Patrick Honohan: Sovereign risk - a world without risk-free assets
Panel comments by Mr Patrick Honohan, Governor of the Central Bank of Ireland, at the BIS
Conference on "Sovereign risk - a world without risk-free assets", Basel, 8 January 2013.
* * *
What's new about sovereign risk since the crisis began? Conceptually, not so much, I would
suggest - and nothing that cannot be fully explained within standard models of finance. But
in practice, and in particular in the euro area, two linked elements that were always
potentially present or implicit have leapt into prominence in a way and to an extent that was
not foreseen. The first is that markets have begun to price default risk in a sovereign's
home-currency; the second is the contamination of the functioning and economic
effectiveness of banks by the weak credit rating of their sovereigns (as well as vice versa).
I have to admit to the possibility that my remarks may be subject to some professional
deformation here, in that my perspective on these matters is likely coloured by my
pre-occupation with the situation in Ireland. Ireland has certainly displayed these two
elements in a dramatic way, but they are evidently present in half a dozen other euro area
countries also and to an extent which has had implications for the functioning of the
Eurosystem as a whole, and therefore on the global financial system.
Let me take these two points in turn. First the pricing-in of sovereign default risk in "home
currency".
Why did the default premium suddenly emerge?
Evidently, even though everyone understood the rules, no such pricing-in occurred for the
first decade of the Eurosystem (Figure 1). Risk appetite was high for much of that period, but
the market's perception of sovereign risk must also have remained low. (Perhaps, despite
Treaty prohibitions, market participants assumed that any sovereign that got into trouble
would be bailed-out). Indeed, sovereign spreads in the euro area were almost totally
insensitive to credit ratings before the crisis (Figure 2).
One often-heard interpretation of what happened during that decade is that the complacent
market environment relaxed the budget constraint on euro-area sovereigns and led them to
borrow recklessly. Actually this story doesn't fit the facts very well. After all, although
sovereign debt ratios in most of the Eurosystem did not fall as much as they could and
should have on the good years, at least they did not increase dramatically before the crisis
(Figure 4). (Private debt ratios, and in particular the size of the bank and near-bank systems
did increase, but that is a somewhat different story, to which I will turn shortly).
It's possible alternatively that there was a multiple equilibrium here, with the "good" or low
interest equilibrium (with a self-fulfilling degree of confidence in the creditworthiness of all the
sovereigns) being selected by the market at the start of the euro, and events during the
financial crisis - not least those associated with Greece - having tripped the system into the
"bad" or high interest equilibrium with default risk premia moving a number of sovereigns into
a more challenging debt sustainability position.
Most likely, what we have seen is a combination of factors: (i) a sharp reduction in risk
appetite resulting in even little-changed debt ratios, as in Italy, looking more challenging and
in need of a risk-premium; and in addition (for most countries) (ii) a sharp increase in debt
ratios as governments reacted to the crisis (including, but not at all confined to, the
socialisation in most countries of some private banking losses through their assumption by
governments) (Figure 4 again). The increased sensitivity of sovereign spreads to ratings, and
the increased range of ratings themselves - both illustrated in Figure 2 - suggest that both
factors are at work.
(As spreads widened in stressed countries, their fluctuations - which would not concern
hold-to-maturity investors - added a risk factor for others and probably ratcheted up the
average level of the spreads.)
In the specific case of Ireland, the depth of the recession and the remarkably high elasticity
of tax revenues and the Government deficit to the downturn, combined with the unfortunate
decision to lock-in a very comprehensive bank guarantee before the potential scale of the
banking losses could at all be appreciated, meant that Ireland's actual and prospective
general government debt made a shocking turnaround from about 25 per cent of GDP in
2007 to 117 per cent just five years later.
Historians will debate the exact triggers for the market's loss of confidence in the Irish
sovereign. Even as late as April 2010, after the first sampling indicated the scale of the
banking losses, sovereign spreads were little more than 1 per cent. By November of that
year (just a few weeks after the Deauville statement which persuaded the markets that
private sector holders of euro sovereign debt would not be immune from loss-sharing) large
banking outflows and spreads exceeding five per cent made recourse to official assistance
inevitable. (Figure 3 shows the plot with some relevant news stories flagged). Perhaps the
most significant take-away from the sequence of spikes and troughs is the fact that some of
them clearly relate to news that is country-specific, some of them to euro area general news.
The same is doubtless true for all of the stressed sovereigns.
Default risk vs. devaluation risk vs. redenomination risk
It's worth pausing to recall that raw sovereign spreads such as we are seeing today in the
euro area are not remotely unprecedented in pre-euro history. On the contrary, they were the
norm as is illustrated by Figure 1. The difference is that these spreads reflected a
combination of default risk and currency risk. During the last fiscal crisis of the 1980s Irish
sovereign spreads ballooned out also. But that was for local currency denominated debt.
