Sovereign debt is at irrational levels

“Monetary stimulus is driving European sovereign debt towards irrational levels which are no reward for the risks involved and make any correction phases more dangerous,” say analysts at Intermoney.

In fact it’s worth keeping in mind what happened with the Bund in the spring of 2015; above all if the prices of raw materials consolidate at current levels (especially oil), given that we would witness an important knock-on effect in this area at the end of 2016 and the beginning of 2017, dragging inflation rates upwards. Against this backdrop, those in Europe who are in favour of limiting banks exposure to sovereign debt will emerge in a stronger position.

The Intermoney experts refer to a report by Fitch regarding the possible implications of continuing with plans to limit the sovereign risk on the EU banks’ balance sheets.

The ratings agency proposed five scenarios:

  • In the first one, the banks would use their own internal models to calculate the sovereign debt risk and their capital needs (some 15 billion euros), an option which would already be used by a third of the big banks in the EU.
  • In the second, the exposure to sovereign bonds could imply a risk weighting of, at least, 10%, and requiring 24 billion euros in capital.
  • The third takes external ratings as a reference for calculating the risk weighting,  requiring 67 billion euros in additional capital.
  • The fourth scenario would be more restrictive, combining the use of external ratings with a risk weighting of 10%, and implying a capital boost of 95 billion euros.
  • The fifth and last option would add a progressive penalty, starting from a certain level of sovereign debt, which would require 170 billion euros of extra capital. In that case, option “b” would consist in offloading nearly 500 billion euros of sovereign debt.

These calculations only show the underlying risks of European sovereign debt, although the recently begun purchases of corporate debt on the part of the ECB just accentuate the distortions in the markets.

*Image: Flickr