Euro Area Sovereign Debt Crisis Research Articles

Increase in home bias in the Eurozone debt crisis: The role of domestic shocks

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 determine 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 expectation 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.

Model uncertainty in Panel Vector Autoregressive models

We develop methods for Bayesian model averaging (BMA) or selection (BMS) in Panel Vector Autoregressions (PVARs). Our approach allows us to select between or average over all possible combinations of restricted PVARs where the restrictions involve interdependencies between and heterogeneities across cross-sectional units. The resulting BMA framework can find a parsimonious PVAR specification, thus dealing with overparameterization concerns. We use these methods in an application involving the euro area sovereign debt crisis and show that our methods perform better than alternatives. Our findings contradict a simple view of the sovereign debt crisis which divides the euro zone into groups of core and peripheral countries and worries about financial contagion within the latter group.

Measuring Contagion-Induced Funding Liquidity Risk in Sovereign Debt Markets

The euro-area sovereign debt crisis demonstrated how liquidity shocks can build up in a sovereign debt market due to contagion. This paper proposes a model based on the probability density associated with the dynamics of sovereign bond spreads to measure contagion-induced systemic funding liquidity risk in the market. The two risk measures with closed-form formulas derived from the model, are (1) the rate of change of the probability of triggering a liquidity shock determined by the joint sovereign bond spread dynamics of the systemically important countries (i.e., Italy and Spain) and small country (i.e., Portugal); and (2) the distress correlation between bond spreads, which can provide forward-looking signals of such risk. A signal of the rate of change of the joint probability appeared in April 2011 before the liquidity shock occurred in November 2011. There exist endogenous critical levels of sovereign spreads, above which the signal materializes. The empirical results show that when funding cost, risk aversion and equity prices pass through certain levels, the rate of change of the joint probability will rise sharply.

Carry funding and safe haven currencies: A threshold regression approach

We analyze which currencies can be regarded as safe haven currencies. Our empirical approach allows us to distinguish between a low- and high-stress regime, and to control for the impact of carry trade reversals and other fundamental determinants. We therefore address the question of whether a supposed safe haven currency only appreciates in times of crises because carry trades are unwound, in which the corresponding currency has served as funding currency, or whether it possesses “true” safe haven qualities; i.e. it provides a hedge in stressful times even after controlling for the impact of carry trade reversals. The latter issue has largely been brushed aside in the extant literature but has important policy implications for the justification of central bank FX interventions in times of crises. According to the estimation results, two currencies, the Swiss franc and (to a lesser extent) the US dollar, qualify as safe haven currencies, and the euro serves as a hedge currency. Results for the yen support its role as a carry funding vehicle, but not necessarily that of a safe haven currency. While the focus is on effective exchange rates, the paper also contains a separate analysis of bilateral euro-based exchange rates, given the euro's prominent role during the euro area sovereign debt crisis.

Government Bond Liquidity and Sovereign-Bank Interlinkages

Banks in the euro area typically hold a large amount of government debt in their bond portfolios, which are valued both for their low credit risk and high liquidity. During the sovereign debt crisis, these characteristics of government debt were severely impaired in stressed euro area countries. In order to understand the transmission channels of stress from government debt markets to the real economy, we augment a standard dynamic macroeconomic model with a banking sector and a market for government debt characterized by search frictions. A sovereign solvency shock modelled as a haircut on government bonds is introduced to study the interaction of sovereign credit and liquidity risk. As banks react to this shock by rebalancing towards highly liquid short-run assets, such as central bank deposits, demand for government bonds collapses, which endogenously worsens their market liquidity. Thus, a sovereign liquidity risk channel from government bond markets to the real sector emerges. Endogenous government bond liquidity negatively affects the funding conditions of the fiscal sector, tightens financing constraints in the banking sector and lowers investment and output. The model is able to match a number of stylised facts regarding the behaviour of sovereign debt markets during the euro area sovereign debt crisis, such as depressed turnover rates and rising bid-ask spreads.

