Wednesday, 17 June 2015

Financing steady disbursements with a credit line and an option for long-term funded debt: an asiento of Philip II

Philip II of Spain
Philip II ruled the first global empire with the limited state resources of the early modern age. As for any state before Waterloo, expenditures were mostly military. The celebrated silver and gold from the Americas were no more than 20 percent of his revenues, and a bit less in the first half of his reign. The fleet, a convoy, brought the precious metals once a year in the early Fall but the quantity was highly variable and unpredictable. The most stable part of the revenues (about a third) was raised through sales taxes that were controlled by the main cities of Castile. The rest was collected by scattered sources, tax farming, ad hoc contributions of the Church, etc... And in this state building period, there was no administration for the collection, monitoring and enforcement of taxation. In order to bridge the gap between expenditures, at designated locations and timings, and these erratic and scattered sources, Philip II used financial contracts, asientos.

In a new EHES working paper, Carlos Álvarez-Nogal and Christophe Chamley analyze a contract that provides a splendid illustration of this matching between regular expenditures, erratic revenues from the fleet and scattered but stable local revenues. The contract also provides an example of smooth conversion of short-term debt into long-term funded debt, long before the debt refinancings in England.

The asiento, a financial contract used
by Philip II
The method of investigation of Álvarez-Nogal and Chamley is grounded on a careful and thorough examination of all the documents that are available in the archives of Simancas, which were set by Philip II himself. These archives contain extraordinary details in the contract (14 pages), in the attachments (47 pages) next to the contract, with the reports of the monitoring royal accountants, and, in a different part of the archives, in the audits that were done years later by the Chamber of Accounts (more than 350 pages). From the archives a new and logical structure of the contract emerges that completely contradicts the data reporting and cash-flow method by Drelichman and Voth (2011) about the same contract.

The Maluenda brothers were successful merchants from Burgos who used their network in trade to develop financial activities. On July 13, 1595, they signed an asiento that committed them to deliver twelve monthly disbursements, of 27,000 ducats each (the first was doubled), in Lisbon. (For simplicity, all the numbers are rounded here. The exact numbers are reported in the paper). The total was therefore 350,000  ducats which is in the upper range of asientos for that period. To put this amount in perspective, a total of 5 million ducats of asientos for a given year would be high, the revenues of the Crown, net of Americas' income, were about 10 million ducats,  and GDP per capita in Castile was probably not lower than 2  ducats per month.

The financing of the disbursements (350,000 ducats) was divided in three parts. First, the Crown made an immediate cash payment for the disbursements until August:  75,000 ducats was paid from the royal coffers in Madrid which the bankers had to deliver in Lisbon as soon as possible. This transfer may have been used for urgent or start-up costs.

The credit part of the contract was therefore only for 275,000 ducats. This part operated like a credit line today with a monthly interest of one percent. The contract identified sources of revenues on which it had first claim. The Crown had much flexibility for the use of these sources of revenues and for the timing of the repayments. Whatever the choices of the Crown, a central and repeatedly emphasized principle of the contract was that an interest of one percent had to be charged on the balance due in each month. The rich documentation shows that this principle was strictly applied.
The repayment of the principal of the credit was divided in two tranches, which can be called here Tranche A for 100,000 ducats, and Tranche B for 175,000 ducats. (In addition, interests would have to be paid). Tranche A paid for, roughly, the rest of the monthly disbursements in Lisbon until the end of the year 1595, while Tranche B paid for the disbursements of the following year, until June. The contract devotes much space to the explicit connection between tranche and disbursements.
Each tranche had a first claim on the incom
Lisbon in the early modern period
e of the fleet of its year, the fleet of 1595 for Tranche A, and the fleet of 1596 for Tranche B. However, and this is the most interesting part of the contract, the Maluendas could also collect Tranche B by the sale of long-term funded debt instruments on behalf of the Crown, and they could choose the source of funding. These were to be taken from a menu: annuities on one head, to be chosen by the banker, at 14%, on two heads at 12%, perpetuals at 7% or 6%, and claims on the Casa de Contratación that managed the Crown's revenues from the Americas. Such were the terms of the asiento in the archives. The application of the contract is described in minute details by its attachments and by the final report of the Chamber of Accounts (Contaduria Mayor de Cuentas).

The Maluenda brothers exercised the option soon after the signature of the contract and, not surprisingly, in the menu of instruments, they selected almost exclusively the annuities on two heads. The sales proceeded briskly and were recorded, following a contractual requirement, in trimestral reports, with the names of the buyers, amounts of each annuity and dates of sale. (All this data is in the attachments).

The asiento illustrates the remarkable flexibility of the credit line with a monthly fixed interest rate. The fast sales of the annuities, even before the bankers had made any disbursement on Tranche B (about 105,000 of ducats sold at the end of 1595, before the disbursement of Tranche B), had freed the fleet of 1596 from the claims of Tranche B. It was therefore decided to shift 40,000 ducats in Tranche A from the fleet of 1595 to the fleet of 1596. The payments from the fleet of 1595 were staggered, beginning in December 1595. The attachments to the contract report the careful computations of the royal accountants about the interest on the balance due, prorated for the exact days of payment by the Crown. It is remarkable that for Tranche B, the cumulated sales of annuities exceeded at any time the cumulated disbursements to the Crown!

In November 1596, Philip II stopped the payment on all asientos, for the third time. On Tranche A, 40,000 ducats was still due. They were eventually paid by the Crown.

The method of Álvarez-Nogal and Chamley, to extract from the archives all available information and to focus on one contract, can be compared with the "coding" procedure of all asientos by Drelichman and Voth (2011), as presented in a study that received a prize. In that study, they take the same asiento as a standard bearer for their method which produces tables of "agreed upon cash-flows" from which they compute their own measure of a rate of return. Their method is not historical and in their data reporting, they do not respect the archival evidence in the contract, from page 3 on. The "coding" misses the elegant and logical structure that has been described here, and it turns the contract on its head since the payments depended on the interest, one percent per month, that is specified in the contract and precisely observed in its execution. They inexplicably dismiss the most interesting option for the long-term funded debt (which had already been described in the literature). Ignoring the attachments, they claim instead ("we know with certainty") that Tranche B had not been paid by the payment stop of November 1596, and that it was subject to a debt reduction, when actually, it had entirely been paid, in advance, by selling annuities. In fact, the Chamber of Accounts found in 1606 that for the entire asiento, the Maluenda brothers had been overpaid 4000 ducats.

This blog post was written by Carlos Álvarez-Nogal,  Associate Professor of Economic History at Universidad Carlos III de Madrid and Christophe Chamley, Professor of Economics at Boston Universtiy.

The working paper can be downloaded here:
http://www.ehes.org/EHES_79.pdf




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