The economy of indebtedness is a reality of the recent years. Over-liquidity facilitated credits, the selection of borrowers being more and more permissive. In this context, the country risk analyst is increasingly concerned about sovereign crisis and its consequences; he raises the natural question, appealing to economic history: What are the states that have recently experienced a sovereign crisis? The answer will be surprising, inducing the idea of a reduced probability of default of the states. What the answer to that question hides is the fact that a significant number of states have avoided collapse thanks to the International Monetary Fund, or as a result of debt restructuring. Beyond liquidity risk, with the highest visibility, a number of other fragilities are particularly noteworthy: the current account deficit, the existence of an overvalued currency, the excessive government deficit, the high governmental debt, the difficult political situation, etc. In Europe, many countries are facing problems due to high sovereigndebt. Not only Greece, but also Spain, Portugal, Ireland or Italy represent well-known cases. Among the causes, we can mention the lack of controlling government deficits, the recession effects, the public accounting opacity, or the inability to use independent monetary policies.
This paper studies the impact of the European sovereigndebt crisis on Portuguese banks’ share prices. I employ an event study methodology to assess the behavior of banks’ share prices before, and after a credit rating announcement in relation to both thesovereign and the banks individually. I find that sovereign credit ratings have a significant impact on banks ’ stock market returns while individual bank credit ratings seem to have little influence. This is probably due to the fact that banks’ credit ratings have been reflecting changes in sovereign ratings rather than any idiosyncratic factors of banks’ solvency. Among the rating agencies studied the most predominant is Standard & Poor’s. Furthermore, I find that the behavior of banks’ stock returns exhibit a certain degree of market inefficiency and anticipation.
In 1986, Portugal joined the European Economic Community (now European Union) and started integration into the European Single Market, which required the gradual dismantling of the constraints on the financial system and, in particular, of the State ownership of banks and insurance companies. Even though the elimination of restraints had already begun in 1983 with banking and insurance activities again opened to national and international private corporations, a new set of liberalising measures were adopted in the late 1980s that included the progressive elimination of administrative limits on interest rates, credit growth, the number and location of bank branches, and compulsory investment in national public debt (Gabriela L. Castro, 2007). The latter element was important as it allowed banks to disinvest in public debt and free resources to finance the private sector. As an alternative, the State gradually increased the sale of bonds to foreign investors (in 2008 they owned 78% of public debt), but this made it more vulnerable to capital flights, as we will see below when discussing thedebt crisis.
As fall out from the 2009–2010 economic and financial crisis, Portugal and Ireland needed financial support to roll over public debt and they both adopted economic and financial adjustment programmes (EFAPs) 1 in 2011 (European Commission, 2011a, 2011b). 1 These euro area countries had external deficits and were more vulnerable to external shocks than those euro area coun- tries that recorded external surpluses. In this article, we assess the determinants of 10-year sovereign yields in Portugal and in Ireland, notably in this context of crisis. In the related literature, Lane (2012) argues that at the moment of the crisis, the euro area had a low degree of fiscal and banking union with identified risks of multiple equilibria when sovereigndebt is high. This ‘bad equilibrium’ leads to the risk of self- fulfilling speculative attacks, that is, an increase in perceptions of default risk induces investors to demand higher yields. Therefore, the rollover of public debt is more difficult and makes default more likely. On the other hand, the European Stability Mechanism and the ECB’s programme to purchase sovereign bonds could attenuate such dire market conditions.
In line with the model’s predictions, Portugal had strong economic dynamism, particularly until the late 1990s. Portugal is quite different from Spain, Greece and Ireland in that economic growth lost momentum at an earlier stage, namely in 2000, when the Portuguese economy faced structural problems that blocked its growth potential. Andrade and Duarte (2011) and Mamede (2012) note that the most relevant constraints to development were (and still are today) the low levels of education in the labour force (aggravated by underinvestment in public education during the dictatorship), the profile of economic specialisation (which is still dominated by industries with low value-added, low levels of technology and low wages that are highly exposed to competition from Eastern European and emerging economies) and its peripheral location in relation to the main European and world markets (entailing relevant cost disadvantages). Despite a significant effort to improve all these blockages through private and public investment, there was still a large distance from advanced Europe in 2000.
