Derivatives in Public Debt Management

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Derivatives in Public Debt Management GUSTAVO PIGA Director, Ph. D. in Money and Finance Dipartimento di Economia e Territorio, Università di Roma Tor Vergata gustavo.piga@uniroma2.it, www.

1 Derivatives in Public Debt Management GUSTAVO PIGA Director, Ph. D. in Money and Finance Dipartimento di Economia e Territorio, Università di Roma Tor Vergata gustavo.piga@uniroma2.it, Prepared for COMMITTEE ON ECONOMIC AFFAIRS AND DEVELOPMENT Over-indebtedness of States: a danger for democracy and human rights Meeting to be held in Paris (Council of Europe Office) Monday, 29 November 2010

2 A Premise I have stopped working on public debt management in Since then I have been working on public procurement economics. In recent months, after 9 years of silence, I have received as many phone calls (from journalists) as I have had in November 2001, asking for interviews on derivatives and (public debt management). The difference? This time I took up the phone. 2

In recent months, after 9 years of silence, I have received as many phone calls (from

3 A Caveat: Are Derivatives More Debt? No. They are a different type of debt. Often a better one. Yes. If derivatives are entered into to window-dress public accounts. P.S.: But why was there a need to window-dress? The fixation with non continuous preferences on public deficit and debt over GDP, a EU unicum. 3

If derivatives are entered into to window-dress public accounts. P.S.

4 My books conclusions, 10 years later The success and the future of EMU is, however, threatened not only by the persistence of high budgetary imbalances, but also by the lack of transparency with which the process of reduction in these imbalances is carried out. (Piga, 2001) 4

budgetary imbalances, but also by the lack of transparency with

5 More in detail... By closely examining derivative transactions by sovereign borrowers, this report has suggested that sufficient transparency in public accounts has not been achieved. In particular, we have shown with a true example in Chapter 4 how derivatives have been used by one large sovereign borrower to window-dress its public accounts. It is likely that this case is not an isolated episode and that some other sovereign borrowers have made use of derivatives to implement window-dressing strategies. 5

in public accounts has not been achieved.

6 Some thingsneverchange... The first deficiency has to do with the fact that disclosure regarding derivative activity by sovereign borrowers is extremely scarce, as explained in Chapter 2. In the absence of disclosure by debt offices, monitoring by government shareholders (i.e., the taxpayers) can only be weak at best, and this lack of disclosure makes debt offices less accountable. 6

sovereign borrowers is extremely scarce, as explained in Chapter 2.

7 And some do (2008) The second deficiency in reporting that has made window-dressing possible has to do with the lack of a proper framework to record derivative transactions in national accounting. This led us to suggest that the Maastricht Treaty might have an additional endogenous effect in the euro zone besides that of putting a ceiling on the government deficit: It might reduce the transparency of national statistics. 7

This led us to suggest that the Maastricht Treaty might have an additional endogenous effect in the euro

8 Whyshouldweworry(still)? There are several reasons to worry about this window-dressing activity through derivatives. First, 8

9 Whyshouldweworry(still)? Second, as most of these operations are carried out to postpone expenditure, the cash cost of these operations might fall on subsequent governments that were not in power at the time these operations were conducted. In turn, these subsequent governments might ask national accountants and supranational monitoring institutions to revise past national accounting figures to cancel the effects of these window-dressing operations. Therefore, these operations introduce political tensions. 9

subsequent governments that were not in power at the time these operations were conducted.

10 Whyshouldweworry(still)? Third, the issue of transparency in government operations is now a key part of the policies recommended by supranational institutions to governments. If these policies were perceived as such [ineffective], they would immediately lose credibility in such countries. And what about regulation of derivative use in the private sector? 10

policies recommended by supranational institutions to governments.

11 Whyshouldweworry(still)? Fourth, these operations have a negative impact on the nature of the relationship between governments and their (private) counterparts If a market maker has provided a government with advice on windowdressing, assistance with window-dressing operations or other inappropriate transactions, it implicates itself with the sovereign borrower. Both know something about the counterpart that might hurt them if this activity were to be made public. While it is obvious that it is in their mutual interest not to reveal such activities, there is also the possibility that one of the two parties might be able to exert undue pressure on the other in future transactions. 11

government with advice on windowdressing, assistance with window-dressing operations or other inappropriate transactions, it implicates itself with the sovereign borrower.

12 Whyshouldweworry(still)? Finally, window-dressing operations themselves will obviously come at a higher cost to the debt office and the taxpayer than a regular transaction. This is because the sovereign borrower will have to compensate the counterpart for exposing it to reputation risk. 12

higher cost to the debt office and the taxpayer than a regular

13 2001 The issue of window-dressing through derivatives is particularly important today in the European Union and especially within the euro zone. As long as accounting and deficit rules are to be disregarded (in substance if not in form), and as long as governments continue to ask important private financial institutions to keep private their knowledge of improper financial engineering, Europe s politicians will find it difficult to convince their electorates of the importance of greater European integration. 13

As long as accounting and deficit rules are to be disregarded (in substance if not in form), and as long as governments continue

14 Democracyand HumanRights? A government might find it more convenient to delay the stabilization program for political purposes while retaining the economic assistance of supranational institutions. A government could attempt to do so by window -dressing public accounts and presenting these accounts as genuine. If successful, a government would obtain essential resources from those supranational institutions and would benefit from the private capital inflows that usually accompany the economic assistance programs of supranational institutions. In turn, this would further postpone any real program of economic stabilization, providing undeserved support to an inefficient(and disingenuous) government. 14

A government could attempt to do so by window -dressing public accounts and presenting these accounts as genuine.

15 Neededin the EU? Reform Access to Statistics. Why still not possible? We have not seen the real documents, Walter Radermacher, head of the European Union s statistics agency Eurostat, said in a Sept. 2 interview in his Luxembourg office. (Bloomberg, September 8, 2010). Eurostat first requested the contracts in February. The European Central Bank refused to disclose internal documents showing how Greece used derivatives to hide its government debt because of the acute risk of roiling (sic) markets, President Jean-Claude Trichet said. (Bloomberg, November 5, 2010). The information contained in the two documents would undermine the public confidence as regards the effective conduct of economic policy, Trichet wrote in an Oct. 21 letter in which he rejected the appeal. Disclosure bears, in the current very vulnerable market environment, the substantial and acute risk of adding to volatility and instability. 15

The European Central Bank refused to disclose internal documents showing how Greece used derivatives to hide its government debt because of the acute risk of roiling (sic) markets, President

16 Neededin the EU? Reform Accountability of Regulators? Of Public Users? Forbidding derivatives for public local entitities. Publishing all transactions with slight delay (Denmark). Whistleblowing legislation? 16

Supplemental Unit 5: Fiscal Policy and Budget Deficits

1 Supplemental Unit 5: Fiscal Policy and Budget Deficits Fiscal and monetary policies are the two major tools available to policy makers to alter total demand, output, and employment. This feature will