Vertical debt spillovers in EMU countries

Journal of International Money and Finance 37 (2013) 468–492

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Vertical debt spillovers in EMU countries Annelore Van Hecke* KU Leuven, VIVES Research Centre for Regional Policy, Naamsestraat 61, 3000 Leuven, Belgium

a b s t r a c t JEL classification: H63 H74 H77 F36 Keywords: Fiscal federalism Public debt Intergovernmental relations Spillovers

This article examines the extent to which subnational governments may drive sovereign risk premiums. Is subnational fiscal policy affecting the interest rates on central government bonds? Furthermore, we focus on a number of causal mechanisms that may mitigate or reinforce these upstream vertical spillovers, i.e. the presence of bailout expectations and subnational borrowing autonomy. Our findings indicate that debt accumulation by subnational governments (SNG) spills over onto sovereign risk premiums when the restrictions on SNG borrowing are weak and when investors believe that subsovereign debts are backed by the center. The results suggest that spillovers may be reduced through a proper design of a country’s fiscal and institutional framework; countries should either bolster the sovereignty of subnational governments by increasing SNG fiscal autonomy, or tightening up SNG borrowing constraints. Ó 2013 Elsevier Ltd. All rights reserved.

1. Introduction Debt is widely recognized as one of the main drivers of sovereign risk premiums. Empirical research, however, traditionally focuses on the influence of central (or aggregate) debt on central government bond yields, neglecting the particular effect of debt accumulation by regional and local governments. This paper argues that subsovereign debt policy may spill over onto central government bond yields. Illustrative of such a spill over effect was the contamination of Spain’s sovereign yields by the debt problems of its Autonomous Communities in 2012. However, this paper does not focus on

* Tel.: þ32 (0)16326838. E-mail address: [email protected]. 0261-5606/$ – see front matter Ó 2013 Elsevier Ltd. All rights reserved. http://dx.doi.org/10.1016/j.jimonfin.2013.06.011

A. Van Hecke / Journal of International Money and Finance 37 (2013) 468–492

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Bond yield of CG

DOWNSTREAM VERTICAL SPILLOVERS

Bond yield of SNG

UPSTREAM VERTICAL SPILLOVERS

Fiscal variables (debt) of CG

Bond yield of SNG

Bond yield of SNG

HORIZONTAL SPILLOVERS Fiscal variables (debt) of SNG

Fiscal variables (debt) of SNG

Fiscal variables (debt) of SNG

Fig. 1. Overview of debt spillovers in a federation.

the developments during the European debt crisis, but aims to explore spillovers over the last two decades. Throughout this paper different kinds of spillovers will be referred to by different terms. Fig. 1 illustrates our terminology.1 Excluding spillovers, the link between own-government fiscal variables and sovereign or subsovereign bond yields is indicated by the block arrows in Fig. 1. A first category of inter-jurisdictional spillovers, horizontal externalities, measures the effect of a subnational government’s (SNG) fiscal performance on the bond yields of its fellow subsovereigns. Second, the effect of the central government’s (CG) fiscal policy on SNGs’ interest rates is captured by downstream vertical spillovers. Third, upstream vertical spillovers represent the influence of aggregated SNG fiscal performance on the central government’s bond yields. The article focuses on this last category of spillovers, a topic that has received very little attention in the literature so far. We aim to (1) investigate whether aggregated SNG fiscal performance bids up sovereign interest rates, (2) quantify this effect, and (3) explore the circumstances that may weaken or reinforce these spillovers. With respect to the latter, the role of bailout expectations and SNG borrowing autonomy as triggers for upstream vertical debt spillovers will be examined. Since fiscal policy will be evaluated by the level of public debt, we speak of debt spillovers between the different levels of government. This article contributes to the literature in several ways. First, it adds to the literature on the determinants of government bond yields. In comparison with former studies that explain central government yields by national debt variables, more detailed insight is provided by taking into account the particular distribution of debt over different levels of government. Second, this article contributes in an innovative way to the scarce literature on vertical interest rate spillovers. Landon and Smith’s (2000, 2007) analysis of the effect of CG debt accumulation on SNG yields is reversed by considering upstream debt spillovers.2

1 A similar scheme can be drawn for a monetary union, replacing “central government” by “supranational authority” and “subnational government” by “member state government”. 2 The paper also complements the literature w.r.t. externalities in public finance in general. Although many studies investigate the interjurisdictional effects of subcentral and central government expenditure and revenue collection programs, there is relatively little analysis of the extent to which debt accumulation interferes with the perceived creditworthiness of other governments in a federation (Landon and Smith, 2000).

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Third, as opposed to previous work, which focuses on one particular federation, we use crosscountry data, allowing for the inclusion of variables that measure in which particular institutional and fiscal framework spillovers are weakened or reinforced. In this context we also investigate the extra cost that bailout expectations may entail for potential guarantor governments, a subject that received almost no attention in the literature so far.3 Recommendations will be derived with regard to the optimal design of a country’s institutional and fiscal framework when debt competences are distributed over multiple levels of government. It is found that fiscal decentralization reduces upstream vertical debt spillovers by bolstering the sovereignty of subnational governments and thereby reducing implicit bailout expectations. Furthermore, restrictions or institutional controls on SNG borrowing imposed by the center showed to be effective for avoiding upstream vertical spillovers. The results will prove important in the light of a significant growth of the subnational debt or debt share in several countries.4 One of the reasons that central governments, when decentralizing, are reluctant to transfer debt or debt competences to subnational governments is exactly the presence of externalities or adverse interest rate spillovers, which make them lose control over their own cost of debt financing. Finally, more understanding is gained about the factors that influence yields of higher-tier governments in systems with multiple levels of government. These insights may prove beneficial to understanding the factors that will possibly affect the yield on Eurobonds whenever the plans5 for future European debt issues would be realized. 2. Causes and consequences of interest rate spillovers There are four sources from which spillovers may arise that are relevant to our study of upstream vertical debt spillovers.6 First, interest rate spillovers may result from the traditional crowding out effect: an expansionary fiscal policy in a single country may reduce the aggregate supply of saving, and hence raise real interest rates (Faini, 2006). A second source of spillovers are bailout expectations, which increase the credit risk premium of the government that provides a guarantee (guarantor), and decrease the risk premium of the government that is backed by this guarantee. The latter effect, which is called investor moral hazard7 because investors charge too low interest rates on centrally backed subsovereign bonds, was examined in several studies, e.g. Heppke-Falk and Wolff (2008), Dell Ariccia, Schnabel, and Zettelmeyer (2006, 2002), Lee and Shin (2008) and Bernal et al. (2010). By contrast, little research effort has been devoted to the question whether bailout expectations increase the default risk premium of guarantor governments. Hence, this effect will be explored in this article. Although central governments usually commit not to bailout subsovereigns, this explicit commitment is mostly not credible because of the time inconsistency problem in bailout policy. The

3 As Feld et al. (2011) point out: “It is striking that all studies focus on the benefits for the governments which are protected by conceivable bailouts; they do not account for the costs of the liable governments in terms of higher risk premia which are associated with the threat of potential bailouts”. 4 For example, over our sample period 1995–2009 the share of SNG debt in total debt increased in Spain by 9 percentage points (or 49%), in Finland by 8 percentage points (or 68%), in Italy by 3.5 percentage points (or 73%) and in Germany by 2 percentage points (or 7%). 5 Cf. the proposal for the issuance of Eurobonds by De Grauwe and Moesen (2009). 6 Two additional sources of spillovers are generally referred to in the literature (Landon and Smith, 2000). First, spillovers may result from monetary accommodation expectations when debt accumulation in one jurisdiction fosters expectations of monetary accommodation by the center, raising the risk premium of all members of the currency union. Second, when borrowers are rewarded or penalized to the extent that they diverge from the benchmark member in a federation or a monetary union, we speak of horizontal spillovers due to yardstick comparisons. These sources are not relevant to our study; monetary accommodation expectations are not relevant within EMU countries that have ceded control over monetary policy to the European authority, yardstick comparisons are not applicable to the particular case of vertical spillovers. 7 A second channel through which bailout expectations affect interest rates is through “debtor moral hazard”: a borrower might show irresponsible behavior in the presence of a financial “safety net”, which increases the subsovereign debt level. Debtor moral hazard and investor moral hazard mostly work in the opposite direction, in a way that the ultimate effect is not known (Lee and Shin, 2004). Empirical studies however primarily focus on the latter effect, neglecting borrower moral hazard.