Eurobond borrowing by the Irish Government remained at fairly tight spreads despite the
high overall debt ratio (higher than today), and the fact that almost half of the national debt
was denominated in foreign currency. The high spreads reflected devaluation expectations
and currency risk generally. And there were devaluations, though less than was baked into
the spreads - by between 250 and 300 basis points on average during the last ten years of
that ill-fated regime, the narrow-band EMS.
It is not that default and devaluation are close substitutes; not at all, and for several reasons.
For one thing, default has potential reputational consequences for the issuer qualitatively
different to those of devaluation. In addition, though, devaluation affects not only the
international value of the Government's debt promises, but also that of all other contracts
denominated in local currency; as a result, depending on the speed of price-resetting
(pass-through) it can affect competitiveness throughout the economy. These differences
have not been sufficiently emphasised, I feel, in recent discussion.
As an example, I could mention the Irish devaluation of August 1986. The main goal of this
important action was restoration of wage competitiveness, not a lowering of the real value of
the local currency-denominated debt. (Indeed, I recall that some domestic policymakers were
confused on this point and thought that the debt burden would actually increase as a result of
translation effect on the foreign currency debt!)
Such currency risk can be so extreme as to make it impossible for the sovereign to issue any
sizable amount of local-currency denominated debt to international lenders. In the literature,
such countries - all in the developing world (and not including Ireland, cf. Figure 5) - were
said to suffer from "Original Sin". Happily, the number of countries suffering "Original Sin" has
been diminishing in recent years. Instead, we have to acknowledge the emergence in market
pricing of a new phenomenon, "redenomination risk".
How can we recognise redenomination risk? This is not straightforward, not least because
the term could refer to a number of different scenarios. One suggested way of approaching
the question is to use econometric estimates of the cross-sectional determinants of
sovereign spreads for foreign currency-denominated borrowing to predict current spreads in
stressed euro area countries: a positive residual might suggest a redenomination risk
premium. Comparisons of current spreads of euro area sovereigns in euro and in foreign
currency-denominated borrowings provides for an alternative approach. My own favourite
approach is to look at the co-movement in the time series of euro area country spreads.
Some of this co-movement can be attributed to fluctuations in market risk-appetite; the
remainder could be interpreted as a system-wide redenomination premium.1 This brief
summary already suggests the complexity and ambiguity of some of the concepts involved
and their measurement.
Evidently, redenomination risk, as imagined by market commentators, combines default and
currency risk in a novel way not contemplated by the Treaty that established the euro area.
The ECB has made clear its determination to do what is necessary to preserve the euro and
remove unfounded euro break-up premia in sovereign yields. The OMT, designed as a
backstop to inhibit negative self-fulfilling market dynamics, provides the necessary tools to
deliver on that commitment. The programme does not go overboard in the direction of
removing the incentive for governments to manage their finances in such a way as to recover
and retain the confidence of the market, but it will ensure that disciplined governments will
not have to pay spreads that could only reflect market concerns about a system break-up. As
announced, the ECB will only buy bonds at the shorter end of the maturity spectrum, but the
OMT can be expected to have an influence transmitted by market forces throughout the yield
curve, and indeed spreads have tightened right across all maturities since the OMT was
announced.
Still, it is not to be expected that the OMT will by itself restore the tight uniformity of spreads
that prevailed for the first decade of the euro. Forcing such a tight uniformity would not be
generally considered safe absent more reliable alternative mechanisms for ensuring
disciplined fiscal policy in the countries concerned. More likely would be a potentially
extended period of sovereign spreads that, albeit narrower than at their worst, remain
material.
Sovereign spreads and the banks
That being so, we need to ask what are the consequences of these spreads for the rest of
the economy, and in particular for the operation of the banking system. Regardless of the
condition of the balance sheet and the profit and loss account of the banks, experience
shows how hard it is for banks in a jurisdiction where the sovereign is under stress to access
the money markets on the finest terms. In essence, the market fears that a stressed
sovereign could in extremis reach to the banks as a source of last resort financing - if
necessary using national legislation to do so. From such a perspective, providers of funds to
banks will tend to price-in the possibility that, at the margin, they could end up as indirect
providers of funds to a stressed sovereign. There are many examples in history of this
happening, and the consequences for bank funding costs have often been severe.2
In other words, while we have all become sensitised to the pressure which socialised
banking losses can place on the sovereign, markets are also acutely aware of the potential
damaging links in the other direction. Either way, there are consequences for the funding
costs of both the sovereign and the banks.
