If anyone can offer a truly sensible rationale for the burgeoning market for sovereign CDS can they please let Euromoney know what on earth it is?
CDS have increasingly become a market reference point for gauging the creditworthiness of G10 countries in the past few months. As systemic fears were cleared up by the blanket provision of bank guarantees and injection of public debt so the CDS on those countries with large financial systems have widened. There is a certain logic to this. Seemingly it supports the view that there is no such thing as a free lunch – for sovereign states that is.
Let us consider what purpose buying protection on a G10 country can actually have. The most logical is that it is a mechanism for rates portfolio managers to manage their economic country risk exposure. While the market-to-market benefits might be apparent – the likelihood of the protection buyer actually being paid out must be remote in the extreme.
When Intesa Sanpaolo printed its €1.25 billion non-guaranteed bond in December, much was made of the fact that its CDS trades inside that of Italy – 110 versus 190. This is clearly anomalous and must surely make a mockery of this so-called market. Is there anyone out there that really thinks it is possible that the Italian state is less creditworthy than one of its finest banks? Does Intesa have an offshore pool of assets that it has stashed away? The suggestion that this is a real market is perhaps pushing things a bit far. It appears, in fact, to be mostly a dealer-to-dealer artifice for which there are a limited number of end users.
Generally the CDS on countries with large financial sectors, such as the UK, have widened substantially in recent months because the state is on the hook for the liabilities of their banks. Poor Austria is quoted at 150bp on the basis of its banks being exposed to eastern Europe. Ireland is just shy of 200bp and Greece is quoted at 243bp.
What is the worth of hedging a sovereign default for the likes of these? Most developed nations are fortunate in that most of their debt is denominated in local currency. This CDS market fails to take into account the fact that it is possible for developed nations to devalue the currency via money supply increases (not so straightforward for eurozone countries – but more on that later). A credit event for sovereign CDS is defined by a failure to pay coupon or principal, a restructuring or the announcement of a moratorium. But given that the vast majority of the UK’s debt, for instance, is local-currency denominated, the likelihood of default must be highly remote. Inflation is a far greater – and, in the current environment, appealing – possibility.
Selling protection on UK sovereign risk to a UK bank makes a lot of sense right now. Let’s face it, if the UK defaults there won’t be a banking system to make a claim anyhow (the same also holds for US banks). Even though UK CDS trading at 95bp is clearly farcical it does cast a shadow over the gilt market. One suggestion, that the treasury should hold a beauty parade among its gilt-edged market makers as a prelude to the government buying a billion or so pounds of credit-linked notes in its own name, has a certain charm about it. This thin CDS market would be squeezed quicker than the pips can squeak.
Detractors will say that a wall of sovereign debt is about to descend and the UK’s will be one of the highest. But nations can increase demand for their debt via regulation. In fact, the UK’s Financial Services Authority has just published a consultation paper on liquidity management that will greatly increase the demand for gilts from UK banks’ treasuries. How convenient.
The funding problem facing peripheral Eurozone countries is difficult, however. They cannot control their money supply and a bail-out is strictly forbidden by Maastricht. Attempts to engineer greater demand for sovereign debt will be less straightforward than for larger economies. There must be a possibility that quantitative easing could be part of the European Central Bank’s policy toolkit. If the ECB was buying Eurozone bonds would it not purchase a basket of Eurozone sovereigns? And perhaps weight that purchase to the cheaper end of the spectrum? Just a thought.