Reducing the Cost of Government Debt: The Italian Experience and the Role of Indexed Bonds

Summary II The pricing of government debt in a number of financial markets is analyzed to see how high-debt countries should manage their liabilities. We focus on the Italian experience and also consider whether indexed bonds can reduce the cost of funding the public deficit. In particular, we attempt to quantify the risk premia that investors require on different forms of government debt. Our approach is market oriented, based on government debt prices observed in the market place. Due to practical considerations, the nature of our analysis is partial equilibrium, rather than general equilibrium. We try to understand how investors price treasury securities and attempt to measure risk premia due to inflation and real interest rates on various forms of debt. Our findings suggest that a government can reduce the cost of debt by increasing its market depth and liquidity and by avoiding financial innovations as a debt management policy. Finally, our analysis suggests that real indexed bonds can reduce the cost of debt, but that the savings for a government can be seriously misjudged by an overly simple analysis.