European policy and markets: Did policy initiatives stem the sovereign debt crisis in the euro area?

We investigate how European policy initiatives influenced market assessments of sovereign default risk and banking sector fragility during the sovereign debt crisis in four adversely affected countries — Portugal, Ireland, Spain and Italy. We focus on three broad groups of policies: (a) ECB policy actions (monetary and financial support), (b) EU programs (financial and fiscal rules as well as financial support in crisis countries), and (c) domestic austerity programs. We measure immediate market impact effects: what policies changed risk perceptions, using CDS spreads on sovereign bonds and banks in this assessment. We employ dynamic panel and event study methodologies in the empirical work. We find that a number of programs initially stabilized sovereign and bank bond markets (e.g. Outright Monetary Transactions program), although announcement and implementation impacts on markets differed in some cases (e.g. second Covered Market Bond Program). Actions designed to shore up sovereign markets often lowered risk assessments in bank bond markets and policies designed to ensure safety and soundness of the European banking system in some cases significantly impacted sovereign debt markets. Finally, a number of policies designed to stabilize markets had surprisingly little immediate impact on either sovereign or bank bond market risk assessments.     

The effect of political factors on sovereign default

This aricle examines the effect of political factors on sovereign default. Using a theoretical model, we find that political instability increases the likelihood of default. To test this theoretical implication, we use a panel logit model to estimate the effect of long- and short-run political factors, along with other macroeconomic variables, on the probability of default. Data from 68 developed and developing countries between 1970 and 2010 is used to conduct the study. Our findings suggest that a country is more likely to default when (i) it has a relatively younger political regime in place; (ii) it faces a higher chance of political turnover; and (iii) it has a less democratic political system. Economic factors are also vital; a country with stronger growth and less external debt is less likely to experience sovereign default. Robustness tests using alternative measures of political risk, trade balance and EMBI sovereign bond spreads also support the baseline findings.     

MARKET DISCIPLINING OF THE DEVELOPING COUNTRIES' SOVEREIGN GOVERNMENTS

In this article, we contribute to the current literature on market disciplining of the sovereign governments of the developing countries by distinguishing both sides of the market discipline hypothesis by adopting three‐stage least square estimation to incorporate the contemporaneous feedback effects between primary structural budget balances and the country's default‐risk premiums. We provide empirical evidence of a unidirectional causal relationship between a country's default‐risk premium and primary structural budget balances with the direction flowing from primary structural budget balances to country's risk premium in 40 developing countries over the period 1975–2008. We also employ the Arellano‐Bond dynamic panel generalized methods of moments estimation to control for this joint determination of primary structural budget balances and the country's default‐risk premium, and find supportive evidence of undisciplined sovereign governments and of nonlinearly behaving well‐functioning financial markets in the sample countries. (JEL C5, G1, G3)     

The sovereign spread in Asian emerging economies: The significance of external versus internal factors

This paper investigates the dynamic relations between external factors, domestic macroeconomic factors with sovereign spreads, debt to GDP ratio, etc. in Asian emerging countries. First, we develop a theoretical model that determines the equilibrium debt level, probability of default and sovereign spread and draw empirical implications. We then employ a Structural Vector Autoregression (SVAR) model to investigate empirically how the spread of sovereign debt is influenced over time by both external and domestic factors. The empirical results show that variations in sovereign spreads are mainly driven by external shocks, with the term structure of US interest rate and the global risk aversion having the most important role. The findings also indicate that shocks from the US have a direct effect on sovereign spread and an indirect effect via domestic macroeconomic fundamentals. Finally, the evidence produced validates the presence of some response patterns of sovereign spread to the external shocks.     

