Derivatives and Public Debt Management BByy Gustavo PigaPiga Published in cooperation with the Council on Foreign Relations DERIVATIVES AND PUBLIC DEBT MANAGEMENT by Gustavo Piga Published in cooperation with the Council on Foreign Relations, New York DERIVATIVES AND PUBLIC DEBT MANAGEMENT Published by the International Securities Council on Foreign Relations Market Association (ISMA) in cooperation with Founded in 1921, the Council on Foreign the Council on Foreign Relations, this report has Relations is a nonpartisan membership been commissioned by ISMA with a view to organization, research center, and publisher. It contributing to public awareness of the manner is dedicated to increasing America's in which governments use derivative understanding of the world and contributing instruments to manage public debt. All ideas to US foreign policy. 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CONTENTS | 7 CONTENTS About the author 11 Editor’s introduction and summary of findings 13 Preface 17 Chapter 1: Derivatives and public debt management 23 1.1 Introduction 23 1.2 The optimal use of derivatives in public debt management 25 1.2.a Public debt management: theory and practice 25 1.2.b The use of derivatives in public debt management 29 1.3 The history of swaps in public debt management 38 1.3.a The wild ‘80s 38 1.3.b The grown-up ‘90s 41 1.4 The future of swaps in public debt management 44 1.4.a Strategic use of derivatives in domestic public debt management 44 1.4.b Trading use of derivatives in domestic public debt management 47 1.4.c Strategic use of derivatives in public foreign debt management 49 1.4.d Trading use of derivatives in public foreign debt management 52 Chapter 2: Counterpart risk management 55 2.1 Credit risk 55 2.2 Managing credit risk 58 2.2.a Notional amount of a contract and risk 58 2.2.b An ISDA Master Agreement 59 2.2.c Rating requirements 60 2.2.d Maximum exposure 63 2.2.e Exposure 66 2.2.f Netting 73 2.2.g Collateral agreements 74 2.2.h Prudent restrictions 77 2.2.i Managing counterpart risk: a comment 78 2.3 Managing counterpart risk: disclosure 81 2.3.a The role of disclosure 81 2.3.b Why is there so little disclosure on derivatives by public debt managers? 82 8 | DERIVATIVES AND PUBLIC DEBT MANAGEMENT 2.3.c The European Commission and the Bank for International Settlements Recommendations 85 2.3.d Disclosing quantitative information 86 2.3.e Disclosing qualitative information 88 2.3.f Credit-risk management 89 Chapter 3: The reform of the national accounting of ffinancialinancial derivatives and the role played by sovereign borrowers 95 3.1 Regulating the accounting of financial derivatives: An introduction to the controversy 95 3.1.a Ensuring stability in Europe 95 3.1.b The role of accounting in ensuring stability in Europe 96 3.2 The supply of regulation: The update of the 1993 System of National Accounts 99 3.2.a The setting 99 3.2.b The treatment of financial derivatives in national accounts 101 3.3 A tale of a controversial reform 105 3.3.a The rift 105 3.3.b Understanding the issues 109 Chapter 4: Accounting risk in government derivative use 117 4.1 Strategies to achieve window-dressing through derivatives 117 4.2 A true episode 123 4.2.a Setting the stage 123 4.2.b Standard active debt management with derivatives 124 4.2.c Using derivatives to window-dress public accounts 126 4.3 The need for a clear accounting framework 129 4.4 Solutions for eliminating ‘accounting risk’ 133 4.4.a A common framework 133 4.4.b A simple framework 134 Summary and conclusions 141 Appendix 147 Bibliography 149 TABLES AND FIGURES | 9 TABLES AND FIGURES Tables 1.1 Global over-the-counter derivatives markets 23 1.2 Derivatives by governments - Notionals outstanding 25 1.3 Effects of swap programs as of December 31, 1999 36 1.4 Sweden - Gross borrowing (SEK millions) 37 1.5 Sweden - Foreign exchange composition July 31, 2000 50 2.1 Counterparts and minimum accepted rating 60 2.2 Counterparts and maturity limits of the derivatives 61 2.3 Denmark - Share of notional by counterpart type 62 2.4 Canada - Share of notional by counterpart type 62 2.5 Counterparts and credit lines 63 2.6 Denmark - Allocation criteria for credit lines 64 2.7 BIS add-ons applied to the notional amount 67 2.8 Kingdom of Belgium - Assessment of exposure 68 2.9 Kingdom of Belgium - Add-ons 68 2.10 Counterparts and exposure calculations 69 2.11 Exchange rate and interest rate sensitivity of the Danish swap portfolio 69 2.12 Denmark - Derivative program 1999 71 2.13 Market value of swaps 72 2.14 Credit Support Annexes as of fall 2000 77 2.15 External limits on derivative transactions 79 3.1 Interest payments as a share of GDP in the EU 97 Figures 1.1 A typical sovereign borrower swap transaction 30 1.2 Ex ante comparative advantage for Denmark in the use of domestic IRSs 31 1.3 Sweden - Expected saving from IRS swaps vs T-bills 32 1.4 German swap spread / French swap spread 34 2.1 Kingdom of Belgium - Warning and blocking limits 65 4.1 A standard cross-currency swap by a sovereign borrower 125 4.2 A non-typical cross-currency swap by a sovereign borrower 127 10 | DERIVATIVES AND PUBLIC DEBT MANAGEMENT ABOUT THE AUTHOR | 11 ABOUT THE AUTHOR Gustavo Piga is Full Professor of Economics at the University of Macerata in Italy. He holds a Ph.D. in Economics from Columbia University, New York, where he also taught as a Visiting Professor in 1998. He has written extensively on public debt management and monetary policy issues. He has been a consultant to the International Monetary Fund (IMF) and the Italian Ministry of the Treasury on issues related to public debt management, and has been a visiting scholar at the IMF and an Adjunct Fellow at the Council on Foreign Relations. He regularly contributes articles on financial issues to Italian newspapers. He is Editor of the Rivista di Politica Economica, Associate Editor of Applied Economics and a member of the Scientific Committee of EuroMTS, the provider of electronic trading platforms used by many sovereign borrowers within the euro zone. 12 | DERIVATIVES AND PUBLIC DEBT MANAGEMENT All reasonable efforts have been made to ensure that the figures provided in this study accurately reflect the source material from which they derive. However, readers seeking to rely on and use these figures in preparing papers, reports etc. of their own are advised to check and obtain the original figures (and permission to use them) from the source. Web site addresses given in this report were active at the time of writing. However, as readers familiar with the internet will be aware, web addresses are open to change. EDITOR’S INTRODUCTION AND SUMMARY OF FINDINGS | 13 EDITOR’S INTRODUCTION AND much clearer international regulation and SUMMARY OF FINDINGS market standards, governments in less developed countries will eventually enter the market for the purpose of misleading foreign lenders and donors about the state of their finances. The International Monetary Fund and the World Bank should therefore pay particular As derivative products have proliferated attention to Piga’s analysis. and the markets have expanded, government calls for greater ‘transparency’ and diligence in * * * their use have grown commensurately. Even market events which have little to do with Piga begins by documenting the growing derivatives per se, such as the collapse of Long use of derivatives, primarily swaps, by sovereign Term Capital Management, evoke pious borrowers. What is driving this growth? As concerns from official circles over the lack of public debt expands, governments are naturally appropriate self-regulation and accountability in focusing more attention on the cost of raising the private sector. funds in the market.