Working Paper. The Greek financial crisis: growing imbalances and sovereign spreads WORKINKPAPERWORKINKPAPERWORKINKPAPERWORKINKPAPERWO

BANK OF GREECE EUROSYSTEM Working Paper The Greek financial crisis: growing imbalances and sovereign spreads Heaher D. Gibson Sephan G. Hall George S. Tavlas MARCH 2011 124 WORKINKPAPERWORKINKPAPERWORKINKPAPERWORKINKPAPERWO

BANK OF GREECE Economic Research Deparmen Special Sudies Division 21, Ε. Venizelos Avenue GR-102 50 Ahens Τel: +30210-320 3610 Fax: +30210-320 2432 www.bankofgreece.gr Prined in Ahens, Greece a he Bank of Greece Prining Works. All righs reserved. Reproducion for educaional and non-commercial purposes is permied provided ha he source is acknowledged. ISSN 1109-6691

THE GREEK FINANCIAL CRISIS: GROWING IMBALANCES AND SOVEREIGN SPREADS Heaher D. Gibson Bank of Greece Sephen G. Hall Universiy of Leiceser George S. Tavlas Bank of Greece* ABSTRACT We discuss he origins of he Greek financial crisis as manifesed in he growing fiscal and curren-accoun deficis since euro-area enry in 2001. We hen provide an invesigaion of spreads on Greek relaive o German long-erm governmen deb. Using monhly daa over he period 2000 o 2010, we esimae a coinegraing relaionship beween spreads and heir long-erm fundamenal deerminans (including a measure of he fiscal siuaion, compeiiveness of he Greek economy, economic aciviy and oil prices, reflecing he high dependence of he Greek economy on impored energy) and compare he spreads prediced by his esimaed relaionship wih acual spreads. We find ha spreads were significanly below wha would be prediced by fundamenals from end-2004 up o he middle of 2005; by conras, since May 2010, acual spreads have exceeded prediced spreads by some 400 basis poins. JEL Classificaion: E63; G12 Keywords: Greek financial crisis, sovereign spreads Acknowledgemens: We would like o hank colleagues a he Bank of Greece for assisance wih daa collecion, in paricular, Elena Argiri, Eleni Gazopoulou, Dora Kosma, Kaerina Kosoni and Angeliki Momsia. The views expressed do no necessarily reflec hose of he Bank of Greece. George S. Tavlas Bank of Greece 21, El. Venizelou Ave., 10250 Ahens, Greece, Tel. +30210-3202370 Fax +30210-3202432 e-mail: gavlas@bankofgreece.gr

1. Inroducion The enry of Greece ino he euro area in 2001 provided ha counry s economy wih a huge dividend in erms of sharply-reduced ineres raes. The nominal ineres rae on 10-year Greek governmen bonds declined from abou 20 per cen in 1994, he ime ha he hen-governmen announced a goal of bringing Greece ino he euro area in 2001, o less han 3 1 / 2 per cen in early 2005. Wih he erupion of he Greek financial crisis in lae 2009, however, ineres raes have sho upward, wih he 10-year governmen bond yield increasing o almos 12 per cen a he end of 2010. To wha exen have he wide swings in yields refleced economic fundamenals? This paper addresses ha issue. We use he ineres-rae spread beween 10-year Greek and German governmen bonds o esimae a coinegraing relaionship beween hose spreads and heir long-erm fundamenal deerminans. Recen work on he deerminans of spreads uses panel coinegraion echniques on high frequency daa where spreads are hypohesised o be driven by various financial marke variables represening credi, liquidiy and marke risks (Doz and Fischer, 2010; Fonana and Scheicher, 2010; Gerlach e al, 2010). By conras, we focus on one counry alone and he macroeconomic deerminans of spreads. We argue ha during he period 2001-2009 he Greek economy was marked by growing, unsusainable fiscal and exernal imbalances. We posi ha he sharp reducion in ineres-rae spreads ha occurred during much of his period did no adequaely reflec hese imbalances. Our empirical resuls provide some evidence for his view. We also provide evidence ha he sharp, upward reversal of spreads following he oubreak of he Greek financial crisis also did no fully reflec fundamenal facors. Thus, boh undershooing and overshooing of spreads have occurred. The remainder of his paper consiss of six secions. Secion 2 describes he origins of he Greek financial crisis, highlighing he crucial role of growing fiscal and exernal imbalances. Secion 3 decomposes he risk premia on Greek sovereign deb ino a par which can be explained by he raing given by he sandard raing agencies and a par which seems o be idiosyncraic o he markes. Secion 4 invesigaes a more fundamenal deerminaion of he spreads by providing a brief overview of he recen lieraure on he deerminans of spreads. Secion 5 presens a fundamenal modelling 5

