With a 50 percent haircut recently given on the Greek sovereign-debt question, investors are increasingly asking what the real risk of sovereign debt is. It would appear that investors underpriced the risk inherent in sovereign debt, especially that of Europe's periphery. One might even go so far as to say that investors made foolish choices in the past and are now getting their just deserts.
Such statements require an assessment of what the specific risk is of holding sovereign debt, and how specific European institutions affected these risk factors.
Debt is in almost all cases collateralized by some asset. A mortgage is backed by the value of the house that it is borrowed against. Student loans are backed against the future earnings ability of the student (or their parents' income and assets if cosigned). In almost all cases debt is collateralized by the asset that it is used to purchase.
Sovereign debt is slightly different, as no clear asset stands ready to serve as collateral. Instead, borrowing is backed by the future taxing capacity of the state. When investors purchase sovereign debt, they do so knowing that if their plans turn out wrong they will not be receiving some portion of that state's assets as the consolation prize. They purchase the bond knowing that the ability to repay is conditioned by the future economic health of the country, and also by its future taxing power. As there is a general negative relationship between tax rates and economic health there is an upper bound on how much tax revenue can be raised in the future to pay off debts incurred today.
When we say that sovereign debt is "risk free," we mean that there is no credit risk. A state is forever able to pay off its nominal liabilities in one of two ways: either it increases its taxes to raise more revenue (through direct taxes), or it monetizes its debt by increasing the money supply (an inflation tax).
Central banks are, by and large, granted some degree of operational independence in order to avoid the second circumstance. The inflation tax is an extremely attractive way for a state to pay for its liabilities. No one pays it directly, and hence there is a reduced chance for "taxpayers" to see the wealth appropriation. A government given direct control of the printing press has an incentive to give higher rates of inflation than the public desires, if only to pay off the debts it incurs. Central-bank independence removes this option.
Sovereign debt is not risk free; the real payoff may differ from the nominal promise. For domestic-debt holders, this arises when inflation occurs. For foreign-debt holders, this risk mainly arises through foreign-exchange risk. In either case the source is the same — inflation reduces the purchasing power of the currency of denomination and thus reduces the real value of the future payment.
Interest rates are set on sovereign debt with these risks in mind. Importantly, if direct default risk is minimized through the state's future taxing capabilities, the lone risk remaining is through inflation or an adverse exchange-rate movement.
The advent of the European Monetary Union brought about an interesting change to the way that investors calculated these risks.
Twelve years ago, what was the risk of purchasing sovereign Greek debt? Direct credit risk was minimized as the Greek government pledged to pay back its investor by increasing future taxes if need be, or by inflating its woes away. Accession to the European Monetary Union made an important change to this risk perception. The European Central Bank (ECB) has, since its inception, been the model of an independent central bank. It was modeled after the German Bundesbank to be wholly separate from the political realm, and thus faced no conflict of interest with eurozone governments when their debt loads became unmanageable.
With Greece's monetary affairs no longer in its own hands, the risk of the country inflating away the nominal value of its debt was removed. No longer did investors need to concern themselves with investing in a bond that would be prone to the political desire for an easy solution. Inflation risk was automatically hedged.
The exchange-rate risk was also eliminated if the potential investor was from the eurozone. With one common currency for what is now 17 countries, no adverse movements could compromise the investor's earnings. International investors still faced this risk, but luckily any exchange-rate movement against the low-inflation and rule-based euro would be more predictable than the discretionary whims of the old Greek drachma.
The result was a quick and substantial reduction in risk on sovereign debt upon accession to the euro. With inflation and exchange-rate risk largely eliminated, investors needed only to weigh whether or not the future taxing capabilities of a state would be adequate to pay off its debt obligations. With the robust economy of Europe's mid-2000s, this was a fairly certain bet.
Indeed, if insolvency occurs, it generally means that your pledged assets are liquidated to pay off your liabilities. For a country, this means that if your only asset is your future taxing power and your liabilities are ongoing expenditures, the hint of insolvency calls for either increased tax revenues (higher taxes) or lower expenditures (fewer government services). Hence, for an investor in Greece, it was reasonable to assume that if the government found itself nearing insolvency in the future, the country would
- reduce government expenditures, or
- increase tax revenues to pay off debt holders.
The sharp increase in interest rates over the past few years has made clear that the risk perception of Greek debt (and that of other periphery European countries) has changed drastically. With the ECB still firmly committed against direct bailouts to specific member states, the increase in yields is not directly attributable to inflation risk. Instead, the increase in risk is created directly by the Greek government's refusal to substantially reduce expenditures or increase its tax revenues. In effect, a sovereign debt that was once free of credit risk is now increasingly at risk.
The recent haircut on Greek debt proves this point, and will in fact exacerbate this situation. The haircut has proven that Greek debt is not risk free and that default, if only partial, is a real possibility. Instead of easing investors' fears of a Greek default, events have concretely demonstrated that the risk expectations on Greek debt should be reset higher. Corresponding higher borrowing costs for the small Hellenic nation will follow.
David Howden is chair of the department of business and social sciences, and associate professor of economics at St. Louis University, at its Madrid Campus, and winner of the Mises Institute's Douglas E. French Prize. Send him mail. See David Howden's article archives.
Empresas Ariztía, una de las tres firmas involucradas en este polémico caso, es propiedad de Manuel Ariztía, tío del director de Indap.
