Do Governments Use Financial Derivatives Appropriately? Evidence from Sovereign Borrowers in Developed Economies

This article provides original evidence on the use of derivatives by sovereign borrowers. Swaps are used both to increase the liquidity of long‐term government bonds and for speculation. However, some sovereign borrowers have also used derivatives to ‘window dress’ their public accounts for the purpose of disguising budget deficits. One actual window‐dressing transaction by a sovereign borrower that used it to facilitate entry into the EMU is described. It is shown that the size of the artificial deficit reduction it achieved through this transaction is large. I argue that window‐dressing through derivatives might prove particularly damaging for the political stability of the EMU, the effectiveness of stabilization programmes in less developed countries, and the credibility of supranational institutions charged with monitoring the soundness of client‐country economic policies. Window dressing also dangerously distorts the relationship between governments and private financial institutions. I suggest proper accounting procedures that should be used to eliminate the possibility of such operations.