debt
management is a system of activities by the state related to the borrowing
and lending of loans, negotiating and complying with the terms of the loan
agreement (terms, prices, interest, stakeholders), modifying the terms of
the interest rates, maintaining the bond spot process and repaying loans on
their maturity.”3
The efficient management of government debt is based on a large
number of agreements that must be completed before governmental debt
managers can be expected to fulfill their obligations in a satisfactory
manner. Since many of these agreements, in terms of technical and
organisational details, depend on the goals that the debt manager may
need to consider in managing government debt, it is important that
government debt managers should know from the very beginning what
these goals are and how they should be achieved.
The main objective of government debt managers is, of course, to
obtain loans needed by the government. This applies to all government
debt managers, regardless of the conditions in their country. Moreover, the
mandate of a government debt manager may include other goals they may
have, be willing to pursue or take into account in the course of their work.
These additional goals can be divided into two large groups:
 Group One – additional goals that are directly related to taking
government loans or managing government debt;
 Group Two – additional goals which government debt managers
may have to consider in the course of the implementation of
other governmental policies.
Group One may include:4 minimising costs and risks associated

with government debt; minimising the market impact on government debt
operations; optimising the maturity structure of debt; optimizing the
currency composition of debt; ensuring efficient management of operations
related to new bond issues. Group Two may include: assistance in
improving the functioning of financial markets; contributing to the
development of the government securities market as a whole or the
increase household savings.
3
ADAMOV, V. Teoriya na finansite (Darzhavni finansi). V. Tarnovo, ABAGAR,
1998, p. 610.
4
Note: The three-year government debt management strategies (2003-2005;
2006-2008 and 2009-2011) include similar definitions of the additional objectives. Source:
MF.
Chapter XIII. The contemporary paradigm of debt management 171
The annually enforced state budget acts include provisions for

government loans as a source of budget revenue.5 The functions of a
government debt manager should be performed by a specialized
department of the Ministry of Finance, the Central Bank or a special
autonomous government agency that operates under the supervision of the
Ministry of Finance and reports directly to the National Assembly.6 In order
to secure the loans needed by the government (which is their main task),
government debt managers should decide what kind of Treasury Bonds to
be issued and in what currency denomination, at what interest rate, for
what periods, whether the IPO should be for discounted or premium bonds,
etc. In this respect, the government debt managers have a wide variety of
options.7 Despite the requirements and expectations of the institutional
investors in government securities, government debt managers should
consider above all the macroeconomic framework. The most economical
and effective scenario would be the auctions of government securities to
achieve the lowest price of the debt at the highest possible level of
investors’ competition. This may be achieved and if the requirement for
high level standardization of bonds offered are met because in that way
they will be more easily traded on the secondary markets. If government
debt managers are willing to support the establishment of well-functioning
markets for financial futures and options, they may require the issue of
large volumes of highly standardized liquid debt instruments.8
Ultimately, the imbalances in public accounts and the consequent
issue of debt securities change the traditional cycle of cash flows in the
national economy (see Figure 13-1). Within the overall cycle of cash flows
which generates the gross domestic product and the national income, there
is now an additional cycle created by the Parliament’s decisions related to
the balance of the state budget as well as the decisions of the debt
manager regarding the government debt and the techniques that will be
used to manage it. The result is debt re-financing also known as "debt
cycle", which is due to the constant borrowing of new loans (by issuing
government securities) to pay the interests and principals of existing loans.
5
Ibid., p. 611.
6
An example for successful innovations in the field of government debt
management is Hungary with its specialized government debt management agency. For
more details see: HUNGARIAN debt management. Central European, Sept. 1998, Vol. 8,
pp. 94-98.
7
For more details see ADAMOV, V. Op. cit. pp. 616-727.
8
The issues related to the development of debt security derivatives are discussed
in great detail in the studies of S. Simeonov. For more details see SIMEONOV, S. Optsiite
(pazari, kontrakti, otsenyavane, strategii). V. Tarnovo, ABAGAR, 1999.
172 Debt management
Debt within the turnover of cash flows

among the main economic agents
Net
export Commodity Sales
markets
Ïîòðåáëåíèå Sales
GDP revenues
TBs Investments
Government
spending Net interests
Households Companies, CB
Government Depreciation
DI Net interests
Government revenues:
Corporate taxes
NDP
Personal
PI Transfer income Social security contributions
payments tax Indirect corporate taxes
Factor
markets
NI Retained
earnings
Legend: GDP – Gross Domestic Product; NDP - Net Domestic Product; NI - National
Income; PI – Personal Incomes; DI – Discretionary Income.
Source: SCHILLER, W., The Economy Today, MacGraw-Hill, p. 121 (with modifications).
Figure 13-1
The main objective of the government debt management policies in

many countries is to minimize the costs associated with the individual
operations related to government loans. In pursuit of this objective,
government debt managers in recent years developed a set of more
systematic and intelligent techniques for "liabilities management" based on
the contemporary portfolio theory.9 Thus the debt managers to a large
extent perform the functions of risk managers. The risks they have to take
into account are related mostly to interest rates and liquidity.10 With regard
9
For more details see PATEV, P. Upravlenie na portfeyla. V. Tarnovo, ABAGAR,
1996.
10
For more details see ADAMOV, V., Holst, J., Zahariev, A. Finansov analiz,
razdel V. Analiz na riska. V. Tarnovo, ABAGAR, 2006, pp. 385-488.
to the external debt, they must also consider the currency exchange rate
risk as well.
2. Contemporary solutions to the global debt

crisis
Since the early 80s and especially in the 90s, the management of
government debt markets and government bonds suffered significant
structural, organizational and regulatory changes. In parallel, there is a set
of policy measures and efforts to improve the efficiency of the national
financial systems in general and the national stock markets in particular.
Changes in the management of government debt and government
securities markets should be viewed as part of a wider process of
transformation that has an irreversible impact on the national financial
systems.
We may consider the date 12 Aug. 1982 to the beginning of the
global debt crisis. On that day the government of Mexico declared a
moratorium on its foreign debt payments. Shortly after that many other
developing countries warned that they faced serious difficulties to repay
their loans to the international banking institutions. Both the private
(London Club) and the official (Paris Club) creditors faced a problem which
was described as the most serious and painful problem for the future of the
global economy – the global debt crisis. The term debt crisis means a
situation in which debtors are unable to service the interest and/or the
principal on their debts within the agreed terms and thus threaten the
financial "health" of their creditors. If their inability to pay is long-standing, it
is generally regarded as insolvency. If it is caused by temporary shortages
of cash then it is defined as a liquidity problem.
In order to synchronize their activities and to overcome debt-related
problems, the creditors established the so-called London Club and Paris
Club of creditors. The London Club of creditors includes private creditors
on the international credit market. The Paris Club includes public lenders
who provide funding within two schemes:
 loans from private banks, which are guaranteed by creditors’
governments;
 loans extended within international agreements.
Due to their membership in these clubs, the creditors are able to

synchronize their positions in negotiations for settlement of debt problems.
The countries with debt problems are concentrated mainly in Latin
174 Debt management
America. In 1989 their combined foreign debt amounted to 566 billion USD
and 61.8% of this amount was owed to private commercial banks.11
Declaring a moratorium on foreign debt payments is an action that
has some inevitable consequences for both the debtor country and the
creditor institutions - public and private. The international law does not
provide for a regulated standard that would guarantee the creditors that
they would get their money back when the debtor country declares a
moratorium. However, the moratorium on payments has unfavorable
consequences for the defaulting country. According to Keith Pilbeam
(1995), a declared insolvency has three major implications:
 the country cannot take new loans;
 the trade with the country is restricted mainly through
protectionist measures imposed by the creditor countries and restrictions on
commercial credits;
 in certain cases the assets of the defaulting country abroad may
be seized by the official authorities of the creditors in garnishment or
seizure of debtor’s assets which are under the jurisdiction of the creditor.
The inability to service their foreign debts and the external isolation
generally lead to political instability in the defaulting countries because they
cannot maintain the level of supply of public goods due to their external
indebtedness. The first anti-crisis programs proposed by the U.S. Federal
Reserve and the IMF provide loans from banks and official institutions in
exchange for implementation of anti-crisis policies designed and monitored
by the IMF. The various programs revolve around three fundamental
strategies for solving the debt crisis:
 restructuring and conversion of external debts;
 economic reforms in the debtor countries;
 cancellation of certain amounts of debt.
Usually the creditors propose a combination of the three strategies,

depending on the specific goals and interests. In 1985 the U.S. Treasury
Secretary James Baker launched a three-year plan, which provides for
banks to extend additional $ 20 billion loans to highly indebted countries in
exchange for market-oriented structural reforms. The results of the Baker
plan were ambiguous. In some countries it failed completely mostly
because the banks weren’t able to raise the necessary funds. In fact, banks
managed to raise about two thirds of the required funds. At the same time
the banks prioritized other market-oriented solutions such as debt-to-equity
11
Statistical data about the size of foreign debts by years can be retrieved from the
websites of the IMF and the World Bank.
swaps, discount repurchases, etc. These alternative solutions provide a

greater reduction of risk exposure of creditor banks. Moreover, the banks
reported insufficiently strict adherence to prescribed by the IMF programs
for structural reforms and stabilization.
The Brazilian moratorium on debt payments in 1987 led to massive
accumulation of bank reserves against losses on loans. As a response to
the Brazilian default Citibank announced that it was building up its loan-loss
reserves and the rest of the banks quickly followed suit. An important
consequence of that action was the rapid development of subprime
markets. First Chile and then Mexico and Brazil reinforced this trend by
implementing schemes to swap part of their debt to equity in domestic
companies. Thus the subprime market grew fast. The traded volumes
increased from USD 2 billion in 1986 to over USD 40 billion in 1989. As a
result in 1989 the market value of debt on average was stabilized at about
35 cents on the dollar with an approximately equal level of loans-loss bank
reserves.
In the beginning of 1988 the U.S. Treasury announced that the
positive effects of the Brady Plan had decreased drastically and
recommended the implementation of a debt-reduction strategy. During
Reagan’s second term of office these views were generally ignored due to
the upcoming presidential elections. However, some US academics and
Congressmen increasingly insisted for some form of debt forgiveness,
including the purchase of debt at subprime market prices by a specially
established international agency that would have the authority to write off
part of the obligations.
The scientific focus shifted from the issue of liquidity to the concept
of excessive indebtedness. Initially the focus was on the problem of
"external transfer" associated with inadequate export. Subsequently the
scientists put forward the idea that there may be an "internal transfer
problem" because of the inability of governments to mobilize sufficient
resources from the domestic private sectors to service foreign debts.
The American economist Jeffrey Sachs argues that the position of
creditor banks can be improved by partial debt forgiveness, because
excessive indebtedness suppresses domestic investments. Paul Krugman
describes his "debt Laffer curve" to show how the estimated market value
of debt increases on the vertical axis to a peak and then falls back while
the nominal value of debt continues to grow along the horizontal axis.
Krugman himself doubts whether the developing countries are on the
correct (i.e. they have manageable amount of debt) side of the curve. On
this side the creditors will benefit by forgiving some debt because the
reduction of debt will increase the chances of payment. Later econometric
studies show that relatively few countries are on that side. For the same
176 Debt management
reason most studies rather deny than confirm the theory of suppression of
investments by excessive debt.
The Wallstreet economist Nicholas Brady studied the controversial
issue of extensive indebtedness in detail. When he replaced J. Baker as
Secretary of Treasury, the new Bush administration paid greater attention
to his ideas. N. Brady assumes that banks have taken insufficient part of
the responsibility and the burden of the crisis is shifted to the public sector.
At the same time the growing interest on the debts of Argentina, Brazil and
other countries as well as the low subprime market prices, which were
successfully used by some countries (e.g. Bolivia which bought back a
substantial amount of its debt at extremely low prices), confirmed the need
for radical changes of the debt-reduction strategy.
The Brady Plan was officially announced in March 1989. The key
element in the plan was to allow the commercial banks to exchange their
claims on developing countries into tradable instruments collateralized with
financial assistance from the IMF, the World Bank and the Japanese
government. The claims of creditor banks are transformed into “new
money” instruments, i.e. the old debt is replaced by new financial
instruments. Although these instruments involved a certain loss on the face
value of the original loans, they were associated with lower risk due to the
collateral (usually bonds and/or U.S. Treasury bonds) securing the
payments (principal and interest) on them. As a result the "debt Laffer
curve" moves up as banks can maintain the same expected value of
repayments, assuming greater security in exchange for smaller claims. The
principal amount was usually collateralized by specially issued US
Treasury 30-year zero-coupon bonds also known as Brady bonds. There
are two main types of Brady bonds. The first type (Par Bonds) were issued
to the same value as the original loan, but the coupon on the bonds is
below market rate. The second type of Brady bonds (Discount Bonds)
were issued at a discount (from 30% to 50% depending on the Brady deal)
to the original value of the loan, but the coupon is at market rate based on
LIBOR. The principal and interest payments on the Brady bonds are
usually guaranteed.
By 1994 18 Brady deals were concluded covering a total of USD
191 bln. of debt equivalent and requiring less than USD 25 bln. of
additional collateral. The first deal with Mexico was closed at the end of
1989 and in May 1990 was signed a principle agreement with Venezuela.
The results of the Brady deals are considered disproportionately beneficial.
For example, Mexico’s debt reduction of USD 15 bln. amounts to less than
half of its GDP. At the same time the change from isolation (due to
indebtedness) to economic stabilization and normalization of the external
sector, led to a sharp drop of the risk premium in local interest rates, which
decreased from 55% before the deal to 30% thereafter. After a decade of
stagnation, the actual investment rapidly increased. Similar effects were
reported for all Brady deal countries. In fact the restored confidence in the
debtor countries is the most important effect of the Brady plan. The
restored inflow and repatriation of private capitals due to the increased
credit rating are the key factors for financing the plan in terms of balance of
payments.
After the success of the Brady Plan (which benefited Bulgaria as
well), in the 21st century the world faced a sudden and dramatic debt crisis
of unimaginable scale. However, this time it did not affect only the transition
countries or the Latin American countries. The crisis was now in the "field
of the affluent countries" and threatened to reshape the adopted norms and
regulations in the financial and fiscal sectors on a global scale. With the
onset of the economic and financial crisis of 2007-2009, when government
funds were generously allocated to rescue banks with liquidity problems,
nobody supposed that the "generous donor countries” would very soon turn
from “doctor” into “patients”. The developments in Greece, Italy, Ireland,
Spain and Portugal show that even the healthy Euro-area system can
suffer serious damage if one or more member-states do not comply with
the general rules related to deficit and debt. As a result of the impact of the
crisis, the Euro-area developed new elements in its monetary and fiscal
policies. They are structured as a comprehensive system of institutions,
measures and instruments for financial assistance in the Euro-area.
On the basis of review of a series of decisions of EU institutions and
the establishment of new tools for financial aid under the jurisdiction of the
Treaty on the Functioning of the European Union, as well as the buyout of
government securities from EU member-states facing financial problems,
the European Union established a starting package of EUR 923 billion12.
The initial campaign-based financial aid (with the participation of the IMF)
was institutionalized by directing the main flow of financial aid into the
European Financial Stability Facility (EFSF). A secondary role was
assigned to the European Financial Stabilisation Mechanism (EFSM).
The European Financial Stability Facility (EFSF) is an organization
registered in Luxembourg on 7 June 2010.13 Its main goal is to safeguard
financial stability in Europe by providing financial assistance to euro area
Member States who cannot service their debt. To fulfill its mission, EFSF
issues bonds or other debt instruments on the capital markets14. Thus it
12
HANS-WERNER SINN, Kai Carstensen. Ein Krisenmechanismus fuer die
Eurozone. Ifo-Schnelldienst. Sonderausgabe. 23.November 2010, p. 1.
13
European Financial Stability Facility (EFSF)./www.efsf.europe.eu/
14
The facility was established under the co-ordination and with the support of the
German Debt Management Office.
178 Debt management
can raise more funds that will then be used to provide loans to Euro-area
member states. The issues are collateralized with guarantees provided by
the Ero-area member states, which, according to EU official documents,
amount to EUR 440 bln. The European Financial Stability Facility (EFSF) is
expected to provide quick, effective and substantial financial aid to Euro-
area member states in order to help them achieve a positive and
marketable liquidity restoration.
The next important element in the new organizational structure of
the Eurozone is the European Financial Stabilisation Mechanism
(EFSM) (see Figure 13-2).
Source: http://ec.europa.eu/europe2020/priorities/economic-governance/graph/index_en.htm
Figure 13-2
It was established on May 9, 2010 by a decision of the Ecofin

