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Working PaPer SerieS no 1079 / august 2009 emu and european government Bond Market integration by Pilar Abad, Helena Chuliá and Marta Gómez-Puig WORKING PAPER SERIES NO 1079 / AUGUST 2009 EMU AND EUROPEAN

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Working PaPer SerieS no 1079 / august 2009 emu and european government Bond Market integration by Pilar Abad, Helena Chuliá and Marta Gómez-Puig WORKING PAPER SERIES NO 1079 / AUGUST 2009 EMU AND EUROPEAN GOVERNMENT BOND MARKET INTEGRATION 1 by Pilar Abad 2, Helena Chuliá 3 and Marta Gómez-Puig 4 In 2009 all publications feature a motif taken from the 200 banknote. This paper can be downloaded without charge from or from the Social Science Research Network electronic library at 1 This paper is based upon work supported by the Government of Spain and FEDER under grant number SEJ , ECO and ECO C04-04; and Institute of Fiscal Estudies (IEF). Gómez-Puig would like to thank the Researchers in the European Central Bank Financial Markets Division for their hospitality during the summer of 2008 and their insightful comments on a previous version of the paper, as well as for providing us with part of the data used in the empirical analysis. The opinions expressed herein are those of the authors and do not necessarily reflect those of the European Central Bank or the Eurosystem. 2 University Rey Juan Carlos & RFA-IREA, Fundamentos del Análisis Económico, Paseo Artilleros, E Madrid, Spain; 3 Universitat Oberta de Catalunya & RFA-IREA; Department of Economics and Business, E Barcelona, Spain; Tel: ; 4 Corresponding author: University of Barcelona & RFA-IREA; Economic Theory Department. University of Barcelona, Av. Diagonal 690, E Barcelona, Spain; Tel: ; Fax: ; European Central Bank, 2009 Address Kaiserstrasse Frankfurt am Main, Germany Postal address Postfach Frankfurt am Main, Germany Telephone Website Fax All rights reserved. Any reproduction, publication and reprint in the form of a different publication, whether printed or produced electronically, in whole or in part, is permitted only with the explicit written authorisation of the or the author(s). The views expressed in this paper do not necessarily reflect those of the European Central Bank. The statement of purpose for the Working Paper Series is available from the website, eu/pub/scientific/wps/date/html/index. en.html ISSN (online) CONTENTS Abstract 4 Non-technical summary 5 1 Introduction 7 2 Related literature 8 3 Model 10 4 Instrumental variables and data 14 5 Results 17 6 Conclusions 20 References 22 Tables 25 European Central Bank Working Paper Series 30 3 Abstract The main objective of this paper is to study whether the introduction of the euro had an impact on the degree of integration of European Government bond markets. We adopt the CAPM-based model of Bekaert and Harvey (1995) to compare, from the beginning of Monetary Union until June 2008, the differences in the relative importance of two sources of systemic risk (world and Eurozone risk) on Government bond returns, in the two groups of countries (EMU and non-emu) in EU-15. Our empirical evidence suggests that the impact of the introduction of the euro on the degree of integration of European Government bond markets was important. The markets of the countries that share a monetary policy are less vulnerable to the influence of world risk factors, and more vulnerable to EMU risk factors. However, euro markets are only partially integrated, since they are still segmented and present differences in market liquidity or default risk. For their part, the countries that decided to stay out of the Monetary Union present a higher vulnerability to external risk factors. Keywords: Monetary integration, sovereign securities markets, bond markets integration. JEL Classification: E44, F36, G15. 4 Non-technical summary The extent of international bond market linkages merits investigation, as it may have important implications for the cost of financing fiscal deficit, monetary policymaking independence, modelling and forecasting long-term interest rates, and bond portfolio diversification. The main objective of this paper is to study whether the introduction of the euro had an impact on the degree of integration of European Government bond markets. We carry out a comparative analysis of the degree of integration of Government bond markets, since the beginning of Currency Union, in two groups of EU-15 countries, those that joined the European Monetary Union (EMU), and those that stayed out. The final goal is the analysis of the impact of Monetary Union on EU-15 debt markets integration with international debt markets (both world debt markets and Eurozone debt markets). We study financial integration, exploiting the implications of asset pricing models. In particular, following Barr and Priestley (2004), we adopt Bekaert and Harvey s CAPMbased model (1995). This model allows partially integrated markets and still has not been used to study bond markets integration in the European