Euro Area Sovereign Debt Research Articles

Forecasting in turbulent times

AbstractSince the beginning of this century, the global economy has been hit by a series of unforeseen shocks, including the Global Financial Crisis, the euro area's sovereign debt crisis, and most recently, the global inflation surge. To motivate this special issue, we provide a brief overview of recent methods that have been proposed to improve the ability of forecast models to predict shocks and to capture their effects once they have occurred. We also propose a method that may allow central banks to respond more quickly to the kind of inflationary surge that occurred from 2020 to 2022 so that those banks would not have misdiagnosed the surge as a temporary phenomenon.

The importance of deposit insurance credibility

Sovereigns usually back up their deposit insurance arrangements to lend them credibility. When the sovereign is in distress, the credibility of deposit insurance might be threatened, with detrimental effects to financial stability. We investigate the behavior of depositors during the euro area sovereign debt crisis to understand the importance of deposit insurance credibility. We find that depositors responded to foreign banks’ decision to convert their subsidiaries into branches. By relocating their deposits into these newly formed branches during a period of sovereign distress, depositors became insured by a deposit insurance scheme with a stronger fiscal backstop. These results document a novel channel through which sovereign-bank links can be reinforced during a crisis: the credibility of deposit insurance.

RETURN SPILLOVERS BETWEEN EMERGING MARKETS’ FINANCIAL STRESS AND EQUITY MARKETS OF BRIC-T COUNTRIES

This study explores the connectedness between selected emerging equity markets (BRIC-T) and the
 Emerging Markets Financial Stress Index (EMFSI). We aim to reveal the extent of spillovers from stock
 market indices to aggregated financial tension in these countries. Empirical investigations are executed
 through Quantile Vector Autoregression analysis. Results show that spillovers occur mainly during extreme
 negative and positive return periods. When we focus on four important phases, namely Global Financial
 Crisis (GFC), the Euro Area Sovereign Debt Crisis, the COVID-19 pandemic, and the Russia-Ukraine war,
 three countries come to the fore. While Brazil has had a substantial and persistent impact across the years,
 during the GFC, two other countries, Russia and Türkiye, seem to induce positive return spillovers toward
 emerging markets’ stress. This impact becomes bilateral in Russia (both in positive and negative returns)
 during the pandemic and the Russia-Ukraine war. Thus, we conclude that among the examined market
 economies, negative or positive return transmissions to emerging market stress are led mainly by Brazil and
 Russia. The importance of energy sources and political factors can account for this result.

Fiscal multipliers within the euro area in the context of sovereign risk and bank fragility

This work quantifies the size of fiscal multipliers in an economy with sovereign and bank default risks. The paper presents an estimated two-region dynamic stochastic general equilibrium model with financial frictions for the euro area, where the interplay of corporate, bank, and sovereign solvency risk affects the transmission of government spending. Sovereign bonds carry a credit risk premium that is particularly sensitive to government indebtedness in some regions of the currency union. The banking system is fragile due to its direct and indirect exposure to sovereign risk and limited loss absorption capacity. By calibrating the model on sovereign and bank riskiness reminiscent of the euro area Sovereign Debt Crisis, we show that adverse financial channels may significantly depress the transmission of expansionary government spending shocks. The modeling approach also enables assessing the scope for monetary and regulatory policies to mitigate financial setbacks and restore the effectiveness of fiscal interventions.

GELİŞMEKTE OLAN PİYASALARIN FİNANSAL STRESİ VE BRIC-T ÜLKELERİNİN HİSSE SENEDİ PİYASALARI ARASINDAKİ GETİRİ YAYILIMI

This study explores the connectedness between selected emerging equity markets (BRIC-T) and the
 Emerging Markets Financial Stress Index (EMFSI). We aim to reveal the extent of spillovers from stock
 market indices to aggregated financial tension in these countries. Empirical investigations are executed
 through Quantile Vector Autoregression analysis. Results show that spillovers occur mainly during extreme
 negative and positive return periods. When we focus on four important phases, namely Global Financial
 Crisis (GFC), the Euro Area Sovereign Debt Crisis, the COVID-19 pandemic, and the Russia-Ukraine war,
 three countries come to the fore. While Brazil has had a substantial and persistent impact across the years,
 during the GFC, two other countries, Russia and Türkiye, seem to induce positive return spillovers toward
 emerging markets’ stress. This impact becomes bilateral in Russia (both in positive and negative returns)
 during the pandemic and the Russia-Ukraine war. Thus, we conclude that among the examined market
 economies, negative or positive return transmissions to emerging market stress are led mainly by Brazil and
 Russia. The importance of energy sources and political factors can account for this result.