Council. It includes a package of measures to preserve the financial
stability in Europe, with a total funds of up to half a trillion Euro.15 The
EFSM was established on the grounds of Art. 122 of the Treaty on the
Functioning of the European Union (TFEU) and an agreement of the
Eurozone member states. An important feature of this facility is the
15
The European Stabilization Mechanism, Council Regulation (EU) Nr.
407/2010,11. Mai 2010.
conditionality principle, applicable to all stand-by agreements in the

practice of the IMF. According to Art. 122 of the TFEU „Where a Member
State is in difficulties or is seriously threatened with severe difficulties
caused by natural disasters or exceptional occurrences beyond its control,
the Council, on a proposal from the Commission, may grant, under certain
conditions, Union financial assistance to the Member State concerned.”
The mechanism shall remain in force only as long as the financial stability
is restored. Each financial aid package (from the EFSF, the EFSM and the
IMF) is implies certain strict and unconditional requirements to the national
fiscal policy. Since the EFSF was assigned the best possible credit ratings
“ААА” by the three major credit rating agencies (Fitch, Moody’s and
Standard&Poor’s16), it is entitled to issue bonds in order to raise the
necessary funds.
On 28 November 2010 the European Council agreed on the need to
set up a permanent crisis mechanism to safeguard the financial stability
of the euro area as a whole.17 The new European Stability Mechanism
(ESM) is based on the existing European Financial Stability Facility. Its
ratification and enforcement is a matter of future overall stability of the
European Union as a whole and the euro area in particular. The new
mechanism is also commonly referred to as a Fiscal Pact.
The above review of the European experience in the management
of international debt is a proof that this academic course, which considers
debt mainly in terms of its “cause” – the budget deficit, is very topical.
Regardless of the measures and actions in resolving the debt crisis taken
worldwide and in Europe and without prejudice to the level of
indebtedness, debt management activities will continue to require an
extremely high level of professionalism and organizational skills.
3. Debt management policy objectives

The comprehensive review of the global economy clearly shows
that during the 70s, which were characterised mainly by an overall decline
of the economic activity due to the oil crisis, there is an almost general
trend of markedly grater requirements regarding government loans.
However, in some countries the government debt actually decreased for
several years in a row due to temporary budget surpluses.18 The debt
managers in these countries used these periods to “take a break” and
16
EFSF. Top credit rating for EFSF’s debut debt issuance. www.efsf.europe.eu/
17
EUROPEAN Stability Mechanism. Statement by the Eurogroup. 28.11.2010.
18
For more details see TAYLOR, A. Buying down the debt: policy by stalemate.
CQ Weekly, 16.10.1999, Vol. 57, Issue 40, pp. 2426-2429.
180 Debt management
optimise the structure of government debt. Budget surpluses are used not
only for repayment of outstanding debts, but also for acquisition of more
liquid instruments in order to make the government debt more liquid and
tradable on the global government debt market. Sometimes these efforts
include the issue of new, more liquid bonds to replace the outstanding non-
illiquid debt. In most countries, the volume of government debt fluctuates
around a certain level when there is not a stable trend for budget surplus or
deficiency, i.e. when there is a divergence in government priorities.
In the past, government debt managers were often assigned
various other tasks beside their main task to provide the funds needed by
their governments. Some of these additional tasks were:
 to minimize the size of the loan;
 to improve the maturity portfolio of the outstanding government
debt;
 to contribute to the development of discount markets (or zero-
coupon bond markets) or stock markets in general;
 to manage long-term household savings, etc.
Since the early 80s, however, government debt managers seem to

have focused again on their primary task to not only cope with the
management of current debt and financial problems, but also ensure that
their governments will be able to take loans at reasonable costs. There are
of course countries where government debt managers reconsider the role
of non-marketable debt instruments such as household savings as efficient
ways to provide loans for their governments. A typical feature of this type of
instruments is that they are not traded on the secondary market and their
liquidity is guaranteed by the buy-back option after a certain period.19
Finally, partly under pressure from Parliament and public opinion,
the government debt managers in a growing number of countries already
pay considerable attention to the national debt and its consequences on
social welfare. Some countries have established special government debt
management agencies whose employees are not paid according to the
regulations regarding the remuneration of civil servants. Considering the
experience of Central and Eastern European countries, the decision of the
Hungarian government at the end of the XXth century to "strip" the Hunga-
rian Central Bank from the responsibility to manage the government debt
by creating a fully autonomous Government Debt Management Agency.20
19
For more details see BEREMSKA, G. Nepazarni dalgovi instrumenti
prednaznacheni za dalgovi investitori. Government Debt Management Seminar, Sofia,
Interpred, 19-20 October 1995.
20
CHANGES in Hungarian foreign debt management. Central European. January
1999 , Vol. 8, pp.33-4.
Governments are forced to develop a more commercial approach to

the management of government debt and to strengthen the role of market
principles in this area in several ways. For example, in the U.S. the system
for determining the primary dealers serves the Central bank (Fed) and the
Treasury while the Federal Reserve Bank regulates the activity of all
primary dealers by defining the selection criteria and means of
communication with them.21
The fact is that today most of the countries which sell their
government securities through tenders prefer the multiple-price auction
technique. In this context it is worth noting that auction techniques are used
by countries which have to resolve a temporary or a more permanent
liquidity crisis and are trying to reduce or restructure their government
debts. In such cases, the multiple-price auction (in which investors making
competitive bids specify the rate or yield they are willing to receive for the
use of their funds and the successful competitive bidders pay the price
equivalent to the rate or yield they bid) is considered by default a more
preferable to the price-based auction (where investors making competitive
bids specify the price they are willing to pay for the security and the
successful competitive bidders are awarded securities at the price they
each bid at the auction or a weighted average price of all bids.)
There are two key factors that contribute to the significant increase
of the volume of government securities and treasury bonds of various
countries traded internationally. The first one is the establishment of
markets for futures and options with an interest rate based on government
debt instruments. The second factor are the active portfolio management
strategies22 used by the international institutional investors, including
syndicated investment institutions.
Government debt managers who strive to make their government
securities more attractive for the foreign investors as well as to make them
more competitive on their domestic markets most often apply a four-
aspect strategy to establish efficient markets for these instruments:23
 organizing the range of government debt instruments offered to
foreign investors;
 increasing the volume of government bond issues demanded by
foreign investors;
21
MICHEVA N. Sazdavane na sistema na parvichni dilari - element na
koordinatsiyata mezhdu parichnata politika i politikata na upravlenie na darzhavniya dalg.
Government Debt Management Seminar, Sofia, Interpred, 19-20 October 1995.
22
For more details see ADAMOV, V., Patev, P., Simeonov, S., Zahariev, A.
Investitsii. V. Tarnovo. ABAGAR, 1999, pp. 427-231.
23
Source: OECD.
182 Debt management
 creating conditions for constant trade (at least within the business
hours of the domestic financial mediators);
 increasing the international awareness of the domestic markets for
government securities through agreements for announcement of
stock market indices and common terms of trade.
We should note that despite some differences in national regulatory

frameworks, the government securities specialists in virtually all countries
have more or less similar functions, namely:24
 to participate actively in the marketing of new issues of
government securities at auctions or otherwise while maintaining
reasonable market relations in carrying out operations with the CB;
 to maintain long-term markets for all government securities they
manage, including in unfavorable market conditions;
 to provide up-to-date market information to the government debt
managers or the central bank acting on their behalf.
At the offset of the global government debt crisis there was a trend
for diversification of the government debt instruments. At that time,
government debt managers faced the problem of covering large or rapidly
increasing needs of their governments for new loans. They had to attract
new categories of investors whose investment preferences required new
types of debt instruments. Thus a significant number of new types of debt
instruments was created - variable interest rate and incremental interest
rate bonds, low-coupon or zero-coupon bonds, indexed bonds, market and
non-market bonds (with extendable maturity period), convertible bonds (i.e.
bonds convertible into other types of bonds under certain the conditions)
and a significant number of small non-marketable savings instruments.25
To summarize the review of the historical development of
competences in the field of debt management, we should point out that the
evolution of financial markets and instruments requires adequate reaction
from the traditional investment instruments – the bonds and the treasury
bills. For this purpose, debt managers should be able to assess not only
their own position as procurers of public funds, but also the opinions of the
individual as well as the institutional investors.
Government debt and securities market policies should provide the
government debt managers with a comprehensive description of their
24
MICHEVA, N. Op. cit.
25
These new and essentially hybrid techniques to attract investors to government
debt instruments is discussed at length in specialized literature – e.g. see HETZEL, R.
Indexed bonds as an instrument to monetary policy. // Economic Review Jan/Feb 1992, Vol.
78, pp. 13-22; ADAMOV, V. Op. cit., pp. 627-641.
objectives and priorities. These objectives are crucial in determining how

they should use the available debt instruments and which techniques to
apply for selling them. This is why the objectives of the government debt
management policy should be reviewed and clarified. The achievement of
the objectives is a challenge for all agents involved in the process of
issuing and subsequent management of debt because they have to cope
with the following three main groups of problems: legal, technical and
financial.26 However, it seems neither possible nor desirable to look for
universal solutions in this field because each economy is unique in itself.
However difficult it may seem to arrive at a detailed classification of
the objectives of government debt management policy, they may be
grouped into the following broad categories:
First. The main objective of a debt manager is to ensure the
loans needed by the government.
Second. Secondary objectives directly related to securing the
loans for the government or managing the government debts: provision of
long-term access of the government to stock markets; minimizing loan-
related costs; efficient and effective management of liabilities in terms of
expenditure and risks; maintaining the assets-liabilities ratio;27 minimizing
market effects on government debt operations; expanding the scope and
the area of distribution of government debt instruments; efficient
management of operations related to new issues; ensuring the proper
operation of the secondary markets for government securities; provision of
balanced maturity structure; provision of a hedged multi-currency debt
structure.
Third. Additional objectives that may have to be considered by
the government debt managers in order to support the implementation of
other policies: assistance in improving the functioning of financial markets;
contributing to the development of the government securities market as a
whole; provision of long-term investment savings options to households;
improving the redistribution of incomes and wealth.
There is also a special objective regarding the interaction between
the government debt management policy and the monetary policy. The
term “loans needed by the government” may be interpreted in two aspects
in terms of the payments due to the outstanding debt. Gross loans include
all new issues of securities while the net loans include only the issues that
actually increase the overall indebtedness of the government. Thus, if they
are not otherwise specified, the “loans needed by the government” shall
mean gross loans. Although the goal to cover the needs of the government
26
ADAMOV, V. Op. cit., pp. 610-611.
27
RADKOV, R., Adamov, V., Zahariev, A. Valuti i valutni sistemi. V. Tarnovo,
ABAGAR, 2000, p. 117.
184 Debt management
for loans seems quite obvious, its importance may have to be highlighted
by the ways in which government debt managers specify it. The loan need
not necessarily be equal to the government budget deficit plus repayments
– the following paragraphs describe some other factors may also be
important in determining its size. These factors determine the types of debt
instruments as well.
Government debt may be a means to reduce the excessive liquidity
of the economy or to dampen an unwanted monetary expansion.28 This
may be achieved through the sale of medium and long-term аdebt
instruments to the non-banking sector.
Government debt managers must have efficient analytical tools to
assess investors’ capacity to provide the loans needed by the government
through the financial market. In the long run the main objective of
government debt management policy is to provide the government with a
long-term access to the financial markets. In order to achieve this objective,
the government (as a borrower) may have to acquire and maintain a first-
class credit rating (see Table 13-1).
Table 13-1
Sovereign credit ratings
Rating
Grade Standard&Poor’s Moody’s
High grade AAA Aaa
(government) АА Аа
А А
Medium grade ВВВ Ваа
ВВ Ва
В В
Speculative ССС Саа
СС Са
С С
Bonds in arrears DDD, ----
DD, D
Bonds in default Е ----
Investor confidence in transition economies or in economies that

have defaulted can be difficult to win and/or restore. This is why
government debt managers should pay particular attention to the means
and methods for establishing such confidence. Reduction of loan-
28
CONGDON, T. The Link between Budget Deficits and Inflation: Some Contrast
between Developed and Developing Countries. Boston, 1990, p. 77.
related costs has been another important aspect of government debt

management in many countries and for a long time. However, borrower’s
expenses often are investor’s incomes. Modern capital markets were
established by:29
 specialized financial institutions (banks) and brokers who “make”
the market and provide financial services;
 investment institutions, private investors and companies which use
the market to buy financial services.
Government debt managers should be familiar with the specific

characteristics and activities of the four main types of investment
institutions:30
 Pension funds. Generally, the social funds in each country account
for a large part of the available investment resources and are
usually managed by the best and most qualified investment
managers and consultants.
 Insurance companies. They accumulate huge volumes of
insurance premiums and invest them on the stock markets.
 Investment trusts. These are specialized companies which invest
in stocks issued by other companies. These trusts may have limited
capital resources, so that the fixed number of shares traded
suggests a potential for quick market capitalization when the
investment is successful.31
 Mutual funds. These are collective investment funds that purchase
stock portfolios to reduce risk. Unlike the investment trusts, the
mutual funds may invest in an unlimited number of different stocks.
Individual investment institutions, despite their specific features, aim

to manage investments most efficiently. Investment theory provides for an
investment decision-making procedure of five consecutive stages. These
stages are the core of investment management and should be performed
for each investor whose money has been managed. The five stages of
investment management process are:32
 Establishing Investment Policy refers to defining the capitals to
be allocated in the capital market as well as the individual
(investor’s) investment objectives.
29
AMLOT, R. Guide to world markets. Boxtree limited - UK. London, 1992, p. 73.
30
AMLOT, R. Op.cit., p. 78.
31
HAUGEN, R. Modern investment theory. Prentice Hall international edition. New
Jersey., 1993, p. 23.
32
SHARPE, W., and Al. Cordon, Investment. New Jersey, 1990, p. 713.
186 Debt management
 Stock analysis which includes identification of the various types

and categories of assets. This stage aims to identify misevaluated
assets.
 Portfolio creation which refers to identification of which assets to
invest in as well as the proportion of funds to be invested in each
type of these assets.
 Portfolio revision which includes identification of portfolio assets
that have to be sold and the assets to replace them with.
 Evaluation of portfolio performance – at this stage the
performance of the portfolio (in terms of risk and return) will be
measured in comparison to a realistic benchmark portfolio.
Each government debt manager can hardly avoid being interested

