Sovereign Risk and Financial Crisis

The International Political Economy of the Eurozone

Silvia Pepino

• Publisher: Palgrave Macmillan
• Year: 2015
• Print ISBN: 9781349573042, 9781137511638
• eBook ISBN: 9781137511645
• Topic: Politics & International Relations
• Subtopic: Business General
• Index: Politics & International Relations

This book provides an original and timely insight into the role that the domestic and international political economy played in the Eurozone sovereign debt crisis, combining an innovative theoretical framework with in-depth bond market analysis.

1

Sovereign Risk, Politics and the Eurozone Crisis

1.1 Introduction

For a number of decades, sovereign risk was considered by most a defining feature of emerging markets. While emerging market economies experienced repeated cycles of booming capital inflows followed by financial crisis, the environment appeared much calmer in advanced economies, with no default reported in the post-war period. Reflecting this, the direct academic study of sovereign risk was mostly concentrated on the emerging world. However, things have changed dramatically in the last few years. In the aftermath of the global financial crisis, advanced economies saw a sharp rise in their actual and contingent liabilities, making medium-term public debt sustainability increasingly challenging. As a result, a number of developed democracies lost their status as “risk-free” borrowers in financial markets: some saw a significant increase in their financing costs in global markets, while a few lost access outright to international finance. The Eurozone sovereign debt crisis represents most dramatically the increased difficulties of developed democracies in global financial markets. The deterioration in public finances and growth prospects was common to a number of developed economies, including the US, the UK and Japan, as well as most Eurozone economies. However, financial markets punished Eurozone sovereigns, and particularly the weaker economies in the Eurozone,¹ more severely than stand-alone developed democracies.² The particular nature of Eurozone sovereign debt, as argued by De Grauwe (2012), likely contributed to accelerating market concerns about sovereign creditworthiness. At the time of writing, it is too early to tell whether the remaining developed-world sovereigns will remain immune to market reversals in the coming years. Against this uncertain backdrop, the re-emergence of sovereign risk as an empirical issue for a new group of countries is bound also to ignite interest in academia in studying its features.

This book places itself in the historical and empirical context described above. It aims to contribute to understanding how international financial markets price sovereign risk in developed democracies, and specifically in the developed democracies of the Eurozone. It alerts readers to the role that the political economy backdrop can play in influencing sovereign credibility, particularly during a sovereign debt crisis. Indeed, the overarching hypothesis of this study is that politics matters for investors’ assessment of developed democracies as well as for emerging-market sovereigns. In particular, as a result of theoretical and empirical analysis, this book argues that the socio-political landscape influences government bond pricing in developed democracies, particularly during sovereign debt crisis. In so doing, it adds a new perspective to the existing academic tradition, which argues that politics had little impact on bond spreads in advanced economies prior to the crisis (mainly Mosley, 2003). Moreover, it extends the coverage of political-economy factors from the domestic to the international sphere, integrating the domestic and international perspectives that have so far mostly been analysed separately. The empirical focus on the Eurozone sovereign debt crisis provides a timely and policy-relevant analysis of an issue of high importance from both positive and normative perspectives. For Eurozone countries, issues related to sovereign creditworthiness go well beyond the boundaries of national policymaking, reaching the heart of the monetary union’s governance infrastructure. The core of this study is concerned with the interaction of politics, economics and financial markets. In particular, it focuses on an area where interactions between an unusually heterogeneous set of factors blend into observable variables in financial markets. To address such an interdisciplinary issue, it gathers insights from a variety of disciplines and aims to avoid artificial boundaries between political and economic sciences, in line with the international political economy tradition.

1.1.1 Key arguments and existing views

This book looks at how the political economy context influences sovereign credibility in developed democracies. In particular, it highlights the domestic and international political economy factors that impacted government bond markets during the Eurozone sovereign debt crisis. We present the study in two steps. First, we develop an international political economy framework for the analysis of sovereign risk perceptions in developed democracies that can be applied to Eurozone countries;³ second, we test the framework empirically through the investigation of two events: the sovereign debt crises that hit Greece and Ireland in 2010. We advance three key arguments in the interpretation of the Eurozone sovereign debt crisis, and the events observed in Greece and Ireland in particular. First, investment analysis evolves over time, so static categorisations of countries such as the traditional division between developed democracies and emerging markets may not hold in the long term. Second, the domestic socio-political system affects sovereign risk perceptions in developed democracies, particularly during a sovereign debt crisis. Third, the financial market credibility of a sovereign under fiscal stress is influenced also by the role of external de facto veto players and the degree of proximity between debtor and international creditors.