Dynamic connectedness between credit and liquidity risks in euro area sovereign debt markets

We examine the dynamic interconnections between sovereign credit and liquidity risks in ten euro area countries at the 5-year maturity with daily CDS data from IHS Markit and high-frequency data from MTS between 2008 and 2018 using the extended TVP-VAR connectedness approach of Antonakakis et al. (2020). We find that, for most of the period, net connectedness is from credit risk to liquidity risk, but this indicator is time-dependent, detecting some episodes where it goes from liquidity risk to credit risk. We set up an event study and discover that most of the latter episodes can be related to several unconventional monetary policy measures of the ECB. Then, we examine the drivers of the connectedness indicator using a Probit model. Our results suggest that a decline in global funding liquidity, monetary policy shocks and economic policy uncertainty increase the probability of risk transmission from liquidity to credit, while tensions in financial markets and the deterioration of fiscal sustainability are factors that reduce such a probability.

The euro area sovereign debt crisis and the sovereign debt Laffer curve: a historic assessment for 1999–2014

This article addresses the historical evolution of sovereign debt trajectories since the beginning of the euro area up to the corresponding sovereign debt crisis, using certain key economic concepts previously proposed by the literature in connection to other historic sovereign debt events. It first recovers the concept of the sovereign debt Laffer curve, which efficiently addresses the non-linear relationship between economic output and public debt issuance. It then presents an important set of theoretic economic concepts that accurately describe the onset of debt vulnerabilities negatively impacting economic growth, therefore linking these fundamental but heterogeneous public debt-related concepts under the unifying concept of the said sovereign debt Laffer curve, which adequately encompasses these heterogeneous concepts. For example, fundamental concepts such as debt vulnerability, ‘debt overhang’, or ‘illiquidity vs. insolvency’ are adequately contextualized under the said Laffer curve. This innovative historical perspective might be useful in the analysis of subsequent sovereign debt crises, as well as in tackling future research in public debt sustainability, namely where the design and implementation of sustainable public debt policies in advanced economies is concerned.

Asset purchase bailouts and endogenous implicit guarantees

This paper provides a theory of endogenous implicit guarantees on risky assets, in which a government’s bailouts take the form of asset purchases to alleviate asymmetric information on private liquidity needs. As a result of asymmetric information, direct transfers to agents are imperfect so that, when more constrained agents are also more exposed to a given asset, asset purchases by the government are optimal. When anticipated, this form of bailouts leads to an endogenous implicit guarantee premium so that otherwise risky assets can be traded as if there are risk-free. This possibility of implicit guarantee is amplified by other financial frictions such as risk-shifting. Finally, I show how this form of bailouts can shed light on the buildup of the euro area's sovereign debt crisis.

Dynamics of the public-debt-to-gdp ratio: can it explain the risk premium of treasury bonds?

We examine the relationship between the risk premium markets demand to hold the Treasury Bonds of a given country and the sustainability of the public finances of the country. We inquire to what extent do markets use the dynamic evolution of the public-debt-to-gdp ratio as an indication of the likelihood of a public debt default. Specifically, our empirical research design involves the following steps: (i) we use the dynamic equation of the public-debt-to-gdp ratio to build forecasts of future values of this ratio in the eurozone countries; (ii) we then use these forecasts in a regression to see how important they are to explain the risk premium implicit in the treasury bond yields. We find that projections of future values of the public-debt-to-gdp ratio do impact current 10 year bond spreads. According to our regressions, markets seem to give more weight to forecasts with a horizon smaller than 10 years. Our results suggest that agents use a relatively simple mechanism to forecast the public debt-to-gdp ratio, a mechanism which can be used while updated forecasts from international organizations are not yet available. On the other hand, according to our estimations, euro area sovereign debt markets ceased to significantly discriminate countries based on their public debt prospects after the 2012 ‘Whatever It Takes” speech and the announcement of the Outright Monetary Transactions (OMT) program—suggesting that these events had a significant calming effect on the markets.Supplementary InformationThe online version contains supplementary material available at 10.1007/s10663-022-09547-8.

