Do (German) State Bond Markets Discount Politics?

Abstract

To what extent do bond market reactions to an unexpected deficit shock depend on state-specific politics? To answer this question, we calculate German state bond spreads over government benchmark paper using information from Datastream for the period 2006-2010. We test for a variety of institutional and political factors. We find evidence that investors base risk perceptions on state specific economic and institutional characteristics. Further, in left-leaning Eastern German states, an increase in unexpected deficit shock had a greater negative effect on a state's risk.