14 April 2021

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

We build a comprehensive narrative of policy decisions to deepen the European Monetary Union (EMU), by classifying documents and press releases issued by the Council of the EU and the European Council during the period January 2010 to March 2020.

We find that these decisions have driven down spreads in periphery countries. We conclude that EU policy-makers have at their disposal the capacity to gain policy space and reduce fragmentation by means of a more credible and resilient institutional framework.

How EMU deepening can reduce financial fragmentation?

The incomplete nature of the European Monetary Union (EMU) affects sovereign debt spreads. On the one hand, because within the EMU, under certain circumstances, some capital destinations may be perceived as safer than others, due to diverging economic fundamentals and the lack of a common safe asset. On the other hand, because the institutional voids in the design of EMU are interpreted as a possibility that the euro area might break up and bonds – at least, some of them – might no longer be denominated in the common currency, the so-called redenomination risk.

Take the creation of a European Recovery Fund as an example. When discussions about its characteristics began, spreads between periphery and non-periphery countries were widening. The final agreement on the recovery fund was able to undo some of this increase. Why was that? Firstly, the Recovery Fund improved fundamentals of the most benefitted Euro Area countries. However, taking into account the large increase in debt from the pandemic, this effect can be considered as marginal. Secondly, once it was clear that the Recovery Fund was going to be financed with common debt denominated in euros, it created an additional channel for risk-sharing within the EMU. Finally, it signalled a strong political will to deepen the European Union and a first step towards a fiscal union, partially filling a void that the original EMU construction had left empty.

The effect of the incompleteness of the monetary union on sovereign spreads has led to a large amount of academic research. The literature has dealt with the issue of how policy announcements or actions affect financial markets mainly by focusing on some specific, salient events. Some papers include Afonso et al (2020), that studies the effect on spreads of the opening of excessive deficit procedures, Bergman et al (2019), that the effect of some important milestones during the last decade on spreads and banking CDS or Corsetti et al. (2018), that analyses changes in the conditions of official lending for Euro Area countries.

Building a narrative about EMU deepening

In Kataryniuk et al (2021), we take a similar but broader approach. To study how political decisions on European integration affect the sovereign bond market, we collect all documents and press releases by the Council of the EU and the European Council (in their different forms) over the past decade, and identify, within this corpus, when political decisions were made. Thus, we compile a complete narrative of European institutions’ decisions regarding economic and financial integration, crisis management and fiscal policy decisions. This allows us to study the effects of these decisions on financial markets without the need of determining, ex ante, which decisions drive sovereign yields. The dataset is public and available for researchers.

In total, we study more than 500 documents. We classify all the discussions (either ending up in a decision or not) into two main groups (see figure 1, numbers between parentheses refer to the total number of decisions in each group). The first group includes events that affect one country. Within this group, we distinguish two categories: (i) crisis management: this category involves mainly bailout programs and their revisions; and (ii) fiscal issues: all topics about national fiscal policy procedures or instruments, most notably excessive deficit procedures, either opened or closed. The second group includes events that affect all countries. Within this category we include topics related to: (i) fiscal integration, like those dealing with common fiscal resources or aimed at enhancing budgetary discipline from a cross-country perspective and/or at a supranational level, such as the approval of the so-called Six-Pack and Two-Pack, or the debates around the Budgetary Instrument for Convergence and Competitiveness (BICC); (ii) financial integration topics, like, for instance, the creation of new institutions, such as the European Stability Mechanism (ESM) or the Single Supervisory Mechanism (SSM), new standards (NPLs) or changes in the main framework governing the European financial institutions (ESM backstop); and iii) Capital Markets Union (CMU) decisions...

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About the authors

Iván Kataryniuk is Head of European and Global Policies at the Bank of Spain. Previously, he worked as a senior economist in charge of the economic outlook of Latin American economies at the same institution, and as an economist for the Economic Office of the President. He holds a MSc in Economics and Finance from CEMFI.

Víctor Mora-Bajén holds a Bacherlor’s degree in International Business and Economics at Universidad Pompeu Fabra and a double Master’s program in Economic Development and Growth taught at Universidad Carlos III and Lund University. He has worked in public policy evaluation at AIReF, the Spanish institution that is part of the Independent Fiscal Institutions (IFIs) network. Later, he worked at the Bank of Spain covering International Trade and European Political Economy topics.

Javier J. Perez is Director of the International Economics and Euro Area Department of the Bank of Spain, and member of the International Relations Committee of the Eurosystem. Before joining the Bank of Spain in 2008, he worked at other institutions, including the European Central Bank, the University Pablo de Olavide of Seville (Spain), the Research foundation centrA (within the Spanish regional public administration), and the University Complutense of Madrid. He holds a Ph.D. in Economics (with distinction) from this latter University. Javier has also been member of the Monetary Policy Committee of the Eurosystem, and of its substructure dealing with public finances, the Working Group on Public Finance. He contributes regularly to policy and academic conferences and publications (see: http://bit.ly/JavierJPerez).

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