in the organization of institutional channels and methods by which he or
she intends to sell government debt instruments as well as the organization
and principles of operation of the secondary markets on which the liquid
government debt instruments will be traded. This is because the trade of
the issued securities on the secondary market is as important as its initial
placement. We may claim that the market mechanism requires continuous
evaluation and reassessment of the already issued securities. Indeed, both
the secondary market and the primary market constitute a complete system
for trade in government securities with its main participants: issuers,
intermediaries (primary dealers) and investors (see Figure 13-3).
The return of “floating rate” (variable rate) bonds is expressed by
their price index (factor). This feature can increase the attractiveness of
government bonds when the interest rates are rising or in times of
uncertainty - it allows the investors to benefit from the rising interest rates
and at the same time to reduce the probability of reporting losses of capital
which would otherwise result from the decline in the prices of bonds.
However, whether and to what extent the “variable rate” bonds will be able
to hedge the anticipated risk depends on their relation to the short-term
interest rate.
Zero-coupon bonds are discount-based securities such as the US
Treasury Bills. Their interest rate is capitalized and is paid with the principal
at maturity. The secondary market profitability of these bonds is calculated
likewise, i.e. as the difference between their purchase value and their
return at maturity. The “Lottery” (also “premium”) bonds are the opposite of
the "zero-coupon" bonds with regard to security of the individual investors
to the profit they will receive. The lottery principle may be applied to the
maturity or the profitability of the bonds within certain limits. The most
common form of this type of repayment of debt (government and/or
municipal) in Bulgaria is the lottery-based repayment of principal at nominal
value. For the first time such securities were issued in 1999 – these were
7-year municipal bonds (see Figure 13-4) with a markedly different scheme
of principal repayment (a two-year grace period and annual repayments of
one fifth of the principal for the remaining five years based on a lottery
principle).
Structure and functions of

government securities markets
primary market secondary market

Ministry of Finance
Primary
Secondary
investors
Treasury
TBs Bond TBs
dealers
Subscription
Purchase
Issue
Sale
Figure 13-3
Principal repayment scheme of municipal bonds

issued by the municipality of Svishtov
100%
80%
60%
40%
20%
0,5 1 1,5 2 2,5 3 3,5 4 4,5 5 5,5 6 6,5 7
Figure 13-4
188 Debt management
Thus the issuers are able to plan their outgoing cash flows relatively
evenly over time.
Exhibits
13а-1. Resolution for taking a municipal loan
with an issue of municipal bonds
On the grounds of to Art. 21, Para. 1, Subpara. 10 and Art. 52, Para. 4 of
the Local Self-Government and Local Administration Act and pursuant to
Art. 3, Para. 1, Art. 4, Para. 1 and Art. 17 of the Municipal Debt Act /MDA/,
with regard of the implementation of “Social and Infrastructure Investments
in the Municipality of …” project and following a public opinion poll
thereabout, with Resolution No. … the Municipal Council of … decided:
To issue municipal bonds to the maximum amount pursuant to
Art. 17, Para. 1, Subpara. 1 of MDA of EUR 12 780 000. The minimum
amount of the loan shall be EUR 8 000 000.
1. The funds will be used for the implementation of “Social and
Infrastructure Investments in the Municipality of …” project according to
Annex No.2.
2. Pursuant to Art. 17, Para. 1, Subpara. 2 of MDA – loan currency –
EURO;
3. Pursuant to Art. 17, Para. 1, Subpara. 3 of MDA – type of debt –
municipal debt pursuant to Art. 3, Para. 1 of MDA – issue of municipal
securities – bonds;
4. Pursuant to Art. 17, Para. 1, Subpara. 4 of MDA – manner of
collateralizing – the bonds shall be secured with collateralized
municipal receivables, future revenues of the Municipality of ... pursuant
to Art. 6, Para. 1, Subpara. 1 of the Municipal Budgets Act, Art. 6, Para.
1 of the Local Taxes and Fees Act, and the block equalization grant for
local activities pursuant to Art. 34, Para. 1, Subpara. 3 of the Municipal
Budgets Act;
5. Pursuant to Art. 17, Para. 1, Subpara. 5 of MDA – terms of redemption:
6. The term of maturity of the issue shall be 11 years as of the date of the
issue. The date of issue shall be the date on which the issued bonds
are registered with the Central Depository AD /CDAD/ and all terms of
the bond loan shall commence as of this date.
7. The term for principal repayment shall be 11 years with 1 year grace
period.
8. The principal shall be repaid with 20 semiannual annuity payments.
9. All payments shall be made at the end of each six calendar months
after the grace period of the issue.
10. All interest and principal payments shall be made by the Central
Depository AD.
11. Pursuant to Art. 17, Para. 1, Subpara. 6 of MDA – floating interest rate
– 6-month EURIBOR plus up to 7% as of the date of issue. Interest and
principal shall be repaid semiannually and during the grace period only
interests shall be paid.
12. Pursuant to Art. 17, Para. 1, Subpara. 6 of MDA – commission fees:
 Investment mediator fee – up to 1.00% of the volume of subscribed
bonds, covering all investment mediation service fees;
 Fees for registration and procession of the issue by the Central
Depository – according to company’s Tariff;
 Fund-raising account fees – according to the tariff of the
corresponding commercial bank;
 Fiduciary services fees – up to 1.00 % of the volume of subscribed
bonds.
14. Pursuant to Art. 17, Para. 1, Subpara. 6 of MDA – other:
 Maximum number of bonds – 12780. The nominal issue value of
each bond shall be equivalent to EUR 1000.
 Type of bonds – all bonds in this issue are registered,
dematerialized, interest-bearing, issued through an initial private
placement and will be registered with the Central Depository AD
(CDAD). All bonds from this issue shall represent equal rights of
claim against the Municipality.
 Bondholder rights – The holders of bonds from this issue shall have
equal rights in terms of claims on a principal equal to the face value
of the bonds (depreciation payments) and on interest (coupon
payment). Bondholders shall not be granted rights of claim against
other creditors of the Municipality.
 Bond subscription - The bonds are offered for subscription to
institutional investors only and paid only in cash. The number of
bonds subscribed by a single investor is not limited. Subscription
shall be considered successfully completed and the loan taken if at
the end of the subscription period the value of subscribed bonds is
at least € 8 million paid in full. Subscription shall also be considered
successfully completed even before the end of the subscription
period if all bonds have been subscribed and paid in full.
 The initial date of the subscription period shall be specified following
the adoption of this resolution and negotiations with potential
institutional investors, but not later than 01 Jan. 2011.
 Subscription deadline shall be 30 days from the initial date. Should
the subscription period expire on a holiday, then the date of expiry
of the subscription period shall be considered the next business
day. In the event that the full volume of the issue has not been
190 Debt management
subscribed within the subscription period, the Municipal Council

shall authorize the Mayor to extend the period with additional 20
days.
 The loan shall be consider taken as of the date of registration of the
issue with the CDAD. The issue shall be registered within two
working days after the date of expiry of the subscription period.
 Bondholders – Initial offering pursuant to Art. 50, Para. 1 of MDA
will be made only to institutional investors pursuant to § 1, Para. 1,
Subpara. “c” of the Additional Provisions of the Law on Public
Offering of Securities, i.e. banks that do not operate as investment
intermediaries, investment companies, contractual funds, insurance
companies, pension funds or any other company the objects of
which require that securities be acquired, held and transferred.
 Investment mediator – The bonds shall be subscribed and paid for
through an investment mediator – a dealer at the Bulgarian Stock
Exchange – Sofia AD (BSE), performing transactions on a
regulated stock market on its own behalf or on behalf of his
customers.
 Fund-raising account – The amounts equivalent to the face value of
the issued bonds shall be transferred to a special fund-raising
account. Partial payment of bond face value is not allowed.
 Bondholders shall be able to prove that they have paid for the
subscribed bonds with payment documents issued for such
transfers to the accounts of their investment mediators.
 Terms of declaring unsuccessful subscription – the subscription
shall be considered unsuccessful if, until the expiration of the
deadline and the extended subscription period, less than 8000
bonds have been subscribed for. Should the subscription be
declared unsuccessful, all principal amounts plus the accrued
interest shall be returned to the persons who have subscribed
bonds within one month of the subscription expiration date.
 Buy-back of bonds – bonds may be bought back by their issuer
after one year from the date of issue, on the date of each coupon
payment, with a notification sent at least 30 day in advance and to
the minimum amount of EUR 100 000 and at additionally agreed
upon buy-back price of up to the total amount of EUR 6 000 000.
 The Municipality will be represented by its Mayor before
bondholders.
 The Municipality authorizes the Mayor to select and conclude a
contract with an investment mediator to draft a proposal for private
offering of bonds from this issue, to organize the placement thereof
and make all other necessary legal and factual actions to implement
this resolution.
 The Municipality authorizes the Mayor to negotiate and conclude a
contract with a fiduciary bank for the purposes of the bond issue.
 The Municipality authorizes the Mayor to negotiate and conclude
the most favorable deposit account contracts with commercial
banks to deposit the generated funds until the implementation of the
relevant activities within the “Social and Infrastructure Investments
in the Municipality of …” project.
 The Municipality authorizes the Mayor to set up a collateral for
future bondholder payments.
 Information required by investors to accurately assess the
economic and financial situation of the municipality and the rights
associated with the issued securities shall be disclosed in the
following order: on the Internet site of the municipality and the
selected investment mediators.
13а-2. Draft Resolution for taking a municipal loan financed by

the Fund for Local Authorities and Governments (FLAG) EAD
…
The Municipality of ... is implementing the “Complex Technical Aid
for Partial Construction of Sewerage with WWTP and Rehabilitation of the
Existing Water Supply Mains in the Town of....” within Priority Axis 1 of the
“Environment” Operational Programme. The funds used to finance project
activities shall be reimbursed upon the approval of eligible costs.
The Fund for Local Authorities and Governments (FLAG) was
established to support municipalities by providing credits at special
preferential terms. For the purposes of implementation of the above
environmental project I herewith propose that the municipality should take
advantage of the Fund and on the grounds of Art. 21 Para.1, Subpara.10 of
the Local Self-Government and Local Administration Act and Art.17 of the
Municipal Debt Act adopt the following RESOLUTION:
1. The Municipality of ... shall sign a credit contract with the Fund
for Local Authorities and Governments - FLAG EAD and take a short-term
credit for the implementation of the “Complex Technical Aid for Partial
Construction of Sewerage with WWTP and Rehabilitation of the Existing
Water Supply Mains in the Town of....” project financed within Priority Axis
1 of the “Environment” Operational Programme with the following contract
terms:
 Maximum amount of the loan – BGN 321 500 (three hundred and
twenty-one thousand and five hundred lev);
 Loan currency denomination – Bulgarian Lev
192 Debt management
 Type of debt – incurred through a municipal loan contract;

 Repayment terms:
- Repayment deadline – up to 12 months from the date of the credit
contract with an option for ahead-of-term repayment in full or
partially without an ahead-of-term repayment fee.
- Sources for repayment of principal – the transfers from the
Managing Authority pursuant to Grant Contract No. XX-YYY-СО74;
 Maximum interest rate, fees, commissions, etc – up to 8,205%
 Loan collateral:
- Collateralizing the receivables of the Municipality of ... pursuant to
Grant Contract No. XX-YYY-СО74, concluded with the Managing
Authority of the Operational Programme, and
- Collateralizing the receivables of the Municipality pursuant to Art. 6,
Para.1 of MDA and the block equalization grant for local activities
pursuant to Art.34, Para.1, Subpara.3 of the Municipal Budgets Act;
2. The Municipal Council authorizes the Mayor to submit a claim to
the Ministry of Regional Development and Public Works for reimbursement
of part of the expenses related to the loan extended by FLAG EAD on the
grounds of Decree of the CM No. 189 of 24 July 2009.
3. The Municipal Council authorizes the Mayor of ... prepare and
submit a credit request to a branch of the Managing Bank – Unicredit
Bulbank AD, to sign the credit contract and the collateral credits as well as
to perform all other necessary legal and factual actions for implementation
of the resolution described in Art. 1 above.
13а-3. Resolution for incurring a municipal debt

through bank loan financing33
R E S O L U T I O N
No. 624
of Municipal Council Meeting

held on 20 Feb. 2006, Minutes No. 54
Regarding: Incurring a long-term municipal debt for implementation

of “Management of Public Technical Infrastructure in
the town of Svishtov” project
33
http://www.svishtov.bg/images/decisions/1158.html
Pursuant to Art. 21, Para. 1, Subpara. 8 and Para. 10 of the Local

Self-Government and Local Administration Act (LSGLAA) and pursuant to
Art. 13 and Art. 17 of the Municipal Debt Act (MDA), Section VІІІ “Municipal
Debt” of the Ordinance on the conditions and procedures from preparation,
implementation and accounting of municipal budgets, Proposal Reg. No.
1331/13.02.2006 and Proposal Reg. No. 1334/15.02.2006 submitted by Mr.
Stanislav Blagov – Mayer of the town of Svishtov, the Municipal Council of
the town of Svishtov DECIDED:
1. The Council accepts the “Management of Public Technical
Infrastructure in the town of Svishtov” project according to Annex 1.
2. The Council authorizes the Mayor of the Municipality of Svishtov
to execute a procedure pursuant to the Municipal Debt Act (MDA) for
incurring a long-term by the Municipality of Svishtov to finance the
implementation of the “Management of Public Technical Infrastructure in
the town of Svishtov” project under the following terms:
2.1. Maximum amount of the debt in terms of nominal value: BGN 2
000 000 лева;
2.2. Debt currency denomination – Bulgarian Levа (BGN);
2.3. Type of debt – long-term bank loan for investment purposes;
2.4. Debt collateralization – receivables of the Municipality of
Svishtov for the period 2006-2013 in compliance with the provisions of Art.
6 of the Municipal Debt Act (MDA) – receivables pursuant to Art. 6, Para. 1,
Subpara. 1 of the Municipal Budgets Act and the block equalization grant
for local activities pursuant to Art.34, Para.1, Subpara.3 of the Municipal
Budgets Act. The Council allows the utilization of collaterals provided by
other institutions provided that they are accepted by the creditor bank in
terms of its contractual obligations and that such collaterals shall not be
considered binding for the Municipality of Svishtov;
2.5. Principal repayment terms – ten equal semiannual payments of
BGN 200 thousand. The first payment shall be made 30 months after the
date of receipt of the first amount of the loan and the last payment shall be
made 84 months after the date of receipt of the first amount of the loan.
The first 24 months after the date of receipt of the first amount of the loan
shall be considered a grace period for principal repayment;
2.6. Maximum interest rate – a fixed annual interest rate for the
whole term of the loan, which shall not exceed 9%;
2.7. Interest accrual and payment – a total of 14 interest payments
at each 6 months from the date of receipt of the first amount of the loan on
the weighted average of the amount of loan utilized during the preceding 6
months, up to 50% of the agreed fixed annual interest rate;
2.8. Loan approval and management fees – a total of up to 1,25%
of the loan paid as a lump sum one month after the contract date according
194 Debt management
to Art. 31, Para. 2, Subpara. 2 of the Municipal Debt Act, exclusive of all
other fees and commissions;
2.9. Terms of utilization – in 2006 and 2007, in parts corresponding
to the payments made to project contractors;
2.10. Engagement fee – up to 0,5% annually on the remaining part
of the loan, payable as a lump sum on the date of the complete utilization
of the loan;
2.11. Default penalty surcharge – up to 5% annually on the default
and for the time of default, without capitalization of the default interest;
2.12. An option for ahead-of-term repayment in full or partially
without an ahead-of-term repayment fee, at a three-month prior notice from
the borrower.
to conduct a procedure for selection of a financial institution to finance the
project.
to appoint a Committee pursuant to Art. 3 above and in compliance with the
requirements of Art. 57 of the Ordinance on the conditions and procedures
from preparation, implementation and accounting of municipal budgets,
which shall comprise … members of the Svishtov Municipal Council and …
members of the Municipal Administration.
5. The Council assigns the Mayor of the Municipality of Svishtov the
task to inform the Minister of Finance within 10 days from the date of
approval of this Resolution about the contents of Art. 1, 2 and 3 thereof.
6. Proposal Reg. No. 1331/13.02.2006 submitted by Mr. Stanislav
Blagov – Mayer of the town of Svishtov regarding the incurring of municipal
debt by the Municipality of Svishtov shall be considered an integral part of
this Resolution.
7. The Council assigns the Mayor of the Municipality of Svishtov the
task to report to the Municipal Council the results of the procedure for
selection of financial institution and the draft contract.
The meeting was attended by 26 members of the Municipal Council.