Financial risks, monetary policy in the QE era, and regulation

At the beginning of the present century, the literature on financial integration focused on the benefits of increased integration. In particular, the literature emphasized that a well-integrated financial system allows economic agents to engage in risk sharing while enhancing the smooth transmission of monetary policy. However, the international financial crisis of 2007-08 and the euro area sovereign debt crisis of 2009-15, brought to the fore the flip side of increased financial integration – namely, that higher financial integration among national jurisdictions creates the potential for destabilizing cross-country spillovers of capital flows. The papers in this Special Issue address financial system vulnerabilities in the aftermath of the 2007-08 financial crisis and the 2009-15 euro area crisis. In particular, the papers assess (1) vulnerabilities arising from such factors as the liberalization of financial systems, cross-country contagion, and climate change, and (2) policy responses, including macroprudential supervision and quantitative easing, to financial instabilities.

Public sector efficiency in the design of a COVID fund for the euro area

This study examines the importance of incorporating public sector efficiency considerations in the design of a “COVID Fund” in the euro area, aimed at providing insurance for member states against common health shocks. To test our proposition, we examine the efficiency of government spending on health during periods of severe resource constraints, which mirrors what occurs during pandemics like COVID-19. Specifically, we considered 19 administrations in the euro area during the global financial crisis and euro area sovereign debt crisis that followed. The results support our proposition. First, they reveal the average efficiency for all 19 administrations to be 0.950, which implies that member countries had wasted about 5% of funds allocated to health during this period. This suggests the need for the supranational institution to first of all ensure improvements in the use of public funds allocated to health by national governments in order to prevent wastage of the financial aid transferred to them during pandemics. Also, two of the four administrations that adopted the Economic and Financial Adjustment Programme of the troika (Portugal and Greece) during the twin crisis were among the most efficient. This suggest that making conditionalities an integral part of the central coordination of health funds during pandemics will result in improvements in the efficiency of funds transferred to member states.

Getting Closer or Falling Apart? Euro Area Countries After the Sovereign Debt Crisis

We study convergence and divergence dynamics in a sample of euro area countries by assembling an extensive dataset that contains information on public spending and policy outcomes in a variety of areas of government intervention including education, health, and civil justice from the early 1990s. We also focus on other important determinants of a country’s economic performance such as the level of regulation of product and labor markets, as well as the trust in political institutions, quality of governance, and inequality. Results show that despite divergent economic growth in the euro periphery countries after the 2010–2012 sovereign debt crisis, the quality of services and level of regulation did not deteriorate or indeed improved, increasing convergence with the core euro countries. However, the euro area sovereign debt crisis dramatically worsened citizens’ perceptions of quality of governance, as well as the level of social trust. This calls in question the future political viability of the EMU project and asks for reform.

Stabilising virtues of central banks: (Re)matching bank liquidity

The liquidity of financial system plays a central role in systemic crises. In this paper, we show that the ECB haircut policies provided an important liquidity support to distressed financial institutions during the euro area sovereign debt turmoil. Using novel, micro data on the pool of collateral eligible to ECB open market operations, we construct a “public” liquidity mismatch indicator (LMI) for the French aggregate banking sector based on the ECB haircuts. We then compare it to the “private” LMI based on the haircuts in private repo markets in the spirit of Bai et al. (2018). The difference between the two indicators represents a new measure of the ECB liquidity support. Our results suggest that the ECB haircut policies indeed helped French banks to reduce the liquidity mismatch. Moreover, higher ECB liquidity support is associated with higher cash and sovereign asset holdings by the French banks as well as with their lower probability of default.

Random forest versus logit models: Which offers better early warning of fiscal stress?

AbstractThis study seeks to answer whether it is possible to design an effective and useful machine learning‐based early warning system signaling a risk of fiscal stress in the near future. To do so, multiple models based on econometric logit and the random forest models are designed and compared. Using a dataset of 20 annual frequency variables pertaining to 43 advanced and emerging countries during 1992–2018, the results confirm the possibility of obtaining an effective model, which correctly predicts 70–80% of fiscal stress events and tranquil periods. The random forest‐based early warning model outperforms logit models both in terms of aggregate forecasting properties and when applied to an example of the euro area sovereign debt crisis. While the very effective random forest model is commonly understood to provide lower interpretability than logit models do, this study employs tools that can be used to provide useful information for understanding what is behind the black‐box. These tools can provide information on the most important explanatory variables and on the shape of the relationship between these variables and the outcome classification. Thus, the study contributes to the discussion on the usefulness of machine learning methods in economics.

Sovereign debt ratings and the country composition of cross-border holdings of euro area sovereign debt

This paper documents how sovereign debt ratings shape the country composition of euro area cross-border holdings of euro area sovereign debt, using granular sectoral security holdings statistics for the period 2009Q4 until 2016Q1. Credit risk is the main risk for bond investors when investing in bonds that are issued in the same currency as the currency of the investor’s home country. Sovereign debt ratings provided by rating agencies give investors key information on the creditworthiness of governments. The results in this paper show that investors respond differently to credit ratings. In particular, we find that investors from core euro area countries respond more to credit ratings than investors from peripheral euro area countries. The results show that banks and insurance companies in core countries hold significantly more sovereign bonds of countries with higher credit ratings. In peripheral countries we do not find a positive relationship between ratings and sovereign bond holdings.

