Importance of Fiscal Fundamentals for Sovereign Risk Spread

Importance of Fiscal Fundamentals for Sovereign Risk Spread

Irena Szarowská
Copyright: © 2018 |Pages: 20
DOI: 10.4018/978-1-5225-4026-7.ch007
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Abstract

The chapter examines the importance of fiscal fundamentals for sovereign risk spread in the period of 1995-2015, and its goal is to test whether stronger fiscal discipline reduces sovereign risk premiums. The empirical evidence is based on unbalanced annual panel data of 15 EU countries (its time span is divided into a pre-crisis and a post-crisis period). The study applies the generalized method of moments. Evidence shows that before the financial crisis, investors generally ignored bond risk factors in individual countries, but that the spreads sharply diverged starting from the year 2008. The results confirm a statistically significant impact of fiscal fundamentals on government bond yield spread. The improvement of the governments' fiscal position reduces sovereign yield spread. In a post-crisis period, findings report the raising of the importance of fiscal variables for spread, and GDP growth became a major determinant of government bond yield spreads, followed by the budget balance and debt development.
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Background

There is no doubt that government bond prices are closely linked to real economic activity through a variety of channels, though the theory does not clearly identify the direction of the causal relationships between variables. Already, Morck et al. (1990) identified main channels through which bond prices are linked to real economic activity. Their theory is supported by the fact that managers of big corporations make their investment decisions based on the information provided by stock markets; and they also argue that equity prices reflect the present value of dividends paid in the future. Figure 1 depicts the main linkages between the economy, the banking sector, and government bond markets. Arrows indicate the channels through which deteriorating conditions in one area affect the other two areas.

Figure 1.

Main linkages between the economy, the banking sector, and the bond market

978-1-5225-4026-7.ch007.f01
Source: Author’s compilation.

The intention of the chapter is to find the main fiscal fundamentals affecting yield spreads of EU countries’ government bonds. The literature has analyzed several determinants of yield spreads. This research is based on the yield spreads of bonds issued by European countries versus the German benchmark figures. Yield spreads result from several reasons. Apart from default risk, the yield spreads are influenced by liquidity risk and market sentiments toward investments in risky bonds.

A wide range of literature deals with determinants of government bond yield spreads. Szarowská (2014) summarizes the results of main studies focused on bond spreads in the EU countries. The results are rather heterogeneous – not only for different samples, but even for rather similar samples such as the Eurozone countries – which a comparison of the results from Lemmen and Goodhart (1999) with those of von Hagen et al. (2011), for example, shows. To a certain extent, these differences may result from different observation periods. Another reason could be seen in a fact that papers also differ considerably with respect to tested variables.

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