Interest rate spreads in Europe have evolved in a way that most researchers find hard to reconcile with the underlying economic fundamentals.
- Some authors take it as evidence of multiple equilibria in government bond markets (see De Grauwe and Ji 2012, Favero and Missale 2012),
- Others just point out the large forecast errors that standard empirical specifications of interest rates would generate (see Aizenman et al. 2012, Beirne and Fratzscher 2012).
Our new research suggests an alternative explanation; private sector issues with creditor seniority. An increasing share of total debt that is held by public creditors (ECB, EFSF/ESM, and IMF, etc) and the total is rising due to the ongoing rescue operations. Under current rules, these public creditors jump to the head of the queue if things go wrong. They have senior status in case of insolvency. The remaining public debt is thus a junior tranche. As such, it requires a higher marginal interest rate. More official lending can create what Gros (2010) in the Irish bailout case called the "seniority conundrum".1
The theoretical motivation of the senior tranche explanation is clear.2 What our new research does is to document it with data and various econometric techniques. We show that there is a close relationship between the senior tranche share of public debt and the interest rate spread (as well as bond prices) in the recent sovereign debt crisis in Europe.
In Figure 1 below, the senior tranche variable in our empirical analysis is defined as the sum of official lending from rescue packages of the IMF and the EU, plus the Target2 liabilities of the respective national central bank. The latter is likely to be considered senior lending by the markets because it is collateralised to a large extent with the country's government debt.3 In fact, it accounts for the largest share in senior trance public lending since the beginning of the 2007/2008 financial crisis. We also test various other measures including the Securities Markets Programme of the ECB, under which the ECB buys government bonds on the secondary market, and domestic bank lending to governments.
Figure 1. Senior Tranche Lending and Government Bond Spreads of countries in crisis
Note: The Figure shows the spread between the interest rate of government bonds in Greece, Ireland, Italy, Portugal and Spain (average) and the German Bunds, both with a maturity of ten years (left scale). The senior tranche proxy (right scale) includes lending by the EFSF, IMF, the ECB’s TARGET2 balances, as well as intergovernmental loans.
In our benchmark regressions, we illustrate the robustness of the correlation between the senior tranche lending and bond prices to the inclusion of several variables in a multivariate model, such as fiscal space, the current account, the real exchange rate, real GDP growth and the debt ratio. In a set of further robustness tests, we then investigate the impact of additional controls, different subsamples and estimation methods. Furthermore, we compare the difference of explaining bond prices and interest rate spreads, as well as different definitions and subcomponents of our senior tranche variable.4
The correlation between the senior-tranche-variable and the bond prices is remarkably robust.5 The large residuals in the regressions of De Grauwe and other authors can be significantly reduced in a regression with a full set of control variables and our proxy variable for senior tranche lending. To illustrate this point, Figure 2 plots the residuals of the interest rate spreads after controlling for fiscal space (panel A), and other control variables (panel B). These residuals are considerably smaller, when including the senior tranche variable (panel C) and country-specific coefficients on the senior tranche variable (panel D).
Figure 2. The De Grauwe Puzzle and Senior Tranche Lending
Notes: All four scatter plots show the residual of a regression with different sets of explanatory variables on government bond spreads. Panels (C) and (D) include the senior-tranche share of public debt.
The understanding of the determinants of interest rate spreads and sovereign bond prices is very important for the current economic policy debate in Europe. Several researchers have argued that high interest rate spreads in Europe are driven by bounded rationality in financial markets and multiple equilibria. If this is indeed the case, the appropriate policy response would be to provide more liquidity to the markets and to expand the tasks of the ECB to assuming the role of a lender of last resort.
What our findings mean for Eurobonds
Other researchers, for instance from the Bruegel think tank in Brussels, have argued that the introduction of Eurobonds would help to solve the European crisis. The idea here is to explicitly partition the debt into a senior and a junior tranche. As a result, the average interest burden would decline due to the joint liability of all European countries for the first 60% of the debt. On the other hand, incentives for fiscal discipline would remain intact because of the high marginal interest rate of the resulting junior tranche, the debt above the 60% level (see Delpla and Von Weizsäcker 2010).
