This paper undertakes an empirical inquiry concerning the determinants of long-term interest rates on US Treasury securities. It applies the bounds testing procedure to cointegration and error correction models within the autoregressive distributive lag (ARDL) framework, using monthly data and estimating a wide range of Keynesian models of long-term interest rates. While previous studies have mainly relied on quarterly data, the use of monthly data substantially expands the number of observations. This in turn enables the calibration of a wide range of models to test various hypotheses. The short-term interest rate is the key determinant of the long-term interest rate, while the rate of core inflation and the pace of economic activity also influence the long-term interest rate. A rise in the ratio of the federal fiscal balance (government net lending/borrowing as a share of nominal GDP) lowers yields on long-term US Treasury securities. The short- and long-run effects of short-term interest rates, the rate of inflation, the pace of economic activity, and the fiscal balance ratio on long-term interest rates on US Treasury securities are estimated. The findings reinforce Keynes’s prescient insights on the determinants of government bond yields.

The most important determinant of an announcement’s impact on bond markets is its relationship to fundamentals, closely followed by its timing. Information which is imprecise but early can affect markets more than news which is precise but late. Governments and private agencies make public announcements on how the economy as a whole is performing at various points over the year. Sometimes the substance of these announcements comes as a surprise, and can have quite an impact on asset prices. […]

This paper presents a new database for financial crises in European countries, which serves as an important step towards establishing a common ground for macroprudential oversight and policymaking in the EU. The database focuses on providing precise chronological definitions of crisis periods to support the calibration of models in macroprudential analysis. An important contribution of this work is the identification of financial crises by combining a quantitative approach based on a financial stress index with expert judgement from national and European authorities. Key innovations of this database are (i) the inclusion of qualitative information about events and policy responses, (ii) the introduction of a broad set of non-exclusive categories to classify events, and (iii) a distinction between event and post-event adjustment periods. […]

This paper provides empirical evidence on the macroeconomic impact of the expanded asset purchase programme (APP) announced by the European Central Bank (ECB) in January 2015. The shock associated to the APP is identified with a combination of sign, timing and magnitude restrictions in the context of an estimated time-varying parameter VAR model with stochastic volatility. The evidence suggests that the APP had a significant upward effect on both real GDP and HICP in action in the euro area during the first two years. The effect on real GDP appears to be stronger in the short term, while that on HICP in action seems more marked in the medium term. Moreover, several channels of transmission appear to have been activated, including the portfolio rebalancing channel, the exchange rate channel, the in action re-anchoring channel and the credit channel.

Despite the frequency of official debt restructurings, little systematic evidence has been produced on their characteristics and implications. Using a dataset covering more than 400 Paris Club agreements, this paper aims to fill that gap. It provides a comprehensive description of the evolving characteristics of these operations and studies the economic dynamics surrounding them. The progressive introduction of new terms of treatment gradually turned the Paris Club from a mere debt collector into a sequenced provider of debt relief. The study finds that more generous restructuring conditions involving nominal relief are associated with higher economic growth. In contrast, agreements including only NPV relief have no positive impact on growth. However, the countries that get these restructuring conditions turn out to be more likely to pursue a prudent fiscal policy after the event than those receiving a nominal haircut. In other words, when deciding upon the type of relief to be granted through debt restructuring, the official sector faces a trade-off between the objectives of stimulating growth and fostering fiscal sustainability.

This Economic Brief looks at the Dutch budgetary framework through the lens of the EU's fiscal rules and compares the budgetary objectives of the national and European level. The Netherlands has a unique budgetary framework that is built around multiannual expenditure ceilings. The underlying principle is that budgetary policy should be trend-based, with a longer-term perspective. Independent macroeconomic forecasts and non-partisan evaluation of the budget plans have a longstanding tradition and predate similar requirements set at the European level. A central element of the national framework is the commitment of a government to adhere to pre-agreed expenditure ceilings over a four-year term. However, experience with meeting the European fiscal targets is mixed, and it appears that the Dutch framework does not necessarily ensure compliance with the European objectives. This note discusses possible reasons for this discrepancy. When compared along different dimensions, the operational objectives of the domestic and EU frameworks are not fully aligned. Long-run sustainability is assessed differently at the national and the EU level. Also, the medium-term objective is not fully operationalised within the national context. Finally, there are methodological differences with regard to the expenditure rules. Overall, this may lead to a dilemma for Dutch policy makers, who use the same policy instruments to fulfil different policy objectives. The current initiative at the EU level towards a greater emphasis on the expenditure benchmark offers an opportunity to bring the Dutch framework closer to the European one. Nevertheless, this analysis is non-exhaustive and a further discussion could identify possible ways to align the objectives, while preserving the successful elements of the Dutch budgetary framework.

The recent unravelling of the Eurozone's financial integration raised concerns about feedback loops between sovereign and banking insolvency. This paper provides a theory of the feedback loop that allows for both domestic bailouts of the banking system and sovereign debt forgiveness by international creditors or solidarity by other countries. Our theory has important implications for the re-nationalization of sovereign debt and the rationale for banking unions.

