Plugging the holes in the sovereign balance sheet

No longer dull, back-room bureaucrats, government debt managers have come out of the dark in the past decade, becoming synonymous with innovation and fancy financial footwork. Securitisations, derivatives, one-shot asset sales, delayed payments, shifting paydays and delayed tax refunds are now everyday tools of the trade in government balance sheet management. But do tighter scrutiny and shrinking asset pools spell the end of the affair with financial gimmickry?

Creative debt management is being driven by overarching political objectives as well as the need to fix gaping holes in domestic balance sheets. In Europe, strategies have been shaped by monetary union and the need to comply with the Maastricht criteria on public deficits and debt. At a sub-national level, US states and European municipalities have fashioned debt policies to fit national ‘balanced-budget’ rules.

“Stagnant growth and ballooning deficits and debts have compounded regulatory changes and constraints, driving government debt and issuance strategies. Governments across Europe have had to become far more proactive in managing their balance sheets,” says Cesare Roselli, executive director on the sovereign desk at Morgan Stanley.

Italy opts for securitisation

One consequence of Italy’s 2005 government debt ratio of 108.5% of gross domestic product (GDP) – not even close to the 60% Maastricht rule – has been its enthusiastic embrace of securitisation techniques.

According to rating agency Standard & Poor’s, overall the Italian government has raised almost €50bn in 17 publicly rated transactions since 1999, and the Istituto Nazionale della Previdenza Sociale has raised more than €15.9bn by securitising delinquent social security contributions. Portugal has also securitised delinquent tax receipts in a bid to bring its budget deficit below the limits set by the European Union (EU) stability and growth pact, selling them at a massive discount to Citigroup. Meanwhile, Germany’s stubbornly high government deficits have also forced it to find non-debt ways to finance its debt. In two transactions last year, it securitised Russia’s Paris Club Debt and the contributions towards pensions of formerly state-owned companies.

“There has clearly been a growing trend towards the use of securitisation technology by European sovereigns responding to a range of developments. We saw increasing activity in line with the run-up to European monetary union, again with the allocation of UMTS [3G] licences, and more recently when the cyclical downturn increased headline deficits,” says Mr Roselli.

Derivatives and structured products are also now common features of debt management office (DMO) strategies. Instruments such as constant maturity swaps enable governments to better manage liabilities because the floating interest rate portion is reset periodically, according to a fixed maturity market rate of a product with a duration extending beyond that of the swap’s reset period. This enables the borrower to realise some form of arbitrage with their usual cost of borrowing.

Growing use by governments has taken the structured note market to a new level, says Mr Roselli. Traditionally the territory of supranationals and agencies, the market has been confined largely to small deals of between €50m-€200m, but Mr Roselli, whose bank led a deal for the Hellenic Republic in April, says that the sovereign participation is changing that.

“This year has seen much stronger sovereign involvement, which has really deepened liquidity. Italy in particular has pushed the market forward with its recent offering of a E2bn structured transaction in a syndicated format, and has already increased the deal,” he says.

Product sophistication is matched by opportunism: governments are quick to exploit any chance to minimise the cost of debt. In Q1 this year, there was a wave of issues as sovereigns sought to take advantage of historically low interest rates. Spain and France, for example, issued 35-year and 50-year notes, respectively. By August this year, the issuance of 30-year debt had exceeded total issuance in 2004.

“DMOs are managing their outstanding debt more actively than ever before,” says Zia Huque, global head of syndicate at Deutsche Bank. “They will use whatever tool is available to save public money – and there are more financial tools available than ever before. In Q1, low interest rates met an extraordinarily tight credit environment that offered sovereigns a compelling reason to term out their funding, so many took advantage of it.”

Pension reform and government pressure have combined to support the trend towards longer maturities. “As governments, via regulators, require pension funds to match their assets and liabilities more effectively, so governments are stepping in to sate the growing institutional appetite for long-dated paper,” says Mr Huque.

Shifting debt

As governments come under greater pressure to cut both costs and spending, more and more responsibility is being pushed down to the sub-sovereign level, to quasi-government bodies, municipalities and regional governments. Government-owned entities and their debt are being deconsolidated; proponents say it will improve performance, others argue it is a debt-cutting device.

In Italy, for example, state-owned bank Cassa Depositi e Prestiti (CDP) was part-privatised. This re-classified the bank outside of general government status and in doing so, reduced government debt by about €11.6bn, plus a further €1bn from the sale of 30% of the government’s stake in the transformed company to private banking foundations.

CDP is also being used as a vehicle to offload government expenditure. For example, a multi-year $20bn covered bonds programme is under way and the proceeds could be used to purchase state assets, so helping the government’s privatisation programme. This year’s budget states CDP will advance up to €2bn to unpaid state suppliers, which the state ‘may’ reimburse within a 15-year period, that it will grant up to €1.4bn to the state against further sales of real estate assets and that it will extend loans up to €6bn to corporations, in line with criteria set out by Italy’s ministry of economy and finance.

CDP is therefore fulfilling some of the roles of central government, but as it no longer comes under the general government definition, the consequent liabilities and spending commitments do not count towards the government’s budget deficit or its debt burden.

