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Why Italy and why not Japan?

At the weekend, I saw three articles asking essentially the same question about sovereign debt crisis contagion: why Italy and why not Japan (the US or Germany)?

They all go through some very contorted logic to explain something that’s quite simple. And none of them give a satisfactory answer.

Think about this for a second. Sure, there’s inflation and currency depreciation risk plus interest rate expectations. But, there is no real difference between the euro zone and the US or Japan except the ability of government to hand you another paper IOU with the exact same amount printed on it when you present that government with an obligation in the currency it created.

When it comes to sovereigns, James Carville might say to you laypeople, “It’s the currency sovereignty, stupid!”

I used to work in the bond markets and I can tell you there are only a few major risks on bonds that investors care about.

Look at it this way: the perfect risk-free bond investment is one in which you are always assured of principle and interest repayment on time and in full and in which there are no currency or inflation risks. There are an infinite number of buyers and sellers, and interest rates are always the same.

For very short-term securities, in which investors can always hold to maturity, here are the risks that all bonds have:

  1. Currency risk. If a country issuing a sovereign currency in today’s fiat currency world mismanages its macroeconomic policy, the result is inflation and currency depreciation. As a domestic investor, you are robbed of the real value of your money by inflation. As a foreign investor, however, you lose real value via currency depreciation. All debt obligations in foreign currency suffer these risks.
  2. Liquidity risk. The Treasury market is the most liquid bond market in the world. That means you stand a safe chance of being able to offload your paper in times of liquidity constraints. If you think of a perfect market as having transparent pricing, an infinite supply of willing buyers and sellers. The fewer willing buyers and sellers there are, the less chance of your getting liquid when you need it.

If you go further out on the curve, the term structure rises due to a number of other risks:

  1. Interest rate risk. Pimco has been talking a lot about financial repression lately. What they are saying is that, irrespective of the inflation or currency risk, a government can hold its interest rates artificially low because ultimately government sets the policy rate which both alters the term structure of rates and future interest rate and inflation expectations. If the US government wanted to, it could keep the Fed Funds rate at zero percent forever. Or it could raise rates overnight, making your investment relatively less valuable.
  2. Inflation risk. Clearly, this introduces uncertainty into the picture. How do you know that the Fed won’t allow inflation to become embedded? You don’t. And that’s why central banks take pain to assure bond investors they will not do so. Otherwise, investors would extract a penalty which would be reflected in the term structure of rates, making long-term debt more expensive. What investors care about is the inflation-adjusted return on their investments not just the nominal return.
  3. Re-investment risk: In mortgage backed securities and high yield markets, there is a special kind of uncertainty risk via options which are embedded in many bonds. These options allow the securities to be ‘called’ or ‘put’ and redeemed at a future point in time. In the MBS market, the homeowners’ call is unfavourable to the investor because homeowners are likely to call i.e. refinance their loan just when interest rates are declining and investors want to hold onto the higher rate security. In the high-yield market, the investor has the opportunity to put the bonds back to the company if it merges or does something else that changes the company’s profile materially. But the company also often has a call option too. Meaning that upside for investors is capped since the company could simply retire the bonds if its credit rating improves.

Remember this, though: if the sovereign mismanages its finances and lets inflation spiral out of control and lets the currency depreciate, every bond denominated in that currency suffers, not just the sovereign. But of course all bonds are issued by legal entities that have specific geographical, industry and company characteristics. New York is not the same as California. And Telewest is not the same as Rover. Preem is not the same as Valero. Credit risk is the real defining element of bond analysis then. All of those other characteristics are shared across individual bonds. Credit risk is what makes each bond issuer unique. Look at Ford versus GM and Chrysler as a case in point.

The reason credit risk is so important is because there is default risk. In capital markets theory, the sovereign debt obligation of a country issuing a currency it creates is thought to have no default risk. Therefore, the rate at which the government borrows is commonly known as the ‘risk-free rate’.

Why? If you go to the government with your paper IOU with $100 printed on it to claim your money, the government can always hand you another paper IOU with the exact same amount printed on it.  They create the currency. There is no risk of involuntary default.

You probably caught that word ‘involuntary’ in the last sentence. That’s the problem isn’t it? It is what I call the ‘Ecuador risk factor’.