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confrontation ex post with a situation of a looming costly subnational government bankruptcy will give strong incentives for undertaking a bailout. Therefore investors make decisions based on implicit bailout expectations, derived from the perceived sovereignty of subnational governments. Sovereignty of regional or local authorities is mainly influenced by a country’s institutional and fiscal framework,8 and more particularly by the presence of vertical and horizontal imbalances in a federation or a unitary country. For example, the centralization of tax competences weakens the credibility of the center’s “no bailout” commitment, since in that case, due to the lack of own fiscal competences, the subsovereign can invoke its inability to solve financial difficulties. Also, a horizontal fiscal equalization system contributes to a spirit of redistribution and increases the likelihood of a bailout of the government that is on the receiving end of the equalization system.9 Third, intergovernmental spillovers may also be caused by interdependent revenues, when governments are linked through interdependent economies or fiscal flows (e.g. when the center’s crisis results in reduced grants to subnational governments) (Landon and Smith, 2000). Fourth, spillovers may result from information contagion, when investors believe that fiscal difficulties of one government signal impending problems with similar borrowers (Landon and Smith, 2000). Governments may benefit or suffer from this “collective reputation” spillovers. In studying the drivers of debt spillovers, this article aims at finding ways to reduce these spillovers. Spillovers are considered problematic because they distort market-based discipline by giving the wrong incentives to borrowers, resulting in negative welfare implications. When governments run up debts, credit markets signal the increased default risk and punish investors by charging a higher interest rate. This way of discouraging unsustainable borrowing is called marketbased discipline10. Market discipline thus refers to the ability of markets (1) to evaluate correctly the default risk premiums and (2) to trigger the appropriate response for government borrowing. Spillovers hamper market-based discipline with respect to the second feature, by giving the wrong incentives to borrowers.11 They entail a redistribution of interest costs among the members of the federation or currency union; the interest rate of guarantor governments is increased, while that of governments that are backed by this guarantee is decreased. As a consequence, the incentives of individual governments will change. Guarantor governments are inclined to issue lower debt. In other words, there will be a crowding out of productive investments in economic systems where the interest rate would otherwise be lower (Schiavo, 2005). Recipient governments, on the other hand, are led by moral hazard and are inclined to accumulate more debt than they are able to service. Not being punished for fiscal profligacy, they might even be encouraged to issue more debt than is optimal from the perspective of the federation or currency union as a whole. It is argued that the debt and deficit limits of the EU Stability and Growth Pact are exactly designed to prevent such suboptimal debt level choices by member states in a monetary union characterized by debt spillovers (Bovenberg et al., 1991). Second, debt spillovers may be considered problematic because of a government’s loss of control over debt financing costs. Although interest rates are already influenced by factors beyond the control of the borrower, such as the investors’ risk aversion, in normal situations, a government can be held responsible for its credit risk premium. This fear of contagion is also inherent to the current sovereign debt crisis.

8 Rodden (2006) identifies several factors that bolster or undermine the no-bailout commitment of the central government, such as (1) the expenditure assignment and the reasons for borrowing (local versus collective goods), (2) the basic powers and obligations of the center (grants-based financing), (3) externalities or the magnitude (too big to fail) and the political or economic importance of regions (too important to fail), (4) the identity of the debt holders, and (5) electoral motivations and political institutions (likelihood of getting a majority in favor of bailout in the legislative chamber). 9 The fiscally prudent government on the contributing end is penalized more for running deficits. 10 Interest rates are exponentially increasing at high debt levels. This nonlinear relationship is also called the credit punishing hypothesis (Bayoumi et al., 1995). 11 As Landon and Smith (2000) argue: “For the market to send the correct signal, the yield on government debt should reflect the fiscal policy stance of the borrowing government alone”. Singh and Plekhanov (2005) point out: “no bailout expectations” is one of the four conditions for market-based discipline to work. The other conditions that have to be satisfied are (1) free and open markets, (2) adequate information available, (3) borrower should have institutions ensuring adequate policy responsiveness to market signals.

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3. Literature review The literature on interest rate spillovers finds its origin in the large strand of research on the impact of a government’s own fiscal stance on its borrowing costs. A range of previous papers has analyzed the determinants of sovereign bond yields, e.g. Alesina et al. (1992), Lønning (2000), Bernoth et al. (2004), Bernoth and Wolff (2008), Haugh et al. (2009), and Gerlach et al. (2010). Studies on the effect of regional fiscal variables on subsovereign yields can be found in Schulz and Wolff (2008), Schuknecht et al. (2009), Bernoth et al. (2004), Bayoumi et al. (1995), Poterba and Rueben (1999), Lemmen (1999), Booth et al. (2007), Küttel and Kugler (2002) and Heppke-Falk and Wolff (2008). Most of the research on interest rate spillovers focuses on horizontal externalities between the members of a monetary union. The empirical literature, however, is inconclusive as to the existence of these spillovers. Table A.1, Appendix A, presents a summary of the literature. Whereas Faini (2006) shows that fiscal imbalances in one EMU member state bid up the interest rate faced by the other participants in the currency union, Schiavo (2005), however, finds no significant effect of two important historical events, namely the German unification (1989) and the Italian fiscal crisis (1992), on the yield spreads of other participants in the currency union (EMS since 1979). In line with the findings of Faini (2006), Claeys (2007) reports that an expansionary fiscal policy with one EMU member spills over onto aggregate Eurozone interest rates. Nonetheless, some indirect evidence is found that interest rate spillovers are global, rather than internal to EMU. Using a global VAR model, Caporale and Girardi (2011) provide evidence of interlinkages between EMU countries. Foreign (that is, EMU aggregate) factors are found to explain 63–85% of the variability of long-term interest rates in EMU member states.12 Bernoth et al. (2004) show that market-based discipline is weaker after the installation of the EMU, since the effect of own-country debt accumulation on interest rates is lower, which can be attributed to markets anticipating fiscal support for EMU countries in financial distress. Ardagna et al. (2007) find that an increase in total OECD government borrowing increases each country’s interest rates, although domestic fiscal policy continues to affect domestic interest rates. A one percentage point increase in the OECD debt-to-GDP ratio raises a country’s government bond yields from 3 to 21 basis points. Arezki et al. (2011) show that sovereign rating downgrades on European financial markets have statistically and economically significant spillover effects both across countries and financial markets. In a recent study, using an event study approach, Mink and de Haan (2013) find that sovereign bond prices of Portugal, Ireland and Spain respond to both news about Greece and news about a Greek bailout. Evidence on horizontal spillovers at the level of SNGs comes from Landon and Smith (2000, 2007) and Leal-Marcos and Lopez-Laborda (2009). Landon and Smith (2000) found that the credit rating of a Canadian province is negatively influenced by the aggregated debt accumulation of the other provinces, although the effect is small. However, in a more recent analysis using bond yields instead of credit ratings, Landon and Smith (2007) found no evidence of horizontal debt spillovers between Canadian provinces, indicating that provincial governments are not perceived to be implicit guarantors of the debt issued by other provinces. Also Capeci (1991) found no evidence of horizontal spillovers between US municipalities, since no significant influence of the variable “other country debt” on US municipal credit ratings was reported. Horizontal spillovers between regional governments are mainly driven by yardstick comparisons. In Landon and Smith (2000), it is found that a provincial credit rating increases when the largest province, Ontario, runs up debts. Ontario thus appears to act as a benchmark for the other Canadian provinces. In a similar analysis, Leal-Marcos and Lopez-Laborda (2009) show that the debt accumulation of the Spanish Autonomous Communities improves a region’s relative performance and hence its credit rating.

12 Investors, however, discriminate between different categories of issuers: debt accumulation in France and Germany reduces the interest rates of other countries, while the opposite holds when new debt is issued in one of the PIIGS countries.

