Default Risk on Government Debt in OECD Countries

Abstract

^^^^Different European countries pay very different interest rates on their public debts. Will these differences disappear if and when exchange rates come to be irrevocably fixed in the European Monetary Union? Or rather will default risks in the high debt countries keep interest rates from converging? To answer this question, this paper investigates whether a perceived default risk is already priced by the market The paper compares the interest rates on public and private financial instruments denominated in the same currencies in 12 OECD countries. A strong correlation is found between the size of public indebtedness and the spread between public and private rates of return. This correlation suggests that the markets perceive a default risk on the public debt of some OECD countries. The size of this default risk is however very small.

Sovereign risk premiums in the European government bond market

“…The inclusion of an indicator of the cyclical stance follows a suggestion of Alesina et al (1992) that default risk depends on the overall economic situation of a country. In an economic slow-down, government revenues decrease, and the probability of default may rise.…”

“…Alesina, De Broeck, Prati and Tabellini (1992) use data from 12 OECD countries and show that the differential between public and private bond yields is positively related to the level of public debt. In a similar vein, Lemmen and Goodhart (1999) and Codogno, Favero and Missale (2003) show that the differential between government bond yields and the corresponding swap yield of the same maturity depends positively on the level of public debt, while Heppke-Falk and Hüffner (2004) find that expected deficits have a positive impact on this differential in Germany, France, and Italy.…”

On the time-varying relationship between EMU sovereign spreads and their determinants

“…This variable is used as a proxy for the state of business cycle and captures the effect of economic growth on spreads according to which sovereign debt becomes riskier during periods of economic slowdown (see Alesina et al, 1992 andBernoth et al, 2004). Hence an increase (reduction) in gind should reduce (increase) spreads by improving (worsening) credit worthiness.…”

Government Debt Denomination Policies Before and After the EMU Advent

“…It is negatively related to the social and political costs of domestic default (see Alesina et al, 1992).…”