Votes: “For” – 17, “Against” – 2, “Abstained” – 7.
CHAIRMAN of the MC: …/signature/ …

/Assoc. Prof. А. Zahariev, PhD/
True with the original: ……………….…………

/L. Mironova/
ANNEX1
Description of Project “Management of Public Technical
Infrastructure in the Town of Svishtov” to be funded with a
municipal loan:
…
The investment project includes the following activities:
 Rehabilitation of road pavements along Aleko Konstantinov str.
from the Veleshana sq. to Tsar Osvoboditel str.
 Rehabilitation of road pavements along Avksentii Veleshki str. from
the Veleshana sq. to the Kaloyan sq.
 Rehabilitation of road pavements along Ilarion Makariopolski str.
from the Kaloyan sq. to Otets Paisii str.
 Rehabilitation of road pavements along Tsar Osvoboditel str. from
the Aleko sq. to Elenka I Kiril Avramovi str.
 Rehabilitation of road pavements along Treti Mart str. from Nove
str. to Studentska str.
 Completion of the rehabilitation works initiate in 2005 on the
Svoboda sq.
The proposed repairs and renovations aim to implement in 2006

most of the activities included in an extremely important and relatively
large-scale project for the overall rehabilitation and re-pavement of the
three main traffic arteries in Svishtov – the main street and the two parallel
bypass routes via the Municipal Hospital and via the railway station and the
port.
The project implementation includes the following activities -
patching of damaged and deformed sections of pavement, repair of low-
bearing capacity areas, filling cracks, making connecting bitumen spill,
overlaying restoration of streets with poor drainage, laying of new surface
layer of asphalt, removal and installation of curbs, repairs to pavements,
incl. replacement of sidewalk tiles, lifting stormwater shafts and manholes
in areas with level changes, leveling and completing the reconstruction of
the "Svoboda" square.
In areas where water-supply mains is critically worn, the “ViK”
municipal company will replace the pipes parallel to the project works. The
type of repairs shall be consistent with the express condition to maintain as
much as possible the existing grade levels and take into account the
commercial and residential properties along these streets. Quantity and
types of work shall be determined by expert evaluation, particularly for
areas covered by the project.
Apart from the reconstruction works on the Svoboda square, the
total length of the streets to be rehabilitated is 3 700 m., and the total
196 Debt management
rehabilitation area is 29 162 m2. The enclosed technical drawings and bills
of quantities describe in detail the works covered by the project.
The total cost of the project is BGN 1 647 thousand including VAT,
of which BGN 1 200 thousand will be provided from the bank loan
proposed herewith and BGN 447 thousand will be provided by the
Municipality of Svishtov. The project is an integral part of the investment
programme of the Municipality of Svishtov for 2006, which is estimated to
exceed BGN 3 mln. All project works shall be completed by the end of
2006.
The main benefits for the Municipality of Svishtov and its citizens,
which motivated the local administration to submit this draft resolution for
incurring of municipal debt for investment purposes, are:
 The project implementation will solve some very pressing problems
- the overall rehabilitation and re-pavement of the three main streets
in Svishtov will normalize the traffic and improve traffic conditions.
 The proposed terms of the long-term investment bank loan may be
considered favorable for the Municipality. All interest and other
costs related to servicing the debt will be compensated in full and
most probably even over-compensated by the expected rise of
petroleum products and road-construction works in the years after
2006.
 The overall rehabilitation and re-pavement of the busiest streets in
town will reduce significantly the costs of maintenance of these
streets in the coming years.
 The effect and cost efficiency of the simultaneous replacement of
worn-out plumbing and the general repair of these streets are
significant.
 The traffic will become safer and more convenient for both the
pedestrians and the vehicles.
 The image of Svishtov will be improved and the town will become
more attractive for tourism and business.
13а-3. Decision of the 41st National Assembly of the Republic of

Bulgaria for participation in the Treaty on Stability, Coordination and
Governance in the Economic and Monetary Union34
27 Jan. 2012
DECISION
for participation of the Republic of Bulgaria in the Treaty on Stability,
Coordination and Governance in the Economic and Monetary Union35
The National Assembly,

– having considered the commitments of the Republic of Bulgaria pursuant
to Art. 5 of the Act concerning the conditions of accession of the Republic
of Bulgaria and Romania and the adjustments to the Treaties on which the
European Union is founded;
– having considered the Treaty on the Functioning of the European Union
and the need to strengthen cooperation between Member States in areas
of common interest;
– welcoming the willingness of the negotiating countries to improve the
conditions for economic growth within the European Union;
– supporting the introduction of strict fiscal rules in Member States’ national
legislation systems through binding rules of a permanent nature that would
guarantee the validity of the fiscal rules over the entire national budget
process;
– having acknowledged that the Treaty on Stability, Coordination and
Governance in the Economic and Monetary Union supports the principles
adopted by the Republic of Bulgaria for maintaining of strict budget
discipline and macro-financial stability;
– supporting the concept that enhanced cooperation on economic and
fiscal policy should not jeopardize the effective functioning of the internal
market of the European Union;
– taking into consideration the position that the Treaty on Stability,
Coordination and Governance in the Economic and Monetary Union will be
applied and interpreted by the Member States in accordance with the
Treaties of the European Union, in particular Art. 4, paragraph 3 of the
Treaty on European Union and the European Union law;
– taking into account the possibility for States with currencies other than
the Euro to apply in part until their accession to the Euro Area and the
abrogation of the derogation under Art. 139, Paragraph 1 of the Treaty on
34
The actual contract is accessible at: http://www.european-council.europa.eu/
media/582311/05-tesm2.en12.pdf
35
http://www.parliament.bg/bg/desision/ID/13834
198 Debt management
the Functioning of the European Union, the rules on budgetary discipline

and economic coordination;
– supporting the objective of the provisions of the Treaty on Stability,
Coordination and Governance in the Economic and Monetary Union to be
included as soon as possible to the Treaties of the European Union,
and pursuant to Art. 86, Para. 1 of the Constitution of the Republic

of Bulgaria and Art. 3 of Decision No. 964 of the Council of Ministers of 30
Dec. 2011
DECIDED:
1. Consents to the participation of Bulgaria in the negotiations of

negotiating a draft Treaty on the Functioning of the European
Union.
2. Supports the ratification by the Republic of Bulgaria of the Treaty
on Stability, Coordination and Governance in the Economic and
Monetary Union under the following conditions:
2.1. The Republic of Bulgaria shall enforce the provisions of
Section III of the Treaty following a ratification from the
National Assembly;
2.2. Provided that Bulgaria's participation in the treaty
should not lead to financial obligations or commitments for
harmonization of the Bulgarian tax policy with the other
contracting parties;
2.3. The Republic of Bulgaria shall enforce the Treaty in its
entirety when this country joins the Eurozone and after
abrogation of the derogation under Article 5 of the Act
concerning the conditions of accession of the Republic of
Bulgaria and Romania and the adjustments to the Treaties
on which the European Union is founded.
This Decision was adopted by the 41st National Assembly on 27

January 2012 and sealed with the official seal of the National Assembly.
Chair of the National Assembly: Tsetska Tsacheva

1. ADAMOV, V. Teoriya na finansite (Darzhavni finansi). V.
2. PRODANOV, St., Zahariev, A., Kuznetsov, Yu., Tsanov, Em.,

Ganchev, Al., Lichev. Al. Modelirane dalgoviya kapatsitet na
obshtinite v usloviyata na fiskalna detsentralizatsiya. // Almanah
nauchni izsledvaniya, vol. 11, 2010, pp. 144-199.
3. PATEV, P. Upravlenie na portfeyla. V. Tarnovo, ABAGAR, 1996.
4. RADKOV, R., Adamov, V., Zahariev, A. Valuti i valutni sistemi. V.
5. SIMEONOV, S. Optsiite (pazari, kontrakti, otsenyavane,
strategii). V. Tarnovo, ABAGAR, 1999.
6. STIGLITZ, J. Economics of the Public Sector. (Bulg. transl. ed.)
Stopanstvo, Sofia, 1996.
7. STRATEGIYA za upravlenie na darzhavniya dalg 2003-2005,
MF.
MF.
MF.
10.ROSE, P. The Financial System in the Economy. New York,
1986.
11.http://www.european-council.europa.eu/media/582311/05-
tesm2.en12.pdf
Keywords
1. Debt crisis
2. Default-related losses
3. Strategies for resolving debt crises
4. London Club
5. Paris Club
6. Baker Plan
7. Paul Krugman’s concept
8. Brady Plan
9. European Financial Stability Facility (EFSF).
10. European Financial Stabilisation Mechanism (EFSM).
11. European Stability Mechanism (ESM).
12. Strategy for development of efficient debt instrument markets
13. Functions of government securities specialists
14. Main objective of government debt managers
15. Multiple-price auction
16. Loans needed by the government
17. Additional objectives of government debt managers
200 Debt management
18. Credit rating

19. Institutional investors
20. Primary Treasury bonds market
21. Secondary Treasury bonds market
22. Floating interest rate bonds
23. Zero-coupon bonds
24. Lottery bonds

1. Provide the broad definition of debt management.
2. What is the main objective of debt management?
3. What are the specific differences between the separate groups of
additional debt management objectives?
4. What are the advantages of the Brady Plan compared to the Baker
Plan?
5. Under what circumstances the floating-rate bonds are preferred by the
investors?
6. Can zero-coupon bonds be traded on the secondary market? If yes,
what are the interests and expectations of sellers and buyers in a
secondary=market deal with zero-coupon bonds?
7. Under what circumstances the zero-coupon bonds are preferred by the
investors?
8. One-year, floating-rate bonds for EUR 200 mln. are offered at an
auction for treasury bills. The primary dealers submitted competitive
bids exceeding the volume of the offered bills as follows: EUR 50 mln.
at 2.5% annual interest rate; EUR 110 mln. at 2.7% annual interest
rate; EUR 30 mln. at 1.8% annual interest rate; EUR 45 mln. at 2%
annual interest rate and EUR 65 mln. at 3% annual interest rate.
Determine the average annual return of the auction observing the
requirement for consecutive acceptance of the most beneficial bids.
9. One-year, floating-rate bonds for EUR 100 mln. are offered at an
at 2.2% annual interest rate; EUR 30 mln. at 2.4% annual interest rate;
EUR 10 mln. at 1.9% annual interest rate; EUR 20 mln. at 1.6% annual
interest rate and EUR 10 mln. at 1.5% annual interest rate. Determine
the average annual return of the auction observing the requirement for
consecutive acceptance of the most beneficial bids.
10. One-year, zero-coupon bonds for EUR 100 mln. are offered at an
at 2.2% discount; EUR 30 mln. at 2.4% discount; EUR 10 mln. at 1.9%
discount; EUR 20 mln. at 1.6% discount and EUR 10 mln. at 1.5%
discount. Determine the average annual return of the auction observing
the requirement for consecutive acceptance of the most beneficial bids.
11. One-year, zero-coupon bonds for EUR 200 mln. are offered at an
at 2.5% discount; EUR 20 mln. at 2.7% discount; EUR 30 mln. at 1.8%
discount; EUR 70 mln. at 2% discount and EUR 65 mln. at 3%
discount. Determine the average annual return of the auction observing
the requirement for consecutive acceptance of the most beneficial bids.
202 Debt management
Chapter summary
The main objective of government debt managers is to take the
loans needed by the government. This applies to all government debt
managers, regardless of the conditions in their country. Moreover, the
mandate of a government debt manager may include other goals they may
have or be willing to pursue or take into account in the course of their work.
A debt crisis is a situation in which debtors are unable to service the
interest and/or the principal on their debts within the agreed terms and thus
threaten the financial "health" of their creditors. If their inability to pay is
long-standing, it is generally regarded as insolvency. If it is caused by
temporary shortages of cash then it is defined as a liquidity problem. The
financial institutions which provide credits on the global debt market have
established the so-called London Club and Paris Club.
A declared insolvency has three major implications: the country
cannot take new loans; the trade with the country is restricted; the assets of
the defaulting country abroad may be seized. Debt crises are usually
resolved using three principal strategies: restructuring and conversion of
external debts; economic reforms in the debtor countries; cancellation of
certain amounts of debt. The Baker Plan and the Brady Plan offer some
original solutions for overcoming the debt crisis and improving the solvency
of the indebted countries. The Treaty on the Functioning of the European
Union enabled the establishment of the following mechanism to counteract
the government debt crisis in the Eurozone – the European Financial
Stability Facility (EFSF), the European Financial Stabilisation Mechanism
(EFSM) and the European Stability Mechanism (ESM).
The aspects of debt management reviewed in this chapter pose
significant institutional and organizational challenges, which should be
analysed and studied in greater detail.
CHAPTER XIV
INVESTMENT ANALYSIS OF DEBT INSTRUMENTS

This chapter develops the competences needed for the
implementation of contemporary techniques for the analysis and evaluation
of debt instruments. At the end of this chapter you will be able to:
 use the basic terminology;
 systemize and calculate the fundamental and specialised
indicators for investment analysis of debt instruments.
The chapter includes two topics:

1. fundamental investment indicators;
2. specialised indicators for investment analysis of debt
instruments.
1. Fundamental investment indicators

The traditional perception of investment analysts’ work presents
their work environment as similar to that of accountants - with many
primary documents, balance sheets, financial statements, etc. Nowadays
investment analysts are often equipped only with specialised hardware and
software applications. Some of the most popular financial analysis tools are
included in the MS Excel application.
The main functions used for the evaluation of investments and
returns are PV, NPV, FV, PMT, IPMT, PPMP, NPER, RATE, IRR, MIRR.1
In order to performs financial analyses we have to identify the main
arguments and variables that are used in various MS Excel functions for
the evaluation of investments and returns. The order of the individual
arguments in the program line to activate the analytical function is strictly
defined. If any argument is omitted there are two possible outcomes:
 the program will produce an error code #NUM;
1
These functions are described in many MS Excel manuals. Here we shall
describe how they are used because of the fundamental importance of the concept of time
value of money in making corporate financial and investment decisions.
204 Debt management
 the function will calculate the default value as shown below:
Table 14-1
Argument Description
Present value Pv Present value of the investment at present
0 (current value)
Future value Fv Value of the investment at the end of the
period (the default argument is 0)
Number of periods Nper The total number of interest payment
periods within the term of investment
Return 1, return 2, Periodic returns of fixed amounts
… return n
Payment Pmt Periodic payments of fixed amounts
Type Type Indicates when payments are due (if type is
omitted, it is assumed to be 0):
0 - at the end of the period
1 - at the beginning of the period
Period Per The sequential number of the payment
period
Rate Rate The interest or discount rate
The PV function returns the present value of an investment. When a

series of payments is discounted the function calculates the present value
of investment which can be correlated with the amount required for
investment. The function can calculate multiple payments or a single lump-
sum payment. The PV function has the following syntax:
=PV(rate;nper;pmt;Fv;type)
The present value of a series of payments is calculated using the

Pmt argument (see Table 14-1). A single lump-sum payment is calculated
using the Fv argument. For both types of payment use both arguments.
The examples below illustrate the process of investment
calculations using MS Excel:2
2
Note: In all figures illustrating MS Excel screens, the abbreviation “лв” stands for
the Bulgarian national currency – Bulgarian New Lev (BGN).
Chapter XIV. Investment analysis of debt instruments 205
Example
A proposed investment project will generate annual returns of BGN
1500 for 7 consecutive years. The initial investment of BGN 8 000 will
return a total of BGN 10 500 for 7 years. In this case the investment
decision would be to either approve or reject the project depending on the
present value of the sequence of the individual returns of BGN 1 500 each.
If the conservative rate of return is 4% (the return of a one-year deposit in a
commercial bank), the discount factor (the alternative for a relatively risk-
free investment of the amount) will be 4%. The result of the calculation of
this investment project will be BGN -9003.8:
=PV(4%;7;1500)3
3
The function is executed by simultaneously pressing the Ctrl+Shift+Enter keys.
Note that the different versions of MS Excel require the program line arguments to be
separated with commas ( , ) or semicolons ( ; ).
206 Debt management
This means that the investment is acceptable, because a return of

