Remember the good old debt shenanigans? Where soon-to-be eurozone countries did everything they could to bring their debt figures down?
Every so often you’d read a story about a clever bit of financial engineering like an off-market swap that looked like debt, smelled like debt, and seemingly wasn’t reported to European statistical agency Eurostat as debt. Even though it should have been.
What is government debt, exactly? When you look at a chart like the below, what do you think is included in the numerator?
“Government debt” often just means the face value of the debt, where that corresponds to the principal payment made at maturity. Interest payments may, or may not, be accounted for. Also discounting is rarely done. In other words, such debt figures are gross simplifications that don’t take account of the characteristics of a sovereign’s debt or its maturity profile.
This often leads to misleading comparisons and can incentivise a sovereign to manipulate their debt stock data, as a recently released NBER working paper by Daniel A. Dias, Christine J. Richmond, and Mark L.J. Wright, points out.
Zero-coupon bond issuance can make the debt statistics look particularly unfavourable, even while the burden may be more sustainable in the absence of coupon payments. By contrast, the higher the coupon, the better the optics potentially get. Italy, case in point (emphasis ours):
Perhaps the best known example of these comes from Italy, which reduced the contractual face value of the stock of government debt by 1.9 percentage points of GDP in 2002 when Italy was close to the Maastricht debt threshold. In this example, the Italian Treasury with the Banca d’Italia bought back long-term bonds with a low coupon in exchange for a smaller amount of bonds with a much higher coupon.
In order to level the playing field, the researchers suggest a measurement called the “zero-coupon equivalent face value” that treats all cashflows as principal.
Another possibility would be to discount the debt in order to respect the maturity profile, but then..
..the appropriate discount rate will vary according to the purpose for which the data will be used; appropriate discount factors will vary over time, across countries and possibly also over contracts; and, the absence of market prices for all but a small subset of sovereign debts.
Ah, nevermind.
Collective action clauses: get out the vote!
This isn’t just about reported statistics though, as collective action clauses also have a tendency to link voting rights to principal values. (Emphasis ours)
Since 2003, sovereign bonds issued under New York law have included collective action clauses which specify the conditions under which the terms of the bond may be changed. As one example of such a clause, Brazil’s 10.25% Global BRL Bonds due in 2028 12 specifies that “the holders of not less than 85% (in the case of Collective Action Securities designated “Type A” or having no designation as to “Type”) or 75% (in the case of Collective Action Securities designated “Type B”) in aggregate principal amount of the outstanding debt securities of that series, voting at a meeting or by written consent, must consent to any amendment, modification, change or waiver with respect to”[emphasis added], amongst other things, repayment terms. That is, voting rights in the event of a restructuring are allocated in proportion to a debt’s contractual face value.
And meanwhile over in Europe..
…the Eurogroup statement of November 28, 2010 (Eurogroup 2010) commits its members to introduce, starting in 2013, “aggregation clauses allowing all debt securities issued by a Member State to be considered together in negotiations” [emphasis added]. Proposals to introduce similar aggregation clauses in non-Euro-area sovereign bonds have also been discussed in policy circles (IMF, 2002). Interpreting this policy broadly, future debt restructuring negotiations would then involve negotiations across a very diverse set of debt instruments including potentially debts issued by both official and private sector creditors, banks and bondholders, issued at different maturities and in different currencies under different governing laws. As a result of this diversity, shares of outstanding principal are unlikely to be representative of the relative financial exposure of different creditors. Moreover, it is conceivable that a desire to maximize voting power in the event of a restructuring might influence the form of debt instrument desired by creditors.
In other words, if you want a say at the restructuring table, you better not be holding high coupon bonds as the principal may be relatively low. Furthermore, across from you at the negotiating table are going to be the likes of supranational organisations with debt that’s high principal, low interest (as in lower than the market rate), not to mention the zero-coupon bond holders.
Go, Gadget, go!
Back for a moment to the more usual debt-hiding shenanigans. Consider public-private partnerships. These are especially handy when a country wants to invest in infrastructure but doesn’t want to increase borrowings. Rather just contract a company to do the work and promise to pay them later. At some point. Down the line.
So what to do then if you want to get a picture of a country’s actual debt profile? For a start you could look at the maturity profile (courtesy of Deutsche Bank, from their very handy and mega-charty sovereign risk monitor):
Or principal and interest payments broken out:
After that you could analyse any bank loans and funds supplied by supranationals, and look at their maturity profiles too. Then hire a private eye auditor to go sleuthing around for any interesting swaps, bits of financial engineering (no, not that one), and public private partnerships. And that’s no even starting with the unknown knowns or unknown unknowns.
Failing that, the next time you see a “government debt” figure, eye it suspiciously. Go on.
Related link:
EU states accused of ‘hiding’ deficits – FT (2005)