Interest rate spreads on government bonds of the EU countries have risen dramatically since the intensification of the crisis after the Lehman default in September 2008 (Sgherri and Zoli 2009). Before that, the interest rates on a government bond compared to that of benchmark bonds (bonds with a very solid status such as German or US government bonds) were much less apart: a spread of 100 basis-points (1 percentage point) was quite exceptional. However, since the start of the crisis, spreads of around 100 basis-points have not been an exception any more, with peaks exceeding 300 basis-points.
Chart 1 shows the interest rate spreads, measured at the time of issuance of the bond, for all non-benchmark EU15 government bonds issued between May 1990 and May 2009 in deutschmark/euro and dollar for which data were available.1
The sharp increase in financing costs for governments has raised some concerns that financial markets do not price the risk underlying certain government bonds appropriately. To avoid “irrational” and “excessive” punishment of financial markets, suggestions have been made to introduce a common bond in the euro area, replacing bonds of national governments.2 Such a bond could resemble the US Treasury bond and be much less prone to volatility. We take up this question by considering whether the factors that drove spreads before the start of the crisis—generalised risk aversion and credit risk-- are still relevant now.3 Assuming that the economic mechanism still works, a second question concerns the extent to which the recent, high spreads can be explained by larger government deficits and debt, and to what extent they are due to a general increase in risk aversion. If fiscal factors have become more important, the benefits of a common bond issuance become very uncertain due to the adverse incentive effects such a bond would create. That is, a country could get away with low fiscal discipline without being “punished” with a higher cost of borrowing by financial markets.
Figure 1. Interest rate spreads for EU central governments (In basis-points)
Source: Dealogic. For other data sources, see Schuknecht et al (2009a).
Interest rates, government finances and risk aversion
In trying to account for the increases in bond yields, we updated and extended an earlier approach to explaining interest rate spreads.4 The empirical results suggest that
- Interest rate spreads increase with higher government deficits and debts relative to GDP as investors perceive the latter as indicators of relative fiscal laxity and a risk probability of (partial) default.
- Interest rate spreads increase with an increase in the general degree of risk aversion in international financial markets measured by the spread between the yields on BBB-rated US corporate bonds and AAA-rated US Treasury bonds, as investors shift their portfolios towards high quality benchmark bonds.
- After the default of Lehman Brothers, the effect of deficit and debt ratios on interest rate spreads became much stronger. A 1 percentage-point increase in the deficit ratio of a country over the German or US deficit ratio now raises the country’s interest rate by about 12 basis points, compared to 3.5 basis points before the crisis. The corresponding number for the debt ratio is 1.2 basis points compared to 0.2 basis points before the crisis.
- Furthermore, the effect of an increase in general risk aversion also matters more since the default of Lehman Brothers, as the sensitivity of the bond spreads to this variable in crisis-times is also higher than before. An increase in the BBB spread by 10 basis points increases government bond yield spreads over US Treasuries by 4 basis points, compared to 2 basis points before the crisis. Furthermore, a similar effect now also holds for government bond yield spreads over German Bunds, which was not there before the crisis. This signals that German Bunds have attained a safe-haven investment status.
Figure 2 shows the relative contribution of fiscal variables and of risk aversion to the estimated spreads prevailing since the start of the crisis for the bonds issued. In high-deficit and high-debt countries (notably Ireland and Greece), the deterioration in fiscal positions on account of the crisis contributed most to the bond spread increase (‘crisis-fiscal’). In other cases, the general risk aversion drove most of the spread increase (‘crisis-BBB spread’). A few countries (Denmark, the Netherlands) have been financially ‘rewarded’ for their fiscal performance (negative ‘crisis-fiscal’ spread), which was better than in Germany or the US.
Figure 2. Estimated spreads during the crisis (% of estimated bond yield spread)
Note: a ‘$‘ sign after the country’s name indicates that the issue was in dollar, else it was in euro.
While the financial crisis has led bond markets to be more vigilant on fiscal developments, it is not guaranteed that the end of the crisis will cause a return to the pre-crisis conditions. In this context, it is worth referring to the experiences of the fiscal crisis of New York City in 1975; US municipal bond markets began to discriminate strongly between state governments with weak and strong fiscal performance only after that crisis and have continued to do so since then. If the change in the pricing behaviour in European bond markets is similarly persistent, the future pressures for fiscal discipline coming from financial markets will be much stronger than in the years before the crisis.
Some policy implications
We conclude that market valuation of the default risk of governments remains a relevant mechanism to discipline fiscal policy, especially - but not only - in times of a financial crisis. Deteriorations in fiscal positions raise credit risk for which investors demand a financial compensation. Calls for more European solidarity, for instance via issuing EU common bonds to avoid an alleged irrationality of financial markets, are not justified. On the contrary, they may result in higher interest rates if market participants anticipate less disciplined fiscal policies as a consequence.
Another policy conclusion of our findings is that fiscal policies in “good” economic times need to be sounder to create leeway for crisis times and avoid the large costs of public borrowing that can arise during a financial crisis. This suggests that compliance with the European rules for public finances, as included in the Stability and Growth Pact, is a necessary condition to safeguard against the high costs of public debt. A timely return to healthier public finances is therefore needed.
Disclaimer: The views expressed are the authors and do not necessarily reflect those of the ECB.
1 While the number of bonds issued by EU15 governments is a multiple of the 330 observations shown, we only include those bonds for which, around the time of issuance, a benchmark bond was issued by the German government (in case of a deutschmark /euro issuance) or the US government (in case of a dollar issuance) with a maturity that is comparable.
2 This possibility for instance has been mentioned by EU Economic Commissioner Almunia, see EurActiv, 4 March 2009.
3 For a recent review of the relevant literature on what affects interest rate spreads see Haugh et al. (2009).
4 The earlier approach is included in Schuknecht et al. (2009a), while the empirical outcomes for the updated approach are in Schuknecht et al. (2009b). A slightly extended version will appear in the ECB WP series in January 2010. These studies look at interest rates on (non-benchmark) bonds of EU15 countries compared to interest rates on benchmark bonds, being the German Bund in case of a bond issued in DM (before 1999) or euro (since 1999), and the US Treasury bond in case of an EU15 governments issuing a bond in dollars.
Bernoth, K., J. v. Hagen and L. Schuknecht (2006) “Sovereign Risk Premia in the European Government Bond Market” SFB/TR 15 Governance and the Efficiency of Economic Systems Discussion Papers, No. 151
Haugh, D., P. Ollivaud and D. Turner (2009) “What Drives Sovereign Risk Premiums? An Analysis of Recent Evidence from the Euro Area”. OECD Economics Department Working Paper, No. 718, Paris.
Mody, A. (2009), “From Bear Stearns to Anglo Irish: “How Eurozone Sovereign Spreads Related to Financial Sector Vulnerability.” IMF Working Paper, 09/108
Schuknecht, L., J. von Hagen and G. Wolswijk (2009a) “Government Risk Premiums in the Bond Market: EMU and Canada”, European Journal of Political Economy 25, pp. 371-384.
Schuknecht, L., J. von Hagen and G. Wolswijk (2009b) “Government Bond Risk Premiums in the EU revisited: The Impact of the Financial Crisis”, CEPR paper No. 7499.
Sgherri, Silvia and Edda Zoli (2009) Euro-area sovereign risk during the crisis, VoxEU.org, 17 November