Copenhagen 2012
The European Sovereign Debt Crisis: Background and
Perspectives
What is the Risk of European Sovereign Debt
Defaults? Fiscal Space, CDS Spreads and Market
Pricing of Risk
by J. Aizenman, M. Hutchison and Y. Jinjarak
Comments by Marcus Miller
University of Warwick
1
What kind of
market,
friends, is this?
Fundamentally
driven;
or fancy free?
2
AHJ analyse the sovereign debt component of the
(largely OTC) CDS market
This amounts to $2.5 trillion in 2010 , which
exceeds the total of US government-issued
international debt ($2.2 tr) and US GDP ($1.5 tr)!
Regression analysis is used to relate sovereign
spreads to fundamentals for 50 countries, over the
period 2005-2011 for 3, 5 and 10 year CDS’ with the
focus on the SWEAP* group in particular.
The fundamentals include two measures of ‘fiscal
space’: debt to tax base and deficit to tax base.
*South-West Eurozone Periphery
3
All-too- brief summary of findings
After a fascinatingh and well-documented empirical analysis,
the authors conclude that:
1. ‘fiscal space is validated as an important determinant of
market-based sovereign risk’, i.e. the fiscal fundamentals
are statistically significant, but
2. there are large prediction errors in pricing SWEAP risk,
with under prediction before the crisis and over
prediction during the crisis.
Two explanations of these prediction errors are suggested:
• Market failure (‘excessive pessimism and overreaction’)
• Expected future fundamentals.
4
3 Comments
• A. FF are treated as exogenous, but -if the deficit
includes debt servicing costs- are likely to be
endogenous. Is there not a risk of bias?
• B. Is there not a possibility of Type II error?
The Maintained hypothesis is ‘spreads reflect current
fiscal fundamentals (FF)’: what of Alternative hypothesis
that ‘there are multiple equilibria’, Calvo (1988)?
• C. Need to add strategic aspects?
1) Games between financial intermediaries.
2) Interaction between markets and government.
5
Caveats
• Definition of Fiscal Fundamentals (debt and deficits)
not too clear from paper, in particular
• Fiscal deficit: is this primary deficit, or does it include
costs of debt service?
(Note that text treats both fiscal fundamentals as ‘risk increasing’ (p.13); but
in regressions it’s the fiscal surplus that is used, hence negative sign.)
• No explicit account is taken of government action
and reaction at national or supranational level. (If one
is considering sovereign default, should variables not be included to
reflect political economy considerations?).
6
Is there a bias because actual market spreads
affect fiscal fundamentals?
SS
Actual spread
Error vector
Predicted
FF
spread,
SS= ∝FF+ ε
∝ 𝐹𝐹
If ε positively correlated with fundamentals, OLS estimate of ∝ will be biased upwards.
αFF
7
Endogenous Fiscal Fundamentals: Calvo’s selffulfilling crisis for solvent sovereign (E0 -> E1)
x
‘Optimal’
level of tax
chosen by
govt
Government expenditure
including cost of debt
service at the safe rate R
x*
E0
g+bRb
g+αbRb
E1
Government
expenditure including
legal costs of default
g
Safe rate
Risky rate
R
𝑅𝑏1
𝑅𝑏
Market Rate,
including
sovereign
Rb spread
8
Market and government: Expected and actual
default - Calvo revisited
45𝑜
Θ
[Θ = rate of default]
1/(1-α)
1
Full
Partial
default
Default :
actual and
expected
1
𝛩
𝑒
𝛩𝑒
Government Reaction
Θ1
R
No
1
Rb
1
𝑅𝑏
Market expectation
45𝑜
1
Θe
9
Maintained and Alternative Hypothesis
Spreads
Alternative
hypothesis multiple equilibria
(Calvo)
𝑅𝑏1
Maintained
hypothesis (Aizenman
et al.) SS= ∝FF+ ε
β
Good
FF
ME
Bad - insolvent
10
Under the alternative hypothesis, there is of
course the problem of ‘equilibrium selection’.
Question: when will the market switch from the
safe rate to one which reflects the partial default
that it causes?
One idea is ‘sun spots’, i.e. exogenous
randomness.
Another is that the switching reflects mixed
strategies in a market game.
11
A CDS ‘market game’ with mixed strategy equilibrium
Payoffs : (Buyer, Seller)
Probabilities in parentheses
(Nash Equilibrium p=2/3, q=1/3
i.e. expected payoff is 1/3 for both
CDS seller (underwriter)
Willing to pay up Will not pay
(q )
(1-q)
players for either action)
CDS buyer
Only insures
Market works
with ‘interest ‘
1, 1
‘Market failure’
0,0
(p )
Goes ‘naked’
(1-p)
Explosive increase
in market
3, -1
Market
implosion
-1,1
12
Frequency distribution of outcomes
Market works
2/9
‘Market failure’
4/9
Explosive increase in market
Market implosion
1/9
2/9
13
Conclusion
The authors are effectively testing the efficiency
of the CDS market in measuring risk of sovereign
default. The results for 2008-2010 imply that
sovereign default risk was over-priced by a
factor of 2.5 to 5 times (fundamentals greatly under-predict the
actual spreads charged in the market).
The authors suggest that market price risk
‘follows waves of contagion’. Are they not
verifying Calvo’s model of multiple equilibria?
14
Appendix
Numerical Example of Calvo Model
• For the case of a country like Italy where the ratio of government
debt to GDP is about 100%, we choose the parameters such that the
critical value of market rates, above which the government will
choose to default, is 7%, and the time consistent equilibrium with
default is 20%. This implies α is about ¼ - i.e. You save ¾ by
default!
Parameters: b=1, g=0.38, R=1.03, α=0.235, c=0.684
• For a country like Germany, where the ratio of government debt to
GDP is close to the Maastricht criteria of 60%, we assume that the
interest rate is 3% (with no default). If so, it turns out that the
government will not choose to default until market rates reach 10%;
and the time consistent equilibrium with default turns out to be over
30%.
15
Current Situation: A schematic outline.
Tax as fraction of GDP
g+rb
0.45
0.42
0.38
g+rb
“Italy”
“Greece”
0.03
0.07
g
b (debt/GDP)
1 1.2 1.6
2.3
Italy on the edge of default.
Greece over the edge?
Debt Write Down
16
What about a country like Greece where debt is 160% of GDP? If
the tax take was as for Italy, namely 45% of GDP, then the
sustainable level of debt turns out to be much higher, if only interest
rates stayed at German levels, but Greece collects a lot less tax than
other European countries. If the tax take goes down from 45% to
42% of GDP, it turns out that debt is unsustainable, even at German
rates and a write down of about 30% to reduce debt to 120% GDP is
needed for sustainability.
(See diagram above)
17