A state differs from a company due to the fact that it has an important feature called sovereignty. In some situations, a state can increase taxation, can operate fiscal changes, can modufy the legal environment, or even print money. These levers obviously can not be used by private actors. Also, often the state is favored relative to private agents in the context of a loan, this privilege meaning, first of all, a lower interest rate. Often, when a country accumulates debt, people are tempted to say that its creditors are not at risk. Government bonds have been perceived as risk-free assets for a log period of time (Landau, 2012). However, sovereign risk has occurred and is present, more than ever, in the global economy. Often, the default is recorded long before a state drains its resources (Reinhart, Rogoff, 2009). Basically, it is the result of an analysis carried out by political factors, which choose the alternative which is favorable. Economic interconnections make unlikely sovereigndebt repudiation in the contemporary world, countries desiring to maintain good quality economic and diplomatic relations. A good economic analyst must, however, make a proper distinction between the concepts of “willingness to pay” and “ability, capacity to pay”. In this context, we mention another relatively rare concept, that of "odious debt", which refers to the "right" of a government to refuse paying a debt inherited from another one, corrupt and of bad faith. Of course, the concept is relatively controversial, the odious nature of debt being difficult to prove; however, a certain influence on the payment behavior of states is present.
We document a novel type of international financial contagion whose driving force is shared financial intermediation. In the London peripheral sovereigndebt market during pre-1914 period financial intermediation played a major informational role to investors, most likely because of the absence of international monitoring agencies and the substantial agency costs. Using two events of financial distress – the Brazilian Funding Loan of 1898 and the Greek Funding Loan of 1893 – as quasi-natural experiments, we document that, following the crises, the bond prices of countries with no meaningful economic links to the distressed countries, but shared the same financial intermediary, suffered a reduction relative to the rest of the market. This result is true for the mean, median and the whole distribution of bond prices, and robust to an extensive sensitivity analysis. We interpret it as evidence that the identity of the financial intermediary was informative, i.e, investors extracted information about the soundness of a debtor based on the existence of financial relationships. This spillover, informational in essence, arises as the flip-side of the relational lending coin: contagion arises for the same reason why relational finance, in this case, underwriting, helps alleviate informational and incentive problems.
In the past three decades, various countries have been hit by severe financial crises: the Mexican “Tequila Crisis” in 1994, the East Asian Crisis in 1997, the Russian Crisis in 1998, the Argentinean Crisis in 2002, the United States of America (USA) Subprime in 2007 and the Lehman Brothers Bankruptcy Crisis (LBBC) in 2008 and, more recently, the European SovereignDebt Crisis (ESDC) in 2010/2011. All these financial crises started in a specific country and region in the globe and, subsequently, their effects spread to other countries and regions. Such transmission of shocks is dubbed contagion (Bonga-Bonga, 2015). Notwithstanding, the contagion term is not consensual, this research follows the largest body of the empirical literature based on the Forbes and Rigobon (2002) designation, where contagion is defined as a significant increase of cross-market linkages after a shock to one country or a group of countries. This contagion effect undermines the purpose of the portfolio diversification, revealing the situation where markets that were assumed to be weakly associated before a shock are subsequently found to be strongly associated in such a way that diversification across markets fails to shield the investors from the unsystematic risk (Gentile & Giordano, 2012, 2013). This definition indicates that, if two markets present a high degree of co-movement during periods of stability and continue to be highly correlated after a shock to one market, this indicate interdependence 5 rather than contagion.
The second theoretical approach to sovereign default risk is described by Haque et al. (1996) as thedebt-servicing capacity approach. In this approach, it is the unintended deterioration of the country’s capacity to service its debt that could cause its default. Countries may be unable to repay their internal or external debt because they are either insolvent or illiquid. The sustainability of a debt, as a result of short-term liquidity or of long-term solvency, is likely to determine the probability of default. Sustainability may be affected, for example, by macroeconomic variables, economic policy, currency crises, short-term budget mismanagement or by internal/external shocks. Thesovereign crises which occurred in recent years (South Korea, Brazil, Turkey, Russia, Ecuador, Argentina) and European debt crisis (that started in Greece, in 2010) illustrate debt-servicing difficulties, ranging from debt rescheduling to outright default that a country may face. A country may be illiquid, while being solvent if creditors decide not to reschedule/restructure short-term debts. On the other hand, excessive long- term debt may be associated with an insolvency situation. In some cases, outright default has been avoided by the intervention of the international financial institutions. However, as discussed by Roubini (2001), though it is not easy, in practice, to differentiate solvency from liquidity, several indicators allow to asses a country’s sustainability.
