Sovereign default risk and state-dependent twin deficits

This paper analyzes the impact of the government debt-to-GDP ratio on the correlation of the fiscal balance and the current account. Above a government debt-to-GDP ratio of 90 percent the correlation of the two balances decreases by 0.16 in a sample of 12 euro area countries and by 0.17 for Greece, Ireland, Portugal and Spain. This paper develops a small open economy model with defaultable government debt and riskless international capital markets to explain the empirical evidence of a state-dependent change in the correlation. In the model high public debt-to-GDP ratios raise sovereign risk premia as the default probability increases, leading to higher uncertainty about future taxes. In this case precautionary savings of households increase and partially compensate current account deficits that result from fiscal deficits. The increase in households' saving reduces the correlation of the two balances by the same magnitude as documented in the data. The model calibrated to Greece matches further business cycle moments and the empirical default frequency.     

Current account imbalances and financial integration in the euro area

While the current account of the euro area as a whole has remained almost balanced in the past two decades, several member countries have sizeable deficits or surpluses. In this paper, we interpret these imbalances as indicators of net capital flows among the euro-area countries. We distinguish between balances against the euro zone and the rest of the world and examine these for the EU-15 countries. We find that for euro members the net flows follow differences in per-capita incomes, even before the introduction of the euro. Our results show further that with the introduction of the common currency the elasticity with respect to per-capita incomes of net capital flows within the euro area has increased for the members of the euro zone. This increase can neither be observed for the flows between the euro members and the rest of the world nor for the flows between the countries that stayed outside the monetary union and the euro zone. We interpret this as evidence for increasing financial integration in the euro area. There is also some evidence suggesting that the introduction of the euro has led to some financial diversion.     

Current accounts and financial flows in the euro area

We construct a new database of bilateral financial flows among euro area countries and their major world partners and explore the role of financial links in the accumulation and then adjustment of current account imbalances in the euro area. The data show that the geography of financial flows can differ quite markedly from trade flow patterns and suggest that the nexus between surpluses in the 'core' with deficits in the periphery went along financial rather than trade interlinkages. In particular, the data document the dominant role of 'core' countries in financing the euro area periphery's current account deficits before the financial crisis, both directly and through intermediating financial flows from outside of the euro area. Most of this financing took the form of debt instruments. Following the withdrawal of private financing from 'core' countries during the crisis, the ECB-mediated funding and other official flows helped the periphery to refinance its liabilities and smoothen the external adjustment.     

The U.S. current account deficit and the expected share of world output

We investigate the possibility that the large current account deficits of the U.S. are the outcome of optimizing behavior. We develop a simple long-run world equilibrium model in which the current account is determined by the expected discounted present value of its future share of world GDP relative to its current share of world GDP. The model suggests that under some reasonable assumptions about future U.S. GDP growth relative to the rest of the advanced countries—more modest than the growth over the past 20 years—the current account deficit is near optimal levels. We then explore the implications for the real exchange rate. Under some plausible assumptions, the model implies little change in the real exchange rate over the adjustment path, though the conclusion is sensitive to assumptions about tastes and technology. Then we turn to empirical evidence. A test of current account sustainability suggests that the U.S. is not keeping on a long-run sustainable path. A direct test of our model finds that the dynamics of the U.S. current account—the increasing deficits over the past decade—are difficult to explain under a particular statistical model (Markov-switching) of expectations of future U.S. growth. But, if we use survey data on forecasted GDP growth in the G-7, our very simple model appears to explain the evolution of the U.S. current account remarkably well. We conclude that expectations of robust performance of the U.S. economy relative to the rest of the advanced countries is a contender—though not the only legitimate contender—for explaining the U.S. current account deficit.     