Assessing Recent Determinants of Borrowing Costs in Sub‐Saharan Africa

This study explores macroeconomic implications of the sovereign bond rush that has been taking place in sub‐Saharan Africa since 2006. The focus is on the sub‐Saharan sovereign bond yields as proxies for the region's ability to raise new funds on international markets. Despite the subcontinent's tour‐de‐force entrance to the international bond market, this paper reveals that recent (since early 2000s) borrowing in foreign currency is not without macroeconomic risk. Empirically this paper finds that sovereign bond yields are significantly influenced by global volatility, commodity prices and global liquidity—all factors that are out of the control of the sub‐Saharan economies in question. These findings suggest that portfolio repositioning by institutional investors prompted by improved growth prospects and implicit monetary policy tightening in the advanced economies or heightened risk perceptions, are likely to result in increased borrowing costs for the sub‐Saharan bond issuers and affect their ability to raise funds in international markets. Furthermore, a change in borrowing costs might lead to higher debt‐service costs and policy uncertainty, which in turn could lead to suboptimal investment levels and, ultimately, hinder economic development.     

Sovereign debt spread and default in a model with self-fulfilling prophecies and asymmetric information

The euro area sovereign debt crisis has renewed interest in government credibility and the risk of default. Recent empirical evidence has shown that the sharp increase in government bond yields cannot be attributed entirely to changes in macroeconomic fundamentals. Contagion effects can occur, and self-fulfilling speculation may arise. In this paper, we develop a theoretical model in the spirit of the second-generation currency crisis models developed by Obstfled (1996). The model describes a strategic game between governments and private investors. Euro area countries face a trade-off as governments may either commit to and implement restrictive fiscal policies or default on debt. The commitment strategy may not be optimal if the fundamentals deteriorate. The policy maker lose part of their credibility, and governments are forced to default. In addition, we introduce uncertainty about the cost of default in the model, which is then able to account for a greater variety of equilibrium. Thus, when the evaluation of the cost of default is asymmetric, prophecies are not always realized and default does not occur. Simulations of the model then show that it offers insights, and can help to account for the situations of Greece and Italy during the sovereign debt crisis.     

The Interactions between the Credit Default Swap and the Bond Markets in Financial Turmoil

We analyse the links between credit default swap (CDS) and bond spreads in order to determine which one is the leading market in the price discovery process. To do that, we construct a sample of CDS premia and bond spreads on a generic 5‐year bond for 17 financials and 18 sovereigns. First, we run panel vector error correction model estimations, showing that the CDS market has a lead over the bond market for financial institutions. This also holds for high‐yield sovereigns, whereas the reverse is found for low‐yield sovereigns in the core of the euro area. We interpret these results according to the relative liquidity of both markets for different types of entities. Second, we check for nonlinearities in the adjustment process. Results show that the CDS market's lead is amplified when default risk increases, during crisis periods, as well as continuously when CDS premia increase.     

Domestic versus External Borrowing and Fiscal Policy in Emerging Markets

This paper presents a model of an emerging market sovereign that can selectively default on its domestic or external creditors. The two classes of creditors have different ways of punishing the government in the event of default, which in turn creates a differential in the sovereign's incentives to default on its domestic versus foreign creditors. We explore the extent to which the possibility of differential treatment of creditors affects the composition of debt. We find that a country characterized by volatile output, sovereign risk, and costly tax collection will want to borrow in domestic as well as in international markets.     

Moving markets? Government bond investors and microeconomic policy changes

Do sovereign bond markets react systematically to microeconomic policy reforms? Some observers suggest that investors are very attentive to supply‐side policies such as those related to labor markets, corporate taxation, and product standards. They argue that, along with macroeconomic outcomes and broad financial market conditions, such reforms affect sovereign bond premiums, for developed as well as emerging economies. In contrast, we predict few systematic effects of supply‐side policy reforms on sovereign bond market outcomes. Our theory draws on a standard three‐equation model of the economy, widely accepted among economic and finance professionals. That model makes few clear predictions regarding the anticipated effects of microeconomic policy changes; as a result, we expect that such reforms will not generate systematic market reactions. Our analyses, based on daily data from 37 countries from 2004 to 2012, indeed reveal little evidence of a systematic bond market reaction to the 47 most significant reforms to corporate taxation and labor market regulation. These results call into question the notion that “bond market vigilantes” play a central role in compelling governments to enact specific microeconomic policy changes.     

