Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Monday, 16 April 2012

Analysing and Trading Sovereign Debt Crises


With the Eurozone crisis making a comeback (quelle surprise) and ECB officials getting worried about US Public Finances (For the record, Bloomberg did not quote Praet saying “Move along, nothing to see here…oh look look smoke across the Atlantic”) it would be an interesting exercise to look at the general question on sovereign debt burden and its sustainability.

The aftermath of the credit crisis has left public finances in tatters in several western countries. But not every country with a large public debt has a debt problem. Therefore it is important to understand the factors and measurement metrics which can help filter the vulnerable from the resilient. An informed capital allocation can then be made.

The four main factors to consider are:
  1. Economic structure – This is a qualitative factor encompassing an economy’s legal framework, regulatory structure, labour and product market flexibility, etc. A capitalist economy is prone to periodic shocks and is equipped to deal with them (Note that this does not advocate laissez faire, governments should and must ameliorate the shocks as Keynes pointed out). However the shock absorbing capacity of the economy can be gummed up by an overextension of the welfare state and over-regulation. Structural flexibility of the US economy is one of the reasons why the US has started to recover.
  2. Debt burden – Although easy but measuring debt burden through the standard metric of debt/GDP is flawed. The numerator and denominator reference different variables. The former only measures government debt while GDP measures the entire value of goods and services produced in a country by both public and private sectors. Since the government accounts for only part of the GDP, the debt/GDP ratio understates the debt burden. A better measure used by some is Debt/Government revenue.
  3. Cost of debt service – This is measured by Interest expense/Government revenue. It is akin to the interest coverage ratio for corporates.
  4. Currency of debt – It matters a great deal if debt is mainly denominated in domestic or foreign currency. Issuance in domestic currency which is under the control of the sovereign allows greater flexibility in managing debt crisis and default (central banking independence stops where a sovereign debt crisis begins).
Let’s look at each in turn to analyse the prospects of selected EU and other developed sovereigns. First, the economic structure and political response to the recession determines how quickly growth resumes. A festering recession leads to entrenchment of vested interests as everyone wants to hold on to their share of the shrinking pie. It also erodes faith in the political structure and may lead to social upheaval. A quick and approximate way to gauge how well an economy is coping with recessionary conditions is by looking at the Misery Index (sum of inflation and unemployment in an economy). It doesn’t substitute for a detailed qualitative analysis but it does act as a warning signal. For an economy, higher the index, bigger the problem. Typically, economies which are structurally more flexible should see faster falls in the index. Graph 1 below shows the Misery Index since 1998 and Table 1 shows it since 2007 when the credit-crunch began.

Graph 1: Misery Index (1998 – 2011)
Source: Eurostat. Based on annual HICP and average annual harmonised unemployment.

Table 1: Misery Index since beginning of credit crunch (2007-2011)

2007
2008
2009
2010
2011
Spain
11.06
15.46
17.78
22.04
24.72
Greece
11.29
11.90
10.78
17.27
20.78
Portugal
11.32
11.22
9.73
13.43
16.54
Ireland
7.47
9.43
10.16
12.11
15.66
United Kingdom
7.59
9.23
9.77
11.09
12.55
United States
7.42
9.60
8.88
11.23
12.15
France
9.97
11.02
9.60
11.47
11.98
Iceland
6.02
16.10
23.30
15.00
11.53
Italy
8.13
10.28
8.58
9.98
11.28
Cyprus
6.10
8.06
5.56
8.81
11.28
Finland
8.49
10.33
9.76
10.09
11.08
Belgium
9.27
11.52
7.88
10.58
10.68
Denmark
5.48
7.03
7.16
9.66
10.28
Sweden
7.83
9.48
10.20
10.28
8.92
Luxembourg
6.88
8.96
5.15
7.37
8.54
Germany
11.01
10.33
7.98
8.26
8.47
Austria
6.63
6.99
5.18
6.08
7.75
Netherlands
5.18
5.26
4.71
5.37
6.93
Norway
3.23
5.93
5.43
5.80
4.50
Japan
3.84
5.38
3.68
4.35
4.24

Source: Eurostat. Based on annual HICP and average annual harmonised unemployment.

As expected, the index has climbed up for all economies since the credit crunch and the four P, I, G, S lead the team. The first interesting point of note is the high ranking of US, UK without any signs of recovery. Given their relative structural flexibility, this is indicative of the severity of the bust and the weakness of subsequent recovery. However, this is not unduly alarming given that recoveries after a housing bust are slow and protracted (average recovery is 5-6 years based on Reinhart and Rogoff’s seminal work). The second interesting point of note is the spike Iceland experienced. The decision to not bail out its banks may be responsible for the rapid turnaround.

