The massive use of derivatives and securitization by sovereign states for public debt
and deficit management is a growing phenomenon in financial markets. Financial
innovation can modify risks effectively run and alter the stability of the public sector
finance. The experience of some developed and developing countries is surveyed to
look at main instruments used and aims of public finance. Financial stability of the
public sector is analyzed considering financial innovation use. The case of Italy and
its scarce disclosure of information are presented. An IS-LM model is used to capture
the effect of financial innovation on fiscal policy for high indebted (European)
industrialized countries, with deficit constraints, starting from Blanchard (1981).
The use of financial innovation can have various effects over debt and deficit
management, given binding external burden (like the European criteria) as far as
risks are properly considered, expectations of fiscal policy are coherent with that of
markets, and no exogenous shock occurs.
Derivatives are thus far the biggest financial innovation used on modem financial markets
worldwide; their notional amount has reached the value of $220 tn OTC at end June 2004 with
an increase of 12% over the last semester. Exchange traded derivatives reached the value of
$288 tn, with a fall of 5% over the last semester. The fall of exchange-traded derivatives is due
mainly to more homogeneous expectations over future path of economic growth (BIS, 2004).
Derivatives are widely used because of their high liquidity degree, low costs (if compared with
the traditional equivalent investment) normal volatility level and leverage effects; market players
are banks, non-financial firms and sovereign states, according to the BIS survey; the disclosure
about single investors’ exposure is not deep enough to get a complete picture of the situation
from the BIS survey, but from 2005 on this lack will be improved. Sovereign states have recently
incurred in these financial instruments because of their ability to provide hedging against interest
and exchange rates, manage debt and sometimes helping in raising funds, e.g., by anticipating
future tax revenue. |