Mispricing of Risk in Sovereign Bond Markets with Asymmetric Information

The likelihood that a government will repay its sovereign debt depends both on the amount of debt it issues and on the government's future ability to repay. Whilst the former is publicly observable, the government may have more information about the latter than investors. This paper shows that this asymmetric information problem impairs the market's ability to differentiate economies according to their fiscal sustainability, and can lead to a disconnect between bond prices and default risk. The model can help rationalise the behaviour of Eurozone bond prices prior to the recent European sovereign debt crisis.     

Rules and risk in the Euro area

We show that stronger fiscal rules in Euro area members reduce sovereign risk premia, in particular in times of market stress. Using a unique data set of rules-based fiscal governance in EU member states, we estimate a model of sovereign spreads that are determined by the probability of default in interaction with the level of risk aversion. The legal base of the rules and their enforcement mechanisms are the most important dimensions of rules-based fiscal governance.     

Sovereign Reputation and Yield Spreads: A Case Study on Retroactive Legislation

This paper uses recent legislation in Austria to establish a link between sovereign reputation and yield spreads. In 2009, Hypo Alpe Adria International, a bank previously co‐owned by the regional government of Carinthia, had been nationalized by Austria's central government in order to avoid a default triggering multi‐billion Euro local government guarantees. In 2015, special legislation retroactively introduced collective action clauses allowing a haircut on both the bonds and the guarantees while avoiding formal default. We document that legislative and administrative action designed to partly abrogate the guarantees resulted in a loss of reputation, leading to higher yield spreads for sovereign debt. Our analysis of covered bonds uncovers an increase in yield spreads on the secondary market and a deterioration of primary market conditions.     

Quantitative properties of sovereign default models: Solution methods matter

We study the sovereign default model that has been used to account for the cyclical behavior of interest rates in emerging market economies. This model is often solved using the discrete state space technique with evenly spaced grid points. We show that this method necessitates a large number of grid points to avoid generating spurious interest rate movements. This makes the discrete state technique significantly more inefficient than using Chebyshev polynomials or cubic spline interpolation to approximate the value functions. We show that the inefficiency of the discrete state space technique is more severe for parameterizations that feature a high sensitivity of the bond price to the borrowing level for the borrowing levels that are observed more frequently in the simulations. In addition, we find that the efficiency of the discrete state space technique can be greatly improved by (i) finding the equilibrium as the limit of the equilibrium of the finite-horizon version of the model, instead of iterating separately on the value and bond price functions and (ii) concentrating grid points in asset levels at which the bond price is more sensitive to the borrowing level and in levels that are observed more often in the model simulations. Our analysis is also relevant for the study of other credit markets.     

How do experts forecast sovereign spreads?

This paper assesses how forecasting experts form their expectations about future government bond spreads. Using monthly survey forecasts for France, Italy and the United Kingdom between January 1993 and October 2014, we test whether respondents consider the expected evolution of the fiscal balance—and other economic fundamentals—to be significant drivers of the expected bond yield differential over a benchmark German 10-year bond. Our main result is that a projected improvement of the fiscal outlook significantly reduces expected sovereign spreads. This suggests that credible fiscal plans affect market experts’ expectations and reduce the pressure on sovereign bond markets. In addition, we show that expected fundamentals generally play a more important role in explaining forecasted spreads compared to realized spreads.     

Fiscal limits and monetary policy: default vs. inflation

This paper studies the monetary policy trade-off between low inflation and low sovereign risk in the environment where fiscal authorities fail to fully ensure the sustainability of government debt. Building on the Fiscal Theory of Price Level (FTPL) and the Fiscal Theory of Sovereign Risk (FTSR), this paper differs in its baseline assumption about the monetary policy objective, which is neither to rule out defaults regardless of inflation costs (as in FTPL), nor to follow inflation targeting regardless of associated sovereign risk (as in FTSR). Instead, we study the case in which the central bank controls the risky interest rate to minimize the probability of default while ruling out large inflation hikes. We show that this policy regime can mitigate default risks only when the central bank is expected to allow sufficient increases in inflation. When agents believe that the central bank's tolerance toward inflation hikes has increased, equilibrium risk premium goes down, suggesting that information concerning changes in the central bank's preferences over inflation directly impacts default risks.     

