Determinants of intra-euro area government bond spreads during the financial crisis by Salvador Barrios, Per Iversen, Ma

1. Determinants of intra-euro area government bond spreads during the financial crisis by Salvador Barrios, Per Iversen, Magdalena Lewandowska, Ralph Setzer DG ECFIN, European Commission - Paper does not necessarily reflect views of the European Commission - “The sustainability of public finances in Belgium: Regional, National and EU perspectives” CEPS seminar,Brussels, 15 June 2011 1

2. European Commission EA gov bonds spreads since 1999… Spreads of 10Y benchmark bonds to German Bund, in basis points 2

3. …and since 2008 Spreads of 10Y benchmark bonds to German Bund, in basis points 3

4. Bond yields before and since the crisis • Countries with higher pre-crisis spreads also with higher financing costs during crisis. • For all countries except GR, IE, PT and ES, financing costs in the crisis period close to the historical average. 4

5. European Commission Outline • Theoretical determinants of spreads, literature overview • Government bond yields and risk aversion • Empirical evidence: The role of public finances and macroeconomic imbalances • Summary and outlook 5

6. European Commission Structure • Theoretical determinants of spreads, literature overview • Government bond yields and risk aversion • Empirical evidence: The role of public finances and macroeconomic imbalances • Summary and outlook 6

7. Determinants of bond spreads a) Credit risk Differences in creditworthiness, risk that issuer fails to meet obligations b) Liquidity risk Differences in the ability of a bond to be converted into cash quickly and without any price discount c) Risk aversion Willingness of investors to take risk, "price of risk“ 7

8. Literature – pre-crisis period • Some pre-crisis studies stress the importance of international factors (see Codogno et al. 2003, EC Policy; Longstaff et al. 2007, J of Finance) • Role for domestic factors, such as government debt and deficits (Schuknecht et al. 2011, EJPE). • Differences in government bond market liquidity have also been found to be significant (Bernoth et al. 2006, ECB WP). • Beber et al. (2009, Rev Fin Studies) find that, while credit risk matters for bond valuation in normal times, liquidity becomes more important in times of financial stress. 8

9. Literature – crisis period • Global risk aversion important factor (see Haugh et al. 2009, OECD WP) • ECB (2009) find important role for credit risk both (measured by CDS spreads) before and since the crisis. • Sgherri and Zoli (2009, IMF WP) find that the sensitivity of sovereign spreads to projected debt changes has significantly increased after September 2008. • Gerlach, Schulz, Wolff (2010, CEPR) find a strong role for risk aversion and the size of banking sector • Attinasi (2011, ECB WP): size of rescue packages without impact on spreads 9

10. Bond yields and fiscal balance 10

11. Bond yields and government debt 11

12. Bond yields and current account 12

13. Bond yields and credit rating Average credit rating S&P, Fitch, Moody‘s. 13

14. European Commission Structure • Theoretical determinants of spreads, literature overview • Government bond yields and risk aversion • Empirical evidence: The role of public finances and macroeconomic imbalances • Summary and outlook 14

15. Sovereign risk factor Construction of sovereign risk factor • Spreads to German Bund decomposed into common and country-specific component (principal component analysis) • First principal component (common sovereign risk factor) • common variation in the sovereign bond spreads of individual countries • explains 75 percent of the total variation in the correlation matrix. • nearly uniform weighting of the sovereign bond spreads of all countries. • Second principal component • significant negative weights on GR, IE, PT • Slightly negative weight for IT, ES • positive weight on all other countries. 15

16. General risk aversion indicator Market segments and raw stress indicators: • Equity market: realised volatility of equity returns (Eurostoxx) • Corporate bond market: spreads on AAA-corporate bonds and spreads on BBB-corporate bonds • Money market: realised volatility in 3-month EURIBOR • Foreign exchange market: realized volatility of Yen/EUR, USD/EUR exchange rate 16

17. Sovereign risk and general risk aversion • Gap between sovereign risk and general risk widened during crisis, in particular since spring 2010. • Sovereign risk elevated, downward shift in general risk. • Transfer of risk from the private sector to the public sector (see also Ejsing and Lemke 2011). 17

18. European Commission Structure • Theoretical determinants of spreads, literature overview • Government bond yields and risk aversion • Empirical evidence: The role of public finances and macroeconomic imbalances* • Summary and outlook 18

19. Estimation approach • Fiscal conditions • fiscal balance for current year, as % of GDP • debt level for current year, as % of GDP • interest payments/total gov revenues • Current account balance (as % of GDP) • Liquidity risk - bid-ask spreads • Risk aversion - general risk factor (PC analysis) • Countries – AT, BE, ES, FI, FR, GR, IE, IT, NL, PT (with DE as benchmark). • Time period – January 2003-December 2009, quarterly data • Methodology – panel regressions, OLS-PCSE (Beck and Katz 1999) 19

20. Results panel regression 20

21. Interaction effects I Impact of budget balance on 10Y gov bond spreads at high level of risk aversion and high debt level 21

22. Interaction effects II Impact of budgetary balance on 10Y gov bond spread at high level of risk aversion and large current account deficit 22

23. European Commission Structure • Theoretical determinants of spreads, literature overview • Government bond yields and risk aversion • Empirical evidence: The role of public finances and macroeconomic imbalances • Summary and outlook 23

24. Summary • International factors such as general risk perception play a crucial role in explaining EA sovereign bond yield differentials. • Role played by domestic factors is smaller, but non-negligible. A deteriorating domestic outlook for fiscal deficits is associated with higher bond yields. • Significant interaction of general risk aversion and macroeconomic fundamentals. Domestic factors have become more important in times of financial stress, when international investors started to discriminate more between countries. • Combination of high risk aversion and large current account deficits tend to magnify the incidence of deteriorated public finances on government bond yield spreads. 24

25. Looking ahead… • Regaining bond market access crucial for programme countries (GR, IE, PT) • Unlikely that spreads will revert to pre-crisis levels in the near future: • Debt levels have increased significantly in a number of countries (relative to German benchmark). • Contingent liabilities assumed by the public sector in rescuing the financial sector will continue to weigh on the outlook for public finances. • Spread widening also correction of (too) narrow spreads in pre-crisis period. • Will greater market discrimination across countries provide higher incentives for governments to attain and maintain sustainable public finances? 25

26. Thank you for your attention 26