Here we go again with talks of the end of the euro. This time, however, the trouble was stirred by President of the European Council himself, Mr. Van Rumpuy. The reason for alarm is well known. As soon as it became clear that Greece would miss, albeit slightly, the deficit reduction targets agreed with the IMF and the EU, the nightmare situation of Irish – and possibly Portuguese – default began to materialise. The EU, together with the European Central Bank and IMF are now keen to draw a reluctant Ireland into accepting a life-jacket package (with strings) of €80-€90 billion, that would stop, in the EU’s mind, the disease from spreading to other vulnerable countries. If it spreads to Italy, that could spell the end.
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 fuelled 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 is now at risk of going 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 that of GDP (Italian Ministry of the Economy 2010). Clearly, the solution to the crisis will require several steps.
- The ECB, who already finances the Irish banks at very low rates, must extend a blanket guarantee of banks’ deposits in order to avert both a bank run and capital flight.
- A drastic restructuring of bank debt is required, balance sheets must be cleaned up and "zombie banks" must be closed down.
- Private creditors must be bailed in sharing the burden.
- 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.
Italy and Ireland
As in the case of Greece, Italy’s concern is the risk of infection. Figure 1 shows the interest spreads between bonds on Europe’s periphery and 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 for Italian (and Spanish) spreads have so far been less severe, even if the Italian spread, at 1.3% in October 20, reached 2% in recent days.
Figure 1. Ten-year spreads
Another useful source of information is credit default swap spreads (CDS), which are updated daily (Fitch Ratings Special Report 2010). In interpreting these data one has to keep in mind a few shortcomings.
- First, CDS spread 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 spread reflects 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 (Amato 2005). Being negotiated over-the-counter, CDS spreads incorporate counterparty risk (Cherubini 2005), 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 CDS spreads on European at 5 years maturity, from 1 January to 22 November
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 countries 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.
We next 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) (see Chan-Lau 2003). Figures 3and 4 show the time profile of conditional default probabilities (known as the swap curve) for Italy 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 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 materialised 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 that jury is still out on Ireland (and Italy), although the grace period will not extend beyond three years.
Amato, Jeffery D (2005), “Risk Aversion and Risk Premia in the CDS Market”, BIS Quarterly Review.
Chan-Lau, Jorge (2005), “Anticipating Credit Events Using Credit Default Swaps, with an Application to Sovereign Debt Crises”, IMF Working Paper 03/106.
Cherubini, Umberto (2005), “Counterparty risk in derivatives and collateral policies: the replicating portfolio approach”
Fitch Ratings Special Report (2010), CDS spreads and default risk.
Hull, John and Alan White (2000), “Valuing Credit Default Swaps I: No Counterparty Default Risk”, Journal of Derivatives, 8(1):29-40.
Italian Ministry of the Economy (2010), Decisione di Finanza Pubblica, 2011-13