Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

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

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

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.


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