Back in 2006, Ecuador President Alfredo Palacio told investors restructuring Ecuador’s external debts was "absolutely necessary" to make yields on Ecuador’s debt lower. He might as well have been saying, "we are going to stiff the foreigners, so run for the hills" because this is how his comments were interpreted. Yields on Ecuador’s debt promptly spiked out of fear of another default. Ecuador had defaulted in 1999 when the Asian financial crisis hit emerging markets in Latin America with contagion. It made a decision to default again in late 2008 at the height of the credit crisis, with new President Rafael Correa calling the external foreign currency debt "immoral and illegitimate".

-Bill Gross: Deficit Hawk, Bond Vigilante

Get that: paying the obligation was “immoral and illegitimate.” Translation: even if we could pay, we wouldn’t. It goes to willingness to pay.

To my ears, that sounds a LOT like the talk we hear now in the US.

But when I see Italy and Japan, I think currency sovereignty: the ability, not the willingness of government “to hand you another paper IOU with the exact same amount printed on it” when you present it with an obligation in the currency of account.

Japan has currency and inflation risk and all the other risks I outlined but it has an infinite ability to hand you government-created IOUs. Italy does not and can be bankrupted as a result. It’s as simple as that.

Update 1844 ET: And if you don’t believe this about Italy and Japan, try France and Germany versus Japan then. These graphs are courtesy of Mike Norman on the Euro debt crisis migrating to the core.

Germany 5yr sovereign CDS

German 5-year sovereign CDS

France 5yr sovereign CDS

France 5-year sovereign CDS

P.S. – To the question of why not Germany (or France), the answer is default risk.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

36 Comments

  1. wh10 says:

    Great post. So frustrating all of these academics (and policy makers) don’t get this.

    ” If the US government wanted to, it could keep the Fed Funds rate at zero percent forever. Or it could raise rates overnight, making your investment relatively less valuable.” … “What investors care about is the inflation-adjusted return on their investments not just the nominal return.”

    I am stilling trying to understand this, with the MMT perspective in mind… why are investors sometimes willing to accept negative real returns on bonds? For example, it seems right now they are, and they have in the past. Is it because the govt provides the currency and reserves with which investors invest in bonds? They don’t have enough other options? Does it have to do with Primary Dealers “making it work?”

    Take your example- the Fed keeps the FFR low during a period of higher inflation. What would the short term rates on treasuries reflect? MMT proponents, such as Galbraith, argue we could keep the average interest rate at, for example, 1% while inflation is at 2% (and this plays into their future debt sustainability outlook).
    http://www.levyinstitute.org/pubs/pn_11_02.pdf

    • David Lazarus says:

      The reason that they are willing to accept such low returns is that stocks are seriously overpriced and very vulnerable. You only have to see the sales of discretionary stocks and you realise that they are pricing in very strong sales. Though with ultra low interest rates they can sustain dividends that can maintain such stratospheric valuations. Once inflation kicks in demanding an increase in interest rates then watch stocks plummet.

      • wh10 says:

        So do you reject the idea that the Govt has complete control over the term structure of treasury rates, if it so chooses?

        • David Lazarus says:

          The government can set the rates within a certain range. If the markets were pricing in high inflation then wanted a real return they would go chasing that return. At the moment the real issue is deflation, so it is wealth retention rather than asset growth. Look at Greece. The ECB has priced in rates of around 3% yet the markets will not touch Greece for less than 17% right now. With the Tea Party pushing for austerity and ultimately default as a consequence, then rates will climb out of the control of the Fed.

          • wh10 says:

            Ed- thoughts on this? Can rates ever climb out of control of the Fed given that they set the FFR (could potentially do it via IOR) and have an unlimited ability to add/subtract reserves?

            What you see in Greece is a product of the fact that they can’t print the Euro, so there is an ability-to-pay default risk there that doesn’t exist in the US. Ed just did a post on this.

            Would that imply though, that there could potentially be a risk premium for willingness-to-pay default in the US? You don’t seem to see it…

          • The Fed can always control either price or quantity, rates or reserve quantity. But that doesn’t mean inflation will play nice with them. If the US were operating near capacity, then manipulating rates too low would cause inflation to spiral out of control. There is no such thing as a free lunch. Whenever the government tries to control something by manipulating it in a way that is inconsistent with market forces, you will see unintended consequences.

            The willingness to pay default premium might be there, but bond price/yield action is dominated by the risk-on/off trade and safe haven bets. I should also add that the demand for Treasuries for use in repo activities may be a force in the market keeping yields down. Yves Smith mentioned this recently.

          • wh10 says:

            That mostly makes sense.

            I would disagree with Lazarus then, both on his premise that 1) rates can climb out of control (since the Fed has ultimate control, potential consequences aside) and 2) that this will result from austerity.