approach. Specifically, we use he mehodology proposed by Johansen (1955a) and Pesaran and Shin (2002) o assess he coinegraing rank of a VAR sysem, and hen proceed o idenify he srucural relaionship deermining Greek spreads. As fundamenal deerminans, we include a measure of he fiscal siuaion, he compeiiveness of he Greek economy, economic aciviy and oil prices (reflecing he high dependence of he Greek economy on impored energy). Secion 6 presens he resuls. In paricular, we compare he spreads prediced by he esimaed relaionship wih acual spreads. We find ha spreads were significanly below wha would be prediced by fundamenals from end-2004 up o he middle of 2005; by conras, since May 2010, acual spreads have exceeded prediced spreads by some 400 basis poins. Secion 7 concludes. 2. The Greek financial crisis: origins 2a. The years of growing imbalances: 2001-2008/09 On January 1, 2001, Greece became he welfh member of he euro area. 1 The moivaion for joining he euro area refleced an assessmen ha he benefis of joining would ouweigh he coss. In wha follows, we discuss hese benefis and coss. Among he benefis conferred by he euro on is members are he following. (1) For counries wih hisories of high inflaion, such as Greece, i lowers inflaion expecaions and, herefore, ineres raes. (2) I eliminaes exchange-rae flucuaions and he possibiliy of compeiive devaluaions among paricipaing counries, hereby reducing risk premia and nominal ineres raes. (3) Wih low inflaion, economic horizons lenghen, encouraging borrowing and lending a longer mauriies. The lenghening of horizons and he reducion in ineres raes simulae privae invesmen and risk-aking, fosering economic growh. The reducions in nominal ineres raes under (1) and (2) lower he coss of servicing public-secor deb, faciliaing fiscal adjusmen and freeing resources for oher uses. 2 1 A is incepion on January 1, 1999, he euro area consised of eleven counries. Five counries have joined he euro area afer Greece s enry, bringing he oal number of members in 2011 o seveneen. For a deailed assessmen of he euro area, see De Grauwe (2007). 2 These advanages of a common currency exis so long as he cenral bank of he moneary union delivers price sabiliy and is credible. In he case of he euro, he European Cenral Bank quickly esablished is ani-inflaion credenials and became credible. 6

In he case of Greece, ineres-rae spreads beween 10-year Greek and German governmen bonds came down sharply in he years running up o, and he years following, enry ino he euro area. These spreads are shown in Figure 1 for he period 1998 hrough 2010 using monhly daa. 3 As shown in he figure, spreads fell seadily, from over 1,100 basis poins in early 1998, o abou 100 basis poins one year prior o euro area enry. Upon enry ino he euro area in 2001, spreads had fallen o around 50 basis poins and coninued o narrow subsequenly, declining o a range beween 10 o 30 basis poins from lae 2002 unil he end of 2007. During he laer period, he absolue levels of nominal ineres raes on he 10-year insrumen flucuaed in a range of 3.5 per cen o 4.5 per cen, compared wih a range of 5.0 per cen o 6.5 per cen in he year prior o euro-area enry. The low-ineres-rae environmen conribued o robus real growh raes. From 2001 hrough 2008, real GDP rose by an average of 3.9 per cen per year he secondhighes growh rae (afer Ireland) in he euro area underpinned by household spending for consumpion, housing invesmen, and business invesmen. Inflaion, which averaged almos en per cen in he decade prior o euro area enry, averaged only 3.4 per cen over he period 2001 hrough 2008. Alhough enry ino he euro area conribued o a period of prolonged and robus growh, and low (by Greece s hisorical sandards) inflaion, wo deep-seaed problems remained unaddressed; he counry coninued o run large fiscal imbalances and he counry s compeiiveness already a problem upon euro area enry coninued o deeriorae. Fiscal Policy. Figure 2 repors daa on fiscal deficis and governmen expendiure and revenue as percenages GDP, beginning wih 2001. As indicaed in he figure, fiscal policy was pro-cyclical hroughou he period 2001 hrough 2009, wih deficis consisenly exceeding he Sabiliy and Growh Pac s limi of 3 per cen of GDP by 3 In 1994, he hen-greek governmen se a goal o ener he euro area on January 1, 2001. The convergence of Greek economic indicaors o hose of oher European Union counries conribued afer 1994 o he narrowing of spreads prior o euro area enry. For an analysis of he Greek economy before euro-area enry, see Garganas and Tavlas (2001). 7

wide margins. 4 Expansionary fiscal policy was mainly expendiure-driven, leading o a rise in he share of governmen spending (o over 50 per cen of GDP in 2009, from abou 45 per cen in 2001). The governmen deb-o-gdp raio remained near 100 per cen hroughou he period 2001 hrough 2009. Compeiiveness. Alhough inflaion in Greece during 2001 hrough 2009 was low by he counry s hisorical sandards, inflaion was relaively-high by euro-area sandards. Inflaion was, on average, more han one percenage poin higher per year han in he res of he euro area (Figure 3). Wage increases, adjused for produciviy changes, also exceeded he average increases in he res of he euro area. Wih boh prices and wages growing a relaively high raes, compeiiveness declined (Figure 4). In he period 2001 hrough 2009, compeiiveness, as measured by consumer prices, declined by around weny per cen; as measured by uni labour coss, compeiiveness declined by abou 25 per cen. Wih relaively high real growh raes and declining compeiiveness, he curren-accoun defici, which had already opped 7 per cen of GDP in 2001, rose o abou 14.5 per cen of GDP in boh 2007 and 2008 (Figure 5). The large and growing fiscal imbalances were clearly no susainable. Upon enry ino he euro area, Greece gave up he abiliy o use wo key ools o adjus is economy in he case of a counry-specific shock. Firs, i los he abiliy o se is own moneary policy. Second, i los he abiliy o change he nominal exchange rae of is own currency. To compensae for he loss of hese ools, he counry needed o have he following: (i) relaively-low fiscal imbalances, so ha fiscal policy could be used counercyclically in case of a counry-specific shock, and (ii) flexible labour and produc markes so ha he counry could be compeiive wihou having o rely on changes in he exchange rae of a domesic currency o achieve and/or mainain compeiiveness. As menioned above, however, compeiiveness declined subsanially during 2001-2009, 4 The European Union s Sabiliy and Growh Pac aims o keep members fiscal deficis below 3 per cen of GDP and heir deb-o-gdp raios below 60 per cen of GDP. Enry ino he euro area is, in par, coningen on he saisfacion of hese fiscal crieria. In he case of he deb-o-gdp crierion, counries can be allowed o join if he deb raio is seen o be approaching he 60 per cen criical value a a saisfacory pace. The laer circumsance applied o Greece. In he year 2000, Greece was allowed enry ino he euro area wih a deb-o-gdp raio near 100 per cen of GDP (because he raio was on a declining pah) and a fiscal defici iniially repored a 3.0 per cen of GDP; he laer figure was subsequenly revised o 3.7 per cen of GDP afer Greece became a member of Europe s moneary union. 8

