We have wondered from the time to time what sovereign CDS on rich nations are actually for. After all, such extreme economic collapse leading to a real event of default would probably mean that the writer of protection would be unable to fulfil their obligations. No matter. As the chart here from Merrill Lynch shows, credit protection on major European governments is not exactly going out of fashion.
(Click for a sharper image)
So credit markets are roughly assigning an 18 per cent probability that Greece will default within the next five years, while Ireland sits at 15 per cent and Italy at 14 per cent, on the Merrill Lynch figures. That compares with 4 per cent for Germany and a one-in-ten chance for the UK
Tolu Alamutu, credit analyst at ML, reckons the chances of default by a eurozone economy are remote. For one, Euro membership makes a full scale run on the currency unlikely, while repercussions for the zone as a whole from a sovereign default mean other Euro countries would have stepped in earlier to help.
But that doesn’t make countries immune to rating downgrades and – as far as Greece, Ireland and Spain are concerned — the Merrill analyst is not advising anyone to bet against the recent trend.
For those European nations outside the eurozone, the situation is stickier – especially the UK. As Alamutu puts it:
In our view, the UK faces a unique set of challenges making the sovereign and the banks especially vulnerable:
- An oversized banking sector, with substantial external liabilities
- A domestic banking crisis
- A potentially vulnerable currency
- Only average government finances
- Government support policy to date
The assets of UK banks are put at 5.3 times government revenues and 117 times Britain’s FX reserves, presenting a colossal contingent liability to HM Treasury. This is only a problem if the underlying assets are problematic and, as Merrill put it, “We believe the issue for the UK is that asset quality deterioration across all lending types is pretty much certain.”
The Great British Krona Pound, meanwhile, cannot be viewed as a true reserve currency given that it accounts for less than 5 per cent of global official FX reserves. Alamutu doesn’t think the Bank of England has sufficient firepower to defend sterling in the event of a speculative attack – and the risk of that can only grow when the UK government’s own finances can at best be described as “average.”
Banking crises tend to be expensive. The Merrill analyst cites a recent Reinhart and Rogoff study showing that government debt tends to rise by an average of 86 per cent in the three years following a crisis, as tax receipts fall and government spending spikes as policy makers fight the recession. Applying the R&R findings to the UK would send the debt-to-GDP ratio from 54 per cent to over 100 per cent – causing Alamutu to ask:
This could result in very significant issues for the government — how sustainable will the UK’s triple-A rating be in such a scenario, for instance? Probably not very. Recall that European sovereigns with such high debt/GDP ratios (Belgium, Italy and Greece) are not rated triple-A, even though these countries are in the Eurozone. The scarier question then is this — if government debt in the UK does rise as much as the Reinhart and Rogoff study suggests, will the funding market still be as open to the UK as it currently is?…
Any threat to the UK triple-A does not just have implications for the Sovereign but for all the governmentguaranteed debt which many of the banks have issued. We are aware that a lot of this issuance has been taken up by investors restricted to buying triple-A paper. As such, any alteration to this rating could result in significant forced selling from this very vital investor base.
Related links:
S&P downgrades Greece – FT Alphaville
I, Ireland – FT Alphaville
So begin the (serious) sovereign downgrades…? – FT Alphaville