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PIIGS update






Having been somewhat out of touch earlier this week, but nevertheless quite aware of all the sudden, new-found agonizing over whether Italy will soon join Greece as a major defaulter, I wanted to get things in perspective. These charts give you an up-to-date look at the status of the risk of major Eurozone sovereign debt defaults, which so far is concentrated in the 5 PIIGS countries. The top chart makes it obvious that Greece is a lost cause. The bottom two charts take Greece out in order to focus on the other four of the PIIGS.

There's been a lot of talk about how Italy's sovereign debt yields, and spreads to Germany, yesterday crossed the line into "no-man's land" (e.g., yields over 7%), meaning that Italy's debt burden has now become unsustainable and the market has thus effectively made an Italian default highly likely. These charts don't support that view. The cost of insuring against an Italian default is still less than that of Ireland and Portugal, and Italian 5-yr CDS are still below the average of high-yield corporate debt.

Of course, given Italy's $2.2 trillion debt, even the hint of an Italian default could have major repercussions, so it's not entirely fair to say that Italy is less likely to default than the typical high-yield bond. Even if an Italian default is still very unlikely, according to CDS and sovereign bond yields, the expected impact of a default is very large and thus is a very legitimate source of concern.

Whether Italy, still one of the world's major economies, would ever reach the point of defaulting on its sovereign obligations is the only question that matters. In the end, this is a political issue, since there is no a priori reason to think that a developed country—even one as overextended as Italy—cannot adopt a responsible fiscal policy course of action. Adopting "austerity" is not equivalent to self-destruction, as those opposed to it try to argue. Austerity is bad for those who have been sucking on the public teat, but it is generally good for the rest of the country. I believe that the adoption of true austerity measures would be quite stimulative for a number of countries, since they would not only restore confidence in a country but would also reduce the suffocating burden of too much government spending and borrowing. The Eurozone debt crisis was brought on primarily by public sector bloat, so reducing that bloat can only be a positive.

One other point: Many are arguing that since the ISDA determined that a "voluntary" write down of Greek debt by private sector banks would not trigger a CDS payout, that CDS spreads are likely trading at artificially low levels since they are much less likely to be the insurance policy that they were originally held out to be. (I note with interest that the CEO of the ISDA has stepped down, no doubt due to this very controversial decision.) Regardless, this does not make the message of 2-yr sovereign yields any less relevant. As the 2nd and 3rd charts show, the relative risk of the four PIIGS is approximately the same, whether measured by CDS or by 2-yr sovereign yields.

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