Macro news and bond yield spreads in the euro area

This paper analyses the effects of newspaper coverage of macro news on the spread between the yield on the 10-year German Bund and on sovereign bonds in eight countries belonging to the euro area (Belgium, France, Greece, Ireland, Italy, the Netherlands, Portugal and Spain) using daily data for the period 1999–2014. The econometric analysis is based on the estimation of a VAR-GARCH model. The results can be summarized as follows. Negative news have significant positive effects on yield spreads in all GIIPS (Greece, Ireland, Italy, Portugal and Spain) countries but Italy before September 2008; markets respond more to negative news, and their reaction has increased during the recent financial crisis. News volatility has a significant impact on yield spread volatility, the effects being more pronounced in the case of negative news and bigger in the most recent crisis period, especially in the GIIPS countries. Further, the conditional correlations between yield spreads and negative news increase in absolute value during the financial crisis (especially in the GIIPS countries), indicating a higher sensitivity of the former to the latter.     

German Wage Moderation and European Imbalances: Feeding the Global VAR with Theory

German labor market reforms in the 1990s and 2000s are generally believed to have driven the large increase in the dispersion of current account balances in the Euro Area. We investigate this hypothesis quantitatively. We develop a three‐region open economy New Keynesian model with search and matching frictions from which we derive robust sign restrictions for wage bargaining and matching efficiency shocks which we term wage moderation shocks. We impose these restrictions on a Global VAR consisting of Germany and eight EMU countries to identify a wage moderation shock in Germany. Our results show that, although the German current account was significantly affected by wage moderation shocks, their contribution to European current account imbalances was negligible. We conclude that the German labor market reforms cannot be the lone driver of European imbalances.     

Have domestic or foreign factors driven European external imbalances?

This paper examines whether domestic or foreign net saving predominantly influences an economy’s international borrowing and lending with reference to the experience of western European economies that have had sizable current account surpluses and deficits since the turn of the century. It proposes that if an international lender country’s current account surplus is positively (negatively) related to its real long term interest rate, then foreign (domestic) factors are driving its external imbalance. On the contrary, for a foreign borrower country if its current account deficit is positively (negatively) related to its real long term interest rate, domestic (foreign) factors drive its external imbalance. On this basis, it shows econometrically for major European lender economies, Germany, the Netherlands, Switzerland and Sweden, that external imbalances this decade were mainly determined by foreign factors, though by domestic factors for Norway. For major borrower economies, Italy, Spain, Portugal, Ireland and the United Kingdom, the results were not significant implying that neither domestic nor foreign factors predominated over this time.     

The stability of short-term interest rates pass-through in the euro area during the financial market and sovereign debt crises

We analyse the dynamics of the pass-through of banks’ marginal cost to bank lending rates over the 2008 crisis and the euro area sovereign debt crisis in France, Germany, Greece, Italy, Portugal and Spain. We measure banks’ marginal cost by their rate on new deposits, contrary to the literature that focuses on money market rates. This allows us to account for banks’ risks. We focus on the interest rate on new short-term loans granted to non-financial corporations in these countries. Our analysis is based on an error-correction approach that we extend to handle the time-varying long-run relationship between banks’ lending rates and banks’ marginal cost, as well as stochastic volatility. Our application is based on a harmonised monthly database from January 2003 to October 2014. We estimate the model within a Bayesian framework, using Markov Chain Monte Carlo methods (MCMC).We reject the view that the transmission mechanism is permanent over time. The long-run relationship moved with the sovereign debt crises to a new one, with a slower pass-through and higher bank lending rates. Its developments are heterogeneous from one country to the other. Impediments to the transmission of monetary rates depend on the heterogeneity in banks marginal costs and therefore, its risks. We also find that rates to small firms increase compared to large firms in a few countries. Using a VAR model, we show that overall, the effect of a shock on the rate of new deposits on the unexpected variances of new loans has been less important since 2010. These results confirm the slowdown in the transmission mechanism.     

Has the euro affected the choice of invoicing currency?

We present a new approach to study empirically the effect of the introduction of the euro on the pattern of currency invoicing. Our approach uses a compositional multinomial logit model, in which currency choice is explained by both currency-specific and country-specific determinants. We use unique quarterly panel data on the invoicing of Norwegian imports from OECD countries for the 1996–2006 period. We find that eurozone countries have substantially increased their share of home currency invoicing after the introduction of the euro, whereas the home currency share of non-eurozone countries fell slightly. In addition, the euro as a vehicle currency has overtaken the role of the US dollar in Norwegian imports. The substantial rise in producer currency invoicing by eurozone countries is primarily caused by a drop in inflation volatility and can only to a small extent be explained by an unobserved euro effect.     

