The relationship between public debt accumulation and default risk under the ECB’s conventional vs. non-standard monetary policy: a panel data analysis of 9 Eurozone countries (2000–2015)

This paper investigates a long-run relationship between public debt accumulation and default risk, represented by Eurozone countries’ bond rates minus German benchmark bond rates for 9 Eurozone countries under the ECB’s conventional vs. nonstandard monetary policy for the period 2000–2015. Along with various unit root tests and cointegration tests, Dynamic OLS (DOLS) and Fully Modified OLS (FMOLS) methods are applied in order to examine a common long-run linkage between bond rates spreads and macro variables concerned without ignoring heterogeneous short-run dynamics. Such techniques directly address the endogeneity issue often encountered in analyses of economic fundamental variables. The empirical evidence reveals that a positive relationship between the bond rates spread and the debt-to-GDP ratio is found during the European Sovereign Debt Crisis and before the Global Financial Crisis in which the conventional monetary policy prevailed, reflecting negative market sentiments on default risk and market discipline. A negative long-run relationship is, by contrast, shown under the effective unconventional monetary policy, implying that overstated (exaggerated) default risk diminished after the ECB’s nonstandard measures. This phenomenon is especially apparent in, but not restricted to, peripheral Eurozone countries where most of the new monetary measures were targeted.