Sovereign Debt Market Research Articles

Regulatory Changes and Long-run Relationships of the EMU Sovereign Debt Markets: Implications for Future Policy Framework

We estimate the time-varying long-run correlations of European sovereign bond markets to identify specific effects that are attributed to changing European regulatory and political dynamics over the last twenty years. Our empirical results from using the DCC-MIDAS methodology indicate that regulatory changes in Europe have created significant and negative impact on the long-run correlations within the month where the regulation is decided to be taken into action. This impact still remains in the following months and robust with respect to the trend component of the long-run correlations. A direct implication is that the more regulations the EU attempts to put in place, the lower the long-run convergence process of sovereign bond markets is. We then analyse the structural shifts in the long-run correlation dynamics with penalized contrasts methodology and try to find out the reasons of these severe changes. Accordingly, some of the structural shifts overlap with the dates of a limited number of regulatory changes, in addition to the major global economic and political events.

Financing for the Post-Pandemic Recovery: Developing Domestic Sovereign Debt Markets in Central America

Financing for the Post-Pandemic Recovery: Developing Domestic Sovereign Debt Markets in Central America

The evolution of European economic institutions during the COVID-19 crisis.

This article argues that the incomplete economic and institutional integration of the euro area has exposed the monetary union to increasing economic divergence, which could be deepened by the COVID‐19 crisis. We discuss how monetary and fiscal measures implemented at the onset of the pandemic have contributed to mitigate the economic consequences of lockdowns, but provided limited insurance to narrow economic gaps across member countries. However, EU countries agreed on July 21, 2020 to develop, for the first time, countercyclical fiscal transfers financed by common debt issuance. We discuss the potential of this instrument to contribute to improve the resilience of the eurozone.

Sovereign illiquidity and recessions.

This paper examines the importance of sovereign debt market liquidity in a New Keynesian environment with wage rigidities and financial frictions à la Kiyotaki and Moore (2012). The analysis implies that, independently of credit risk, a decrease in the liquidity of government bonds has significant detrimental effects on output, employment and investment. A shut down of sovereign debt market for one quarter generates a 7% drop in output and investment as well as a 2% increase in unemployment. Also, in a framework where the only sources of variation are private and public liquidity shocks, sovereign bond market illiquidity can account for most of the output drop in Italy between 2011q2 and 2013q1. These results suggest that European Central Bank’s (ECB) temporary policies taken in 2012 aimed at rising liquidity seem to have prevented a more prolonged and deeper economic downturn.

Avoiding a Lost Decade -- Sovereign Debt Workouts in the Post-COVID Era

All sovereign debt restructurings risk undershooting (providing less debt relief than is needed to restore the country to long-term sustainability) or overshooting (extracting more debt relief from creditors than turns out to have actually been necessary). Of these, undershooting will be the greater risk in sovereign debt workouts in the post-COVID era. Bondholders can be expected to prefer short and shallow debt restructurings that provide near-term debt relief (time enough to sell out of sticky positions). As for the future, creditors will endorse Doris Day’s assessment — que será será. For their part, politicians in the debtor country may also prefer a quick restructuring that provides abundant short-term debt relief even if it complicates the life of the next administration. The last time a systemic emerging market sovereign debt crisis was handled through a series of short and shallow debt restructurings was in the 1980s. It bequeathed to the debtor countries what is still called the Lost Decade. Can a similar fate be avoided in the decade that has just begun?

Bailouts, Inflation, and Risk-Sharing in Monetary Unions

This paper presents a new rationalization for bailouts of sovereign debt in monetary unions, such as those observed during the recent Euro crisis. It introduces a model where member countries of the monetary union are ex-ante identical, and each derives utility from consumption and disutility from the union-wide inflation rate. The union’s central bank is utilitarian and lacks commitment. Countries borrow or save in a market for nominal sovereign debt in response to idiosyncratic income shocks, with countries that receive positive income shocks saving and countries that receive negative income shocks borrowing. Ex post, the monetary union’s central bank will attempt to devalue sovereign debt through surprise inflation, as this will redistribute income from rich creditor countries to poor debtor countries. Creditor countries choose to bailout debtor countries because bailouts will weaken the redistributive motives of the central bank and forestall surprise inflation. As bailouts in this environment constitute a payment from lucky creditor countries to unlucky debtor countries, they mimic a risk-sharing arrangement that insures against income shocks. The payments made by creditor countries are incentive-compatible due to the shared currency and inflation rate in the monetary union. This ability of countries to provide each other with incentive-compatible insurance constitutes a novel theory of optimal currency areas. This insurance benefit of the monetary union is largest for countries with negatively correlated income shocks, in contrast to the classic Mundell-Friedman optimal currency area criterion.