BGN 10 500 for 7 years at a discount rate of 4% would require an
investment of BGN 9003.08 while the proposed project requires an
investment of BGN 8 000 only.
If the investment project generates a lump-sum return of BGN 10
500 at the end of the seventh year, the PV function will be modified as
follows:
=PV(4%;7;;10500)
This result does not meet the initial investment requirements

because we have to invest BGN 20.86 more to generate a return of BGN
10 500 at the end of the seven-year period compared to a risk-free
investment of BGN 7979.14 (instead of BGN 8 000 required by the
proposed investment project).
The additional separator (semicolon) after the Nper argument
defines the missing Pmt argument and thus the future value (Fv) argument
is 10 500.
The net present value (NPV) of an investment is calculated by using
a discount rate and a series of future payments (negative values) and
income (positive values):
CFt
(14-1) NPV    NICO ,
(1  Rate) t
where:
CF is the annual cash flow;
NICO – the net investment costs;
Rate – the required rate of return of the project;
t – the period at the end of which the cash flows occur.
Whether the project is accepted or rejected depends on the polarity

of the NPV value. A positive value means that the project will be rejected
whereas a negative value means that the project will be accepted. The MS
Excel PV function has the following syntax:
=NPV(rate;value1,value2….,value 29)
Value 1, value 2, etc. are 1 to 254 arguments representing the

payments and income. In terms of calculation possibilities, NPV is better
than the PV function. While PV allows only for constant cash flows, NPV
allows the use of variable cash flow values. Alternatively, PV allows cash
flows to begin either at the end or at the beginning of the period whilst with
the NPV function the payments are at the end of the period by default.4
Example
An investment project requires initial investment of BGN 50 000 and
will generate the following returns for 4 years: BGN 3 000, 17 000, 24 000
and 16 000 at a discount rate of 10%.
4
Note that if NICO have to be paid at the beginning of the first period, the first
value must be added to the NPV result (with a negative polarity), not included in the values
arguments. If the investment costs are paid at the end of the first period, their value will be
included in the values arguments as a negative value 1.
208 Debt management
=NPV(10%;2000;17000;24000;16000)-50000
The result of BGN - 4 263.37 requires that the project should be

rejected. If NICO is paid at the end of the first discount period, its value will
be included in the arguments as value 1.
=NPV(10%;-50000+2000;17000;24000;16000)
The result of BGN 282.08 allows us to accept the investment

project.
The FV returns the future value of an investment based on periodic,
constant payments and a constant interest rate.
=FV(rate;nper;pmt;pv;type)
The payment argument (Pmt) is the payment made each period and
the present value (Pv) argument is used for a single lump-sum payment.
Example
You intend to deposit BGN 4 000 in a deposit account at fixed

annual interest rate of 8% at the beginning of each year for 20 years.
=FV(8%;20;-4000;;1)
The MS Excel FV function calculates that in 20 years the balance of

your deposit account will be BGN 197 691.69.
If you deposit initially the amount of BGN 6 000 and keep the other
arguments unchanged, in 20 years the balance of the account will be BGN
225657.43.
=FV(8%;20;-4000;-6000;1)
The PMT function calculates the annuity payment for a loan based
on constant payments and a constant interest rate:
=PMT(rate;nper;pv;fv;type)
Example
You intend to take a loan of BGN 10 000 which must be repaid for
48 months with constant monthly payments. The annual interest rate is
12%.
=PMT(1%;48;10000)
210 Debt management
The formula calculated a monthly annuity of BGN 263.34.
The IPMT function calculates the interest payment of the annuity for
a loan for a given period:
=IPMT(eate;per;nper;pv;fv;type)
For the example above, the interest payment for the first period
(month) will be calculated as follows:
=IPMT(1%;1;48;10000)
The calculated result of BGN 100 corresponds to the calculations in

the “Anuitet-primer.xls” file.
The PPMT function is similar to IPMT. The difference is the annuity

component that is calculated - while IPMT calculates the interest, PPMT
calculates the payment on the principal for a given period. For any period
the sum of the results of these two functions should be equal to the
annuity.
The PPMT function has the following syntax:
=PPMT(rate;per;nper;pv;fv;type)
For the above 4-year loan of BGN 10 000 based on periodic,

constant payments and a constant monthly interest rate of 1%, the
payment on the principal for the first month will be BGN 163.34.
=PPMT(1%;1;48;10000)
212 Debt management
The NPER function calculates the number of periods for an

investment based on periodic, constant payments and a constant interest
rate:
=NPER(rate;pmt;pv;fv;type)
Example
Assume that a household can save BGN 400 each month and use
this amount to repay a consumer loan of BGN 8 000 at an annual interest
rate of 10%. The formula calculates the number of periods required to pay
off the loan.
=NPER((10/12)%;-400;8000)
The formula returns a result of 21.97 months required to pay off the
loan. The function can be used only if the monthly annuity is equal to or
greater than BGN (10/12)%) х 8000, which is BGN 66.67. If this condition is
not observed the function will return the #NUM! error value.
Return on investments is calculated with the RATE, IRR and MIRR

functions.
The RATE function returns the interest rate per period of an annuity
(the return on investment per period or as a lump sum.)
=RATE(nper;pmt;pv;fv;type;guess)
The payment (pmt) argument is used for payments made each

period and cannot change over the life of the annuity while the future value
(fv) argument is used for a single lump-sum payment. The guess is your
guess of what the rate will be. if it is omitted, MS Excel will use a default
guess value of 0.1 (10%).
Example
To evaluate an investment that will generate 4 payments of BGN 2500

each. The initial investment is BGN 7 000.
=RATE(4;2500;-7000)
214 Debt management
The IRR function is used often for investment analyses. It returns

the internal rate of return for a series of cash flows by determining a
discount factor value for which the NPV of the investment project will be
equal to zero. The function has the following syntax:
=IRR(values;guess)
The values argument is an array or a reference to cells that contain

numbers for which you want to calculate the internal rate of return. The
function assumes that payments are generated at the end of each period
and that each cell represents one period. When the function returns an
error #NUM! value, you may include the guess argument. The value of this
argument is usually between 0.1 and 1.00 (i.e. between 10% and 100%).
Example
The initial cost of an investment project is BGN 1 mln. You expect
net incomes for the next 5 years of BGN 200 000, 280 000, 330 000, 200
000 and 390 000 respectively. The formula will calculate an internal rate of
return of 13.57%.
The MIRR (modified internal rate of return) function is similar to IRR

but it calculates the modified internal rate of return for a series of periodic
cash flows considering both the cost of the investment and the interest
received on reinvestment of cash. It also takes into account the possibility
of financing the investment with borrowed funds, generating incoming and
outgoing interest cash flows.
=MIRR(values;finance_rate;reinvest_rate)
The finance_rate argument is the interest rate paid on the money

used for investment. The reinvest_rate argument is the interest rate
received on the cash flows as you reinvest them.
Example
The initial cost of an investment project is BGN 1 mln. You expect
net incomes for the next 5 years of BGN 200 000, 280 000, 330 000, 200
000 and 390 000 respectively. The initial investment cost of BGN 1 mln. will
be covered with a bank loan at an annual interest rate of 9%. The interest
on the reinvestment of cash during the implementation of the project is
expected to be 7%. The formula calculates an internal rate of return of
13.57%.
=MIRR(A1:A6;9%;7%)
216 Debt management
The modified internal rate of return of 10.99% exceeds the cost of

investment and thus the project can be accepted for financing.
2. Specialised indicators for investment

analysis of debt instruments
The returns on the capital market is measured by means of the
yield-to-maturity (YTM) of bonds. The main characteristics of treasury
bonds are:
 market price of the bond (P);
 number of years to maturity (n);
 the value of the annual coupon payment (С).
In order to calculate the yield-to-maturity (YTM), we have to
compare the market price of the bonds with the current value of the future
coupon payments. In other words, the yield-to-maturity is a discount
percentage at which the market price of the bonds is equal to the current
value of the future coupon payments. Depending on the organisation of
coupon payments we can use the following calculation techniques:
 to calculate YTM of annual coupon payments -
C C C BV
(14-2) P   ...   ,
1  r  1  r 2
1  r  1  r n
n
where: BV is the book value of the bond.
 to calculate YTM of semi-annual coupon payments -

C/2 C/2 C/2 BV

(14-3) P   ...  
1  r / 2 1  r / 22
1  r / 2 1  r / 22n
2n
Here the number of coupon payments double at the expense of changes in

the discounting scheme. The formula may also be expressed as:
C/2 C/2 C/2 C/2 BV
(14-4) P   ...   
1  r  1  r 
0, 5 1
1  r n 0 , 5
1  r  1  r n
n
 to calculate YTM of quarterly coupon payments -

C/4 C/4 C/4 BV
(14-5) P   ...  
1  r / 4 1  r / 42
1  r / 4 1  r / 44n
4n
In general, the principle of calculation of yield-to-maturity is to converge the

interest rate on the debt (the bond coupon) and the market price of the
bond (see Figure 14-1).
In order to analyse the relation between the bond market price and
its yield-to-maturity we shall consider a 5-year bond with fixed annual pay
rate of 10% payable semi-annually, a face value of BGN 10 and:
а) market price of BGN 11.50

0,5 0,5 0,5 10
(14-4’) 11,50    ...  
1  r  1  r 
0,5 1
1  r  1  r 5
5
The calculation returns a YTM=r=0.064432.
b) market price of BGN 8.50

0,5 0,5 0,5 10
(14-4’) 8,50    ...  
1  r  1  r 
0, 5 1
1  r  1  r 5
5
In this case YTM=r=0.143010.
c) market price of BGN 10.00

0,5 0,5 0,5 10
(14-4’) 10,00    ...  
1  r  1  r 
0, 5 1
1  r  1  r 5
5
In this case YTM=r=0.10, i.e. the yield-to-maturity is equal to the

coupon rate.
218 Debt management
Interest rate and yield-to-maturity

0 1 2 3 4 5 6 n n
1
BV 1  r n
1
C 1  r n
1
1  r 
6
C 1
C 1  r  5
1
C 1  r 4
1
C 1  r  3
1
r  YTM
C 1  r 2
1
C 1  r 
Figure 14-1
The above calculations lead to the following conclusions:
a) When the market price of the bond is greater than its nominal value (i.e.
the bond is selling at a premium), YTM is less than its coupon rate.
b) When the market price of the bond is less than its nominal value (i.e.
the bond is selling at a discount), YTM is greater than its coupon rate.
c) When the market price of the bond is equal to its nominal value (i.e. the
bond is selling at par), YTM is equal to its coupon rate.
The operations with fixed-interest securities on the secondary

market clearly demonstrate that the changes in the market price of the
bonds affect their yield-to-maturity. Considering the above example, if we
assume that at the end of the second year the bondholder (who has bought
the bond for BGN 11.50) will sell the bond at its present market value
(which, due to a significant increase of the interest rate, is BGN 9.7), the
YTM will be 1.1054%. This value is actually a lot lower than the initial yield
calculated when the bond was purchased on the primary market

(YTM=6.4432%).
0,5 0,5 0,5 9,7
(14-4’) 11,50    ...  
1  r  1  r 
0,5 1
1  r  1  r 3
3
This shows that the interest rate is a key factor for the dynamics of
the market value of debt securities with fixed income. Moreover, the effect
is an inverse relationship - an increase in interest rates leads to a decrease
in the market value of fixed-income bonds and a decrease in the market
value of fixed-income bonds reduces the yield-to-maturity of bonds sold on
the secondary market.
In MS Excel, the yield on securities is calculated using the YIELD

and YIELDMAT functions.
YIELD has the following syntax:
= YIELD (settlement; maturity; rate; pr; redemption; frequency;
basis)
YIELDMAT has the following syntax:

= YIELDMAT (settlement; maturity; issue; rate; pr; basis)
Basis is the type of day count basis to use. It may have values
between 0 and 4, which mean:
0 US 30/360
1 Actual/Actual
2 Actual/360
3 Actual/365
4 European 30/360
Example
A bond has a settlement date of the 31st January 2003, a maturity
date of the 31st December 2007, an issue date of the 1st January 2000, a
coupon of 5% annually with semi-annual payments and a settlement price
of BGN 98 at face value of BGN 100. The calculation uses the standard
basis of 30/360 (value 0):
220 Debt management
Another important indicator used for investment analyses of

securities is their DURATION. This function returns the annual duration of a
security with periodic interest payments. Duration is calculated using the
following formula:
T
 PV (C )t t
(14-6) D t 1
,
P0
where:
D is duration in years (a whole number or a decimal fraction);
PV(Ct) is the present value of coupon payments at a moment t for a
discount equal to the YTM;
P0 is the present market price of the bond;
T is the time to maturity of the bond.
Using the above example, the formula will return:

The function has the following syntax:

= DURATION (settlement;maturity;coupon;yld;frequency;basis)
The duration of this 7-year bond defines the cash flows generated
before and after 24 May 2005 (4.395 years after the date of issue).
The analysis of securities traded on the money market shows that
their yield should be determined using a different methodology.5 it is based
on the bank discount method of calculating the quoted yield on a zero-
coupon debt security with face-value discount:
 d 360 
(14-7) BDR   x ,
N t 
where:
5
In order to preserve the consistency with the above examples, the calculations
below are based on an example published in: ANGELOV, A. Lihveni strukturi v usloviyata
na valuten bord. V. Tarnovo, ABAGAR, 2002, pp. 14-17.
222 Debt management
BDR is the bank discount rate;

d is the discount as a lump sum;
N is the bond’s face value;
t is the number of days to maturity.
Therefore, for a treasury bill with face value of BGN 100, maturity in
72 days and discount of BGN 1.58, the yield calculated using the bank
discount method will be:
 1,58 360 
(14-7’) BDRN 100;d 1,58;t 72   x   7,90%
 100 72 
A specific feature of the bank discount method is that the treasury

bill with face value of BGN 100 is selling for BGN 98.42 and that the
method is based on the mathematical year of 360 days instead of the
calendar year of 365 days.
In order to rectify this problem we may re-calculate the bank
discount rate as a modified bond yield (MBY):
365 xBDY
(14-8) MBY  ,
360  txBDY 
where: BDY is the bank discount rate as a decimal number.
Thus the yield of the 72-day bond is calculated as:

365 x0,079
(14-8’) MBYBDY 0,079,t 72   8,14%
360  72 x0,079
The modified bond yield may alternatively be represented as:6

 d 365 
(14-9) MBY   x 
N d t 
 1,58 365 
(14-9’) MBY   x   8,14%
 98,42 72 
This yield is greater than the yield calculated using the bank
discount rate because the calculation is based on 365 instead of 360 days.
However, this formula simply presents the multiplication of the interest
coupon in time. If we take into account the changes in the interest rate over
time, then we have to include an option for complex interest on the money
market.
6
KNOTT, G. Financial Management. London, Macmillan, 1991, p. 232.
365
 d  t
(14-10) EYMM  1   1
 N d 
365
 1,58  72
(14-10’) EYMM N 100,d 1,58,t 72  1    1  8,41%
 98,42 
If we assume that at every 72 days the interest may be invested at

the same interest rate, we may define the effective yield on money markets
(EYMM) for the same treasury bill (see 14-10’).”
Exhibits
14а-1. Method for analysis of debt exposures of commercial loans

