The Greek Job
By Satyajit Das
The reaction is reminiscent of Captain Renault (played by Claude Rains) in Casablanca: “I am shocked, shocked to find that gambling is going on in here.“
Use of derivatives to disguise debt and arbitrage regulations and accounting rules is not new. In the 1990s, Japanese companies and investors pioneered the use of derivatives to hide losses – a practice called “tobashi” (from the Japanese, tobasu, the verb, means “to make fly away“).
Derivatives, such as interest rate and currency swaps, are used to alter the nature and currency of the cash flows on existing assets or liabilities. Transactions entail exchanges of one stream of payments for another. At the commencement of the transaction, if the contract is priced at current market rates, then the current (present) vale of the two sets of cash flows should be equal (ignoring any profit). The contract has “zero” value – in effect, no payment is required between the parties.
Using artificial “off-market” interest or currency rates, it is possible to create differences in value between payments and receipts. If the value of future payments is higher than future receipts, then one party receives an up-front payment reflecting the now positive value of the contract. In effect, the participant receives a payment today that is repaid by the higher than market payments in the future – identical to the characteristics of a loan. Any number of strategies involving combinations of different derivatives can achieve this effect.
Greece may be merely following the precedent of another Club Med member. In 2001, academic Gustavo Piga identified the case of an unnamed European country, that everyone assumed was Italy, using derivatives to provide window dressing to meet its obligations under the European Union (EU) Maastricht treaty. There were accusations and counter accusations. The report vanished from the International Securities Market Association (ISMA) web site.
It was alleged that in December 1996, Italy used a currency swap against an existing Yen 200 billion bond ($1.6 billion) to lock in profits from the depreciation of the Yen. The swap was done at off-market rates. Italy set the exchange rate for the swap at the May 1995 level rather than the rate at the time of entering the contract.
Under the swap, Italy paid a rate of dollar LIBOR minus 16.77% reflecting the large foreign exchange gain built into the contract for the counterparty. Given that LIBOR rates were around 5.00%, the interest rate paid by Italy was negative. In effect, the swap was really a loan where Italy had accepted an off-market unfavourable exchange rate and received cash in return.
The payments were used to reduce Italy’s deficit helping it meet the budget deficit targets of less than 3% of GDP (gross domestic product). Between 1996 and 1997, Italy had cut its budget deficit from 6.7% to 2.7% to meet the EU target. The suspicion was that, well, it hadn’t exactly cut the deficit but, among other things, it had used derivatives to provide window dressing.
There were suspicions that other EU countries also used similar structures to fiddle their books to meet the Maastricht criteria.
The Greek transactions are believed to be similar cross-currency swaps linked to the country’s foreign currency debt, structured with off-market rates. The swaps are believed to have notional principal of approximately $10 billion with maturities between 15 and 20 years.
Other financial products can also be used to reduce the level of reported debt. These include securitisation of future public sector receipts, the use of non-consolidated borrowing institutions, private-public financing arrangement supported indirectly by the State and leasing rather than direct ownership of assets. Greece may have also used some of these arrangements.
Although no illegality is involved, the arrangements raise important questions about public finances and financial products.
The episodes raise questions of the skills of regulators and reporting agencies in understanding and dealing with financial structures. They highlight inadequacies of public accounting.
Reported debt statistics fail to provide adequate information of the level of borrowing, the real cost of debt and also the future repayment commitments. Under international standards, such an off-market swap would have had to be accounted for by public corporations on a mark-to-market requiring greater disclosure of the details, especially the large negative market value (representing future payment obligations) as a future liability.
For example, the real effect of the Greek transaction is not clear. Analysts suggest that the cash received from the transactions may have reduced the country’s debt/GDP ratio from 107% in 2001 to 104.9% in 2002 and lowered interest payments from 7.4% in 2001 to 6.4% in 2002. However, the large negative market value of the currency swaps (representing future payment obligations) does not appear to have been reported as a future liability for Greece.
Such arrangements provide funding for the sovereign borrower at significantly higher cost than traditional debt. For example, in the Greek swaps, these costs include charges for counterparty credit risk in the swap and hedging costs for the interest rate and currency risk. In addition, the cash bears a higher rate than the normal credit margin on the sovereign’s debt. In part, this reflects the premium for an illiquid loan compared to a more liquid, tradable conventional bond.
The true cost to the borrower and profit to the counterparty is also not known, due to the absence of any requirement for detailed disclosure in derivative transactions.
Derivative professionals argue that derivatives are used to hedge and manage risk. While they do play this role, derivatives are now used extensively to circumvent investment restrictions, accounting rules, securities and tax legislation.
Current proposals to regulate derivatives do not focus on this issue. The policy case for permitting applications of derivatives is not clear.
As the Greek Job highlights, simple borrowing and lending can be readily disguised using derivatives exacerbating risks and reducing market transparency. Regulators need to heed Francois de La Rochefoucauld’s warning: “We are so accustomed to disguise ourselves to others that in the end we become disguised to ourselves.“
An earlier version was published in the Financial Times, London.