Signaling virtue or vulnerability? The changing impact of EMU on government bond spreads

Abstract

Abstract Do bond-spreads of developed countries behave differently under different exchange-rate regimes? Focusing on the experience of European monetary integration, we find that the impact of exchange-rate regimes on spreads depends on the macroeconomic context. When inflation counted as the greatest risk to bondholdings, Economic and Monetary Union (EMU) was advantaged over flexible and fixed exchange rates, because of its in-built inflation-control mechanisms. Since debt-sustainability became the primary risk, exchange-rate rigidity has been a liability because it constrains governments’ response to adverse shocks. Employing a moving-window analysis for 12 EMU-members plus 10 ‘comparators’, we find that inflation was penalized under flexible and fixed exchange-rate regimes, but not under EMU. From the early 2010s on, inflation carried no penalty under any exchange-rate regime. Debt and deficit did not affect spreads until the late 2000s. Since then, EMU-members incurred larger and more prolonged spreads penalties for deficits and debt than countries in other exchange-rate regimes.