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credit default swaps

Prospects Weekly: The up-tick in market tensions have caused CDS rates to rise sharply

The up-tick in market tensions following recent bank downgrades, partial nationalizations and elections have caused CDS rates to rise sharply, although in most countries they remain below their fall 2011 highs. Stock markets have also tumbled, exchange rates depreciated and the turmoil has contributed to falling commodity prices. The real side effects of the recent bout of market nervousness remains uncertain, however based on the relative size of the financial turmoil, its impact could be half as severe as the GDP growth deceleration (relative to earlier forecasts) observed in the fall of 2011.
Contagion from renewed tensions in the Euro Area appears less extensive than in the fall of 2011. Recent bank downgrades, partial nationalizations and elections have caused developing and high-income country stock markets to lose about 12 percent of their value since May 1st, giving up almost all of the gains generated over the preceding 4½ months. Yields on high-spread economies have risen, while those of safe-haven assets have declined. Virtually all developing economy currencies have lost between 3 and 7 percent against the U.S. dollar. Credit default swaps (CDS) rates have also increased significantly. Nevertheless, CDS rates in non-European high-income and developing economies remain well below their July 2011 levels. Emerging market bond spreads, although up are still 149 basis points lower than in October.
Real side effects of the recent increase in market nervousness remain uncertain. It is too soon to observe the impact of the renewed financial-market turmoil on the real-side of the economy, but it is likely to be negative — particularly in high-income Europe. How negative is of course unknown. To-date, Euro Area financial market indicators have deteriorated about half as much as they did in the fall of 2011 (relative to July 2011), which suggests that the hit on activity could be about half as severe as in the fall of 2011 — when Euro Area quarterly growth rates declined by about 0.5 percentage points relative to expectations in June 2011 and whole year growth was off about 0.2 percent.
The recent increase in market nervousness has driven commodity prices downward. Since the beginning of May, crude oil prices have fallen 15.8%, influenced primarily by concern that financial turmoil will cut into global growth and oil demand (improving supply conditions and easing tensions with Iran helped as well). Recent events also contributed to falls in copper and aluminum prices of 11.2% and 5.4% respectively. Many agricultural commodity prices have declined as well (corn, cotton and rubber), which should help relieve inflationary trends in developing countries. Developing countries are not expected to suffer large impacts if financial tensions do not worsen, and lower commodity prices will buffer those impacts for importers. However, for commodity exporters, lower commodity prices will reduce government revenues, weaken current account positions, and if long-lasting, will cut into growth.

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Prospects Weekly: Market confidence has been rattled once again

Market confidence has been rattled once again following recent election results in France and Greece. However, credit default swaps rates, while up, remain well below their fall 2011 highs. Through March, retails sales have continued strengthening among both developing and high-income economies, although weakness still persists in the Euro Area. Notwithstanding the post-crisis appreciation in the currencies of several developing countries, in general, their currencies still remain below pre-crisis peaks.
Euro Area sovereign debt concerns have resurfaced once again. Following elections in France and Greece, the political landscape in the Euro Area has changed. The new French President-elect has indicated his intention to add a growth component to the EU fiscal treaty, while the Greek elections were inconclusive, and the influence of anti-austerity parties has increased markedly. These events, plus the announced bail out of one of Spain’s largest banks have rattled investors’ confidence once again. Credit default swap rates (CDS) have risen by 95.3, 37.3, 25.8 and 19.4 basis points in Portugal, Spain, Italy and France, respectively between 4th and 9th May. Among other Euro Area countries, CDS rates are up an average 5.2 basis points, but remain 116.5 basis points below their fall 2011 peaks.
Retail sales continue to strengthen across most regions. Easing inflationary pressures, rising employment strong credit growth, and in some cases lower policy rates have contributed to an up-tick in developing country retail sales volumes during the three months ending February (10.7%, 3m/m saar). The strength of developing-country domestic demand is also reflected in their import demand, which increased at a 19 percent annualized pace over the same period. In the U.S., improving labor market and consumer confidence conditions have boosted retail sales growth. Even in Europe, where consumer confidence remains low, retail sales expanded in March - the first increase in 5 months. Nevertheless, demand remains shackled by high unemployment and ongoing fiscal austerity. Looking forward, recent easing in oil prices could support real-incomes and further boost retail sales.
Despite substantial appreciations since the trough of the crisis, the real-effective exchange rates of many developing countries remain below pre-crisis peaks. Measured from post-crisis troughs the currencies of many developing countries have appreciated strongly (by more than 30 percent in many cases). However, measured on a longer-term perspective, the real-effective exchange rates of currencies of Indonesia, Brazil, Russia, India and Turkey remain below pre-crisis peaks. Among major middle-income countries, China’s Renminbi has appreciated the most. While capital flows have contributed to short-term volatility, the appreciation since 2005 among commodity exporters like Brazil, Indonesia, and Russia appears to mainly reflect higher commodity prices.

