sovereign risk
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Sovereign Risk and the Euro
Lorenzo Bini Smaghi Member of the Executive Board
European Central Bank
London Business School 9 February 2011
Introduction
The economic and financial crisis –
the worst since WWII –
has produced an unprecedented
increase in public deficits and debts in all advanced economies
The ability of these countries to take the necessary actions to bring the public debt under control is being increasingly challenged, also by financial markets
The challenge has started in the euro area
1
Government deficits have increased everywhere
General government deficit(as a percentage of GDP)
Source: IMF WEO October 2010
0
2
4
6
8
10
12
14
Euro area UnitedStates
Japan UnitedKingdom
2007 2009
2
And so has public debt
General government gross debt(as a percentage of GDP)
Source: IMF WEO October 2010
0
50
100
150
200
250
Euro area UnitedStates
Japan UnitedKingdom
2007 2015
3
Stabilisation of the debt in 2013
General government gross debt(as a percentage of GDP)
0
20
40
60
80
100
120
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Euro area (IMF)United States (IMF)
Source: IMF WEO October 2010
4
Within the euro area the dispersion is large
Source: European Commission's economic forecast autumn 2010
General government deficit
(as a percentage of GDP)
-3
0
3
6
9
12
15
Gre
ece
Irel
and
Spai
n
Portu
gal
Slov
akia
Fran
ce
Bel
gium
Cyp
rus
Slov
enia
Net
herla
nds
Italy
Mal
ta
Aus
tria
Ger
man
y
Finl
and
Esto
nia
Luxe
mbo
urg
2007 2009 Euro area 2009
5
Also in terms of debt
Source: European Commission - Autumn 2010 Forecast
(as a percentage of GDP)
General government gross debt
0
30
60
90
120
150
180
Gre
ece
Italy
Irel
and
Bel
gium
Portu
gal
Fran
ce
Ger
man
y
Aus
tria
Spai
n
Mal
ta
Cyp
rus
Net
herla
nds
Finl
and
Slov
enia
Slov
akia
Luxe
mbo
urg
Esto
nia
2007 2012 Euro area 2012
6
And ageing is bound to make things worse
Source: European Commission Ageing Report 2009
Projected change in age-related government expenditure, 2007-2060(percentage points of GDP)
NB: Some countries have, in the meantime, introduced pension and/or health care reform which should reduce long-term increases in age-related spending
Euro area
0
4
8
12
16
20
Luxe
mbo
urg
Gre
ece
Slov
enia
Cyp
rus
Mal
ta
Net
herla
nds
Spai
n
Irel
and
Bel
gium
Finl
and
Slov
akia
UK
Ger
man
y
Portu
gal
Aus
tria
Fran
ce
Italy
Esto
nia
7
Three ways to reduce the debt burden
A: Fiscal adjustment
B: Inflation
C: Default / Restructuring
…or a combination of the above
8
In the euro area inflation is ruled out
The Treaty requires the ECB to ensure price stability
Monetary financing is prohibited
…and markets trust it
9
Inflation expectations remain well anchored
Five-year forward break-even inflation rate five years ahead
Sources: Reuters, ECB, Federal Reserve Board staff calculations, Bank of England
1.75
2.00
2.25
2.50
2.75
3.00
3.25
3.50
Jan.09 Apr.09 Jul.09 Oct.09 Jan.10 Apr.10 Jul.10 Oct.10 Jan.11
Euro area US UK
10
Also in surveys of professional forecasters
Source: Consensus Economics
1.0
1.5
2.0
2.5
3.0
3.5
2004 2006 2008 20101.0
1.5
2.0
2.5
3.0
3.5
EA United Kingdom United States
Inflation expectations six to ten years ahead(annual percentage change)
11
This leaves only two ways
Plan A: Fiscal adjustment
Plan B: Default / Restructuring
12
All euro area countries have programmes to reduce the deficit/GDP to below 3% by 2012-2013
Greece and Ireland are implementing EU/IMF adjustment programmes
IMF, EU and EU countries are providing Greece and Ireland with unprecedented financial assistance
EU countries have created the EFSF and changed the Treaty to create the ESM in 2013
Euro area countries have opted for Plan A
13
Markets/Academics/Commentators have doubts
The reasoning is the following:
1. The required fiscal adjustment is too costly
2. It cannot be politically sustained
3. EA solidarity will not hold
4. Therefore the only solution left is “Plan B”:
-
(partial) default/restructuring
-
Exit/split the euro
14
Markets have reflected these doubts
5-yr Sovereign CDS Spreads
(basis points)
Source: CMA DataVision via Datastream
0
250
500
750
1000
1250
Jan.09 Apr.09 Jul.09 Oct.09 Jan.10 Apr.10 Jul.10 Oct.10 Jan.11
GermanyFranceItalySpainGreeceIrelandPortugal
15
Source: Commodity Futures Trading Commission (CFTC)
Euro
-120
-100
-80
-60
-40
-20
0
20
40
60
80
100
120
140
Jan 09 Apr 09 Jul 09 Oct 09 Jan 10 Apr 10 Jul 10 Oct 10 Jan 110.94
1.00
1.06
1.12
1.18
1.24
1.30
1.36
1.42
1.48
1.54
1.60
1.66
1.72
Net EUR Pos itions (LHS)EUR/USD Rate (RHS)
Also affecting confidence in the euro
16
What’s missing in the reasoning?