Table 2 looks at debt burden and debt sustainability for the selected countries. 

Table 2: Debt burden and sustainability

Gross Debt /Revenue (2010)
Interest /Revenue (2010)
Difference between real interest rate and GDP growth (2010)
Austria
149%
5.59%
-1.05%
Belgium
198%
6.75%
-0.82%
Cyprus
147%
5.57%
0.72%
Denmark
79%
3.09%
0.60%
Finland
92%
2.10%
-2.31%
France
166%
4.84%
-0.52%
Germany
192%
5.72%
-1.17%
Greece (pre-PSI)
365%
14.59%
6.19%
Ireland
279%
9.12%
4.12%
Italy
258%
9.77%
1.74%
Luxembourg
47%
1.01%
-1.70%
Netherlands
142%
4.46%
1.01%
Norway
97%
2.27%
-1.65%
Portugal
224%
7.23%
3.44%
Spain
168%
5.32%
0.42%
Sweden
78%
1.38%
-4.04%
United Kingdom
206%
7.92%
-0.20%
United States
305%
9.21%
-0.33%
Japan
719%
9.15%
2.69%

Source: Eurostat, IMF

The chart below shows it graphically for selected countries. The size of the bubble indicates the difference between real interest rates on government debt and real GDP growth rates.

Chart 2: Debt burden and sustainability

Here also the problem with the peripherals becomes clear. Moreover, as the data is only until 2010 (waiting for IMF to update WEO database) the chart provides a more upbeat picture. For example, Spanish debt/revenue will go close to 200% based on a 70% debt/GDP ratio. The real standout though is Japan which seems to be in a league of its own. The other interesting observation is the comfortable position of Germany against others. Combined with a declining Misery Index (Table 1), this partly explains Germany’s confidence and associated failure to understand the apocalyptic urgency of the situation.

The final piece of the picture is the currency of debt. Even though the economic situation in US and UK looks poor according to the metrics above, the fact that they control the currency in which their debt is issued alleviates the credit risk. But in accordance with the first law of financial dynamics (risk can neither be created nor destroyed, it can only be transformed from one form to another) credit risk appears as inflation risk. The ultra loose monetary policy coupled with QE means that if reduction in debt is required in future, it will occur due to inflation. In the case of Japan, this is almost a foregone conclusion. The adjustment will take place through currency depreciation. Therefore, the recent slide in the Yen is probably the start of a major long-term move.

For European peripherals the situation is dire. They have issued in what is effectively a foreign currency and thus the only two routes open to them are either painful internal adjustment (aka austerity) or default. The scale of internal adjustment required makes it very difficult if not impossible as a course of action (especially in light of the Misery indices). Therefore barring a last minute monetisation and fiscal union, the Eurozone is marching towards catastrophic failure.

Finally to use this analysis for trading/investment requires establishment of some correspondence between these fundamental metrics and market data. An examples is to use a naïve equally weighted ranking of all the four metrics (Misery Index, Gross debt/Revenue, Interest/Revenue, Difference between real interest rate and GDP growth) and plot it with the respective 5Y CDS spreads (Graph 3).

Graph 3: CDS spreads vs average rank
Table of data:

Average Rank
5Y CDS spread (bps)
(CoB 13/4)
Greece
19
6,886
Ireland
16
580
Portugal
15
1,097
Italy
15
435
United States
14
29
United Kingdom
13
64
Japan
13
100
Spain
12
502
Belgium
10
252
Cyprus
10
1,140
France
9
187
Germany
8
72
Netherlands
7
118
Austria
7
162
Denmark
7
118
Finland
5
66
Norway
4
23
Sweden
3
45

The following trading/investing inferences can be drawn:
  1. Japanese CDS looks too high compared to US/UK given that adjustment is likely to be through currency depreciation and inflation rather than outright default (more so given the loss of face involved in default).  Though at the moment selling Yen vs Dollar seems a better trade. The CDS differential is too low and Japan CDS can spike as people mistakenly rush in to buy at the first sign of trouble.
  2. Austria seems too high compared to Netherlands. This is primarily due to overblown fears about Austrian bank exposure to Central and Eastern Europe (CEE).
  3. German spreads appear too low given it is not solely in charge of monetary policy and its intransigence to monetisation. The latter is important especially in the light of TARGET2



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