Sunday, January 5, 2014

5/1/2013: Euro periphery in CDS markets: 2013

One of the core improvements in the Irish economic conditions over 2012-2013 period relates to the decline in Government bonds yields and associated reduction in the Credit Default Swaps spreads (CDS spreads). In particular, bonds and CDS spreads have been referenced often enough as showing Ireland's 'divergence' from the euro area peripherals.

Here are some stats and charts based on CDS data and implied cumulative (5-year) probability of default (CPD) for the euro area peripheral states:

Summary table first, showing changes in CDSs and CPDs over 2013

The table above shows that Irish CDS performed well, but not as strongly as those of all other peripheral states, save Portugal and Italy. In fact, Ireland CDS decline over 2013 at -81.8 was slightly slower than the average for Italy, Portugal and Spain (-87.3), while our CPD decline of -5.16 percentage points was slightly faster than the average CPD decline for Italy, Portugal and Spain (-5.02 percentage points). The reason for the latter outperformance is made clear in the last bullet point of this post.

In absolute terms, however, Irish CDS are signalling stronger sovereign performance when it comes to risk of default:

But Spain is catching up in terms of CPD and in terms of CDS spreads.

Here is Ireland's progression in 2012-2013 showing that most of the improvement was priced in 2012, rather than over the last year:

And looking at the year-end position puts forward several core points about our sovereign debt risks:

  • Irish CDS have shown strong declines since the beginning of 2012
  • Irish CDS declines do not warrant a conclusion that we are distinct from other peripheral countries. Instead, the conclusion should be that we (alongside Spain and Italy) are distinct from Portugal and Greece. This is intuitive, given that Italy did not have to raise bailout funding, while Spain raised bailout funding solely for banks recapitalisations. Recall that Ireland was tipped into the bailout by the banking crisis and that absent banking crisis, we could have, potentially, sustained Exchequer funding without the need to resort to a bailout. This is not to downplay very substantial deficit pressures that we had ex-banks. But it is to point out that we are different from Portugal and Greece, both of which had to raise funds to shore up almost exclusively sovereign funding.
  • Irish CDS since the beginning of 2012 are carrying heavier weighting on probability of default estimates: in the last two charts, our CPD is priced along the mid envelope of (CDS, CPD) quotes, while Greece implies underpricing of the probability of default (along the lower envelope). Our probability of default is slightly over-estimated compared to Portugal and Spain, but is in line with Italy. This potentially relates to the point raised above in relation to speed of our CPD declines over 2013: we might be experiencing an over-due repricing (very slight) in the relationship between the CDS levels and implied estimates of the probability of default.

Less drama-prone interpretation of data than what the thesis of 'Ireland has decoupled from the peripherals' suggests...

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