1

Copenhagen 2012

Comments by Marcus MillerUniversity of Warwick

The European Sovereign Debt Crisis: Background and Perspectives

What is the Risk of European Sovereign Debt Defaults? Fiscal Space, CDS Spreads and Market

Pricing of Risk by J. Aizenman, M. Hutchison and Y. Jinjarak

2

What kind of market,

friends, is this?

Fundamentally driven;

or fancy free?

3

AHJ analyse the sovereign debt component of the (largely OTC) CDS marketThis amounts to $2.5 trillion in 2010 , which exceeds the total of US government-issued international debt ($2.2 tr) and US GDP ($1.5 tr)!Regression analysis is used to relate sovereign spreads to fundamentals for 50 countries, over the period 2005-2011 for 3, 5 and 10 year CDS’ with the focus on the SWEAP* group in particular. The fundamentals include two measures of ‘fiscal space’: debt to tax base and deficit to tax base.

*South-West Eurozone Periphery

4

All-too- brief summary of findingsAfter a fascinatingh and well-documented empirical analysis, the authors conclude that:

1. ‘fiscal space is validated as an important determinant of market-based sovereign risk’, i.e. the fiscal fundamentals are statistically significant, but

2. there are large prediction errors in pricing SWEAP risk, with under prediction before the crisis and over prediction during the crisis.

Two explanations of these prediction errors are suggested:• Market failure (‘excessive pessimism and overreaction’)• Expected future fundamentals.

5

3 Comments• A. FF are treated as exogenous, but -if the deficit

includes debt servicing costs- are likely to be endogenous. Is there not a risk of bias?

• B. Is there not a possibility of Type II error? The Maintained hypothesis is ‘spreads reflect current fiscal fundamentals (FF)’: what of Alternative hypothesis that ‘there are multiple equilibria’, Calvo (1988)? • C. Need to add strategic aspects? 1) Games between financial intermediaries. 2) Interaction between markets and government.

6

Caveats• Definition of Fiscal Fundamentals (debt and deficits)

not too clear from paper, in particular• Fiscal deficit: is this primary deficit, or does it include

costs of debt service?(Note that text treats both fiscal fundamentals as ‘risk increasing’ (p.13); but

in regressions it’s the fiscal surplus that is used, hence negative sign.)

• No explicit account is taken of government action and reaction at national or supranational level. (If one is considering sovereign default, should variables not be included to reflect

political economy considerations?).

7

Error vector

SS

FF

Actual spread

Predicted spread,

αFFSS= ∝FF+ ε If ε positively correlated with fundamentals, OLS estimate of ∝ will be biased upwards.

Is there a bias because actual market spreads affect fiscal fundamentals?

8

No default

Partial default

Full default

R

E1

E0

𝑅𝑏1

x*

g

xg+bRb

Rb

g+αbRb

Safe rate Risky rate

Endogenous Fiscal Fundamentals: Calvo’s self-fulfilling crisis for solvent sovereign (E0 -> E1)

Government expenditure including cost of debt service at the safe rate R

‘Optimal’ level of tax chosen by govt

Market Rate, including sovereign spread

Government expenditure including legal costs of default

9

Government Reaction

Θ

11

𝑅𝑏1𝛩𝑒

1

RRb

1

1/(1-α)45𝑜

Default : actual and expected

𝛩𝑒

Market expectation

Partial default Θ1

45𝑜

Full

No

Θe

Market and government: Expected and actual default - Calvo revisited

[Θ = rate of default]

10

Spreads

FFβ

Good ME Bad - insolvent

𝑅𝑏1

Maintained hypothesis (Aizenman et al.)

Alternative hypothesis - multiple equilibria (Calvo)

Maintained and Alternative Hypothesis

SS= ∝FF+ ε

11

Under the alternative hypothesis, there is of course the problem of ‘equilibrium selection’. Question: when will the market switch from the safe rate to one which reflects the partial default that it causes?One idea is ‘sun spots’, i.e. exogenous randomness.Another is that the switching reflects mixed strategies in a market game.

12

Payoffs : (Buyer, Seller)

Probabilities in parentheses(Nash Equilibrium p=2/3, q=1/3

i.e. expected payoff is 1/3 for both

players for either action)

CDS seller (underwriter)

Willing to pay up (q )

Will not pay

(1-q)

CDS buyer Only insures with ‘interest ‘ (p )

Market works

1, 1

‘Market failure’

0,0

Goes ‘naked’(1-p)

Explosive increase

in market

3, -1

Market

implosion

-1,1

A CDS ‘market game’ with mixed strategy equilibrium

13

Market works2/9

‘Market failure’ 4/9

Explosive increase in market 1/9

Market implosion2/9

Frequency distribution of outcomes

14

ConclusionThe authors are effectively testing the efficiency of the CDS market in measuring risk of sovereign default. The results for 2008-2010 imply that sovereign default risk was over-priced by a factor of 2.5 to 5 times (fundamentals greatly under-predict the actual spreads charged in the market).

The authors suggest that market price risk ‘follows waves of contagion’. Are they not verifying Calvo’s model of multiple equilibria?

15

Numerical Example of Calvo Model

• For the case of a country like Italy where the ratio of government debt to GDP is about 100%, we choose the parameters such that the critical value of market rates, above which the government will choose to default, is 7%, and the time consistent equilibrium with default is 20%. This implies α is about ¼ - i.e. You save ¾ by default!

Parameters: b=1, g=0.38, R=1.03, α=0.235, c=0.684

• For a country like Germany, where the ratio of government debt to GDP is close to the Maastricht criteria of 60%, we assume that the interest rate is 3% (with no default). If so, it turns out that the government will not choose to default until market rates reach 10%; and the time consistent equilibrium with default turns out to be over 30%.

Appendix

16

b (debt/GDP)

2.31.2

0.38

0.45

0.42

Tax as fraction of GDP

1

0.030.07

g

g+rbg+rb

“Italy”

“Greece”

1.6

Debt Write Down

Current Situation: A schematic outline.

Italy on the edge of default. Greece over the edge?

17

What about a country like Greece where debt is 160% of GDP? If the tax take was as for Italy, namely 45% of GDP, then the sustainable level of debt turns out to be much higher, if only interest rates stayed at German levels, but Greece collects a lot less tax than other European countries. If the tax take goes down from 45% to 42% of GDP, it turns out that debt is unsustainable, even at German rates and a write down of about 30% to reduce debt to 120% GDP is needed for sustainability.

(See diagram above)