Question

You are the chief fiscal officer for a municipality and have been directed by the mayor's office to lead government of a writing debt policy statement. You are aware of the risks borrowings money and the grave importance of strong internal control. what must be include in this policy if it is to be effective?

Answer 1

Meaning of Debt Policy

Debt Policy means written guidelines which directs laws of debt issue in a state/area or country. They are written to manage debt practices and debt limits, rules and regulations for debt practices. A debt policy should be a sound and perfect because it will affect the money supply in that particular area. Debt is a source of money for the lender, on which the lender pays interest. The continuity of interest payment and payment of debt on time is a must for the lender otherwise the debt would turn bad debt.

Reason for a Good Debt Policy:

Government use debt policy to either increase or decrease the flow of money in the economy. When government wants to increase the flow of money it would decrease the rates of borrowing and vice-versa. The flow of money is decreased during the inflation cycle in the economy because common people have already more money and more demand with them that ultimately give rise to more inflation and higher costs. Higher debt costs would contract the money from people's hands because borrowing would become costly. The government does opposite in the case of depression cycle of the economy it decreases the cost of debt/borrowing which results in more money with the people and more money in the economy.

Thus, the purpose of making a debt policy is to normalise the state of economy as well as control and manage the debt practices in the economy or a particular area.

Main Contents to be included in a Debt Policy:

1. Debt Limits: The maximum limit of debt to be taken should be mentioned in the policy. The debt practices can be prepared by state constitution or a local charter. There are different types of debts available like long term, variable, short term. The debt limits should include acceptable range for each sort of debt.

2. Debt Structuring Practices: There are a number of debt practices which should be included like the maximum term of the debt, use of variable/fixed rate debt, debt payment pattern and average maturity of debt.

3. Policy & methods for Issue of debt: The way of issue of debt should also be a part of debt policy. For example seeking the help of professionals, using credit rating for issuance of debt, criteria of sale of mortgaged assets of bad debts etc.

4.Policy for Managing debt: It means managing the issued debt. These practices may include investment of secured debt proceeds like bonds, laws for compliance etc.

5. Permission for the use of Derivatives: The policy should clearly state that the borrowers can use derivatives or not. However it is a separate practice, but if the policy has provisions for the use of derivatives then a policy for derivatives should be maintained separately.

Conclusion:

Summing up a debt policy, it only means a list of laws of debt that not only have sections for issue of debt but also have provisions for the best management practices & laws in it. The debt policy depends upon the state of the economy as well as the investment practices present in that particular economy. It should be made not only seeing the internal economic conditions but also the external conditions of the world so that the best practices can be obtained with best results.