Archive for November, 2013

Loose Lips Sinking Markets?

The ECB in July 2013 published an extremely interesting paper on “The Impact of Political Communication on Sovereign Bond Spreads.” Here are some highlights.

Keep in mind that, “Euro area countries are more exposed to the risk of self-fulfilling crises whereby investors generate a liquidity crisis that can degenerate into a solvency crisis.”

Correcting for financial, economic and other political events, this study finds that political communication – both of a positive and negative nature – does have a daily contemporaneous effect on sovereign bond yield spreads.

Similarly, an interesting finding is that economic fundamentals appear not to have a significant influence on bond spreads in the short term, but are instead overwhelmed by statements, credit rating changes and country specific events.

Bond investors will price risk appropriately only if the realistically face a danger of default. Governments will run sound fiscal policies only if they know that they are not going to be bailed out by the euro area and that they might face higher financing costs. This debate about incentives and principles is a fully legitimate one in open democratic societies. However, it has sent a possibly destabilising message to potential investors in the bonds issued by troubled countries, namely that those bonds are not safe assets because the probability of a complete redemption was seen as reduced, and this with a perceived (semi-)official sanction. Investors have therefore demanded a large risk premium. This, in turn, may have contributed further to the fiscal problems in the peripheral euro area countries over the past two years. Policy-makers are therefore confronted with a certain trade-off between conducting open democratic debates and respecting the needs of the financial markets, reflected by the controversy over the notion of a “democracy in conformity with market needs.”

This study does not find any strong empirical evidence that the amount of political communication has an impact on the level of government bond yields. Rather, our finding is that the connotation of the communication determines the type of impact on government bond yields: positive communication can lead to a compression of spreads, whereas negative communication can cause a widening of pspreads.

Communication policy would be more effective if certain principles were respected in the design and implementation of politicians’ communication strategies.

At several points during the crisis, certain types of political communication may have added uncertainty rather than certainty to market perceptions about the sovereign debt crisis in the euro area, and that unconstructive and inconsistent communication can have real and tangible effects on countries, their financing conditions, and by extension, on their populations, as well as on the cohesion of the euro area.

I fear that one can safely argue that the impact of governmental change in Germany in 2009 and especially the entry of the FDP into power was not a good thing for the Eurozone.

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