Wednesday, 2 March 2011


Our Leader Yorgo often says, in his more closely scripted statements, that Greece's biggest problem is its credibility deficit, not its Government deficit. This line goes down very well with world leaders because it seems to them to signal that we want to become a respectable country.

Now there's at least some evidence to help us measure how true the statement is. Although the source of this is a paper by IMF staff (which is admittedly suspect these days), it's a paper that sets out to discuss a very different issue, with regards to very different countries. Hence, I'm inclined to believe that there is no foul play involved.

The academic minds over at the IMF set out to discover whether being able to issue investment grade (i.e. not junk) bonds makes any difference for debtor countries. Investment-grade is a largely arbitrary distinction, but it generally means that, in a credit rating agency's opinion, you have a less than 10% chance of defaulting within 5 years. But investment grade issuers are also, in investors' minds, tantamount to the club of 'decent' debtor countries - the ones that frankly just don't default. It's not a conviction that's based on facts, but it is one that is hard to shake; Greece's ratings for instance held out long after investors had given up hope.

This illusion of 'decency' is in principle what Greece wants to regain. If, the reasoning goes, we could just get back into the cosy club of good debtors it would make a difference even if our fundamentals hadn't really improved. Credit ratings will of course lag this transition (indeed they lag everything), but the idea is that once we've got our 'credibility' back we'll go back to investment grade in no time. This begs the question: how big is the effect of investment-grade status? Apparently it reduces spreads (against US treasuries) by 36%.

Note that this is above and beyond what can be justified by fundamentals. It comes from investors' unwillingness to believe that such a country could ever default; however, even with this, the yield of ten-year bonds for a country with Greece's fundamentals would come in at 8.9% (calculations based on this). While this would still make Greek spreads higher than those of Portugal, it is just under my viability benchmark of 9.25% (which was, however, calculated before a further upward revision of our debt figures). This means that, if Greece could once again bask in the glow of investor confidence for a moment, as well as carry out all possible reforms successfully within three years, the suspension-of-disbelief effect would bring us back onto a viable trajectory.

This is essentially a vindication of the Vayanos et al case for avoiding a Greek default and I hope it comes to pass. The problem, however, is that the suspension of disbelief effect was a collective delusion of investors which has been shattered by the sovereign debt crisis. To paraphrase an old saying, even if Greece manages to get to the spring (of hopium, or cool-aid or whatever), will there be anything there left to drink?

So to conclude, fixing the 'credibility deficit' would, ceteris paribus, indeed put Greece on a potentially sustainable path as per Yorgo's observations. The problem is that the cetera are not paria and the investor-grade bonus probably just doesn't exist anymore, except perhaps (almost certainly) for triple-A rated sovereigns. Until of course, they too come into question.


  1. Mano,

    One point that occured to me regarding the investment grade premium is that it is also a matter of market mechanics. Many institutional investors are confined to holding IG only instruments, and are also prevented from shorting them. This would mean that a portfolio manager at a mutual or pension fund would seek the highest possible return while staying within the IG domain, thus driving even the lowest rated IG bonds up. Accordingly, once a country loses its IG status, all those institutional investors will inevitably be forced to dump the paper, which I assume only solidifies the IG premium.

  2. Very true. In principle this should not matter, as in an efficient market the prices of bonds should return to what is dictated by the fundamentals following a brief period of intense arbitrage. If nothing has changed why should the absence of institutional investors matter?

    However I think we are both implying one or both of two things:

    a) that institutional investors either *are* 'dumb money' or they *attract* dumb money like small cleaner fish trailing a whale. There are people who believe that the presence of institutional investors will bid up bonds beyond fundamentals. It may even be true.

    b) that institutional investors bring massive liquidity. This reassures investors big and small that they're getting a 'fair' valuation, and when they go, people require an additional premium to hold paper that can become illiquid at short notice.

    However, note also the IMF paper notes a similar bias not just around investment-grade status (which of course is found to generate a crucial step change), but around every step up the ratings. See page 10 for the regression table. (Actually, double check this as I may be reading the methodology wrong).

  3. Dimitris Vlachos29 April 2011 at 10:36

    I think it's also a sort of chasing returns prisoner's dilemma. If as an institutional investor you can get 40 bps more by buying Greece over Germany, even if you know you're not being compensated enough for that risk, it takes A LOT of balls to say you're not going to drink the kool-aid when your competitors are very much drinking it and making more than you are. Even if eventually you turn out to be right in saying that GGBs were overpriced, timing that call is impossible.

  4. Very true! Extra point for every time either of us says 'kool aid'. I hope it catches on in some Greek translation - like κουτόχορτο.

  5. Dimitris Vlachos30 April 2011 at 16:30

    Of course I forgot to mention, in addition to mutual funds limited to IG instruments only, banks who wanted to retain their capital ratios also were very thirsty for the kool-aid. Give them a zero risk weighted asset with no FX or interest rate risk at an additional 40 bps yield and they couldn't care less if we lied about our debt and deficit when we joined the euro. Well, I guess they kind of care now...

  6. +1 point. Just goes to show really. If you can't value a vanilla bond held to maturity, what hope in hell do you have of valuing ANYTHING?

    Brawndo: The thirst mutilator.
    It's got electrolytes! It's what plants crave!


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