BS on sovereign credit risk

Today, Lorenzo Bini Smaghi is delivering a speech at the Forum for EU-US Legal-Economic Affairs in Rome. The main subject of Policy rules and institutions in times of crisis is “the risk of a confusion of roles, which may generate moral hazard and ultimately delegitimise the institutions and undermine their credibility.”

The stability of public finances in particular, Bini Smaghi maintains, is based on two mechanisms: the credibility of the fiscal authorities, and the ability of the markets to accurately assess sovereign credit risk. Therein lies the rub…

Assessing sovereign risk is “a matter of evaluating, not only from an economic but also from a political perspective, the capacity and determination of a country to attain and maintain a primary budget surplus necessary to stabilise the debt-to-GDP ratio.” No argument here. But then Bini Smaghi posits that markets fail to price risk appropriately “when conditions are fraught with uncertainty or there are crises of confidence.”

He provides an interesting example:

The graph depicts 5-year CDS premia against S&P ratings for selected countries. Note the “double standard” that market participants in the market for sovereign credit risk insurance have come to use during the eurocrisis. Six euro countries are now being regarded as among the twenty riskiest countries worldwide, Bini Smaghi objects.

He lists a (strict) subset of conditions markets have to satisfy before they can be deemed to correctly price a security using risk-adjusted discounting, including the absence of collusion, valid models for the term structure of interest rates, full availability of information or rational behaviour. From his reminder, he concludes that “the situations in which markets are able to correctly assess prices may be the exception rather than the rule, particularly in times of financial stress.” As if markets can only be said to “work” if they adhere to the theory. One would have thought markets are not exactly a practical application of a true theory. Rather: a theory is only to be verified/falsified by its (lack of) explanatory/descriptive/predictive power of the reality it purports to model. And that reality is the market.

Going back to his original definition of sovereign credit risk assessment, a case could be made that the dichotomy in CDS pricing reflects to some extent the political design faults of the eurozone, its dreadful handling of private sector involvement or the uncertain outcome of the current process(ion) towards a fiscal union — or scission [strike out what is not applicable]. Or why would the hysteresis-like return of confidence after a country regains access to the financial markets not be rational?

The strict separation between monetary (~ liquidity) and fiscal (~ solvency) institutions that characterises the eurozone depends on markets behaving perfectly, according to Bini Smaghi. If the latter do not “correctly” discipline fiscal authorities and distinguish solvency problems from liquidity problems, the monetary policymaker — the ECB — cannot wash its hands of what is happening on the markets. The transition between liquidity-determined equilibria and solvency-determined equilibria becomes “unpredictable and may be caused by speculative behaviours, which tend to be self-fulfilling.” As the markets for government securities are the linchpin of monetary policy in Europe, any malfunctioning there requires intervention by the ECB to safeguard its policy transmission mechanism (read: the banking system).

By actively intervening in the market for sovereign debt, the ECB does away with the market’s ability to (mis)price credit risk, de facto transforming the latter in inflation risk — and conjuring up moral hazard for the politicians and bankers. By not intervening at all, the ECB delivers some countries to the folly of the markets.

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