During the last 20 years the importance of the reoccurring phenomenon of debt default has prompted an enormous volume of theoretical and empirical literature on sovereigndebt. 4 Initially, most of this research focused on why countries ever chose to pay their debts puzzled by the fact that few direct legal sanctions can be used against sovereign borrowers. Eaton and Gersovitz (1981) argue that sovereign countries might repay their debts because they would otherwise develop a reputation for defaulting and thereby lose access to international capital markets. Bulow and Rogoff (1989) challenged this explanation showing that for reputation to enforce contracts the debtor country would have to be excluded from all international markets including those that allow thesovereign country to sell financial assets such as stocks, bonds, and insurance contracts. Subsequently, Cole and Kehoe (1995, 1998) showed that the ability of reputation to support debt depends on the alternatives open to the country, its relationships in the international arena, and assumptions made about institutions.
Existing studies on EMU government bond yields, or their spread against Germany, fall into two broad categories, respectively covering the period prior to and following the global financial crisis. Both groups of studies typically follow the general literature on government bond yields modelling the latter on three main variables (see e.g. Manganelli and Wolswijk, 2009): First, an international risk factor capturing the level of perceived financial risk and its unit price. Typically, this is empirically approximated using indexes of US stock market implied volatility or the spread between the yields of US corporate bonds against US treasury bills. Second, credit risk, reflecting the probability of default on behalf of a sovereign borrower, typically approximated using indicators of past or projections of future fiscal performance. Indeed, existing evidence suggests that markets attach additional risks to the loosening of observed fiscal positions (see e.g. Ardagna et al., 2004; Afonso and Rault, 2010) and shifts in fiscal policy expectations (see e.g. Elmendorf and Mankiw, 1999). Third, government bond yields are linked to liquidity risk. This source of risk refers to the size and depth of thesovereign bonds market and captures the possibility of capital losses due to early liquidation or significant price reductions resulting from a small number of transactions. Liquidity is a variable particularly difficult to measure empirically, usually approximated using bid-ask spreads, transaction volumes and the level of or the share of a country’s debt in global/EMU-wide sovereigndebt (see e.g. Favero et al., 2010, Arghyrou and Kontonikas, 2012).
More recently, the literature on financial-real economy linkage recorded a new wave, exploring the impact of the financial and the euro area sovereigndebt crises on credit institutions and firms’ decisions. While the financial crisis directly affected banks’ financial health and the functioning of the interbank markets, thesovereigndebt crisis may have affected financial markets and the financial institutions through several channels. Sovereigndebt tensions had a direct negative impact on the market value of sovereigndebt securities. Moreover, financial systems were also perceived as more vulnerable as thesovereign capacity to provide financial assistance decreased. In this context, banks’ funding costs also increased. In a second round, the increases in sovereign yields may have induced changes in banks’ decisions, contributing to portfolio adjustments, such as an increase in sovereign holdings for less risk averse institutions. These securities presented higher returns (which improve profitability), while they did not imply additional capital needs (zero risk weights in terms of capital requirements). This strategy may reinforce the bank-sovereign linkage. It may also imply a decrease in credit supply to other economic segments (i.e. a crowding out effect).
