Outlook for sovereign stress

Abstract

This chapter deals with the complications for issuers generated by the pressures of perceptions of an increase in sovereign stress, in particular whereby the market suddenly perceives the debt of some sovereigns as risky. The borrowing environment for governments has become even more difficult than before due to the complications generated by sudden shifts in sentiment and perceptions of risk associated with certain sovereigns: the so-called swings in the risk-on and risk-off trades.A lack of consensus on how to measure and price sovereign risk is an important obstacle in assessing sovereign stress. This also complicates assessing changes in the supply of safe public assets. Since the track-record of sovereign risk pricing is not very impressive, suggested market measures of this risk (including ratings) should be treated with great caution. One should, therefore, be very cautious in concluding that the sovereign debt of an OECD country has indeed lost its risk-free or ultra-safe status. Moreover, rating downgrades for several OECD sovereigns and changes in borrowing rates give conflicting signals. This also means that downgrades and their implications for the supply of safe sovereign assets should not be taken at face value but more carefully scrutinised. Concerns over a possible euro area breakup resulted in fragmentation between sovereign funding markets. However, stresses in European sovereign debt markets have been reduced, in part due to important recent policy initiatives such as the announcement by the European Central Bank of its Outright Monetary Transactions (OMTs) programme. As a result, convertibility risk (redenomination risk) associated with fears of a possible euro breakup was diminished.