Sovereign bonds: the grave of leaders

A decade ago, the sovereign risk premium was the talk of the town; it opened every news programme and was a topic of conversation even in the lifts. Europe – yes, Europe – saved the lives of us ‘profligate’ countries, so to speak, through the ECB’s intervention in the secondary markets for sovereign bonds. We were even given the nickname PIGS (pigs in Spanish). The ECB has just stopped buying new debt – albeit ‘temporarily’ – from Greece and Italy, whilst it continues to buy from Spain once again – and is now only purchasing debt to the value of that which is maturing. Furthermore, it has announced an interest rate rise as soon as it returned from the summer break. For Spain, this is a catastrophe and could lead to the government’s downfall before June 2023, when Spain is due to hold the rotating presidency of the European Union.

By Miguel Ángel Temprano

30 June 2022 Reading time: 3.20 mins

Just over ten years ago, I got fed up with having to explain what the sovereign risk premium actually was at dinner parties with friends. Everyone was talking about it, although unfortunately not everyone knew what it really was. Then the same thing happened to me with the reasoning behind negative interest rates.

But as if it were a case of ‘déjà vu’, I think I’m going to have to ‘refresh’ my friends’ knowledge. And not because I don’t want to – that’s what friends are for – but because it would spell disaster for my country.

“I can’t remember how many times I’ve explained what the sovereign risk premium is; I’m afraid I’m going to have to do it again”

Zapatero’s government fell because of its appalling economic management. Despite what many believe, or would have us believe, the economy is not ideological. We live where we live and are subject to the rules of our environment. Economic ideology is no longer up for debate; therefore, 95 per cent of the economy is purely a matter of management. Well then, although his management was disastrous – a fact subsequently acknowledged even by those close to him – the trigger for his downfall was the sovereign risk premium, caused by a deficit which, although we were told was 3 per cent, was later shown to be 13 per cent.

Well, actually, the trigger wasn’t the sovereign risk premium; it was the price of the government bond.

Let’s go into a bit more detail, especially for those new to the subject. Countries issue government debt to cover the year’s deficits and refinance previous ones, as without a surplus it is not possible to reduce debt. This debt is issued with different maturities for the sole purpose of reducing the average interest rate on the total debt as much as possible.

“Investor confidence in a state is not built on acclamation; it is built by investors buying the bonds it issues to refinance its debt”

It stands to reason that, for shorter-term loans, investors lend money to governments at a lower interest rate, given that the risk of default is lower, as the time horizon is better known. However, governments would prefer to borrow as much money as possible – by issuing bonds – over the long term, as most of these bonds are redeemed at maturity, unlike our mortgages; and, whilst we’re at it, at the lowest possible interest rate.

Well, as a result of the previous crisis and government overspending – primarily in Mediterranean countries – confidence in our governments plummeted and the yield on the benchmark sovereign bond – the 10-year bond – reached as high as 7 per cent in some cases.

Don’t ask me why, as I don’t know the answer – or at least not the simple answer. When a country issues debt, whatever the maturity, if there isn’t at least three times the demand for it, it is considered that there is no confidence in it. Anyone would ask, ‘But wouldn’t it be enough simply to find buyers for the amount requested? That way, 100 per cent of the issue would be placed.’ Well, no. Consequently, the level of confidence that needs to be generated in the market is such that the government’s management must be impeccable, so that if you issue €100 worth of debt, you find buyers for €300’s worth, even if you ultimately only place the proposed €100.

As prudence in the management of public funds is conspicuous by its absence – and our government is a prime example of this – the ECB decided, in the wake of the US Federal Reserve’s actions, to intervene in the market; that is, to buy sovereign debt from Eurozone countries. It made these purchases based on a series of parameters, which have since shifted and taken a turn for the worse (the ‘PIGS’ – an acronym coined by some imbecile at Goldman Sachs in London, standing for Portugal, Italy, Greece and Spain).

The ECB does not operate in the primary market – that is, when the government in power issues the debt – but in the secondary market, that is, when the debt issued begins to trade freely on the secondary market – the stock exchange.

In the case of the ECB, it did not buy on the primary market not because its founding treaty prevented it from doing so, but because a purchase on the secondary market – that is, on the stock exchanges – is much more efficient for regulating the yields on the bonds that the Member States in question will subsequently issue on the primary market.

“The large-scale purchase of sovereign bonds issued by EU Member States immediately results in a reduction in the cost of new issues for those Member States”

For example, the ECB steps in and buys Spanish government bonds on a massive scale, which immediately leads to the price becoming more expensive for the buyer (for the same amount of money invested, they will receive less interest); in other words, the new bond can be issued at a lower interest rate and the government in question will save money throughout the bond’s lifetime.

