Sovereign Bond Spread Drivers in the EU Market in the Aftermath of the Global Financial Crisis

Abstract

Recently the world economy was confronted to the wo rst financial crisis since the great depression. This unprecedented crisis sta rted in mid-2007 had a huge impact on the European government bond market. But, what a re the main drivers of this “perfect storm” that since 2009 affects EU governme nt bond market as well? To answer this question, we propose an empirical study of the determinants of the sovereign bond spreads of EU countries with respect to Germany dur ing the period 2003-2010. Technically, we address two main questions. First, we ask what proportion of the change in sovereign bond spreads is explained by changes i n the fundamentals, external factors, liquidity and market risks. Second, we distinguish between EU member states within and outside the Euro area and question whether long -run determinants of spreads affect EU members uniformly. To these ends, we employ pane l data techniques in a regression model where spreads to Germany (with virtually no d efault risk) are explained by set of traditional variables as well as a number of policy variables. Results reveal that large fiscal deficits and public debt, as well as liquidi ty and political risks are likely to put substantial upward pressures on sovereign bond yiel ds in many advanced European economies over the medium term.