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From Goldman’s Francesco Garzarelli, it doesn’t get starker than this…Sovereign Risk Spreading Like a Wildfire
Pressures on Euro area sovereign bond markets have progressively intensified and spread like a wildfire. Sparking the flames has been in the introduction in early June of ‘substantial’ private sector involvement in the restructuring of Greek debt, crystallizing the notion of default risk in sovereign securities. Pro-cyclical policies, including the introduction of provisional capital buffers related to government bond holdings by banks and higher initial margin requirements on repo at private clearing houses, have all but fanned the flames. Meanwhile, ‘firewalls’ to mitigate contagion across the financially integrated EMU countries are still under construction, as ECB President Draghi has lamented at the end of last week.
Garzarelli goes on to make an incredibly crucial point about pre-Euro days…
The damage to asset prices and investors’ confidence since the start of the third quarter has been substantial. The 2-yr yield differential among the three main Euro area countries – Germany, France and Italy, which account for two thirds of its combined GDP – is now as wide as in the early 1990s, i.e., before the introduction of the Euro (France-Germany: 130bp; Italy-Germany: 583bp). This is important because, in pre-EMU days, sovereign risk had its main outlet in the currency market. Indeed, controlling for the FX risk through forwards rates, yield differential across sovereigns were actually by comparison quite small relative to current gyrations.
The weakening of the domestic currency associated with the rise in yields in pre-EMU days constituted an important ‘safety valve’, boosting (at least for a while) GDP growth and helping mitigate the negative impact on domestic demand of the fiscal retrenchment that typically followed. The fact that, by contrast, pressures for yields to go higher now do not find any compensation in the form of easier financial conditions makes the current situation perilous, and a threat to the fiscal adjustment itself (Jari Stehn and Lasse Nielsen have written about these issues).
Ultimatley, it was the solution to the Greek debt drama that caused the contagion.
This highlights the relevance of the Greek PSI. By reducing the face value of its liabilities a country can divert fiscal resources from debt servicing to demand management. If Greece has altered its relative debt burden, why can’t other highly indebted EMU countries do the same? To be sure, the issue is clearly more complex than this. Greece still needs to rely heavily on foreign official sector to plug its deficit net of interest payments. But what about when a primary balance has been re-established? And where does this leave Italy’s incentives – the country is already running a primary surplus, and half of it debt stock is held by non residents.
It is easy to recognise how highly destabilizing these dynamics could potentially be. At the outset of the crisis, it was understood that public debt held by the private sector would be moved onto the public sector’s balance sheet, under the condition that beneficiary countries would continue deleveraging. This is reflected in the replacement of redeeming bonds in Greece, Ireland and Portugal with long maturity loans. The prospect of a restructuring of debt introduced by the Greek PSI, if applied to one of the larger sovereigns, would represent a sizeable destruction of wealth across the area with profound confidence effects.
Consider that at least 50% of each EMU member’s sovereign debt is held by the non domestic sector, and that 85% of claims against sovereigns of the Euro area are held by residents of the area itself, mostly highly integrated and levered financial institutions. Similarly, the risk of an exit from EMU of any of its constituents would result in the breakup of an irrevocable international agreement, with grave ramifications for the system of payments. No wonder banks around the Euro area are selling government securities and depositing the proceeds with the ECB, as Jernej Omahen has recently documented.
Garzarelli’s conclusion: It’s time to bring in the firefighters.
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