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While there is a fairly large body of research related to horizontal debt spillovers in currency unions, very little attention has been paid to the issue of vertical interest rate spillovers within countries with multiple levels of government. In a seminal contribution, Landon and Smith (2000) found evidence of downstream vertical debt spillovers; the central government’s indebtedness was found to have a negative effect on provincial governments’ credit ratings in Canada. In Landon and Smith (2007), provincial-federal spreads were found to go up by 4.3 basis points when the central government’s debt-to-GDP ratio increases by one percentage point. The expected depreciation rate of the Canadian dollar counts for 3.0 basis points of this spillover, while the remaining 1.3 basis points are explained by the increased risk of provincial default. Similar findings are reported in Leal-Marcos and Lopez-Laborda (2009), who applied the analysis to Spain. A higher federal debt level was found to be linked to lower credit ratings of the Spanish Autonomous Communities. Upstream vertical interest rate spillovers have received almost no consideration in the literature. The notable exception is Feld et al. (2011), who study the impact of Switzerland’s cantonal-municipal bailout regime on cantonal-federal bond spreads. The findings show that, before the no-bailout of Leukerbad in 2003, the municipals’ fiscal situation was reflected in cantonal bond yields. In a theoretical paper, Heremans and Heylen (1985) argued that there are no upstream interest rate spillovers when regions can be considered as small open economies. This is the case when there are many regions in a federation and/or when budgetary decentralization is small, conditions which apply to local governments in particular. Such subnational governments are price takers, and consequently have no influence on financial markets. Hence, local debt financing would have no effect on the Belgian interest rate. When it comes to the Belgian regional governments, Heremans and Heylen (1985) do not consider them to be small open economies, and expect a macroeconomic effect of regional debt financing, dependent on the size, on national monetary and exchange rate policy.

4. Methodology 4.1. Theoretical model For our analysis, we build on the portfolio model of bond yield differentials13 developed by Bernoth et al. (2004). From this model, the following expression for the differential between the interest rate on a domestic bond, r, and the yield on a foreign bond, r*, was derived.

 
 Sð1 þ rt  st Þ2 1  Pte Pte st rt  rt lt e   þ ¼ Pt 1  þ 1 þ rt 1 þ rt 1 þ rt wt =Ft þ wt =Ft ð1 þ rt Þ

(1)

With Pte the expected default probability of the domestic government14 st the recovery rate when a default occurs lt the expected transaction cost in the domestic bond market15 S the total supply of bonds issued by the domestic government wt and wt the wealth of the domestic and foreign investor respectively ft and ft the coefficients of relative risk aversion for the domestic and foreign investor respectively

13 Interest rates are based on the risk-free rate, and increased by risk premia for default risk, liquidity risk, inflation risk (risk that the purchasing power of the cash flows will decline) and devaluation risk. Most studies calculate yield spreads vis à vis a benchmark government which issues debt in the same currency in order to concentrate on the differences in default and liquidity risk. 14 The foreign asset is considered risk-free. 15 The transaction cost in the foreign market is normalized to zero.

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Hence, the yield spread can be decomposed into three terms: (i) the default risk premium, which depends positively on the expected default probability of the risky issuer country, Pte , and negatively on the recovery rate, st, (ii) the liquidity risk premium, which increases with a higher transaction cost, lt, and (iii) a country-specific risk premium, which depends on the variance of the default probability, Pte , the gross nominal return, (1 þ rt), the level of relative risk aversion of the domestic and foreign investors, ft and ft , and the total supply of bonds, S, relative to total wealth (Bernoth et al., 2004).

4.2. Extension of the model An extension of this bond yield differentials model is developed to account for upstream vertical debt spillovers from subnational to central governments. To this purpose, we elaborate on the expected default probability, Pte , which depends negatively on the expected central government’s creditworthiness, Et ðCtC Þ.

vPte  <0 vEt CtC

(2)

The CG’s creditworthiness, in turn, depends (i) on its own budgetary position, and (ii) if vertical spillovers prevail, on the fiscal performance of the lower-tier governments which potentially will be P bailed out. Let xCt be a vector of fiscal performance indicators16 of the CG and i xit the aggregate of the fiscal variables of subnational governments i, then

  X Et CtC ¼ Ct xCt þ gt xit

! (3)

i

gt captures the effect of vertical spillovers. When gt ¼ 0, the CG’s creditworthiness is expected to be independent of the fiscal stance of its SNGs, which means that no spillovers are present. gt > 0 signals the presence of positive upstream vertical spillovers. If gt ¼ 1 (or gt equals the coefficient of xCt ) subnational and central debt are substitutes with respect to their influence on the center’s default probability. In that case, investors expect that SNG debt is fully backed by the center.17 gt < 0 points at negative upstream vertical spillovers, which may prevail when the CG’s creditworthiness is assessed relatively to the performance of its lower-tier governments, which act as a benchmark. Furthermore, different sources of upstream vertical spillovers are considered by decomposing gt. The expression for the creditworthiness of the central government now becomes   X X X X Et CtC ¼ Ct xCt þ gCO xit þ gIt R xit þ gIt C xit þ gBt E xit t i

i

i

! (4)

i

P k With gt ¼ k gt CO Crowding Out effect IR Interdependent Revenues. IC Information Contagion. BE Bailout Expectations. The remainder of this paper focuses on the role of bailout expectations as a trigger for intergovernmental externalities. Hence, expression (4) is reduced to

16 In the empirical analysis, only debt will be considered as an indicator of fiscal performance. However, deficits and other fiscal indicators could also be used, cf. suggestions for further research. 17 yt > 1 might indicate that the central government is punished more severely for SNG debt accumulation since the SNG’s behavior is beyond its control.

A. Van Hecke / Journal of International Money and Finance 37 (2013) 468–492

  X X X gkt Et CtC ¼ Ct xCt þ xit þ gBE xit t ksBE

475

! (5)

t

i

IR IC The conjoint effect of externality sources aside from bailout expectations, ðgCO t þ gt þ gt Þ, will be measured by the direct effect of the aggregated SNG debt on the CG’s bond yield differential in our estimation specification (6). Bailout expectations are difficult to measure directly, because of the time inconsistency problem: Ex ante, the central government mostly makes a “no-bailout commitment”, denying liability for SNG debt, or gBE ¼ 0:. Ex post, the cost of SNG financial distress may be too large, such that the center will shift t extra money to troubled SNGs. If explicit no-bailout policies are regarded as not credible by investors, the latter make educated guesses about whether the center implicitly guarantees SNG debt, making gBE t _0:. In this contribution, implicit bailout expectations will be derived from a country’s institutional and fiscal framework, in particular from the presence of vertical fiscal imbalances (grants-based financing) and SNG borrowing autonomy (cf. infra).

4.3. Model specification for empirical testing We make use of the following estimation specification to investigate spillover effects on the yield differential between EMU country j and the benchmark country Germany (indicated by an asterisk), 

C;j C;j rt  rtC ¼ b0 þ b1 xt þ b2

X i

i;j

j

j

xt þ b3 st þ b4 st

X

i;j

C;j

j

j

xt þ b5 lt þ b6 ft þ b7 Controlst þ mj þ εt

i

(6) xC;j t

With capturing CG fiscal variables in country j at time t, including the CG’s debt level, squared debt level (to allow for a non-linear relationship) and its fiscal balance. P i;j j 18 i xt the aggregated SNG debt of country j at time t. st a measure of bailout expectations, based on country j’s fiscal framework at time t. Using German bond yields as a benchmark for Eurozone countries is common practice in the literature. However, it can be argued that Germany lost its benchmark status at the start of the euro crisis when it became influenced by the flight-to-quality behavior of investors.19 We argue that the flight-to-quality issue is not problematic for our sample period, which runs from 1995 to 2009, because (1) a recession dummy corrects for crisis-specific effects in 2008 and 2009, and (2) a robustness check (cf. infra) indicates that our results are not sensitive to the exclusion of the last two years of our sample period. Also, most explanatory variables are expressed as differentials relative to the German values, to ensure that the measured effects can be ascribed to changes in country j’s bond yield, and are not caused by contemporaneous developments in Germany. The implicit assumption is that fiscal variables affect the yield of the benchmark country in the same way as they affect other countries’ yields. Regression (6) addresses the following hypotheses. Hypothesis I. The central government’s interest rate differential increases with the aggregated debt level of its subnational governments. This hypothesis deals with the presence of upstream vertical interest rate spillovers, which are quantified by b2 þ b4 sjt . If b2 þ b4 sjt ¼ 0, no evidence on spillovers is found. b2 þ b4 sjt s0 indicates that there are some negative or positive externalities attached to SNG debt accumulation. Hypothesis II.