Global Justice: Why not State jurisdictions in transnational financial disputes?

Abstract The article brings the debate about Global Justice to the centre stage of the Sovereign Debt Restructuring (SDRs) field. The judicial system that intervenes in sovereign debt conflicts was not on the agenda of the last reform processes activated in this field. In the NML Capital vs. Argentina (NML) trial, judges from different instances and different jurisdictions issued declarations of the same dimensions related to the same object of litigation. The article makes a comparative analysis of the argumentative strategies that judges used at the time of justifying their positions in order to show the tensions in which they incurred. It is explained that: a) these tensions are the result of agents -the judges- that must take decisions in a context of crossroads where the expected option in accordance with usual legal practices would undermine their own position in the field of sovereign debt market; b) these crossroads are rooted in the structural limits of the judicial system in which these agents operate. Contrary to what official statements postulate, it is argued that these limits conspire against the possibility that state courts provide Justice in transnational disputes, in which they must judge another equally sovereign State.

Avoiding Sovereign Default Contagion: A Normative Analysis

Sovereign debt crises happen in waves, spreading from one country to the other. The euro-area debt crisis of 2011-12 is a good example of that. Stress in the sovereign debt market quickly spread from Greece and Ireland to Portugal, Spain, and Italy.

The Efficiency of Sovereign Debt Markets in the EMU: Truth or Mistruth?

Ever since the last financial crisis, the efficiency of financial markets has been widely challenged. On the basis of sovereign debt markets in the European Monetary Union (EMU), we tried to contrast some reservations about the market efficiency existing in the literature with findings coming from our empirical analysis of weak-form efficiency. To do so, we first outlined the crux of the efficient market hypothesis. Secondly, we show the main reservations in relation to this concept. Then, after a brief review of outcomes from contributions in this area, we conducted a three-stage empirical procedure that Worthington and Higgs (2006) as well as Borges (2009) had employed to stock markets analysis. Then, the results were evaluated and conclusions were drawn. To sum up, we did confirm the weak-form efficiency on examined sovereign debt markets from the EMU. That suggests that a random process plays a key role in shaping bond yields. Finally, neither theoretical nor practical reservations deflate the weak-form efficiency in the public debt markets of the EMU.

The Role of Macroeconomic Variables in Sovereign Risk

The sovereign debt market has gathered a lot of attention post the global financial recession therefore it is very important to study how the countries of the eurozone countries can be shielded from all internal and external risks. This can be achieved by examining the macroeconomic determinants of the sovereign risk. Based on the results of the panel regression, it becomes evident which financial indicators are contributing to the sovereign risk. In terms of the stochastic properties, when homogeneity is assumed among the cross-sectional units, all the variables appeared to be level stationary except for the total government bond yield. However, when heterogeneity is assumed among the countries, variables such total government bond yield, GDS as a percentage of GDP, total credit to private sector, employment as a ratio to total GDP, and bank credit are level none stationary. Consequently, these findings will help identify the variables that can be used to approximate the movement of the government bond yield.

