Governments in advanced economies face growing pressure to increase public spending. This column finds that debt issuance in euro area countries whose bonds are considered relatively safe drives up interest rates in both the issuing country and in other ‘safe’ countries. This new type of spillover, which differs from contagion effects and default risk spillovers, implies that total debt issued in ‘safe’ countries matters more for sovereign interest rates than which country issues it. This insight strengthens the case for common fiscal rules – to safeguard euro area financial stability and to ensure a fair sharing of fiscal burdens.
Public spending needs in advanced economies are on the rise. Governments face growing pressure to facilitate the green transition (Wolff and Darvas 2022), to tend to ageing populations, and to enhance resilience amid heightened geopolitical risks (Beetsma et al. 2024). These trends contribute to an increase in required public expenditure over the next decades.
To deliver on these expenditure needs, it will be paramount for governments to continue issuing debt at low interest rates and to avoid high interest rate payments. In advanced economies, sovereign bond interest rates are low, in part because they command a ‘convenience yield’ premium driven by the strong demand for safe, liquid, and generally ‘convenient’ assets (Tambalotti et al. 2018). Will convenience yields continue to contribute to low interest rate burdens?
The literature has established that a scarce supply of safe assets is an important determinant of convenience yields (Vayanos et al. 2016, Krishnamurthy and Vissing-Jorgensen 2012). However, previous studies have focused on one sovereign issuer in isolation, ignoring potential spillovers across countries.
Would rising debt in one country erode another country’s convenience yield, and thereby drive up its debt servicing costs? In a new paper (Arcidiacono et al. 2024), we study how a country’s convenience yield is impacted by the debt issuance policy of its neighbours. Previous work has shown that a country’s convenience yield declines when its debt increases. This is because investors demand a higher interest rate – and a lower convenience yield – to absorb additional debt (Krishnamurthy and Vissing-Jorgensen 2012, Jiang et al. 2020). However, little is known about the impact of debt issuance in other countries.
Figure 1 shows the potential magnitude of cross-border impacts on yields from an increase in one country’s debt supply. On 14 December 2022, at 10:00 CET, the German Public Debt Management Agency announced its debt issuance plan for the following year, which exceeded investors’ expectations. In line with the findings of the previous literature, German yields rose across maturities (left panel). Within seconds, the French yield also surged, closely following the movements in the German yield, despite the news being about German supply. The Italian yield also displayed substantial co-movement, but less than the French yield. Our work takes advantage of such events to systematically quantify these spillover effects.
Figure 1 Spillover effects of German debt issuance announcement on 14 December 2022
Convenience yields in the euro area
In advanced economies, governments often sell bonds at yields lower than the risk-free rate adjusted for the default risk premium. This gap, called the convenience yield, exists because sovereign bonds provide non-financial services like safety, liquidity, and collateral value to investors.
Convenience yields can be large and imply substantial savings in terms of debt interest payments. While much attention has been given to the US, standard measures of the convenience yield in Europe reveal that they are also relevant for many euro area countries. Convenience yields range from ten to 40 basis points for ‘safe’ countries with low default risk, such as Germany, France, Finland, the Netherlands, Austria, and Belgium. In contrast, they are close to zero for riskier countries, such as Spain, Italy, and Portugal (Figure 2). A back-of-the-envelope calculation suggests that the convenience yield saves Germany around €9 billion each year.
Figure 2 Safe euro area countries earn a larger convenience yield
Direct and indirect impacts on convenience yields from debt supply shocks
Higher debt supply in a country erodes that country’s convenience yield. For example, Jiang et al. (2020) use a panel of euro area countries to estimate that a one percentage point increase in the debt-to-GDP-ratio decreases the convenience yield by 0.33 basis points. But how does such an increase in debt affect the convenience yield of other euro area countries?