despie he already large curren-accoun deficis a he ime of enry ino he union. Moreover, insead of providing he role of an auomaic sabilizer, he pro-cyclical sance of fiscal policy aced as a major source of shocks. 5 Neverheless, he low levels of ineres-rae spreads during 2001-08 sugges ha financial markes paid lile aenion o he unsusainabiliy of he fiscal and exernal imbalances during ha period. 6 2b. The wake up call The global financial crisis ha eruped in Augus 2007, following he collapse of he US subprime morgage marke, iniially had lile impac on Greek financial markes; spreads on he 10-year insrumen, which were in a range of 20 o 30 basis poins during January hrough July of 2007, remained in he viciniy of 30 basis poins for he remainder of 2007 and he firs few monhs of 2008 (Figure 1). Wih he collapse (and sale) of Bear Searns in March 2008, spreads widened o abou 60 basis poins, where hey remained unil he collapse of Lehman Brohers in Sepember. The laer even brough spreads up o around 250 basis poins during he firs few monhs of 2009, bu hey gradually came back down o abou 120 basis poins in Augus and Sepember of 2009. Then came a double shock in he auumn of 2009. Two developmens combined o disrup he relaive ranquiliy of Greek financial markes. Firs, in Ocober he newlyeleced Greek governmen announced ha he 2009 fiscal defici would be 12.7 per cen of GDP, more han double he previous governmen s projecion of 6.0 per cen. 7 In urn, he 12.7 per cen figure would undergo furher upward revisions, bringing i up o 15.4 5 Given ha inflaion in Greece during 2001-2009 was higher han he average inflaion rae in he res of he euro area, he ECB s single nominal ineres rae mean ha real ineres raes in Greece were relaively low. Wickens (2010) argues ha his siuaion warraned igher fiscal policy. 6 As menioned in Secion 3, however, real ime fiscal daa undersaed he severiy of he fiscal siuaion. The real-ime daa ypically indicaed ha he fiscal imbalances were declining. Subsequen revisions of he daa showed ha he imbalances were, in fac, increasing. 7 On is websie, he Bank of Greece publishes monhly cash daa on he cenral-governmen (as opposed o he general-governmen) fiscal accouns. These daa are available wih a wo-week lag relaive o he monh for which hey apply. The daa poined o a sharp, worsening rend in he cenral-governmen fiscal defici during he course of 2009. In his connecion, in early Sepember 2009 (ahead of he general elecion in Ocober) Bank of Greece Governor, George Provopoulos, alered he leaders of he wo main poliical paries of he deerioraing fiscal siuaion and he need of srong correcive acions. See Ziras (2009). 9

per cen of GDP 8. Second, in November 2009 Dubai World, he conglomerae owned by he governmen of he Gulf emirae, asked crediors for a six-monh deb moraorium. Tha news raled financial markes around he world and led o a sharp increase in risk aversion. In ligh of he rapid worsening of he fiscal siuaion in Greece, financial markes and raing agencies urned heir aenion o he susainabiliy of Greece s fiscal and exernal imbalances. The previously-held noion ha membership of he euro area would provide an impenerable barrier agains risk was shaken. I became clear ha, while such membership provides proecion agains exchange-rae risk, i canno provide proecion agains credi risk. The wo shocks se-off a sharp and prolonged rise in spreads, which, by-and-large, coninued hroughou he course of 2010. As shown in Figure 1, spreads on 10-year sovereigns widened from abou 130 basis poins in Ocober 2009 o around 900 basis poins one year laer. The widening ook place despie an agreemen in early May 2010 beween he Greek governmen and he Inernaional Moneary Fund, he European Cenral Bank, and he European Commission, for a hree-year, 110 billion adjusmen loan under which he Greek governmen commied o lower is fiscal defici o 8.1 per cen of GDP in 2010 and o below 3.0 per cen in 2014. 9 Also, he widening occurred amid news ha he European Cenral Bank had embarked on a programme o purchase hose governmen bonds he spreads of which were seen as having risen for reasons unrelaed o he fundamenals. To wha exen did he rise in Greek spreads during 2010 relae o facors oher han he fundamenals? We address his issue in wha follows. 8 Par of he subsequen increase was due o a reclassificaion of some public enerprises. The enerprises in quesion, which had previously been excluded from he general governmen accouns, were brough ino hose accouns. 9 The loan also commis he governmen o underake wide-ranging srucural reforms aimed a making he economy more compeiive. The 8.1 per cen defici arge for 2010 does no include he reclassificaion of public enerprises, menioned above, which leads o an increase in he 2010 and 2011 fiscal deficis. 10

