How can a government manage liquidity risk effectively?

A government can manage liquidity risk effectively by ensuring significant cash reserves. Maintaining cash reserves allows the government to meet its short-term obligations and unexpected expenses without having to liquidate longer-term investments at potentially unfavorable prices. This approach provides a safety net, ensuring that funds are available to navigate fluctuations in cash flows, especially during economic downturns or when revenue is lower than anticipated.

While long-term assets can provide returns over time, they may not be easily converted to cash without incurring losses, which does not help in liquidity risk management. Investing solely in long-term assets can create vulnerabilities if immediate cash is needed.

Diversifying the portfolio can help in managing overall investment risk and providing more stable returns, but it does not directly address the need for readily available cash.

Issuing short-term debt regularly can provide liquidity; however, it also introduces additional risks and obligations that may not be sustainable in the long run, especially if the government faces difficulties in refinancing or if interest rates rise.

In summary, ensuring significant cash reserves is a fundamental strategy for managing liquidity risk, as it directly prepares the government to handle immediate financial needs effectively.