2 • 2011
Editorial
The ongoing apparently contagious public or sovereign debt crisis in Europe represents the third phase of the financial crisis since it really gained momentum after the collapse of Lehman Brothers in 2008. The notion that an initial financial collapse, either in the form of a balance of payments or banking crisis, or both, is followed by a severe economic recession which, in turn, is generally followed by a public debt crisis is fairly robust and can be backed by empirical evidence from relevant crisis periods. However, given the importance of the implied sovereign credit risk in financial markets, surprisingly little systematic research has been done on the potential common sources of global macroeconomic risks that drive sovereign credit. As also argued by some leading economic researchers,[1] this issue is important, and understanding the nature of the underlying sovereign credit risk is critical, because sovereign debt markets are large and rapidly increasing in size. Furthermore, the nature of sovereign credit risk has a direct effect on the ability of financial market participants to diversify the risk of global debt portfolios, and it may also play a central role in determining both the cost and flow of capital across countries.
Recent research efforts have taken up the issue of explaining the determination of sovereign credit risk from a novel perspective. To elaborate briefly, instead of using sovereign bond data, we could use new sets of sovereign default credit swap (CDS) contracts on the external debt of a number of developed and less developed countries to extract information on the likely determinants of sovereign credit risk. Sovereign CDS contracts function as insurance contracts that allow investors to buy protection against the event that a sovereign defaults on or restructures its debt. Sovereign CDS data has the advantage over sovereign bond data that it allows one to identify directly the investment returns generated exclusively by changes in sovereign credit risk.
Recently obtained research results[2] suggest that there is a surprisingly high degree of commonality in sovereign credit spreads. Decomposing the underlying sources indicates that two thirds of the variation in sovereign credit spreads can be accounted for by a single underlying factor in a sample of countries over the first ten years of the new millennium. The contribution of this single factor is even higher during 2007–2009, ie during the first three years of the most recent crisis. Moreover, sovereign credit risk seems to be driven more by global market factors, risk premia and investment flows than by country-specific fundamentals. Although explanations based on local economic factors, global financial market factors, global risk premia measures and global market liquidity factors all appear statistically important for explaining sovereign credit risk, the most significant factors are US stock and high-yield markets, the volatility risk premium embedded in the VIX index and flows into global fixed income funds. Furthermore, evidence indicates that there are significant risk premia in sovereign credit returns. These risk premia are first and foremost compensation for bearing the risk of the global macroeconomic factors that drive sovereign credit. Once these global macroeconomic risk premia are controlled for, there is little if any country-specific risk premium.
Importantly, these results suggest that the market is dominated by global investors and, in particular, that the commonality is consistent with the idea that the marginal investor prices risk with a global portfolio. Furthermore, the effect of global liquidity on the market is consistent with the view that funding shocks faced by large institutional investors translate into shocks to the liquidity of financial assets. Overall, the evidence seems to point to the view that commonality in sovereign credit spreads may have its roots in the sensitivity of these spreads to the funding needs of major investors in the sovereign credit markets.
These new results are very important and more research on them is clearly worth the effort. This new perspective on sovereign credit risk has been overshadowed by the almost single-minded emphasis in the previous literature on the incentives faced by sovereign debtors to repay their debt. This latter point is, of course, important, but it may miss the potentially more important policy point that the real policy problem lies elsewhere.
[1] See in particular F. A. Longstaff, J. Pan, L. H. Pedersen and K. J. Singleton, ‘How Sovereign is Sovereign Credit Risk?’, August 2009, http://www.anderson.ucla.edu/x1924.xml.
[2] See F. A. Longstaff et al. (op. cit.).