by Don Alexander, MBA
Associate, RSD Solutions Inc.
The recent surge in the peripheral European country bond spreads has been a major source of concern to financial markets, as investors try to estimate whether it is a change in fundamentals or shifting market sentiment. It is similar to risk management where we have to understand the source of risk. Paul de Grauwe and Yuemei Ji attempt to address this issue in a Jan. 2012 VOXEU communique called Mispricing of Sovereign Risk and Multiple Equilibria in the Eurozone.
De Grauwe & Li note that markets were wrong in placing the same risk premium on Greek bonds as on German bonds from 2001-08. Since the start of the sovereign debt crisis, financial markets are making errors in the other direction – they overestimate risks... Now they are wrong in overestimating the risk that the peripheral countries will default.
The surge in peripheral country spreads since 2010 is disconnected from fundamentals such as debt-to-GDP ratios and current-account positions, and is more attributable to negative market sentiment. De Grauwe & Li note that after investors long ignored high debt-to-GDP ratios, the resulting surge in negative sentiment caused a rise in spreads. However, standalone countries with high debt ratios were immune to these liquidity crises and did not experience an increase in spreads. This was consistent with earlier research that found government bond markets in a monetary union are more fragile and susceptible to self-fulfilling liquidity crises.
The Eurozone crisis is also a story of systemic mispricing of sovereign debt, which in turn led to macroeconomic instability and multiple equilibria. The underpricing of sovereign risk in 2001-2008 in the peripheral countries led to unsustainable booms in consumption and real estate. The overpricing of sovereign risk since 2010 led to a self-fulfilling downward spiral into bad equilibria characterized by solvency crises and deep recessions.
The lesson for policymakers is that when spreads are tightly linked to underlying fundamentals such as the debt-to-GDP, the best option for spread reduction is to improve debt fundamentals. In contrast, any disconnect between spreads and fundamentals, a policy of exclusive focus on debt reduction will not be sufficient and force countries into a bad equilibrium. This can be achieved by active ECB liquidity policies that prevent a liquidity crisis in government bond markets turning to a self-fulfilling solvency crisis.
The lesson is that any policy aimed at improving fundamentals through fiscal austerity and a policy of liquidity provision from the central bank are not substitutes, but complements. In contrast, any country that is a member of a monetary union hit by a liquidity crisis that leads to a disconnect between spreads and fundamentals, will require both policies. These policies should not be seen as “either/or” options.
The systematic mispricing of sovereign risk in the Eurozone intensifies macroeconomic instability, leading to bubbles in good years and excessive austerity in bad years. The failure to address these issues has increased the duration and the cost of crisis resolution. Perhaps, we can learn some lessons for risk management.
For more on this follow the link: www.voxeu.org/index.php?q=node/7553