he New Public Management reform, in the wake of a deep inancial crisis, focused on the use of market mechanisms for market delivery, the fragmentation of public units, pressure on eiciency, and pressure on private-sector management styles (Hood, 1991). No attention has been paid to political issues related to enhancing the quality of democracy or securing civic engagement. One reason is that the reform agenda focused on aspects that needed to be changed. In the 1980’s, as in the recent sovereigndebt crisis, political aspects of democracy were thought not to be at risk. hus, changes focused on inancial performance and the way this could be improved by governments. Moreover, reform initiatives appeared to separate political values from the decision-making process. Waldo’s argument (1948) of a trade-of between democracy and eiciency supported this alternative. he understanding is that political agenda and democratic procedures can place rigid restrictions on eicient management (Svara, 2008). Waldo (1948) believes in a negative, linear relation between eiciency and democracy, explained by the impossibility of reconciling two diferent views of public administration: the irst, drawn from a managerial perspective, relies on the primacy of an eicient government through the discretional power of bureaucrats, their expertise and the use of market so- lutions; the second, closer to political science, is based on the primacy of democracy, legitimacy, and civic engagement. Dollery (2010) and Overeem (2008) claim that this is a recurrent clash portrayed in the literature under diferent excuses. It has been called as the tension between technical knowledge and peoples’ will, discretionary power and legitimacy or a dispute between bureaucracy and civic culture, a trade-of between local voices and diversity, accountability, and political responsiveness, and a primary concern with structural eiciency. Waldo’s classic argument of a negative relation has been tested under diferent contexts yet with inconsistent results (Gasiorowski, 2000; Skelcher, 2007; Vigoda, 2002).
Here we propose a related measure that takes very seriously the realization that thedebt accumulation equation for any country involves variables that are stochastic and closely intertwined. By taking these aspects into consideration, the notion of debt sustainability is expanded to studying the stochastic properties of thedebt dynamics. We propose a VAR (Vector Auto Regression) to estimate the correlation pattern of the macro variables and use it to implement Monte Carlo simulations. These simulations allow us to compute “risk probabilities”, i.e., probabilities that the simulated Debt to GDP ratio exceeds a given threshold deemed risky (say, 75% of GDP). 3 The time-series of such probabilities is then used to investigate whether or not it is correlated with the market risk assessment, measured by the spread on sovereign dollar denominated debt. The application of our methodology for Brazil shows that even though thedebt could be sustainable in the absence of risk, there are paths in which it is clearly unsustainable. Furthermore, we show that properties of thedebt dynamics are closely related to the EMBI+ Brazil spread. Next Section describes the data used and performs a few debt decomposition exercises. Section III presents the core methodology and the application to Brazilian data. Section IV concludes.
Schelling (1960: 22) was the first to note that weakness is often a strength in negotiation, as ‘the power to constrain an adversary may depend on the power to bind oneself’ (see also Giavazzi & Pagano 1988). In this article, we illustrate this process with a paradigmatic case study: Portugal – the Troika’s ‘good pupil’. While it appears that the autonomy of governments was weakened by the crisis, it has also made them stronger in relation to other domestic actors – a process that has allowed ministers to pass measures they privately desired but could not have passed ‘in normal times’. We further demonstrate that executives’ capacity to advance their own agenda also depends on their preferences for specific policies. In the policy fields where the government favoured spending cuts or neoliberal structural reforms, ministers used thesovereigndebt crisis strategically to overcome resistance to those reforms. When this was not the case, executives and international lenders engaged in a bargaining process, the final outcome of which depended on each actor’s resources. We show congruence between this state of affairs and the public discourse of leaders. Contrary to our expectations, we found limited evidence of blame-shifting to international actors, but we clearly observe a strategy of depoliticisation in which both the material constraints and the discourse used to frame them are employed to construct imperatives around a narrow selection of policy alternatives.
Meanwhile, deep concerns also spread to Ireland and Portugal (see Exhibit 12). The former, about 6 months after Greece, negotiated a three year financial assistance package of €85 billion, mainly caused by a huge banking exposure to the domestic property bubble and the resulting need for the recapitalization of some important banks 29 . In the case of Portugal, the high deficit and debt level, combined with other structural imbalances and the political disagreement on austerity measures, led the country to call for assistance in April 2011 30 . The unfavorable developments continued in the following months and directly impacted BPI. The incapacity of Greece to reach the targets established under the economic adjustment program pushed the country to a second bailout. In February 2012, the Eurogroup formally announced the terms for an exchange offer for Greek public debt, materializing the involvement of the private sector in thedebt restructuring operation, frequently referred to as PSI “ Private Sector Involvement” 31 . BPI’s total exposure to Greek sovereigndebt amounted to €634 million.
