Do green financial policies offset the climate transition risk penalty imposed on long-term sovereign bond yields?

Asset valuations in high-carbon sectors face significant corrections due to climate risks. This paper specifically analyses whether markets impose a penalty on long-term sovereign bonds issued by countries facing higher climate-related transition risk while rewarding those that have implemented green financial policies to mitigate these risks. We find that higher carbon dioxide emissions and a lower sustainable development score (both proxies for transition risks) lead to an increase in long-term sovereign bond yields. However, the presence of green financial policies appears to offset this climate transition risk premium.     

Fiscal Rules and Government Financing Costs

This paper assesses the effect of fiscal rules on sovereign bond spreads over the short and medium term, for 34 advanced countries and 19 emerging market economies, over the period 1980–2016. Our results, based on impulse response functions, show that the dynamic impact of fiscal rules on sovereign yield spreads is negative and statistically significant, at around 1.2–1.8 percentage points, implying lower government borrowing costs. This result stems essentially from the advanced economies subsample. We also find that more fiscally responsible countries are the ones for which a fiscal rule reduces the government's borrowing costs. Moreover, in times of recession, a fiscal rule leads financial markets to reduce the risk premiums on government bonds. Finally, when it comes to design features of fiscal rules, independent monitoring of compliance to the rule, done outside government, also reduces sovereign spreads.     

Global Pricing of Carbon-Transition Risk

The energy transition away from fossil fuels exposes companies to carbon-transition risk. Estimating the market-based premium associated with carbon-transition risk in a cross section of 14,400 firms in 77 countries, we find higher stock returns associated with higher levels and growth rates of carbon emissions in all sectors and most countries. Carbon premia related to emissions growth are greater for firms located in countries with lower economic development, larger energy sectors, and less inclusive political systems. Premia related to emission levels are higher in countries with stricter domestic climate policies. The latter have increased with investor awareness about climate change risk.     

Can enhancing financial inclusivity lower climate risks by inhibiting carbon emissions? Contextual evidence from emerging economies

Climate change is regarded as a global concern whereby lowering climate risks, especially by curbing greenhouse gas emissions, has become a critically important policy agenda worldwide. Hence, this study assesses whether financial inclusion, alongside energy efficiency improvement, renewable energy use, economic growth, international trade, and urbanization, can mitigate carbon dioxide emissions in 22 emerging economies. Considering the period of analysis from 2008 to 2018 and utilizing econometric methods robust to handling cross-sectionally-dependent, heterogeneous, and endogenous panel data, the findings reveal that financial inclusion is directly associated with higher discharges of carbon dioxide. Contrarily, energy efficiency improvement and higher share of renewable energy in the aggregate energy consumption level inhibit carbon dioxide emissions. Moreover, energy efficiency gains moderate the financial inclusion-emissions nexus by jointly reducing carbon emissions with greater financial inclusivity. Finally, the results indicate that economic growth, international trade, and urbanization trigger climate risks by boosting the emission figures. In light of these findings, several carbon dioxide-mitigating policies are recommended for neutralizing climate risks in emerging countries of concern.     

Has the CDS market influenced the borrowing cost of European countries during the sovereign crisis?

This paper assesses the potential influence of the growing CDS market on the borrowing cost of sovereign states during the European sovereign crisis. We analyze the sovereign debt market to ascertain the pattern of information transmission between the CDS and corresponding bond markets. Our methodological innovation is the use of a non-linear specification rather than the linear VECM specification customarily employed. Using a panel smooth transition model during the 2008–2010 period, we find that: 1) linearity tests clearly reject the null hypothesis of a linear transmission mechanisms between the bond and the CDS markets; 2) market distress alters the mutual influence and 3) the higher the distress the more the CDS market dominates the information transmission between CDS and bond markets.     

Will banning naked CDS impact bond prices?

