Sovereign spread divergence owing to inflation and redenomination risk countered by unconventional monetary policy in the Eurozone

Abstract

Using a panel vector error correction (VECM) model, we assess sovereign spread divergence in the Eurozone. Recent literature defines redenomination risk as a member state's unilateral exit from the Eurozone, estimated by the quanto Credit default swaps (CDS) spread (qCDS). We show that sovereign spread divergence is driven not only by the qCDS but also by inflation and US dollar liquidity shocks. We also find evidence that the balance sheet structure better describes the European Central Bank's (ECB) unconventional monetary policy (UMP) shocks than the shadow rate. Such policy shocks had a greater impact in the early 2020s than between the global financial crisis and the COVID-19 pandemic (2008Q1–2019Q4). Thus, this paper makes a new contribution to the debate on the ECB's instruments to maintain price stability objectives and avoid divergence of sovereign bond yields while emphasizing cross-central bank swap lines.