Sovereign Yield Spreads During the Euro Crisis: Fundamental Factors Versus Redenomination Risk

• Author: Benjamin Weigert,Jens Klose
• Date: 01 March 2014
• Published date: 01 March 2014
• DOI: http://doi.org/10.1111/infi.12042

Sovereign Yield Spreads

During the Euro Crisis:

Fundamental Factors Versus

Redenomination Risk

Jens Klose and Benjamin Weigert

Scientific Staff of the German Council of Economic Experts, Wiesbaden

Abstract

The intensity of the euro crisis has been reflected in significant increases

in sovereign bond yields in the most troubled countries. This has

triggered a deba te over whether t his increase can be at tributed solel y to

fundamental factors or whether part of the increase represents redeno-

mination risk that one or more countries will drop out of the European

Monetary Union and reintroduce their own national currencies. Using a

novel market‐based indicator from the virtual prediction market

Intrade, this paper explores whether such systemic risk is present in

the yield spreads of nine euro‐area countr ies. We find that redenomina-

tion risk has played a r ole in the determ ination of sovereig n yields, and

that this risk is rel ated to the expect ed valuations of ne wly introduce d

currencies: those of Portugal, Ireland, Spain and Italy are expected to

depreciate, while newly introduced currencies of other countries are

expected to appreciate following a break‐up of the EMU.

The authors would like to th ank Christoph Schm idt, Claudia Buch, St effen Osterloh and

two anonymous referees for their helpful commen ts.

International Finance 17:1, 2014: pp. 25–50

DOI: 10.1111/infi.12042

© 2014 John Wiley & Sons Ltd

‘Risk premia that are rela ted to fears of the revers ibility of the Euro are unaccep t-

able, and they need to be addressed in a fundamental manner.’(ECB President

Mario Draghi, August 2012)

‘Es gibt fundamental e Zweifel der Märkte an der Sich erheit der Währungs union.’

There are fundamenta l doubts on the financial markets about the integrity of

the [European] monetary union. (Bundesbank President Jens Weidmann,

10 July 2012)

I. Introduction

The European debt crisis that unfolded in 2010 has culminated in a deep

crisis of confidence, raising fundamental doubts over the integrity of the

euro area. While the Europe an treaties do not prov ide any explicit opt ion to

exit the European Monetary Union (EMU), evidence has mounted that

market participants nevertheless believe that one or more members of the

euro area might exit. The redenomination risk –the risk that a country will

unilaterally exit the EMU and redenominate its public and private liabilities –

perceived by financial markets finally led ECB President Mario Draghi to

announce, in August 2012, that the ECB ‘will do whatever it takes’to preserve

the integrity of the euro area. However, economists are divided regarding the

existence of redenomination risk. Therefore, in this paper, we examine empiri-

cally whether such risk has contributed to rising yield spreads across euro‐area

countries.

By joining the EMU, a country establishes a permanent relationship that

comes with costs and benefits. In retrospect, benefits arose inter alia with the

introduction of the euro, when long‐term interest rates for virtually all

member countri es converged to th e level of Germ any (Figure 1), i nitiating

strong credit demand in parts of the EMU. In Ireland and Spain, borrowing

mostly occurred through the private sector (Bielsa and Duarte 2011,

Lane 2011); in Italy, it mostly took place through the public sector and in

Greece, it occurred through both the private and public sectors

(Antzoulatos 2011, Lane 2012).

The outbreak of the crisis in the euro area revealed the costs of membership

in the EMU. Because EMU member countries accumulate debts in a currency

that they cannot themselves generate, they cannot rely on monetary policy

tools either to achieve external devaluation t o support the necessary real

adjustments needed to regain price competitiveness or to spur inflation to

diminish the real value of nominal private and public debt. Instead, these

countries must sustain a long‐lasting and painful process of internal devalua-

tion and, if their fiscal positions are not well balanced, fiscal austerity.

26 Jens Klose and Benjamin Weigert

© 2014 John Wiley & Sons Ltd