Guest Post: Euro Area Sovereign Risk During the Crisis

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Editor's Note: Silvia Sgherri is a Senior Economist at the International Monetary Fund, where she has contributed to recent editions of the Regional Economic Outlook for Europe. Her views do not represent those of the IMF.

While the use of public resources is critical to cushion the impact of the financial crisis on the euro-area economy, it is key that the entailed fiscal costs not be seen by markets as undermining fiscal sustainability. From this perspective, to what extent do movements in euro area sovereign spreads reflect country-specific solvency concerns? A recent IMF Working Paper suggests that euro area sovereign spreads tend to co-move over time as they are mainly driven by a common time-varying factor, mimicking global risk repricing. Since October 2008, however, there seems to be evidence of increased financial market awareness about the potential fiscal implications of national financial sectors’ frailty and future debt dynamics.


On the heels of the crisis, sovereign risk premium differentials in the euro area have been widening. Although the perceived risk of default for euro area countries remains generally low, financial markets appear to have been increasingly discriminating among government issuers while requiring overall higher risk premiums. Specifically, the spreads on the yield on 10-year government bonds over Bunds spiked in January 2009 for various euro area members, accompanied by downgrades of sovereign debt ratings for Greece, Spain, and Portugal, and a warning for Ireland. The rebound of euro area sovereign spreads is particularly noticeable from a historical perspective, as it follows a prolonged period of remarkable compression of sovereign risk premium differentials, which had been raising doubts about financial markets’ ability to provide fiscal discipline across euro area members.

Understanding what has prompted the latest widening in euro area sovereign interest rate differentials is key for policymaking. Does the observed rise in sovereign spreads reflect increased financial market concerns about the worsening fiscal accounts of most euro area countries following the financial crisis? Indeed, while the use of public resources has been critical to stem further job losses and to break the adverse loop between the financial system and the real economy, it has also implied a significant deterioration in the budget positions of most euro area members and ballooning government debts. If such a deterioration is seen by the market as undermining a country’s long-term fiscal sustainability, persistent increases in sovereign spreads may arise. These could, in turn, have a major impact on a government’s marginal funding costs, possibly undoing the beneficial effects of declining risk-free interest rates and partly offsetting the stimulus effects of measures taken to deal with the crisis.

Using monthly data on spreads between the yield on ten-year sovereign bonds between ten euro area countries and Germany over the period January 2003 to March 2009, empirical analysis shows that changes in sovereign default risk premiums have mainly reflected global risk factors—such as shifts in risk aversion in financial markets. Favorably, since March 2009 global risk factors seem to play a much smaller role, mirroring an improvement in market’s perception of the euro area cyclical outlook starting from 2009Q2. On the other hand, though, there is also evidence that since October 2008 markets have become somewhat more concerned about the potential fiscal implications of national financial sectors’ frailty and future debt dynamics.
Evidence of increased financial market’s awareness—and, thereby, discrimination ability in the face of country-specific policy actions—is extremely compelling from a policy viewpoint. In particular, it seems to support the position that restoring trust in the financial system is key—not only to shape the recovery, but also to increase the effectiveness of fiscal stimulus measures while reducing future governments’ financing costs. At the same time, it strengthens the argument for a credible commitment to medium-term fiscal consolidation and a clear exit strategy from a supportive policy stance as the crisis abates. Casting short-term fiscal expansion within a credible medium-term framework and envisaging fiscal adjustments as economic conditions improve could conceivably help euro area governments curb solvency concerns in financial markets. Structural reforms—tackling aging-related public costs looming ahead and enhancing potential growth and, thereby, medium-term revenue prospects—are also likely to work in the same direction. Together, these measures may be able to ensure that yesterday’s global financial crisis does not sow the seed of tomorrow’s vicious domestic debt dynamics.

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