context. Moreover, it has only been used to analyse the impact of one kind of common or systemic risk factor over bond or stock returns behaviour (see Hardouvelis, Malliaropulos and Priestley (2006 and 2007)). Our aim is to separate each individual country s Government bond return into three effects: a local (own country) effect, a regional (Eurozone) effect, and a global (world) effect; and to establish whether there are significant differences within EMU and non- EMU participating countries. That is, whether the participation in the Monetary Union is an important factor that determines the different impact of world and regional risk on each EU-15 Government bond market. As far as we know, this is the first empirical study that applies this methodology to analyse the impact of the euro on European Government 5 bond markets integration with a weekly dataset that covers almost ten years since the introduction of the common currency. Our empirical evidence suggests that the introduction of the euro had a very important impact on the degree of integration of European Government Bond Markets. The markets of those countries that share a monetary policy are less vulnerable to the influences of world risk factors and more vulnerable to EMU risk factors. However, they are only partially integrated with the German market since their markets are still segmented and present differences in their market liquidity or default risk. This result suggests that benefits from portfolio diversification are still possible within the Monetary Union. On the other hand, the countries that decided to stay out of the Monetary Union and maintain their monetary autonomy present a higher vulnerability to external risk factors. So, government bonds from EMU countries may have a better safe-haven status compared to non-emu countries. 6 1. Introduction The market capitalization of international bond markets is much larger than that of international equity markets. However, compared to the large body of literature on international equity market linkages (see Bessler and Yang (2003), among others) few empirical studies have been carried out of bond systemic risk or international bond market co-movements. The extent of international bond market linkages merits investigation, as it may have important implications for the cost of financing fiscal deficit, monetary policymaking independence, modelling and forecasting long-term interest rates, and bond portfolio diversification. Conversely, more has been written on emerging countries, where a very important question in the study of yield co-movements is the analysis of the relative influence of fundamental variables on their behaviour (see Cifarelli and Paladino, 2006), and on volatility spillovers in international bond markets (see Cappiello et al. (2003), Christiansen (2003), or Skintzi and Refenes (2006), among others) Little has been written on the sources of co-movements in Government bond markets in the European context. Studies of this issue include Geyer, Kossmeier and Pischer (2004), Gómez-Puig (2009a and 2009b), and Pagano and Von Thadden (2004). The aim and methodology of the present paper are completely different from those of the studies just mentioned. Here, we study financial integration, exploiting the implications of asset pricing models. In particular, following Barr and Priestley (2004) who assess the degree of integration of the US, UK, Japan, Germany and Canada bond markets, we adopt Bekaert and Harvey s CAPM-based model (1995). This model allows partially integrated markets and still has not been used to study bond markets integration in the European context. Moreover, it has only been used to analyse the impact of one kind of common or systemic risk factor over bond or stock returns behaviour (see Hardouvelis, Malliaropulos and Priestley (2006 and 2007)). Ten years after the introduction of the euro, the aim of this paper is to compare the differences in the relative importance of two sources of systemic risk (world and Eurozone risk) on Government bond returns since January The model used in this paper draws on Barr and Priestley (2004), 7 but goes beyond it. As far as we know, this is the first empirical study that applies this methodology to analyse the impact of the euro on European Government bond markets integration with a weekly dataset that covers almost ten years since the introduction of the common currency. The main objective of this paper is to study whether the introduction of the euro had an impact on the degree of integration of European Government bond markets. Therefore, we will carry out a comparative analysis of the degree of integration of Government bond markets in two groups of EU-15 countries: those that joined the European Monetary Union (EMU) and those that stayed out. Our sample will span the period since the beginning of Currency Union until June Our intention is to separate each individual country s Government bond return into three effects: a local (own country) effect, a regional (Eurozone) effect, and a global (world) effect, and to establish whether there are significant differences between EMU and non-emu participating countries. That is, we analyse whether participation in the Monetary Union is an important factor which determines the differences in the impact of world and regional risk on each EU-15 Government bond market. The rest of the paper is organized as follows. Section 2 summarizes the related literature. The model is explained in Section 3. The instrumental variables and data are described in Section 4. Section 5 reports the results and, finally, Section 6 draws the main conclusions. 