Is free riding affecting market discipline in the Euro sovereign bond market?

Cooke, Christopher (2009) Is free riding affecting market discipline in the Euro sovereign bond market? Doctoral thesis, London Metropolitan University.


The aim of this research is to investigate how the failure of the members of the EMU to uphold the goals of the Stability and Growth Pact (SGP) has affected the Euro sovereign bond markets and its ability to enforce market discipline. To date 7 of the 11 member states of the Euro zone have violated the principles of this pact, and yet the bond market has shown little appetite to punish those with high deficits and national debts. The danger going forward is that each country will find ways to justify growing fiscal deficits, contented in the knowledge that there will be no formal pressure from other EMU countries and that the interest rate burden will be the equivalent for all EMU countries. Thus, there appears to be an element of "free-riding" by those governments who feel there is an unwritten bail-out in the workings of the system (despite official pronouncements to the contrary). Therefore my research investigates whether monetary union has weakened the disciplinary function of the Euro debt markets. To this end, I carried out an investigation of the microstructure of European bond markets, and in particular the effects on Liquidity risk with the introduction of electronic trading. There is clear evidence that increased transparency has benefited the bond market by increasing liquidity and thereby reducing liquidity risk. Building a testable model I place the "liquidity risk premium" in its historical context and highlight the dominant role of credit risk in explaining the yield differential with the eurozone. I expand on the research carried out by Cantor and Packer (1996) on the determinants of sovereign's yields and apply their model to the members of the eurozone. This shows that one of the two pillars of the SGP, government deficits, is almost completely ignored by the market in assessing sovereign risk. Instead, GDP per Capita and Debt/GDP seem to be the main drivers in determining the yield of a sovereign. Also, in contrast to Cantor and Packer results, where the yield curve increases in a convex shape as the risk ofdefault increasest,h e eurozonec urve is much more concavei n nature,w hich agrees with my "free-riding" hypothesis. Building on the research carried out by Dunne, Moore and Portes (2006), I employ cointegration to model the inter-relationships between different issuer bonds. However, rather than look for a benchmark issuer, I use the model to explore the common regional drivers and investigate the systemic effects that resemble a tacit "bail-out" condition. I show that the regional effect dominates the individual or country specific risk within the bond market. This shows that investors see the eurozone as a single bloc rather than as separate issuers individually responsible for their own debt. Using an Error Correction Model I investigate the short-run dynamics of bond yields and relate these to the underlying fundamentals of the respective issuer, with low risk issuers having higher speed-of-adjustments than high risk sovereigns. This corresponds to investors views of the 'core members' eg. Germany, France etc. are more homogeneous than and the 'outer members', Italy, Greece, Portugal etc. In conclusion, my research shows that there are significant issues of "free-riding" within the eurozone bond market and it is still far from efficient.

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