Prof. Jayanth R. Varma's Financial Markets Blog

About me       Latest Posts       Posts by Year       Posts by Categories

Sovereign Limitations

I wrote a column in the Financial Express this week about the limitations of the government in dealing with financial crises:

The ongoing global crisis has seen the government assume an ever increasing burden to keep the financial system afloat. But governments are not omnipotent, and emerging market governments are even more constrained. Investment bankers who thought they were omniscient during the boom have turned out to be clueless. It is perfectly possible that governments that appear omnipotent today will begin to look powerless before we are finished with this crisis.

The first signal regarding this is coming from the credit default swap market where one can buy insurance against default by corporate or sovereign borrowers. As of end–November, this market quoted a premium of ½% per annum to insure against a default by the US government. This is comparable to the premium that one would pay to insure a building against fire. Of course, all insurance premia reflect not only the actuarial probability of loss, but also a compensation for risk and the CDS premium does so to an even greater extent than in normal insurance. Yet, a ½% CDS premium indicates a frighteningly high probability of a default by the world’s sole superpower.

Another point of comparison is that ½% was roughly the CDS premium for insuring against default by India and several other major emerging markets in mid 2007. In other words, the US is perceived to be as risky today as India was in mid 2007. Before the crisis began, the CDS premium for the US was less than 0.1%. A five fold increase in the CDS premium clearly indicates that the risk perception has increased dramatically as the US government has taken more and more risk on to its own balance sheet.

We see a similar phenomenon in other countries as well. The cost of insuring against a default by the UK is as high as 1%. On the other hand, a country like Germany which still retains a conservative fiscal balance sheet enjoys significantly lower spreads than the US, UK or Japan.

In 2002, Japan encountered the same problem as it went on a fiscal binge to try and support its ailing economy. The rating agency Moodys downgraded the world’s second largest economy which was then the biggest creditor nation on earth to a single A rating placing it below Botswana which was then receiving foreign aid from Japan.

This time around, the ratings agencies have confined themselves to acting against small countries like Iceland which used to have a AA+ rating not too long ago, but has had its sovereign rating cut to BBB- (just one notch above junk). This has happened mainly because Iceland has assumed most of the liabilities of its banking system. The rating agencies are hesitant to take harsh action against major countries like the US or the UK since these agencies are themselves in the dock for the silly ratings that they gave to mortgage securities. It is obviously not a good idea for the rating agencies to antagonise the government that holds the regulatory sword of Damocles over them. The doubts about sovereign creditworthiness are instead being expressed by impersonal markets in the form of CDS premia.

In emerging markets like India, the worries about creditworthiness are even greater for a variety of reasons including foreign currency external debt and weaker institutional structures. Since the Indian government itself does not have foreign currency bonds outstanding, the CDS market relies on sovereign proxies like the State Bank of India. Using this sovereign proxy, the CDS premium for insuring against default by India has widened from about ½% in mid 2007 to about 4% by end November 2008. At its peak during the panic of October 2008, this premium was over 7½%.

We must also keep in mind the fact that India entered the crisis with a weak fiscal situation. Falling oil prices may reduce some of the off balance sheet obligations of the government, but a slowing economy will also reduce tax revenues. The fiscal position will thus remain precarious if not worsen further. What this means is that the Indian government must perforce be highly selective in terms of the bailouts that it provides. It has to distinguish between systemically important financial intermediaries, other financial entities and the general corporate sector. If the state expends its scarce fiscal resources supporting everybody that seeks help, then it might find itself too weak if and when the more systemically important entities need assistance.

During a downturn, many corporate entities will need to go through a debt restructuring if they have a liquidity or solvency problem. This debt restructuring may involve maturity extension, debt reduction or debt-equity swaps where creditors take significant losses, but shareholders suffer even more. If this causes losses to the the banks, their shareholders would also take a hit in the process. It is only after all this is exhausted that government support needs to be considered.

Posted at 11:00 am IST on Sun, 14 Dec 2008         permanent link