Since the intensification of the financial crisis in 2009, long-term government bond yields have increased spectacularly in several Eurozone countries. Whereas core countries seem to have benefitted from a flight-to-quality effect, peripheral economies have suffered from the abrupt revision of market expectations. In the latter case, the yield is on average significantly higher than that justified by the deterioration of fiscal indicators. This observation opens the way for considering the combination of both internal and external imbalances as a potential explanation of the rise of rates.
Figure 1 Evolution of sovereign bond yields, public debt and net foreign assets, 2000-2014
In Figure 1, we illustrate the evolution of real long-term sovereign yields, public debt, and net foreign assets for selected developed countries. When analysing these variables, some ‘decoupling’ is observed between the yield and its usual fundamentals. In fact, some big economies exhibit decreasing interest rates, whereas their fiscal imbalances have deteriorated over time. This is the case, for instance, in the US, Germany, and France. In contrast, the default risk premium for the peripheral group (Ireland, Portugal, and Spain) increases considerably at the end of the period, even though the respective debt-to-GDP ratios present a similar increasing pattern to what is observed in some of the aforementioned core countries.
In this context, the widening differentials of sovereign yields among core and peripheral countries might reflect some concerns about external imbalances that are considered ‘abnormal’ by investors. Indeed, the observed increase in the default risk premium for peripheral economies at the end of the period coincides with a very high and rapid deterioration of their external imbalances. In contrast, in core countries, where net foreign assets are either positive or negative but relatively contained, interest rates tend to decrease. In this sense, we postulate that a net foreign asset position which has deteriorated significantly beyond a certain level is considered as a differentiating factor in which a higher yield would be necessary to attract investors in order to compensate them for a higher risk. When this risk is not present, traditional macroeconomic fundamentals will explain the behaviour of sovereign rates.
Disentangling the effect of two debt overhangs
A large empirical literature has addressed the determinants of sovereign bond yields. However, the bulk of these works are mainly related to the evolution of national fiscal conditions (Laubach 2009). More recently, some studies have introduced non-domestic variables to account for financial globalisation. For instance, Grauwe and Ji (2013) and Poghosyan (2014) assign the recent uncoupling between fiscal variables and sovereign bond to the over-reaction of financial markets, whereas Constantini et al. (2014) include the competitiveness differentials as a long-term determinant of sovereign yields.
We use a dynamic panel approach to explain the determinants of long-term sovereign bond yields for OECD countries over the period 1980-2014, with a particular focus on the 2009 financial crisis episode (Ben Salem and Castelletti 2016). We explore two issues in particular: What role do fiscal variables play in sovereign yields dynamics? And how does the net international investment position fill in the observed gap between fiscal variables and sovereign bond yields?
To estimate the extent to which external imbalances may have contributed to the increase in sovereign spreads in certain countries, we rely on an error-correction equation. In addition to the standard determinants in the literature such as the debt-to-GDP ratio, external imbalances are introduced as explanatory variables to capture the effect of competitiveness deterioration on the rise of country risk. The short-term dynamics are captured by changes in inflation, short-term real rates, GDP and public debt.
The idea is that a favourable international investment position keeps interest rates at a lower level than that implied by fiscal variables only. Indeed, we explore threshold effects in the effect of net foreign assets and public debt on sovereign bond yields, using the Macroeconomic Imbalance Procedure of the European Commission as a starting point. Among these indicators, the threshold in our baseline estimates is set at -50% for the net external position. This value takes into account the fact that in our data, sovereign yields seem to react to lower levels of the external position than is seen in the Macroeconomic Imbalance Procedure.
Our results suggest that fiscal imbalances of the peripheral group have certainly contributed to their increasing sovereign risk, but that this is not the only factor that comes into play. External imbalances are also identified as an important driver of the interest rates surge after the 2009 economic crisis. This alternative interpretation is not necessarily inconsistent with the fiscal fragility idea but may also reflect concerns about the solvency of the private sector.
In effect, if a country uses its borrowed foreign funds to finance consumption rather than investment, then its ability to repay might come into question. This situation may have an impact on sovereign issuers even if this behaviour is circumscribed only to the private sector. For instance, during a financial crisis, sovereign credit risk can rise significantly through private-sector bailouts which increase public sector liabilities and the inherent risk of a public debt overhang.
We find that a one-point increase in the debt-to-GDP ratio induces a long-term increase of only 1.6 basis points in the yield if the external position of the country is favourable. Nevertheless, if the competitiveness of the country is highly negative, the same increase in the public debt will push the yield up by 3.2 basis points. In this sense, we find that a net foreign position which has deteriorated has been a differentiating factor for investors.
The relevance of our specification is confirmed by the forecast exercises (in-sample and out-of-sample) conducted after 2007. Indeed, our model succeeds in capturing the sharp increase in sovereign bond yields experienced by the European peripheral countries and reproduces the trajectory of core economies fairly well, as shown in Figure 2.
Figure 2 Sovereign yields: Actual and in-sample and out of sample fitted values (forecast starting in 2011)
Policy lessons
Understanding what has driven recent developments in sovereign yields is of particular interest for policymakers. If the observed widening of sovereign yields reflects the concerns of the market about a country’s external imbalances and their consequences on financial stability, investors will keep discriminating among sovereign issuers until sound policies are foreseen. Indeed, the simulations performed on the basis of our estimations allow a benchmark level for long-term interest rates to be evaluated. In such a setting, a difference between this benchmark and the observed rates could give some quantitative assessment about the risk of a positive interest shock on fiscal sustainability.
References
Ben Salem, M and B Castelletti Font (2016), “Which combination of fiscal and external imbalances to determine the long-run dynamics of sovereign bond yields?”, Banque de France working paper series No. 606.
Costantini, M, M Fragetta and G Melina (2014), “Determinants of sovereign bond yield spread in the EMU: an optimal currency area perspective”, European Economic Review 70: 337-349.
Grauwe, P D and Y Ji (2013), “Self-fulfilling crises in the Eurozone: An empirical test”, Journal of International Money and Finance 34: 15-36.
Laubach, T (2009), “New evidence on the interest rate effects of budget deficits and debt”, Journal of the European Economic Association 4(7): 858-885.
Pogoshyan T (2014), “Long-run and short-run determinants of sovereign bond yields in advanced economies”, Economic Systems 2014 38(1): 100-114.