3. Spreads and he risk premium In he 2010 repor on Financial Inegraion in Europe (April 2011) from he European Cenral Bank (2011), a simple model of risk premia for sovereign deb yields is explored. In his secion, we exend his model in erms of is specificaion and esimaion mehodology, applying he model o he case of Greek sovereign deb. In general, we may hink of he relaionship beween a counry s deb yields and ha of a risk-free counry (say, Germany) as being simply ha of equaliy plus a risk premium, ha is: R gr = R ge + ρ + ε gr R ge R where is he yield on Greek 10-year bonds, is he yield on German governmen bonds, ρ is a ime varying risk premium and ε is an error erm. The risk premium may vary wih a number of facors, including he fundamenals of he economy in quesion. In he ECB repor menioned above, he focus is on he raings given o a counry by he credi raing agencies and we focus on hese raings in his secion. (We urn o he fundamenal facors in he nex secion.) We decompose he risk premium ino wo componens, one of which can be jusified on he basis of marke informaion 1 ρ and one which is essenially irraional 2 ρ as:. Then, parameerising he model slighly differenly, we may resae he relaionship R gr 2 ) ge 1 = (1 + ρ R + ρ + ε (1) We focus on credi raing revisions on Greek sovereign deb during he period and include hem in his relaionship as dummy variables 10. These revisions are: D1 D2 1/1/2000-4/11/2002 4/11/2002-16/12/2004 Moody s upgraded Greek deb from A2 o A1 Fich downgraded Greek deb from A+ o A 10 We do no use all downgrades since some downgrades are simply repeas of wha oher raing agencies have effecively done. 11

D3 D4 14/1/2009-8/12/2009 8/12/2009 - end-period Hence, we may resae he relaionship as: Sandard and Poor s downgraded Greek bonds from A+ o A Sandard and Poor s downgraded Greek bonds from A o BBB+ R gr 2 ge = (1 + ρ ) R + D1 + D2 + D3 + D4 + ε (2) In he ECB sudy, his relaionship is esimaed in firs differences, using OLS for a rolling window of daa. We would argue ha he firs difference specificaion is inappropriae for a number of reasons. (1) Differencing he above equaion would produce a non-inverible moving average error process which would presen esimaion problems. (2) The credi raing dummies were no differenced and, hence, he ECB sudy confuses he relaionship beween he risk premium and he spread 11. (3) In addiion, wih high frequency daa, he changes in yields may no be very closely linked and much of he relaionship may be los if sufficien lags are no included. We also argue ha he use of OLS as an esimaion echnique is inherenly inappropriae as he underlying assumpion of OLS is ha he parameers of he model are consan while he risk premium is clearly mean o be ime varying. OLS is no herefore a consisen esimaor of a rue ime-varying parameer and will yield biased resuls. We, herefore, propose o esimae he following model using he Kalman Filer. The measuremen equaion is: R gr ge 1 D1 + α 2D2 + α 3D3 + α 4D ε (3) = β R + α 4 + and he sae equaion is: γ β = β 1 + ϖ ω ~ N(0, e ) (4) We esimae his model by maximum likelihood using daily daa on 10-year benchmark yields for boh Greek and German governmen bonds 12. The resuls are 11 The ECB (2011) firs difference he ineres-rae daa, bu keep he dummies in levels. Effecively, his procedure leads o he resul ha a permanen change in raings leads o a permanenly growing spread. 12 See he Appendix for deailed daa sources. 12

presened in Table 1. The wo iniial changes in raing are no paricularly significan while he laer are imporan in erms of generaing a sizable risk premium. The variance of he sae equaion is also quie large indicaing an imporan degree of ime variaion in he oal risk premium. The unexplained risk premium is given by he sae variable β. This is shown in Figure 6, where values above uniy show he excess risk premium. The unexplained risk premium began o rise in lae 2008 in advance of he firs downgrade of Greek governmen bonds in early 2009. When his occurred, he unexplained risk premium fell back o normal levels. However, afer his, and despie furher downgrading in lae 2009, he unexplained risk premium coninued o rise hrough 2010, indicaing ha he spread on Greek bonds became considerably larger han can be explained by he downgrading alone. There are, of course, a range of oher facors which may have been influencing he markes ha are no capured by he credi raing schemes alone, alhough he credi raings aim a capuring he effecs of a counry s main fundamenal variables. Clearly, in he case of Greece, he credi raings did no capure all of he facors ha impaced on spreads. In wha follows, we invesigae a more srucural approach o he risk premium o see if his can offer a beer explanaion of he unexplained premium. 4. The deerminans of spreads: an overview Much of he earlier work on he deerminans of sovereign spreads relaes o emerging marke economies and covers exernal deb raded during he 1990s (Min, 1998; Ferrucci, 2003; Grandes, 2007; Baldacci e al., 2008; Alexopoulou e al., 2010). The spread, in line wih he idea ha i reflecs he risk premium required o induce agens o lend o he borrower, is ypically modelled as a funcion of he probabiliy of defaul and he loss given defaul. These, in urn, are relaed o a se of fundamenals ha can be grouped ino four broad caegories: liquidiy/solvency risks, macroeconomic fundamenals, exernal shocks, and marke risks. In general, he lieraure finds suppor for each of hese poenial deerminans of spreads. 13

