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The Wilder View

Europe’s at it Again…

Key European CDS are starting to turn in the more northern direction again, as the German-French ‘pact for competitiveness’ faces near-unanimous pushback across Europe.

cds_spreads.JPG

Credit default swaps (CDS) are a market security used by investors to buy 5-yr protection (in this case) against default (or the like). As the spread rises the implied probability of default does too. Current market values imply a 39% probability of default by the Irish sovereign (listed in legend), 20% by that of Spain, and 14% by the Italian sovereign, etc. Cash bond spreads are blowing out again, too, where Spain now must pay a 216 bps premium over Germany on a 10-yr loan (the sovereign bond). I’d say that’s not totally irrational.

I completely understand why these negotiations are stalling. I’m Spain – it’s not clear that Spain commented against the pact based on this article, but I digress – why would I agree to a deal that forces more ‘competitive’ measures, which really just means quashing indexed wage growh, reducing the government deficit, adhering to a fiscal policy rule (which, by the way should be modeled after Germany’s debt brake), and adopting a standardized tax rate? Okay, I will if you (Germany) will. Meaning, I’ll increase my competitiveness by stripping away aggregate demand if you allow prices to rise. I’m Germany – no way. (Please see my previous post which argues that a successful transition to a more stable Eurozone depends on higher Germany inflation.)

Der Spiegel spells it out pretty succinctly in an article that is now two weeks old but still totally relevant:

Germany will only agree to additional guarantees for the euro rescue fund — as the Commission and other parties have called for — if its partners approve its competitiveness pact.  

Simply put: we (Germany) will only agree to eventually bail you out if you agree to our harsh demands at that time, or you agree to our harsh demands now. You’re choice.

This political drama is far from over. (More exciting analysis below the jump)

Here’s another little fact to think about: The price to buy protection against a default by the Japanese sovereign is just 77 bps, that’s only 23 bps above that for the German sovereign. This is ironic because Germany is the premiere demander of fiscal austerity, while Japan is not (to say the least) with gross debt equal to 221% of GDP (according to the IMF) – or is it?

The table below lists common characteristics usually associated with rising CDS spreads (CDS spreads are current as of 4pm today and may vary according to pricing source): the stock of debt held by foreigners (any currency denomination) and the stock of gross public debt. The final column illustrates the ability of a country to print fiat currency that is not backed by anything but government decree.

I think it’s pretty clear: Japan and the US have very elevated government debt, but low external holdings AND can print their own money to finance liabilities (which by the way are in most part denominated in their respective currencies). Clearly markets’ attach weight to this simple fact via low CDS spreads.

table.JPG

To be continued….


Originally published at Angry Bear and reproduced here with permission.

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Otaviano Canuto

Otaviano Canuto is Senior Advisor on BRICS Economies in the Development Economics Department, World Bank, a new position established by President Kim to bring a fresh research focus to this increasingly critical area. He also has an extensive academic background, serving as Professor of Economics at the University of Sao Paulo and University of Campinas (UNICAMP) in Brazil.

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