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Government Risk Premiums in the Bond Market: EMU and Canada

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  • Schuknecht, Ludger
  • von Hagen, Jürgen
  • Wolswijk, Guido

Abstract

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.

Suggested Citation

  • Schuknecht, Ludger & von Hagen, Jürgen & Wolswijk, Guido, 2007. "Government Risk Premiums in the Bond Market: EMU and Canada," CEPR Discussion Papers 6579, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:6579
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    References listed on IDEAS

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    Keywords

    bail out; fiscal policy; government debt; interest rates; regional public finances;

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt
    • H74 - Public Economics - - State and Local Government; Intergovernmental Relations - - - State and Local Borrowing

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