2. Related Literature Some recent literature has assessed the relative importance of systemic and idiosyncratic risk in EMU sovereign yield spreads (see Geyer, Kossmeier and Pischler (2004), Gómez-Puig (2009a and 2009b) or Pagano and von Thadden (2004)). Geyer et al. (2004) estimate a multi-issuer state-space version of the Cox-Ingersoll-Ross (1985) model of the evolution of bond-yield spreads (over Germany) for four EMU countries (Austria, Belgium, Italy and Spain). Their main findings are that (i) one single ( global ) factor explains a large part of the movement of all four processes, (ii) idiosyncratic country factors have hardly any explanatory power, and (iii) the variation in the single 8 global factor can be explained, to a limited extent, by EMU corporate-bond risk, but by nothing else. The most striking finding of the Geyer et al. study is the virtual absence of country-specific yield-spread risk. Pagano and von Thadden (2004), despite the considerable differences in the methodology and data used, also agree that yield differentials under EMU are driven mainly by a common risk (default) factor and suggest that liquidity differences have at best a minor role in the time-series behaviour of yield spreads. Gómez-Puig (2009a and 2009b) estimates panel regressions for two groups of EU-15 countries (EMU and non-emu) including both domestic (differences in market liquidity and credit risk) and international risk factors. Her results present evidence that it is domestic rather than international risk factors that mostly drive the evolution of 10-year yield spread differentials over Germany in all EMU countries during the seven years after the beginning of Monetary Integration. Conversely, in the case of non-emu countries, adjusted yield spreads are influenced more by world risk factors. The fact that these countries do not share a common Monetary Policy might explain these results, which may also show that government bonds from EMU countries have a better safe-haven status than those of non-emu countries. These results are consistent with the empirical evidence presented by other authors like Cappiello, Hördahl, Kadareja, and Manganelli (2006), who used a completely different methodology to investigate whether the introduction of the euro had an impact on the degree of integration of European financial markets. Controlling for the impact of global factors, they document an overall increase in co-movements in euro area financial markets, especially in bond markets, suggesting that integration in the euro area has progressed since the introduction of the single currency. In contrast to previous studies, they propose two methodologies to measure integration: one that relies on time-varying GARCH correlations, and the other on a regression quantile-based co-dependence measure (see Cappiello, Gérard, Kadareja and Manganelli, 2005). Another perspective is given by Christiansen (2003), who assesses volatility spillovers in European bond markets. She finds strong evidence of volatility-spillover effects from both the US and Europe into individual European bond markets. For EMU countries, regional effects have become 9 dominant over both own country and global effects. The opposite applies to non-emu countries where pure local volatility effects are substantial. Finally, a number of papers have studied financial integration exploiting the implications of asset pricing models. The works by Barr and Priestley (2004) and Hardouvelis, Malliaropulos and Priestley (2006 and 2007) are in this vein. In particular, Barr and Priestley (2004) use a version of Bekaert and Harvey s (1995) CAPM-based model to analyse the degree of integration of the US, UK, Japan, Germany and Canada bond markets, and find strong evidence that national markets are only partially integrated into world markets. Around one quarter of total expected excess returns is related to local market risk, the remainder being due to world bond market risk. A similar methodology is used by Hardouvelis et al. (2006 and 2007) to analyse the impact of EMU on European stock market integration. They present evidence linking the process of increased integration of European stock markets to the prospects of the formation of EMU and the adoption of the euro as the single currency. Specifically, these authors show that in the second half of the 1990s, expected stock returns in Europe became increasingly more determined by EU market risk and less by local risk. However, this methodology has not yet been used to study bond markets integration in the European context. 