DP8637 | Sovereign spreads in the Euro area: Which prospects for a Eurobond?

Publication Date

01/11/2011

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Abstract

In this paper, we provide new evidence on the determinants of sovereign yield spreads and contagion effects in the euro area in order to evaluate the rationale for a common Eurobond jointly guaranteed by euro-area Member States. We find that default risk is the main driver of yield spreads, suggesting small gains from greater liquidity. Fiscal fundamentals matter in the pricing of default risk but only as they interact with other countries? yield spreads; i.e. with the global risk that the market perceives. More important, the impact of this global risk variable is not constant over time, a clear sign of contagion driven by shifts in market sentiment. This evidence points to a discontinuity in the disciplinary role of financial markets. If markets can stay irrational longer than a country can stay solvent, then the role of yield spreads on national bonds as a fiscal discipline device is considerably weakened, and issuing Eurobonds can be economically justified.