Covered Interest Rate Parity Deviations in External Emerging Market Sovereign Debt

Non-US dollar denominated external emerging market debt issuance in euros, yen, and sterling has grown substantially in recent years. This article is the first study to explore how non-dollar external emerging market bonds violate covered interest rate parity relative to their dollar-denominated external emerging market debt counterpart bonds for a given country. Such mispricing in the post-Great Recession era creates arbitrage opportunities for investors and suggests that emerging market country policymakers could create fiscal savings by instead issuing external sovereign debt in dollars more cheaply (versus non-dollar developed world currencies like euro, yen, and sterling) and swapping the proceeds to non-dollar currencies with currency forward and spot transactions. Such hypothetical fiscal savings from switching to dollar funding collectively are estimated to be more than $1 billion annually. TOPICS:Fixed income and structured finance, exchanges/markets/clearinghouses, emerging markets Key Findings • This article is the first study to explore how non-dollar external emerging market bonds violate covered interest rate parity relative to their dollar-denominated external emerging market debt counterpart bonds for a given country. • Such mispricing creates investment opportunities and suggests that by instead more cheaply issuing external sovereign debt in dollars (versus non-dollar developed world currencies like euro, yen, and sterling) and swapping the proceeds to non-dollar currencies, emerging market country policymakers could create substantial fiscal savings from switching to dollar funding.

Role of deposit insurance schemes on financial markets

In the paper, 109 deposit insurance schemes have been evaluated in terms of their investment policies designed for funds collected from banks. Almost half of them develop investment strategies involving the activity on the financial markets. Nevertheless, the strategies have to be compliant with the applicable local regulations. The aim of the paper is to evaluate the impact that deposit guarantors may have on the financial markets, mainly on the sovereign debt market. In this regard at least two mechanisms negatively influencing the stability of national sovereign debt market have been identified. The research confirmed that the activity of deposit guarantee funds may have destabilising effects but they have not been addressed so far in legal framework for deposit insurance schemes.

Arbitrage in International Sovereign Debt Markets? Evidence from the Inflation Protected Securities of Six Countries

We consider an arbitrage strategy that exactly replicates the cash flow of a sovereign nominal bond using inflation swaps and inflation‐linked bonds. The strategy reveals a violation of the law of one price in the G7 countries, which is largest for the eurozone. Testing the strategy's exposure to deflation, volatility, liquidity, and macro‐economic risks shows the observed mispricing is a risk premium, which is more pronounced in the eurozone. We find less support that financial limits to arbitrage explain the mispricing. We conclude that pure long‐run arbitrage opportunities persist when these strategies are exposed to intermediate financial risks.

Time‐Varying Price Discovery in Sovereign Credit Markets

We analyze the time-varying nature of the price discovery process in the sovereign debt market over the sample period January 2006 – September 2015. In particular, we test whether the cointegration relationship that should tie bond and CDS spreads together holds over the entire sample. In addition, we investigate which (if any) of the two markets leads the price discovery in each of a number of sub-samples. We focus on ten European countries (Portugal, Italy, Ireland, Greece, Spain, Netherland, Germany, France, Austria, and Belgium), the UK, and the US. We find that while for all the peripheral countries but Greece the CDS and bond spreads show a long-run equilibrium relationship over the full sample, this is not the case for core European countries, the UK, and the US. Moreover, when the cointegration relationship fails to hold, none of the two markets appears to lead the price discovery process.

Covered Interest Rate Parity Deviations In External Emerging Market Sovereign Debt

Non-U.S. dollar denominated external emerging market debt issuance in euros, yen, and sterling has grown substantially in recent years. This paper is the first study to explore how non-dollar external emerging market bonds violate covered interest rate parity relative to their dollar-denominated external emerging market debt counterpart bonds for a given country. Such mispricing in the post-Great Recession era creates arbitrage opportunities for investors and suggests that emerging market country policymakers could create fiscal savings by instead more cheaply issuing external sovereign debt in dollars (versus non-dollar developed world currencies like euro, yen, and sterling) and swapping the proceeds to non-dollar currencies with currency forward and spot transactions. Such hypothetical fiscal savings from switching to dollar funding collectively are estimated to be more than $1 billion annually.