3. Model We assume that Government bond excess returns (r t) for country i are linearly related to world and local information variables as follows: r i,t=a i+b W iz W i,t-1+b L iz L i,t-1+ ε i,t (1) where Z W i represents the world variables, Z L i, represents local variables for country i, and ε i,t is an error term. 10 Equation (1) is consistent with a range of asset pricing models, and with any level of integration. If a market is fully integrated, the local variables should be absent from Eq. (1). Similarly, if it is completely segmented, the world variables will be absent. We estimate this equation by OLS to identify the relevant world and local instruments. Once the instruments are identified, we adopt Bekaert and Harvey (1995) s CAPM-based model and assume that excess returns in country i are generated by the following version of the conditional international CAPM: r i,t= θ W λ w,t-1 cov t-1 (r w,t, r i,t)+ (1- θ W ) λ i,t-1 var ( r i,t) + e i,t (2 ) In equation (2), θ W is interpreted as a measure of the degree of integration with world bond markets, λ w,t is the world price of risk, and λ i,t is the local price of risk. The excess return on the world portfolio Government s bonds is modelled similarly as: r w,t= λ w,t-1 var( r w,t) + e w,t (3 ) When markets are completely integrated the coefficient θ W takes the value 1, and the variance term in Equation (2) is reduced to zero. To model the conditional covariance matrix we use a multivariate GARCH model. Specifically, we use the BEKK model proposed by Engle and Kroner (1995). This model can be written as: H t=c C + A e t-1 e t-1 A + B H t-1b (4) where C is a (NxN) symmetric matrix and A and B are diagonal (NxN) matrices of constant coefficients. By doing this, we allow the variances to depend only on lagged squared errors and lagged conditional variances and the covariances to depend only upon cross-products of lagged 11 errors and lagged conditional covariances (see Bollerslev et al. (1988) and De Santis and Gerard (1997, 1998)). Following the financial literature (see Bekaert and Harvey, 1995 and De Santis and Gerard, 1997, among others), we model the price of risk as a function of a set of information variables. As the price of risk must be positive (see Merton, 1980), the functional form that we assume is: λ w,t-1 = exp ( K w Z w t-1) (5) λ i,t-1= exp ( δ L Z L i,t-1) (6) We estimate a system of equations using the Quasi-Maximum Likelihood method. Bollerslev and Wooldridge (1992) show that the standard errors calculated using this method are robust even when the normality assumption is violated. Then, we estimate equations (2), (3) and (4) jointly with the price of risk (equations (5) and (6)), for each of the local Government bond markets, and for the world Government bond market. This estimation is implemented in two steps. First, we estimate the world equation, and then impose the results on the individual countries in 13 bivariate regressions (10 EMU countries, and 3 EU-15 countries that did not join the euro in 1999). We thus restrict the estimates of the world Government bond market price of risk and of the coefficients in the conditional variance of the world market variance to be the same in all countries. Once these estimates are imposed on each bivariate regression, in the second step we will obtain the following for each country: θ W i (the estimated level of integration with the world bond market) and δ L i (the vector of estimated coefficients for the local price of risk). As we explained in the previous sections, our analysis goes beyond Barr and Priestley (2004) and Hardouvelis et al. (2006 and 2007), who only analyse the impact of one kind of common or systemic risk factor over bond or stock returns behaviour respectively. Unlike them, our aim is to compare the differences in the relative importance of two sources of systemic risk (world and Eurozone risk) on Government bond excess returns since the beginning of Monetary Union, in the two groups of countries (EMU and non-emu) in EU-15. This is the reason why we also assume 12 that excess returns (r t) for country i are linearly related to regional (EMU) and local information variables as follows: r i,t=a i+b E iz E i,t-1+b L iz L i,t-1+ε i,t (7) where Z E i represents the regional (EMU) variables, Z L i, represents local variables for country i, and ε i,t is an error term. If we consider that r e,t represents the excess return of the Eurozone Government bond portfolio and replace r w,t by r e,t in equations (2) to (5), we will obtain another system of equations for each of the local bond market and the Eurozone bond market. In particular, analogously to equation (5), the Eurozone price of risk will follow this functional form: λ e,t-1= exp ( K E Z E t-1) (8) We also estimate this system in two steps and obtain, for each country, θ i E (the estimated level of integration with the Eurozone Government bond market), and δ L

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