In this paper we propose a hypothetical distress insurance premium (DIP) as a measure of the European banking systemic risk, which integrates the characteristics of bank size, default probability, and interconnectedness. Based on this measure, the systemic risk of European banks reached its height in late 2011 around € 500 billion. We find that the sovereign default spread is the factor driving this heightened risk in the banking sector during the European debt crisis. The methodology can also be used to identify the individual contributions of over 50 major European banks to the systemic risk measure. This approach captures the large contribution of a number of systemically important European banks, but Italian and Spanish banks as a group have notably increased their systemic importance. We also find that bank-specific fundamentals predict the one-year-ahead systemic risk contribution of our sample of banks in an economically meaningful way.

This study contends that Caribbean countries cannot adequately surmount their fiscal and debt challenges in the absence of binding rules that are geared toward entrenching fiscal discipline, curbing fiscal procyclicality, and improving budget transparency and credibility. Distilling global lessons and taking due cognizance of Caribbean countries' idiosyncrasies, the paper explores key technical, operational and institutional issues in the design, implementation, and monitoring of fiscal rules that might be relevant for Caribbean countries that currently do not have legislated rules. Results from simulations carried out to determine welfare effects and the extent of volatility of key macroeconomic variables under various fiscal rules scenarios suggest that of the different types of simulated fiscal rules, expenditure rules perform best in terms of reducing macroeconomic volatility, and in that regard, appear to be the most welfare-enhancing. This is believed to be the first study to carry out such a simulation exercise for Caribbean countries. The findings of the study evince useful insights for policymakers on how to improve the design and conduct of fiscal policy for better fiscal and, by extension, development outcomes.

In this paper we model the super-replication of payoffs linked to a country’s GDP as a stochastic linear program on a discrete time and state-space tree to price GDP-linked bonds. As a byproduct of the model we obtain a hedging portfolio. Using linear programming duality we also compute the risk premium. The model applies to coupon-indexed and principal-indexed bonds, and allows the analysis of bonds with different design parameters (coupon, target GDP growth rate, and maturity). We calibrate for UK and US instruments and carry out numerical experiments to illustrate the effects of risk factors and bond design parameters on prices and risk premia, and to compare coupon-indexed and principal-indexed bonds. Results shed light on the policy question whether the risk premia of these bonds make them beneficial for sovereigns. The findings from UK and US data affirm that both coupon-indexed and principal-indexed bonds can benefit a sovereign, with an advantage for coupon-indexed bonds. This finding is robust, but a nuanced reading is needed since there are many inter-related risk factors and design parameters that affect prices and premia.

In this paper we analyze the mechanisms through which bank and sovereign distress feed into each other, using a large sample of emerging market economies over three decades. After defining “twin crises” as events where bank crises and sovereign defaults combine, and further distinguishing between those bank crises that end up in sovereign defaults and vice-versa, we study what differentiates “single” and “twin” events. Using an event analysis methodology, we document systematic differences between “single” and “twin” crises across various dimensions. We show that many of the regularities often associated with either “bank” or “debt” crises are present in twin events only. We further show that “twin” crises themselves are heterogeneous events: the proper time sequence of crises that compose “twin” episodes is important for understanding these events. Guided by these facts, we use discrete-variable econometric techniques to assess the main channels of distress transmission between crises. We find that balance sheet interconnections, credit dynamics, financial openness and economic growth are important drivers of twin crises. Our results inform the flourishing theoretical literature on the mechanisms surrounding feedback loops of sovereign and bank stress.

Do governments default on debt denominated in their own currency? We introduce a new measure of sovereign credit risk, the local currency credit spread, defined as the spread of local currency bonds over the synthetic local currency risk-free rate constructed using cross currency swaps. We find that local currency credit spreads are positive and sizable. Compared with credit spreads on foreign currency denominated debt, local currency credit spreads have lower means, lower cross-country correlations, and are less sensitive to global risk factors. Global risk aversion and liquidity factors can explain more time variation in these credit spread differentials than macroeconomic fundamentals.

Emerging country governments increasingly issue bonds denominated in local currency. Despite this recent development, the markets for foreign and local currency government bonds exhibit a substantial degree of segmentation. First, we show that a standard asset pricing model with representative foreign investor cannot price both local and foreign currency government bonds. Second, we show that the share of local currency debt held by foreign investor is a significant determinant of the degree of market segmentation. Third, we propose a simple model of partially segmented markets that replicates the observed empirical regularities.