18

Bailout expectations reinforce vertical debt spillovers.

Subnational government variables are the aggregate of state and local government variables. For example, the ECB uses interest rate swaps (IRS) rates as a benchmark in its recent report on financial integration (ECB, Financial Integration in Europe, April 2012). 19

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Hypothesis II states that when investors expect a bailout of troubled SNGs and ask too low risk premiums on SNG debt (investor moral hazard), the guarantor party has to bear the cost. The larger the risk (SNG debt level), the larger this cost. Hence, bailout expectations reinforce the effect of SNG debt on CG bond yields. b4 in regression (6) tests whether this hypothesis holds. We expect debt spillovers to be conditional on the presence of bailout expectations. In addition to this spillover effect, a direct or “level” effect of bailout expectations on CG bond yields P can be expected. This effect would be captured by b3 þ b4 i xi;j t in Equation (6). However, we will not be able to test this effect since our measure of bailout expectations is time-invariant and will produce no results in Fixed Effects regressions (cf. infra). Finally, in our robustness checks, we will take account of another channel through which bailout expectations may affect CG interest rates; i.e. through “debtor moral hazard”. In the presence of a financial “safety net” or a guarantee from a higher-tier government, a SNG borrower may be inclined to behave irresponsibly, piling up large amounts of debt. In other words, the SNG debt variable might be endogenous in Equation (6). Therefore, Equation (7) and Hypothesis III are added to the analysis.

X

i;j j j j xt ¼ d0 þ d1 st þ d2 Controlst þ nt

(7)

i

Hypothesis III. More regional debt is accumulated when bailouts are expected. A joint estimation of Equations (6) and (7) allows the testing of Hypotheses I to III simultaneously. Since the error terms εjt and njt of Equations (6) and (7) are assumed to be correlated, the Seemingly Unrelated Regressions (SUR) technique will be used. 5. Data Our empirical analysis is based on data for the period of 1995–2009, and covers 13 out of 17 EMU countries.20 Nominal interest rates (yield to maturity) on 10-year government bonds, denominated in euro, are gathered from the IMF’s International Finance Statistics (IFS) database. Yield spreads (on a yearly basis) vis à vis the benchmark country Germany are illustrated in Figure B.2, Appendix B. Debt data21 for the different levels of government (central, regional and local) were collected from the IMF’s Government Finance Statistics (GFS) database. For Germany, an alternative data source, viz. the database of the Statistisches Bundesamt Deutschland, is used, since the considered time period was not fully covered by the IMF GFS. Subnational debt data is only available on an aggregated basis without distinction between the different constituencies within a particular government level. National GDP data from Eurostat was used to calculate debt-to-GDP ratios for the different government tiers. Other fiscal indicators, such as the balance-to-GDP ratio,22 were gathered from the same sources. SNG debt-toGDP ratio’s are shown in Figure B.3, Appendix B. As can be seen, the German SNG debt-to-GDP ratio exceeds 20% and is increasing from 1995 to 1998, from 2000 to 2005, and from 2008 onwards. Figure B.4 plots the SNG debt-to-GDP differential with respect to Germany. The influence of the choice for Germany as a benchmark on the obtained empirical results is negligible; since a strong growth of German SNG debt is observed while the German interest rate falls, our findings of vertical debt spillovers will be underestimated, rather than overestimated, such that the main conclusions will still hold. A proxy for bailout expectations or soft budget constraints is derived from a country’s institutional and fiscal framework. More particularly, the vertical fiscal gap, or the amount of grants-based financing of subnational governments is used. The larger the transfers or grants that flow from the center to the

20 Data are missing for Cyprus, Malta and Slovenia. Because of its high leverage on the estimation results, the observation for Estonia is excluded from the analysis. 21 To obtain the gross debt position of a government level, we subtracted the entries “shares and other equity” and “financial derivatives” from the stock of all liabilities, cf. GFS Manual (2001): “all liabilities in the GFS system are debt except for shares and other equity and financial derivatives” p129. 22 The net operating balance is defined as revenue – expense.

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Table 1 Borrowing Autonomy. Borr. Aut. regime

AC

RBC

CA

NIR

Countries

Ireland

Estonia, Greece, Italy, Luxembourg, Slovakia

Austriaa, Belgium, Germany, Spain

Finland, France, Netherlands, Portugal

a

From 1995 till 1998, Austria is classified under the RBC regime.

subnational level, relative to total SNG revenues, the more doubt can be raised against the sovereignty of these SNGs, fostering bailout expectations. Investigating the circumstances in which bailouts occurred in Australia, Germany, Italy and Sweden, Von Hagen et al. (2000) confirm that SNGs that do not dispose of strong tax bases are more eligible to bailouts.23 The vertical fiscal imbalance (VFI) measure of country j at time t is calculated as follows.

P j

VFIt ¼ P

i;j i Grantst

i Total

i;j

Revenuet

(8)

Data with respect to the different sources of SNG revenues is collected from IMF GFS and the OECD Fiscal Decentralization Database. For our empirical analysis, the dummy variable “High VFI” is introduced to be used in interaction variables. Otherwise, interaction variables, both measured as differentials and thus including negative values, would not be uniquely defined.24 The cut-off point of 0.44 is the median value of the country averages in our sample. The interaction variable “High VFI*SNG debt” investigates whether interest rate externalities are more likely when a country’s VFI is above the median value of EMU countries. An illustration of the High VFI dummy can be found in Figure B.5, Appendix B. In Belgium, Greece, Ireland, Italy, the Netherlands and Spain, more than 44% of SNG revenues are grants. For measuring the effect of SNG borrowing autonomy, dummy variables are constructed based on the classification of subnational borrowing controls in Singh and Plekhanov (2005). Four different institutional approaches to constrain subnational borrowing are distinguished, going from selfimposed rules (market discipline), cooperative arrangements between the CG and SNGs, and rulebased controls, to administrative constraints on SNG borrowing. When no limits are imposed on SNG borrowing,25 our no imposed rules (NIR) dummy is coded one. Under the cooperative arrangements (CA) regime, SNG borrowing controls are designed by a negotiation process between the central and subnational governments. Under the rule-based controls (RBC) regime, central governments try to constrain SNG borrowing by imposing a fiscal rule, such as a restriction on the budget deficit or the debt level, or a “golden rule” which limits borrowing to investment purposes. When the CG exercises direct and strict control over subnational borrowing by administrative procedures, such as review and authorization of subnational borrowing operations or setting limits on the overall SNG debt, we speak of administrative constraints (AC). A classification of EMU countries according to their SNG borrowing regime is provided in Table 1. It should be noted that the cooperative arrangement system prevails in all federal countries. Borrowing constraints may work in two directions: the lower scope for discretion of fiscal policy may reduce SNG debt levels and hence decrease vertical spillovers, or spillovers may be increased because the centrally imposed restrictions may harm the SNGs’ sovereignty and fiscal responsibility, fostering bailout expectations. Rodden (2006) demonstrates that SNG borrowing autonomy in a framework of grants-based financing reinforces SNG moral hazard and bailout expectations, since SNG deficits are increased.

23 For example, the Swedish local government bailouts between 1996 and 1998 occurred after the central government has restricted the ability of the municipalities to change local tax rates. 24 For example, (0.5)*(0.5) ¼ 0.5*0.5. Also, since CG debt is expressed as a differential, we define the quadratic term not as the square of the differential, but the differential of the squares of a particular country’s and Germany’s CG debt-to-GDP ratio. 25 SNGs, however, may adopt their own fiscal rule, e.g. in an attempt to improve their credit rating.

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A. Van Hecke / Journal of International Money and Finance 37 (2013) 468–492 Table 2 Correlation matrix.