Based on the results of our paper, we argue that both proposals should be treated with caution. Although standard variables – such as debt to GDP ratios – do not fully explain interest rates and bond prices, this may not be due to multiple equilibria. Instead, the ongoing process of rescue operations of the public rescue funds and the ECB’s contribution to the rescue operations that are reflected in the Target2 imbalances themselves appear to contribute to the continued high interest rates of countries in crisis.
Regarding the proposal from Bruegel, Europe might already be quite close to the sketched out scenario in their paper. Even without explicit joint liability for the first 60% of debt, countries in crisis are largely borrowing from official sources at low interest rates, while simultaneously facing a high marginal interest rate in the markets.
On 26 July, Mario Draghi, president of the ECB, stated that the ECB will do "whatever it takes" to save the euro. This statement has widely been interpreted as accepting the lender of last resort function. However it did not bring down interest rates substantially – one week later, interest rates in Spain for instance where again above 7%. On 2 August, he added that "the concerns of private investors about seniority will be addressed". According to our analysis, this later statement seems more relevant for future path of interest rates in Europe.
Aizenman. J, KM Kletzer, and B Pinto (2005), "Sargent-Wallace meets Krugman-Flood-Garber, or: why sovereign debt swaps do not avert macroeconomic crises", Economic Journal, 115(503):343-367.
Aizenman, J, M Hutchison, and Y Jinjarak (2011), "What is the risk of european sovereign debt defaults? Fiscal space, CDS spreads and market pricing of risk", NBER Working Paper No. 17407.
Beirne, J and F Fratzscher (2012), "The Pricing of Sovereign Risk and Contagion during the European Sovereign Debt Crisis", Mimeo Working Paper.
Bolton, P and O Jeanne (2009), "Structuring and Restructuring Sovereign Debt: The Role of Seniority", Review of Economic Studies, 76(3):879-902.
Corsetti, G, B Guimaraes, and N Roubini (2006), "International lending of last resort and moral hazard: A model of IMF’s catalytic finance", Journal of Monetary Economics, 441-471.
De Grauwe, P and Y Ji (2012), "Self-Fulfilling Crises in the Eurozone. An Empirical Test", CESifo Working Paper No. 3821.
Delpla, J and J Von Weizsäcker (2010), "The Blue bond proposal", Breugel Policy Briefs 420, Brussels.
Dooley, MP and MR Stone (1993), "Endogenous Creditor Seniority and External Debt Values", Staff Papers - International Monetary Fund, 40(2):395-413.
Favero, C and A Missale (2012), "Sovereign spreads in the Eurozone: which prospects for a Eurobond?", Economic Policy, 27(70):231-273.
Garber, PM (1999), "The target mechanism: Will it propagate or stifle a stage III crisis?", Carnegie-Rochester Conference Series on Public Policy, 51(1):195-220.
Gros, D (2010),"The seniority conundrum: Bail out countries but bail in private, short-term creditors?", VoxEU.org, 5 December.
Sinn, H-W and T Wollmershaeuser (2012), "Target Loans, Current Account Balances and Capital Flows: The ECB's Rescue Facility", Forthcoming in International Tax and Public Finance.
Steinkamp, S and F Westermann (2012), "On Creditor Seniority and Sovereign Bond Prices in Europe", Institute of Empirical Economic Research Working Papers No. 92, Osnabrück University.
1 Although de jure they differ with respect to seniority, de facto markets appear to view them as senior.
2 See for example Aizenman et al. (2002), Bolton and Jeanne (2009), Corsetti et al. (2006), Saravia (2010).
3 See also Garber (1998) and Sinn and Wollmershäuser (2012).
4 Similar results have been found in the Latin American Debt crisis. For instance Dooley and Stone (1993) show that the share of domestic bank lending – also viewed as senior – was an significant determinant of interested rate during the debt crisis of the early 1980s.
5 When it comes to things as entwined as bailouts, government debt markets and macroeconomics, one can never really establish causality. In this case the causality surely runs both ways. More public debt is piled on when sovereign yields spike and public-sector queue jumping surely leads private debt holders to demand a higher risk premium.