A Brief Update on Yields, CDS Spreads and Implied Default Probabilities
Currently there are a number of weak spots in the global financial edifice, in addition to the perennial problem children Argentina and Venezuela (we will take a closer look at these two next week in a separate post).
There is on the one hand Greece, where an election victory of Syriza seems highly likely. We recently reported on the “Mexican standoff” between the EU and Alexis Tsipras. We want to point readers to some additional background information presented in an article assessing the political risk posed by Syriza that has recently appeared at the Brookings Institute. The article was written by Theodore Pelagidis, an observer who is close to the action in Greece.
As Mr. Pelagidis notes, one should not make the mistake of underestimating the probability that Syriza will end up opting for default and a unilateral exit from the euro zone – since Mr. Tsipras may well prefer that option over political suicide.
Note by the way that the ECB has just begun to put pressure on Greek politicians by warning it will cut off funding to Greek banks unless the final bailout review in February is successfully concluded (i.e., to the troika’s satisfaction). The stakes for Greece are obviously quite high. There are two ways of looking at this: either the ECB provides an excuse for Syriza, which can now claim that it is essentially blackmailed into agreeing to the bailout conditions “for the time being”, or Mr. Tsipras and his colleagues may be enraged by what they will likely see as a blatant attempt at usurping what is left of Greek sovereignty, and by implication, their power.
Image via Arabia Monitor
We have already discussed Russia’s situation in some detail in recent weeks (see for instance “Will There Be Forced Official Sellers of Gold”). As regards Ukraine, its economy is already doing what observers are merely expecting to happen with Russia’s economy in light of the recent decline in crude oil prices. In other words, It is no exaggeration to state that Ukraine’s economy is in total free-fall. The country’s foreign exchange reserves have declined precipitously, most of the central bank’s gold has been mysteriously “vaporized”, and what is left of it has turned out to be painted lead (no kidding, the central bank’s vault in Odessa was found to contain painted lead bars instead of gold bars – the thieves didn’t even bother with using tungsten).
Last year Ukraine’s GDP contracted by an official 7% and this year another contraction of 6% is expected. Ukraine’s government will need an additional 15 billion dollars to remain afloat, but there is currently no-one who wants to provide the money. The EU is itself short on funds, and JC Juncker let it be known that:
“There is only a small margin of flexibility for additional financing next year. And if we fully use our margin for Ukraine, we will have nothing to address other needs that may arise over the next two years.”
Somewhat earlier, the authorities in Kiev asked Brussels for a third program of macro-financial aid in the amount of €2 billion. European commissioner for neighborhood and enlargement policies, Johannes Hahn, said the EU was prepared to continue aid to Kiev but only in exchange for concrete results of reforms. Finland’s Prime Minister Alexander Stubb said the EU would not take any decisions on extra financial aid to Ukraine right now because the country had not implemented the essential structural reforms yet.”
We have little doubt that Ukraine’s technocratic prime minister Yatsenyuk is committed to implementing the reform demands, mainly because he has no other choice. However, in spite of Ukraine’s new government taking a few noteworthy steps to limit corruption (e.g. by appointing foreigners to head several important economic policy related ministries), the rotted edifice of the state’s administrative structures cannot be repaired overnight.
As a friend recently remarked to us, if one asks Ukrainians about this topic, most will report that the degree of corruption in the country is simply utterly beyond the imagination of Western observers. We would also guess that for many Ukrainian officials and civil servants, it has simply become a question of survival (i.e., many are forced to somehow improve their meager incomes). Anyway, for more than two decades, corruption has been a way of life in Ukraine for all strata of the administration from the very top down. This likely explains why economic growth in Ukraine has never recovered beyond the levels attained immediately after the dissolution of the Soviet Union. It has the by far worst economic growth record of the post-Soviet states.
To be sure, Russia is a den of corruption as well – but contrary to Ukraine, the rule of the oligarch mafia was seriously disrupted when Vladimir Putin took over. Although the oligarchs of yore were then replaced with new ones, their political influence has been vastly diminished compared to the Yeltsin era. Nothing comparable has ever happened in Ukraine.