Plan A is considered “too costly” but there is no assessment of the costs of Plan B
In fact, Plan B is itself extremely costly, in economic and political terms
Plan B can be more costly than Plan A:
- For the country itself
- For the other euro area countries
17
Plan B has been implemented only in developing countries
Over the last 20 years, 19 countries out of 120 IMF programmes had debt restructuring:
1998 Ukraine, Russia, Pakistan, Venezuela 1999 Gabon, Indonesia, Pakistan, Ecuador 2000 Ukraine, Peru 2001 Argentina, Cote d'Ivoire 2002 Moldova, Seychelles, Gabon 2003 Dominican Republic, Paraguay, Uruguay 2004 Grenada 2005 Dominican Republic 2006 Belize
A closer look at Plan B
18
The experience shows
Plan B has large reputation / penalty costs
• Loss of market access
• Higher future borrowing costs
• Trade sanctions by creditor countries
Broader costs to the domestic economy
• Output losses
19
High borrowing costs and contagion
Evolution of the EMBIG spreads around crisis episodes (in basis points)
Source: Haver Analytics.
0
1000
2000
3000
4000
5000
6000
7000
8000
2001 2002 2003 20040
500
1000
1500
2000
2500
3000Argentina Brazil (rhs)Uruguay (rhs)
20
EMEs’ experience is not a good guide
The experience of the emerging market economies (e.g. Brady plan) cannot be directly applied to the current situation in advanced economies
Default in EMEs was typically the result of a foreign exchange crisis, which increased the burden of the foreign debt in an unsustainable way
Fiscal adjustment was unsustainable as it fuelled exchange rate depreciation, which increased the burden of the debt
21
EMEs’ experience is not a good guide (2)
The default/restructuring of the debt in developing countries mainly affected foreign creditors
When domestic creditors were involved, very restrictive measures were implemented through administrative and capital controls (e.g. corralito
in Argentina)
22
Restructuring/Default in advanced economies
Affects domestic residents’ wealth:
-
directly through the holdings of government debt by the private sector
-
indirectly, through the role played by government guarantees in the financial sector
Produces strong contagion in other countries
23
Residents hold a large share of government debt
Source: ECB
Euro area: holdings of government debt by residents and non-residents (end 2009)(share of total debt)
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
Debt held by non-residents of the Member State
Debt held by residents of the same Member States
24
Impact on the domestic financial system
A restructuring of sovereign debt has a direct effect on the solvency of domestic financial institutions inter alia
through:
-
direct holding of government debt
-
access to collateralised credit
-
government guarantees
25
As shown by the strong correlations: Greece
Source: CMA DataVision via DatastreamLatest observation: 3 Feb. 11. Note: Five-year CDS; basis points.
0
250
500
750
1000
1250
1500
Jan.09 Apr.09 Jul.09 Oct.09 Jan.10 Apr.10 Jul.10 Oct.10 Jan.11
Sovereign CDSAlpha BankEFG Eurobank Ergasias SANational Bank of GreecePiraeus Bank
26
Ireland
Source: CMA DataVision via DatastreamLatest observation: 3 Feb. 11. Note: Five-year CDS; basis points.