Example: Consider a commercial loan for a term of 130 days. The
lender agrees under the condition that if the credit is repaid within 10 days
then the trade discount of the credit will be 5%. This agreement is
represented as: X/Y Neto Z
where:
Z is the term of the commercial loan;
Y is the last allowed day for preliminary repayment;
X is the discount rate for preliminary repayment;
On an annual basis this is: X/(100-X)x(360/(Z-Y)), therefore the
annual interest rate for this commercial loan (without interest capitalisation)
will be calculated as: (5/(100-5))х(360/(130-10)) = 15.79%
Explanation: A 5% trade discount per 100 units of commercial
credit means that 95% of the bond face value will be paid within 10 days
(100 units – 5 units = 95 units). Therefore the remaining 5 units are the
interest the lender will collect if the bond is redeemed on the 130th day. The
term of the loan is between day 10 and day 130, i.e. 120 days, which on an
annual basis is 3х120=360.
224 Debt management
Figure 14а-1. Annual non-capitalised interest rate of

commercial loans with discount repayment
Figure 14а-2. Annual capitalised interest rate of

commercial loans with discount repayment
226 Debt management
14b-1. Method for the calculation of annuity repayment plans
r n 1 r n r  1
K a n , aK n
r r  1 r 1
Figure 14b-1. Main components for the calculation of annuities

and repayment plans
Figure 14b-2. Annuity repayment plan for a 10-year loan with 10 annuities
(annual repayment)
228 Debt management
Figure 14b-3. Annuity repayment plan for a 10-year loan

with 20 annuities (semi-annual repayment)

with 30 annuities (four-month repayment)
230 Debt management

with 40 annuities (quarterly repayment)

with 60 annuities (bi-monthly repayment)
232 Debt management

with 120 annuities (monthly repayment)
14c-1. Determining the corporate bond yield curve

in Bulgaria for 2011
Through empirical analyses we can determine the bond yield curve

of Bulgarian public companies for 2011 for alpha=2.39%7 and
beta=25.52%.8 The value of “alpha” is taken from the Government Debt
Monthly Bulletin issued by the Ministry of Finance and represents the yield
of one-year government securities at the auction in December 2010.9
The value of “beta” is calculated using the financial information for
Bulgarian public companies considered “benchmarks” for the Bulgarian
economy (Table 13с-1). By comparing the three-year average data for
interest expense on their income statements with the total amount of
current and non-current bank loan liabilities, we determine the interest rate
on the loans taken by each of the companies. We additionally calculate the
period-average "Debt/Assets" ratio.
Table 13с-1
Sofarma AD 2008 2009 2010 Average:
Interest expenses from the IS 8599000 6721000 6169000 7 163 000.00
1. Non-current liabilities on loans
taken from banks and non-
banking financial institutions 71826000 53054000 101783000 75 554 333.33
2. Current liabilities on loans
Total liabilities to CB: 130051000 77660000 105712000 104 474 333.33
Loan price 0.066120214 0.08654391 0.05835667 0.07

Assets: 378978000 405236000 464731000 416 315 000.00
D/A 0.3431624 0.19164141 0.22746922 0.25

Albena AD 2008 2009 2010 Average:
Loan price 0.067738422 0.03779936 0.03148597 0.05

Assets: 455585000 464379000 460003000 459 989 000.00
D/A 0.278121536 0.23927223 0.21534642 0.24
7
Darzhaven dalg (mesechen byuletin). Ministerstvo na finansite, 2010,
December, p. 7.
8
This exhibit is based on: ZAHARIEV, A. Optimizatsiya na kapitalovata
struktura na firmite v Balgariya (2011) – tehnologiya i praktika. // Dialog, 2012, N 1.
9
http://www.minfin.bg/bg/statistics/1
234 Debt management
Neochim AD 2008 2009 2010 Average:

Loan price 0.16371423 0.03992905 0.15737615 0.12
Assets: 162878000 156549000 142636000 154 021 000.00
D/A 0.063077887 0.16925691 0.07684596 0.10

М+С Hydraulic AD 2008 2009 2010 Average:
Interest expenses from the IS 688000 419000 297000 468 000.00
Loan price 0.092647455 0.07639015 0.0667866 0.08

Assets: 55633000 50141000 56848000 54 207 333.33
D/A 0.133481926 0.10939152 0.07822615 0.11

Kaolin AD 2008 2009 2010 Average:
Loan price 0.039234003 0.03480532 0.04629009 0.04

Assets: 197060000 219749000 218759000 211 856 000.00
D/A 0.293347204 0.3118285 0.31383395 0.31

Monbat AD 2008 2009 2010 Average:
Loan price 0.050870392 0.03757767 0.04862224 0.05
Assets: 152250000 182535000 193563000 176 116 000.00
D/A 0.179599343 0.20191744 0.20623776 0.20
These empirical debt financing profiles are entered into a table

(Table 14с-2) and subjected to regression modeling using the Data
Analysis Tools of MS Excel.
Table 14с-2
Public company D/A Debt interest rate
Sofarma AD 0.254091 7.03%
Albena AD 0.244247 4.57%
Monbat AD 0.195918 4.57%
М+С Hydraulic AD 0.107033 7.86%
Kaolin AD 0.306337 4.01%
Neochim AD 0.103060 12.03%
The value of the “Alpha” coefficient in the regression for calculating

the interest rates for the various D/A levels is assumed to be zero.10 The
output confirms the statistical significance with a confidence level of 95%
(Table 14с-3). Thus the corporate bond yield is calculated using the “alpha”
determined at the auction of the BNB and the multiplied by the D/A values
“beta” calculated from the empirical analysis of the 6 benchmark public
companies. The results are shown in Table 14с-4.
Figure 1. Regression calculation of the “beta” coefficient
Table 14с-3
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.7602095
R Square 0.5779186
Adjusted R Square 0.3779186
Standard Error 0.0514775
Observations 6
ANOVA
10
i.e. you should check the “Constant is Zero” checkbox (see Figure 1).
236 Debt management
Signifi-
df SS MS F cance F
Regression 1 0.018142 0.018142 6.846055 0.059016
Residual 5 0.01325 0.00265
Total 6 0.031391
Standard
Coefficients Error t Stat P-value Lower 95% Upper 95%
Intercept 0 #N/A #N/A #N/A #N/A #N/A
D/A 0.2552157 0.097541 2.616497 0.047297 0.004479 0.505953
Table 14с-4
D/A IR (%)
0.00 2.39%
0.05 3.67%
0.10 4.94%
0.15 6.22%
0.20 7.49%
0.25 8.77%
0.30 10.05%
0.35 11.32%
0.40 12.60%
0.45 13.87%
0.50 15.15%
0.55 16.43%
0.60 17.70%
0.65 18.98%
0.70 20.26%

1. ADAMOV, V., Holst, J., Zahariev, A. Finansov analiz. V.
2. ANGELOV, A. Lihveni strukturi v usloviyata na valuten bord. V.
3. ZAHARIEV, A. Optimizatsiya na kapitalovata struktura na firmite
v Balgariya (2011) – tehnologiya i praktika. // Dialog, 2012, N 1.
4. PATEV, Pl., Kanaryan, N. Upravlenie na portfeyla. V. Tarnovo.
ABAGAR, 2008.
Keywords
1. MS Excel functions PV, NPV and FV
2. MS Excel functions PMT, IPMT, PPMP and NPER
3. MS Excel functions RATE, IRR and MIRR
4. Yield-to-maturity
5. MS Excel functions YIELD and YIELDMAT
6. Duration
7. Bank discount rate
8. Modified rate of return of bonds
9. effective yield on money markets (EYMM)
10. 3/5 Neto 100
11. Annuity payment plan
12. Number of annuity payments
13. Duration of one annuity period
14. Interest rate for one annuity period
15. Interest factor for one annuity period

1. A proposed investment project will generate annual returns of BGN
1000 for 5 consecutive years. Evaluate the project using the MS Excel
PV function if the initial investment cost of the project is BGN 4 220 and
the annual discount rate is 8%.
2. An investment project requires initial investment of BGN 46 900 and will
generate the following returns for 4 years: BGN 4 700, 16 578, 23 459
and 16 123 at a discount rate of 10.5%. Evaluate the project using the
MS Excel NPV function.
3. You intend to deposit BGN 3 000 in a deposit account with a fixed
annual interest rate of 7.2% at the beginning of each year for 25 years.
Determine the current balance on the account at the end of the period.
4. You intend to take a loan of BGN 6 000 which must be repaid for 3
years with constant monthly payments. The annual interest rate is 13%.
a) Calculate the size of the annuity.
b) Calculate the interest payment at the end of the 12th month.
c) Calculate the principal payment at the end of the 20th month.
5. Evaluate an investment which will generate 5 annual payments of BGN
2 000 each. The required initial investment cost is BGN 8 400.
6. An investment project requires initial investment of BGN 5.2 mln. The
expected returns for the next 5 years are: BGN 2.1 mln., 1.1 mln., 2.12
mln., 0.74 mln. and 1.3 mln. Calculate the internal rate of return.
238 Debt management
7. The initial cost of an investment project is BGN 2 mln. You expect net
incomes for the next 4 years of BGN 820 000, 485 000, 710 000 and
1.29 mln. respectively. 45% of the initial investment cost will be covered
with your own funds and the remaining 55% with a bank loan at an
annual interest rate of 8%. The interest on reinvestment of cash during
the implementation of the project is expected to be 6.5%. Calculate the
modified internal rate of return.
8. Consider a treasury bill with face value of BGN 100, maturity of 92 days
and a discount of BGN 1.98. Determine the yield-to-maturity using the
bank discount method. Determine the effective yield on the money
market.
9. Consider a bond with a settlement date 31 Jan. 2004, a maturity date
31 Dec. 2006, issue date 1 Jan. 2001, coupon of 6% annually with
quarterly payments and a settlement price of BGN 97.25 at a face value
of BGN 100. Calculate the bond’s yield-to-maturity and duration using
the standard basis of 30/360 (value 0).
10. Determine the annual capitalised interest rate for a commercial loan
with a discount repayment of 3/12 Neto 112 and a basis of 365 days.
12. Determine the annual non-capitalised interest rate for a commercial
loan with a discount repayment of 6/18 Neto 200 and a basis of 365
days.
13. Determine the annual non-capitalised interest rate for a commercial
loan with a discount repayment of 5/20 Neto 130 and a basis of 360
days.
16. Determine the annuity size of a foreign currency loan with the following
terms:
Size of the loan in Euro: K 100 000,00 €
Number of annuity payments: n 120
Duration of one annuity period in months: T 1
Yearly interest rate: IRy 10,00%
17. Determine the annuity size of a foreign currency loan with the following
terms:

18. Determine the annuity size and the repayment plan for the first 5
annuity payments for a foreign currency loan with the following terms:
19. Determine the annuity size and the repayment plan for the first 5
annuity payments for a foreign currency loan with the following terms:
20. Determine the annuity size and the repayment plan in BGN and USD
for a foreign currency loan with the following terms:
Size of the loan: K 600 000,00 $
Exchange rate BGN/USD 1,44
240 Debt management

23. Determine the corporate bond yield curve in increments of 5% (up to
D/A=60%) for alpha=2.30% and beta=0.20.
24. Determine the corporate bond yield curve in increments of 10% (up to
D/A=90%) for alpha=2.00% and beta=0.25.
Chapter summary
The traditional perception of investment analysts’ work presents
their work environment as similar to that of accountants - with many primary
documents, balance sheets, financial statements, etc. Nowadays
investment analysts are often equipped only with specialised hardware and
software applications. Some of the most popular financial analysis tools are
included in the MS Excel application.
The returns on the capital market are measured by means of the
yield-to-maturity (YTM) of bonds. The main characteristics of treasury
bonds are the market price of the bond (P); the number of years to maturity
(n) and the value of the annual coupon payment (С).
In order to calculate the yield-to-maturity (YTM), we have to
compare the market price of the bonds with the current value of the future
coupon payments. The yield-to-maturity is a discount percentage at which
the market price of the bonds is equal to the current value of the future
coupon payments.
When the market price of the bond is greater than its nominal value
(i.e. the bond is selling at a premium), YTM is less than its coupon rate.
When the market price of the bond is less than its nominal value (i.e. the
bond is selling at a discount), YTM is greater than its coupon rate. When
the market price of the bond is equal to its nominal value (i.e. the bond is
selling at par), YTM is equal to its coupon rate.
The DURATION function returns the annual duration of a security
with periodic interest payments. The duration of a security is determined
based on its yield-to-maturity as a discount factor.
CONCLUSION
It may be noted that the analysis of the debt burden concerns

mainly the distribution of the tax burden amongst members of a generation
or among generations. This makes the results of the analysis very complex
and contingent. Thus, according to Lerner's concept, the internal debt does
not create a burden for the future generations because it is simply a
transfer of income within a given generation. On the other hand, however,
according to the model of overlapping generations, deficit financing creates
a real burden for the future generations. The Neoclassical concept of debt
is focused on the crowding-out of private investments. When they
decrease, the process of capital formation also slows down, in turn
reducing the productivity of future generations. In fact, the burden means a
loss of future income due to less investment of private capital today. In
Ricardo's model, the voluntary transfer of wealth among generations
removes the crowding-out effect of debt financing.
Obviously, the varying theoretical models are based on different
hypotheses regarding the debt burden. Econometric research has provided
conflicting results as well. This requires that the debt burden should be
analysed using additional analyses. These analyses should take into
account the shadow economy as an important deficit financing factor. The
existence of a shadow economy means a reduced tax base, leading to a
reduction in tax revenues and an increase in deficit financing. With the
development of the taxation system, tax evasion has continually adopted
new forms. They result from changes in the organisation of revenue
collection and are associated with both total and partial concealment of
income and with the disqualification of income (transfer of part of the profit
as costs, etc.). For many a lawyer and accountant tax evasion has become
a profitable business. The increase of tax evasion is heavily influenced by
the nature of the socio-economic system, the tax culture of the taxpayers,
and the will of the government to punish tax evaders and tax fraud.
The lack of clear evidence on the burden of debt issue makes its
evaluation very complex and multilayered. It requires that the theoretical
assumptions and models should be applied with great skill to the specific
debt formation conditions, i.e. to identify the specific benefits and harms of
deficit financing in the short and longer periods of time. For many countries
finding alternatives to reduce their debt burden is of primary importance. Its
specific structure requires them to develop closer relations with the
countries of the leading international financial institutions in order to
maintain the status of a solvent debtor.
Conclusion 243
The choice of debt instruments determines the techniques for their

marketing, i.e. the methods to be used to issue various debt instruments or
distribute them among investors. Generally, there are various categories of
selling techniques. The choice of a technique is determined by several
factors, including the type of debt instruments to be sold, the types of
investors that are targeted, the stage of development of monetary and
bond markets and the overall climate of the capital market in terms of
inflation and interest rates. Government debt operations usually involve
transfers of large amounts of money between the accounts of the
government and the economy. These transfers can have a significant
impact on liquidity and on interest rates which is why the policies of
government debt management and monetary policies should interact as
much as possible.
Governments, in their role of issuers of a variety of debt instruments
and managers of significant amounts of debt, should enter into certain
agreements that would allow government debt managers to perform their
functions and routine tasks in the most effective way. The institutional and
organisational problems related to government debt management, which
must be resolved in one way or another, can be quite complex and
multidimensional. In practice the solutions to these problems vary from
country to country and depend largely on the traditions of the country in
terms of managing the public sector as a whole.
The development of more systematic and precise approaches for
active management of not only the external government debt but also of
internal government debt is the new field for the development of
competences of government debt managers. This essentially new debt
management concept is based on the principle of the implementation of a
unified approach to the management of the national wealth and in
particular the public sector. In this context, debt management is subject to
the rules and mechanisms for management of national wealth. The actual
management of the national wealth should follow the classical
recommendation that the government should be responsible for its financial
affairs "with the prudence of the individuals regarding their own financial
affairs". This is why we now speak not only of active "liability management"
but also of "asset management", i.e. management of the external financial
assets of the government.
This academic course has become extremely topical and important
in the context of the global financial and economic crisis and in particular
the debt crisis of 2008-2009, which affected the European Union. With its
support for the Fiscal Pact Bulgaria made the next step to joining the
Eurozone.
244 Debt management
In summary, the "Debt Management" academic course discusses

issues related to both the scientific viewpoint of deficit financing and the
practice of government debt managers. The discussed problems and
issues confirmed the thesis for the direct correlation between deficit
financing theory and debt management techniques.
TERM CASE STUDY IN DEBT MANAGEMENT
name, surname(s)
major, faculty No.
TERM CASE STUDY

in
Debt Management
Dear colleagues,
This case study aims to provide you with the opportunity to apply
the theoretical knowledge you have acquired in the field of debt
management in practice. The main objective of this case study is to
improve and verify your skills in order to analyse and assess the debt
status and trends of a particular economy as well as to evaluate factors
associated with the possibility of taking active measures for the
management of public debt.
This case study will further expand the knowledge you have
acquired from the academic textbook. You are expected to demonstrate
initiative and a creative approach to the case study tasks.
The result of your case study assessment will form part of your final
grade for the course in "Debt Management ".
We wish you success!
Assoc. Prof. Andrey Zahariev, PhD