Given the scale of banking in the euro area, even a relatively small difference in funding
costs can be consequential. Once again, the Irish situation dramatises what can happen
when the two-way feedback loop between banks and sovereign causes a loss of access to
risk-free rates. As is well known, the Irish banks have suffered severe loan losses in the
aftermath of the bursting of the property price and construction bubble which they had so
enthusiastically financed. Very sizable capital injections (about 50 per cent of GNP from the
Irish Government alone - a sum which proved too great to be financed without the protection
of an IMF programme) have ensured that the Irish banks more than satisfy regulatory
requirements once again, but their future profitability is constrained by the emergence and
likely persistence of the sovereign spreads, and the knock-on effect of the spreads on the
banks' funding costs.
Euro-area risk-free rates are not now the most relevant indicator of the marginal cost of funds
to the Irish banking sector. It is, of course, true that the Irish banks (like those in other
stressed countries) have been drawing heavily on ECB refinancing facilities during the crisis,
especially following the huge outflow of funds that occurred in early 2009 and again in the
last few months of 2010. This access to refinancing has been vital to the continuing operation
of the banking system, and it has come at the policy rate.
(Let me mention as an aside a curious feature of the current monetary policy environment in
the euro area. The two key ECB rates - the main refinancing operations rate and the deposit
rate - are 75 basis points and zero, respectively. Access to both the refinancing and deposit
facilities are both close to all-time highs. But in practice, the bulk of the refinancing is going to
banks in the stressed countries, while the bulk of the deposits are placed by banks in
non-stressed countries. To the extent that the stressed countries have tended to have
weaker economic performance during the crisis, this pattern might be considered
paradoxical. But it is of course a reflection and semi-automatic consequence of the
fragmentation which has developed in the euro area. To be sure, the ECB policy rate is
clearly below the marginal cost of funds in the stressed countries.)
But access to ECB funds at the policy rate is limited by the availability of eligible collateral
and the haircuts that are applied to such collateral (despite the relaxation of eligibility
criteria). About 20 per cent of the total financing of the three going concern Irish controlled
banks comes from this source at present (16 per cent of the balance sheet total).
Competition for deposits therefore remains strong and rates high.
It's not just that higher bank funding costs will now be passed on to new borrowers, adding
headwinds to the economic recovery, though that is certainly a factor. Indeed, the lower
policy interest rates set by the ECB since the crisis began have only been partly transmitted
to borrowers in Ireland and in the other stressed euro area countries (Figure 6). (As is seen
by the results of a recursive regression exercise, the pass-through from policy rate to Irish
residential mortgage SVR rates has halved since the start of the crisis - Figure 7.) Some of
this can be rationalised as reflecting a higher credit risk-premium being charged by the
banks, but some is also due to the higher marginal cost of funds.
Worse still for the health of the banks, and their ability to contribute to the economic
recovery, is the fact that they are still coping with the consequences of their marginal cost of
funds having delinked so sizably from the ECB policy rate.
These consequences arise because of the long-term mortgage contracts the banks made
when they assumed that their marginal cost of funds would always remain close to the
(risk-free) policy rate. Suffice it to say that a large block of residential mortgages was granted
at interest rates which track the ECB policy rate plus a very low spread. These tracker
mortgages, many of which have an average remaining maturity of 15-20 years or more, yield
less than the marginal cost of funds (Figure 8 which is drawn on the assumption, not strictly
valid, that the average spread of the trackers over policy rate was unchanged over time). In
effect, by assuming that their cost of funds would not deviate much from the ECB policy rate,
the banks exposed themselves to a very large "basis risk". In principle, they could escape
this trap if there were a willing purchaser (public or private) with access to funding at a cost
that is not contaminated by the sovereign stress. Until such a purchaser comes forward, the
banks will have to continue to fund this portfolio at a loss, even on performing mortgages,
whose effects will spill over onto their customers and their owners (not least the State).
Conclusion
Irish Sovereign spreads may no longer be bloated by redenomination risk, but at 300 basis
points at the long-end, they do seem to reflect a credit risk premium that is poor reward, so
far, for what has been a sizable fiscal adjustment effort.
Reflecting on where we have got to, it seems that there are distinct parallels with the fiscal
crisis of the EMS period. As I mentioned, spreads (then reflecting devaluation risk) exceeded
what would have been needed ex post to compensate for actual exchange rate movements
by almost the same amount (250-300 basis points). Those spreads were transmitted to the
banking system then also.
The Irish financial situation is relatively extreme, and as such illustrates clearly some of the
key problems that have been faced also in other stressed parts of the euro area.
While it has delivered a much lower inflation rate, the euro is no longer insulating financial
markets from the impact of excessive debt in member countries. The early insulation of the
monetary transmission mechanism from fiscal problems of participating countries has worn
through. The pernicious feedback loop from banks to sovereign and from sovereign to banks
that re-emerged in the crisis remains strong and damaging.
Getting back to the "good" equilibrium will require a healing process which removes the
market's fear of default. It is inevitably a protracted process needing not only firm adherence
to consistently disciplined policies but also the creation of institutions that can prevent future
crises, or at least cope with them better if they cannot be avoided.

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