This paper focuses on risk premiums paid by central governments in Europe and sub-national governments in Germany, Spain, and Canada. With regard to the European governments, we are interested in how these premiums were affected by the introduction of the euro. Using data for bond yield spreads relative to an appropriate benchmark, for the period 1991-2005, we find that risk premiums incurred by central governments of EU member states respond positively to central government debts and deficits. This is consistent with the notion of market-imposed fiscal discipline. We find that German states and, among them, especially those usually receiving transfers under the German fiscal equalization system, enjoyed a very favourable position in the financial markets before EMU as their risk premiums did not respond to fiscal balances. This special status seems to have disappeared with start of EMU. Monetary union, therefore, imposes more fiscal discipline on German states. In contrast, Spanish provinces paid risk premiums related to their fiscal balances both before and after the start of EMU. Both German and Spanish sub-central governments paid fixed interest rate premiums over their national governments which became smaller after the introduction of the euro and are more likely to be interpreted as liquidity premiums. We also estimate empirical models of risk premiums for Canadian provinces for which we find financial market penalties of adverse fiscal balances and debt indicators. However, as in the case of Germany before EMU, those provinces that typically receive transfers under the Canadian fiscal equalization scheme have a more favourable bond market treatment than others. The evidence of market discipline at work in European government bond markets supports the notion that the no-bailout clause in the EU Treaty is credible. JEL Classification: E43, E62, H63, H74.
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Paper provided by European Central Bank in its series Working Paper Series with number
879.
References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
António Afonso & Pedro Gomes & Philipp Rother, 2006.
"What “Hides” Behind Sovereign Debt Ratings?,"
Working Papers
2006/35, Department of Economics at the School of Economics and Management (ISEG), Technical University of Lisbon..
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Kerstin Bernoth & Jürgen von Hagen & Ludger Schuknecht, 2006.
"Sovereign Risk Premiums in the European Government Bond Market,"
Discussion Papers
151, SFB/TR 15 Governance and the Efficiency of Economic Systems, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich.
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