Macro news and stock returns in the Euro area: A VAR-GARCH-in-mean analysis

This paper analyses the effects of newspaper coverage of macro news on stock returns in eight countries belonging to the euro area (Belgium, France, Germany, Greece, Ireland, Italy, Portugal and Spain) using daily data for the period 1994–2013. The econometric analysis is based on the estimation of a VAR-GARCH-in-mean model. The results can be summarised as follows. Positive (negative) news have significant positive (negative) effects on stock returns in all cases. Their volatility has a significant impact on both stock returns and volatility; specifically, an increase in news volatility is always associated with a decrease in stock returns. Markets are particularly responsive to negative news, and the reaction is bigger in the PIIGS countries, and during the recent crisis period.     

The euro area sovereign debt crisis: Identifying flight-to-liquidity and the spillover mechanisms

Looking at the daily period between January 2006 and December 2012, besides the traditional credit and liquidity risks, which explain the developments of sovereign yields relative to the Bund for Greece, Ireland, Portugal, Spain and Italy, two additional factors have played a key role in the developments of euro area sovereign yield spreads: flight to liquidity benefiting the German Bund and the spillover effect from Greece. The flight to liquidity premium, which is estimated by constructing the spread between a German state guaranteed agency bond and the Bund, is behind the pricing of all euro area spreads and, specifically, is the only factor explaining the sovereign spreads for Finland and the Netherlands. The spillover effect from Greece, which is identified using complementary approaches, has contributed to developments in spreads of countries with weaker fiscal fundamentals, a lower degree of competitiveness and a higher need of foreign financing. However, a large fraction of the spillover across countries remains unexplained.     

Does the ECB act as a lender of last resort during the subprime lending crisis?: Evidence from monetary policy reaction models

We investigate whether the ECB aligns its monetary policy with financial crisis risk in EMU member countries. We find that since the outbreak of the subprime crisis the ECB has significantly increased net lending and reduced interest rates when banking and sovereign debt crisis risk in vulnerable EMU countries (Greece, Ireland, Italy, Portugal, and Spain) increases, while no significant effect is identified for the pre-crisis period and relatively tranquil EMU countries (Austria, Belgium, France, Germany, and the Netherlands). These findings suggest that the ECB acts as a Lender of Last Resort for vulnerable EMU countries.     

What causes exchange rate volatility? Evidence from selected EMU members and candidates for EMU membership countries

We allow for monetary, real, and financial variables to assess the relevant importance of each of the variables to exchange rate volatility in the case of selected EMU members and candidate countries. Ex-ante analysis shows that volatility in the Polish zloty/euro and the Hungarian forint/euro forex markets can be influenced by the monetary-side of the economy. On the other hand, ex-post analysis shows that forex markets in France, Italy and Spain had been influenced, during the pre-EMU era, by monetary and real shocks. However, the Irish pound exchange rate per ECU had been affected by only real shocks.     

Heterogeneity of the determinants of euro-area sovereign bond spreads; what does it tell us about financial stability?

In this paper, we assess the movements of euro area sovereign bond yield spreads vis-à-vis the German Bund as processes specified across different levels of volatility and subject to movements in asset prices and economic conditions. The determinants we use are grouped into domestic and euro-area aggregates, thus allowing us to derive results on their relative explanatory power and compare them across time and the spectrum of countries. We find that volatility influences the deterministic processes of the euro area sovereign spreads and that identical determinants have effects on spreads that vary considerably across countries. Furthermore, we find that variables reflecting investment confidence conditions and perceptions for the upcoming economic activity are significant determinants and their significance remains, to a large extent, even when controlling for fiscal variables.     