AC RBC CA NIR

High VFI

SNG debt

0.36 0.11 0.05 0.31

0.17 0.08 0.12 0.09

Borrowing Autonomy is indeed correlated with vertical fiscal imbalances, as can be seen in Table 2. Less borrowing autonomy is given to SNGs when VFI or bailout expectations are high. In addition, Table 2 also presents the correlation with the SNG debt level relative to Germany. The two extremes, full CG control (administrative constraints) when VFI is high, and no CG control on SNG borrowing when VFI is low, turn out to be the most effective in restraining the SNG debt level. Additionally, the European Commission’s Fiscal Rules Index (FRI) will be included, to measure the effect of budgetary stringency employed on all governments within the respective EMU countries on vertical debt spillovers. As a further explanatory variable, we include the degree of decentralization of power within a particular country, defined as the ratio of subnational governments’ expenditures versus total government expenditures. Central, regional and local government expenditures data were gathered from IMF GFS and the OECD Fiscal Decentralization Database. For the incorporation of additional control variables, the standard approach in the literature is followed. Studies investigating sovereign bond yields also typically include26  The investor’s risk aversion in international bond markets. Following the strategy of Bernoth et al. (2004), we use the yield spread between low grade US corporate bonds (BBB) and benchmark US government bonds as an empirical proxy.27 Data was gathered from the website of the US Federal Reserve System.28  The liquidity of central government bonds is accounted for by including a country’s relative market size, as illustrated in Equation (9).29 It was shown by Gravelle (1999) that the correlation between market size and the conventional measure of liquidity, i.e. bid-ask spreads, is significantly negative.

C;j

lt

C;j

D ¼ P t C;j j Dt

(9)

 An EMU dummy, coded one when a particular country joins the EMU.30 It should be noted that this variable also captures the enhanced liquidity after the introduction of the EMU.  Exchange rate risk before the start of the EMU is included by adding percentage changes in the exchange rate of former national currencies against the euro. Exchange rate data were gathered from Eurostat.  The inflation rate, relative to German inflation.

26 Political variables were not included since we expect no additional effect on interest rates, compared to their direct effect on government debt for which quite some supportive evidence exists; see e.g. Volkerink and De Haan (2001). 27 Bernoth et al. (2004) argue that the empirical literature on sovereign spreads of emerging markets shows that spreads are sensitive to US risk factors. 28 http://research.stlouisfed.org/fred2/categories/22. 29 For this calculation, the debt variables which are expressed in local currency were transformed to debt in euros. 30 Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain joined the EMU in 1999, Greece in 2001, Slovenia in 2007, Cyprus and Malta in 2008 and the Slovak Republic in 2009.

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Table 3 Estimation results. Dep. var: gov bond yield

(1)

CG balance CG debt CG debt2 Risk Aversion Liquidity EMU Exch. rate Inflation Recession Decentralization SNG debt High VFI*SNG debt Federal*SNG debt Timetrend Constant Observations R2

10.06 2.46 3.35 0.05 0.83 0.65 8.40 0.26 0.99 1.93

(2) 10.79 2.41 3.06 0.15 5.52 0.71 7.75 0.26 0.86 1.89 5.74

(3.61)*** (1.63) (1.00)*** (0.11) (8.65) (0.21)*** (4.29)* (0.05)*** (0.30)*** (1.57)

0.03 (0.03) 1.36 (1.04) 152 0.460

(3) (3.65)*** (1.63) (1.03)*** (0.14) (10.08) (0.21)*** (4.32)* (0.05)*** (0.32)*** (1.57) (4.70)

0.05 (0.03)* 0.16 (1.62) 152 0.467

14.14 1.57 2.57 0.35 21.05 0.75 8.03 0.23 0.57 1.72 26.75 20.48

(4) (3.57)*** (1.56) (0.98)*** (0.14)** (10.36)** (0.20)*** (4.09)* (0.05)*** (0.31)* (1.49) (7.00)*** (5.25)***

0.09 (0.03)*** 3.03 (1.70)* 152 0.524

13.89 2.34 3.13 0.38 23.96 0.80 8.93 0.23 0.57 1.47 31.28 20.86 8.46 0.09 3.66 152 0.536

(3.54)*** (1.61) (1.02)*** (0.14)*** (10.39)** (0.20)*** (4.09)** (0.05)*** (0.31)* (1.48) (7.37)*** (5.21)*** (4.65)* (0.03)*** (1.72)**

Fixed Effects regressions, standard errors in parentheses. *p < 0.10, **p < 0.05, ***p < 0.01.

 The business cycle or macro-economic situation is included using a recession dummy, defined in Equation (10).31 This variable captures the effect of the economic and financial crisis for the years 2008–2009.

j Recessiont

¼

8 < 1 if :

GDPjt GDPjt1 GDPjt1

<0

(10)

0 otherwise

 A timetrend, to control for time-varying effects. Table B.1, Appendix B, presents the summary statistics of the different variables employed in the analysis. 6. Empirical results In our dataset, we are confronted with unobserved heterogeneity across panels.32 Hence, a correction is made for country-specific variance of the error term by using Fixed Effects regressions.33 The results of the empirical analysis are presented in Tables 3 and 4.34 Table 3 focuses on vertical spillovers within a framework of grants-based financing, while Table 4 investigates the role of a country’s SNG borrowing regime. Column (1) in Table 3 shows that the coefficients of the standard control variables have the expected sign. First, a positive net budget balance of the CG is associated with cheaper CG

31

This definition was taken from the study of Decramer et al. (2011). The null hypothesis which says that the country dummies are not jointly significant is rejected at standard significance levels. 33 The Fixed Effects (FE) approach is the most appropriate econometric technique, since (1) the countries of our focus are “one of a kind” and not randomly drawn from an underlying population, in a way that the unknown country-specific effects are correlated with the independent variables, and (2) the Hausman test yields a c2-test statistic of 74.5, rejecting the Random Effects model at the 1% significance level. 34 The correlation matrix of the variables employed in the analysis can be found in Table C.1, Appendix C. 32

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Table 4 Estimation results with borrowing autonomy. Dep. var: gov bond yield

(1)

CG balance CG debt CG debt2 Risk aversion Liquidity EMU Exch. rate Inflation Recession Decentralization SNG debt SNG debt*AC SNG debt*RBC SNG debt*CA Fiscal Rules SNG debt*Fiscal Rules Timetrend Constant Observations R2

10.79 2.41 3.06 0.15 5.52 0.71 7.75 0.26 0.86 1.89 5.74

(2) (3.65)*** (1.63) (1.03)*** (0.14) (10.08) (0.21)*** (4.32)* (0.05)*** (0.32)*** (1.57) (4.70)

0.05 (0.03)* 0.16 (1.62) 152 0.467

12.90 2.57 3.26 0.10 8.29 0.71 6.87 0.25 0.99 0.07 14.10 9.06 26.27 16.60

(3) (3.38)*** (1.59) (0.96)*** (0.13) (9.38) (0.20)*** (3.96)* (0.05)*** (0.29)*** (1.58) (4.81)*** (13.40) (5.04)*** (4.12)***

0.07 (0.03)** 0.71 (1.57) 152 0.568

13.22 2.03 2.92 0.20 4.53 0.72 7.75 0.24 0.69 1.78 5.22

(3.68)*** (1.63) (1.03)*** (0.14) (10.00) (0.21)*** (4.23)* (0.05)*** (0.32)** (1.60) (5.09)

0.19 4.07 0.09 0.29 152 0.498

(0.39) (2.65) (0.03)** (1.68)

Fixed Effects regressions, standard errors in parentheses. < 0.10, **p < 0.05, ***p < 0.01.

