Florian Schuster

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This paper studies the emergence of sovereign bond yield spreads in the Eurozone prior to the financial crisis. While spreads were close to zero in European government debt markets until the mid-2000s, they have persistently widened since then in many member states. We employ a difference-in-differences approach to analyze this phenomenon. We find that the Eurosystem’s move from unconditional to conditional collateral eligibility of sovereign bonds, as part of the 2005 Single List reform, was the institutional change triggering the emergence of sovereign spreads in the Euro Area. Conditional eligibility becomes effective predominantly through a periphery premium: higher yields have been demanded from countries whose business cycles deviate most from the average Eurozone cycle. In contrast, spreads did not arise in response to adverse macroeconomic and fiscal fundamentals. 

Why did we write the paper? 

From our previous work on European fiscal rules, we drew three conclusions. First, interest payments, and country-specific risk spreads therein, constitute a major driver of budget deficits and debt-to-GDP developments in many member states. Second, as the monetary union lacks an explicit tool to ensure fiscal discipline on the national level, it makes use of spreads sending market signals to governments, meant to incentivize prudent fiscal policy. Third, according to the EU Commission’s legislative proposal from April 2023, market expectations about sovereign bond spreads are supposed to be used as inputs in debt sustainability analyses (DSA). Thus, spreads have an important economic and regulatory impact, making it necessary to develop a good understanding of their drivers and origins. If we knew more about their relationship to macroeconomic variables and the Eurozone’s institutional setup, we could make constructive proposals on how to deal with them in the fiscal and monetary framework. 

What did we learn? 

We learned that the established view that sovereign spreads are primarily reflective of differences in macroeconomic and fiscal fundamental data, such as debt levels, GDP growth rates, budget deficits, etc., is short-sighted. In contrast, we find that spreads emerged in response to the European Central Bank’s (ECB) new collateral framework in 2005 – called the Single List – which implied that sovereign bonds were henceforth no longer unconditionally eligible as collateral but had to satisfy eligibility criteria. Conditional eligibility cast doubt on the default-risk-free status of Eurozone government debt. 

With respect to the channels by which the effect of conditional eligibility arose, we learned that markets started demanding premia from countries whose business cycles are significantly off the average Eurozone cycle. Since these member states are commonly grouped under the term periphery, as opposed to the more aligned core Euro Area, we frame this channel the periphery premium. In contrast, spreads did not emerge in countries that had exhibited adverse macroeconomic or fiscal positions before the event. 

However, in the subsequent pre-crisis period, fundamental variables prove to have influenced the evolution of sovereign spreads over time. We observe effects gaining significance after the event, which is in line with previous studies focusing on later periods. Hence, our results suggest that fundamental variables have turned into relevant determinants of sovereign spreads contingent on the adoption of conditional collateral standards. 

To sum up, our main learning is that sovereign spreads in the Eurozone owe their existence to an institutional change and business cycle dissimilarities among member states instead of differences in fundamental macroeconomic and fiscal information. Hence, institutions matter, and considering how spreads complicate debt reductions by causing substantial economic costs, we came to think that the Eurozone should assume a more judicious way of dealing with them.  

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