Revelations that Enron exploited accounting loopholes to disguise bank debt as prudent risk management activity will undoubtedly fuel calls for greater government scrutiny of corporate banking and accounting practices. But how effective will such scrutiny be when governments engage in the same activities?
The New York Times reports that Enron received $3.9bn in bank loans between 1992 and 2001, which was never reported on its books as debt. Rather, by using swaps transactions that mimicked loans, but which Enron claimed publicly to be hedges for commodities trades, the company was able to misrepresent an increase in debt as a reduction in risk.
In November, a report by the International Securities Market Association (ISMA) and the Council on Foreign Relations (CFR) documented similar behaviour by the Italian government. Facing the possibility of exclusion from the first wave of euro entrants on the grounds of fiscal profligacy, the Italian Treasury undertook highly unusual yen-lira swaps transaction, undervaluing the lira by 44 per cent, which precisely mimicked a large loan.
The contract required Italy to make negative interest payments to the bank in the amount of Lira-Libor minus an astounding 1,677 basis points in 1997 (meaning that Italy received funds) and then in effect to reverse the payments in September 1998. This reduced Italy's official deficit in 1997 only by raising it in 1998.
The parallel with the Enron transactions is uncanny. Like Enron, Italy took on debt but chose to represent it as a hedge for a yen bond it had issued in May 1995, which matured in September 1998. As with Enron, the hedge explanation was clearly misleading. If it had been a hedge, the exchange rate used would simply have been the market rate at the time the swap transaction was entered into. Off-market rate swaps were clearly selected for the purpose of producing interest revenue in 1997, with euro entry as the goal.
The Treasury does not deny this. It justifies it, however, using an explanation that is in part irrelevant and that in part implicates it clearly.
The irrelevant part of the explanation is that the Treasury was concerned that a yen appreciation could increase Italy's debt, thus jeopardising the country's hopes of entering the eurozone. So the swaps were structured to protect against its debt rising over the course of 1997. But Italy's debt was 110 per cent of gross domestic product in 1997, well beyond the 60 per cent Maastricht barrier. The European Union never intended to enforce the debt limitation, only the annual deficit limitation. Italy's deficit was forecast to be within striking distance of the 3 per cent barrier and the swaps legally affected only the deficit. The debt argument is a red herring.
The damning part of the explanation is the admission that Italy was taking a cash advance in 1997 against an expected foreign exchange profit in 1998. Under accounting rules, this is simply impermissible. Borrowers cannot use loans to anticipate capital gains on a bond.
It is clear that the existence of the yen bond was merely a convenient pretext for Italy to borrow money that it could then misclassify as a hedge, just as Enron's commodities trades were a pretext for its own disguised borrowing.
How widespread is this sort of financial chicanery among sovereign borrowers? It is very difficult to know, since these deals are done over the counter with no public paper trail. Gustavo Piga, author of the ISMA/ CFR report, uncovered the Italian transaction quite accidentally. But there are powerful reasons for concern.
First, governments have clear incentives to cook the books. The EU continues to impose fiscal expenditure restrictions on eurozone governments, violation of which can result in censure and fines. The International Monetary Fund imposes fiscal conditionality on its client governments, which naturally have a strong incentive to keep the Fund from closing the money spigot. Derivatives can be used to shuffle cash flows through time in ways that current accounting rules do not prevent.
Second, banks are only too willing to market derivatives tricks to their big client governments, particularly when it puts them at the front of the queue for future bond issues and privatisations.
Third, if the integrity of government financial data is fatally undermined, the damage to stock and bond markets will dwarf the "Enron effect" that has recently pummelled the Dow.
Enron's window-dressing of its public accounts should clearly be a matter of government concern, since it is governments that impose the accounting rules. But the problem of government accounting abuse may in fact be far more serious, bringing to the fore that age-old question: who shall guard the guardians?
Benn Steil is Andre Meyer senior fellow in international economics at the Council on Foreign Relations.