The immediate effect of monetary union on EU-15 sovereign debt yield spreads

Abstract

Yield spreads (corrected for exchange rate risk) over 10-year German securities of European Union (EU) countries that did not join Economic and Monetary Union (EMU) experienced an average decrease of 14.20 basis points during the first 3 years after the beginning of Currency Union. Conversely, Euro-area countries' adjusted spreads registered an average rise of 11.98 basis points in the same period. This article examines the elements (a possible change in the relative importance of domestic or international risk factors) behind these results using both panel estimations in the two groups of countries and a country-by-country specification in each of them.

Acknowledgements

I thank the participants in all the seminars where this article has been presented for their useful comments. I would also like to thank Analistas Financieros Internacionales, S.A. who have kindly provided part of the data used in the empirical analysis. Special thanks to Jordi Galí and Jaume Ventura, for their insightful comments on previous versions of this article. I alone am responsible for any errors remaining in the final version.

Notes

¹ The introduction of the euro also implied a strong sovereign bond market growth which, as De Bondt and Lichtenberger (2004) point out, has also been translated to the corporate bond market and has benefited economic activity in the Euro area.

² This correction is broadly explained in Gómez-Puig (2008).

³ In Gómez-Puig (2008), we estimated a dynamic model but the introduction of a lag of the dependent variable did not improve the results.

⁴ Nevertheless, it is important to note that, although EMU countries do not have monetary policy autonomy, they do not present the same response pattern to ECB decisions (Clausen and Hayo, 2006).

⁵ In Gómez-Puig (2006), we deeply analysed the effect of market size on liquidity.

⁶ The existence of a very liquid futures bond market in Germany also represents an additional advantage of holding German bonds.

⁷ Within the Euro-area: Austria, Finland, Greece, Ireland and Portugal present an overall amount of public sector outstanding debt below the $100 billion level, while The Netherland's entire amount of outstanding public debt is between $100 and $200 billions. Outside the Euro-area: only Denmark presents an amount slightly below the $100 billion level.

⁸ Table 4 presents the starting benchmark dates used by Datastream as well as the characteristics of the different benchmarks that compose the yield and swap series for non-EMU participating countries, while the references used in the case of Euro-participating countries are described in Gómez-Puig (2008).

⁹ These specifications are broadly explained in Gómez-Puig (2006, 2008).

¹⁰ In the case of EMU-countries, we only show the results for the first specification, which have been drawn from Gómez-Puig (2008).

¹¹ Altavilla and Landolfo (2005) analyse whether the ECB and the Bank of England have a different behaviour during recession and expansion. The results confirm that whilst the primary goal of the ECB consists of achieving price stability, the Bank of England contemporaneously targets output and inflation.