Hypnosis Before Wake-up Call?! The Revival of Sovereign Credit Risk Perception in the EMU-Crisis Ingo Bordon German Development Institute Bonn Kai Daniel Schmid Macroeconomic Policy Institute Duesseldorf Michael Schmidt Graduate School of Economics, Finance, and Management Frankfurt INFINITI Conference 2014 Prato, June 2014 1 / 14
Convergence and Re-widening of Public Bond Yields (i) Long-term Interest Rate (GIIPS) 30 20 10 0 ESP GRC ITA IRL PRT 1980 1990 2000 2010 Data source: OECD Economic Outlook, IMF World Economic Outlook. 2 / 14
“Wake-up Call”-explosion of Spreads What determines spectacular increase in long-term interest rates in EMU periphery countries? important question because of severe destabilizing and self-enforcing impact in the crisis Perspectives on this issue from the literature: reconsideration of fundamentals (Basurto et al. 2010, Kopf 2011, Sinn 2012) psychological component: “expectational shift”, “wake-up call”-phenomenon (Arghyrou/Kontonikas 2012, DeGrauwe 2011, IMF 2010, von Hagen et al. 2011) “overpricing”: disregard of fundamentals in crisis (DeGrauwe/Ji 2013) 3 / 14
“Hypnosis Before Wake-up Call”-hypothesis What is the role of public debt for pricing sovereign risk? Has this role changed over time? search for better understanding of re-pricing leads us to consider pricing behavior before EMU-convergence disentangle “risk bubble” from “fear bubble” Assumptions role of public debt changed twice as Maastricht treaty also caused shift in pricing behavior gradual (but severe) disregard of fundamentals: “hypnosis”-phenomenon pricing of public debt in crisis might be comparable to pre-convergence era 4 / 14
Data Cross-country panel annual data from 1980-2012 21 OECD countries: Australia (AUS), Austria (AUT), Belgium (BEL), Canada (CAN), Switzerland (CHE), Denmark (DNK), Spain (ESP), Finland (FIN), France (FRA), Germany (GER), Great-Britain (GBR), Greece (GRC), Ireland (IRL), Italy (ITA), Japan (JPN), the Netherlands (NLD), Norway (NOR), New Zealand (NZL), Portugal (PRT), Sweden (SWE), United States (USA) Data Sources OECD Economic Outlook AMECO IMF World Economic Outlook 5 / 14
Regime Approach - Country- and Time-clusters Define 9 Regimes via 3 Time Periods across 3 Country Groups “PreEuro”-period “ConEuro”-period “Crisis”-period 1980–1993 1994–2007 2008–2012 ( T = 14) ( T = 14) ( T = 5) 1 4 7 OECD-21 ex EMU-11 AUS, CAN, CHE, DNK, GBR, JPN, NOR, NZL, SWE, USA ( N = 10) EMU-11 ex GIIPS 2 5 8 AUT, BEL, GER, FIN, FRA, NLD ( N = 6) GIIPS 3 6 9 ESP, GRC, IRL, ITA, PRT ( N = 5) 6 / 14
Regime Approach - An Illustration (i) GIIPS, 1980-1993 (ii) GIIPS, 1994-2007 0 1999 1996 1999 0 2004 2004 2004 1994 1988 1999 1999 1995 2005 2004 2003 2002 2004 2005 1997 2006 1993 1987 2005 2003 1997 1998 2000 2003 2003 2007 1987 1993 2003 2000 2002 2002 1997 1996 2002 2001 1991 20052006 1998 1997 1994 1988 1992 1986 1990 1989 1985 1986 2005 1998 2000 2006 2007 1996 2001 1988 1987 1988 1990 1991 1992 1995 1993 1993 2007 2006 2001 1994 1995 2007 1992 1989 2002 1998 1989 1991 2006 1996 1995 1990 1986 1984 2001 1985 1991 1992 1989 1987 2001 Real Interest Rate Spread Real Interest Rate Spread 1986 1990 2000 -10 1984 2007 2000 -5 1985 1983 1985 1984 1994 1988 1980 1999 1987 1981 1982 1983 1993 1983 1981 1992 1996 1984 1989 1980 1982 1982 1995 1997 1981 1982 1983 19801981 1983 -20 -10 1985 1998 1984 1980 1981 1990 1980 1982 1991 1986 1994 -30 -15 ESP GRC ITA IRL PRT ESP GRC ITA IRL PRT 20 40 60 80 100 120 20 40 60 80 100 120 Public Debt to GDP Ratio Public Debt to GDP Ratio (iii) GIIPS, 2008-2012 2012 20 15 Real Interest Rate Spread 2011 10 2009 2012 2010 2011 2011 5 2009 2010 2012 2010 2009 2009 2009 2010 2010 2011 2011 0 2008 2008 2008 2008 2008 -5 ESP GRC ITA IRL PRT 50 100 150 200 Public Debt to GDP Ratio 7 / 14