Surviving the perfect storm: The role of the lender of last resort☆

When banks are hit by a severe liquidity shock, central banks have a key role as lenders of last resort. Despite the well-established importance of this mechanism, it is challenging to analyze it empirically. We explore a unique setting in which banks suddenly lost access to market funding due to contagion fears at the onset of the euro area sovereign debt crisis. Using monthly data at the loan, bank, and firm level, we test the role of the central bank in a scenario of imminent collapse. We find that the liquidity obtained from the central bank played a key role in temporarily supporting the supply of credit to the real economy. However, the subdued loan demand, together with moral suasion and carry trade incentives, led to an increase in banks’ sovereign bond holdings using central bank funding.

Public debt, sovereign spreads and the unpleasant arithmetic of fiscal consolidations

AbstractIn response to severe fiscal consolidation policies implemented after the Great Recession and the euro area sovereign debt crisis, many have questioned the effectiveness of fiscal consolidations in reducing the burden of public debt. This paper revisits this fundamental policy debate qualitatively and quantitatively, studying conditions under which primary budget balance changes can successfully reduce government debt‐to‐GDP ratios. We first illustrate these conditions through a partial equilibrium setting. We then investigate the conditions quantitatively using a medium‐scale New Keynesian DSGE model calibrated on periphery countries of the euro area. The analysis highlights the critical role of sovereign spreads in driving the debt‐to‐GDP dynamics following a restrictive primary balance shock. Fiscal consolidations turn out to successfully reduce the debt‐to‐GDP even for fairly low elasticities of spreads to fiscal variables. However, their effectiveness is quantitatively moderate and varies crucially with the initial spread level, with the degree of monetary policy accommodation, and with the responsiveness of market investors to economic fundamentals.

Eurobonds: Three Lessons from China’s “Debt Centralization/Decentralization” Experience

Abstract Eurobonds, dubbed as Coronabonds in the context of the current coronavirus crisis, are being hotly debated among the euro area member states amid the COVID-19 pandemic. The debate is in many ways a retread of the euro area sovereign debt crisis of 2011–2012. As China’s “debt centralization/decentralization” experience is comparable with the introduction of Eurobonds in the European Union (EU) in terms of institutional mechanism design, we review our previous series of studies of China’s “debt centralization/decentralization” experience to shed some light on the Eurobonds debate. We obtain three key lessons. First, the introduction of Eurobonds in EU is likely to soften the budget constraint of the governments of the euro area member states. Second, it is also likely to strengthen the moral hazard incentives of the governments of the euro area member states to intentionally overstate their budget problems. Finally, the magnitudes of the moral hazard effects generated by the introduction of Eurobonds in EU are likely larger than their respective counterparts in China.

The political economy of euro area sovereign debt restructuring

The establishment of a sovereign debt restructuring mechanism (SDRM) is one of the important issues in the academic debate on a viable constitution for the European Monetary Union (EMU). Yet the topic seems to be taboo in official reform contributions to the debate. Against this backdrop, the article identifies the SDRM interests of key players, including the European Commission, the European Parliament, the European Central Bank and national governments. The empirical section takes advantage of the recently established EMU Positions Database. The findings confirm political economy expectations: Low-debt countries support an EMU constitution that includes an insolvency procedure whereas a coalition of high-debt countries and European institutions oppose it. The analysis points towards a possible political-economic equilibrium for coping with sovereign insolvencies: an institutional set-up without an SDRM and with hidden transfers. Recent European fiscal innovations in response to the Covid-19 solvency shock confirm this prediction.

Collateral in Bank Lending During the Financial Crises: A Borrower and a Lender Story

We analyse whether and to what extent both firm and bank soundness are associated with the use of collateral in bank lending, and whether these relationships changed during the global financial crisis and the euro-area sovereign debt crisis. By using a large dataset of 2 million observations at bank and firm level covering the years 2007-13, we find that the degree of collateralization is higher for firms that are financially stressed and have low capitalization and that it increases further for these borrowers during downturns. In addition, we find that collateral policies are tighter at sounder banks, that is, at banks that are more capitalized and have a lower burden of bad loans. This result is consistent with the existence of a negative link between bank soundness and risk-taking in bank lending.