0
300
600
900
1200
1500
Jan.09 Jul.09 Jan.10 Jul.10 Jan.11
0
500
1000
1500
2000
2500
3000
3500
4000
4500
5000Sovereign CDSAllied Irish Banks Bank of IrelandIrish LifeAnglo Irish Bank (rhs)
27
Portugal
Source: CMA DataVision via DatastreamLatest observation: 3 Feb. 11. Note: Five-year CDS; basis points.
0
200
400
600
800
1000
Jan.09 Apr.09 Jul.09 Oct.09 Jan.10 Apr.10 Jul.10 Oct.10 Jan.11
Sovereign CDSBanco Comr. PortuguesBanco Espirito SantoCaixa Geral de Depositos SABanco BPI SA
28
Spain
Source: CMA DataVision via DatastreamLatest observation: 3 Feb. 11. Note: Five-year CDS; basis points.
0
100
200
300
400
500
600
Jan.09 Apr.09 Jul.09 Oct.09 Jan.10 Apr.10 Jul.10 Oct.10 Jan.11
Sovereign CDS Santander
BBVA Banco Popular Espanol SA
Caixa d'Estalvis de Cataluny Caja de Ahorros y Monte de Piedad
La Caja de Ahorros y Pension
29
Effects on the banking system
A sovereign default/restructuring produces
major losses for domestic banks and fuels a bank run by depositors, which triggers:
-
Administrative measures, capital controls
-
Restructuring of bank liabilities (bonds, deposits..)
-
Credit crunch
30
Effects on the real economy
Very sharp contraction, through:
-
Direct wealth effects
-
Credit crunch
-
Non market measures
Social/political repercussions difficult to assess
(it’s not by chance that default/restructuring has occurred mainly in non-democratic systems)
31
Contagion
Default/restructuring in one country tends to produce immediate contagion effects in other countries
This would impact on financial stability in the euro area as a whole
32
Contagion
Source: Datastream and ECB calculations
Note: basis points, last observation 27 Jan 2011. Extracted from daily data on 5-year euro area sovereign CDS. CDS series and the Principal Component are standardized.
Aug08 Nov08 Feb09 May09 Aug09 Nov09 Feb10 May10 Aug10 Nov10
-1.5
-1
-0.5
0
0.5
1
1.5
2
1st Principal ComponentCross-sect. average of standardized CDS
33
Would exiting the euro make it easier?
The fear of exiting the euro would accelerate the bank run by domestic residents (to withdraw euro)
The domestic banking system would lose access to euro area financial market and to ECB refinancing, and would have to reduce in parallel its assets
The redenomination of financial instruments in new (devalued) currency would trigger cross-
border litigation but possibly also within the country
The country would lose access to EU facilities and funds
34
Is there an “optimal timing”?
When primary balance is achieved, and thus the government does not need to tap the market
The negative impact of Plan B is not lower while most of the costs of Plan A have been paid (especially politically)
When markets are better prepared (now?)
The experience of Lehman Brothers’ collapse, which was anticipated for some time, shows that markets are never fully prepared for such a systemic event
35
To sum up
Plan B implies:
Restructuring Wealth effect Demand shock
Impact on the banking system
Investment Lower capital stock Supply shock
Plan A implies:
Increase in primary surplus Demand shock
36
Plan A
37
Plan A is made on the basis of an assessment that the country is solvent
Plan A consists of:
1. Fiscal and structural adjustment in the member state to ensure debt sustainability
2. Reform of the governance of euro area to safeguard stability in the euro area
Plan A
38
The solvency of a sovereign is different from that of a company or a financial institution
Solvency of a sovereign depends on ability/willingness to implement the adjustment programme, against any alternative scenario
In particular, the ability/willingness to:
-
tax (personal, corporate, special..)
