Tuesday, December 1, 2009

Weekly Hurriyet Column: Greece stuffed on turkey day

Below is the unedited version of my column for this week. You can read the final version at the Daily News website. As you can see, I am quite capable of coming up with cheesy titles without any movie references:). Also note that the copy editors caught FeneVbahce and corrected it, to my dismay:). But as long as Azize continues with the whining, fenev will always be fenev:)...

Two remarkable events marked Wednesday night, as Americans were getting prepared for the annual stuffed turkey with cranberry sauce feast.

First, your friendly neighborhood economist’s team Besiktas beat Manchester United 1-0 at Old Trafford after a 3-0 easy home win over Istanbul archrivals Fenevbahce over the weekend. Around the same time and (almost) equally noteworthy, Turkish credit default swaps, or CDSs, at just below 200 basis points, traded flat with Greece’s for the first time ever.

CDSs are derivatives that insure against losses stemming from a credit event. In the context of a country, this translates into a contract that protects against a bond default by that country. A spread of 200 basis points means that it costs 200,000 dollars to insure 10 million dollars of debt.

It then follows that CDSs are an indicator of the market's current perception of sovereign risk. Moreover, it is quite straightforward, after assuming an expected recovery rate, to quantify that risk by calculating the default probability implied by the spread. A 20 percent recovery rate, the market convention for the quotation of many CDS contracts, yields an annual default probability of 2.1 percent for a 200 basis points spread.

This may not seem much, but it is complete catastrophe, to paraphrase Nikos Kazantzakis’ Zorba, if you consider that Greek CDSs were at 5 basis points merely a couple of years ago. In fact, the recent equalization with Turkey owes much more to the upward trajectory of Greek CDSs than to a downward move by their Turkish counterparts, which, despite having moved down from early-year highs of around 500 basis points rapidly during the great spring liquidity flush, have nevertheless been hovering around 200 basis points since mid-summer.

It is important to note that such an interpretation is a little bit simplistic. For one thing, the CDS market, despite its sheer size, is rather illiquid, and according to data from Depository Trust and Clearing Corporation, a clearing house for over-the-counter derivatives, Greek CDSs have been particularly illiquid recently, which means that prices can swing wildly on low volumes.

Even if you adjust for liquidity, you have to remember that CDS spreads also depend on global factors. For example, in my previous life as a bank economist, I and my coauthor Ilker Domac found out that US interest rates and global risk appetite weigh much more on Turkish CDSs than domestic developments. In fact, sovereign CDSs tend to move together a lot although country-specific factors do affect long-run trends and structural breaks.

The sharp rise in Greek CDSs in the last few days owes mostly to Dubai World’s six-month debt standstill. But this still does not tell us why Greece responded to the Dubai jitters more than its peers in the EU, or even Turkey. According to Financial Times’ Gillian Tett, the answer lies in what she coins as the perception of tail risks. Such black swans, as I like to call them, in homage to Nassim Nicholas Taleb, have been off the charts for some time, and Tett is right to note that Greek CDSs have acted as a painful wake-up call.

But unlike Tett and Royal Bank of Scotland’s Tim Ash, whose comments appeared in the special Bayram Edition of this paper, and despite my flashy title, I do not think Turkey compares that favorably with Greece fiscally. It is true that as Ash notes, Turkey’s absolute numbers look much better, but I have been arguing for a long time that simple debt to GDP ratios do not make much sense.

Unfortunately, Turkey’s fiscal position and its implications are harder to decipher than Greece’s, which partly explains the favorable view. This is where I will pick up next week.

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