We develop a tractable partial equilibrium model to analyze the impact on the bond market generated by a ban on naked credit default swaps (CDS). We demonstrate that such a ban will have a negligible impact on the borrowing costs if CDS speculators are risk averse and take positions which are small relatively to the amount of debt outstanding. We find that the ban only excludes from the market moderately pessimistic investors, and induces the most pessimistic to implement their strategy on the short side of the bond market. Despite the sovereign debtor benefits from the reduced yields on the issued bonds, he will suffer from a diminished borrowing capacity after the ban. Such findings suggest that regulators should consider other measures to reduce instability arising from excessive speculation in derivatives markets.     

Sovereign bonds and flight to safety: Implications of the COVID-19 crisis for sovereign debt markets in the G-7 and E-7 economies

This study investigates the implications of the COVID-19 pandemic for sovereign debt in the G-7 and E-7 economies and explores the notion of sovereign bonds as a safe haven. Using a set of panel regression and dynamic connectedness TVP-VAR approaches, our results reveal that the impact of COVID-19 global case numbers on sovereign bonds has been contingent on the level of the country's financial and economic development. More precisely, our findings suggest that G-7 countries, where economic development is typically higher, have seen a negative effect of the COVID-19 pandemic on sovereign bond yield: sovereign 10-year bond yields declined as the number of COVID-19 global confirmed cases increased in G-7 countries. However, in E-7 countries, where economic growth and development are typically lower, sovereign bond yields responded positively to the initial increase in COVID-19 global confirmed case numbers, but this positive effect is not statistically significant. We also find that the G-7 and E-7 economies have a strong time-varying connectedness in relation to their bond markets and this effect is more pronounced in G-7 economies. Daily Infectious Disease Equity Market Volatility is likely to be the strongest predictor of total connectedness. Concomitantly, we shed new light on the predictive power of the number of COVID-19 confirmed cases and deaths, and the Daily Infectious Disease Equity Market Volatility Tracker on the interdependence of these sovereign bond markets. Overall, this paper highlights the heterogeneous effect of the COVID-19 pandemic on sovereign bond yields in G-7 and E-7 countries and the notion that the developed economies, with their developed sovereign bond markets, are still seen as a safe haven during times of crisis.     

Income Growth,Energy Consumption,and Carbon Emissions: The Case of China

The paper examines the long-run relationship among per capita income, energy consumption, and carbon emissions in China during 1953–2008. We employ the Toda—Yamamoto procedure to test the Granger causality in a vector autoregressive (VAR) model with levels. We find strong evidence of bilateral Granger causality running between income and energy consumption and unilateral Granger causality running from carbon emissions to income. We further provide policy suggestions to address the energy and sustainable development dilemma in China. These include diversifying the energy mix and exploiting renewable energy, enhancing energy efficiency, transforming the economic growth pattern, and reducing the reliance on resource- and energy-intensive industries.     

Public debt,bailouts, and common bonds

We look at a model where countries of different sizes provide local public goods with positive spillovers. Matching grants can give rise to optimal expenditure levels, but countries can induce bailouts. We study the characteristics of these bailouts in a subgame-perfect Nash equilibrium and how these characteristics are affected by the introduction of common bonds. Partial substitution of common for sovereign bonds has two implications. First, it lowers the average and marginal borrowing costs of countries which may be eligible for bailouts. This effect leads to higher borrowing in these countries irrespective of their bailout expectations. Second, the lower borrowing costs mitigate the incentives of countries to induce a bailout and, therefore, constrain the parameter set for which a soft budget constraint equilibrium exists. As a result, the introduction of common bonds can also be in the interest of those countries that provide the bailouts.     

The impact of distressed economies on the EU sovereign market

Financially distressed economies inside the European Union (EU) are being blamed for producing a general increase in borrowing costs. This article analyzes the channels of default risk transmission within the EU countries using the information content in the sovereign Credit Default Swap (CDS) market. We proceed in two directions. First, we test the existence of cross-border volatility effects between the central and the peripheral EU countries. Second, we explore the effect of distressed economies on the default and risk premium constituents of sovereign default swaps. We show a significant volatility spillover from distressed to central European Economic and Monetary Union (EMU) economies. This causality pattern leads to a significant impact on the default swap risk premia. On average, the risk premium accounts for approximately 42% of central EMU spreads and 56% of the spreads for those countries outside of the EMU. The peripheral risk also affects the default component of central economies, although its impact is lower.     

