Commentary
The derivative and the state: a relationship of paradoxes
Without the power to set interest rates and influence the market, national governments have used derivatives contracts to create budget stability. But it’s a solution worse than the problem.
Financial derivatives are emblematic of the present condition of some countries. Indeed, they perfectly render the inversion between the political power and finance.
In this regard, the Italian case is typical. In our country, the adventure began in 1985 (under the Craxi government), with the financial law that allowed the minister of economy to stipulate derivative contracts. Four years earlier, the famous “divorce” between the economics minister and the Bank of Italy had taken place, a key event in the history of the country, on which the future of the public debt would depend. In 13 years, from 1981 to 1994, the debt-to-GDP ratio rose from 57.7 percent to 120 percent.
No longer protected by the central bank, the debt exploded because of the rise in interest rates, decided solely by the market. But what is the relationship between the divorce and the derivatives? Simple: the latter were conceived as a (partial) remedy for the damage caused by the minister of economy. In order to understand this statement, we need to clarify, what we mean by “derivative contract.”
Generally, a derivatives contract’s value “derives” from the performance of an asset or enterprise. For example, John undertakes to deliver to Jerry 100 kilos of wine in six months at today’s price. If the price of wine falls after six months, John will have benefited because he already sold the wine at a higher price. If the price increases, Jerry wins.
From this perspective, there is always a bet (or prediction). Whether it is wine, oil or interest (or exchange) rates, the philosophy is the same. If a state fears an increase in interest rates on its debt securities, for example, it may enter into a derivative contract to block them from the one recorded at the time of their issue. A bargain, one would say.
In reality, these contracts conceal a pitfall linked to the expectation of the other party. It is not by chance that they are called “interest rate swaps.” There is an exchange (swap) for a period equal to that of the issued security; one party (the state) undertakes to pay a flow of interest calculated on a fixed rate, while the other (a bank), a flow calculated on a variable rate.
Conclusion: If the rate decided by the (variable) market is lower than the fixed rate provided in the contract, the state will have lost out.
This risk is also inherent in derivative contracts entered into on fixed-rate issues, aimed at lengthening the average life of a debt (swap duration), avoiding that at maturity the new issues deal with rates that have risen in the meantime. Every three months, the Italian Bank publishes a table showing the numbers of these contracts, under the item “derivatives portfolio.”
For the first quarter of 2018, their notional value was €124 billion and €682 million (the portion of debt “insured” with derivatives), out of a total of €1.94 trillion and €524 million in government securities issued (6.43 percent). However, notional value does not mean market value: that is, the value on which the policyholder’s profit or loss actually depends.
In recent years something has changed in the market. For example, there was a significant decline in interest rates following the launch of the European Central Bank’s government bond purchase program.
What is the differential between the fixed rate provided for these contracts and the real, market rate? The doubt is that in the game of quantitative easing there is an ambivalent result: on the one hand the state has gained ( less onerous debt service, overall), and on the other hand it has lost (on the derivatives it pays higher interests than the real ones).
Paradoxically, the surge in the spread of recent days is a breath of fresh air for derivative contracts. However, it is a pity that it penalizes us for everything else, from the growth of the interests to the distrust of the markets.
Other doubts remain. Italy’s debt has increased by €700 billion over 10 years. Over the same period, public expenditure decreased by about 2 percent. In addition, thanks also to the ECB’s purchase program, savings on interest expense have been around €50 billion in recent years.
How can this be explained? Perhaps the derivatives have something to do with it? And what is the risk for the future?
In a June 2015 publication by the Parliamentary Budget Office, it was stated that as of Dec. 31, 2014, “the Treasury’s exposure to derivatives showed a negative market value of more than €42 billion.”
Of course, in the last seven years the losses have been around €8 billion per year (for this year, the DEF 2017 has estimated them in €5.1 billion). And this has contributed to the swelling of the debt well beyond the limit imposed (and obtainable) by the spiral of interest payable.
What is there to say? They lost a bet with the citizens’ money.
Back to the beginning. The 1981 divorce before and the birth of the single currency after cut the direct relationship between political institutions (government and parliament) and monetary institution. As a result, in all these years, the financial markets set the conditions for financing the state’s needs.
Our debt is like a flag: its sustainability depends on context factors and investor strategies. In this context, derivatives have been used as protective shields against market uncertainty, to defend themselves against speculation.
But the remedy was worse than the evil. The banks, which are the counterpart, have the power to influence the market that the state does not have. An issue that inevitably requires the reform of the European institutions and, above all, of the ECB.
Originally published at https://ilmanifesto.it/derivati-sul-debito-il-gioco-dazzardo-di-stato/ on 2018-06-03