Below is a chart showing current 5 year CDS spreads on Greece, Russia and Ukraine in a three in one package. Note that the scales are different for each (they are color coded). Ukraine’s CDS spread is at about 2028 basis points, which is the third worst reading in the world at present, below the cost of insuring against a default of Venezuela and Argentina. Greece comes next with a CDS spread of 1407 basis points. Russia with 547 basis points looks positively creditworthy by comparison (in fact, Russia’s total public debt only amounts to approx. 15% of GDP; it is one of the least indebted governments in the world). Nevertheless, the situation has obviously worsened quite a bit for Russia as well.
5 year CDS spreads on Russia (white line), Ukraine (green line) and Greece (red line). Keep in mind that the scales are different. Ukrainian CDS spreads are very volatile – they just declined by 338 basis points overnight – click to enlarge.
From these CDS spreads one can calculate the implied annual probability of default under different recovery assumptions (i.e., the percentage creditors can expect to recover after a default has occurred). The lower the recovery assumption, the lower the implied default probability. The most widely used recovery assumption is 40%, which we have employed in the charts below as well. Unfortunately the handy calculator we have found for this purpose for some reason doesn’t include Greece (possibly because after the PSI haircut, CDS on Greek debt ceased to trade for a while). However, one can make a rough estimate based on the implied default probabilities for other countries.
The implied annual default probability for Russia under a 40% recovery assumption stands at 7.6%, for Ukraine it stands at 17.1%.
We were unable to find a chart of Ukrainian bond yields that makes sense to us; there once existed a 10 year dollar-denominated bond, but Bloomberg’s chart of this bond yield is ends in mid 2013, and is therefore no longer relevant (possibly the bond was redeemed). Russian and Greek 10 year yields look as follows:
Russia’s 10 year government bonds now yield a little over 14%. The three year bond yield stands at 15.9%, so the yield curve is currently inverted (as a result of Russia’s central bank hiking short term rates to 17.5%).
Greek 10 year government bond yields currently stand at 10.25%. Three year yields however stand at 13.5%, so the yield curve remains inverted as well.
It is a bit of a mystery to us why Russian CDS spreads are so much lower than Greek ones, while Russian bond yields are significantly higher. Normally we would assume that embedded foreign exchange related expectations are playing a role in this, but since a Greek default would almost certainly entail a return to the drachma, this shouldn’t make that much of a difference. It seems therefore possible that some of these instruments are in fact mispriced. Of course, one needs to keep in mind that Greece’s government is de facto bankrupt and would have to declare insolvency if its bailout were revoked, while Russia’s government is far from insolvent and actually quite unlikely to become so.
Finally, here are long term charts of the ruble and the Ukrainian hryvnia. Both currencies are quite weak, but the hryvnia’s plunge has been noticeably bigger and more persistent since 2008 than the ruble’s, as the latter initially recovered from its 2008 crisis losses.
USDRUB, weekly – click to enlarge.
USDUAH, weekly – click to enlarge.
Russia seems the least likely of these countries to actually suffer payment difficulties, but much will depend on future developments in energy prices and the ruble. Greece and Ukraine are both dependent on foreign public sector lenders and their willingness to throw more good taxpayer money after bad. Neither country can expect these foreign lenders to be overly patient or willing to countenance deviations from their conditions.
Given the political and economic realities in Ukraine and Greece, outright defaults can therefore not be ruled out. One needs to keep a close eye on developments in CDS spreads and bond yields over coming weeks and months, as in both cases a further deterioration of the situation would have ramifications that go well beyond the countries directly concerned. In the short term, this may be more pertinent to Greece due to its connection with the EU and the euro area, but a more pronounced economic implosion and further destabilization of Ukraine would likely also harbor more wide-ranging dangers. The happy bubble in risk assets could presumably be derailed a bit if any of the possible worst case scenarios were to become manifest.