Over the past year, euro area sovereign yields have exhibited an unprecedented degree of volatility. In March 2009 the spread between the yield on a 10-year Greek government bond and the yield on a German Bund of equivalent maturity was as high as 280 basis points (bp). By September 2009 the same spread had dropped below 120 bp. In January 2010, it had climbed back up to over 380 bp. Other government bonds have followed a similar trajectory with volatility being higher among higher-debt, lower-rated sovereigns. Likewise, the credit default swap, in other words the premium investors are willing to pay to insure the same Greek bond against a credit event, during the same period has also moved from a level of around 50 bp, up to almost 300bp, down to 100 bp, and up again to 350 bp.
Movements in government bonds yields can have significant macroeconomic consequences. A rise in sovereign yields tend to be accompanied by a widespread increase in long-term interest rates in the rest of the economy, affecting both investment and consumption decisions. On the fiscal side, higher government bond yields imply higher debt-servicing costs and can significantly raise funding costs. This could also lead to an increase in rollover risk, as debt might have to be refinanced at unusually high cost or, in extreme cases, cannot be rolled over at all. Large increase in government funding costs can thus cause real economic losses, in addition to the purely financial effects of higher interest rates.
As the crisis unfolded, several factors might have affected the valuations of sovereign bonds. First, the global market price for risk went up, as investors sought higher compensation for risk. Deleveraging and balance sheet constrained investors developed a systemically stronger preference for a few selected assets vis-à-vis riskier instruments. This behavior not only benefited sovereign securities as an asset class at the expense of corporate bonds and other riskier assets, but also introduced a higher degree of differentiation within the sovereign spectrum it self.
Second, as the crisis spread to the public sector and policy authorities stepped in to support troubled financial institutions, probabilities of distress went up across sovereigns. In this context, two distinct channels may be identified: a domestic channel, as fundamentals started deteriorating, and an external channel, as higher probabilities of distress spread among sovereigns. This paper aims to assess to what extent the large fluctuations observed in euro sovereign spreads reflect changes in global risk aversion or they reveal the insurgence of country-specific risk, via worse fundamentals or contagion from other countries.
Some discussion of the existing literature on euro sovereign spreads, and how this work differs from it, is warranted. The paper by Afonso and Strauch (2004) find that specific policy events in 2002, when the Stability and Growth Pact came under close market scrutiny, had only temporary and limited impact on swap spreads. Using a broader information set with data from before and after the start of EMU, Bernoth, et al (2004) show that yield spreads are affected by international risk factors and reflect positive default as well as liquidity premia. They conclude that the monetary union does not seem to have weakened the disciplinary function of credit markets. Codogno, et al (2003) draw similar conclusions.
Contents
I. INTRODUCTION
II. DATA AND CONSTRUCTION OF THE MAIN VARIABLES
- A. THE INDEX OF GLOBAL RISK AVERSION (IGRA)
B. THE SPILLOVER COEFFICIENT (SC)
III. ESTIMATION METHODOLOGY AND MAIN RESULTS
- A. THE ESTIMATION MODEL
B. ESTIMATION RESULTS
IV. DISCUSSION
V. POSSIBLE EXTENSIONS
VI. CONCLUSIONS
References
Annexes
Annex I
Annex II
Annex III
Annex IV
Annex V
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