Sovereign Debt Ponzi-Schemes and Credit Risk in the EMU

Abstract

The interconnections between financial markets and macroeconomic stability of sovereigns is currently under the spot light. In fact, all members of the European Monetary Union (EMU) experienced in the past years some degree of economic distress caused by chain-reaction mechanisms; however, reactions to financial shocks differ greatly among them. The credit risk score attributed to a country by rating agencies express indeed also the resiliency to financial disturbances. The first goal of this work is to build a quantitative credit risk score that combines macroeconomic and financial variables, which can also help in explaining the country-specific reactions. We select as macroeconomic variables the primary fiscal deficit and the ratio public debt/GDP, that are also subject to limitations after the Maastricht Treaty (1992). We add market yields of government bonds, that provide a timely insight into financial markets’ expectations. Their trend is moreover at the origin of chain-reaction mechanisms: e.g. Greece’s default (debt restructuring) became unavoidable since the country debt was excluded from secondary market. We chose to follow the ideas of Minsky (1992) to connect these quantities by an economic model. In the government budget equation, we forecast future interest expenses thanks to the current market yield, so as to infer whether the state is a Ponzi debtor. Based on this, we define a non-linear credit-score, from which a default probability (PD) is derived. We compare it to the PD implied from the CDS market for a panel of EU countries and we assess whether a cointegration relationship exists between the two time series. In fact, the econometrics of integrated VARs provides long-run equilibrium relationship to be the natural economic interpretation of cointegrating relations (Johansen, 1995). We rely therefore on the existence of such a relation as an indicator of the country weakness in resist against financial shocks, since it shows how a temporary lack of public balance equilibrium affects market confidence in the long run.