-
cut expenditure
-
sell assets
Assessing solvency
39
The adjustment programme defines a primary budget surplus which would stabilise and reduce over time the debt/GDP, on the basis of:
-
the interest rate level
- growth
-
the level of debt
Debt sustainability analysis
40
Primary balances needed to stabilise
debt-to-GDP ratio
Debt stability conditions
Spain Portugal Ireland GreeceDebt-to-GDP ratio projected for 2012* 73.0 92.4 114.3 156.0
r-g2 1.5 1.8 2.3 3.14 2.9 3.7 4.6 6.26 4.4 5.5 6.9 9.4
*European Commission autumn 2010 forecast
Primary balances needed to stabilise the debt-to-GDP ratio (at the level projected by the European Commission for 2012) in the long-run (steady state) under different assumptions for the interest rate-growth differential
41
The adjustment is substantial: Greece
Greece: projected general government debt and primary balance under
current EU/IMF programme (percentage of GDP)
Source: IMF - Second review under the Stand-By Arrangement
-15
-10
-5
0
5
10
15
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
0
40
80
120
160
Primary balance (% of GDP) (lhs)General government debt (rhs)Real GDP growth (percent) (lhs)
42
And in Ireland
Source: IMF - Staff Report - Request for an extended arrangement
The primary balance figure for 2010 has been corrected for the one-off impact of government support to Irish banks
Ireland: projected general government debt and primary balance under
current EU/IMF programme (percentage of GDP)
-15
-10
-5
0
5
10
1520
09
2010
2011
2012
2013
2014
2015
0
40
80
120
160
Primary balance (% of GDP) (lhs)General government debt (rhs)Real GDP growth (percent) (lhs)
43
But not unprecedented
General government primary balance(as a percentage of GDP)
Sources: OECD, IMF
Ireland
-10
-5
0
5
1019
81
1982
1983
1984
1985
1986
1987
1988
1989
60
80
100
120
140
prim a ry ba la nc ere a l e ffe c tive e xc ha nge ra te (1980=100)
44
The interest rate on the programme is aligned with IMF rules and procedures
Interest rate ± 6% can ensure debt sustainability
What is key is the rate at which countries have borrowed, from the market or through the IMF/EU programme
If successful, the Program can be lengthened (standard procedure in the IMF)
EFSF could be made more effective, e.g. linking the interest rate to performance (while remaining non-concessional)
The interest rate level
45
The debt level
The higher the debt level, the higher the primary surplus required to stabilise the debt
However, a primary surplus is needed in most cases
In the case of Greece, the primary surplus required to stabilise and reduce the debt after 2013 is ±
6%
If the debt were cut by one-third, the primary surplus would still be relevant
46
Primary balances needed to stabilise
debt-to-GDP ratio
Debt stability conditions (repeat)
Spain Portugal Ireland GreeceDebt-to-GDP ratio projected for 2012* 73.0 92.4 114.3 156.0
r-g2 1.5 1.8 2.3 3.14 2.9 3.7 4.6 6.26 4.4 5.5 6.9 9.4
*European Commission autumn 2010 forecast
47
Primary balances needed to stabilise the debt-to-GDP ratio (at the level projected by the European Commission for 2012) in the long run (steady state) under different assumptions for the interest rate-growth differential
Restoring sustainability
The previous slide shows that if the primary surplus needed to achieve sustainability is considered too high because the market interest rate is high, there are two ways to restore sustainability:
-
reduce the interest rate burden (and lengthen the maturity), while keeping it non-concessional
-
haircut on debt
For (official) creditors the first solution is preferable because it involves no capital loss
48
Market ways to reduce the debt burden
Under discussion: buy back at market prices (lower than nominal), by the member state or through the EFSF, subject to strict conditionality
Win-win situation:
-
reduces the debt burden
-
provides market liquidity
-
short-term investors can sell (at a loss)
49
Restoring pre-crisis growth will be difficult
Source: European Commission’s economic forecast autumn 2010
Note: Real GDP per capita refers to gross domestic product at 2000 market prices per head of population.