*p

borrowing; an increase of the CG’s net surplus-to-GDP relative to Germany by one percentage point decreases the CG’s bond yield differential by approximately 10 basis points. Second, debt accumulation has an upward (although not significant) effect on central government bond yields. Both findings are in line with the hypothesis of market-based discipline in financial markets. The effect of CG debt on sovereign interest rates is, however, exponentially decreasing. This contradicts the credit punishing hypothesis, which states that the positive relationship between debt accumulation and interest rates is exponentially increasing, but is consistent with previous findings in Bernoth, von Hagen, and Schuknecht (2004). Central governments are punished by financial markets for accumulating debt, but less when the debt level rises to a high. An explanation for this may be found in horizontal spillovers and bailout expectations from the supranational EU government. Furthermore, countries that join the EMU enjoy a 65 basis points lower interest rate on their government bonds relative to Germany. In all estimation specifications, risk aversion and inflation have the expected upward effect on CG bond yield differentials, while liquidity decreases the cost of CG borrowing. An exchange rate increase relative to the euro has a significant negative effect. Although the risk of devaluation is thought to decrease bond prices (and hence, to increase yields), a negative coefficient can be found when this effect is dominated by the phenomenon of “carry trade” by investors who borrow in low interest rate countries and invest in high interest countries, and therefore sell the national currency of the former and buy the national currency of the latter, bringing along devaluation and revaluation with respect to the euro in, respectively, low and high interest countries. Next, risk premia are found to increase during a recession; during the economic and financial crisis in 2008 and 2009, CG interest rates went up by 57–99 basis points on average. Finally, central governments of decentralized states seem to borrow at more favorable terms than others, although the effect is not significant; a central government that transfers one percent of its expenditure competences to the SNG level relative to Germany saves about 1.9 basis points in the relative interest payments on its debt. Estimations (2) to (4) add our variables of interest, indicating that not the inclusion of SNG debt in itself, but the inclusion of the interaction between SNG debt and vertical fiscal imbalances, adds significantly to the explanatory power of our model. The marginal effect of SNG debt on CG yield differentials is significantly negative for all values of High VFI and Federal, contradicting Hypothesis I of

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positive upstream vertical debt spillovers. If a country’s SNG debt-to-GDP level relative to Germany goes up by one percentage point, its CG pays up to 30 basis points less on its debt issues. A possible explanation may be that, although a correction for the decentralization of expenditures is made, the SNG debt variable still captures the effect of the decentralization of public debt (since decentralization is also expected to shift debt and debt responsibilities to the SNG debt level, having a positive effect on CG creditworthiness).35 Estimation (3) indicates that markets do consider bailout expectations when pricing central government bonds. Vertical fiscal imbalances clearly have an upward effect on SNG debt spillovers. The downward effect of SNG debt on the center’s bond yield for SNGs with high VFI is not as strong as for SNGs with low VFI. In other words, a CG’s default risk decreases less when its SNGs accumulate debt in an institutional context of high VFI, or, the positive (interest-rate reducing) effect of decentralizing debt on sovereign rates is significantly lower when the center remains liable for these debts. Finally, spillovers resulting from a one percentage point increase in the relative SNG debt ratio are 8.5 basis points larger in federal countries. Table 4 illustrates the effect of a country’s SNG borrowing regime on vertical debt spillovers. Tighter restrictions and institutional controls are thought to reduce the eligibility of SNGs for bailouts. Our findings show that the lowest sovereign borrowing costs are associated either with no controls on SNG borrowing or with strict administrative controls. By contrast, rule-based controls and cooperative arrangements are found to have an upward effect on CG bond yields. For an explanation, it is important to take a look at the correlation matrix in Table 2. The imposition of subnational borrowing controls clearly depends on the presence of grants-based financing or vertical fiscal imbalances. Restrictions increase with the extent of VFI. The second column of Table 2 illustrates that the SNG debt level is restrained either by administrative constraints, imposed in an environment of high VFI, or by strengthening the fiscal competences of SNGs (reducing VFI). Both strategies reduce bailout expectations and hence the effect of SNG debt accumulation on CG bond yield differentials. Hence, sovereign spreads seem to increase when the situation is unclear to investors. Rule-based controls and cooperative arrangements confuse investors; bailouts are implicitly expected, because of the presence of VFI, but not explicitly acknowledged by the CG, such that no protecting measures are taken by CG policy makers to severely restrict SNG borrowing. In conclusion, the results teach us that, in order to decrease debt financing costs, CGs should either strictly control SNG borrowing in situations of high VFI, or reduce the ratio of grants-based financing. Additionally, the last column of Table 4 tests the effect of the Fiscal Rules Index (FRI), employed by the European commission to measure budgetary stringency within EMU member states, on vertical spillovers. Stricter fiscal rules within a member state are found to have a downward effect on CG bond yields and to further weaken vertical upstream spillovers,36 although the effects are not significant.

6.1. Robustness checks First, as previously mentioned, the exogeneity of the SNG debt variable is examined, leading to a joint estimation of a system of equations in which SNG debt is endogenous. Using Seemingly Unrelated Regressions (SUR), Equations (6) and (7) are estimated simultaneously. A positive effect of bailout expectations (VFI) on SNG debt would support our hypothesis of borrower moral hazard. This hypothesis is confirmed in Table 5. The SNG debt ratio is 9 percentage points higher in countries with high vertical fiscal imbalances. Furthermore, it is found that expenditure decentralization reduces the SNG debt ratio relative to Germany with 0.15. Table 5 shows that the findings of the previous section still hold when borrower moral hazard is controlled for.

35 36

A “debt decentralization” variable is not included because of collinearity problems with the CG and SNG debt variables. Negative spillovers are reinforced, or positive spillovers are weakened.

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A. Van Hecke / Journal of International Money and Finance 37 (2013) 468–492 Table 5 Estimation results: SUR with country fixed effects. Gov. bond yield diff CG balance CG debt CG debt2 SNG debt High VFI Federal High VFI*SNG debt Federal*SNG debt Decentralization EMU Risk Aversion Liquidity Exch. rate Inflation Recession Timetrend Constant Observations R2

13.89 2.34 3.13 31.10 4.89 0.77 20.86 8.46 1.44 0.80 0.38 23.95 8.93 0.23 0.57 0.09 6.61 152 0.79

(3.23)*** (1.46) (0.93)*** (6.71)*** (1.16)*** (1.35) (4.74)*** (4.23)** (1.35) (0.18)*** (0.13)*** (9.46)** (3.72)** (0.05)*** (0.28)** (0.03)*** (3.11)**

SNG debt SNG balance High VFI Decentralization Federal Recession Constant Observations R2

0.23 0.09 0.15 0.07 0.02 0.25 152 0.65

(0.22) (0.01)*** (0.05)*** (0.01)*** (0.01)*** (0.01)***

SUR Regressions with country fixed effects, standard errors in parentheses. *p < 0.10, **p < 0.05, ***p < 0.01.

As a second robustness check, we look for potential endogeneity in the analysis, which may be present when the SNG debt level is affected by the level of CG bond yields (for example when because of expensive borrowing at the center some borrowing is shifted to the SNG level). In Table D.1, Appendix D, the lagged SNG debt level is included as an instrumental variable. The results confirm our previous findings. Finally, we check the robustness of the analysis to the exclusion of the crisis years 2008 and 2009, since the results may be influenced by flight-to-quality issues in our benchmark country Germany. Table E.1, Appendix E, shows that coefficients only slightly differ from those in Table 3.

7. Conclusions This article examines the extent to which subnational governments may drive sovereign risk premiums. Based on a panel of EMU countries from 1995 to 2009, our results indicate that subnational government (SNG) debt reduces rather than increases central government (CG) bond yield differentials. A possible explanation may be that the SNG debt variable captures the effect of public debt decentralization, having a positive effect on CG’s debt level and creditworthiness. However, important insights are derived on the potential role of intergovernmental fiscal relations for reducing vertical debt spillovers. Evidence is provided that grants-based financing of SNGs reinforces spillovers by fostering bailout expectations. In other words, a CG’s default risk increases when its SNGs accumulate debt in an institutional context of high vertical fiscal imbalances, relative to the situation when VFI is