The most complete study of this matter published so far in the international political economy sphere is Mosley (2003): in her analysis of government bond markets between 1981 and 1997, she finds that investors in developed democracies focus on a limited number of macroeconomic shortcuts to inform their country choices, with little interest in politics. Bernhard and Leblang (2006b) identify an impact of political processes on interest rate volatility, but do not analyse the broader role of institutional and societal features. Similarly, Alesina and Roubini (1997) uncover some evidence that US bond markets are impacted by fluctuations in opinion polls ahead of presidential elections, consistent with the predictions of partisan political cycle theories. Meanwhile, empirical studies of Eurozone government bond spreads (for example those of Codogno et al., 2003; Manganelli and Wolswijk, 2009; Attinasi et al., 2009) do not engage with the role of political factors. However, the fundamentally political nature of sovereign debt itself (as highlighted by Eaton et al., 1986) and a preliminary observation of events during the Eurozone sovereign debt crisis suggest that political institutions and the international political economy context should be found to assume considerable relevance for financial markets. In order to explain the narrower focus of investors in developed democracies, Mosley (2003) argues that investors distinguish between developed democracies, which are assumed to be “good credits”, and emerging markets, which carry default risk. While financial markets impose broad constraints on government policy autonomy in emerging markets, they impose only narrow constraints in developed democracies. To take a step further in the analysis, we propose a dynamic model of investor behaviour, where markets update their pricing strategies over time, and where the distinction of sovereign borrowers between developed democracies and emerging markets may not hold all the time. In so doing, we place financial market behaviour in an intermediate position between full efficiency and complete irrationality, as in the work of Lo (2004) and Willett (2000). Specifically, we argue that whenever default risk becomes salient, and typically in a sovereign debt crisis, investors will broaden the scope of their analysis to include political factors, in developed democracies as well as in emerging markets. When a sovereign borrower approaches a situation in which a choice concerning default is potentially to be made, political trade-offs emerge that may not have been as strong, or even relevant, in good times. As a result, politics becomes increasingly important in assessing sovereign creditworthiness, and financial markets will take account of this, adapting valuation models to changing circumstances.

