Britain ranks below Peru in new ‘sovereign risk’ world order

Peru: not as risky as Britain

Britain ranks below Peru in a new analysis by one of the world’s biggest fund managers of the risk to investors who buy government bonds. Norway, Sweden and Switzerland are the least risky bond issuers among 44 countries analysed in the BlackRock Sovereign Risk Index. At the other end of the scale, also in descending order, Egypt, Portugal and Greece are reckoned to be the most risky.

Britain falls near the middle of this new world order, ranking directly below Russia, China, Czech Republic, Israel and Peru. Some small comfort may be taken from the fact that gilts issued by the British Government are reckoned to be a better bet than bonds issued by France, the Philipines and Poland; which rank directly below Britain.

Dissatisfaction with credit rating agencies such as Standard & Poor’s, Fitch and Moody’s – which have issued nearly 100 sovereign risk downgrades since the global credit crisis began – prompted BlackRock to begin collating its own analysts’ views earlier this year. It claims back-testing of this analysis suggests it is more accurate than the credit rating agencies’ and that the current crisis will continue with more government’s getting into trouble with excess debt.

Benjamin Brodsky, managing director of fixed interest at BlackRock said: “Our initial analysis was judgmentally based, and contemporaneously validated by a high correlation with sovereign credit default swap (CDS) market spreads. Over recent months we have constructed the back history of this approach running from, taking care to use ‘real-time’ data.

“In this quarterly update for the index, we complement our earlier analysis, showing how the BlackRock Sovereign Risk Index (BSRI) has outperformed both ratings agencies and sovereign credit default swap spreads in highlighting downgrade risks.

“Considering heightened activity within the Eurozone periphery in recent years, we present a case study that focuses on Greece, Ireland, Italy, Spain, and Portugal. We show how the BSRI would have led agency activity over the span of these countries, while leading markets in their shift from complacency.”

As independent analysis from the Centre for Economics and Business Research suggests Britain might be better off if the eurozone breaks up, Ewen Cameron Watt, managing director of investment strategy at BlackRock, said: “Driven by multiple fundamental insights to the nature of sovereign credit risk, the BSRI presents a useful tool for profiling the strengths and weaknesses of countries against one another.

“Our research suggests these insights can lead rating agency activity, with an excellent track record at preceding downgrades, and historically would have highlighted areas of market complacency.

“As a backdrop for the future, we believe the multi-decade compilation of sovereign and banking crises by Reinhart and Rogoff presents a compelling case that in recent years financial markets have been complacent about risks that have always been present and, as more countries approach their upper limits of sustainable leverage, a return to a higher incidence of crises seems likely.”

A fundamental shift of economic wealth from West to East is underway and relative valuations of international bonds reflect that transition. Mark Dampier of wealth managers Hargreaves Lansdown put it most succinctly: “The emerging markets have the savings; the developed world has the debt. Sooner or later, prices will reflect those facts.”

Avoiding triggering Greek sovereign CDS is a mistake

Should policymakers attempt to prevent credit default swaps?

Credit default swaps (CDS) are supposed to serve as a form of insurance against default.  A sovereign CDS provides insurance against a country defaulting.  If such insurance is not available, then companies and investors, wishing to insure themselves against the possibility of a country defaulting, will either have to reduce their exposure to such an event (eg by selling their holdings of that country’s bonds) or hedge in some other way (eg by going short on that country’s bonds).

In the run-up to the 21 per cent Greek default announced on July 21st, Eurozone policymakers were quite explicit that they would try to design the default in such a way that credit default swaps would not be triggered.  They doubtless thought this a clever wheeze, imagining it would punish those who had used CDS to speculate upon the possibility that Greece would default (how wicked of them!) and might deter others from using CDS to speculate upon Portugal or Italy defaulting.

Of course, one immediate consequence of this was that investors sold their Greek CDS.  But once the July 21st deal was announced, there were consequences for Italy, also.  Italian bond yields spiked.  Partly this was because selling Italian bonds became the key way of speculating upon total collapse of the euro.  And partly it was because if firms and investors wanted to hedge against / speculate about Italian default, they could no longer trust Italian sovereign CDS.  Net Portuguese CDS positions have fallen more than 30 per cent in recent months, and Italian net positions more than 25 per cent, despite increased perceived risk that these countries will default.  As a predictable consequence, Italian bond yields went above 6 per cent.

Following last night’s quasi-deal, the whole concept of a sovereign CDS in the Eurozone appears to be finished.  If losing even 50 per cent of your money on Greek government bonds doesn’t trigger payout on the CDS insurance you purchased, what is the point of them?  Eurozone sovereign CDS are now virtually worthless.

The question now is, once the halo of the EFSF leverage is gone, what are the implications of the death of the sovereign CDS market for Italian bond yields?  Had the larger Greek default triggered CDS payouts, one might reasonably have expected Italian bond yields to fall (at least once the initial dust had cleared), because the credibility of insurance was greater.  But what now?  Had everyone already assumed that Italian and Portuguese sovereign CDS were worthless, or were there some poor souls still hoping they might provide some protection?  If the latter, then we should expect Italian and Portuguese yields to rise (eventually), as a consequence – at least until financial markets can produce some new credible mechanism for providing insurance.

We can observe a paradox here.  In this financial crisis, governments have insisted upon destroying the functioning of capitalism by providing implicit state insurance of banks, through bailouts and debt guarantees.  At the same time, governments have sought to destroy the system of market insurance of banks (and others) that existed through the private sector – through sovereign CDS.  Dumb?  You might very well say that…

Thanks to drift towards fiscal union, Britain is now more creditworthy than Germany

Wow! It now costs more to insure German sovereign debt against default than that of the UK, not withstanding anarchy on London streets. As the graphic below, brought to my attention by Conservative Party researchers via Andrew Lillico, demonstrates, it has become more expensive to buy “credit default swaps” (CDS) for German debt than for British.

Now obviously CDS prices need to be treated with a certain degree of scepticism. The market is thin and not really representative of underlying credit risk. Though the spread has narrowed considerably over the past year, Germany can still raise money more cheaply than the UK.

Never the less, this is a powerfully symbolic moment.

Unfortunately, this is not a function of the UK becoming more creditworthy. It is because as the eurozone moves towards a eurobond and shared responsibility for sovereign debt, Germany is becoming less so. According to calculations circulating in the German press, an interest rate 1 percentage point higher than otherwise would cost the German taxpayer around £20bn annually, or approximately equivalent to the fiscal transfer that still takes place between West and East Germany. Do the Germans want to subsidise the rest of Europe to that degree. I don’t think so.

See this brilliant Otmar Issing commentary for the most powerful articulation I’ve yet seen of what may loosely be described as the German view. European Central Bank intervention may temporarily have succeeded in depressing Italian and Spanish bond yields, but the political debate on Europe’s now unmistakable drift to fiscal union has yet to be had. How long can even the mighty Germany maintain its triple A rating once it assumes responsibility for Italy’s debts? This is a crisis which is going to run and run.