Greece’s floundering financial status has led some financial experts to closely examine sovereign risk. Sovereign risk can rise when sovereign debt increases as a result of regular government spending and when sovereign debt increases in response to an external shock, such as a banking crisis. Both of these occurred recently, in some places together. As the Bank for International Settlements has noted, sovereign credit quality in developed economies has declined in recent years, although at the same time, the global crisis has necessarily increased the level of protection implemented against sovereign risk.
The global financial crisis that originated in the US and spread to Europe was the first to increase sovereign risk, as countries sought to bail out banks and implement fiscal stimulus packages to prevent contagion. Ludwig (2014) refers to the repricing of sovereign risk after the common shock of the financial crisis “wake-up call contagion.” Pricing of sovereign risk behaved differently before and after the crisis, as market participants became more sensitive to risk and were impacted by regional, rather than strictly local, macroeconomic fundamentals (Gomez-Puig et al. 2014). Fiscal stimulus, however, resulted in larger fiscal deficits and reduced the ability of governments to repay debt, pushing up sovereign risk. Banks and sovereigns became intertwined as the crisis spread. Heightened sovereign risk then impacted bank lending as funding costs increased, creating a liquidity squeeze (Cantero-Saiz et al. 2014). Funding costs may rise as lenders’ perceived economic risk increases, and/or as strained public finances raise the cost of financial intermediation (Corsetti et al. 2012).
Banks’ positions deteriorated as sovereign risk rose. Sovereign exposure by banks to potential contagion was impacted through several channels: a guarantee channel, an asset holdings channel, and a collateral channel (De Bruyckere et al. 2013). Assets or collateral held in the form of sovereign debt all faced potential losses, and explicit or implicit government guarantees lost credibility. Further, banks and sovereigns became further connected as the crisis wore on, as public sector balance sheets were used to shore up financial sectors.
Assessing the true level of sovereign risk became critical at this time, as credit default swap (CDS) spreads failed to fully reflect the reality of sovereign risk (procyclically overstating or understating risk). Pricing of sovereign risk pre-crisis reflected country fundamentals far less than pricing of sovereign debt during the crisis, especially in the peripheral European countries that underwent a deterioration in sovereign debt (Beirne and Fratzscher 2013). CDS spreads followed a weak form of price efficiency during the crisis but remained volatile (Gunduz and Kaya 2014). Greece and Portugal experienced increasing spreads that reflected not only their own default risk, but also spillover effects of default risk from other peripheral countries (Kohonen 2014).
A number of new models were proposed to better assess sovereign risk. Analysis based on macroeconomic fundamentals, most importantly the net international investment position to GDP ratio and the public debt to GDP ratio, has been proposed by Agliardi et al. (2014). Modeling of sovereign risk contagion (“default risk connectedness”) based on CDS and bond yield data has been carried out by Gatjen and Schienle (2015). Commercial sovereign risk models have been created by Thomson Reuters (the Starmine Sovereign Risk Model), BlackRock (BlackRock Sovereign Risk Index), and others to prevent investment in countries with a Greece- like surge in sovereign risk. Even another aspect of sovereign risk was proposed, currency redenomination risk, referring to the risk that a euro asset would be redenominated into a devalued legacy currency (De Santis 2015).
At this point, it is well recognized that assuming zero risk for sovereign exposure is a mistake. European banks in particular held insufficient capital to guard against sovereign risk stemming from both domestic and non-domestic sovereign bond holdings. Korte and Steffen (2014) refer to this as the “sovereign subsidy,” or amount of sovereign risk that is unaccounted for. The way in which the sovereign subsidy is applied is through classification of highly rated government bonds as highly liquid assets, exclusion of zero-risk weighted sovereign bonds from limits to large expo?sures, use of low capital requirements for government bond-collateralized exposures, and low capital requirements on select sovereign exposures. The European Systemic Risk Board (2015) produced recommendations to improve Basel III treatment of sovereign exposure. For banks, these include tightening Pillar 1 capital requirements to account for sovereign exposure, improving Pillar 2 requirements through implementation of stress tests or qualitative guidance on diversification, and enhancing Pillar 3 disclosure requirements on sovereign exposure. Still, reform is slow in the making because selling zero- or low-risk bonds is extremely attractive to governments. Governments are loath to reclassify sovereign bonds as risky.