North and Weingast (1989) provide the seminal paper for analysing the domestic political sources of sovereign credibility. Comparing the experiences of England and France in the early modern era, they argue that a higher number of institutional checks and balances in the political system boost sovereign credibility in financial markets. The findings of North and Weingast and their disciples appear, however, to conflict with the predictions of the “consolidation” literature – represented, for example, by Roubini and Sachs (1989) and by Alesina and Roubini (1997) – which postulates that greater political fragmentation makes fiscal consolidation more difficult. MacIntyre (2001) proposes a compromise between the two approaches to explain differing degrees of capital outflows across countries during the Asian financial crisis of the 1990s: financial markets dislike excesses in both policy volatility and rigidity, and thus prefer intermediate veto-player configurations. MacIntyre’s focus is strictly on institutional veto players and on emerging markets.⁴ Developed democracies, however, present considerably less variation in the distribution of formal veto authority and do not occupy the extremes found in emerging markets. In the context of this debate, we argue that differences in institutional veto-player constellations are not sufficient for understanding how markets distinguish between sovereign borrowers in developed democracies. Instead, we posit that investors take into account the broader socio-political system. In particular, we identify the degree of socio-political contestation, as well as the interaction between the number of formal veto players and socio-political contestation, as relevant for sovereign credibility. Moreover, strong external creditors may act as external de facto veto players, particularly when the possibility of external bail-out – from the International Monetary Fund (IMF), European institutions or bilateral sources – emerges as an additional option available to a government under fiscal stress.⁵ In these circumstances, we argue that the preferences of those players will also influence sovereign risk perceptions in the debtor country. Broadly, we argue that financial markets will assess sovereign borrowers more favourably when there is greater economic, financial and ideological proximity between debtor and creditor countries. Indeed, the higher the direct and indirect costs are perceived to be, the less likely is a sovereign borrower to default on its debt to external creditors. The issue-linkages approach to sovereign debt highlights, for example, that trade sanctions can act as an incentive to sovereign debt repayment (Bulow and Rogoff, 1989a). Indirectly, reputational theories of sovereign debt (Eaton and Gersovitz, 1981; Tomz, 2007) also underscore the importance of external considerations for the decisions of ailing sovereign borrowers. On the other hand, the strong creditor country is more likely to be willing to provide assistance if it faces a high level of exposure (and thus potential losses) towards the debtor, either directly or indirectly through its banks or companies. In a similar vein, the literature on the political economy of IMF lending highlights the role of US interests in IMF lending decisions (Woods, 2003; Oatley and Yackee, 2004). Crucially, the focus of this book on the analysis of political economy factors is not intended to downplay the importance of economic and financial variables as sources of sovereign debt crisis and indicators of sovereign stress. Sovereign debt crises are very complex events, and a huge set of factors can interact to determine the overall crisis outcomes. Political factors should be seen as contributory factors to a sovereign debt crisis, rather than as exclusive drivers. With regard to the Eurozone sovereign debt crisis, in particular, a number of scholars have highlighted the specific fragilities of the Economic and Monetary Union (EMU) governance system that increase the vulnerability of member countries to sovereign debt crisis (for example, Featherstone, 2011; De Grauwe, 2012; De Grauwe and Ji, 2012). We take a different approach, adopting concepts from the international political economy sphere in order to analyse the crisis as it unfolded, rather than focusing on the economic and institutional conditions that led to it.

1.2 Sovereign risk, developed democracies and financial crisis

1.2.1 A major test for state–market relations

The global financial crisis which started in 2007 shook many of the convictions prevailing among economists, financial market practitioners and policymakers. In particular, the relationship between financial market players and national governments assumed new, unexpected contours. The financial crisis followed a period when the balance of power had appeared to be shifting from national governments towards the increasingly globalised marketplace (Strange, 1996). But, as crisis hit, national governments, central banks and international institutions had to intervene forcefully to shore up markets, bail out financial institutions and support the real economy. Public money flowed in billions from governments to banks in the US, the UK and many other countries. In the process, numerous banks were nationalised, de jure or de facto. Public authorities made it a priority to strengthen their regulatory and supervisory grip on financial institutions and markets.

In these circumstances, the contradictory position of financial markets with respect to the desired role of the state emerged starkly. In spite of their advocacy in good times of a retrenchment in the role of the state, markets more than welcomed state protection during the crisis. As Walter and Sen pointed out, “The financial turmoil … brought home once again the lesson that financial sector actors prefer rapid and deep state intervention during crisis” (2009, p. 168). Meanwhile, the rescue programmes of the US administration received mixed reviews outside the financial institutions that benefited from these. Stiglitz (2009a) highlighted the risks of “the privatizing of gains and the socializing of losses”, while suggesting that the toxic asset purchase plan outlined in late March 2009 amounted to a “robbery of the American people” (Stiglitz, 2009b). By unveiling striking weaknesses in financial markets and institutions, the crisis appeared at first to have put some power back into the hands of nation-states. Willingly or under compulsion, states found themselves the determinant forces in the future of financial markets, choosing which institutions and sectors to support, owning a large part of the banking sector, and dictating new and increasingly more pervasive rules. However, this also raises the question of whether the new state of affairs was one additional symptom of “regulatory capture” or represented a real re-balancing of power away from the globalised private sector and towards the nation-state. Indeed, the additional financing needs faced by sovereigns soon started to push in the opposite direction: sovereigns were more than ever in need of raising abundant and reasonably priced financing in international financial markets, and this strengthened a key channel for the capacity of the financial market to sanction and influence government policies.

