External Public Debt, Trade Linkages and Contagion During the Eurozone Crisis

• Author: Giorgio Galeazzi,Eleonora Cutrini
• DOI: http://doi.org/10.1111/twec.12470
• Published date: 01 September 2017
• Date: 01 September 2017

External Public Debt, Trade Linkages and

Contagion During the Eurozone Crisis

Eleonora Cutrini and Giorgio Galeazzi

Department of Law, University of Macerata, Macerata, Italy

1. INTRODUCTION

THE first decade of the European Monetary Union has been marked by a rise in interna-

tional demand for sovereign debt of the participating countries, especially those of the

Eurozone periphery. An unprecedented reduction in the share of domestic sovereign debt

holdings took place, even though financial institutions of the Euro area itself mainly kept on

holding external public debt of peripheral countries. The integration of financial markets

within the EMU provided an important stimulus for the Periphery, but the financial crisis has

highlighted the adverse facets of an excessive exposure to foreign debt, even though denomi-

nated in the same currency.

Furthermore, the unfolding of the Eurozone crisis has confirmed the close link between

excessive private and banking debt accumulation and sovereign default risk within countries.

During the Great Recession (2008–09), the bailout of financial institutions and the fiscal stim-

ulus to counteract the downturn of the real economy brought about a deterioration of public

finance (due to a fall in government revenues and the increase in public expenditures). The

consequent rise in public debt/GDP ratios has contributed to increase the sovereign default

risk, which, in turn, may have worsened banks’ funding and lending conditions. Hence, the

banking crisis emanating from the US subprime loan crisis, first preceded and then accompa-

nied the Euro area sovereign debt crisis.

Since the Eurozone debt crisis is a multifaceted phenomenon, various interpretations have

been put forward in the current debate (sovereign debt crisis, current account crisis and bank-

ing crisis). This pluralistic perspective has helped to better understand its causes and transmis-

sion mechanisms and to suggest policy recommendations. That notwithstanding, the policy

debate was somewhat flawed by misconceptions that emerged around the notion of an envis-

aged ‘contagion’ within the Eurozone, affecting mostly peripheral countries. The rhetoric of

contagion was essentially based on a warning of transmission of the Greek crisis, with domino

effects eventually confined only to other countries of the EMU periphery on the basis of

structural similarities and common fiscal vulnerabilities. The prospect that other countries

could be transformed in another Greece case has provided a compelling cautionary tale for

the adoption of austerity programmes by those Eurozone countries that were more fragile,

both in terms of fiscal fragilities, and in terms of competitiveness. Austerity was the last-resort

We are especially grateful to Daniel Gros for discussion and comments received at the Villa Mondrag-

one International Economic Seminars at Tor Vergata University in Rome, June 2014 that have helped us

to significantly improve our paper. A previous version of this paper was presented at the INFER Annual

Conference 2014 held at the Gabriele d’Annunzio University, Pescara, Italy, at the XIX AISSEC Con-

ference “Overcoming The Crisis: Inequality And Unemployment In Advanced And Emerging Countries,

June 2014, University of Macerata, Italy and at the Conference ‘Large-scale Crisis: 1929 vs. 2008’,

Universit

a Politecnica delle Marche, Ancona, Italy in December 2015. We are grateful to Federico

Boffa, Eleonora Cavallaro, Enrico Marelli, Francesco Pastore and Ulrike Stierle-von Schu

̈tz for useful

comments. All errors are ours.

©2016 John Wiley & Sons Ltd

1718

The World Economy (2017)

doi: 10.1111/twec.12470

The World Economy

policy experiment, adopted by only Peripheral economies while they were suffering from a

second recessionary phase, to enforce the ongoing institutional changes on European

economic governance, and it was justified by the urgency of containing contagion.

To explain the Eurozone crisis and its main manifestation –that is, the exceptional

increase in sovereign bond spreads –it is useful to understand why some governments

become unable to borrow on world markets. Apart for recognised global common factors

(such as the abrupt change in market sentiments and the escalation in risk aversion), as well

as fiscal and macroeconomic fundamentals, we believe that tensions in the Eurozone sover-

eign bond markets may not be fully understood unless wider cross-border financial interdepen-

dence is also taken into account. Over the past two decades, the global economy has

experienced profound changes. Growing trade and financial integration may have altered the

nature and strength of cross-border transmission of shocks. Particularly, the successful catch-

ing-up process of emerging economies has led some scholars to advocate the hypothesis of a

decoupling, according to which the emerging economies may continue to keep growing rela-

tively robustly even when the advanced world undergoes a severe downturn.

1

We suggest that

the view that a decoupling of emerging economies may have affected investors’ behaviour,

by redirecting their risk appetite towards sovereign bonds of emerging economies. This can

be considered an additional channel of international financial spillovers that has become evi-

dent more recently, once the emerging countries got into a crisis with beneficial effects on the

Euro area sovereign spreads. Therefore, a possible ‘substitution effect’ may account for the

investors’ behaviour during the Eurozone crisis and magnified the instability of sovereign

bond markets. Once member countries of the European monetary union are downgraded to

the status of emerging economies (as suggested by De Grauwe and Ji, 2012), financial mar-

kets could have redirected their attention to sovereign bonds of ‘stand-alone’ emerging mar-

kets, perceived as less fragile than member countries of the Eurozone.

