By Anthony Harrington
The Bank for International Settlements (BIS) has just released the proceedings of its seminar on sovereign risk, "Sovereign risk: a world without risk-free assets?" held in Basel at the start of January this year. Schooled again and again by one EU sovereign debt crisis after another, we have all grown accustomed by now to questioning the old axiom that government bonds in major advanced markets represent a "risk-free" asset class. So from that stand point, there is nothing new about the question the BIS posed for its conference.
However, the BIS seminar was a serious affair and not one to take popular assumptions at face value: in his foreword to the seminar's proceedings, BIS Managing Director Jaime Caruana made the following point:
Let me be clear that a world of financial markets without something approximating a risk-free sovereign strikes me as a world that would be very complex, and one that we would not want to live in.
What Caruana is referring to here, quite simply, is that if we conclude that the international financial system is fundamentally unstable, which is what the idea of no risk-free sovereign actually posits, then we are in really serious trouble. The BIS, of course, is a fundamental part of the regulatory machine. It has to believe in the effectiveness of monetary policy tools combined with fiscal policy tools, or it may as well disband itself and go play golf or whatever. The BIS is quite happy to agree, in principle, that there is no such thing as a risk-free asset, strictly speaking. Caruana's point, however, is a bit different. As he puts it:
We used to live in a world where sovereign risk was so low that investors could behave as if that debt was risk-free. the situation was a bit like air travel: we all know that the risks are not zero when we get on a plane but they are low enough for most of us to behave as if they were truly minimal... But what would the world look like if sovereigns were unable to win back their all-but-risk-free status? The consequences could be far reaching.
In something of an understatement Caruana points out that one of the first effects would be to pose "significant policy implications and challenges". When markets get even a hint of the potential for a sovereign default, the scale involved is so large, even for a small country, that panic sets in and stock prices and currency pairs around the world start gyrating. Setting policy in that kind of an environment is, er, tricky... Then there is the fact that advanced market sovereign debt tends to be the benchmark against which other, riskier assets are priced. We are all familiar with the idea of "risk-free plus x%", as a formula for looking at whether spreads on riskier assets are increasing, as against the risk free rate, or reducing. This is one of the prime ways of judging how the "hunt for yield" is picking up, and whether bubbles are forming in certain asset classes, with people taking on loads of underpriced risk. The usefulness of this "view" diminishes fast when the risk-free rate starts shifting, instead of being a stable entity. As Caruana says, the world gets frighteningly complex, frighteningly quickly once you really start seeing major risk creeping into "risk-free" assets. Worse, fund flows become unpredictable and highly volatile as institutions and investors hunt for somewhere "safer" to park their money.
Caruana puts the downside of sovereigns losing their all-but-risk-free status in very measured tones, but what he is sketching out are the early steps on a path to global economic meltdown - survivable if the contagion is contained to one or two major sovereign's but it is difficult indeed to see how such a containment would be arranged:
Ominous too are the financial stability implications of sovereigns losing their all-but-risk-free status. As they do so, foreign investors unload their sovereign bond holdings onto domestic investors. The resulting rise in funding costs for the sovereign means increased borrowing costs for banks, which pass these on to corporate and household borrowers. In the bond market investors make even multinational firms headquartered in the country pay up. Meanwhile the sovereign's backing for the banking system loses its credibility in the marketplace, so that the bank's sovereign debt holdings become a source of weakness instead of strength.
All this is scary stuff. The proceedings represent a very solid, deeply considered set of views and are well worth reading in their entirety (181 page pdf!).