Economics Weekly - Sovereign credit risk to remain in the spotlight? Weekly economic data preview - UK RICS and BRC surveys may show a thaw in economic activity
Economics Weekly 8 March 2010
Sovereign credit risk to remain in the
The travails of Ireland and, more recently, Greece have turned the spotlight back on the sovereign credit markets.
Since November last year, sovereign credit spreads in Greece have widened sharply amid growing fears that the countryâ€™s fiscal
problems could precipitate a prolonged economic stagnation or a sovereign
default. It is not only Greece, however, that has been affected. Fears of contagion have pushed
the spreads of other countries higher, particularly those perceived to have
weak fiscal positions. In this weekly we look at some of the main measures of
sovereign credit risk and assess what they imply for country default in 2010.
For countries which share the same currency, such as members of
the Euro-zone, the easiest way of measuring sovereign credit risk is to assess the
cost of each countryâ€™s government borrowing in relation to a benchmark - namely
Germany (widely seen as the anchor for inflation expectations). Chart a
shows the evolution of 10- yr spreads over German bunds since 2005 for a select
group of Euro-zone countries. Perhaps not surprisingly, the under-performance
of Greece and Ireland has been marked. With 10-yr German bunds currently yielding 3.1%,
the spread indicates that Greece is having to pay over twice as much as Germany for 10-year euro-denominated debt.
While comparisons of sovereign bond spreads provide an accurate
assessment of credit risk within the Euro-zone, they cannot be accurately applied
to countries that have their own currency. This is because the prevailing level
of short-term interest rates also has a key bearing on the level of government
bond yields. Abstracting from credit and liquidity issues, a 10-year government
bond yield can, broadly speaking, be considered to be the marketâ€™s best guess
of what the official short-term policy rate is likely to average over the life
of the bond. For countries that have independent currencies and so different
inflation targets (either implicit or explicit), the expected evolution of the short-term
policy rate is likely to be very different.
In order to adjust for this, a better way of looking at sovereign
credit spreads is on a swap-adjusted basis. This gives an indication of the
credit risk relative to either three-month Libor or, more appropriately, the
overnight index swap rate (OIS) - the benchmark cost of risk-free overnight
Chart b shows the OIS-adjusted sovereign credit spreads for a
selection of countries. Although OIS rates fluctuate in response to changes in
conditions in the wholesale market, the OIS-adjusted spread is, we
believe, the cleanest measure of sovereign credit risk available. As the chart
shows, spreads for all these countries have widened since early 2008. Since the
start of the
year, however, the sovereign credit premia of Greece and the UK have risen the most. Nevertheless, UK spreads are not out of line with Germany or the US, despite popular belief. On this measure, the real risk is,
indeed, Greece and Ireland.
There is another measure of sovereign credit risk which has
received a high degree of publicity in the recent past - namely, sovereign
credit default swaps (CDS). Sovereign CDS spreads measure the annual premium
payable to protect against a sovereign default. For example, a spread of 100bp on
a 5-year US dollar CDS contract with a notional value of $10m would cost $100k
per annum - implying a probability of default over 5 years of 5%. Chart c shows
how various sovereign CDS spreads have moved since September 2008. Not surprisingly,
those countries that have experienced a widening in their bond spreads have
also seen their CDS spreads move higher.
While useful as a gauge, CDS data should be treated with caution.
Firstly, because they are relatively illiquid, they can easily be distorted by sudden
bouts of speculative pressure (as has already been the case in a number of
markets). Second, CDS are used for purposes other than default protection. For
example, an asset manager that has an overweight position in a region can rebalance
a portfolio by buying the regionâ€™s sovereign CDS, without needing to sell the underlying
assets. Thus, market activity may have little to do with the underlying
perception of default, but still move the price significantly.
While sovereign credit premia have risen, interestingly this has
not been reflected in non-sovereign credit spreads: AAA investment-grade spreads
have narrowed sharply (see chart d). In the sterling markets, the reduction in
investment grade spreads has been accentuated by corporate bond purchases by
the BoE as part of its asset purchase programme. Taken at face value, the reduction
in the spreads of blue-chip companies like Unilever, 3i and Tesco suggests the
market now views these names to be nearly as safe as the sovereign credit that
underpins them. This calls into question whether the widening in sovereign
spreads is really justified.
What is the
outlook for sovereign risk?