In he lieraure, solvency risks are usually relaed (posiively) o he overall level of deb (relaive o GDP) or he governmen defici-o-gdp raio and he curren-accoun imbalance relaive o GDP (which deermines he sock of exernal usually foreign currency deb). Liquidiy risks relae o he abiliy of he sovereign o access he foreign currency required o service he deb accumulaed; as such hese risks are negaively relaed o expor growh and he raio of inernaional reserves o GDP, and posiively relaed o he deb service raio (deb servicing/expors). Macroeconomic fundamenals examined in he lieraure include inflaion, compeiiveness (as measured by he real effecive exchange rae), he erms of rade, and growh. Spreads are expeced o be posiively relaed o inflaion, which provides an indicaion of macroeconomic sabiliy. Compeiiveness and he erms of rade affec he build-up of deb and he abiliy of he counry o generae he foreign exchange required o repay. (They are expeced o be negaively relaed o spreads.) Finally, counries ha are growing a relaively-fas raes usually find i easier o service a given level of deb. For emerging marke economics, oil prices (or, more generally, commodiy prices) and inernaional ineres raes end o be he mos imporan sources of exernal shocks. The laer are usually proxied by a US dollar-denominaed ineres rae since he predominance of emerging marke exernal deb is denominaed in dollars. Finally, he level of spreads is someimes relaed o marke condiions. In his connecion, Ferruci (2003) ess wheher spreads are posiively relaed o marke risk (he risk ha secondary marke prices migh move agains he bond holder) and liquidiy risks (he risk ha bond holders canno liquidae heir holdings wihou reducing secondary marke prices). Ferucci proxies he former wih he S&P 500 equiy index and he laer wih he spread beween yields on deb beween high and low-raed US companies. Baek e al. (2005) consruc a risk appeie index for developed and emerging markes based on he rank correlaion coefficien beween marke reurns and volailiy. A posiive correlaion coefficien indicaes risk-seeking behaviour whereas a negaive one suggess risk-avoiding behaviour. Greaer risk appeie is expeced o be negaively relaed o he overall level of spreads. An alernaive measure of global risk aversion, used by Grandes (2007), is an index of US corporae bonds raed BB (junk bonds). 14

An addiional facor ha is considered o influence spreads in emerging markes is poliical risk (Baldacci e al., 2008). The poenial significance of his variable sems from he seminal work of Eaon and Gersoviz (1981), who draw aenion o he imporance of willingness-o-pay, and no jus abiliy-o-pay, as a deerminan of he probabiliy of defaul. Baldacci e al. (2008) measure poliical risk by aking he firs principal componen of he World Bank s governance index and he Heriage Foundaion s economic freedom index. An alernaive measure (which also allows sub-indices o be calculaed) used by Baldacci e al. (2008) incorporaes informaion from he Inernaional Counry Risk Guide daabase. Boh measures are found o be significan and posiive deerminans of spreads (ha is, an increase in poliical risk is associaed wih a rise in spreads). Finally, some auhors invesigae he exen o which conagion is a deerminan of spreads for emerging marke economies. Grandes (2007), in his sudy of Lain American counries for he period 1993-01, includes dummies o cover poenial conagion from he Mexican, Russian and Brazilian crises. All hree dummies are found o be highly significan. In conras, Min (1998) finds no evidence ha he Mexican crisis shifed he level of spreads across developing counries upwards. As noed, he above lieraure focuses on emerging marke economies. The lieraure on sovereign spreads in more developed counries (including euro-area counries), in addiion o considering macroeconomic fundamenals, also focuses on common rends across counries and global financial condiions more generally. Consequenly, panel daases are ypically used o allow cross-counry similariies and differences o be exploied in idenifying he common inernaional facor 13. In he ligh of he ongoing sovereign deb crisis affecing euro-area counries, a number of papers have focused on he deerminans of spreads in euro-area counries. Doz and Fischer (2010) seek o explain spreads by decomposing spreads o generae counry-specific defaul probabiliies. A GARCH-in-mean approach allows he auhors o exrac perceived defaul probabiliies whils conrolling for macroeconomic deerminans of spreads along wih a measure of financial sabiliy (he movemen in he equiy index 13 See, for example, Favero e al., 1997; Codogno e al. 2003; Geyer e al., 2004; Gerlach e al., 2010. 15

of counry x relaive o an overall equiy index for he euro area) and disress (corporae bond spreads). The sample of daily daa runs from February 2002 o end-april 2009. They find srong evidence of a break in March 2008 wih he rescue of Bear Searns. Prerescue, he measure of financial disress corporae bond spreads is negaively relaed o sovereign spreads as corporae and sovereign bonds are perceived as subsiues; posrescue, he coefficien urns posiive. A he same ime, during he pre-rescue period a real appreciaion has a negaive impac on spreads as real appreciaion is inerpreed as evidence of growh and real convergence; pos-rescue, he impac is srongly posiive. Fonana and Scheicher (2010) use weekly daa on CDS spreads and benchmark bond spreads from January 2006 - June 2010. Their main aim is o examine arbirage beween CDS spreads and bond spreads. However, he auhors also examine he deerminans of spreads, using various financial marke measures as explanaory variables. These measures include he implied volailiy of he S&P500 equiy index, corporae CDS premia (as a measure of credi marke risk), idiosyncraic equiy volailiy (capuring counry-specific facors) and ousanding bonds/gdp. They conclude ha credi marke facors (corporae bond spreads) are imporan in explaining sovereign spreads; indeed, hey are found o be more imporan han eiher he equiy marke variables or deb. From Sepember 2008, he auhors find ha counry-specific facors are also priced ino bonds markes. Gerlach e al. (2010), using euro area counry spreads beween 2000 and 2009, find srong suppor for he hypohesis ha spreads are driven many by inernaional risk consideraions. However, beyond inernaional risk, counries wih large banking secors are found o be more sensiive o changes in aggregae risk. Thus, spreads in such condiions widened more han would be expeced following he increase in risk associaed wih he global financial crisis. The auhors also find evidence ha spreads vary wih counry-specific facors, such as governmen deb and fiscal balances. Georgousos and Migiakis (2010) examine he exen o which moneary unificaion has led o complee financial inegraion beween euro area bond markes by focusing on he deerminans of bond spreads, including corporae bond spreads, he slope of he yield curve (conaining informaion on inflaion and growh), inflaion differenials, equiy reurns and he difference beween he inerbank rae and he cenral bank refinancing rae. The auhors use a Markov swiching mehodology, which allows 16