Optimal monetary policy in an economy with incomplete markets and idiosyncratic risk

This study investigates an incomplete markets economy in which the saving behavior of a continuum of infinitely lived agents is influenced by precautionary saving motives and borrowing constraints. Agents can use two types of assets (interest bearing IOUS and money) to smooth consumption. Money is valued because of a timing friction in the bond market. In particular, the bond market closes before agents observe their idiosyncratic productivity shock. I find that the Friedman rule is not optimal for this economy. The results indicate that the optimal allocation has a rate of inflation of 10%, and a positive amount of private credit held by the government. A positive inflation rate transfers resources from agents with big endowments to those holding bonds which improves risk sharing, and therefore, welfare. However, for higher rates of inflation, agents economize on money holdings, offsetting the insurance effects, and causing a reduction in welfare. Furthermore, higher rates of inflation discourage agents from borrowing, and the endogenous lower bound on bond holdings is higher than the exogenous borrowing limit. High rates of inflation, therefore, exacerbate frictions in the bond market.     

The IMF in a world of private capital markets

In analyzing the IMF attempts to stabilize private capital flows, we contrast cases where banks and bondholders do the lending. Consistent with banks’ natural advantage in monitoring, they reduce spreads as they obtain more information through repeat transactions with borrowers. By comparison, repeat borrowing has little influence in bond markets, where publicly-available information dominates. But spreads on bonds are lower when they are issued in conjunction with an IMF-supported program, as if the existence of a program conveys positive information to bondholders. The influence of IMF monitoring in bond markets is especially pronounced for countries vulnerable to liquidity crises.     

Credit default swaps and the market for sovereign debt

In this paper, we analyze the determinants and effects of credit default swap (CDS) trading initiation in the sovereign bond market. CDS trading initiation is associated with a 30–150 basis point reduction in sovereign bond yields, with greater yield reductions accruing to higher default risk economies. For countries with high default risk, rated B or lower by Standard and Poor’s, CDS initiation is also associated with significant price efficiency benefits in the underlying market. CDS trading initiation is more likely following increases in local equity index volatility, index spreads for regional and global CDS markets, or depreciation of the local currency relative to the US dollar, and decreases in a country’s ability to service foreign debt. Our results are robust to selection bias controls based on these factors.     

On the exposure of insurance companies to sovereign risk—Portfolio investments and market forces

A sovereign debt crisis can have significant knock-on effects in the financial markets and put financial stability at risk. This paper focuses on the transmission of sovereign risk to insurance companies as some of the largest institutional investors in the sovereign bond market. We use a firm level panel dataset that covers large insurance companies, banks and non-financial firms from nine countries over the time period from 1 January 2008–1 May 2013. We find significant and robust transmission effects from sovereign risk to domestic insurers. The impact on insurers is not significantly different from that on banks but larger than for non-financial firms. We find that systemically important insurers are more closely linked to the domestic sovereign. Based on European data, we show that risks in sovereign bond portfolios are an important driver of insurer risk, which is not reflected in current insurance regulation (incl. Solvency II in Europe).     

Banks and sovereign risk: A granular view

We investigate the determinants of sovereign bond holdings of German banks and the implications of such holdings for bank risk. We use granular information on all German banks and all sovereign debt exposures in the years 2005–2013. As regards the determinants of sovereign bond holdings of banks, we find that these are larger for weakly capitalized banks, banks that are active on capital markets, and for large banks. Yet, only around two thirds of all German banks hold sovereign bonds. Macroeconomic fundamentals were significant drivers of sovereign bond holdings only after the collapse of Lehman Brothers. With the outbreak of the sovereign debt crisis, German banks reallocated their portfolios toward sovereigns with lower debt ratios and bonds with lower yields. With regard to the implications for bank risk, we find that low-risk government bonds decreased the risk of German banks, especially for savings and cooperative banks. Holdings of high-risk government bonds, in turn, increased the risk of commercial banks during the sovereign debt crisis.     

