The Clusters of Economic Similarities between EU Countries: A View Under Recent Financial and Debt Crisis

Abstract

1. Introduction Herman Van Rompuy argues that Eurozone will in the near future most probably retain its unique character of a monetary union in which fiscal policy remains in the hands of the Member States. The overall goal, therefore, has to be to make Member States more mindful of their responsibilities towards themselves and the other members of the club. The action--or lack of action--of one affects all. (European View, 2010). On the other hand, Stuckler et al. (2010) advocate that reducing government deficits is, in principle, simple--cut costs or free up money. Governments should always spend money efficiently, but there are also at least five ways to increase their finances. One short-term measure is the sale of government assets (i.e. privatization); alternatively, governments can stimulate the economy by increasing the money supply; a third option is to borrow more money; a fourth option is to increase taxes; the final option, adopted by any government, is to cut public spending. Before the debt crisis started the spread of each EU country, 10 years government bond against Germans correspondently, are not strongly correlated with index government debt to GDP. According to Simone Manganelli and Guido Wolswijk (2009), in the run-up to the European Economic and Monetary Union (EMU), interest rate spreads of the euro-area 10-year government bonds against the German benchmark have declined dramatically. The decline reflected mainly the introduction of the euro and the subsequent removal of exchange rate risks. However, developments in spreads after that are more puzzling. Developments in the fiscal positions of euro-area governments seem, at first sight, to offer only a limited explanation for this. In the work of Codogno, Favero and Missale (2003), movements in yield differentials on euro-zone government bonds are mostly explained by changes in international risk factors, as measured by US swap and corporate bond spreads relative to the US Treasury yields. These international factors affect spreads because they change the perceived default risk of government bonds in the euro zone. Liquidity factors play a less significant role, though. The impact of international risk on yield differentials in Austria, Italy and Spain, is explained by their debt-to-GDP ratios relative to Germany. Default risk explains a substantial part of changes in yield spreads in Italy and Spain. Yield differentials for all the other countries are also significantly affected by international risk factors, although independently from debt-to-GDP ratios. This suggests that bonds issued by these countries are viewed as imperfect substitutes of German bonds for reasons not related to their debt ratios. International risk may have an impact because of differences in liquidity but also because of unobservable fundamentals, such as the reputation of the issuing government, or because of greater uncertainty of future budget surpluses. Greater trading volumes significantly reduce yield differentials in France, Greece, the Netherlands and Spain, while other traditional indicators, such as bid-ask spreads, have no effect. Even in such countries, however, international risk-related factors appear the main source of variation in yield differentials. France is the only country where liquidity matters more than international risk. Finland and Ireland, the two countries with the lowest debt-to-GDP ratio, also show no reaction to international risk factors. Yields on euro-zone government bonds have been increasingly correlated across issuers. This is a sign of enhanced integration that is explained by the common denomination in euro. However, additional policy steps to increase financial market integration by means of increased efficiency both in primary and secondary markets, although desirable, would not deliver a 'seamless' bond market in the euro area. The risk of default, though small, remains an important factor explaining movements in yield differentials. …