Working Paper: CEPR ID: DP8637
Authors: Carlo A. Favero; Alessandro Missale
Abstract: In this paper, we provide new evidence on the determinants of sovereign yield spreads and contagion effects in the euro area in order to evaluate the rationale for a common Eurobond jointly guaranteed by euro-area Member States. We find that default risk is the main driver of yield spreads, suggesting small gains from greater liquidity. Fiscal fundamentals matter in the pricing of default risk but only as they interact with other countries? yield spreads; i.e. with the global risk that the market perceives. More important, the impact of this global risk variable is not constant over time, a clear sign of contagion driven by shifts in market sentiment. This evidence points to a discontinuity in the disciplinary role of financial markets. If markets can stay irrational longer than a country can stay solvent, then the role of yield spreads on national bonds as a fiscal discipline device is considerably weakened, and issuing Eurobonds can be economically justified.
Keywords: contagion; eurobonds; sovereign debt crisis
JEL Codes: No JEL codes provided
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| eurobonds (G15) | risk of default (G33) |
| eurobonds (G15) | crisis propagation (H12) |
| default risk (G33) | yield spreads (G12) |
| fiscal fundamentals (E62) | yield spreads (G12) |
| global risk (F65) | yield spreads (G12) |
| shifts in market sentiment (E32) | yield spreads (G12) |