Fiscal policy and default risk in emerging markets

Emerging market economies typically exhibit a procyclical fiscal policy: public expenditures rise (fall) in economic expansions (recessions), whereas tax rates rise (fall) in bad (good) times. Additionally, the business cycle of these economies is characterized by countercyclical default risk. In this paper we develop a quantitative dynamic stochastic small open economy model with incomplete markets, endogenous fiscal policy and sovereign default where public expenditures and tax rates are optimally procyclical. The model also accounts for the dynamics of other key macroeconomic variables in emerging economies.     

The impact of sovereign risk on bond duration: Evidence from Asian sovereign bond markets

This paper examines the effect of sovereign risk on bond duration. We compare the sovereign risk-adjusted duration for U.S. dollar-denominated Asian sovereign bonds with their Macaulay duration for both investment grade bonds and speculative grade bonds. We find that the sovereign risk-adjusted duration is significantly shorter than its Macaulay counterpart for all bonds, regardless of their bond rating and their maturity. Further, the “shortening” effect of sovereign risk on duration gets stronger as bond rating deteriorates and in recessionary conditions. Our findings provide strong support for the importance of adjusting for sovereign risk when bond portfolio managers apply the popular duration measure to hedge interest rate risk.     

Sovereign bond markets with political risk and moral hazard

A model of interest rates on sovereign bonds with default risk is presented. The model accounts for interaction between interest rates and default risk. Multiple equilibria and stability issues are examined. The model explores the level of debt that markets will tolerate in a context where there is uncertainty about output growth, fiscal discipline, real exchange rates, and IMF intervention. The effect of likely IMF assistance on the debt ceiling is shown to be large.     

On the Transmission Mechanism of Monetary Constraints to the Real Side of the Economy

Contrary to the predictions of the theory underlying international finance, inflows of capital triggered by financial liberalisation have neither equalised real interest rates nor increased income growth in many emerging economies. We explain this puzzle by developing a model that combines the balance‐of‐payments constraint approach to economic growth with a less stringent version of the real interest rate parity hypothesis. The model’s foundations are based on robust empirical findings or well‐established macroeconomic models. We show that a perverse combination of income elasticities of demand for imports and exports generates slow income growth and high real interest rates. As domestic income grows and imports rise faster than exports, the real exchange rate is expected to depreciate in order to clear the balance of payments (or the foreign exchange rate market). An incipient capital outflow arises and interest rates increase. Faster adjustment in capital rather than in the goods market therefore generates a higher real interest rate differential between the domestic small open‐economy and the rest of the world. The long run analysis shows that a constant degree of risk aversion implies a positive equilibrium real interest rate differential that affects economic growth. A permanent increase in default risk driven by persistent current account imbalances thus impacts on long run growth. The model’s results are illustrated with evidence from the three major Latin America economies: Argentina, Brazil and Mexico.     

Sustainable financing for climate and disaster resilience in Atoll Islands: Evidence from Tuvalu and Kiribati

This paper examines the financing of disaster risk management. Future climate and disaster risks are predicted to impose increasing financial pressure on the governments of low‐lying atoll nations. The aftermath of a disaster, such as a cyclone, requires financial means for quick response and recovery. We quantify the appropriate levels of financial support for expected disasters in Tuvalu and Kiribati by building on the Pacific Catastrophe Risk Assessment and Financing Initiative (PCRAFI)‐calculated likely costs for disasters. To these, we add estimates of the potential effects of distant cyclones, droughts, sea‐level rise, climate change and large‐scale disaster shocks as they are predicted to affect low‐lying atoll islands. The present paper focuses on the potential contribution of the sovereign wealth funds (SWF) of Tuvalu and Kiribati in reducing reliance on foreign aid for ex‐post disaster risk management. We forecast the future size of SWF using Monte Carlo simulations. We examine the long‐term sustainability of SWF and the feasibility of extending their mandate for disaster recovery.