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Sovereign risk
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Sovereign risk

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  • 1. Sovereign Risk and the Euro Lorenzo Bini Smaghi Member of the Executive Board European Central Bank London Business School 9 February 2011
  • 2. 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
  • 3. Government deficits have increased everywhere General government deficit (as a percentage of GDP) 14 2007 2009 12 10 8 6 4 2 0 Euro area United Japan United States Kingdom Source: IMF WEO October 2010 2
  • 4. And so has public debt General government gross debt (as a percentage of GDP) 250 2007 2015 200 150 100 50 0 Euro area United Japan United States Kingdom Source: IMF WEO October 2010 3
  • 5. Stabilisation of the debt in 2013 General governm gross debt ent (as a percentage of GDP) 120 100 80 60 Euro area (IMF) 40 United States (IMF) 20 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Source: IMF WEO October 2010 4
  • 6. Within the euro area the dispersion is large General government deficit (as a percentage of GDP)15 2007 2009 Euro area 200912 9 6 3 0 -3 Germany Luxembourg Slovakia Cyprus Belgium Italy Slovenia Greece Austria Netherlands Estonia France Malta Portugal Ireland Spain FinlandSource: European Commissions economic forecast autumn 2010 5
  • 7. Also in terms of debt General government gross debt (as a percentage of GDP) 180 2007 2012 Euro area 2012 150 120 90 60 30 0 Luxembourg Slovenia Netherlands Germany Ireland Finland Slovakia Belgium Portugal France Greece Italy Cyprus Estonia Spain Austria MaltaSource: European Commission - Autumn 2010 Forecast 6
  • 8. And ageing is bound to make things worse Projected change in age-related government expenditure, 2007-2060 (percentage points of GDP)201612 8 Euro area 4 0 Italy Luxembourg Germany Cyprus Slovakia France Belgium Finland Slovenia UK Portugal Ireland Greece Malta Austria Estonia Netherlands SpainSource: European Commission Ageing Report 2009NB: Some countries have, in the meantime, introduced pension and/or health care reform which should reduce long-term increases in age-related spending 7
  • 9. Three ways to reduce the debt burden A: Fiscal adjustment B: Inflation C: Default / Restructuring …or a combination of the above 8
  • 10. 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
  • 11. Inflation expectations remain well anchored Five-year forward break-even inflation rate five years ahead 3.50 Euro area US UK 3.25 3.00 2.75 2.50 2.25 2.00 1.75 Jan.09 Apr.09 Jul.09 Oct.09 Jan.10 Apr.10 Jul.10 Oct.10 Jan.11Sources: Reuters, ECB, Federal Reserve Board staff calculations, Bank of England 10
  • 12. Also in surveys of professional forecasters Inflation expectations six to ten years ahead (annual percentage change) 3.5 3.5 3.0 3.0 2.5 2.5 2.0 2.0 1.5 1.5 1.0 1.0 2004 2006 2008 2010 EA United Kingdom United StatesSource: Consensus Economics 11
  • 13. This leaves only two ways Plan A: Fiscal adjustment Plan B: Default / Restructuring 12
  • 14. Euro area countries have opted for Plan AAll euro area countries have programmes toreduce the deficit/GDP to below 3% by 2012-2013Greece and Ireland are implementing EU/IMFadjustment programmesIMF, EU and EU countries are providing Greeceand Ireland with unprecedented financialassistanceEU countries have created the EFSF and changedthe Treaty to create the ESM in 2013 13
  • 15. Markets/Academics/Commentators have doubtsThe 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
  • 16. Markets have reflected these doubts 5-yr Sovereign CDS Spreads (basis points) 1250 Germany France 1000 Italy Spain Greece Ireland 750 Portugal 500 250 0 Jan.09 Apr.09 Jul.09 Oct.09 Jan.10 Apr.10 Jul.10 Oct.10 Jan.11Source: CMA DataVision via Datastream 15
  • 17. Also affecting confidence in the euro Net EUR Pos itions (LHS) Euro EUR/USD Rate (RHS) 140 1.72 120 1.66 100 1.60 80 1.54 60 1.48 40 1.42 20 1.36 0 1.30 -20 1.24 -40 1.18 -60 1.12 -80 1.06 -100 1.00 -120 0.94 Jan 09 Apr 09 Jul 09 Oct 09 Jan 10 A pr 10 Jul 10 Oct 10 Jan 11Source: Commodity Futures Trading Commission (CFTC) 16
  • 18. 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
  • 19. A closer look at Plan BPlan B has been implemented only in developingcountriesOver the last 20 years, 19 countries out of 120IMF programmes had debt restructuring: 1998 Ukraine, Russia, Pakistan, Venezuela 1999 Gabon, Indonesia, Pakistan, Ecuador 2000 Ukraine, Peru 2001 Argentina, Cote dIvoire 2002 Moldova, Seychelles, Gabon 2003 Dominican Republic, Paraguay, Uruguay 2004 Grenada 2005 Dominican Republic 2006 Belize 18
  • 20. 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
  • 21. High borrowing costs and contagion Evolution of the EMBIG spreads around crisis episodes (in basis points) 8000 3000 Argentina Brazil (rhs) Uruguay (rhs) 7000 2500 6000 2000 5000 4000 1500 3000 1000 2000 500 1000 0 0Source: Haver Analytics. 2001 2002 2003 2004 20
  • 22. 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