Nonlinear spillovers between euro area sovereign bond markets

Summary: This paper examines nonlinear spillover effects between sovereign bond markets of six euro area countries (France, Ireland, Italy, Germany, Portugal, and Spain), four of which were among the hardest hit by the sovereign debt crisis, by applying a nonlinear Granger causality test of Diks and Panchenko (2006). The test is applied on the sovereign bond yield dynamics (i.e. yield changes) time series for the time period from 3 January 2000 - 31 August 2011. We also test for pure spillovers between sovereign bond yield dynamics, i.e. the spillovers after controlling for common and regional factors that impact the sovereign bond yield changes of all countries simultaneously. To verify if the nature of spillovers has changed after the start of the euro are sovereign debt crisis, we test for the nonlinear spillovers for the whole observed period and separately for the period before and after the start of the euro area sovereign debt crisis (period from the start of April 2010 until the end of our sample, i.e. 31 August 2011). The results of our study show that strong bi-directional Granger causality exists between the investigated sovereign bond markets. Very similar results are obtained whether the regional and world factors are or are not controlled for. We find strong bi-directional non-linear Granger causality for the investigated euro area countries prior the euro area sovereign debt crisis. After the start of the euro area sovereign debt crisis the interdependence between the markets has reduced. We can no longer detect non-linear spillovers running from Germany and France to the periphery euro area countries. The findings of this study have important implications for the policymakers as they show that shocks spill-over quickly across the sovereign bond markets and the intensity and nature of spillovers can change throughout time. The sovereign bond markets of the core euro area decoupled from the periphery euro area sovereign bond markets after the start of euro are debt crisis. The findings are also of relevance for individual investors in the sovereign bond markets for the purpose of portfolio diversification.Keywords: sovereign bond markets, spillovers, non-linear Granger causalityJEL classification: F21, F36, G15, H63(ProQuest: ... denotes formulae omitted.)IntroductionSince the early 2010 euro area sovereign debt crisis has been on the top of the international, especially euro area economic policy agenda. The euro area sovereign debt crisis, triggered by mounting concerns about the public debt sustainability of Mediterranean countries and Ireland quickly spread across (i.e. spilled-over to) the euro area sovereign bond markets, thereby raising the question of public debt sustainability and management and the macroeconomic effects of the sovereign debt crisis. Prompted by financial market pressures, large-scale fiscal austerity measures have been announced in practically all monetary union member states.The knowledge of the size and nature of exposure of sovereign bond to market spillovers can help policymakers gain insight into public financing constraints and the external risks faced by national economy and their economic agents (Metiu, 2011). This knowledge is relevant also for private financial market participant. Since the works of Markowitz (1952) and empirical evidence of Grubel (1968) financial practitioners adhere to international diversification in order to reduces total risk of their international portfolio(s). When spillovers occur, the dependence between the returns of assets increases and the advantages of international diversification of investment portfolio reduces (Ling and Dhesi, 2010). Rational investors shall respond to changing patterns in dependence by adjusting their portfolios (Savva and Aslanidis, 2010).The most frequently applied methods in the literature on financial markets interdependence include the vector autoregressive (VAR) models, Granger causality tests (Malliaris and Urrutia, 1992, Gilmore and McManus, 2002), GARCH models (Tse and Tsui, 2002; Bae et al. …

Government Bonds Ammunitions for the ECB Quantitative Easing

The aim of this paper is to investigate a range of financial techniques and policy strategies for a Quantitative Easing (QE) program by the European Central Bank (ECB) that would rely on Euro area government bonds purchases under various modalities and guises. In particular, we provide an empirical study of different possible QE arrangements, with a special focus on a proposal of a securitization structure that could clear the different sovereign bonds from credit risk and heterogenerity. The securitization framework proposal is compared with a program of Euro-area public debt direct purchases under two alternative scenarios of: i) pari-passu creditor status of the ECB with respect to private investors; ii) preferred creditor status of the ECB. We consider three cases of “un-managed” (fixed composition) direct purchases according to which member states bonds are purchased in proportion to: i) the “capital key” representing equity holdings of ECB’s shares; ii) a “liquidity-key” representing the relative amount of sovereign bonds outstanding; iii) an equally-weighted portfolio of sovereign bonds. We evaluate the impact of various SPV characteristics - such as bond tranche attachment choice - as well as various financial market scenarios. For these choices we provide a risk management analytical framework based on Monte Carlo simulations. This allows us to compute the probability distribution of credit losses under various credit spreads and default correlation scenarios as well as to design appropriate stress testing procedures to gauge the robustness of our proposed GBB QE solutions. In this version of the paper our modelling strategy relies on the Gaussian copula assumption in default risk correlation. Using end of October 2014 CDS market quotes for 10 Euro-area sovereign bond market, as well as an estimate of a Gaussian copula measure based on historical CDS quotes time series, we conclude that the expected loss would be about 75 basis points on a 5 year horizon for a senior tranche bond with 30% attachment (that is absorbing losses on the government bond portfolio beyond 30% of its value). For all practical purpose, such expected loss and the corresponding credit spread value would be similar to the risk of the German Bund as measured at the same valuation date. As for the junior tranche bond credit risk, we reckon credit spreads between 200 and 300 basis points - depending on the underlying assumptions - which would be comparable with Portuguese government bond credit risk at the same valuation date. Our stress test analysis - based on historical data recorded in November 2011 (Euro area sovereign debt crisis acme) - shows that the securitization structure would effectively limit the credit risk increase on the senior tranche to 5-6% of expected losses estimated in our benchmark case on a 5 year horizon. As one should expect, this fairly solid protection to the senior tranche would come at the cost of a huge credit deterioration for the junior bond tranche to an expected loss level of 60%. This implication should make the junior tranche bond a financial product suitable only for sophisticated institutional investors.

