Debt Deals Haunt Europe

Investors Re-Examine Complex Financial Maneuvers Used to Hide Borrowings

By CHARLES FORELLE AND SUSANNE CRAIG

Concerns that Greece and other struggling European nations may not be able to repay their debts are focusing investor attention on another big worry: Economies across the Continent have used complex financial transactions—sometimes in secret—to hide the true size of their debts and deficits.

Investors long turned a blind eye to European governments' aggressive bookkeeping, aimed at meeting the euro zone's fiscal ceilings. Countries using the euro currency have a rich history of exotic maneuvers aimed at meeting rules requiring members to cap debt levels at 60% of their gross domestic product and their annual budget deficits to no more than 3%. Despite criticism, European leaders deemed many of these moves acceptable as they sought the long-planned currency union.

To try to meet the targets, which were aimed at building trust in the stability of the euro, governments over the years have sold state assets, bundled expected future payments into securities to hawk and even, in the case of Greece, insisted to the Eurostat statistics authority that large portions of its military spending were "confidential" and thus excluded from deficit calculations. In 2000, Greece reported that it spent €828 million ($1.13 billion) on the military—about a fourth of the €3.17 billion it later said it spent. Greece admitted to underreporting military spending by €8.7 billion between 1997 and 2003.

Portugal classified subsidies to the Lisbon subway and other state enterprises as equity purchases. After learning that, Eurostat made Portugal redo its accounting in 2002. The country revised its 2001 deficit from €2.76 billion, or 2.2% of GDP, to €5.09 billion, or 4.1%—well over the limit.

France arranged a deal with the soon-to-be privatized France Telecom in 1997 under which the company paid the government a lump sum of more than €5 billion. In return, France agreed to assume pension liabilities for France Telecom workers. The billions from France Telecom helped narrow France's budget gap to around €40 billion in 1997; it reported a deficit for that year of 3% of GDP—right on the target, and helping it to join the euro.

Even Germany, Europe's largest economy, tried to reappraise gold reserves for a fast fix in 1997, though it backed off after resistance from the country's central bank.

Countries "look for things because it helps their arsenal of techniques used to reduce their budget deficits," says James D. Savage, a University of Virginia professor who is an authority on EU budgeting. "The problem for Eurostat is the flourishing of new financial instruments and techniques. Member states are going to try to take advantage of them."

Adding to the difficulties, EU regulators have few tools for forcing euro-zone countries to adhere to fiscal requirements.

Contagion issues have deeply concerned both policy makers and investors as the Greek debt crunch has unfolded over the past weeks. The cost to insure against a Greek default remains near record highs. Moreover, bond offerings from Spain, Ireland and Portugal in the past two weeks have succeeded primarily because they paid higher-than-usual yields.

Last week, such worries exacerbated market jitters over Europe's debt woes and could complicate Greece's plan this week to sell more debt, bankers and investors say.

In recent weeks, countries' use of currency swaps has drawn attention. In such transactions, often benign, countries might borrow in a currency not their own, for example, and use a derivative to offset the risk of currency fluctuations. But these instruments can also be used to artificially massage cash flows and liabilities, to meet debt and deficit thresholds.

Investors paid little attention to the often-opaque derivative deals until concern of a Greek default began to rattle markets. The closer scrutiny also comes against the backdrop of exploding budget deficits in many European countries and fears about the stability of the euro. Governments across Europe pumped hundreds of billions of euros into their economies to combat the financial crisis, sending national debt levels soaring.
Euro-zone governments are under no obligation to disclose the precise nature of the derivative agreements they enter into, making it nearly impossible for investors to discern the potential risks associated with them. Eurostat permitted the use of such transactions to adjust debt figures until 2008.

While other maneuvers may have had more impact on debts and deficits, swaps are one tool countries have used regularly over the years to help meet the euro-zone requirements. In some cases, governments undertook numerous such transactions, often without publicly disclosing them, making it difficult for investors to gauge the impact on a country's finances.

Goldman Sachs Group Inc. did 12 swaps for Greece from 1998 to 2001, according to people familiar with
the matter. Credit Suisse was also involved with Athens, crafting a currency swap for Greece in the same time frame, according to people familiar with the matter.

Deutsche Bank executed currency swaps on behalf of Portugal between 1998 and 2003, according to spokesman Roland Weichert. Mr. Weichert said Deutsche Bank's business with Portugal included "completely normal currency swaps" and other business activity, which he declined to discuss in detail. The currency swaps on behalf of Portugal were within the "framework of sovereign-debt management," Mr. Weichert said. The trades weren't intended to hide Portugal's national debt position, he said.

The Portuguese finance ministry declined to comment on whether Portugal has used currency swaps such as those used by Greece, but said Portugal only uses financial instruments that comply with EU rules.
European officials said last week that EU regulators didn't know about a particularly controversial "off-market" currency swap structured in 2001 by Goldman Sachs for Greece. Officials say they believe the problem isn't widespread but a number of prominent European politicians, including German Chancellor Angela Merkel, have called on authorities to have a closer look at the transactions and whether banks helped governments distort their books.

A 2008 Eurostat report, however, says questions about how to account for off-market swaps like the one used in Greece were raised as early as 2007. The report said it provided detailed guidance about how to handle some forms of them. Eurostat didn't respond to a request for comment.

Eurostat tried for years to change the rules on use of swaps. European finance ministries in 2000 overruled Eurostat, arguing that they needed as much flexibility as possible to manage debt loads.

It wasn't until 2008—a decade after the deals became popular—that Eurostat was able to revise its rules to push countries to include swaps in their debt and deficit calculations. Still, critics say that too little is known about countries' continued exposure to the deals that are already out there.

Goldman's 12 currency-swap agreements for Greece, in addition to allowing the country to lock in an exchange rate, had another advantage: The fixed rates meant under European accounting rules that Greece could record its foreign-currency debt at the rates in the swap contract—no matter how rates fluctuated later. That could protect it from seeing its recorded debt levels spike in the future.

But even though the swaps prettied up the accounting, they didn't affect the underlying economics: A drop in the euro would leave Greece with a losing swap position. In 2000 and 2001, that happened, according to people familiar with the situation.

In 2001, Goldman and Greece came up with a now-controversial solution: a new off-market swap. It agreed in the future to convert yen and dollars into euros at an artificially favorable rate.

Greece could use that rate when it recorded its debt in the European accounts—pushing down the country's reported debt load by more than €2 billion, according to people familiar with the matter.

In exchange for the good deal on rates, Greece had to pay Goldman. The amount wasn't revealed. A payment would count against Greece's deficit, so Goldman and Greece came up with another twist. Goldman effectively loaned Greece the money for the payment, and Greece repaid that loan over time. But the two sides structured the loan as another kind of swap. Treated as a swap, the deal didn't add to Greece's debt under EU rules. All told, the marginal benefits were small. Greece's total debt as a percentage of GDP fell from 105.3% to 103.7%, and its 2001 deficit was reduced by a tenth of a percentage point in GDP terms, according to people close to Goldman.

Gikas Hardevoulis, a former advisor to the then-prime minister of Greece, said the trade should not have been done. "It was done to dress up the debt figures by some smart idiot in the finance ministry" he said.
Greece's remaining exposure to the complicated arrangement remains unclear.
—David Crawford, Robin Sidel, Jonathan House and Deborah Ball contributed to this article. Write to Charles Forelle at charles.forelle@wsj.com