A consistent theme we have heard over and over this year is that there is no credit risk for a sovereign borrower that has an independent central bank and can resort to debt monetization. Even Martin Fedstein in his excellent Project Syndicate piece, The French Don’t Get It, writes,
French officials have now reacted to the prospect of a credit rating downgrade by lashing out at Britain. The head of the central bank, Christian Noyer, has argued that the rating agencies should begin by downgrading Britain. The finance minister, Francois Baroin, recently declared that, “You’d rather be French than British in economic terms.” And even the French Prime minister, Francois Fillar, noted that Britain had higher debt and larger deficits than France.
French officials apparently don’t recognize the importance of the fact that Britain is outside the eurozone, and therefore has its own currency, which means that there is no risk that Britain will default on its debt. When interest and principal on British government debt come due, the British government can always create additional pounds to meet those obligations. By contrast, the French government and the French central bank cannot create euros.
But will they?
Unlike the relatively benign quantitative easing of the past few years to goose markets and the economy, the consequences of monetizing bond maturities due to a loss of confidence in a sovereign’s ability or willingness to pay its debt would have severe consequences. Initial conditions and state variables, such as confidence and the monetary transmission mechanism, matter significantly when a central bank decides to crank up the printing press.
If faced with the prospect of a sovereign default, monetary authorities and policymakers would be forced to make a political choice of who pays the debt: 1) bond holders by allowing the sovereign to default; or 2) domestic residents through the loss of their savings during a hyperinflationary debt monetization.
Some countries, such as Bulgaria in the mid-1990’s monetized their debts, which resulted in hyperinflation and inflicted severe pain on their residents. Russia, on the other hand, defaulted on their domestic debt in 1998, much of which was held by foreigners, including hedge funds, such as David Tepper.
Unfortunately, it’s very difficult to decompose the various risk premia in a sovereign bond yield. The IMF made a valiant effort with the 10-year U.S. Treasury yield in 2010. Note the credit risk premium entering the picture after the bursting of the credit bubble in 2007/08.
We sense a dangerous complacency haunting the bond markets.
(click here if chart is not observable)