The German government, aside from its securitisation programme, has been working to quell the rise in its debt ratio. It has been selling share-holdings in what were government-owned companies such as Deutsche Telekom via KfW, a state-owned development organisation whose liabilities and commitments are not consolidated with government figures. “KfW raises money in the capital markets to buy the shares from the Federal government and, while it sells off the shares over time, there is clearly an element of frontloading to these transactions that has an ‘optical effect’ on government finances,” says Moritz Kraemer, sovereign analyst at Standard & Poor’s.

In Europe and the US, there has been a more direct transfer of financing responsibilities from central governments to local governments and municipalities, for projects in infrastructure and healthcare.

“Entities that benefit from funding are increasingly being made to take the responsibility for raising the funding and managing the debt,” says Charlie Berman, co-head of European fixed income capital markets at Citigroup. “In France, CADES, which began as a vehicle specifically designed to amortise social debt, and with a medium time life-span, has been transformed into a dynamic borrower with an open-ended life, issuing 30-year bonds and inflation-linked securities.”

Risk sharing and transparency

Underlying all these trends is the move towards the sharing of risk and reward between the public and private sectors, says Jeff Diehl, head of public sector origination at HSBC. Western governments are increasingly employing the sorts of project finance technology used in the developing world. The structures typically put in place for a pipeline project in Africa, for example, are now being employed to raise funds for the London Underground under the banner of public-private partnerships.

Jeff Diehl, HSBC

“Infrastructure and other costs are very ‘chunky’ expenses – and the payback is often not until the back-end of the project, a long way down the line. Governments therefore see a lot of sense in sharing the risk and the expense,” says Mr Diehl.

While some argue that devolving funding responsibility and debt management is a cynical ploy to massage the figures, others counter that some such changes also increase the transparency of government finances. “In France, social security deficits have been transferred to CADES (the Social Security Debt Repayment Fund) to ensure transparency. The size of the liability is known, and the French public and investors can clearly see how the tax that they pay to CADES is contributing to the reduction of that liability,” says Michael Ny, director at Credit Suisse First Boston.

The pressures of deficits and regulatory change are not the only things driving the transformation of sovereign balance sheet management. The push towards open government, combined with access to information and financial technology, means that governments are working in different ways, says Mr Ny. “The move from cash to accrual accounting over the past decade or so means that governments now have more information about the composition of their balance sheet, and the risks that the balance sheet is facing. This enables them to be more proactive managers, using a broad range of financial tools to manage those risks.”

Michael Ny, CSFB

This is government financiers behaving like chief financial officers. Says Mr Ny: “In New Zealand, for example, government departments are no longer run by ‘departmental heads’. Instead, the head of the department is a CEO, running the department using private sector principles, with multi-year budget and capital plans, GAAP (Generally Accepted Accounting Principles) balance sheets, and full responsibility and accountability for delivering services.” Privatisation of the DMO The creation in 2000 of the Bundesrepublik Deutschland-Finanzagentur GmbH in Germany is a clear illustration of this trend. Set up as a private company, but under the control of the German ministry of finance, the Finanzagentur can hire at the market rate and has built up specialist expertise that serves as a kind of think-tank to advise the ministry on restructuring Germany’s €900bn debt.

It translates the ministry’s decisions into capital markets deals and its express purpose is to compete effectively in international capital markets and thus cut debt management costs. The ministry is responsible for non-budget funding, including off-balance sheet transactions such as the Paris Club Debt securitisation.

Finanzagentur managing director Gerhard Schleif says its mission is to manage public debt using all market segments and instruments. When the Bundesbank was involved in Germany’s debt management process, it used to avoid the money markets because it feared a conflict of interest with its activities as the central bank; Germany therefore relied heavily on medium to long-term funding and had very little short-term debt.

“We are now very active in the money markets, which has enabled us to reduce our funding costs. We have a limit of about €25bn for overnight funding and are using our asset portfolio of €20-€30bn to participate in the repo market. We are also setting up lending facilities for bund paper and are active in the Eonia (Euro OverNight Index Average) swaps market, where we hedge our short-term market risk,” says Mr Schleif.

End of an era?

Whether one believes that governments have employed clever financial technology and one-off use of public assets to avoid more painful structural change, or that these merely represent a sophisticated asset-liability management culture at government level, is the era of sovereign financial gimmickry over? Even Italy, the most enthusiastic proponent of securitisation and deconsolidation, has stated that it aims to phase out one-off measures for deficit reduction purposes by 2006.

Standard & Poor’s Mr Kraemer believes the trend is at least slowing. “We have seen the peak of fiscal massaging,” he says. “First, Eurostat, the organisation responsible for monitoring European government accounting, is increasingly stringent about what can be taken off the balance sheet. Second, a lot of the highest quality assets have already been sold off, so it will anyway become more and more difficult for some governments to use securitisation as a financing tool.

“Last, governments have been given more ‘wiggle’ room. The loosening of the stability pact rules to allow more time to bring deficits back into line takes a lot of the pressure off governments to employ such innovative techniques.”