A Time-Series Postmortem on Eurozone Financial Integration and the Debt Crisis: Modeling and Policy Implications

ABSTRACTMultivariate cointegration tests on daily 10-year sovereign bond yields show the decline in Eurozone financial integration occurred in three stages before September 15, 2008 and involved at most six of the original 11 countries. Long-memory factors indicate sovereign yields in Germany, the Netherlands and Finland drove the cointegrated systems. Models of yield spreads confirm that different approaches are necessary to explain cointegrated versus non-cointegrated yields spreads. The debt crisis is examined using daily yield spreads, Baa-Aaa spreads and CDS fee spreads. After June 30, 2010, yield and CDS fee spreads were nearly equal in several countries and Baa-Aaa spreads had returned to their 2007 levels. Thus, mostly fiscal fundamentals reflected in CDS fees spreads explain yield spreads. After mid-2010, Granger causality tests show greater evidence that CDS fee spreads "cause" yield spreads. Cointegration and error correction models show more explicitly that CDS fee spreads "drive" yield spreads, with little evidence of the reverse. Thus, the disparate fiscal fundamentals across Eurozone countries drive sovereign yields.JEL Classifications: F36, E43Keywords: Eurozone; financial integration; sovereign yields; debt crisis; cointegration; long-memory components(ProQuest: . denotes formulae omitted.)I. INTRODUCTIONThe official integration of Eurozone financial markets was mostly a matter of membership in 1999 and resulted in sovereign yields converging across Eurozone countries, but yield spreads quickly diverged during the financial crisis. Using established time-series methods and more technical definitions of integration, the decline in financial integration is shown to have occurred in three stages during 2007- 2008 and effectively ended September 15, 2008 with the announced bankruptcy of Lehman Brothers. The sovereign debt crisis followed closely behind the financial crisis. The debt crisis is modeled here using daily 10-year sovereign yield spreads, U.S. Baa- Aaa corporate bond spreads and credit default swaps (CDS) fee spreads.1 The results suggest different approaches to modeling yields and yield spreads across the original 11 Eurozone countries. Also, since mid-2010 the degree of fiscal integration has driven the degree of financial integration.Financial markets in two or more countries are integrated if sovereign bonds in the countries pay the same interest rate (Jappelli and Pagano, 2010), with a similar result for equities. Implicit in this definition is that yields are cointegrated, since non- cointegration means interest rates across countries drift apart for extended periods of time, violating the one-price condition. Thus, cointegrated sovereign yields with zero mean bond spreads represent financial integration. Cointegrated yields with small but statistically significant yield spreads suggest a weaker form of integration. Yields spreads that are non-cointegrated over time indicates the lack of integration.Daily data are necessary to analyze day-to-day market dynamics across the Eurozone. Unfortunately, the use of daily data excludes important variables, such as quarterly government deficit- and debt-to-GDP ratios. However, using daily yields spreads, Baa-Aaa bond spreads and CDS fee spreads, together with the time-series techniques of cointegration, error correction, long-memory components and Granger causality, important insights can be obtained into modeling and interpreting day-to-day market dynamics involving sovereign yields and CDS fee spreads, plus the increased dependence between Eurozone fiscal fundamentals and financial integration.Of particular interest in analyzing the financial crisis are the specific time intervals over which sovereign yields are cointegrated and the mean spreads versus Germany that occurred during those intervals. The three periods of cointegration identified during 2007-2008 show that sovereign yields for at most six of the original 11 Eurozone countries responded to one another and not just global and individual- country risks identified in previous studies. …