Now, a similar analysis is undertaken of the Greek and German markets during the crisis periods identified for the Greek market. Observing the yields (Figure 9), we can see that it is the subprime crisis at the end of 2008 that causes markets to diverge. Correlations (Figure 10) computed through the econometric DCC – IGARCH (1,1) model show that the values are close to 1 from 2007 to Q2 2008. We also observe evidence of flight-to-quality at the end of 2009, with correlation shifting from positive to negative values, such as in the Portugal-Germany case, assuming values even more negative in early 2010, when the IMF-EU program for Greece was initiated. It is interesting to notice that this large fall in correlation between Portugal and Germany and Greece and Germany occurred at the end of 2009. In November and December 2009, incorrect practices were identified in Greece revealing the true value of the Government Debt, which caused an immediate downgrading of Greek bonds into non-investment grade. It is also important to note that from this date onwards, the correlations between the Portuguese and German bond markets and the Greek and German bond markets were negative for most of the time. However, the Greek rescue plan led to a short-run increase in the correlation with Germany. The same benign effect is observed for Portugal (with an increase in the correlation with Germany and mostly a decrease in the correlation with Greece) and for Ireland (with a decrease in the correlation with Portugal).
The dynamics of the emerging markets crises with the characteristic sudden stops of capital inflows are inconsistent with smooth movements in current accounts and the level of foreign debt. This inconsistency remains with the neutrality of the business cycle against the external interest rate shocks predicted by conventional models of business cycles when analysed in a small open economy. One important reason for this inconsistency is the role assigned to international creditors. An assumption of conventional business cycle models is the perfection of the international credit markets. In other words, a small open economy is able to borrow funds at a fixed risk-free rate up to a point limited only through the extent of its wealth.
21 estimated models, since these variables originated violation of the assumption of the absence of multicollinearity among the independent variables, we could not test the hypothesis H2 and therefore conclude whether the increase in government debt and the public deficit would lead to a reduction of lending to Portuguese SME. However, using the Pearson regression coefficients can be said that the small enterprises debt is strongly correlated in reverse with thedebt of government and large business. This means that when you register an increase in thedebt of large business, government and the public deficit, lending to small and medium decreases. In fact, at company level, and as found APB (2012), Farinha e Prego (2013), Ferrão (2012), Iyer et al. (2010) and Paulo (2012), credit granted to SME was the one who showed greater reduction after the financial crisis. Finally, we conclude by applying the Chow test for a 5% significance level, the downturn in 2010 (break point) is statistically significant in the models M1, M3 and M4. This result allows, in some way, say that the European sovereigndebt crisis had an influence on the behavior of loans, since the year 2010 was marked by the Financial Economic Assistance request from Greece and Ireland.
The evidence of unit roots triggered the emergence of tests that clearly identify the stationarity property of a time series data. The Augmented Dickey Fuller (ADF) and Phillips-Perron (PP) are among the most usual in pioneer studies. This analysis therefore began by carrying out these two tests for all variables included in the study. Only anoverview of the results from both tests is presented below to avoid unnecessary complexity (detailed table results are available by request). The ADF and PP tests indicated that the null hypothesis of a unit root in the stock price levels cannot be rejected for any time series, while a unit root in the first differences of the stock prices is rejected at the 5% significance level. The stock prices thus follow an integrated process of order one. Notwithstanding, the absence of any structural break effects is an important limitation associated with both ADF and PP tests. When dealing with finite samples, the standard tests for unit root (non-stationarity hypothesis test) are biased toward accepting the null hypothesis when the data-generating process is in fact stationary, especially when we are closely to having a unit root. Different theories on phases of economic development and growth postulate that an economic relationship changes over time. More recently, several studies noted that such tests may incorrectly indicate the existence of a unit root, when in actual fact the series is stationary around a one-time structural break (e.g. Zivot and Andrews, ). Their argument is based on the fact that conventional unit root tests may be reversed by endogenously determining the time of the structural break.