Sovereign Risk and Financial Crisis

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

As highlighted in Chapter 1, the existing literature suffers from an under-investigation of the role of politics in driving investment decisions. In the case of developed democracies in particular, the issue is often rapidly dismissed on the grounds that political institutions do not matter for portfolio allocation across those economies, since these institutions themselves are supposed to have contributed to eliminating sovereign risk. This assumption is particularly surprising in the case of sovereign debt markets, since sovereign risk has inherently political connotations. Moreover, in the presence of international financial markets with stronger financial and trade inter-linkages and, crucially, higher cross-border bond ownership, a wider web of interests is affected by a potential sovereign default decision. As a result, international political factors are also likely to play a role. The importance of international factors is further reinforced whenever the possibility of an international bail-out is introduced into the picture. Indeed, mainstream economists highlight the fact that the quality of political institutions is a fundamental determinant of a country’s debt tolerance level (Reinhart et al., 2003). Accordingly, economists and political scientists have made a few attempts at investigating the political features more or less conducive to default in emerging markets (for example Kohlscheen, 2007). However, there has been limited investigation of the role of politics in affecting risk premia in what are normally denominated “developed democracies”, including Euro area members, be these recent or long-standing “graduates” to the club.

Greece and Ireland were the first two countries to be hit by the EMU sovereign debt crisis: Greece was the first victim, in the first half of 2010, and Ireland followed in the second half of the same year. While the sovereign debt crises were dramatic events in both countries, their severity, length and final outcome were clearly different1: Greece restructured its debt in March 2012,2 while Ireland returned to the markets for funding by July of the same year.

Between the beginning of October 2009 and May 10, 2010, financial markets’ attitude towards Greek sovereign debt changed dramatically. In the space of six months, Greece went from being considered a de facto risk-free credit to being singled out as the riskiest in the world. As financing costs surged and access to market finance was closed, in early May 2010 the country received an aid package from the rest of the EMU and from the IMF, after weeks of debate about how the crisis should be dealt with. This episode also led to the creation of the European Financial Stability Facility (EFSF), which provided the Eurozone with an emergency facility ready to be used in case of future need. The creation of the EFSF was not to prove the end of the sovereign debt crisis for either Greece or the Euro area, but it certainly represented a major turn in the policymakers/financial markets dialectic as well as a historic moment for the evolution of the nature and institutional structure of the monetary union and the EU itself.

From August 2010, financial markets’ concerns about the creditworthiness of the Irish sovereign increased significantly, due to large contingent liabilities from bank bail-outs and guarantees, as well as the direct impact on public finances of the real-estate collapse and deep economic recession. Market pressures intensified in late October; by mid-November, Ireland was requesting financial aid from the newly created EFSF as well as from the IMF. While Greece had received bilateral help from EMU countries, Ireland was the first country to receive multilateral assistance from EMU partners through a joint facility. During the crucial period running from mid-August to early December 2010, financial market attitudes towards the Irish sovereign deteriorated dramatically. The move was the culmination of a real-estate, banking and economic crisis that by 2010 had been three years in the making. Some re-pricing of sovereign bond yields had already occurred since the financial crisis hit: Ireland entered the crisis with one of the lowest risk premia in the EMU; by early 2009, they were the highest in the region. However, until then, the move had remained well contained and had little consequence in terms of Irish sovereign capacity to access external finance. Also, part of the move was reabsorbed later in 2009, coinciding with the decline in global risk aversion. However, in the space of a few weeks during the second half of 2010, the fundamental deterioration and the increasing burden of large actual and contingent liabilities related to bank rescues came to a head for the sovereign. In just a few weeks, markets not only moved Irish sovereign debt from the “good credit” to the “bad credit” category, but went so far as to place it on a par with some of the worst credits in the world, leaving the entity unable to raise finance in the private marketplace.

This book contributes to a better understanding of how international financial markets price sovereign risk in developed democracies, and especially in the developed democracies of the Eurozone. In particular, it identifies and highlights the influence of political economy factors in driving investors’ assessment of sovereign risk. Additionally, it extends the focus from the domestic sphere to include international factors. From the empirical perspective, it provides a timely look at one of the main events in the financial history of the last few decades, the Eurozone sovereign debt crisis. Indeed, the Eurozone crisis provides a strong real-life motivation for engaging with these issues, for both positive and normative purposes.