Thursday, November 10, 2011

PIIGS update

Having been somewhat out of touch earlier this week, but nevertheless quite aware of all the sudden, new-found agonizing over whether Italy will soon join Greece as a major defaulter, I wanted to get things in perspective. These charts give you an up-to-date look at the status of the risk of major Eurozone sovereign debt defaults, which so far is concentrated in the 5 PIIGS countries. The top chart makes it obvious that Greece is a lost cause. The bottom two charts take Greece out in order to focus on the other four of the PIIGS.

There's been a lot of talk about how Italy's sovereign debt yields, and spreads to Germany, yesterday crossed the line into "no-man's land" (e.g., yields over 7%), meaning that Italy's debt burden has now become unsustainable and the market has thus effectively made an Italian default highly likely. These charts don't support that view. The cost of insuring against an Italian default is still less than that of Ireland and Portugal, and Italian 5-yr CDS are still below the average of high-yield corporate debt.

Of course, given Italy's $2.2 trillion debt, even the hint of an Italian default could have major repercussions, so it's not entirely fair to say that Italy is less likely to default than the typical high-yield bond. Even if an Italian default is still very unlikely, according to CDS and sovereign bond yields, the expected impact of a default is very large and thus is a very legitimate source of concern.

Whether Italy, still one of the world's major economies, would ever reach the point of defaulting on its sovereign obligations is the only question that matters. In the end, this is a political issue, since there is no a priori reason to think that a developed country—even one as overextended as Italy—cannot adopt a responsible fiscal policy course of action. Adopting "austerity" is not equivalent to self-destruction, as those opposed to it try to argue. Austerity is bad for those who have been sucking on the public teat, but it is generally good for the rest of the country. I believe that the adoption of true austerity measures would be quite stimulative for a number of countries, since they would not only restore confidence in a country but would also reduce the suffocating burden of too much government spending and borrowing. The Eurozone debt crisis was brought on primarily by public sector bloat, so reducing that bloat can only be a positive.

One other point: Many are arguing that since the ISDA determined that a "voluntary" write down of Greek debt by private sector banks would not trigger a CDS payout, that CDS spreads are likely trading at artificially low levels since they are much less likely to be the insurance policy that they were originally held out to be. (I note with interest that the CEO of the ISDA has stepped down, no doubt due to this very controversial decision.) Regardless, this does not make the message of 2-yr sovereign yields any less relevant. As the 2nd and 3rd charts show, the relative risk of the four PIIGS is approximately the same, whether measured by CDS or by 2-yr sovereign yields.


Benjamin Cole said...

Looks like the Eurozone might have been a bad idea--it allowed some nations, such as Itlay , to borrow in euros--benefitting from the currencies stability.

If Italians had to borrow in lira and Greeks in drachmas, they would have run up against increased borrowing costs a long time ago.

And now, those two nations are trapped--they cannot print more lira and drachmas and deleverage that way.

It's like being in a monetary torture chamber, not controlling your own currency. Austerity is one solution, but if doing so shrink GDP, then it is counterproductive.

As they cannot inflate their way out of their messes, look for Greek and Italy to renege on debts.

Let us hope the USA never enter into a currency union. Now we can print money and pay off our debts. A better option is fiscal responsibility, but having a back-up plan is always good.

Frankly, I doubt US leadership (the GOP debates remind me of The Gong Show and the D-Party drinks red ink) can balance the federal budget, and in the end we will print our way to deleveraging.

The sooner the better.

Public Library said...

I am more inclined to side with how Mr Pettis describes the current plight of Europe. This is a German born problem and a simple balance of payments issue. Therefore it is Germany and their policy that is the only way to save the system as is.

Prior to the EUR, many of the so-called bloated countries were actually quite thrifty, and vice versa for Germany. Germany was a one of the leading deficit countries during the prior 10 years before the euro.

"Germany and the thrifty Europeans largely learned to love thrift only after the euro was established.

So how do we explain the European crisis? One theory is that the European crisis was caused by the moral turpitude and spendthrift habits of lazy Europeans along the periphery, in sharp contrast to the hard-working and thrifty countries of the center. According to this theory it is unfair to demand that Germans clean up the mess.

If you believe this theory, you are going to have to explain what happened in 2000 that turned thrifty Italians, French and Irish into spendthrifts, and that turned ordinary Greeks, Portuguese and Spaniards into even worse spendthrifts. You will also have to explain why spendthrift Germans in the 1990s suddenly morphed into the stolid, thrifty creatures of legend."

The right loves to point fingers at bloated governments and the lazy populace while at the same time using government to provide cheap insurance for their leveraged or asymmetrical financial activities.

PerformanceSpeaksForItself said...

I'm interested to hear your opinion on "unintended consequences" -- specifically, whether the latest euro-deal in which CDS are not being honored in a Greek restructuring has changed risk models and led banks, et al., to dump bonds, e.g., Italy, in order to reduce risk.
Also, one thing I have learned from you is to pay attention to the trajectory rather than a data point. Doesn't the trajectory of Italian yields and CDS (without ECB intervention) say something about the increasing likelihood of "restructuring"? I know "all Italy needs is a credible plan", but don't you think that's a long shot with their politicians? And forget this 4% deficit nonsense -- Italy is pretty deep in recession according to the PMI figures, see also today's -4.8% MoM Industrial Production figures.

puffer said...

Scott -

If Greece negotiated 50% forgiveness on debt held by the private sector, why would the Italians ever feel compelled to pay in full? I'm afraid the example has been set. What would a 50% haircut on all privately held Italian debt do to the system?
I fear the repercussions would be severe.