            Austerity will prolong the balance sheet recession and slow or reverse the move towards full capacity. This is not a recipe for demand-pull inflation in and of itself. So, assuming nothing else changes, low interest rates would be “consistent with market forces” (i.e., Japan).

          • David Lazarus says:

            I agree with wh10 that there would be be no demand pull inflation, and that the balance sheet recession would be prolonged. All the inflation we experience now is cost push which is largely a consequence of QE.

            What will happen over the longer term is that interest rates will climb as a consequence of increased default risk. Such a risk is only likely after prolonged austerity.

            Though the US could still maintain low interest rates for many years, but such low rates will have a disastrous impact on savers and pensions.

          • wh10 says:

            Mr. Lazarus- almost on the same page as you!

            My additional question for you would be why you think interest rates would continue to climb because of increased default risk in the US. Is this because you think we will continue to bump up against the debt ceiling?

          • David Lazarus says:

            I think that the increased default risk is purely political. Certainly that is the case right now. Without austerity I do not think that default is a risk. Gradually growing employment will increase tax revenues and reduce deficits. Austerity will increase that risk.

            Longer term if federal deficits are the only way to allow private sector deleveraging then it will take more than a decade to resolve. It will require multiple increases in the debt cap. Without the government being able to maintain spending the economy will suffer as debts will become unsustainable. That will lead to a tsunami of defaults of the middle classes and further bank losses. Will that mean more bank bailouts?

          • wh10 says:

            Got it and agree with the viewpoint.

    • I think investors accept negative real returns for a number of reasons: liquidity risk, disinflation/deflation expectations, etc. The most important factor of course is that the government is manipulating the yield curve and suppressing yields. What a lot of people are realising now is that money is created by government . So government can control that money and its price if it so chooses. Traditionally, the fed focuses on price (yield) only on the short end via the Fed funds rate. But now that we are in this economic strait jacket it has moved to trying to change yield further out the curve. And it can do this because it has an infinite ability to add or subtract reserves by buying or selling interest-bearing assets.

      I take a dim view of this kind of central planning where many MMT proponents feel that this yield curve action is necessary to alleviate the stress associated with private sector deleveraging. Moreover, some MMT proponents think that higher yields are just subsidies for the rentier class (bond investors). To me, low yields rob savers of income and distort resource allocation. They create an incentive for leverage and therefore support asset-based economic policies that have proved so destructive over the past generation. I say this as someone who takes the Austrian view of malinvestment seriously.

      • David Lazarus says:

        I agree, higher short term rates will act as an incentive for deleveraging for individuals. It will also boost savers and pensioners incomes, which will offset some of the income reductions. That is why I think interest rates should have a cap and collar. If the economy is over heating then if interest rates were at their cap then cuts government spending needs to be used or taxes raised. To refuse to use the various weapons in the governments armoury is stupid.

  2. Namazu says:

    I think it’s a little less simple. For example, there are plenty of near substitutes for euro-denominated Italian bonds, whereas JGBs have a large captive market (as does the US, in a more complicated way.) The magnitude of this effect should become clearer in the next few years as Japan’s population ages and that market contracts.

    • See the update on France and Germany. That will show you that it really is about default risk.

      • Namazu says:

        Still not reflected in German bond yields, though, and the Germans can’t print money any more than Italy can. I haven’t worked in the bond market: what am I missing?

        • It may be reflected there as it may be in US yields as well. But the default risk is still considered marginal at this point so the yields are not exploding. For Bunds and Treasuries inflation and interest rate expectations are driving the longer-term yields right now because the economic outlook is weakening.

          You are right that these countries’ bonds in the euro zone are competing against one another and that the yield reflects the different credit and default risks that investors see. So again, the difference between Italy and Germany owes to default and credit (downgrade) risk.

          • Namazu says:

            Here’s an attempt to square the circle: a priori, Germany cannot print euros and therefore bears actual credit risk. However, an all-seeing, all-knowing, hyper-efficient market realizes that the ECB will by necessity transform itself into something more like the Fed or BOJ well before that shortcoming is tested. Alternatively, bond investors believe they will be at worst paid back in some new currency at a fair conversion rate.

          • I am with you there. I think bond investors realise that Ireland, Greece and Portugal would be cut lose given their debt loads and lack of centrality to the euro experiment. On the other hand, Spain and Italy are different. They are on the periphery but only halfway. Germany and France are at the core and would never be subject to default. But of course, as we see in the US, never is a word that has to be used sparingly. Hence the increase in credit default swaps.