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Prospects Weekly: Financial markets battered by Eurozone sovereign- and liquidity-risk fears

Global financial markets were hit hard this week, unconvinced that European leaders are doing enough to prevent contagion of the sovereign-debt crisis in Greece—as widespread financial contagion could push the global economy back into recession. The credibility of the Greek rescue package is being questioned, given the severity of the adjustment (11% share of GDP cut in the fiscal deficit over 3 years) and public outcry against the austerity measures. Countries with high sovereign debt, fiscal deficits and contingent liabilities, in particular, are at risk of contagion, but current heightened market-uncertainty is leading to flight-to-quality, which could raise rates across countries. Investors are also wary that, as many countries face substantial fiscal consolidation ahead, the implementation of fiscal exit-strategies could be highly synchronized and poses downside risks to global growth—although the coming adjustments may not be wholly unprecedented at the country level.
Greece‘s unfolding debt crisis and mounting concerns over Eurozone sovereign- and liquidity-risk battered world financial markets. Equities tumbled and credit default swaps (CDS) spreads soared, even after Greece reached a bail-out package with the EU and IMF last weekend. CDS spreads for Greece, Spain, Portugal, and Italy jumped to fresh record-highs and this year’s gains on global equities have been wiped out. Worries about elevated European debt, tightening credit, and Eurozone cohesiveness led to further depreciation of the euro, which hit a 14-month low against the U.S. dollar (as of May 6). Benchmark U.S. Treasuries surged on a general flight-to-quality, which if sustained would lead to higher borrowing costs across nearly all countries.
Mounting pressures on government coffers have raised concerns about sovereign-debt sustainability. Already elevated sovereigndebt levels are likely to rise over the near-term across many countries, given the degree of fiscal deterioration since the onset of the crisis. Private sector debt is also elevated and contributing to rising non-performing loans that represent significant contingent liabilities, should banks need to be recapitalized. Uncertainty about these dynamics has been centered on Greece— with a fiscal deficit of 13.6% and sovereign external debt of 107% (as shares of GDP)—but increasingly on other economies (many in Europe) with high fiscal deficits, debt and contingent liabilities, and on Eurozone cohesiveness given these stresses and the decline in competitiveness of debt-burdened members. Spillover risks are also tied to international banks pulling out of third countries to cover losses in Europe, and to a possible credit freeze.
The extent of fiscal adjustment that individual countries are facing is not wholly unprecedented, as over 20 high-income countries made deficit reductions of at least 5% of GDP since the 1970s— including Israel’s 11% share of GDP cut achieved in 3 years. However, many of these countries benefited from exchange-rate depreciation. While some countries have begun tightening fiscal policies—despite the compounding negative effects on growth, given the lack of fiscal space—many more countries will also pursue significant fiscal adjustment in the near-term, once economic recovery becomes more firmly established. This is likely to result in highly synchronized consolidation, posing downside risks to global growth, likely putting pressure on aid to developing countries.

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