Here at the Global Macro Monitor we perceive a rapidly changing financial landscape. The concept of risk-free is being redefined as we write and analysts are now forced to look at the systemic risk caused by a banking system’s exposure to their domestic sovereign. This, not in Ecuador, but now in the core of Western Europe!
The BIS released a report today that included the below chart, which we thought was very interesting and relevant to today’s market. It measures the percentage of equity capital each country’s banking system is exposed to the domestic sovereign. Italy’s banks, for example, have more than 60 per cent of their equity exposed to the government, which partially explains how the sovereign finances such a large portion of its deficits internally.
As the perceived credit risk of the Italian government increases, however, the banks, who are highly exposed, will likely reduce their holdings and willingness to purchase new bonds or debt, thus leading to a potential domestic buyers strike. This is how a downward spiral develops, which, if not aggressively addressed can lead to a sovereign funding crisis. The feedback between the financial sector and the sovereign further complicates the policy response.
The same is true with Japan. However, Japanese banks’ exposure to the government is in a different universe and is illustrated on the right axis. Now can you guess who has been financing Japan’s massive fiscal deficits?
Let’s hope our leaders in Washington have their “Sputnik moment” very soon as they watch Europe come unravelled over fiscal and debt mismanagement. Is it possible both parties can have an epiphany about the current fragility of market confidence in highly indebted sovereign borrowers and how difficult it is to regain that confidence? In the next 11 days and with a sub-3 per cent 10-year bond yield?
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