  • 23. 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
  • 24. 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
  • 25. Residents hold a large share of government debt Euro area: holdings of government debt by residents and non-residents (end 2009) (share of total debt) 1 0.9 0.8 0.7 0.6 Debt held by non-residents of the Member State 0.5 0.4 Debt held by residents of the same Member States 0.3 0.2 0.1 0 Source: ECB 24
  • 26. 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
  • 27. As shown by the strong correlations: Greece 1500 Sovereign CDS 1250 Alpha Bank EFG Eurobank Ergasias SA National Bank of Greece 1000 Piraeus Bank 750 500 250 0 Jan.09 Apr.09 Jul.09 Oct.09 Jan.10 Apr.10 Jul.10 Oct.10 Jan.11Latest observation: 3 Feb. 11. Note: Five-year CDS; basis points.Source: CMA DataVision via Datastream 26
  • 28. Ireland 1500 5000 Sovereign CDS Allied Irish Banks 4500 Bank of Ireland 1200 Irish Life 4000 Anglo Irish Bank (rhs) 3500 900 3000 2500 600 2000 1500 300 1000 500 0 0 Jan.09 Jul.09 Jan.10 Jul.10 Jan.11Latest observation: 3 Feb. 11. Note: Five-year CDS; basis points.Source: CMA DataVision via Datastream 27
  • 29. Portugal 1000 Sovereign CDS Banco Comr. Portugues 800 Banco Espirito Santo Caixa Geral de Depositos SA Banco BPI SA 600 400 200 0 Jan.09 Apr.09 Jul.09 Oct.09 Jan.10 Apr.10 Jul.10 Oct.10 Jan.11Latest observation: 3 Feb. 11. Note: Five-year CDS; basis points.Source: CMA DataVision via Datastream 28
  • 30. Spain 600 Sovereign CDS Santander BBVA Banco Popular Espanol SA Caixa dEstalvis de Cataluny Caja de Ahorros y Monte de Piedad 500 La Caja de Ahorros y Pension 400 300 200 100 0 Jan.09 Apr.09 Jul.09 Oct.09 Jan.10 Apr.10 Jul.10 Oct.10 Jan.11Latest observation: 3 Feb. 11. Note: Five-year CDS; basis points.Source: CMA DataVision via Datastream 29
  • 31. 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
  • 32. 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
  • 33. 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
  • 34. Contagion 2 1st Principal Component Cross-sect. average of standardized CDS 1.5 1 0.5 0 -0.5 -1 -1.5 Aug08 Nov08 Feb09 May09 Aug09 Nov09 Feb10 May10 Aug10 Nov10Source: Datastream and ECB calculationsNote: basis points, last observation 27 Jan 2011. Extracted from daily data on 5-year euro area sovereign CDS. CDSseries and the Principal Component are standardized. 33
  • 35. Would exiting the euro make it easier?The fear of exiting the euro would accelerate thebank run by domestic residents (to withdraw euro)The domestic banking system would lose access toeuro area financial market and to ECB refinancing,and would have to reduce in parallel its assetsThe redenomination of financial instruments innew (devalued) currency would trigger cross-border litigation but possibly also within thecountryThe country would lose access to EU facilities andfunds 34
  • 36. Is there an “optimal timing”?When primary balance is achieved, and thus thegovernment does not need to tap the marketThe negative impact of Plan B is not lower while most of the costsof Plan A have been paid (especially politically)When markets are better prepared (now?)The experience of Lehman Brothers’ collapse, which was anticipatedfor some time, shows that markets are never fully prepared for sucha systemic event 35
  • 37. 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
  • 38. Plan A 37
  • 39. Plan A 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 38
  • 40. Assessing solvency 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 39
  • 41. Debt sustainability analysis 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 40
  • 42. Debt stability conditions Primary balances needed to stabilise debt-to-GDP ratio Spain Portugal Ireland Greece Debt-to-GDP ratio projected for 2012* 73.0 92.4 114.3 156.0 r-g 2 1.5 1.8 2.3 3.1 4 2.9 3.7 4.6 6.2 6 4.4 5.5 6.9 9.4 *European Commission autumn 2010 forecastPrimary balances needed to stabilise the debt-to-GDP ratio (at the level projected by the European Commission for2012) in the long-run (steady state) under different assumptions for the interest rate-growth differential 41
  • 43. The adjustment is substantial: Greece Greece: projected general government debt and primary balance under current EU/IMF programme (percentage of GDP) 15 160 10 120 5 0 80 -5 Primary balance (% of GDP) (lhs) General government debt (rhs) Real GDP growth (percent) (lhs) 40 -10 -15 0 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Source: IMF - Second review under the Stand-By Arrangement 42
  • 44. And in Ireland Ireland: projected general government debt and primary balance under current EU/IMF programme (percentage of GDP) 15 160 10 120 5 0 80 -5 Primary balance (% of GDP) (lhs) General government debt (rhs) 40 Real GDP growth (percent) (lhs) -10 -15 0 2009 2010 2011 2012 2013 2014 2015 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 43
