Increase in Home Bias and the Eurozone Sovereign Debt Crisis

Abstract

One of the most striking consequences of the recent episode of sovereign debt market stress in the Eurozone has been the increase in the share of public debt held by the domestic sector in fragile economies. However, the causes and potential consequences of this increase were only given scarce attention in the literature on the Euro area sovereign debt crisis. In order to fill this gap, we first identify the shocks that impact the variation in the share of sovereign debt held at home in an SVAR model on a sample of Eurozone countries between 2002 and 2014, distinguishing between external and domestic shocks. Thanks to several alternative tests, we show that home bias in sovereign debt responds positively to country-specific fundamentals and expectations shocks but we find no evidence that the increase in home bias is destabilizing per se in the short-run. Second, a stylized theoretical model backed by the empirical results predicts that the consequences for sovereign debt crisis depend on the relative impact of domestic initial destabilizing shocks and increased home bias. The analysis suggests that an increase in home bias in times of sovereign debt stress, despite reflecting deteriorating fiscal conditions, may make default less likely.