Empirical Model Regress Yield Spreads Against Germany on Public Debt to GDP-ratio and Standard Set of Macroeconomic Fundamentals 1 Spread = ( Debt ⊗ R ) β 1 + ( Debt 2 ⊗ R ) β 2 +( X ⊗ R ) β 3 + TD β 4 + CD β 5 + U Average Partial Effect of Public Debt to GDP Ratio λ = ∂ Spread = β 1 + 2 β 2 × Debt ∂ Debt 1Fixed-effects model as baseline (Beirne/Fratzscher 2013, DeGrauwe/Ji 2013) 8 / 14
Hypotheses Hypotheses for GIIPS Country Cluster H1: Effect of Debt changes across time periods λ 3 > λ 6 & λ 6 < λ 9 H2: Effect of Debt in “Crisis”-period is not different from “PreEuro”-period λ 3 = λ 9 H3: Effect of Debt is not different from core-EMU countries in “ConEuro”-period λ 5 = λ 6 Effect of Debt is different from core-EMU countries in “PreEuro”-period H4: and “Crisis”-period λ 2 < λ 3 & λ 8 < λ 9 H5: Contribution of Debt to spreads falls from the “PreEuro”-period to the “ConEuro”-period and rises from the “ConEuro”-period to the “Crisis”-period 9 / 14
Baseline Estimation Results Total Effects of Public Debt to GDP Ratio Across Regimes 2 .12 .08 .04 0 -.04 1 2 3 4 5 6 7 8 9 2Marginsplot: 95%-CI; regression with robust standard errors, year dummies and country fixed effects 10 / 14
Selected Robustness Dimensions Alternative Panel Estimators exploit large T asymptotics and impose some more structure on covariance matrix ( Driscoll/Kraay (1998) Standard Errors and Panel Corrected Standard Errors) Dynamic Model (include lagged dependent variable) POLS on differenced model (ordinary FE) GMM estimators ( Arellano/Bond (1991) and Blundell/Bond (1998)) Pairwise Variation of Regime Break Dates (1993/94, 1994/95, 1995/96 versus 2007/08, 2008/09) Consider Additional Fiscal Information (Primary Balance to GDP-ratio) 11 / 14
Explanatory Power Analysis - Levels Contributions to Levels of Yield Spreads (GIIPS) 3 30 Publ. Debt Time Component Other Fundament. Resid. Country-FE & Const. 20 10 0 -10 3 6 9 3 6 9 3 6 9 3 6 9 3 6 9 ESP GRC IRL ITA PRT 3Regimes - 3: “PreEuro”-period; 6: “ConEuro”-period; 9: “Crisis”-period 12 / 14
Explanatory Power Analysis - Changes Contributions to Changes in Yield Spreads (GIIPS) 4 20 Public Debt Time Component Other Fundamentals Residual 10 0 -10 3/6 6/9 3/6 6/9 3/6 6/9 3/6 6/9 3/6 6/9 ESP GRC IRL ITA PRT 4Regimes Changes - 3/6: “PreEuro”-period to “ConEuro”-period; 6/9: “ConEuro”-period to “Crisis”-period 13 / 14
Conclusion and Implications Institutional Changes of EMU Heavily Affected Financial Markets’ Weighting Schemes overwhelmingly strong impact of expectational shifts due to institutional changes (EMU) and macroeconomic shocks (crisis) Pricing Mode has Changed Twice Maastricht treaty initiates “hypnosis”-effect “wake-up call” causes second rebalancing effect bursting “risk bubble” Qualification of “Overpricing”-hypothesis no clear indication of “fear bubble” as default risk assessment in “Crisis”-period comparable to “PreEuro”-period 14 / 14
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