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Liquidity, Government Bonds and Sovereign Debt Crises

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  • Francesco Molteni

Abstract

This paper analyses the European financial crisis through the lens of sovereign bond liquidity. Using novel data we show that government securities are the prime collateral in the European repo market, which is becoming an essential source of funding for the banking system in the Euro area. We document that repo haircuts on peripheral government bonds sharply increased during the crisis, reducing their liquidity and amplifying the raise in the yields of these securities. We study the systemic impact of a liquidity shock on the business cycle and asset prices through a dynamic stochastic general equilibrium model with liquidity frictions. The model predicts a drop in economic activity, inflation and value of illiquid government bonds. We show that an unconventional policy which consists of purchasing illiquid bonds by issuing liquid bonds can alleviate the contractionary effect of liquidity shock. A Bayesian structural vector autoregressive model for the Irish economy confirms empirically the negative impact of a rise in haircuts on the value of government bonds.

Suggested Citation

  • Francesco Molteni, 2015. "Liquidity, Government Bonds and Sovereign Debt Crises," Working Papers 2015-32, CEPII research center.
  • Handle: RePEc:cii:cepidt:2015-32
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Rodica HINCU & Svetlana BILOOCAIA, 2017. "The International Practice of Government Securities Market Development: Comparative Analysis and Conclusions for the Republic of Moldova," Economics and Applied Informatics, "Dunarea de Jos" University of Galati, Faculty of Economics and Business Administration, issue 3, pages 68-77.
    2. Vivek Prasad, 2015. "Balanced Budget Tax Cuts in a Liquidity-Constrained Economy," Manchester School, University of Manchester, vol. 83, pages 87-119, September.
    3. Buschmann, Christian & Schmaltz, Christian, 2017. "Sovereign collateral as a Trojan Horse: Why do we need an LCR+," Journal of Financial Stability, Elsevier, vol. 33(C), pages 311-330.

    More about this item

    Keywords

    repo; haircuts; government bonds; liquidity shock; quantitative easing;

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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