The Price of Sovereign Risk

What did we think of European Commission President Jose Manuel Barroso’s comments last week on the UK and Europe? Here is an extract:

United Kingdom
David Wogan | Robert Harding World Imagery | Getty Images
United Kingdom

I find it a little bit ironic that some people are suggesting for Britain a role comparable to that of say Norway or Switzerland. Norway or Switzerland are two marvelous countries, I very much admire, the most advanced countries in the world in fact with great qualities of life. But I think Britain is expecting a bigger role in the world than small countries.

Very kind of him to describe Norway and Switzerland in such flattering terms, I daresay. I’m not sure what a “bigger role in the world” does for the quality of life of the UK citizen and taxpayer though, but I thought I’d look at it in another way, from the perspective of sovereign risk. And what a surprise, his two minnows score pretty highly there too.

Since the financial crash investors have been struggling to find safe-haven assets that are truly risk-free. The size of the U.S. economy, and the liquidity of U.S. Treasurys, means that U.S. sovereign assets will always be the No.1 choice for the risk-averse investor. U.S. T-bills have been yielding a handful of basis points for some time now and are the saver’s equivalent of placing cash under the mattress. Their near-zero yield reflects their risk-free status and the worldwide flight to quality we have observed since 2008. When S&P downgradedU.S. Treasurys last year, yields remained unchanged and even fell for some tenors, such are the risk-free credentials of the world’s only reserve currency.

Certainly U.S. Treasurys are safe assets. But are they the safest? Not if one considers the calculations of those whose job it is to price credit risk. A glance at today’s prices shows the following credit default swap (CDS) levels for 5-year protection on sovereign risk, in basis points:

Belgium 199

France 171

Japan 96

Germany 84

UK 64

USA 49

The UK a better credit risk than Germany? Helmut Kohl would never believe it. But Germany is tainted with euro zone problems and that drags its price down. The USA sits comfortably at the bottom of our list, a trifling 49 bps to insure your risk against U.S. default for five years. The prices above seem to make intuitive sense and would probably not surprise the interested layperson on the street.

But there are safer countries still for one to place one’s funds in (such a pity their sovereign bond markets are so small). Step forward Mr Barroso’s two most favorite holiday centers: Switzerland, with a 5-year CDS priced at 47 bps and Norway with 5-year insurance protection at 33 bps. Perhaps there is something to be said for avoiding a “bigger role in the world” and concentrating on quality of life?

The CDS price chart is worth noting for what it tells us about risk profile and sovereign credit. The U.S. is a special case due to the status of the U.S. dollar, but all the other countries need to beware of running economic policies that are deemed unsustainable. Just two years ago the spread between the smallest and the biggest number on our list above was just 75 bps, today it is double that (and at the end of last year it was nearly 400 bps). A higher CDS price means higher borrowing costs for the sovereign and more pain for the taxpayer. Clearly Norway and Switzerland don’t have that problem.

Perhaps if governments of more heavily indebted countries spent less effort on trying to maintaining a bigger role in the world and more effort on balancing their books, the body that Mr Barroso represents wouldn’t be in so much economic trouble in the first place…

Professor Moorad Choudhry is Treasurer, Corporate Banking Division, Royal Bank of Scotland.

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