A recent (January 13, 2009) column in the Financial Times by John Authers provides a good example of a logical slip on the banana peel of an alleged link between the external value of the euro, the likelihood of the eurozone breaking up and sovereign default by a eurozone national government. Versions of this fallacy can be found all over the place, even in the writings of those who ought to know better.
The relevant passages from Authers’ The Short View follow in full:
“Greece has always been treated as a peripheral eurozone member, not only in geography. Even before last year’s civil unrest, its bonds traded at a significantly higher yield than those of Germany – showing a higher perceived default risk.
The market is nervous about other nations on the eurozone’s periphery, notably Ireland and Spain, which grew overextended during the credit bubble.
A eurozone country defaulting and leaving the euro is close to an unthinkable event. But Friday’s news from Standard & Poor’s that Greece and Ireland were on review for a possible downgrade, followed yesterday by Spain, left many thinking the unthinkable.
The spread of Greek bonds over German bunds is 2.32 percentage points, almost 10 times its level of two years ago. Spanish spreads yesterday rose above 90 for the first time. An Intrade prediction market future puts the odds on a current eurozone member leaving the euro by the end of next year at about 30 per cent.
The euro dropped more than 1 per cent against the dollar within minutes of the Spanish news, and is down 9.8 per cent in the last few weeks.”
Three issues are being linked in this passage. The emergence of high levels of sovereign default risk premium differentials between different eurozone member states, the external value of the euro and the likelihood of the eurozone breaking up. There is no self-evident link between these three issues. The first is neither necessary nor sufficient for the second or the third. More than that, the threat or reality of sovereign default by a eurozone member state is much more likely to reduce that country’s incentive to leave the eurozone than to increase it.
It is obviously true that market perceptions of sovereign default risk in the eurozone (as reflected in CDS rates) are rising across the board and are now very high indeed by historical standards. According to Markit, on 12 January 2009, Germany’s 5-year CDS rate was 44 basis points, France’s 51 basis points, Italy’s 155 basis points and Greece’s 221 basis points. The same is true, of course, for the US, with a CDS rate of 55 basis points and and for the UK, with a 103 basis points CDS rate. Sovereign CDS markets may not be particularly good aggregators and measures of default risk perceptions because issuance is patchy and trading is often light, but the numbers make sense.
In addition to the average level of sovereign default risk premia rising across the world, the differentials between the sovereign default risk premia of the various eurozone members have risen. The spreads on the yield on 10 year government bonds over Bunds on January 12 was 88 basis points for Austria and Belgium, 52 basis points for France, 90 basis points for Spain, 105 basis points for Portugal, 135 basis points for Italy, 171 basis points for Ireland and 233 basis points for Greece. These numbers are not directly comparable with the spreads between the CDS rates reported earlier, both because they refer to default risk over different horizons (5 years for the CDS and 10 years for the government bonds) and because the government bonds are traded in liquid, organised markets while CDS are traded over the counter.
Greece and Ireland were put on credit watch (on a negative outlook) last week by the Standard & Poor’s, and this week Portugal and Spain followed. The actual downgrade today of the Greek sovereign debt rating by Standard & Poor’s from A to A minus, only five days after the country was put on credit watch by the same rating agency, will no doubt increase both the level of the Greek sovereign default risk premium and the spread over Bunds of the Greek sovereign 10-year bond yield. The ECB has adopted the (self-imposed) rule that it will not accept as collateral in repos and at the marginal lending facility (its discount window) sovereign debt rated lower than A minus. If the ECB/Eurosystem stick to this rule, the next downgrade of Greek sovereign debt could have a major impact on the Greek government’s marginal funding costs. The three countries remaining on credit watch – Ireland, Portugal and Spain – are likely to suffer actual downgrades in their credit ratings in the very near future. It is surprising to me that Italy has not even been put on a negative outlook as yet. I expect this will not be long in coming as the eurozone economies continue to deteriorate, increasing government deficits, and rising default risk spreads undo the beneficial effect on sovereign funding costs of declining risk-free interest rates.
It is certainly possible that a eurzone government will default on some of its debt in the near future. It will no doubt be presented as a ‘restructuring’ of part of the sovereign debt, but the markets and the courts interpreting the covenants associated with CDS for the non-performing sovereign debt instruments will recognise what happens as an event of default.