The Stability of Short-Term Interest Rates Pass-Through in the Euro Area During the Financial Market and Sovereign Debt Crises

We analyse the dynamics of the pass-through of banks’ marginal cost to bank lending rates over the 2008 crisis and the euro area sovereign debt crisis in France, Germany, Greece, Italy, Portugal and Spain. We measure banks’ marginal cost by their rate on new deposits, contrary to the literature that focuses on money market rates. This allows us to account for banks’ risks. We focus on the interest rate on new short-term loans granted to non-financial corporations in these countries. Our analysis is based on an error-correction approach that we extend to handle the time-varying long-run relationship between banks’ lending rates and banks’ marginal cost, as well as stochastic volatility. Our empirical results are based on a harmonised monthly database from January 2003 to October 2014. We estimate the model within a Bayesian framework, using Markov Chain Monte Carlo methods (MCMC).We reject the view that the transmission mechanism is time invariant. The long-run relationship moved with the sovereign debt crises to a new one, with a slower pass-through and higher bank lending rates. Its developments are heterogeneous from one country to the other. Impediments to the transmission of monetary rates depend on the heterogeneity in banks marginal costs and therefore, its risks. We also find that rates to small firms increase compared to large firms in a few countries. Using a VAR model, we show that overall, the effect of a shock on the rate of new deposits on the unexpected variances of new loans has been less important since 2010. These results confirm the slowdown in the transmission mechanism.

Exporting Sovereign Stress: Evidence from Syndicated Bank Lending during the Euro Area Sovereign Debt Crisis*

We show that after the start of the euro area sovereign debt crisis, lending by non-GIIPS European banks with sizeable holdings of GIIPS sovereign bonds declined relative to nonexposed banks. This effect is not driven by changes in borrower demand or by other shocks to banks’ balance sheets. We also find that affected banks withdrew from all foreign markets with the exception of the USA, suggesting an increase in home bias. The slowdown in lending continued after ECB’s LTRO in December 2011, but it was lower for banks that increased their risky exposures in the early stages of the crisis.

Increase in Home Bias and the Eurozone Sovereign Debt Crisis

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.

New Economic Governance in the European Union: Another Constitutional Battleground?

The regulatory responses to the global economic and financial crisis and the subsequent euro area sovereign debt crisis raise serious constitutional questions not only at the supranational, European level, but mainly also at the level of the Member States; developments, fuel the long-standing debate on the relationship between the supranational legal order and the (constitutional) legal orders of the Member States, or as Micklitz and Schebesta (The European Court of Justice and the Autonomy of the Member States, 2012) put it ‘the challenge […] to define the limits of European integration inward looking’. This may put the much referred to cooperation and dialogue between the national highest (constitutional) courts and the CJEU to the tested yet again, in particular when observing the trend with some national highest (constitutional) courts to ‘not only perceive themselves as the ultimate guardian of fundamental rights, but increasingly also more broadly as defenders of a broader constitutional identity.’ Hereafter, this contribution commences with a brief flashback to the beginnings of European economic and monetary union (EMU) highlighting that the current judicial discourse on European economic governance and its democratic credentials is anything but new, as it finds its roots in the Treaty on the European Union. This contribution provides an overview of the new legal framework pertaining to economic policy coordination in the euro area and its impact on the national policy sphere is offered, followed by an analysis of a selection of decisions by national highest (constitutional) courts, thereby focusing on their dealing with the constitutional impact of various aspects of the European regulatory response to the crisis. In the concluding section a preliminary answer to the question raised in the title of this contribution is given.