Indeed, the flip side of the increase in the real or perceived role of the state was a burgeoning financial burden. In many cases, the financial risks assumed by financial institutions were transferred wholesale to national governments. The destiny of banking systems and their respective sovereigns became inextricably linked. While smaller countries with proportionally huge banking sectors (as in the case of Iceland, where bank assets amounted to more than 1,000% of GDP prior to the collapse) tipped over relatively quickly, larger or more diversified countries, such as the UK and the US, faced a massive increase in public debt, set to haunt the nations for years to come. The increase in actual and contingent liabilities assumed by the public sector in financial sector rescues was compounded by a sharp underlying deterioration in public finances as a consequence of real-estate crisis, recession and surging unemployment, as well as by the cost of expansive fiscal policy measures put in place to try to cushion the fallout of the financial crisis for the real economy and society in general. The situation was made worse by the fact that a number of advanced economies had failed to adjust their public finance situation during good times, and aging populations added to the longer-term sustainability risks.

The fulcrum of the global financial crisis and its real economy and public finance repercussions was in developed democracies, while emerging market economies fared much better overall. In the advanced economies as a whole, public debt rose sharply from 74% of GDP in 2007 to 104% of GDP in 2011, having already been on an upward trajectory in the preceding three decades. Meanwhile, over the same period, public debt was fairly stable in emerging markets, hovering in a range between 33% and 39% (IMF, 2012). General government debts are now above 100% of GDP in the US, Japan and a number of Eurozone countries;⁶ only a few advanced economies, such as Australia, Switzerland, Sweden and Norway, have maintained healthy public finances. True, the extent and nature of the deterioration in the last few years and the magnitude of overall problems differ across countries; nevertheless, this was a widespread trend in the advanced economies. In turn, the increase in debt did not go unnoticed in financial markets, which started to require higher rewards in order to provide funding for the governments of a number of advanced economies and to insure against government default. As the “risk-free” status of developed democracies, as a group, was put in doubt, investors started to differentiate more markedly among sovereign borrowers within the category. On the one hand, borrowing conditions deteriorated sharply for troubled advanced economy sovereigns: government bond yields rocketed for countries such as Greece, Portugal and Ireland, hit by outright sovereign debt crisis, and increased significantly in other developed democracies, such as Italy and Spain. By the end of June 2012, ten-year government bond yields were 5.8% in Italy, 6.3% in Spain, 10.2% in Portugal and 25.8% in Greece. On the other hand, sovereigns considered relatively stronger have seen falling funding costs in the period since the beginning of the global financial crisis: government bonds in these countries benefited from a mixture of safe-haven flows, monetary easing and, in some cases, outright central bank purchases.⁷ By the end of June 2012, ten-year government bond yields had fallen to 1.6% in the US, 1.7% in the UK and 1.5% in Germany (Figure 1.1).

1.2.2 Sovereign risk and developed democracies

As a result of the developments described above, the issue of sovereign default risk in developed democracies re-emerged in financial markets, with investors discriminating more carefully within the group. In this context, the concept of “risk-free” government debt in developed democracies was a crucial casualty of the financial crisis. Doubts about the absolute credibility of developed democracies’ capacity and willingness to repay their debts in the near and distant future emerged first and most dramatically in developed economies considered to be in the most vulnerable positions, but they were not limited to these and reached all the way to US Treasury debt. Some even started to question whether academics and market practitioners could still use Treasury yields as the reference “risk-free” interest rate (De Keuleneer, 2008). The marked deterioration in the ratings attributed to the government bonds of developed democracies by specialised agencies (as shown for example by BIS,⁸ 2012) is another symptom of this trend. The sharp downgrades in the debt of the most troubled countries, such as Greece and Portugal, are not surprising and indeed came late relative to underlying and market developments, but it is remarkable how even the US and French governments lost their AAA...

Table of contents

• Cover
• Title Page
• Copyright
• Contents
• List of Tables and Figures
• Preface
• 1. Sovereign Risk, Politics and the Eurozone Crisis
• 2. An IPE Framework for Sovereign Risk
• 3. Bond Spreads, EMU Design and the Run-up to the Crisis
• 4. The Greek Sovereign Debt Crisis
• 5. The Irish Sovereign Debt Crisis
• 6. The International Political Economy of the Eurozone Sovereign Debt Crisis
• Notes
• Bibliography
• Index