Would a eurozone national government faced either with the looming threat of default or with the reality of a default be incentivised to leave the eurozone? Consider the example of a hypothetical country called Hellas. It could not redenominate its existing stock of euro-denominated obligations in its new currency, let’s call it the New Drachma. That itself would constitute a further act of default. If the New Drachma depreciated sharply against the euro, in both nominal and real terms, following the exit of Hellas from the eurozone, the real value of the government debt-to-GDP ratio would rise. In addition, any new funding through the issuance of New Drachma-denominated sovereign bonds would be subject to an exchange rate risk premium, and these bonds would have to be sold in markets that are less deep and liquid that the market for euro-denominated Hellas debt used to be. So the sovereign eurozone quitter and all who sail in her would be clobbered as regards borrowing costs both on the outstanding stock and on the new flows.
A sharp depreciation of the nominal exchange rate of the New Drachma vis-a-vis the euro would for a short period improve the competitive position of the nation because, with domestic costs and prices sticky in nominal New Drachma terms, a nominal depreciation is also a real depreciation. Nominal rigidities are, however, less important for eurozone economies than for the UK, and much less important than in the US. Real rigidities are what characterises mythical Hellas, as it does real-world Greece, Italy, Spain, Portugal and Ireland. The real benefits from a nominal exchange rate depreciation would be eroded after a year – within two years at most – before you could say cyclical recovery. The New Drachma would be a little currency in a big global financial market system – not an instrument to be used to gain competitive advantage or to respond efficiently to asymmetric shocks, but a source of extraneous noise, excess volatility and persistent misalignments, rather like sterling.
A eurozone member state faced with the prospect of sovereign default, or just having suffered the indignity of sovereign default, would be immensely relieved to be a member of the eurozone. The last thing it would want to do is give up the financial shelter provided by membership in the eurozone to try and emulate Iceland, New Zealand or the UK.
Was the depreciation of the euro that more or less coincided with the sovereign credit warnings and the Greek downgrade (although it started earlier) due to increased concern about the fiscal sustainability of some eurozone member states? Who knows? And what is more: who cares? The eurozone member states no doubt welcome the weakening of the euro, which had become the world’s second most overvalued currency, just as UK Ltd welcomed the decline in sterling, which reached more than 25 percent from its previous peak until the recent weakening of the euro. Depending on the fiscal measures taken by the sovereigns of the fiscally challenged nations, and depending on the response, if any, of the ECB to the threat or reality of sovereign default, any response of the euro can be rationalised.
I view the widening of the sovereign risk spreads inside the eurozone as a welcome development. With the revised Stability and Growth Pact effectively emasculated as a fiscal discipline device, it is essential for national fiscal discipline in the euro area, that the market believes (1) that national sovereign debt is indeed just national, not joint and several among all eurozone member states, and (2) that the ECB will not bail out ex-ante or ex-post a eurozone member state that gets itself into fiscal problems. The very low sovereign risk premium differentials in the early years of the eurozone were worrying to me, because it seemed to indicate that the markets believed that a fiscally incontinent government would be bailed out by the other eurozone national governments or by the ECB. The new larger and healthier sovereign risk premium differentials indicate that the markets may be able to provide more fiscal discipline than suggested by the early years of the common currency. That is good news indeed.
So we may well see sovereign defaults by EU national governments, both inside and outside the eurozone. But it is more likely in my view that Scotland will leave the sterling monetary union (and the United Kingdom) and adopt the euro as its currency than that an existing eurozone member will leave the eurozone. We shall see.
Correction (made at 17:10 on January 15, 2009).
On October 15, 2008, the ECB announced that the Eurosystem would lower the credit threshold for marketable and non-marketable assets from A- to BBB-, with the exception of asset-backed securities (ABS), and impose a haircut add-on of 5% on all assets rated BBB-. This expansion of eligible collateral is, however, temporary: “The list of assets eligible as collateral in Eurosystem credit operations will be expanded as set out below, with this expansion remaining into force until the end of 2009.” I expect that the ECB will extend this temporary relaxation of credit thresholds if by the end of the year there is still trouble in euroland.