for endogenous swiching beween regimes of low and high volailiy. The resuls sugges ha he deerminans of spreads vary across regimes and counries, suggesing ha financial inegraion is sill incomplee. 5. Daa and mehodology In conras o much of he exising lieraure, which largely focuses on panels, he purpose of his paper is o focus on he deerminans of spreads in one paricular counry, Greece, using ime series coinegraion echniques. The daa sample is monhly and runs from January 2000 o Sepember 2010. Our aim is o idenify he fundamenal macroeconomic deerminans of governmen bond spreads. In paricular, we seek o idenify he fundamenal long-run deerminans of spreads for he 10-year benchmark Greek bond relaive o he German 10-year bond. We hen use hese deerminans o assess wheher here is any evidence of marke overshooing or undershooing. Thus, we purposely avoid using financial marke daa o explain movemens in spreads. Measures of risk or risk appeie based on financial marke daa may help in racking acual spreads, since financial marke condiions across counries end o be highly correlaed, bu hey do no explain he fundamenal deerminans of spreads a he naional level. Thus, our aim is o idenify he exen o which he evoluion of Greek spreads reflecs Greece s economic fundamenals. We focus on he macroeconomic variables ha were found o be significan deerminans of spreads in much of he lieraure and which emerge from he narraive par of his paper. The variables used are as follows. Firs, we include a measure of he fiscal siuaion. Poenial explanaory variables are he raio of governmen deb-o-gdp and he defici-o-gdp raio. Since Greece s enry o he euro area in 2001, Greek fiscal daa have been subjeced o a number of revisions, someimes several years afer he iniial (real-ime) release of he daa. These revisions have ofen involved upward revisions of he fiscal imbalances, generaing negaive surprises. In order o capure he news (or surprise) elemen ha has figured srongly in he Greek experience, we also consruc some real ime fiscal daa. To he bes of our knowledge, his is he firs ime such a variable has been consruced and is impac 17

on spreads invesigaed. In paricular, using he European Commission Spring and Auumn forecass 14, we creae a series of forecas revisions. For example, he revision in he Spring 2001 forecass is he 2001 defici/gdp raio in he Spring compared o he forecas for 2001 made in he Auumn of 2000. This procedure allows us o generae a series of revisions (see Figure 7), which, when cumulaed over ime, provides a cumulaive fiscal news variable (see Figure 8). Clearly, he variable underesimaes he exen of fiscal news which acually emerged during he period. For example, when he newly eleced governmen revised he fiscal daa in Auumn 2004, upward revisions of he defici occurred no only for 2004 (capured in our variable), bu also for he years 2000-2003. Anoher example is given by he revisions o he defici in 2009. In he Auumn 2009 forecass, he defici for 2009 was revised upwards o 12.7 per cen of GDP from he 5.7 per cen forecas in he Spring. This revision, however, does no accoun for subsequen revisions o he 2009 defici which occurred in 2010 and brough he figure o 15.4 per cen. To help accoun for hese subsequen revisions, we also include a series of he laes esimae of he fiscal defici (as a percenage) of GDP in our empirical work. Second, we seek o capure he decline in compeiiveness experienced by he Greek economy since enering moneary union. Wih he exchange rae fixed, he Greek price level relaive o ha of Germany provides a measure of real appreciaion. We also examine he impac of he rade and curren accouns (as percenages of GDP). Third, economic aciviy has been found o be an imporan deerminan of he abiliy of a counry o mee is obligaions. Given ha GDP daa are available only on a quarerly basis, we use he rae of change of a monhly coinciden indicaor of economic aciviy consruced by he Bank of Greece o provide a measure of growh (Hall and Zonzilos, 2003). Finally, we assess he effecs of several exernal facors, in paricular, he price of oil. The Greek economy is he mos oil-dependen economy in he euro area, and macroeconomic aggregaes are sensiive o changes in he price of oil. Unlike much of he lieraure, we do no es for he significance of foreign ineres raes given ha almos 99 per cen of Greek governmen deb is denominaed in is domesic currency, he euro. 14 The European Commission publishes forecass only wice a year. 18

We iniially esimae a co-inegraed VAR reaing all variables, excep for oil prices, as endogenous. This procedure generaes a long-run relaionship beween spreads and he variables discussed above. Along he lines of Ferucci (2003), we use he long-run relaionship o generae a series of spreads prediced by he macroeconomic fundamenals. A comparison of prediced wih acual spreads allows us o commen on he degree o which he acual spread appears o overshoo and/or undershoo boh in he pre-crisis and crisis periods. The primary objecive here is o idenify he srucural relaionship which deermines he long-run behaviour of he Greek spread. We herefore need o consider he issue of he formal idenificaion of a coinegraed VAR. The idenificaion problem for non-saionary models can be saed using he srucural and reduced form vecor equilibrium correcion model VEqCM 15, which are as follows. A p 1 s s 0 = A j z j + α β ' z 1 + δ + j= 1 z ε (5) p 1 j= 1 z = Γ z A ε (6) j 1 1 j + A0 αβ z 1 + A0 δ + 1 0 Here z is a vecor of N variables (as described above), A and Γ are marices of j A 1 0 A j suiably dimensioned parameers where Γ =, δ is a vecor of deerminisic componens, s α, s β are he srucural loading weighs and coinegraing vecors respecively and have he dimensions sysem. The erm ε N r o reflec he reduced rank naure of he is a vecor of whie noise error erms. Using (5) and (6) we can sae he idenificaion problem as simply one of being able o uniquely deermine he parameers in he srucural model (5) from he esimaed reduced form model (6). In his sense he problem is formally idenical o he Cowles-Commission idenificaion problem. However, he idenificaion problem for he model (5) and (6) is differen in a fundamenal way o he Cowles-Commission (or sandard) idenificaion problem. This is because i now consiss of wo disinc pars. The firs par is he problem of uniquely 15 See Davidson and Hall (1991), Canova (1995) and Pesaran and Smih (1998). 19