Courts as Information Intermediaries: A Case Study of Sovereign Debt Disputes

When foreign sovereigns default on their debt, creditors sometimes sue them. These creditors are sophisticated actors, and they sue even though courts can do little to force a sovereign to satisfy a judgment. Why do they sue? This Article argues that courts serve as information intermediaries that strengthen reputational enforcement in the international sovereign debt market. It shows, through a case study of sovereign debt defaults and disputes, three ways in which courts play this role. First, in hard cases, courts clarify reputational signals by publicly determining whether breach occurred. Second, through discovery and fact finding, they mitigate information asymmetries concerning aspects of sovereign behavior during default that are difficult to monitor. Third, they provide a forum for shaping the norms by which behavior is judged. The sovereign debt market thus relies on a hybrid of legal and nonlegal enforcement. Parties appeal to the law to determine rights and detect bad behavior. At the same time, they depend on reputation to discourage violations. Contracts scholars debate the extent to which nonlegal mechanisms such as reputation can support trade. Recognizing that courts can function as information intermediaries implies that courts can expand the range of markets that reputation can support. Under certain conditions, courts can supplement legal remedies by transmitting accurate and credible information about market participants’ expectations and behavior.

¿Gobernanza financiera?: comparación de las matrices políticas de las que emergieron las CACs 2003 y 2014

Resumen El discurso de la gobernanza fomenta la producción de modalidades regulativas de alcance global a partir de lógicas diferentes a la del mercado y a la del Estado. Los promotores de los modelos de Cláusulas de Acción Colectiva (CACs) de 2014 señalaron que la matriz política que los diseñó se construyó en buena medida sobre la base de la experiencia de la reforma contractual precedente (2001-2003); ahora bien, también advirtieron de su carácter innovador. Este artículo compara las matrices políticas de las que emergieron las CACs 2003 y 2014 mostrando quiénes participaron en ellas y cómo se articularon. El análisis muestra empíricamente que en ambos procesos se involucraron prácticamente los mismos agentes, aunque a partir de una dinámica de cooperación diferente: los rasgos típicos-ideales de la gobernanza se visualizan más en la segunda que en la primera experiencia. Sin embargo y a contramano de lo que postulan sus promotores, se argumenta que se trata en los dos casos de formas de gobernanza imperfecta que excluyen estratégicamente de los procesos de producción de estas normativas globales a aquellos agentes con potencialidad para disputar el poder a las elites que dominan el mercado de deuda soberana desde la década de los años 1970/1980.

Capital flows and sovereign debt markets: Evidence from index rebalancings

We analyze how capital flows into the sovereign debt market affect government bond prices, liquidity, and exchange rates. To address endogeneity concerns, we construct a measure of informationless capital Flows Implied by (mechanical) Rebalancings (FIR) in the largest emerging markets local currency government debt index. FIR is associated with higher returns and greater depth in the sovereign debt market after the rebalancings. Also, larger inflows (outflows) are associated with greater currency appreciations (depreciations). Our results highlight the increasing importance of capital flows driven by demand shocks, due to the growing relevance of benchmark indexes as the preferred habitat for institutional investors.

The New Guano: Legal Enforcement in Modern Sovereign Debt Markets

This essay examines the significance of the decades-long litigation against Argentina following that country’s default and subsequent restructuring of its public debt. Although litigation spanned nearly two decades, most accounts focus on the so-called pari passu injunction: the extraordinary remedy that ultimately induced Argentina to pay. Yet the litigation is more important for what it reveals about the evolving structure of sovereign debt markets. Effective legal enforcement does not require new law—or, anyway, not much new law. It requires specialized litigants, ready access to capital, and the ability to further mitigate the risk of investing in litigation through portfolio diversification. Such actors and mechanisms are routinely present in other forms of civil litigation, but have until recently played a limited role in sovereign debt markets. The lasting significance of the NML litigation is that it marks their arrival in force.

Debt, Defaults and Dogma: Politics and the Dynamics of Sovereign Debt Markets

Using data from 40 nations, we obtain new stylized facts regarding the impact of political leanings of the ruling government on sovereign debt yields and fiscal policy. Left-wing governments' yields are 166 basis points higher and 23% more volatile than yields of right-wing governments. Moreover, left-wing governments face more counter-cyclical yields. Left-wing governments have higher levels of government spending and right-wing governments collect lower tax revenue as a percent of GDP. A calibrated sovereign default model with elections and two politically heterogeneous policy makers who differ in the marginal impact of their fiscal choices on their re-election probabilities delivers the above-mentioned facts.