Common Currency and Determinants of Government Bond Risk Premiums

Abstract

The problem of governments’ over-indebtedness is one of the most important
challenges for today’s EMU governance. As numbers suggest, the problem of
extensive deficits has appeared in the EMU long before the burst of the global
financial crisis. We suspect that the membership in a currency area might be
partially blamed for such progression of indebtedness. This paper examines
the determinants of government risk premiums in the EU Member States to
answer if the risk premium assigned by the market may give currency area
Member States additional incentives for profligacy. Controlling other factors,
we investigate the pattern in which fiscal deficits and GDP growth affect the
yield of 10-year-maturity government bonds in the euro area and the non-euro
area EU Member States. Our results are straightforward. The market penalizes
EU countries that do not belong to the euro area for bad economic performance
and extensive deficits from 4 to 7 times stronger. Our estimates confirm the
strong impact of the common credibility problem in the EMU but also suport
the key role of financial stress in determining the cost of government debt.