Best of the Week
Most Popular
1. Gold vs Cash in a Financial Crisis - Richard_Mills
2.Current Stock Market Rally Similarities To 1999 - Chris_Vermeulen
3.America See You On The Dark Side Of The Moon - Part2 - James_Quinn
4.Stock Market Trend Forecast Outlook for 2020 - Nadeem_Walayat
5.Who Said Stock Market Traders and Investor are Emotional Right Now? - Chris_Vermeulen
6.Gold Upswing and Lessons from Gold Tops - P_Radomski_CFA
7.Economic Tribulation is Coming, and Here is Why - Michael_Pento
8.What to Expect in Our Next Recession/Depression? - Raymond_Matison
9.The Fed Celebrates While Americans Drown in Financial Despair - John_Mauldin
10.Hi-yo Silver Away! - Richard_Mills
Last 7 days
Corona Virus Wuhan Global Pandemic 2020 Deaths Forecast and Market Consequences - 28th Jan 20
Palladium Surges above $2,400. Is It Sustainable? - 27th Jan 20
THIS ONE THING Will Tell Us When the Bubble Economy Is Bursting… - 27th Jan 20
Stock Market, Gold Black Swan Event Begins - 27th Jan 20
This Will Signal A Massive Gold Stocks Rally - 27th Jan 20
US Presidential Cycle Stock Market Trend Forecast 2020 - 27th Jan 20
Stock Market Correction Review - 26th Jan 20
The Wuhan Wipeout – Could It Happen? - 26th Jan 20
JOHNSON & JOHNSON (JNJ) Big Pharama AI Mega-trend Investing 2020 - 25th Jan 20
Experts See Opportunity in Ratios of Gold to Silver and Platinum - 25th Jan 20
Gold/Silver Ratio, SPX, Yield Curve and a Story to Tell - 25th Jan 20
Germany Starts War on Gold  - 25th Jan 20
Gold Mining Stocks Valuations - 25th Jan 20
Three Upside and One Downside Risk for Gold - 25th Jan 20
A Lesson About Gold – How Bullish Can It Be? - 24th Jan 20
Stock Market January 2018 Repeats in 2020 – Yikes! - 24th Jan 20
Gold Report from the Two Besieged Cities - 24th Jan 20
Stock Market Elliott Waves Trend Forecast 2020 - Video - 24th Jan 20
AMD Multi-cores vs INTEL Turbo Cores - Best Gaming CPUs 2020 - 3900x, 3950x, 9900K, or 9900KS - 24th Jan 20
Choosing the Best Garage Floor Containment Mats - 23rd Jan 20
Understanding the Benefits of Cannabis Tea - 23rd Jan 20
The Next Catalyst for Gold - 23rd Jan 20
5 Cyber-security considerations for 2020 - 23rd Jan 20
Car insurance: what the latest modifications could mean for your premiums - 23rd Jan 20
Junior Gold Mining Stocks Setting Up For Another Rally - 22nd Jan 20
Debt the Only 'Bubble' That Counts, Buy Gold and Silver! - 22nd Jan 20
AMAZON (AMZN) - Primary AI Tech Stock Investing 2020 and Beyond - Video - 21st Jan 20
What Do Fresh U.S. Economic Reports Imply for Gold? - 21st Jan 20
Corporate Earnings Setup Rally To Stock Market Peak - 21st Jan 20
Gold Price Trend Forecast 2020 - Part1 - 21st Jan 20
How to Write a Good Finance College Essay  - 21st Jan 20
Risks to Global Economy is Balanced: Stock Market upside limited short term - 20th Jan 20
How Digital Technology is Changing the Sports Betting Industry - 20th Jan 20
Is CEOs Reputation Management Essential? All You Must Know - 20th Jan 20
APPLE (AAPL) AI Tech Stocks Investing 2020 - 20th Jan 20
FOMO or FOPA or Au? - 20th Jan 20
Stock Market SP500 Kitchin Cycle Review - 20th Jan 20
Why Intel i7-4790k Devils Canyon CPU is STILL GOOD in 2020! - 20th Jan 20

Market Oracle FREE Newsletter

Nadeem Walayat Financial Markets Analysiis and Trend Forecasts

The Risk of Sovereign Debt

Interest-Rates / Eurozone Debt Crisis Dec 07, 2011 - 10:05 AM GMT

By: David_Howden

Interest-Rates

Best Financial Markets Analysis ArticleWith a 50 percent haircut recently given on the Greek sovereign-debt question, investors are increasingly asking what the real risk of sovereign debt is. It would appear that investors underpriced the risk inherent in sovereign debt, especially that of Europe's periphery. One might even go so far as to say that investors made foolish choices in the past and are now getting their just deserts.


Such statements require an assessment of what the specific risk is of holding sovereign debt, and how specific European institutions affected these risk factors.

