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Sovereign Risk Premia and the International Balance Sheet: Lessons from the European Crisis

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Abstract

The external dimension has emerged as an important factor in the euro debt crisis. The crisis has also shown that fluctuations in risk premia can be dramatic. We investigate the relevance of the net international investment position for sovereign risk perception and the role of market uncertainty in this relation. Furthermore, we ask whether the composition of net external assets, in terms of debt and equity instruments, is relevant in explaining sovereign risk premia and their fluctuations in time. We find that both public debt and NIIP are subject to fluctuations in risk premia; the external variable is more sensitive to the uncertainty of future expectations, and net external debt is what drives this result. Net foreign debt liabilities are associated with a lower government bond yield spread when market optimism justifies their presence with high future growth patterns; however, it becomes an important risk factor for sovereigns when global uncertainty increases and the capacity to repay foreign debt becomes a concern. Portfolio equity and FDI are related to sovereign risk in a stable manner, while a given amount of net external debt can be associated with government yield spread spikes as high as 4 %.

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Notes

  1. see Appendix 6B.

  2. Liquidity risk is intended here as the risk of not being able to liquidate positions in a short time.

  3. In Gibson et al. (2012) the dependent variable is treated as nonstationary, as the sample ends in 2010, before the reversion occurred with the announcement of the OMT program.

  4. We ran models including current account and primary balance variables. They were not relevant, hence we opted for the more parsimonious specification.

  5. Except Italy and Greece, which exceed the threshold for most of the time period, such a high level of public debt has been reached by some governments only for brief periods after the global financial crisis, before consolidation took place

  6. In our sample, only Ireland ever recorded such a low level of public debt relative to Germany.

  7. We therefore abstract from the constant and the VIX coefficient, which are the same for every country.

  8. When we exclude each of the other countries in turn, all the results are qualitatively unchanged and quantitively very similar.

  9. From the updated version of Lane and Milesi-Ferretti (2001).

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Acknowledgments

I thank an anonymous referee for helpful comments. I am grateful to Philip Lane and the macro working group participants for stimulating discussions. I also thank the Irish Research Council for a research scholarship.

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  1. Institute for International Integration Studies, Trinity College Dublin, Dublin, Ireland

    Benedetta Bianchi

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  1. Benedetta Bianchi
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Correspondence to Benedetta Bianchi.

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Bianchi, B. Sovereign Risk Premia and the International Balance Sheet: Lessons from the European Crisis. Open Econ Rev 27, 471–493 (2016). https://doi.org/10.1007/s11079-015-9382-8

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