EMU deepening and sovereign debt spreads: using political space to achieve policy space

Iván Kataryniuk, Víctor Mora-Bajén () and Javier Pérez
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Víctor Mora-Bajén: Banco de España

No 2103, Working Papers from Banco de España

Abstract: Sovereign spreads within the European Monetary Union (EMU) arise because markets price-in heterogeneous country fundamentals, but also re-denomination risks, given the incomplete nature of EMU. This creates a permanent risk of financial fragmentation within the area. In this paper we claim that political decisions that signal commitment to safeguarding the adequate functioning of the euro area influence investors’ valuations. We focus on decisions conducive to enhancing the institutional framework of the euro area (“EMU deepening”). To test our hypothesis we build a comprehensive narrative of events (decisions) from all documents and press releases issued by the Council of the EU and the European Council during the period January 2010 to March 2020. We categorize the events as dealing with: (i) economic and financial integration; (ii) fiscal policy; (iii) bailouts. With our extremely rich narrative at hand, we conduct event-study regressions with daily data to assess the impact of events on sovereign bond yields and find that indeed decisions on financial integration drive down periphery spreads. Moreover, while decisions on key subjects present a robust effect, this is not the case with prior discussions on those subjects at the Council level. Finally, we show that the impacts arise from reductions in peripheral sovereign spreads, and not by the opposite movement in core countries. We conclude that EU policy-makers have at their disposal signicant “political space” to reduce fragmentation and gain “policy space”.

Keywords: Euro area; EU integration; sovereign spreads; financial fragmentation (search for similar items in EconPapers)
JEL-codes: E44 F36 G14 (search for similar items in EconPapers)
Pages: 67 pages
Date: 2021-01
New Economics Papers: this item is included in nep-eec and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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