Wednesday, 25 February 2009

European sovereign debt: how sovereign is it?

By Juan Pablo Painceira

The possibility of a sovereign default in the Eurozone has been worrying not only the countries in question, but also European authorities and the global financial system. CDS spreads (or risk premiums) on European sovereign debt have widened dramatically in the last 6 months. In February, the situation deteriorated further and European sovereign CDS traded higher than companies rated close to the “junk” level! The main suspects for sovereign default would be Ireland and Greece with the risk premium around 250bp (over Germany) and to a lesser degree Spain and Portugal; but, even Germany (the benchmark EU sovereign), Austria and Belgium have suffered from the widening of CDS spreads.

So, what are the main reasons for this dark scenario? The causes, of course, lie in the unfolding of 2007-08 financial crisis and range from current account concerns to government deficit financing, passing on export demand and external finance problems. This year was already a scheduled year with huge sovereign bond issuance in which has been piled up with new finance needs, mainly stemming from banking bailout plans.

However, the role of ECB interventions to shore up the European money market has not been fully highlighted by the media and analysts as one of the main causes of widening on European risk premiums. Since the beginning of crisis, the ECB has decreased the quality of credit collateral in its repo-operations and other lending operations with the banking system. Basically, the banking system has been allowed to access the ECB’s standing facilities using securities with lower ratings or, even worse, with no trading at all. In simple words, the banking system has raised its finance needs through financial operations where they pump their bad assets into ECB’s balance sheet. In the end, it has effectively created an over supply of prime rated securities in the market and mostly important for European countries there has been a kind of crowding out between “toxic” banking securities and sovereign bonds. Financial investors can transform a “frog” into a “princess” through the ECB’s standing facilities so what would be the reason of buying a “princess” if you can buy much cheaper a “frog” and.…..

In the traditional economic theory, the solution to deal with the problem is straight forward, increased labour market flexibility! The relative price of wages would be the only adjustment mechanism in these countries given that devaluation is not possible within a single currency. So, it is clear that we have a great asymmetry between banking and sovereign debt! The result is that European states have to raise funds to cover their banking recapitalisation plans at a much higher fiscal cost and this is partly caused by its own central bank’s interventions!!

George Soros raised a related point in the FT, he claims the creation of Eurozone government bond market would help deal with the government finance problem. The problem is that right now the implementation of a European Treasury would only reinforce the financial interests managing the banking recapitalisation and not meet the needs of European population as might at first appear to be the case. The promises in public social investments coming with this new authority would be only carrots, in the end the sticks would be on our heads!


  1. There may additionally be some so-called "techincals" as soverign hedges can be used to hedge a variety of illiquid positions that might previously have sat unhedged on bank balance sheets - eg loans, counterparty derivative exposure. Although this would not typically give regulatory capital relief it would lower "risk" and would lower VaR-based reg cap on trading book assets. Similar effects were seen in the ABX index where it was effectively the only tool to hedge residential mortgage securitisations and hence was "oversold". CDS indices can exhibit similar effects. Mark-to-market accounting greatly increases the incidence of such hedging as firms attempt to reduce balance sheet volatility of what might otherwise be hold-to-maturity assets.

  2. You are right, the sovereigns can be used to hedge those positions. However, it seems it hasn't happened once that those CDS have widened! Moreover, part of those illiquid assets has became liquid assets through ECB's standing facilities.

  3. Anecdotally I hear risk control departments are still forcing increased hedging even with spreads at these levels. Poor trading decision the desk would say (should have hedged before but not much sense locking in your unrealized loss now) but of course the inconvenient fact that equity value is floored at zero means that even 'small' further mark-to-market losses are now a problem. Hence banks are forced to continue hedging at elevated prices and with whatever comes to hand. Not to say this is a mre important element than the ECB - only that this is pushing in the same direction.

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  5. If so, it makes sense the increase of government bonds holding by banks in the last weeks. Yes, the movement is in the same direction. In order to keep those hedge effective (I mean profitable), then the banks would make a similar movement (trading) of what the hedge funds did (or have done) with the banks CDS spreads.

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