Like poor pupils, our government has not done its homework during this period and has run up all sorts of expenditure, as new debt and the refinancing of old debt ended up being bought by a benevolent buyer, the ECB, and we were paying far less for it than our management would have determined in a normal market.

Just to give us an idea. According to information provided by the Bank of Spain, since June 2018 – when the PSOE government came to power – public debt has risen by 16 per cent of GDP, reaching 117.7 per cent of GDP at the end of March this year, but thanks to the ECB, the average maturity of this debt has risen from 7.13 years to 8.12 years and the average interest rate has fallen by 81 basis points (0.85 per cent).

To put it simply, we’re much more in debt, so the buyer takes on more risk over a longer term and charges less for it, rather than more interest. I’m sure you’ll agree it’s a bargain.

Bear in mind that, in order to achieve this, the ECB has acquired 30 per cent of our total outstanding public debt. Bearing in mind that 44 per cent of our total debt is held by non-residents, it is easy to see that only 11 per cent is held by non-residents – in other words, we do not generate a great deal of enthusiasm abroad for investing in us.

“As if on spring, the ECB has stopped buying new Spanish debt and the cost to the State of our long-term bonds has risen dramatically”

As soon as the ECB announced that it was going to stop buying our debt, the cost of Spanish sovereign bonds rose for the issuer – that is, the Spanish State – by approximately 300 basis points (3 per cent), of which approx. 120 basis points (1.2 per cent) occurred in less than 15 days. This sparked panic within the government – although the Minister for the Economy is reluctant to admit it – as well as within the European Commission and the ECB, and led the ECB to backtrack. The ECB would continue to buy bonds from these Mediterranean countries as they matured – bonds that were doomed to disappear: the ‘pandemic bonds’.

To put it plainly, as soon as the ECB stopped propping us up, our ship began to sink at an incredible speed. Oh! And the Italian one is just like ours.

But this only proves one thing: we cannot survive without the ECB’s help.

Let’s move on to another important concept: ‘the primary and secondary deficits’.

The primary deficit is the deficit arising purely from day-to-day management – in other words, revenue minus expenditure. It’s as if a family didn’t have a mortgage to pay. If we add interest on the debt to this, we arrive at the secondary deficit – the one we’re all familiar with.

I believe that the minimum requirement for any government would be that the primary deficit should at least be zero – in other words, that they should not spend more than they take in.

Well, the European Commission has forecast that, at this rate, Spain will have an annual primary deficit of 2 per cent until 2032. If we add to that the exorbitant interest on the debt – given that we would not have the support of the ECB – just imagine what will happen, because interest payments alone already account for an additional 2 per cent of the deficit.

“The EU Commission’s figures for the coming years regarding the deficit are simply devastating.”

Zapatero fell from power over something even less significant than this.

Let’s look at the picture. Inflation of around 8.5 per cent, growth of around 4.5 per cent (it will be much lower, but only time will tell), and pensions, which account for 13 per cent of our GDP, are index-linked. Approximately 15,500 million just for the increase (roughly 1.2 per cent of the additional deficit). If, on top of that, pensions grow by around 3 per cent a year due to natural population growth, then tell me where the money is going to come from, unless the ECB lends it to us.

But of course, up until now we’ve been acting rather cocky – even though I don’t agree with him, the government in power at any given time is my government – but now, without the ECB, sooner or later countries like the Netherlands, Austria, Finland or Germany are going to say, ‘That’s it; if you want help from the ECB, make the cuts – and make them in areas that are red lines for this coalition government’. And the first of these is the ban on indexing pensions to the CPI, which has been heavily criticised by these countries, because they do not have such a system.

I realise it’s really cool to be the current holder of the EU presidency, and I realise that for a president with the mindset this one has shown, that must be a massive boost, but will he be able to hold on until June next year if he loses the support of the parties close to him?

Let’s not forget that if Brussels gets tough, you either go along with it or the ECB won’t back you, and if it doesn’t, the last thing you’ll be worrying about is your own ego.

I understand that the parties supporting the government, as you have acknowledged on numerous occasions, are in an enviable position. A weak government that needs all their support. Even to flush the toilets in the parliamentary offices.

But will they all – because he needs everyone’s support – back spending cuts such as those which Europe forced Zapatero to implement? Will they support the de-indexation of pensions after having promised it in all of Spain’s official languages – I don’t know how many, I admit, I’m uneducated, I only speak Castilian, and sometimes not even that – and even in Aramaic and Ancient Greek?

I’ll leave it at that, but to conclude, we could define a sovereign bond as a dune which, despite being made of sand, seems to be alive and which sometimes buries leaders who have lived their lives in the comfort of a carpet.