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low. Furthermore, it is found that spillovers depend on whether, and to what extent, SNG borrowing autonomy is limited within a particular country. When rule-based constraints or cooperative arrangements prevail, SNG debt accumulation does increase CG yield spreads. Two strategies contribute to lower refinancing costs; CGs should either exercise strict administrative control over SNG borrowing in situations of high vertical fiscal imbalances, or strengthen the tax bases of subnational governments (reduce VFI). Our robustness checks show that the results still hold when borrower moral hazard, endogeneity and flight-to-quality aspects during the economic and financial crisis are controlled for. Our analysis provides useful insights for the optimal design of a country’s institutional and fiscal framework in order to reduce interest rate spillovers. Countries that are reluctant to devolve debt competences to regional and local authorities are given a tool for controlling the risk of adverse externalities. Second, our study illustrates that implicit liabilities for SNG debt in a non-credible nobailout regime impose sanctions on the guarantor government. Theoretically, the results are also applicable to every monetary union where a government’s interest rate is affected by the debt policy of another jurisdiction. Interest rate spillovers are inherent to the current sovereign debt crisis in the European Union. The proposed creation of eurobonds would replace part of the current horizontal spillovers by vertical externalities, similar to the ones studied in this paper. Hence, this operation will come at a cost for possible guarantors, such as Germany. These spillover effects can be mitigated either by reinforcing the (perceived) sovereignty of the debt issuer or by imposing strict administrative controls on debt issuance. When choosing the former option, the creation of eurobonds should be accompanied by fiscal competences at the European level, as was also argued by Heremans and Van Hecke (2012). However, the recently adopted Six Pack and Fiscal Compact measures rather point at the second solution. This study leaves a number of issues open, which may be resolved through future research. First, since we use aggregated figures for SNG debt, we implicitly assume that one euro of debt is the same, no matter which SNG of a particular country issues the debt. However, bailout expectation asymmetries may exist between regions within one country. For example, poor regions that receive transfers from a fiscal equalization system are more likely to receive a bailout than rich regions on the contributing end. Also VFI asymmetries may exist within countries such as Spain, where the decentralization rate is asymmetric between the Autonomous Communities. Second, no separate analysis was made for regional and local government debt spillovers. The reason is that, by focusing on EMU countries and taking Germany as a benchmark, the number of federal countries in the dataset is limited. A number of recommendations can be made regarding future research in this area. First, further investigations could check the results for a larger set of countries. Including non-EMU countries requires some adaptations of the empirical model, such as the appropriate choice of a benchmark country. Second, a promising line of study would be to repeat the analysis for other measures of fiscal performance rather than debt accumulation. Upstream vertical interest rate spillovers can also be the consequence of large deficits of subnational governments. Acknowledgments Earlier versions of this paper were presented at the VVE-day of Scientific Economic Research in Antwerp, the IWH/INFER Workshop on Applied Economics and Economic Policy in Halle, Germany, and the 2012 IIPF Congress in Dresden, Germany. I am grateful for comments from participants at those meetings. I would also like to thank Prof.dr.em. Dirk Heremans, Prof.dr. Marc De Broeck (IMF), Prof.dr. Joep Konings, Prof.dr. Carine Smolders and Prof.dr.em. Paul De Grauwe and an anonymous referee for their constructive comments. This research was supported by the Policy Research Centre Budgetary and Tax Policy of the Flemish government (Steunpunt Fiscaliteit & Begroting).

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Appendix A. Overview of the literature

Table A.1 Overview of the literature and empirical evidence with respect to horizontal and vertical interest rate spillovers Paper

Time period & jurisdictions

Evidence of horizontal spillovers?

Evidence of vertical spillovers?

Faini (2006)

9 EMU countries, 1979–2002

/

Schiavo (2005)

Germany, Italy, EMU 1980–2004

Claeys (2007)

8 EU countries, 1960–2004

Caporale and Girardi (2011)

11 EMU countries, 1999–2010

Bernoth et al. (2004) Ardagna et al. (2007) Arezki et al. (2011)

13 EMU countries, 1991–2002 16 OECD countries, 1960–2002 Selected European countries, 2007–2010

Capeci (1991)

136 municipalities in 1982 and 1987

Mink and de Haan (2013) Landon and Smith (2000)

GIPS countries, 2010

Yes: Expansionary fiscal policy in one EMU member affects overall level of interest rates for EMU as a whole No: No significant effect of German unification and Italian fiscal crisis (1992) on EMU interest rate Yes: Indirect: A country’s deviation from average EU fiscal conditions does not affect that country’s relative spread. A small crowding out effect is found at EMU level Yes: Foreign factors explain the largest percentage of variability in long-term interest rates in EMU countries. Yes: Indirect: EMU reduces effect of debt on interest rates Yes: Increase in total OECD borrowing increases each country’s interest rates Yes: Sovereign rating downgrades have spillover effects both across countries and financial markets No: No significant influence of the variable “other country debt” on US municipal credit ratings Yes: Sovereign bond prices respond to news about Greek and news about a Greek bailout. Yes: Regional credit rating goes up when Ontario accumulates debt, and down when other regions do

Landon and Smith (2007) Leal-Marcos and LopezLaborda (2009) Feld et al. (2011)

9 Canadian Provinces, 1974–1997

9 Canadian Provinces, 1983–2003 14 Spanish Communities, 1992–2007 Swiss cantons, 1981–2007

No: No significant impact of aggregate provincial debt to GDP on provincial government bond yields. Yes: Regional credit rating goes up with debt creation of other regions

/

/

/

/

/ / /

/

/

Yes: Regional credit rating worsens when federal government accumulates debt. Yes: Regional-federal spreads increase with federal government debt-to-GDP level. Yes: Regional credit rating worsens when federal government accumulates debt. Yes: Before the no-bailout of Leukerbad in 2003, the municipals’ fiscal stance was reflected in cantonal bond yields.

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0

Gov Bond Yield (%) 5 10 15 20

Appendix B. Illustration of data

1995

2000

2005

2010

Year Austria/Slovenia Cyprus Finland Germany Ireland Luxembourg Netherlands Slovak Republic

Belgium/Spain Estonia France Greece Italy Malta Portugal

Gov Bond Yield Differential 0 5 10

Figure B.1. Evolution of central government bond yields in levels. Source: IMF IFS and own calculations

1995

2000

2005

2010

Year Austria/Spain Cyprus Finland Greece Italy Malta Portugal Slovenia

Belgium Estonia France Ireland Luxembourg Netherlands Slovak Republic

Figure B.2. Evolution of central government bond yield differentials w.r.t. Germany. Source: IMF IFS and own calculations

486

Belgium

Finland

France

Germany

Greece

Ireland

Italy

Luxembourg

Netherlands

Portugal

Slovak Republic

.3 .2 .1 0 .3 .2

SNG debt

.1 0

1995

2000

2005

2010 1995

2000

2005

2010 1995

2000

2005

2010

0

.1

.2

.3

Spain

1995

2000

2005

2010

Year Figure B.3. Evolution of the ratio of SNG debt to national GDP in EMU countries. Source: IMF GFS, OECD Decentralization Database and own calculations

A. Van Hecke / Journal of International Money and Finance 37 (2013) 468–492

0

.1

.2

.3

Austria

Belgium

Finland

France

Greece

Ireland

Italy

Luxembourg

Netherlands

Portugal

Slovak Republic

Spain

-.3 0 -.1 -.2 -.3 0

SNG debt/GDP differential

-.1 -.2 -.3 1995

2000

2005

2010 1995

2000

2005

2010 1995

2000

2005

2010 1995

2000

2005

2010

A. Van Hecke / Journal of International Money and Finance 37 (2013) 468–492

-.2

-.1

0

Austria

Year Figure B.4. Evolution of the SNG debt to GDP differential w.r.t. Germany. Source: IMF GFS, OECD Decentralization Database and own calculations

487

488

Belgium

Finland

France

Germany

Greece

Ireland

Italy

Luxembourg

Netherlands

Portugal

Slovak Republic

1 .5 0 1

High VFI

.5 0

1995

2000

2005

2010 1995

2000

2005

2010 1995

2000

2005

2010

0

.5

1

Spain

1995

2000

2005

2010

Year Figure B.5. High Vertical Fiscal Imbalance in EMU countries. Source: IMF GFS, OECD Decentralization Database and own calculations

A. Van Hecke / Journal of International Money and Finance 37 (2013) 468–492

0

.5

1

Austria

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Table B.1 Summary statistics Variable Gov bond yield

CG balance

CG debt

Risk aversion

Liquidity

EMU

Exchange rate

Inflation

Recession

Decentralization

SNG debt

High VFI

Federal

Timetrend

AC

RBC

CA

Mean Overall Between Within Overall Between Within Overall Between Within Overall Between Within Overall Between Within Overall Between Within Overall Between Within Overall Between Within Overall Between Within Overall Between Within Overall Between Within Overall Between Within Overall Between Within Overall Between Within Overall Between Within Overall Between Within Overall Between Within

0.61

0.00

0.31

1.93

0.08

0.67

0.00

1.17

0.08

0.12

0.16

0.50

0.25

8.00

0.08

0.36

0.23

Std. dev.