deermining A0 in (1). Since β ' z are a se of saionary variables (as hey are he coinegraing combinaions of he non-saionary variables), in his sense every erm in equaion (6) is saionary and his leads o he sandard idenificaion problem, which is ha of uniquely deermining A 0. This problem gives rise o he sandard rank and order condiions. However, even if his firs idenificaion problem is deal wih, his sill leaves a second par of he problem unresolved. This second problem arises because even if A 0 is known, we canno uniquely deermine he srucural coinegraing vecors from he reduced form esimaes. The problem of idenifying he srucural coinegraing vecors is well known. Thus + + 1 i is easily seen ha α and β are no idenified in general since α β = α β = αpp β for any non-singular ( r x r ) marix P (roaion). Hence in he reduced rank case he longrun par of he model is no idenified. This is rue even if A 0 is known, and i is his ha leads o he second par of he idenificaion problem. To resolve i, i is necessary o deermine r, and idenify β wih a compleely separae procedure. To deermine he coinegraing rank, r, we can use sandard ess. The nex sep is more difficul. To achieve full idenificaion of he enire model, boh he conemporaneous coefficiens and he long-run coefficiens β need o be idenified. These are logically separae issues, A 0 as here are no mahemaical links beween resricions on A 0 and hose on β. I follows ha resricions are required o idenify β even if resricions on A 0 were known. Conversely, 16 β have no mahemaical implicaion for he resricions on A 0. The derivaion of formal idenificaion crieria of he long-run in a VEqCM is he main subjec of Johansen and Juselius (1990) and Pesaran and Shin (2002), where i is demonsraed ha a necessary order condiion for exac idenificaion is ha here are k = r 2 resricions on he β vecors. Johansen (1995a) and Pesaran and Shin (2002) also give a necessary and sufficien rank condiion for exac idenificaion, which, for 16 I remains possible hough ha he economic inerpreaion of a resriced se of coinegraing vecors β z may have implicaions for he naure of resricions on A 0 ha will be economically ineresing, paricularly when A* is resriced via α. Mahemaical, and possibly economic, linkages hen do exis beween resricions on he adjusmen coefficiens α and hose required o idenify β - see Doornik and Hendry (1997). 20

example, rules ou dependence amongs he r 2 resricions. In general, if he number of available resricions k exacly idenified, and when k < r 2 he β sysem is under-idenified, if k = r 2 he β sysem is > r 2 he β sysem is over-idenified and, subjec o he rank condiion being saisfied, he over-idenifying resricions are esable. The mehodology employed in wha follows is o begin by assessing he coinegraing rank of our VAR sysem and hen o proceed o idenify he srucural relaionship ha deermines he Greek spread. We will hen presen he impulse responses of he VEqCM for compleeness, bu our main focus will be on he long-run coinegraing vecor which deermines he spread, as his will allow us o idenify he deparures from he equilibrium spread. 6. Resuls We begin by esimaing a sandard VAR of order 3 based on he Schwarz/Akaike informaion crierion, wih he objecive o minimise he VAR lengh subjec o passing a selecion of LM ess for serial correlaion. The resuls of he chosen VAR are presened in Table 2. As usual, he VAR coefficiens have very lile economic ineres as he individual coefficiens are no inerpreable. All ha is imporan a his sage is ha he VAR residuals are generally well-behaved; in his case, he VAR residuals pass a range of LM ess for serial correlaion and seem well behaved. Table 3 presens he resuls for he sandard Trace and Maximum Eigenvalue ess for coinegraion. Boh ess rejec he hypohesis of no coinegraion, implying here is a leas one coinegraing vecor. The hypohesis ha here is only one vecor canno be rejeced a convenional levels of saisical significance. This implies ha we have one coinegraing vecor. In line wih he exising lieraure, he resuls provide suppor for he significance of relaive prices, economic aciviy and oil prices. In addiion, our measure of fiscal news is also imporan in explaining movemens in Greek spreads. Oher variables he final (laes) esimaes of he fiscal-defici-o-gdp raio, he deb-o-gdp raio, and measures of he rade or curren accouns of he balance of paymens were found o be insignifican because heir effecs were capured by oher (significan) variables. Thus, movemens in relaive 21