Another issue is that resources for dealing with this type of financial destabilization within the eurozone must be strengthened. Macroeconomic stabilization tools available to countries within the eurozone are limited, as there is no regional fiscal policy, but interest and exchange rates are shared (Ballabriga 2014). Eurozone countries cannot issue debt in their own currencies, a fact that has helped to transform heightened sovereign risk into sovereign crisis. Therefore, while monitoring for sovereign risk is certainly important, it has limited effect if stabilization tools do not function well. Eurozone countries are not equal in terms of risk, yet they are forced to operate within the same monetary and currency specifications without sufficient fiscal coordination.
While the European Central Bank was forced to operate outside its mandate by purchasing sovereign debt as a lender of last resort, it was necessary to do so since member countries do not control the currency and therefore cannot guarantee that they will repay sovereign bonds. Going forward, however, a mechanism to promote the ECB as lender of last resort in the bond market would help to backstop sovereign bond markets in the face of increasing financial fragility. It has been noted that the lack of safe bonds presents a problem, as sovereign bonds reflect fiscal conditions outside the control of the central authority. To combat this problem, Illing and Konig (2014) suggest the construction of synthetic euro bonds, a portfolio of all euro bonds weighted by members’ contribution to GDP.
Steps toward the creation of a European banking union have been made; this is one positive outcome of the eurozone crisis. The banking union requires an integrated supervision system. However, the process of setting up a banking union has slowed as countries with strong banks balked at turning over supervision to a central authority. Therefore, centralized banking control has been limited, and countries agreed to the supervision of the 130 largest banks (Eichengreen 2014).
Conditions in the eurozone’s periphery gradually improved. Spain’s level of sovereign risk has improved as fiscal austerity has been implemented to reduce the fiscal deficit. As Yuan and Pongsiri (2015) note, fiscal austerity practices generally led to reduction in CDS spreads. Ireland’s sovereign risk has also declined due to the presence of economic growth and declining debt ratios. However, overall sovereign risk in the eurozone’s peripheral countries remains somewhat high as fundamentals lag behind. France, for example, has insufficiently adjusted its fiscal deficit in the face of high structural unemployment and low growth. Italy has rebounded even slower than France and other eurozone peers as competitiveness has declined and unemployment has remained high. Cyprus continues to face high levels of debt and a weak banking sector. In the eurozone overall, signs of weakness in the core financial systems are still apparent. In EU-wide bank stress tests conducted in October 2014, 25 out of 130 banks failed. Credit risk exposure was responsible for the majority of these failures.
Greece in particular has faced a plunging sovereign rating, having been downgraded to CCC- by Standard & Poor’s after defaulting on a €1.6 billion loan installment in June. Greece’s fundamentals are quite poor, with extremely high unemployment and poor growth due to stifling austerity measures, an inefficient public sector, and burdensome pension system. It has been projected that Greek debt may peak at 200 percent of GDP and fall to 150 percent of GDP by 2024; however, Cline (2015) asserts that the debt burden is lower than it actually appears due to concessional interest rates on debt owed to the euro area’s official sector.
Sovereign risk is in a state of flux at present as recovery from the eurozone crisis will take time to become fully established. Still, Calice et al. (2013) show that coordinated action from the eurozone dampened the sharply negative impact of the crisis on trade and sovereign debt instruments for several troubled eurozone countries. The authors use time-varying vector autoregression in order to illustrate the impact of cross-liquidity effects on eurozone sovereign debt and CDS spreads during the crisis.
The eurozone’s quantitative easing policy has reduced returns on eurozone bonds, with some returns even being sold at a negative yield. This policy has reduced yield spreads relative to the German Bund, compressing risk and reducing the overall size of the sovereign bond market. The risk of sovereign debt default is being shared between the European Central Bank and the national central banks, which hold 92 percent of purchased bonds on their balance sheets. The extent to which quantitative easing will get the eurozone back on the path to growth and stability has yet to be seen; so far, the outcome is mixed. Going forward, it is hoped that Europe can overcome its exhausting state of sovereign fragility and move toward a unified recovery.