Már Guðmundsson: Sovereign risk - a world without risk-free assets?
Remarks by Mr Már Guðmundsson, Governor of the Central Bank of Iceland, in a policy
panel at a seminar on "Sovereign risk - a world without risk-free assets?", Bank for
International Settlements, Basel, 8-9 January 2013.
* * *
I would like to cover three issues in my remarks. First, I will reflect a bit on the title of the
seminar and some of the more specific questions directed at this panel. Second, I will
discuss the nexus between sovereign risk and banking fragility, using Iceland as a case
study - after all, the Icelandic experience is probably the reason that I am taking part in this
interesting seminar in the first place. Third, and again with reference to the Icelandic case, I
will reflect on the connection between sovereign ratings of advanced countries and actual
sovereign defaults.
The title of this seminar is Sovereign risk: a world without risk-free assets? As has been
repeatedly pointed out, there is, strictly speaking, no such thing. The default probabilities of
even the strongest sovereigns are not zero, and they increase as the horizon gets longer.
Furthermore, the real income stream of nominal government bonds is uncertain. The same
applies to the FX income stream facing foreign investors, and then there are risks such as
the possible introduction of capital controls, which will not count as defaults as long as debt is
serviced on time in the domestic currency of the sovereign without discrimination between
domestic and foreign investors.
Although it is important to bear all this in mind, it is nothing new. Furthermore, it does not
constitute a major problem for the functioning of capital markets as long as the default
probabilities of sovereigns seen to be providing so-called risk-free assets are perceived to be
so low at the relevant maturities that they can largely be ignored. The question we are faced
with is whether this is still the case and what the future will bring in this regard, given that
both the market and the rating agencies perceive an increase in sovereign risk. The jury is
still out, but my current prediction is that, in the foreseeable future, the supply of risk-free
assets according to this definition will be very significantly greater than zero.
Advanced countries with grade-A ratings are and will be issuing a lot of debt in the near term,
and the high price that the best-perceived sovereign debt is carrying is a reflection of strong
demand rather than weak supply. In spite of everything we have gone through, there has
been no sovereign default of any advanced country apart from Greece since the interwar
period. Yes, many of these countries have been downgraded lately, but what that means in
terms of actual default probabilities is not clear to me at this point, although it might be
somewhat clearer after the next session. The fact of the matter is that advanced countries
have both considerable means and strong incentives to avoid default. Even Iceland was able
to avoid a default after the collapse of 90% of its financial sector and its deepest recession
since the interwar period. So, for the post-war period, Walter Wriston has been largely right so
far, in saying that "countries don't go bust" - as far as advanced countries are concerned -
although he was wrong as regards all countries. And what holds for advanced countries in this
respect does so increasingly for the more important and advanced EMEs.
I am not denying that sovereign risk has increased, more broadly speaking. Higher deficits
and debt levels and weaker growth prospects bear witness to this. But the degree to which
this translates into higher default probabilities in the narrow sense is not clear. My prediction
is that default probabilities will remain low for most advanced countries.
What, then, about the reaction of rating agencies and markets? Here again, we have the
question of what rating agencies are actually trying to measure. I have long experience of
dealing with them in my current and past jobs, and I have the sense that they are measuring
something more than default probabilities. Partly, therefore, a downgrade by one or two
notches within an investment-grade category could be consistent with my view. Then, on top
of that, there is a significant amount of evidence to suggest that ratings do not see through
the cycle. So the rating agencies and the markets are probably overestimating sovereign risk
at the current juncture, in the same way that they underestimated it prior to the crisis. There
is one important proviso to this statement, however: the negative feedback loop between
sovereign risk and bank fragility, which in historical terms has been particularly severe in the
recent period. Thus, for some countries, the markets might be factoring in further
socialisation of private sector losses. Therefore, in addition to medium-term fiscal
consolidation, a weakening of the nexus between sovereign risk and banking fragility is key.
And that is where Iceland comes in.
The collapse of Iceland's three cross-border banks in early October 2008 was the most
noticeable event in the unfolding of the financial crisis that hit the country that year. The
combined balance sheets of these banks was 10 times Iceland's GDP, and their combined
bankruptcy, measured in terms of balance sheets, ranks second in size in the international
history of corporate failures, only after Lehman Brothers. And this happened in a country that
ranks among the smallest in the world. We are still dealing with the complications that this
entails, as can be seen in our overblown and unbalanced IIP and the controls on capital
outflows.
Before the collapse, the banking system had expanded very rapidly, growing in just five
years from a combined balance sheet of less than 2 times GDP (at the end of 2003) to
almost 10 times GDP (in mid-2008). Most of this expansion was cross-border, and a
significant part of it was really off-border, having very little to do with Iceland, as both
financing and investment took place abroad.
In the panic that gripped global financial markets after the collapse of Lehman Brothers,
these banks were faced with a wholesale run on their foreign currency liabilities and were
therefore heading towards a default on those liabilities in the absence of LOLR assistance in
foreign currency. However, given the size of the balance sheets, it was impossible for the
Icelandic authorities to provide such assistance on their own, and it could have been
catastrophic for the credit of the sovereign if they had made a full-scale attempt to do so.
The Icelandic authorities' actions were based on the assumption that the banks were solvent,
which in turn was based on published financial accounts and the analysis of the supervisor.