Real GDP(average growth 1999-2008)
0.0
1.0
2.0
3.0
4.0
5.0
6.0
Irela
nd
Gre
ece
Spai
n
Uni
ted
Stat
es
Uni
ted
King
dom
Euro
are
a
Portu
gal
Ger
man
y
Japa
n
Real GDP per capita(average growth 1999-2008)
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
Irela
nd
Gre
ece
Spai
n
Uni
ted
King
dom
Uni
ted
Stat
es
Euro
are
a
Ger
man
y
Japa
n
Portu
gal
50
But growth is key
Restore competitiveness
-
mainly through domestic adjustment
Lack of exchange rate flexibility
-
not an excuse
Structural reforms are essential
51
Devaluation is no panacea
Source: European Commission
Trade openness across euro area countries (exports plus imports in % of GDP, nominal)
0
20
40
60
80
100
120
140
160
180
Fran
ce
Italy
Gre
ece
Spai
n
Portu
gal
Euro
are
a
Finl
and
Ger
man
y
Cyp
rus
Aus
tria
Slov
enia
Net
herla
nds
Slov
akia
Bel
gium
Mal
ta
Irel
and
0
50
100
150
200
250
300
350
Luxe
mbo
urg
52
Structural reforms start to be implemented
Greece
Competition and productivity
–
Deregulation of transport and energy sectors–
Opening up of closed professions
–
Implementation of Services Directive –
Restructuring of state-owned enterprises and bringing in of private management
53
Labour market flexibility and labour supply–
Reduction of employment protection
–
Facilitating use of part-time work/flexible work arrangements
–
Reform of the arbitration system
Pension reform–
Extensive reform to improving long-run sustainability
–
Simplification of fragmented system, with universal, binding rules on contributions and corresponding entitlements
–
Increase in retirement age to 65 and contributory period for full pension from 35 to 40 years
54
Ireland
Financial system:•
Stabilise and downsize the banking sector
•
Improve solvency and funding of viable banks•
Quick resolution for non-viable banks
•
Increase confidence in viable banks by fully recognising losses in loan portfolios
•
Burden-sharing by holders of subordinated debt
Product and labour markets •
Reduction of the minimum wage
•
Reform of the unemployment benefits system•
Deregulation of sheltered sectors of the economy
55
Portugal
50 structural measures announced mid-December 2010 to be legislated by end-March 2011, including:
•
Fostering the export sector and investment in R&D with tax incentives
•
Reducing administrative burdens of the export sector •
Strengthening wage flexibility and reducing overall employment protection
•
Improving the rental market•
Reducing the size of informal economy
56
Spain
Product markets•
End 2009: transposition of Services Directive
•
Early 2010: streamlining of procedures for business creation
Labour market•
June 2010: improvements to some aspects of hiring system and collective bargaining, improving firms’ flexibility
57
Spain
Pension reform •
January 2011: approval of draft pension reform bill, agreed with social partners, including gradual increase in the retirement age (from 65 to 67) and increase in contributory period for full pension (from 15 to 25 years)
Financial system•
Mid 2010: restructuring of the “cajas de ahorro”, reform of legal framework, extension of options for issuing equity capital
58
The impact on competitiveness is starting
Compensation per employee
(Annual % changes)
Source: European Commission (Autumn 2010 forecast).
-2
-1
0
1
2
3
4
5
6
7
2010 2011 2012
Germany Greece Ireland Portugal Spain
Average 1999-2008
59
European governance has evolved
In less than one year:
Financial support for Greece (April 2010)
Creation of the EFSF (May 2010)
Reform of the SGP (October 2010)
Change in the Treaty for ESM (Dec 2010)
“Comprehensive Package” (March 2011)
If not sufficient…“We will do what is needed”
60
Why so slow?
Fiscal adjustment and governance reform are costly in the short term, from an economic and political view point
Governments tend to take the political cost only when they can explain to their constituencies that the alternative (default, euro instability) is much more costly
The evidence that the alternative is more costly emerges only under the pressure of the markets
61
Sources: Bloomberg, Thomson Reuters Datastream and ECB calculations.
Greece
Spread over German 10-year government bond yield (2009-2010; daily data; in basis points)
Data: Bond yield spreads vis-à-vis the German 10-year government bond, end-of-day data.
-100
0
100
200
300
400
500
600
700
800
900
1000
Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10
11 May 2010
Rescue plan
22 February 2010EC/ECB mission
Action has been delayed
62
Action has been delayed
63
Sources: Bloomberg, Thomson Reuters Datastream and ECB calculations.
Ireland
Spread over German 10-year government bond yield (2010; daily data; in basis points)
Data: Bond yield spreads vis-à-vis the German 10-year government bond, end-of-day data.
-100
0
100
200
300
400
500
600
700
Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10
07 Dec 2010Presentation of 2011 budget
28 August 2010Dow ngrading by S&P
28 Nov 2010Announcement of the IMF/EU program
11 May 2010Rescue plan
Conclusions
Plan A is painful, but most likely it is less costly than the alternative:
-
for the debtor countries
-
for the creditor countries
There are ways to make Plan A less costly, “more effective”, conditional on a positive adjustment track
Need to avoid moral hazard
64
Conclusions
(2)
Euro area governments are committed to Plan A
Plan A will deliver stronger fundamentals over the medium term for the euro area and for the member countries
65
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