Már Guðmundsson: Sovereign risk – a world without risk-free assets? Remarks by Mr Már Guðmundsson, Governor of the Central Bank of Iceland, in a policy panel at a seminar on “Sovereign risk – a world without risk-free assets?”, Bank for International Settlements, Basel, 8–9 January 2013. *  *  *  I would like to cover three issues in my remarks. First, I will reflect a bit on the title of the seminar and some of the more specific questions directed at this panel. Second, I will discuss the nexus between sovereign risk and banking fragility, using Iceland as a case study – after all, the Icelandic experience is probably the reason that I am taking part in this interesting seminar in the first place. Third, and again with reference to the Icelandic case, I will reflect on the connection between sovereign ratings of advanced countries and actual sovereign defaults. The title of this seminar is Sovereign risk: a world without risk-free assets? As has been repeatedly pointed out, there is, strictly speaking, no such thing. The default probabilities of even the strongest sovereigns are not zero, and they increase as the horizon gets longer. Furthermore, the real income stream of nominal government bonds is uncertain.
The bank ratings then started to fall in early 2008 and then plunged to sub-investment grade after the banks had collapsed. The sovereign rating, however, although it fell over the course of 2008, never fell to sub-investment grade with Moody’s and S&P, and it only fell below investment grade with Fitch Ratings after the president sent the so-called Icesave deal to a referendum in January 2010. It is now back to investment grade with all three agencies. It is interesting to see how both ratings and market perceptions evolved around two key dates in September/October 2008, when decisions were taken that could drastically affect sovereign risk. The first date was 29 September, when an announcement was made of the Government’s intention to take a 75% ownership stake in one of the three cross-border banks, an action that should increase sovereign risk. The other date was 6 October, when Parliament passed the so-called Emergency Act, which severed the nexus between the sovereign and the private banks and drastically reduced objective sovereign risk. Both the rating agencies and the market got the sign of the first event right: S&P downgraded the sovereign by one notch and Glitnir by one notch the day after; Fitch downgraded them the next day by two and three notches, respectively; and Iceland’s sovereign CDS spread shot up to almost 600 in the first two days after the announcement, from around just over 300 in the days prior.