Convergence of Government Bond Yields in the Euro Zone: The Role of Policy Harmonization

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Convergence of Government Bond Yields in the Euro
Zone The Role of Policy Harmonization
Denise Côté and Christopher Graham International
Department
28 April 2006
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Motivation

• Since the early 1980s, long-term government bond
  yields in the euro zone have declined, in line
  with those in other industrialized countries

• By the time the euro was introduced in January
  1999, bond yields across the euro zone countries
  had largely converged to that of Germany (the
  euro zone's largest economy)

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Motivation

• Why does convergence of national yields to a
  stable level with reduced risk matter?

• Reduces various risks gt less uncertainty
  regarding the value of funds over time

• Cheaper access to debt financing

• Contributes to financial stability

• Stimulates investment and output within
  converging countries

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Motivation

• What factors can drive convergence of long-term
  bond yields to a stable level with reduced risk
  and maintain it over the long term?

• One explanation, by the ECB
• Convergence driven by anticipation of the
  introduction of the euro and corresponding
  elimination of exchange rate risk (ECB Monthly
  Bulletin November 2003)

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Motivation

• Our goal
• To examine how monetary and fiscal policies
  adopted on the path to EMU, including the
  introduction of the euro, contributed to the
  convergence of national long-term government bond
  yields in the euro zone

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Outline

• 1. Institutional Background

2. Our Approach

• 3. Empirical Analysis
• Panel analysis
• Currency risk

4. Conclusions
5. Policy Implications
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Institutional Background

• Maastricht Convergence Criteria (1993)

1) General government deficit to GDP 3
2) Gross general government debt to GDP 60
3) Inflation 1.5 ppt above average of 3 best
performing countries in terms of price stability
4) Long-term interest rate 2 ppt above average
of 3 best performing countries in terms of price
stability
5) Exchange Rate Mechanism respected for at least
2 years prior to adoption of euro (15)
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Our Approach

• Assess convergence of long-term government bond
  yields resulting from

• Increased harmonization of monetary and fiscal
  policies on the road to EMU

• The introduction of the common currency itself

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Analytical Approach

• Empirical Analysis

• Cointegration and panel estimation techniques
  applied over 1980Q1 - 2002Q4

• Estimate 10-year government bond yields using a
  set of long-term determinants
  expected inflation, government
  balance, government debt and world interest rate

• Apply to a pool of nine EMU countries

• Compare to 2 control-groups EU3 (UK, Denmark and
  Sweden) and OECD4 (Australia, Canada, Norway and
  Switzerland)

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Euro zone Estimates

• All estimated parameters are of the expected
  sign, except the debt-to-GDP ratio

Parameter German Yield as World Yield US Yield As World Yield
Expected Inflation 0.83 0.83
Fiscal Balance ( of GDP) -0.18 -0.17
World Interest Rate 0.72 0.23
Adjustment Speed (ECM) -0.080 (6.09) -0.060 (5.00)

• Fiscal balance parameter consistent with Orr,
  Edey Kennedy (1995), Brook (2003)

• Parameter on world interest rate three times
  larger when real German yield is used (Knot de
  Haan 1995)

• Speed of convergence to long-run equilibrium is
  faster when using the German yield

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EU3 Estimates

• Parameters qualitatively the same as for the euro
  zone

Parameter German Yield as World Yield US Yield As World Yield
Expected Inflation 0.76 0.85
Fiscal Balance ( of GDP) -0.23 -0.11
Fiscal Debt ( of GDP) 0.05 0.04
World Interest Rate 0.82 0.36
Adjustment Speed (ECM) -0.059 (2.82) -0.042 (2.01)

• Debt ratio is now of expected sign

• Adjustment slower than for euro zone countries

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OECD4 Estimates

• Parameters qualitatively similar to those for
  euro zone and EU3

Parameter German Yield as World Yield US Yield As World Yield
Expected Inflation 0.87 0.91
Fiscal Balance ( of GDP) -0.06 -0.05
World Interest Rate 0.49 0. 33
Adjustment Speed (ECM) -0.048 (3.10) -0.037 (2.48)

• Impact of fiscal balance slightly reduced

• Debt ratio not significant

• Adjustment slower than for euro zone, but similar
  to EU3

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Summary of Panel Results

• Summary of results for euro zone, EU3 and OECD4
• In the long-run, 10-year bond yields driven by

• Expected inflation

• Developments in larger country's bond yields

• To a lesser extent, effects of persistent changes
  in general government fiscal balances (debt ratio
  for EU3)

• Results robust (expected inflation, ECM lags
  Y-gap)

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Summary of Panel Results

• Results suggest
• Convergence driven by policy harmonization
  (especially monetary policy)

• Not confined to members of the common currency or
  common market

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Currency Risk

• Plot two corporate bonds
• Same issuer ? same default risk
• Different countries ? different currency and
  liquidity risks

• Currency risk declined gradually and had
  essentially disappeared before adoption of euro

• Liquidity risk remains and is very small

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Conclusions

• Harmonization of monetary and fiscal policies
  greatly contributed to convergence of long-term
  government bond yields in the euro zone by
  prompting convergence of their long-run
  determinants

• Convergence in the euro zone cannot be attributed
  primarily to the strict introduction of the euro,
  since EU3 and OECD4 also experienced a similar
  convergence

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Policy Implications

• Long-term estimates imply decreasing trend for
  euro zone yields

• Current average yield is below trend for cyclical
  reasons

• Given current policy, trend should remain low

• Mitigates financial risk

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Convergence of Government Bond Yields in the Euro
Area The Role of Policy Harmonization
Denise Côté and Christopher Graham International
Department
28 April 2006
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Empirical Analysis

• General long-run specification, based on theory
• RLt a1ecpit a2gbalt a3gdebtt a4rrlwt ut
  (1)

ecpi expected inflation
gbal General government fiscal balance as of
nominal GDP (surplus, -deficit)
gdebt Gross general government debt as of
nominal GDP
rrlw U.S. or German 10-year government real
bond yield (measure of the world real yield)
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Estimation of Panel Error Correction Model
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Estimation of Panel Error Correction Model
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Estimation of Panel Error Correction Model
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