Editors' Note

Our journal, I am proud to say, has been at the forefront of the coverage of the recent euro area sovereign debt crisis. And ordinarily, I would focus this editors’ note on extolling the virtues of the articles in this current issue that look back at the crisis and take lessons from it. Indeed we have a wonderful set of pieces: two on credit rating agencies and how they performed during the crisis (not so well), two on how litigation over sovereign immunity questions has played out quite differently in various jurisdictions around the world (and particularly, France and Hong Kong), one on the problem of empty voting in the sovereign debt context (the recent restructuring in Greece having brought to the fore certain key issues) and finally an article on the question of how secure deposits in euro area banks are these days, given the bail in provisions in recent EU legal texts (an issue that is at the forefront of the recent debates over the direction future banking regulation in the EU should take).

Persistence in the banking industry: Fractional integration and breaks in memory

Certain “spurious long memory” processes mimic the behavior of fractional integration in that the variance of their sample mean behaves like that of a fractionally integrated process of some order D . We show, however, experimentally that a fractional integration test may discriminate between spurious long memory of order D and integration of order D . Further, we suggest a test for the null hypothesis that the order of integration does not change from one subperiod to another. It simply builds on the difference of the estimates from the respective subsamples that are split exogenously. Upon appropriate normalization a limiting standard normal distribution arises. With these methods we tackle the question whether international and sectoral bank equity index returns are fractionally integrated and whether the memory parameters have changed. The daily data are split into three regimes: one pre-crises subsample, a second including the collapse of the Lehman Brothers bank, and a third covering the Euro area sovereign debt crisis. In particular, we provide evidence that both turmoils had differing international effects. • Integration test may discriminate between spurious long memory and true fractional integration. • Test for the null hypothesis that the order of integration does not change. • International and sectoral bank equity index return. • Collapse of the Lehman Brothers bank and the Euro area sovereign debt crisis had differing effects.

New Insights on the US OIS Spreads Term Structure During the Recent Financial Turmoil

The paper investigates the statistical features of the US OIS spreads term structure during the recent financial turmoil, originating from the subprime crisis and the ensuing euro area sovereign debt crisis. By means of a comprehensive econometric modeling strategy, new insights on US money market dynamics during the latter events are achieved. In particular, three common factors, bearing the interpretation of level, slope and curvature factors, are extracted from the term structure of US OIS spreads; the latter are found to convey additional information, relatively to commonly used credit risk measures like the TED or the BAA-AAA corporate spreads, which might be exploited, also within a composite indicator, for the construction of a macoreconomic risk barometer and macroeconomic forecasting.

New insights on the US OIS spreads term structure during the recent financial turmoil

The article investigates the statistical features of the US OIS spreads term structure during the recent financial turmoil, originating from the subprime crisis and the ensuing euro area sovereign debt crisis. By means of a comprehensive econometric modelling strategy, new insights on US money market dynamics during the latter events are achieved. In particular, three common factors, bearing the interpretation of level, slope and curvature factors, are extracted from the term structure of US OIS spreads; the latter are found to convey additional information, relatively to commonly used credit risk measures like the TED or the BAA-AAA corporate spreads, which might be exploited, also within a composite indicator, for the construction of a macroeconomic risk barometer and macroeconomic forecasting.

Carry Funding and Safe Haven Currencies: A Threshold Regression Approach

In this paper, we analyze which currencies can be regarded as safe haven currencies. Our empirical approach allows us to distinguish between a low and high stress regime, and to control for the impact of carry trade reversals and other fundamental determinants. We therefore address the question of whether a supposed safe haven currency only appreciates in times of crises because carry trades are unwound, in which the corresponding currency has served as funding currency, or whether it possesses “true” safe haven qualities; i.e. it provides a hedge against global stock market losses in stressful times even after controlling for the impact of carry trade reversals. The latter issue has largely been brushed aside in the extant literature but has important policy implications for the justification of central bank FX interventions in times of crises. According to the estimation results, two currencies, the Swiss franc and (to a lesser extent) the US dollar qualify as safe haven currencies, and the euro serves as a hedge currency. Results for the yen support its role as a carry funding vehicle, but not necessarily that of a safe haven currency. While the focus is on effective exchange rates, the paper also contains a separate analysis of bilateral euro-based exchange rates, given the euro’s prominent role during the euro area sovereign debt crisis.