In the euro area, bonds provided by different sovereigns share the same currency and operate under a very similar institutional framework. Therefore, they should provide similar ‘convenience’ services to investors and should be perceived as substitutable to some extent. Under this microeconomic analogy, sovereign issuers are sellers that compete to provide services to their consumers, which are the investors. Their prices (their convenience yields) should therefore be interconnected, as greater supply from a competitor is expected to lower the prices of all substitutable products.
To estimate cross-border effects on convenience yields, we identify country-specific debt supply shocks from the official communication of public debt management agencies over 2009-2023. The key assumption is that such communication events contain news which are the main driver of movements in financial markets in the minutes around their release. The anecdotal evidence presented in Figure 1 supports this assumption.
Our main analysis focuses on spillovers originating from Germany. We estimate the change in euro area convenience yields in response to a change in the German convenience yield in the aftermath of a debt supply shock. We highlight two main findings.
First, spillovers among ‘safe’ countries are almost one-for-one. When the German convenience yield increases by one basis point, convenience yields increase in France by 0.92 basis points, in the Netherlands by 0.97 basis points, and in Finland by 1.19 basis points. These estimates are precisely estimated and highly statistically significant (Figure 3).
Figure 3 Convenience yield spillovers from Germany
Note: The bars show the response of ‘safe’ countries’ convenience yield to a debt supply shock in Germany. The shock is normalised to correspond to a one percentage point increase in the German convenience yield.
Second, spillovers to euro area countries perceived as ‘more risky’ by investors are typically smaller, noisy, and statistically insignificant. For example, the estimated response of the convenience yield in Italy is an increase of only 0.79 basis points, while the convenience yield decreases by 0.43 basis points in Spain.
These findings are robust and not specific to Germany. In the case of Germany, we use a battery of alternative state-of-the-art estimators that confirm our results. We also document very similar one-to-one spillover effects from France to other ‘safe’ countries, including to Germany. Spillovers from France to ‘risky’ countries are again insignificant.
The first result highlights that safe euro area sovereign bonds are treated as highly substitutable by investors. We show in additional results that the class of highly substitutable safe bonds also includes investment-grade corporate bonds and bonds issued by the EU. For these bonds, we estimate similarly large and highly significant spillover effects.
A new fiscal spillover
The substitutability of safe sovereign bonds and the interconnectedness of their convenience yields gives rise to an important externality: the costs of one country issuing more debt (i.e., lower convenience yield and higher interest rates) accrue both to the issuing country and to other similarly safe countries.
This is a new form of fiscal spillovers. These spillover effects of country-specific debt issuance that we document are operative among safe countries and even in the absence of default risk. These are different from the spillovers propagating because of contagion and flight-to-safety behaviour and originating from changes in risk and risk perception.
What does it mean for policy?
Our findings suggest that sovereign debt issuance has broader effects than previously thought. In the euro area, the costs of fiscal policies are not isolated, even among countries with relatively low sovereign risk. This potentially has consequences for debt sustainability and fiscal coordination.
For safe countries to secure high convenience yields, low sovereign yields, and fiscal sustainability, it matters how much safe debt is issued in total, and it matters less which country issues debt (e.g. whether debt is issued by France or Germany). When Germany issues more debt, for example, the spillover effects lead to rising sovereign yields in other low-risk countries, making it more expensive for them to borrow.
The policy takeaway is clear: euro area countries need to coordinate fiscal policies to internalise these spillover effects when coordinating fiscal policies. The temptation for countries to rely on a low interest rate as a sign of financial health may overlook the fact that their yields are partially driven by low debt issuance in other countries. This strengthens the abundant literature making the case for better coordination of national fiscal policies (Tabellini 2016, Thygesen et al. 2018, Ilzetzki 2021, Leandro et al. 2021, Weymuller et al. 2022).
In conclusion, understanding how bond markets interact within the euro area offers critical insights for managing sovereign debt and ensuring long-term fiscal sustainability. These spillovers underscore the importance of fiscal cooperation, especially in unions where sovereign bonds can be highly substitutable and individual actions can ripple through the entire system.
Source : VOXeu
