Question

What do you understand by the term "Risk Free Interest Rate"? How do you rationalize this concept with phenomena characterized by the Government of Barbados’ debt restructuring in 2019?

Answer 1

Meaning and Definition

Risk-free rate refers to the yield on top-quality government stocks. It is often called the risk-free interest rate. The risk-free benchmark, for the majority of investors, is the US Treasury yield – other assets are measured against it. When an investment is risk-free, it means that the actual return that an investor obtains equals the expected return.
When investors purchase assets, they have returns that they expect to make over a year, six-months, or other time horizons.The actual returns they get during that time may not be the same as their expected returns – there is a ‘risk’ that they might not do as well as they expected.

In the world of finance and investments, risk is viewed in terms of how different actual returns are from expected returns. US Treasury bonds’ expected returns are always the same as their actual returns, hence they have a risk-free rate.

Risk-free rate vs. Other rates

When comparing risk-free with other types of investments (risky investments), you will see that they behave differently – their returns do not correlate in the market.

If we all accept that the first definition of a risk-free rate is that the investment has a guaranteed return, and a risky investment does not, this lack of correlation between the two types of investments will always exist.

“An investment that delivers the same return, no matter what the scenario, should be uncorrelated with risky investments with returns that vary across scenarios.”

The fiscal adjustment is proceeding as programmed, with the authorities targeting a 6 percent of GDP primary surplus for FY2019/20. Full year effects of reforms set in motion during FY2018/19, including the introduction of several new taxes (an airline travel fee, room levies, a new fuel tax, and a new health service contribution), are helping to achieve this target. A broadening of the base of the VAT and the land tax, implemented in March 2019 in the context of the FY2019/20 budget, are also supporting revenue. The budget approved for FY2019/20 provides a solid basis for the targeted fiscal consolidation.

Reducing transfers to SOEs is key for sustainable fiscal consolidation. At close to 8 percent of GDP in FY2017/18, transfers to SOEs had become a significant burden on the budget, and a major contributor to fiscal risks. Under the BERT program, grants to SOEs are targeted to decline to under 6 percent of GDP by FY 2021/22, by a combination of: (i) much stronger oversight of SOEs, supported by improved reporting and tighter control over SOE borrowing; (ii) cost reduction, including reduction of the wage bill; (iii) revenue enhancement, including an increase in user fees, combined with investments to improve services delivered by SOEs; and (iv) mergers and divestment.

Reducing transfers to SOEs is key for sustainable fiscal consolidation. At close to 8 percent of GDP in FY2017/18, transfers to SOEs had become a significant burden on the budget, and a major contributor to fiscal risks. Under the BERT program, grants to SOEs are targeted to decline to under 6 percent of GDP by FY 2021/22, by a combination of: (i) much stronger oversight of SOEs, supported by improved reporting and tighter control over SOE borrowing; (ii) cost reduction, including reduction of the wage bill; (iii) revenue enhancement, including an increase in user fees, combined with investments to improve services delivered by SOEs; and (iv) mergers and divestment.

Summary

The developments relate to two heavily-indebted emerging market countries moving in opposing directions:

Barbados appears to have reached agreement with its international creditors on debt restructuring and relief, including a 26.3% haircut.

Lebanon is facing political instability which threatens to undermine its currency peg and is pushing its debt to yield levels that appear to discount write-downs.