Why Italy and why not Japan?

At the weekend, I saw three articles asking essentially the same question about sovereign debt crisis contagion: why Italy and why not Japan (the US or Germany)?

• Noahpinion: Why Japanese government bond yields are so low
• TheMoneyIllusion » Paul Krugman poses a very difficult question
• Italy Versus Japan – Paul Krugman

They all go through some very contorted logic to explain something that’s quite simple. And none of them give a satisfactory answer.

Think about this for a second. Sure, there’s inflation and currency depreciation risk plus interest rate expectations. But, there is no real difference between the euro zone and the US or Japan except the ability of government to hand you another paper IOU with the exact same amount printed on it when you present that government with an obligation in the currency it created.

When it comes to sovereigns, James Carville might say to you laypeople, “It’s the currency sovereignty, stupid!”

I used to work in the bond markets and I can tell you there are only a few major risks on bonds that investors care about.

Look at it this way: the perfect risk-free bond investment is one in which you are always assured of principle and interest repayment on time and in full and in which there are no currency or inflation risks. There are an infinite number of buyers and sellers, and interest rates are always the same.

For very short-term securities, in which investors can always hold to maturity, here are the risks that all bonds have:

1. Currency risk. If a country issuing a sovereign currency in today’s fiat currency world mismanages its macroeconomic policy, the result is inflation and currency depreciation. As a domestic investor, you are robbed of the real value of your money by inflation. As a foreign investor, however, you lose real value via currency depreciation. All debt obligations in foreign currency suffer these risks.
2. Liquidity risk. The Treasury market is the most liquid bond market in the world. That means you stand a safe chance of being able to offload your paper in times of liquidity constraints. If you think of a perfect market as having transparent pricing, an infinite supply of willing buyers and sellers. The fewer willing buyers and sellers there are, the less chance of your getting liquid when you need it.

If you go further out on the curve, the term structure rises due to a number of other risks:

1. Interest rate risk. Pimco has been talking a lot about financial repression lately. What they are saying is that, irrespective of the inflation or currency risk, a government can hold its interest rates artificially low because ultimately government sets the policy rate which both alters the term structure of rates and future interest rate and inflation expectations. If the US government wanted to, it could keep the Fed Funds rate at zero percent forever. Or it could raise rates overnight, making your investment relatively less valuable.
2. Inflation risk. Clearly, this introduces uncertainty into the picture. How do you know that the Fed won’t allow inflation to become embedded? You don’t. And that’s why central banks take pain to assure bond investors they will not do so. Otherwise, investors would extract a penalty which would be reflected in the term structure of rates, making long-term debt more expensive. What investors care about is the inflation-adjusted return on their investments not just the nominal return.
3. Re-investment risk: In mortgage backed securities and high yield markets, there is a special kind of uncertainty risk via options which are embedded in many bonds. These options allow the securities to be ‘called’ or ‘put’ and redeemed at a future point in time. In the MBS market, the homeowners’ call is unfavourable to the investor because homeowners are likely to call i.e. refinance their loan just when interest rates are declining and investors want to hold onto the higher rate security. In the high-yield market, the investor has the opportunity to put the bonds back to the company if it merges or does something else that changes the company’s profile materially. But the company also often has a call option too. Meaning that upside for investors is capped since the company could simply retire the bonds if its credit rating improves.

Remember this, though: if the sovereign mismanages its finances and lets inflation spiral out of control and lets the currency depreciate, every bond denominated in that currency suffers, not just the sovereign. But of course all bonds are issued by legal entities that have specific geographical, industry and company characteristics. New York is not the same as California. And Telewest is not the same as Rover. Preem is not the same as Valero. Credit risk is the real defining element of bond analysis then. All of those other characteristics are shared across individual bonds. Credit risk is what makes each bond issuer unique. Look at Ford versus GM and Chrysler as a case in point.

The reason credit risk is so important is because there is default risk. In capital markets theory, the sovereign debt obligation of a country issuing a currency it creates is thought to have no default risk. Therefore, the rate at which the government borrows is commonly known as the ‘risk-free rate’.

Why? If you go to the government with your paper IOU with $100 printed on it to claim your money, the government can always hand you another paper IOU with the exact same amount printed on it.  They create the currency. There is no risk of involuntary default.

You probably caught that word ‘involuntary’ in the last sentence. That’s the problem isn’t it? It is what I call the ‘Ecuador risk factor’.

Back in 2006, Ecuador President Alfredo Palacio told investors restructuring Ecuador’s external debts was "absolutely necessary" to make yields on Ecuador’s debt lower. He might as well have been saying, "we are going to stiff the foreigners, so run for the hills" because this is how his comments were interpreted. Yields on Ecuador’s debt promptly spiked out of fear of another default. Ecuador had defaulted in 1999 when the Asian financial crisis hit emerging markets in Latin America with contagion. It made a decision to default again in late 2008 at the height of the credit crisis, with new President Rafael Correa calling the external foreign currency debt "immoral and illegitimate".

–Bill Gross: Deficit Hawk, Bond Vigilante

Get that: paying the obligation was “immoral and illegitimate.” Translation: even if we could pay, we wouldn’t. It goes to willingness to pay.

To my ears, that sounds a LOT like the talk we hear now in the US.

But when I see Italy and Japan, I think currency sovereignty: the ability, not the willingness of government “to hand you another paper IOU with the exact same amount printed on it” when you present it with an obligation in the currency of account.

Japan has currency and inflation risk and all the other risks I outlined but it has an infinite ability to hand you government-created IOUs. Italy does not and can be bankrupted as a result. It’s as simple as that.

Update 1844 ET: And if you don’t believe this about Italy and Japan, try France and Germany versus Japan then. These graphs are courtesy of Mike Norman on the Euro debt crisis migrating to the core.

Germany 5yr sovereign CDS

France 5yr sovereign CDS

P.S. – To the question of why not Germany (or France), the answer is default risk.