Min

Max

Observations

1.31 0.66 1.15 0.03 0.02 0.02 0.33 0.33 0.10 0.64 0.00 0.64 0.08 0.08 0.01 0.47 0.19 0.43 0.02 0.01 0.02 1.89 1.34 1.38 0.28 0.03 0.28 0.12 0.12 0.04 0.05 0.05 0.03 0.50 0.52 0.00 0.43 0.45 0.00 4.33 0.00 4.33 0.28 0.29 0.00 0.48 0.48 0.13 0.42 0.42 0.13

1.19 0.03 1.47 0.12 0.03 0.13 0.37 0.33 0.09 1.25 1.93 1.25 0.14 0.13 0.11 0.00 0.07 0.07 0.09 0.01 0.08 4.86 0.02 4.94 0.00 0.07 0.06 0.34 0.32 0.26 0.26 0.23 0.22 0.00 0.00 0.50 0.00 0.00 0.25 1.00 8.00 1.00 0.00 0.00 0.08 0.00 0.00 0.09 0.00 0.00 0.51

10.11 2.27 8.45 0.08 0.04 0.09 0.96 0.83 0.57 3.23 1.93 3.23 0.13 0.11 0.04 1.00 0.73 1.60 0.12 0.01 0.13 10.61 4.75 7.04 1.00 0.14 1.01 0.13 0.06 0.00 0.02 0.10 0.07 1.00 1.00 0.50 1.00 1.00 0.25 15.00 8.00 15.00 1.00 1.00 0.08 1.00 1.00 1.09 1.00 1.00 0.49

N ¼ 175 n ¼ 12 T ¼ 14.58 N ¼ 177 n ¼ 12 T ¼ 14.75 N ¼ 160 n ¼ 12 T ¼ 13.33 N ¼ 180 n ¼ 12 T ¼ 15 N ¼ 160 n ¼ 12 T ¼ 13.33 N ¼ 180 n ¼ 12 T ¼ 15 N ¼ 180 n ¼ 12 T ¼ 15 N ¼ 180 n ¼ 12 T ¼ 15 N ¼ 168 n ¼ 12 T ¼ 14 N ¼ 180 n ¼ 12 T ¼ 15 N ¼ 160 n ¼ 12 T ¼ 13.33 N ¼ 180 n ¼ 12 T ¼ 15 N ¼ 180 n ¼ 12 T ¼ 15 N ¼ 180 n ¼ 12 T ¼ 15 N ¼ 180 n ¼ 12 T ¼ 15 N ¼ 180 n ¼ 12 T ¼ 15 N ¼ 180 n ¼ 12 T ¼ 15

490

Table C.1 Correlation matrix

Gov bond yield diff. CG balance CG debt CG debt2 SNG debt High VFI High VFI*SNG debt Federal Fed.*SNG debt Decentralization EMU Risk aversion Liquidity Exch. rate Inflation Recession Timetrend

Gov b. Yield

CG bal.

CG Debt

CG Debt2

SNG Debt

High VFI

1.00 0.38 0.33 0.32 0.11 0.20 0.26 0.09 0.10 0.28 0.35 0.07 0.01 0.00 0.40 0.19 0.17

1.00 0.51 0.47 0.15 0.07 0.15 0.02 0.01 0.43 0.20 0.21 0.25 0.13 0.03 0.43 0.15

1.00 0.97 0.13 0.43 0.44 0.06 0.01 0.19 0.18 0.04 0.48 0.13 0.06 0.02 0.25

1.00 0.02 0.46 0.50 0.01 0.07 0.27 0.15 0.03 0.47 0.10 0.08 0.00 0.19

1.00 0.28 0.13 0.44 0.25 0.63 0.22 0.06 0.24 0.19 0.21 0.17 0.47

1.00 0.89 0.16 0.02 0.29 0.03 0.00 0.20 0.15 0.18 0.03 0.07

High VFI*SNG debt

1.00 0.07 0.11 0.02 0.11 0.02 0.14 0.13 0.24 0.07 0.08

Fed.

Fed.*SNGdebt

Decentr.

EMU

1.00 0.94 0.53 0.02 0.01 0.15 0.10 0.12 0.02 0.06

1.00 0.46 0.11 0.00 0.16 0.06 0.13 0.01 0.05

1.00 0.15 0.01 0.06 0.05 0.19 0.06 0.02

1.00 0.38 0.05 0.04 0.18 0.16 0.59

Risk avers.

1.00 0.02 0.09 0.07 0.57 0.44

Liq.

1.00 0.08 0.15 0.01 0.03

Exch. rate

1.00 0.15 0.00 0.27

Infl.

Rec.

Timetrend

1.00 0.24 0.19

1.00 0.45

1.00

A. Van Hecke / Journal of International Money and Finance 37 (2013) 468–492

Appendix C. Regression diagnostics

A. Van Hecke / Journal of International Money and Finance 37 (2013) 468–492

491

Appendix D. Estimation results with lagged SNG debt variable

Table D.1 Estimation results with lagged SNG debt variable Dep. var: gov bond yield

(1)

CG balance CG debt CG debt2 Risk aversion Liquidity EMU Exch. rate Inflation Recession Decentralization Timetrend SNG debtt1 High VFI*SNG debtt1 Federal*SNG debtt1 Constant Observations R2

10.06 2.46 3.35 0.05 0.83 0.65 8.40 0.26 0.99 1.93 0.03

(2) (3.61)*** (1.63) (1.00)*** (0.11) (8.65) (0.21)*** (4.29)* (0.05)*** (0.30)*** (1.57) (0.03)

1.36 (1.04) 152 0.460

11.40 3.04 3.20 0.10 6.05 0.68 6.96 0.30 1.01 1.50 0.05 5.62

(3) (3.74)*** (1.72)* (1.03)*** (0.13) (9.83) (0.22)*** (4.51) (0.06)*** (0.30)*** (1.62) (0.04) (4.86)

0.19 (1.52) 148 0.477

13.91 2.35 3.00 0.22 16.06 0.66 5.93 0.26 1.04 1.25 0.10 22.24 17.69

(4)

1.81 (1.49) 148 0.537

14.16 2.93 3.40 0.24 18.90 0.68 6.56 0.27 1.09 0.85 0.10 26.23 18.22 6.64 2.35 148 0.546

(3)

(4)

(3.60)*** (1.63) (0.97)*** (0.13)* (9.63)* (0.21)*** (4.28) (0.06)*** (0.29)*** (1.54) (0.04)*** (6.21)*** (4.46)***

(3.58)*** (1.66)* (1.00)*** (0.13)* (9.73)* (0.20)*** (4.27) (0.06)*** (0.28)*** (1.55) (0.04)*** (6.66)*** (4.44)*** (4.13) (1.52)

Fixed Effects regressions, standard errors in parentheses. *p < 0.10, **p < 0.05, ***p < 0.01.

Appendix E. Estimation results excluding crisis years

Table E.1 Estimation results excluding crisis years Dep. var: gov bond yield

(1)

CG balance CG debt CG debt2 Risk Aversion Liquidity EMU Exch.rate Inflation Decentralization Timetrend SNG debt High VFI*SNG debt Federal*SNG debt Constant Observations R2

6.03 1.90 3.38 0.26 3.57 0.59 11.12 0.38 2.00 0.06

(2) (5.03) (1.97) (1.14)*** (0.19) (10.25) (0.28)** (4.59)** (0.06)*** (1.67) (0.04)

2.29 (1.28)* 129 0.555

6.34 1.94 3.22 0.20 0.59 0.62 10.86 0.38 1.99 0.07 3.17

(5.07) (1.97) (1.17)*** (0.21) (12.31) (0.29)** (4.62)** (0.06)*** (1.67) (0.04) (5.15)

1.36 (1.98) 129 0.556

9.21 1.19 2.71 0.00 18.68 0.61 10.39 0.34 1.81 0.11 22.83 19.12

(4.88)* (1.88) (1.12)** (0.21) (12.72) (0.27)** (4.38)** (0.06)*** (1.59) (0.04)** (7.35)*** (5.34)***

1.61 (2.05) 129 0.605

8.00 2.37 3.39 0.05 24.15 0.70 11.69 0.35 1.45 0.10 28.54 19.63 9.59 2.68 129 0.620

(4.85) (1.95) (1.16)*** (0.21) (12.83)* (0.27)** (4.37)*** (0.06)*** (1.58) (0.04)** (7.78)*** (5.27)*** (4.75)** (2.09)

Fixed Effects regressions, standard errors in parentheses. *p < 0.10, **p < 0.05, ***p < 0.01.

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