Contagion during the Greek sovereign debt crisis

We examine the impact of news about Greece and news about a Greek bailout on bank stock prices in 2010 using data for 48 European banks. We identify the twenty days with extreme returns on Greek sovereign bonds and categorise the news events during those days into news about Greece and news about the prospects of a Greek bailout. We find that, except for Greek banks, news about Greece does not lead to abnormal returns while news about a bailout does, even for banks without any exposure to Greece or other highly indebted euro countries. This finding suggests that markets consider news about the bailout to be a signal of European governments' willingness in general to use public funds to combat the financial crisis. Sovereign bond prices of Portugal, Ireland, and Spain respond to both news about Greece and news about a Greek bailout.     

The Euro Changeover and Its Effects on Price Transparency and Inflation

Despite the expectations of economists that the euro changeover would have no effect on prices, European consumers perceived the opposite. To shed some light on this puzzle, we develop a model of imperfect information in which cheaper goods experience higher price growth after the changeover. Retailers, aware of consumers' difficulties in adopting the new currency, use currency changeovers to increase profits by increasing prices. The lower the price transparency after the changeover, the higher the euro-related inflation. Using data on inflation (Eurostat) and price levels (Economist Intelligence Unit), we show that although the euro changeover did not significantly increase inflation, it nevertheless had a distortionary effect on prices. After the changeover, cheaper goods had higher inflation, and this effect was stronger in countries in which people found dealing with the new currency problematic.     

Euro area government bonds – Fragmentation and contagion during the sovereign debt crisis

The paper analyzes the integration of euro area sovereign bond markets during the European sovereign debt crisis. It tests for contagion (i.e., an intensification in the transmission of shocks across countries), fragmentation (a reduction in spillovers) and flight-to-quality patterns, exploiting the heteroskedasticity of intraday changes in bond yields for identification. The paper finds that euro area government bond markets were well integrated prior to the crisis, but saw a substantial fragmentation from 2010 onward. Flight to quality was present at the height of the crisis, but has largely dissipated after the European Central Bank's (ECB's) announcement of its Outright Monetary Transactions (OMT) program in 2012. At the same time, Italy and Spain became more interdependent after the OMT announcement, providing our only evidence of contagion. This suggests that countries have been effectively ring-fenced, and Italy and Spain benefited from the joint reduction in yields following the OMT announcement.     

Target loans, current account balances and capital flows: the ECB’s rescue facility

This paper presents the first comprehensive Target database of the Eurozone and interprets it from an economic perspective. We show that the Target accounts measure the intra-Eurozone balances of payments and indirectly also international credit given through the Eurosystem in terms of reallocating the ECB’s net refinancing credit. We argue that the Euro crisis is a balance-of-payments crisis similar to the Bretton Woods crisis, and document to what extent the Target credit financed the current account deficits and outright capital flight in Greece, Ireland, Portugal, Spain and Italy. To prevent the ECB from undermining the allocative role of the capital market, we propose adopting the US system of credit redemption between the District Feds.     

The demand for eurozone stocks and bonds in a time-varying asset allocation framework

This paper analyzes the short and long-run demand for traditional financial asset classes in eleven founding eurozone members. Our sample period starts from the introduction of euro till 2017. We calculate the welfare losses stemming from ignoring the demand for domestic and eurozone equities and bonds, for various levels of risk aversion. Our results show that the bonds of eurozone countries are, in general, desirable for short-run only. However, in Ireland, Portugal and Spain the bonds are desirable for both short-run and long-run investment horizons. Stocks exhibit both short-run and long-run desirability for all countries except Greece. The Greek stocks are desirable for short- run only.     

Inflation Differentials between Spain and the EMU: A DSGE Perspective

This paper estimates a dynamic stochastic general equilibrium model of a currency union with nominal rigidities to explain the sources of inflation differentials between the Economic Monetary Union (EMU) and one of its member countries, Spain. The paper finds that productivity shocks account for 85% of the variability of the inflation differential. Demand shocks explain a large fraction of output growth volatility but not variability in inflation differentials. In addition, the estimated model finds evidence that inflation dynamics are different across countries in the nontradable sector only. Finally, the Balassa–Samuelson effect does not appear to be an important driver of the inflation differential during the EMU period.