prices bes capure he effec of changes in exernal compeiiveness on spreads, whereas real-ime news abou he fiscal aggregaes, as measured by revisions o he Commission s forecass, bes capures he governmen s fiscal siuaion. We hen consruc a coinegraed VAR, imposing he resricion of one coinegraing vecor and given ha r=1 we need only one resricion o idenify he relaionship as a srucural one deermining he spread (his is o normalise he coefficien on he spread o be -1). The loading weigh (he α s ) from he equaion for he Greek spread is correcly signed and he coinegraed VAR is sable. In Figure 9, we presen he impulse responses of he Greek spread using he sandard Cholesky decomposiion for he shocks 17 o he oher endogenous variables. Wih he excepion of he response of he spread o cumulaive fiscal news, he oher impulse responses are as expeced. Iniially, he spread reacs incorrecly o an innovaion o fiscal news ha is, good news iniially causes he spread o rise, bu afer some monhs i falls o negaive values, as expeced. In order o assess deviaions of spreads from heir long-run equilibrium values, we proceed o esimae a simple OLS model of he coinegraing vecor. Moving o a simple OLS esimaion is consisen wih he exisence of only one coinegraing vecor in he model. The resuls are presened in Table 4. As is clear from ha able, explanaory variables ener he long-run equilibrium regression wih he correc sign. The resuls sugges ha an increase in economic aciviy or cumulaive good fiscal news reduce he spread; by conras, a rise in Greek prices relaive o German or a rise in oil prices cause he spread o increase. The relaive economic imporance of he variables can be derived by calculaing he impac on spreads of a one sandard deviaion increase in each of he explanaory variables (based on he raionale ha a one sandard deviaion change is acually observed in he daa iself). The larges effec comes from relaive prices: a one sandard deviaion increase in Greek prices relaive o German prices causes spreads o rise by 225 basis poins. This resul highlighs he imporance of he deerioraion in compeiiveness for he erms on which he governmen can borrow. By conras, economic aciviy has an 17 Noe ha since oil prices are assumed o be exogenous, hey do no appear in he impulse response funcions. 22

imporan beneficial effec. A one sandard deviaion increase in economic aciviy causes spreads o fall by 138 basis poins. The impac of cumulaive fiscal news is smaller, bu noneheless significan a one sandard deviaion increase in our cumulaive fiscal news variable (defined as good news) causes spreads o fall by 54 basis poins. I should be recalled, however, ha alhough our fiscal variable aims o capure he effec of fiscal surprises, by consrucion, i likely undersaes he magniude of hose surprises. Finally, he effec of oil prices is, no surprisingly, relaively small, wih a one sandard deviaion increase in he price of oil causing spreads o rise by only 17 basis poins. Figure 10 graphs he acual spread along wih ha prediced by he long-run equilibrium equaion in Table 4, allowing us o idenify periods of undershooing and overshooing of acual spreads. We define undershooing and overshooing as cases where he difference beween acual and prediced spreads lie ouside he sandard error bands around he residuals ploed in Figure 10. The firs period in which he acual spread deviaes significanly from he prediced spread runs from he end of 2004 unil he beginning of 2005. This period corresponds o he ime (in lae 2004) ha a newly-eleced Greek governmen revised he fiscal deficis, leading o real larger deficis for he period 2000-2004. I appears, however, ha spreads did no respond o hese revisions spreads were significanly lower han prediced. During ha period, spreads were in a range of 10 o 25 basis poins; on average, hey were some 120 basis poins below wha is prediced by our model. The second period during which acual spreads significanly deviaed from hose prediced by he model occurs a he end of our daa sample. From mid-2009, prediced spreads rose sharply, mainly in response o he succession of fiscal surprises; from lae 2009 hrough he firs quarer of 2010, prediced spreads exceeded acual spreads by significan amouns (usually by over 100 basis poins). Subsequenly, acual spreads rose sharply and, beginning in May 2010, acual spreads exceeded prediced spreads; he difference became significan in June and remained significan hrough he end of our sample period (in Sepember 2010). For example, whereas prediced spreads were jus over 500 basis poins in Sepember 2010, he acual spread, a around 900 basis poins, was abou 400 basis poins higher. Thus, our resuls sugges ha here have been episodes 23

of boh significan undershooing and significan overshooing during he period since Greece joined he euro area. 7. Conclusions Enry ino he euro area provided Greece wih he opporuniy o benefi from he credibiliy of he moneary policy of he European Cenral Bank and he resuling environmen of relaively-low inflaion raes and low nominal ineres raes. In urn, he low ineres raes reduced he cos of servicing he public-secor deb, faciliaing fiscal adjusmen and freeing resources for oher uses. Insead of aking advanage of his environmen o adjus he economy, during he period 2001-2009 successive Greek governmens ran fiscal deficis ha averaged over 6 per cen of GDP and hey increased he share of governmen spending in he economy. In his paper, we firs presened evidence on ha par of he risk premium unexplained by he credi raing of he Greek sovereign. Afer rising in lae 2008, i reurned o normal levels following a downgrade in early 2009. However, hereafer, despie furher downgrades, he unexplained risk premium coninued o rise. To undersand hese resuls furher, we moved on o model spreads as a funcion of economic fundamenals. The resuls sugges ha, o some exen, he markes may have helped lull he Greek governmens ino believing ha he low ineres-rae environmen would be a permanen feaure of he Greek economy. Our findings srongly suppor he view ha he low-levels of ineres-rae spreads reached in he mid-2000s were no jusified by he economic fundamenals. In urn, afer he crisis eruped in 2009, ineresrae spreads appear o have srongly oversho in an upward direcion. The markes verdic of Greece s fiscal and exernal imbalances may have come lae in he day, bu when i came, i came wih a vengeance. 24

Appendix: Daa sources Spread: 10-year benchmark German governmen bond minus 10-year benchmark Greek governmen bond - ECB Saisical Daa Warehouse monhly average. Fiscal daa: from Commission forecass published in European Economy and Governmen Fiscal Saisics published by Eurosa. The forecass are semi-annual; he acual daa, quarerly. All series are inerpolaed. Trade and curren accoun daa: aken boh from Bank of Greece and EL.STAT. Quarerly series were inerpolaed. Relaive prices: log difference of he monhly seasonally-adjused harmonised index of consumer prices (HICP) beween Greece and Germany Thomson-Reuers DaaSream. Economic aciviy: rae of change of coinciden indicaor of economic aciviy consruced by Bank of Greece (Hall and Zonzilos 2003). Oil prices: US dollars per barrel of Bren crude oil (FOB) Thomson-Reuers DaaSream. 25

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