  • 45. But not unprecedented General government primary balance (as a percentage of GDP) Ireland 10 140 5 120 0 100 -5 80 -10 60 1981 1982 1983 1984 1985 1986 1987 1988 1989 prim a ry ba la nc e re a l e ffe c tive e xc ha nge ra te (1980=100)Sources: OECD, IMF 44
  • 46. The interest rate levelThe interest rate on the programme is alignedwith IMF rules and proceduresInterest rate ± 6% can ensure debt sustainabilityWhat is key is the rate at which countries haveborrowed, from the market or through theIMF/EU programmeIf successful, the Program can be lengthened(standard procedure in the IMF)EFSF could be made more effective, e.g. linkingthe interest rate to performance (while remainingnon-concessional) 45
  • 47. 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
  • 48. Debt stability conditions (repeat) Primary balances needed to stabilise debt-to-GDP ratio Spain Portugal Ireland Greece Debt-to-GDP ratio projected for 2012* 73.0 92.4 114.3 156.0 r-g 2 1.5 1.8 2.3 3.1 4 2.9 3.7 4.6 6.2 6 4.4 5.5 6.9 9.4 *European Commission autumn 2010 forecastPrimary balances needed to stabilise the debt-to-GDP ratio (at the level projected by the European Commission for2012) in the long run (steady state) under different assumptions for the interest rate-growth differential 47
  • 49. Restoring sustainabilityThe previous slide shows that if the primarysurplus needed to achieve sustainability isconsidered too high because the market interestrate is high, there are two ways to restoresustainability: - reduce the interest rate burden (and lengthen the maturity), while keeping it non-concessional - haircut on debtFor (official) creditors the first solution ispreferable because it involves no capital loss 48
  • 50. 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
  • 51. Restoring pre-crisis growth will be difficult Real GDP Real GDP per capita (average growth 1999-2008) (average growth 1999-2008)6.0 4.05.0 3.5 3.04.0 2.53.0 2.0 1.52.0 1.01.0 0.50.0 0.0 Germany Portugal Germany Portugal Kingdom Ireland Greece United Euro area Japan Kingdom Ireland Greece United Japan Euro area Spain Spain States States United United 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. 50
  • 52. But growth is key Restore competitiveness - mainly through domestic adjustment Lack of exchange rate flexibility - not an excuse Structural reforms are essential 51
  • 53. Devaluation is no panacea Trade openness across euro area countries (exports plus imports in % of GDP, nominal) 180 350 160 300 140 250 120 100 200 80 150 60 100 40 50 20 0 0 Italy Germany Belgium Ireland Slovakia Slovenia Cyprus Portugal Finland Spain Austria Malta France Greece Netherlands Euro area LuxembourgSource: European Commission 52
  • 54. 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
  • 55. Labour market flexibility and labour supply – Reduction of employment protection – Facilitating use of part-time work/flexible work arrangements – Reform of the arbitration systemPension 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
  • 56. 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
  • 57. 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
  • 58. 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
  • 59. 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
  • 60. The impact on competitiveness is starting Compensation per employee (Annual % changes) Germany Greece Ireland Portugal Spain 7 6 5 4 3 2 1 0 -1 -2 Average 1999-2008 2010 2011 2012Source: European Commission (Autumn 2010 forecast). 59
  • 61. European governance has evolvedIn 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
  • 62. Why so slow?Fiscal adjustment and governance reform arecostly in the short term, from an economic andpolitical view pointGovernments tend to take the political cost onlywhen they can explain to their constituencies thatthe alternative (default, euro instability) is muchmore costlyThe evidence that the alternative is more costlyemerges only under the pressure of the markets 61
  • 63. Action has been delayed Greece Spread over German 10-year government bond yield (2009-2010; daily data; in basis points) 1000 900 22 February 2010 EC/ECB mission 800 700 600 500 400 300 200 100 0 11 May 2010 Rescue plan -100 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Sources: Bloomberg, Thomson Reuters Datastream and ECB calculations. Data: Bond yield spreads vis-à-vis the German 10-year government bond, end-of-day data. 62
  • 64. Action has been delayed Ireland Spread over German 10-year government bond yield (2010; daily data; in basis points) 700 28 August 2010 Dow ngrading by S&P 600 11 May 2010 Rescue plan 500 400 300 28 Nov 2010 200 Announcement of the IMF/EU program 100 07 Dec 2010 Presentation of 2011 budget 0-100 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10Sources: Bloomberg, Thomson Reuters Datastream and ECB calculations.Data: Bond yield spreads vis-à-vis the German 10-year government bond, end-of-day data. 63
  • 65. 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
  • 66. 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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