2

It is typically assumed that countries with higher public debt held by non-residents should

be more apt to default on it.

3

However, as long as the composition of holders of public debt

shifted from foreign investors to domestic banks, spillovers between sovereign risks and

national banking systems may become tougher.

The empirical literature has devoted a huge attention to contagion in a broad sense and to

the associated banking-sovereign nexus. However, much less has been said on the role of

cross-border banking flows and of foreign holdings of sovereign debt. In particular, it remains

unclear how the ‘home bias’ effect in government debt holding could have actually deepened

1

In the decoupling debate, the distinction between trend and cyclical decoupling has gained promi-

nence. While long-term trend decoupling is a well-established stylised fact due to higher trend growth

rates of emerging market economies, little evidence has been produced so far on the alleged business

cycle decoupling between advanced economies and emerging ones, especially during recessions (see

Yetman, 2011; and Cutrini and Galeazzi, 2012 for a survey and some evidence).

2

The problem of member countries of a monetary union described in De Grauwe and Ji (2013) is simi-

lar to problems faced by emerging countries that issue debt in a foreign currency, usually the dollar.

These countries may be forced to a ‘sudden stop’ of capital inflows leading to a liquidity crisis.

3

There are several possible reasons for a negative role of debt held by non-residents on investors’ per-

ception of risk. External public debt is outside the control of the State that issues it: for example, it can-

not tax on it. Moreover, the prices of public securities are more vulnerable to speculation (Gros, 2011).

Furthermore, the higher foreign public debt relative to the national public debt the more the country is

going to decrease its total wealth (the revenues for interest on government bonds flow out of the country

and the country wealth decline).

©2016 John Wiley & Sons Ltd

HOME-BIAS EFFECT IN THE EUROZONE CRISIS 1719

the banking-sovereign feedback loop. The present paper is mainly an attempt to fill this gap.

We assess the potential impact of international capital flows in the Eurozone crisis and, in

particular, the changing composition of sovereign debt by nationality of bank holders.

Moreover, we innovate with respect to the received literature in two additional ways. First,

drawing from the long-lasting literature on contagion in currency crisis and particularly on the

Glick and Rose (1999) seminal contribution, we also consider the role that trade linkages may

have had in spreading tensions within the Eurozone sovereign markets. Second, we assess the

role played by the substitution effect between the sovereign bonds of emerging markets and

the Eurozone sovereign bonds. It is conceivable that investors have considered the former

safer than the latter, once risk aversion started to soar.

We show that the ratio of public debt held by foreign banks over domestic banks is a sig-

nificant determinant of sovereign bond yield differentials across European countries. When

controlling for alternative financial linkage variables, and possible reverse causality, results

are robust. Also, they further clarify that a decrease in international demand contributes to

explaining higher spreads during the crisis (consistent with Arslanalp and Poghosyan, 2014)

while rising domestic banks’ exposure to sovereign risk increased spreads. We thus suggest

that the net effect –that is the re-nationalization of sovereign debt, through the purchase of

bonds by national banks associated with the withdrawal of foreign investors –may have

increased the country-specific risk (consistent with the ‘home bias’ in debt exposure in

Acharya and Steffen, 2013). We also find that trade patterns are important in understanding

the diffusion of the Eurozone crisis, particularly for the periphery. Moreover, wider financial

spillovers related to changing investors’ preferences in favour of emerging countries appear to

have had a non-negligible impact on European sovereign bond markets pressure.

Finally, our analysis confirms previous findings in the literature in two major accou nts.

First, our results sound consistent with the hypothesis of a misperception of sovereign risk not

only during the crisis period but also before the crisis. Second, we found a higher and signifi-

cant impact of the public debt ratio over GDP and of real labour productivity during the cri-

sis. This evidence sounds consistent with the fundamental or wake-up call contagion

hypothesis and it holds true particularly for the periphery.

The paper is structured as follows: Section 1 reviews the relevant literature. Section 2

describes the main stylised facts that constitute the interpretative framework that has guided

our empirical test. Section 3 presents the methodology for the empirical analysis and the

econometrics issues that we have taken into account. Section 4 summarises the main results,

puts forward some conjectures to interpret them and presents some robustness checks. Finally,

Section 5 makes some concluding remarks and derives policy implications.

2. LITERATURE REVIEW ON DEBT CRISIS IN EUROPE

The Eurozone crisis, its main causes and manifestations have been investigated from differ-

ent research perspectives. Initially, the sharp rise in Euro area sovereign spreads revitalised

interest in whether high debt countries pay a risk premium on their public debt.

4

On the

determinants of sovereign bond yield spreads, a consensus has emerged on three main issues:

4

Even before the Eurozone crisis, several studies focused on how sovereign risk premia (that incorpo-

rates devaluation and default risk) can be identified empirically and how large they were in the European

Monetary Union (e.g. Codogno et al., 2003; Bernoth et al., 2004; Faini, 2006; Longstaff et al., 2007), in

the United States (e.g. Bayoumi et al., 1995) and in OECD countries (Alesina et al., 1992).

©2016 John Wiley & Sons Ltd

1720 E. CUTRINI AND G. GALEAZZI