Last month, David Beckworth at Macro and Other Market Musings had some interesting thoughts on the global shortage of safe assets. His essay got me thinking about what is a safe asset? Beckworth alludes to two definitions of ‘safe’: (1) a credit being AAA-rated, (2) satisfying a certain level of liquidity to be used in repo markets (an important aspect of U.S. credit transactions). I would agree with (2), but not necessarily (1).
Why does a ‘safe’ asset need to be AAA? To be sure, the share of AAA sovereigns of 76 developed and developing/emerging sovereigns fell by 3% in 2011 compared to 2007. This should hardly be surprising, given the weak recoveries and leverage that exists in the developed markets. But it’s liquidity, and to a lesser extent sovereign risk, that matters and not the rating, per se. Furthermore, ‘safe’ is a matter of perspective.
Liquidity is a prerequisite for a safe asset, so that investors can purchase this asset in even the harshest of times. The United States runs the most liquid bond and currency market in the world; it can satisfy demand from flight-to-safety in times of stress. But one can think of liquidity in another manner: The ability to print fiat currency that is used to honor the debt instrument (asset). The U.S. government issued just 8% of its external government debt position in non-dollar form. Better put, the U.S. is a ‘safe’ asset because it’s a market large enough to satisfy broad demand. And the U.S. government is always going to be able to honor its debts. Liquidity is the most important definition of a safe asset, rather than the rating.
Norway prints its own currency, in which most of its bonds are denominated. However, it will never be a safe asset. The bond market is just not capable of satisfying broad demand during times of stress. So while Norway has enjoyed AAA status since 1975 (according to Bloomberg), it’s never going to be a safe-haven bond market for the global economy. Norway may be perceived as ‘safe’, though, due to its AAA status; but that’s of secondary concern.
And now I get to my second point: Perception of safety. On December 5, 2011, S&P put the entire euro area (EA) on credit watch negative, including Germany. If Germany were downgraded to AA+, does this mean that it is less ‘safe’? I would argue quite the opposite. Specifically, for all EA investors - using external debt statistics from the World Bank/IMF, I calculate that EA government debt held outside the EA amounts to 24% of GDP – the bund market (the German sovereign bond market) would enjoy an increase in safe haven status relative to other European economies. The reason is that EA investors are likely euro investors, and Germany is the most liquid and perceived safest debt market in the EA. So unless you want to take currency risk, which detracts from the 'safety', then EA investors are likely to flock to 'safe' within the EA.
Until the German investors themselves start to seek non-euro assets, the German bund market is likely to increase in ‘safety’ from the perspective of euro (as a region or the currency) investors without regard to the rating of the sovereign. This goes against intuition that safe assets have higher ratings.
More on safe assets in another post. That’s enough for today.