Cash-rich firms and carbon emissions

We investigate whether corporate cash holdings affect carbon dioxide emissions. Using a sample of 5402 firm-years observations from 943 U.S. firms during 2007–2017, we find that carbon emissions are lower in firms with higher corporate cash holdings. The effect of cash holdings on carbon emissions is more pronounced in firms with low leverage and less financial constraints. Our channel analysis further unveils that renewable energy consumption and carbon abatement investment are higher in cash-rich firms, which transmit lower carbon emissions. Our findings are robust to different identification strategies and alternative measures of cash holdings and carbon emissions. Overall, our paper provides novel evidence on the role of corporate cash holdings in mitigating carbon emissions.     

Delivering green economy in Asia: The role of fiscal instruments

Asia’s ongoing rapid economic growth is successfully lifting millions of poor out of the vicious cycle of poverty, but that performance comes at a price. The unprecedented growth we witness today is also rapidly driving resource consumption to unsustainable levels. Local production and consumption-led growth is causing a considerable increase in external costs, such as deforestation, and knock-on effects, such as increased emissions including greenhouse gas (GHG); depletion of non-renewable resources; pollution of rivers; desertification; flooding; and long term climate change. Currently, the region accounts for about 40% of GHG emissions, which is expected to rise to almost 50% by 2030 if the business-as-usual trajectory projected for the region is not altered. Countries in the region are taking action when it comes to the transition to a green economy. When compared to other regions, Asia has the highest rate of policy innovations that can help in the transition to a green economy. Even though fiscal instruments in-use are to some extent already altering aggregate demand of resources and economic activities, resource allocation, and distributive capacity of the economy, instrument such as “carbon tax” that has the real potential to contain rising emissions and save economies from getting locked into carbon-intensive pathways are yet to be adopted widely. Tax on natural resources extraction is yet to be implemented in wider scale despite of rampant destruction of natural resources and environments and increase in associated GHG emissions. Sporadic adoption of fiscal instruments is not going to be enough, if Asia as a region, is to transition to a green economy. In addition, there are substantial implementation barriers that need to be eased for wide-scale adoption and diffusion of green fiscal instruments.     

Macroeconomic imbalances,financial stress and fiscal vulnerability in the euro area before the debt crises: A market view

This paper tries to identify the macro-financial imbalances that exposed the euro area countries to fiscal stress before the outbreak of the European debt crises. Contrary to conventional wisdom that interprets fiscal stress in terms of fiscal sustainability, we focus on short-term fiscal vulnerability as reflected by the conditions of debt refinancing in the sovereign bond markets. We find that market-based indicators capturing risk perceptions of sovereign debts have been influenced by the indicators defined in the European Macroeconomic Imbalance Procedure (MIP) and by variables of financial vulnerability. When pricing the risk of sovereign bonds, the holders of government debts take into account not only the macroeconomic imbalances but also factors such as banking distress, corporate bond risk, liquidity risks in the interbank market or the volatility of stock prices.     

House prices, consumption, and monetary policy: a financial accelerator approach

We consider a general equilibrium model with frictions in credit markets used by households. In our economy, houses provide housing services to consumers and serve as collateral to lower borrowing cost. We show that this amplifies and propagates the effect of monetary policy shocks on housing investment, house prices and consumption. We also consider the effect of a structural change in credit markets that lowers the transaction costs of additional borrowing against housing equity. We show that such a change would increase the effect of monetary policy shocks on consumption, but would decrease the effect on house prices and housing investment.     

Implied liquidity risk premium in the term structure of sovereign credit default swap and bond spreads

In this study, we focus on the dynamic properties of the risk-neutral liquidity risk premium specific to the sovereign credit default swap (CDS) and bond markets. We show that liquidity risk has a non-trivial role and participates directly to the variation over time of the term structure of sovereign CDS and bond spreads for both the pre- and crisis periods. Secondly, our results indicate that the time-varying bond and CDS liquidity risk premium move in opposite directions which imply that when bond liquidity risk is high, CDS liquidity risk is low (and vice versa), which may in turn be consistent with the substitution effect between CDS and bond markets. Finally, our Granger causality analysis reveals that, although the magnitude of bond and CDS liquidity risk is substantially different, there is a strong liquidity flow between the CDS and the bond markets, however, no market seems to consistently lead the other.