Bank Funding Costs for International Banks

This paper investigates the determinants of bank funding costs for a sample of internationally active banks from 2001–12. We find that changes in banks’ unsecured funding costs are associated with bank-specific characteristics such as an institution’s credit worthiness and the return on its market value, and importantly, on the level and quality of capital. Similarly, market factors such as the level of investor risk appetite, as well as shocks to financial markets—notably the US subprime crisis and the Euro Area sovereign debt crisis—have also been key drivers of the sharp rise in bank funding costs. We also find evidence that large systemically important institutions have enjoyed a funding advantage, and that this advantage has risen since the onset of the two crises. With the exception of Euro Area periphery banks, by end-2012 the rise in funding costs had generally been reversed for most major banks as a result of improvments in bank asset quality as well as steps taken to increase resilience, notably higher capitalization. Our results suggest increased capital buffers may potentially support bank lending to the real economy by reducing bank funding costs.

The euro area sovereign debt crisis: Can contagion spread from the periphery to the core?

We examine the determinants of joint default risk of euro area countries during 2007–2011. To accomplish this, we recover joint default probabilities from individual CDS contracts. In contrast to earlier theoretical studies, we find that financial linkages are an active contagion transmission channel only in the case of the troubled periphery euro area economies. During the current sovereign debt crisis, real economy linkages play a more important role in transmitting shocks from the euro area periphery towards its core. Countries that have stronger trade interconnections with troubled economies tend to have a higher expected joint default risk.

Long-Term Bank Funding Cost: Does Sovereign Matter?

We analyze the long-term funding costs faced by banks from US, UK and euro-area on the international bond market with a focus on the value of implicit and explicit public guarantees. By looking at the risk-premia at issuance on 5,500 bonds, we find that: i) both explicit guarantees as well as sovereign creditworthiness have a substantial effect on the cost of bonds; ii) large institutions enjoy lower issuance costs, most likely due to the too-big-to-fail safety net; iii) since the onset of the global financial crisis, systemic banks (the so called G-SIFIs) underwent an enhanced market discipline paying an additional premium on new bond issuances. In particular, we show that non AAA-rated governments add a burden to the cost of debt issuance by the domestic banking system. This implicit negative support intensified in the most acute phase of the euro-area sovereign debt crisis: we estimate that the absence of the backing of an AAA-rated government amounted, ceteris paribus, to an average increase of 150bp in the cost paid by banks when issuing unsecured bonds in 2011. However, once we restrict the sample to banks for which CDS spreads are priced in the market – usually larger institutions which are more involved in the issuance activity – we find that the bond premium reflects more closely the characteristics of each institution (soundness and creditworthiness), with the role of government somewhat reduced. By distinguishing between banks’ absolute size and systemic relevance, we find that financial investors were able to disentangle the two issues. Or results suggest that the larger the magnitude of the balance sheet the lower the premium paid at launch on bonds, which in turn suggests that the safety net benefits granted to too-big-to-fail institutions encompass also lower funding costs on the primary bond market. At the same time, we find that there are matters of concern regarding the systemic relevance of financial institutions: their involvement in complex derivative trades and their business model have made them less transparent and less easy to price. In this respect we find evidence of enhanced market discipline: since the onset of the global financial crisis systemically important banks – which before the crisis were enjoying a reduction in the spread – paid, ceteris paribus, a larger premium of around 50 basis points on their bond issuance.

PERSPECTIVES OF THE EURO AREA SOVEREIGN DEBT CRISIS FOR THE BRAZILIAN ECONOMY

The objective of this article is to show the perspectives of the euro area sovereign debt crisis for the Brazilian economy. The euro area sovereign debt crisis, beginning in 2010, could be seen as fallout of the global financial crisis of 2008/09. The ways to the crisis for Portugal, Ireland, Italy, Greece and Spain were different: Credit booms and housing bubbles, banking crises, unsustainable public indebting. The impacts on Brazil were felt in 2011 and 2012 with the Brazilian economy almost stagnating. The article evaluates the impacts of the global financial crisis 2008/09 on the Brazilian economy through real and monetary channels, as well as through the contagion of expectations, to find similarities with the present crisis. The main influence was the fall of Brazilian exportations and the credit crunch following the failure of Lehman Brothers in September 2008. The article supposes that the impacts of the euro area crisis shall be less problematic than that of the global financial crisis of 2008/09, because exportations are geographically more diversified and a credit crunch could be confronted by the BNDES and the public banks in Brazil. But the main argument is that the stability of Brazilian institutions, the geographical diversification of exportations and the increasing demand for commodities by the emerging markets in Asia will soften the impacts of the present crisis for Brazil, supposing that contagion of the sovereign debt crisis in the euro area will not expressively hit the more important economic powers in Europe and the world. The causes of the stagnating Brazilian economy in 2012 probably are not only the problems in the euro area.