Monday, 11 October 2010

Financial Markets Finally Awake to Eurozone Risk

This year the Eurozone has suffered its first existential crisis. Ongoing turmoil in financial markets has exposed the vulnerability of the public debt position in several Eurozone member states. The financial spreads amongst Eurozone countries against the benchmark (10-year German bond) Bund, which gauge the medium-term risk in the Eurozone, have not only escalated to historic highs but also have displayed increasing tendency to be skewed (roughly measured by the gap between median and average), as a group of countries are finally perceived as increasingly risky by financial market participants. A typical response to this crisis has been to ask for a Stabilisation Fund to support distressed Eurozone (EZ) economies and for meaningful restrictions to be placed on public debt levels for EZ member states. This may not be where to begin.

Two obvious factors explain the widening of these spreads, which in a credible monetary union ought to be negligible (as they should reflect mostly some small liquidity preferences for holding one country's public debt over another, with currency risk not really a concern). One of the consequences of the financial crisis is that financial markets are more willing to price risk into financial contracts and so a given quantity of risk, will wish to be paid a greater excess return than in the period prior to the crisis. The second reason is that the perceived quantity of risk has risen on average but also for some states in particular, as the first round response to tightening credit conditions and a contraction of world demand has been a large one-off increase in the level of public indebtedness.

The OCED report that that the level of outstanding government debt for advanced economies in 2009 was around 50% higher than its 2006 level (, p. 19) but this alone seems unlikely to be able to explain the overall and specific increase in sovereign spreads. Part of the reason for the increase in spreads is their ‘compression’ to very low levels in the period leading up to 2007, which exaggerated the apparent change pre- and post-crisis. The question then is why did financial market prices, traded by highly intelligent and resourced investment bankers, for Eurozone sovereign debt display such insouciance to both the construction of a “non-optimal currency area” EMU and to the ongoing implication that public debt levels would have to rise as countries increasingly turned to fiscal policy to stabilise their domestic economies? What were the impediments to use of all available information? It is surely not that much news that certain Mediterranean states have public debt overhangs and were not especially well synchronised to the German economic cycle?

The favourite set of theories may be that there is a tendency for financial prices to herd, in the absence of full information. Some story involving the end of the business cycle, the longevity of the Euro, and belief in an implicit bail-out encouraged some herding which promoted a compression trade – buying higher yield sovereign debt funded in the currency of a lower yield sovereign. But a little more transparency on fundamental debt positions in the event of a prolonged asymmetric shock might have scared the markets into demanding country-level risk premia somewhat earlier. And so I can't help thinking that this kind of information and scrutiny on an on-going basis, alongside assessment of debt positions, may be of more value than a currency stabilisation fund.

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