Multilateral Loans and Interest Rates: Further Evidence on the Seniority Conundrum

• Date: 01 April 2017
• Published date: 01 April 2017
• Author: Frank Westermann,Sven Steinkamp
• DOI: http://doi.org/10.1002/ijfe.1575

RESEARCH ARTICLE

Multilateral Loans and Interest Rates: Further Evidence on the

Seniority Conundrum

Sven Steinkamp | Frank Westermann

Institute of Empirical Economic Research,

Osnabrück University, Osnabrück,Germany

Correspondence

Sven Steinkamp, Institute of Empirical

Economic Research, Osnabrück University,

Rolandstrasse 8, 49069 Osnabrück,

Germany.

Email: sven.steinkamp@uni‐osnabrueck.de

JEL Classification: F34; G12; H81

Abstract

During Europe's sovereign debt crisis, interest rate spreads have been highly corre-

lated with the share of multilateral loans that were considered senior to private mar-

kets. As both variables are potentially endogenous, we follow 2 different approaches

to analyze the direction of causality. First, we use a set of instr umental variable

regressions where the differences between sovereign ratings serve as instruments.

Second, we analyze a new panel survey dataset on seniority and interest rate expec-

tations. In both approaches, we find evidence for the seniority conundrum, that is, a

positive impact of multilateral loans on interest rate spreads.

KEYWORDS

creditor seniority, euro area, government bond spreads, interest rates,recovery rate, sovereign debt

1|INTRODUCTION

The pattern of interest rates in Europe has been the center of

debate on public rescue policies in recent years. De Grauwe

and Ji (2013) first pointed out that interest rates are not well

explained by macroeconomic fundamentals, a result con-

firmed by several other researchers (e.g., Aizenman,

Hutchison, & Jinjarak, 2013; Beirne & Fratzscher, 2013).

This detachment from fundamentals has often been taken as

evidence for the existence of multiple equilibria and the

short‐term nature of liquidity shortages in Europe.

Chamley and Pinto (2011) and Gros (2010) pointed out

an alternative explanation

1

: They argue that investors might

have been worried about the preferred credit status of public

rescue packages. In Steinkamp and Westermann (2014), we

illustrated that interest rate spreads of 10‐year government

bonds vis‐à‐vis Germany have indeed been highly correlated

with the share of multilateral loans in total government debt

of the countries in crisis. We have interpreted this share as

a proxy for the senior tranche of public debt and documented

that the partial correlation is robust to the inclusion of the

literature's standard control variables.

The correlation between interest rates and the share of

senior tranche lending, however, can clearly be endogenous.

On the one hand, public rescue packages drive private inves-

tors into a junior position vis‐à‐vis official sector creditors

and lower their expected recovery rate. Private markets thus

require a higher marginal interest rate after the International

Monetary Fund (IMF) the European Stability Mechanism

(ESM), and other senior lenders enter the market.

2

On the

other hand, there is a policy motivation behind these rescue

packages: They aim to keep interest rates reasonably low

and target the interest rate spreads of countries in crisis.

The causality can plausibly run both ways.

In this paper, we take two different approaches to disen-

tangle the effects. First, we estimate the magnitude of a pos-

sible senior tranche effect using instrumental variables (IV)

regressions. Second, we analyze recently released survey data

of the Ifo institute. These data are now available with a

panel dimension, which allows us to pursue a differences‐

in‐differences identification strategy.

As a first instr ument in our IV regressions, we take

advantage of heterogeneity in rating agency decisions that

allows us to construct a proxy of expectations about

recovery values: Although some rating agencies based their

decisions on both the probability of default and expected

recovery values, others assess the probability of default

only. The difference between these—transferred to a

Received: 29 September 2015 Revised: 24 November 2016 Accepted: 12 February 2017

DOI: 10.1002/ijfe.1575

Int J Fin Econ. 2017;22:169–178. Copyright © 2017 John Wiley & Sons, Ltd.wileyonlinelibrary.com/journal/ijfe 169