Economic fundamentals and Eurozone sovereign spreads: will the good news continue?

Spreads between government bond yields in the Eurozone periphery and Germany have fallen to the lowest levels in 3 to 4 years. There are two major factors behind this. The first is the speech by ECB President Mario Draghi on 26 July 2012 promising ‘to do – within its mandate – whatever it takes’ and the ECB's Outright Monetary Transactions initiative of summer 2012. This has been successful in eliminating fears of an imminent Eurozone break‐up. The second factor is the improvement in economic fundamentals in the periphery countries, particularly in Ireland, Spain and Greece. Previous econometric work on the role of economic fundamentals at the country level has focused almost entirely on government debt and government deficit to GDP ratios. The true fundamentals have been obscured by market panics and by the fact that markets really only took full account of these fundamentals from the end of 2010. Before the middle of 2007, markets ignored the build‐up of stresses between Eurozone countries. Once amplification of perceived risks by market panics and the shift from inattention to full market attention are taken into account, a far more nuanced picture emerges of what country fundamentals really matter for sovereign spreads. In addition to excessive government debt, deteriorating competitiveness, excessive private debt, and housing market crises spilling into banking systems, have been especially prominent in the countries at the periphery. In Ireland and Spain, declining relative unit labour costs and the fading of the housing crisis have recently been important in narrowing spreads against Germany. The econometric model also suggests that good news on relative growth and inflation help narrow spreads. Prospects for further narrowing of spreads for Greece and especially for Spain look good. Once the current bout of falling spreads is over, the underlying picture suggested by the estimated model is less good for Ireland, Italy and Portugal and for the euro area core economy, France. In all four cases, the government debt to GDP ratio has been deteriorating, and for France and Italy, competitiveness has not improved significantly. For France, another factor is the rising level of the private debt to GDP ratio. For Ireland, scope is limited for the effect on the spread of further improvements in competitiveness and housing market recovery.