Here’s a eurozone-focused — but very eloquent — description of the sovereign contagion problem.
From Independent Strategy:
In engineering there is a stress point when a structure will start to vibrate at what is called its “natural frequency” (think of a bicycle frame at speed). Left to its own devices, natural frequency vibrations will increase exponentially until the structure crashes. Have we reached this point of natural frequency for the euro?
The argument in favour is that, at current yields, there are few natural buyers for the sovereign bonds of EMU states that account for around 25% of Eurozone GDP. Venerable pension institutions and life insurance companies have bought these bonds by the truckload for 50 years on the understanding that their risk in doing so was only interest-rate volatility. Now the risk has been magnified by concerns for creditworthiness or solvency. So the pension fund and life insurance investors have become natural sellers of at least part of their substantial sovereign bond portfolios because the risk category has changed and no longer matches the institutions’ liability profile.
The arithmetic is pretty compelling. The countries in the ‘contagion area’ of the Eurozone (namely Spain, Portugal, Greece, Ireland and unexpectedly, Belgium) account for about one-fifth of Eurozone GDP. And their sovereign debt accounts for about the same ratio (Figure 2).
However, if pension funds and other investors were overweighted in their portfolios towards contagion area bonds in the hunt for higher yields, they would have around 30% of their fixed income assets in these sovereign bonds. Also, while the Eurozone average primary budget deficit is 3.6% of GDP in 2010, the contagion area is running a 6% of GDP deficit. So the repricing of sovereign bonds to reflect credit risk rather than just interest-rate risk makes these institutions massive natural sellers of 30% of Eurozone sovereign debt.
As we pointed out in our book, Sovereign DisCredit! (published by lulu.com and in our report, Sovereign Discredit, 9 March 2010), when sovereign bonds lose their risk-free status, it’s a financial earthquake because so many other assets get repriced as a consequence. That is why contagion will quickly embrace other asset categories in the credit space and beyond it — such as equities and commodities. The same logic also indicates how the pain of sovereign repricing will be distributed beyond the banking sector to pension funds and life insurance companies if defaults or debt restructuring become the order of the day.
For the moment, however, the pressing issue is that, deprived of their constituency of long-term investors, many weaker Eurozone states cannot fund themselves. And there will be a massive overhang of their bonds to be sold should things get better, as they inevitably will. This is the cascade effect of asset repricing once sovereign debt is no longer perceived as risk-free.
Crisis contagion can happen not only between states but also within them. It can spread from a country’s sovereign debt to its other forms of foreign liability. Take Spain as an example. According to IMF and BIS data, foreign ownership of Spain’s sovereign debt is the equivalent to 31% of GDP. But add in private sector foreign debt (generously excluding intercompany lending from abroad) and the total jumps to 142% (Figure 3). For how long would the Spanish private sector’s access to foreign credit survive a sovereign debt crisis in the country?
How long, indeed.
Interesting to note this article, from Risk, currently doing the rounds:
Spanish banks are said to be examining what impact the increasingly hostile credit environment could have on their funding needs.
Full Independent Strategy note in the Long Room.
Related links:
What happens when the risk-free rate isn’t free? – FT Alphaville
Goodbye to the risk-free rate rate – FT Alphaville
On the not-unlimited investor appetite for government bonds – FT Alphaville