sovereign risk

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)


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)


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


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


Sovereign CDSAlpha BankEFG Eurobank Ergasias SANational Bank of GreecePiraeus Bank

26

Ireland


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


0

200

400

600

800

1000


Sovereign CDSBanco Comr. PortuguesBanco Espirito SantoCaixa Geral de Depositos SABanco BPI SA

28

Spain


0

100

200

300

400

500

600


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

sovereign risk

Economy & Finance

current euimf

primary surplus

european commission

year government

general government

thomson reuters

euro area

gdp ratio