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Moorad Choudhry on Contagion: Time to Get Real

Your columnist had a Eureka moment this week, while contemplating euro zone worries and contagion (a completely different topic next week, I promise!).

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The revelation is this: investors have got to stop looking for a free lunch, however implicitly, and governments have got to get serious about running a manageable budget deficit.

Simple once you know how! Here is what did it: Italian sovereign debthas always been a healthy percentage of its gross domestic product.

A line from my article last week, and absolutely right.

The public sector debt burden in many countries is so onerous that it is unlikely that it will ever be repaid, and yet investors have been blithely buying up their bonds because they are “developed” economies and pay a bit more than genuine risk-free assets; and when one is being graded on quarterly returns, every little helps.

But this is exactly the problem: investors have been treating sovereigns differently from corporates, when the reality is that they have much in common with corporates and can go bust.

It’s time to view sovereign debt in this light.

In the years leading up to EU monetary union, and in the 10 years after its inception, “convergence” was all the rage as sovereign credit spreads narrowed towards the benchmark risk-free German yield spread.

Italy, with a large public debt market, benefitted from this as much as the southern euro zone countries.

Even though economic fundamentals (including productivity, competitiveness and export performance) were not converging towards German levels, bond yieldswere.

Investors believed implicitly that no euro zone country could default.

But why apply a different logic to sovereign authorities? If I borrow funds to set up a fruit 'n veg stall, my debt price wouldn’t converge to HM Government levels just because I issued the debt in sterling.

And yet Italy, with its healthy debt-to-GDP ratio, as well as Greecewith its interesting economic statistics, and the other peripheral countries, were all trading within 150 bps of German levels just two years ago, even after a global banking crash (I refer here to 3-year credit default swaps).

Now the prices for Italy, Spain, Portugal, Ireland and Greece range from 300 to 3000 bps, whilst Germany’s has stayed in the 30s.

It’s the ultimate free lunch, a yield pick-up for risk of an obligor that no-one thinks will actually ever default, whatever its yield spread, simply because it’s a sovereign.

Or better still, a sovereign issuing in the same currency as the Federal Republic of Germany.

The other side of the equation benefits too – governments can run large budget deficits because they assume there will always be private sector lenders out there who will buy their bonds.

The result is a breakdown of fiscal discipline, and a budget process that loses sight of the reality that today for some countries there is no more money.

The sooner an administration realises that, currency union or not, running up a debt level that looks like it will never be repaid means that one day people will stop lending it money, then the sooner we can have a proper evaluation of how economies and the public sector can be restructured along more sustainable lines.

We noted in this column some weeks previously that genuine risk-free assets are dwindling, and the paradox is that as the yield spread on them falls to not much more than zero, investors look to other sovereign assets that they feel are not really default risks but still pay a healthy spread.

The rest is, if not history, definitely painful.

If one is going to invest in sovereign risk, then expect that there is a risk the sovereign will default, and do not assume that taxpayers will bail you out.

After all, why should they? Much of the debate on the euro crisis has focused on the extent to which private investors should suffer a loss (can we please, please stop using the term “haircut” in this regard? A haircut is the amount by which a lender of cash against collateral adjusts its cash amount so that it is over-collateralized. Let’s call a loss of capital a loss of capital!).

But they are precisely the ones that should be on the hook on occurrence of default – they invested in the risky asset, so they wear the risk.

It isn’t of course this black & white, because these private investors include many EU banks, and some fear a repeat of the 2008 bank crisis if an EU sovereign defaults.

But is anyone suggesting that the current muddle-through is any form of solution? As adherents of the Chicago school this column believes strongly that the fair value of an asset is what a buyer and seller agree to trade that asset at.

However it’s clear that the market has been mispricing sovereign default risk for some years now, both pre- and post-crash.

Time to get real, and realize that the “no free lunch” maxim applies in all regions and all asset classes.

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The author is Head of Business Treasury, Global Banking & Markets, Royal Bank of Scotland, and Visiting Professor at London Metropolitan University.