AFTER FAILING TO abide by its own internal guidelines, sidestepping industry best practice, and ignoring internationally agreed standards, a one-time star borrower is brought low. Underlying this is a combination of highly structured financing – often suggested and effected by competing investment banks – and inconsistent accounting. This has disguised the true, excessive extent of the borrower's debt. All of the deals involved might have been legal, but their revelation has left investors shocked and out of pocket.
It sounds like the depressingly familiar tale of corporate accounting in the Enron era: but the sort of borrower we are talking about is a government not a corporate. And the governments involved are the very ones that have explicitly set themselves the task of borrowing responsibly – western Europe's EU members.
Governments have always been two-faced in these matters. They like to borrow and spend money liberally while maintaining a reputation for fiscal prudence. In Europe the combination of the recently reformed Stability and Growth Pact and an economic downturn that has made deficits worse has increased the pressure that governments are under.
Now, it is the administrations of Berlusconi, Blair, Chirac and Schröder, not corporates, that are stretching out along the razor's edge of what is acceptable in financing and accounting. It is finance ministers such as France's Breton, the UK's Brown, Germany's Eichel and Italy's Siniscalco, not CFOs, that are looking at ways to massage the books. And it is government borrowing officials, and the agencies that borrow for many governments, rather than corporate treasurers, that are having to come up with the trade ideas to achieve it.
"There is a huge amount of creativity going on right now," says an analyst at a European bank.
That raises the question: is there enough transparency? And is the entire European government bond market, totalling €2.94 trillion, trading on the basis of a misrepresentation of the true extent of government indebtedness?
Back to basics
There is a whole range of things governments are doing that investors and taxpayers should be paying more attention to. "You go from the basic tricks through to genuinely creative stuff like some of the pension transfers," says the analyst.
The basic tricks are truly basic. When the EU's statistical agency, Eurostat, announced revised figures for Greece's general government debt and deficit last year, one reason it increased the debt to 110% of GDP at the end of 2003 up from 103% was that Greece had been under-reporting military expenditure and over-estimating social security surpluses. It confirmed long-held suspicions, after a time when Greek government bond yields had all but converged with those of core European governments. "We've always known Greece was obligations as revenue. If a corporate tried using such gimmicks it might send a sell signal to sceptical investors who, post WorldCom and Parmalat, are increasingly vigilant. Have governments been getting away with tricks corporates no longer dare use?
"You have to think about government accounts as you think about corporate accounts," says Gary Jenkins, European head of credit research and fundamental strategy at Deutsche Bank. That means looking not just at the headline numbers but in some detail at the notes outlining what accounting techniques have been used to allow those numbers.
Of course, this is not entirely new. "In the 1990s, it was alleged that the French government took responsibility for funding France Telecom's pensions and pocketed the assets," says Stephen Yeo, senior consultant at pensions consultancy Watson Wyatt. "But by keeping them off balance sheet, France got a windfall gain. In accounting terms, that is absurd."
In 2003, Belgium assumed Belgacom's pension liabilities. Rather than transfer Belgacom's funded scheme, its assets were liquidated and paid to the government in cash. Although the government can use the cash to cut its debt, the unfunded pension liabilities are not incorporated under the Maastricht definition of general government debt. Hey presto! Without the deal, Belgium would have had a budget deficit in 2003. With it, it recorded a 0.2% surplus.
Belgacom's future pension liabilities are estimated at €5 billion, or 1.9% of GDP. That makes it the biggest one-off measure by any EU country relative to GDP. It's not just the Club Med countries (Greece, Italy, Spain and Portugal) that are testing the limits. "Belgium has been transparent and worked hard to bring its deficit down with surpluses," says Price. "To suddenly find them relying on one-off measures was a little bit sad." Investors should be on the look-out for more of this.
Growing pressure on governments to address the problem of unfunded pensions has resulted in similar deals elsewhere.
More systematically, many governments borrow large sums not in their own name but through state-supported or implicitly guaranteed vehicles. This is beyond accounting gimmickry, it's a bold-as-brass casting off of government liabilities. Germany's KfW is state-owned and state-guaranteed. "How that isn't on the German government's balance sheet I don't know," says a debt syndicate banker.
Off-balance-sheet transactions also include sovereign ABS deals. Italy has done a series of them, and even Germany is becoming increasingly active. Last year it securitized Russian bilateral debt receivables through the €5 billion Aries transaction. Sovereign ABS deals must be cleared by Eurostat, although sovereigns have jumped the gun by booking them as cutting Maastricht debt while waiting for a Eurostat ruling. Where they have succeeded in treating the proceeds of securitization as revenue and not borrowing, sovereigns have arguably got away with accounting sleight of hand that corporates today can only dream of using.
Some types of infrastructure finance create contingent liabilities that should appear in some form on a government balance sheet but don't always do so, because the borrower is a private contractor or an SPV. The most prominent examples are found under the UK's private finance initiative (PFI), which at March 1 this year had clocked up projects with a combined capital value of more than £34 billion ($61 billion) completed and operating. Several commentators reckon that the UK's off-balance-sheet liabilities under PFI and similar public-private partnerships are worth about £40 billion .