Contract standardisation serves many important functions in the sovereign debt market: among these, it saves time and money in preparing documents and endows widely-used terms with a shared public meaning, which in turn saves investors the costs of acquiring information, facilitates secondary market trading and reduces the scope for mistakes in the judicial interpretation of contract terms. Sovereign debt issuers and investors claim to value standardisation and list it as an important contractual objective. Issuers generally insist that their bond contracts are standard and reflect market practice. Variations from past practice and market norm must be explained in disclosure documents and through market outreach. Standardisation is not just part of the fabric of market expectations: international policy initiatives to prevent and manage financial crises rest on the assumption that sovereign debt contracts follow a generally accepted standard. Such initiatives would make no sense in the absence of standardisation. In fact, sovereign bond contracts are not nearly as standardised as market participants and policy makers seem to suggest. It is common to see a handful of negotiated terms embedded in a mish-mash of different generation industry models, sprinkled with bits of creative expression that no one can explain, usually attributed to some long-forgotten lawyers. At least some of the variation appears to be deliberate. However, to the extent that it is inadvertent, variation can be costly. For example, it can make contracts internally inconsistent, vulnerable to opportunistic lawsuits and errors of judicial interpretation. Variation could also make debt instruments less liquid, especially during periods of market stress. The problem of inadvertent variation would diminish substantially if sovereign debt markets were to adopt a more centralised, modular approach to contracting, whereby a subset of widely-used non-financial terms would be produced by an authoritative third party (a public, private, or public-private body) and incorporated by reference in individual transactions. […]

The Medium-Term Debt Management Strategy (MTDS) framework was endorsed by the Boards of the International Monetary Fund (IMF) and the World Bank (WB) in 2007. This endorsement and the mandate to help countries build capacity in this area, and past G-20 attention to debt management issues, reflect a recognition that sound debt management is critical both to macroeconomic stability and to the development and functioning of the financial markets. The Bank and the Fund have collaborated to deliver a large volume of MTDS-based technical assistance to numerous, mostly middle and lower income countries. Donors have recognized the importance of this work and have been generous in their support. The assistance has taken many forms, including country visits by staff and experts, the delivery of regional training events, and the organization of forums.This note describes how capacity building on MTDS has been adapted to keep abreast of country needs

In this paper we express the opinion that sovereign debt sustainability analysis must be augmented by stochastic correlated risk factors and a risk measure to capture tail effects. Crisis situations can thus be adequately specified and analyzed with sufficient accuracy to warrant the relevance of policy decisions. In this context there is significant scope for optimization modeling for both strategic planning and operational management. We discuss diverse aspects of the problem of debt sustainability and highlight modeling approaches that can be brought to bear on the problem. Results with the fictitiuous, but nor unrealistic, Kingdom of Atlantis, which is sinking under excessive debt, illustrate the proposed models.

Can economic growth increase public debt? Previous studies on the debt-growth nexus focused on the effects of debt on growth. We present a new and opposite perspective by showing that growth can reinforce deficit spending. We construct a model of endogenous public debt driven by political myopia. The model shows that economic growth induces short-sighted politicians to increase public debt and that this effect is magnified by the extent of political myopia. We test the model’s predictions using a panel of U.S. states over the period 1963-2007. Our identification strategy rests on constitutionally-entrenched differences in gubernatorial term limits that provide plausibly exogenous cross-state variation in political time horizon, and aggregate national TFP shocks that are exogenous to individual states. We find that a one standard deviation positive TFP shock induces an approximate $480 increase in real per capita public debt in politically myopic states.

This paper explores the empirical relationship between government debt and future macroeconomic activity using data on twenty advanced economies throughout the post-war era. We use robust inference techniques to deal with the bias arising from the persistent nature of debt to GDP ratio as an endogenous predictor of GDP growth. Our results show that statistical significance of the coefficient on the debt ratio in predictive regressions changes considerably with the use of robust inference techniques. For countries with relatively low average debt ratios we find a negative threshold effect as their debt ratios increase toward moderate levels. For countries with chronically high debt ratios, GDP growth slows as relative government debt increases, but we find no significant threshold effect.

Rejecting a common assumption in the sovereign debt literature, we document that creditor losses (“haircuts”) during sovereign restructuring episodes are asymmetric across debt instruments. We code a comprehensive dataset on instrument-specific haircuts for 28 debt restructurings with private creditors in 1999–2015 and find that haircuts on shorter-term debt are larger than those on debt of longer maturity. In a standard asset pricing model, we show that increasing short-run default risk in the run-up to a restructuring episode can explain the stylized fact. The data confirms the predicted relation between perceived default risk, bond prices, and haircuts by maturity.

This paper studies spillovers among US and European sovereign yields. We provide a new method based on absolute magnitude restrictions of the impact matrix to identify the countries that were the main sources of spillovers. Despite the large size of shocks from euro area stressed countries, connectedness among sovereign yields declined between 2008 and 2012 due to financial fragmentation, particularly between countries with more divergent business and fiscal cycles. We show that none of the sovereign yields are insulated from foreign shocks and that shocks to the Greek bond market in 2010 explained 20-30% of the variance of sovereign yields in stressed countries, while in 2011-2012 Italy (not Spain) was the source of systemic risk.