On that premise, the authorities tried to build defences against potential foreign currency
liquidity problems at the banks by negotiating swap lines and tapping foreign capital markets,
in both cases with limited success. Now, however, we know that there were hidden
vulnerabilities in the banks' capital positions.
There was also a failed attempt to nationalise one of the banks in late September 2008. It
was indeed fortunate that it did fail, as nationalising the bank would have turned a bank
foreign currency refining problem into a sovereign problem, with the serious risk that the
sovereign might have defaulted on such foreign currency payments.
In this light, and given the lack of international cooperation, the Icelandic authorities were
forced to consider radical solutions. Although they were not necessarily articulated fully at the
time, these solutions entailed several goals: preserving a functioning domestic payment
system, ring-fencing the sovereign in the case of bank failures, limiting the socialisation of
private sector losses, and creating the conditions for rebuilding a domestic banking system.
In essence, the adopted solution saved the domestic operations of the banking system by
splitting up the banks and allowing the international part to go into a resolution process.
Furthermore, in order to stop an incipient run on domestic deposits, all deposits in Iceland
were declared safe and all deposits in Icelandic-headquartered banks were given priority
over other unsecured claims. As a result of these measures, the domestic payment system
functioned more or less seamlessly throughout, and common citizens had continuous access
to their deposits.
There are still a number of misconceptions about this process in international discussions.
There have been claims that Iceland allowed its banking system to collapse, with what now
seem reasonable results, and that others should consider doing the same. The fact is that
Iceland kept the domestic part of its banking system running throughout; otherwise, the
consequences would have been dire. Some have claimed that the banks were nationalised.
They were not. The old banks are private companies. They are in winding-up proceedings
governed by law; they are not under the control of the Government. The Government has a
majority stake in only one of the new banks. Others have claimed that Iceland defaulted and
got away with it. The opposite is true. The credit of the sovereign was preserved, and all debt
obligations have been paid on time. Moreover, the investment-grade credit ratings from
Moody's and S&P were preserved throughout the crisis. This is why the sovereign has been
able to tap international capital markets twice so far since the crisis struck.
So the bottom line is that a sovereign default was avoided in spite of an almost
unprecedented financial collapse and the worst economic recession since the interwar years.
A key to that result was the ring-fencing of the sovereign from the collapse of the private
banks. All debt service payments on sovereign debt, in both domestic and foreign currencies,
have been made in full and on time. But the avoidance of default during the crisis does not
come without the willingness to use the means available to avoid that outcome, even in very
adverse situations, and the ability to endure the temporary hardship that comes with it. In
addition, Iceland - like Ireland, probably - was helped by a relatively good fiscal position
prior to the crisis. The fiscal consolidation that began in 2010 and has already resulted in a
significant primary surplus was subsequently an important factor in restoring external
confidence, which fell to what, in retrospect, seems an unjustifiably low level. In Iceland's
case, the overall effort was made easier by the outside assistance of the IMF, the Nordic
countries, and Poland. The same consideration applies to the hardest-hit EU countries and
should be kept in mind when assessing their probability of default.
Finally, let me say a few words about credit ratings and market perceptions in the Icelandic
saga, which broadly conforms to more general patterns. Both the sovereign and the private
Icelandic banks were assigned triple-A ratings by Moody's for a period prior to the crisis (the
sovereign from October 2002 to May 2008 and Kaupthing Bank from February 2007 to
April 2007). In the case of the banks, the stated argument was that the Government would
stand behind them in times of difficulty. We now know that this was nonsense, given the size
of the banks and the scale of their international activities. In case of the sovereign, this rating
was not so bad after all!
The bank ratings then started to fall in early 2008 and then plunged to sub-investment grade
after the banks had collapsed. The sovereign rating, however, although it fell over the course
of 2008, never fell to sub-investment grade with Moody's and S&P, and it only fell below
investment grade with Fitch Ratings after the president sent the so-called Icesave deal to a
referendum in January 2010. It is now back to investment grade with all three agencies.
It is interesting to see how both ratings and market perceptions evolved around two key
dates in September/October 2008, when decisions were taken that could drastically affect
sovereign risk. The first date was 29 September, when an announcement was made of the
Government's intention to take a 75% ownership stake in one of the three cross-border
banks, an action that should increase sovereign risk. The other date was 6 October, when
Parliament passed the so-called Emergency Act, which severed the nexus between the
sovereign and the private banks and drastically reduced objective sovereign risk. Both the
rating agencies and the market got the sign of the first event right: S&P downgraded the
sovereign by one notch and Glitnir by one notch the day after; Fitch downgraded them the
next day by two and three notches, respectively; and Iceland's sovereign CDS spread shot
up to almost 600 in the first two days after the announcement, from around just over 300 in
the days prior. But both the rating agencies and markets got the sign of the second event
completely wrong, with further downgrades and the CDS peaking at 1473 on 10 October. It
took them a while to correct this, and the CDS was down to around 180 by the end of 2012.
To be sure, there were other things going on at the time, but still!
Let me conclude by saying that the Icelandic case seems to support the conclusion that it is
premature to state that we are in or heading towards a world without risk-free assets in the
narrow sense. It will take policy mistakes of gigantic proportions in several parts of the world
to get there. But the risk is not and never has been zero.