Academic journal article Public Finance and Management

What Explains the Surge in Euro Area Sovereign Spreads during the Financial Crisis of 2007-09?

Academic journal article Public Finance and Management

What Explains the Surge in Euro Area Sovereign Spreads during the Financial Crisis of 2007-09?

Article excerpt

ABSTRACT

This paper explains the determinants of widening sovereign bond yield spreads vis-à-vis Germany in selected euro area countries during the period end-July 2007 to end-March 2009, when the financial turmoil developed into a full-blown financial and economic crisis. Emphasis is given to the role of fiscal fundamentals and government announcements of substantial bank rescue packages. The paper finds that higher expected budget deficits and/or higher government debt ratios relative to Germany contributed to higher government bond yield spreads in the euro area during the analyzed period. More importantly, the announcements of bank rescue packages have led to a re-assessment, from the part of investors, of sovereign credit risk, first and foremost through a transfer of risk from the private financial sector to the government.

JEL classification: E62, E43, G12

Keywords: Fiscal Policy, Sovereign Spreads, Fiscal Announcements

(ProQuest: ... denotes formulae omitted.)

1. INTRODUCTION

Since September 2008, for most euro area countries the long-term government bond yield spreads to Germany have widened markedly. Since the starting of the Economic and Monetary Union (EMU) and until the first half of 2008, bond yields of EMU governments' debt had generally been relatively close. Over this period, the average bond spread of 10-year sovereign bonds, relative to the benchmark German bund, had been about 16 basis points (bps).1 For the Greek 10-year sovereign bonds, the spread to the benchmark German bund had been on average just about 30 bps. After the intensification of the financial crisis in September 2008, government bond yields differentials relative to Germany have increased dramatically for most euro area countries (in March 2009 the average spread between the Greek government bond and the German bund was about 270 bps).

This unprecedented surge in sovereign bond yield spreads reflected increasing concerns in financial markets about some governments' capacity to meet their future debt obligations. In addition to a higher cost of borrowing, the increase in sovereign bond yield spreads may signal that investors are less willing to provide funding to sovereign borrowers. In the extreme, this would threaten the latter's ability to access capital markets. The economic literature on the determinants of long-term government bond yields, has found evidence of the market-based fiscal discipline hypothesis according to which financial markets ask a higher default premium to countries that borrow excessively (Goldstein and Woglom 1991; Bayoumi et al. 1995).

The widening of sovereign bond spreads vis-à-vis Germany was interpreted by many observers as a welcome reassessment and differentiation of country risks. This is also understandable in the context of the European fiscal framework. The Stability and Growth Pact not only hinges upon the concept of peer pressure, i.e. that European countries among themselves "urge" countries with excessive deficits to correct them, but also on the idea that financial markets exert pressure, as well, via higher bond risk premia. This differentiation of country risk across the euro area was virtually absent before the financial crisis.

This paper provides an empirical analysis of the determinants of long-term government bond yield spreads for selected euro area countries over the period from 31 July 2007 to 25 March 2009. In this way, the analysis captures developments in bond spreads since the early stages of the financial crisis, when its consequences for the euro area appeared limited to a few banks, up to its intensification, when uncertainty in financial markets heightened considerably. Indeed, in the euro area, the first signs of the crisis were felt since end-July 2007, when the German government rescued the Deutsche Industriebank (IKB) due to its exposure to the US sub-prime mortgage market.

Largely following the literature, this paper looks at the main determinants of long-term government bond spreads, such as: (i) a country's credit risk, as captured in particular by the relative soundness of its expected fiscal position; (ii) international risk aversion, which in times of heightened uncertainty could be higher for some euro area countries than for others; and (iii) market liquidity risk, which may be related to the relative size of sovereign bond markets. …

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