As noted previously on FT Alphaville, Greece’s newly-controversial currency-swap is by no means a new story: Risk magazine covered the deal as far back as 2003.
That European Union authorities have only now requested information about the deal presumably tells us more about the inner workings of Brussels than it does about Greek finances.
Indeed, Finance Minister George Papaconstantinou was quick to point out there was nothing untoward or illegal about a sovereign government taking out an exotic financial instrument with a Wall Street counterparty, especially not back in the heady days of 2002.
In fact, the practice was so prevalent that Standard & Poor’s covered the issue in a note — published in 2002 — entitled “Accounting for Innovation: Treatment of Off-Balance-Sheet Public Sector Financing Operations”.
As they rather presciently observed, “efficient” accounting was just as much the norm on a government level as it was a corporate one back then (our emphasis throughout):
As a result of recent corporate credit quality problems, the scrutiny of accounting policy and practices among listed companies has become acute.
Similar issues, albeit on a much more modest scale, have also started to emerge regarding some governments’ accounting procedures. Trying to take advantage of the leeway that public accounting rules allow is a legitimate objective. Governments facing strong pressures to reduce or contain public sector borrowing requirements will be particularly inclined to use all the freedoms that accounting rules permit.
Although this is not a uniquely European phenomenon, the Maastricht criteria on debt and deficits have galvanized many European governments to embark on more innovative approaches to bring deficit and debt levels below the critical levels.
Although public accounts provide fewer opportunities to choose accounting techniques than in the corporate sector, a gamut of innovative financial operations has sprung up over recent years, which appears to be increasingly important for public sector funding. Just as corporations use an array of admissible (and sometimes inadmissible) accounting measures to improve and smooth reported earnings to appease shareholders, governments increasingly care about constant, if gradual, improvement of reported fiscal performance.
And here, according to S&P, are the most common ways that governments went about smoothing out their revenue streams:
If innovative operations were to impact future fiscal flexibility in a more substantial way than in the past, ratings implications would be possible. To date, however, Standard & Poor’s has not revised its ratings or outlook on any central, regional, or local government solely on the basis of these transactions. The transactions covered in this report are:
· Securitization of future public sector receipts;
· Swaps that have borrowing characteristics;
· Private financing initiatives, through which public investment and operating expenditures are contracted out; and
· The creation of public nonconsolidated borrowing institutions.Governments can derive various benefits from these techniques. In particular, smoothing revenue streams can improve the public authority planning and spending process. As will be argued below, the availability of the transactions mentioned above can, if only in the short term, enhance fiscal flexibility, providing more opportunities to actively manage cash flows.
Structured transactions can attract new investors who were not previously direct investors in government debt, and cost efficiency could improve where private sector management leads to better public service delivery. At the same time, however, shifting debt from the government’s balance sheet in these ways can just as easily indicate fiscal pressure.
And on swaps in particular:
Debt management practices of public entities have become increasingly sophisticated. This is true not only of sovereign issuers, but also of many local and regional governments. Highly skilled finance professionals now typically staff debt management offices and operate with a clear mandate to minimize risk-adjusted borrowing cost.
Although this process is in no way limited to Western Europe, the advent of the euro, with its wider market for euro-denominated products, has accelerated an existing trend. Swaps have become a common feature of highly developed debt strategies, for example to increase liquidity in public issues or manage currency and interest-rate risks. In the overwhelming majority of cases, swaps are used as hedging instruments that should not put fiscal flexibility at risk.
Partly as a result of using swaps, however, debt managers have often been successful in reducing the average cost of government borrowing and smoothing interest payments and amortization schedules, thereby contributing to fiscal improvements. Swaps have many purposes, which can range from the straightforward to the very complex.
Uneven transparency in reporting information on government use of derivative instruments provides debt managers and politicians with an opportunity to actively manage their headline budget performance. Such operations include zero-coupon swaps without applying accrual accounting.
This swap will eliminate any interest obligations until maturity, when all accrued interest will be paid out at once. Another form of off-market-rate transaction occurs when a public debt manager enters a domestic interest rate swap, receiving fixed but paying floating rates, and requesting that a fixed payment be lower than the rate available in the swap rate at the time.
As this swap has a negative value for the public borrower, compensation will consist in an upfront payment from the swap counterpart. This operation, if not amortized over the life span of the swap contract, could undermine the accruals principle of recording financing costs. In effect, both described transactions constitute only borrowing: the public debtor receives a positive cash flow today at the cost of higher outlays in the future.
The key takeaway from S&P’s report being:
The effect on fiscal flexibility is clear: an immediately improved liquidity position is traded for higher inflexibility in the future. Recorded headline debt ratios decline today if the “borrowing component” of the off-market swaps is not recorded as debt and used to reduce current explicit borrowing.
Fundamentally, nothing has changed, however. Whether or not the implicit (or “camouflaged”) borrowing via derivatives is included in official debt statistics, it is real and needs to be serviced during the remainder of the derivative contract. This sort of window-dressing has no impact on underlying fiscal flexibility. There remains the risk, however, that the short-term liquidity relief afforded by the implicit borrowing could hamper government resolve to implement structural reforms that put public finances on a more solid and permanent footing.
In sum, de facto borrowing swaps do not have a positive impact on fiscal flexibility. If anything, they help to undermine transparency and, therefore, jeopardize trust in official accounting. Where uncertainty about the effective debt exposure of a government increases, an additional risk spread on the concerned issuer’s securities might be demanded by investors, thereby potentially defeating even the intended short-term purpose of improving the cash flow.
Absolutely nothing that Brussels should have been worrying about nearly a decade ago, then…
Non European-Union authority types can peruse the full note in the Long Room. European Union types should, frankly, have read it eight years ago.
Related links:
Greece v everyone, Eurostat and currency swaps edition [UPDATED] - FT Alphaville
The Greeks’ swap probe – FT Alphaville
Greece’s personal wealth comedy – FT Alphaville