  3. Daniel says:

    Does not the answer to this question look something like this, with italy as spain and japan as Britain?

    http://www.ft.com/intl/cms/s/0/f30b14f8-75ab-11e0-80d5-00144feabdc0.html#axzz1SULFhJNP

    • No, it’s about default risk plain and simple.

      As Wolf says:

      “If there were doubts about the UK government’s liquidity, creditors would sell bonds in return for sterling deposits. They might then sell those sterling deposits for foreign currency. The pound would depreciate. But new holders of sterling deposits would need to buy sterling assets, probably including bonds. If the worst came to the worst, the Bank of England could tide the government over until fiscal stringency worked. The depreciation of sterling would also stimulate net exports, raising confidence in fiscal prospects. Thus, the UK cannot face a liquidity crisis in its sterling debt and any doubts about solvency are likely to lead to helpful adjustments.”

  4. fresno dan says:

    It seems to me that a lot of this goes back to the “rational economic actor” view. Considering how bondholders bought up MBS’s, and there apparent willingness to still believe Moodys, Fitch and S&P, I would question the intelligence and rationality of bond buyers.
    You give Ecuador as an example.
    http://www.tradingeconomics.com/ecuador/real-interest-rate-percent-wb-data.html
    Is that a RATIONAL interest rate if you consider that Ecuador appears willing to default at the drop of a hat?

    http://www.fxstreet.com/fundamental/interest-rates-table/
    In this table, Iceland pays only 4.5% – is that really an objective discounted cash flow analysis? Is Australia really more likely to default than Iceland?
    And I confess, I do not understand how the table determines that Italy pays negative interest, which seems at odds with the news about Italy.

    Is there a site that actually gives interest rates of different countries in an apple to apple manner?

    • David Lazarus says:

      Don’t forget that Iceland did not take its bank losses onto its books, like Ireland. Therefore it was able to get its finances into shape much faster. They also benefited from a substantial devaluation in the currency.

  5. fresno dan says:

    Sorry to post twice in one day.
    So I find a site where at least I can compare apples to apples
    http://online.wsj.com/mdc/public/page/2_3022-govtbonds.html

    And I see that Spain and italy aren’t all that high – 4-5% But Portugal and Greece are off the charts. So why all the news about Italy? And why is the UK the lowest? It is the country least likely to use inflation to resolve debt?
    And Portugal a year ago was 3% (2 year) – it seemed to me pretty obvious that portugal was one of the PIGS, so why was the interest rate so low?
    If the last two bubbles has taught me anything, it is that the reality based price and market price often do not coincide.

    • Dan, everyone is talking about Italy because it is the third-largest economy in the euro zone. It is a core euro zone member and a founding member of the EU. So the concept that its bonds would be under assault goes to the very heart of the European project. When you look at these countries, the bond market are saying that Greece will default and Portugal and Ireland will likely default. Recently, the markets are suggesting the risk of default has increased in Italy and Spain as well. ALL of the rise in interest rate spreads within the euro zone has to be considered credit and default risk since the other macro issues are the same.

      • fresno dan says:

        Well, I know you know much much more about this than me. But I would ask, what information is now available about Italy, that a person of average intellect and fairly well versed with reality now knows that they didn’t know a year ago?
        I lost the link that gives Italy GDP, its deficit, and its interest rate – but what I can’t reconcile is if these rates are set in a dispassionate, green eye shade manner, how can these rates fluctuate so much (or are they really fluctuating that much?)? I mean, did the bond buyers assume that the Italian government would go to all the couches in government offices, remove the cushions, and find billions of euros? Wouldn’t it be a pretty straight forward matter to look at revenue, spending, and see that deficits weren’t going to go lower?
        Maybe the market has no idea of what is going to happen…

        • The outcomes in Greece, Portugal, Ireland and Spain affect the outcome everywhere else in the euro zone. I suspect that is also why credit default swaps on France and Germany are more expensive now. What bond holders now know is that the macro environment is likely to be weaker, the support from the ECB less and the political will to draw a line under this lower. All of those things make the potential for default higher as investors flee riskier paper and this creates a self-fulfilling dynamic as bond yields make deficit reduction impossible. This spell contagion because only the ECB can provide short-term liquidity and when they don’t step in, things spiral quickly.

          • David Lazarus says:

            Yes but it is not a liquidity problem. It is a solvency problem in many of the banks. While french and german CDS spreads have been increasing, though they still do not truly reflect the risks of some of their banks. It is when that fact becomes apparent it looks like contagion.