Debt is in almost all cases collateralized by some asset. A mortgage is backed by the value of the house that it is borrowed against. Student loans are backed against the future earnings ability of the student (or their parents' income and assets if cosigned). In almost all cases debt is collateralized by the asset that it is used to purchase.

Sovereign debt is slightly different, as no clear asset stands ready to serve as collateral. Instead, borrowing is backed by the future taxing capacity of the state. When investors purchase sovereign debt, they do so knowing that if their plans turn out wrong they will not be receiving some portion of that state's assets as the consolation prize. They purchase the bond knowing that the ability to repay is conditioned by the future economic health of the country, and also by its future taxing power. As there is a general negative relationship between tax rates and economic health there is an upper bound on how much tax revenue can be raised in the future to pay off debts incurred today.

When we say that sovereign debt is "risk free," we mean that there is no credit risk. A state is forever able to pay off its nominal liabilities in one of two ways: either it increases its taxes to raise more revenue (through direct taxes), or it monetizes its debt by increasing the money supply (an inflation tax).

Central banks are, by and large, granted some degree of operational independence in order to avoid the second circumstance. The inflation tax is an extremely attractive way for a state to pay for its liabilities. No one pays it directly, and hence there is a reduced chance for "taxpayers" to see the wealth appropriation. A government given direct control of the printing press has an incentive to give higher rates of inflation than the public desires, if only to pay off the debts it incurs. Central-bank independence removes this option.

Sovereign debt is not risk free; the real payoff may differ from the nominal promise. For domestic-debt holders, this arises when inflation occurs. For foreign-debt holders, this risk mainly arises through foreign-exchange risk. In either case the source is the same — inflation reduces the purchasing power of the currency of denomination and thus reduces the real value of the future payment.

Interest rates are set on sovereign debt with these risks in mind. Importantly, if direct default risk is minimized through the state's future taxing capabilities, the lone risk remaining is through inflation or an adverse exchange-rate movement.

The advent of the European Monetary Union brought about an interesting change to the way that investors calculated these risks.

Twelve years ago, what was the risk of purchasing sovereign Greek debt? Direct credit risk was minimized as the Greek government pledged to pay back its investor by increasing future taxes if need be, or by inflating its woes away. Accession to the European Monetary Union made an important change to this risk perception. The European Central Bank (ECB) has, since its inception, been the model of an independent central bank. It was modeled after the German Bundesbank to be wholly separate from the political realm, and thus faced no conflict of interest with eurozone governments when their debt loads became unmanageable.

With Greece's monetary affairs no longer in its own hands, the risk of the country inflating away the nominal value of its debt was removed. No longer did investors need to concern themselves with investing in a bond that would be prone to the political desire for an easy solution. Inflation risk was automatically hedged.

The exchange-rate risk was also eliminated if the potential investor was from the eurozone. With one common currency for what is now 17 countries, no adverse movements could compromise the investor's earnings. International investors still faced this risk, but luckily any exchange-rate movement against the low-inflation and rule-based euro would be more predictable than the discretionary whims of the old Greek drachma.

The result was a quick and substantial reduction in risk on sovereign debt upon accession to the euro. With inflation and exchange-rate risk largely eliminated, investors needed only to weigh whether or not the future taxing capabilities of a state would be adequate to pay off its debt obligations. With the robust economy of Europe's mid-2000s, this was a fairly certain bet.

Indeed, if insolvency occurs, it generally means that your pledged assets are liquidated to pay off your liabilities. For a country, this means that if your only asset is your future taxing power and your liabilities are ongoing expenditures, the hint of insolvency calls for either increased tax revenues (higher taxes) or lower expenditures (fewer government services). Hence, for an investor in Greece, it was reasonable to assume that if the government found itself nearing insolvency in the future, the country would

1.reduce government expenditures, or
2.increase tax revenues to pay off debt holders.

The sharp increase in interest rates over the past few years has made clear that the risk perception of Greek debt (and that of other periphery European countries) has changed drastically. With the ECB still firmly committed against direct bailouts to specific member states, the increase in yields is not directly attributable to inflation risk. Instead, the increase in risk is created directly by the Greek government's refusal to substantially reduce expenditures or increase its tax revenues. In effect, a sovereign debt that was once free of credit risk is now increasingly at risk.

The recent haircut on Greek debt proves this point, and will in fact exacerbate this situation. The haircut has proven that Greek debt is not risk free and that default, if only partial, is a real possibility. Instead of easing investors' fears of a Greek default, events have concretely demonstrated that the risk expectations on Greek debt should be reset higher. Corresponding higher borrowing costs for the small Hellenic nation will follow.

David Howden is a PhD candidate at the Universidad Rey Juan Carlos, in Madrid, and winner of the Mises Institute's Douglas E. French Prize. Send him mail. See his article archives. Comment on the blog.

© 2011 Copyright Ludwig von Mises - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules