Wednesday, 3 July 2013

Interest Rates on Sovereign Bonds: The Price of Debt

The aspect probably most sought after by the financial industry of both government and corporate bonds is yield. Yield indicates the yearly return a bond will give its owner based on the interest payments he will receive and the price the investor will acquire it for. Although at the time of issue a bond's yield equals its interest rate, the situation is soon altered as trading makes the two deviate. Yet, from the sovereign's point of view, the most important aspect of bond issuance should be the interest rate, for the simple reason that it reflects the price it has to pay for the credit received.

The rationale behind this idea is simple: when a nation has to pay more to get credit, its possibilities for growth are diminished as it is obliged to allocate more of the yearly budget to service existing debt, depriving resources from the economy both through decreased government spending as well as increased taxation or unnecessary money printing. In addition, funds employed to service the debt could have been used more effectively in promoting more growth, which in its turn would decrease the debt burden and the borrowing costs promoting a benevolent cycle. In the Eurozone, the situation is exacerbated by the fact that no nation has the liberty to use a sovereign currency, thus increased borrowing costs are a burden the taxpayer unavoidably has to assume.

On examining the current data on bond interest rates (one has to do some data mining to find what the average interest rate paid is) one of the most interesting aspects is that bond interest rates were increasing even before the crisis for some countries. The following is a graph of the interest rates on bonds of 9 Eurozone countries from 2001 to 2011 (data obtained from World Bank and Eurostat. Cyprus did not have any data at the World Bank database prior to 2007)

Not surprising, the lowest interest rate throughout the years has been the one of Germany, yet the Cyprus one is rather amazing. Historically, the island now notorious for setting a precedent on depositor bail-ins, had at a time been paying interest rates with a spread of approximately 7.5% from the German one. Yet, as it appears, the market caught up with what had been going on and in 2011 Italy, Ireland and Greece had taken her place as the leading interest payers in the region. Unfortunately, the World Bank database was not yet updated for 2012 data.

Nevertheless, although the numbers are not up-to-date, they indicate that the market has much predicting power, even in the case of sovereigns. Italy's interest rates have been on the rise since 2010 as have been Greece's and Portugal's although Italy has not yet requested any assistance, Portugal required assistance a year later and Greece did not file for help until mid-2010 and the aid received was for restructuring the debt. In addition, France has also seen interest rates rise in the last two years (2010-2011) as a result of increasing uncertainty about the state of her economy. One can safely assume that data for 2012 would indicate that interest rates in the troubled countries have further increased while in safer countries like Germany they have decreased.

This, is supposedly a problem the OMT should have addressed. When at the issuance of government bonds, the yield (which equals to the interest rate) in higher than a threshold (and importantly the country is still in the markets, i.e. not considered junk), the ECB has pledged to intervene and purchase the bonds itself. Yet, even at relatively lower interest rates than the threshold, a country's ability to service it's debt is severely affected if the interest due is high. For example, with debt at 108% of GDP in 2011, Portugal had to pay more than 5bn euros just for interest payments or approximately 10% of her revenues. The percentage for Greece was 17% of revenues while for Germany and France was just over 5%, making troubles for the Greeks even harder as they have to generate a large amount of money just to cover their interest expenses, without addressing any other problems.

Thus, if the problem of extracting large amounts of money from the population to cover increasing interest rates is not addressed, then recovery will almost certainly be delayed for even longer. As governments cannot print any new money, increased interest rates as a result of uncertainty and fear about the sovereigns' futures can only signify that more funds would be taken from the real economy and given to non-productive uses, creating a vicious cycle. This, will only add to the abundance of problems faced by the South while not promoting any solutions whatsoever.

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