Last Updated: 2 June 2023
Sovereign credit investors are increasingly concerned about risk in Europe’s leading countries
Two charts put out yesterday by Markit’s credit analyst Lisa Pollack suggest that contagion risk may be moving to European countries previously considered safe.
The first chart shows the net notional exposure to credit default swaps (CDS), referencing the three countries currently priced by the CDS market as most likely to default (Greece, Ireland, Portugal, in that order). The net notional value of CDS represents the sum of default protection purchased by buyers in the market, and is therefore a gauge of the level of investors’ interest in insuring against the risk of the relevant country defaulting on its debts.
The second chart measures net notional CDS volumes for the five largest European economies: Germany, France, the UK, Italy and Spain, over the same period.
Demand for credit protection against Greek default has actually fallen by over a third during the last year, points out Pollack, while for Portugal and Ireland the volume of insurance written via CDS has also fallen substantially.
The first chart is prima facie evidence that Greece’s slow drift towards default is not being provoked, as some European politicians have suggested, by speculators buying huge volumes of CDS to push credit spreads wider. The absolute level of CDS protection purchased on Greece—around US$5.5 billion—is also small when compared with the country’s total debt (€310 billion, according to the BIS).
There are also some technical factors behind the fall in demand for CDS on Europe’s riskier countries. For example, Portugal took the lead last summer in agreeing to post collateral with its market counterparties (historical market practice has been for postings of the collateral underlying derivatives contracts between banks and sovereigns to be one-way only, meaning that governments have historically insisted on some form of security from bank counterparties to back the latters’ promises, but have typically not felt obliged to offer the same surety in return). With this particular government now offering collateral to dealers, says Pollack, demand from the market to buy default protection has fallen.
However, there’s been a sharp rise in net notional CDS outstanding on the supposedly safer sovereign credits in Europe, as the second chart shows. Demand for protection against a French default has doubled in a year, for example, while for the supposedly default risk-free UK (given the country’s control of a currency that it can, in theory, devalue at will) there’s been a six-fold rise since 2008 in the volumes of CDS held.
Part of the rise in demand for sovereign credit risk insurance over the last few years has come from banks’ internal credit departments, which have undergone a complete reassessment of the way they monitor and hedge counterparty exposures since the financial crisis, says Michael Hampden-Turner, credit strategist at Citi. Whereas previously most sovereign bonds and exposures to governments via derivatives contracts were considered risk-free by dealers, since 2008 these have all been hedged as a matter of course, he explains, and banks have dedicated counterparty valuation adjustment (CVA) desks to fulfil this role. A decent part of the increased demand for sovereign CDS is coming from such sources, says Hampden-Turner.
However, with the rise in demand for CDS protection on Europe’s largest countries, it’s also easy to see that investors are hedging against the risk of contagion from the weaker periphery. This is particularly the case since Europe’s blind insistence on a “no default at any cost” policy has had the effect of tying the stronger EU member states to the riskier ones, via such bailout programmes as the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM).
Although we’ve ignored the price of insurance—the cost of default protection for Germany (45bp), France (79bp) or the UK (58bp) is still ten or 20 times lower than for the most stressed Eurozone states—the steady increase in interest in hedging against the default risk of governments previously considered rock-solid is a trend worth following closely.
Forget Greece, where default is surely a done deal and it’s only a question of when and whether it’s a single or two-step write-down of debts. It’s French, German and UK CDS contracts you need to watch if you want to gauge the real risks to the financial system.