Friday, February 19, 2010

The (2001) illustrated sovereign currency swap

Ta-dah — a theoretical sovereign currency swap purportedly presented to European officials in the early years of the new millennium. The diagram was drawn up in 2001 by Gustavo Piga, an Italian academic specialising in public debt and monetary policy issues. It’s part of a 150-page International Securities Market Association-commissioned report on derivatives and “public debt management.”

In the report, the author talks about the possible use of derivatives as window-dressing tools to help conceal public debt levels, at a time when Eurostat, the body charged with collating eurozone statistics, was drawing up its European System of Accounts (ESA 95).

Here’s what Piga says happened:

When the author, during a meeting, pointed out the transaction shown in Figure 4.2 to a European official who is supposed to monitor such transactions, the reaction the author received was indicative of the absence of firm national accounting principles over the use of derivatives by governments. The first thing this official said about this transaction was that “it is all right…We would not oppose it.” When the author explained his concern to the official, the latter recognized the problem but dismissed the need for action by saying that “for the time being we would not challenge such a transaction.” Shortly afterwards in this meeting he admitted that the problem was more serious than he first thought. He acknowledged that “we don’t have anything in ESA 95 to oppose it,” underlining the absence of a firm national accounting framework to deal with these window-dressing transactions. He concluded by opening the door to corrections in the system of national accounts by stating: “Today, it’s true. The door is open to such deals. It is worth examining whether ESA 95 should have a sentence to forbid this.”

Risk Magazine, first to report on the Greek swap issue, points out that Eurostat responded with “not, perhaps, the reaction Piga had expected.” Instead of forbidding the deals, the organisation decided to allow the swaps in ESA 95, even providing a theoretical example of how a swap-induced decline in a government’s debt could be worked out in official statistics, according to Risk.

It wasn’t until 2008, when Eurostat published updated guidance on the use of derivatives, that such window-dressing currency swaps became “impossible”, Risk says. Previous Eurostat guidance, as reported by the Wall Street Journal, had suggested that Eurostat had decided to value outstanding foreign currency-denominated debt using market exchange rates — not at swap-agreed rates.

The point, though, is that Eurostat had ample opportunity to catch these things.

It wasn’t until Greek debt became a `problem,’ that currency swap arrangements concealing debt levels, really became a problem for Eurostat.

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