Essays on sovereign debt in the euro area

This dissertation explores the interaction between sovereign debt and investor preferences in the euro area during the recent crisis from both a theoretical and an empirical perspective. From an empirical perspective, in Chapter 2 (written with Marco Pagano and Saverio Simonelli), we investigate the relationship between the divergence of sovereign yields and CDS premia and the rise in banks' home bias, as well as its rationale. Our approach is based on (i) the decomposition of yield differentials and CDS spreads in a country-specific and a common risk component via a dynamic factor model and (ii) the estimation of a vector error-correction model on 2008-12 monthly data. We find that (i) in euro area periphery countries, banks increase their domestic exposure in response to increases in country risk and (ii) in most euro area countries, banks respond to an increase in the common risk factor by raising their domestic exposures. Finding (i) suggests distorted incentives in periphery banks' response to changes in their own sovereign's risk. Finding (ii) indicates that, when systemic risk increases, all banks tend to increase the home bias of their portfolios, making the euro area sovereign market more segmented. Policy implications are finally drawn from these findings. From a theoretical perspective, Chapters 3 and 4 analyze the interactions between macroeconomic fundamentals and debtor and creditor incentives through the lenses of dynamic general equilibrium models with strategic sovereign default. In Chapter 3, I provide a theoretical framework to understand three phenomena occurred at the onset of the recent sovereign debt crisis: (1) the increase in investor risk aversion, (2) the reversal in the process of union-wide financial integration and (3) the rise in the perceived imperfect substitutability of government bonds. Advancing a novel approach to modelling optimal portfolio strategy, the model assumes investors to exhibit preferences with a constant elasticity of substitution between bonds, which is inversely related to the degree of risk aversion, perceived financial segmentation and imperfect asset substitutability. Consistently with empirical evidence, a low elasticity, representing adverse market sentiments, implies a high sensitivity of yields to macroeconomic fundamentals. In an empirical assessment, the model captures several features of Greek sovereign yields, debt and default before and during the crisis. Finally, Chapter 4 proposes a comprehensive analytical framework for the assessment of fiscal sustainability in the euro area. The standard Eaton-Gersovitz model is enriched with two novel features to reflect salient features of euro area economies. First, the presence of domestically held debt implies that a sovereign default, through lower repayments on sovereign debt, determines both benefits for the public sector and costs for private domestic investors. As the sovereign seeks to maximize domestic welfare, a higher domestic share of debt increases the government's incentives to honor its obligations and, thus, expands its borrowing opportunities. Second, the introduction of credible supranational fiscal rules creates the possibility for self-fulfilling debt crises and, accordingly, increases the borrowing costs for the government. In this way, fiscal rules reduce the sovereign's optimal level of debt and foster market-based fiscal discipline. In an empirical application, the calibrated average euro area country faces a low risk of default, but it can reap both welfare and sustainability gains through fiscal consolidation.Ph.D.Includes bibliographical referencesby Niccolo Battistin