246 Debt management
Part 1
The origins and development of the debt burden in Bulgaria
Case study inputs:

The tables below present information about the Republic of Bulgaria
for the period of its incurrence of debt. The information has been taken
from the World Debt Tables. The individual items are presented with their
original descriptions in English.
Based on the information included in the tables you should be able
to:
 evaluate the status of the Republic of Bulgaria’s external sector for
the period.
 describe the causes that led to the debt crisis.
 analyse the individual debt characteristics.
 assess the role of the IMF in overcoming the debt crisis.
 apply the models and concepts regarding the strategic role of
government debt and its impact on the political cycle, considering
the situation of a left-wing government being replaced by a right-
wing one.
 evaluate the effect of the balances on analytical currency accounts
on the debt crisis.
 comment on the relation between external government debt and the
state of the external sector.
 considering the information from Chapter 12, make predictions
about Bulgaria’s future level of debt.
Note: The case study is based on the information published in

the “World Debt Tables” in 1992.
Term Case Study 247
1985 1986 1987 1988 1989 1990 1991 1992

1. SUMMARY DEBT DATA
TOTAL DEBT STOCK 3852 5866 8256 8934 10124 10876 11970 12146
(EDT)
Long-term debt 3802 5806 7905 8305 9270 9813 9987 9951
(LDOD)
Public and publicly 3802 5806 7905 8305 9270 9813 9987 9951
guaranteed
Private non-guaranteed 0 0 0 0 0 0 0 0
Use of IMF credit 0 0 0 0 0 0 414 590
Short-term debt 50 60 351 629 854 1055 1569 1605
of which interest arrears 0 0 0 0 0 225 766 1535
on LDOD
Official creditors 0 0 0 0 0 5 27 42
Private creditors 0 0 0 0 0 220 740 1493
Memo: principal arrears 0 0 0 0 3 356 1443 5021
on LDOD
Memo: export credits 1304 1520 1620 1703 1238 4798 2836 2721
TOTAL DEBT FLOWS 1921 2828 2994 2675 2770 875 787 566
Disbursements 1921 2828 2994 2675 2770 875 391 284
Long-term debt 0 0 0 0 0 0 396 282
IMF purchases 960 1255 1574 1856 1904 872 114 167
Principal repayments 960 1255 1574 1856 1904 872 114 82
Long-term debt 0 0 0 0 0 0 0 85
IMF purchases 1011 1583 1711 1098 1091 -21 687 -334
Net flows on debt 50 10 291 278 225 -24 15 -733
of which short-term debt 218 299 416 482 675 510 159 248
Interest payments 215 296 404 455 623 452 104 183
(INT)
IMF charges 0 0 0 0 0 0 6 35
Short-term debt 3 3 12 28 52 58 49 30
Net transfers on debt 793 1284 1295 615 416 -531 528 -582
Total debt service 1178 1554 1989 2338 2579 1382 273 415
(TDS)
Long-term debt 1175 1550 1977 2311 2527 1324 218 264
248 Debt management
1985 1986 1987 1988 1989 1990 1991 1992

IMF purchases and 0 0 0 0 0 0 6 121
charges
Short-term debt (interest 3 3 12 28 52 58 49 30
only)
2. AGGREGATE NET RESOURCE FLOWS AND NET TRANSFERS (LONG-
TERM)
NET RESOURCE 961 1573 1420 820 866 7 333 244
FLOWS
Net flow of long-term 961 1573 1420 820 866 3 277 202
debt (ex. IMF)
Foreign direct 0 0 0 0 0 4 56 42
investment (net)
Portfolio equity flows 0 0 0 0 0 0 0 0
Grants (excluding 0 0 0 0 0 0 0 0
technical coop.)
Memo: technical coop. 0 0 0 0 0 0 0 0
Grants
NET TRANSFERS 746 1277 1017 365 243 -445 229 62
Interest on long-term 215 296 404 455 623 452 104 183
debt
Profit remittances on 0 0 0 0 0 0 0 0
FDI
3.MAJOR ECONOMIC AGGREGATES
Gross national product 17498 20130 28111 22573 21099 18854 11229 10967
(GNP)
exports of goods and 11520 9958 11570 10551 9618 7070 4193 5976
services (XGS)
of which workers’ 0 0 0 0 0 0 0 0
remittances
Imports of goods and 11729 10976 12398 11056 10464 8905 4339 5568
services (MGS)
International reserves - - - - - - - -
(RES)
Current account balance -136 -951 -720 -402 -769 -1710 -77 452
4.DEBT INDICATORS
EDT/XGS(%) 33.4 58.9 71.4 87.4 105.3 153.7 285.5 203.2
EDT/GNP(%) 22 29.1 29.4 39.6 48 57.6 106.6 110.7
TDS/XGS(%) 10.2 15.6 17.2 22.2 26.8 19.5 6.5 6.9
INT/XGS(%) 1.9 3 3.6 4.6 7 7.2 3.8 4.2
Term Case Study 249
INT/GNP(%) 1.2 1.5 1.5 2.1 3.2 2.7 1.4 2.3

RES/EDT(%) - - - - - - - -
RES/MGS(MONTHS) - - - - - - - -
short-term/EDT(%) 1.3 1 4.3 7 8.4 9.7 13.1 13.2
Concessional/EDT(%) 0 0 0 0 0 0 0 0
Multilateral/EDT(%) 1.2 3.2 4.8 6.2 5.8 5.7 7.1 9.2
5.LONG-TERM DEBT
DEBT 3802 5806 7905 8305 9270 9813 9987 9951
OUTSTANDING(LDOD)
guaranteed
Multilateral 47 188 400 400 591 616 852 1113
Concessional 0 0 0 0 0 0 0 0
IDA 0 0 0 0 0 0 0 0
Non-concessional 47 188 400 551 591 616 852 1113
IBRD 0 0 0 0 0 0 61 152
Bilateral 46 211 763 912 914 1046 1161 1149
Bonds 0 0 0 0 238 327 340 332
Commercial banks 2589 3727 4580 4752 5868 6660 7054 6817
Other private 1120 1680 2161 2089 1660 1163 580 540
Private nonguaranteed 0 0 0 0 0 0 0 0
Memo: total commercial 2589 3727 4580 4752 5868 6660 7054 6817
banks
DISBURSEMENT 1921 2828 2994 2675 2770 875 391 284

guaranteed
Multilateral 43 130 192 185 67 44 261 264
IDA 0 0 0 0 0 0 0 0
IBRD 0 0 0 0 0 0 58 92
Bilateral 39 159 472 244 29 36 10 3
250 Debt management

Bonds 0 0 0 0 240 65 0 0
Other private 617 1041 1158 949 646 155 14 12
banks
PRINCIPAL 960 1255 1574 1856 1904 872 114 82

REPAYMENTS
guaranteed
Multilateral 0 0 0 19 25 30 24 0
IDA 0 0 0 0 0 0 0 0
IBRD 0 0 0 0 0 0 0 0
Bilateral 9 12 13 33 10 1 1 24
Bonds 0 0 0 0 0 0 0 0
Other private 385 565 819 929 1069 601 70 39
banks
NET FLOWS ON DEBT 961 1573 1420 820 866 33 277 202
guaranteed
Multilateral 43 130 192 166 42 14 237 264
IDA 0 0 0 0 0 0 0 0
IBRD 0 0 0 0 0 0 58 92
Bilateral 30 146 459 212 19 36 10 -21
Term Case Study 251
Private creditors 887 1297 769 442 805 -46 30 -41
Bonds 0 0 0 0 240 65 0 0
Commercial banks 655 821 430 422 988 335 87 -14
Other private 232 476 339 20 -423 -446 -57 -27
Memo: total commercial 655 821 430 422 988 335 87 -14
banks
INTEREST 215 296 404 455 623 452 104 183

PAYMENTS(LINT)
guaranteed
Multilateral 0 4 7 12 16 13 49 60
IDA 0 0 0 0 0 0 0 0
IBRD 0 0 0 0 0 0 0 7
Bilateral 1 1 2 2 2 0 1 47
Bonds 0 0 0 0 0 15 10 16
Other private 65 114 161 164 186 85 19 19
banks
NET TRANSFERS ON 746 1277 1017 365 243 -449 173 20

DEBT
Public and publicly 746 1277 1017 365 243 -449 173 20
guaranteed
Multilateral 43 126 185 155 26 1 188 204
IDA 0 0 0 0 0 0 0 0
252 Debt management
IBRD 0 0 0 0 0 0 58 85
Bilateral 30 145 457 209 18 35 9 -68
Private creditors 673 1006 375 1 199 -484 -24 -116
Bonds 0 0 0 0 240 49 -10 -16
Commercial banks 506 644 197 145 569 -2 62 -54
Other private 167 362 178 -144 -609 -531 -76 -47
Memo: total commercial 506 644 197 145 569 -2 62 -54
banks
DEBT SERVICE (LTDS) 1175 1550 1997 2311 2527 1324 218 264
guaranteed
Multilateral 0 4 7 30 41 43 74 60
IDA 0 0 0 0 0 0 0 0
IBRD 0 0 0 0 0 0 0 7
Bilateral 10 13 15 35 12 1 1 71
Bonds 0 0 0 0 0 15 10 16
Other private 449 678 980 1093 1255 686 89 58
banks
INDISBURSED DEBT 3096 3089 2196 1908 702 271 425 139
Mamorandum items
LDOD
Term Case Study 253
Variable rate LDOD 2996 4567 5906 6343 7324 7696 7812 7755
Public sector 3802 5806 7905 8305 9270 9813 9987 9951
LDOD
Private sector 0 0 0 0 0 0 0 0
LDOD
6.CURRENCY COMPOSITION OF LONG-TERM DEBT (PERCENT)

Deutsche Mark 18.4 23.6 26.9 26 29.7 34 33.3 31
French Franc 0 0 0 0 0 0 0 0
Japanese Yen 4.5 4.7 5.5 5.9 6.5 6.6 6.8 6.6
Pound Sterling 0.4 0.3 0.3 0.4 0.3 0.3 0.2 0.2
Swiss Franc 6.9 6.1 7.9 7.1 7.1 7.7 7.3 6.5
U.S.Dollars 52.2 48.2 43.5 45.5 46.6 42 44.6 47.7
Multiple currency 13.4 11.3 10.1 8.5 5.3 2.5 0.7 1.6
Special drawing rights 0 0 0 0 0 0 0 0
All other currencies 4 5.4 5.4 6.1 6 6.3 6.7 6
7.DEBT RESTRUCTURINGS
Total amount 0 0 0 0 0 0 427 277
rescheduled
Debt stock 0 0 0 0 0 0 0 0
rescheduled
Principal 0 0 0 0 0 0 377 219
rescheduled
Official 0 0 0 0 0 0 336 219
Private 0 0 0 0 0 0 41 0
Interest rescheduled 0 0 0 0 0 0 45 57
Official 0 0 0 0 0 0 42 57
Private 0 0 0 0 0 0 3 0
Debt forgiven 0 0 0 0 0 0 0 0
Memo: interest 0 0 0 0 0 0 0 0
forgiven
Debt stock reduction 0 0 0 0 0 0 0 0
of which debt 0 0 0 0 0 0 0 0
buyback
8.DEBT STOCK-FLOW RECONCILIATION
Total change in debt - - - 678 1190 744 1102 176
stocks
Net flows on debt - - - 1098 1091 -21 687 -334
Net change in - - - 0 0 225 541 769
interest arrears
254 Debt management
Interest capitalised - - - 0 0 0 45 57
Debt forgiveness or - - - 0 0 0 0 0
reduction
Cross-currency - - - -389 57 617 -38 -318
valuation
Residual - - - 31 -42 77 132 -2
9. AVERAGE TERMS OF NEW COMMITMENTS
ALL CREDITORS
Interest(%) 8.5 7.4 8.2 8.5 9.3 9.1 8.2 0.0
Maturity(years) 7.3 9.1 6.6 5.4 5.1 3.4 11.6 0.0
Grace period(years) 3.7 3.7 3.4 3.5 3.3 2.3 6.2 0.0
Grant element(%) 5.2 10.9 6.3 5.1 2.6 2.3 9.1 0.0
Official creditors
Interest(%) 8.4 7.1 8.2 8.3 9.4 9.3 8.2 0.0
Maturity(years) 10.5 11.6 8.4 9 4.3 6.1 11.7 0.0
Grace period(years) 5.7 4.6 4.2 4.1 2.2 3 6.3 0.0
Grant element(%) 7.1 14.6 7 8 1.9 2.6 9.2 0.0
Private creditors
Interest(%) 8.5 7.5 8.2 8.5 9.3 9.1 7 0.0
Maturity(years) 6.9 8.5 6 5.2 5.1 3.1 2.8 0.0
Grace period(years) 3.5 3.5 3.1 3.5 3.3 2.3 0.9 0.0
Grant element(%) 5 10.1 6 5 2.7 2.3 4.8 0.0
COMMITMENTS 2016 2585 1880 2476 1716 563 655 0
10.CONTRACTUAL OBLIGATIONS ON
OUTSTANDING LONG-TERM DEBT
TOTAL
Disbursement 3 2 2 1 1 1 0 0
Principal 743 526 161 491 416 208 195 125
Interest 170 139 110 101 68 46 32 17
Official creditors
Principal 220 101 71 333 380 204 195 125
Interest 113 102 96 92 66 46 32 17
Bilateral creditors
Term Case Study 255
Principal 85 68 47 107 187 183 174 104
Interest 65 61 57 54 46 32 19 60
Multilateral creditors
Principal 135 33 24 225 193 21 21 21
Interest 48 41 39 38 20 14 12 11
Private creditors
Principal 523 425 90 159 36 4 0 0
Interest 57 37 14 9 2 0 0 0
Commercial banks
Principal 386 227 16 103 0 0 0 0
Interest 26 12 5 4 0 0 0 0
Other private
Principal 137 198 74 56 36 4 0 0
Interest 31 25 9 5 2 0 0 0
Calculations and results from Part 1:

256 Debt management
Term Case Study 257
258 Debt management
Term Case Study 259
260 Debt management
Term Case Study 261
Part 2 Modelling the market behaviour of BG DISC bonds