  6. Chaos says:

    There can’t be malinvestment when there is underinvestment and unemployment. Anything > 1. At full capacity there can be malinvestment, only with crony non-functional governments (yes I know, the usual, but that will happen too anyway either rates are low or high, corporate capture)

    The problem of credit expansion is fixed by increasing capital requeriments and provisions, progressive taxes (to drain excess inflation that will end in asset speculation), etc.

    I don’t see the causality where: higher rates -> better investment (ie. non-speculative). There is no empirical correlation. Also free-risk income for the rich (the ones holding debt instruments) is completely unnecessary and inflationary.

    • David Lazarus says:

      There is plenty of malinvestment from prior to 2007, that has still not been shaken out by. It has been sustained by the ultra low interest rates. Higher interest rates and I am not talking about above 10%, even 5% base rates would be sufficient to eliminate some risks of malinvestment. With zero rates any investment will be worth a punt. It has such a low hurdle to become profitable. I do agree with you on taxation and regulation, being effective with such risks.

      • Chaos says:

        Yes I agree prior to 2007 malinvestment was common (massive housing bubble), but I don’t agree that higher rates would have changed anything.

        Indeed I don’t believe central banks have much control over anything, is mostly an illusion. Credit expansion is a function of economic expectatives, more than interest rates. If things go well, credit will keep expanding no matter if you have 5% or 0.5% rates, this will keep going as long as wages can keep up, because ultimately what will mark the peak credit is the leverage capacity of the population, how deep in debt it can go. The rates are just a matter of how fast you get there, not if you will or won’t get there. Indeed higher rates can prop up malinvestment: demanding higher returns favours ponzi finance and bubbles (housing), traditional business (real economy) can’t keep up in a competitive world.

        However I was talking about the current time and public spending. I don’t think we can talk about much malinvestment when economy is running well below full capacity and real unemployment/underemployment is sky-high in a lot of countries. So even ‘digging holes in the ground’ is better than doing nothing (just an hyperbole, but you get the point).

        As economy picks up and gets better, then you can let the market do their usual thing about malinvestments: competition. Malinvestment is destroyed in a daily basis wherever you are on the business cycle, major malinvestment (bubbles) have to be fixed in other way, using broad-spectrum tools like interest rates is quite inefficient.

        IMO central banks should just stay as a lender of last resort to protect deposits, nothing else (banks should have failed), and probably be joint with treasuries (which should stop issuing long bonds), but that’s a whole other debate… and right now, of little practical utility.

        • What you are saying about interest rates is patently false. If you have ever run or financed business investments, you should know from those experiences that the interest rate plays a key role in your investment decisions. The same is true for households and mortgages. It’s simply ridiculous to act like interest rates play no role in steering resource allocation.

          • Chaos says:

            Ok, bad explaining: I’m not saying they play no role, I’m saying rising rates by central banks don’t prevent bubbles or malinvestment (which is, anyway, sort of a sui generis and subjective definition). Indeed, rising rates in a ‘heating’ economy can even increase capital flows in the current globalized market and make matters even worse.

            I don’t think there is a single case where rising rates by a central bank did prevent a bubble from happening. I think banks ‘self-regulate’ the credit expansion and interest rates, whether the central banks manipulate interest rates or not, so the theory that central banks low interests rates lead to malinvestment is wrong.

            As long as the asset price keeps increasing, and because the interest income gets reinvested in the asset bubble the dynamic will continue (a virtual wealth effect because increasing equity prices). Off course you can rise interest rates to 20%, and kill the ordinary economy in the way. That’s why I said this broad-spectrum tool is really inefficient.

          • Understood. That makes sense now. I wouldn’t make a categorical statement about rising rates not pricking bubbles though. n the flip side, supporting some of what you’re saying, Warren Mosler argues that raising rates doesn’t slow an over-heated economy because it adds income to the consumer channel which initially increases consumer demand rather than retraining it.

          • David Lazarus says:

            In order to take the wind out of bubbles interest rates can help. Though I do think that they can never be raised enough to stop an asset bubble because of the impact on the rest of the economy. That is why there are no cases of interest rates preventing bubbles. Higher interest rates do deter some people actually joining the bubbles near the top because of the cost.

            Asset bubbles will continue because governments positively encourage them though poor tax policy. Mainly because capital gains are treated so favourably by taxation. It is why boardroom pay has exploded via stock options.

            I agree that interest rates are a blunt weapon and really should be constrained with a cap and collar. As they clearly have not stimulated the economy at the current low rates. Though the consequences of asset bubbles do flow into the real economy and vice versa when they collapse.