The decoupling between public debt fundamentals and bond spreads after the European sovereign debt crisis

ABSTRACT

We contribute to the literature that documents empirically that the relationship between public debt fundamentals and sovereign bond spreads in Spain, France, and Italy (versus Germany) weakened after the 2010–2012 episode of sovereign debt markets’ significant distress. To construct our measure of public debt fundamentals, we build on the literature that combines the Value at Risk approach with the estimation of the correlation pattern of public debt dynamics’ macroeconomic determinants via Vector Auto Regressions (VARs) to estimate the probability distribution of alternative debt trajectories. Since we incorporate in the VAR new information in a sequential manner, we are able to retrieve time-varying probabilities that characterize the expected behaviour of debt at a given point in time in the future. We then empirically confront such probabilistic indicators with market-derived sovereign bond spreads.

KEYWORDS:

• Public debt sustainability
• fiscal policy
• European Union

JEL CLASSIFICATION:

• H63
• H68
• E61
• E62

Acknowledgment

We thank participants at June’s 2020 CEMLA’s Joint Research Network meeting for comments and suggestions. The views expressed in this paper are the authors’ and do not necessarily reflect those of the Bank of Spain or the Eurosystem.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

¹ Spreads are computed against the German Bund. This choice is motivated by its safe asset status within the Eurozone. As a result, sovereign spreads can be used as a measure of market default-risk perceptions, as well as capital market fragmentation.

² A related, though different strand of the literature looks at the determinants of sovereign debt yields/spreads, as summarized, for example, in (Afonso and Jalles 2016).

³ This choice does not affect significantly our results.

⁴ These included the Outright Monetary Transactions (OMT), which was aimed at reducing redenomination risk, and the Very Long term refinancing operations (VLTRO).