Determine the dependence of the price of Bulgarian DISC bonds
(Y) on the prices of the bonds issued by Argentina (Х1), Mexico (Х2) and
Brazil (Х3) using single and multiple regression and correlation analyses of
the date included in the tables below:
Table 1
Price per 1 USD
Date DISС-BG Par-ARG Par-MEX FLIRB-BRA
28/JUL/24 31/MAR/23 31/DEC/19 15/APR/09
1 04.1.1999 70.000 73.250 81.250 54.625
2 01.2.1999 68.000 70.750 79.000 48.125
3 01.3.1999 69.750 70.250 79.625 52.875
4 01.4.1999 67.000 73.250 84.875 63.500
5 03.5.1999 68.500 75.250 86.375 71.375
6 01.6.1999 65.250 69.250 83.000 64.000
7 01.7.1999 67.750 70.000 83.750 68.500
8 02.8.1999 68.750 65.500 81.250 67.625
9 01.9.1999 67.375 68.000 83.000 66.000
10 01.10.1999 68.750 71.375 85.250 69.875
11 01.11.1999 74.125 75.750 87.375 72.750
12 01.12.1999 78.000 75.250 90.750 74.875
13 03.1.2000 80.125 79.125 93.500 80.750
14 01.2.2000 78.750 77.500 92.750 78.000
15 01.3.2000 82.375 82.250 95.750 82.000
16 03.4.2000 80.250 84.250 98.000 84.375
17 01.5.2000 76.500 85.125 97.875 82.000
18 01.6.2000 75.500 82.625 97.625 81.000
19 03.7.2000 79.000 80.500 98.125 83.500
20 01.8.2000 80.375 81.000 99.375 84.375
21 01.9.2000 81.375 82.000 103.000 88.000
22 02.10.2000 76.500 80.250 103.250 87.250
23 01.11.2000 74.750 75.375 101.375 85.500
24 01.12.2000 72.750 74.000 102.000 84.375
25 02.1.2001 75.750 76.125 99.500 84.375
Note: The return (r) may be calculated in two ways:
68.000  70.000
1) rDISC BG( 02/ 01,1999)   0.0285714
70.000
68.000
2) rDISC  BG( 02/ 01,1999)  Ln  0.0289875
70.000
262 Debt management
Table 2
Single-factor regression of return on investment
in DISC-BG (Y) related to the return on investment in PAR-ARG (X1)
1 2 3 4 5 6 7 8 9 10
Y  Y Y  Y  X  X X  X  Y  Y X  X    y  ŷ 2
2 2
Month Y X
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
SUM
Analytical calculations:
Y  EY   Yi / N  ……………= (average return of Y)
 2Y   Y  Y  / N  1  ………… (variation of Yi)
2
 Y   2Y  ……………. (standard deviation of Yi)

COVY.X   Y  Y X  X / N  1  …………..(cov(Yi,Xi))
b  COVY, X /  2X  ……………. (beta coefficient)
Term Case Study 263
 
a  Y  bX  …………….. (alpha coefficient)
X  EX   X i / N  ………….. (average return of X))
 2X   X  X  / N  1  ……………. (variation Xi)
2
 X   2X  ………….. (standard deviation of Xi)

r 2   2Y   2 /  2Y = ……………. (determination ratio)
r  r 2  COVY, X /  X  Y  ………….. (correlation ratio)
 2  ……………..
Regression line equation:

Y  a  bX  ................  .................X
Calculations, analysis and assessment of the relationship:

264 Debt management
Table 3
in DISC-BG (Y) related to the return on investment in PAR-MEX (X2)
1 2 3 4 5 6 7 8 9 10
Y  Y Y  Y  X  X X  X  Y  Y X  X    y  ŷ 2
2 2
Month Y X
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
SUM
2

Term Case Study 265
 
2

 2  ……………..

Y  a  bX  ................  .................X

266 Debt management
Table 4
in DISC-BG (Y) related to the return on investment in FLIRB-BRA (X3)
1 2 3 4 5 6 7 8 9 10
Y  Y Y  Y  X  X X  X  Y  Y X  X    y  ŷ 2
2 2
Month Y X
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
SUM
2

Term Case Study 267
 
2

 2  ……………..

Y  a  bX  ................  .................X

268 Debt management
Multi-factor regression dependence of the return on investment in DISC-BG

(Y) on the returns on investments in PAR-ARG (X1), PAR-MEX (X2) and
FLIRB-BRA (X3), for a confidence interval of 95%.1
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations 24
Analysis of variation
(ANOVA)
Df SS MS F Significance F
Regression
Residual
Total
Analytical coefficients values

Standard Lower Upper
Coefficients Error t Stat P-value 95% 95%
Intercept
X Variable 1
X Variable 2
X Variable 3
Evaluation of the analytical results of the multi-factor regression:
1
We recommend the MS Excel add-in “Tools/Data Analysis/Regression” for
calculation of the multi-factor regression.
Term Case Study 269
270 Debt management
Part 3 Investment analysis of Bulgarian Brady bonds
Consider the following bonds:

DISС-BG Par-ARG Par-MEX FLIRB-BRA
28/JUL/24 31/MAR/23 31/DEC/19 15/APR/09
Issuer: Bulgaria Discount (DISC)

Coupon: 6 month Libor + 81.25 bps (floating)
Tranche A: 6 month LIBOR + .8125% semiannual coupon
Coupon Desc: (January 28 and July 28). Tranche B: 6 month LIBOR +
1.3125% semiannual coupon (January 28 and July 28).
Matures: 07-28-24
Country: BULGARIA
Date issued: 07-28-94
Guarantor: None
Form: Registered notes
Issue Amount: 1,850.36 US (millions)
Currency: US
Denomination: 250,000
Day Count: Actual/360
Amortization: Bullet
Issuer: Argentina Par
Coupon: Step up (floating)
Semiannual coupon (on May 31 and Nov 30): yr 1: 4%; yr 2:
Coupon Desc: 4.25%; yr 3: 5%; yr 4: 5.25%; yr 5: 5.5%; yr 6: 5.75%; yr 7 -
30: 6%.
Matures: 03-31-23
Country: ARGENTINA
Guarantor: None
Form: Registered Bonds
Issue Amount: 12,492 US/DM (millions)
Currency: US, DM
Day Count: 30/360
Issuer: Mexico Par
Coupon: 6.25 (fixed)
Coupon Desc: Payable semiannually; Currency/coupon basis: USD/6.25%,
Term Case Study 271
DFI/5.31%, FF/6.63%, ITL/10.75%, Yen/3.85%.

Matures: 12-31-19
Country: MEXICO
Guarantor: None
Form: Registered bonds
Currency: US, C, DFL, DM, FFR, Y, LIR
Day Count: 30/360
Options: Callable on any
Issuer: Brazil Front Loaded Interest Reduction Bond (FLIRB)
Semiannual coupon. Year 1: 4%; Year 2-3: 4.5%; Year 4-5:
Coupon Desc:
5%; Year 6 and thereafter: 6 month Libor + 81.25 bps.
Matures: 04-15-09
Country: BRAZIL
Guarantor: None
Form: Registered and Bearer Notes
Issue Amount: 1,737.01 US (millions)
Currency: US
Day Count: 30/360
13 equal semiannual payments of 7.69% (starting on Apr 15,
Amortization:
2003)
Calculate the yield-to-maturity (YTM) and the duration for a time period t
…… ( t  [1;25] ) using the settlement dates and market prices from Table 1.
272 Debt management
Term Case Study 273
Sample calculation of single-factor regression of the dependence

of return on investment in DISC-BG (Y) on the return on investment
in DISC-ARG (X1) for 1999.
(13 observations, 12 iterations of return)
1 2 3 4 5 6 7 8 9 10
Observati Ri=Y Rm=X Ri- (Ri-Risr)^2 Rm- (Rm- (Ri-Risr) x  ^2
on Risr Rmsr Rmsr)^2 (Rm-Rmsr)
1 -0.02899 -0.03473 -0.04025 0.00162 -0.0411 0.00169 0.0016 -0.026 0.0007
2 0.02541 -0.00709 0.01415 0.00020 -0.0135 0.00018 -0.0001 0.018 0.0003
3 -0.04022 0.04182 -0.05148 0.00265 0.0353 0.00125 -0.0018 -0.063 0.0039
4 0.02214 0.02694 0.01088 0.00012 0.0205 0.00042 0.0002 0.004 0.0000
5 -0.04861 -0.08309 -0.05987 0.00358 -0.0895 0.00801 0.0053 -0.030 0.0009
6 0.03760 0.01077 0.02634 0.00069 0.0043 0.00002 0.0001 0.024 0.0006
7 0.01465 -0.06645 0.00339 0.00001 -0.0728 0.00531 -0.0002 0.027 0.0007
8 -0.02020 0.03746 -0.03146 0.00099 0.03103 0.00096 -0.0009 -0.041 0.0017
9 0.02020 0.04844 0.00894 0.00008 0.0420 0.00176 0.0003 -0.004 0.0000
10 0.07528 0.05949 0.06402 0.00410 0.0530 0.00282 0.00340 0.046 0.0021
11 0.05096 -0.00662 0.03970 0.00158 -0.0130 0.00017 -0.0005 0.043 0.0019
12 0.02688 0.05021 0.01562 0.00024 0.0437 0.00192 0.00068 0.001 0.0000
AVE/SU 0.01126 0.00643 0.01587 0.02452 0.00805 0.0132
M
Y  EY   Yi / N  0.011258 (average return of Y)
 2Y   Y  Y  / N  1 
2 0.001442 (variation of Yi)
 Y   2Y  0.037979 (standard deviation of Yi)
COVY.X   Y  Y X  X / N  1  0.000732 (co-variation (Yi,Xi))
b  COVY, X /  2X  0.328452 (beta coefficient)

 
a  Y  bX  0.009146 (alpha coefficient)
X  EX   X i / N  0.006429 (average return of X)
 2X   X  X  / N  1 
2 0.002229 (variation of Xi)
 X   2X  0.047217 (standard deviation of Xi)
r 2   2Y   2 /  2Y = 0.166748 (determination ratio)
r  r 2  COVY, X /  X  Y  0.408347 (correlation ratio)
2       / N  1  (variation of )
2 0.001202
274 Debt management

Y(DISC-BG) = 0,009146 + 0,0328452X(DISC-ARG)
Graphical representation of the regression line equation for the return

of an investment in DISK-BG and the return of an investment in Par-
ARG for 1999 (monthly observation)
Instructions for using the MS Excel add-in

Tools/Data Analysis/Regression
Term Case Study 275
276 Debt management
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284 Debt management
TABLE OF CONTENTS
Introduction 7
Chapter І. Introduction to the theory of deficit financing 11

1. General characteristics of deficit financing 11
2. Classical concepts of deficit financing 14
Chapter ІІ. The Keynesian theory of deficit financing 19

1. The research of J. M. Keynes 19
2. The contribution of A. Hansen 21
3. The approach of A. Lerner 22
Chapter ІІІ. Modern theories of the budget deficit 27

1. The theories of Tobin and Buchanan 27
2. The model for distribution of burden among overlapping
generations
29
3. Neo-classical concept 32
4. The Ricardo-Barro theorem 37
Chapter ІV. Theories for the strategic role of government debt 43

1. The theory of government policy in the conditions of unstable
temporal preferences
43
2. A positive theory of the fiscal deficit and government debt
48
286 Debt Management
3. A political model of the strategic role of debt 51

1. Public wealth 65
2. The club wealth theory 68
Chapter VI. The anatomy of the state redistribution effects 73

1. The technology of state redistribution impact 73
2. Budget balance and inter-generational redistributions 79
Chapter VII. Instruments for defining the status of the external 89

sector
1. Indices for defining the status of the external sector of the 89
economy
2. International currency balances – deficit and debt analysis tools 100
3. Analytical currency balances in terms of product 102
4. Analytical currency balances in terms of factor 104
5. Consequences of the deficits in the analytical currency balances 108
Chapter VIII. Macroeconomic analysis of the external deficit 115

financing
1. Reasons for deficit financing through external loans 115
2. Dimensions of debt dynamics and cycles 120
Chapter IX. Shadow economy and tax evasion 129

1. Shadow economy and tax evasion – definitions and forms of 129
manifestation
2. Aspects of taxation effects on the shadow economy 135
Chapter Х. Tax evasion and tax fraud concepts 141

1. Tax circumvention as a criminal activity 141
Contents 287
2. Models for optimal tax “circumvention” 144

3. Alternative tax “circumvention” and tax fraud concepts 148
Chapter ХІ. Measuring the shadow economy and tools for 161
counteracting it
1. Tools to counteract the “shadow” economy 161
2. Methods for measuring the shadow economy 162
Chapter ХІІ. Deficit financing in Bulgaria 173

1. Origination and development of the debt crisis in Bulgaria 173
2. Measuring and evaluation of deficits and indebtedness 179
3. Solutions to the deficit and debt problem 183
Chapter ХІІІ. The contemporary debt management paradigm 189

1. General characteristics of debt management 189
2. Contemporary solutions for the global debt crisis 194
3. Debt management policy objectives 200
Chapter ХІV. Investment analysis of debt instruments 223

1. Fundamental investment indices 223
2. Specialised indices for investment analysis of debt instruments 236
Conclusion 242
Term Case Study in “Debt management” 245
Bibliography 285
288 Debt Management
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Book · January 2012

Distance Learning View project

Human Capital Investment View project

The user has requested enhancement of the downloaded file.

ABAGAR Publishing House

Assoc. Prof. Andrey Zahariev, PhD – author

At the beginning of August 2011 the global financial system was

The application of deficit financing of government budgets leads to

macroeconomic effects, relationship with the shadow economy and

In order to prove these basic assumptions, we have to widen the

Chapter І. Introduction to the deficit financing theory

Chapter ІІ. The Keynesian theory of deficit financing

Chapter ІІІ. Modern theories regarding the budget deficit

Chapter ІV. Theories regarding the strategic role of government debt

Chapter V. The role of the state in the economy

Chapter VI. Anatomy of the state redistribution function

Chapter VIII. Macroeconomic analysis of external deficit financing

Chapter IX. The shadow economy and tax evasion

Chapter Х. Concepts of tax evasion and tax fraud

Chapter ХІІ. Deficit financing in Bulgaria

1. The origin and development of the debt crisis in Bulgaria

Chapter ХІІІ. The contemporary paradigm of debt management

Chapter ХІV. Investment analysis of debt instruments

Introduction to the chapter

The chapter includes two subtopics:

1. The general characteristics of deficit

 budget deficit structure;

The structure of the budget deficit is classified by four levels of

Another point of view to consider is when the budget deficit is

possibility, although this is practically very hard to achieve) equal to the

Despite the popular belief that debt is a governmental "problem",

The use of any of these instruments is in direct relation to the policy

2. Classical concepts of deficit financing

Smith is explicitly against the use of loans as a method of financing

Recommended additional sources:

Questions for self-evaluation and discussion

Introduction to the chapter

The chapter covers three topics:

Keynesianism still empowers government institutions with beneficial ideas

For Keynes, this is why the propensity to consume, the marginal

practical application in the late 20th century through the mechanisms of

interest accrued on these bonds will be returned to the fund owners as

unemployment, but never for both of them simultaneously. In cases of

In response to the arguments against debt financing of budget deficits,

Recommended additional sources:

Questions for self-evaluation and discussion

Introduction to the chapter

The chapter covers four topics:

1. The theories of Tobin and Buchanan

2. The model of burden distribution between

The overlapping-generations model includes precisely these three

The income generated by each representative of the three

The overlapping-generations model

1. Income generated $24,000 $24,000 $24,000

The results of the above model are:

The young generation of 2015 has a lifetime consumption stream

government’s debt policy. Most calculations using this framework suggest

3. The neo-classical concept

sector draws on the pool of resources available for investment, private

The crowding-out effect can be avoided via the external financing of

External funding and production capacity

In cases of loan-based financing, the members of future