Over the coming months, ongoing uncertainty about the economic and
fiscal outlook risks putting further upward pressure on sovereign credit spreads,
particularly those countries where public sector indebtedness is under the
microscope. While there is a possibility that Greece could default if its fiscal austerity programme is unsuccessful,
good demand for last weekâ€™s 10-yr bond offering suggests the market still has
an appetite for Greek debt, albeit at a price.
In the UK, credit spreads have widened but they remain well below the
peripheral highly indebted countries of Europe. Indeed, the
probability of a UK sovereign default remains negligible. Firstly, the size and
dynamics of the UK are very different to Greece. Secondly, although the UKâ€™s budget deficit is at record high ( close to 13% of GDP), the level
of public sector debt is no worse than in many of the other major economies.
Third, the average duration of UK government debt is far longer than most other countries; thus the
UK is not exposed to significant roll-over risk.
Lastly, and perhaps more importantly, in contrast to Greece, the UK can, in theory, in a worse case scenario resort to eroding the
real value of its debt through debasing its currency. Given the long-term cost
to economic stability, we suspect this would only ever be considered as a last
resort. Nevertheless, it underscores the point that sovereign credit spreads on
countries with independent monetary policies are more a reflection of their
perceived volatility than they are about the sovereignâ€™s true probability of
Adam Chester, Senior UK Macroeconomist
Weekly economic data preview 8 March 2010
UK RICS and BRC surveys may show a thaw
in economic activity
ô€‚„ The British may be obsessed with the weather, but unusually cold
conditions in January certainly affected some highfrequency economic
indicators, weighing on UK retail sales and mortgage approvals. However, the arctic weather
is likely to have supported January industrial production, due this week, via a
boost to utilities output, while manufacturing output is forecast to have been
more subdued. Some February data are due from the British Retail Consortium
(BRC) and Royal Institute of Chartered Surveyors (RICS) and the better weather
should have supported activity. Indeed, the CBI distributive sales survey was
surprisingly strong in February and we should get a rebound in the new buyer
enquiries index in the RICS survey, though the house price balance may be
little changed. Overall, it looks as if the economy continued to expand in the
first quarter, but there are certainly good reasons to be cautious about
prospects, not least because underlying domestic demand is likely to remain
subdued and export growth has yet to benefit fully from the weaker pound. MPC
members, including Barker and Dale, will provide their thinking on economic
prospects this week. Following Greeceâ€™s bond sale success last week (see below), it will be the turn of
the UK this week to offer Â£3bn of 2022 nominal bonds and Â£0.9bn of 2032
ô€‚„ Last week saw a generally higher level of confidence in euro-zone
government bond markets as Greece announced a further â‚¬4.8bn of fiscal consolidation measures and
launched a keenly anticipated â‚¬5bn 10-year bond issue. In response, the spread
of 10-year Greek government bond yields over comparable German bunds has
narrowed further to around 290bp, compared with 350bp or so a week earlier. But
for all this relief, Greece remains under pressure from the ratings agencies and so must
adhere to the fiscal consolidation plan in its enhanced form. That will involve
considerable sacrifice for some time to come. Following Marchâ€™s ECB monetary
policy decision where the main refinancing rate was left on hold at 1% but
further steps were taken to unwind â€˜unconventionalâ€™ policy stimulus measures,
this week sees a fairly light economic data calendar. The main highlight is
likely to be January industrial production figures for the eurozone along with
associated national data in a variety of countries including Germany, France and Italy. Exports â€“ widely acknowledged as a volatile driver of overall
economic activity â€“ remain healthy and we look for January euro-zone industrial
production to rise by 1.3% month-on-month following a decline of 1.6%
previously. Beyond this, final Q4 GDP data will be released for Italy, following the preliminary Q4 estimate of a 0.2%
ô€‚„ The relative excitement of the US labour market report last week gives way to retail sales, consumer
confidence and trade data this week, while the Treasury will issue $74bn of
notes and bonds. The near 10-point fall in the Conference Boardâ€™s consumer
confidence index in February caused jitters in the financial markets, though
this was not reflected in the University of Michigan (UoM) consumer sentiment survey. We will get the preliminary
March reading of the UoM survey this week. Official February retail sales are
also due and may fall back after a stronger-than-expected monthly rise of 0.5%
in January. US trade data are also due and may show a widening of the deficit in
January. The bottom line is that, with underlying inflation remaining low and
economic recovery in its early stages, supported by an inventory rebound and
policy stimulus measures, the Fed is not likely to raise interest rates until
the latter part of the year at the
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