Here we go again with talks of the end of the Euro. This time, however, the row was stirred by President of the European Council in person, Mr. Van Rumpuy. The reason for this alarm is well known. As soon as it became evident that Greece would miss, albeit slightly, the deficit reduction targets agreed with the IMF and the UE, the nightmares of Ireland and Portugal default immediately materialized. the European Union, together with the European Central Bank and International Monetary Fund are now keen to draw a recalcitrant Ireland into accepting a life-jacket package (with strings) of 80-90 billion Euro, that would stop, in the EU mind, the disease from spreading to other vulnerable countries. Clearly, the ultimate crack would be Italy’s default.
Private and Public Debt
It is well known that, unlike in Greece, the Irish crisis does not stem from the public sector, but from irresponsible investments by banks which, having fueled the housing bubble, now find themselves insolvent. The government, in an attempt to bail out the banking system, has opened a chasm in the public accounts (the deficit is estimated at 32.5% of GDP), and now risks to go bankrupt. Unlike the deficit, public debt is quite manageable (estimated around 80% of GDP in 2010). In contrast, private debt, which covers the liabilities of households, financial institutions and firms, amounts to nearly nine times of GDP (see Table1, in Italian). Clearly, the solution to the crisis will require several steps. 1. The ECB, who already finances the Irish banks at very low rates, must extend a blanket guarantee of banks’ deposits in order to avert a bank run plus capital flight. 2. A drastic restructuring of bank debt is required, balance sheets must be cleaned up and “zombie banks” must be closed down. 3. Private creditors must be bailed in sharing the burden. 4. NAMA, the National Asset Management Agency , the “bad bank” created in May for these purposes, will need more financial support .Not surprisingly, the severe fiscal austerity plans provided by the government (cuts to 3.8% of GDP in 2010 and about 7% for each of the next two years) will hardly reassure markets. They are necessary measures, but wholly inadequate to the task of preventing the meltdown of the financial system.
Table 1: Gross National Debt and Its Components (% GDP)
Source: Italian Ministry of the Economy, Decisione di Finanza Pubblica, 2011-13
Italy and Ireland. As in the case of Greece, Italy’s concern is the risk of infection. Figure 1 shows the PIIGS’ interest spreads with the German ten-year Bund. The Greek, Irish and Portuguese spread, have been crawling up since April, and then shot up November. It is interesting to note that the consequences on Italian (and Spanish) spreads have so far been minor, even if the Italian spread, at 1.3% in October 20, reached 2% in recent days.
Figure 1: PIIGS Spreads
Another useful source of information is credit default swap spreads (CDS), which are updated daily (1). In interpreting this data one has to keep in mind a few shortcomings. First, CDS spreads are very, very volatile, much more volatile than debt yields. On May 11, 2010, for instance, the 5-years cumulative default probability of Greece fell by 11.5 percentage points in just one day. It’s hard to attribute this jump to anything “fundamental”, while it is reasonable to see it as a reflection of news or market sentiment. Second, CDS spreads reflect not only the perceived default probability of borrowers, but also the liquidity constraints of insurance buyers and sellers, the changes in risk aversion, and the optimism/pessimism about recovery rates (2). Being negotiated over-the-counter (OTC), CDS spreads incorporate counterparty risk (3), in addition to credit risk. In short, CDS spreads typically tend to overestimate bad events.
Figure 2 shows the implied (cumulative) probability of default implied by PIIGS’ CDS spreads at 5 years maturity, from January 1st to November 22nd. (4)
Figure 2: Cumulative probability of default implied by 5-year CDS
The good news is that the probability that CDS spreads assign to a default of Italy in the next five years (around 12.7%) is significantly lower than that of Ireland (34%) and Portugal (28%); moreover, the surge in risk perceptions occurred in November does not appear to have significantly contaminated Italy. The correlation coefficient between Italy’s and the other PIGS fell from 0.825, in the period January-August, to 0.433, in September-November. The bad news is that, in the past few days, the default probability curve shows signs of crawling up.
Next, we exploit the fact that CDS are traded daily at several maturities, which allows us to compute not only the cumulative, but also the conditional default probability (the hazard rate, i.e. the probability that the government will default at time t conditional on surviving until that t-1) (5). Figures 3 and 4 show the time profile of conditional default probabilities (known as the swap curve) forItaly and Ireland, calculated at different points in time. In normal times the slope of the swap curve is flat or slightly positive, reflecting more uncertainty about the more distant future. In times of stress, however, the slope typically turns negative, mirroring fears that the country may not survive in the short term, but, if it does, it will not default later on.
This is exactly what has happened in Ireland at maturities beyond three years, as can be seen from Figure 3 by comparing the term structure as of March 2010, the blue line at the bottom, to the term structure in late November, the green line at the top. Although the probability levels are much lower for Italy, the same twist in the slope of the swap curve has materialized in Italy, compare the blue and green lines in Figure 4
Figure 3: Ireland Swap Curve
Figure 4: Italy Swap Curve
We interpret this evidence as suggesting the final verdict on Ireland (and Italy) is not out yet, although the grace period will not extend beyond three years.
(2) See Amato (2005): Risk Aversion and Risk Premia in the CDS Market. (3)For a description of how to evaluate counterparty risk in CDS contracts, see Cherubini (2005): Counterparty risk in derivatives and collateral policies: the replicating portfolio approach. (4) We used the Euro vs. Libor curve as term structure of interest rate, and followed the methodology described in Hull and White (2000): Valuing credit default swaps I: No counterparty default risk. The calculations assume a recovery rate of 60%, the risk free rate is assumed to be equal to BBBB (5) See Chan-Lau (2005): Anticipating Credit Events Using Credit Default Swaps, with an Application to Sovereign Debt Crises, for an application of the swap curve analysis to sovereign default crises in South America.
Originally published at VOX and reproduced here with permission.
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